HM Treasury

Taxation, work and welfare

Independent Enquiry into a tonnage tax

A Report by The Lord Alexander of Weedon QC


Executive summary 

i. Our shipping industry and the skills of our seafarers have long been part of our success as a trading nation.

ii. Whilst still significant, the industry has been in steady decline for the past 20 years yet growth in world trade offers significant prospects for expansion. The stock of skilled seafarers is dwindling and their average age is increasing. Without a revival, especially of the number of trained officers, there will soon be a shortfall well below the needs of the shipping and shore-based related maritime industries.

iii. Successive governments have sought through training grants and substantial tax breaks to arrest the decline. But the most that can be said for past attempts is that they may have diminished its pace.

iv. It is the Government's policy to intervene to help reverse the decline. In "British Shipping - Charting a new course", the Government, the industry and the trades unions committed to a partnership involving a package of measures to do so. The policy document recognised the importance of fiscal competitiveness but did not commit the Government to do more than study the arguments for a "tonnage tax".

v. A tonnage tax, which has increasingly been introduced, with some early success, by nations such as Norway and the Netherlands, creates an effectively tax-exempt fiscal regime for shipping companies. The introduction of tonnage tax regimes has been approved within recent EU guidelines, designed to permit EU countries the low tax environment which will enable them to compete internationally.

vi. It is accepted by all those I have consulted, including Government departments, the industry and trades unions, that without a user-friendly and virtually tax-exempt environment there is no real prospect of achieving the aim of Government policy to revive the industry. A tonnage-based form of corporation tax is the means proposed to achieve this fiscal environment. Evaluation of it was at the core of my terms of reference.

vii. The present fiscal regime for the industry is unsatisfactory. A combination of group relief, of 25% capital allowances and of "roll-over relief" means that the industry as a whole pays no more than about 1.5% corporation tax. But deferred tax liabilities and the impetus towards tax-driven investment are unpopular. So the current tax breaks are not cost-effective. By contrast, the tonnage tax is seen as bringing greater certainty and clarity about tax liabilities and costs. It is undoubtedly the perception of the industry that it would be more user-friendly to investors than the present regime.

viii. The Department of Environment, Transport and the Regions concludes on balance that the economic case for the tonnage tax is sound. The key to revival of the industry is seen as more UK direct ownership of shipping leading to more training of UK seafarers, especially officers, with consequent substantial benefit to the shore-based related industries. It is envisaged that there would be more registration of vessels here, which is not part of the economic case but is likely in turn to increase the employment of both officers and ratings.

ix. The industry accepts that it should formally commit to a training ratio of introducing one cadet each year for every 15 officers as a condition of entry into the tonnage tax. The commitment would be implemented by means of company training plans, which would also require ship operators to review the training and recruitment of ratings and take full account of wastage. It would maintain the present level of trained officers but would not alone meet future potential shortfalls in related sectors. The Department of Environment, Transport and the Regions is willing to take responsibility for overseeing the Maritime Training Trust's monitoring of the training programmes aimed at meeting this obligation. The industry has also made a "commitment" to use its best efforts to increase the numbers in training by 25% a year over several years which if achieved would redress the wider shortfall.

x. I believe that without a user-friendly and virtually tax-exempt regime, the Government's policy will be almost certain to fail, and to do so quickly. Past subsidies have not worked well. Yet no-one can be over-confident that even with the most fully supportive package of measures the policy will succeed. There must always be doubts about the principle of subsidy and its potential effectiveness. This heightens the need to design the tonnage tax in such a way as to minimise anticipated costs and any possibility of tax avoidance. Most of the discussions with the industry and Inland Revenue have focused on exploring whether a satisfactory design could be achieved.

xi. With this help and in the light of the conclusions that I have formed on certain issues of principle where there was no common ground between the industry and the Inland Revenue, I believe that a satisfactory design for a tonnage tax is possible. I have set it out in some detail at paragraph 92. In summary, companies engaged in shipping would have the option of joining the regime for a minimum period of 10 years or remaining within standard corporation tax. Profits from shipping in the UK would be ring-fenced according to agreed, workable definitions. Unlimited 25% capital allowances would no longer be appropriate to a virtually tax-exempt regime and any capital allowances for ships leased to companies within the tonnage regime should be significantly restricted. However, in view of the importance of securing the centre of gravity of international shipping companies in the UK, foreign profits from shipping would be included within the tonnage tax regime, subject to particular ring-fencing and anti-avoidance provisions.

xii. The Inland Revenue has made various estimates of the annual cost of the regime after five years of operation. They are much affected by the approach towards capital allowances for ships leased into the regime. On the assumption that all such capital allowances were excluded:

Whilst this approach of removing allowances is attractive in principle, I accept that there is currently a case for retaining some form of allowances for leasing, if the regime is to be sufficiently attractive in terms of fiscal incentives as well as its structural characteristics. My preferred approach is to cap the level of allowance available on each vessel leased into the regime:

These figures are necessarily uncertain and illustrate that the decision taken on leasing allowances would markedly affect the cost of the tonnage tax to public funds. My own preference would be to limit the cap to £20 million per vessel. But you may want to consider with your officials whether this is over-rigorous. In any case, I suggest that the level of the cap should be reviewed over time.

xiii. I believe that any decision to introduce (or refuse) a tonnage tax should be made as soon as possible so that the industry may have the confidence and certainty to do its planning. It should not be deferred until the outcome of the work of the Code of Conduct Group reporting to the EU Council of Finance Ministers.

xiv. If the shipping industry is to be revived, a package of measures is necessary, as is recognised in "Charting a new course". It is obviously important to examine sympathetically the case for other potential measures which may improve the competitiveness of the UK shipping industry, such as extending the Foreign Earnings Deduction and expanding the Crew Relief Costs Scheme. But I believe that a form of tonnage tax is fundamental to this package.

xv. It is obviously for the Government to decide on the priorities for public finances but, as "Charting a new course" recognised, our shipping industry is currently in danger of dying a gradual death. I am not surprised that several interests have made the point to me that this is "make or break" time. It may well be this realisation which has brought the Government, the industry and the trades unions together in a partnership to secure its future and which has led to the industry's willingness to accept a formal commitment to training. I advise that an effectively tax-exempt regime along the lines I describe in paragraph 92 is workable and necessary if this partnership is going to have the opportunity to implement the policy of reviving the industry to which the Government is committed.

Report to the Chancellor of the Exchequer


1. You announced this study in your Budget statement on 9 March 1999 in the following terms:

"The shipping industry has put to me the case for enhanced training incentives and for a lower rate ring-fenced tonnage tax. While I am attracted to these options I have to be satisfied that lower tax rates will not become a vehicle for tax avoidance and I am grateful to Lord Alexander of Weedon for agreeing to conduct an independent study of the national and international issues involved."

2. My specific terms of reference have been:

"To conduct an independent study of the case for, and the design of, a lower rate ring-fenced tonnage tax and additional enhanced training incentives, for the shipping industry, taking account of the Government's objectives for shipping, and the national and international competitiveness issues involved, concluding as soon as it is practical."

3. The issue sounds as dry as dust, but the Department of Environment, Transport and the Regions (DETR), the shipping industry, shipping trades unions and shore-based maritime industries see it as vital to the future of shipping and related activities in the UK.

4. I have sought submissions from representatives of the shipping industry, tax experts, trades unions and Government departments. A series of meetings was held with my encouragement between several of these interests to seek wherever possible to resolve uncertainties about various issues and to refine to a minimum the remaining areas of difference. This process proved most helpful. I am grateful for the most constructive approach often working to tight timetables shown by all those involved. Claims for confidentiality were minimal, and where made were understandable, which has helped a frank and open dialogue. The full submissions and notes of meetings are all available for you and your advisers should you wish to see them, including all the source documents to which I cross-refer in the margin of this report. This process has enabled the detailed issues of principle and design of a tonnage tax to be considered in depth.

5. This report sets out my central reasoning and conclusions. It:

A set of appendices provides further detailed information on aspects of the tonnage tax.

6. Throughout this report, I have concentrated on the key elements of my terms of reference and sought to answer two crucial questions. First, I have assessed whether there is a case for introducing a tonnage tax in the UK. I have done this by considering the available evidence in the context of the Government's objectives for the industry. Second, I have considered the optimal design for such a regime, conscious that where the potential benefit is neither certain nor overwhelming it is particularly important to minimise the cost and possibilities for tax avoidance. This is where it has proved necessary to take forward detailed work. In this complex area, with the help of the Inland Revenue and the industry, we have made real progress in developing the proposal for a tonnage tax to meet the concerns you expressed in your Budget statement. We have designed ring-fencing arrangements which could, I believe, work effectively to limit the scope for avoidance. They include a novel restriction on the ability of companies within the tonnage tax regime to benefit from capital allowances through finance-leasing.

