Why is the UK government encouraging companies to use tax havens?

Plans by the government to change Controlled Foreign Companies (CFC) rules are threatening to deny the developing world billions of pounds in tax revenues. The current CFC rules discourage UK companies from using tax havens, by requiring them to pay UK levels of corporation tax whether they are based in the UK or abroad. This system discourages the practice of profit shifting and protects the tax incomes of both the UK and developing countries.

The changes were proposed in the Budget earlier this year and will mean that companies will only be charged full corporation tax when using tax havens if UK tax revenues are threatened. In spite of calls by the IMF, UN and World Bank for the government to look into how this will affect countries in the developing world, the government have refused. The Treasury argue that

“It is not sustainable for developing countries to protect their revenue using our tax rules, a much better way is to build their capacity and capability to collect the tax that they are due.”

To an extent this statement is true, building up the ability of developing countries to collect their own tax is the way forward. But the government’s new CFC rules will reduce the income of many countries. Considering the fact that tax revenues are a much more sustainable income for countries than aid it would be sensible to build up the capacity of these countries to collect their own tax revenues before thinking about changing the CFC rules. According to ActionAid, African governments receive more than ten times more income from tax revenues than from aid. However, this will inevitably fall once the new rules come into force, with the developing world losing out on up to £4billion.

Progress has been made towards improving the tax collection ability of governments. DfID have helped a number of countries improve their tax collecting capabilities. Rwanda is a good example of this; their government has increased tax revenues six-fold over the last decade. But this is only a drop in the ocean compared to what needs to be done. Governments face numerous problems that hinder tax collecting such as Capital Flight (the process by which assets are removed from a developing country and stored overseas), corruption and a lack of transparency. These problems, along with the fact that under the current system tax havens already cost developing countries more than three times the amount they receive in aid, means that the new rules could be very detrimental to poorer countries.

The watering down of the CFC rules will mean that there is no incentive to stop UK corporations based abroad from using tax havens. UK companies who shift their profits from one country to a tax haven will no longer be charged UK tax rates. This will encourage tax avoidance at a time when governments all over the world could do with more money. The Treasury argues that the relaxed CFC rules along with reduced corporation tax will encourage investment and growth, but their own estimates predict that Britain will lose out on £1billion a year in lost tax revenues.

These changes could potentially by very costly for both the developing world and Britain. The UK government has committed to increasing foreign aid to 0.7% of GDP but the impact of this pledge will be nullified by the actions of the Treasury. The UK government should listen to the numerous international organizations, charities and the International Development Committee who all argue that a ‘spillover analysis’ should be carried out first to see what impact the changes will have on developing countries. The Treasury’s response that they are only responsible for UK tax revenues is understandable but we do not live in isolation, we live in a global community and we should do what we can to encourage UK companies to act ethically and responsibly.

* Adrian Sanders is a Focus deliver in Paignton, Devon, and was the MP for Torbay from 1997 to 2015.

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  • The plans for reform of the CFTC rules are generally welcomed among the UK tax practitioner community as a common sense modernisation of the rules. The reforms seek to impose UK taxes only where taxable profits arising from a company’s activities undertaken in the UK are artificially diverted to low tax jurisdictions.

    It is true that profits earned by overseas subsidiaries that are not repatriated to the UK parent company may be diverted to low tax jurisdictions, but most developed countries have some form of CFC legislation and ultimately UK tax rules are designed to collect UK taxes.

    Assistance to developing countries in improving their tax collection regimes and establishing their own CFC legislation should still be provided.

    in terms of overall impact, I would suggest that the Common Consolidated Corporate Tax Base (CCCTB) is more of a priority.

    The CCTB is a single set of rules that companies operating within the European Union (EU) could use to calculate their taxable profits. This would mean that a company would only have to comply with one EU system for computing its taxable income instead of dealing with up to 27 different sets of rules. The CCCTB would not affect the discretion of EU countries to set their own national rate of corporate taxation. It is not designed to harmonise tax rates, but instead would ensure consistency between national tax systems in the EU.

    Once established this may well prove a useful template for developing countries in improving their own corporate tax legislative regimes.

  • Richard Dean 31st Aug '12 - 7:44pm

    The changes seem sensible – indeed the current arrangements look colonial and paternalistic. A better way is to provide assistance in developing tax laws and systems of collection, and even to charge for that assistance. Countries don’t develop unless they take the reins themselves..

  • Richard Swales 31st Aug '12 - 8:09pm

    The UK with its non-dom rules is one of the best tax havens going, as relocating to a major business and cultural capital like London is lot less likely to trigger anti-avoidance provisions than moving to BVI. Is Britain going to give up the non-dom rules? Wouldn’t be in the national interest? Fine, then don’t expect smaller, (otherwise) poorer countries to stop being tax havens either.

