Economic systems have changed throughout the years, but the institutions involved in the making of the economic policy tend to have changed slowly. This has been a fact with the Treasury, which has been the centre of economic policy making in Britain, and one in which its considerable influence has remained one of the constraints of British economic policy.
THE TREASURY AND THE ECONOMY - TAX IMPLICATIONS ON BORROWING ON THE EURO-DOLLAR MARKET *
A. Introduction
Economic systems have changed throughout the years, but the institutions involved in the making of the economic policy tend to have changed slowly. This has been a fact with the Treasury, which has been the centre of economic policy making in Britain, and one in which its considerable influence has remained one of the constraints of British economic policy. Finance ministries had been powerful in making decisions about how much money is to be raised from whom and how it is to be spent, decisions which affect the whole range of government policy. The principle responsibility of the Treasury is the overall management of the economy, taxation, the preparation of the budget, the control of public expenditure, monetary policy, financial institutions and markets and overseas finance.
The internationalisation of economic policy is reflected in the structure of the Treasury. In early 1967, there was some concern in the Treasury concerning the Euro-dollar market *: the first related to the condition to which the UK attached to a number of approvals for access to Euro-dollar finance. If a guarantee given to a subsidiary was called, or when a borrowing had to be paid off, this could only be done through a refinancing operation though the UK which allowed immediate implementation of a contractual liability with investment currency. This condition was attached to protect the investment currency pool from the burden, which the meeting of these obligations could impose. However, in many cases the lack of failure (or conspicuous success of an overseas operation to which Euro-dollar finance was specifically related) made potential lenders unwilling to contemplate refinance. The Bank of England were not aware of any instance where a UK borrower had been unable to refinance, but the growing number of approvals for access to external capital and the fairly substantial volume of refinancing requirements with which the market was faced meant that some companies found themselves unable to refinance.
The second point was potentially much more serious. Although, in 1967, the rules in the UK specified that borrowing should be appropriate (e.g. for at least a five year period for non-criterion investments), the UK had for long tacitly recognised that, short of Euro-bond finance, all that was possible in the market was to obtain Euro-dollars on a six or twelve month roll-over basis. In arrangements of this type there was no commitment on the part of the lender to refinance at the end of the initial roll-over period, though this was invariably done and the lender undertook to use his best endeavours to produce this result.
However, it was also important for the UK to remember that certain circumstances had arisen in the availability of funds in the Euro-dollar market to the extent that, with the best will in the world, lending banks were unable to roll-over the funds they have advanced to UK direct investors abroad. This produced an extremely awkward situation in which the borrowers were being pressed to repay, possibly before they had received any earnings from the overseas investment. If neither the UK borrower nor its overseas subsidiary were able to refinance by borrowing elsewhere, the UK would probably have no alternative but to allow recourse to investment currency. If a number of firms were in the same situation in the circumstances envisaged, this was a very substantial burden on the pool. While the UK needed to insist on external finance for many direct investment projects there was nothing the UK could do about this. When the borrowing was by a bond issue this particular problem did not arise because the lending was for a specified term, but it was impracticable to insist on bond issues for the relatively small projects that was financed with Euro-dollars. The issue terms would be quite unattractive to the borrower. So, whether a UK company borrows in the Euro-bond market or elsewhere will depend on the constellation of interest rates at the time, as well as on the tax position.
B. Activities of London banks in the Euro-dollar market
American companies and their UK subsidiaries were making greater use of the Euro-dollar market to finance their operations outside the US. This was one of the main reasons for the switch in the pattern of issues in the Euro-bond market from straight bonds to convertibles, which are the most popular American method of raising long term finance. This led to the question to whether exchange controls applications for inward investment projects gave much of a clue to the likely pattern of inward direct investment over the next twelve months. It was the notion that there was a steady flow of applications, many of which now involved Euro-dollar borrowing for switching into sterling as the principle method of finance .
Exchange control attitude to Euro-dollar borrowing for the finance of domestic investment by UK firms: there had been fairly strong exchange control objection to this. The UK had for some time been willing to allow Euro-dollar borrowing for investment projects in the UK. There had been few cases. Relative attractiveness of Euro-dollar borrowing depended on comparative interest rates, and for the short term borrowing the cost of forward cover. Secondly, tax factors were relevant. For firms without fairly substantial overseas income Euro-bond borrowing has been impracticable until now because the only means of effecting an issue on terms acceptable to an overseas subscriber (payment of interest gross unconditionally)meant that the interest paid (necessarily under a foreign loan contract) was not allowable as an expense for UK corporation tax purposes. This made such borrowing totally uneconomic . Section 22 of the Finance Act 1968, had changed the position, and interest paid in foreign currency under foreign loan contracts is now treated as an expense.
