Cicero Policy Briefer

Issue 24, May 2008

Taxes on foreign profit threaten more than headquarter locations

By Michael Devereux, Director, Centre for Business Taxation, University of Oxford

This week’s decision by the pharmaceutical company Shire to shift its headquarters to Ireland is the most dramatic response yet to proposals from the UK government to reform the way it taxes foreign income earned by UK companies.

These proposals were made last summer. After much debate, there was hope that revised proposals would be included in the Budget, but they have now been delayed to the summer. We might infer that officials are having difficulty in formulating plans. If so, that is not surprising: developing appropriate taxation of foreign income is no easy task.

The Government would like to exempt from UK tax profits earned abroad by UK companies, instead of taxing dividends repatriated to the UK as it does now. That is reasonable: most other countries already do this, and the UK raises very little revenue from taxing repatriated dividends while almost certainly distorting the financial and organisational decisions of UK companies.

But difficulties arise because the Government fears that exempting foreign income will make it easier for UK companies to avoid paying taxes on UK income: that is, that income currently declared in the UK would in future be shifted abroad to escape paying UK tax. (Not surprisingly, UK businesses dispute this.) So the Government proposes to replace the existing anti-avoidance rules governing the foreign income of UK companies with a new, and tighter, “controlled company (CC)” regime. It is the threat of this proposed CC regime which is said to have induced Shire to move to Ireland.

One might expect that the natural way to protect the UK tax base would be to tighten rules on transactions used to shift profit out of the UK—transfer prices on goods and services into and out of the UK, and on the extent of borrowing in the UK. But the Government has not proposed this route. Instead, it proposes to tax the worldwide passive income - interest, royalties and dividends - of all foreign affiliates of UK companies. This is a significant extension to current practice.

On the face of it, this approach is odd. The proposals do not attempt to police the boundary over which the Government has legitimate concern—whether income arises in the UK or elsewhere. Instead it has created a new boundary—passive vs. active income—which would be policed on a worldwide basis. This might be justified if these boundaries were very similar—that is, if virtually all passive income arising in affiliates of UK companies anywhere in the world really was a return to activity in the UK. But that is very hard to believe.

A UK tax on passive income generated outside the UK could be far more significant for companies like Shire than the odd percentage point on the UK corporation tax rate.

At the same time, relying on an artificial boundary between passive and active income will add to the complexities of an already complex tax system, and could allow active income generated in the UK to be shifted abroad to avoid tax.

So why does the Government not simply aim to tighten rules governing the taxation of income arising in the UK ? One factor is the case law of the European Court of Justice, which increasingly limits the use of rules which treat foreign income differently from domestic income.

But there is a more fundamental is sue. The international tax system requires businesses to allocate their worldwide profits between the countries in which they operate. But modern business is global. Costs may arise in one country and income in another. Different parts of a company, located in different countries, interact to generate higher profit. This makes the allocation of profit increasingly difficult to administer. But more than that, in many cases, there is simply no conceptual basis on which to allocate profit between countries.

Many might respond that over time a set of rules has been constructed to allow the system to work, and that significant sums are still collected in corporation tax. But—probably unwittingly—the Government seems to have declared otherwise. It is concerned about taxable income departing the UK, but apparently believes it can only protect the UK tax base by introducing a worldwide tax system. This has repercussions beyond even whether some UK headquarters move to Ireland. It casts doubt on the continued survival of existing forms of corporation tax.

Michael Devereux is the Director of the Centre for Business Taxation at the University of Oxford and can be contacted here.

This article is based on the paper “Taxing Foreign Profit: Economic Principles and Feasibility”, by Michael Devereux, prepared for a conference of the European Tax Policy Forum and the Institute for Fiscal Studies on 21 April 2008. The paper, with executive summary, can be downloaded here. The conference programme can be downloaded here.