Power to make regulations about the taxation of securitisation companies

Finance Bill – in a Public Bill Committee am 10:45 am ar 5 Gorffennaf 2016.

Danfonwch hysbysiad imi am ddadleuon fel hyn

Question proposed, That the clause stand part of the Bill.

Photo of Rebecca Long-Bailey Rebecca Long-Bailey Shadow Chief Secretary to the Treasury, Member, Labour Party National Executive Committee

I want to say a few words about the clause; although it might not seem exciting at first glance, it really is, so listen carefully to what I am about to say.

Three principal themes underpin the Labour party’s approach to the provisions in clauses 61 and 64, which we will come to later—in particular, those relating to the taxation of financial products. First, we need to ensure that, when the UK leaves the EU, its arrangements for regulating taxation and financial activity serve the country best and protect it from abusive practices such as tax avoidance and financial crime. Those arrangements must demonstrate the highest levels of transparency and probity.

Secondly, we need to ensure that the infrastructure supporting the UK economy accords with international standards on taxation and regulation, including the relevant OECD and International Accounting Standards Board models, which are applicable to this Bill. Finally, we need to secure Britain’s place in the world by ensuring that it maintains the highest international standards.

The Bill’s proposals on the taxation of financial instruments may appear on the surface to be merely technical, but they raise a number of significant questions about the organisation of our economy and infrastructure in the near future. Clause 61 appears to be a simple extension of the corporation tax treatment of securitisation companies to the taxes Acts generally. However, in 2008 the non-existent regulation of securitisation structures amplified a medium-sized storm in the US real estate market, and it became a fully-fledged banking crisis. I would like to ask the Minister how closely HMRC and the Treasury have considered the risks that the provision will be used for tax avoidance purposes.

Experience suggests that, if we alter the basis on which tax is levied, financial institutions will attempt to create derivative products that generate losses for tax purposes on, before and after the transition between the two tax codes, as we saw in the case of Inland Revenue Commissioners v. Scottish Provident Institution 2003 and many other cases in Hudson’s “The Law on Financial Derivatives”.

Just in the reported cases, there are several examples of financial institutions using slippery derivative products, for want of a better phrase, to avoid tax liability, such as Prudential plc v. Revenue and Customs Commissioners 2008. In that case, Chancellor Morritt held that banks should not be entitled to dictate the tax consequences of their transactions by attributing particular descriptions to them. That sort of tax avoidance, using changes in the tax treatment of products, has been criticised by Professor Alastair Hudson as

“a veritable industry in off-the-peg tax avoidance schemes”

in his book “The Law on Financial Derivatives”. Has the Minister considered the misdescriptions that might be possible under this provision?

To return to the particulars of clause 61, securitisation structures operate by transferring assets—whether subprime mortgages, credit card receivables or similar cash flows—into off balance sheet special purpose vehicles. Ordinarily, the profits, or cash flows, received from those assets pass through the special purpose vehicle to the investors who have acquired bonds in the special purpose vehicle. Usually, the residual amounts—the focus of clause 61—that are left in the special purpose vehicle are small, compared with the sums paid to the investors. However, as with all such artificial financial structures, it is possible to manipulate those amounts.

If the residual amounts held by special purpose vehicles are to be saved from withholding tax, as clause 61 proposes, and are to be treated in a different manner for tax purposes—although the provision does not make plain exactly what the different tax treatment will be—that makes it possible for the payment flows through a special purpose vehicle to be raised artificially so that larger sums could benefit from this different tax treatment.

Will the Minister confirm what is stopping an unscrupulous financial institution involved in the off-the-peg industry of tax avoidance derivatives from passing large sums—otherwise subject to withholding tax as payments of interest, for example—through special purpose vehicles? Have the Government considered in detail how such cash flows should be treated to prevent artificial or abusive tax avoidance?

Furthermore, securitisation products, in the form of collateralised debt obligations, use complex derivatives as part of their structure—namely, credit default swaps. The purpose of credit default swaps has always been to permit two things: first, speculation on the creditworthiness of companies and Governments issuing bonds; and secondly, a form of artificial insurance. A feature of credit default swaps and all other credit derivatives is that they are flexible tools—so flexible, in fact, that they are ideal for manipulating tax statutes for tax avoidance purposes.

Professor Alastair Hudson has described the inherent flexibility of financial derivatives in his book “The Law on Financial Derivatives”, which I recommend to the Minister for his summer holidays. Professor Hudson states that

“different legal structures and different pricing structures can generate different commercial and structural results out of substantially similar subject matter”.

As he shows, it is possible for options contracts to be reorganised as swaps, and vice versa, so the possibilities for tax avoidance are endless. Consequently, it would be simple for financial institutions to repackage their payment obligations to achieve whatever characteristics are most helpful for tax purposes. I fear that clause 61 is really only the tip of the iceberg. There is a serious general point behind the specificity of my concerns about the clause.

As we debate the Bill, the country finds itself in new territory. In theory, without the strictures of EU legislation, it will be open to us to create our own regulations to govern derivatives as well as the rest of the financial markets. There are many critics of the way in which the EU has chosen to regulate derivatives for the first time. For example, the use of private businesses as central clearing counterparties and trade repositories, which gather information about transactions that have been conducted, has created a new set of risks concerned with the solvency and performance of those private businesses. What if they go insolvent themselves during a future financial crisis? As private businesses, they will necessarily invest their own money, and it is perfectly possible that in the midst of a crisis they will fail to liquidate their investments in time to meet their obligations to their members. In such a situation, it will be the taxpayer—again—who will have to bail out the markets.

