The Future Of The Finance Centre

Nigel Feetham, Hassans

24 January 2001

This story is reproduced by kind permission of Panorama at http://www.panorama.gi

A Comment on the proposals being considered by the Gibraltar Government for reform of business taxation:

The subject of tax reform has occupied the minds of politicians, practitioners and academics ever since the modern tax system was introduced. The type of tax system that countries have adopted has, in many ways, reflected their economic development status at varying stages of their history. Since it is not possible to review the tax laws of every jurisdiction, the best approach may be examine the evolution of the UK tax system, which has been adopted by many jurisdictions as a model, for the purposes of our enquiry.

Interestingly, the early British Colonial tax system was based on the concept of the 'arising' and 'remittance' basis of taxation. Under the arising basis of taxation, income arising in the jurisdiction, that is, income generated within the jurisdiction, was taxable.

The British tax system then developed the concept of the remittance basis for foreign income, a concept that the UK, to some extent, still has today with respect to personal taxation. Thus, non-source income was taxed only when it was remitted back to Britain. This suited the British tax administration and the then-pattern of British international trade. As a trading nation with an Empire, when overseas wealth was created in the Colonies under British control, it was generally brought back to Britain. One has to remember that the global economy was not developed as it is today, and wealth was rarely kept overseas.

This pattern did subsequently change, and the strategy of British companies operating overseas evolved in favour of investing profits within the infrastructure of the Colonies. As a result, less foreign income was remitted to Britain, and less taxation revenue was being raised. So, the British tax system eventually moved away from the remittance basis of taxation and towards the test of residence for establishing whether a trade had a local source.

This meant that if a company were resident for tax purposes in the UK, it would be taxed on an arising basis on its income, whether or not those profits were remitted. This gave rise to a body of judicial authorities on what constituted residence for tax purposes, and an attempt by companies conducting foreign business to assert non-residence status and thereby avoid payment of taxes.

The residence requirement eventually became irrelevant. A foreign investor incorporating a subsidiary, which only carried on business in the host country, so that its income was foreign-source income as far as the parent jurisdiction was concerned, achieved the same result and avoided payment of taxes on foreign-earned income.

That, in very simplistic terms, is a brief overview of the development of the modern British tax system. Many countries have subsequently adopted similar principles into their tax legislation, and these concepts therefore serve as a suitable background for any discussion on the subject.

As the above illustrates, tax systems do evolve, and the legitimacy of any system is achieved through the principle of acceptability. In some countries' tax regimes the system is simply designed to maximise revenues from all commercial activities, wherever that commerce is conducted, and such jurisdictions are also normally associated with high rates of tax. In others, the tax regime is designed to stimulate the economy, and tax is only levied on commercial activity to the extent that is absolutely necessary to sustain the public sector and the needs of the Exchequer.

When considering a government's approach to the taxation of international commercial activities by companies based within its jurisdiction, the key issue is determining the extent to which existing tax regimes are open to challenge, and to examine what measures can be taken to reform the system and bring it within internationally-accepted parameters, whilst, at the same time, avoiding a negative impact upon the local economy. To that extent, offshore territories like Gibraltar should be able to adopt such tax legislation as has been adopted in other jurisdictions and which has been accepted internationally.

Accordingly, a number of former British Colonies historically have adopted the British tax concept of the remittance basis on foreign source income. This is also known as the territorial tax principle, which effectively means that income arising outside the country is exempt from tax. This is the principle underlying the taxation policies of Hong Kong, Singapore and Malaysia.

Hong Kong and Singapore are leading offshore jurisdictions and also have substantial economies. Significantly, to my knowledge, neither is on the so-called "OECD blacklist", so the tax systems in effect in both countries would, presumably, be acceptable to the OECD.

Under such a system, there would no longer be any need to recognise the concept of the Tax Exempt Company, or the ring-fenced tax regime, which discriminates in favour of non-residents. All companies would be treated on the same basis. This is a perfectly valid and accepted tax concept and almost every tax system recognises the legitimacy of this principle.

In the case of direct foreign investment, Gibraltar is close to that position already as far as subsidiaries and non-resident companies are concerned, and essentially the same result is reached in the case of a local branch because of the "separate entity" method of calculating branch profits. Even the Parent-Subsidiary Directive in the EU accepts that relief for foreign tax may be given either by the credit method or by exemption, which seems to accept and condone the legitimacy of the territorial system, at least as far as direct investment is concerned. Historically, even the French corporate tax system dating back to the beginning of the century was based on the territorial principle.

This regime which I have been advocating for Gibraltar would also contemplate that certain types of income would be zero-taxed. The system would be of a general nature and therefore neutral, but may also operate to the advantage of foreign investors. This would include classes of income where it would not necessarily be easy to subscribe a foreign source.

The result of adopting this system would be that foreign investors would pay no tax in respect of foreign source income, but the system would not discriminate against domestic taxpayers as it does currently. The tax regime would apply to both foreign and domestically-owned companies. The tax benefits would therefore be open to all, since tax would be territorial in scope. It would, however, be necessary, in certain cases, to bring income from a foreign source back into the tax net, and thereby limit certain exemptions.

This is not entirely dissimilar to the system of tax the Government is actively considering. The Government's proposal seems to be to introduce a 'general' zero rate of tax in respect of certain types of income. This, it is to be assumed, would cover most activities that are currently carried out by Tax Exempt Companies. At the same time, the Government proposals appear to contemplate the cutting of corporate tax to lower levels, whilst not lowering personal taxes from their current high levels. This obviously raises the question as to whether this is necessary at all, and whether this is motivated more by party political considerations than any need to adhere to internationally-acceptable taxation practices.

Implementation of the Government's proposals would also have the effect of reducing the level of tax revenues collected by the Government from large businesses operating in Gibraltar. I accept that it is a legitimate political objective, but is one which appears to be most correctly viewed in a political rather than fiscal context.

I conclude these observations by noting that the concerns of the OECD are not as clear as they seem to be. If the concerns were initially about taxation then, in my opinion, transparency and exchange of information are now the two major issues, which, according to perceived OECD wisdom, inhibit unfair tax competition. There is therefore, in my opinion, scope for negotiation with the OECD on pure tax issues.

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