Wednesday, 1 May 2013

Tax avoidance #2: The GSK loan trick

In an earlier post I argued that tax avoidance is not as immoral as many politicians insist on claiming, but instead reflects the failure of those same politicians to enact laws that are designed to be consistent and foolproof. I also argued that, contrary to conventional wisdom, tax avoidance cannot and should not be tackled through the use of international treaties or agreements, but should instead be countered through the use of unilateral action. The growing use of "baseball arbitration" by the USA and other countries is a salutary warning in this respect for it could in particular enable multinationals to reduce their tax bills by playing countries off against each other in an increasingly damaging game of winner-takes-all. 

The solution therefore must be for countries to be self-reliant, rather than being reliant on others. To demonstrate the point I will outline some of the most common tax avoidance schemes currently in use by multinational companies and then demonstrate how I believe such schemes could be countered through simple changes to UK tax law. The first such example I have chosen centres on one of Britain's biggest companies. 

GlaxoSmithKline (GSK) is a world-renowned pharmaceutical company. However in recent years it has also found itself in the media headlines regarding its tax avoidance strategies in various countries around the world. 

In 2006 it settled a long-running transfer pricing case in the USA, while more recently it won another transfer pricing case against the Canadian government. However, last year a Panorama programme for the BBC highlighted a different type of avoidance scheme employed by GSK that specifically affects its UK operations. The scheme itself used intra-company loans to reduce GSK's corporate tax bill, but as the Panorama programme also highlighted, GSK is not the only company that has apparently used this type of scheme. The programme also alleged that Northern & Shell, the company run by Richard Desmond that owns Express Newspapers and Channel 5 has also operated a similar scheme. But the implications for this type of tax avoidance stretch much wider than the practices of these two companies as this type of avoidance is also closely related to other schemes used by companies such as Wales and West Utilities and the holding companies of certain well-known football clubs that have been subject to corporate takeovers. These so-called leveraged buy-outs (LBOs) also rely on debt to reduce future corporation tax liabilities, and it doesn't stop there. Much of the housing buy-to-let market also exploits similar tax loopholes. The big question then, is how should the tax rules be changed so that such schemes can be permanently outlawed? 

In the Panorama programme it was claimed that the GSK tax avoidance scheme worked as follows. The parent company in the UK sets up a subsidiary in an overseas tax haven (e.g. Luxembourg). The overseas subsidiary then loans the UK parent company a large sum (say £6.34bn) and the UK parent then pays interest (totalling maybe £124m) back to the offshore subsidiary. This interest is then deducted from the UK company's gross profits before it has to pay its corporation tax (at 28%). The scheme thus saves the parent company £34.72m in UK corporation tax. 

Of course the money paid in interest to the offshore subsidiary will be taxed instead by the overseas tax authority (in this case Luxembourg ), but as the tax haven is chosen so that this tax rate is generally much lower than the normal rate of UK tax the net saving can be considerable. In this particular case the money GSK allegedly paid to its subsidiary in Luxembourg was apparently only taxed in Luxembourg at 0.5%, thereby representing a considerable saving. 

Richard Brooks of Private Eye summarized such schemes as follows: "The company puts its money into Luxembourg and borrows it back. It just sends money round in a circle and picks up a tax break on the way." 

As a result, even to the most casual of outside observers, these schemes appear to be performing an "artificial" function. This "artificialness" arises from four distinct properties of the schemes that differentiate them from "normal" business loans. 
(i) The lender and the borrower are essentially the same person, group of people, or organization. 
(ii) The loan is issued by a company that is not necessarily a registered financial services company. 
(iii) The interest rate of the loan is not market tested. In other words, the same loan from the same source and under the same conditions is not freely available to other borrowers or lenders. 
(iv) The borrower is generally seeking to maximize the interest paid, not to minimize it. As a result the interest rate can in effect be set unilaterally by the borrower rather than through competitive negotiation with the lender. 

Properties (iii) and (iv) are clearly evident in the loan arrangements of Wales and West Utilities. The company was created as a result of National Grid's decision to sell part of its gas distribution network in 2005. Since that sale National Grid has paid over £1bn in corporation tax, yet Wales and West Utilities has paid nothing on its similar activities over the same period. 

The reason for this is that the holding company of Wales and West Utilities charges Wales and West Utilities an interest rate of 21% on the loan used to purchase the company. This interest rate is more than three times the standard market loan rate and coincidentally is just sufficient to wipe out the operating profit of Wales and West Utilities. Therefore it pays no tax. 

The Solution: 
This form of tax avoidance could be tackled quite simply by outlawing tax deductions for any loans that exhibit any of the features labeled (i)-(iv) above. Instead the following restrictions should be applied to the eligibility of all loan interest for tax relief in order to eradicate the problem once and for all. 

(i) The company loaning the money and the company borrowing the money must have no significant commonality of ownership. They must have different directors and different shareholders, and one company cannot be owned in any significant part by the other, or be part of the same corporate group, even if one company is operating in a different tax jurisdiction. 

(ii) The company providing the loan must be a financial institution regulated in the UK by the FSA or FCA. Loans from institutions outside the UK would then not be tax deductable. While some will argue that this might put up finance costs for legitimate loans, the counter argument is that using such overseas lenders increases the UK balance of payments deficit which is also undesirable. This condition is however essential if large multinationals are not to exploit their dominant position within the shadow banking system to further inflate their own already considerable stockpiles of cash at the expense of ever lower national tax revenues and greater wealth inequality. 

(iii) The company receiving the loan must also be able to show that the interest rate is market tested. In practice this will mean that the company receiving the loan must be able to demonstrate that it is not the only customer of the company providing the loan but that there are many other customers of the same financial provider. 

(iv) The company receiving the loan must be able to show that the interest rate has been set in line with the market rate and has not been inflated for its own benefit. In practice this will mean that the company taking out the loan must be able to point to tenders from other FSA/FCA regulated loan providers that are at a higher rate of interest. 

If these measures were enacted and implemented then most of the loan schemes used by companies like GSK and Wales and West Utilities would immediately become either unworkable or unprofitable. None of this requires new tax treaties with other countries (although it may require existing treaties to be shredded - no bad thing!) All that is required is political will, a bit of intelligence from our elected politicians, and a new tax law.

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