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Darling Faces Crucial Decision On Taxation Of Foreign Profits

by Jason Gorringe,, London

20 April 2009

Tax experts are urging British Chancellor Alistair Darling to proceed with proposals to exempt certain foreign dividends from income tax in the 2009 budget, due on April 22, whilst delaying controversial anti-avoidance measures which would accompany the reforms.

The foreign profits tax reform package has been under discussion by the government and multinationals since 2006. The thrust of the proposals, which would move the UK towards a more territorial system of taxation, whereby foreign dividends would be exempt from UK tax, has been generally welcomed by business. However, serious concerns have been raised over proposed measures that would limit the amount of interest on debt that companies could use to offset tax in UK, known as the worldwide debt cap - so much so that many experts believe the disadvantages of the debt cap will ultimately outweigh the benefits of the dividend exemption.

"Addressing specific issues around the taxation of foreign profits – notably the proposed ‘debt cap’ - and showing evidence of progress towards the stated goal of a territorial tax system (which would not seek to tax profits earned overseas) would be welcome (in the budget)," commented Sue Bonney, head of tax at KPMG Europe. She went on to observe:

“Although in many ways, the taxation of foreign profits is a deeply technical area of corporate tax, it is of fundamental importance to the UK’s overall tax competitiveness. The UK rules have been found to be in breach of European Law and there is a reform process underway. Broadly the principles unveiled so far as regards exempting foreign dividends are welcome but there are some significant issues with the proposed legislation accompanying these changes – the so called ‘debt cap’ designed effectively to stop upstream loans by UK parented multinationals and to prevent inward investors putting more debt into the UK than is required to finance the worldwide group.”

“It is recognised that the UK tax system should prevent inward investors from “dumping” debt into the UK. However, there are already many rules to stop this from occurring and it is therefore questionable whether or not a new rule is required."

“It is true that HMRC have listened to taxpayers concerns to a certain extent and an Update Note on modifications to the proposals was released on April 7. However, the new rules will still apply an annual test which will override other rulings, therefore creating further uncertainty in the UK tax system. They could also apply where there are perfectly legitimate commercial reasons why debt would be put into the UK which exceeds the worldwide group debt – for example where the group overall is cash rich or has no external debt but it is desirable to make an acquisition in the UK using some debt finance for treasury and cash management reasons. In the current environment we should be surely encouraging not restricting inward investment.”

According to KPMG, there are good arguments for withdrawing the worldwide debt cap as it currently exists and, if it is thought necessary, replacing it with a rule which targets upstream loans into the UK.

“We understand that the rules will not come into force immediately and that the start date will be announced on budget day," Bonney continued. "The delay is good news to the extent it will allow time to solve the various issues identified and give time to taxpayers to understand how the eventual rules will affect them. What is unfortunate is that it appears that the delay in the debt cap rules will be accompanied by a delay in the dividend exemption. We would prefer to see these rules introduced immediately as a number of groups are waiting to bring back sizeable dividends to the UK as soon as they can do with incurring an unnecessary tax charge.”

Bill Dodwell, head of tax policy at Deloitte agrees that the government should move quickly to introduce the dividend exemption, which would act almost as a stimulus measure. But he implored Darling to delay the start of the debt cap rules to allow time for the reforms to bed in.

"Our view remains that the package should go ahead, but the debt cap measures should be left out to allow for more work," he said. "We believe that there are sufficient Exchequer protections in the package, so that tax would not be put at risk and the dividend exemption would encourage UK groups to bring back funds to the UK."

Debate over the government's foreign profits proposals is not confined to the UK. Earlier in the year, the Washington-based National Foreign Trade Council (NFTC), which represents the interests of about 300 of America's largest companies, expressed its "deep concern" over the draft legislation - including the dividend exemption itself - in a letter to Chancellor Darling.

"The proposed legislation is very wide reaching and complex, and its introduction in its current form would cause great uncertainty both for existing and potential inbound investors," wrote Bill Reinsch, President of the NFTC, who went on to warn: "These factors will have a negative impact on the UK's attractiveness as a location for inward investors and could lead to the overall foreign profits package (including the dividend exemption) being seen as making the UK less competitive in the international arena."

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