Governments Move to General Principles to Combat Aggressive Tax Planning
For several days in the early summer, the news media in the United Kingdom were dominated by the apparently shocking revelation that a well-known TV comedian had not been paying “enough tax.” Tales of show business personalities deliberately or naively underpaying tax are fairly common on both sides of the Atlantic, but this was something different.
When the story first broke, the comedian involved, Jimmy Carr, initially put up a robust defense saying, “I pay what I have to and not a penny more.” But as the news coverage developed, it became apparent that he had been involved in arcane but, according to Mr. Carr’s advisers, entirely legal arrangements to reduce his effective tax rate from 50% to just 1%. Even US presidential candidates apparently stop with the tax planning at 13%.
In broad terms this remarkable result was achieved by directing what might otherwise have been his taxable income from his lucrative UK appearances to a corporate service provider established in a tax haven. What happened to the funds offshore has not been made public, but it is likely that the bulk of the income was paid into a form of unregulated pension fund. Mr Carr’s financial requirements in the UK were then met by long-term loans from the offshore fund that were not taxed as income in Mr. Carr’s hands because of his contingent liability to repay the amounts advanced. It is unclear whether any of the parties seriously expected those loans ever to be repaid.
The BBC reported that Mr. Carr was just one of around a 1,000 UK residents using the scheme, which had been marketed under the hubristic title “K2,” to shelter almost £170 million from tax each year, but it is unlikely that many Britons found these disclosures surprising. There seems to be an assumption in the national psyche that the wealthy enjoy benefits that are not available to the general population. But what made Mr. Carr’s position unusual, and perhaps explains why the media chose to make an example of him in particular, is that in his comedy performances he commonly rails against just the sort of behavior of which he was now accused. In a recently broadcast satirical sketch, he had even lambasted one of the high street banks for its role in exactly the same sort of offshore tax planning.
Within 24 hours Mr Carr apologized to the world (via Twitter, of course) for using the offshore arrangements calling it a “terrible error of judgment,” but not before the usual media pundits and a few politicians, including the prime minister, David Cameron, had come out to condemn Mr Carr’s tax planning at this time of national austerity as “morally wrong.”
Cat and Mouse?
Poor Mr. Carr; despite the hysterical media coverage, the majority of judicial and expert opinion is on his side and most tax professionals would strongly disagree with Mr. Cameron’s implied assertion that there is a moral aspect to taxation. To talk about the morality of tax assumes that for every person or transaction, there is an objective ‘right amount of tax’ that should be paid, but if that were true, we would not require tax laws at all and our tax lawyers would need to be moral philosophers.
Which of us can honestly say that if the law did not require us to pay tax we would pay it voluntarily? The imposition of tax is entirely law based in the same way as sports and even driving on the roads are based on systems of rules and regulations.
But, in addition to the rules, some games have something extra, the unwritten “spirit of the game” that has developed over time and is, in a sense, the morality of the game. There is nothing similar in relation to driving so, in the UK at least, the highway code creates a morality of the road by including an express rule that, “you must not drive without due care and attention . . . [or] . . . reasonable consideration for others.” Could something similar be done in relation to the tax code?
Many tax professionals talk about their relationship with the tax authorities as though it were a chess game or even a game of cat and mouse. Can it really be “morally wrong” for Jerry to outwit Tom?
General Anti-Avoidance Rules
From the UK government’s perspective, the timing of the K2 story could hardly have been better in that it came just a few days after the government commenced consultation on the introduction of a general anti-avoidance rule or GAAR. Past attempts to introduce a GAAR have always stalled, but now minsters could point to a front page example of egregious tax avoidance that a GAAR would target.
Although the process has only just begun, it is only a consultation on the detail of the scheme. There is very little doubt that the GAAR will be introduced in 2013, and the majority of the draft legislation is already publicly available.
GAAR would write a general principle into the UK tax law that the government may set aside any arrangement where “if, having regard to all the circumstances, it would be reasonable to conclude that the obtaining of a tax advantage was the (or a) main purpose of the arrangement.”
