FIDs abolition branded a 'penalty on success'

City lawyers are becoming increasingly dismayed at the Government's confusion over foreign income dividends (FIDs).

The Chancellor of the Exchequer, Gordon Brown, evidently felt that abolishing FIDs in the Budget would be a means of raising revenue in a way that would pass unnoticed by the majority of the electorate. They are due to be scrapped in April 1999.

FIDs are an aspect of advance corporation tax (ACT), which is payment made to the Inland Revenue whenever dividends are paid. The amount is then credited against the actual level of corporation tax which is assessed nine months after the end of the financial year.

The problem arises with foreign income. Because it is deemed to be taxed at source - that is, overseas, where it is earned - there is no tax against which to claim the ACT credit in the UK. A company with a large proportion of its income derived from foreign operations will therefore accumulate tax credits which it cannot use.

It was because of this penalty on exports that the then Chancellor, Norman Lamont, introduced FIDs in 1984, allowing companies to pay dividends on foreign income without attracting ACT.

When these anomalies were pointed out to the Treasury following the Budget, the paymaster general, Geoffrey Robinson, announced that petitions for retaining FIDs would be heard "sympathetically". This has led to speculation among City lawyers that they might stay after all.

"It's a frightful cock-up," said Clifford Chance tax partner Peter Elliott. "The effects may not have been appreciated. Brown hasn't had a lot of time to think his way into this and he appears to have been let down by his advisors."

"It's a penalty on success," said Mark Kingstone, a partner at Linklaters & Paines.

He dismissed the argument that discouraging dividend distributions would help investment. "There is no explanation other than tax gathering."

Fiona Ferguson, a partner at Slaughter and May, said: "It penalises those companies which conquer the hardest markets, such as Pilkington in Germany, where tax rates are high."

According to Kingstone, the effect of abolishing FIDs will be that more decisions will be made for tax rather than operational reasons - for example, an increase in dividends issued as shares rather than as cash. But he warned a compromise on FIDs could be even worse.

It has been suggested that the Government should establish a threshold of foreign income above which a company could pay FIDs. Kingstone said this would encourage those below the threshold to move operations abroad, or not to invest in the UK in the first place.

Ferguson cited the case of Billiton, the base metals division of South African company GemCorp, which is currently being floated on the London Stock Exchange and will go immediately into the FT-SE 100. Ferguson suggested that without FIDs and with all its income derived from overseas, the company would probably have listed in another jurisdiction.

The Treasury is arguing that scrapping FIDs was a corollary to scrapping the tax credit on dividends paid to pension funds. With tax credits, domestic dividends were always more attractive to institutional shareholders, so that only companies with high levels of foreign income were likely to pay FIDs.

With tax credit gone, it is worth paying FIDs on much smaller proportions of foreign income. EMI, for example, has announced it will pay FIDs for the first time this year, taking advantage of the two-year lag before they are due to be abolished. It expects to save £23m.

Robinson has said that international holding companies will not be affected by the end of FIDs, but this has prompted criticism that foreign companies will be better treated in the UK than domestic companies.

"The only proper reform would be to abolish ACT itself," said Kingstone.