CinnabarRed's tax thread

[CinnabarRed]

This may be an act of supreme arrogance on my part - if so, I apologise profusely! But it seems that a lot of people have got questions about tax policy and the morality of taxation, which is my professional field.

So this thread is your chance to ask me any questions you have in this general area. I promise to explain what I know, be honest and clear when I don't know the answer, and distinguish between facts (for which I will provide a reference) and my opinion.

So over to you! I'll be back in the morning to answer any questions posted tonight.

PS: I won't be providing taxation advice to anyone!

An informed voice is more than welcome so no it is not arrogance at all.

How can we squeeze more tax money out of the banks??... Do you think that we ought to be trying to do this? And is it possible to treat the bailed out banks differently from those which did not directly take State handouts, or would this be detrimental the the profits of those banks from which we hope to get our money back, eventually? And does the taxpayer expect to get any money back (with interest), or is it actually being written off as a bad debt from which the only organisations not to suffer in the long term are those which created the debt in the first place?...

Cinnabar -

My request - Could you just cut and paste here, your excellent posts on the Monbiot "corporate coup d?etat" article and your posts on Vodafone? Both excellent and great to have in one thread.

• or if just give me permission and I'll do it for you.

Thanks .

Yes, I'd like to see those posts too. They were very informative.

OK. Vodafone. What happened is this:

In 2000 Vodafone bought the German Mannesmann group. I forget the sums involved but they were huge. Can we use £50bn for the purposes of this thread without anyone wrongly assuming it to be the correct sum?

Vodafone borrowed the money in the UK. It had to because the banks required it to secure the borrowing over its profitable worldwide businesses. Vodafone then incorporated a Luxembourg subsidiary. The Lux sub had £50bn of equity but no debt. The Lux sub incorporated a German sub, and lent the German sub £50bn. The German sub bought Mannesmann.

So what were the implications? The German sub had interest expense that it had to pay to its Lux parent, that it could relieve against the German profits of Mannesmann. I don't have any issue with that because it's a good example of source taxation - a German expense incurred to buy profitable German businesses.

The Lux sub had interest income paid to it from the German sub, and no expenses. But Luxembourg is the tax haven of Europe. Its tax authorities agreed a ridiculously low tax rate on the interest as an incentive to Vodafone to include Lux in the deal at all (not that it's specific to Vodafone - the Lux authorities offer the same deal to anyone who asks. They rationalise that they'd rather collect 8% on something than 37% on nothing). Now frankly, that's Luxembourg's business, not the UK's.

In the UK, there was interest expense on the borrowing from the bank and no immediate income. Because one of the fundamental differences of holding shares (in the case in Lux sub) rather than lending debt is that the return on shares in the form of dividends is discretionary whereas debt interest has to be paid.

The Revenue wasn't happy about Lux. There are specific anti-avoidance provisions that say that if a UK company has a foreign sub, and that sub pays a materially lower amount of tax than an equivalent UK company would then the profits of the foreign sub are taxed on the UK company as if it had earned the profits itself. So the Revenue said to Vodafone that it should pay UK tax on the Lux interest income.

What the Revenue hadn't reckoned on was that way back when the UK joined the European Union it signed the Treaty of Rome. And among all the other stuff that's in there are clauses that say that all companies within the EU are entitled to establish their businesses anywhere within the EU without being discriminated against due to where they're based). Vodafone argued that it was being discriminated against because it was entitled to have subs anywhere the hell it liked in Europe without the UK tax system penalising it for the European locations it chose. And Vodafone won.

(BTW, when I say Vodafone won the argument, I meant with the Revenue - it did go through some of the lower courts, which found in favour of Vodafone, but didn't make it to the Supreme Court. In my view if it had done then Vodafone would have won. The Revenue did bloody well to get £1.1bn out of them - I think Vodafone probably bottled it a bit!)

That's not a loophole, which might be defined as creating an unexpected outcome from the legislation- it's an unambiguous and inevitable outcome of the UK signing the TreatyIVodafone'st not Vodafone's fault that the UK government wasn't smart enough to realise all the implications of what it had signed up for.

The aspect of this that Vodafone really took advantage of was the fact that there's a fundamental difference in the UK tax treatment of debt and equity invested in a (in this case Lux) subsidiary. If the UK was stupid enough to try to treat equity like debt and compute an interest like return to the parent then at a stroke it would make itself the harshest parent company regime in the world. No-one does it. And that's because economically debt and equity are fundamentally different.

