International Tax

Global tax competition hots up

Governments must recognise that corporation tax rates must be internationally competitive if they want to attract and retain companies and jobs, says a new survey from KPMG. But cutting tax rates is an ongoing process and leading nations must continue to drive down rates if they are to stay competitive. Having been a world leader in cutting taxes, the UK is finding itself quickly caught by other countries.

KPMG points out that while the UK�s standard corporation tax rate of 30% superficially seems low - compared with rates in the past - it is actually now only marginally less than EU and OECD averages. The UK faces particularly severe challenges on rates from Ireland, the Netherlands and Belgium, which are all seeking to increase their share of international and European corporate headquarters.

Between 1996 and 2003, average corporate tax rates in EU member states fell from 39% to 31.68%, and in OECD countries from 37.5% to 30.79%. Tax rates in Ireland fell by 21.88% and in Belgium by 15.38%.

KPMG�s head of strategic tax policy, John Battersby, said: �Using comparisons of rates in isolation can be dangerous - the total tax burden on a company�s activities is of major relevance. This survey is important because by having an informed overview of trends in corporate tax rates around the world, we can see to what extent countries are seeking to provide a competitive environment for business.�

The survey also stresses that direct taxes are only part of the story. Corporations will also take into account other direct costs, such as pensions obligations, national insurance payments in the UK and employers� social insurance contributions in France and Germany (see �Social insurance hits problems�, p8). They will also consider financial incentives for investment and tax law.

But countries are not only finding corporate tax revenues potentially eroded by international competition. European Union member states may also lose their ability to set their own rates. In its paper Damned If We Don�t, Ernst & Young has urged the UK Government to transform radically the country�s tax system, or risk finding its corporate tax system dismantled by the European Court of Justice. Recent ECJ judgements, said Ernst & Young, have found that the UK and other EU tax systems breach EU law where they are deemed to favour home businesses over companies based in other member states.

David Evans of Ernst & Young�s European Tax Team said: �The [UK] Government are very quick to tell us that they won�t support tax harmonisation, but the Commission�s proposals aren�t the immediate concern. The ECJ is completely independent of political processes and it is intent on removing tax barriers in the single market. Opening up the tax systems of Europe could be very positive for those businesses that can benefit, but it�s happening in an unplanned and random way, depending on what cases the ECJ gets to hear. And then the Government has to respond on a case-by-case basis, which means they�re always on the back foot.�

Aidan O�Carroll, national head of tax, added: �In our paper we suggest that the Government pre-empts this whole situation and gets control of the tax system back into the hands of the politicians. They can either get involved in the harmonisation process instead of trying to pretend it isn�t happening, or they can go it alone with unilateral measures. The Corporation Tax reform project is an ideal opportunity not only to modernise the UK system but also to ensure it can withstand the scrutiny of the ECJ. What the Government shouldn�t do is allow the uncertainty to drag on. It�s the last thing business needs.�

Ernst & Young argues that its view is supported by statements issued by the Treasury as part of the Budget paperwork, in which it said that it is �determined to protect the corporation tax system against legal challenges under European law�.

David Nickson and David Evans of Ernst & Young responded: �We said that unless the Government used the corporation tax reform process quickly to fortify the system against charges of discrimination, we would see tax harmonisation by the European courts without any political control of the process. Our view is vindicated. But the lack of any clear direction in the Government�s statement puts the future of corporation tax in the balance. Continued uncertainty will not be good for business.�

It had also been expected that Australia�s Budget last month would see a big cut in its corporation tax rates, following the country�s review of international taxation. Instead cuts were largely focused on income tax, particularly for low earners. This was in part aimed at stimulating the economy by encouraging higher consumer spending.

