Finance Bill

Public Bill Committee, 21 May 2002.

Standing Committee F

(Except clauses 4, 19, 23, 26 to 29, 87 to 92, 131 and 134 and schedules 1, 5 and 38) - Clause 40 - Treatment of deductions from payments to sub-contractors

Howard Flight (Conservative, Arundel and South Downs)

We and the industry broadly welcome this clause, which provides a cash flow advantage and in part resolves some long-standing problems, but I want to raise two issues, one of which appears as a starred amendment.

First, in parallel territory in the context of IR35, a similar problem was dealt with by ESCC32 for the tax year 2000–01 and its application to subsequent years was to be reviewed. I should be grateful if the Government would confirm that the measure will apply to 2001–02.

Secondly, clause 40 does not provide for tax deducted from payments under the construction industry scheme to reduce PAYE liability to account for tax on payments under that scheme made by an unincorporated taxpayer. Would it not be appropriate to put incorporated and unincorporated organisations on the same basis under the regime?

Although the provision is welcome, the construction industry scheme remains a problem because the Inland Revenue does not always enforce or police it effectively. There are minor improvements in the Bill, but there is a long way to go. Non-compliance and slack administration have the effect that some businesses may be hit hard while others are not noted. Are the Government considering resources to enable the scheme to be more efficient and policed more effectively? If not, is it worth continuing with it?

Dawn Primarolo (Labour, Bristol South)

Good morning, Mr. Benton.

I shall deal first with the general comments of the hon. Member for Arundel and South Downs (Mr. Flight) about the construction industry scheme. The clause applies only to that scheme. The Government are between the devil and the deep blue sea. The hon. Gentleman's right hon. Friend the Member for Fylde (Mr. Jack)—I think I can call him my right hon. Friend as well—was in the same difficult position as me. People argued that they wanted the scheme to be more tightly drawn and administered. However, when the compliance regime and its enforcement appeared to restrict activity in which they might want to engage, they came back with the argument that it is controlled

too tightly and is unfair on the industry, which undermines operations.

In response to demands from industry, the previous Government consulted, and it was agreed that the construction scheme would be put in place. Once it was put in place, people started to complain about it—what a surprise. They did not notice that that was going to happen, or they had not appreciated that it was going to happen. In the middle, the Inland Revenue struggles to ensure that it collects the proper amount of tax from the taxpayer.

My approach now, working with the industry and the trade unions, is to review. With representatives of all the organisations that participate in the construction industry, we have undertaken a fundamental reassessment of whether the current scheme, which has to be amended each year, is based on sound principles. One of the big issues that has come up has been whether we could move to electronic issue of the certificates. Industry and the Government are quite keen to achieve that. We are looking closely at how we are taking forward the scheme with the construction industry. I do not want to rush in and change the scheme, so I am taking the approach of stabilising it and making adjustments where it is sensible to do so. However, behind that, with the industry, trade bodies and the trade unions, I am considering the whole operation of the scheme very carefully.

The issuing of a certificate does not mean that a person is self-employed; it simply reflects how they should pay tax and whether a deduction should be made. I am more than happy, as we move to more detailed consultation, to ensure that the hon. Member for Arundel and South Downs is kept informed of that and is able to participate in it. The problem with the construction industry is that ''one size fits all'' does not work. It is a complex industry and we need to fine tune. I hope that that is helpful to the hon. Gentleman in showing the Government's thinking on how we are going to stabilise the operational scheme and ensure that everyone is happy with it.

Extra-statutory concession A32 applies in 2001–02. The hon. Member for Arundel and South Downs asked a question that was really about sole traders and partners, and their scope in the legislation. That brings us back to the point that I made about the scheme in general. We have sole traders, companies, individuals and partnerships. Our tax system treats each in a slightly different way. If we said that all those working in the construction industry had to be treated in the same way because they were in the same industry, we would have some difficulty. As I understand it, the hon. Gentleman was probing to establish why we do not bring partners and sole traders into the scope of the clause. We do not think that it is necessary to bring them in, and the feedback from the industry to date shows that the 18 per cent. deduction rate is about right for sole traders and partners. In practice, that is close to their final tax liability. I am not saying that some may have to pay slightly more, or less, but we think, as does the industry in our consultations, that overall it is a reasonable approximation. However, as with all tax rates and thresholds, this must be kept

under review. If circumstances altered, we would return to the matter. A theoretical problem is being advanced, but we have no information—nobody can give us any, even though we have asked for it—on whether it is a real problem that we should put right. I want to wait until the situation is more than anecdotal because of the issues it creates elsewhere in the scheme.

The 18 per cent. figure is about right for sole traders and partners. However, that was not the case for companies that paid under deductions, the majority of which faced serious cash-flow problems because some or all of the deductions that they suffered were due to be repaid to them—they paid us, we kept it and then we paid it back. The clause deals with real issues for companies. We have had no indication that a problem exists for partnerships or sole traders, but if one emerges over the next year, the Government will return to the matter. Rather than tinker with the scheme every year, we are yet again working with the industry to establish a scheme with which everyone is happy and which works well.

In the construction industry there is the problem of bogus self-employment. The Inland Revenue pursues compliance, but that sometimes becomes difficult because sub-contractors are chased through sub-contractors, and companies are not always able, or willing, to disclose information that we need.

I hope that I have explained to the hon. Member for Arundel and South Downs the main points relating to his amendment that was not selected. I take it that it would have been a probing amendment. I hope that I have allayed his fears for now.

Howard Flight (Conservative, Arundel and South Downs)

I thank the Paymaster General for her helpful reply.

Question put and agreed to.

Clause 40 ordered to stand part of the Bill.

Clause 41 - Reallocation within group of gain or

Joe Benton (Labour, Bootle)

With this it will be convenient to discuss new clause 4—Company ceasing to be a member of a group—

'.—(1) In subsection (1)(c) of section 179 of the Taxation of Chargeable Gains Act 1992 (company ceasing to be a member of group) for ''six'' substitute ''two''.

(2) In subsection (6)(a) of that section for ''6'' substitute ''2''.'.

Howard Flight (Conservative, Arundel and South Downs)

Clause 41 contains measures relating to reforms for which businesses have been calling for some time, and the Institute of Directors has welcomed them. The clause improves flexibility.

Section 179 of the Taxation of Chargeable Gains Act 1992 was introduced to combat the ''envelope scheme'', in which groups disposed of an asset pregnant with capital gain by transferring it to an intra-group, or to a special-purpose company, on a no-gains-no-loss basis, and then sold shares, rather than

the asset, in that company. The scheme was organised so that the capital gain from the sale of shares in the special-purpose company was lower than the gain that would have come from the sale of the assets in isolation. Under the section, the transfer of the original asset intra-group is taxed if the special-purpose company leaves the capital gains group within six years of the asset's transfer. The resulting de-grouping provision was inflexible and permitted no roll-over or ability to use capital losses elsewhere in the group. This clause and clause 42 seek to address those problems. However, six years is a long time to wait, and many straightforward commercial transactions are caught by the period. That other main criticism of the section has not been addressed.

The new stamp duty anti-avoidance clauses that we shall discuss later catch similar transactions but use a two-year time limit. Therefore, new clause 4 proposes a two-year time period. It has the support of the Chartered Institute of Taxation, which takes the view that it would be sufficient to counteract envelope schemes, so we hope that the Government will consider sympathetically putting the time limit in line with the stamp duty arrangements.

Ruth Kelly (Labour, Bolton West)

Good morning, Mr. Benton. It is a pleasure to have you in the Chair this morning.

I thank the hon. Member for Arundel and South Downs for his comments, which were made in a very constructive way, as usual. He recognised the fact that businesses have been calling for the reforms for some time, that they welcome the changes and that the changes will provide useful flexibility to businesses when restructuring.

The hon. Gentleman very ably explained the purpose of the original de-grouping charge, which is a long-standing anti-avoidance provision. It prevents tax from being lost when a company leaves a group, taking with it an asset that has been transferred to it tax free from another member of the group. The hon. Gentleman gave the example of a special-purpose vehicle being set up and then sold.

The de-grouping charge is triggered if the transferee company leaves the group within six years of the asset transfer. It operates by reference to a six-year period in order to strike an equitable balance between two competing considerations, which I shall outline. I hope that I can reassure the hon. Gentleman that reducing the period to two years is not a sensible manner in which to proceed.

The measure protects the Exchequer against a form of tax avoidance that is not time limited. There is a good case for saying that the provision should not be time limited at all and, as a matter of principle, it is right that groups should not be able to escape tax on gains by transferring assets to companies that then leave the group. In that regard, the tax, which is a tax on gains, is quite different from the stamp duty charge, which is a transaction tax. Therefore, there is a different issue in principle as to how the tax should be collected and the appropriate period in which to do it.

The other competing consideration that we must take into account is that, because companies and groups must maintain records of their transactions in order to comply with the provision, an unreasonable burden would be imposed if there were no time limit. Six years has long been seen as a relatively reasonable compromise. It is consistent with the period over which companies must keep records relating to their tax assessments, and we are not persuaded by the argument that it causes major compliance difficulties.

As the hon. Gentleman said, clause 41 and clause 42, which we shall discuss shortly, make significant changes to the de-grouping charge. Clause 41 will allow a gain or loss arising when a company leaves a group to be reallocated elsewhere within the group, thus creating greater flexibility in offsetting losses and gains. Clause 42 enables gains that arise on business assets to qualify for roll-over relief if the conditions for such relief are otherwise met.

As the hon. Gentleman said, businesses wanted the changes, which were widely consulted on and widely welcomed. They will stop the de-grouping charge being an impediment when companies wish to restructure for commercial reasons and are much more important to business than any potential change to the six-year rule. We are not persuaded that further relaxation of the de-grouping charge is either necessary or desirable, so I urge the Committee not to accept the hon. Gentleman's new clause.

Howard Flight (Conservative, Arundel and South Downs)

May I just ask whether, under the arrangements in clause 41, the Minister sees any other way in which totally innocent transactions that would otherwise have been caught under the six-year rule can escape being treated unfairly? The logic of leaving the six-rule year, which is why a six-year period is taken, shows that the intention of the clause is finally to tidy up all unfair or problematic issues that existed before.

Ruth Kelly (Labour, Bolton West)

I hope that the hon. Gentleman accepts the principle that companies should not be able to restructure in order to avoid legitimate tax being paid. It is right in principle to collect that tax regardless of the time period involved. The six-year rule is a reasonable balance between the competing tensions of the need to collect tax and minimising compliance burdens on business. It does not inhibit commercial transactions because it is about providing companies with greater flexibility.

As I said, businesses need to keep tax records for that length of time. Significant technological advances mean that it is easier than in the past to keep records and track asset transfers, and that that not a significant burden on companies. If companies come to us with evidence that it is a significant burden, we shall obviously think of ways in which to reduce the compliance burden further. However, I do not see it as an impediment to business.

Howard Flight (Conservative, Arundel and South Downs)

As I said at the outset, we are generally happy with the clause, as is business. I was pleased to hear the Economic Secretary's comment that the Government will keep the issue under review. The crucial issue concerns what is sufficient to counteract the envelope scheme arrangements.

Question put and agreed to.

Clause 41 ordered to stand part of the Bill.

Clause 42 ordered to stand part of the Bill.

Schedule 7 agreed to.

Clause 43 - Exemptions for disposals by companies

Howard Flight (Conservative, Arundel and South Downs)

As is evident, most of the points that we wish to raise are covered in amendments to schedule 8. The clause seeks to achieve something on which there has been extensive consultation with business over a number of years. Again, we give the clause a tick in principle, but there are quite a lot of outstanding concerns about schedule 8.

The clause contains a wide-ranging anti-avoidance provision, the meaning of which is unclear. If the provision were enacted, it would create substantial uncertainty and could exclude from the exemption a broad category of transactions that we are assured it is not intended to exempt. Most of the forthcoming amendments relate to that, but I want to put on record that in principle we welcome the objective of the clause and the constructive approach to addressing that territory.

Ruth Kelly (Labour, Bolton West)

I thank the hon. Gentleman for his words of welcome. There has indeed been very extensive consultation on the clause. It was announced in Budget 2000 that the Government would consult on the possibility of introducing a roll-over relief for gains on substantial shareholdings held by companies. In June of that year, the Inland Revenue issued a technical note outlining possible roll-over relief. In November, another technical note was issued outlining the form of the roll-over relief and raising the possibility of an exemption as an alternative to that. In the following Budget there was an announcement that the exemption for company gains would be examined in the context of wide-ranging consultation on the direction of company tax reform. That was followed in June by a substantial consultative document on large business taxation, which discussed both roll-over relief and exemption in a wider context. At around the same time, draft clauses were published for comment in the pre-Budget report. In March this year the Chancellor confirmed that exemption would be introduced from 1 April and the final draft legislation was published. The provision has been welcomed by the business community and is an integral part of our programme for modernising company taxation. The new regime will enable United Kingdom companies to restructure rapidly and flexibly in response to emerging global opportunities without being constrained by the tax system.

Question put and agreed to.

Clause 43 ordered to stand part of the Bill.

Schedule 8 - Insurance and mutual trading companies

Edward Davey (Liberal Democrat, Kingston and Surbiton)

I beg to move amendment No. 82, in page 151, line 37, leave out paragraph 5.

I, too, welcome you to the Chair, Mr. Benton. I also welcome the thrust of clause 43 and schedule 8, as did the hon. Member for Arundel and South Downs. There has been a huge amount of consultation on the provisions, which have been widely welcomed by business and the tax profession. Their objective, which I am sure all Committee members share, is to ensure that the UK remains a competitive place for the location of holding companies of multinationals. The Government's approach to the matter has been exemplary. They ensured that significant consultation took place and that the draft legislation was available for consultation.

I prefaced my comments with that welcome so that the Committee realises that the aim of amendment No. 82 and subsequent amendments to the schedule was to be constructive. We have listened to outside bodies that have read the Bill and are pleased with the thrust of it but see the need, even at this late stage, for improvement so that it meets the Government's objectives.

Amendment No. 82 was suggested to me by the Confederation of British Industry, which wrote to all Committee members. When it approached me, I listened to what it had to say, read its background briefing and was convinced that there is a case for the Government to look again at the anti-avoidance measures that they are introducing with the new exemption. Paragraph 5 of new schedule 7AC to the Taxation of Chargeable Gains Act 1992, which schedule 8 introduces and the amendment would remove, is widely drawn. The general nature of the anti-avoidance provisions has caused concern. Some of the meaning of that paragraph is unclear to many experts, who have put hot towels on their heads and tried to work out what lies behind it. I shall give some examples.

Line 44 on page 151 refers to ''substantial''. That must be clarified. I understand that the Inland Revenue intends it to mean 20 per cent. rather than 10 per cent., but that must be made clear. Concern has also been expressed about the phrase, ''represents untaxed profits'' in line 45, because a strict reading of those words by the courts might exclude many transactions that the Inland Revenue had assured business it intended to exempt. There is lack of clarity there.

Line 1 of page 152 refers to

''arrangements from which the sole or main benefit that could be expected to arise . . . is that the gain on the disposal would, by virtue of this Schedule, not be a chargeable gain.''

The word ''arrangements'' is defined in line 20 to include

''any scheme, agreement or understanding, whether or not legally enforceable''.

That definition is very vague in terms of previous tax legislation. It would cause some concern to tax advisers who believe that the test is too vague, as they would not feel certain when they advised companies. I want to focus on that uncertainty, because it is a problem.

If we are creating a general anti-avoidance mechanism, about which there is a lack of clarity and certainty, the benefits from the overall policy will not be so easily realised. The situation may arise where companies have been advised that a disposal would be exempt, but it turns out not to be. Significant business decisions might be made that are later found to incur a huge tax penalty, whereas if that had been known beforehand, those changes would not have been made.

If Labour Members feel that we are making a point that is too technical, or that may not be valid because there is certainty in the legislation, they should consider the Inland Revenue's response to business concerns. The Inland Revenue has, quite properly, consulted business about its concerns and has said that it will publish guidance and a statement of practice. I suggest that that is not the best way forward. I am told that statements of practice are highly complicated, do not get away from uncertainty and—of most concern—could be overridden by the courts. If there were a challenge, the courts would not necessarily have to abide by the statement of practice. They would look at the legislation, and might give a strict interpretation of the words therein.

That raises the question of why the Inland Revenue has decided to take that approach. I understand that it was concerned that the new exemption could be abused. All those who are concerned about securing the Exchequer and supporting the taxpayer should be concerned about that too. When challenged, the Inland Revenue has not managed to come up with convincing examples of the types of schemes that the general anti-avoidance measure is designed to catch. I am told it has come up with a complex, theoretical idea based on the use of financial derivatives, but those lawyers who have looked at the Revenue's example have said that that would be covered by case law. No example suggests that such wide-ranging anti-avoidance power is needed.

If Labour Members are concerned that such anti-avoidance measures are needed, they should rest assured because other anti-avoidance measures would apply in this case. There are existing requirements on trading activity and there are minimum holding periods in the Bill. Section 179 of the Taxation of Chargeable Gains Act 1992 contains other relevant anti-avoidance measures, as does the control of foreign companies legislation. All of that provides a framework of anti-avoidance legislation that would assist the Government's purpose as set out in new schedule 7AC (5).

If the Government want some sort of extra anti-avoidance provision over and above the measures that I have described, rather than going down a general route, they could engage business in a final round of consultation—I know there has been an extensive period of consultation—before Report to see whether a slightly less draconian, more satisfactory and more targeted approach can be taken to meet the concerns that officials and Ministers may have. If the Government do not accept amendment No. 82—I guess that they probably will not—will Ministers at least assure us that before Report they will continue

the welcome practice they have shown throughout the legislation and give an undertaking to the Committee to meet business, in the form of the CBI and possibly other representatives, one more time to see whether the concerns of both the Government and business could be met and answered in some other way?

Howard Flight (Conservative, Arundel and South Downs)

I want simply to add that it is interesting that the CBI has specifically said that it feels that the statement of Inland Revenue practice is unsatisfactory because it does not adequately clarify the position, is not a substitute for clear and understandable legislation and is liable to be overwritten by the courts if they are called on in future to interpret the strict wording of the schedule. It says that it is disappointing that in an era in which the tax law rewrite programme is introducing a new approach to tax legislation, Parliament is being asked to approve unclear legislation that will effectively give the Revenue discretion, subject to intervention by the courts, on how to apply the exemption, which it feels is undesirable in principle.

John Burnett (Liberal Democrat, Torridge and West Devon)

I welcome you to the Chair, Mr. Benton. I hope that it will be in order for me to comment on the generality of schedule 8, and in particular clauses 20 and 21, which limit the exemptions to trading companies. If that is not in order at this stage, Mr. Benton, please let me know and I shall address the matter later in the stand part debate.

Joe Benton (Labour, Bootle)

Order. I should prefer the hon. Gentleman to leave his remarks on the generality of the schedule until the stand part debate.

John Burnett (Liberal Democrat, Torridge and West Devon)

Thank you, Mr. Benton.

Mark Hoban (Conservative, Fareham)

May I, too, welcome you to the Chair, Mr. Benton?

I welcome clause 43, which is important for business. Having worked with clients on transactions in which tax issues played an important part in their timing, I know that the measures in the clause are to the advantage of business, and it is therefore not surprising that businesses have given them a warm welcome.

I want to pick up on the comments made by my hon. Friend the Member for Arundel and South Downs and by the hon. Member for Kingston and Surbiton (Mr. Davey) on the scope of new schedule 7AC(5), a matter on which not only the CBI but the Chartered Institute of Taxation has made representations. This morning, Committee members will have received representations from the Institute of Chartered Accountants in England and Wales, of which I am a member, concerning the clause. Interestingly, the ICAEW's view is that paragraph 5, which contains the anti-avoidance measures, is so widely drafted that it appears to catch almost any disposal, which is a concern to industry as a whole. If the Revenue were improperly to apply paragraph 5, that would risk emasculating a relief which business regards as very important.

As the hon. Member for Kingston and Surbiton said, we need greater certainty in the taxation of transactions. The ICAEW states:

''The paragraph hands too much discretion to the Revenue to decide what transactions will qualify for the relief and what will not. Taxpayers are entitled to be taxed according to the law and not untaxed by Revenue practice.''

That is a legitimate concern, and I hope that Ministers will consider whether it would be appropriate to withdraw the clause so that they can consider whether specific anti-avoidance regulations could be drafted to tackle examples, with which I am sure that they are armed, of transactions that they are trying to rule out. They need to see whether there is a more specific way of ensuring that transactions are not structured to avoid tax, which would give a greater degree of certainty to businesses and their advisers.

Mark Field (Conservative, Cities of London and Westminster)

I want briefly to support what other Conservative Members have said.

As a matter of strategy, I am concerned that too much authority will be in the hands of the Inland Revenue if it has discretion on those matters, which would be a retrograde step. I appreciate that when the Economic Secretary dealt with the previous clause she referred to the concept of anti-avoidance. One could cynically suggest that much of the feeling on the matter from accountancy experts and those in other related professions derives from an attempt to discover avoidance measures on their clients' behalf. It is wrong that a company should have to structure its affairs to maximise the amount of tax that it pays. Although I support what the Government are trying to do, there is far too much discretion in the Revenue's hands, and such a lack of certainty will be damaging to business. I would be grateful for guidance on how the Government intend to ensure that the Revenue's discretion is kept to a minimum.