The other thing to bear in mind is to speculate over what Vodafone might have done if it didn't use the Lux structure to buy Mannesmann. The simplest thing would have been to borrow in the UK and have the UK buy Mannesmann direct. The problem then would have been that the interest expense wouldn't have been matched against the German income, so the source taxation principle wouldn't have been met. Plus the UK would still suffer exactly the same stinking great interest expenses, so there was no tax lost to the Exchequer.

Finally, at the time of the deal, Vodafone would have expected to pay UK tax when it started to receive dividend income from Mannesmann. Dividends are now exempt from tax, a deliberate policy decision by the previous government to make the UK an attractive location for US businesses to use to invest into Europe.

This is going to be long. Sorry. I'm going to start from the presumption that you, gentle readers, are intelligent but not familiar with international tax concepts, so will go back to absolute basics. Apologies if that sounds patronising, it's not intended to.

Suppose a company has a successful product, but its core market is already at capacity. It has two choices about what to do next. It can invent new products to sell to its core customers (e.g. Apple inventing the ipod, iphone and ipad). Or it can find new customers for its existing product. Some companies start to market the existing product to a different segment of the market (e.g. Johnson's selling baby products for adult use); others expand overseas.

It's more risky for companies to expand overseas than stay in the same country. The foreign market isn't familiar to them, and a procuct that sells brilliantly here might tank elsewhere (remember M&S's disasterous foray into France and Germany?). So companies need an extra incentive to open foreign markets.

I'll come back to how the tax system can provide that incentive in a minute. Just for now I need to run you though the two structures that companies can use to do business abroad.

The first is to incorporate a subsidiary company overseas. There are several business advantages to this - some locals prefer to trade with a local company; it's easy for the UK parent company to see how much it's investing in its overseas subsidiary company and how much profit it's making; employment law is easy). However, there are several disadvantages too, around increased admin costs (filing fees, audit costs, local regulatory requirements, etc).

The alternative is to open a branch. A branch is just a business place owned by a UK company in a foreign country. It's exactly the same as Waitrose opening a new store in Amersham when it already had one in Chesham (guess where I live!) except that the new store is in a different country. It's quick, easy and cheap to open a branch.

So let's go back to how the tax system can incentivise overseas investment.

Under the current system, the UK will generally not tax an overseas subsidiary. Which is good news if the subsidiary is profitable, but a bit of a bugger if it's make losses (which you would expect in the early years due to start up costs). By comparison, a branch's results are taxed directly on the UK company. If it makes losses then the losses are automatically offset against the UK company's other profits. If it makes profits then it will be taxed on them in the UK.

So what companies generally do when they start to trade overseas is start off with a branch (for as long as the overseas business is making losses, because it can use the losses against its UK profits) and then move the overseas business into a subsidary company once is starts to make profits (because the UK company won't be taxed on the subsidiary's profits until such time as they're brought back to the UK, generally as dividends).

This is all very well established and familiar. Only the most hardened of tax activists view it as abusive - the Revenue certainly doesn't. The Revenue accepts that it's a good model for encouraging UK companies to expand, which is good for the UK economy as a whole.

The problem comes because some sectors use branch structures for non-tax reasons. Banks are one, and by far the largest. By banks, BTW, I don't mean investment banks - I mean the retails banks that we all have accounts with.

Let's take a moment to think about how retail banks make their money. Very broadly, they take in deposits from the likes of us and invest them elsewhere. Some they lend out as mortgages and loans (charging more in interest to the borrowers than we receive on our deposit accounts); some they speculate on the stock markets because they hope to get higher returns; and some they put aside for a rainy day (although not nearly enough, as we now know....)

In any case, they need to move very large sums of money many, many times per day. It's much easier to move money between a branch and its head office than between a subsidiary and a parent company. So banks generally have branches overseas taking in deposits, and a UK head office.

(If you like to think it analogies, think of this: if you go out on the town and don't want to take a handbag with you, then you need to have somewhere else to put your cash. You could put it in your pocket or give it to a kind friend who does have a handbag. If you want to buy a drink, it's much quicker if you can just reach into your pocket to pay. If your mate has it then you have to find her - and she's bound to be either sobbing in the loos or snogging some random bloke (or possibly that's just my mates!) - then get her attention, then wait while she roots around in her purse, etc etc.)

Banks have long complained that they have no choice but to operate using overseas branches, but doing so puts them at a disadvantage against both other UK companies (who can use subsidiaries if they want to) and foreign banks (many of whom operate in countries which don't tax branches in the same way that the UK does - more on that later).