�Disappointingly, the Government has ducked an opportunity to tackle the key tax issue for Australian companies seeking to compete internationally, while retaining their head offices in Australia,� said Peter Collins, a partner in PricewaterhouseCooper�s international tax and structuring practice in Australia. �By ignoring the longer term benefits of reforms recommended by the Board of Taxation, the much touted review of international taxation has delivered little change other than a promise to exempt controlled foreign companies from Australian tax and press ahead with tax treaty updates. Significantly, big Australian businesses with foreign expansion plans will continue to face a high cost of capital for funding offshore investments. Conversely, there are no new measures to make Australia any more attractive to foreign investors. The Government has indulged in low cost tinkering, rather than address our long term international competitiveness.�

ACCA responded more positively, but warned that proposals may take too long to implement and offer too little. It argued that the Government�s rules for controlled foreign companies (CFCs) and its �tariff� based regime on overseas investment income, which subject companies or individuals with overseas investments to complex tax rules, have impeded inward investment and created unnecessary bureaucracy for all who are affected.

ACCA believes CFC rules could be simplified quickly by applying them to any countries where corporation tax is 75% of the Australian rate, in addition to expanding the exempt country list. The Australian Government says that reforms cannot be introduced before July 2004, but China is now offering tax breaks to attract inward investment and Australia could be left behind, suggests ACCA.

Richard Francis, head of ACCA Australia, said: �The bias against overseas income and investment has impeded Australian business competitiveness. It is vital that the Government provides equal treatment for domestic and overseas income and comprehensively reforms the CFC rules as soon as possible. We are concerned that a delay until 1 July 2004 will mean that any subsequent legislation will be watered down from the present announcement and could be �too little too late� in the light of developments elsewhere in the Asia Pacific region.�

UK productivity falling behind

Britain�s position in the global market must in future rest on providing quality, innovation and unique products, no longer relying on its ability to offer a relatively low cost environment, according to a review of UK productivity conducted for the Government by Professor Michael Porter of Harvard Business School.

Economic reforms since 1980 have greatly increased the UK�s competitiveness, suggests the Porter report UK Competitiveness: Moving to the Next Stage. But other countries have copied the steps taken by Britain, such as reducing regulation and cutting taxes. The UK must now consider its future strategy, opting for a different emphasis.

�A public consensus on the direction of the transition and on the next stage of the country�s competitiveness would help to manage the uncertainties of this process,� concluded the report. �The absence of such a consensus at a time when the old policy approach is running its course explains much of the puzzlement and even pessimism in the current UK debate.�

Over the last two-and-a-half decades, the UK�s economic performance has improved markedly. This is illustrated by a range of economic measures: prosperity has increased, hours worked per employee have risen, as have the rates of employment and labour force participation. Yet economic productivity in the UK still lags behind key competitor nations, particularly the United States, France and Germany. It is only by raising skill levels in the labour force, increasing capital investment and making better use of technology that the UK will compete more effectively on an international stage.

Whilst it is easy for UK citizens to be aware of the significant economic improvements achieved in recent decades - bar a hiccup in the early 1990s, when the economy hit serious problems - it is sobering to compare GDP per capita with other countries. The US outperforms the UK on this measure by 40%, with the Swiss better-off by 20% over the UK, and Japan by 11%, Germany by 6% and France and Sweden by 3%.

Moreover, the distribution of income across the nation is much less even in the UK than in its key competitor nations. There are serious incidences of poverty in the UK. Porter�s report says: �The existence of such pockets of poverty indicates an untapped potential for productivity growth as well as a social challenge. It is also a signal for remaining weaknesses in the business environment, such as lack of training, discrimination, a low level of local government responsibility, and the separation of social and economic problems.� He adds that it is unclear whether Government attempts to alleviate the situation in recent years have been successful.

One of the great UK policy successes in recent years, says Porter, has been in increasing the number of people in work. �Many Continental European countries have gone down the road of making lower productivity employment unattractive and have suffered high unemployment; the UK has instead increased incentives for work. The UK did significantly reduce unemployment, and did not resort to cutting the average employee�s working week.�

But capital investment in the UK is severely short of competitor nations. Judged per hour worked, it is 60% short of France�s figure, 32% below that in Germany and 25% behind the US. Other key factors are in exports, where the UK�s position is stable; in attracting inward investment, where performance has been very good, but is falling; and in innovation, where the UK performs badly.

