1969 was facing a difficult liquidity situation in which, the Treasury had favoured for some time steps to enable public and private borrowers to borrow foreign currencies in the Euro-bond market. This was a means of meeting some of their financing requirements and, at the same time, of increasing the nations reserves. However, the issue of tax was causing some problems with the British government.
The issue in which a local authority may be able to pay interest gross on an issue of bearer bonds denominated in foreign currency was a welcome opportunity, as if this was accepted, it was likely that one local authority, the GLC, would begin negotiations. The Bank of England took the view that it was advantageous that the first Euro-bond issue by a public borrower was the GLC. Due to this reason, they wanted to get the position on the tax difficulty cleared up as soon as possible. Their understanding seemed to be that, since GLC borrowing would be secured on a domestic asset (the GLC rate revenues), it would not qualify for the permission to pay interest gross conveyed in the 1968 Finance Act.
It was clear that there was a genuine obstacle standing in the way of GLC and other local authorities borrowing foreign currency abroad, and it was necessary to consider means of removing an impediment to foreign currency borrowing by UK local authorities in the Euro-bond markets. It was suggested that the required provision should be generalised in order to cover nationalised industries or private sector borrowers as well as local authorities; to cover a direct charge on UK assets as well as the indirect one that arised from a subsequent loan contract, which was the particular problem of local authorities; and to limit the arrangements to foreign currencies, excluding currencies of the Scheduled Territories. Looking at the tax position on foreign borrowing - any UK borrower wishing to tap sources of funds in the international capital markets needs to take into account the following two points:
(a.) He will have to contrive a means of paying interest to the lenders gross without formality, because this is a demand of lenders in the international capital markets.
(b.) He will naturally wish to be able to charge the interest payable on his borrowing as an expense for the purpose of UK tax assessments.
(2). Payment of interest gross
Euro-bond issues were not practicable unless the borrower undertook to pay interest gross, and it was therefore important to be clear as to the terms on which London, other local authorities and the nationalised industries could arrange borrowing on gross terms. It was possible for a local authority or nationalised industry to arrange to pay interest gross, without attracting any UK tax charge, provided that the interest has an overseas source in the hands of the bond-holder . This interest has an overseas source if; firstly the loan contract is made abroad, secondly if the loan contract is governed by foreign law, thirdly if the interest is payable abroad, and there is no UK paying agent. Finally if the loan is not secured on any specific assets or revenue in the UK.
The Revenue had to consider all the specific arrangements before they took a final view that it takes the relative interest outside the UK tax charge. In their sterling borrowing hitherto, the local authorities had secured their loans on their revenue, largely from rate income. The fourth condition would preclude this. On the basis of the forth requirement being fairly inflexible, there was no means by which the local authorities could secure their loans (if for good reasons they wished to do so) on any assets or income in the UK .
It was important to clarify the point of whether there was any difficulty for the GLC in making a Euro-bond issue provided that the borrowing contract was signed abroad. To enable the authority to pay interest gross, to give the interest a foreign source, it was necessary for the four conditions to be met. The fourth condition was of extreme concern the provision that the loan should not be secured on any specific assets or revenue in the UK. The concern was that the GLC and other local authorities almost invariably secured their sterling borrowings of rate income, they would wish to do the same in the Euro-bond market, and the fourth provision would effectively preclude them from paying interest gross. It was far from clear that it would be necessary for the GLC or any other local authority to offer a lien on the rates if they undertook a Euro-bond issue .
It seemed that, it was almost certainly necessary to give an indirect lien in the following way. On the basis that the loans to the cities Oslo, Bergen and Copenhagen being regarded by the bond market as the relative precedents, it was necessary for the GLC to give a negative pledge to the effect that if on any subsequent borrowing a security is given, then this security will be available equally for the bond issue. It seems likely, that if the fourth provision was indeed inflexible, then the negative pledge would also fall foul of the Revenue requirements, and it would not be possible for the authority to pay interest gross. This seemed like a very tiresome procedure which involved three possibilities; firstly the Revenue may conclude, on reflection, that the revenue to which reference is made; in the fourth provision (that the loan is not secured on any specific assets or revenue in the UK.) relates to trading income, and does not therefore cover the rate or other income of local authorities; there will therefore be no problem. Secondly, the law could be amended in the 1969s Finance Act. Thridly, the local authorities might discontinue their practice of securing sterling loans against rate income .
