Chancellor set for a U-turn on foreign income dividends

The Government is expected to announce an embarrassing U-turn on last week's Budget measures to abolish foreign income dividends (FIDs) in 1999. Following fierce lobbying by UK multinationals, the Inland Revenue is expected to allow companies that make around 80 per cent of earnings overseas to continue paying FIDs.

The Budget measure by Gordon Brown, Chancellor of the Exchequer, has led to a rush of companies announcing decisions to either start paying FIDs for the first time or increase the amount of total dividends paid as FIDs before the abolition takes effect.

Siebe and Reuters are set to join Allied Domecq, EMI and Marling which yesterday revealed plans to pay FIDs for the first time. Tate & Lyle, the sugar company, indicated that it might pay more of its total dividend as a FID. Burmah Castrol, the oil giant, said it would not rule out paying all dividends as a FID. And after announcing results earlier this week, Tomkins said privately it was considering FIDs.

Brian Hardy, finance director of Burmah Castrol, said: "Clearly if the door's going to slam shut on FIDs, it makes sense for finance directors to scuttle around and sweep up as many benefits from FIDs now as we can."

Ironically, the reason for companies' sudden love affair with FIDs stems from another Budget measure - the abolition of tax credits on dividends paid from UK earnings. Before the Budget, many companies which earned enough overseas to justify payment of a FID chose not to do so because it disadvantaged powerful, non-tax paying institutional investors. These investors preferred UK dividends which carried an attractive tax credit which could be reclaimed, allowing them to receive a gross dividend.

FIDs, however, are normally paid net and are worth less to investors. But with the tax credit removed and all investors receiving net dividends, companies are free to reap the full benefits of paying FIDs.

The primary attraction of FIDs is that, unlike normal dividends, they do not incur advance corporation tax (ACT). Companies which make little profit in the UK, and therefore have a low mainstream corporation tax bill, cannot offset ACT paid on dividends against tax. This pushes up the tax charge and depresses earnings. This was the main reason for the corporate uproar when the Government announced the end of FIDs. Without FIDs, companies will have to pay more ACT. Not only does this raise tax charges, but is a double tax on overseas earnings.

A source close to Siebe, the engineering company, said that FIDs had become more attractive since the Budget: "We didn't want to pay FIDs before the Budget because we would have had to pay them gross to keep investors happy. But now we can use FIDs to take ACT immediately off our balance sheet."

Kathleen O'Donovan, finance director at BTR, said that companies may be tempted to lower FID payments. This is because investors will no longer have to be placated by enhancing the FID to counter the disparity from gross UK dividends.

John Harlow, head of corporate tax at Reuters, said that while the group did not have a ACT problem, the company wanted to maximise ACT capacity available: "Our ability to pay dividends or return cash to our UK shareholders depends on us having ACT capacity. It's a very hot issue for us."

Both BTR and Burmah Castrol said one way to justify the abolition of FIDs would be to scrap ACT.

Mr Hardy said: "There is only one long-term solution - to scrap ACT and replace it with the system in the US and Australia ... where companies pay corporation tax bills in advance in instalments. This gives the treasury the cash flow it needs during the year. It's a much fairer system."