Criticisms of business management in the UK - from secretary of state for trade and industry, Patricia Hewitt - for productivity weakness is not endorsed by the Porter report. He argues that management and its decisions are both a cause and an effect of the wider economic environment, therefore management practices �are not at the core of the UK competitiveness challenge�.

Rebecca Harding, chief economist at The Work Foundation (formerly the Industrial Society), which promotes the effective management of business, argued that in this year�s Budget the chancellor, Gordon Brown, had already gone some way towards addressing the weaknesses identified in the Porter report. �This was a clever Budget from a confident chancellor which did something different from previous Budgets - it attempts to encourage culture and behavioural change,� she said. �It takes a bottom-up approach to improving productivity through measures to encourage investment in small businesses, increase levels of employment and entrepreneurship, as well as improve skills and tackle productivity at a regional level.

�Research done by The Work Foundation�s Panel of Inquiry into Work and Enterprise suggests that there needs to be a far better micro-economic strategy that really joins up the drive to improve skills and innovation at the level of the individual, thus putting some humanity into productivity. That means joining up the skills agenda and the innovation agenda through getting social partners talking to each other, based on their commitment to improving productivity at the individual level.�

The Chartered Institute for Personnel and Development (CIPD) took the opportunity offered by the publication of the Porter review to argue that collaborative, coaching styles of leadership could help solve the UK�s low productivity. A new CIPD publication, Coaching for the Future, suggests that the focus of attention for human resources professionals should be boosting personal productivity, giving all employees the scope to organise themselves while providing the �tools and boundaries�.

Author of the guide, Janice Caplan, said: �A leadership model that focuses on coaching and collaboration will result in a happier, more satisfied and, hence, more productive workforce. The growth of speciality coaching demonstrates that all industry sectors and job roles, from board-level executives to IT staff, can benefit.

�Discussions about boosting UK productivity have of late focused on areas such as work/life balance and flexible working. It is just as important to ensure that, while at work, employees get the support they need to develop and succeed.�

All change for IFAs

The starting gun may have been fired marking a revolution in the UK financial services market, with Bradford & Bingley�s purchase of leading independent financial adviser Holden Meehan. It builds on the radical rebranding of B&B as an intermediary, already firmly established with its purchase three years ago of leading mortgage brokers Charcol.

B&B is already the UK�s largest IFA, based upon its Charcol and MarketPlace brands. It is increasingly moving away from the direct provision of loans, to act as an intermediary for a range of lenders� products. However, it has recently purchased a large mortgage portfolio from General Motors, apparently confirming its intention to stay in the market for loans as well as advice.

In the new environment, B&B�s main competitors could be leading banks such as Barclays, rather than existing major IFAs such as Chase de Vere and RJ Temple. It looks increasingly likely that many larger privately owned IFAs will be bought by leading financial services corporations, leaving smaller IFAs struggling to compete. The fall-out could have serious implications for accountancy firms which are also IFAs.

The shake-out in the market was sparked by a new structure for the financial advice market unveiled by the UK�s Financial Services Authority last November. This will end the existing system of �polarisation�, introduced in 1988. Under polarisation, financial products were either sold by truly independent advisers, or else by representatives tied to one company who could only sell that company�s products.

Outgoing chairman and chief executive of the FSA, Sir Howard Davies, said: �The polarisation rule has not delivered the consumer benefits hoped for when it was introduced. We are convinced that a free market will help consumers more. In future, consumers will find it easier to shop around for the best product and providers will be free of the anti-competitive constraints that have made it difficult for them to offer consumers that choice.�

The depolarisation rules will enable firms currently restricted to selling just one company�s products to sell products on behalf of other providers as well. Those firms claiming to be independent will have to advise across the whole market and offer clients the option of fee-based advice. And there will be requirements on product sellers to give clients more transparency on their services and costs. Independent advisers will not be able to recommend products from companies which own more than 10% of their equity.

