By overloading balance sheets with debt, companies claim tax relief on the interest payments and then shift profits offshore. Here's how.
Airbnb is the most recent example in the news of a company avoiding UK taxes through accounting loopholes. One of the least well known loopholes is by using debt to shift profits, reduce tax bills and increase returns for their shareholders. Here’s how it’s done.
By overloading balance sheets with debt, companies claim tax relief on interest payments and effectively shift profit to low/no tax jurisdictions. The tax relief reduces their taxable profits and tax liability.
Consider the example of Arqiva, a telecommunications company which controls a network of over 1,000 radio and television transmission sites. It is owned by the Canadian Pension Plan and Macquarie Bank through a network of offshore companies.
It is heavily financed by shareholder loan notes bearing interest rate of 13-14 per cent even though the interest rates are at a record low.
The audited accounts of, as CityAM puts it, “cash flush” Arqiva Group Limited for the three year period to 30 June 2016 show sales of £2.567 billion, gross profit of £1.639 billion and operating profits of £794 million.
The company reported interest payments of £1.516 billion to completely wipe out its taxable profit. This practice is also enabling the company to accumulate losses which it can offset against future profits and reduce its tax bill.
For the last three years, holders of shareholder notes (the ultimate controllers) received £739 million, all without any withholding tax i.e. no tax is deducted at source.
The payment, if entirely made to offshore entities is likely to be tax-free as many offshore places levy low/no corporation or income tax.
Arqiva has paid virtually no corporation tax for nearly a decade, but in 2013 the government rewarded it with a £150 million taxpayer funded contract.
Thames Water provides another example. From December 2006 to March 2017, Thames Water was owned by Macquarie Bank. For 11 years Thames operated through a labyrinth of companies, with some registered in Caymans. Returns for Macquarie and its investors averaged between 15.5% and 19% a year.
For the period of its ownership Macquarie received estimated £1.2 billion in dividends, but this was not the only return. Thames Water was loaded with intra-group debt through entities in the Cayman Islands and elsewhere.
Its debt ballooned from about £2.4 billion to £10 billion and interest payments swelled the charges for customers. Tax relief on interest payments reduced corporate tax liability.
For the period 2007 to 2015, the company’s accounts show that it paid £3.186 billion in interest to other entities in the group alone. This would have been paid without deduction of any withholding tax.
Entities in the Caymans and other low/no tax jurisdictions would have received the amounts tax free. At the same time, Thames water would have been able to claim a tax deduction for the interest payments.
Thames Water paid about £100,000 in corporation tax for the period 2007 to 2016.
Variations on the above arrangements are used by numerous companies to avoid UK corporate tax. The 2007-08 banking crash showed us that highly leveraged companies become financially unstable and cause losses to creditors, employees and taxpayers.
Yet governments incentivise companies to take on more debt. They can get tax relief on interest payments even though debt is not necessarily used to finance UK operations.
Ordinary individuals cannot claim tax relief on interest payments whether for the purchase of sole residence on anything else. The rationale is that tax relief on interest payments distorts markets, creates bubbles, unfairness and financial instability.
Yet the same is forgotten when public subsidies are handed out to corporations.
This week Parliament begins consideration of the Finance Bill. It contains clauses to implement recommendations from the Organisation for Economic Co-operation and Development (OECD) which would limit the amount of tax relief on interest payments that companies can claim.
The rules are complex but the restrictions do not apply to interest paid to third party lenders on loans used to fund public-benefit projects (i.e. PFI projects). The new rules may make marginal difference but cannot check the tax avoidance impulses of companies.
The effective reform would be to abolish tax relief on all interest payments by corporations, with the exception of retail banking. Inevitably, there would be howls of protest from businesses that have got used to public subsidies and tax avoidance.
Businesses receive tax relief for numerous costs (purchases, rent, rates, wages, plant and machinery) incurred for the production of goods and services, but payments of dividends and interest are distributions of profits rather than costs of producing goods/services and therefore should not receive any tax relief.
Whether assets are financed by debt or equity is a matter of managerial risk preferences and how the returns are to be shared by various providers of finance. Those risk preferences and profit sharing arrangements should not be subsidised by the state or taxpayers.
Prem Sikka is Emeritus Professor of Accounting at the University of Essex. He tweets here.
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