Guest Blog: Tax Competition and the Diverted Profits Tax

The Chancellor of the Exchequer is a busy man. Given George Osborne’s broad hegemony over almost all government policy, he could be forgiven if some aspects of government policy were working against others. However, this appears to be happening within the Treasury itself, with respect to corporate taxation policy.

We have seen the Chancellor promise further cuts to the headline rate of Corporation Tax, firmly establishing Britain as having the lowest corporate tax rate of all of the world’s major economies.

‘A new 18 per cent rate of corporation tax – sending out the loud and clear the message around the world: Britain is open for business.’

While it may be folly to pay too much regard to the headline rate (capital allowances, for example, remain comparatively low by international standards) it remains a very clear statement of intent: to bolster Britain’s tax competitiveness by further lowering tax rates. But can we square the Chancellor’s fondness for inter-state tax competition where Britain benefits with his efforts to shut down tax competition for others through the Diverted Profits Tax (DPT)?.

Tax competition: as bad as it seems?

Tax competition is entirely compatible with, if not encouraged by, the free-trading economic model to which the UK has subscribed for the entirety of its modern history. The free market capitalism to which the Chancellor is undoubtedly an adherent sees the market allocating its resources to the locations and functions that are most profitable. Taxation is every bit a factor in this allocation, in the same way as regulatory environment, national infrastructure, labour costs, access to materials, and market-provision. How states compete is a political choice, with differing approaches easily being attributable to the left and right of the political spectrum. While Germany may well have higher corporate tax rates, an enterprise that locates there clearly values the infrastructure and skilled workforce which that higher tax environment provides.

However, George Osborne clearly sees Britain’s competitive edge as coming, increasingly, from its fiscal policy.

The patent box has no purpose other than to encourage enterprises to locate their research and development arms in the UK. The ongoing cuts to Corporation Tax can only be construed as intended to have a similar, but much broader, effect. And  it is arguable that the Chancellor is right to do so. Tax competition is intrinsically linked to the conservative free market ideology to which the Chancellor is sworn.

This is not simply a Tory ideology, however. It is the ideology that permeates the entire free market economy in which the UK sits. In the EU, the role of tax competition in the free market economy has been repeatedly recognised by the ECJ as being an essential element of the EU’s internal market. In Commission v. France the Court held that the fact that a company gains a tax advantage by establishing in a Member State cannot of itself justify the imposition of disadvantageous tax treatment by another Member State. In Barbier the court held that measures that deprive residents of a Member State from benefitting from more favourable tax treatment in another Member State constitute an obstacle to the movement of capital within the meaning of Article 63 TFEU.

If the very purpose of free movement is to ensure the allocation of resources to their most efficient location, it logically follows that measures which inhibit shopping around for the most favourable environment for those resources must surely be unlawful. It certainly follows that such prohibitions run contrary to the free market principles at the very core of the EU Internal Market.

Pulling in two directions at once

George Osborne clearly sees value in confounding opponents by working in two, sometimes ideologically opposite, directions simultaneously (a kind of political ‘hedge’). Take for example the Chancellor’s substantial reductions in public expenditure while, at the same time, increasing the tax burden on the highest earners. This allows him to defend himself against complaints about the former by drawing people’s attention to the latter. The Chancellor appears to have sought to establish a hedge for his Corporation Tax policies by seeking to appear to clamp-down on lawful tax avoidance.

The Diverted Profits Tax (dubbed the ‘Google Tax’) seeks to shut down not simply those arrangements that are artificial or abusive, but effectively any lawful arrangement that results in an enterprise paying significantly less tax than it would have done in the UK. It provides that arrangements which lawfully bring take profits outside UK tax are brought back within UK tax where the amount of tax that is payable elsewhere on those profits is less than 80% of that which would otherwise have been taxable in the UK. Read in these terms, the DPT appears to provide that any arrangement that takes advantage of more favourable tax conditions in another jurisdiction is prohibited, regardless of whether it is artificial or abusive or not.

In essence, the DPT seeks to bring to an end lawful tax competition between states.

There is an obvious ideological and political contradiction between, on the one hand, seeking to enhance Britain’s competitiveness by slashing away at the UK’s corporation tax rate; while, on the other, seeking to shut down all lawful tax competition between states.

At first glance this might appear to be a clever strategy on the part of the Chancellor: attract businesses in with a low rate of tax, and then prevent anyone else from undercutting the UK further by locking them in using the DPT. However, if you look beyond the abstract conceptual difficulty in resolving these two positions, there are two potential risks attached to the Chancellor’s approach. First, successful implementation of the DPT could result in swift duplication by other states. Second, the success of one approach highlights the failings of the other.

A risky strategy?

The DPT is a unilateral act, and history has taught us that states do not take kindly to unilateral action with respect to corporate taxation.