We could, of course, tell the banks to poke it. Personally, I don't think that's a smart thing to do. I calculate (based on figures from the Office of National Statistics) than banks hand over around £50 billion of tax to the Exchequer each year. To put that into context, the whole annual tax take is £450 billion, so £1 in every £9 of tax collected comes from banks. We really do need them to be here and to be doing well.

The alternative is that some banks are seriously considering moving their headquarters out of the UK.

So the solution that's being proposed is to level the playing field between branches and subsidiaries. In other words, that branch profits shouldn't be taxed in the UK, but neither should branch losses be relieved (which would mean that it would no longer matter whether overseas profits were earned in a subsidiary or a branch, because the UK tax implications would be the same). It's called a branch exemption system.

Turning to Monbiot's article:

• these are currently only proposals. The consultation period closes today. It is genuinely the case that the Treasury will weigh up all of the responses received and may well change its policy as a result. To present it as a foregone conclusion is disingenous.

• It's factually incorrect to say that the UK is only the second country (behind Switzerland) to implement a branch exemption. Many, many other jurisdictions do.

• And it's nothing to do with tax havens either. Retail banks don't have deposits in tax havens because there aren't enough customers to take deposits from! The notable exceptions are the Channel Islands and the Isle of Man, but there's already specific legislation to deal with them.

• It's misleading to say that businesses will be able to offset the costs of funding their overseas branches against UK profits. It implies that profits will be exempt but losses will still be relieved. That's not the case. What he means is that if a UK company borrows to expand overseas then it will be allowed a tax deduction for that borrowing irrespective of whether its overseas business is structured as a branch or a subsidiary. That's a critical point that's necessary to level the playing field between the two.

• the proposals are not designed to drain wealth and jobs from the UK. Quite the contrary. They're designed to keep wealth and jobs in the UK by encouraging the banks to stay here. Remember that £50 billion of tax they pay?

• any business which does try to funnel its earnings through a tax haven will be taxed under a different part of the UK tax legislation. It's complicated, but I'm happy to go into more details if people want. Please trust me that it's practically impossible to shove profits into a tax haven and NOT have them taxed in the UK.

• It is true that the branch exemption is only proposed to apply to large companies. That's because the Treasury wants to continue to provide tax incentives for small and medium businesses to start trading abroad (by allowing them to offset overseas branch losses against UK profits, as outlined above). It's meant to help smaller businesses, not shaft them.

• It's true that many members of the advisory committees come from big business. There are two reasons for this. The first is that big business finds it easier to spare one individual to a government committe than small business does. The second is that many of the proposals relate to international taxation and many small and medium businesses don't operate internationally (and so don't have relevant experience). BTW, the committees are also packed with academics and retired judges for balance.

• Tax havens again: Monbiot thinks that they've been legitimised. With all due respect, I disagree. You may have heard the phrase "race to the bottom" - it's the idea that "good" jurisdictions have to sink to the level of "bad" jurisdictions in order for their tax systems to remain competitive. But I don't see that in practice. Instead, what's happening is an emerging consensus in the international tax community about the norm of best practice, with intense pressure on non-compliant countries to step in line. In fact I've just been hired by a tax haven to assist it reform . The "Treasure Islands" book is a cracking read, but some of it is incorrect and much of it is already out of date.

• In my view, the tax system does enrich the megawealthy. I find it distasteful in the extreme. But it's nothing to do with branch exemption proposals. If you want to campaign, campaign against the private equity funds, whose partners can tax plan their personal tax rates down to a lower level than their cleaners'. Robert Peston writes very well on this.

• It is factually correct that there is a net flow of financial resources from poor countries to rich countries. However, I dispute that it's tax motivated. It's also factually correct that rich countries have higher tax rates than poor countries. It doesn't make sense - from a pure tax perspective - to transfer profits from low tax poor countries to high tax rich ones; you'd just pay more tax! By far the most significant issue is corruption in poor countries. We all need to campaign for international assistance to stamp out corruption - that should be the message we scream from the rooftops.

Rabbitstew

If I were called in by the government today, and asked to devise a way to extract more tax from banks, my first question would be why do you want to do that?

I reckon banks account for about £1 in every £9 collected. That's broadly in line with the amount you'd expect from the financial services industry, which amounts to about 13% of GDP. So banks aren't necessarily shirking tax in the way that people think they are.

That said, it's not uncommon for one industry to be singled out for special treatment. The profits of companies which extract oil from the North Sea are taxed at double the rate of other companies. In theory you could do the same with banks. However, the big difference is that a ruddy great oil rig in the middle of the North Sea is about as fixed in place as you can get - its owners can't up and move it to another oil field and still expect to strike oil. So the oil companies are over a barrel (if you'll excuse the pun!).

