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British-based multinationals would be allowed to repatriate billions of pounds of foreign profits tax-free to the UK, under proposals being drawn up by the Treasury to improve the competitiveness of the British tax system.

The Treasury will issue a consultation paper this spring to discuss the option of bringing the British system into line with mainland Europe, which does not tax foreign dividends. The potential reforms – which are not expected to result in an overall tax cut for companies – are likely to be accompanied by stringent anti-avoidance measures and potential new restrictions on the deductibility of interest costs.

Sterling rose on Wednesday in response to the news, climbing 0.4 per cent against the dollar to $1.9804, and 0.4 per cent against the euro to $0.6785. as some investors made comparisons with the US Homeland Investment Act which boosted the dollar in 2005

Business groups say the change would help the UK attract more corporate headquarters and boost investment in the country.

They have told the Treasury that tax revenues would benefit because offshore cash would be repatriated and used to eliminate debt and fund share buybacks and dividends.

The Treasury’s main concern – voiced during informal discussions with business over the last year – has been that the reforms might result in tax leakage by encouraging companies to borrow in Britain to invest in lower-tax countries overseas.

Tax specialists have been encouraged by comments made by the Treasury in Budget documents, which said it had held a “productive dialogue with business on the taxation of foreign profits in the context of maintaining the overall competitiveness of the UK”.

It said that options included a European-style “participation exemption” for foreign dividends, as well as a different approach to the anti-avoidance rules that impose tax on profits generated in low-tax jurisdictions.

Chris Sanger, of Ernst & Young, said the comments were “very encouraging”, suggesting another important step towards satisfying the demands of multinationals for improvements to the tax system. In recent months, it has announced a more business-friendly approach to administering taxes for large companies and cut the corporation tax rate for them.

Although the cut in the tax rate in the Budget was accompanied by controversial reforms of capital allowances, the package was designed to benefit the highly profitable, mobile multinationals which have complained about the waning competitiveness of the British system.

The exemption of foreign dividends would be greeted with delight by British-based multinationals which have become increasingly frustrated by the complexity of the existing rules. Even though the total tax yield for foreign dividends is estimated at just a few hundred million pounds, the rules cause headaches for companies trying to minimise tax bills while generating enough reserves in the UK to pay dividends.

The momentum for reform has built up as a result of lobbying by Britain’s largest companies, which earn an increasingly large proportion of their profits overseas. At a time of growing tax competition between jurisdictions, they argue that the Treasury does not have an inherent right to tax multinationals’ global profits.

Rulings by the European Court of Justice in Luxembourg have added to the pressure for reform. Some of the existing rules on taxing foreign profits have been found to discriminate against companies in other member states.

The Hundred Group of finance directors of the UK’s largest companies last year informed the Treasury that exempting foreign dividends “is viewed as a logical and indeed inevitable next step to shore up the competitive ness of the UK tax regime in a manner which is consistent with the EU treaty.”

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