There is a pervasive understanding amongst the public, journalists and politicians that tax avoidance is all ‘perfectly legal’.
This idea is promoted by tax advisors who have a direct financial interest in convincing their clients that what they are doing will not get them into trouble.
It is propagated by the media, who, on the advice of media lawyers seeking to avoid being sued for libel, include the blanket statement that tax avoidance is ‘perfectly legal’ in almost every article exposing the practice.
The claim that tax avoidance is ‘legal’ is used as defence by companies who are accused of the practice, and the idea has been adopted by politicians who claim that businesses and individuals have a moral (not legal) obligation not to engage in tax avoidance.
Even HMRC’s own definition of tax avoidance makes reference to “bending the rules” (not breaking them), and stating that tax avoidance involves “operating within the letter, but not the spirit, of the law”.
This idea, that all tax avoidance is legal, is a myth. In most cases tax avoidance is not legal at all, and for several decades courts around the world have taken an increasingly aggressive stance towards tax avoidance schemes, striking them down and imposing penalties on those involved.
HMRC, the UK tax agency, claims to have won pretty much every time it has challenged a tax avoidance scheme in court in recent years.
Illegal or Unlawful?
When something is said to be illegal, many people think that this means the act in question can result in some sort of criminal penalty, such as a fine or a prison sentence.
Because tax avoidance is not a criminal offence, many commentators, even those harshly critical of the practice, have come to the view that this makes it legal.
As Brooke Harrington, an academic, wrote in an article about the Panama Papers,
“What Mossack Fonseca and its counterparts all over the world really provide is the expertise that allows their clients to stay just on the right side of the law—or far enough into the legal grey zones that the clients have a real chance to prevail if they end up in court. That’s why many of the people who have seemingly been exposed by this leak will likely never face charges of any kind. To the extent that Mossack Fonseca’s work facilitated crime, that was a bug rather than a feature….
Some of the activity uncovered in the Panama Papers will turn out to be illegal. But if past is prologue, then the majority of what we learn from the leak will merely be embarrassing for those exposed—showing them to be opportunistic and perhaps unethical, but not criminal. And that is why many of the people named in the documents are unlikely to see the inside of a courtroom concerning the services that Mossack Fonseca provided to them: not because they have the power now to quash prosecutions (with some notable exceptions!), but because some time ago they had the power to hire expert advisers who carefully designed their tax-avoidance (or law-avoidance) strategies.”
What these commentators miss is the distinction between acts which are unlawful and those which are illegal. Black’s legal dictionary describes the term unlawful in the following terms:
‘“Unlawful” and “illegal” are frequently used as synonymous terms, but, in the proper sense of the word, “unlawful,” as applied to promises, agreements, considerations, and the like, denotes that they are ineffectual in law because they involve acts which, although not illegal, i.e., positively forbidden, are disapproved of by the law, and are therefore not recognized as the ground of legal rights, either because they are immoral or because they are against public policy.”
This line of thinking counts as unlawful acts that have no legal effect. The recent Supreme Court judgment in the case of the R vs the Prime Minister is a case in point. In that case the Supreme Court determined that the Prime Minister’s advice to the Queen to shut down (or prorogue) Parliament was ‘unlawful’, which meant that the act of ‘prorogation’ had no effect. In the words of Lady Hale, the prorogation, a ceremony where Royal Commissioners enter the House of Lords with an order from the Queen to close Parliament “was as if the Commissioners had walked into Parliament with a blank piece of paper. It too was unlawful, null and of no effect.”
Tax avoidance, as viewed by the courts, frequently falls into this category. Tax avoidance takes advantage of the fact that the wording of the law may not be clear, or that a particular law conflicts with another, creating ambiguity around how the law should be applied. Because it seeks to exploit gaps and loopholes in the law, it is not positively prohibited, but public policy is very clearly opposed to tax avoidance. What this means in practice is that the courts can determine that a tax avoidance scheme has no effect, reversing the advantage that any taxpayer sought to gain, and imposing a civil penalty. For the tax avoider, the transactions entered into are as if they were blank sheets of paper.
