Sir David Varney

Varney Review of Tax Policy in Northern Ireland

Room 2/29 HM Treasury

1 Horseguard's Road

LONDON

SW 1A 2HQ

29 June 2007

Dear Sir David

Institute of Chartered Accountants in Ireland Statement on Northern Ireland Corporation Tax Policy

I refer to our meeting of 18 June 2007 at Government Buildings in Dublin where my colleagues and I met with you to outline the position of the Institute of Chartered Accountants in Ireland in relation to your current review of tax policy in Northern Ireland.

The Institute of Chartered Accountants in Ireland (ICAI) is the largest and longest established accountancy body in the island of Ireland. It has over 15,000 members, and it is the leading voice of the accountancy profession in Ireland. The Institute was established by Royal Charter in 1888. Its activities and those of its members are governed by its Bye-Laws and by Rules relating to professional and ethical conduct.

The position of the Institute of Chartered Accountants in Ireland is that it fully supports the introduction of a reduced corporation tax rate in Northern Ireland to a level of 12.5%, being the same as the rate applicable in Ireland. Without any prejudice, for the sake of avoiding ambiguity in this letter, we will refer to the respective territories as Northern Ireland and the Republic of Ireland.

We presented you with our views on three key areas, namely:

• An analysis of why a reduced corporation tax rate in Northern Ireland is vital to Northern Ireland's future economic growth.
• An analysis and rebuttal of the technical arguments which have been presented over the years as a rationale for not providing Northern Ireland with a separate corporation tax rate.
• The experience of a low corporate tax rate in the Republic of Ireland.

Dealing with each of these issues in turn.

1. An analysis of why a reduced corporation tax rate in Northern Ireland is vital to Northern Ireland's future economic growth.

Northern Ireland is unique relative to the other regions of the United Kingdom in that it shares a land border with the Republic of Ireland and its economic prosperity in the global economy is closely linked to its interaction with the Republic of Ireland through the evolution of an island economy. Northern Ireland can benefit from its position of being both a political and economic region of the UK and an integral part of the island economy. The British and Irish Governments recognise this unique inter-dependent economic relationship and have recently committed to collaborate in spatial planning on the island of Ireland, to the mutual benefit of North and South.

ICAI has already noted and welcomed the “Comprehensive Study on the All Island Economy” published by the Secretary of State for Northern Ireland, Rt. Hon. Peter Hain MP and the Irish Minister for Foreign Affairs Dermot Ahern TD, on 27 October 2006. This very important Study sets out a vision of “a strong, competitive and socially inclusive island economy with strong island wide economic clusters, whose development is not impaired by the existence of a political border”.

In the recent past, as a result of political instability there was a brake on the fullest realisation of economic potential in Northern Ireland. This brake has now been removed and the new reality in Northern Ireland is that all the people for the first time can rally around and be loyal to a common focus, a Power Sharing executive that hopefully will deliver a new and better future that all can identify with and feel part of. This new common loyalty is capable both of completely transforming the political and economic landscape of Northern Ireland, and providing a best practice model worldwide for conflict resolution.

Currently there is much international goodwill towards Northern Ireland, particularly in the United States, the European Union and the Republic of Ireland. The Republic of Ireland is at present the fourth largest investor in the UK economy. This goodwill can be transformed into Foreign Direct Investment if we can transfer the economy from one heavily dependent on the public sector to one driven by investment and entrepreneurship – an economy characterised by self sufficiency rather than subsidy. However the goodwill will not last forever; we have perhaps an 18 month window of opportunity to capitalise on it.

