UK Tax Policy and the Euro-dollar Market

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A. Introduction

The view of the UK Treasury and the Inland Revenue was that, the way was now open for the nationalised industries and the local authorities to borrow in this way, if the UK wanted this to happen, and that the Boards and authorities concerned were prepared to go ahead.

This led to a very important issue, which had to be fully recognised. The amendment to the Finance Bill will allow interest payments to be paid free of tax only where the bond of stock was issued through an overseas agent subject to foreign law. It did appear to mean that, when a Euro-bond was issued in London, withholding tax will still apply where the interest was paid out of UK income. Thus the effect of the amendment would be to impair the status of the London issuing houses since if the amendment leads to a rise in this type of borrowing they will be effectively excluded from participating in the increase: an increase which will derive entirely from the UK sources. It was envisaged that the UK would have a presentational problem on its hands. As, if the UK government wanted a public sector authority to borrow in foreign currencies, it had to approve in their arranging for the issue to be made through an overseas agent and in an overseas centre. In short, the UK government had cut out the possibility of the public sector itself utilising the Euro-dollar resources of London with regard to its borrowing operations .

The tax change, under which interest paid on foreign currency borrowing for home investment would be treated as an expense for corporation tax purposes, though designed to encourage such borrowing by the nationalised industries, would create an incentive also for the UK commercial concerns. Given the rate structure in the Euro-dollar market, the new tax incentive may well create substantially increased interest by UK firms, particularly those with overseas income, in currency borrowing for home activity. A central question was, how would this be regarded under the exchange control rules? There had been little interest shown by UK firms in this type of activity but given the prime need to strengthen the reserves, it plainly made sense to allow firms to borrow fairly freely in the Euro-dollar market for home investment if they found it attractive to do so. The UK government’s attitude, was that, if UK firms want to borrow on appropriate terms in Euro-dollars for home investment, they would normally be allowed to do so .

Hence, due to Lever’s proposal: An insertion of a provision in the Finance Bill was needed, to allow a corporation tax deduction in respect of interest paid on Euro-dollar bond issues, where the funds were to be invested in the UK . The change would serve no useful purpose unless the UK firms concerned were prepared to arrange for their loan contracts to be signed outside the UK, e.g. in Switzerland or Luxembourg. The reason for this was as follows: Subscribers to Euro-bond issues were interested in no shares other than those on which interest was paid gross of local tax. Under the provisions of the 1952 Income Tax Act, UK borrowers may not pay interest gross to non-residents unless the interest had a non-UK source in the hands of the bond-holder. For UK companies (including the nationalised industries) the latter condition can be complied with only by the conclusion of the approximate loan contract abroad. There are strong Revenue arguments against any relaxation, in which, Lever and the official Treasury had been inclined to accept.

However, it should be noted that; firstly, the change would not affect materially the position of the potential UK borrower who has substantial overseas income. Secondly, in respect of other companies, including the nationalised industries other than the Air Corporations, the change would encourage foreign currency borrowing only if the relative contracts are established abroad under foreign law. Thirdly, much of the extra banking business, which was created by the change, would therefore benefit overseas rather than London banks .

This meant that, the UK were not in the position, or able to hold the situation of the proposed change, and would face early pressure for the relaxation of the income tax rules on payment of interest gross. This was what the Revenue had always foreseen, and what led them to resist any changes, even changes in the corporation tax .

B. Opinions of the Inland Revenue

On the 26th June 1968 a confidential meeting on Euro-dollar borrowing was held by Lever, the Inland Revenue, the Treasury and Mr. Stainton of the Parliamentary Counsel. Lever first raised the question of an arrangement by which interest might be paid gross on loans raised in the Euro-dollar market. It was emphasised that Lever was anxious not to allow payment of interest gross to UK residents, but that it was possible to pay interest gross to non-UK residents without excluding UK banks from taking part in the arrangement of these loans .

However, the Revenue stated that they were not going to accept a position where interest was paid gross in London to UK residents. This was based under the rule that interest could not be paid gross, except where existed a non-UK source. Various Court decisions, interpreted by the Revenue, meant that the Revenue were prepared to regard interest payments as having a non-UK source when they were made under a contract concluded abroad under foreign law, with a foreign paying agent, even where the income which were used to pay the interest was itself generated in the UK . This was a new different area, as statute law did not cover it in any detail, and decisions had to be taken on interpretation based on a few court decisions. Under these circumstances, it was possible that some modification of the Revenue’s existing rules were possible. For example, it was possible to accept that a UK bank in London might pay interest gross in external sterling to non-resident accounts, as in practice this was a very similar operation to a foreign bank paying gross abroad in a foreign currency. However, it was not possible to legislate in this area in the Finance Bill of the time, as there was no time to work out the necessary complicated clause .