The Public Records shows the liabilities of British and foreign banks in the UK at the end of April 1968. Total US dollars in the market have been put at about $16 billion in 1967, but much of this is several times on-lent, so that the total of liabilities outstanding is larger.
Obstacles to borrowing abroad
Possible obstacles included , firstly higher costs of issue, which may offset the interest advantage. Secondly, the exchange risk. United Kingdom residents are not allowed to take forward cover until six months before capital repayment is due and it is therefore the risk itself, rather than the cost of cover, which is a deterrent. Thirdly, tax problems. Until 1968, interest paid in foreign currency under foreign loans contracts was not allowed as an expense against United Kingdom corporation tax, but this was changed in the 1968 Finance Act. It is however still necessary to show that the loan contract was completed by a foreign agent under foreign law. This requirement did not prevent London banks from playing a large part in arranging borrowing. Finally, exchange control. This did not seem to be a serious obstacle at all. There had been the policy to allow foreign currency borrowing for investment in the UK in most cases, though there has been no active encouragement of such borrowing. Borrowing abroad to finance investment of a kind which would have low priority under the rules for domestic credit restraint would not be allowed.
Borrowing in the form of Euro-bonds which are convertible into equities has a disadvantage from the United Kingdom point of view because if foreigners exercise the option dollar bonds are converted into sterling equities and can be sold to United kingdom residents for external sterling. A contingent claim on the reserves is thus created much earlier than in the case of a long-term dollar debenture, which cannot be sold to a United Kingdom resident except through the investment currency market and therefore does not affect the reserves until maturity. Despite this drawback, United Kingdom companies are allowed (subject to certain requirements) to issue convertibles so that they are not put at a disadvantage compared with American borrowers .
C. Financing Nationalised Industries Investment
1. Introduction
The financing of new investment by the nationalised industries was considered taking into account practice in the private sector and with particular reference to the financing of investment from loans (including borrowing overseas), from current charges, or from taxation, having regard to the requirements of cyclical policy. In 1968, the nationalised industries, (including for the first time), the steel industry, were planning to invest nearly £1,800 million, of which £690 million was to be raised by the industry itself (provided the price increases they had proposed was all endorsed by the NBPI), borrowing the remaining £1,110 million from the Exchequer .
The amount for which the industries themselves were to borrow depended upon their financial performance. Since 1962 the performance of most of the major industries had been measured against five-year financial targets for which they were set in accordance with the White Paper on the financial obligations of the nationalised industries . Furthermore, those industries that were in a monopoly position, targets was not considered a major factor. As, targets could easily be achieved merely by raising prices, meaning that the system did not, therefore, give a very effective incentive to efficiency.
During the late 1967, the nationalised industries (except the National Coal Board) only had powers to raise money (other than for temporary borrowing) with the consent of the responsible Minister and the approval of the Treasury by two methods: firstly, issues of fixed interest stock, which may need not be guaranteed by the Treasury, the terms and timing of which have to be agreed by the Treasury. Secondly, advances by Ministers made out of monies issued from the Consolidated Fund .
The National Coal Board were able to borrow only from the Exchequer, and had no power to issue stock. It was suggested at the time by the UK government, that the nationalised industries could raise additional funds by medium to long term borrowing in the Eurobond market. The present capacity of that market appeared to be of the order of $2,500 million a year, and it was not unreasonable to suppose that British public sector borrowers could raise $200 million to $300 million a year in this market , if they were able to offer the right terms.
There were however, a number of impediments to Eurobond issues by nationalised industries: Firstly, bonds issued in the Eurobond market had to be bearer bonds on which interest was paid without deduction of tax or proof of residential status. Secondly borrowing on an issue of Eurobonds would generally be more expensive than borrowing from the Exchequer, both because the rate of interest was higher and because the expenses of making and managing the issue would have to be met. Thirdly, the borrower would have to carry, or to be explicitly relieved of, the exchange risk. Fourthly, no nationalised industry (except the British Overseas Airways Corporation) had power to borrow other than in sterling . Finally, borrowing abroad dis not solve the problem of resources.
2. Medium and Long Term Euro-Dollar borrowing
On the 24th July 1967, the SEP Committee commissioned a study on Measures to strengthen the gold and dollar reserves including, an increase of borrowing in the Euro-dollar market . The Chancellor asked Lever to advise him on the issue which was put forward in reply of the SEP remit. At the same time, in response to another SEP remit, the Chancellor circulated to the President of the Board of Trade and the Secretary of State for Economic Affairs a memorandum dated 15th September on Financing National Industries Investment, which included a section on Euro-dollar borrowings. The three Ministers discussed the memorandum on 18th September and agreed that the possibility of the industries borrowing in the Euro-dollar market, while unlikely to produce large sums, should be further examined at the official level and by the Economic Advisor to the Treasury and Dr Kaldor .