The current challenge for the UK shipping industry

7. Our shipping industry and the skills of our seafarers have been a crucial part of our success as a trading nation. They have in turn bred internationally regarded shore-based industries including the supply of marine equipment, shipbuilding, ship repairing, ship broking, freight futures, maritime finance, maritime law and arbitration, marine insurance and ship classification. This success has never been achieved without cost: Cabot's great voyage, Drake's opportunism and Admiral Rodney's fight with the Dutch for control of the American trade routes demanded courage, verve and investment. Yet they paid off handsomely and are a part of our history of which we are justifiably proud.

8. But concern for a strong shipping industry is not just rooted in nostalgia. For, with the growth of world trade, the shipping industry is continuing to expand globally. Not surprisingly, many countries prize a successful shipping industry and want to share in this growth. Competition is intense, even if conducted in a more prosaic way than in the days of buccaneers and Man o 'Wars.. It springs from low cost flag of convenience environments, from a high quality industry in some Far Eastern countries, and increasingly, with the benefit of new tonnage tax regimes, from other members of the European Union, including recently and notably the Netherlands. The location of ownership, flagging (registration) and management activities is very "footloose", since it can easily be transferred from one country to another. This makes it vital to have regard to the fiscal regimes in other countries if we want to maintain a successful shipping industry in the UK. The modern armoury in the battle for success invariably includes a virtually tax-exempt fiscal regime.

9. The size of the UK shipping industry still remains significant. In terms of trading vessels, ships owned or managed here account for about 6% of the world's merchant shipping. Our shipping industry is accepted to be cost-efficient with world class operations in many areas. Yet, for all that, it is currently in steady, continuing, decline. source: "Charting a new course"

10. The UK direct-owned fleet, which is regarded as the critical catalyst for generating employment and skills, is in long-term decline at the rate of about 4% a year. Tonnage fell from a peak of 50 million dwt (dead weight tonnes) in 1975 to only 9.7 million dwt in 1998. The UK registered fleet has declined even more. Only 20% of the UK-owned trading fleet is registered in the UK, while until the late 1970s it was almost unknown for UK-owned ships to be registered elsewhere. The Chamber of Shipping has forecast "further decline in ship owning" in the present environment. source: "Charting a new course"

11. There has also been a heavy decline in the number of seafarers (of officers by some 78% and of ratings by 65% from 1980 to 1997). The current level of under 500 officer cadets entering training each year is much lower than required to meet the long term needs of and opportunities for skilled people in the shipping and shore-based industries. This has potentially serious consequences for the continued strength of these related industries, in which the UK has long had such a dynamic and leading role. Increasing the number of seafarers, particularly officers, is a key aim of those who seek to revive the shipping industry. source: "Charting a new course"

12. This continuing and apparently inexorable decline has been a concern to successive governments. It has been regularly remarked on by Select Committees of the House of Commons, especially on Employment (in 1994) and on Defence (in 1997). Most recently, in June 1999, the Environment, Transport and Regional Affairs Committee published its report, "The Future of the UK Shipping Industry". It said that: "The UK shipping industry is in a parlous condition, and radical measures are required to arrest and reverse its decline". It argued that: "the case for ensuring that the UK has a strong shipping industry ... is overwhelming". source: "The Future of the UK Shipping Industry", paragraphs 32 and 78

13. Successive governments have regarded this industry as valuable to the country and so have given fairly generous financial support. In the past, shipping has been granted special tax breaks and there have been substantial grants towards training officer cadets as well as favoured income tax treatment of some UK seafarers through the Foreign Earnings Deduction. The total cost of such measures is estimated currently to average about £85 million a year. These measures have no doubt lessened the pace of decline. But no one suggests that existing measures albeit costly are going to be capable on their own of stabilising the industry, let alone sparking a renaissance. Without further assistance, continuing decline in the industry and diminution of the supply of experienced seafarers seems a certainty. The more such decline in maritime experience continues, the less will be the chance of arresting and reversing it.

14. This Government has sought to address the issue more comprehensively and to do so urgently. The White Paper on the Future of Transport in July 1998 set out the main aims of an integrated shipping policy: to facilitate shipping as a means of carrying our trade, to foster the growth of an efficient UK-owned merchant fleet, to promote the employment and training of British seafarers, and to encourage UK ship registration.

15. The concern to look at measures to support shipping was reflected in the Shipping Working Group, a body involving representatives from the industry, trades unions and Government departments which was set up in late 1997 and reported in March 1998. The conclusions of the Shipping Working Group reflected substantial accord and enthusiasm shared by the participants for a package of measures to enhance the industry. source: "White Paper on the Future of Transport"

16. The White Paper was followed in December 1998 by "British Shipping - Charting a new course" which set out the Government's policy and objectives for the shipping industry. In his foreword, the Deputy Prime Minister stated: "The Government does not accept that the long decline in the British merchant navy should simply be allowed to continue". He added: "The future offers substantial opportunities for Britain's shipping and the Government is committed to working with the shipping and maritime-related sectors and trades unions to exploit those opportunities to the full." source: "Charting a new course" This key document sets out the reasons for an "interventionist policy for UK shipping" to "rescue this vital national asset and the UK's maritime economic future". It rejects any argument that we should allow the industry to atrophy and out-source our shipping needs, on the ground that: "Relying so heavily on foreign supply is too risky". What is required is "the sustained recruitment and employment of British seafarers, which in turn depends heavily on the continued participation and viability of British companies in international shipping". This statement of policy is clearly an essential starting point in determining whether it is right to create a new fiscal regime.

17. It is also important to note that the target of the proposed new fiscal regime is, in the first instance, to increase the direct ownership of shipping by companies within the UK. It is not suggested that registration of vessels in this country should be a touchstone for eligibility of entry into a new fiscal regime. Nor is it suggested that, alone, management of shipping operations would revive the industry in the way that the Government seeks. The DETR submitted that: "Direct ownership does have the virtue of being a robust and well-defined concept, and does have a clear link with the government's shipping policies. We believe that UK direct ownership is the best current measure of shipping activity taking account of economic and policy interests, and in particular is the most relevant definition for ships and companies undertaking training of UK officers". Increasing UK ownership will not only be the most effective way of promoting UK training: it may also spill over into growth in the registration of ships in the UK. But to make UK registration a precondition for joining the tonnage tax would deprive companies of the operational freedom in various parts of the world which they understandably seek.

18. The critical importance of international fiscal competitiveness to the shipping industry is highlighted in "Charting a new course". It states that "Shipping investment ... tends to be drawn to low tax regimes. Likewise, in international joint ventures, preference is given to partnership vehicles in tax-free regimes, with future investment similarly directed". It recognises that it is now normal for some countries, including other European countries, to create a substantially tax-free environment to retain and attract shipping investment. "Charting a new course" claims that the UK's fiscal environment results in the lowest level of assistance (measured in terms of net present value as a percentage of capital cost) available for investing in an identical ship in any European country apart from Spain. The Inland Revenue cast some doubt on the detailed analysis behind these comparisons. In particular, it questioned whether it is right to look at average incentives rather than marginal incentives measured by different means, as well as raising more technical methodological concerns. It also argued that neither measure conveys the incentive to leave one particular regime for another source: "Charting a new course" paragraph 121 and chart 5 But for all that some of the detailed comparisons with other countries may be debatable, it is clear that for the industry to be internationally competitive it requires, amongst other attributes and supportive measures, a virtually tax-exempt and user-friendly fiscal regime.

19. In other areas, such as training and regulation, "Charting a new course" included in its 33 measures specific commitments to positive intervention to benefit the industry. It was emphasised that the whole package was necessary to give the policy a prospect of success. Nevertheless, whilst acknowledging that a tonnage tax had been adopted with apparent early success by some other European countries, the Government went no further at that time than to agree to discuss fiscal options with the industry in the run-up to the Budget without any commitment to implementation. It also made plain that any amelioration of the current regime would be conditional on investment by the industry in the UK seafarer base. In the event there were no substantive discussions of this complex issue in the limited time remaining before the Budget.

Existing corporation tax on shipping companies

20. The impetus to change the fiscal regime might suggest that the overall tax burden on the shipping industry is oppressive. In fact, the current generous tax reliefs mean that the entire shipping industry pays on average no more than a total of £20 million a year in corporation tax.

21. For although the shipping industry currently falls within normal corporation tax rules it receives special treatment in two important respects. First, whereas under normal accounting rules depreciation rates are calculated on the useful life of a long-life asset (which in many cases a ship could well be classified as being), and for tax purposes are assumed to be 6% a year, shipping is permitted for tax purposes the depreciation rate of 25% of the balance at the start of each accounting period. Second, shipping companies are granted "roll-over relief" of capital allowance balancing charges under which they may defer tax arising from the sale of ships (namely the difference between sale value and tax depreciated value) and recognise it gradually over the life of the replacement ship. In addition, shipping companies have extra flexibility as to when to take the benefit of the allowances.