Lever, nevertheless, stated that he was interested in further exploring the extent to which UK banks were able to take part in loans raised abroad. However, he was content that the law was not altered involving the definition of “foreign source” income in the Finance Bill. So, the clause was approved in principle. Lever raised the question of allowing in the clause for loans the interest on which might, at the option of the lender, be paid in sterling. There was no objection to this in the meeting, provided the option was exercised at the discretion of the lender .

The “machinery problem” of the Inland Revenue

However, this issue was not passed onto Lever, because of “the machinery problem” caused by certain large barriers that were raised by the Inland Revenue . There was three issues of principle: firstly, non-resident borrowers paying interest through London – (if they are not paying interest through London there is no reason why any aspect of UK taxation should affect them). Here there is a “machinery problem”, the Affidavit procedure, which has been removed. Secondly, UK borrowers paying abroad – provided that the bonds are denominated in foreign currency and held only by non-residents, and that the issue formally takes place in a foreign market, gross payment of interest without formality is possible and, under the proposed Finance Bill change, payment will count as an expense before assessment to Corporation Tax. Finally, UK borrowers paying through London – it is here that the problems still remained. The primary problem through London would almost certainly disqualify borrowers from payment gross of tax, with or without an Affidavit procedure. The Inland Revenue will be considering whether, provided the borrowing is in the form of foreign currency bonds, with interest payable in foreign currency, and to be held only by non-residents, they could agree to payment of interest gross, without requiring the additional non-UK features of issue abroad and payment abroad .

What was not clear was, assuming that the Inland Revenue were to decide that they could allow payment gross of tax even with Issue X and payment Y in London, but on the narrower limitations of foreign currency denomination and interest and non-resident holders, the Inland Revenue would still have to take special steps to remove the obligation of Affidavit procedure, or whether this would simply not apply in any case .

Obstacles to raising foreign currency loans by UK companies

The law and the practice of the Inland Revenue was unsatisfactory in relation to Section 52 (5) and provided obstacles to the raising of foreign currency loans by UK companies. It was considered, by the Inland Revenue that there was no justification for the continued separation between annual interest payable to residents and to non-residents . These obstacles were:

Firstly, relief is not available in cases where a loan has been raised for purely investment purposes, e.g. the acquisition of a new subsidiary. This construction is an obstacle to foreign borrowing in cases where the borrower has insufficient Case IV or Case V income, and it ignores the realities of much foreign investment where the acquisition of an existing business will almost always be made through the acquisition of shares. Furthermore, it ignores the Revenue’s own practice in allowing “short interest” incurred on loans used to purchase capital assets rather than as working capital .

Secondly, relief is not available for interest payable in the currency of a country outside the Scheduled Territories when it is payable either to a company which controls or is controlled by the UK company liable to make the interest payments or to a company which is under the control of a third company which also controls the UK company. This refusal to allow inter-group interest payments is an obstacle to foreign borrowing in cases where, for good practical and business reasons, a foreign subsidiary, having acted as the primary borrower from the foreign lenders with the guarantee of the UK parent company, relends the proceeds of the foreign currency loan to its UK parent company on the same terms as those applicable to the underlying loan. The subsidiary/parent company loan can be made on a short-term basis which could be renewed year by year so that the interest would qualify as “short interest” and therefore be allowed against corporation tax. However, this would not be satisfactory in the case where the foreign lenders wishes to take security by a charge on the parent company’s indebtedness to its foreign subsidiary. Also, there is some doubt whether a 360-day loan between parent and subsidiary, which is renewed year after year, would be regarded as a short-term loan .

Thirdly, to obtain relief, the interest must be paid to a non-resident. It is not practical for UK issuers of foreign public bonds to obtain evidence of residence from persons who obtain payment of interest at paying agencies outside the UK. The Inland Revenue will not unconditionally accept that interest paid in those circumstances is in fact paid to non-residents and cases have been known, to mark their position, where the Inland Revenue only allow 99% of the interest payments to be charged against corporation tax. This position is inequitable and penalises the UK borrower for a situation over which it has no control. It seems to fail completely to recognise the exchange control and paying collecting agent tax regulations relating to the holding by residents of the UK of foreign currency securities. Under those regulations, a UK resident can only hold foreign currency securities through an authorised depositary and upon receipt by the relevant bank of any interest or dividend payments the bank is obliged to deduct and account for any applicable UK income tax .