However, this problem did not arise for the nationalised industries, because they did not, secure their loans on specific assets or income. The Chancellor of the Exchequer (on the 15th January 1969) approved the conclusion that foreign currency bond issues by nationalised industries were desirable as a contribution to Britains foreign currency financing problem, and that the Government should offer to carry the exchange risk so as to facilitate the making of such issues and other local issues . It was noted that the GLC might be debarred for tax reasons from making such issues. If local authorities were in fact debarred, or the GLC decided not to make an issue, it will not be worth extending this arrangement to local authorities as well as nationalised industries. It was finally decided that, if the GLC were not debarred and they have firm plans to make an issue, then the door can be opened to local authorities .
The obvious thing to do was for the local authorities to make an issue unsecured. It seems that unsecured borrowing was a normal procedure in Continental capital markets. However, the borrower was normally expected to provide a negative pledge. E.g., the Euro-bond markets may take some issues by the cities of Oslo, Bergen and Copenhagen as precedents. These cities borrowed without security, but provided a negative pledge to the effect that if on any subsequent borrowing a security was given, then this security would be available equally for the bond issue. If a local authority must provide adequate security when it is borrowing in this country, then it seems that the negative pledge would result in a borrower providing security in the foreign currency market as well. This falls foul of the revenue requirements. This is a difficulty, which does not stand in the way of a possible foreign currency issue. An appropriate amendment to the Finance Act is necessary .
A tax problem arose, because the Revenue considered that income paid by a UK borrower does not qualify as foreign source income, and is therefore outside the UK tax net, unless the loan is not secured on any specific assets or revenue in the UK. The problem arises for the GLC and other local authorities from the authorities traditional practice of giving a lien on the rates and other revenues in respect of their London market loans, and the insistence of Euro-bond subscribers on receiving special most favoured nation treatment. This means that the local authorities will almost certainly be required to agree to insertion in the loan agreement of a security provision on the lines of those in the loan agreement for the cities of Copenhagen, Bergen and Oslo. The result, if Revenue stand by their interpretation of the statutory position, is that the act of creating a lien on rate income in the first Sterling loans after the Euro-bond issue will cause the interest paid by the local authority to revert to the status of UK income source, thus coming within the tax charge .
The position of the local authority would be impossible in this situation. It would be regarded as part of the preliminary negotiations as well as in the loan agreement itself, to indicate that interest would be payable gross and yet would be inserting in the agreement a second provision which would be bound in a relatively short time to frustrate its ability, within the law, to fulfil the first requirement. This problem did not arise for the nationalised industries, because it was never their practice to create a lien on UK assets because they borrow under Treasury guarantee. The solution was to remove the offending Revenue requirement in respect of overseas borrowing by the nationalised industries and commercial borrowers (for simplicity and to avoid highlighting the position of the local authorities) . There were four alternatives: firstly, to abandon the idea of foreign currency borrowing by the local authorities. Secondly for the local authorities to abandon their old-established practice of creating lien to secure their sterling issues. Thirdly, a less statutory interpretation by the Revenue of the statutory position to regard the interest payable on these issues as retaining its foreign source connotation even when the indirect pledge became effective. Finally, to amend the law.
Examining these alternatives, the first alternative was unquestionable, especially since the GLC and Manchester had relative borrowing powers. The second alternative was impracticable. The third alternative was a possibility. So it seemed that the fourth choice was fairly obviously the right solution .
The point was that bond issues could be made in the Euro-bond market only if the borrower undertakes to pay interest gross. That the relative interest income has to be given a foreign source (based on the four requirements). The only point of difficulty arose on the fourth the requirement that the loan should not be secured on any specific assets or revenue in the UK. The problem had arisen only for the nationalised industries where it may be necessary to create an indirect security where the borrower is called upon to give a direct security in a subsequent loan .
