Page last updated at 13:28 GMT, Tuesday, 25 November 2008

Change to tax on foreign profits

Analysis
Chris Sanger
Head of tax policy at Ernst & Young

Chris sanger
Chris Sanger, Ernst & Young

The chancellor's pre-Budget report (PBR) represents a strong step forward for UK multinationals.

And it is potentially a turning point in the UK's battle to remain a competitive regime for headquarter companies.

Prior to the report, the Treasury had experienced a spate of companies leaving the UK.

Some had chosen instead to locate their headquarters in Ireland or the Netherlands.

The action in the PBR aims to provide companies with the certainty needed to stem the tide of departures.

Draconian proposals

The primary impetus for leaving the UK has been the continued uncertainty over the government's approach to the taxation of profits made in overseas subsidiaries.

This change... should encourage companies to bring back to the UK those profits sitting trapped offshore

Under rules originally implemented in 1984 and tightened ever since, the UK has sought to tax profits made offshore, even if they have little, if any, link to the UK.

The proposals made by the Treasury in 2007 threatened to extend the scope of tax even further, leading many companies to rethink the wisdom of leading their businesses from the UK.

A change in direction had been signalled in July this year, with a welcome softening of the stance and confirmation that draconian proposals would be withdrawn.

Many thought that this would lead to the positive proposals that had been included in the package also being lost, and hence the PBR announcement is a welcome confirmation of action.

Symbolic

The precise proposals will be set out in draft legislation published next month, but the form of them is well known already, given the extended period of consultation.

In essence, dividends from overseas subsidiaries will no longer be subject to UK tax, subject to a few provisions to avoid the rules being used to artificially reduce tax on profits originating in the UK.

Since the UK currently receives little tax revenues from overseas dividends, this change is more important for its symbolic importance and the fact that it should encourage companies to bring back to the UK those profits sitting trapped offshore.

Of more importance from a competitive perspective is the statement buried deep in the pre-Budget report.

This states that the government will act to move the UK's tax system "towards a territorial approach", such that it does "not tax profits that are genuinely earned in overseas subsidiaries".

This change in approach to the controlled foreign company rules could herald a new era in competitiveness for the UK, if followed to its logical conclusion.

New proposal

Of more concern, however, is the confirmation that the Treasury wishes to proceed with the so-called "worldwide debt cap".

Under current rules, any UK company can obtain a tax deduction for interest costs provided that they are incurred on a commercial basis.

Under the new proposals, UK companies will only be allowed to a tax deduction to the extent that those interest costs are matched by costs incurred by the worldwide consolidated group.

This means that UK companies owned by cash-rich multinationals or sovereign wealth funds may face an increase in tax merely because of the capital structure of their worldwide groups.

This promises to be a controversial policy and we can expect much of the time between now and the Budget to be taken up with discussions with government.

The proposal could potentially undermine the UK's prime position in the inward foreign direct investment league.

At the very least, it appears odd that the UK should seek to attract investment from debt-laden overseas multinationals but impose an effective penalty on those with stronger balance sheets.

The big question is whether these measures will deliver the sea-change in attitude that the UK has needed for so long.

With the positive noises from the PBR, this looks far more likely but, as always, the real test will come when the legislation, and hence the detail, is published in December.

The opinions expressed are those of the author and are not held by the BBC unless specifically stated. The material is for general information only and does not constitute investment, tax, legal or other form of advice. You should not rely on this information to make (or refrain from making) any decisions. Always obtain independent, professional advice for your own particular situation.



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