The banks are different in that their value is tied up in their intellectual property and employees, both of which can be moved out of the UK if the banks want to enough. Sure there would be costs of doing so, particularly reduced access to the City of London, but at some stage there's a tipping point and some of the banks will leave (HSBC, for example, is truly global. There's no real reason for it to be in the UK as opposed to anywhere else, when you stop to think about it.)

The other factor is that the banks operate globally and can bugger off to NY or HK if they want. We'll only get significant amounts of cash out of the banks when there's a global consensus as to how they should be treated.

Personally, even if there was more cash to come from the banks I would rather that it were set aside in a bail out fund so that we'll never again be in a position where the entire UK economy can be held to ransom by the threat of a big bank failing.

I don't think it would be appropriate to treat the bailed out banks differently. It would put them at too much of a competitive disadvantage. Not very fair on the thousands of bank clerks and office workers who didn't earn the megabucks or bring down the economy.

Finally, you asked whether the taxpayers will get our money back with interest. Are you assuming that the government lent them money? That's not the case - the government injected cash as equity, so the UK now holds shares in the bailed out banks. In theory, there should be a profit if the UK sells its holdings when the shares are worth more than it paid for them.

Thanks Cinnabar for reposting some very important information in a well thought out way.

I'm not rich, far from it but I do get tired of people who are all banker bashing and claim all businesses are fat cats screwing the poor without any facts and a shaky understanding of the subject in hand they read from the Daily Mail or the Guardian who seem to want to challenge the DM on truth bending reality stories.

Thanks, CinnabarRed - very helpful. I agree with Niceguy2: it is useful to get information from someone who clearly doesn't have a shaky understanding of the subject and who doesn't give emotional, knee-jerk, defensive or patronising responses.

Well, I have to confess that I haven't got much time for the investment banking community at the moment. It offends me greatly that they're back to paying enormous bonuses when everyone else is still struggling, especially as the direct and indirect taxpayer subsidies kept them afloat in 2008 and 2009 - they just seem unwilling or unable to understand why we might have an ethical objection.

If I were to look for more tax from the banks it would be via another round of bank payroll tax on bonuses. But as I said above, I think it's more important to boost their capital bases and set aside cash for a bail-out fund.

Really interesting - thanks Cinnabar.

Hi, CinnabarRed,

I'm interested by your comment that "in theory" there should be a profit if the UK sells its holdings when the shares are worth more than it paid for them. Why is this only a theory? Were they acquired at such a gross overvalue that there's no hope of them ever being worth more than the original investment made; do you expect the UK to sell them at a loss rather than wait for a profit; do you expect the UK to keep hold of its shares forever rather than sell; or is there some other reason why the potential profit is only theoretical?

ps I know we still don't know exactly how much the toxic debts amount to.

No we don't know and chances are we never will either.

But the key thing to remember is that the UK government did not simply take over the bank debts. The Asset Protection Scheme is in essence an insurance policy, in the same way that you or I would buy car insurance.

So all the talk of trillions of pounds of liability is a bit disingenuous since the chances of all the banks debts going bad is about as likely as Directline finding every policyholder crashing their cars at the same time. In theory it could happen......

In fact, RBS recently were in talks to exit the APS because aside from confidence, it seemed to be an expensive policy which gave them very little. IIRC they can't claim for the first £60billion of losses and their total liability was about £200billion i think. So its like having insurance for your car worth £2000 but you have to pay the first £600 yourself. You may wonder why bother.

So as each bank exits the APS, we (the UK taxpayer) will have earned a few hundred million for providing the insurance and yes...theoretically we were on the hook. But to date, I've not heard of any bank actually calling on the govt to pay up (please correct me if I am wrong).

Hi rabbitstew. Apologies for lax wording. When I said "in theory" I only meant that any gain is only theoretical until it's actually realised.

The thing about the toxic debt is that it won't necessarily stay toxic. Considerable chunks of it related to the US housing market, which was in a bubble situation in 2007 and early 2008. Lenders were prepared to give stupid mortgages to uncreditworthy people on interest-only terms because they just assumed that house prices would continue to rise forever - the plan was that the mortgage holders would eventually sell their houses at a profit and use that to pay off the debt. Of course in 2008 the US property market crashed and the poor mortgage holders were left in negative equity. However, once US house prices rise enough then there won't be negative equity any more and the debts will not longer be toxic (at least until the next US housing slump).

