| At the time in 1967, UK firms were allowed to raise money by short term loans in the Euro-dollar market*. This had caused an inflow of funds into Britain, however this money was not included in the Balance of Payments figures. If borrowing from medium and long term was undertaken, this would involve an inflow of funds which would also be included. This was considered an important proposal as it would assist the UK government to coping with short term external factors (i.e. balance of payments). |
ECONOMIC POLICY MAKING:
UK TAX MEASURES TO ENCOURAGE EURO-DOLLAR BORROWING
A. Introduction: Encouraging Euro-dollar Borrowing
At the time in 1967, UK firms were allowed to raise money by short term loans in the Euro-dollar market*. This had caused an inflow of funds into Britain, however this money was not included in the Balance of Payments figures. If borrowing from medium and long term was undertaken, this would involve an inflow of funds which would also be included. This was considered an important proposal as it would assist the UK government to coping with short term external factors affecting the balance of payments such as the Middle-East crisis and Rhodesia .
However, how do you raise short-term finance? Do UK firms borrow short-term Euro-dollars direct through the Euro-dollar market, or do they borrow from merchant banks and accepting houses who in turn borrow Euro-dollars? As, private sector borrowers were able to borrow in the Eurobond market (subject to Bank of England permission) without any amendment of the tax law being necessary, by borrowing through a non-resident subsidiary in Luxembourg. If this was the case, then the UK did not have to amend the tax law to enable British private sector companies to borrow on eurobonds for domestic investment, though the Inland Revenue would have taken a poor view of the UK encouraging tax avoidance in this way. Nevertheless, there was a risk of tax avoidance: Exchange Control risk. If a UK resident buys these bonds misrepresenting himself as a non-resident, perhaps by employing a foreign nominee, then in order to escape detection he is likely to arrange for the interest payments not only to be paid to the nominee abroad, but to be held there on his behalf. To do this without Exchange Control permission, it was an offence against the Exchange Control Act, but the chance of detection would have been small. It would have involved a cost to the UK balance of payments, which would not be allowed by UK Exchange Control, e.g. extra travel expenditure, or buying a house abroad, or the purchase of foreign currency securities otherwise than with investment currency .
The reason why major British companies had not at the time fully utilised the Euro-market is not because of official restrictions, but because of straight commercial considerations. It was usually cheaper to borrow at home; and even when it was not, the difference in cost had not been considered sufficient to outweigh the exchange risk that the company would run in incurring debts denominated in one currency to purchase assets denominated in another. If the government wished to encourage companies to borrow Euro-dollars it would have itself to take on the exchange risk. That the desirability of Euro-bond borrowing depends upon, firstly, the medium-term prospects for the UK balance of payments. If the deficit is temporary, in the near future the balance of payments may be expected to be strong, the value of having dollars now may be high in relation to the cost of paying them out (in servicing of the loan) in the years ahead. Secondly, the use to which the additional reserves would be put. Such borrowing would have the advantage of bringing an immediate improvement in the capital account of the balance of payments .
B. Tax impediment
In response the suggestion of whether it was desirable to encourage public corporations and local authorities to borrow abroad, certain issues involving tax impediment in the UK were considered. Removing the tax impediment to such borrowing was seen as crucial if the public authorities were to borrow in the market. Three cases emerged :
1. The recipient is entitled to exemption from UK tax on interest under a double taxation agreement (eg, the agreements with USA Switzerland, Germany, Netherlands); in these cases any tax deducted can be reclaimed and arrangements are commonly made for paying the interest in full.
2. The rate of UK tax to which the recipient is liable is limited to, say 10 or 15 per cent under a double taxation agreement (eg. The agreements with Canada, Japan, Israel, and unpublished agreements with Belgium and France); tax deducted in excess of the prescribed rate can be reclaimed and we have recently started arrangements for paying interest less tax at only the prescribed rate.
