Osborne’s £7 billion error on company inversions

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George Osborne wrote a letter to Alistair Darling on Friday as a consequence of the reported news that Regus, Charter and Henderson are all leaving the UK for a combination of Jersey and Ireland. This is what he wrote:

Dear Alistair,

I'm sure you are as concerned as I am about the news that Regus, Henderson Group and Charter are thinking of leaving the UK, citing concerns over the tax environment. This news follows previous announcements by Shire and United Business Media that they are relocating to Ireland. It is further evidence of the damage done to the UK by the confusion you have caused in the last year over the future of our business tax regime, combined with the fact that ten years of a Labour Government has left us with some of the highest corporate tax rates in the European Union.

In order to prevent more companies from leaving, I urge you to consider in advance of this autumn's Pre-Budget Report the proposals we have developed on corporation tax. This involves, as an initial step, reducing the main corporation tax rate from 28% to 25%. Given the parlous state of the public finances, this should be paid for by simplifying the capital allowances in the way we have proposed. This would go some way towards undoing the damage the government has done by failing to keep pace with European tax rates. As I'm sure you are aware, when the Conservatives were in power, Britain had the fourth lowest rate of corporation tax in the EU, whereas we now have only the nineteenth lowest rate.

I would also urge you to implement the proposals that I commissioned from Lord Howe for a permanent simplification of the tax system. These include a new Office of Tax Simplification to examine the tax system and make proposals for simplification, and a new convention that changes to tax law should be made no later than the Pre-Budget Report. This would bring greater certainty and proper consultation in place of damaging uncertainty and a lack of consultation we have seen, as illustrated by your recent decisions over the taxation of foreign profits and Capital Gains Tax.

As you demonstrated in last year's Pre-Budget Report, you are capable of adopting Conservative proposals. With companies leaving Britain, weakening an already ailing British economy, I urge you to adopt our proposals in order to restore our competitiveness and help prevent any more companies from deciding to leave the UK.

Yours sincerely

George Osborne MP

The simple fact is that George Osborne has got his arguments completely wrong. For those of us who are UK taxpayers his lack of grasp of this issue is very worrying indeed. It doesn't inspire confidence that this is the man to lead the UK economy through either a time of economic difficulty or during which issues of tax management will be of significance.

Let's be clear what the issue is that is causing these corporate inversions (for that is what they should, correctly be called). The issue is relatively straightforward. It is whether or not the UK should tax companies resident in the UK on their effective worldwide income or whether we just tax them on income arising here in the UK alone.

The UK along with the USA has always been a country that taxes on a residence basis i.e. we tax, at least in theory on the basis of worldwide income. We do that in two ways. First we make sure that companies cannot shift what we call their passive income into low tax locations. Passive income is that which they have to expend little activity to earn. It includes interest on bank accounts, royalties, rents and other such investment type income which could, but for this rule be easily relocated to a tax haven and so entirely avoid tax in the UK if we took no steps to stop this activity.

We do take steps to stop this through what is called Controlled Foreign Company legislation. If a UK company owns a foreign subsidiary which has mainly passive income then basically (and I summarise, let's be clear) we reserve the right to deem that foreign company to be resident in the UK even though it isn't, and we tax it here as if it is in the UK. We're not unusual in doing this. About 26 countries do this. They're mostly OECD states, unsurprisingly.

The second way we tax a company on its worldwide income is by making all dividends received by a company in the UK subject to UK corporation tax, with credit being given in full for any tax paid on the profits that gave rise to those dividends in the country where that profit was originally earned. So, in effect "active income" i.e. profit earned from trade can have UK profit on it deferred pretty much at will if earned overseas so as not to restrict real foreign investment in productive capacity and real income generation but if for any reason that income then gets sent to the UK for onward transmission to the shareholders of the UK company it is taxed at the UK rate, if higher (which despite rumours to the contrary, is by no means always). The logic for doing this is pretty simple, but important: for example, credits are given to UK tax payers for income tax purposes at 20% on dividends they receive. This is because it is assumed that at least this level of tax will have been paid by he company. Without charging foreign source income to UK tax that may not be the case.