22. The importance of the capital allowance regime is heightened by the fact that the capital charge associated with a new vessel is almost always the major cost element in running a ship (claimed by one company often to be four or more times the operating costs). In cash-flow terms, this allows shipping companies to benefit by deferring tax through continually investing in new ships, using tax losses arising in the first few years to offset under the group relief the profits from non-shipping activities. The allowances can also be claimed by a financial institution which has bought a ship to lease to a shipping company, in which case the shipping industry benefits to the extent that the tax allowances are shared with it in the form of lower interest repayments. But for capital allowances (including those to which the shipping industry would be entitled to like any other industry, as well as those which apply specially to it), the corporation tax currently paid by the industry would be of the order of £80 million a year.

23. This existing tax regime is clearly based on a longstanding acknowledgement that the shipping sector is worthy of special treatment. It has the potential to reduce the effective rate of tax close to zero. Indeed, it is clear that some shipping companies pay very little or no corporation tax currently. The Inland Revenue estimates that the average effective tax rate is currently 1.5% compared with 15-20% typically for other industries. However, this access to special allowances inevitably introduces tax planning into the industry's financial calculations in a way which may distort what would otherwise be more straightforward commercial decision-making processes.

24. This is one reason that the shipping industry has been seeking an alternative. Difficulties posed by the existing tax system, especially for smaller shipping companies raising finance, are summarised in "Charting a new course": "Larger UK companies ... may be able to emulate foreign regimes in terms of realised tax levels. But this is not generally the case for UK companies operating smaller fleets". OT Africa Line, a medium-sized UK shipping company, referred to: "the problems with raising finance for operations such as ours given the complications of the existing tax structure". I enlarge on this point in paragraph 38 below. source: "Charting a new course" paragraph 123

An alternative tonnage-based corporation tax regime

25. So, the existing tax regime is generous but it is for the most part unloved. For some years, the industry pressed for a return to 100% capital allowances which had prevailed for all long-life assets until 1984. But increasingly the majority of the industry has come to favour the availability of an option for individual companies of a different tax structure, called the tonnage tax (shorthand for a tonnage-based corporation tax). It suggests that this basis of tax should be available as an option for the shipping industry, but leaving it open to individual shipping companies to pay normal corporation tax. Once the option is exercised it is accepted that the company will normally need to remain in the tonnage tax regime for a substantial period of, say, 10 years.

26. The tonnage tax has become increasingly favoured in some other European countries. It was first introduced in Greece, in recent years has been adopted in Norway (in 1996) and the Netherlands (in 1996), and is being implemented in Germany. In each case it has been introduced as a part, but an essential part, of a package of measures to make them more attractive locations for certain shipping activities. Whilst it is too early to assess their success clearly, and the overall nature of each country's package is important, nonetheless the increases in ship ownership, registration, employment and shipbuilding activities in the Netherlands and Norway have been quite impressive.

27. A tonnage tax contrasts with the generic corporation tax system under which a company's tax liability is based on the commercial profits which the company has made in the year. It ignores actual profit and instead computes a notional profit on the basis of the number and size of ships operated and taxes this profit, rather than the commercial profit, at the normal corporation tax rate. The tonnage rate is generally set so that notional profits, and hence actual corporation tax paid, are minimal. The mechanism seems to be an ingenious device for obtaining virtual tax exemption compatible with international tax treaty obligations. It departs from normal corporation tax principles of taxing actual profits to introduce a notional basis which bears no relationship to actual profits earned. But, widely recognised as a sensible and pragmatic way of achieving a low-tax regime, it has formed the focus of this enquiry. No-one has put forward any alternative or more desirable scheme for achieving effective tax exemption. I turn to consider its potential benefits for the shipping industry.

The advantages of a tonnage tax for the shipping industry

28. The case for a tonnage tax regime was forcefully and consistently urged on me in nearly all submissions. The Chamber of Shipping regards it as fundamental to what it describes as "a make or break" situation for our shipping industry. The Chamber states:

"British shipping is at a watershed. Urgent action is needed because of:

29. These views were supported by the National Union of Marine, Aviation and Shipping Transport Officers (NUMAST): "The tonnage-based tax is of critical importance to our industry and, we believe, to providing the environment that will stop the haemorrhaging of our maritime skills and the decline of our merchant fleet." The Rail and Maritime Transport union (RMT): "see the tonnage tax as essential to assisting the revival of British shipping". The TUC gave their strong support.

30. The view of the DETR is obviously highly important, so I set out their summary in full:

"Without a tonnage tax it seems likely that any new investment and much existing shipping business will be lost to the UK; indeed, the indications are that this process could happen relatively quickly as those companies which have held investment decisions pending finally "jump ship". Without securing a significant UK industry there seems little prospect of developing the maritime skills base and employment ... In short, a tonnage tax is widely regarded as integral to the success of the Government's shipping policy. If we fail to create an appropriate environment for British shipping, the industry - both shipowners and unions - will consider that we have defaulted on our side of the partnership. In these circumstances, we believe that there would be a poor prospect of securing the objectives set out in "Charting [a new course]"."

31. The DETR supported this argument by pointing out that after the withdrawal of 100% first-year capital allowances against corporation tax in 1984 the tonnage of UK direct-owned ships fell by over 20% in two years. Tonnage has further dropped by 25% over the past three years following the introduction of tonnage tax regimes elsewhere in Europe. These examples appear to demonstrate neatly the importance of fiscal competition.

32. The DETR's representatives confirmed to me orally their views that a more attractive fiscal environment was critical and that the only proposal that had been made to achieve this was the tonnage tax.

33. The importance of a competitive fiscal regime is confirmed by the submission of P&O. They draw attention to the rationalisation taking place among shipping companies seeking to develop worldwide operations and enhance their scale of activity. Pressures from partners are necessarily driving such merged activities to locate in the most favourable tax environments. In 1996 P&O merged their container business in P&O Nedlloyd, a UK parent company, with Dutch and UK operating companies. Inevitably, the incentive going forward is to locate new investment by the combined group in the more favourable tax regime. P&O indicated that expansion of their partnership was under active consideration. Prospective partners would currently not expect the parent company to be in a "full tax" regime or any part of the shipping profit to be subject to UK tax. They would wish to ensure that the existing shipping profits were not subject to corporation tax, to prevent a tax liability arising on dividends paid up to a parent company from overseas subsidiaries, and to guard against UK tax on newly merged activities as a result of a British participant. P&O and Royal Nedlloyd have stated an intention to seek a listing for P&O Nedlloyd and say that a structure which is internationally competitive is a prerequisite. In the view of P&O, all these considerations would mean our current regime would be perceived as comparatively unfavourable. This would result in pressure towards locating management and investment overseas.

34. P&O say that they do not want to transfer their businesses overseas and that they want to see the UK as a flourishing maritime centre that attracts other shipping companies. P&O represents 40% of the UK industry on a gross earnings basis. They have declared their commitment to supporting the Government's policy by stating at the time of the Budget that, if a satisfactory tonnage tax were to be introduced, they would bring an additional 49 of their ships to the UK register, increasing at once the tonnage on the register by 75%. They would also over the next three years raise the number of British cadets in training from 170 to 310 and "would expect to go beyond this over time". Lord Sterling, Chairman of P&O, confirmed to me that his intention to take these steps would be regarded as a firm commitment if you were to announce promptly in favour of a decision to introduce a satisfactory tonnage tax regime in the next Finance Bill with appropriate backdating.

35. A number of other shipping companies also responded. OT Africa Line supported the position of the Chamber of Shipping and said that: "We are convinced that the prompt introduction of a tonnage tax ... would enable us to expand and extend our operations". Other companies, which responded confidentially, were supportive of reducing the fiscal burden on shipping in the UK and recognised the potential role of a tonnage tax.

36. We were also provided with evidence, some of it anecdotal, about the future location and investment decisions that might be driven by the introduction of a tonnage tax. While obviously none of this is certain, it tends to support the view that there is potential to attract further development of the industry.

37. It is clear from these extracts that the industry favours the increasingly fashionable tonnage tax. But why, given that the present UK tax structure produces such a low effective tax charge, does the industry regard it as so essential? The first reason concerns the nature of the fiscal environment which it would create. The second relates to the sustenance of a climate of partnership between business, trades unions and the Government to regenerate shipping.

38. Fiscal environment. For many companies the tonnage regime may not significantly affect the level of tax payments. Their liabilities may currently be deferred indefinitely if a high enough level of investment is maintained. Instead, it would appear that the tonnage tax would have particular structural advantages for shipping over the existing corporation tax system:

39. All these are cogent advantages which may well be more important to the perception of the UK as a tax-friendly environment than the simple difference in the level of tax payable. The existing tax breaks were introduced on an empirical, almost haphazard, basis apparently without any detailed consideration of whether they were the most cost-effective form of support for the industry. In contrast, the tonnage tax has widespread support within the industry as a sensible and pragmatic way of achieving a low-tax regime for shipping but also offering some other important advantages. The industry stresses that the cost of the change need not be high and the advantages are principally structural.