C. Public Sector and nationalised industry foreign currency borrowing

(1). Introduction

1969 was facing a difficult liquidity situation in which, the Treasury had favoured for some time steps to enable public and private borrowers to borrow foreign currencies in the Euro-bond market. This was a means of meeting some of their financing requirements and, at the same time, of increasing the nation’s reserves. However, the issue of tax was causing some problems with the British government.

The issue in which a local authority may be able to pay interest gross on an issue of bearer bonds denominated in foreign currency was a welcome opportunity, as if this was accepted, it was likely that one local authority, the GLC, would begin negotiations. The Bank of England took the view that it was advantageous that the first Euro-bond issue by a public borrower was the GLC. Due to this reason, they wanted to get the position on the tax difficulty cleared up as soon as possible. Their understanding seemed to be that, since GLC borrowing would be secured on a domestic asset (the GLC rate revenues), it would not qualify for the permission to pay interest gross conveyed in the 1968 Finance Act.

It was clear that there was a genuine obstacle standing in the way of GLC and other local authorities borrowing foreign currency abroad, and it was necessary to consider means of removing an impediment to foreign currency borrowing by UK local authorities in the Euro-bond markets. It was suggested that the required provision should be generalised in order to cover nationalised industries or private sector borrowers as well as local authorities; to cover a direct charge on UK assets as well as the indirect one that arised from a subsequent loan contract, which was the particular problem of local authorities; and to limit the arrangements to foreign currencies, excluding currencies of the Scheduled Territories. Looking at the tax position on foreign borrowing – any UK borrower wishing to tap sources of funds in the international capital markets needs to take into account the following two points:

(a.) He will have to contrive a means of paying interest to the lenders gross without formality, because this is a demand of lenders in the international capital markets.

(b.) He will naturally wish to be able to charge the interest payable on his borrowing as an expense for the purpose of UK tax assessments.

(2). Payment of interest gross

Euro-bond issues were not practicable unless the borrower undertook to pay interest gross, and it was therefore important to be clear as to the terms on which London, other local authorities and the nationalised industries could arrange borrowing on gross terms. It was possible for a local authority or nationalised industry to arrange to pay interest gross, without attracting any UK tax charge, provided that the interest has an overseas source in the hands of the bond-holder . This interest has an overseas source if; firstly the loan contract is made abroad, secondly if the loan contract is governed by foreign law, thirdly if the interest is payable abroad, and there is no UK paying agent. Finally if the loan is not secured on any specific assets or revenue in the UK.

The Revenue had to consider all the specific arrangements before they took a final view that it takes the relative interest outside the UK tax charge. In their sterling borrowing hitherto, the local authorities had secured their loans on their revenue, largely from rate income. The fourth condition would preclude this. On the basis of the forth requirement being fairly inflexible, there was no means by which the local authorities could secure their loans (if for good reasons they wished to do so) on any assets or income in the UK .

It was important to clarify the point of whether there was any difficulty for the GLC in making a Euro-bond issue provided that the borrowing contract was signed abroad. To enable the authority to pay interest gross, to give the interest a foreign source, it was necessary for the four conditions to be met. The fourth condition was of extreme concern – the provision that the loan should not be secured on any specific assets or revenue in the UK. The concern was that the GLC and other local authorities almost invariably secured their sterling borrowings of rate income, they would wish to do the same in the Euro-bond market, and the fourth provision would effectively preclude them from paying interest gross. It was far from clear that it would be necessary for the GLC or any other local authority to offer a lien on the rates if they undertook a Euro-bond issue .

It seemed that, it was almost certainly necessary to give an indirect lien in the following way. On the basis that the loans to the cities Oslo, Bergen and Copenhagen being regarded by the bond market as the relative precedents, it was necessary for the GLC to give a negative pledge to the effect that if on any subsequent borrowing a security is given, then this security will be available equally for the bond issue. It seems likely, that if the fourth provision was indeed inflexible, then the negative pledge would also fall foul of the Revenue requirements, and it would not be possible for the authority to pay interest gross. This seemed like a very tiresome procedure which involved three possibilities; firstly the Revenue may conclude, on reflection, that the “revenue” to which reference is made; in the fourth provision (that the loan is not secured on any specific assets or revenue in the UK.) relates to trading income, and does not therefore cover the rate or other income of local authorities; there will therefore be no problem. Secondly, the law could be amended in the 1969’s Finance Act. Thridly, the local authorities might discontinue their practice of securing sterling loans against rate income .