However the Revenue view stated that if by such a provision a loan became subsequently secured on assets or income in the UK, then the source could no longer be regarded as foreign. This problem did not arise for the nationalised industries, as they borrow under Treasury guarantee. Therefore, two possibilities were either to abandon the idea of local authority foreign currency borrowing in the face of this tax difficulty or, alternatively to modify the loan established practice under which the local authorities charge their London market borrowing on their rate income. The first possibility was clearly unsatisfactory, due to the potential gain for the reserves, which would have been forgone. The second was considered impracticable. Therefore the tax position was the only consideration. There was a strong case in the longer term for removing the loophole through which income has a UK source in all but the legal sense can be paid gross to non-residents .
The policy was to encourage foreign currency borrowing, and to encourage UK borrowers to use the artificial foreign source route to the fullest extent possible. There was no objection on principle to any modifications on the proposed legislations in order to get the maximum benefit from it. A subsidiary point had arisen as a result, as whether it was necessary or desirable to confine the amendment to the local authorities. The tentative view was that there were advantages in generalising the change to apply for all UK borrowers. As it would have been impractical if the nationalised industries or private sector borrowers were called upon to introduce a charge on UK assets in their loan contracts, and because the tax change was confined to the local authorities, were inhibited from further foreign currency borrowing .
The possibility of local authorities borrowing in foreign currencies unsecured was governed by Section 197 of the Local Government Act 1933 (extended by Schedule 4 (43) of the London Government Act 1963) to include the Greater London Council and the London Boroughs) which required that all moneys borrowed by a local authority in England and Wales should be secured on all revenues of the authority, except any money borrowed by way of a temporary loan or overdraft without security. It seemed that there was no possibility of local authorities being able to borrow unsecured, except at the very shortest term, either in sterling or in foreign currencies. Also that local authorities could have had difficulty in meeting the requirements of the international capital markets for payment of interest gross. A clause was needed in the 1969 Finance Bill to get over the difficulty, giving wider facility to the tax difficulties which obstructs foreign borrowing. As the present tax arrangements had the effect that in order to be able to pay interest gross, borrowers had to arrange loans in contracts ruled by foreign law and with interest payable overseas. This gave rise that there needed to be some changes in the fiscal rules to allow straightforward borrowing in London to qualify for payment of interest gross .
(3). Tax arrangements on borrowing by UK companies from non-residents
Lever with the Inland Revenue and the Treasury reached a conclusion in January 1969, which involved three separate suggestions which were designed to facilitate borrowing by UK companies from non-residents. The conclusion was that there was no particular need for further relaxation and that the three particular suggestions could not be recommended .
Payment of interest gross
The first suggestion was that UK companies should be permitted to pay interest due to non-residents on overseas loans gross of UK tax, irrespective of the source of the interest or the residence of the paying agent.
The suggestion arises because (a) in respect of interest which has a UK source, tax is deductible unless the interest is bank deposit interest, short interest, interest payable on certain British Government securities and interest exempted under a double taxation agreement. (b) Subscribers to Euro-bond issues require payment of interest gross without formality and will not subscribe on other terms .
UK borrowers at the time met the requirement at (b) provided that they arrange their loan contracts so as to give the interest a foreign source; in essence this means that the relative loan contract must be established under foreign law and the interest is paid overseas. Such arrangements are not particularly difficult to set up and they involve no tax or other penalty on the borrowing company. The disadvantages are: first, that it would be slightly easier, and certainly more straightforward, if UK companies could set up their arrangements through London agents; secondly, that the need to use an overseas base may seem to be a little undignified particularly for an important UK company or a nationalised industry; and thirdly, that the modest professional fees and commissions associated with the handling of these arrangements go abroad instead of remaining in London .