The real world of financial transactions
Most taxes arise out of a financial transaction, money changing hands. For example, income tax is a tax on income, VAT is a tax on the purchase of goods or services for consumption, stamp duty is levied on sale of property.
A few taxes are driven by events, such as inheritance tax, but even here the transfer of assets on death can be a deemed disposal of assets. Corporation tax, as a tax on profits can be thought of as arising out of a series of transactions.
Within any tax jurisdiction, different types of transactions are taxed at different rates and subject to various allowances, with some transactions not being taxed at all. For example, in general if you receive cash as a loan, you are not taxed on the money you receive, because it is expected that you will have to pay the money back. If however you receive money as payment for work, it would be subject income tax and national insurance.
Tax avoidance schemes seek to exploit these differences by making sure that payments are made in a way which attract the minimum amount of tax possible.
The problem for tax avoiders is that financial transactions exist in the real world, and tax law is intended to reflect those real world transactions. As stated by Lord Carnwath LJ in the Barclays Mercantile case, tax statutes “draw their life-blood from real world transactions with real world economic effects”. When money changes hands it does so for a reason, and that reason is important when it comes to the application of the law.
Lawyers can not simply draw up a contract which claims that a payment between an employer and employee is not income when everyone involved was clear that in the real world this was really income. Such an arrangement would be viewed as a sham, and probably cheating the revenue, a criminal offence which can result in long prison terms.
Instead, tax avoiders try to put in place a series of legitimate transactions in order to move money from one place to the other whilst attracting little or no taxation. Each transaction may, when viewed in isolation, be a lawful payment which does not attract taxation, but the net effect will be to get the money from one party to another which has the same real world effect of another transaction which would normally be subject to tax.
When payments cross borders this process is much easier, and different countries have different rules regarding different types of income which multiplies the opportunities of tax avoidance. The mismatch between the laws of different countries allows tax advisors to construct more routes and pathways through the legal system that avoid tax.
When tax avoidance was legal – the Duke of Westminster’s case
Under a historic interpretation of tax law, these types of tax avoidance schemes really would have been considered to be perfectly legal. In 1936 the House of Lords considered a case involving the Duke of Westminster, who had set up a scheme to avoid paying tax on income he used to pay his servants.
Instead of paying his servants a weekly wage, lawyers acting for the Duke drew up a deed which stated that they were to receive an annuity paid in weekly installments. Payments of annuities were deductible from the Duke’s income for tax purposes, wages paid to his staff were not.
The annual payment was not deemed to be a sham because the payment was not dependent on the servants doing any work, and the contract even permitted them to seek work elsewhere and still receive the payments. The real legal effect of the transaction was considered to be closer to that of a pension than a wage. However, side letters between the Duke’s solicitors and the servants noted an understanding that they would continue to work for the Duke.
The Revenue argued that regardless of the legal form of the payments, the substance of the transactions was that of a wage, and should be taxed as such.
The House of Lords found in the Duke’s favour in a split decision. The precedent was set that when it came to tax, the courts should only apply a strict literal interpretation of the law. In the view of Lord Tomlin, to do otherwise would “involve substituting ‘the incertain and crooked cord of discretion’ for ‘the golden and streight metwand of the law’.”
As noted by Lord Steyn in Commissioners of Inland Revenue vs McGuckian, the Westminster Doctrine, combined with the approach of the courts to look at each stage of a series of transactions in isolation “allowed tax avoidance schemes to flourish to the detriment of the general body of taxpayers”. The result, Lord Steyn went onto say, “was that the court appeared to be relegated to the role of a spectator concentrating on the individual moves in a highly skilled game: the court was mesmerised by the moves in the game and paid no regard to the strategy of the participants or the end result. The courts became habituated to this narrow view of their role.”
