Public anger over tax avoidance is palpable. Politicians are keen to capitalise on this but find themselves in hot water because there are ‘skeletons’ in their closet. This article aims to assist them. It will briefly define tax avoidance before examining the relationships between tax avoidance and the British constitution; Parliamentary intention and common law; morality; and fairness. Finally it will outline how politicians can navigate the issue politically and through policy.
Tax compliance, evasion and avoidance
Tax compliance is paying the tax owed. Tax evasion is not paying the tax owed and is an offence. It is a huge, worldwide problem. Global Finance Integrity estimated that in 2012 developing countries lost US$991.2 billion in illicit financial outflows, dwarfing global aid budgets.
Tax avoidance, sometimes called tax mitigation, planning or efficiency, is the grey area between compliance and evasion. It is a process where a person reorganises their activities and reduces the amount of tax owed or prevents that amount being increased by something unrelated to their activities’ economics. Avoiders work either solely within the confines of English law (domestic tax avoidance), or by arbitraging tax competition between different countries (international tax avoidance). It is legal. The Duke of Westminster principle states:
Every man is entitled, if he can, to order his affairs so as that the tax attaching under the appropriate [Finance] Acts is less than it otherwise would be. If he succeeds in ordering them so as to secure this result, then, however unappreciative the Commissioners of Inland Revenue or his fellow taxpayers may be of his ingenuity, he cannot be compelled to pay an increased tax.”
So if tax avoidance is legal, what’s all the fuss about? To begin to answer that question, we must first look at the issue through a wider lens.
Tax avoidance and the British constitution
Britain has an uncodified constitution composed of legislation; common law; convention; and royal prerogative. Legislation is supreme above the other three limbs. Subject to some limited caveats, Parliament is our sovereign. Contrast that to our American cousins, where sovereignty is found in a formal piece of paper.
Therefore we have no constitutional rights that are supreme over any institution of government. Instead the British constitution is based on freedom. We can do anything (murder, theft, refuse to pay tax) unless government specifically forbids or prescribes something. The constitutional risk of legal error lies with government, not the citizen.
However, our constitution is not completely different to our democratic neighbours. One important similarity is the role of the judiciary in interpreting the intent of Parliament. Our constitution recognises MPs don’t know everything and so measuring Parliamentary intention is not to ask “what are Parliamentarians actually thinking when passing a law?”. Parliament’s intent is about our sovereign institution’s objective intent, not the subjective desires of MPs. However, Parliament doesn’t normally publish a legal “Pssst! This is what we really meant!” with Acts and so its intent is evidenced by the black letter of legislation itself, including loopholes. Sadly, the English language is inherently imprecise; furthermore the meaning of words can change over time; and new technologies can alter the interpretation of words drafted years before. Therefore the judiciary has the role of interpreting Parliamentary intent in a changing world. The tools it uses are designed to protect Parliament’s supremacy.
This has an important consequence for the tax avoidance debate. If Parliamentary intention, as interpreted by the judiciary over time, is unclear as to how much tax we have to pay, we don’t have to pay that tax. The conclusion is that any ambiguity in the tax code is an explicit expression of Parliamentary intention that allows us to exercise our constitutional freedom to avoid paying tax.
It’s at this point of the analysis that the debate is distorted to suit political goals. The definition of tax avoidance set out above is so wide it is politically useless. If a poor person chooses to buy food over clothes, they have inadvertently structured their spending activities to reduce their VAT payments. A person investing in an ISA is probably intentionally avoiding income tax on a normal saving account’s interest. Politicians will never accuse either of tax avoidance; it’s political nonsense. Government policy and politicians have instead accepted the definition that tax avoidance is bending the rules of the tax system to gain a tax advantage that Parliament never intended.
This definition assumes Parliament intends to create an unavoidable tax system; a patently flawed assumption. Proponents of it sometimes point to jurisprudence, e.g. Lord Nolan’s dicta in the Willoughby case. However he, like other judges arguing similarly, limited his opinion to a single section of the tax code, after careful (and arguably incorrect) consideration. In precedent setting opinions, judges are reluctant to make sweeping jurisprudential statements.
Nevertheless, politically and constitutionally a question arises: is Parliament’s intent clear?
Tax, Parliamentary intent and the common law
Parliament’s jurisdiction is national, not global so it cannot intend to govern foreign activities. Therefore, international tax avoidance fails to meet the accepted definition as it acts in a sphere where Parliament has no intent. Furthermore, international tax avoidance is facilitated by Parliament’s removal of capital controls during the 1970s. This decision is inconsistent with any contention that international tax avoidance is outside its intent.
