The consultation on the taxation of foreign profits of British companies has generated much debate over the past few months.

The departure of a number of multinationals' headquarters from the UK has been blamed on fears of increased taxes on the profits of their overseas subsidiaries. At one level, this is not surprising. The imposition of extra tax on overseas companies owned by British multinationals would place those companies at a competitive disadvantage, unless there are other factors to justify the extra tax burden.

The recent departures imply that those factors are less than the perceived burden. However, the Government needs to levy taxes, so what should the Treasury be considering? Few would argue with the Government taxing profits generated by activities in the UK; corporation tax is imposed by many countries. Once this is accepted, given the global environment, the tax system needs to militate against the natural incentive to divert profits that would have been in the UK to other locations. This justifies the present controlled foreign company (CFC) rules.

However, the rationale does not apply to profits that would never have been in Britain in the first place. In those cases, the UK's tax base can be protected adequately through ensuring that trading with those companies is undertaken at “arm's length” prices (under transfer pricing rules). In practice, the present regime could deliver a sensible outcome, with the CFC rules protecting against abuse of Britain's tax system.

The provisions include a “motive” exemption that stops the rules applying where there is no intent to deplete the UK tax base. Profits not covered by the CFC rules are taxed only when they are remitted to the UK, and then only to the extent that tax has not been suffered at UK rates on those profits. Altogether, this means that Britain does not receive much tax on the overseas profits, which is both fair and consistent with many other jurisdictions.

There are a number of factors causing concern, of which the most apparent is the proposed change to the CFC rules, extending taxation to much more overseas profit. This follows a perceived shift in the operation of the motive test, with companies now being asked to prove that those overseas profits could not, rather than would not, have been generated in the UK. This shift from “would” to “could” is a fundamental extension of UK taxation and threatens to undermine the motive exemption. Luckily, the situation is reversible and the Government has the opportunity to act to return the UK to its former position, or even to enhance it.

First, we need to remember the genesis of these CFC proposals: a request by companies to simplify the rules applying when subsidiaries pay dividends into the UK. Given that very little tax is collected, the proposal was to exempt the profits altogether, reducing administration for everyone. This is obviously attractive. However, the Treasury is logically concerned that, without further change to the CFC rules, this exemption could result in more profits being diverted from the UK. This unease demands a tightening of the CFC rules, which then taxes much more profit than only the amount likely to be diverted offshore.

So the rules scaring multinationals are triggered by the exemption that multinationals have asked for: a case of “be careful what you wish for”. The challenge for any Treasury changing the tax regime is that multinationals will have many different perspectives, depending on their circumstances. The Treasury needs to deliver a tax regime that works for the UK as a whole.

Given this, what should the Treasury be doing? First, it must convince business that it understands the issue. A clear statement confirming that the UK is seeking to tax only UK profits and those diverted from the UK - on the “would” rather than the “could” test - would be a good start.

Secondly, looking at the proposed changes, the Treasury might conclude that the best option would be to continue with the status quo, or something similar. This is consistent with the Treasury's discussion document and is a valid outcome of any consultation. This would be disappointing to some but may be better than the alternative. Another option would be to rework the new CFC proposals, consistent with the “would” test. This approach risks extending the uncertainty and so would require an explicit statement to address natural scepticism.

Finally, looking for some positives, the consultation has demonstrated that multinationals are mobile. The introduction of incentives for multinationals (for example, a reduced rate for exploitation of intellectual property) could, therefore, reverse the trend. This consultation should have increased the Treasury's understanding of the motivations and mobility of multinationals. Positive action could address the negative uncertainty and position the UK to compete more favourably in the future.