UK Changes To Taxing Foreign Profits Would Carry Economic Risk

The UK tax authority is proposing sweeping changes to how it taxes individuals for company distributions and capital reductions, in an effort to modernize outdated legislation, remove distortions, and ensure economically similar payments receive consistent tax treatment.

But the proposals are a departure from long-established rules that underpin the UK’s attractiveness as a place to do business and invest, especially for individuals moving to the UK or for those who are UK-based but have investments in foreign companies. The proposals also risk inflicting collateral damage on wider commercial activity and retail investors.

Like many jurisdictions, the UK recognizes a distinction between returns of value that constitute income (like most dividends) and capital (such as on a liquidation). For decades, the rules have allowed business structures based outside the UK to return value to UK shareholders that’s taxable as income, capital, or a mixture, typically reflecting the underlying commercial substance. This is much harder for UK resident companies to achieve, because the tax rules deem most returns of value from UK companies to be income.

The changes, unveiled June 23 in a consultation, would extend income tax treatment to a broader range of transactions, including returns of value from non-UK resident companies (such as share buybacks). The argument for this is that it levels the playing field, putting individual UK investors in an equivalent position regardless of whether they hold UK or non-UK shares.

The cost of making the change, however, would be significant disruption to UK economic activity and, in our view, may outweigh any upside. It’s difficult to reconcile with the UK’s stated policy of seeking economic growth through making the UK a more attractive place for talented globally mobile individuals to live, work, and invest — a policy partly achieved by ensuring predictability and stability within the tax system.

We see the following as likely areas of disruption:

• Internationally mobile individuals with significant non-UK assets are less likely to settle in the UK if their investment returns (such as share buybacks) would be taxed as income rather than capital — even where the nature of the underlying event is capital.
• In a private capital context, where funds often participate in share buybacks that return exit proceeds on the sale of an underlying portfolio company, the UK would be a materially less attractive place to establish an investment management business if foreign gains are taxed as income for co-investing managers.
• The retail and mass affluent investment market, in which there is broad-based participation from UK individuals, would face significant disruption if widely marketed investment products — typically organized through non-UK companies or funds — lose their current tax treatment.

None of these outcomes would reflect UK government policy on ensuring tax stability, increasing the attractiveness of the UK internationally, or increasing participation of private wealth in capital markets.

The design problem, as we see it, is that these changes are trying to deal with an issue around perceived unfair outcomes: for example, where economic activity that would generate income if carried on in the UK would produce a capital gain if the ultimate return of value to shareholders is through a repurchase of shares in a foreign company. However, the proposals don’t include a suitable filter to target only those cases that currently generate the “wrong” tax outcome.

The better option would be to introduce a principles-based approach which could overlay, rather than replace, the existing framework.

The consultation acknowledges that this type of approach has been tried, such as the “transactions in securities” anti-avoidance rules, and that these rules require updating. We think the government should focus on this aspect so that a modernized, strengthened, and targeted set of anti-avoidance rules can help police the line between income and capital, without repealing the entire system for taxing foreign profits.

Originally published by Bloomberg Tax.

Macfarlanes is a pre-eminent law firm advising a global client base across Private Capital, Private Wealth, M&A and Disputes.

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