Ruth Kelly (Labour, Bolton West)

I thank the hon. Member for Kingston and Surbiton for his opening comments that clause 43 is drafted in exemplary fashion, and that it was a good idea for the legislation to be available in advance for widespread consultation. That input has been valuable, and we have learnt much from consulting business and others who will be affected. We continue to learn from them, and we remain in dialogue with industry. Indeed, a partner in a major firm of accountants recently wrote in the Financial Times:

''measures such as . . . the substantial shareholdings relief show what a good consultative process can achieve''.

In the context of generous relief and substantial shareholdings, the amendment would remove a provision that will protect the regime against exploitation. The protection is designed to prevent companies from realising untaxed investment returns by way of shared disposal, where the gain on the disposal would be exempt under the new regime.

It was recognised by many participants in the consultation process that we have legitimate concerns about the potential abuse of the exemption provided by the regime. We are particularly concerned that schemes could be created for converting untaxed income into tax-free capital gains. The draft legislation published at the time of the pre-Budget report last November sought to tackle those concerns by excluding certain types of financial and investment activity from being qualifying trading activities under

the regime. Business told us that that approach was too wide and could result in the exclusion of many genuine trading operations, but it continues to accept the validity of our concerns.

In consultation with the business community and through listening to its concern that the legislation was too widely drafted, we developed an alternative, suggested test. That test, which the hon. Member for Kingston and Surbiton queries, will prevent a gain from qualifying for an exemption where certain conditions are satisfied and tax-avoidance arrangements exist. The arrangements must be such that the sole or main benefit that can be expected to arise from them is that the gain would be exempt under the substantial shareholdings regime. The scheme is designed merely to take advantage of that loophole, and does not relate to any fundamental commercial activity.

Notwithstanding that extensive consultation, I have read the comments of the CBI and others about the provision's scope since the publication of the legislation, and am aware that there have been continuing mutterings about its being drawn too widely. In the light of those fears and earlier consultation with industry, the Inland Revenue is preparing detailed guidance that will set out the scope of the provision. The guidance is being prepared in close consultation with industry. The Revenue also seeks comments from all other parties who have an interest. When finalised, the detailed guidance will be published as a statement of practice, which should reassure the hon. Gentleman to some extent and allay companies' worries about the provision. It will demonstrate the Revenue's view that the provision is narrowly focused.

The need for tax-avoidance arrangements from the outset ensures that all normal disposals of substantial shareholdings will be unaffected by the anti-avoidance rule. It is important to put on the record that the vast majority of disposals of substantial shareholdings will not be affected by the anti-avoidance legislation. The Revenue has already received a number of encouraging comments that that is likely to be the case. For example, in its comments on the Finance Bill, the Chartered Institute of Taxation said:

''We are pleased that the Revenue are to publish guidance on the application of paragraph 5 and that further discussions will be held''.

Why did we decide to provide guidance rather than put everything in legislation? It is much easier to capture schemes, which can be very varied, and to be more flexible and illustrative in guidance than in legislation. We have received various suggestions as to how we might put beyond doubt in statute, if we were to write such legislation, the circumstances that would not be excluded from the scope of the exemption. However, a provision that dealt explicitly with every situation that might arise—even if they could all be predicted—would be too long to be practicable. The current tests have the benefit of being short and readily comprehensible, so I am not attracted to the idea of tinkering with them.

The hon. Member for Kingston and Surbiton raised the Inland Revenue example, which gives a case in which avoidance might occur. In the example, if a company were to arrange for a subsidiary to buy a package of financial derivatives that were held such that it constituted the carrying-on of a financial trade and then sell the shares and subsidiary before the profits from the derivatives were realised, the gain on the sale of the shares would be exempt. We think that that is unlikely to happen in practice, as the gain will be captured by this anti-avoidance measure.

The hon. Gentleman and others raised concerns about uncertainties in the drafting of the legislation. It might be helpful to try to allay some of his concerns about that. He asked about the term ''arrangements'' in the schedule. The term is used elsewhere in tax legislation; it is not new. For example, it is used in the enterprise investment scheme. He also said that the interpretation of the term ''substantial'' is uncertain. However, there is already guidance on the meaning of ''substantial'' in the context of capital gains tax taper relief, and the Inland Revenue has confirmed that it will also apply in this context. The detailed drafting issues that the hon. Gentleman raised have already been dealt with or are not new, and I am sure that people will come to understand that as they look more closely at the legislation.

The hon. Gentleman said that so much uncertainty affects paragraph 5 that it is no longer useful. The anti-avoidance provision will have no application whatsoever in the vast majority of cases, and companies understand that it will not apply if they are carrying out reasonable rearrangements and restructurings. Again, I hope that that allays his concerns. He queried whether we would be willing to meet the CBI to discuss the matter. The Inland Revenue has been in close contact with the CBI and others in the development of the guidance. Indeed, I believe that it has a meeting with the CBI on the anti-avoidance legislation later this week.

Edward Davey (Liberal Democrat, Kingston and Surbiton)

I am pleased that the Inland Revenue is meeting with the CBI to discuss the guidance. Will they consider possible changes to the legislation, so that we could revert to the matter on Report, possibly through Government amendments?

Ruth Kelly (Labour, Bolton West)

I strongly believe that the consultation with the CBI and others will satisfy them that the drafting of guidance meets their concerns. We always keep in contact with the industry and it is only right that we do so. Avoidance measures change from year to year, so we return to the provisions in the natural course of events.

I believe strongly that if we provide generous relief to companies, we, as the Government and the Exchequer, have a duty to protect ourselves against schemes that are specifically set up to avoid paying tax. I urge the Committee to reject the amendment because it would provide no effective protection against the exploitation of this generous and valuable relief.

Edward Davey (Liberal Democrat, Kingston and Surbiton)

I am grateful for the Minister's long and comprehensive reply and I am sure that those who read our proceedings will find it useful as an indication of the Government's thinking. However, she quoted

the Chartered Institute of Taxation's briefing and suggested that it was pleased with the Inland Revenue's approach. The same briefing stated:

''In our view, the anti-avoidance provisions of new Sch 7AC para 5 are too widely drawn given that the relief is intended to be easy to use.''

There is a discrepancy. The Minister argued that the provision is narrowly drawn—

Ruth Kelly (Labour, Bolton West)

Perhaps I can comment on what the hon. Gentleman has said. I believe that some of the concerns of the Chartered Institute of Taxation have been allayed since their briefing and following consultation with the Inland Revenue. We are developing guidance that will be translated into a clear statement of practice in due course and it will be clear that the provision is very narrowly focused and not wide ranging.

Edward Davey (Liberal Democrat, Kingston and Surbiton)

The Minister is slightly more up to date than I am in relation to briefing from the Chartered Institute of Taxation, so I shall bow to her and say that perhaps I need to talk to the institute. It is good to have that on record. This has been a useful debate and I shall talk to both the CBI and the institute. I hope that the Committee will be kept informed of how the discussions with the Inland Revenue are progressing. They seem to have been constructive. If that continues and if we have greater consensus when we come to Report, we shall have made progress. I do not wish to press the amendment. On the understanding that, if the issue is not sorted out during the consultation, we can return to it on Report, I beg to ask leave to withdraw the amendment.

Amendment, by leave, withdrawn.

Howard Flight (Conservative, Arundel and South Downs)

I beg to move amendment No. 64, in page 153, line 3, leave out 'or interests in shares'.

This technical amendment was prompted by the Law Society to ensure that a shareholding is not excluded from the new exemption for substantial shareholdings if the interest in the company is held by way of instruments other than shares—for example, convertible loan stock. The point of concern is that a wholly owned subsidiary could fail the test for a substantial shareholding if it has an issue of a normal commercial loan held by another group company. If a company owned 100 per cent. of the shares in a subsidiary, which issued to the parent company a limited recourse loan of a convertible security, that security would not be treated as a normal commercial loan, and if during any period the interest on the security were equal to the amount of profits available for distribution to equity holders, the parent company would not be entitled as a holder of ordinary shares to any of the company profits available for distribution and would thus fail the test for holding a substantial shareholding in a subsidiary, although the subsidiary might be wholly owned for the purpose of group relief under the CGT grouping test. This small amendment seeks to avoid that problem, which I trust was unintentional.

Ruth Kelly (Labour, Bolton West)

I listened with great interest to the hon. Gentleman's comments because I was eager to learn the amendment's purpose, which was not—I hope that this will not embarrass him—completely clear on first

reading. By way of background, I should point out that the substantial shareholdings provisions apply not only to shares but to interests in shares. For those purposes, a company has an interest in shares if it owns them together with one or more persons. If the substantial shareholdings provisions did not include interests in shares, the disposal of an interest in shares would give rise to a chargeable gain or allowable loss. That would contrast with a gain or loss on the disposal of shares, which would be exempt, were the necessary conditions met. It would also mean that a company had a choice when disposing of shares. If such shares stood at a gain, it would be possible to dispose of them and to benefit from an exemption on their disposal. If they stood at a loss, it might be possible for a company to arrange to dispose only of an interest in them.

The amendment moved by the hon. Member for Arundel and South Downs is aimed at circumstances in which a company has a substantial shareholding in another company, which makes it a creditor of that company in respect of certain types of loan. He believes that that may cause the substantial shareholding requirement to fail. He has explained that the amendment relates to cases in which an investing company holds 10 per cent. or more of the ordinary shares in another company and is also a creditor. He suggests that in those circumstances the shares may be prevented from being a substantial shareholding because they do not provide the necessary entitlements to 10 per cent. or more of the profits and assets of the company in question. The rights that the investing company enjoys as a loan creditor may instead satisfy those entitlements. There may be something in the point raised by the Law Society, but it is difficult at this stage to know whether that is a significant and practical point, or whether it is purely theoretical.

John Burnett (Liberal Democrat, Torridge and West Devon)

The Economic Secretary has made a comprehensive exposition of the problem. I wonder whether the Revenue will consider inherent rights of convertibility in loan stock, and whether those inherent rights should be taken into account when it considers the definition of ''substantial shareholding'' in that context.

Ruth Kelly (Labour, Bolton West)

Let me deal with the point made by the hon. Member for Arundel and South Downs, and I shall come to the hon. Member for Torridge and West Devon (Mr. Burnett) in a moment.

The amendment would remove the reference to interest in shares from sub-paragraph (1), but leave unaffected the way in which it applies to shares. The hon. Member for Torridge and West Devon has suggested that we should consider another way of remedying that proposal. At this stage, I am clearly not going to commit the Government to his precise recommendations, but we shall look at what he has suggested and I shall write to him on that point. There will, of course, be other points of detail on the application of the substantial shareholdings provisions to actual cases that emerge over the coming months, and we are determined to ascertain whether there are practical problems that need to be addressed.

John Burnett (Liberal Democrat, Torridge and West Devon)

I am extremely grateful to the Economic Secretary for that assurance. I should like

to receive her letter in the near future because we should like to debate the matter again, perhaps on Report.

Ruth Kelly (Labour, Bolton West)

I shall ask the Inland Revenue to consider the hon. Gentleman's proposal. If he has a point, we will respond positively to him on it, but I do not want to commit myself to accepting it today. I will provide an assurance that we will respond quickly to the hon. Gentleman's points so that the Committee can have the benefit of that letter before we return to the subject. During the coming months, the Inland Revenue will continue to consult the consultative group and others on the operation of the legislation, which will enable any practical difficulties that emerge from that process to be dealt with. If a real practical issue needs to be addressed in the light of operating experience, we can return to it.

Howard Flight (Conservative, Arundel and South Downs)

I am glad to hear the Economic Secretary comment that if, on further consideration, the Government accept that there is a practical issue, they will look to address it. I deliberately read into the record circumstances that were not just theoretical. On the basis of what she said, I beg to ask leave to withdraw the amendment.

Amendment, by leave, withdrawn.

Mark Hoban (Conservative, Fareham)

I beg to move amendment No. 39, in page 153, line 5, leave out '10' and insert '5'.

Joe Benton (Labour, Bootle)

With this it will be convenient to take amendment No. 40, in page 153, line 7, leave out '10' and insert '5'.

Mark Hoban (Conservative, Fareham)

These are probing amendments. Their purpose is to understand why the Government chose 10 per cent. as the right number for substantial shareholding. I understand that in the Netherlands, the figure is 5 per cent. In Germany, there is no de minimis limit on substantial shareholdings. We need to ensure that the corporate environment in the UK is competitive in terms of taxation, and encourages companies to invest and to realise their gains where appropriate. Many in industry are relieved that the limit is as low as 10 per cent. The consultation paper stated 30 per cent., and some people are grateful that the figure is now 10 per cent. That is not a reason for the Government to be complacent on the matter, as I am sure the Economic Secretary would expect me to say.

In what is a complex commercial environment, I wonder whether 10 per cent. is too high a limit. There is a growing number of examples of transactions, perhaps on a cross-border basis, where there are strategic shareholdings below 10 per cent. Those transactions are not cases of companies simply taking short-term positions, but part of a process of ensuring that they can play a part in developing new markets in various territories. We heard from the telecom sector that, when new mobile phone licences were issued, several overseas companies invested relatively small stakes that were strategic in intent,

which formed part of their plans to develop mobile phone services internationally.

It is with those transactions and the general complexity of transactions in mind that I have tabled an amendment to query whether 10 per cent. is too high a figure. A low limit, such as 5 per cent., might be better. It is important to ensure that we maximise corporate efficiency by enabling businesses to conduct transactions for economic purposes, not simply for tax purposes. Tax should not act as a barrier to investment or divestment. The Paymaster General said on Thursday that the tax should not distort behaviour. A limit such as this may well distort behaviour. I would be grateful if the Economic Secretary would outline the Treasury's thinking on the 10 per cent. figure, notwithstanding the general welcome that industry has given to that much lower limit.

Howard Flight (Conservative, Arundel and South Downs)

At the end of the day, the purpose of clause 43 is to keep the UK competitive as a base for multinational businesses, when there are several costs arising from the Budget on other matters, and when the competitiveness of the UK has generally declined. The question at the centre of clause 43 is: are we competitive enough compared to, for example, Holland?

Ruth Kelly (Labour, Bolton West)

I thank the hon. Member for Fareham (Mr. Hoban) for his amendment, which gives me an opportunity to put on record why we chose the threshold of 10 per cent. as opposed to any other number and why we did not devise a different, perhaps more complex test, to distinguish between shareholdings that are structural to a business rather than those that are simply a passive portfolio of investments. The desire to be able to distinguish between those two types of arrangements is the key to the threshold.

The rules must differentiate holdings in some way. During the consultation period, we explored the possibility of operating an alternative to a numerical test. We had hoped to devise a test that would distinguish absolutely between structural holdings and passive investment holdings, whatever the size of the holding. The test would have had to be sufficiently robust to be proof against manipulation according to whether gains or losses were expected. Unfortunately, it was not possible to devise such a test. That is why we settled on a numerical test, which has the merits of being easy to understand and straightforward to apply.

We listened to what business told us during the consultation period. It was content with the 10 per cent. figure. We believe that it will target the vast majority of structural holdings while excluding the bulk of portfolio holdings. It has been widely accepted as the most appropriate solution. To reduce the figure to 5 per cent., as proposed in the amendment of the hon. Member for Fareham, would considerably increase the number of portfolio investments that would qualify for the exemption. We accept that some holdings between 5 and 10 per cent. may be structural, and we have not completely abandoned the idea of seeking an alternative workable test to differentiate between the two. However, until such a test emerges, I

am not persuaded that it would be right to abandon the threshold requirement.

The hon. Gentleman discussed the situation in other countries such as the Netherlands and Germany. A wide range of thresholds operates in other countries that have similar reliefs. The hon. Gentleman gave examples of two that have lower thresholds, but others apply higher thresholds. The key is that Governments structure the relief, including the qualifying threshold, to reflect their underlying policy objectives. The threshold that we have set makes what I readily admit is a fairly rough and ready distinction between portfolio and commercial investments. A balance must be found, and a threshold of 10 per cent. is the right level to set to avoid capturing the vast majority of portfolio investments. On those grounds, I do not support the hon. Gentleman's amendment.

Rob Marris (Labour, Wolverhampton South West)

Do the Government intend in paragraph 8(1)(a) that it should be 10 per cent. of the company's ordinary issue share capital?

Ruth Kelly (Labour, Bolton West)

I confirm that that is the case.

Mark Hoban (Conservative, Fareham)

I am grateful for the Economic Secretary's explanation of the way in which she arrived at the 10 per cent. figure. It sounds as though she has adopted a very pragmatic approach and I appreciate the basis on which the test has been developed because of my experience with quantitative tests of what is or is not strategic. People party to shady agreements may frame if not manipulate them to give an appropriate level of control according to their tax or accounting needs at the time. Therefore, I understand why she decided on a numerical limit.

I am not persuaded, however, that 10 per cent. is necessarily the right number. The Economic Secretary said that there could be situations in which shareholdings of between 5 to 10 per cent. are strategic. As I said in my opening remarks, this is a probing amendment. I am grateful that the hon. Lady put on record the rationale for her decision.

Mark Field (Conservative, Cities of London and Westminster)

I was intrigued by the comments of my hon. Friend the Member for Fareham and the Economic Secretary. Will my hon. Friend comment on the fact that the initial consultation exercise suggested that the portfolio holding should be at the level of 30 per cent.? Perhaps that lets the cat out of the bag as to the Government's real intentions.

Mark Hoban (Conservative, Fareham)

It is not entirely clear why the Government started off with 30 per cent.

Dawn Primarolo (Labour, Bristol South)

We have to start somewhere.

Mark Hoban (Conservative, Fareham)

I suspect that starting at a higher level allows the Government to retreat graciously to 10 per cent., which they know will gain broad acclaim from the industry. Perhaps that is the explanation for which my hon. Friend was searching, although we did not hear it from the Economic Secretary.

The Government must carefully consider the measure, including the 10 per cent. limit. I hope that those who read the record and who have an interest in the legislation, make further representations on behalf of industry and commerce. I beg to ask leave to withdraw the amendment.

Amendment, by leave, withdrawn.

Howard Flight (Conservative, Arundel and South Downs)

I beg to move amendment No. 63, in page 157, line 18, at end insert—

'or would have been so treated as not involving a disposal or acquisition but for the application of paragraph 4 above'.

Joe Benton (Labour, Bootle)

With this it will be convenient to discuss amendment No. 62, in page 157, line 20, after '136', insert

'or would have applied but for the application of paragraph 4 of above'.

Howard Flight (Conservative, Arundel and South Downs)

These are further technical amendments prompted by the Law Society. Their purpose is to ensure that a share exchange or reorganisation, which would not have otherwise given rise to a disposal for tax purposes, will not result in a period of ownership coming to an end for an entitlement to exemptions on gains from substantial shareholdings. The argument is that it would be incorrect on principle for a period of ownership to be terminated by a share exchange or other reconstruction normally treated as not involving disposal. The amendments are designed to apply when the transaction would have fallen within section 127 of the Taxation of Chargeable Gains Act 1992 but for paragraph (4) of new schedule 7AC to that Act.

Ruth Kelly (Labour, Bolton West)

The amendments relate to the interaction of substantial shareholdings provisions and the general capital gains freeze for transactions such as share exchanges. Such transactions are complex and the Inland Revenue will publish guidance on the more difficult aspects, particularly as they relate to groups of companies. In this technical area, I shall try to keep matters as simple as possible.

A typical share exchange may arise in a takeover: a company exchanges its shares in the company being taken over for new shares in the acquiring company. For example, company A may hold shares in company B, then company C takes over B and issues its own shares to A in exchange for the shares that A holds in B; A now holds shares in C, which holds shares in B. I apologise to the Committee for going into detail, but it is important for the record.

To avoid company A incurring an immediate tax charge on any capital gain arising from the transaction, it is normally treated as not having disposed of the shares in company B for the purposes of tax on chargeable gains. In the jargon, it is said that the new shares held by A in company C stand in the shoes of the original shares in B. In a substantial shareholdings context however, that general rule would produce a harsh result if the shares held by A and B would have qualified for an exemption but the new shares in C would not qualify for an exemption on a subsequent disposal. In order not to disadvantage A in such circumstances, the general stand-in-shoes provisions are switched off with the result that there is a disposal on takeover. On that disposal, benefits from the substantial shareholdings exemption, and the new shares, will normally have an acquisition cost for capital gains purposes that reflects their market value at the time of the share exchange. In effect, the shares of the company making the takeover—company C in the example—are a completely new holding. The shares in company B

are treated as having been disposed of. In no sense do the shares in company C stand in the shoes of the original shares of company B. It is therefore right in principle that the holding period for the new shares commences when the investing company receives them on the exchange.

We do not accept that it is reasonable for the investing company to wait 12 months before it can benefit from exemption on the disposal of new shares. That is no different from a situation in which the investing company acquires shares in other circumstances, quite outside a takeover. It would be anomalous if we made an exception in that sort of case. The way that the provision works seems to be consistent with the approach of the capital gains provisions generally and is right in principle. On that basis, I urge the Committee to reject the amendment.