There are other good reasons for charging foreign profits to UK tax though. The most important is that if business knows that profits they manage to shift out of the UK to a foreign location will be taxed upon their return then at least some of the cost of relocating those profits abroad will be wasted, and so the incentive to shift profit is reduced. This would not matter much if the UK was able to successfully challenge most transfer pricing abuse by UK companies, but the reality is that this is not the case. Evidence from my own work on the effective tax rate of major UK companies and location specific information from the States (especially by Marty Sullivan of Tax Notes) shows that major companies are seasoned abusers of transfer pricing rules, and especially with regard to passive income. The shifting of investment income, intellectual property and other forms of passive income is now considered a well remunerated game by big business and the Big 4 accountants. The reality is that this seriously threatens the UK tax base and the territorial basis of taxation we use, backed up by controlled foreign company legislation, is one of the most effective methods we have of challenging this relocation of profit.

Now let's be clear that in this case there is no issue here with regard to the tax rate. It is an issue to do with the tax base: whether profits are going to be properly subjected to UK tax or not and whether it is right and proper to have anti-avoidance measures in place to ensure that this happens.

This is readily apparent in the case of the companies leaving. Neither UBM or Shire who have already left have paid any significant UK tax. Charter has according to reports I have seen has apparently not been paying UK tax and whilst I have only had opportunity for a brief review of Regus' accounts it looks pretty unlikely that they are making any significant contribution to the UK exchequer given the low level of their effective tax rate. Hendersons are a financial services company giving them massive opportunity to shift where they seek to record their profit base (subject to HMRC challenge).

So why have these companies left, or why are they threatening to go? Simply because following the European Court of Justice decision on Cadbury Schweppes the UK was told to revise its CFC rules so that whilst they could apply them to passive income it could only do so to active income if it could be shown that there was no motive to the transaction that relocated profit bar the saving of tax (again, I know I summarise).

That is why HMRC issued a review of these rules. It has to narrow its CFC rules on active income but at the same time make any change revenue neutral. Given that HM Revenue & Customs wishes to retain revenue neutrality in any change (and there is no reason for the UK Treasury to give foreign profits a tax subsidy which would arise otherwise, and I think most would agree) the corollary was that the rules on passive income had also to change to ensure tax collection was maintained by curtailing abuse.

This has lead companies who have not been paying tax in the UK right now, despite being tax resident here, to decide it is time to flee the UK in case under the new rules they will pay tax. No serious taxpayer is leaving: not one so far. And the reason is obvious: for serious taxpayers, many of whom are real companies doing real things and making real money from real activity the existing UK tax structure is already very generous and any change in the CFC rules will be a net advantage to them. You won't hear them saying that, but this is the reality.

So, in that case let's go back to George Osborne. What he's saying is that this so called 'exodus' has something to do with tax rate. It hasn't. It has to do with tax base. He's completely missed the point.

Second he thinks that cutting the tax rate by 3% will mean that these companies will stay. No they won't. Staying will mean they will potentially pay tax at 25% rather than 28% when at present they pay nothing at all because they can abuse the existing rules. A difference of 3% when for these companies the real option is actually paying nothing or something is clearly not going to impact their decision. 25% is no more attractive than 28% to them: they just don't want to pay at all. Osborne has again quite clearly missed the point.

However, that would be an extraordinarily expensive mistake. He would give away 3% on the corporation tax rate to induce companies to stay when the reality is that this will have no bearing on their decision. My research showed that in 2006 the effective tax rate of UK companies was 22% on a downward trend. Let's call that 21% now. Give away 3% out of this and one seventh of the corporation tax yield goes. That is budgeted to be around £50 billion this year (near enough) and that means Osborne's mistake would cost £7 billion. That's some error of misunderstanding.

Third he says we should simplify the UK tax laws. Let's be clear: what we're talking about in this whole review is what are in effect anti-avoidance rules. So what happens if we abolish them? Put simply, avoidance will go up. That's what they are there to stop. Why should any Chancellor want to let some people in the economy increase their abuse of the tax rules at cost to the rest of us, especially when that abuse would increase the gap between rich and poor, something Osborne has so recently said to be of concern to him? If he is honest in his objective of trying to tackle inequality (and let's assume he is) then he has once again shown a massive error of judgement and understanding in making the suggestion he has in his letter.

All in all it's a staggering admission of lack of understanding of how the tax system works, why it is constructed as it is, what the duty of a Chancellor is and what prospect there might be of sound fiscal management if he took the keys to Number 11.

I've hardly been uncritical of the current and immediate past tenants of that address, but at least they are fulfilling their proper governance duties and they show understanding of why we actually have the legislation that is in place. It's a sad fact that so far George Osborne is not doing so. There's a real prospect he might get into office within 18 months or so. He's got a lot to learn. He certainly can't make mistakes at the rate he is showing here.

That, by the way is also not the end of the story. I'll deal with what he could actually have said later.