While in the recent past, the Northern Ireland and the Republic of Ireland economies have had many similarities, a fundamental difference has been the lower corporation tax rate for trading companies in the Republic of Ireland of 12.5%. It is recognised that the low corporation tax rate has been one of the central reasons that the Republic of Ireland has been very successful in attracting Foreign Direct Investment (FDI) to the island and achieving a significant improvement in economic performance relative to its island neighbour. This is illustrated below:

GDP Per Capita as a Percentage of EU15 Average
	1972%	2004%
Northern Ireland	72	84
Republic of Ireland	68	123

We acknowledge that Northern Ireland has achieved GDP growth levels at 2 to 3% above GB in recent years and that employment is at a record high. However this growth in GDP has been driven mainly by public sector spending growth at approximately 5% per annum, which represents approximately 61% of Northern Ireland GDP (compared to 35% in the Republic of Ireland). The Northern Ireland public sector employs one in three of all workers and 60% of all females in employment. Furthermore over 530,000 people (41% of NI working age population) are not economically active (compared to 12% in the Republic of Ireland).

We believe that the regional economic strategy outlined recently by Minister Hanson would only close the wage gap of 75% of the Great Britain private sector and Gross Value Added (80% of Great Britain average) by 0.5%. This would not provide the necessary catalyst to reduce the annual subvention from Great Britain of £6.8bn.

The extent of underdevelopment in the private sector in Northern Ireland is characterised by:

• 89% of local firms employing fewer than 10 people.
• Only 65 companies employing more than 500 workers.
• 10 companies accounting for 50% of all NI exports.
• Northern Ireland having the second-lowest level of business formation of the 12 UK regions.
• Northern Ireland has the second lowest level of business growth in the UK.

We believe that to complement investment in infrastructure and skills in addressing this underdevelopment, it will be necessary to offer a corporation tax rate similar to the Republic of Ireland. This corporation tax rate is essential to successfully attract sufficient FDI onto the island of Ireland. At the same time it will provide the necessary government intervention to encourage private sector investment in order to create wealth, and ultimately fund services within Northern Ireland so that UK central budget deficit funding can be reduced.

2. An analysis and rebuttal of the technical arguments which have been presented over the years as a rationale for not providing Northern Ireland with a separate corporation tax rate.

Over the years, various arguments have been presented why a reduced rate of corporation tax in Northern Ireland would not be a feasible proposition. We took the opportunity at our meeting to rebut the arguments and would now summarise these as follows:

a) A Northern Ireland corporation tax rate of 12.5% would encourage tax avoidance through artificial fiscal migration of profits

The aim of a low corporation tax rate in Northern Ireland is to encourage economic inward investment into Northern Ireland from large multinationals who would benefit from a low corporation tax rate as a result of basing genuine economic activity in the Province.

Whilst it is recognised that there would be a fiscal incentive for existing businesses located in the United Kingdom to migrate some or all of their operations to Northern Ireland, we believe that such migration of economic activity is unlikely to occur on a significant scale and therefore, the real concern would be for a fiscal migration without an underlying migration of economic activity.

We would point out that the existing transfer pricing legislation contained within the Income Tax and Corporation Taxes Act 1988 (ICTA 1988) already contains transfer pricing legislation (based on the OECD principle of arms length transfer pricing) which deals with transactions between corporates located in the United Kingdom. We believe that these rules in themselves should be sufficient to discourage purely fiscal migration of profits to Northern Ireland in respect of large UK based corporate groups who may consider such migration as an attractive tax mitigation strategy.

Transfer pricing has always been an issue for the Republic of Ireland vis a vis the countries of origin of Foreign Direct Investment. Nevertheless, there has not been one arbitration case on intercompany pricing dealt with under the EU Arbitration Convention. This provides that where two Revenue authorities disagree on the resolution of a transfer pricing issue, then each appoints experts to get together to resolve the matter.

b) Low corporate tax rates encourage tax avoidance through individuals incorporating their businesses for purely fiscal reasons

We acknowledge the concern that the tax base in Northern Ireland could be eroded as a result of incorporation of business entities for purely fiscal reasons.

We would point out that such incorporation has not proven to be the experience in the Republic of Ireland since the introduction of a low corporation tax rate. The rationale for the lack of incorporations is outlined later in this letter but once again we believe that any potential exposure to loss of revenue from “fiscal only” incorporation can be addressed by an appropriate amendment to the taxes legislation dealing with corporate entities.