Howard Flight (Conservative, Arundel and South Downs)

Further to that matter—I must confess that I am getting out of my depth—I think that Deloitte and Touche has taken up with the Revenue its diagnosis that paragraph 4 may give rise to an unintended effect in certain circumstances. As set out in the explanatory notes, new schedule 7AC (4) is designed to disapply special stand-in-shoes provisions in certain circumstances. As drafted, the operation seems to result in the stand-in-shoes provisions continuing to apply to a transaction.

I do not want to burn up the Committee's time with full detail, but my secondary point is to ask the Economic Secretary if she is entirely happy that paragraph (4) is correct. If a share exchange or reorganisation would not give rise to disposal for tax purposes, it should not result in a period of new ownership coming to an end for the purposes of the new exemption. It was not clear whether the hon. Lady was agreeing with that principle but objecting to the other potential effects of the amendment.

Ruth Kelly (Labour, Bolton West)

These rules are certainly formidably complicated. What I would say in mitigation is that they have been around for a long time. The complexity surrounding them is not gratuitous, but arises from a policy desire to provide relief from a tax charge in certain circumstances. If the rules were not in place, there would be a charge to tax on any gain arising on the straightforward exchange of shares when one company was taken over by another. I think that the rules are necessary.

The point that the hon. Member for Arundel and South Downs raised about Deloitte and Touche is covered in the detailed guidance that is being set out by the Revenue. I do not accept that the clause is in any way distorting commercial behaviour. Share exchanges and other forms of company reconstruction will normally continue to be tax neutral for corporation tax purposes at the time of the event. If one holding of shares were treated as disposed of for tax purposes and another were treated as acquired, it seems wrong that the new holding should inherit the history of the original shares. That would be appropriate only if the new holding were

standing in the shoes of the original holding. On those grounds, I would continue to urge the Committee to reject the amendment, but perhaps the hon. Gentleman will consider withdrawing it.

Howard Flight (Conservative, Arundel and South Downs)

I think that the Economic Secretary has satisfied me that where shares stand in shoes, they will qualify for the new exemption. The intent of the amendment was to probe that matter and, on that understanding, I beg to ask leave to withdraw the amendment.

Amendment, by leave, withdrawn.

Howard Flight (Conservative, Arundel and South Downs)

I beg to move amendment No. 38, in page 169, line 41, at end insert—

'Part 6

Clearance procedure

40 (1) Paragraphs 1, 2 or 3 of this Schedule shall be deemed to have effect (and the requirements mentioned therein shall be deemed to have been met), in relation to an investing company where the Board have, on the application of the investing company, notified the investing company concerned that the Board are satisfied that the exemptions in paragraphs 1, 2 or 3 of this Schedule apply to that investing company and that the requirements mentioned in paragraphs 1, 2 or 3 have been met.

(2) Any application under sub-paragraph (1) above shall be in writing and shall contain particulars of the operations or transactions that are to be effected by the applicant and the Board may, within 30 days of receipt of the application or of any further particulars previously required under this sub-paragraph, by notice require the applicant to furnish further particulars for the purpose of enabling the Board to make their decision; and if such notice is not complied with within 30 days or such longer period as the Board may allow, the Board need not proceed further on the application.

(3) The Board shall notify their decision to the applicant within 30 days of receiving the application or, if they give notice under sub-paragraph (2) above, within 30 days of the notice being complied with.

(4) If the Board notify the applicant that they are not satisfied as mentioned in sub-paragraph (1) above or do not notify their decision to the applicant within the time required by sub-paragraph (3) above, the applicant may within 30 days of the notification or of that time require the Board to transmit the application, together with any notice given and further particulars furnished under sub-paragraph (2) above, to the Special Commissioners; and in that event any notification by the Special Commissioners shall have effect for the purposes of sub-paragraph (1) above as if it were a notification by the Board.

(5) If any particulars furnished under this paragraph do not fully and accurately disclose all facts and considerations material for the decision of the Board or the Special Commissioners, any resulting notification that the Board or Commissioners are satisfied as mentioned in sub-paragraph (1) above shall be void.'.

Amendment No. 38 would implement arrangements for a clearance procedure, to which I referred earlier. Before I comment on that, I must point out that one effect of clause 43 would be to encourage vendors to dispose of shares. However, the new intellectual property rules in clause 48 encourage purchasers to acquire assets. The Bill contains a contradiction that needs to be addressed.

One of the main criticisms implicit in the comments about the lack of clarity is the need for a clearance process. Without such a process, groups will be expected to dispose of shares, which may have large capital gains, without knowing explicitly whether they will qualify for the exemption. Even after the more detailed statement of practice to which the Economic Secretary referred, a statutory clearance procedure such as that suggested in the amendment would

provide the key element of certainty and would be welcomed by businesses.

The statement of practice may be sufficient to persuade the various tax lawyers and accountants that a clearance procedure is not necessary, but as the schedule stands, Conservative Members have concluded that the only way round the lack of clarity is to put in a clearance procedure.

John Burnett (Liberal Democrat, Torridge and West Devon)

I want only to add to the points made by the hon. Member for Arundel and South Downs. Business needs certainty and that should be a principle of the tax system. I question whether the proposed statement of practice will make allowance for all the myriad circumstances that will arise in any proposed transaction for which exemption is sought under the provisions. It is therefore entirely reasonable that there should be a short and swift clearance procedure and I endorse the proposal.

Ruth Kelly (Labour, Bolton West)

The proposal essentially concerns a formal clearance mechanism for the Inland Revenue.

Howard Flight (Conservative, Arundel and South Downs)

Statutory.

Ruth Kelly (Labour, Bolton West)

Statutory. For practical reasons, I am going to argue that it would not be appropriate for the Inland Revenue to provide such a statutory clearance mechanism, and if businesses looked at it carefully they would not want it for reasons that I shall explain.

We have already had a substantial exchange this morning about whether the legislation is particularly unclear and whether additional certainty can be generated by the Inland Revenue's guidance. Although I am not going to repeat that debate, I hope that that guidance will allay the concerns that have been expressed. The amendment models the clearing mechanism on existing clearing mechanisms, but such a formal statutory clearing mechanism would impose substantial costs.

Michael Jack (Conservative, Fylde)

So that we might have that added clarity, will the Economic Secretary give us one or two examples of the existing mechanisms to which she referred?

Ruth Kelly (Labour, Bolton West)

I shall certainly expand on the existing clearing mechanisms and how they operate, but I want to say a few words about why such a mechanism would not be appropriate. I shall come back to the right hon. Gentleman's point in due course.

As I said, the provisions to accept gains and losses on substantial shareholdings have been subject to extensive consultation. The regime has been widely welcomed for providing groups of companies with the flexibility to restructure rapidly in response to emerging global opportunities without being constrained by the tax system. Let us consider the resource implications of having a statutory clearing mechanism for both business and the Revenue. The existing clearance procedures are targeted at transactions such as company reconstructions, demergers, the purchase by a company of its own shares, and provisions that cancel tax advantages arising from certain transactions in securities. It is well known that many applications for clearance are made simply because the facility exists and not because of any real uncertainty in the legislation. The Revenue

knows from talking to accountants that many applications are made at the insistence of clients, even when the accountant is certain of the tax position. As a result, a very small percentage of applications are refused clearance.

The number of clearance applications is already large. There are, for example, more than 4,000 a year on company reconstructions alone. Disposal of a shareholding is a much more common transaction than a company reconstruction. The number of disposals of substantial shareholdings to which the exemption could apply is therefore likely to be much larger and the resources that would have to be devoted to clearance applications, both by companies and their advisers and by the Inland Revenue, would make a clearance procedure an impractical proposition. The costs would be significant, even though, in the great majority of cases, there would be no doubt as to whether the exemption applied.

My second reason for rejecting the amendment is that it would be difficult to operate the statutory clearance procedure satisfactorily. Many of the conditions for exemption apply either immediately before or immediately after the time of the disposal. A clearance application, by definition, would be made in advance of the disposal taking place and would have to be considered on the basis of the company's expectation of the facts at the time of the disposal.

In some cases, it would be difficult to determine whether the conditions were met within the context of a formal clearance application when there were strict time limits. The position might change and the facts might be different when the transaction took place. There would be a doubling up of work to consider the clearance application and then to check whether the conditions were actually satisfied after the disposal had taken place. There could be void clearances even when the facts were fully and accurately stated when the application was made.

In response to the hon. Member for Torridge and West Devon, there are less formal and more satisfactory and appropriate ways of seeking guidance in such cases. The most appropriate way might be for companies and their tax advisers and accountants who are in genuine doubt about whether a provision will apply to discuss the matter with the tax inspector who deals with accounts criteria, such as whether the company is a trading company for purposes of capital gains tax taper relief. For that relief, the company's inspector is prepared to enter into correspondence in cases where there is uncertainty and there is no reason why such an arrangement should not apply to the substantial shareholdings regime.

For those essentially practical reasons, it is not in the interests of business to have a formal statutory clearing mechanism. The more informal approach, with advice being taken from the inspector, will work more appropriately and minimise costs.

Howard Flight (Conservative, Arundel and South Downs)

I hope that the Minister was saying diplomatically that the Revenue would be happy to operate an informal clearance procedure as opposed to a statutory procedure. It is common ground that even

after the detailed code of practice there will be grey areas because the territory is so complicated. When dealing with companies, the Revenue has an excellent record of being practical, so I am just about content with an informal procedure. Will the hon. Lady confirm that that is what she was saying? If so, I shall withdraw the amendment, but if not, we may want to return to the matter on Report.

Ruth Kelly (Labour, Bolton West)

To clear up the point about the sort of advice that the Revenue is able to give, in accordance with existing code of practice 10, the Revenue will advise taxpayers of its view on the application of the law to a particular transaction if there is genuine uncertainty as to the interpretation of the law, provided that the full facts and circumstances have been laid out for the Revenue and the relevant law is contained in a recent Finance Act. In addition, the Revenue will give post-transaction rulings advising on the tax implications of the transaction once it has been carried out.

In practice, therefore, there is an arrangement that will work well in the case of substantial shareholdings, that will minimise the burden on businesses and that will, in due course, be welcomed by business as a much more practical way of proceeding on the issues.

Howard Flight (Conservative, Arundel and South Downs)

I beg to ask leave to withdraw the amendment.

Amendment, by leave, withdrawn.

Question proposed, That this schedule be the Eighth schedule to the Bill.

John Burnett (Liberal Democrat, Torridge and West Devon)

Now is the time for me to probe one or two of the philosophical points behind the schedule; I may be over-egging it. The provision is welcome—no one doubts that—but it would not be churlish to ask the Economic Secretary to tackle a further matter that arises from the schedule and clause 43. It appears to some that the Government's philosophy or underlying assumption when they introduced the provision was that trading companies are good and investment companies carrying on bona fide commercial investments are bad. In this day and age, such a view is mistaken. It is a dated assumption that virtually every large holding company quoted on the stock market is an investment company.

Provisions in the Bill define trading groups, into which most companies will probably fall. However, I draw the Economic Secretary's attention to one or two obvious points. Investment companies employ people who pay tax, often at very high rates, and they should be encouraged. We want to retain investment companies in this country and encourage new investment companies to locate here. The measure is wholly welcome for trading companies and groups.

I ask the hon. Lady to deal with this fundamental point. Investment is the sine qua non to all business and commercial activities and it is absolutely vital to our economy. In a nutshell, my argument is that the distinction is now completely dated and I hope that the Economic Secretary will tell us that the Government

are reconsidering their views, which are not really relevant to a modern, thriving and growing economy. We must encourage investment companies. I am not talking about companies that are involved in tax avoidance and so on, but about investment companies that carry on bona fide commercial investments.

Howard Flight (Conservative, Arundel and South Downs)

I second the hon. Gentleman's comments. Indeed, the Chartered Institute of Taxation raised the same matter. It thinks that the distinction between trading and investment companies is inappropriate in the context. Furthermore, it is unsatisfactory that the disposing group has to be a qualifying trading company, both before and after the disposal of shares in a trading company, which appears to have been carried over from the initial consultation process when a deferred system rather than exemption was proposed. As I understand it, that could lead to the extraordinary result that a UK holding company would be exempt from corporation tax on all disposals except the last one, putting the UK at a disadvantage, particularly against Germany and the Netherlands.

Thirdly, I understand that there could be anomalies between the clause and the proposed legislation on derivatives. I would flag that up for further discussion later in the Bill. Finally, can the Government be urged to include a trading purpose option in addition to the minimum holding?

Ruth Kelly (Labour, Bolton West)

I thank hon. Members for their comments on the schedule. I certainly enjoyed the description by the hon. Member for Torridge and West Devon of his vision of how the British economy might develop in the next 10 or 20 years. To understand the terms of the provision and its restriction to trading companies, it is important to grasp how it arose. When consultation on the relief for substantial shareholdings began, it was in the context of a deferral relief—the disposal proceeds would then have to be reinvested in qualifying trading assets. The exemption that we are introducing contains no reinvestment requirement.

John Burnett (Liberal Democrat, Torridge and West Devon)

Will the hon. Lady give way?

Ruth Kelly (Labour, Bolton West)

Will the hon. Gentleman let me continue for a moment? We sought to maximise the likelihood that the disposal proceeds would be used in the way that contributed most to our fundamental policy objective of increasing UK productivity. The trading provisions are designed to achieve that.

Our tax system already distinguishes in many ways between trading and investment activities, and the holding and management of property is regarded for such purposes as an investment activity. However, there is nothing to prevent a property company that is a member of a trading group from benefiting from the exemption if it disposes of shares in a trading company, a holding company or a trading group or sub-group. Property companies will not necessarily lose out as a result of the changes.

I can tell the hon. Member for Arundel and South Downs that we published in the Budget press release the shape of future consultation on the measures. Perhaps I should not go into all the details, but we said that one of the issues that the consultation would

review was the scope for greater alignment between the treatment of investing companies and that of trading companies. I am not going to pre-empt the review or its conclusions, but that will be considered. I am sure that the hon. Member for Torridge and West Devon will make representations to the review, as will other interested parties.

On trading purpose other than activity, the purpose for a group of activities is difficult to operate; activity is an easier concept. In practice, purpose can be evidenced only by actual activity. I do not believe that there is a significant difference between the two. In conclusion, I hope that all Committee members will be able to support the schedule.

John Burnett (Liberal Democrat, Torridge and West Devon)

The Economic Secretary is right that distinctions, often artificial, between bona fide investment companies and trading companies riddle our tax system. I welcome the fact that the matter will be reviewed, and hope that the review will take into account the points made by Opposition Members, especially those that relate to enhancing our economy and the attraction of the United Kingdom as a first-class trading location.

Question put and agreed to.

Schedule 8 agreed to.

Clause 44 - Share exchanges and company reconstructions

Howard Flight (Conservative, Arundel and South Downs)

The clarification definitions that the clause covers apply only for CGT purposes, which could lead to anomalies between CGT and other taxes, stamp duty in particular. I flag that up for when we come to the relevant clause. The Chartered Institute of Taxation says that it would like confirmation that the clarification provisions are not intended to introduce any substantive change in the law.

Ruth Kelly (Labour, Bolton West)

The clause and schedule 9 reform the capital gains rules for share exchanges, takeovers and other forms of company reconstruction. It is important for businesses and investors alike that the rules should cater for all the situations that may arise in practice and that they should be on a firm statutory footing. The changes that we are making will do just that.

The rules will prevent tax on capital gains standing in the way of commercial reconstructions, rolling over any gain that would otherwise arise on the reconstruction. The current rules, which go back to the introduction of CGT in 1965, are not entirely satisfactory. There has always been some uncertainty about what types of corporate reconstruction qualify as a scheme of reconstruction, because there has been no formal definition of that expression. People have had to rely on judgments and court cases, which stretch back to the early years of the last century and inevitably reflect the different business world of that era. Over the years, the Inland Revenue has filled the gap to some extent by publicising what it regards schemes of reconstruction to be.

Last year, a court decision established that some types of reconstruction that the Revenue had accepted as schemes of reconstruction did not qualify as such in law, which caused unease in the business community. The decision prevented a variety of arrangements from qualifying as schemes of reconstruction, although there was no policy reason why they should not benefit from favourable tax treatment. Therefore, we are introducing new provisions to restore the position to what it was before the court decision. They put an end to the uncertainty that surrounds qualification for schemes of reconstruction by defining it in the Bill. We have also taken the opportunity to extend the scope of the provisions for share exchanges to companies that do not have share capital by treating the interests of members as though they were shares. The provisions will now apply to exchanges involving companies limited by guarantee, for example.

The hon. Member for Arundel and South Downs asked about the interaction of the provisions with the stamp duty regime. CGT and stamp duty are entirely different taxes, with different aims and separate rules. I can assure him, however, that modernisation of the statutory regime, to which we shall come in due course and which was announced in the Budget, provides an opportunity to reconsider the stamp duty rules for schemes of reconstruction. Consideration of the reconstruction reliefs is included in the modernising stamp duty consultation process, which is intended to produce new legislation in next year's Finance Bill. If any anomalies arise, we shall have an opportunity to take them into account.

For those reasons, I believe that the clause and schedule 9 will be widely welcomed by business for the certainty and coverage that they provide.

Question put and agreed to.

Clause 44 ordered to stand part of the Bill.

Schedule 9 - Chargeable gains: share exchanges

Howard Flight (Conservative, Arundel and South Downs)

I beg to move amendment No. 71, in page 173, line 31, after 'capital', insert

', preference share capital or debentures'.

Joe Benton (Labour, Bootle)

With this we may discuss the following amendments: No. 72, in page 173, line 33, after 'capital', insert

', preference share capital or debentures'.

No. 73, in page 173, line 34, after 'capital', insert

', preference share capital or debentures'.

No. 74, in page 173, line 37, after 'capital', insert

', preference share capital or debentures'.

No. 75, in page 173, line 39, after 'capital', insert

', preference share capital or debentures'.

No. 83, in page 173, line 41, after 'capital', insert

'preference share capital or debenture capital'.

No. 76, in page 173, line 42, after 'capital', insert

', preference share capital or debentures'.

Howard Flight (Conservative, Arundel and South Downs)

The amendments deal with essentially the same technical issue, which was raised by the Law Society. Clause 44 and the schedule provide welcome codification of the definition of reconstruction for the purposes of capital gains tax reliefs, and the amendments would ensure that company reconstructions included those in which not only ordinary shares, but preference shares or debentures were exchanged for new shares. The Law Society raised several specific points, although I will not read out a great addendum. The Government could, however, usefully consider such points before the Bill becomes law.

Ruth Kelly (Labour, Bolton West)

I cannot support amendments Nos. 71 to 76, but I hope to persuade the hon. Gentleman that they are not necessary.

A company may wish to simplify its capital structure as it goes through a scheme of reconstruction, and the amendments are designed to facilitate that. However, various arrangements that are already in place and which meet the requirements in the Bill will enable a company's structure to be simplified in that way. For instance, the company can reorganise its capital structure before starting the scheme of reconstruction, or the successor company can reorganise its capital structure afterwards. We have included provisions in the Bill to allow for such changes.

I should also note that the meaning of ordinary share capital is quite wide. For example, participating preference shares can count as part of a company's ordinary share capital. Some companies with preference shareholders will, therefore, have no difficulty in simplifying their share capital.

I do not oppose amendments Nos. 71 to 76 simply because companies can already effect a scheme of reconstruction by making arrangements fit their circumstances. The problem is that the amendments would have the undesirable effect of widening the scope of what is a reconstruction of a company beyond reasonable bounds. The essential feature of such a scheme is that those who effectively own the business before the reconstruction are still the owners afterwards. We have preserved that key concept in the new provisions by requiring that only holders of ordinary shares receive ordinary shares in the arrangements for the reconstruction. It is the holders of ordinary shares who own the business, because they are entitled to the profits.

That essential feature of reconstructions has received long-standing approval from the courts and we should not abandon it, but that is what amendments Nos. 71 to 76 would do. They would allow debenture holders and others who are not co-owners of the business to acquire an ownership stake. Arrangements whereby the ownership of a business is passed to someone else could then be structured as schemes of reconstruction and would benefit from the capital gains rollover treatment that applies to such schemes. For that reason, I must ask the Committee to reject the amendments.

Howard Flight (Conservative, Arundel and South Downs)

I understand the point of principle that the Minister raises, and I do not want to undermine it. I simply want to know what the position will be within the existing parameters if our amendments are not made. Will there be a problem with reconstructions that are designed to simplify a company's capital structure, where ordinary shares are issued to preference shareholders or debenture holders of the original company or companies?

Ruth Kelly (Labour, Bolton West)

I do not believe that that is the case. There is nothing in the new rules to prevent such companies from effecting a scheme of reconstruction. It is merely that preference shareholders and debenture holders cannot be issued ordinary shares in the reconstruction. If a company wishes to simplify its capital structure and go through a reconstruction, it can arrange its matters in such a way that they fall within the meaning of reconstruction as it is now defined. I hope that that reassures the hon. Gentleman.

Howard Flight (Conservative, Arundel and South Downs)

I thank the Minister for her comments. The Government might want to look at that area in a little more detail, but I beg to ask leave to withdraw the amendment.

Amendment, by leave, withdrawn.

Schedule 9 agreed to.