However, this problem did not arise for the nationalised industries, because they did not, secure their loans on specific assets or income. The Chancellor of the Exchequer (on the 15th January 1969) approved the conclusion that foreign currency bond issues by nationalised industries were desirable as a contribution to Britain’s foreign currency financing problem, and that the Government should offer to carry the exchange risk so as to facilitate the making of such issues and other local issues . It was noted that the GLC might be debarred for tax reasons from making such issues. If local authorities were in fact debarred, or the GLC decided not to make an issue, it will not be worth extending this arrangement to local authorities as well as nationalised industries. It was finally decided that, if the GLC were not debarred and they have firm plans to make an issue, then the door can be opened to local authorities .

The obvious thing to do was for the local authorities to make an issue unsecured. It seems that unsecured borrowing was a normal procedure in Continental capital markets. However, the borrower was normally expected to provide a “negative pledge”. E.g., the Euro-bond markets may take some issues by the cities of Oslo, Bergen and Copenhagen as precedents. These cities borrowed without security, but provided a negative pledge to the effect that if on any subsequent borrowing a security was given, then this security would be available equally for the bond issue. If a local authority must provide adequate security when it is borrowing in this country, then it seems that the negative pledge would result in a borrower providing security in the foreign currency market as well. This falls “foul” of the revenue requirements. This is a difficulty, which does not stand in the way of a possible foreign currency issue. An appropriate amendment to the Finance Act is necessary .

A tax problem arose, because the Revenue considered that income paid by a UK borrower does not qualify as foreign source income, and is therefore outside the UK tax net, unless the loan is not secured on any specific assets or revenue in the UK. The problem arises for the GLC and other local authorities from the authorities’ traditional practice of giving a “lien” on the rates and other revenues in respect of their London market loans, and the insistence of Euro-bond subscribers on receiving special most favoured nation treatment. This means that the local authorities will almost certainly be required to agree to insertion in the loan agreement of a security provision on the lines of those in the loan agreement for the cities of Copenhagen, Bergen and Oslo. The result, if Revenue stand by their interpretation of the statutory position, is that the act of creating a lien on rate income in the first Sterling loans after the Euro-bond issue will cause the interest paid by the local authority to revert to the status of UK income source, thus coming within the tax charge .

The position of the local authority would be impossible in this situation. It would be regarded as part of the preliminary negotiations as well as in the loan agreement itself, to indicate that interest would be payable gross and yet would be inserting in the agreement a second provision which would be bound in a relatively short time to frustrate its ability, within the law, to fulfil the first requirement. This problem did not arise for the nationalised industries, because it was never their practice to create a lien on UK assets because they borrow under Treasury guarantee. The solution was to remove the offending Revenue requirement in respect of overseas borrowing by the nationalised industries and commercial borrowers (for simplicity and to avoid highlighting the position of the local authorities) . There were four alternatives: firstly, to abandon the idea of foreign currency borrowing by the local authorities. Secondly for the local authorities to abandon their old-established practice of creating lien to secure their sterling issues. Thirdly, a less statutory interpretation by the Revenue of the statutory position to regard the interest payable on these issues as retaining its foreign source connotation even when the indirect pledge became effective. Finally, to amend the law.

Examining these alternatives, the first alternative was unquestionable, especially since the GLC and Manchester had relative borrowing powers. The second alternative was “impracticable”. The third alternative was “a possibility”. So it seemed that the fourth choice was “fairly obviously the right solution” .

The point was that bond issues could be made in the Euro-bond market only if the borrower undertakes to pay interest gross. That the relative interest income has to be given a foreign source (based on the four requirements). The only point of difficulty arose on the fourth – the requirement that the loan should not be secured on any specific assets or revenue in the UK. The problem had arisen only for the nationalised industries where it may be necessary to create an indirect security where the borrower is called upon to give a direct security in a subsequent loan .

However the Revenue view stated that if by such a provision a loan became subsequently secured on assets or income in the UK, then the source could no longer be regarded as foreign. This problem did not arise for the nationalised industries, as they borrow under Treasury guarantee. Therefore, two possibilities were either to abandon the idea of local authority foreign currency borrowing in the face of this tax difficulty or, alternatively to modify the loan established practice under which the local authorities charge their London market borrowing on their rate income. The first possibility was clearly unsatisfactory, due to the potential gain for the reserves, which would have been forgone. The second was considered impracticable. Therefore the tax position was the only consideration. There was a strong case in the longer term for removing the “loophole” through which income has a UK source in all but the legal sense can be paid gross to non-residents .