In short, we believe that the introduction of a low corporation tax rate will not cause an erosion of the tax base as a result of entities incorporating for purely fiscal purposes.

c) The EU Treaty may preclude the introduction by the United Kingdom of a distinct rate of tax in Northern Ireland

The European Court decision of the Portuguese Republic v The Commission of The European Communities – the “Azores Case”^(a) has received considerable attention. Whilst it is outside the scope of this submission to make a detailed comment on the case, we would refer to the following points:

1. In the case, the ECJ confirmed that it is possible for more than one corporation tax rate to be applicable within the territories of a member state without such a regime necessarily constituting a state aid or being in violation of the EU treaties. In particular, in paragraphs 56 and 57, and in paragraphs 63/64/65 and 68, the court described circumstances in which regional differences in corporation tax rates within a member state would be in compliance with EU law. These paragraphs are set out in the attached appendix.

It can be seen from the extracts quoted that there are two situations where a Northern Ireland corporation tax rate could be distinct from such a rate or rates elsewhere in the UK without conflict with EU law.

Firstly it could be achieved by having several regional corporation rates within the UK rather than one national rate from which the Northern Ireland rate would be a derogation. Such an arrangement would require a wider redistribution of fiscal powers within the UK than would be involved in a simple enactment by either the central parliament in Westminster or on a devolved basis by the regional assembly at Stormont of a corporation tax rate applicable to corporate income in Northern Ireland. Such devolution of power would not appear to present technical difficulties in terms of EU law, nor, as is discussed elsewhere in this letter any insurmountable technical difficulties in terms of prevention of tax avoidance within the UK. The decision as to whether such an approach presents difficulties would seem to rest more on UK political considerations than on technical or legal considerations. Political considerations are outside the remit of this letter, however we do appreciate that there would be an element of reshaping the entire UK tax system to facilitate a reduction in tax rates purely for Northern Ireland.

Secondly, a corporation tax rate applicable in Northern Ireland which differs from that applicable in the rest of the UK would be compliant with EU law if the Northern Ireland Assembly adopted such a rate on foot of lawful powers to do so, and accepted the political and financial consequences of that decision. To achieve this it would be necessary that the Northern Ireland Assembly should be given competence over the corporation tax rate applicable in the province and that the financial consequences of such a cut in the rate of corporation tax should be borne by the Assembly and should not be compensated for by an increased subsidy from central funds of the UK. We believe that this second situation is entirely feasible.

It will require investigation and clarification with the EU Commission as to whether the second situation outlined above would only be met if the tax receipts from corporation tax arising in Northern Ireland were to accrue directly to the Assembly. An alternative, which would probably be more acceptable in both Westminster and Stormont, and at the same time meet the EU Commission requirements would be that any shortfall in tax receipts arising from the corporation tax rate cut in Northern Ireland were directly reflected in a cut in the funds made available to the Northern Ireland Assembly from central UK funds. In the later case it is recognised that a reduction in the corporation tax rate would need to be matched by a reduction in the Northern Ireland ‘Block’ subsidy.

2. The UK Government supported the Portuguese case against the Commission and highlighted the issue of autonomous self elected regional governments which voted for a reduced tax rate in cases where the financial consequences of the decision were borne by the region, without a linked and countervailing subsidy from other regions or from the centre. It is also relevant to point out that the Commission, in its statement in response to the United Kingdom's intervention, denied that its approach might hinder the exercise by Northern Ireland of the powers conferred on them in tax matters.
3. The Commission and The Court did accept that a regional tax rate could qualify for a derogation from Article 87 of the Treaty if as a result of size and geographical position that the possibilities of a territory achieving economies of scale were substantially limited for firms resident there, which were subject to significant additional costs as regards production and access to markets.^(b) As Northern Ireland has both high energy and transport costs in comparison to the rest of the UK, we believe that this derogation would be available to enable a reduction in the rate of corporation tax.
4. The introduction of a separate corporation tax rate for Northern Ireland can also be achieved by means of derogation from Article 87 of the EU Treaty, which precludes certain forms of state aid by EU member states. Article 87 operates on a highly regulated and institutionalised way which has evolved by virtue of the powers prompted by the commission in Article 88. We would argue that Article 87 provides sufficient flexibility to allow a distinct corporation tax rate to operate within Northern Ireland without the United Kingdom being in contravention of the EU Treaty. We believe that the Commission would look favourably upon such a derogation as a result of the recent restoration of devolved assembly in Northern Ireland and that this can be seen as a means of copper fastening such devolution and generating economic prosperity to a region which has historically lagged behind the rest of the United Kingdom both in terms of economic prosperity and levels of private sector emloyment.
   ICAI acknowledges that the European Commission has already recognised the uniqueness of Northern Ireland as a region within the UK and its interdependent relationship with the Republic of Ireland. For example, in 1972 Northern Ireland was allowed to have Category 1 status within the European Union, even though its GDP was 72% compared to the qualifying baseline of 70% of the EU 15 average. Furthermore over the last number of years, the European Union has injected special European Peace Funds into Northern Ireland and the six border counties of the Republic of Ireland.

