Michael Gove, the UK’s Environment Secretary had some harsh words for the water industry recently.
“They have shielded themselves from scrutiny, hidden behind complex financial structures, avoided paying taxes, have rewarded the already well-off, kept charges higher than they needed to be.”
The bit he missed from his speech was, “and the government I am a part of has encouraged them to do exactly that.”
The state of the UK’s water industry is a national scandal, but one that has been understood for some time. I wrote about this issue in 2013, together with the previous water regulator, Sir Ian Byatt. The rampant profiteering by many water barons is what is behind the public support for the main opposition party Labour’s plans to renationalise the industry.
The original intention of water privatisation was to put the industry into the hands of the public via the stock exchange. The idea was to have broad based ownership of water companies via the stock market. The new publicly listed companies would provide a stable revenue stream for savers and pension funds, whilst attracting new investment into the industry.
The big story of the global economy over the decade has been inequality, with fewer and fewer people owning an increasing share of assets. It is a a story that has played out in the water industry too. Apart from a few remaining companies like Severn Trent and United Utilities, all of England’s water companies are now owned by private equity – a form of ownership preferred by high net worth individuals and sovereign wealth funds.
This change in the ownership model has had far reaching consequences for the industry, and offshore tax havens play a key role. Broadly speaking shareholders in stock market listed companies receive a share of the profits of the company. Profits are distributed to them after tax is paid which means there is less of an incentive to avoid tax in their country of residence.
In privately held companies offshore structures can be employed to move profits out of a company, and into a tax haven shell, before tax is paid. The favoured tactic of the water industry has been to drown their tax bills in debt.
Since privatisation water companies have borrowed tens of billions of pounds. The money has been handed to owners in special dividend payments and the resulting interest on the loans washes away any profit, leaving little to tax. Profit then reappears later as capital gains when the company is sold – a transaction that almost always happens offshore, or where money has been borrowed from the owner, as interest repayments made to other offshore companies.
And fair play to Mr Gove – his speech for the first time sees a government minister explicitly calling out the water industry’s high gearing ratios, low tax rates and use of specific jurisdictions like Cayman.
But what is the government doing about it? Last year the OECD made a few tentative steps towards reform, suggesting that member states placed a limit on how much interest companies could deduct from their tax bill. The cap they suggested, limiting deductions to 30% of operating profit, would not have impacted the vast majority of multinational companies and was widely considered to be weak – but it would have hit the water industry. Thames Water, the UK’s largest water company, paid out about 55% of its operating profit in interest payments in the last financial year.
However, water companies, and all the other infrastructure companies which rely on debt structures to avoid paying taxes in the UK, can rest assured. The government has got their back. When the government came to implementing the OECD’s recommendation in the 2017 Finance Act, they added in a specific exemption for infrastructure companies. Infrastructure, would not be subject to the debt cap, and could continue deducting as much debt as they liked from their tax bills.
The water industry is not alone in its use of debt in its tax structures. Much of UK infrastructure, from major airports like Heathrow (which has hardly paid any corporation tax over the last decade), to power networks and ports have used debt to scrub corporate profits.
As the Paradise Papers revealed, offshore companies and complex debt arrangements are also used, e.g. by Blackstone to avoid paying taxes on rents gained from offices and shopping centres in the UK. They too can carry on: the definition of infrastructure was broad enough to include commercial property.
The argument made by the government at the time was that these companies had specific models that require them to use a lot of debt. That is certainly true, but it is not a business model that we should be seeking to encourage.
Calling out the privatised water industry for failing to meet its broader responsibilities is all well and good. But it is the UK tax system that subsidises debt-driven tax avoidance across its entire infrastructure. It is a system that is very clearly not in the public interest, but there is a massive private interest in allowing this to continue.
Our view at the Tax Justice Network is that there is no reason to treat the interest on money borrowed from the owners of a company any different from dividends. For that reason companies should not receive any tax deductions on interest paid to related parties. You can read our full briefing on debt and how companies use debt to avoid taxes here.