Merchant bankers at home and abroad had been urging for some time that if certain tax impediments were removed UK firms and public bodies would be able to raise large sums in medium and long term issues of Euro-dollar bearer bonds. Studies of the question in the past have concluded that the advantages of more Euro-dollar borrowing were outweighed by the disadvantages of altering the tax system.
General balance-of-payments considerations
Proposals for promoting more overseas borrowing were based upon the Governments policies on overseas borrowing since they took office in 1964. A variety of measures in the fields of exchange control and taxation had substantially improved the capital account of the balance of payments, through restriction of outward investment, liquidation of portfolio investments abroad, both private and state owned, and increased inward investment. As a result, in the first half of this year the UK had an actual surplus on the private element in the capital account of nearly £40m .
Exchange control arrangements had for some time encouraged overseas borrowing by UK firms to finance overseas investment. It was also the policy, with few exceptions, to give consent for overseas borrowing to finance investment at home and a fair amount of such borrowing took place though not by bond issues. As the UK had a large inflow of capital in the shape of direct investment, no further steps were taken to encourage overseas borrowing to finance investment at home. In principle the UK Government at the time believed that, an industrially developed country should be able to promote sufficient savings to cover its domestic investment. The UK accepted the need to transfer resources to under-developed countries through aid programmes, thereby accepting the corollary that the developed countries should have a surplus of domestic savings for landed abroad . This meant that the UK had expected to be net exporters of capital on balance, and aimed to offset this by at least an equivalent surplus on the current account of its balance of payments.
The UK government argued that in temporary balance of payments difficulties, it should be allowed to fortify its reserves by overseas borrowing. As a short term policy, temporary borrowing had been adopted on a large scale in the shape of IMF loans and Central Bank assistance, and the retention in London through interest rate policy of a reasonably high level of short term money. However, as a long-term policy, overseas borrowing was large enough to turn the UK into net importers of capital. This was designed to permit a larger volume of imports than would otherwise had been possible. This was inconsistent with the objectives for the balance of payments set out above, and carried the danger that the UK would gear its economy to an excessively high propensity to import. Taken far enough of this would produce an inadequate surplus or even an actual deficit on current account, which would expose the UK to many dangers. Borrowings had, of course, to be repaid and this involved a continuing burden on the capital account of the balance of payments as well as a burden on current account through payments of interests . Moreover, the UK could not count on a steady flow of borrowing to finance a current deficit and any interruption for whatever reason would expose the deficit with all familiar consequences.
All these dangers apply with particular force to portfolio borrowing to finance domestic investment which would almost certainly take place anyway. They do not apply with anything like the same force in inward direct investment. The UK positively encouraged this in the early 1960s and its volume had grown rapidly. Though even this movement had become dangerous if it was carried too far, direct investment does not give the UK the full benefits of technological and managerial know-how as well as an immediate benefit to the balance of payments and the reserves. These advantages had in practice proved to be large and important.
Possible scale of Euro-dollar borrowings
The Bank of England estimated in 1967, that UK concerns would be able to raise up to $200m a year in Euro-bond issues, if the tax impediments were removed . This was an estimate of the supply of funds. Whether the demand would match the supply was hard to say. The removal of the tax impediments could be expected to increase the demand to some extent since the cost of borrowing would be slightly reduced. At the time there was an interest advantage of about ¾ per cent in Euro-bond borrowing on the UK capital market, 6¾ per cent against 7½ per cent, though this is offset in fact by higher expenses of issue. A substantial increase in UK borrowing might narrow the differential still further. UK borrowers would also had to bear the exchange risk since they could not get forward cover for medium and long term borrowings. It was impossible to forecast how far UK firms in the private sector would find it worthwhile to borrow Euro-dollars rather than borrow at home. There was no question of their being able to borrow more easily abroad, given the highly developed state of the UK capital market. The greater scale of Euro-bond issues by concerns in European countries has undoubtedly been due in part to weak capital domestic markets; while the large scale borrowings by US business corporations have been entirely to finance overseas investment.
Special considerations applied to the possible demand for Euro-bond issues by UK nationalised industries and local authorities. Only BOAC, BEA and the GLC had the power to borrow abroad, others had to take power in new legislation. There was no interest incentive to borrow Euro-dollars for nationalised industries since they got all their capital finance at Exchequer lending rates which were , at the time in 1967, at the same level as Euro-dollar rates for medium and long term loans . Local authorities found that Euro-dollar rates rather lower than some of the market rates at which they had borrowed, but even this differential will progressively disappeared if the establishment of the National Loans Fund resulted, as was expected, in a decrease in total market borrowing by local authorities. Finally, the exchange risk detered public bodies from borrowing abroad. It should be noted that much of the Euro-dollar borrowing by public bodies in Europe had been forced on them because they had not received sufficient finance from their governments. This was a policy that the UK were deciding, bringing similar pressure on public bodies in the UK to induce them to borrow abroad.