Clause 45 - Taper relief: holding period for business assets

Howard Flight (Conservative, Arundel and South Downs)

We have not tabled any amendments to the clause, but I want to make several points. The clause is a positive step, as it reduces the holding period necessary for business assets to obtain maximum taper relief. It has been broadly welcomed, but it does not address certain anomalies. For example, the holder of a business asset can never reduce his taxable gain to nil, whereas the holder of a non-business asset can do so, if indexation is greater than the gain.

That situation arises because the maximum taper relief is 75 per cent. of the gain and 25 per cent. is taxed. Indexation allowance, which applies to non-business assets provides an inflationary allowance such that the index cost of the asset is effectively what someone would pay today for the same asset, if it had risen in value by the rate of inflation. That means that only the real increase in value is taxed.

If an individual held a business asset since January 1985, with an original cost of £100,000, and sold it this year for £200,000, the unindexed gain would be £100,000. Taper relief would be £75,000, leaving £25,000 charged to tax, so he would have to pay tax of £10,000, if he was a 40 per cent. taxpayer. However, if the asset was a non-business asset, the individual would be able to claim indexation allowance of some £91,000, and pay tax at 40 per cent. of £3,460. That anomaly arises because the retail prices index increased by 91.34 per cent. from January 1985 to April 2002, which is the proportion that can be attributed to inflation. In that case, the holder of the non-business asset would be better off than the holder

of the business asset. Perhaps the Government would address that to allow the holder of an asset on which taper relief can be claimed to elect for indexation allowance to apply and for the asset to be treated as if it were not a business asset, if that would benefit him.

We will come to another anomaly in subsequent clauses, which has been pointed out by the Chartered Institute of Taxation. That is the unfairness of the situation that applies to someone who acquired shares in the company for which they work before September 2000. Supposing an employee, who was made redundant last month, sells his shares later this year and, through no fault of his own, finds that 25 per cent. of his gain is deemed to be a non-business asset. Assuming that he is a higher rate taxpayer, the marginal rate of tax will be 70.5 per cent. For every £1,000 gain, £250 will be taxed in full at 40 per cent., so £750 will be subject to 75 per cent. taper relief. Therefore, the total tax burden on each £1,000 gain will be £175, which is 70.5 per cent.

We have tabled an amendment to clause 46, a starred amendment, which would allow individuals, in calculating the length of ownership, to discount the time when the asset was used for non-business purposes. That would not help in the particular examples of retirement or redundancy, but it would deal with the unfairness between pre-2000 and post-2000 business assets.

Chris Grayling (Conservative, Epsom and Ewell)

I rise to address a couple of points, the first of which follows on from the comments made by my hon. Friend the Member for Arundel and South Downs.

On business and non-business assets and potential changes of status in relation to an organisation, Ministers need to be mindful of the situation that can often exist in the early stages of the formation of a business, and in particular the stages in its development when it is backed by venture capital. It is often the case that a person who sets up a business does not end up leading it further down the track. It is very common for somebody to take a business through its first, and possibly its second, round of financing, and then discover that as the business becomes established and developed the investors who are supporting it bring in an additional group of managers to add new experience to it. Very often the person or persons who founded the business may find themselves moving on, retaining shareholdings and no longer working for the company. It is important to tackle that anomaly because it could have an adverse effect that we would not want on entrepreneurial groups in our society and I hope that the Economic Secretary will give that due consideration.

Secondly—I refer hon. Members to my declaration in the Register of Members' Interests—I want to probe the status of property assets with the Economic Secretary. In which cases will property assets become business assets? In relation to the burgeoning residential property market and people's involvement as investors in that marketplace, what is the status of property under clause 45? In which circumstances, if any, will it be classified as a business asset?

Michael Jack (Conservative, Fylde)

I rise to underscore the remarks made by my hon. Friends. The Economic Secretary will have had the very helpful briefing, which deals with some of those matters, from the Chartered Institute of Taxation drawn to her attention. It is probably as well to point out that all such matters are drawn to the attention of Treasury Ministers, who have copious briefings on how to deal with them. I look forward with great interest to what she has to say on those points.

I should like to take our discussion of clause 45 a little further. Although I welcome the fact that the tapered arrangements for the lowest rate of capital gains tax now apply after two years rather than after four, as they did previously—it is a pleasure to see when a sinner repenteth—I should like the Economy Secretary to spend a few moments explaining the rationale for that move.

When tapered tax was introduced, the Government told us that it was good and virtuous. They told us that it would aid investment in British industry. They told us that short-termism was a bad thing, and therefore a taper over a much longer period was entirely to be applauded irrespective of the questions about complexity that Conservative Members raised. On page 49 of the Red Book, clause 45 is justified by reference to

''simplification of the CGT regime to reduce compliance costs, in particular for those who invest in business and for employees.''

What a turnaround by the Government. They introduced the complexity that capital gains tax represents and we now have to unpick it. I should be interested to know the reasoning behind that gradual move.

Will the Economic Secretary tell us why tapered tax has to be applied at two years, rather than at three years, one year or zero years? She is shrugging her shoulders and smiling in her delightful way, but there must be a reason why the Government took that decision, about which it would be helpful for both Parliament and the world of business to know more. She is well versed in economic analysis and is a highly intelligent person who should have no difficulty in providing information on economic gains under the previous regime of longer tapered arrangements. Can she say how much more investment took place as a result of the arrangements that the clause will reverse? How did British productivity gain from such complexity, and what will be the gains from the change to a two-year regime? Can she expand on the Government's policy, philosophy and approach to capital gains tax?

The clause makes a clear distinction between business and non-business assets. Discussions on previous clauses have illustrated that an economic effect can be achieved in the economy through investment in non-business assets. It is about time that the Government outlined their philosophy on capital gains tax, because in successive Finance Bills we have seen a piecemeal unpicking of tapered tax arrangements. The Economic Secretary and the

Government owe it to the House and the country to lift the lid a little on their approach to that tax.

John Burnett (Liberal Democrat, Torridge and West Devon)

I endorse the point made by Conservative Members about people owning disqualifying business assets pre-April 2000. It is preposterous that they must wait until April 2010 to receive full capital gains tax relief, whereas those who acquired an asset after the change in rules receive that relief significantly earlier.

During the Finance Bill a year ago, the right hon. Member for Fylde and I took that up with the Economic Secretary, but we were never given a satisfactory explanation for that preposterous state of affairs. I am indebted to the Chartered Institute of Taxation for its remarkably lucid parable about Fred and Jim, who both worked for Successful plc. Because poor old Fred held shares prior to April 2000, he would qualify for the 10 per cent. rate of tax only if he were to sell them in April 2010; Jim would get the tax advantage because he held shares after April 2000. That is unsatisfactory because it will not reward individuals who have worked hard, and risked their assets and money, for longer. Those people need rewarding. I look forward to the Economic Secretary's endeavour to defend what many people consider to be indefensible.

Ruth Kelly (Labour, Bolton West)

I, too, am indebted to the Chartered Institute of Taxation for providing the Opposition Benches with such valuable ammunition, amusing anecdotes and illuminating examples. I intend to deal with them all in my response.

First, I shall address the point of principle raised by the right hon. Member for Fylde. He referred to what we have said about previous Finance Bills, such as that introducing greater relief for business assets was good and virtuous, and that short-termism was bad. What we did then, and are continuing to do, is introduce a taper relief that means that a tax bill diminishes the longer an asset is held. That is the fundamental principle; it is key to our agenda to reward enterprise, encourage work and increase productivity. I do not accept that our fundamental motive in making the changes has changed in any respect.

John Burnett (Liberal Democrat, Torridge and West Devon)

Fred would disagree with what the Economic Secretary has said because he has held the asset for a long time and is not getting the reward to which she rightly said he is entitled.

Ruth Kelly (Labour, Bolton West)

I hope that, in dealing with the point about what the relief is designed to do, I shall also answer the point raised by the hon. Gentleman.

Why do we have the taper relief? What is its purpose and what is it designed for? I would argue strongly that the Government are not in the business of cutting taxes for no purpose. We are in the business of promoting enterprise and rewarding entrepreneurship, to make commercial decisions more valuable and, hopefully, to promote the direction of investment.

Howard Flight (Conservative, Arundel and South Downs)

Surely the Government are also in the business of increasing productivity and economic

growth, which require the most efficient use of capital. The argument on tapering rates is about locking money into assets that are not ideally allocated. We are all in full agreement on enterprise, motherhood and apple pie, but there is a much bigger second issue relating to capital taxation, which is the efficient use of capital.

Ruth Kelly (Labour, Bolton West)

I completely agree with the hon. Gentleman, but as he and other hon. Members will understand, we believe that there is actually a market failure concerning start-up and growth companies. We can take action and encourage productivity by the use of the tax system and other policy levers at our disposal. We continue to use the tax system to promote long-term investment and to discourage short-termism.

Mark Hoban (Conservative, Fareham)

The Economic Secretary is about to launch into a discussion on why long-term investment is good. If long-term investment is good and short-term bad, why are the Government shortening the taper?

Ruth Kelly (Labour, Bolton West)

The hon. Gentleman interrupted me in mid-flow. If only he had waited, he might have heard the answer. The change that we are making this year will specifically build on the success of earlier reforms and, in particular, encourage investment in start-up and growing companies. For such companies, equity investments are a vital source of finance. However, venture capitalists and other early-stage investors frequently invest with a view to realising their capital in less than two years, so we have designed the taper specifically to take into account the natural mode of operation and interests of venture capitalists, and their investments in start-up businesses. We are doing that to promote the productive potential of this country, to encourage business start-ups and to encourage the right sort of investment to take place.

Several hon. Members rose—

Ruth Kelly (Labour, Bolton West)

I shall take a couple of interventions, and then I must deal with some of the more specific points raised.

Chris Grayling (Conservative, Epsom and Ewell)

Surely we want the venture capital industry to consider the long-term support of businesses, rather than making a short-term buck. A tax system that encourages them to get in and out within two years does nothing to encourage the long-term support of businesses by venture capital firms.

Ruth Kelly (Labour, Bolton West)

I do not think that the hon. Gentleman's point is realistic. We have a system in which investment in entrepreneurs and start-up companies is usually short term. We do not want to cut out from all the potential gains that we are offering all the companies that make a very valuable investment in start-up companies. It is only right to recognise that their period of investment is usually shorter than that of other companies where investment is held for long periods.

Mark Field (Conservative, Cities of London and Westminster)

I am happy to give the Economic Secretary the benefit of the doubt in this matter. I suspect that it is just unintended consequences rather than anything malign that she has in mind. I must confess, as someone who benefited from the old system

of taper relief when it came to selling my business on entering the House, that I should tread carefully in this regard.

I am concerned that the two-year arrangements effectively make it easier for hit-and-run merchants constantly to set up businesses during a short period of time. Instead of encouraging enterprise and entrepreneurship, they will encourage the worst aspects of the process. Companies will be set up quickly and individuals will move from company to company to take advantage of the very favourable regime for capital gains tax taper relief.

Ruth Kelly (Labour, Bolton West)

I do not accept that. Holding an asset for 12 months or two years by investing in a company for 12 months or two years is a very valuable benefit to start-up companies, which is what we are specifically trying to encourage. A 12-month or two-year period will not encourage a hit-and-run exercise by investors. The measure will have a huge beneficial effect.

Rob Marris (Labour, Wolverhampton South West)

Will my hon. Friend the Economic Secretary refer to chart 3.1 on page 49 of the Red Book and tell us what the hit-and-run rate of capital gains tax is in the United States and Ireland, where entrepreneurship seems to be much better after 42 months?

Ruth Kelly (Labour, Bolton West)

The chart speaks for itself and hon. Members can refer to it at their leisure.

The right hon. Member for Fylde asked about publishing an economic analysis of the impact of the provision. The Inland Revenue is committed to evaluating the impact of the taper relief reforms, but time has been too short to obtain concrete information to analyse. The Revenue continues to draw on the experience of a standing consultative review group of outside interests. It is consulted whenever practical on reforms to taper relief and other suggested changes.

On some of the more specific points raised, the hon. Member for Arundel and South Downs suggested that we should consider reducing capital gains relief to zero. The effective tax rate on gains for higher rate taxpayers is now 10 per cent. after two years. I would argue strongly that that not only provides a real incentive to invest in business and encourage share ownership by employees, but it is not clear that making the taper more generous would promote additional cost-effective activity and improved investment performance. I also believe that individuals who make and realise substantial gains should be liable to some tax on those gains.

The hon. Gentleman suggested that non-business assets can be contrived to have a gain of zero, but the indexation allowance applies only to April 1998, which is a matter of contention in the Committee. After that, it does not apply to business assets or non-business assets, so his point is neither practical nor significant.

Howard Flight (Conservative, Arundel and South Downs)

I was simply saying that the issue is arbitrary. The arithmetic was correct. I was not proposing a zero rate in principle, but asking whether the Government had thought about giving people the option in the rare circumstances in which a long-standing business asset might be banished by the business taper relief.

Ruth Kelly (Labour, Bolton West)

The appropriate answer is that it would be very complex to have a system of election into indexation or taper relief as circumstances dictate. We are trying to incentivise behaviour, so we are looking to the future rather than the past.

That brings me to the argument that apportionment is wrong in principle. The hon. Member for Epsom and Ewell (Chris Grayling) referred to apportionment that follows from the need to have two tapers to distinguish productive investment from passive wealth. Time apportionment produces an accurate result when the value of an asset increases uniformly over time, and for many assets that will be a reasonable approximation. Apportionment is a simpler and cheaper system than a valuation-based approach. It is perfectly fair that an asset that has not been a business asset throughout the relevant period of ownership should be treated less generously than one that has. The whole point of a more generous business asset taper is to provide for a lower charge on the gain that accrued while the asset was indeed a business asset. Therefore, it would be unfair to make other poorer taxpayers pay an extra £200 million in tax to end apportionment for no obvious economic or social benefit.

The hon. Member for Arundel and South Downs suggested that employee shareholdings should remain business assets after retirement. We give employees business asset taper relief on their shareholdings because they align their interests with those of the company and have an incentive to work more productively. We cannot benefit from increased productivity if they have left work. It is neither unfair nor contrary to the aim of business asset taper relief to give it only for the time that the relevant conditions of a business asset taper are satisfied.

It would be unfair to other taxpayers who hold shares that are non-business assets to give relief to ex-employees for periods when the relevant conditions of a business asset taper were not satisfied, simply because those people had satisfied them at some point. Employees who retire would benefit from business asset taper relief on any disposal within 10 years of retirement. It is right that a relief should dwindle the longer they hold the shares as non-employee investments.

The hon. Member for Epsom and Ewell asked whether residential property qualified as a business asset. As I understand it, residential property does not normally qualify and is defined as a non-business asset for taper relief. However, there are exceptions to that general rule. Property that is let to a qualifying company and used for trade can qualify as a business asset. I hope that we are interpreting the issue reasonably.

John Burnett (Liberal Democrat, Torridge and West Devon)

Would furnished holiday lettings also qualify?

Ruth Kelly (Labour, Bolton West)

I shall have to write to the hon. Gentleman on that issue to clear it up for him.

I think that I have clearly set out our rationale on the tax. We want to encourage appropriate and

valuable economic activity. We do not want to distort the market for start-up finance. The regime is simple and appropriate, and will encourage investment in shares and productive activity.

Michael Jack (Conservative, Fylde)

I am grateful to the Economic Secretary for those words. I am delighted to hear that the Inland Revenue will produce some analysis to explain how tapered tax operates and, I hope, what its economic effect is. I eagerly anticipate that.

I also thank the Economic Secretary for agreeing that economic activity was turned off and start-ups were damaged as a result of the original proposals. She said that the purpose of the clause was to address a market failure. The failure would not have been there in the first place had the Government not introduced the original tapered tax regime. If they now say that there is time to change it and put forward an economic rationale, there must have been something wrong with the original proposals. I am grateful to her for confirming that on the record.

Question put and agreed to.

Clause 45 ordered to stand part of the Bill.

Clause 46 ordered to stand part of the Bill.

Schedule 10 - Chargeable gains:

Howard Flight (Conservative, Arundel and South Downs)

I beg to move amendment No. 30, in page 179, line 30, at end insert—

'Conditions for shares to qualify as business assets

1A (1) Paragraph 4 (conditions for shares to qualify as business assets) is amended as follows.

(2) In sub-paragraph (2) for ''if at that time'' substitute ''if at the time it was acquired''.

(3) In sub-paragraph (3) for ''if at that time'' substitute ''if at the time it was acquired''.

(4) In sub-paragraph (4) for ''if at that time'' substitute ''if at the time it was acquired''.'.

This is the amendment to which I referred during the stand part debate on clause 45. It is designed to deal with what we still consider to be a potential unfairness in the treatment of people who work for a business, people who have been made redundant and people who have retired. As the Minister pointed out, if the holder of the shares leaves the qualifying appointment, the shares become non-business assets. On a later sale, the proceeds are divided into business and non-business gains and taxed at different rates. It is quite a complicated calculation. A person who sells while employed could easily pay a lower level of capital gains tax than a person who held the shares for a longer period and sold them in retirement.

The Economic Secretary's justification did not entirely stand up. I refer to an earlier debate, in which the Government seemed to have no qualms about imposing a tax rate that is now 52 per cent. on the main options, which are designed to encourage people to work hard and to make a success of business. The Government speak with a forked tongue about

motivating employees in smaller and medium businesses.

The amendment seeks to clarify the position by freezing the status of the shares by reference to whether the person was an employee or a trustee acting on behalf of an employee at the time the shares were acquired. It would not apply to someone who had inherited the shares, who is clearly in a different position. Nor would it apply to non-share assets, because qualification relates to use in a business. The Chartered Institute of Taxation has suggested that paragraph 4 is deemed to have had effect from 6 April 1998, which would deal with the problems.

Mark Hoban (Conservative, Fareham)

May I add to my hon. Friend's comments? In many respects, there is a world of difference between the circumstances of someone who has shares as a consequence of his or her employment and retires, choosing not to sell the shares but to enjoy their income, and someone who is no longer an employee of the firm but is required to hold on to the shares, or is forced to make a sale as a consequence of their employment being terminated. In private companies, there may be agreement that an employee must sell their shares if they resign from the firm. Clearly, if they take a while to reach agreement with the employer, some part of the gain may be taxed on the basis that the shares are non-business assets. There is an issue if a sale is forced on an employee.

There are other situations, perhaps as a consequence of a flotation, in which certain shareholders are locked in for a period. For employees at the time of flotation, the lock-in agreement is not lifted on their departure from the company. They may be forced to hold on to the shares for one or two years after they cease to be an employee. On the basis of current legislation, the shares are treated as business assets for the period as an employee, but are treated as a non-business asset and, as a consequence, incur a high capital gains tax charge for the period after they left employment, even though they cannot realise the shares until the lock-in agreement has expired.

The amendment addresses a series of anomalies in which people must account for a non-business asset gain. It is important that the Government recognise cases in which employees, through no fault of their own, must pay a high capital gains tax charge as a consequence of the distinction between non-business and business assets.

Ruth Kelly (Labour, Bolton West)

I remind the Committee that the generous business assets taper relief, which is available to all employees of companies, is designed to achieve productivity benefits. The relief encourages employees to hold shares in the company for which they work. That in turn leads employees to align their interests with those of the company and its owners. Clearly, we cannot obtain such benefits once employees have retired, or moved to employment somewhere else. No matter how closely their interests are aligned with their former company, there is no productivity gain to be had there. We had that debate earlier. On those grounds, we would have nothing to gain from the cost of the relief. As I explained earlier,

in order to pay for that relief, other taxpayers would have to pay more in tax.

Of course, business assets taper relief is not all lost when an employee ceases to work for the company concerned. The ex-employee continues to obtain the benefit of business assets taper relief on a disposal in the following 10 years, if he or she does not qualify for business assets taper relief on other grounds—for example, if the company is an unlisted trading company.

I am not sure that amendment No. 30 helps the situation or does what the hon. Member for Arundel and South Downs wishes it to do. By focusing merely on the status at the time of acquisition, it means that an asset that was not a business asset at that time could never become a business asset. For example, those assets that were not business assets in 1998 but became business assets from 6 April 2000 thanks to the Finance Act 2000 reforms would now revert to being non-business assets. I know that the Opposition Members did not like the way in which those reforms took effect, but this amendment would not provide a solution to their concerns.

In addition, the amendment opens up an avoidance risk. A company might turn from trading to investing, and business assets taper relief would still be retained. The amendment fails to support the policy aim of encouraging employees to align their interests with those of their employer, is wasteful, and risks tax avoidance.

The hon. Member for Arundel and South Downs suggested that apportionment is extremely complex in some senses. I would like to reassure the Committee that the Inland Revenue has published tables detailing the apportionment fractions for an asset that was a non-business asset up to 6 April 2000, and an business asset from that point on. I hope that those tables will be help to reduce the complexity for individuals who seek to use them.

Mark Field (Conservative, Cities of London and Westminster)

I appreciate that the Government want to ensure that there is an alignment of interests, as the

Economic Secretary rightly says. However, the concern is that at the time of the acquisition those interests may be very much aligned. As set out powerfully by my hon. Friend the Member for Fareham, it may be increasingly the case that acquisition, or options passed on, can only vest some years ahead. The provisions on the acquisition of such options may be being put into place for all the right reasons. However, as my hon. Friend rightly pointed out, if a company then gets taken over, an employee may find himself in very difficult situation several years down the line before he is able to develop the option.