The policy was to encourage foreign currency borrowing, and to encourage UK borrowers to use the artificial foreign source route to the fullest extent possible. There was no objection on principle to any modifications on the proposed legislations in order to get the maximum benefit from it. A subsidiary point had arisen as a result, as whether it was necessary or desirable to confine the amendment to the local authorities. The tentative view was that there were advantages in generalising the change to apply for all UK borrowers. As it would have been impractical if the nationalised industries or private sector borrowers were called upon to introduce a charge on UK assets in their loan contracts, and because the tax change was confined to the local authorities, were inhibited from further foreign currency borrowing .

The possibility of local authorities borrowing in foreign currencies unsecured was governed by Section 197 of the Local Government Act 1933 (extended by Schedule 4 (43) of the London Government Act 1963) to include the Greater London Council and the London Boroughs) which required that all moneys borrowed by a local authority in England and Wales should be secured on all revenues of the authority, except any money borrowed by way of a temporary loan or overdraft without security. It seemed that there was no possibility of local authorities being able to borrow unsecured, except at the very shortest term, either in sterling or in foreign currencies. Also that local authorities could have had difficulty in meeting the requirements of the international capital markets for payment of interest gross. A clause was needed in the 1969 Finance Bill to get over the difficulty, giving wider facility to the tax difficulties which obstructs foreign borrowing. As the present tax arrangements had the effect that in order to be able to pay interest gross, borrowers had to arrange loans in contracts ruled by foreign law and with interest payable overseas. This gave rise that there needed to be some changes in the fiscal rules to allow straightforward borrowing in London to qualify for payment of interest gross .

(3). Tax arrangements on borrowing by UK companies from non-residents

Lever with the Inland Revenue and the Treasury reached a conclusion in January 1969, which involved three separate suggestions which were designed to facilitate borrowing by UK companies from non-residents. The conclusion was that there was no particular need for further relaxation and that the three particular suggestions could not be recommended .

Payment of interest gross

The first suggestion was that UK companies should be permitted to pay interest due to non-residents on overseas loans gross of UK tax, irrespective of the source of the interest or the residence of the paying agent.

The suggestion arises because (a) in respect of interest which has a UK source, tax is deductible unless the interest is bank deposit interest, short interest, interest payable on certain British Government securities and interest exempted under a double taxation agreement. (b) Subscribers to Euro-bond issues require payment of interest gross without formality and will not subscribe on other terms .

UK borrowers at the time met the requirement at (b) provided that they arrange their loan contracts so as to give the interest a foreign source; in essence this means that the relative loan contract must be established under foreign law and the interest is paid overseas. Such arrangements are not particularly difficult to set up and they involve no tax or other penalty on the borrowing company. The disadvantages are: first, that it would be slightly easier, and certainly more straightforward, if UK companies could set up their arrangements through London agents; secondly, that the need to use an overseas base may seem to be a little undignified particularly for an important UK company or a nationalised industry; and thirdly, that the modest professional fees and commissions associated with the handling of these arrangements go abroad instead of remaining in London .

None of these objections was particularly powerful, and there was no evidence that they inhibit borrowing possibilities at all. The small inconvenience and possible indignity of arranging a loan contract governed by foreign law, once the decision to borrow from foreign sources has been taken, does not appear to affect potential borrowers – one nationalised industry commented revealingly that it meant no more than a day in Luxembourg for the directors. The amounts involved in professional fees are trifling and there is no suggestion that foreigners involved in the loan arrangements could use them as a point of entry for wider operations.

Against these modest and in part merely presentational advantages, there were strong objections against changes in the principles and practice of taxation of the kind which would be involved in the payment of interest gross .

In general and in common with other countries the UK sought to tax all income arising within its borders, wherever the recipient of the income resides, and the law was constructed accordingly. The right to charge income having a UK source was of course given up in many double taxation agreements in relation to investment income, but this was always subject to reciprocity by the other country and on the understanding that the other country will in general tax the income concerned in full. In the case of interest the UK had gone further and surrendered unilaterally its right to tax short interest, bank deposit interest and certain interest on Government securities going abroad. There was the further special case of loans based on contracts governed by foreign law, where UK tax law may in principle provide for the deduction of tax, but the UK had to recognise that the lender may be able to sustain a refusal to accept less than the full amount of the interest, and the UK had adopted the somewhat artificial convention that the interest on a loan where the contract was governed by foreign law was regarded as deriving from a source outside the UK, provided that it was paid outside the UK and that the loan was not secured on specific assets in the UK. It was under this arrangement that UK borrowers issued Euro-bonds with payment of interest gross .