But there are now serious doubts whether the depolarisation system - likely to begin towards the end of the year - will be in consumers� best interests. A new report from leading market analysts, Datamonitor, predicts that IFAs will find their market position in serious decline, while the big banks are set to become market leaders for a wider range of financial products.

In recent years IFAs have increased their market share in the sale of new life and pensions policies by an average of 12.2% annually. The shift from the sale of such products directly by providers has led to many totally getting rid of their direct sales forces - Prudential, Britannic and Sun Life of Canada have all done so. Lloyds TSB also recently announced that it was also cutting hundreds of jobs from its direct sales forces in subsidiaries such as Scottish Widows, but this owes more to the decline in the investment market rather than a response to the strengthening position of IFAs.

Datamonitor predicts that IFAs� market strength will quickly decline once depolarisation takes effect. Market share of life and pensions policies is expected by the analysts to slip from 66.2% to 56.9% by 2008. Not only will the new structures favour the banks and building societies, but, says Datamonitor, the introduction of simpler pensions as proposed in the Sandler review will lead to more �execution-only� arrangements, by-passing IFAs. In the pensions sector, IFA share could fall by 18.6% in five years, with banks� share rising by 16%.

Datamonitor�s financial services analyst and author of the report, Alan Shields, explained: �The new regulations that are due to be introduced by the FSA will see the competitive landscape of distribution in retail life, pensions and investments products change markedly, with banks set to enter the fray as competitors. Unlike previous proposals, however, the new regulations have been hailed by the industry as a smart move - they allow IFAs to assess and define their own business models rather than dictating rules to them.

�In the new depolarised market, banks will have the competitive advantage, able to leverage their considerable distribution networks and make it harder for IFAs to distinguish themselves as expert advisers. It will be in the hands of IFAs to decide how they can best compete in this new environment, whether they stay independent and focus on relationships, form strategic partnerships, focus on wealthier clients or just consolidate to survive.

�IFAs will lose out particularly in the distribution of annual pensions products that will require less and less advice and be sold from an increasing number of institutions. They will, however, maintain a strong footing in more complex investments that require expert independent advice. Most importantly, there will be a wealth of advice available at a cost which will not restrict investment products to the wealthy, encouraging UK citizens to save for their future.�

PKF Financial Planning is one of several IFAs owned by accountancy firms. Managing director, Frank Williamson, said that he thought that the final shape of the new advice regime could yet be amended further - and should be. He would like a much greater guarantee of real independence from financial advisers.

�The impact on our business is, at the moment, extremely difficult to predict,� said Williamson. �The way the proposals have been handled and the extent of delays suggests that not everything is done and dusted. I am not delighted [at the proposals as they stand] because I believe it�s bad news for clients and for the industry. It�s back to the bad old days when people couldn�t trust the advice they were given.�

However, PKF thinks the proposals could strengthen its own position in the market, as the firm will stress its independence from product providers. Further, because PKF�s client base - as with many other accountancy firms that are IFAs - tends to be with small firms and high net worth individuals, it is dealing with people who are better able to pay fees for advice. Williamson argued that IFAs closely tied to product providers are likely to find their market position untenable. �Pseudo-independence is not sustainable,� he suggested.

Social insurance hits problems

German chancellor, Gerhard Schröder, has announced that he is to increase his country�s tobacco tax by a third from next January, to help finance the country�s financially troubled health system and reduce employer and employee contributions to social health insurance. It forms part of a wider drive to improve the country�s economic performance and conform to the rules of the EU�s growth and stability pact.

While many countries paying for healthcare through direct taxation or private health insurance see the social insurance model as highly successful, the perception within such countries as Germany and France is more critical. There is no doubt that both countries benefit from excellent health services, but they are very expensive.

Chancellor Schröder is committed to reducing social health insurance contributions from 14.3% of gross wages down to 13%. This responds to warnings from the administrators of insurance schemes that without major reforms there will be rising deficits leading to premiums increasing to at least 15% of gross wages. This is despite earlier reforms to the system which were intended to cut costs. The measures form a key element of his Agenda 2010 proposals to increase labour market flexibility.

