Tax under attack

Corporation Tax and corporate governance arrangements for water companies could be in line for a shake-up, warns Nigel Hawkins

In recent months, Westminster’s media-driven politicians have been gunning for various sectors, notably electricity and water. In the case of the latter, there is increasing concern about water companies’ very low Corporation Tax payments and the seemingly inadequate corporate governance requirements applying to private equity-owned firms.

Of course, in seeking to minimise their Corporation Tax liabilities, water companies are hardly alone. Indeed, the political focus recently has been on far bigger corporate fish, such as internet giants Google and Amazon, and Starbucks, which aspires to the highest of ethical standards.

Nevertheless, Thames Water’s admission that – due primarily to massive capital allowance offsets – it paid no Corporation Tax at all on its £549 million operating profit in 2012/13 has certainly raised eyebrows despite Ofwat’s financial expert, Keith Mason, confirming at Ofwat’s recent City briefing that this unusual tax scenario had been expected.

Many tax experts would argue that current Corporation Tax law is riddled with anomalies that enable highly profitable companies to pay far less than they should. Ofwat’s chairman, Johnson Cox, recently addressed this issue in a Daily Telegraph article. He pointed out that “it has been alleged that some (water) companies use shareholder loans to avoid UK taxation”.

Of course, seeking to minimise tax payments through avoidance schemes is not illegal, unlike tax evasion, which has not been alleged against any UK water company. There is, too, Lord Clyde’s celebrated tax dictum from the 1920s: “No man in the country is under the smallest obligation, moral or otherwise, so to arrange his legal relations to his business or property as to enable the Inland Revenue to put the largest possible shovel into his stores.”

Whether this principle should apply to large corporate entities is a moot point, although virtually every major business employs tax experts to prevent the metaphorical shovel penetrating too deeply.

Ofwat’s stance on this issue is unequivocal. Its modelling – as part of the periodic review process – assumes a tax “wedge” for each year which water companies strive to outperform – and often succeed. Furthermore, by assuming a far lower leverage ratio than that actually adopted by private equity-owned water companies, Ofwat’s influence on the level of the tax-take is hardly notional.

A distinctly radical approach could require water companies to apply to Ofwat for an interim determination for any Corporation Tax liability that exceeds a modest threshold figure. In Thames’ case, ultra-low Corporation Tax payments seem likely for the foreseeable future, especially if the £4 billion-plus Thames Tideway Tunnel scheme becomes a reality. Indeed, this project was partially responsible for the recent interim determination application that Ofwat did not appear to welcome at its City briefing. It could raise average local water bills by up to £29 next year.

More generally, the Treasury could cut the 21 per cent Corporation Tax rate planned for next year, a policy that is constrained by the need to fund public expenditure of well over £700 billion a year. Corporation Tax currently yields around £41 billion per year.

Nevertheless, there remains a powerful macro-economic case for sharp reductions in Corporation Tax, especially as the development of internet-based companies makes collection so difficult. Indeed, large companies are becoming increasingly focused on low tax environments. This trend had been a major factor behind the boom in Ireland before its economy was shattered by the collapse of its banking sector.

For water companies, the international element does not apply, but their high capital expenditure and the related capital allowances are key. The Treasury could place further limits on the use of capital allowances or it could impose a minimum percentage tax-take.

The dominance of private equity ownership of the water sector, which has arguably encouraged greater efficiency outside the glare of a listed plc, is also relevant. Currently, of the ten water and sewerage companies that were privatised in 1989, half are in private equity ownership, with just three – United Utilities, Severn Trent and South West Water (through Pennon) – still retaining an active public quotation.

Typical of private equity ownership has been the more aggressive financing approach with a far higher debt-to-equity ratio than had hitherto been felt ­appropriate. Given the low debt rates of recent years, this approach has been vindicated. In the past periodic review, Ofwat had allowed a 3.6 per cent real cost for debt. According to Cox’s recent calculations, debt now has a cost of “no more than 1.25 per cent”.

Such a financial environment clearly benefits private equity investors – many of whom are international pension funds – but the benefits to local consumers have been less apparent. There is concern, too, about the accountability of private equity investors, with the level of public disclosure being less onerous than that applied to quoted undertakings.

For some companies operating in a genuine competitive sector, such as Alliance Boots, which was taken into private equity in 2007, the case for more disclosure is less compelling. But for water and energy distribution companies, which operate in de facto monopoly markets, there should be more public accountability and openness, especially about their finances. Perhaps, as part of an updated Companies Act, all UK utilities, especially those in private equity ownership, should be required to publish detailed annual reports.

Clearly, as work on the next periodic review cranks up, with water companies presenting their business plans, some of these issues will need addressing. Despite Ofwat’s “fast-tracking” option, it seems unlikely that any water company’s initial offer will be so tempting that Ofwat can press its fast-forward button, which theoretically could lead to differing cost of capital assumptions being applied across the major water companies.

All round, the water sector’s profile looks set to rise sharply over the next 18 months. Even if the trend for a continuing rise in prices is reversed in April 2015, both the taxation and accountability issues will continue to attract attention, as will contentious projects, particularly the Tideway Tunnel.

If Ofwat addresses some of Cox’s published concerns about the sector’s financial management, the water firms may find they’ve never had it so good.

Nigel Hawkins is a director of Nigel Hawkins Associates which undertakes investment and policy research

This article first appeared in Utility Week’s print edition of 6th September July 2013.

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