Caught in the ACT rap

Reuters may not only have been too clever for its own good, but for everybody else’s as well. The cash-rich media giant’s plans to return more than u600m of excess funds via a special share issue to its investors were spoiled last week by Chancellor Kenneth Clarke’s announcement that such schemes would be disallowed under the forthcoming Finance Act.

Almost u125m of advance corporation tax (ACT) credits might have wound up in the hands of non-taxpayers since gross funds – pension funds, charities and personal equity plan (PEP) managers – would have bought the special shares from tax-paying investors, then claimed back the ACT.

The Chancellor also took some of the icing off oil company SHV’s special dividend offer to sweeten its bid terms in its attempt to buy out the rest of gas company Calor.

Opinion remains divided as to whether the Treasury over-reacted. But the Chancellor does face criticism for creating uncertainty about the future of the imputation system for dividends, and speculation mounts that further tax credit restrictions will be introduced in the next Budget.

Roger Muray, a partner in Ernst & Young’s capital markets group, said the Revenue’s crackdown was ‘overkill’ and ‘a major impediment to over-capitalised companies returning cash to their shareholders’.

However, KPMG’s head of tax, Ian Barlow, disagreed. ‘We weren’t surprised,’ he said. ‘Special dividends associated with takeover bids were a taxpayer subsidy. This use of the imputation system wasn’t something the Government planned for.’

The National Association of Pension Funds said the move ‘won’t have a big effect on pension funds or PEP income’, even though Inland Revenue figures suggest that the Treasury expects to save u400m in 1998-99.

In fact, John Rogers, a director of NAPF Investment Services, was positively sanguine about the announcement. He also took the KPMG line. ‘Pension funds enjoyed the income from special dividends and share buy-backs while it was available,’ he said. ‘But we’re not surprised that the Chancellor looked at it. It was an unexpected windfall. Those unexpected windfalls are going to be few and far between now.’

But one unexpected effect of the Reuters-inspired clampdown may be that the Treasury will now take a broader and deeper look at ACT. ‘It may have been the proverbial straw that broke the camel’s back,’ one City economist said.

ACT generates almost #11bn in revenue for the Treasury. But it is unique in that, because it is merely a pre-payment of corporation tax, cutting the ACT rate has the effect of increasing government revenues, since it reduces the pool of Treasury funds which can be reclaimed by non-taxpayers.

The NAPF is concerned, for example, that the ACT rate may be reduced again, having been cut from 25% to 20% in the 1993 Finance Act. That move cost gross funds #1bn in lost dividend tax credits, according to Treasury estimates. (The NAPF’s recent Green Budget called for the ACT rate to be increased to 24%, the same as the basic rate of income tax, although this proposal was derided by many tax experts.)

The Institute for Fiscal Studies’ Green Budget warned: ‘A future government short of revenue might find that a tempting solution is to reduce the rate of ACT.’

Maurice Fitzpatrick, head of economics at Chantrey Vellacott, estimated that a cut in the rate of ACT to 15% could raise as much as u1.4bn – enough to finance a 1p cut in the basic rate of income tax. ‘ACT appears to be a victimless tax,’ he said. ‘And nothing appeals more to a politician than a victimless tax.’ He pointed out that there was virtually no political backlash the last time the ACT rate was cut.

KPMG’s Barlow added: ‘Kenneth Clarke is not particularly purist in his approach when it comes to tax. Whereas Lawson was a great intellectual, this Chancellor is a bit more pragmatic. If he’s a bit short of tax revenue, he doesn’t care where he gets it.’

But sums of this magnitude would hit pension funds hard. Rogers said it would ‘probably force companies to put more funding into their pensions at the expense of their own competitiveness and capital investment’. Otherwise, pension benefits will be affected as the lost revenue has a compounded effect over decades to come.

The IFS believes a reduction in the rate of ACT would also hit higher rate taxpayers, because their dividends are taxed at 40%. If the rate of ACT is cut to 15%, they will have to pay an extra 25% tax on their investment income, rather than 20% as they do now.

The Institute for Fiscal Studies added that the imputation system is also under attack from overseas. German chemicals giant Hoechst, for example, is taking court action against the UK Government because it is not allowed to reclaim the ACT on the dividends paid to it by its UK subsidiaries.

But UK companies are allowed to pay dividends to UK parents without any ACT payment. Hoechst argues that this is unlawful discrimination under European law.

One rarely mooted possibility is that the ACT reclaim system will be scrapped. This, according to analysts at investment bank UBS, would save the Government up to #5bn a year. But it would create a massive funding problem for pension schemes at a time when the Government’s social security reforms are effectively privatising pension provision. ‘That would be an invidious step,’ E&Y’s Muray warned.

In any event, City uncertainty is likely to make the markets nervous until the Chancellor comes clean as to whether he intends to erode the imputation system any further.

TAXING TIMES FOR REUTERS

Price Waterhouse and Robson Rhodes were involved in advising Reuters on its special dividend share issue, as were barristers John Gardiner QC and Richard Bramwell QC. SBC Warburg also advised, together with a US law firm.

Despite this wealth of tax advice, it was expected that the Inland Revenue would invoke anti-avoidance provisions which would make it difficult for tax credits to ‘stream’ into pension funds and charities. They would have to prove that they bought the shares for investment reasons, not for the tax credits.

But a company spokeswoman explained that two other options were ruled out by UK and US tax authorities:

– An off-market share buy-back was successfully used by Reuters three years ago when shareholders were invited to tender their stock to the company. But the Inland Revenue refused to give tax clearance for a second attempt, ruling that part of the purchase price would be classified as a capital repayment, with no tax credit.

– An on-market share buy-back would have been acceptable to the Revenue, but the US Internal Revenue Service has more onerous restrictions on such open market purchases. And with 25% of its shares in US hands, Reuters wanted to treat all its shareholders equally.

Reuters could simply have paid very large ordinary dividends over the next three years – ‘plain vanilla’ dividends, as UBS put it. The Chancellor’s statement still allows them. Reuters claims, though, that it wanted to give its shareholders the opportunity to cash in on the promised three-year dividend stream immediately, and so bundled it up into a special share issue.

The company is now waiting to see what the Finance Bill contains before making any further decision. For now, a series of back-to-basics cash dividends looks the most likely outcome.