3. The recipient is liable to the full rate of UK tax.
In the case of double taxation agreement cases, it may have been the case that the necessity to make a claim to relief from UK tax had the effect of discouraging would be lenders. The UK Treasury had already simplified the double taxation agreement claim forms; and it was questionable to the UK if much more could be done, by way of streamlining the mechanics of claiming relief, to smooth out the difficulties in these cases. The impediment lay in the potential lenders reluctance to expose himself to tax in his own country. In these cases, the UK Treasury would normally ask the other country to confirm that a claimant is one of their residents and in return the UK government would notify the other country what the claimant is claiming. Section 195, Income Tax Act 1952, was a provision for which government securities may be issued with the condition that the interest shall be exempt from UK tax if the beneficial owner is not ordinarily resident in the UK. In considering a Section 195 exemption, it was borne in mind that a substantial proportion of the lenders are likely to be resident in countries with which the UK had a double taxation agreement providing for exemption from, or the limitation of, the UKs tax on interest. Assuming that the lender did not wish to cheat his own Revenue authorities, he will, if there was an exemption agreement with his country, finish up in the same position as at present .
Although a Section 195 exemption would protect the non-resident who is minded to evade tax at home from disclosure to his tax authorities, it was necessary for the UK to be satisfied that the claimant was not ordinarily resident in the UK and therefore entitled to exemption. It was therefore considered that, the case for extending Section 195 to local authorities looked a shade stronger than it did in 1964. However, the case for extension to other public bodies, such as nationalised industries was much weaker. These other bodies were grouped with those of private industry and were not with the central government. If these were allowed to borrow abroad on terms that the interest would be tax-free to non-residents there would be no substantial ground for refusing the same concession to the borrowing of private industry. The UK govt recognised that companies in the private sector were able to secure effective exemption for non-resident stockholders by various means, but in the UK government views this did not affect the matter. In any case these private borrowings were largely made in order to finance trade and investment abroad, which would not normally be the case with the public bodies. There was no doubt, however, that if Section 195 was extended to the foreign currency borrowings of local authorities there would be continual pressure for their extension to private industry .
C. Proposals from the Financial Secretary
Lever had for some time been looking with officials (especially Rawlinson) at the question of whether UK firms should be able to borrow in the Euro-dollar market for home investment. A meeting was held on 11 October 1967, with the Bank of England, the Inland Revenue and the Treasury, and presented before it a proposal . At the time firms were able to borrow for investment abroad, or for home investment only when they had sufficient overseas income to cover the interest on the loan, or for short-term funds. Lever stated that the proposal was encouraged not
solve the countrys balance of payments problems, but simply as a modest measure which could make a small contribution towards, improving the balance of payments
an addition to the countrys reserves of foreign exchange, and provision of a little more room within which the government might manoeuvre within its policy of maintaining parity .
The proposal involved the following actions that, UK firms would no longer be penalised by the tax laws when they borrow in the Euro-dollar market, for home investment on exactly the same terms as hold for the borrowing of this type which is favoured . To the sense that the firms would be able to: firstly, issue through an overseas agent bearer bonds subject to foreign law on which the interest is payable abroad. Secondly, pay interest gross without inquiry and thirdly, charge interest paid against profits, before corporation tax. To give effect to the proposal, the only change which would be needed would be a clause in the Finance Bill to allow deduction of interest payments on borrowing abroad in non-sterling currencies from profits before corporation tax.
At the time (as of October 1967) UK firms borrowed in the Euro-dollar market when they were able to set the interest charges against their profit before corporation tax - that is for loans of not more than 12 months for either home or overseas investment, but for loans of over 12 months only where the interest charges are matched by overseas income or where the loan is for overseas investment. This in itself was an anomalous position, for the penalised category of medium or long-term borrowing for home investment, when there was no overseas investment income which did not have a different economic effect from the favoured categories of borrowing. There are two other major anomalies .
First, while firms are able under the tax laws to borrow short-term for home investment, but not for longer than 12 months, the Bank of England requires that wherever possible such short-term loans are given the effect of medium or long-term loans by seeking assurances that the loans will be rolled over, that is renewed for a reasonable number of years. The Bank does this to try to reduce the danger of rapid withdrawal of funds. But in so acting, the Banks policy conflicts with and is impeded by existing Revenue law. This problem would be met by a proposal of the kind we have examined, under which firm commitments to medium or long-term loans could be given, rather than the present uncertain assurances.
