Labour set for battle over company tax

The system is biased against investment, says one side. Governments should not meddle with it, says the other. Peter Rodgers and Roger Trapp examine the arguments

The Labour Party is about to be be assaulted by a new barrage of lobbying by industry and the City against proposals to reform corporation tax.

Next week the Commission on Public Policy and British Business, set up by the Labour-leaning Institute for Public Policy Research, is to recommend extensive changes in corporation tax.

But although the changes are backed by some top tax experts, including the Institute for Fiscal Studies, they are strongly opposed by City institutions and by many companies.

The commission, which includes well known businessmen such as David Sainsbury, George Simpson of GEC and Lord Hollick of United News and Media, is however expected to have a strong influence on Labour policy.

This was acknowledged yesterday by Tony Blair, the Labour leader, in an interview with the Financial Times, in which he hinted that some of its policies would be adopted by Labour. Although he did not refer specifically to tax, he said the commission's basic analysis of Britain's education problems and the reasons for its economic underperformance were "interesting and essentially correct".

There are two main tax issues at stake. The first is a reform of capital gains tax, which is not strictly a corporation tax question but does affect most companies.

Labour has endorsed proposals by the CBI to introduce a new tapered capital gains tax whose impact would diminish the longer an asset is held. The theory is that this would encourage a long-term view among investors and make it easier for industry to find the money to invest.

The proposal already appears to have hit the buffers. Ken Etherington, chairman of the CBI tax committee and head of tax at BAT said: "We suggested tapering at one stage but there are problems." The CBI is instead proposing no more than a broad review of CGT. The Commission is believed to see a tapered CGT as problematical as well, and Labour is now thought to have gone lukewarm.

As one tax expert said, "The Duke of Westminster would benefit from a lower rate of tax on long-term investments, but quite of lot of people on the street would not. They often sell investments early because they need the cash."

A far more controversial change to be proposed by the commission is the reform of corporation tax itself. The basic logic is similar - the belief that the present tax system encourages companies to distribute profit to shareholders as dividends, rather than retain it for investment.

This bias is a long standing theme of the IFS, perhaps the best known independent tax experts in the UK, and influential advocates of reform.

Labour has been guarded about its corporate tax plans, beyond pledging a windfall tax on privatised companies. Mr Blair has denied suggestions that Labour plans other tax-raising moves against industry. But he could reform corporation tax in a self-financing way, without adding to the overall burden on industry. This is what the Commission wants.

Furthermore, Gordon Brown, the shadow chancellor, has cited with approval a study of the claimed tax bias towards dividends which was started two years ago by Stephen Dorrell, then Financial Secretary to the Treasury, but blocked by City and industry opposition.

In its classical form, the argument is about whether capital markets should be seen as an unfettered mechanism for recycling cash through the City - in the form of dividends - from companies with surpluses to those in need of money for investment, or whether government should interfere with the process.

Benedict McHugo, head of tax at the Association of British Insurers, spoke for many specialists when he said: "The tax system should be neutral, neither encouraging nor discouraging distribution of profits, which is a matter of commercial policy."

However, the IFS, the commission and many academics and tax experts think the system is not neutral, and discriminates against investment. To solve this problem, the Commission has backed the IFS proposal for a new allowance for corporate equity (ACE).

At present, money kept in a company is in effect taxed at a higher rate than if it is distributed as a dividend. This is because if it is paid out as a dividend, the company pays advance corporation tax before distributing it. But tax exempt investors - especially the pension funds - claim a rebate of the ACT, which is fundamentally an advance payment of income tax, collected by the company.

The net result is to reduce the effective rate of tax on dividends to below the 33 per cent corporation tax paid on profits that are retained. One side effect is that it is actually cheaper to finance investment out of debt, where the interest is tax-deductible, rather than equity.

Under the ACE proposal, the tax bias in favour of dividends would be ended, by giving retained profits an allowance against corporation tax. The allowance would be based on the notional interest the retained money would earn for the company.

The commission suggests the change should be phased in slowly, over at least 10 years, to reduce the cost, so eventually the profits from increased business investment would make it revenue-neutral for the Treasury.

However, this change would have enormous repercussions. As Malcolm Gammie, tax partner at the solicitors Linklaters & Paines said, the ACE proposals envisage the end of the so called imputation system of taxation, which includes ACT.

This would cause an enormous row. A foretaste was given in 1993 when Norman Lamont lopped the rate of ACT from 25 to 20 per cent, saving the Treasury pounds 1bn in rebates to institutional investors. (This is the one tax rate cut that actually produces an increase in revenue.)

A drop in net dividends leads inevitably to a drop in the valuation of the whole stock market. Because pension fund income would be reduced by as much as pounds 4bn -pounds 5bn a year if the rebate went, many funds would fall into deficit on their actuarial valuations, and companies would have top them up.

John Whiting, tax partner with accountants Price Waterhouse and council member of the Chartered Institute of Taxation, argues that if an incoming government cuts ACT to 10 per cent, it could fund a 10 per cent basic rate of income tax without doing anything else. But he questioned whether people were "attacking the symptoms rather than the cause".

Nevertheless, the perception that dividends are bad is still widespread. Directors of many private companies such as Alastair Stoddart, chairman of Cearns & Brown, a food distribution business, say they do not wish to float because of the pressure that will put on them to keep shareholders happy rather than invest.

However, Mark Goyder, director of the Centre for Tomorrow's Company, which is seeking to promote sustainable growth in business, said "In the 1970s, business managers used to say they'd love to do it but the unions would not let them; now, they say they'd love to do it, but the City won't let them."

Mr Etherington, of the CBI tax committee, said "The CBI view is that companies want a stable system. Unless there is a major reason for departing from the imputation system - which we don't see - we would like it to be kept."

He would favour the ACE system as the best option if Britain were starting from a clean sheet of paper and if other countries were going down the same route. But the only possible reason he could see for such a fundamental change was a possible adverse decision from the European Court of Justice, where Hoechst and Pirelli are alleging unlawful discrimination under European law. A European subsidiary of a UK company does not pay ACT, but a UK subsidiary of a European company does.

The strongest opposition to any Labour tinkering with ACT comes from City institutions. Mr McHugo of the ABI, referring to the the impact on the valuation of pension funds, said: "This could be a vicious circle for industry. Any idea of phasing it out over 10 years seems to concede that it is damaging."

Anne Robinson, director of the National Association of Pension Funds, disputed the claim that there is a link between retained profits and investment, saying: "Evidence for the advantages of retained profits is not robust. In countries like Germany it is looking rather unattractive at the moment." She added "What is the compelling reason for changing it? When Labour actually get into office they are going to find out how things work, and not rely on papers by the IFS."