UK tax legislation already includes numerous targeted anti-avoidance rules, many of which use similar concepts of “tax avoidance” but each of which applies only to a particular area of the tax code tax. The introduction of a GAAR would allow some of the targeted anti-avoidance rules to be repealed, but most are likely to remain because the GAAR will have a higher hurdle for its application. In many cases, targeted anti-avoidance rules will apply if the taxpayer undertakes a transaction with the sole or main purpose of avoiding the particular part of the tax code; by contrast, a tax-driven arrangement would need to be demonstrably “abusive” in order for it to be challenged under the GAAR.
A number of other countries are moving to adopt their own forms of GAAR. They include Canada, Australia, New Zealand, Germany, France, South Africa and India. The United States moved in the same direction by imposing a general requirement by statute in 2008 that transactions must have “economic substance.” US tax lawyers are now sparring with the tax authorities over whether the government needs to issue an “angel” list of types of transactions that companies need not worry will be found to lack such substance.
A representative of the firm that marketed the K2 scheme is reported to have told a seminar of businessmen: “The Revenue closes one scheme, we find another way round it.“ Although rules are in place to require most tax schemes to be disclosed to Inland Revenue, the government is still playing catch up, changing the rules to close down schemes after they have already been used. The main benefit of a GAAR from the government’s perspective is that it will enable the government to get ahead of the game in challenging the most egregious forms of avoidance.
The GAAR will augment the interpretation of the letter of the tax law by giving Inland Revenue and the courts the ability to consider transactions against the broader purpose of the tax legislation. Consequentially, the GAAR is expected to be most effective where the principles underlying specific tax rules are clear.
For older legislation there is a recognized difficulty with this approach because of the need first to identify the purpose of the rules. If all a court has to look at is the black letter of the law, it is arguably being asked to identify what Parliament intended to say in order to “improve” what it actually did say. In that case, the court would be at risk of making law.
However, in recent years, there has been a deliberate move towards purposive legislative drafting so that new tax legislation often commences with an acknowledgment of what it is intended to achieve. Although there may still be technical issues with the interpretation of such purposive drafting, because courts will continue to be loath to make good the failings of the legislature, it undoubtedly lays the ground for the application of a GAAR that looks to apply the principles and purpose of the tax code.
The GAAR will operate in relation to individual income tax, corporation tax and most other tax charges in the UK except value-added tax.
The government has also indicated that the GAAR will be used in the interpretation of double tax treaties which, it says, is consistent with the OECD model commentary. Where the GAAR applies, the tax authorities will be able to counteract the planned tax avoidance by taxing the abusive arrangement on a “just and reasonable” basis.
At first sight, the ambit of the GAAR appears to be very wide. An arrangement can be set aside if “obtaining of a tax advantage was the (or a) main purpose of the arrangement.” The reference to a “main purpose” is familiar from the existing targeted anti-avoidance rules, and Inland Revenue’s view is that any purpose that is more than incidental is a main purpose.
However, the GAAR is only intended to catch “highly abusive contrived and artificial” schemes, so its reach is reduced by a double reasonableness test in relation to whether a particular arrangement is abusive.
A tax arrangement is only abusive if, having regard to all the circumstances, “entering into or carrying out the arrangement cannot reasonably be regarded as a reasonable course of action.” The consultation document provides a useful guide to how the GAAR should operate. It says “the GAAR is intended to be capable of altering the tax consequences of abusive arrangements if the consequence claimed is one that manifestly would not have been countenanced by Parliament.”
Broadly, the question to be asked of any tax scheme is, “what would Parliament have said if it had known the rules would be used like this?”
The introduction of the GAAR will undoubtedly change the nature of aggressive tax planning in the UK, but it is unlikely to encroach significantly on the sort of tax planning undertaken by the majority of businesses and entrepreneurs. Ironically, it is even arguable that the K2 scheme would not fail the double reasonableness test, so if it survives challenge under the current law, it would not, in any case, be susceptible to the GAAR.