Merrill leaves hole in London’s finances

Two years ago, when Merrill Lynch reorganised its European operations by shifting its main subsidiary to Dublin, the decision sparked concerns that the investment bank was moving business away from London to take advantage of lower tax rates in Ireland.

But following the credit crunch it is likely to be many years before Merrill needs to worry about paying British corporate taxes again.

As a result of a quirk of the investment bank’s internal structure, the majority of huge losses it has suffered as a result of the global credit crisis have been booked through its London-based subsidiary.

The result is that Merrill Lynch International, the bank’s UK subsidiary, has accumulated a $29bn operating loss, which it can offset against future profits. “They’re permitted to carry that forward to set against profits of the same trade,” says one London-based tax expert.

Merrill’s figures, revealed in a regulatory filing, illustrate how the US subprime meltdown is directly affecting the UK government’s tax receipts, which are already under pressure from the slowing housing market and economic slowdown.

However, the City of London is not the only financial centre feeling the pinch. In New York, politicians are becoming increasingly concerned about the impact on the city’s tax base of the hefty losses suffered on Wall Street.

“It will be a number of years before Wall Street starts paying taxes again,” Michael Bloomberg, the mayor of New York, said at a press conference this week in Manhattan. “They will carry forward all of those losses.”

Many financial groups have already recorded sizeable income tax benefits. In the first half of the year, Citigroup recorded a $2.3bn income tax benefit after recording a $4.5bn pre-tax loss from continuing operations. Merrill had a $4.2bn tax credit in 2007.

Merrill is not the only bank to suffer heavy losses. However, rival bankers expressed surprise that the bank’s writedowns had been channelled through its UK subsidiary.

UBS, another victim of the subprime meltdown, said this week that the majority of its losses had been booked in the US. Most of Citigroup’s losses have also been reported in the US, where they occurred.

Merrill’s losses arose from its holdings of collateralised debt obligations backed by US subprime mortgages. Even though many of the CDOs were created by bankers based in New York, the bank booked the majority of the business through Merrill Lynch International, its London-based subsidiary, which handles most of its trading and derivatives operations.

According to people familiar with the bank’s structure, Merrill has historically booked most of its global trading and derivatives activity through London.

This was partly because British regulators have traditionally been quicker to adapt the tax code and banks’ capital requirements for new financial structures. The UK’s low corporate tax rates were also attractive.

Nevertheless, the losses highlight the ways in which the credit crisis has dented the industry that in recent years has been responsible for a significant chunk of corporate taxes.

Large banks accounted for about 30 per cent of the UK’s corporation tax receipts last year, according to a study by PwC, the accounting firm. But this figure is likely to be lower this year as a result of writedowns across the banking sector.

Meanwhile, Wall Street banks are estimated to account for about 20 per cent of New York state’s revenues and 9 per cent of the city’s tax receipts. Traditionally, financial groups have paid taxes on the earnings in advance – a measure that protects them from being fined for underpayments.

As a result, the huge tax losses they are accumulating could prompt the banks to ask the government for refunds as well as sharp reductions in future tax liabilities. That, in turn, would worsen the fiscal plight faced by both New York city and state.

New York state is projected to record a $26bn deficit during the next three years and a $630m shortfall in the current year.

David Paterson, New York’s governor, said recently that tax receipts from banks had fallen sharply during the past few months.

However, bankers point out that financial institutions also contribute to the tax base by employing large workforces who pay income tax and sales taxes.

Indeed, from the City of London’s perspective, Merrill’s heavy tax losses may provide a welcome boost at a time when employment is under pressure: “With this kind of a tax loss to work with, Merrill might decide it makes sense to shift business to the UK from other parts of the world,” a tax expert says.