What of domestic tax avoidance? Sadly our domestic tax law doesn’t examine the economic whole of a person’s or business’ activities and say they must pay x. That is not Parliament’s intention. Instead, it taxes the nuts and bolts of a taxpayer’s activities. We tax income, capital, dividends, profits. We ask if a cashflow is debt or equity? Is it a contractual, regulatory or fiduciary relationship? It’s a centuries old approach to taxing people, business and transactions.
This approach isn’t appropriate for the complexity of modern day transactions. Therefore the judiciary in fulfilling its constitutional role, created the Ramsay principle; if a transaction has pre-arranged artificial steps that serve no commercial purpose other than to save tax, the proper approach is to tax the effect of the transaction as a whole. Problem solved? No, because it occasionally asks the court to overstep its constitutional authority and make policy decisions. Two cases, decided on the same day, demonstrate this. Barclays v Mawson and IRC v Scottish Provident.
In both cases, the parties created a genuine commercial transaction that also created a tax benefit. Barclays financed a gas pipeline. In IRC, they entered into and exercised an option to purchase government gilts. However, the parties also agreed second transactions that removed any commercial risk from the first, leaving behind the tax benefits. Despite their similarity, the court upheld Barclays’ deal and struck down IRC’s. Why?
It’s necessary to read between the judgements’ lines. IRC took advantage of an overnight change in law; a one off. Barclays used a global infrastructure financing mechanism. Ruling against Barclays might harm an economically important market; a policy decision. The court decided that finding against Barclays would be an “unrealistic” interpretation of the Ramsay principle. In short, it was ok because everyone does it. Both decisions were legally correct and constitutional. Their inconsistency creates confusion in the tax code though. Decades of such judgements and a massive increase in the volume of tax legislation create an ambiguous, complicated tax code that easily facilitates tax avoidance.
This is a direct result of Parliamentary intention to tax bits of our activities, not their economic whole. Parliament intends to create a tax code that facilitates tax avoidance. To contend otherwise clouds the current political debate; it also gives Parliamentarians an excuse to avoid their constitutional duty to provide a coherent tax code by claiming that they have done their job. Our resulting tax code is unfit for purpose and makes the UK unattractive to foreign investors. I once created a complex avoidance structure for two foreign investors in English infrastructure because overseas regulation required a cosmetic change in their investment mechanisms. This triggered an anti-avoidance provision in English law despite no change in the transaction’s economics. The time and expense of this avoidance restructuring killed any appetite these investors had for new British investment.
Tax avoidance is constitutional; legal; harmful to business and the economy; and in line with Parliamentary intent. Is it morally suspect?
Tax and morality
Many leading politicians call tax avoidance immoral but what is morality? Morality labels conduct by measuring it against a commonly accepted standard of behaviour. The morality of society can differ to the moral ideals of an individual; I can deem avoidance immoral whilst society doesn’t. To be practicable, compliance with society’s morality must be possible without particular skills or knowledge.
This isn’t a full definition of morality; simply factors that if unsatisfied, renders a social morality non-existent. For example, once society deemed homosexuality immoral. Homosexuals didn’t need particular skills to comply. Slowly, this standard changed for society, but not everyone agrees. Today the social morality is to (at least) not persecute homosexuals, requiring forbearance (which does not require particular skills) from those who disagree.
What is tax’s accepted behavioural standard? Is it “you must pay tax”? Then the quantum paid is irrelevant. Is it “you must pay the tax owed”? Then Parliament must be clear on the quantum owed to measure compliance. It is not. How about “you must not avoid tax”? This also requires certainty on the amount not be avoided and ignores our constitutional freedom.
Furthermore, both tax compliance and avoidance require special skills and knowledge. Those with complex activities require accountants and lawyers and may have to negotiate the total bill with HMRC. Even for most individuals, employers carry out their income tax calculation because the rules are complicated.
Tax compliance and avoidance cannot yet have a clear moral status for all society because tax is complex and ambiguous. That just doesn’t seem fair.
Tax and fairness
Whilst morality compares conduct against a common standard, fairness preserves balance in society. It redresses injury or guides the distribution of benefits and burdens amongst different classes of individuals. For example, violence against others is immoral, but it would be odd to call assault unfair. It might be unfair to split sweets unequally between siblings, but it’s not a social immorality.
Fairness therefore determines the criteria for different treatment of separate cases for various purposes. Refusing to sell alcohol to a short woman is unfair, but not to a tall girl; age is an accepted class distinction for purchasing alcohol but height is irrelevant to any differentiation within or between these two classes.
Fairness is integral to tax. Society regards everyone as one class with the primary obligation to pay tax and we all have an equal constitutional freedom to avoid it. However, in popular consciousness, wealth is a relevant differentiating criterion for the former activity but not for the latter. Those who can pay more, should.