d) The introduction of a separate corporation tax rate in Northern Ireland will result in a net loss of revenue to the Treasury

It has been the experience in the Republic of Ireland, and can be reasonably foreseen as a likely consequence of a reduction in the corporation tax rate in Northern Ireland, that a resulting increase in economic activity arising from a low rate of corporation tax is reflected not only in a long term increase in corporation tax receipts but also in significant increases in Income Tax (PAYE), National Insurance, Local Authority rates and Value Added Tax as well in other less significant levies and taxes.

Where the consequences of a reduction in the CT rate in Northern Ireland had to be reflected in the pattern of expenditure by the Assembly or in the pattern or rates of other taxes in the province in the short term in particular, it would be both necessary and appropriate to consider to what extent any increases in the proceeds from these other taxes, or indeed all of the receipts from these taxes within the province should be made available to the Assembly to finance its expenditure, with a reduction in the transfer from central funds of the UK correspondingly. If the consequences of a CT rate reduction is to be borne by the Assembly, it may be necessary to link the central funding to the Assembly in a wider context than CT alone.

However, it should be possible to take a more narrow view of matters, if that is considered essential for UK political reasons, so as to ensure that the consequences of a cut in the CT rate is reflected in Assembly controlled expenditure in the province. In the short term such a cut in rate is likely to result in a reduction in receipts from CT, notwithstanding that in the longer term it should lead to an increase in CT receipts. Were the approach taken of having a CT rate in Northern Ireland which was lower than the national UK rate (which as pointed out above is only one possible approach to achieving an EU compliant local CT rate in Northern Ireland), it would be desirable to analyse the short term options available to the Assembly in terms of impact on expenditure or on alternative sources of local finance.

3. The experience of a low corporate tax rate in the Republic of Ireland.

The experience in the Republic of Ireland over the last 10 years has clearly demonstrated that progressive tax policies contribute to economic success. The reduced rate of Corporation Tax is one component of a succession of tax policies which have operated in the Republic.

• Rates of VAT have remained high in comparison to European norms, to an extent which has seen the total VAT take in the Republic exceed the total income tax take.
• The income tax base both for corporates and individuals has been broadened. For example, accelerated tax depreciation is a thing of the past, reliefs for pension contributions are subject to limits derived from the capital value of the pension fund.
• Ceilings have been removed from the employer's contribution to national insurance
• Capital Taxes rates now equate to the standard rate of income tax

Another factor which is most commonly overlooked is that rates of corporate tax on passive income stand at 25%. Therefore the composite rate applying to companies is, on national figures, in the order of 16%.

All these matters are interlinked. When the Capital Gains Tax rate dropped from 40% to 20% the amount of tax raised immediately doubled. The Republic of Ireland now has both an effective venture capital industry and a thriving financial services industry. The introduction of the 12.5% rate of Corporation Tax hugely benefited these sectors.

a) Close Companies

We have already identified for you that incorporation is not used as a vehicle for tax avoidance, owing to the close company regime operating in the Republic of Ireland. The surcharge on undistributed investment income together with the surcharge on professional services income mean that the effective tax rate on small family companies wishing to shelter income from the higher personal tax rates is an effective 40% for investment company income. This compares to our 41% individual tax rate. Of course individuals also have PRSI to pay, currently 5% up to income of €100,000 and 5.5% on incomes over this level. The equivalent tax rate for service companies is 25.62%.