While the UK may be a lone actor at present, other states are watching closely how the UK implements the DPT. The OECD has also tacitly endorsed such measures in its recent BEPS recommendations. If the UK succeeds in curtailing base erosion through the DPT, it is highly likely that other states will implement similar measures. And the likelihood of such those counter-measures being implemented in other states is exacerbated by the fact that the UK is perceived to be seeking to erode those other states’ tax bases through its low rate of corporation tax.

This exposes the practical inconsistency in the Chancellor’s approach. If the DPT is a success, leading other states to follow the UK in implementing such a tax, and lawful tax competition between states is severely curtailed, what’s the point in slashing the UK’s corporate tax rate? Conversely, if it fails, and tax competition remains despite the DPT, what was the point of the DPT in the first place?

Stuart MacLennan (@SensibleStu) is an Assistant Professor at the China-EU School of Law.

Tax loss, business and personal service companies

Reform of the taxation of personal service companies was top of everyone’s list of tips for the Autumn Statement. Reform was widely briefed. But “not yet” was the message. Although it remains on the cards it was not delivered by the Autumn Statement.

Most of what follows I wrote on the morning before the Autumn Statement. I had intended it to be a piece congratulating David Gauke, Financial Secretary to the Treasury, on delivering a much needed policy reform. Obviously I can’t publish that piece. But instead of adding ‘wasted my morning’ to (the bottom of) my (long) list of complaints about the Conservative Government I offer it, mildly revised, as an argument for the reform we need.


To understand why personal service companies are used you need to start with two important facts about the tax system and one about the nature of the employment relationship.

Tax Fact One

First, liability to operate PAYE – to deduct income tax and NICs from payments made to employees – rests with the employer. If the employer (call it ‘XCo’) doesn’t operate PAYE properly, XCo (almost always) carries the can. Even if the consequence of that failure is that the employee (MrY) is better off.

This has the important consequence that every time XCo engages MrY on a ‘freelance’ or self-employed basis XCo takes on risk that HMRC will, later, say that MrY was an employee, leaving XCo with a substantial bill for failing to operate PAYE.

Tax Fact Two

Second, there are lots of advantages for both XCo and MrY to MrY being self-employed.

Above a certain threshold (currently, annualised, £8,112), all income paid by XCo to an employed MrY attracts a 13.8% surcharge. Payments made to a self-employed MrY don’t attract that surcharge.

MrY is also – in cash terms at least – better off. On earnings of between £8,060 and £42,380 an employed MrY will pay NICs of 12% but a self-employed MrY will pay 9%. A self-employed MrY also enjoys a cashflow advantage – and a more generous regime for deducting his expenses.

And the advantages for XCo are not merely cash advantages. It gets to engage MrY with fewer (expensive) employment rights.

XCos are often prepared to share with MrYs some of their advantages in the form of higher pay to encourage them to agree to ‘self-employment’. Sometimes, properly understood, these arrangements are abusive and involve MrY undervaluing his employment law rights – and sometimes they don’t.  Indeed, there are many cases where (for this and other reasons) MrY will not work for XCo unless he is engaged on a self-employed basis. There is no hard and fast rule.

Employment Fact

The one fact about employment is this.

If MrY has a direct relationship with XCo, he doesn’t get to choose whether he’s an employee or not. Whether he is or not depends on the proper legal characterisation of what he does and what his contract with XCo says. But if MrY is engaged through a personal service company (PSC) to supply his services to XCo he will almost always be self-employed. So XCo and MrY can transform what would be a relationship of employment into a relationship of self-employment by interposing a PSC between them.


The reasons for these tax differences – if there are reasons, and there might be – are poorly understood. I have explored them in some detail here. Many argue forcefully that they should be eradicated. For what it’s worth, for my own part I am not, or not yet, in that camp.

The reasons for the employment differences are also coming under some scrutiny: see Jeremy Corbyn’s speech at Party Conference here and my response here.


When in 1999 the then Government announced the introduction of IR35 its stated objective was to tackle the use by both engagers and workers of personal service companies to arbitrage tax differences: my Tax Fact Two above.

It sought to achieve its objective by, in effect, ignoring the interposition of a PSC between XCo and MrY. It asked whether, if XCo employed MrY directly he would be an employee or self-employed?

If the answer was “employed” XCo would have an obligation to operate PAYE (see Tax Fact One). And XCo would bear the risk of getting it wrong. At least, that was what was originally proposed.

But XCos didn’t like that risk and they lobbied Government furiously. And the then Government caved and put the liability on the PSC instead.

And that turned out to be a fatal error.

Because, instead of looking at a (relatively small) number of XCos, an overstretched and under-resourced HMRC had to undertake extensive and complex investigations into a (relatively large: tens or hundreds of thousands) number of PSCs.