Second, the governments policy has been to compel UK companies owned abroad to borrow overseas rather than in the UK to finance their investment. It seems illogical to encourage this borrowing abroad for investment here and to virtually forbid UK firms from voluntarily undertaking such borrowing.
Tax difficulties
The only obstacle which existed at the time to firms borrowing abroad in the manner proposed was that, firms could not deduct the interest they would have to pay gross on the loan from their profits before corporation tax. The tax avoidance and evasion arguments have been advanced when the possibility of increased borrowing in the Euro-dollar market had been discussed.
Deduction of interest before corporation tax was allowed where a firm had borrowed abroad for investment abroad, or where it has overseas income to cover the interest payments. Deduction was also allowed without restriction for interest payments on short-term loans abroad (as at home). The only excluded category is therefore interest paid on borrowing abroad for home investment, where the money is borrowed for more than 12 months and there is no overseas income. This limitation could be easily avoided by a company which was prepared to operate the roundabout system; which the appearance of overseas income can be generated quite artificially, but which enables the firm to deduct interest paid gross as if it had genuine overseas income.
Economic assessment of the proposal
Lever stated that while his proposal need not result in any net addition to the capital being attracted to the UK for the total of borrowing abroad was a matter to be decided by the government - it should produce a small shift from short-term to medium or long-term borrowing. While short-term money could be withdrawn from the country very rapidly, this was not possible with money borrowed with medium or long-term loans.
It was pointed out that during October 1967, a very high proportion of borrowing from abroad was by short-term loans. It was considered during the meeting that it would be very desirable to secure a shift in this amount from short to medium or long-term loans. Not only would such a shift reduce the extent to which funds could be withdrawn rapidly, but it would mean better terms of borrowing. Short-term loans were often negotiated when funds were urgently needed, and it was not always possible to bargain effectively when negotiating long-term loans. A further advantage would be a reduction in the extent to which our interest rate policy was governed by the need to keep in the UK the large amount of short-term funds held here. The stock of short-term funds was very large, and any relaxation induced by switching the small amounts likely to medium or long-term loans would be very small. A step in the right direction of greater freedom of interest rate policy .
There was then discussion of the achievement of imports of capital by repatriation of the dollar portfolio. Lever stated that the imports of capital which had been achieved were generally regarded as a success. But while such imports were of course valuable at certain times, they could be purchased at too high a price. The repatriation of the dollar portfolio secured imports of capital by selling very profitable investments; it was surely desirable whenever possible to encourage borrowing abroad to achieve imports of capital, rather than to sell the dollar portfolio.
The meeting arised with the conclusion that, it seemed unlikely that Euro-dollar borrowing would bring into the reserves as much as was obtained from the 25% scheme of dollar portfolio repatriation, but Euro-dollar borrowing might reduce the extent to which it was necessary to repatriate funds from the portfolio. What mattered was not what happened in the past, but what was to be future policy. A move to help the reserves by encouraging Euro-dollar borrowing was preferable to further restrictions to the management of the dollar portfolio for such encouragement was freeing firms from restriction and opening up a wider area within which firms could choose their method of finance .
The next question was the amount of borrowing from abroad which it was desirable to undertake. It was pointed out that since the UK government came to power in 1964, strong measures had been taken to correct the outflow of capital funds and put right the capital account of the balance of payments. On capital account these measures had been very successful, and the UK were now in the position of being net importers of capital on the private account. It was arguable whether it would be sensible to allow further growth of capital imports, especially if there was any question of further improvements in the capital account being used to avoid action needed to correct the current account .
On the other hand, it was said that while the UK would not want to be net importers of capital in the long-term, but should generate at least enough savings for our own investment, for the time being there was no way of telling that the UK had, by achieving a surplus on the private capital account, achieved the right balance. The UKs reserves as of 1967, were low, and this made the UK vulnerable to withdrawals of funds at times which the UK could not control. It would be convenient in these circumstances to have other sources of credit, from which at least to some extent the UK could make good the effect of these withdrawals; E.G. the French who had large gold and foreign currency reserves had rightly thought it right to force one of their nationalised industries to borrow in the Euro-dollar market to finance domestic investment rather than to deplete their reserves .