�Restructuring and renewal of the welfare state has become a necessity,� said Schröder in launching his proposals. �The structure of the social welfare system has remained practically unchanged for 50 years. Many of the instruments of social security and welfare are now creating social injustice by excluding millions from work.�

The primary motivation for the reforms is the recognition that non-wage labour costs have become the major bar to job creation in Germany. Between 1982 and 1998 these costs rose from 34% to 42% of wage bills. �Non-wage costs have reached a level that has now almost become unbearable for employees,� said Schröder. �On the employer�s side they are an impediment to creating new jobs.�

As well as increasing the direct tax contribution towards social insurance, Schröder is also seeking to reduce the cost of health treatment by 20bn euros (£14bn) annually - 10% of the total bill - by cutting drugs costs and other measures. New restrictions on patients� choice are to be introduced which will penalise people who make appointments with a specialist without first being referred by a general practitioner. Patients will have to pay a fee each time they visit a doctor.

There is also to be a separation of health insurance from income protection during illness. In future workers will be required to take out private insurance to provide long term sickness benefit. Certain other insurance benefits, including maternity grants, are to be paid from direct taxation.

France has similarly been struggling with the economic implications of its social health insurance system. Since 1998, employer and employee social health insurance contributions have been augmented by an additional tax on earned and unearned income, with income tax now the majority component of payment for the insurance. The irony is that it was a Socialist Party Government that shifted the financial burden away from employers, in order to assist the creation of more jobs.

There is, though, a widespread belief that France�s medical system needs to undergo further reform in order to also reduce costs. Many commentators argue that drugs are responsible for too high a proportion of system costs and the Government has been attempting to persuade doctors to shift to the prescription of more generic rather than branded drugs. (Only 3% of drugs prescribed by French doctors are generic, compared with 60% in the UK.) Meanwhile, France was brought to a halt for one day last month when public sector unions went on strike to protest at the current Government�s attempts at tackling the parallel financial crisis in pensions. France�s unfunded pensions system is unsustainable with an ageing population and the Government intends to reduce benefits to public sector workers.

An increasing number of commentators are now warning that current arrangements for health and pensions in Germany and France must be subject to fundamental reforms. Any system heavily funded by employers is likely to undermine attempts at full employment. With healthcare, moreover, pressures are rising in line with costs, as new technology and more expensive drugs have created medical inflation of 7.5% annually. Failure to control health and pensions costs in the two countries has driven up public spending, contributing to deficits above the limit set under the EU�s growth and stability pact.

Despite the problems afflicting social health insurance, the British opposition Conservative Party has indicated it is strongly attracted to proposing such a system for the UK as an alternative to the funding of the NHS from direct taxation. The Adam Smith Institute, a think-tank which has been highly influential on Conservative policies, argues that the great attraction of social insurance is the empowerment of patients by enabling them to exercise much greater choice over which doctors and hospitals they use.

Dr Eamonn Butler, director of the Adam Smith Institute, adds that the issues of healthcare and pensions funding should be recognised as closely related, with the same pressures affecting each. In his view, the benefits of social health insurance is not the use of co-funding by employer and employee, which is not an essential element of social insurance.

�There�s 101 different ways of doing social insurance,� said Dr Butler. �Our view, and there is growing support for this, is that pensions are no longer something which employers are able to provide. In the old days, when people worked from 16 to 65 for one employer, it might have made sense to have an employer-funded mechanism. These days it doesn�t. Often these days you have big pension funds running large financial deficits, with small companies attached to them. It is bizarre and unsafe.

�Fundamentally, it is an employee who should contribute to a pension. If an employer wants to chip in that�s fine, but there should be no tax relief for doing so. Ideally that is what we think should happen for health insurance as well. There would have to be state support for people with existing conditions - the state would simply pay into your insurance or pension scheme. Politicians love to stick these things onto employers, but that�s wrong.� He added that workers who lost employer-paid pensions contributions should be entitled to full compensation by having their salaries topped-up.