Despite these special exceptions, the UK considered that the principle of its right to tax income arising within its borders remained broadly intact, and that any further erosion of it, except on the clear basis of reciprocity, would be mistaken.

The potential dangers were considerable. Willingness to give up its right unilaterally would undoubtedly make it more difficult to secure reciprocal exemption in double taxation agreements. There were many cases in which a concession given unilaterally would involve loss of revenue without countervailing advantage, thus: some deduction of UK tax may be acceptable to the lender if he is resident in a country with which the UK has a double taxation agreement and in which he can credit his UK tax against his own country’s tax charge – the effect of a concession from the UK would be a benefit to the revenue authorities of the other country. Some of the UK’s agreements provide for interest to be taxed in the country in which it arises at some low fixed rate, usually 10% or 15% – here the tax the UK would give up would be completely lost, because claims to a partial repayment of the UK’s 41¼ % charge on interest have to be made through the other country’s revenue and it must be assumed therefore that the lenders concerned are not striving to remain anonymous from their own authorities; and coming closer to the field of Euro-bond issues, the UK tax deduction is regarded as acceptable in the case of other fixed interest borrowing and to refrain from taking UK tax in such circumstances would be an absurd self-denial .

In the particular case of Euro-bond issue, there would of course be no direct tax loss, given the UK’s assumption that potential borrowers are already able to adopt the method of a loan contract under foreign law which avoids UK tax liability in any case. But it is difficult to envisage an arrangement under which a concession could be confined to Euro-bond issues without encroaching on important fiscal principles elsewhere .

Finally, although the UK are content to adopt the artificial convention that the interest on loan contracts set up under foreign law derives from a source outside the UK, the whole discussion is addressed to Euro-bond issues whose proceeds are used for domestic investment in the UK, and a more realistic appreciation would recognise that the true source of the interest is within the UK. On economic grounds, therefore it was considered reasonable and right for the UK to demand its tax entitlement. At the time in the late 1960s, the UK were content to waive this in the interest of encouraging a source of foreign borrowing .

However, there were still those in the Treasury and the Inland Revenue who considered, that the UK’s arrangements of the time had gone too far, and that there would be a weighty case in the medium term, when the UK could afford to be less encouraging towards foreign currency borrowings, for reverting to a more rational and defensible arrangement under which all interest paid out of income generated in the UK is subject to UK tax, unless reciprocal tax agreements apply. Generally, there were dangers in making fundamental changes in the tax system – or indeed peripheral changes which bear upon fundamental principles of the system – as part of arrangements designed to meet a balance of payments and reserves situation which was expected to improve over the years ahead. So, it was concluded that the balance of argument was overwhelmingly against the suggested change .

Interest on loans in Sterling Area Currencies

The second suggestion, was that the concession in Section 22 of the 1968 Finance Act should be extended to enable companies in computing their profits to deduct interest in respect of loans denominated in any currency of the Outer Sterling Area as well as loans covered in the Section 22 concession denominated in foreign currency. The object was to facilitate borrowing in currencies of the Outer Sterling Area as well as foreign currencies, particularly prompted by the thought that Kuwaiti funds might well be a promising source of overseas borrowing .

There was no ground of tax principle for dispensing less generous tax treatment (for the purpose of computing profits) in respect of loans denominated in sterling area currencies. Also, that, there would be no difficulty in principle in allowing a payer of interest a deduction in computing his profits for interest paid on a sterling area currency loan made to enable him to earn these profits. The difficulty was the serious practical one that further liberalisation of the treatment of interest going abroad would much enhance the dangers of avoidance and evasion of tax. The avoidance danger was that profits earned in the UK would be drawn out of the country without suffering any Corporation tax, through the creation of artificial loan liabilities. Thus, a company can lend money to an overseas associate (on interest free terms) and the associate can lend the money back to another UK member of the group which then incurs a liability to pay interest abroad, and may thus be able to pay in interest gross of UK tax. If the associate is resident in a tax haven, part of the profits of the group have then effectively been taken out of the UK tax net. This could be achieved under the existing law of the 1960s, but the scope for such avoidance schemes was considerably restricted by the fact that the associate either had to be in a non-sterling country (when exchange control comes into operation), or a double taxation agreement had to be invoked to enable the interest to be paid gross – and there were provisions in double taxation agreements designed to prevent the misuse of the reliefs allowed under them . Extension of the Section 22 concession to loans denominated in sterling would make it practicable for UK borrowers to pay interest gross to a sterling area country (for example a West Indian tax haven) without deduction of tax, and such avoidance schemes would be much more difficult to counter. Anti-avoidance provisions similar to those appearing in out double taxation agreements could be included in the necessary legislation, but these might well be ineffective since it would be difficult for Inspectors to link up a chain of associated lending operations designed to take advantage of the concession. It was then suggested that, the UK should not then be able to consult the other country’s Revenue to confirm that the relief was not being abused .