Joe Benton (Labour, Bootle)

Order. It is becoming a speech now.

Mark Field (Conservative, Cities of London and Westminster)

I was wondering whether it was getting close to 1 o'clock.

Ruth Kelly (Labour, Bolton West)

Opposition Members have raised a variety of situations in which people lose out through no fault of their own. Of course, there will always be situations that are complex. In the legislation, we have sought to put things as simply as possible. I have explained the rationale behind the clause, and on those grounds I suggest that the Committee rejects the amendment.

Howard Flight (Conservative, Arundel and South Downs)

I was interested to note that the Economic Secretary repeated the trading versus investment argument referred to earlier, and automatically subscribed to the argument that there is something wicked about investment, which a company desperately needs, and something virtuous about trading in relation to business assets. Capital gains tax arrangements have become a nightmare for citizens, and have been so structured it will be quite tricky for us to reform them in due course. We still think that that is a serious issue.

It being One o'clock, The Chairman adjourned the Committee without Question put, pursuant to the Standing Order.

Adjourned till this day at half-past Four o'clock.

Standing Committee F

Finance Bill

Schedule 10 - Chargeable gains: taper relief: minor amendments

Rob Marris (Labour, Wolverhampton South West)

On a point of order, Mr. Gale. The acoustics in this Room are absolutely appalling. I have average hearing for a man of my age and am finding it difficult to hear some hon. Members make their contributions in Committee. Talking to other members of the Committee over lunch, I found that they are having similar difficulties. I wonder whether the House could do something to improve the acoustics in the Room because the microphones are for the use of Hansard, not for boosting sound levels.

Roger Gale (Conservative, North Thanet)

I am tempted to say that hon. Members who are having difficulty should have voice training. The microphones are indeed for the use of Hansard only and there are no loudspeakers in the Room. However, I heard what the hon. Gentleman said—indeed, I heard what he said very clearly. Perhaps hon. Members will remind themselves of the need slightly to project in this Room. Nevertheless the hon. Gentleman has made a serious point that I do not wish to treat frivolously, and I shall draw it to the attention of the Serjeant at Arms.

Howard Flight (Conservative, Arundel and South Downs)

I will bellow as far as it is possible, Mr. Gale. It crossed my mind that the point just raised might have something to do with the subject matter.

Amendment No. 30 deals with one of the injustices in the business taper rules. It also deals with the issue of those who acquired business assets before 2000 being taxed more than those who acquired them after 2000.

We have raised the issue before, and the Government presented a pragmatic argument, but it is important to remember that perceived fairness among individuals in the workplace is an important issue that allows a company to function well and its work force to be homogenous. Those who have been at a company for the longest, have put in more over time and have had their business assets longest perceive it as unfair that they should pay more tax.

We are not going to persuade the Government and, if it were possible, we would like to put the issue to a vote, but for various reasons amendment No. 84 has remained starred. We have raised the issue, and a pragmatic answer is not sufficient given the reality of the workplace. We shall not put the matter to a vote, however, and I beg to ask leave to withdraw the amendment.

Amendment, by leave, withdrawn.

Howard Flight (Conservative, Arundel and South Downs)

I beg to move amendment No. 31, in page 181, line 16, leave out 'means' and insert 'includes'.

This is a technical amendment to cure a drafting defect. Schedule 10(5) defines the term ''interest in shares'', which is welcome because the acquisition or disposal of an interest in shares is often a significant taxable event. The definition in the Bill is probably too restrictive, however: it is confined to cases of co-ownership. It excludes cases in which an individual acquires a less than full interest in shares because, for example, legal title is lodged with a trustee, nominee or separate contractor under a separate contractual arrangement.

Circumstances in which that could occur include an award of shares to an employee subject to the risk of forfeiture, a case on which the Chancellor of the Exchequer introduced a new income tax regime in 1998. If that were not regarded as an interest in shares, an individual would not be regarded as having ownership for the purposes of taper relief and would be exposed to the full rate of capital gains tax upon the shares' sale. That would sabotage the thinking behind the Chancellor's reforms to the tax and penalise a large number of employees. I trust that the Economic Secretary to the Treasury will either tell me that there is a miraculous interpretation of the schedule that we have missed, or confirm that there has been a mistake in drafting, which the amendment would correct.

Ruth Kelly (Labour, Bolton West)

Welcome to the Chair this afternoon, Mr. Gale. The hon. Member for Arundel and South Downs (Mr. Flight) has moved, as he said, a technical amendment. His concern, however, is not valid and I hope that I can persuade him of that.

The definition of an interest in shares that will be introduced into the taper relief rules by schedule 10 corresponds exactly to that which applies to the new substantial shareholdings provisions, and does not represent any change for taper relief. It focuses on an interest in shares that people have if they own them together with someone else, which is exactly what we had in mind when we framed the taper rule. The reason why we have included a definition in the substantial

shareholdings provisions is because we were urged to do so by representative bodies that commented on the draft legislation that was published at the time of the pre-Budget report—they wanted clarity, and we have given it to them. Schedule 10 provides the same clarity for taper relief.

The hon. Gentleman suggested that a person who holds shares subject to forfeiture holds an interest in those shares as distinct from holding the shares themselves. The Inland Revenue's view is clear: for tax purposes the taxpayer holds the shares, and what matters is the beneficial ownership of the shares. The amendment would create uncertainty in an area in which we are bringing clarity, as it would leave wide open the question of what constitutes an interest in shares for taper relief. On those grounds, I suggest that the Committee rejects the amendment. I hope that the hon. Gentleman accepts my points and withdraws it.

Howard Flight (Conservative, Arundel and South Downs)

I am delighted to be advised that the concerns that our tax counsel raised about drafting have been covered. The second point is slightly grey on the area of law, but, if I understand correctly, it is covered by an Inland Revenue statement of practice. I beg to ask leave to withdraw the amendment.

Amendment, by leave, withdrawn.

Schedule 10 agreed to.

Clause 47 - Use of trading losses against chargeable gains

Howard Flight (Conservative, Arundel and South Downs)

I beg to move amendment No. 12, in page 32, line 19, leave out from 'relief)' to end of line 21 and insert—

'for ''disregarding section 3(1) of the Taxation of Chargeable Gains Act 1992 and the effect of this section'' substitute ''disregarding the effect of this section and either section 2A (taper relief) or section 3(1) (annual exempt amount) of the Taxation of Chargeable Gains Act 1992 as the person elects for the year of assessment in question.''.'.

The clause is intended to allow individuals to benefit from both taper relief and trading losses in the same year. The points that I shall make may be slightly convoluted.

As we understand the clause, the choice that will be presented to people for the early-stage operations of disposing of business assets could, unintentionally, be unattractive. Under section 2 of the Taxation of Chargeable Gains Act 1992, taper relief is given to reduce capital gains on business assets. It works to reduce taxable gains through a taper that depends on the length of the ownership of the business asset. It is available if the total chargeable gains for the year exceed current-year and brought-forward capital losses and the taper is applied to the net gain after deducting those capital losses. Section 72 of the Finance Act 1991 allows individuals to set trading losses against capital gains by treating the maximum amount of loss as a capital loss. The maximum amount is currently the net capital gain after taper relief but before the annual exemption. It should be noted that

as section 72 of the 1991 Act treats a trading loss as a capital loss, taper relief is applied to the net gain after setting off the trading loss.

The interaction of the two measures seems to mean that an individual could have trading losses in excess of their gross capital gains but, because of the way in which the taper works, could not reduce their capital gains to nil. The Bill increases the maximum amount of trading loss that can be set against the capital gain to the gross gain before taper relief. That in turn allows individuals with trading losses in excess of their capital gains to reduce the gains to nil. It also means that the benefit of taper relief is lost. That could penalise sole traders who need to realise funds by selling a business asset and use the cash raised to turn the unprofitable business around. The tax saved by each £10,000 of trading loss used in this way is £1,000 for assets held for more than two years, but £4,000 of tax could be saved if the loss were used against trading income.

The amendment would give taxpayers the option to elect to lose either taper relief or the annual allowance. That may sound an odd idea, but it might force the Government to explain why taxpayers must lose both. Although it would be relevant only in specific circumstances, the provision is a stealth tax nasty, although I believe that it was intended to be helpful. The Institute of Directors and the Chartered Institute of Taxation have also noted the anomaly.

Ruth Kelly (Labour, Bolton West)

We have accepted that, under existing rules, the determination of the amount of trading losses that can be deducted from a gain is not as generous as it should be. The maximum amount is restricted to an amount equal to the gain that would be chargeable to tax after taking taper relief into account. The purpose of the provision is to correct that anomaly. It introduces a modest change that will increase the amount of trading losses that can be set against capital gains. As a result, trading losses can be deducted from a gain if they do not in total exceed it. We have been encouraged to make the change by representative groups and we would, rightly, be criticised if we allowed the anomaly to be perpetuated.

Amendment No. 12 would introduce a change that was neither simple nor appropriate. It would allow a person to elect that trading losses be set against gains up to an amount equal to their total gains before the annual exempt amount was deducted. If such an election were made, the amount of the losses set off would be restricted to the total gains after taper relief had been applied, thus negating the effect of the clause.

The amendment would also provide taxpayers with the choice of making an alternative election: to set trading losses against gains up to an amount equal to the total gains before they are tapered. If such an election were made, the total amount of losses set off would be restricted to the total gains after the annual exempt amount had been deducted. The purpose of that alternative election is to allow a claimant to elect that their trading losses be used to reduce gains only to the level of the annual exempt amount and not, as now, to nil.

We believe that it is right in principle that the amount of trading losses capable of being set against gains is not restricted by reference to the tapered gain or to the gain after the annual exempt amount has been deducted. Allowing trading losses to reduce capital gains down to the level of the annual exempt amount would also be inconsistent with the treatment of capital losses that arise in the same year as chargeable gains. The rule is that such losses are set off against gains to arrive at a net figure, without taking the annual exempt amount into account. The general principle that the amount of losses that can be deducted is not restricted by allowances applies equally to the taxation of income. Reliefs for trading losses, management expenses and so on are given by way of deduction from total income. There is no case for making an exception for setting off trading losses against capital gains.

Amendment No. 12 would have a further effect: most, if not all, claimants would have to make an election to ensure that they did not lose out as a result of the anomaly in the current rules. Therefore, the amendment would not be a simplification; instead, it would add significant complexity to the system.The elective element in clause 47 is merely transitional. If the new method of deduction is of benefit to people incurring trading losses in the tax years 2002-03 or 2003-04, they may elect for it to apply. However, from the tax year 2004-05 onwards, the new rules will apply to all relevant claims. Clause 47 makes the rules for trading loss relief operate in a simpler and fairer way.

Michael Jack (Conservative, Fylde)

I ask this out of a genuine wish for information. The Economic Secretary is arguing that the proposal in the substantive clause should be accepted instead of the amendment of my hon. Friend the Member for Arundel and South Downs. Are the carry-forward provisions for unused trading losses and capital losses in the substantive clause or in the amendment?

Ruth Kelly (Labour, Bolton West)

Obviously, I have been discussing the general clause, because it is necessary to understand it in order to understand the complexity that would be introduced by the proposal of the hon. Member for Arundel and South Downs. However, the substance is clearly in the clause rather than the amendment. Amendment No. 12 would complicate the process and run counter to the way in which relief is given for losses in other contexts. Therefore, I urge the Committee not to accept the amendment.

Howard Flight (Conservative, Arundel and South Downs)

I do not think that the Economic Secretary has answered the pertinent question raised by my right hon. Friend the Member for Fylde (Mr. Jack). To try to explain the matter in simple language, clause 47 corrects one anomaly but creates another one. In essence, a sole trading business in need of cash may be forced to surrender valuable tax losses for the future in order to save on the capital gains tax in the year in question. The Government are not happy with our amendment. Although the issue is specific, I cannot believe that the clause accords with

Government policy, which is supposed to be about endeavouring to help small new businesses. The Chartered Institute of Taxation suggested that the implementation of the rule in clause 47 might be put back a year or two and that the treatment should be available by election, so that the individual can choose to sit on a small loss instead of obtaining taper relief to preserve losses to carry forward.

One anomaly has been addressed but another situation has opened up. I do not think that that is the intention of the policy. The issue is quite technical, but I ask the Government to consider further the point that has been raised. On full digestion, I believe that they will agree that clause 47 is not exactly what they want.

Ruth Kelly (Labour, Bolton West)

The change is essentially one that will reduce tax charges. People will be able to set a greater amount of trading losses against their capital gains and, by doing so, generally reduce the charge to tax. If it is helpful to the Committee, the carry-forward provisions are not changed by the clause. Unused trading losses carried forward can be set against future trading profits. I do not think that the concerns of the hon. Member for Arundel and South Downs are valid.

Howard Flight (Conservative, Arundel and South Downs)

What the Economic Secretary has just said is extremely important. For the sake of clarity, is she arguing that, if there are greater trading losses than are needed to take advantage of the taper relief, those that are not used can definitely be carried forward against future profits? Clause 47 does not quite say that. I would be interested to know how it works—not now, but in a letter perhaps. That is the exact point that we are endeavouring to get at; if it is covered, we are happy.

Ruth Kelly (Labour, Bolton West)

I will write to the hon. Gentleman explaining the technicalities behind the interpretation of the clause. If there is anything there, we will certainly consider it.

Howard Flight (Conservative, Arundel and South Downs)

I beg to ask leave to withdraw the amendment.

Amendment, by leave, withdrawn.

Clause 47 ordered to stand part of the Bill.

Clause 48 - Election to forego roll-over relief on transfer of business

Howard Flight (Conservative, Arundel and South Downs)

I beg to move amendment No. 65, in page 33, line 11, after 'apply', insert

'to the full gain arising on the incorporation of the business or a proportion thereof as specified in the election'.

We have tabled the amendment to make the election apply only to part of the gain, as suggested by the Institute of Directors. The purpose is to allow people who incorporate their business and then dispose only of some of the shares in a two-year period to disapply incorporation relief on the proportion of the gain arising on the shares disposed, and not on the whole gain. The Chartered Institute of Taxation suggests a

full review of the reliefs available on incorporation, particularly if lots of unincorporated businesses arise; we discussed earlier the issue relating to people choosing to incorporate as a result of the tax advantages of incorporation. If that happens as we anticipate, the whole territory may need more consideration.

Ruth Kelly (Labour, Bolton West)

The amendment would introduce an unwelcome complexity to the way in which capital gains tax incorporation relief applies. First, to give a little background to the Committee, I think that it would be useful to explain incorporation relief.

Such relief enables the owners of an unincorporated business to transfer it to a company as a going concern without facing an immediate capital gains tax charge on the disposal of the assets transferred. The relief prevents capital gains tax acting as a disincentive for a growing business to incorporate. It works by rolling over the gains on the assets of the business into the shares acquired in the company. The gain comes into charge when the shares are eventually disposed of.

Incorporation relief does not always work to the taxpayer's advantage because any capital gains tax taper relief that has accrued on the transferred assets will not be inherited by the shares. That means that, if the shares are disposed of two years after the transfer, the business owner might have been better off if he or she had not received the benefit of incorporation relief.

The clause deals with that concern. It will allow the business owner to opt out of incorporation relief after the event, and incur the capital gains tax charge on the transfer of assets to the company with the appropriate taper relief intact. The rules proposed in the clause for an election to opt out of the relief are straightforward and simple. The change will reduce tax charges in the majority of cases where shares in the company are sold within two years of the transfer.

Amendment No. 65 would introduce a special provision for cases in which only some of the shares are sold in that period. That would introduce some significant additional complications, which I fear are not addressed by the amendment. For example, it would be necessary to cater for circumstances in which more than one class of share was involved and the different classes carried different rights to the assets that had been transferred. Furthermore, rules would be needed to deal with situations in which the assets transferred did not all qualify for the same rate of taper relief.

Clause 48 introduces a modest but worthwhile change that will reduce some of the stress of the incorporation decision. We are introducing it in response to specific representations that we have received. I am not attracted to the idea that we could tinker with it in order to deal with the points made by the hon. Member for Arundel and South Downs. The amendment would introduce additional significant complexity, and it is not clear how people would benefit from it.

Howard Flight (Conservative, Arundel and South Downs)

For simplification, I think that the Minister is saying that the Government do not agree in principle that it should be possible to make the election in respect of a proportion of a business corresponding to which shares are disposed of within two years of incorporation and to receive incorporation relief on the remaining part of the business. Why does she not feel that that ought to be addressed?

Ruth Kelly (Labour, Bolton West)

This is a question not of principle but of pragmatism. Every taxpayer who made a disposal of shares soon after incorporation would, under the hon. Gentleman's proposal, feel compelled to work through every possible combination of full and partial elections to see which gave the best results. The legislation would have to be considerably expanded to cater for the different circumstances that needed to be addressed by a partial election.

I do not dispute the fact that the amendment would benefit some people. However, I do not believe that it would be worth while to include the amendment because of the additional complexity that it would introduce, which would be to the disadvantage of the majority of owners who incorporate their businesses. What we hear from businesses is that they would like the tax system to be simpler. The proposals in clause 48 would help many people in a simple, straightforward way. It is the inherent complexity, not the principle, of the amendment that I cannot accept.

Howard Flight (Conservative, Arundel and South Downs)

This is not a huge issue, but it is one that was raised by the Institute of Directors, so some elements of business do have concerns about it. I understand the Minister's logic and do not think that the matter is sufficiently material to put it to a vote. However, the Government might, in the interests of fairness, think about whether there is a simpler way to address the point. I beg to ask leave to withdraw the amendment.

Amendment, by leave, withdrawn.

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

Roger Gale (Conservative, North Thanet)

With this, it will be convenient to take new clause 5—Taper relief: holding period for business assets when roll-over relief on transfer of business assets applies—

'.—(1) After section 162(3) of the Taxation of Chargeable Gains Act 1992 (roll-over relief on the transfer of business) insert—

''(3A) For the purpose of computing any chargeable gain accruing on the disposal of any new asset that is eligible for taper relief under subsection (3) above the qualifying holding period for taper relief shall be deemed to have commenced on the period after 5th April 1998 when the business so transferred under subsection (1) above was held and to have ceased upon the disposal of the new asset.''.'.

Howard Flight (Conservative, Arundel and South Downs)

In effect, our re-jigging of clause 48 by new clause 5 is in order to ensure that the taper relief clock is not stopped and then restarted under the election that is proposed in the Bill, the effect of which would be to waste the number of days during which the business was being incorporated because they were insufficient to contribute to a whole year to qualify for taper relief at the time of incorporation. If, at the time

of incorporation, the business had been held for one year and 11 months, the 11 months would be lost if the election were made, and there would be one whole qualifying year for taper relief; that would make 50 per cent. of the gain chargeable under the taper relief provisions. However, if our re-jigging were accepted, the new shareholder would be able to sell the shares only one month after incorporating the business, and would then qualify for two complete holding years. In turn, that would mean only 25 per cent. of the gain being chargeable.

Ruth Kelly (Labour, Bolton West)

I have already spelled out how clause 48 improves the way in which capital gains tax and corporation relief work. The clause is being introduced in response to representations, and it is simple and straightforward to understand. On those grounds, I have to say that I am not attracted to new clause 5.

First, the clause aims to assign the taper history of the business assets to the shares received on the transfer, thus removing the need to opt out of incorporation relief. I would argue, however, that the assets of the business—for example, the buildings and goodwill—are not the same as the shares issued in exchange for them. It is right in principle that the taper clock on the shares should start when they are issued.

Secondly, the assets might in practice have several different histories for taper purposes. They might have been acquired at different times or be classified as a mixture of business and non-business assets. It would be extremely complex to translate accurately and fairly the different taper histories of the business assets into one value that could be applied to the shares received. New clause 5 deals with that neatly by ignoring the assets altogether and focusing instead on the earliest time after 5 April 1998 when the business was held by the person claiming incorporation relief. That is certainly a simple way of dealing with the issue, but it is also entirely inappropriate. It would, in effect, enable gains on all assets transferred to the company to benefit from a taper history extending back several years, irrespective of how long they had been assets of the business.

Clause 48 will allow a business owner to elect to opt out of incorporation relief and incur the immediate capital gains tax charge on the transfer of the assets to the company, but with the appropriate taper relief intact. That straightforward and simple change, which has been sought by representative bodies, will reduce tax charges in the majority of cases when the shares in the company are sold within two years after the transfer. On those grounds, I have no hesitation in recommending that the Committee reject new clause 5 and agree to clause 48 standing part of the Bill.

Howard Flight (Conservative, Arundel and South Downs)

In simple terms, the Minister is saying that the clause is an improvement on the present situation, which is the case. In new clause 5, we raise the potential unfairness that, in the example, 11 months could be lost if the election were made. The Minister says that it is not worth the complication of trying to deal with that. It is not a fundamental issue of the new regime, but it is worth thinking about.

As we are debating clause stand part as well as new clause 5, I also raise the fact that the time limits imposed might be relaxed by a year. The limits proposed in the Bill are meant to tie in with deadlines for filing returns. The Institute of Directors has suggested more relaxed limits in order to correspond to the normal patterns for other claims such as trading loss relief, so that taxpayers can finalise all their elections together to optimise their tax positions.