Tax avoidance violates fairness in two ways. First, significant reductions to your tax bill requires wealth; money to invest and fund expensive advisors. Many are excluded from their constitutional freedom by an unrecognised criterion for differentiation. This leads to public anger, even though many would do the same if they could. Secondly, it counteracts the recognised differentiating criterion in tax compliance and creates a viscous circle; the wealthy pay less shifting the tax burden to the poor which they cannot avoid.
The VAT avoidance example outlined above is the clear exception, which explains the lack of political capital in labelling everyone as tax avoiders. ISAs and pensions are also limited exceptions; some people can’t afford these products. Their poverty and the fiction of the accepted definition of tax avoidance, denies them a political voice in the debate.
How to restore balance to our unfair tax system? Constitutional reform says walnut, sledgehammer. Instead, we preserve our constitutional freedom and call on government to empower wider society to engage in complex tax avoidance markets. Pigs will then fly. That leaves only the more difficult solution; restrict the potential to enjoy our constitutional freedom.
Tax politics and policy
Politicians must end the fiction that tax avoidance subverts Parliamentary intention and stop emphasising better enforcement. HMRC cannot grasp the scale of problem; their tax avoidance estimates (£3.1 billion in 2012/13) are laughably low. If the line between evasion and avoidance was clear, lawyers and accountants would enforce it.
In 2012, Ed Miliband said it wasn’t “for politicians to lecture people about morality”; he was right. Notwithstanding some politicians’ moral convictions, society cannot agree a moral standard for tax. A line on morality speaks to some and marginalises others. It’s not the centre ground that wins elections. It shouldn’t be used.
Politicians should emphasise that it is unfair that only the super wealthy can aggressively avoid tax whilst the poor cannot. The latter part of that statement helps avoids a moral judgement upon the wealthy. Finally, no politician should claim never to have avoided tax. It’s both unbelievable and unlikely to be true, even if they believe that it is.
The policy battle has two fronts: domestic and international. It’s inadequate on both counts. For the former, the effectiveness of anti-avoidance provisions and disclosure rules is countered by the fact that they’re also an extension of the problem; they exacerbate the code’s complexity (as my infrastructure example above shows). The new General Anti Avoidance Rule (GAAR) is a red herring. It contains a dreaded “double reasonableness test” which any law student will tell you renders it almost redundant; the GAAR guidance admits its narrow scope.
The deplorable state of our centuries old tax code must be modernised for a global business environment; the Ramsay principle must be at the legislation’s heart. This is easier said than done. The government should set up a royal commission on tax reform during the next Parliament.
In the interim, two measures could be implemented that would help prevent further perpetuation of the problem. First, we need a widely defined General Anti Avoidance Principle (GAAP) that empowers courts to review transactions as an economic whole and preserves Parliamentary sovereignty. If policy makers don’t like a judgement, they can legislate to reverse it (which they did after the Barclays case). Second, policy based drafting should be included within tax legislation. This is itself a constitutional change, but would help lawyers and courts give wider interpretation to statute when unanticipated circumstances arise in a diversifying global market.
To tackle international tax avoidance there are over 3000 double tax treaties between nations. However they also don’t tax the economic whole of a transaction and do little to address global tax evasion. Sadly there are few signs of an international movement for true reform. We need a culture of co-operation, not competition, between tax systems. For those new to the subject, I recommend Nicholas Shaxson’s book “Treasure Islands”.
Three key areas need to change. First, the secrecy and corruption of tax havens must end. Britain has soft power over many but other countries must challenge the havens within their sphere of influence too. This should be the key foreign policy objective of the next government. London is one of the world’s biggest tax havens though; vested interests in Whitehall and the City of London Corporation must be challenged.
Secondly, the free flow of capital around the world needs to be addressed. Money is not a commodity to be freely traded. Unlike other goods and services, the relationship between the buyer and seller of finance is rarely equal. A less than perfect global system of financial controls was created at the Bretton Woods Conference in 1944; it can be done again.
Finally, the lack of transparency within corporations and each domestic tax system must be addressed. Rich countries must be more transparent about the flow of capital from developing countries to them. Currently, we look to the OECD for improving transparency. Instead, we should turn to the UN as developing countries’ interests are better represented there than in the OECD.
Tax avoidance is a fundamental freedom under the British constitution and so politicians must be careful in capitalising on public anger over tax avoidance for electoral returns. It will take years to sort out the mess and international co-operation is essential. The debate must be framed correctly, in terms of fairness and without questioning the moral integrity of tax avoiders. Parliamentarians must end the fiction that tax avoidance is about subverting the spirit of the law and take responsibility for the mess they and their predecessors created. Nationally we need a royal commission, a GAAP and policy based drafting of new tax laws. Internationally we need to end the secrecy and corruption of tax havens (including London), capital controls and improved transparency between nations more generally. It will be a long road and we should start soon, preferably on 8 May 2015.
Mark Rowney is a solicitor and former research fellow at IPPR.