Niceguy2 - I seem to recall that joining the APS was a condition of receiving equity finance from the government. I genuinely don't know how easy it would be for a state owned bank to exit?

I don't want to turn this into a Guardian-bashing thread (I don't want to bash anyone - just set out some facts to allow people to make their own minds up).

But I did find this entertaining.

order-order.com/2011/02/21/the-guardian-uncut-and-full-of-cant/

(When reading it remember that the link is to a right wing blogger who will bring his own biases to the table. However, when you cut through the cheap digs at the Guardian he has the facts pretty much correct.)

Cinnabar - yes Guido was enjoying him/herself yesterday . This was the most retweeted blog yesterday (apparently). More to come....

And thanks for this thread.

Thanks for setting everything out clearly - conflicting newspaper reports do start to get very confusing after a while.

Thanks for this. very educational.

Just wondering what you think on the calls for companies to report publicly on tax paid and profits on a country basis?

The more I think about country-by-country reporting, the more misguided it seems to be.

1. The people best placed to judge whether companies are paying the right amount of tax in a given jurisdiction are the local tax authorities. The local tax authorities already have access to all the information they need to reach a judgement, and way more that is available through financial statements. (If they don't then the appropriate route to obtain more information should be to request that the local parliament award them further investigative powers.)

1. Tax campaigners believe that if they had this information then it would reveal all kinds of nefarious behaviour from companies. In particular, they believe that businesses are systematically pulling profits away from developing countries and into tax havens, through transfer pricing. Transfer pricing is the process by which two companies in a group determine the price at which they should trade between themselves for goods and services. Christian Aid produced two reports which claimed to demonstrate this systematic abuse ("Death and Taxes" and "Transfer Mispricing"). However, the methodologies used as so flawed as to render the repotrs meaningless. I'll explain why if you like, but it will be a separate post in its own right.

1. Company accounts are prepared for the benefit of the company's stakeholders - shareholders, lenders, employees, customers and suppliers, the tax authorities - to allow them to judge the performance of the company. They are not prepared for the benefit of tax campaigners, and I'm uncomfortable with the idea that tax campaigners (or any other pressure group, for that matter) should have the right to demand additional information that the users of the accounts themselves don't feel they need.

1. Country-by-country reporting is aimed squarely at big business. The average length of a PLC's accounts is already more than 250 pages. There are very few people in the country with the skill and knowledge to read and genuinely understand a set of PLC accounts. I don't think that adding to the information provided will actually gain anything, given my points at 1 and 2 above.

1. Don't underestimate the additional admin burden this would place on PLCs. Country-by-country reporting would only give meaningful information if each country's information was provided on a consolidated basis and full reconciled from actual tax charge to expected tax charge based on local tax rate without this is would be impossible to understand the effect of local tax rates and tax legislation). These consolidations and reconcilliations are not prepared by companies as a matter of course when they produce their financial statements - the consolidation is generally only done at topco level. So this really would be a massive increase in work. As an aside, I chuckle when campaigners say that the accounting firms are biased against CBC reporting - from an auditor's perspective it would be a gift in terms of increased audit fees....

1. What would the tax campaigners actually do with the information if they had it? Picket Switzerland? They can't get any more ranty than they are already....

1. There is a real and genuine problem with corruption in developing countries, and I believe that it is by far the most significant reason why developing countries find it so difficult to support business and raise taxes. I am genuinely concerned that the focus on tax and country-by-country reporting steals attention and energy from what should be the real fight.

An interesting twist on this - if you look at the UK deficit figures, it is pretty unarguable that while there was a small persistent deficit through the early 2000s, the vast increase came with the bank bail outs. (So here on the National Statistics site shows the deficit jump from under 3% to nearly 7% of GDP)

Because of the massive increase in the UK's sovereign debt, we are now seeing serious cuts in public spending.

But if, as suggested above, it has simply been a question of acquiring shares in the banks, which can then at some time in the future be disposed of, potentially even at a profit then to me this begs two questions:
a) are these shares considered as assets by the govt - and if so how are they valued?

and b) why are such serious cuts in public spending needed?

Is it because we have to assume that all the possible debts we are guaranteeing could go bad at the same time, however unlikely the scenario? ie we are having to sit on money rather than spend it, so that the banks can play about with their money rather than sit on it just in case?

Or is the 7% just a result of quantitative easing and other methods used to help the banks, plus less money being available to fund our spending commitments because of a general dive in the economy?

I'd be interested in Cinnabar's take on this.

But part of the jump in deficit is because of the fact during the recession, tax yields went down whilst spending on benefits went up. So in effect a double whammy.