UK Tax Policy and the Euro-dollar Market

Written by admin on May 4th, 2011

payment of interest gross .

In general and in common with other countries the UK sought to tax all income arising within its borders, wherever the recipient of the income resides, and the law was constructed accordingly. The right to charge income having a UK source was of course given up in many double taxation agreements in relation to investment income, but this was always subject to reciprocity by the other country and on the understanding that the other country will in general tax the income concerned in full. In the case of interest the UK had gone further and surrendered unilaterally its right to tax short interest, bank deposit interest and certain interest on Government securities going abroad. There was the further special case of loans based on contracts governed by foreign law, where UK tax law may in principle provide for the deduction of tax, but the UK had to recognise that the lender may be able to sustain a refusal to accept less than the full amount of the interest, and the UK had adopted the somewhat artificial convention that the interest on a loan where the contract was governed by foreign law was regarded as deriving from a source outside the UK, provided that it was paid outside the UK and that the loan was not secured on specific assets in the UK. It was under this arrangement that UK borrowers issued Euro-bonds with payment of interest gross .

Despite these special exceptions, the UK considered that the principle of its right to tax income arising within its borders remained broadly intact, and that any further erosion of it, except on the clear basis of reciprocity, would be mistaken.

The potential dangers were considerable. Willingness to give up its right unilaterally would undoubtedly make it more difficult to secure reciprocal exemption in double taxation agreements. There were many cases in which a concession given unilaterally would involve loss of revenue without countervailing advantage, thus: some deduction of UK tax may be acceptable to the lender if he is resident in a country with which the UK has a double taxation agreement and in which he can credit his UK tax against his own country’s tax charge – the effect of a concession from the UK would be a benefit to the revenue authorities of the other country. Some of the UK’s agreements provide for interest to be taxed in the country in which it arises at some low fixed rate, usually 10% or 15% – here the tax the UK would give up would be completely lost, because claims to a partial repayment of the UK’s 41¼ % charge on interest have to be made through the other country’s revenue and it must be assumed therefore that the lenders concerned are not striving to remain anonymous from their own authorities; and coming closer to the field of Euro-bond issues, the UK tax deduction is regarded as acceptable in the case of other fixed interest borrowing and to refrain from taking UK tax in such circumstances would be an absurd self-denial .

In the particular case of Euro-bond issue, there would of course be no direct tax loss, given the UK’s assumption that potential borrowers are already able to adopt the method of a loan contract under foreign law which avoids UK tax liability in any case. But it is difficult to envisage an arrangement under which a concession could be confined to Euro-bond issues without encroaching on important fiscal principles elsewhere .

Finally, although the UK are content to adopt the artificial convention that the interest on loan contracts set up under foreign law derives from a source outside the UK, the whole discussion is addressed to Euro-bond issues whose proceeds are used for domestic investment in the UK, and a more realistic appreciation would recognise that the true source of the interest is within the UK. On economic grounds, therefore it was considered reasonable and right for the UK to demand its tax entitlement. At the time in the late 1960s, the UK were content to waive this in the interest of encouraging a source of foreign borrowing .

However, there were still those in the Treasury and the Inland Revenue who considered, that the UK’s arrangements of the time had gone too far, and that there would be a weighty case in the medium term, when the UK could afford to be less encouraging towards foreign currency borrowings, for reverting to a more rational and defensible arrangement under which all interest paid out of income generated in the UK is subject to UK tax, unless reciprocal tax agreements apply. Generally, there were dangers in making fundamental changes in the tax system – or indeed peripheral changes which bear upon fundamental principles of the system – as part of arrangements designed to meet a balance of payments and reserves situation which was expected to improve over the years ahead. So, it was concluded that the balance of argument was overwhelmingly against the suggested change .

Interest on loans in Sterling Area Currencies

The second suggestion, was that the concession in Section 22 of the 1968 Finance Act should be extended to enable companies in computing their profits to deduct interest in respect of loans denominated in any currency of the Outer Sterling Area as well as loans covered in the Section 22 concession denominated in foreign currency. The object was to facilitate borrowing in currencies of the Outer Sterling Area as well as foreign currencies, particularly prompted by the thought that Kuwaiti funds might well be a promising source of overseas borrowing .

There was no ground of tax principle for dispensing less generous tax treatment (for the purpose of computing profits) in respect of loans denominated in sterling area currencies. Also, that, there would be no difficulty in principle in allowing a payer of interest a deduction in computing his profits for interest paid on a sterling area currency loan made to enable him to earn these profits. The difficulty was the serious practical one that further liberalisation of the treatment of interest going abroad would much enhance the dangers of avoidance and evasion of tax. The avoidance danger was that profits earned in the UK would be drawn out of the country without suffering any Corporation tax, through the creation of artificial loan liabilities. Thus, a company can lend money to an overseas associate (on interest free terms) and the associate can lend the money back to another UK member of the group which then incurs a liability to pay interest abroad, and may thus be able to pay in interest gross of UK tax. If the associate is resident in a tax haven, part of the profits of the group have then effectively been taken out of the UK tax net. This could be achieved under the existing law of the 1960s, but the scope for such avoidance schemes was considerably restricted by the fact that the associate either had to be in a non-sterling country (when exchange control comes into operation), or a double taxation agreement had to be invoked to enable the interest to be paid gross – and there were provisions in double taxation agreements designed to prevent the misuse of the reliefs allowed under them . Extension of the Section 22 concession to loans denominated in sterling would make it practicable for UK borrowers to pay interest gross to a sterling area country (for example a West Indian tax haven) without deduction of tax, and such avoidance schemes would be much more difficult to counter. Anti-avoidance provisions similar to those appearing in out double taxation agreements could be included in the necessary legislation, but these might well be ineffective since it would be difficult for Inspectors to link up a chain of associated lending operations designed to take advantage of the concession. It was then suggested that, the UK should not then be able to consult the other country’s Revenue to confirm that the relief was not being abused .

The scope for evasion of tax on interest received by individuals resident in this country would also be extended if UK borrowers were able to claim a deduction in computing their profits for interest paid on sterling area currency loans and it thus became practicable to pay interest gross to sterling area countries. Interest from an overseas source paid through a UK paying agent or collected by a UK collecting agent was subject to UK’s “foreign dividends” machinery; interest on British Government securities payable gross to persons not ordinarily resident in the UK was policed in a similar way. This machinery ensured that where dividends or interest are paid direct to a UK resident, tax was deducted and accounted for to the Revenue by the paying or collecting agent. To evade tax on such income, therefore, a UK resident had either to make it appear that the income was payable to a non-resident or that he had to keep it entirely outside the paying and collecting agent machinery – either by retaining the income abroad or by having it remitted to this country in a form which does not bring it within the taxing machinery. If the income was left abroad, the UK were not likely to find out about it (unless the UK learn of it indirectly, e.g. in the course of a back duty investigation) . Often however, the individual would want to use the income in the UK and this was difficult to arrange without coming within the taxing machinery, particularly if the income was in a non-sterling currency.

While therefore evasion of tax on interest payable abroad was possible under existing arrangements the scope for it was restricted. Furthermore, many individuals prefered to buy bonds of UK companies rather than of foreign companies. To extend the Section 22 concession in the manner proposed would have enabled UK borrowers to pay interest gross on sterling area currency loans under

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