Ruth Kelly (Labour, Bolton West)

I believe that the deadline is long enough to enable people to make elections in time to obtain the most favourable tax treatment that could apply to their circumstances. That is the critical point. The longer the election period, the more complicated the record keeping and tax calculations will be and, in the end, the higher the interest payments become. The time limit is reasonable and representative bodies seem to be content with it.

Question put and agreed to.

Clause 48 ordered to stand part of the Bill.

Clause 49 - Shares acquired on same day: election for alternative treatment

Howard Flight (Conservative, Arundel and South Downs)

I beg to move amendment No. 22, in page 34, line 15, leave out 'on same day' and insert 'by employees'.

Roger Gale (Conservative, North Thanet)

With this we may take the following amendments: No. 23, in page 34, line 17, leave out

'on the same day and in the same capacity'

and insert

'in circumstances in which those shares qualify as business assets for the purposes of section 2A by virtue of paragraph 4(2) of Schedule A1'.

No. 24, in page 34, line 17, leave out 'on the same day' and insert

'during any thirty-day period.'.

Howard Flight (Conservative, Arundel and South Downs)

With your indulgence, Mr. Gale, may I point out that amendments Nos. 22, 23 and 24 were tabled as an alternative to amendment No. 21, so I wonder whether I could speak to all of them at the same time.

Roger Gale (Conservative, North Thanet)

Yes, if the Committee is happy for the amendments to be regrouped, given that they all relate to the same clause. We may begin to enter the territory of the stand part debate, but I am happy to include amendment No. 21 with the group that I announced. However, the Committee needs to be aware that if there is to be a Division on amendment No. 21, it will have to be moved separately at the appropriate time.

Therefore, with the amendments that I have announced, it will be convenient to take amendment No. 21, in page 34, line 24, leave out from 'where' to ', or' in line 26 and insert

'paragraph 44, 45 or 46 of that Schedule (exercise of option to acquire shares) applies'.

Howard Flight (Conservative, Arundel and South Downs)

I thank you, Mr. Gale.

Amendment No. 21 is our preferred way of addressing an issue of which the Government may be aware, as it has been raised by the leading lawyer on government law and enterprise management incentive schemes. Amendments Nos. 22, 23 and 24 are less effective alternatives to amendment No. 21.

The amendments attempt to cure what might have been a drafting oversight in the Bill. The intention is to provide employees with the right to elect that certain sales of shares can be charged to capital gains tax where there is a possible gain. The choice arises because, in certain circumstances, the shares may have been acquired under an option without being liable for income tax. The Bill cites two situations in which that can arise--the exercise of a company share option and one category of EMI option--but it omits too further types of EMI options. There is no sensible reason to distinguish between those different cases of EMI option, a category of tax-exempt incentives introduced by the Chancellor in 2000. It makes good sense to ensure consistent treatment, especially in a provision that is designed to be helpful and to simplify the tax position of employees.

Ruth Kelly (Labour, Bolton West)

Clause 49 deals with the specific circumstance on which we received representations. We were told that some employees and companies periodically have a day on which they exercise options to acquire shares under the various share schemes operated by their employers. The employees then arrange to sell some of the shares to pay any income tax liabilities associated with the acquisition. Clause 49 focuses on a small subset of those cases. It typically applies where people who acquire shares in their company through different schemes on the same day have an income tax liability for some of those shares but not for all of them. The effect of the clause is to enable employees to pay that charge by selling some of their shares without incurring unexpected capital gains tax liability on the sale. It does that by changing the relevant rules.

I am delighted that the hon. Member for Arundel and South Downs has recognised that amendments Nos. 22, 23 and 24 are not the appropriate way to deal with the issue, and has decided to concentrate on amendment No. 21. Although we are not minded to accept amendments Nos. 22 to 24, we can accept the hon. Gentleman's amendment--[Interruption.] I am pleased to see that the hon. Gentleman appreciates our acceptance.

We have given the matter careful consideration in the light of representations received after the publication of the Bill. I am satisfied that amendment No. 21 is within the spirit and policy of clause 49. The amendment alters the way that the clause treats shares acquired by exercising enterprise management incentive—EMI--options. The point is that some EMI options incur an income tax charge when they are exercised, and others do not.

Clause 49 divides shares acquired under EMI options into two different categories, depending whether an income tax charge arises when the option

is exercised, and distinguishes between the different types of EMI option. We are concerned that the provision should be simple for people to understand and apply, and the clause keeps things simple by dividing shares into just two categories: those acquired via a share option with no income tax charge attached are in one category; and all other shares are in the other. The different types of EMI option follow that division under the rules that we propose.

That is arguably the wrong result. Instead, all shares acquired via EMI options should be put in the same category as shares acquired via a share option with no income tax charge attached. That is a better result, because it will enable more people to take advantage of the new ordering rule for the disposal of shares.

I must point out, however, that re-shaping the two categories of shares in the way proposed by amendment No. 21 will not always produce a more advantageous result than that currently achieved by the clause. In certain circumstances, some people could find themselves unable to take advantage of the new provisions because of the proposed change.

We have been assured, however, that on balance it is better to make the change. No one will be worse off than they are under the current capital gains tax rules and the change will let some people take advantage of the new provisions in circumstances where they would otherwise not have be able to do so.

There is a second point to be considered: whether amendment No. 21 makes the rules proposed in clause 49 more complicated to operate. We are always concerned with compliance and the complexity of the system. On the face of it, the amendment introduces more complexity because the category of shares acquired by exercising options will include both shares with income tax liability attached and shares without. A mixed category looks more difficult to work out than a plain one. In practice, however, it should not be difficult to work out which category particular shares fall into. People should know whether shares have been acquired by exercising an EMI option, and knowing that will tell them which category of shares they have.

I am therefore persuaded that amendment No. 21 is sensible and would make a worthwhile change to clause 49. I am grateful to the hon. Gentleman for proposing it and invite the Committee to agree to it.

Howard Flight (Conservative, Arundel and South Downs)

I am delighted, and thank the Minister for her kind comments. I seek your guidance, Mr. Gale, on the technicalities. It appears that it would it be appropriate for me to beg leave to withdraw amendment No. 22 so that we can vote on amendment No. 21. I beg to ask leave to withdraw the amendment.

Amendment, by leave, withdrawn.

Amendment made: No. 21, in page 34, line 24, leave out from 'where' to ', or' in line 26 and insert—

'paragraph 44, 45 or 46 of that Schedule (exercise of option to acquire shares) applies'.—[Mr. Flight.]

Howard Flight (Conservative, Arundel and South Downs)

I beg to move amendment No. 66, in page 36, line 46, leave out 'acquired' and insert 'disposed of'.

The amendment relates to one of the issues raised by the Institute of Directors. It seeks to apply the relief to all disposals after 6 April 2002, not only to shares barred after that date; hence it would bring forward the relief and let it apply to more people.

Ruth Kelly (Labour, Bolton West)

Despite the Committee's natural enthusiasm for the previous amendment, I cannot support amendment No. 66, and I hope to persuade the hon. Gentleman that it is unnecessary. It would allow the new election to apply whenever the shares were acquired, but there is a strong practical reason for not doing that. It would add considerable and unwelcome complexity to the provisions.

The normal rule for shares acquired before 6 April 1998 requires them to be pooled with all other shares of the same class in the same company. Extending the election to shares acquired before 1998 would therefore necessitate modifying all the rules relating to the pooling of shares. Restricting the new rules introduced by clause 49 to those acquired on or after 6 April 2002 avoids all the complications that modifying the pooling rules would bring. In any case, there was no need for the provisions to have an earlier commencement date, because we have satisfactorily addressed the problem put to us in the representations that we received. The intended target of the provisions are those people who sell some of the shares in question almost as soon as they have exercised the option to acquire them. Indeed, they may sell the shares on the same day. The usual reason for people wanting to make an early sale of some of the shares is, as we have heard, that they incur an immediate income tax liability on the exercise of their option and they want to pay that tax charge out of the proceeds.

There is another reason why amendment No. 66 is not acceptable. If the taxpayer elects for the new identification rule to apply, it affects all disposals of shares acquired on the day in question. The amendment, however, has effect only in relation to disposals on or after 6 April 2002. That would set up a conflict of rules, as some of the shares would have been disposed of before that date. As I understand the amendment, the normal identification rule would apply to disposals before 6 April 2002 and the new rule would apply to disposal of the rest of the shares. That is a recipe for utter confusion, as the rules would conflict with each other.

In any case, the amendment is entirely unnecessary. Given the reasons for clause 49, I recommend that the Committee does not accept the amendment.

Howard Flight (Conservative, Arundel and South Downs)

I accept that the primary intention of the clause is as described--to deal with situations when people are forced to sell shares because of the high taxation on group share option schemes. As I said earlier, the issue was raised by the IOD; it needed an

airing, but it is not fundamental to the main problem that the clauses seeks to deal with. I beg to ask leave to withdraw the amendment.

Amendment, by leave, withdrawn.

Clause 49, as amended, ordered to stand part of the Bill.

Clause 50 - Deduction of personal losses from gains treated as accruing to settlors

Howard Flight (Conservative, Arundel and South Downs)

I beg to move amendment No. 52, in page 37, line 15, leave out 'has' and insert

'and Schedule (set off of losses treated as accruing to settlors) to this Act have'.

Roger Gale (Conservative, North Thanet)

With this it will be convenient to discuss the following: Amendment No. 53, in schedule 11, page 185, line 22, leave out from beginning to end of line 44 on page 187 and insert—

'(2) After subsection (5) (computation of tax in cases where gains treated as accruing to settlor etc in respect of trust gains) insert—

''(6) Subsections (4) and (5) above shall cease to have effect for the year 2003-04 and subsequent years of assessment.''.'.

New schedule 1—Chargeable gains: set off of losses treated as accruing to settlors—

Introduction

1 The Taxation of Chargeable Gains Act 1992 (c. 12) is amended in accordance with paragraphs 2 to 6.

Section 2

2(1) Section 2 (persons and gains chargeable to capital gains tax, and allowable losses) is amended as follows.

(2) In subsection (2) (computation of capital gains tax), for the word ''and'' at the end of paragraph (a) substitute—

''(aa) any attributed loss accruing to that person, and''.

(3) After that subsection insert—

''(2A) Where on a disposal a loss accrues to trustees of a settlement in circumstances where, had it been a gain that gain would have been attributed to another person by virtue of sections 77 or 86, then that person may elect for that loss to be an attributed loss accruing to that person for the purposes of subsection (2) above for the year of assessment in which the disposal occurs.

(2B) Attributed losses must be deducted first from any gains accruing to a person by virtue of sections 77 and 86 chargeable for the year in question before they may be deducted from any other chargeable gain.''.

Section 77

3 In section 77 (charge on settlor with interest in settlement), in subsection (1) at the end insert ''No deduction of any loss shall be made by the trustees in respect of any disposal which gives rise to a loss which the settlor informs them is to be regarded as an attributed loss for the purposes of section 2(2).''.

Section 86

4 In section 86 (attribution of gains to settlors with interest in non-resident or dual resident settlements), after subsection (1), insert—

''(1A) For the purposes of subsection (1)(e) above no account shall be taken of any disposal which gives rise to a loss which the settlor informs the trustees is to be regarded as an attributed loss for the purposes of section 2(2).''.

Section 86A

5 In section 86A (attribution of gains to settlor in section 10A cases), after subsection (8) insert—

''(8A) For the purposes of this section, no account shall be taken of any disposal which gives rise to a loss which the settlor informs the trustees is to be regarded as an attributed loss for the purpose of section 2(2).''.

Section 87

6 In section 87 (attribution of gains to beneficiaries), before subsection (4) insert—

''(3Z) In making any computations under this section, no account shall be taken of any disposal which gives rise to a loss which the settlor informs the trustees shall be regarded as an attributed loss for the purpose of section 2(2).''.

Commencement

7 This Schedule applies to persons and gains chargeable to capital gains tax and allowable losses in the year 2003-04 and subsequent years of assessment.

Election for Schedule to apply for years earlier than 2003-04

8(1) This Schedule also applies, if the person so elects, in relation to chargeable gains and attributed losses accruing to a person in any of the years of assessment 2000-01, 2001-02 and 2002-03.

(2) An election under this paragraph—

(a) must be made by notice given to an officer of the Board no later than 31st January 2005;

(b) where attributed losses may be regarded as arising in respect of two or more settlements, may be restricted to those regarded as arising in respect of the settlement or settlements specified in the election.

(3) All such adjustments shall be made, whether by way of discharge or repayment of tax, the making of assessments or otherwise, as are required to give effect to an election under this paragraph.

(4) Where—

(a) a person makes an election under this paragraph for any one or more of the years of assessment 2000-01, 2001-02 and 2002-03, and

(b) the effect of the election, or (as the case may be) both or all of them taken together, is to increase the total amount of tax that the person is entitled to recover from the trustees of a particular settlement for those three years under section 78(1)(a) of the Taxation of Chargeable Gains Act 1992 (c. 12) or paragraph 6 of Schedule 5 to that Act,

the trustees of that settlement must join in the election, or (as the case may be) each of them that has that effect or contributes to it.'.

Howard Flight (Conservative, Arundel and South Downs)

By way of background, when the rules on settlor trusts were changed, it was the Government's objective to render the settlor liable to the gains of income of such trusts as if they accrued to him directly. The provisions of clause 50 have been generally welcomed, but they raise two questions.

If the clause is to apply to the deduction of losses from gains treated as accruing to persons, why should someone elect for it to apply the other way round, to deem losses to accrue and be deducted from gains realised by him? Given that the Government's main intention was to look through the trust, why does the provision work one way and not the other? Extensive legislation provides that settlors recognise trust gains as their own. As it stands, losses remain with the trustee and are netted off against gains within the trust before they are attributed to the settlor.

The amendment would extend the intended changes to trust taxation, to permit settlors to offset their losses against their direct gains. It would allow the taxpayer to choose between accelerating the benefit of losses in trust by taking the risk of higher taxable gains from the trust in future, and leaving the position as it stands.

The changes that we propose are designed to be compatible with schedule 11, irrespective of whether our amendments to that schedule are accepted.

Amendment No. 53 deals with a different issue, and I hope that the Economic Secretary will tell me that it is not necessary. As we understand it, the clause would also remove taper relief to settlors if they opted for the choice provided in it. We cannot see the logic for doing so when the trust's gains and losses are to be viewed as exactly pari passu, as if the settlor owned them directly.

I apologise for the length of new schedule 1, but we understood from the Bill Office that there was no alternative way to address the issues. It is necessary to achieve the transfer of losses and gains both ways, which requires a complete amendment to schedule 11.

Ruth Kelly (Labour, Bolton West)

I should begin by setting out the background to settlor-interested trust provisions. I shall then explain what the clause does, before dealing with why I believe that the amendment should be rejected.

People set up trusts for many and varied reasons. Some are purely tax-related; others are nothing to do with tax. The tax system respects the fact that there are trusts and that they are separate entities, but we must ensure that people cannot obtain an unfair tax advantage by putting assets into a trust. For that reason, we have long had special rules that charge the person who set up the trust—the settlor—tax in respect of gains realised by the trustees of a trust. The special rules apply when the settlor, or his or her close family, can benefit from the trust. The rules ensure that the right amount of tax is collected. The settlor may claim reimbursement from the trustees for the tax that he or she pays.

In broad terms, the clause restores the rules that applied before the introduction of the Finance Act 1998, so that settlors can set their available capital losses against gains that are attributed to them in that way. I readily admit that doing so will introduce complexity into the rules, because of the interaction with taper relief. It is because of that additional complication that we decided, when introducing taper relief in 1998, that it would be better to have a simple rule so that personal losses could not be offset against such attributed gains. However, we have come to the view that that can produce harsh results in certain cases and that it would be more equitable for people to set their personal losses against the attributed gains.

Amendments Nos. 52 and 53 and new schedule 1 would allow a settlor to obtain the benefit of losses realised by trustees and set them against all their gains. In effect, the amendments would set up a single pool for the gains and losses of a settlor from which they, or members of their close family, would benefit.

For settlors with genuine non-tax reasons for setting up trusts, the amendments would completely undermine the fact that they had transferred their property to them. For those settlors who set up trusts for tax reasons, it would make setting up trusts a one-way bet against the Exchequer. Indeed, those proposals would open up a real risk of tax avoidance, as people could use the election and juggle the timing

of disposals to maximise the deduction of losses against gains. The amendments would cost about £25 million a year without taking into account any behavioural change caused by people exploiting them for the purpose of tax avoidance.

Howard Flight (Conservative, Arundel and South Downs)

I do not understand the logic of permitting losses in a trust to be offset against personal gains, but not permitting gains in a trust to be offset against personal losses. As the Economic Secretary just said, tax legislation treats the situation as if a trust did not exist. I cannot see the logic of making a change one way but not the other.

Ruth Kelly (Labour, Bolton West)

The trust rules on settlors and interest exist to ensure that the right amount of tax is paid. As I have explained, settlors have the power to claim reimbursement from trustees for any tax that they pay. Allowing settlors to set trust losses against personal gains would mean that a settlor would benefit at the expense of the beneficiaries of a trust. I shall explain that later.

At the moment, trustees' losses are set against their gains. That reduces the sum with which trustees have to reimburse a settlor where a settlor pays tax on an attributed gain, which leaves more for beneficiaries. Under the proposals, the losses would personally benefit a settlor, and more would have to be paid out of that trust's funds to reimburse a settlor for attributed gains, which would leave less money for beneficiaries. That cannot be right. In effect, the amendments would give a settlor the power to benefit from a trust in a way not envisaged by the original deed of settlement.

It will come as no surprise to the Committee that in this very complex area of the tax code, amendments Nos. 52 and 53 and new schedule 1 are not free of errors, some of which would open up new tax-avoidance possibilities. The proposals would, for example, allow untapered losses to be set off against amounts attributed in respect of tapered gains. It is quite unfair to obtain such an advantage just by involving a trust in the process. The amendments and new schedule are wrong in principle, would have a significant cost and would give rise to tax avoidance, and I therefore ask the Committee to reject them.

Howard Flight (Conservative, Arundel and South Downs)

Will the Economic Secretary explain a point raised again by amendment No. 53? My understanding of clause 50 is that the quid pro quo of personal losses being offset against trust gains is the loss of taper relief on trust gains. What is the logic for that?

Ruth Kelly (Labour, Bolton West)

I hope that I can reassure the hon. Gentleman on that particular point. I am advised that taper relief will not be lost under the clause. Trustees will not apply taper relief because the settlor will get it.

Howard Flight (Conservative, Arundel and South Downs)

I thank the Economic Secretary for that answer, which concerns an unfairness that has not been addressed. Although I appreciate the issue about the position of the settlor versus that of the beneficiary, the logic of having the offset one way and not the other is strange, but it is not a huge issue. The Government considered the situation that resulted in clause 50 and

I now request them to consider it the other way, because I cannot believe that they intended their reforms to produce a situation that is worse than if the assets were owned directly by the settlor.

I beg to ask leave to withdraw the amendment.

Amendment, by leave, withdrawn.

Clause 50 ordered to stand part of the Bill.

Schedule 11 agreed to.

Clauses 51 and 117 ordered to stand part of the Bill.

Clause 52 - Tax relief for expenditure on research and development

Howard Flight (Conservative, Arundel and South Downs)

I think that everyone, particularly large companies, is pleased with the inclusion of the clause in the Bill and with the fact that a volume-based scheme is being introduced for large companies. However, the difference between the schemes for SMEs and large companies will lead to difficulties when small companies grow into large companies and vice versa. We believe in principle that there should be some integration between the two and our amendments to schedule 12 address that in part.

The complexity of the legislation and the continuing difficulty in determining whether expenditure falls within the definition of research and development will make it difficult for companies to decide in advance whether proposed expenditure will qualify for the new relief, and we have tabled amendments to schedule 12 to sharpen the definition. Those points of principle underlie the amendments that have been tabled to schedule 12.

Edward Davey (Liberal Democrat, Kingston and Surbiton)

I welcome you to the Chair, Mr. Gale. It is important to tease out some of the policy issues that lie behind the approach in the clause. It has been long heralded and there has been significant consultation on the new research and development tax credit. The Government listened to that consultation and changed their original proposals. However, it is worth having a short debate on whether that approach alone is sufficient to achieve the policy objectives.

There has been debate over a long period about the need for a research and development tax credit. Small allowances and support for research and development have been provided, but nothing as substantial as what is proposed now. Governments have said in the past that a tax credit would not do the job and have argued that most of the extra research and development that would gain the credit would have happened anyway, so there would be a high deadweight cost. The Government's proposal seeks to deal with that by trying to achieve extra research and development for

taxpayers' expenditure, but there has always been a question in many people's minds about whether the provision would make a marked improvement.

The reason for that scepticism is that until recently the results of several studies on how other countries use such tax credits were equivocal. Evidence from some countries showed that their effect was limited and that large amounts of taxpayers' money was spent, with no major behaviour change in the private sector.

