Making Scottish corporation tax work

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Whatever happens on September 18 I am quite sure that Scotland is going to flex its tax muscles sometime in the near future. In our out of the union the Scottish parliament is going to want to use its power to use tax to intervene in its own economy for the sake of the people it governs. That is one of the basic functions of tax and it is one of the basic functions of democracy, with the two being pretty intimately linked in our combined national histories.

There are problems with this idea though. If Scotland sets its own tax rates there is a first problem. How is it decided which part of the profit that is earned across the UK as a whole is to be taxed in which country? And if Scotland then sets its own tax rules that are distinctly different from the Rest of the UK (rUK), as seems likely given that it has already established its own GAAR, how is the interface between the two tax systems to be managed?

I happen to agree with Martin Wolf this morning that Scotland really does need to take a risk on monetary union if it wins independence. I also happen to think that it would, whatever it does with the currency, be wise to take less risk when it comes to tax.

I am not saying it should not set its own tax rate. That's not my job, although I happen to think it should not start a race to the bottom. What I instead think is that it does need to be wary of putting companies off trading in both the rUK and Scotland and that it has to make it as easy as possible for that to happen, especially when it is so commonplace at present.

By this I mean that I believe that when there are companies in the future who trade in both Scotland and rUK, whether Scotland is independent or not, then the simplest possible system of allocating profits between the two places must be adopted to minimise the tax cost of trading in both territories (you can't use the word countries anymore: it's not yet clear if it applies to rUK). If that is not done there will be the nightmare of, for example, transfer pricing rules applying across this border and issues relating to the allocation of finance, intellectual property, and so many other areas long exploited for tax abuse purposes that will have to be tightly regulated at some costs unless alternative thinking is applied.

That alternative thinking is available.  I believe that there will be an urgent need for Scotland and rUK to enter into a corporation tax agreement that will embrace unitary principles. I can see no other way to make the arrangements for separate taxation of profits viable.

Unitary tax apportions profits between places. In the case of the UK we do, of course, already have arrangements in place to determine profits for the existing country as a whole. For individual companies these are clear: they are taxed on a worldwide basis excepting the fact that tax is not due on overseas dividends received. Controlled foreign company rules do not change this: they define which companies are within the scope of the tax charge. The point of mentioning these facts is that these rules do not undermine the logic of sharing a current UK tax base between Scotland and rUK.

How does the sharing take place? It would simply be the case that if a company had a taxable presence in both countries then profits before allowances for things like R & D and capital spending (which may differ between the territories) would be apportioned between the two on the basis of a formula. The formula would, I suggest, be based in the first instance on where customers are, or if they are not in either territory (because they are export sales) from where they are serviced and secondly on the number of employees in each territory. This second part of the formula relating to employees could be weighted by either the number of employees, or their gross pay, or both elements given equal weighting. I do not suggest including assets in any formula: they're just too nebulous to value under current accounting rules and too hard to identify in too many cases.

So, if a company makes, say, £1 billion in the UK as a whole and has 80% of its sales in rUK and 20% in Scotland then half its profits would be allocated on this basis: £400 million would go to rUK and £100 million to Scotland. If staff were in a different ratio, say 60% rUK and 40% Scotland then the split of the remaining half of profit would be £300 million rUK and £200 million to Scotland. Overall rUK would have £700 million of profit and Scotland have £300 million.

There is no more cost effective and regulation light method of achieving a break in the tax union than this. The alternative is massive accounting reform, the parting of the ways for accounting purposes for many groups and very real barriers to trade as a result, which worries me for both parts of the arrangement and whether or not there is to be independence or not.

Of course these formulas are not perfect. I accept that, but then accounting is at least as imperfect in the first instance, and maybe more so. But crucially the arrangement does respect fiscal sovereignty. Note that it is profit that is apportioned. That could be accounting profit. It may, more likely, be profit after disallowances and before tax relief, but this is all subject to negotiation, and if one party wished to allow something the other does not the relevant proportion could be adjusted after the apportionment had taken place. The granting of capital allowances would, I suggest, always be a post apportionment issue, which is why I suggest assets are kept out of the formula or the risk of trade off and double counting becomes significant. The importance point to make is that profit apportionment does not require a consistent tax base: that is simply not true.

Why do this? Several reasons. First, it's simple and would provide certainty when there will be enough other issues to deal with.

Second, it is cost effective for business and tax authorities when the alternatives look very costly.

Third, the data will exist. It will have to for OECD international taxation rules in the future.

Fourth, and I stress it, this creates sovereignty in ways that totally separate  taxation that might be more easily gamed cannot.

I suspect that this is not high on anyone's agenda right now. But it needs to be, and soon.