It seemed that, the late 1960s, the UK was in no position to refuse additions to its reserves. Not only was there no prospect of a solution to the current account problem, but the burden of debt on the country was such that it was only realistic to expect that it would have to be lengthened in some way. In these circumstances, even the relatively small amounts of medium or long-term funds which might be attracted to the country by Euro-dollar borrowing would be helpful. It was pointed out that there was an inconsistency between the present practice (of 1967) of putting some pressure on a foreign firm with a UK subsidiary to finance investment in the UK from foreign funds, and the practice of discouraging UK firms to borrow abroad if they wished to do so .
D. Reviewing the Financial Secretarys Proposals
It was clear that Levers main object was to remove the impediment to Euro-bond borrowing by UK companies which arose out of the fact that the interest paid on such loans was not deductible for purposes of the Corporation Tax, whereas interest in the case of other loans was deductible. Lever seemed to have realised that this objective could be equally attained by disallowing interest generally for purposes of the corporation tax. The impediment arose not because the interest payments do not qualify for exemption from the corporation tax charge, but solely because, this penalty whilst other forms of borrowing did not. It would thus have the same advantages in encouraging long-term overseas borrowing as Levers proposal.
However apart from removing the impediment to overseas borrowing, Lever stated that the disallowance of interest as a deduction from profits for corporation tax purposes had the following additional advantages: firstly, it would increase tax revenue by £200m in a full year, and by £130-180m in the initial year, depending on whether it applied to interest paid after a certain date or to accounting periods ending by certain date . It would thus make it possible to make a compensating reduction of 5% points in the corporation tax without any loss of revenue.
Secondly, Lever recognized that it would remove an element of serious distortion in the present structure of the corporation tax which encourages borrowing by prior charges and discourages the raising of equity capital. This is against the long run interest of the smooth functioning of the financial markets . Thirdly, it would ease the problems of government finance in that the heavy borrowing on debentures by industrial and commercial companies narrows the market for gilt-edged.
Finally, it would make interest and credit policy very much more effective than it is at present. The fact that for both companies and individuals, the effective cost of loans is so much lower than their nominal cost makes the demand for loans far more insensitive to changes in interest rates than used to be the case when tax rates were modest.
The proposal would of course affect the position of banks and finance houses who would continue to treat interest paid to depositors as a trading expense. If this proposal was to be adopted, Lever stated that it ought not of course to be confined to corporation tax. However, there were strong reasons for disallowing the deduction of interest payments from taxable income in the case of income tax as well: The treatment of interest as a deduction of taxable income enabled wealthy individuals to borrow in order to use the money for the purchase of securities with a low coupon yield and a high redemption yield. This was a profitable operation when the securities bought are gilt-edged in the neutral zone and not subject to capital gains tax .
Lever also recognized that, ordinary hire purchase transactions could be dressed up in such a way that tax in the interest element in the contract was repaid to the standard-rate taxpayer and for surtax. This alone involved a considerable loss of revenue, and is indefensible on equity grounds. The same holds for personal loans generally. If a man borrows in order to meet personal expenditure this is an application of his (present or future) income. It is not a charge on his income, and should not entitle them to a tax remission any more than spending on durable consumer goods .
Finally, Lever stated that the deduction of interest on business loans was a survival from the early conception of looking upon the income tax as a tax on income regarded as an object and not as a tax on persons. Differentiated and graduated according to personal finance. Mortgage interest required special treatment which can be justified on the same kind of social grounds as the housing subsidy as a means of encouraging home ownership, and could be dealt with by an appropriate extension of the present option scheme .
However, the anomaly of the situation, (in which there was a tax discrimination against overseas borrowing for home investment), the main difficulties that arose were: firstly defining the exemption, which would be needed for banks and finance houses, would be extremely difficult. Secondly, the net cost of borrowing to industry would go up by two-thirds. Thirdly, the change would have an intolerable impact on companies with a high gearing structure, to which they are committed in the form of debentures. In many cases it produce a situation of chromic loss. Finally, the 1965 Finance Act produced fiscal pressure favouring a capital structure with high gearing and many companies have responded to these pressures, thereby incurring long-term commitments. Lever believed that to accept the proposed change would be to completely reverse engines - and would have a devastating effect on business confidence .