  • The UK High Court ruled in the Vodafone 2 case that the UK controlled foreign company rules were incompatible with EU Law in the light of the Cadbury Schweppes case.

    The final words of Justice Evans-Lombe sum up his ruling:the CFC legislationmust be disapplied so that, pending amending legislation or executive action, no charge can be imposed on a company such as Vodafone under the CFC legislation

    This ruling was significant for subsidiaries of UK companies based in EU jurisdictions, such as Ireland, as it effectively renders the UK CFC rules inapplicable (at least prior to the 2007 Finance Act amendments).

    It leaves open the possibility for UK multinationals with EU resident subsidiaries, which have been caught by CFC rules, to make claims for repayments of tax levied under the rules in prior years. It also provides a monumental analysis of the obligation to interpret domestic legislation so as to comply with EU law.

    UK rules attribute certain income of an overseas subsidiary which is subject to a tax rate less than 75% of the UK rate, to its UK parent, taxing those profits in the UK, with credit for foreign tax paid by the subsidiary. The rules are targeted at passive income and several let outs exist, including where the main purpose of the establishment of the subsidiary was not the avoidance of tax (themotive test).

    Cadbury concerned the application of the UK CFC provisions to Irish IFSC treasury companies. It determined that such rules constituted a clear restriction of the EC Treaty Freedom of Establishment doctrine.

    However, this ruling accepted that this restriction might be justified in certain circumstances, such as where the ability to transfer profits and losses between jurisdictions in a discretionary manner undermined the power of Member States to tax economic activities carried out in their territory.

    The conclusion was that CFC rules are compatible with European law to the extent that their application is restricted to wholly artificial arrangements, i.e. those which did not involve genuine economic activity in the host state. But they should not restrict the right of establishment in another EU State.

    The ECJ left it up to the UK courts to decide:
    – whether this limitation to artificial arrangements could be read into the wording of the UK motive test, (if yes, the determinant of whether a UK CFC tax liability arose was whether there was adequate substance or not in the host State), or
    – whether the existing UK CFC rules could not be construed with this limitation in mind and therefore can never apply to EU subsidiaries.

    Vodafone 2 has provided the answer.

    Vodafone effectively contended that Cadbury rendered the UK CFC provisions redundant and inoperable because the limitation to artificial arrangements could not be read into the wording of the UK legislation.

    The UK Special Commissioners disagreed but the High Court has accepted this argument. The pre-Finance Act 2007 UK CFC provisions have thus been effectively disapplied in respect of EU subsidiaries.

    In an effort to deal with Cadbury, new legislation was introduced in the UK in 2007, effectively allowing for elimination of the CFC charge where certain conditions are met. It refers specifically to where the CFC has a business establishment in a Member State.

    It remains to be seen whether Vodafone 2 continues to render the rules inoperable for periods beginning after this legislation became effective, but Justice Evans-Lombe commented that he doubted the FA2007 sections were compliant with the freedom of establishment principle.

    In this environment of uncertainty it was imperative that UK CFC legislation be brought in line with EU law to provide a more certain environment for businesses.

  • Adrian – I fear you are parroting the ill thought out Action Aid campaign that was previously posted on LDV some months ago – and has been comprehensively discredited here and elsewhere. Just because an NGO is campaigning on it doesn’t mean they right.

    Joe explains the context well above but one further nuance: the current outmoded UK CFC rules actually discourage multinationals from investing in developing countries as they can often result in that investment being subject to extra UK tax! I’ve frequently had that situation where ordinary business activities in developing countries have fallen foul of the broad scope of the existing rules, despite the original intention of these rules being about combating the use of “tax havens”.

    The old CFC rules were out of date, poorly drafted, continued to be in breach of EU law and were in urgent need of reform. The revised rules have been through one of the most comprehensive consultation exercises ever and, aside from being still a little too complicated in their construction, are actually quite sensible (and it’s not often you get to say that about detailed tax law changes).

  • But Adrian, the CFC rules have buggerall to do with helping developing countries. You might as well ask for an impact assessment on developing countries of, say, the decision to build HS2 or to introduce the pupil premium. It’s a complete red herring: CFC rules are about protecting the UK tax base and taxing foreign profits from all other countries, including developing ones. If you wanted to increase the income and attractiveness of developing counties to investment then your best bet would be to abolish the CFC rules altogether!

    The CFC rules have literally *nothing* to do with helping developing countries, your £4bn number is absolute nonsense (the correct number is zero) and this is just about the reddest, fishiest herring imaginable.

  • Joe, I agree with you on this that the British government is basically between a rock and a hard place with respect to compatibility between EU and UK law.

    A question arising in my mind is whether indirect benefits accrue to the Treasury – remember that Britain has jurisdiction over a number of tax havens, which because of their wealth place very little (if any) financial demands on the Treasury. Perhaps there is a case for making the Falkland Islands a tax haven to help offset the cost of maintaining the military presence…

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