And if they found a relationship that, ignoring the interposition of the PSC, looked like employment they had to challenge it in the courts.

And each of those cases would have no formal read-across to other PSCs: so HMRC had to litigate them case by case.

And very often, even when HMRC won, it couldn’t collect the tax. The PSC would simply wind itself up and MrY would start a new one. So common was this practice that it acquired a name: ‘Phoenixism’.

Meanwhile, XCo carried merrily on. It continued to have an incentive to engage MrY as self-employed. And so long as a PSC was involved – which the XCo insisted on – XCo enjoyed the benefit of the arrangement and took none of the risk.

And, so far as MrY was concerned, he too could carry on enjoying his share of the rewards. There was only a modest risk of HMRC enquiring – and if it did only a modest risk of any consequences.


The solution to this is remarkably simple. We need to revert to plan A.

The liability needs to rest on XCo. XCo will then show an interest in whether MrY really is an employee. And if he is, XCo will operate PAYE – and MrY will gain employment rights. As the system stands it fails to incentivise anyone to be interested in whether the right tax is paid. It really is as simple as that.


We are talking very substantial sums of money.

The best recent estimates suggest a population of 200,000 personal service companies (see paras 18 and 19 here) used particularly by workers engaged in the oil and gas and IT sectors.

If you assumed (a) average weekly earnings of £800 for those 200,000 and (b) all workers were self-employed, the difference between between Class 1 NICs (paid by the employed) and Class 2 and 4 NICs (paid by the self-employed) would be in the order of  £1.2bn.

HMRC have provided an estimate of the difference between all Class 1 NICs (paid by the employed) and Class 2 and 4 NICs (paid by the self-employed) of £2.56bn.

And these figures are before the cashflow advantage and the benefit of the more generous deductibility regime.

Against that the population of MrYs who would be taxed under PAYE if engaged directly by XCos would be much smaller than 200,000. It may well be that a figure of around £500m would be of the right order.

However, it should also be noted that the creation of a new £5,000 tax free band for dividends could open up further and much more substantial opportunities for avoidance which exceed this £500m in scale.

Guest Blog: Asset Sales and Future Revenues

Asset sales have become a bit of a feature under the current Chancellor in his attempt to meet debt reduction targets.

In the Spending Review, it was announced that Government will explore selling its 49% stake in NATS (National Air Traffic Services) and look at options for privatising the Land Registry. Government also has a more general long-term ambition to sell Government-owned assets, and set up UK Government Investments to deliver a £23 billion programme of asset sales – including bank shares and its stake in Eurostar – earlier this year.

A key question, however, is whether this makes sense for the taxpayer.

There are a number of non-financial reasons why Government should sell such assets. In some cases, the private sector might run such assets more efficiently. In other cases, privatisation could be a route to creating a more competitive market with more than one provider.

But if the fundamental reason behind selling an asset is to improve the public finances, then it is clear that part of the criteria must involve balancing the money received by selling the asset today against the revenues that would have carried on flowing to Government if the asset had remained in Government hands.  NATS, for example, generated £450 million in turnover and £82 million in operating profit in 2013-14.

But how should sales proceeds today be balanced against further income tomorrow?  Ignoring inflation for the moment, suppose you had an asset that you could sell for £100 to pay down your debt. But this asset gives you a 10% annual return. To decide whether to sell or not, you would need to compare this 10% annual return against the interest rate you pay on your debt. If that debt interest rate is, say 15%, then you are probably better off selling the asset and repaying debt. If it is, say 5%, then you would make more money in the long-term by keeping the asset and not paying down your debt straight away. So the asset return needs to be compared to your cost of borrowing to work out how valuable it is.

For Government, the cost of borrowing has been falling over recent years and has recently been at all-time lows. One might, therefore, think that this should change the costs and benefits of selling assets to pay down debt. In fact, there was a sign in this week’s Spending Review that Government does indeed think that the relative value of its assets has changed because its cost of borrowing has fallen (Paragraph 2.76 of the Spending Review).

Or at least on one asset – student loans –the Government’s Spending Review effectively said that it now values the further income (comprising future interest and principle repayments) from its portfolio more highly than it used to – because its cost of borrowing has fallen. As pointed out by an IFS paper when the changes were first mooted, this makes the student loan system look cheaper.

But it also begs the question of why the same would not apply to revenues generated by other assets Government holds, and why we are embarking on more asset sales now, when borrowing costs are so low. Perhaps the answer is that asset sales help reduce debt in the short-term, which nicely fits with the Government’s targets. But the end result – as often pointed out by the OBR – is that debt simply goes up again later.

Nida Broughton (@fiveminuteecon) is Chief Economist at the Social Market Foundation (@smfthinktank), an independent public policy think tank, where she leads research on public spending, employment and economic growth.