40. Partnership. It is clear that there is currently a potent and apparently committed partnership between the Government, business and trades unions seeking to revive the shipping industry. What all parties envisage is that a package of measures should make our industry internationally competitive. The TUC said that: "If the whole package is implemented then the effect will be greater than the sum of its parts. It would signal a new direction in UK maritime operations which would maximise the psychological lift given to the industry". I can understand this view. Conversely, it seems probable that all sectors would lose conviction that the Government were truly committed if it were to reject the tonnage tax proposal. The policy would be perceived to be holed below the waterline before it left port.

41. I have considered these arguments about the potential benefits of the tonnage tax regime for the shipping industry. I turn to assess whether the tonnage tax would be acceptable within European Union guidelines, the pros and cons of the tonnage regime for the wider economy, and whether it could be designed in such a way that would make it workable, affordable and resilient to attempts to use it as a device to avoid tax.

European Union considerations

42. The need to permit a low tax environment in the form of tonnage tax to help the European shipping industry be more competitive has been clearly endorsed by the European Union in its Maritime State Aid guidelines. The maritime transport industry is considered a special sector for the consideration of state aids. The current guidelines were adopted in July 1997, with the following aims: "the objective of State Aid within the common maritime policy is to promote the competitiveness of the EC fleets on the global shipping market" and "... promoting a safe and competitive [European] Community fleet with the employment of the highest possible number of Community seafarers". This leads to the conclusion that "support measures for the maritime sectors should aim at reducing fiscal and other costs and burdens borne by the EC shipowners and EC seafarers towards levels in line with world norms". The fact that these directions are clearly designed to allow the shipping industries of EU member states to compete internationally provides additional support for the view that a virtually tax-exempt environment is integral to the opportunities for success of a national shipping industry. Without the tax regimes permitted by these or similar guidelines, the countries of the EU would have no prospect of competing internationally for a share of the shipping industry.

43. The DETR concludes that: "The concept[s] of a shipping tonnage tax, of this being an "option" on an entire shipping company basis, of ring-fencing, of flag neutrality, with respect to the tonnage within the scheme are ... familiar to the Commission and are, in principle, compatible with the Treaty provisions as exemplified by the Maritime State Aid guidelines". An official of the European Commission, in giving evidence to the Environment, Transport and Regional Affairs Committee confirmed this point: "The tonnage tax is one of the measures within the guidelines that [EU] Member States can adopt if they want to help their fleet". source: "The Future of the UK Shipping Industry", paragraph 76

44. Separately, Finance Ministers of the EU Member States have agreed a Code of Conduct for business taxation "to curb harmful tax measures" which "affect, or may affect, in a significant way the location of business activity in the Community". The Code is a political agreement between governments which commits countries to remove tax measures if they are found, by the Council of Finance Ministers, on the advice of the Code of Conduct Group, to be "harmful" under the criteria set out in the Code. The list of existing measures which are being considered as potentially harmful is long and no doubt tonnage regimes in other countries will fall for consideration. The Inland Revenue confirmed that if the UK were to introduce a tonnage tax it might need to be assessed under the Code of Conduct. A UK Minister, Dawn Primarolo, the Paymaster General, chairs the Group. Its work is clearly important as an impetus to reduce and rationalise subsidies within EU countries. It could be argued that this country should defer introducing a tonnage tax regime until it is known what the Group will advise and whether the Council of Ministers takes action. But I would expect that countries that had so recently introduced a tonnage tax would be reluctant to surrender it so soon after it had been approved within the state aid guidelines. In any event, I would regard our standing back while competitor countries currently seek to develop their industry as too "hair-shirt" and too disadvantageous for our industry. If any change is needed, it should be introduced promptly. The conclusions of the Council of Ministers when adopting the Code of Conduct stressed "the need to consolidate the competitiveness of the European Union and the Member States at international level".
source: Conclusions of the ECOFIN meeting on 1 December 1997 concerning taxation policy

Spillover benefits for the rest of the economy

45. "Charting a new course" did not examine in depth how the benefits of a more friendly tax environment would flow through the economy. In essence, it argued that it would promote investment in the UK direct-owned shipping fleet. This would provide economic benefit in the form of investment and enhancement to national earnings, with some stimulus to greater UK ship registration, and to the maintenance and enhancements of a previously diminishing stock of UK seafaring officers and with some enhanced prospects for ratings. There would also be some benefits associated with our defence needs and our influence internationally on safety and environmental protection. It is worth seeing how these arguments stack up.

46. The Shipping Working Group estimated that the increase in profits of the industry would be expected to be £60 million a year by 2012. The Chamber of Shipping suggested that this figure could prove conservative. Because of the nature of the tonnage tax, however, there is no prospect of these extra profits directly benefiting the Exchequer.

47. The British Marine Equipment Council pointed out that a recent DTI study had noted that only 33% of the sales of marine equipment were to the domestic industry. This suggests that we have a powerful industry that can compete internationally and that a strong UK industry would generate far more orders.

48. The environmental argument, now routinely deployed in support of so many causes, seems fairly slight in this case. It is true that the key international organisation (the International Maritime Organisation), is based here, that our environmental and safety standards for registration are high and properly observed and that the UK's negotiating strength internationally depends in part on our reputation and our fleet. However, the associated direct benefits from a rise in UK registrations would be very small. Significant environmental benefits could only be achieved by transporting more goods by sea than road. The tonnage tax is not designed to achieve this and I have seen no evidence that it would do so.

49. The defence argument is somewhat stronger. The Royal Navy's immediate support needs are met by the Royal Fleet Auxiliary, which is a member of the Chamber of Shipping, comprises the largest fleet operating under the UK flag and is the largest employer of UK seafaring ratings. The Ministry of Defence is also acquiring its own in-house "Ro-Ro" and container vessels. Any extra merchant shipping requirements are met by chartering on the open market. It is only in the very last resort that UK shipping would be requisitioned, in which case a core of UK owned or flagged vessels is important. At present, there are enough useful flag merchant ships and UK seafarers for our defence purposes. But, adverse wastage and ageing trends in the supply of seafarers, which could take a long time to reverse, are a concern. Unless they are addressed, the point might be reached where we had difficulty especially if we had to take unilateral action to defend our interests, in manning ships with UK seafarers.

50. On a wider level, the concern about the stock of UK seafarers and especially officers is at the heart of the case for regeneration of our shipping industry. As the Environment, Transport and Regional Affairs Committee noted: "The shipping industry is unusual because of the number of industries it supports, not only directly, but by providing a pool of suitably qualified ex-seafarers. Without a significant British shipping industry the onshore industries, including Maritime London, would face extreme difficulties". I turn to this in more depth. source: "The Future of the UK Shipping Industry", paragraph 32

Training and employment

51. UK officers are highly regarded throughout the world. There are about 17,000 UK officers, of whom some 55% are employed on UK-owned fleets, divided approximately 60:40 between vessels registered in the UK and those registered elsewhere. The average age of UK officers is on a rising trend, with 70% of them over 40 years old. The training time is long, and unlike many continental countries, is based on an apprentice-style system, where much of the training takes place at sea supported by periods of college education. In many other European countries, a large component of the training is university-based (or similar) and is part of the state-funded further or higher education system. In contrast, the industry funds 50% of training costs in the UK.

52. Recruits enter training with often only modest formal educational attainments yet the skills of our officers after such training bear international comparison and reflect the success of our training scheme and the way it is carried out. The majority of college based study is undertaken in the 3-4 year training period leading to the seafarer's first certificate of competence. But it takes about a decade of sea service and experience and college training before a Class 1 (Master and Chief Engineer) certificate is achieved. The DETR rightly points out that unless we start to reverse the decline now the long lead time for training may mean we are not in a position to prevent the loss of the industry.

53. The importance of training is already acknowledged by the contribution which the Government currently makes through SMarT (Support for Maritime Training). The Government has committed to provide sufficient long-term funding for SMarT to meet demand in key training categories. This support is forecast to increase from £6.4 million in 1999-2000 to £23.4 million by 2007-08. It could be argued that to increase the number of officers it would be better to provide much more money for training rather than to rely on the indirect effects which may flow from greater UK ship ownership. After all, the shortage of officers is international and not merely national. An interim study for the International Shipping Federation in 1998 suggested that by 2006 the shortage of officers in the European Union might reach 35,000. Why not leverage our skills and mobilise recruitment through an ever more attractive and well promoted training regime?

54. Unfortunately this argument immediately hits a reef. Most of our cadet training and senior officer employment is on board UK-owned ships. Without increasing UK ownership there will not be an increase in berths. This is why the DETR recognises that it can only encourage training through grants but that the commitment has to come from the shipping industry. They therefore propose to link a tonnage tax to a training commitment.