The Government have been fortunate in many ways because further studies have been carried out in recent years to discover the objective of tax credits. Today's Government policy has been instructed by lessons from other countries. The policy is undoubtedly needed because Britain's performance on research and development has been lamentable for a long period, particularly when military R and D is excluded from the overall figures. I am convinced that we need to pursue the route that we are on, because international evidence is overwhelming—I speak as someone who is generally reluctant to go down the route of extra tax credits and reliefs.

I hope that the general policy direction receives support from all hon. Members. Can the Paymaster General reassure us that the debate does not rest here and that the Government will deal with other aspects of R and D policy? It would be out of order for me to mention competition policy, regulation policy and so on, but a more imaginative use of the grant system is needed. For example, ideas are being developed for an old-fashioned way of promoting R and D, namely offering prizes. The Government, a research institute or a royal society could offer a prize for the first person or body to achieve a particular breakthrough. Emerging evidence from the past few years suggests that that is a cost-effective way to promote R and D. Only one sum of money would be offered, but if one ensured that it was the right amount and that it created the right incentive, an awful lot of extra research would be carried out in the private sector for a small amount of public money.

The international evidence suggests that the provisions in the clause are the right approach, but I hope that the Government have an open mind to alternative approaches so that we can turn Britain's performance on R and D to better effect for our economy's productivity performance over the longer term.

Howard Flight (Conservative, Arundel and South Downs)

I support the comments of hon. Members. I shall add one specific and separate point on improving R and D performance. We could reconsider patent law and have a two-stage patent arrangement. The first stage would take products up to the point of licensing, and the second would deal with specific needs thereafter. That would be particularly valid to the pharmaceutical industry. In the round, we want measures that will increase R and D activity here rather than overseas. As well as tax incentives, the relative attractions of patent law are important.

The Paymaster General (Dawn Primarolo): I shall make a few brief remarks, but the debate on these amendments should tease out in more detail many of the points raised by hon. Members.

I welcome the positive comments from the hon. Member for Kingston and Surbiton (Mr. Davey). They echo comments by the Society of British Aerospace Companies, the Confederation of British Industry and the Federation of the Electronics Industry, to mention but a few.

Jim Cunningham (Labour, Coventry South)

A number of us who have lobbied for several years appreciate the move on tax credits, but may I ask my hon. Friend a question? If we consider a company such as Rolls-Royce which has put considerable expenditure into research and development, is it the Government's intention to retain what they call lift-off loans, along with the tax credit?

Dawn Primarolo (Labour, Bristol South)

I am afraid that I am not in a position to answer specifically the question posed by my hon. Friend, which is similar to the point that the hon. Member for Kingston and Surbiton made, concerning Government policy across the board in the encouragement of research and development. In the statement that my right hon. Friend the Secretary of State for Trade and Industry made last week on manufacturing, she specifically focused on aerospace as well as the pharmaceutical, chemical and car industries. The appointment of Sir Richard Evans to chair the innovation and contracts team that will advise the Department of Trade and Industry is crucial. Rolls-Royce itself may be the subject of debate in relation to some amendments.

Yesterday, I was with David Marshall at a conference in the south-west, where there are a great many aerospace companies. We should be in no doubt that the tax credit will enormously help investment into research and development in this country. As we go through the amendments, we will see how the small and medium-sized tax credit on research and development and the larger company research and development tax credit fit together.

Underpinning all companies is a 100 per cent. deduction for research and development on current and capital expenditure. That underpins everything. On top of that, the two tax credits are boosting—they are super-plus credits. For the small and medium-sized companies, there is a 50 per cent. boost; for large companies, it is 25 per cent. Without drifting into the amendments, it will come out later in the debate why they are different, and what the Government are trying to achieve.

The historic position for the United Kingdom is that investment in research and development—with the exception of pharmaceuticals, perhaps—lags behind that of other major economies. To stick with the example of aerospace, we have the second largest aerospace industry in the world. We are second only to the United States, with a complete capacity to design, develop, manufacture and deliver. That is obviously enormously important, and great strides have been made in the past, but more must be made in the future.

We have considered the position on international comparisons and what other countries are doing to give assistance to their companies for research and development. Putting in place the large company element, the value of the credit for research and development as a percentage of gross domestic product will be second only to that of Canada. That is the only G7 country that will—marginally—be ahead of us. We will be spending more, using the tax credit, than the United States or France, which have traditionally invested more than us.

Michael Jack (Conservative, Fylde)

On a point of clarification, and I apologise if I have missed something, but will the Paymaster-General explain why she is talking in general terms about the operation of the research and development tax credit? For example, the Marconi part of BAE Systems in the United States consolidates its company accounts in the United Kingdom but incurs research and development expenditure of a qualifying nature in the United States. How does that operate in relation to the credit?

Dawn Primarolo (Labour, Bristol South)

That is the subject of one of the amendments, but I shall make my general comments now. I have taken the challenge to compare and contrast that the right hon. Gentleman often poses to Ministers. Perhaps if I give my response in the general debate on the clause, it will set the matter in context. I shall compare and contrast how and why the small and medium-sized enterprises tax credit is different from the larger company tax credit.

The obvious headlines are the rate of relief and whether it is payable; the subcontractor issue, which relates to the point that the right hon. Gentleman is making; intellectual property rights—there is a variation there—and the definition of research and development. Every one of those subjects relates to amendments, but I shall just discuss them briefly now.

The rate of relief for research and development costs for small and medium-sized companies is 150 per cent.; it is 125 per cent. for large companies. We have to draw a line somewhere. I should also just say as a caveat that in all the consultations the industry and professional associations were clear that we had to have simplicity, transparency and certainty. There was much discussion about the different ways to operate the credit, whether based on volume or incrementally. Hon. Members will have seen the outcome of that debate.

A reason for the difference between 150 and 125 per cent. is that small and medium-sized companies face particular difficulties attracting finance, especially for research and development. For example, banks often find it difficult to assess the worth of a project. That is a real problem for small and medium-sized companies. In addition, the difference in the effective rate of the subsidy is smaller for larger companies. Typically, it is 9.5 per cent. for small companies and 7.5 per cent. for large companies, because smaller companies pay tax at a lower rate. We are considering the introduction of a system, and more detailed explanations will come up when we deal with the amendments.

Another issue is whether relief is payable. For small and medium-sized companies, the credit is payable for a loss-making company, whereas it is not for larger companies. Loss-making companies carry credits forward until they make a profit, but smaller companies cannot always do that. Obviously, we are trying to create an environment in which research and development are undertaken in this country. That is the purpose of the measure. The reasons that apply are the same as those that I gave for the size of the credit. For instance, the difficulty that small and medium-sized companies have in finding financing reflects the fact that the finance market sometimes fails specifically to assist them.

A payable credit also has public expenditure and state aid implications, and we had to be very careful and consider the laws. On subcontractors, we might discuss Rolls-Royce again when we deal with the amendments later. For small and medium-sized companies, the company funding the contract gets the credit, but for large companies, the company undertaking the research and development gets the credit. It is a natural preference to give the credit to the funding company, as it makes the decisions and takes the risks. However, for the large company, the credit essentially rewards all UK-based research and development, whether or not it is funded from abroad. That would not occur, on the whole, for small and medium-sized companies. By their very nature, they operate in one country.

To answer the right hon. Member for Fylde, we do not want to give credit, if we can possibly avoid it, for R and D undertaken elsewhere, by non-resident subsidiaries of UK multinationals. When we discuss the amendments, we shall see how our measures interact with tax treaties and other issues to ensure that that does not happen. By focusing on UK R and D, we have been able to deliver an enhanced rate of credit for the same Exchequer cost. What we have tried to do has been to produce a usable credit that maximises the rate at which we can pay it, by ensuring that it benefits UK investment. We have been greatly assisted in our detailed discussions in relation to tax by both the companies and the professional accounting bodies.

Claire Curtis-Thomas (Labour, Crosby)

My hon. Friend should be aware that I have recently been in discussion with some of my engineering colleagues, with particular reference to the R and D tax credit. First, I pass on their congratulations concerning the consultation that took place to ensure that the R and D tax credit was gifted to large companies. I also applaud the moves that the Government have made to ensure that the tax credit is passed on to third-party suppliers. As my hon. Friend will be well aware, large companies have, in the recent past, evolved their research capacity out of third parties. There was great concern that they would miss the bonanza. Can she comment on the future viability of such organisations, particularly with reference to the substantial enhancement for R and D?

Roger Gale (Conservative, North Thanet)

Order. I have allowed the hon. Lady to intervene, so I shall allow the Minister to answer the specific point if she wishes to do so. Clause 52 is a narrow clause; it is really a trailing clause for schedule 12 and, although I appreciate that these are complex issues, and interlinked, we are effectively entering into a stand part debate on schedule 12. As swiftly as possible, we should put clause 52 to bed then move to the amendments to schedule 12 and have a proper debate in the proper place.

Dawn Primarolo (Labour, Bristol South)

It would make it far easier for me, as the Minister, to respond if we could deal with the points in context. If my hon. Friend the Member for Crosby (Mrs. Curtis-Thomas) will allow me, I shall return to her point on how the large company tax credit will operate vis-a-vis not-for-profit organisations—universities, for example—when we debate the amendments.

My final two points of concern set the scene for the clause. The first is the issue of intellectual property rights. Small and medium-sized companies must retain some, however small, intellectual property rights within their R and D. There are obvious reasons for that, given their size. There is no requirement on large companies, and we must ensure that the United Kingdom research and development of foreign multinationals qualify in order to encourage inward investment, because that is part of the issue.

My second point concerns the definition of research and development. First, for small and medium-sized credit, we are using the DTI guidelines. After a great deal of discussion, we are using the same guidelines for large companies. They are based on the research and development definition of the Organisation for Economic Co-operation and Development and underpin the UK accounting standards and the R and D credits of other countries. That becomes crucial when making international comparisons and considering the possibility of what might be called double dipping, or getting credit from two different countries for doing the same research. That issue is part of the subject of the amendments. Although I welcome hon. Members' contributions to date, perhaps we are just setting the scene for how the provisions vary so that now we can tease out in the amendments why they do so. I should perhaps conclude my remarks on the clause and save further detailed discussion for the debate on the amendments.

Roger Gale (Conservative, North Thanet)

I call Mr. Jack, but very specifically on clause 52.

Michael Jack (Conservative, Fylde)

Indeed, Mr. Gale, I would not have risen had I not wished to make a specific point while we are considering things in the round. In the Red Book, the amount of money that the Government are going to expend on research and development tax credits in the financial years 2003-04 and 2004-05 is shown as a flat figure of £400 million. Will the Paymaster General put my mind at rest on that? For example, if the R and D tax credit is more successful than she has outlined, can I assume that that £400 million is not an upper limit, that this is not a cash-limited figure?

I was intrigued as to why the sum was deemed as flat instead of, for example, a rising trend of numbers. There may well be a very good explanation, for which I would be grateful.

Dawn Primarolo (Labour, Bristol South)

The figure is not cash-limited and the figures assume the ability of the companies, on the information we have to date, to draw down on new investment to do that new R and D work. The right hon. Gentleman is quite right. If the measure is astronomically successful, the figure could rise. That would be good for the British economy as a whole, good for all the figures in the Red Book and not something of which the Government would take a dim view.

Question put and agreed to.

Clause 52 ordered to stand part of the Bill.

Schedule 12 - Tax relief for expenditure on research and development

Howard Flight (Conservative, Arundel and South Downs)

I beg to move amendment No. 25, in page 189, line 9, after 'enterprise', insert—

'or a small or medium-sized enterprise which makes an election pursuant to paragraph 16A below'.

Roger Gale (Conservative, North Thanet)

With this it will be convenient to consider amendment No. 26, in page 194, line 35, at end insert—

'Regulatory simplification

16A. (1) In respect of any financial year any small or medium-sized enterprise may elect to forego the reliefs available to it under Schedule 20 to the Finance Act 2000 (tax relief for expenditure on research and development) and instead claim relief under this Schedule as if it were a large enterprise.

(2) Any election pursuant to this paragraph must be made in writing to the Inspector of Taxes prior to the end of the financial year in question.'.

Howard Flight (Conservative, Arundel and South Downs)

The two amendments are straightforward and echo the brief remarks that I made at the beginning of the stand part debate on clause 50. It is entirely understood and correct that the reliefs available to SMEs are more favourable than those offered to large enterprises. However, comments that we have received from industry leaders lead us to believe that some of the conditions attached to the reliefs for small companies could be onerous and it might be simpler for small companies to claim a less restricted, albeit less generous, relief under this new measure. It would also, obviously, for those who chose to do that, render the transition from small to large much simpler. Both the IOD and the CIOT have suggested that it would be sensible to move to a simple, volume-based system in general.

Roger Gale (Conservative, North Thanet)

The issues are complex and inter-related. As is my custom, I am perfectly prepared to allow a wide-ranging debate on the understanding that we do not then have a schedule stand part debate at the end. Insofar as Members find it convenient to discuss broader issues I am perfectly happy for that to happen.

Edward Davey (Liberal Democrat, Kingston and Surbiton)

The principle behind the amendment needs applauding. If the Minister is not going to accept it, I hope that she can explain how she envisages companies growing and developing from one tax credit to the next.

The Minister was gracious to the Committee in the previous debate and explained the background and how the credits would work. That was a helpful reminder but I am still not clear whether, if a company grows over the period of the R and D investment and moves from one definition to the next, it will suffer penalties. How will the transition in its growth be managed within the tax system? That is an important issue. We should be grateful to the hon. Member for Arundel and South Downs for tabling the amendment because, if the R and D is successful, the company will grow. The Minister might argue that if the company is successful, the tax credit should be capped because the earnings that result from its growth will mean that it no longer needs the subsidy.

Investors will be putting in risk capital and expecting a certain return. Has the Minister analysed the relation between the two credits? Will she be able to reassure investors that their expected returns will not suddenly diminish because of the complex interrelations in the system?

Dawn Primarolo (Labour, Bristol South)

I am not attracted to amendments Nos. 25 and 26. In fact, they represent real danger for small and medium-sized companies with regard to the entitlement to the 50 per cent. addition. If there were an opt-out, they could come under pressure, because the 50 per cent. is given in return for what they undertake themselves. Subcontractors may be attached to a larger company, which will be entitled to the larger company benefits.

The hon. Member for Kingston and Surbiton referred to what happens when companies grow. The amendments would allow a small or medium-sized company to opt out of the tax credit for those sizes of company and be treated as a large company instead. It is far from clear why a company would want to opt out of receiving 50 per cent. in favour of receiving 25 per cent.

Under our proposals, a small or medium-sized company will be able to claim the existing credit for a company of that size on its own R and D and an extra deduction of 50 per cent., rather than the 25 per cent. that will go to the larger companies. There will be a possibility of a cash payment if the venture is loss making. If the company opts out, it will lose the cash payment option and its tax credit is reduced from 50 to 25 per cent. In addition, a small and medium-sized company, having protected its position vis-a-vis the 50 per cent., may still be able to claim the large company credit for expenditure on work financed by someone else—for example, subsidised work or work by a subcontractor for a large company.

The proposed new paragraph in schedule 12 is headed ''Regulatory simplification,'' but it is hard to see what the simplification is or what other benefits it would allow. It would add to the length of the Bill,

create new uncertainty over the status of the small and medium-sized company and could cause serious problems. Hon. Members may find it easy to imagine a contract being drawn up between a large company that wants access to a tax credit and a smaller company that would receive a tax credit at a greater rate, that would benefit to a greater extent and that might come under pressure for contract reasons to opt out of the better entitlement. Therefore, I am not at all attracted to the amendment.

The hon. Member for Kingston and Surbiton suggested that the Bill would make the rules for small and medium-sized businesses too complex. He asked how a business would move from one category to another and suggested that it would be simpler to allow them to choose. The Government and officials at the Inland Revenue and the Department of Trade and Industry have put a huge amount of effort into discussing with small and large companies how to make the rules as simple as possible, while allowing benefits to flow from that.

Michael Jack (Conservative, Fylde)

I am following the Paymaster General's argument carefully. Will she say what would happen if a large company took over an SME, whose R and D activity it found to be especially attractive, thereby giving the smaller company the enhanced credit that she mentioned a moment ago? Would the status quo of the smaller company remain, although it had become a wholly owned subsidiary of the larger company?

Dawn Primarolo (Labour, Bristol South)

Perhaps I can answer that question in a slightly different way. It is not always possible to provide in legislation for such changes of status, and some discussion with the Inland Revenue will still be necessary. Of course, we hope that SMEs will grow into larger companies, and we want to encourage that. However, we should recognise that they will go through a transition. The effects of that transition will be eased by the definition of ''small or medium-sized enterprise'', which will allow a small company to continue qualifying as such in the year after it ceases to meet the criteria. None the less, at the end of the transition period, the company may fall within the definitions of ''large company'' and therefore fall within the tax credit regulations. We recognise that SMEs will be under a different pressure.

We have tried to keep the scheme as simple as possible but it must be able to operate. The precise definitions of ''R and D'' and how they will work in practice following the DTI guidelines are still being discussed with the CBI and other trade and accountancy bodies, as was referred to on the Floor of the House. The detail of many of those issues will need to be set out, but the essential point is to recognise that SMEs operate under different conditions and, therefore, if they are to be able to undertake R and D, will attract slightly different rules from large companies. The two sets of rules must co-exist as simply as possible to deal with the transition across boundaries. That is what the Government have tried to achieve, and that is why the consultation exercise opted for a volume-based rather than an incremental

scheme. The points that hon. Members are making about complexity would be writ large if we had an incremental scheme.

Both the Chartered Institute of Taxation and the Law Society of England and Wales are of the view that the way in which the credit will operate will provide for a clear system in terms of how companies claim. Until we see that in operation, I cannot say that all of the matters are settled and dealt with. However, we believe that companies and professional bodies should continue discussing with us the finer qualities of the provisions.

I return to a point made by the hon. Member for Kingston and Surbiton. This debate is not the final word on how the provision will operate or on how we should review it and make sure that it improves. Nor it is the final word on Government policy in continuing to encourage research and development, growth and productivity because of their clear benefits to the British economy in terms of jobs and skill levels.

I hope that Opposition Members realise that an opt-out for small and medium-sized companies would be bad, because they could come under pressure to give up what clearly are good benefits. We want the two credits to interact with a sufficiently light touch to ensure that SMEs do not find themselves squeezed, or having to operate under unreasonably complex rules. That is certainly what everybody is saying to us. Frankly, if it is good enough after all the consultation, we should give the legislation the opportunity to work before adding complexities to provide for things such as opt-outs.

I ask the hon. Member for Arundel and South Downs to wait and see how the tax credit operates. If people still have problems, I am sure that the Opposition will come back next year, if the Government do not, with suitable amendments. I ask the hon. Gentleman to withdraw the amendment.

Howard Flight (Conservative, Arundel and South Downs)

The thinking behind the amendments was, first and self-evidently, that if an SME was nearly up to the limit, rather than getting caught with the problems caused by having one set of rules one year and another set the next, it might be more simple for them to go straight to the large company rules. The Minister has allayed that fear to some extent by saying that there will be a year's grace.

Another thought behind the amendments was that, as we were advised, some of the conditions attaching to the more generous SME reliefs are pretty onerous and demanding, and that that might act as a disincentive to SMEs to take them up. The Minister has not said anything specific about consultation with SMEs, but one of the attractions of the large company reliefs is that they are drafted in a simple and straightforward fashion, whereas existing reliefs for SMEs are quite complex. If an SME was not sure whether it would meet the requirements of the more generous provisions, but was sure that it would certainly meet the wider requirements, it might want to take them up.

The amendments are in essence probing amendments. As the Minister accepts, there is more work to be done in this area. However, I would like to hear a little more from her on whether the conditions attaching to existing SME reliefs are demanding and have therefore resulted in their underuse.

Dawn Primarolo (Labour, Bristol South)

We have received no representations that the rules are too complex—quite the reverse. The SME tax credit is more generous and has a lighter touch than the large company tax credit. It should precisely recognise the slightly different circumstances of SMEs. I cannot understand the hon. Gentleman's logic. He says that the provision is too complex, so it should be made less complex by adding highly complex rules under which a company could give away all the extra benefits—Lord knows why it would want to—and pretend that it is a large company. A large company would be given less than a small or medium-sized company. Small and medium-sized companies that become large companies are protected in the transition, which is appropriate, given the planning.

The hon. Gentleman needs to understand that SME tax credit for R and D was provided for in the Finance Act 2000. There has not been a stampede to the Treasury's door from SMEs saying that they want the scheme for large companies instead, because it is less generous.

Howard Flight (Conservative, Arundel and South Downs)

The Paymaster General has not answered the key question that lay behind the input that we perceived, which is about how much take-up there has been from provisions of the 2000 Act. We have been advised that many SMEs have found the arrangements too complex to bother with. The crude thinking was that, on the basis of the large company schemes being much simpler although not as good, it would be better for SMEs to take them up. Have the 2000 Act provisions been taken up?

Dawn Primarolo (Labour, Bristol South)

My understanding is that they have, but I do not have the figures on take-up to hand. The hon. Gentleman will understand that investments in R and D require a long planning period before the tax credit comes in.

I find it incredible that the hon. Gentleman is asking me to believe that plenty of criticism has poured to him so that he can make his point in Committee, but not to the Government, who could have amended the legislation and ensured that there was no problem. The subject has not been reported to us as a problem by SMEs.