The scope for evasion of tax on interest received by individuals resident in this country would also be extended if UK borrowers were able to claim a deduction in computing their profits for interest paid on sterling area currency loans and it thus became practicable to pay interest gross to sterling area countries. Interest from an overseas source paid through a UK paying agent or collected by a UK collecting agent was subject to UK’s “foreign dividends” machinery; interest on British Government securities payable gross to persons not ordinarily resident in the UK was policed in a similar way. This machinery ensured that where dividends or interest are paid direct to a UK resident, tax was deducted and accounted for to the Revenue by the paying or collecting agent. To evade tax on such income, therefore, a UK resident had either to make it appear that the income was payable to a non-resident or that he had to keep it entirely outside the paying and collecting agent machinery – either by retaining the income abroad or by having it remitted to this country in a form which does not bring it within the taxing machinery. If the income was left abroad, the UK were not likely to find out about it (unless the UK learn of it indirectly, e.g. in the course of a back duty investigation) . Often however, the individual would want to use the income in the UK and this was difficult to arrange without coming within the taxing machinery, particularly if the income was in a non-sterling currency.

While therefore evasion of tax on interest payable abroad was possible under existing arrangements the scope for it was restricted. Furthermore, many individuals prefered to buy bonds of UK companies rather than of foreign companies. To extend the Section 22 concession in the manner proposed would have enabled UK borrowers to pay interest gross on sterling area currency loans under overseas loan contracts, and this would substantially increase the field in which evasion could take place. Admittedly, UK residents were already able to buy Euro-dollar bonds issued by UK companies, but for this purpose they must either pay the investment currency premium (which would make the investment unattractive) or evade the exchange control. Bonds issued in sterling currencies by UK companies would be more attractive to UK residents and it would be more difficult to counter evasion of tax on interest on such bonds .

Against these severe practical difficulties, the UK had to counter the possible benefits to the balance of payments and reserves of overseas borrowing in sterling area currencies. If the proposed additional facility did not increase the total amount of overseas borrowing, but merely replaced some foreign currency borrowing by some borrowing in sterling area currencies, this would be unwelcome. To the extent that the UK obtaining sterling area currency prevented the sterling area country concerned from an equivalent diversification of its reserves into foreign currency. The UK’s borrowing in this form would be as good as foreign currency borrowing. But the more likely situation would be that the sterling lending to the UK would be only partly an alternative to diversification and would mainly be offset by a reduction in sterling holdings .

There was however the question of the extent to which the additional facility would open the way to increased overseas borrowing. This was not easy to judge. There was no shortage of available funds for foreign currency borrowing, but an important element in the reluctance of potential UK borrowers to commit themselves was the exchange risk associated with foreign currency borrowing, particularly where the proceeds were to be used for domestic investment. It was thought that the deterrent effect of this risk would be smaller in the case of sterling area currency borrowing, but even this judgement was doubtful. The fact was that experience of the reaction of other countries to UK’s devaluation in November 1967 had demonstrated the probability that, on any future similar occasion, the stronger sterling area currencies would not move with UK sterling . Adding to this, the fact that the sterling area currencies which were most likely to be available for overseas borrowing are those of the countries in relatively strong balance of payments and reserves positions, such as Kuwait, it becomes rather doubtful whereas UK borrowers will in general see the additional facility of sterling area currency borrowing as being so attractive as to increase their overall willingness to borrow.

On balance, it seemed likely that the additional facility of borrowing in sterling area currencies would induce some switching by UK borrowers from foreign currency to sterling area currency which would be disadvantageous, and might be offset to some extent by willingness to borrow on a rather larger scale in this form. There certainly seemed to be no ground for thinking that the additional facility would create a substantially greater level of overseas borrowing, and it was concluded that it was not worth embarking on this against the background of substantial difficulties in tax evasion which would unavoidably be associated with it .