55. The need for more officers is highlighted by the strength and requirements of our shore-based infrastructure. A University of Wales study, which the DETR regards as definitive, identified nearly 17,000 jobs in more than 25 shore-based sectors which employers would prefer to fill with seafarers. University of Wales: "A study of the UK economy's requirement for people with experience of working at sea" (B M Gardner & Dr S J Pettit, July 1996 For 70% of these jobs, seafaring experience was considered essential. Most of these jobs were filled by the most fully trained officers with Class 1 certificates. As the DETR noted: "Practical seafaring experience generally remains the key element in the mix of competences which is sought by shore-based sectors in appointing seafarers."

56. With my own background in law and finance, I am obviously very aware of the importance and quality of these shore-based City and law-based industries. Their value is well summarised by the Baltic Exchange. London is the world's largest provider of maritime services with a value assessed by British Invisibles of some £1.5-2 billion a year. We are an attractive base for overseas ship managers, with well known assets of time zone, language, stability and culture. These overseas owners with agencies here are sustaining over 4,500 jobs, contributing £100 million in tax revenue, and bringing work to City firms which specialise in services related to shipping. They see the industry being dynamised further by any increase in the UK-owned industry. By contrast, the Baltic Exchange believes that: "[the] pool of maritime excellence is fast diminishing and the strengthening of the UK fleet is probably the only way of reversing that process". They also point to the decline in the once strong New York shipping infrastructure which followed the decline of its shipping industry and say "without a national shipping industry and the associated skills base, London's position as the world's biggest maritime centre would be vulnerable." Lloyd's Register takes the same view. I wholly agree with them both as to the opportunities and the dangers.

57. The same University of Wales study found that to meet the shore-based industries' demand for trained manpower will require the recruitment annually of 1,200 cadets. University of Wales: "A study of the UK economy's requirement for people with experience of working at sea" (B M Gardner & Dr S J Pettit, July 1996 Whilst this would not remedy imminent shortages, it would achieve a steady situation in the longer term. But recruitment was just under 500 for the year 1998-99 and in recent years before then it has averaged about 450. Last year's increase is suggested to reflect a new optimism about the Government's proactive approach to UK shipping. But even if this increase could be sustained, there is obviously an increasingly concerning shortfall.

58. The formal training offer made by the industry as a precondition of eligibility to the tonnage tax is a "minimum training obligation", "to recruit each year one UK officer trainee for every 15 existing officers posts, regardless of whether the existing post was currently filled by a UK officer or one from another country." After three years this would mean in broad terms that there would be one officer cadet under training for every five officer posts.

59. The Chamber of Shipping has also made a "commitment" on behalf of its members to "make every effort to increase the recruitment and training of British cadets and ratings by 25% each year on a cumulative basis". No doubt this achievement would depend in large measure on the extent to which the package of measures including the tonnage tax dynamises the UK direct-owned industry. The industry will use their best endeavours to achieve this growth, but neither they nor the DETR nor the trades unions regard it as a precondition for an entry to the tonnage tax. The achievement of this "commitment" will also depend on the extent to which the overall package of measures dynamises the industry and recruitment by individual companies supported by the Chamber of Shipping succeeds.

60. It is less clear what growth in the industry would do for ratings. The number of UK ratings has fallen by some 65% between 1980 and 1997. The Ratings Task Force is studying the opportunities for ratings. Ready access for deep sea shipping industry to low-cost world labour markets means that, in the absence of any EU action to "protect" its seafarers, the employment of European ratings in essentially unskilled roles is simply unviable. University of Wales: "A study of the UK economy's requirement for people with experience of working at sea" (B M Gardner & Dr S J Pettit, July 1996

61. However, there is scope to consider what opportunities might exist for training ratings for more skilled roles and to become officers. The RMT submitted that: "it is vital that a written commitment to training seafaring ratings is spelt out as a condition for shipping companies qualification for the tonnage tax". The industry, however, preferred a non-formal "commitment" to double the current intake within three years and begin a new structure and programme for rating training, including bringing at least 50 ratings a year into training as officer cadets.

62. The industry's offer clearly demonstrates a determination to increase training and employment and to try to meet the need for trained officers. But there are nonetheless concerns as to its adequacy. The formal link of the tonnage tax to training alone would not satisfy demands for trained and experienced officers in related sectors. Its extra cost to the industry of about £4.5 million a year after five years is small when compared against the financial and other advantages of the tonnage tax. The commitment to ratings is less than the RMT would wish. I therefore asked the industry and DETR to explore together the prospect of further commitments.

63. The industry felt it difficult to increase the formal obligation which would be a condition of the tonnage tax. It argued that shipowners might still locate in the Netherlands where the cost of training is lower and pointed to other measures that the Government would need to implement without which its "best endeavours commitment" to 25% annual increases would be "difficult to achieve".

64. However, it confirmed more clearly the full content of its various commitments and targets and agreed with the DETR and the trades unions a mechanism for implementing the minimum training obligation in the form of individual company training plans. This mechanism forms a new amplification of the binding obligation. The training plans would:

65. The body to be charged with monitoring the minimum training obligation is envisaged to be the new Maritime Training Trust, advised by the Merchant Navy Training Board. The DETR is prepared to oversee the operation of the Trust and to determine whether the commitments for eligibility to the tonnage tax have been met. In short, companies participating or applying for the tonnage tax will be required to submit training plans to the DETR. The trust will check on progress against them and will also collect payments (a levy) from shipping companies that are unable to provide training themselves and use the revenues for supporting other training initiatives. However, given the option for a company to contract-out its minimum training obligation (so that another shipping company carries out its training obligation on its behalf), I would hope that this "opting out" of providing training by paying the levy is considered only in exceptional circumstances.

Economic arguments for and against a tonnage tax

66. Whilst many arguments point strongly to the imperative of tonnage tax if the Government's policy to reverse the decline of the shipping industry is to have any prospect of success, its potential gains have to be weighed against the basic taxation principles. In general, subsidies are understandably viewed with caution. The UK remains amongst the lowest providers of aid to industry within the European Union, accounting for just 4% of the total provided by EU countries. The case for intervention in the market is normally only justified where market failures exist. Subsidies may result in a higher level of activity in the subsidised industry but can distort the price mechanism and hence the allocation of resources. see Appendix V. But they can increase economic efficiency where there is a failure of the market to allocate resources correctly in the first place. It can be argued that we should leave the shipping industry to decline, and outsource our needs. But this presumes there is no external value to preserving the industry. If there is such a value, the cost of support has to be weighed up against the external value. In the case of shipping, it can be properly argued that the benefit to the shipowners of training seafarers is less than the total benefit to society, which includes the significant and arguably crucial benefits to our valuable shore-based industries. This cannot, because of the need for suitable training berths and appropriate supervision, simply be addressed by providing more resources for training.

67. The DETR concludes "on balance" that the case for supporting the shipping industry can be sustained on economic grounds. They point out that the UK has a comparative advantage in important maritime sectors accounting for at least 75% of the industry earnings and in offshore activities which require trained and experienced UK seafarers. Without domestic action they argue that these advantages would be threatened by the entrenched nature of support measures in other countries.

68. Arguments based on comparative advantage would have more cogency if it were probable that the overseas subsidies would only be temporary. The value of preserving an industry during a stormy period until it could flourish in a non-distortionary environment with its comparative edge would be high. But it is unrealistic to suppose that internationally shipping industry subsidies will be eliminated enough in the near future to level the playing field. What, however, these comparative advantages do suggest is that if our industry is granted a package of measures which enable it to compete with other countries it has distinct competitive qualities which raise the prospect of success in achieving the Government's objectives.

69. The "spillover" or indirect and induced effects of the growth in UK ownership notably in the onshore marine equipment and shipping services sectors must not be seen as an automatic economic gain. First, there is some considerable uncertainty as to whether the linkages would be achieved, and if so, about their extent. The DETR concludes that growth in the UK-owned fleet is crucial, and has a significant prospect of being achieved. They see the indirect effects as "positive, although probably not overwhelmingly so". The Inland Revenue are less sanguine on both accounts. Second, there is a generally accepted economic view that subsidised increases in output from related activities would not contribute to an increase in the total output of the economy or an increase in the general level of employment. In short, the question arises whether the extra resources for shipping and related activities would have been diverted from more productive and profitable uses. Schumpeter's "creative destruction" may be more efficient in promoting overall national growth.

70. I see the force of these arguments. They were very properly advanced to me, not least by some who were sceptical about the wisdom of seeking to support this industry and the nature of the benefits which would result.