We have invested a great deal of time and taxpayers' money in the R and D credit. The policy is important to the Government, and I can assure the hon. Gentleman that if it was not working as well as it should and required amendment, we would take those considerations on board and do our best to amend it. The Inland Revenue is full of talented and able people, but mind readers they are not. Given that no one has pointed out why the scheme should be changed, it is

difficult for me to engage with the hon. Gentleman in a theoretical discussion on a complexity about which no one is complaining.

Indeed, the reverse is true: the scheme has been widely welcomed and is being used. People have had nearly two years to comment on it, and complaints are not coming through. If they do, I shall ensure that they are looked at, because I want the policy to be a success.

Howard Flight (Conservative, Arundel and South Downs)

I am very glad to hear the Paymaster General's comments. She will find that the take-up has been extremely disappointing, and that there is something in the issue of complexity. However, I do not want to bang on about the matter. If my claim is substantiated, I am glad to hear that the Government will want to consider simplification. The amendments simply sought to offer a short cut to simplification, but the matter has had a valuable airing. They were probing amendments, and one or two interesting facts have come out of the discussion. I beg to ask leave to withdraw the amendment.

Amendment, by leave, withdrawn.

Howard Flight (Conservative, Arundel and South Downs)

I beg to move amendment No. 54, in page 189, line 24, at end insert—

'3A. A company's ''qualifying R and D expenditure'' shall not include any amount in respect of which, under the law of any territory outside the United Kingdom, the company is entitled to a deduction for the purposes of any foreign tax which exceeds the amount of such expenditure.'.

I had understood, when the main reliefs were announced, that they would relate only to R and D undertaken in the UK and there was an issue about the relative attractions of Canada and other such places. I was interested to hear the Paymaster General say that that was how the measures had been cast. As far as our adviser and I can see, clause 52 contains no restriction that any expenditure benefiting from enhanced tax relief should be incurred in the UK. Conceptually at least, the relief could be used to allow foreign groups to obtain additional tax relief for R and D expenditure routed through UK companies. The UK Exchequer could suffer without any additional R and D being carried out here.

The Paymaster General referred to the scope of the relief to R and D carried out in the UK being limited by European Union law. The amendment seeks both to limit the scope of any potential abuse by ensuring that no relief is given where another territory is giving a super-deduction for the same expenditure under its tax laws and to make it clear that double dipping is prohibited.

Dawn Primarolo (Labour, Bristol South)

I thank the hon. Member for Arundel and South Downs for his assistance in scrutinising the legislation to ensure both that companies do not use it in a way in which it is not supposed to be used and that expenditure is directed precisely to enrich the research and development capability in the UK.

The hon. Gentleman specifically raised the problem of tax incentives in other countries and how foreign multinationals that are not based here would operate. We raised that issue in last year's consultation. If a company is able to claim a tax incentive in another

country, why should we give another credit in the UK? However, we decided that such a restriction was not justified, and the problem that he has identified would not exist. Our new credit focuses on direct R and D costs—staff costs and consumable stores—of a company within the charge to UK tax, and the bulk of such costs would not be eligible for any foreign tax incentive. We are not giving credit, in general, for the costs of subcontracted work, including work subcontracted to a foreign business. That is another crucial difference between the tax credit for small and medium-sized companies, which would probably not have the ability to subcontract work to a foreign business, and the tax credit for large companies. Very little expenditure will actually qualify for an incentive in more than one country.

If we were to introduce a restriction, it could cause some multinational groups to locate outside the UK research and development activity that might otherwise have been conducted here, which is not the result that we want. The amendment is unnecessary in any case, because foreign R and D relief would almost certainly be cancelled through the operation of double taxation relief. Foreign tax relief will reduce the amount of double tax credit given against UK tax, allowing the UK Exchequer to benefit from foreign R and D credit. A company's overall tax liability will be reduced only by the UK tax credit, and not by a foreign tax credit as well. To go further than that and deny the UK tax credit would just be punitive and unnecessary.

Others have scrutinised that point, and the detailed views that we received in the consultation argued against such a restriction, which would inadvertently work against R and D. As well as large companies, a number of well-respected representative bodies, including the Chartered Institute of Taxation, the Institute of Chartered Accountants in England and Wales and the Law Society, criticised the idea. For those reasons, and after careful consideration of the design, the Government are satisfied that we can prevent such a restriction. However, if it turned out that something untoward was going on, and there was what we politely call ''tax leakage'', we would deal with it. We are trying to strike a balance throughout the Bill between protecting the Exchequer and recognising the commercial reality of the how companies operate.

Iain Luke (Labour, Dundee East)

The hon. Member for Arundel and South Downs made a valid point. I know from being involved in the all-party group on tyres, and from comments from the Chartered Institute of Taxation, that the tyre industry is wholly owned by companies outwith the UK, which is unfortunate given the UK's pioneering role. Given the complications of decisions on tax credits, the only thing that will save the industry is R and D credit. It will allow the industry to invest in high-quality techniques, which would beat off competition from the far east. The hon. Gentleman's points were pertinent. Will the Paymaster General bear in mind the tax credit issues that relate to the tyre industry?

Dawn Primarolo (Labour, Bristol South)

Certainly. My hon. Friend raises an important point about how the tax credit operates. It will encourage research and development in the United Kingdom, particularly in industries that large multinational companies may be financing from outside the UK. My hon. Friend's example was of the tyre industry being financed from outside the UK when its R and D occurred here. Such an industry would qualify for tax credit.

The hon. Member for Arundel and South Downs made a slightly different point. He wanted to ensure that companies did not get double credit—from the United States and from the United Kingdom—for the same R and D. My response was that the operation of tax treaties, and the rules for calculating tax, would ensure that that did not happen. A multinational that accessed R and D tax credit in another part of the world could not access R and D tax credit in the UK—even if it tried to get it for different R and D—because that would make for complicated rules on distinguishing where research happened. We want our tax treaties and tax system to operate normally by ensuring that there is no double relief. I hope that I have reassured the hon. Gentleman that we are quietly confident that our rules will prevent behaviour that could cost the Exchequer money.

Howard Flight (Conservative, Arundel and South Downs)

I am pleased to hear the Paymaster General's response, for which I thank her. The fundamental objective is to ensure that R and D happens here. I understood from discussions with CBI representatives last autumn that we are in a competitive game, particularly with Canada where there are attractive incentives—hence the argument in favour of the provision. The double dip is a secondary point. It strikes me that the schedule has been cleverly crafted, particularly within EU constraints, so that the net effect is that virtually all R and D takes place here. I beg to ask leave to withdraw the amendment.

Amendment, by leave, withdrawn.

Michael Jack (Conservative, Fylde)

I beg to move amendment No. 77, in page 189, line 30, after 'incurred', insert ', whether directly or indirectly'.

Roger Gale (Conservative, North Thanet)

With this it will be convenient to take the following amendments: No. 78, in page 189, line 32, after 'stores', insert ', or

(c) on accommodation.'.

No. 79, in page 189, line 32, at end insert

', or

(c) on applicable direct overheads, such amount to be calculated on a just and reasonable basis.'.

Michael Jack (Conservative, Fylde)

Amendments Nos. 77 and 79 are conveniently linked because they deal with aspects of staffing costs relating to the research and development tax credit. Amendment No. 78 deals with matters concerning accommodation. I would like to proceed carefully through this small series of amendments because their implications are quite technical.

Amendment No. 77 deals with the fact that many large companies and groups outsource certain expenditure. Indeed, many groups have a service company through which all their staff are employed, and where the costs are recharged to the relevant individual companies. As the Paymaster General will know, in terms of the R and D tax credit, matters connected with staffing costs that are allowable are provided for by paragraph 17(b) of the schedule, which states when read in conjunction with the first part of the paragraph that the provisions of paragraph 5 of schedule 20 to the Finance Act 2000 apply for the purposes of schedule 12 as they do for schedule 20. The definition of staffing costs of a company provided for by paragraph 5 of schedule 20 to the Finance Act 2000 is the one relevant to amendments Nos. 77 and 79.

As for amendment No. 77, the proposed legislation does not accommodate the fact that outsourcing costs or group recharges would qualify for relief even when expenditure relates to staffing costs, as the payroll is not undertaken by the company carrying out the research and development. I understand from those in the accountancy profession that that is likely to be a significant issue for large companies and groups. In their judgment, it does not seem to be in the spirit of the legislation, which is what the Paymaster General outlined in her earlier remarks: to encourage research and development in the United Kingdom. The amendment would ensure that relief would be given for outsourcing costs and intra-group recharges, where such expenditure would otherwise fall in paragraph 4(3).

Amendment No. 79 uses as its base the same analysis of the staffing costs, so I will not repeat that. Again, we have a situation in which many large companies calculate a fixed-cost rate when they apply to relevant projects being undertaken in order to provide suitable costing information for management accounting purposes. The cost rate typically includes employee costs and a measure of overhead, and I am sure that the Paymaster General will immediately appreciate that that is an important accounting point.

In order to comply with the proposed legislation, apart from determining which projects are qualifying research and development, many large companies will have to deconstruct the project cost rate to separate out the pure employment costs—hence the point I was making about the definition of allowable employment costs in the provision. To determine the qualifying staffing costs on that strict basis, as referred to in the previous amendment—paragraph 5 of schedule 20 to the Finance Act 2000—many companies will have to set up completely new systems of recording time and costings.

Although the basis of schedule 20 may be relatively simple to operate for SMEs with a small number of R and D staff, it is not appropriate for large companies that have several thousand employees engaged in research and development. Again, it is felt that that does not accord with the Government's objective of encouraging R and D in the United Kingdom. Therefore, the proposed solution as exemplified in the amendment is that qualifying expenditure for research

and development should include not only the staffing costs of those employees engaged in research and development but an appropriate element of direct overhead. It is felt that that would help large companies to continue with their current operating cost management systems and make it easier to apply and reduce compliance costs. That is complicit with what the Paymaster General said was the objection of the large companies.

I turn to amendment No. 78. Under the Finance Bill provisions, we are aware of what qualifies in terms of relief for R and D. However, the definition of qualifying expenditure does not include accommodation costs. Where a lease is entered into for the purposes of providing relevant accommodation for R and D, tax relief will be available only on 100 per cent. of the rental payments, rather than 125 per cent. of the new provisions. Given, for example, the unique conditions, such as sterile environments, that might be required for research and development in the electronics or aerospace industry, it is felt that it is inconsistent not to allow research and development relief for relevant accommodation costs. The proposal for that, therefore, is that qualifying expenditure for R and D should include not only the staffing costs, to which I referred in previous amendments, but the relevant accommodation costs.

Mark Hoban (Conservative, Fareham)

I congratulate my right hon. Friend the Member for Fylde on the way in which he has introduced the series of amendments. He has picked up some important issues about what forms a cost base for R and D activity, and he has highlighted the Bill's narrow definition of the type of costs that will gain, in the words of the Paymaster General, super-plus relief.

We have to recognise that a lot of R and D takes place in very expensive premises. People who travel up the M1 regularly will have seen the research centre of GlaxoSmithKline in Hertfordshire. That is an obvious and powerful embodiment of the issue of whether we give the extra, enhanced relief to office costs and the costs of property that large companies incur when they engage in significant amounts of R and D. If we are to encourage and stimulate research and development in the United Kingdom, we must ensure that a broad base of costs is taken into account. I shall be intrigued—if the Paymaster General has the information—to know what representations have been received from pharmaceutical and electronics companies about the structure of costs that they incur. My concern is that if we give relief on a relatively small part of their cost base, it will not trigger the increase in R and D expenditure that we hope would arise from the introduction of this relief for large companies.

I support the amendments proposed by my right hon. Friend. He has raised some valid points that strike to the core of whether the relief will be attractive and will stimulate the growth in R and D expenditure that the Paymaster General hopes for.

Dawn Primarolo (Labour, Bristol South)

Unfortunately, I have to tell the right hon. Member for Fylde that I do not think that his amendments will be helpful. If it came to a vote, I

would have to ask my hon. Friends to vote against them. I hope that I shall be able to explain why. The hon. Member for Fareham (Mr. Hoban) touched on what industry might say to us. It would be inappropriate for me to name companies. However, to date with regard to, for instance, outsourcing IT, staffing or accommodation costs, we have received only one representation from one company. We are discussing that with that company, which is not in pharmaceuticals.

The response so far from all the companies involved, given that the matter has been in consultation for so long, has been very positive. Of course we accept, as do the companies, that it is difficult to draw lines, particularly in relation to staff costs where staff are involved in R and D to varying extents. However, the R and D guidelines on this issue attempt to make a reasonable distinction. In developing those guidelines we have been, and continue to be, in detailed discussions on the operation of the new tax credits with the very industries to which Opposition Members refer.

The amendments are designed to include as qualifying expenditure for large companies—interestingly enough, no equivalent measure is proposed for SMEs—''indirect expenditure'' and two new items of expenditure besides staffing costs and consumables, namely accommodation costs and overheads.

The inclusion of indirect costs by amendment No. 77 could give the principal credit for some element of subcontracted expenditure, which could effectively mean that a double credit would be awarded. The international situation, where a company could receive a credit from more than one country, which we were discussing in a previous debate, could occur here in the UK through the operation of those rules. The companies would receive a double credit, as the design of the large company scheme assumes that credit goes to the person carrying out the work. The amendment might not work, as paragraph 4(2) already requires a company to carry out R and D directly.

Including the amendment would mean that the Government might pay twice for the same research and development, perhaps raising our costs by as much as £100 million, which does not seem sensible. In addition, it would require complex rules to define the term ''indirect''. By widening the scope of the R and D tax credit, amendments Nos. 78 and 79 would also increase the cost. If the credit is to achieve its aims, it needs to remain focused. The more things that qualify, the lower the rate we can afford and the less the impact of giving that boost to R and D. That has to be part of the equation and of the balance in the Government's consideration of how much can be afforded and where that can be directed to greatest effect.

The amendments would add complexity. Companies would have to track a wider range of costs, for example making more apportionments for shared costs such as electricity.

Mark Hoban (Conservative, Fareham)

The Paymaster General needs to reflect on the fact that many such costs are calculated and apportioned by companies anyway. Their own costing

systems for R and D for manufacturing will allocate costs among various activities. I am not sure that complying with the terms of the amendments moved by my right hon. Friend the Member for Fylde would require businesses to do much more than they do at the moment. There is a greater risk that they would have to deconstruct their existing cost bases to ensure that they comply with the schedule as drafted.

Dawn Primarolo (Labour, Bristol South)

I want to come to the point about deconstruction because the hon. Gentleman is making that point with regard to one company only, as far as we know. It is a large and important company, but to make room for the difficulties of one company by making the rules for all companies complex is not a sensible approach and would risk adding distortions and increasing costs. For example, some companies would be able to claim a credit for a proportion of their rent but not for a proportion of the cost of a new building. That is clearly not right, especially given what the hon. Member for Fareham said about competing and contributory costs.

If R and D is outsourced, the company that carries out the work will qualify, so if we were to allow the principal contractor also to qualify, two payments would be made. That takes us back to the point that I was making about double credit and back to our discussion on a previous amendment about the pressure from large companies to make smaller companies opt out of their 50 per cent. to gain access to 25 per cent. Then there is the subcontracting issue, which is dealt with by virtue of the fact that the SMEs get access to the R and D work.

Work may be outsourced to a company resident in another country. It would be out of the question to allow that because it would be inconsistent with the focus of the tax credit on R and D undertaken in the United Kingdom. As I have said, it would be inappropriate for me to name the company that has recently raised several issues relating to deconstructing costs, the ratio of subcontracting and the huge importance of IT in research and development. At least one large company that has spoken to us will experience some difficulties because of the substantial contracting out of those costs.

I can tell the right hon. Member for Fylde that, although I am not attracted to amending the Bill to make room for one company, because it will make the provisions more complex for others, none the less some important issues are being discussed further with that company to try to ensure that the rules do not inadvertently exclude it from receiving R and D money to which it would have been entitled. Hon. Members must keep it firmly in their minds that the purpose of the tax credits for small and large companies is to recognise that there might be subcontracting, but to bring that R and D to the UK, so that we get the benefit. There would be no point in us funding, through a subcontracted chain, subcontractors outside the UK, because we would not get the benefit

of the R and D. The principal company will have to consider that, but in asking hon. Members to reject the amendment, I can tell the right hon. Member for Fylde that issues surrounding IT outsourcing and staff costs have been drawn to my attention by a particular company, and we will do our best to address those issues without compromising the underlying principles of the tax credits. I hope that, on that basis and having aired his points, the right hon. Gentleman will feel able to withdraw the amendment, at least for now. If he is not satisfied, I am sure that he will return to the issue in future.

Michael Jack (Conservative, Fylde)

I am most grateful for the way in which the Paymaster General dealt with the issue of tax credits. I am in the fortunate position of not knowing to which company she was referring, because those in the accounting profession who raised the matter with me also did not name it. In a way, I am delighted not to know, because she has implied that in relation to the IT outsourcing there may be wider issues.

Returning to the Paymaster General's wider comments, we shall have to see how we go, as we are in uncharted territories. I should say at the outset that it would be foolish to proceed to press to a Division amendments that would act in the context of untested legislation and might not deliver what was required. However, much of what the Paymaster General is saying could form the basis of future discussion. Perhaps in due course some guidance, a practice note or an appropriate publication could be produced to assist people in understanding the area covered by the amendments.

Dawn Primarolo (Labour, Bristol South)

I am grateful to the right hon. Member for Fylde for giving way immediately. I can assure him that we intend to produce guidance or practice notes, and that the discussions on that subject are taking place. Guidance would ensure that companies could navigate the more difficult points, be clear about their entitlement and receive it.

Michael Jack (Conservative, Fylde)

I am most grateful to the Paymaster General. I do not want to detain the Committee with having more forensic examinations and pursuing the cost aspects, but there are some complex matters in the part of the Finance Act 2000 from which I quoted. For example, some may find complex the issue of what percentage of a person's time counts towards R and D and ask whether a smaller percentage does not count towards it.

Amendment No. 78 deals with accommodation costs. I do not want to put words into the Paymaster General's mouth, but it seemed implicit that the subject might be reconsidered. The Government would surely not want to make it unnecessarily difficult for specialist facilities required for R and D to benefit from the provisions of the credit. I know from my constituency experience with BAE Systems that the company has had to construct a specialised facility to design the stealth characteristics of modern fighter aircraft. I would hate to think that the financing of such a facility could not benefit from credit relief because of a small technicality.

I take comfort from the way in which the Paymaster General responded, and look forward to reading the clarifying material. As she says, we may want to return to the matter when we all have more experience under our belts. I beg to ask leave to withdraw the amendment.

Amendment, by leave, withdrawn.

Dawn Primarolo (Labour, Bristol South)

I beg to move amendment No. 61, in page 192, line 24, leave out 'any' and insert 'that'.

The amendment corrects a deficiency in paragraph 11. As with the credit for small and medium-sized companies, our aim for the large company measure is to keep the concept of R and D in step with accounting definitions. Accounting principles allow a company in some circumstances not to reflect R and D expenditure in the profit-and-loss account but to defer it to a future year when it may be matched by some income from the activity. In line with that, we wanted to give the R and D tax credit when expenditure appears in the profit-and-loss account, but the Bill as drafted produced the opposite effect by using the word ''any'' in paragraph 11(2). I know that the Committee will accept the amendment as I have explained and apologised for the drafting error.

Amendment agreed to.

Michael Jack (Conservative, Fylde)

I beg to move amendment No. 80, in page 194, line 44, at end insert—

'17A (1) Paragraph 5(1) of Schedule 20 to the Finance Act 2000 shall be amended as follows.

(2) In paragraph (a) delete ''other than'' and insert ''including''.

(3) In paragraph (b) after ''company'' insert ''together with any Class 1A national insurance contributions paid by the company''.'.

The amendment again goes to the minutiae of the measure, but it is on an interesting detail. As I understand the proposals, when an employee takes a cash option instead of a company car, the cash option will qualify for R and D relief. However, the provision of a company car as a benefit in kind will not. The amendment addresses that issue, which is undoubtedly important to those to whom the company car matters.

Dawn Primarolo (Labour, Bristol South)

The amendment broadens the cost base of the credit and reduces the rate of the relief, which can be ill afforded in such a targeted measure. It would be distortive, because although we give R and D tax credits on current expenditure, the credit for benefits in kind and class 1A national insurance would not all be for current expenditure. The design of the scheme tries to avoid the complexity and distortion that are created by focusing on simple staff costs and consumable stores, which are the main extra costs of R and D. The scheme tries to stay clear of complex apportionments.

I believe that the right hon. Gentleman's amendment would give us much more complexity for no increase in R and D expenditure, so I ask my hon. Friends to reject it if it is put to the vote.

Michael Jack (Conservative, Fylde)

My amendment was very much a probing one, and in a way I felt that it was slightly mean to table it in the light of the bigger picture that the Paymaster General outlined. None the less, it is important to have heard the Government's view on the subject. I beg to ask leave to withdraw the amendment.

Amendment, by leave, withdrawn.

Schedule 12, as amended, agreed to.

Further consideration adjourned.—[Mr. Sutcliffe.]

Adjourned accordingly at three minutes to Seven o'clock till Thursday 23 May at half-past Nine o'clock.