None of these objections was particularly powerful, and there was no evidence that they inhibit borrowing possibilities at all. The small inconvenience and possible indignity of arranging a loan contract governed by foreign law, once the decision to borrow from foreign sources has been taken, does not appear to affect potential borrowers one nationalised industry commented revealingly that it meant no more than a day in Luxembourg for the directors. The amounts involved in professional fees are trifling and there is no suggestion that foreigners involved in the loan arrangements could use them as a point of entry for wider operations.
Against these modest and in part merely presentational advantages, there were strong objections against changes in the principles and practice of taxation of the kind which would be involved in the 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 countrys 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 UKs 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 UKs 41¼ % charge on interest have to be made through the other countrys 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 UKs 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 UKs 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 countrys 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 UKs 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 overseas loan contracts, and this would substantially increase the field in which evasion could take place. Admittedly, UK residents were already able to buy Euro-dollar bonds issued by UK companies, but for this purpose they must either pay the investment currency premium (which would make the investment unattractive) or evade the exchange control. Bonds issued in sterling currencies by UK companies would be more attractive to UK residents and it would be more difficult to counter evasion of tax on interest on such bonds .
Against these severe practical difficulties, the UK had to counter the possible benefits to the balance of payments and reserves of overseas borrowing in sterling area currencies. If the proposed additional facility did not increase the total amount of overseas borrowing, but merely replaced some foreign currency borrowing by some borrowing in sterling area currencies, this would be unwelcome. To the extent that the UK obtaining sterling area currency prevented the sterling area country concerned from an equivalent diversification of its reserves into foreign currency. The UKs borrowing in this form would be as good as foreign currency borrowing. But the more likely situation would be that the sterling lending to the UK would be only partly an alternative to diversification and would mainly be offset by a reduction in sterling holdings .
There was however the question of the extent to which the additional facility would open the way to increased overseas borrowing. This was not easy to judge. There was no shortage of available funds for foreign currency borrowing, but an important element in the reluctance of potential UK borrowers to commit themselves was the exchange risk associated with foreign currency borrowing, particularly where the proceeds were to be used for domestic investment. It was thought that the deterrent effect of this risk would be smaller in the case of sterling area currency borrowing, but even this judgement was doubtful. The fact was that experience of the reaction of other countries to UKs devaluation in November 1967 had demonstrated the probability that, on any future similar occasion, the stronger sterling area currencies would not move with UK sterling . Adding to this, the fact that the sterling area currencies which were most likely to be available for overseas borrowing are those of the countries in relatively strong balance of payments and reserves positions, such as Kuwait, it becomes rather doubtful whereas UK borrowers will in general see the additional facility of sterling area currency borrowing as being so attractive as to increase their overall willingness to borrow.
On balance, it seemed likely that the additional facility of borrowing in sterling area currencies would induce some switching by UK borrowers from foreign currency to sterling area currency which would be disadvantageous, and might be offset to some extent by willingness to borrow on a rather larger scale in this form. There certainly seemed to be no ground for thinking that the additional facility would create a substantially greater level of overseas borrowing, and it was concluded that it was not worth embarking on this against the background of substantial difficulties in tax evasion which would unavoidably be associated with it .
Loans for Non-Trade Activities
The third suggestion was a further extension of Section 22 concession to allow deduction for Corporation Tax purposes for interest paid on loans in support of other and general purposes, as well as the purpose of the borrowers trade already covered by Section 22.
Even if there were an argument on balance of payments grounds for making some further relaxation in the treatment of interest, there was no reason why the right to pay interest to non-residents gross should be extended beyond the field of borrowing for trade purposes. Overseas borrowing of money which will be used in a UK business, and thus tend to strengthen the whole UK economy, was one thing. Borrowing abroad and thereby placing a continuing burden on the current balance of payments for the purpose of, say, buying a villa at Cannes, was quite another. Restriction of the concession to loans for trade purposes meant that the concession was available for direct investment, but not portfolio, but it was far from clear that the UK wanted to encourage domestic portfolio investment by UK borrowers using foreign currency finance. The UK certainly did not want to encourage such borrowing to finance or facilitate the payment of import deposits, and indeed in general it seems untimely of such thinking of unrestricted access to foreign borrowing which might in many directions have interfered with attempts to control domestic credit . |