71. Taxation is not, however, neutral in the way it raises revenue and sends signals about the activity which the Government believes should be encouraged. Nor are we considering from a neutral starting position whether we are justified in strict economic terms in subsidising the shipping industry. We have already done so for some time. The last Government took action, both by tax incentives and training subsidies, to give support. The cost of existing measures is currently about £85 million a year (in the range £60-100 million), comprising fiscal measures worth around £75 million a year (in the range £50-100 million) and non-fiscal measures worth about £9 million a year (including about £6-7 million on training, and rising in total to about £24 million by 2007-08). But these already significant subsidies are not cost-effective because of the distortionary consequences that I have set out earlier. The overall benefit is at most some unquantified diminution in the pace of decline. The policy of the present Government is clear: to reverse that decline. This involves seeking a more effective, user-friendly way of creating a more benign fiscal regime.

72. At present, tax incentives are normally granted across the board, or horizontally, as for small businesses and research and development. But support for individual industries is not precluded, as the recent treatment of the film industry demonstrates. In the case of the shipping industry, there are prospects of securing benefits to an industry and related industries which have been national strengths. "Charting a new course" is positive that these benefits can be achieved. Its conclusions state: "With the commitment of each of the stakeholders, vital national assets and the maritime economic future of the UK can be secured". Whilst not all those I consulted were as confident, it is clear Government policy to make a serious attempt to achieve this. All the material that I have seen convinces me that without improving the fiscal environment with a firm and swift commitment to a tonnage tax the chance of success of that policy will be minimal.

Cost and design of a tonnage tax

73. Where, however, the benefits are inevitably far from proven, it is highly important to approach the design of such a tax system rigorously so as to minimise the necessary cost and to make it work simply, efficiently and with minimal opportunity for tax avoidance. So, what form should a tonnage tax take and how much would it cost the Exchequer?

74. The first point to make about the cost is that, although essential to make the calculations, it is impossible to be precise about comparisons of potential costs, for the following reasons in particular:

75. The second point is that the cost would depend crucially on the design of the tonnage tax. The choice of design would affect the tax paid by an individual shipping company or a group of companies. It would also be important in driving decisions by that company which might have consequences for tax revenue, in particular in determining whether it chooses to remain within the standard corporation tax regime or opts into the tonnage tax. Finally, it would determine the risks of tax avoidance. It is common ground between the parties that the tonnage tax should be ring-fenced, and indeed this was a key part of your Budget announcement.

76. The starting point for an assessment of the costs of the tonnage tax is simple: it is the difference between the corporation tax currently paid by shipping (about £20 million a year for that part of the industry intended to be eligible for the tonnage tax) and the likely yield from the tonnage tax (up to about £5 million a year). This gives a baseline of about £10-15 million a year if 75% of the industry were to join the regime.

77. The scope of activities covered by the tonnage tax would also have a bearing on this. Most notably, the cost of including certain limited offshore activities in the North Sea, which would be for consideration, is inevitably uncertain and would depend crucially on its precise design, but the best estimate by the Inland Revenue has been an extra cost of £10 million a year. Currently only certain North Sea activities qualify for the special capital allowances for ships.

78. Two further sets of potential costs would arise from the interaction between shipping and non-shipping companies. The first is group relief, which would be consequential from the change to a tonnage regime. The second and potentially more expensive cost would be that of leasing, depending on the extent to which part of the current regime continues for companies within the tonnage tax.

79. Group relief. Currently some shipping company profits are sheltered from corporation tax by being offset by taxable losses incurred by other companies in the same group. Conversely, some non-shipping company profits are offset by losses in shipping companies owned in the same group. Ring-fencing shipping companies for tax purposes within the tonnage tax will make it impossible for these practices to continue. So, to the extent that the former outweighs the latter, and that groups are able to ensure that the former category of group relief can offset alternative profits from a non-shipping company still within the group, the effective loss of corporation tax revenue by the Exchequer is increased when the shipping company enters the tonnage regime. This is estimated to amount to up to £5 million a year.

80. Leasing. This is by far the most difficult issue in the design of the tonnage tax. The availability of capital allowances to finance lessors for ships leased to companies within the tonnage tax regime potentially increases the cost very significantly and makes the cost more uncertain. Finance-leasing provides an external source of taxable profits, which accrue to the financial lessor, against which capital allowances with the current generous 25% rate of depreciation can be offset. Benefits are shared between the financial institution (in the form of lower tax bills) and the company leasing the asset (in the form of lower interest charges). To continue this under a tonnage tax would enable shipping companies to benefit from generous capital allowances despite not having taxable profits against which to offset them. This would create an extra incentive to lease rather than purchase vessels. Removing access to capital allowances for lessors of ships to companies in the tonnage tax would cut the overall cost of the regime to up to £15 million a year (or even produce a small increase of revenue of up to £5 million) relative to the existing regime. In contrast, permitting allowance to continue at 25% would increase the total costs of the tonnage regime to about £50-70 million a year, even if investment were to remain static. There would also be a larger risk of tax avoidance. The industry initially proposed that the current rule should remain unchanged so that a lessor would be able to claim 25% allowances on ships leased into the tonnage tax regime. This was said to avoid any distortion and leave neutral rates of finance being offered to tonnage tax and non-tonnage tax companies.

81. I was from early on in this enquiry unconvinced by this argument and concerned as to whether it would be right to continue the principle of capital allowances at all. These were devised as part of the normal corporation tax regime and the assumption was that they would be set against tax otherwise payable. This philosophy does not easily translate to a tax-exempt regime. Why should shipping companies, as well as having the considerable benefit of tax exemption, also have the benefit of allowances designed to be set against tax? These doubts were increased by the Inland Revenue's concern that leasing increases the scope for avoidance unless accompanied by extensive anti-avoidance provisions. The shipping industry has itself argued strongly that the existing structure of tax incentives is not cost-effective. Indeed, the principal advantage of the tonnage tax is said to be greater structural clarity and certainty rather than the reduction in the already low level of tax actually paid. An attempt to preserve some part of the present unsatisfactory and costly system does not sit easily with this contention.

82. All this suggests that the bold course would be to abolish capital allowances for shipping companies opting for the tonnage tax at the same time as introducing the tonnage regime. The industry will be receiving virtual tax exemption and other support measures agreed with Government and will be able to compete against other countries on the basis of our comparative advantages originating from our seafaring skills and maritime culture. The Chamber of Shipping has to some extent faced up to the logic of the argument that the "volume of leasing should be restricted" and that "it should be possible to have an effective restriction on the cost of leasing into [the] tonnage tax". However, they argued strongly that at least some capital allowances should continue to make sure that our regime does not comparable unfavourably with, for example, the Dutch. It is suggested that the form of the investment relief available in the Netherlands could add to the attraction of their regime and that this needs to be allowed for.

83. In practice, it is worth noting that there has been a general trend in the UK towards reducing the potential benefits of capital allowances available through leasing. Furthermore, strictly speaking, neither the Netherlands nor Germany offer comparable leasing and capital allowance schemes in combination with their tonnage tax regimes. The German scheme appears effectively to permit leasing-type arrangements between companies within the same group to benefit from accelerated depreciation at 25%, but not through financial institutions in the manner which has been proposed in the UK. No tax benefit is available from a normal finance-lease in the Netherlands although the Dutch regime does include an "Enterprise Investment" scheme (the "CV" limited partnership structure) which provides finance for some shipping companies with tax benefits, but the Chamber of Shipping conceded that its "availability is limited by the willingness of private investors of a particular age ... The supply is relatively small ... and it is likely to diminish in the future ...".

84. The supply of capital in the UK for finance-leasing is not infinite, partly because of banks' unwillingness to expose themselves too much to a single business sector. But the combination of a large tax benefit and growing competition within the financial services sector and perhaps other sources of leasing finance to find higher margin businesses would, in my view, ensure that the take-up of finance-leasing for the shipping industry is unlikely to be severely constrained by the market alone.

85. Not surprisingly, as noted above, the industry see complete abolition of capital allowances for vessels leased into the tonnage regime as too draconian. The Inland Revenue acknowledges the concern that this could lessen the attractiveness of the tonnage tax and so diminish the very prospect of success which prompted its introduction. The Inland Revenue and the industry agreed that rules could be devised which would limit or cap the allowances given to lessors on ships leased to tonnage tax companies.

86. Alternatives suggested to me to restrict allowances included:

These estimates were made by the Inland Revenue. The industry broadly agrees with them, although they feel that they might be slightly on the high side. They obviously contain uncertainties such as how much extra investment would take place and in what sorts of vessels (and in particular costs might be higher if new investment were to be all or very largely in small or medium-sized vessels). The second and third illustrations carry slightly more risk of tax avoidance than straight allowances at 10%. However, a significant advantage of the capped approach would be that investors in small and medium sized ships will find 25% allowances through finance-leasing on all or much of the cost of their ships plus a tonnage tax an attractive combination. It would also help to ensure a remaining source of finance-leasing for these shipping companies who currently find investment finance most difficult to obtain. In contrast, capped allowances would have little incentive value for the largest cruise ships, which are judged to be sufficiently profitable to find the tonnage tax alone sufficiently attractive without allowances.

