The taxman changes the rules to prevent banks from dodging tax on bond buybacks.
HM Treasury has forced Barclays (LSE: BARC) to pay £500 million in corporation tax, which it attempted to avoid by creating two tax-avoidance schemes.
Barclays buys back bonds
The big bank fell foul of HM Revenue & Customs (HMRC) by dodging tax on the profits it made by buying back its own bonds at below their par value.
Under an accounting standard known as FAS 157, banks make a notional profit when their credit ratings are cut and their bond values fall. For instance, mega-bank HSBC (LSE: HSBA) booked a $3.9 billion profit in 2011 from fair value gains booked against movements in its own debt.
Barclays went further than most banks. From 5 December 2011, instead of banking notional profits, it actually bought back its own bonds in the market, thus crystallising these gains. For example, a bond issued at £100 and bought back by Barclays at £80 would effectively generate a profit of £20, thanks to a future liability being reduced.
However, Barclays created a scheme to avoid paying corporation tax on any profits made from buying back its own debt. What's more, the bank created a second scheme for investment funds, designed to claim tax credits from HMRC on non-taxable income. In other words, this second scheme reclaimed tax that had never been paid in the first place.
The taxman strikes back
Having 'pushed the envelope' too far, Barclays has been slapped down by the powers that be.
The Treasury is to introduce new legislation to prevent Barclays and other banks from avoiding tax on bond buybacks. In an unusual step, this regulation is to be retrospective, forcing Barclays and other banks to pay tax on bond buybacks since December 2011.
According to Reuters, Barclays faces a tax hit of £120 million on estimated profits of £450 million from buying its own bonds. As a result of closing both tax loopholes, the Treasury has forced Barclays to pay an extra £500 million into its coffers.
In addition, the Treasury estimates that banning these latest tax-avoidance schemes will prevent £2 billion of future tax avoidance. Then again, to put this figure into context, it's not much more than one day's government spending!
Tell us your tax dodges
As I write, Barclays shares are fractionally down at 243.4p, having slipped to 240p earlier this morning. Hence, its market value of £27 billion has hardly been affected by this latest news.
While shareholders in the bank may be disappointed with this setback, Barclays had no choice but to admit what it was doing to the authorities.
In 2004, HMRC introduced a 'forced disclosure' rule that forced any person or organisation exploiting a new, legal tax loophole to notify the tax authority within days of its launch. This allows HMRC to act swiftly to clamp down on what it regards as 'excessive or abusive' tax avoidance.
As well as compulsory disclosure of legal tax-avoidance plans, Barclays is a signatory to the Banking Code of Practice on Taxation, as are all the UK's biggest banks. This code, introduced in June 2009, requires banks and their customers to meet their tax obligations in full, without engaging in tax avoidance. In this instance, the Treasury believes that Barclays' actions breached this code.
Finally, tax-dodging schemes are like cockroaches -- there's never just one lurking around. Although Barclays has owned up to being the bank at the centre of this tax storm, other banks have surely created comparable rule-testing schemes. Hence, I expect similar announcements from rival banks in the weeks ahead.
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