In effect, the Westminster Doctrine made tax avoidance ‘perfectly legal’ and created an industry of tax advisors whose job it was to look for gaps and loopholes in the law. It also provoked the government into writing increasingly detailed legislation to account for every loophole it found.
The Ramsay Principle
The Duke of Westminster’s case, and in particular the often quoted phrase that “Every man is entitled if he can to order his affairs so that the tax under a tax statute is less than it would otherwise be”, lives on in the popular conception of tax avoidance, but the courts moved on from Westminster a long time ago.
In 1982 the Court of Appeal reconsidered the Westminster Doctrine in Ramsay vs Inland Revenue Commissioners. This case involved a tax avoidance scheme which took the avoider though a series of transactions which had no purpose other than to create an artificial loss which could be offset against a real capital gain which had been made on the sale of a property.
The loss existed on paper only, there was no real loss to the taxpayer, other than the fees he paid to the people who operated the scheme. In the words of the tax advisors who constructed the scheme quoted in the judgment – “the scheme is a pure tax avoidance scheme and has no commercial justification.”
Under the Westminster Doctrine the scheme would have been successful, because all of the transactions entered into were genuine transactions and executed in a series would produce the desired effect.
Despite this, in what Lord Steyn later described as an “intellectual breakthrough”, the court found that they should not be considered to create a loss for tax purposes because taken as a whole they created no real loss to the tax avoider. The paper loss should therefore be disregarded and the tax imposed on the gain.
In his judgement Lord Wilberforce stated that “The Capital Gains Tax was created to operate in the real world, not that of make-belief… it is a tax on gains… it is not a tax on arithmetical differences.”
The case had wide implications for tax law in the UK, establishing the Ramsay Doctrine, the precedent that transactions which may have been technically legal under a strict interpretation of the law, could in fact be disregarded by the revenue authority if they were designed with the sole purpose of avoiding taxation.
In coming to his judgment Lord Wilberforce cited the opinion of a US judge in a case involving income tax:
“The Income Tax Act imposes liabilities upon taxpayers based upon their financial transactions. … If, however, the taxpayer enters into a transaction that does not appreciably affect his beneficial interest except to reduce his tax. the law will disregard it.”
Lord Wilberforce stated that the opinion displayed “a process of thought which seem to me not inappropriate for the courts in this country to follow.”
How the courts have viewed tax avoidance after Ramsay
Following the decision in Ramsay, a clear line of authority has developed where the courts will determine a tax avoidance scheme to have no effect if they believe the scheme to be contrary to the purpose of tax law.
This line of authority has developed a process for dealing with tax avoidance. First, the courts have consider whether a scheme is constructed for the purpose of tax avoidance.
A much cited case in tax law is the case of Barclays Mercantile, where The House of Lords described tax avoidance in the following terms:
“structuring transactions in a form which will have the same or nearly the same economic effect as a taxable transaction but which it is hoped will fall outside the terms of the taxing statute. It is characteristic of these composite transactions that they will include elements which have been inserted without any business or commercial purpose but are intended to have the effect of removing the transaction from the scope of the charge.”
Once the attempt at tax avoidance has been identified, the court can then disregard the avoidance transactions and seek to apply tax law in the way in which it was intended to apply, i.e. in the absence of tax avoidance.
As set out by Lord Brightman in Furniss v Dawson:
“the inserted steps are to be disregarded for fiscal purposes. The court must then look at the end result. Precisely how the end result will be taxed will depend on the terms of the taxing statutes ought to be applied.”
This end result will be a matter of interpretation and in doing so judges have to look at the purpose and spirit of legislation. As set out in Inland Revenue Commissioners v McGuckian:
“in determining the natural meaning of particular expressions in their context, weight is given to the purpose and spirit of the legislation.”