87. I am conscious that in the end the judgement has to be pragmatic. Whilst I have found it hard in principle to justify continuing leasing allowances in what would be a virtually tax exempt regime, the advice of the industry and Inland Revenue is that to withdraw this altogether would carry a risk that the tonnage tax regime might not be sufficiently attractive. In that event, the success of the very policy which underlies the tonnage tax would be in doubt. It seems desirable to avoid this risk. So, it would seem to me reasonable as a commercial judgement to allow leasing allowances to continue but with cap to ensure the benefit principally goes to small/medium sized operators. It is important to set this cap as low as is reasonably practical to prevent the otherwise modest cost of tonnage tax increasing too strongly. It would be good to achieve this with a cap of £20 million, but this may not be attractive to those companies with ships in the range between £40 million and £60 million (which make up a large proportion of the value of the current order book). My preference is for a £20 million cap, but you may wish your officials to consider whether my approach is too rigorous and whether the cap should be at, say, £30 million. In any event, the initial cap will need to be kept under review.

Foreign profits from shipping

88. The industry proposes that the tonnage tax regime will apply to foreign dividends from overseas shipping subsidiaries effectively to exempt them from UK corporation tax. This would make the UK an attractive location for an international shipping and holding company. It would remove the potential obstacle to joint ventures and acquisitions of overseas companies which would not want to risk overseas profits currently enjoying a favourable tax regime being caught by UK corporation tax. see Appendix VI The Inland Revenue points out that, whilst the whole area of the taxation of international companies with activities in the UK is currently under review, this country currently taxes the worldwide income of UK residents giving credit for foreign tax. To the extent that foreign profits are repatriated, this provides export neutrality, so that a UK investor should be indifferent between investing here or overseas; the same overall rate of tax would be paid on the returns. The Inland Revenue acknowledges that the inclusion of both domestic and foreign profits from shipping in a tonnage tax regime would maintain capital export neutrality for shipping activities. But they say that such capital neutrality would not provide the desired incentives to come into and stay in the UK. They point out that such treatment would bring into sharp relief the favourable treatment of income from shipping worldwide compared with other industries. They also raised concerns about tax avoidance, to which I have already referred.

89. I consider that foreign shipping dividends should be within the tonnage tax regime. Capital neutrality between export and inward investment remains desirable. In the case of shipping this would mean including foreign shipping dividends within the tonnage regime. This treatment of foreign dividends would mark a break with the existing practice, but in the context of retaining export neutrality with a virtually tax-exempt domestic industry.

90. The commercial arguments of the industry also seem realistic. Certainly, there is evidence that some other countries treat foreign profits from shipping more favourably than the UK would do if foreign earned profits from shipping were not included within a UK tonnage tax regime. Notably, the Netherlands does not impose tax on any dividends remitted to international parent or holding companies, and this makes the Netherlands an attractive location for such companies. To require payment of tax on remittances would make the basic regime less attractive. Parent companies might well move offshore, skewing the centre of gravity of group operations away from this country.

91. However, I appreciate the need for this element of the scheme to be tightly guarded to minimise the scope for tax avoidance. The industry and Inland Revenue have agreed some important design specifications to avoid abuse.

Detailed design

92. I felt it right to resolve as many detailed design issues as possible in formulating my advice. In light of discussions between the Inland Revenue and the shipping industry and my own views on leasing and foreign dividends, I recommend the following regime. There are a few minor issues which may fall for further discussion but I believe that all the essential issues are covered in this design. The unresolved issues are asterisked in the main text and set out in Appendix VIII. What is encouraging is that the Inland Revenue and the Chamber of Shipping who have seen this design in draft form accept that it covers all key areas and is workable.

(a) Optionality

A shipping company, or group of companies, will have the option to participate or to remain in the standard corporation tax regime, subject to all qualifying shipping activities within a UK group being taxed on the same basis.

(b) Tax liability

A participating company's taxable profits will be derived by reference to the net tonnage of each of the ships it operates, whether owned directly or leased. It will pay corporation tax at the normal rate on the derived profit. The rates of profit will be derived as follows:

Net tonnage Derived profit per 100 net ton per day
0-1,000 £0.60
for the excess up to 10,000 £0.45
for the excess up to 25,000 £0.30
25,000 or more £0.15

These rates broadly accord with the rates of tonnage tax in the Netherlands. I have not assessed the pros and cons of different rates, but it would seem sensible to set rates similar to the Dutch.

(c) Eligibility - qualifying vessels and activities

Eligibility depends on a company operating one or more ships and being involved in qualifying shipping activities. Qualifying activities may also include ancillary activities within certain limitations (see below).

Qualifying ships must be seagoing, at least 100 gross registered tons, and can include vessels owned or chartered so long as time charters are limited to no more than 75% of the total tonnage.

Vessels must be engaged in transporting goods or passengers or involved in marine assistance. They may also be involved in providing services necessarily provided at sea, including cable-laying and diving support vessels. (*)

Inclusions and exclusions:

(i) to the extent that they carry out qualifying activities, eligible vessels would include: coastal vessels, hovercraft, offshore supply vessels, tugs and anchor-handling vessels, vessels chartered by the Ministry of Defence, most shuttle tankers, aggregate dredgers;

(ii) the following vessels would not be eligible: all vessels below 100 gross tons, fishing and factory support vessels, pleasure craft, harbour and river ferries, floating supermarkets and restaurants, fixed and floating oil rigs and platforms, FSPOs (floating production storage and offtake facilities), FSUs (floating storage units), flotels (floating accommodation used in the offshore industry), existing dedicated shuttle tankers already benefiting from the petroleum revenue tax regime;

(iii) there is an argument that vessels engaged in oil and gas exploration and exploitation should also be included within the regime: seismic and survey vessels, stand-by vessels, crane barges and vessels, diving support vessels, pipe-laying vessels, tugs and anchor-handling vessels (involved in oil and gas related activities). However, it is noted that their inclusion might conflict with the Government's policy towards securing revenues from the North Sea under which foreign shipping is taxed (subject to double taxation agreements). The Government would need to assess the relative importance of this and shipping-related objectives and the extent to which profits would be covered, as in the case of other services at sea. (*)

(d) Eligibility - ancillary activities

The extent of allowable ancillary activities will be determined according to the sector of shipping in which the company is involved. Any ancillary activities not disregarded or above permitted levels would be subject to normal corporation tax. (*)

There would be three categories of allowable ancillary activities, each with their own limits:

(i) shipping-related activities which do not qualify as shipping activities for the purpose of the tonnage tax eligibility - such as ship management and technical services. These must be genuinely subservient to the main shipping activity carried out by the shipping entity;

(ii) activities integral to the operation of shipping in that sector but also carried out on behalf of third parties, allowed up to agreed levels (for example as a percentage of turnover or warehouse floor space);

(iii) incidental income, such as commission from third party's ticket sales or freight transport bookings, allowed at de minimis levels.

Inclusions and exclusions:

(i) port activities can be included only where onshore activity is part of the primary operation of transporting goods or passengers by sea;

(ii) investment income (other than short-term investment of working capital) and gains not the result of shipping activities must be isolated and subject to normal corporation tax;

(iii) shipping-related ancillary activities bought in from third parties or at arm's length, whether or not they satisfy the ancillary activities definition, may be disregarded.

(e) Eligibility - qualifying presence

A company must undertake the "strategic and commercial management" of vessels within the tonnage tax regime from the UK (as required by the guidelines on Maritime State Aids). A method to determine that this criterion has been achieved will be required. (*)

(f) Joining - elections

Election into tonnage tax could be made by a group of companies under common control on behalf of all qualifying shipping activities carried on by any of its members within the UK tax net. No qualifying shipping activities undertaken by its members within the UK tax net would be permitted to remain outside the tonnage tax.

Election would be for 10 years, renewable at yearly intervals.

(g) Joining - window of entry

An election to join would be made during the 12 months following Royal Assent.

It would normally first apply to the accounting period at the time of election. However, in certain circumstances it would be permissible either to backdate or to defer entry:

(i) for a company which wished to make an early entry but having opted for preliminary discussions with its tax inspector was unable to agree and implement the necessary arrangements before the accounting period had ended, then with the agreement of the inspector entry could be backdated;

(ii) if participating would require corporate restructuring rather than solely accounting adjustments, then in certain circumstances entry to the tax could be deferred to the accounting period following that in which election was made.

It is recommended that in exceptional circumstances, a company unable to elect to join the tonnage tax within the initial window of entry, may be permitted to join at a point five years later. Arrangements would be needed to prevent forestalling and to assess under which conditions a company might be eligible. (*)

Otherwise, existing companies have a further opportunity to opt in after 10 years.