Moves are being made in the US Congress to dismantle many of the Dodd-Frank Act protections surrounding derivatives. The UK finds itself at a crossroads. We either ensure that our financial markets are properly regulated, for the protection of the financial institutions themselves as well as the country at large, or we run the risk of the City of London—alongside the first-class business currently conducted there—becoming the drain through which the world launders its dirty transactions.

Although clause 61 appears to be mainly technical, it conceals some important issues. In that spirit, I ask what work the Treasury and HMRC have done in proposing this change. The proper regulation of securitisation products and all derivatives will be an important issue in the establishment of the new British economy. In a paper published on 16 March 2016, HMRC makes explicit reference to the international accounting standards that were created in 2005 in relation to securitisation companies and suggests that this change in the taxation of securitisation

“is not expected to have any significant macroeconomic impacts.”

Those accounting standards were created by the International Accounting Standards Board after careful consultation with experts around the world, but all those minds together failed to anticipate the financial crisis that we experienced in 2008. That is a clear lesson for us all about the unintended consequences that can flow from too little care being expended on such reforms. I hope that the Minister can alleviate the concerns that I have raised in relation to clause 61.

It may help all Committee members if I point out that if you want to take part in the debate—and everyone is encouraged to take part in the debate—it is usually a good idea to signify that by some means: a nod, a smile or even, more obviously, by rising to your feet. Otherwise, I am as much in the dark as everyone else.

Photo of David Gauke David Gauke The Financial Secretary to the Treasury

Clause 61 will make a simple technical change to widen the scope of the power to make regulations about the taxation of securitisation companies included in the Corporation Tax Act 2010. It will enable the Government to make changes in regulations to remove uncertainty over the tax treatment of what are referred to as residual payments in the securitisation sector. That uncertainty generates a large number of requests to HMRC for clearances, which creates an administrative burden on both businesses and HMRC. Making the tax position clear will improve the customer experience. It has been welcomed by the securitisation sector and will improve the UK’s competitiveness as a financial centre.

Securitisation companies are a particular type of financial entity in which financial assets such as loans are transferred to a special purpose vehicle as security for debt issued to investors in the capital markets. Securitisation is an important way of getting more credit or liquidity flowing into the economy and of keeping down the costs of UK businesses’ borrowing and finance. The securitisation regime has worked well since its introduction, but the current rules have been in place since 2006. They need updating, to reflect recent changes to accounting standards and market developments.

One area of uncertainty that has grown as the securitisation sector has developed over recent years involves residual payments. Residual payments arise because securitisation companies typically contain more financial assets than are likely to be required in order to repay investors, meet transactions costs and retain a small profit. That excess protects against possible poor performance of the assets and allows the securitisation company to obtain an attractive credit rating. The uncertainty that arises is that residual payments may, in limited circumstances, be treated as annual payments for tax purposes and therefore be subject to withholding tax under the Income Tax Act 2007. Whether or not residual payments are treated as annual payments will depend on the facts of each case.

Uncertainty over the withholding tax rules affects the ability of law firms to issue a legal opinion on which ratings agencies can base the credit rating of the securitisation. That has a negative impact on the competitiveness of the UK securitisation sector. Currently, the uncertainty is addressed by companies writing to HMRC to seek clearance that residual payments will not be annual payments and so can be paid without withholding tax. That is an administrative burden for businesses. We would like to clarify the position by removing the potential withholding obligation in regulations, but the existing power is not wide enough to do so.

The changes made by the clause will amend the existing power to make regulations concerning the application of the Corporation Tax Acts to securitisation companies. The clause will extend the power to cover the wider taxes Acts, including the income tax Acts. That will permit changes to be made in regulations to ensure that the requirement to deduct income tax from annual payments will, as intended, not apply to residual payments made by securitisation companies. It will have a negligible cost to the Exchequer. Updated regulations under the amended power will be developed in consultation with interested parties.

The hon. Member for Salford and Eccles raised the role of securitisation in the financial crisis, which we could have spent plenty of time debating. However, while there were significant problems and faults in the US securitisation market, the UK and EU securitisation markets remained relatively robust. The global regulatory framework for securitisation has been completely overhauled since the crisis, including through increased capital requirements, reform of the oversight of credit ratings agencies and improved transparency rules.

The clause will not mean that securitisation companies pay less tax or face less scrutiny from HMRC. There is no statutory definition determining whether a payment is an annual payment. That must be decided based on characteristics established in case law. HMRC’s view is that the overwhelming majority of residual payments will never be annual payments. The change will clarify the position by placing the tax treatment on a statutory footing, removing uncertainty for taxpayers. There is no policy change here.

In terms of what is to stop large sums from being artificially passed through these vehicles, the notes have to be issued wholly or mainly to external investors. The SPVs are conduits and do not retain the profits. On how we treat such cash flows to prevent avoidance, under the payment rules an SPV is taxed on a small retained profit that has to be paid out to investors within 18 months.

This simple change to primary legislation has been welcomed by the industry. It will allow changes to be made in regulations to make the tax rules applying to securitisation companies work as intended. It will also make it easier for UK businesses to raise finance through securitisations, making those businesses and the UK securitisation sector more competitive. It will remove uncertainty over the appropriate tax treatment and need for businesses to consult HMRC on this issue before entering into securitisation transactions and it will ensure that the tax treatment of residual payments will be treated consistently. I therefore hope that the clause will stand part of the Bill.

Question put and agreed to.

Clause 61 accordingly ordered to stand part of the Bill.

Clause 62