Loans for Non-Trade Activities

The third suggestion was a further extension of Section 22 concession to allow deduction for Corporation Tax purposes for interest paid on loans in support of other and general purposes, as well as the purpose of the borrowers’ trade already covered by Section 22.

Even if there were an argument on balance of payments grounds for making some further relaxation in the treatment of interest, there was no reason why the right to pay interest to non-residents gross should be extended beyond the field of borrowing for trade purposes. Overseas borrowing of money which will be used in a UK business, and thus tend to strengthen the whole UK economy, was one thing. Borrowing abroad and thereby placing a continuing burden on the current balance of payments for the purpose of, say, buying a villa at Cannes, was quite another. Restriction of the concession to loans for trade purposes meant that the concession was available for direct investment, but not portfolio, but it was far from clear that the UK wanted to encourage domestic portfolio investment by UK borrowers using foreign currency finance. The UK certainly did not want to encourage such borrowing to finance or facilitate the payment of import deposits, and indeed in general it seems untimely of such thinking of unrestricted access to foreign borrowing which might in many directions have interfered with attempts to control domestic credit .

D. Conclusion

The general conclusion was therefore negative on all three suggestions, which was open to strong objections of fiscal principle or practice and did not offer commensurate advantages. Levels of overseas borrowing by UK companies for domestic purposes had hitherto been modest. The joint judgement of Lever, the Inland Revenue and the Treasury was that tax differences have played little or no part, and that the most important influences had been fears of exchange risks on the one hand and relatively easy access to funds on the domestic market on the other. Therefore it was considered that there was no mechanical or technical changes which could usefully lead UK companies in the direction of greater borrowing abroad.

In response towards this, Lever recommended the following inclusion in the 1969 Finance Bill of a clause which would authorise the Treasury to direct, in respect of any specified loan raised by a local authority in the currency of a country outside the Scheduled Territories: firstly, that the interest should be payable without deduction of tax at source. Secondly, that it should be exempt from UK tax so long as the stock or bonds in question are held by a non-resident. Thirdly, that the Capital should not be subject to any present or future UK tax on capital where the beneficial owner was neither domiciled nor ordinarily resident in the UK .

The purpose of this clause was that it was in the “public interest” for nationalised industries and large authorities to borrow on the Euro-dollar market . The Chancellor of the Exchequer in his Budget Speech clarified this point and further explained that the proposed Finance Bill clause was designed to facilitate foreign currency borrowing by local authorities :

“A point which has been urged upon me from time-to-time is that some of our public authorities should be enabled to take advantage of funds available in the international capital markets for long-term borrowing, and in doing so bring support to our reserves. The House is aware that a number of nationalised industries are being encouraged in this direction, with the assistance of special arrangements which have been devised to relieve them of exchange uncertainties, and indeed the Gas Council has completed arrangements, and in part funds, from total borrowings of over £30m recently. I am anxious that this facility should be available to local authorities also, and I propose to include in the Finance Bill a clause which will remove a minor tax obstacle which at the moment prevents this”.


* Here are two very similar definitions of the term Euro-dollars:

Robert Gilpin, (The Political Economy of International Relations, Princetown University Press, 1987, p. 314-315), states that: The Euro-dollar market received its name from American dollars on deposit in European (especially in London) banks yet remaining outside the domestic monetary system, and the stringent control of national monetary authorities.

Enzig and Quinn (The Euro-dollar System: practice and theory of international interest rates, MacMillan Press, 6th edition, 1977, p. 1) state that: the Euro-dollar system is a term used to describe the market in dollar deposits and credits which exists outside the United States of America.

This paper is based on the following PRO files:

T 295/628: Tax Measures To Encourage Eurodollar Borrowing: (A) Payment Of Interest Gross On UK Bearer Bonds; (B) Allowance Of Annual Interest As A Deduction From Corporation Tax. (5/06/1968 – 8/01/69). File Number: 2FEC 123/76/01 “PART B”

T 295/560: Tax Measures To Encourage Eurodollar Borrowing: (A) Payment Of Interest Gross On UK Bearer Bonds;(B) Allowance Of Annual Interest As A Deduction From Corporation Tax. (10/01/69 – 30/04/69). File Number: 2FEC 123/76/01 “PART C”

T 295/628: Confidential letter on Euro-dollar borrowing for home investment, from Mr. D.A. Walker to Mr. Littler of the Treasury, on 5th June 1968.

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