However individuals need to take salary and dividends from their companies, which also attract income taxes at the marginal rates.

b) Tax Treaties

A reduction in Corporation Tax rates does not necessitate the re-negotiation of tax treaties. Tax treaties do not mention actual tax rates. Ireland's treaty network has worked very successfully despite the operation of a number of different corporation tax rates at different times for different sectors.

Conclusion

We understand that you are carrying out a broad based consultation with the relevant stakeholders in the Northern Ireland economy. We are aware that you have already been provided with both qualitative and quantative analysis including the report prepared by the Economic Research Institute of Northern Ireland entitled “Assessing the Case for a Differential Rate of Corporation Tax in Northern Ireland”. To this extent, we do not propose to provide any additional economic data in respect of this submission.

We do however urge you to recommend that Northern Ireland be granted a differential corporation tax rate from the rest of the United Kingdom. We would recommend that this corporation tax rate be equivalent to that applicable in the Republic of Ireland, being 12.5% for economic profits derived from economic trading activities. (For the avoidance of doubt, we would accept that the existing corporation tax rate should continue for profits and income derived from non trading and investment activities).

We are of the opinion that there are no technical or legal grounds why such a corporation tax cannot be applied to Northern Ireland and if such reasons exist, we are firmly of the opinion that amendments to the Taxes Act would be sufficient to overcome any concerns of inappropriate loss of tax revenue.

Northern Ireland would not only benefit from a low corporation tax rate but absolutely requires it in order to enable it to grow and prosper under the terms of the devolved powers that now exist in the Northern Ireland Assembly.

We look forward to the publication of your report in the Autumn.

Yours sincerely

Eamonn Donaghy FCA

Chairman, ICAI Northern Ireland Tax Committee

Appendix 1

Paragraph 2(c) – Extract from European Court of Justice decision in the case of The Portuguese Republic v The Commission of The European Communities (C-88/03)

56 It is clear from the foregoing that in order to determine whether the measure at issue is selective it is appropriate to examine whether, within the context of a particular legal system, that measure constitutes an advantage for certain undertakings in comparison with others which are in a comparable legal and factual situation. The determination of the reference framework has a particular importance in the case of tax measures, since the very existence of an advantage may be established only when compared with ‘normal’ taxation. The ‘normal’ tax rate is the rate in force in the geographical area constituting the reference framework.

57 In that connection, the reference framework need not necessarily be defined within the limits of the Member State concerned, so that a measure conferring an advantage in only one part of the national territory is not selective on that ground alone for the purposes of Article 87(1) EC. […]

63 In paragraph 50 et seq of his Opinion, the Advocate General specifically identified three situations in which the issue of the classification as State aid of a measure seeking to establish, in a limited geographical area, tax rates lower than the rates in force nationally may arise.

64 In the first situation, the central government unilaterally decides that the applicable national tax rate should be reduced within a defined geographic area. The second situation corresponds to a model for distribution of tax competences in which all the local authorities at the same level (regions, districts or others) have the autonomous power to decide, within the limit of the powers conferred on them, the tax rate applicable in the territory within their competence. The Commission has recognised, as have the Portuguese and United Kingdom Governments, that a measure taken by a local authority in the second situation is not selective because it is impossible to determine a normal tax rate capable of constituting the reference framework.

65 In the third situation described, a regional or local authority adopts, in the exercise of sufficiently autonomous powers in relation to the central power, a tax rate lower than the national rate and which is applicable only to undertakings present in the territory within its competence. […]

68 It follows that political and fiscal independence of central government which is sufficient as regards the application of Community rules on State aid presupposes, as the United Kingdom Government submitted, that the infra-State body not only has powers in the territory within its competence to adopt measures reducing the tax rate, regardless of any considerations related to the conduct of the central State, but that in addition it assumes the political and financial consequences of such a measure.