Contrary to the view that the law allows wealthy individuals and corporations to employ sophisticated legal mechanisms to avoid the spirit of the law, these legal principals provide a great deal of protection for tax the tax system from abuse. They have been used by the courts to find against complex tax avoidance schemes where a great deal of effort has been expended in attempting to find a way past the law.
An important demonstration of the willingness to the judiciary to take on complex tax avoidance schemes was the judgement of the UK Supreme Court in UBS vs HMRC; DB vs HMRC.
This case involved a tax avoidance scheme on the payment of bankers bonuses by Deutsch Bank and UBS. Both banks had set up offshore companies to pay bonuses in shares rather than cash. The shares would be redeemable for cash, which mean that the end result would be that the bankers would access cash without the usual income and national insurance charges. The offshore companies were carefully constructed in order to take advantage of certain exemptions in the law around the payment of bonuses in shares.
Lawyers for the tax avoiders argued that the law being considered (the Income Tax (Earnings and Pensions) Act 2003), contained detailed anti-avoidance measures. The tax avoidance scheme had been careful not to fall foul of these anti-avoidance provisions. As a result, they argued, the courts should not infer any further anti-avoidance purpose to the legislation which was not already set out in statute.
The Supreme Court rejected this view. It found that there were a number of reasons why the government might want to exempt payment in restricted shares from tax, including the promotion of employee share ownership. Providing an avenue for bankers to receive their cash bonuses tax free was not one of those purposes. The court also took the view that the inclusion within the Act of anti-avoidance measures simply re-enforced the argument that the intention of lawmakers in enacting the legislation was not to facilitate tax avoidance.
All this is not to say that all forms of tax avoidance as it is broadly understood will be determined to be unlawful. There have been occasions when judges, in looking at the facts of a particular case, have found that although a taxpayer engaged in a tax avoidance scheme, their actions were not in fact contrary to the “purpose and spirit of legislation” they were using, and the tax avoidance was successful. However, given that the intent of the tax avoider is almost always to defeat the spirit of the law, then such cases will be rare.
As the Hong Kong Final Court of Appeal stated in The Collector of Stamp Revenue and Arrowtown Assets Limited:
“The ultimate question is whether the relevant statutory provisions, construed purposively, were intended to apply to the transaction, viewed realistically. Where schemes involve intermediate transactions having no commercial purpose inserted for the sole purpose of tax-avoidance, it is quite likely that a purposive interpretation will result in such steps being disregarded for fiscal purposes. But not always.”
There are also cases which never make it to court, where the status of the avoidance is ambiguous. For example, some of the avoidance schemes devised by banks, tax lawyers and accountants are so innovative and complex, it only becomes clear that they are unlawful when tested in court, but since the Revenue usually resolves cases without going to court, companies claim that their actions were not unlawful.
What is clear is that the blanket statement that tax avoidance is “perfectly legal”, is ridiculous.
Real world impacts
Once this is understood, there are far reaching consequences.
The Ramsay principal was established over 35 years ago. It began a clear line of legal authority on how the courts will consider the legality of tax avoidance schemes that remains in effect today and has been confirmed in a number of high profile cases since.
Yet tax advisors, lawyers and accountants have continued to construct and market tax avoidance schemes that are obviously unlawful, claiming that they are in fact “legal”.
Is it really possible that these advisors are unaware of the legal risks they are creating for their clients? Or is it the case that many tax advisors, including leading firms of accountants, are engaging in a giant mis-selling scam.
Afterall, when these schemes are challenged, it is the clients and not the advisors that are left with a large bill and a penalty to pay, the advisors keep their fees.
There will be little sympathy for large corporations left in this position, but for individuals who may have been tempted by the idea of a “legal” tax reduction, the impacts of a large unexpected tax bill can be devastating.
Economic transactions, including taxes, do have real world effects, and for that reason it is important that journalists, politicians, researchers and others with a voice do not spread the myth that tax avoidance is all perfectly legal.