A new shipping company in the UK, or a company whose activities qualify for the first time, may elect to join the tonnage tax from the date of becoming liable to UK tax or becoming a qualifying company. The election must be made within 12 months of that date.

(h) Joining - clearances

There should be a non-mandatory system of clearances (ie prior agreements between the Inland Revenue and a company that it is eligible and about the way in which the regime will apply to it). These would normally operate on the basis that:

(i) companies or groups of companies can elect into the tonnage tax without seeking clearance;

(ii) tax inspectors cannot grant clearance without adequate information;

(iii) using the applications procedure for the purposes of tax planning will not be permitted;

(iv) the Inland Revenue will take steps to ensure a consistent approach.

(i) Operation of the regime - ring-fencing

Ring-fencing provisions would prevent a company transferring profits from outside the regime into it or transfer losses outside the regime. This would require:

(i) arms' length values to be used for transactions within the group taking place across the ring-fence;

(ii) rules on the capitalisation of a company to ensure that the cost of debt-finance relating to the shipping activity was not claimed outside the ring-fence;

(iii) there would be no access to group relief between shipping and non-shipping activities within a group;

(iv) various anti-avoidance rules to preserve the ring-fence. In some cases these would need to be more onerous than their equivalents within the normal corporation tax system.

(j) Operation of the regime - capital allowances and leasing

On entry, a company's general capital allowance pool will be split. Any shipping-related capital allowances balancing charges arising after the pool is exhausted will be phased out using a sliding scale. Rollover relief will remain available where a replacement vessel is acquired between 12 months before and two years after the disposal of the original ship.

There is a good case that if a company leaves the regime after its 10-year election expires it should re-enter the normal corporation tax system with no deferred tax liability, although this might involve costs which are not included in the headline figures in this report. (*)

No capital allowances would be available to lessors in the case of sale and lease-back or defeased or collateralized leasing, where the lessor does not carry the greater part of the risk as part of the leasing arrangement.

Allowances available to lessors leasing to companies within the tonnage tax regime will need to be restricted. My own preference would be to continue allowances at 25% but cap them at £20 million per vessel. But as set out in paragraph 87, you may wish your officials to test whether this is too rigorous. In any case, the cap should be reviewed regularly. Leases in place before the announcement of the tonnage tax would be unaffected by the new restrictions. (*)

Industrial buildings allowances. A shadow regime will be needed to operate during the tonnage tax.

(k) Operation of the regime - capital gains

Capital gains on the sale of assets used wholly and exclusively for the purposes of the shipping trade should be free of corporation tax on capital gains, to the extent that gains accrue after a company has entered the tonnage regime.

For assets which cross the ring-fence, that part of the gain referable to the period when the asset was outside the ring-fence would be chargeable on the eventual disposal of the asset (subject to normal reliefs available at the time). (*)

(l) Operation of the regime - foreign profits

It is recommended that foreign dividends earned from shipping activities and returned to a company within the tonnage regime should be exempt from normal corporation tax. To qualify for this treatment:

(i) the company from which the dividend is being remitted must be wholly engaged in shipping activities, as defined for the ring-fence within the UK;

(ii) full information on the company's activities must be available to the recipient of the dividend.

In cases not meeting these conditions, special rules may be needed to deal with Controlled Foreign Companies. (*)

(m) Operation of the regime - training link

A company participating in the tonnage regime must meet a minimum training obligation and comply with the rules of the scheme to provide the operating body, the Maritime Training Trust, with training plans, updated as necessary.

A company failing to meet the conditions of the training link may be subject to fines and ultimately to discharge from the tonnage regime. (*)

(n) Operation of the regime - anti-avoidance provision

Legislation would include a "sweep up" anti-avoidance provision aimed at moves to exploit the regime by complying with the form rather than the substance of the rules intending to ring-fence the regime. (*)

(o) Exiting the regime

In principle, it is recommended that a company leaving the tonnage tax naturally at the expiry of is election should do so without assuming tax liabilities relating to their activities from either before or during its participation in the regime (see capital allowances above).

A company which leaves the regime before the end of its election period because it leaves the UK, ceases to qualify, goes out of business, or terminates it shipping activities will need special exit provisions. In general, there is a good case that such a company should pay retrospective profits-based corporation tax, without any ability to surrender losses retrospectively and should not be allowed to re-enter the tonnage regime for at least 10 years. Special consideration might be needed in exceptional circumstances for reasons of equity.

93. In leaving the design issue, I should note that the Inland Revenue suggested, and I can understand why, that the complexity of the ring-fenced regime will increase the burdens it faces which may need to be allowed for in manpower terms.


94. I have considered whether the proposed more favourable regime would distort competition significantly. The DTI did not suggest that it would. The CBI referred to the importance of the "integrity of the corporate tax system as a whole" but noted that there "seems a strong case" for special treatment for shipping. It added that it would be important to avoid fiscal distortions between "land-based" and "sea-based" sectors in the UK providing the same service and that it would be important to consider the effectiveness of ring-fencing arrangements. The DETR concluded that some limitation might need to be placed on the percentage of turnover which a company inside the tonnage tax regime can earn from secondary activities. The only concern expressed in practice was by Eurotunnel, who point out that they are in fierce competition with cross-channel ferries which should not be further advantaged. Competitive issues between ferries and Eurotunnel are, however, wider. It is also worth noting that Eurotunnel receives payments under a Minimum Usage Charge irrespective of actual use. So different considerations may affect the two. But in any event introducing a UK tonnage tax would is not expected to significantly reduce the tax paid by ferry companies. Moreover, P&O has confirmed that a ferry company operating the short-Channel routes could currently organise itself in a way which would enable it to qualify for the Dutch tonnage tax regime and have treaty protection against tax liabilities in the UK. see Appendix V

Timing of a Government decision

95. Initially the industry hoped that I would be able to advise in time for you to consider whether to amend the current Finance Bill. But during the course of our meetings they indicated that this was now impractical given that complex issues remained to be resolved and that the design of the tax would be both novel and detailed. They said that an announcement by the Chancellor that a tonnage tax would be included in next year's Finance Bill, with an option to enter the regime backdated to 1 January 2000 would give the appropriate stimulus to the industry. I agree. If you accept my advice, I would support an early announcement to that effect, so as to allow companies to take important pending decisions and to build on the current impetus to revive the industry.

Further issues

96. Throughout this enquiry, I have been struck by the importance of ensuring that the employment, training and tax terms of the shipping industry in the UK must be competitive. The industry made a number of points which they had not yet persuaded the Government of at the time of "Charting a new course". Chief among these is the case for extending the Foreign Earnings Deduction (FED) to UK seafarers engaged in short-sea and coastal shipping. At present, FED removes income tax from seafarers employed on ships provided that they spend at least half the year outside the UK and no more than 183 consecutive days here. Many seafarers on coastal and short-sea routes are therefore excluded. There is therefore a tendency for trained UK seafarers to seek employment on routes which do qualify and instead to employ foreign seafarers (who benefit from similar tax exemptions from their own governments) on the routes closest to the UK. The Environment, Transport and Regional Affairs Sub-Committee of the House of Commons argued that: "as a matter of urgency, the Government should consider how best to end [this] anomaly". Other measures regarded as priorities by the industry are the expansion of the Crew Relief Costs scheme to cover reliefs of UK crews on UK-owned ships of all flags and reliefs within the UK and rest of the EU and a small change to allow voluntary payment of Class 1 national insurance contributions by UK seafarers on foreign-flagged vessels. The same dynamic for creating a tonnage tax should in my view lead to as sympathetic consideration as possible being given to such steps which affect the package of support measures. source: "The Future of the UK Shipping Industry", paragraph 86


97. I have obviously not addressed the priority which this measure should receive relative to other demands on public finances, whether from other aspects of transport policy or from unrelated Government responsibilities and commitments. This question was quite properly outside my remit since it is, after all, the role of Government to take such decisions. But I believe that the Government's policy for shipping cannot be achieved without creating a tonnage tax regime to ensure a fiscal environment which is, and is perceived to be, user-friendly both in the sense that it is tax-exempt or virtually so and that it offers certainty and clarity. The existing structure is unsatisfactory. It acknowledges the principle of subsidy, provides substantial backing to the industry, yields comparatively little tax, but is not commercially attractive to companies or investors. The DETR, the industry and the trades unions are willing in partnership to attempt to revive the industry and promote skilled employment to benefit seafarers and those who switch from active seafaring to join the valuable shore-based industries. Whilst the economic case alone is not wholly convincing, and the success of the policy in a highly competitive market is far from assured, the future of our shipping industry is now at a critical point. Without attempting the tonnage tax, further decline seems inevitable and may soon reach a point where it will become irreversible. A tide of enthusiasm and commitment is flowing, and if it is allowed to ebb the opportunity may not come again. So I advise acceptance of the proposal with the design which I have indicated

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