Royal Bank of Scotland wanted to ask shareholders for permission to pay bonuses twice the size of salaries to sidestep EU rules

George Osborne is embroiled in a City pay row after plans by Royal Bank of Scotland to hand its bankers bonuses equivalent to 200% of their salaries were blocked.

The move means RBS will have to comply with a European Union bonus cap of 100% of annual pay and prompted a warning from the bailed-out bank over the detrimental impact on its operations.

Labour accused the chancellor of being in a "terrible muddle" over the EU bonus limit, fighting a legal battle to have it declared unlawful while imposing it on the 81%-taxpayer owned bank.

A senior Conservative MP, Andrew Tyrie, called for UKFI – the body that controls the taxpayer stakes in bailed-out banks – to be scrapped. "It is difficult to argue that RBS is operating on an arm's length, commercial basis, free from government interference," he said.

The Edinburgh-based bank spoke of the "commercial and prudential risk" to its operations, signalling a potential row with the chancellor after the relationship had thawed following the September appointment of chief executive Ross McEwan.

The other big British banks – including bailed-out Lloyds Banking Group – are asking their shareholders to back plans to pay out bonuses twice the size of salaries, which is permitted under the bonus cap. RBS, which lost £8.3bn last year, will not put any proposal to a vote at the annual general meeting in June.

Osborne denied any ministerial pressure on UKFI in an interview with the BBC but it is believed that the body had originally not been planning to vote against the higher bonus limit.

The government is not stopping RBS handing McEwan £1m a year in "allowances" – in effect doubling his salary – as a route to sidestep the EU bonus cap. Other top bankers at the bailed-out bank – which handed more than £1m each to 77 of its bankers last year – will also be handed these allowances, which are also being used by other banks to maintain the size of their top bankers' pay.

McEwan will not get the "allowance" in 2014 and will no longer receive annual bonuses, a move expected to reduce his pay to a third of his competitors'. His base salary is £1m a year and he receives £40,000 a year in benefits, including the cost of flights to his native New Zealand and a housing allowance. In 2015, RBS will be able to hand him bonuses worth twice his salary, allowance and pension entitlement, which total £2.3m.

The chancellor met McEwan and spoke to the chairman, Sir Philip Hampton, on Thursday at the end of a long-running consultation over the loss-making bank's pay policies as business secretary Vince Cable was urging companies to show restraint on top pay.

On Friday as RBS published its annual report, it said: "UKFI has informed the board that it will vote against any resolution which proposes a 2:1 ratio. In these circumstances the board expects such a resolution would fail and it will therefore not be brought to the AGM."

There was no mention of UKFI's opposition in the prepared statements in the annual report by Penny Hughes, the non-executive director who chairs the remuneration committee. "Research indicates that 99% of executives in the FTSE 100 at executive committee level or above have a variable to fixed pay ratio that exceeds 1:1," she said.

"I know it is not always easy to accept, but if RBS is to thrive we must do what it takes to attract and keep the people who will help us achieve our goals. We think that the right positioning of the business is to be commercial. While we are sensitive to public opinion, particularly given our ownership structure, the ability to pay competitively is fundamental to getting RBS to where we need it to be," she said.

She was unavailable to elaborate but bBuried in the risk disclosures in the bank's 560 page annual report was a reference to an "exodus of talented staff" caused by the bank's changing strategy to restore its profitability after incurring more than £45bn of losses since its 2008 bailout.

One shareholder in RBS warned that the bank might now have little option but to increase salaries.

A Treasury spokesman welcomed the decision by RBS not to put the bonus cap to a shareholder vote. "Under the new strategy set out by RBS's chief executive, Ross McEwan, RBS is heading in the right direction, but it has not yet completed its restructuring and remains a majority publicly owned bank. So an increase to the bonus cap cannot be justified and the government made clear it would not have supported such a proposal."

The government defended its support for bonus plans at Lloyds, where its stake has fallen to below 25%. "We have made clear: there will be no rise in the bonus cap for an RBS still in recovery; but a bonus cap at Lloyds reflects the progress it has made in getting money back for taxpayers."

Investors to sue for £1bn

Five of Britain's biggest investors are to file lawsuits against Royal Bank of Scotland next week, saying they were misled over its huge cash call in 2008, and claiming more than £1bn.

Legal & General – the biggest investor in RBS at the time of the £12bn rights issue in May 2008 – and Standard Life, Prudential, Aviva and Universities Superannuation Scheme are expected to file claims on Wednesday.

The former RBS boss Fred Goodwin asked shareholders to stump up £12bn to bolster the bank's capital position, which had fallen dangerously low. Lawsuits already filed against RBS over the rights issue also sue Goodwin and ex-RBS chairman Sir Tom McKillop, along with other former executives.

RBS is now 81% owned by the government, which had to bail it out.

The case is likely to take years to resolve and could cost RBS billions of pounds in compensation. It could also result in Goodwin having to appear in court as the bank's key witness. RBS said it would defend the claims.

Reuters