Hence, Lever, with the help of Rawlinson, had managed to convince himself, and to others in the Treasury that considerably more use could be made of the Euro-bond market, to the advantage of the liquidity of the UK balance sheet. Although this was an extremely controversial issue, as it seemed to Lever that no legislation would be required, merely changes in exchange control. The market was still flourishing.
E. Conclusion
The possibility of increasing borrowing in the Euro-dollar market was reviewed for enabling UK companies to borrow in it to finance home investment. The Bank of England estimated that Euro-dollar borrowing as proposed would bring in some $200m a year. However, this was a considerable underestimate, especially as the Euro-dollar market continued its phenomenal growth. The main difficulty about implementing Levers proposal was that a tax change was required. The change was that firms should be allowed to deduct interest paid gross abroad from their profits before corporation tax, in the same way as they were allowed to deduct interest when they borrowed abroad short-term, or on medium or long-term, where by chance they had sufficient overseas income from other and unrelated sources to cover the interest charges or where the investment was overseas .
Lever wanted to make two changes : firstly to allow a corporation tax deduction in respect of interest paid on Euro-dollar bond issues where the funds raised are used for domestic investment. Secondly to allow payment of interest gross to non-resident holders of Euro-dollar bonds issued in association with domestic investment.
Both changes were very substantial. The main merits of Levers proposal was that the UK should do something to encourage enhanced Euro-dollar borrowing by UK firms, in particular for domestic investment. This was the main reason for the Gas and Electricity Bill, (which was published on Friday May 10th 1968). This Bill gave these industries power to raise money abroad. The primary purpose of the Bill was in fact to increase the borrowing limits of the gas industry, but the opportunity was taken to obtain legislative powers for both the gas and electricity industries. A press conference was held by the Ministry of Power, since they had been given some indication that the press would be mainly interested in the new borrowing facilities.
The UK took the line that the provision of these powers was a response to the requests of the industries concerned who, in the past, had expressed interest in the possibility of borrowing long-term overseas. The UK also pointed out that the Bill merely brought the industries into line with the air corporations who already possessed these powers. However, the UK government stressed that the use of the powers would depend upon the approval of the Minister concerned and the Treasury and that this approval would be determined by the circumstances prevailed at the time. The explanation was received with considerable scepticism, and the Treasury was pressed very hard to admit that the government was considering pushing the industries on to overseas capital markets. It was interesting to note that the possibility that the nationalised industries might borrow abroad was strongly criticised. The press took the view that the government would be mortgaging the national industries in a further attempt to bolster the reserves.
Nevertheless, the Bank of England requirement was that short-term Euro-dollar loans should be rolled over applied only to those loans the proceeds of which are to be used to finance outward investments. This was consistent with the rule that where outward investments are financed by borrowing abroad the borrowing must be on appropriate terms. The Bank of England stated that, as the Euro-dollar borrowing was to finance investment in the UK, they did not set any term to the borrowing. The reason was that, to have a tax rule which singled out for specially adverse treatment one form of borrowing abroad, namely borrowing for more than one year to finance investment in the UK, seemed to be silly .
ENDNOTE
* Here are two very similar definitions of the term Euro-dollars:
Robert Gilpin, (The Political Economy of International Relations, Princetown University Press, 1987, p. 314-315), states that: The Euro-dollar market received its name from American dollars on deposit in European (especially in London) banks yet remaining outside the domestic monetary system, and the stringent control of national monetary authorities.
Enzig and Quinn (The Euro-dollar System: practice and theory of international interest rates, MacMillan Press, 6th edition, 1977, p. 1) state that: the Euro-dollar system is a term used to describe the market in dollar deposits and credits which exists outside the United States of America.
This paper is based on the following PRO file:
T 295/453: Tax Measures To Encourage Eurodollar Borrowing: (A) Payment Of Interest Gross On UK Bearer Bonds; (B) Allowance Of Annual Interest As A Deduction From Corporation Tax. (4/7/1967-23/5/1968). File Number: 2FEC 123/76/01 PART A |
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