Tax difficulties
The UK government were always been advised by merchant bankers who specialised in Euro-bond issues that no issue could succeed unless it was in the form of bearer bonds, interest on which is payable without deduction of tax and without inquiry as to the holders place of residence. In response towards this point, the Inland Revenue set out the objections to allowing this. The arguments were complex but the following attempted to bring out the salient points :
Payment of interest gross would not by itself be a new departure. This was already allowed: in the case of interest paid by banks; where the UK has a double taxation agreement with another country under which each country gives up tax on interest going to residents of the other; where interest on certain Government securities is paid gross to non-residents; and where UK residents do not have to account for tax on interest on money borrowed abroad in such circumstances that the interest does not have a UK source.
But where interest has a United Kingdom source the general rule, apart from interest paid by banks, is that payment gross is only permitted if the Revenue are satisfied after enquiries about the residence status of the recipient. Where exceptionally, as in the case of War Loan, payment gross is permitted without enquiry the Revenue receive details of the payments made .
Some countries did not charge a withholding tax on interest. It was, however a common practice to levy a statutory withholding tax of around 25 per cent, but to give up under a double taxation agreement part or all of the tax on interest paid to residents of the country with which the agreement is made. Where United Kingdom tax was given up under a double taxation agreement the Exchequer was compensated for the loss of revenue in respect of interest flowing to the other countrys concession on interest flowing to the United Kingdom. There would be no such compensation if the United Kingdom gives up taxation unilaterally, and the loss revenue would often accrue not to the lender but to his own countrys Exchequer .
Limitation of payment of interest gross to specified types of securities (as already done for certain Government securities) would limit the loss of revenue. Lever proposed that only non-sterling bonds were to be exempt. The Inland Revenue did not think that this position could be held and that bonds in sterling area currencies would have to be exempt as well.
Serious difficulties would arise if no enquiry as to residence were made. This was the Revenues main safeguard against evasion of tax by UK residents. It was true that so long as the UK had exchange control, including the system of authorised depositories, UK residents will not be able (without breaking the law) to avoid paying tax on Euro-bond interest . However, exchange control was not with the UK for ever (and had to be radically modified when the UK joined the Common Market), and it was not considered desirable to make a tax change (which could hardly be other than permanent) which relied on the maintenance of exchange control.
However that may be, payment of interest gross without enquiry had two further undesirable consequences: Firstly, It would extend the possibility of evasion of tax by United Kingdom residents. Admittedly a United kingdom resident who has money abroad can already evade tax if he acquires foreign securities (including securities issued abroad in certain circumstances by United kingdom companies) and keeps them abroad in breach of exchange control. Payment of interest gross without enquiry would also enable him to evade tax on interest from Euro-bonds paid from a UK source. Secondly, foreign lenders would be able to avoid disclosing to their own revenue authorities a holding of Euro-bonds on which interest was paid gross from the UK. As things are they have to present a certificate from their own revenue to prove non-residency. The abandonment of enquiry would thus help evasion of other countries tax. This would be inconsistent with the provision in most existing double taxation arguments for mutual assistance in preventing tax evasion. (The arrangements in the case of War Loan are not open to this objection; the Revenue receives details of the non-resident recipients of interest, which are made available under a double taxation agreement to the taxation authorities of the recipients own country; the information would not be available in the case of bearer bonds .
D. Conclusion
The UKs long-term balance of payments objectives was to achieve a surplus on current account sufficient to match out net lending abroad, mainly to underdeveloped countries, and, in the shorter term, to repay its IMF and other debts. As a short term policy, short term borrowing abroad had been adopted on a large scale to fortify the reserves. But as a long term policy, overseas borrowing designed to permit a larger volume of imports than would otherwise be possible, was inconsistent with the UKs balance of payments objectives, and carried the danger that the UK would gear its economy to an excessively high propensity to import.
The particular form of longer term borrowing abroad which was proposed, through Euro-bond issues, was unlikely to bring in worthwhile sums to the reserves. Since for the private sector the exchange risk and higher costs of issue were likely to outweigh any interest advantage; while for the public sector there was not even an interest advantage. Euro-bond issues would only succeed if the important tax changes were made, to which the Inland Revenue saw serious objections.
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 chapter is based on the following PRO files:
T 295/452: The Euro-Dollar Market: Exchange Control Aspects (8/8/67- 18/12/68). File Number: 2FEC 123/01 B
