19 October 2016

The Government’s new tax plans risk damaging British companies

By Rachel Kelly

The tax landscape has changed dramatically in recent years – and public interest in tax matters has reached unprecedented levels. Headlines about aggressive tax avoidance scandals involving tech giants and global coffee brands have helped shape public opinion towards big business.

As a result, politicians are working overdrive to try to address public concerns, close loopholes and ensure businesses pay their “fair share”.

Yet public hostility to tax avoidance is so strong that neither the voters nor politicians appear to give equal consideration to the potential unintended consequences of these headline-grabbing measures. “Tax avoidance” is such a dirty phrase that it’s very difficult to have a balanced debate on the subject. But the issues are not black and white and can’t be sensibly debated in a 20-word tweet.

For example, in its understandable zeal to ensure that all pay their taxes, the government is set to introduce a set of new anti-avoidance measures recommended by the OECD. This arcanely named “Base Erosion and Profit Shifting” (or “BEPS”) initiative is well intentioned, but will have dangerous unforeseen outcomes.

One of the OECD’s key recommendations for BEPS is that tax relief on interest costs should be restricted to a percentage of a company’s earnings. The proposals are inspired, at least in part, by the way in which some multinational firms have used the current ambiguity in the international tax system to reduce their tax bills – in particular the shifting of profits from one country to another, or the racking up of artificial debts between different branches of the same company.

But the result is that these rules have been designed to address the tax behaviour of “conventional” multinationals. They don’t work well, or deliver a fair tax outcome, for businesses that rely heavily on debt for genuine commercial reasons – even when they are wholly UK-based, with no risk of profit-shifting overseas.

As a new report published today by the Centre for Policy Studies makes clear, this could have significant adverse consequences in particular for the real estate and infrastructure industries – sectors where firms take on significant up-front debts (to buy land or pour concrete) in order to make profits down the line.

What do I mean by this? The principal rule in the OECD plan is that tax relief on interest costs will be restricted to 30% of a company’s earnings. There will be a secondary “group ratio” rule for more capital-intensive firms with commercially higher interest costs.

Today’s report outlines a number of issues with the proposed group ratio rule: namely that it will add additional costs, complexity and uncertainty for real estate businesses – and make it more expensive for them to invest.

Historically, all interest paid to an independent third party (such as a bank) would be tax deductible on the grounds it is a legitimate business expense. In exactly the same way as a plumber buys piping or a restaurant buys food, real estate businesses buy money. In addition, interest paid to a related party would also be deductible, providing it meets certain criteria. Under these new proposals, this longstanding principle will no longer apply.

These changes represent a huge shift in traditional tax principles in the UK. Until now, it was widely accepted that genuine expenses of a businesses should be deductible for tax purposes. This allows businesses to forecast accurately how much tax they will pay on their activities and therefore assess whether or not a project or investment will be viable.

Adding complexity and uncertainty to this process makes assessing viability harder and riskier – which is likely to put off many investors, particularly those with lower risk appetites. This at a time when new investment in both housing and infrastructure is desperately needed.

The CPS report estimates that the new rules could cost these sectors as much as £700m per year – with obvious negative implications for investment and jobs. These adverse consequences will be worst felt by businesses involved in property development, which is particularly bad news for the regeneration of our brownfield sites and the development of much-needed housing stock.

While the government’s intention to crack down on tax avoidance is commendable, the question must be posed: at what cost is it willing to pursue these objectives? And is it fair that businesses in some sectors should suffer disproportionately from these tax avoidance measures, even when there is no risk of tax avoidance?

It is clear that government’s proposed implementation deadline of April 2017 is far too ambitious. It does not allow sufficient time to consider the impact of these new measures, or for businesses to adapt. Furthermore, because the UK is pushing ahead of its European peers, these changes risk damaging the UK’s competitiveness.

In an ideal world, the Government would amend these proposals to better target incidences of tax avoidance and avoid penalising capital-intensive industries. As a minimum, it should postpone their implementation until it is clear how other countries will respond.

Rachel Kelly is senior policy officer at the British Property Federation