Another day, another ‘tax mitigation using a service company’ story. Ken Livingstone, who at an earlier stage in his colourful career might have been regarded as the least likely of people to be engaged in tax avoidance, has been challenged by Boris Johnson, his main rival in the London Mayoral campaign, over paying fees for media appearances into a company owned by Mr Livingstone and his wife. Mr Livingstone’s response that Mr Johnson makes similar arrangements have been denied.
One can only admire the magnificently disingenuous response of Ed Miliband that Mr Livingstone has “paid every pound of tax” that he is required to. Whilst I am sure this reflects an admirable desire to clarify in the (no doubt throughly confused) public mind that no crime has been committed, it does not exactly deal with all of the issues which appear to be at stake.
The question of where the dividing line between legitimate tax mitigation and abusive tax avoidance should be drawn has become a very live one in recent years, particularly in the wake of the banking crisis and the subsequent downturn, which has given rise, not least in the tax profession itself, to a feeling that the more spectacularly artificial forms of tax avoidance are no longer acceptable.
The discussion has been fuelled by revelations about the apparently extremely favourable deal cut with Vodafone by Dave Hartnett of HMRC over a large scale but possibly rather flimsy piece of offshore tax avoidance, and about the fact that banks continue to engage in highly aggressive offshore tax avoidance activity. As mentioned in a previous post, there has also been much comment about government engagement of consultants operating through service companies, and it is to this strand of the argument that the Livingstone spat belongs.
The history of anti-avoidance is an interesting one. It first became a major issue in the 1970s, when the UK ‘enjoyed’ a top rate of income tax of 98%, and tax avoidance for the first time became something of a major industry. Anti-avoidance legislation suffered from the handicap that it tended to be targeted at particular perceived abuses, and the ingenuity and dexterity of the avoidance industry comfortably outpaced the response time of HMRC and the Treasury.
Help was at hand, however, from the judiciary, in the form of what became known as the Ramsay principle, after the defendant in the case in which it was first outlined by a senior judge. In simple terms, the principle was that, if a step was inserted into a series of transactions with no commercial purpose other than the saving of tax, HMRC and the courts were entitled to disregard that step in assessing the tax consequences of those transactions. HMRC had a good run for a while in using the Ramsay principle to strike down particularly artificial avoidance schemes, but it has its limits, which were, over time, both defined by the judiciary and recognised by those who design tax avoidance schemes.
The next step taken by the authorities was to require the advance disclosure of tax avoidance schemes, where such schemes are capable of mass marketing, as opposed to being of specific reference to a particular clients unique circumstances. This enables HMRC to close down schemes more quickly, as it knows about them earlier, but such schemes continue to be developed and marketed.
So how did this impact upon the vast majority of the tax profession who are not engaged in devising and marketing such schemes? Because such schemes did not really impinge upon our day to day lives, we tended to give them little thought, and to be fairly ambivalent about them. It was important to know about them, because sometimes giving a client full advice on a particular situation does involve covering the possibility of using an avoidance scheme. I have never recommended them, but if a client is interested in using one then I owe it to the client to offer appropriate advice and assistance.
In my experience the vast majority of clients are not interested in using artificial schemes, because of the attention they inevitably draw from HMRC. Many in the tax profession also became uncomfortable, in the light of the financial crisis of 2007 onward, about the whole concept of artificial tax avoidance, and sought to distinguish what we would regard as ‘everyday’ tax planning (what I describe to clients as ‘sleep at night’ tax planning) from artificial forms of avoidance. The term coined for this everyday tax planning was ‘tax mitigation’.
If I was asked to distinguish between the two, I would say that avoidance seeks to use the tax legislation for a purpose it was never intended to fulfil, and to make use of the precise wording of legislation where that wording does not achieve the exact purpose intended by the legislators. On the other hand, mitigation simply seeks out the most tax-efficient way of structuring a transaction, without flouting the apparent intention of the legislation.
This distinction is in my view a valid one. In the 1930s case of the Duke of Westminster, Lord Tomlin said:
“Every man is entitled if he can to order his affairs so as that the tax attaching under the appropriate Acts is less than it otherwise would be.”
Similarly, in Ayrshire Pullman Motor Services and Ritchie, Lord Clyde said:
“No man in this country is under the smallest obligation, moral or other, so to arrange his legal relations to his business or to his property as to enable the Inland Revenue to put the largest possible shovel into his stores.”
so there is senior judicial opinion to the effect that tax mitigation is acceptable.
Of course one of the exciting things about tax is that it is constantly evolving, and so are public attitudes to tax issues. One of the things that history teaches us in this respect is that politicians and the media can be relied upon to misunderstand and misrepresent matters relating to tax mitigation, but they can also reflect changing public sentiment as to where the mitigation/avoidance divide lies. A couple of examples should show what I mean.
1. The ill-fated zero rate of corporation tax
In autumn 2001, in happier economic times, Chancellor Gordon Brown had the brilliant idea of introducing a zero rate band of corporation tax on the first £10,000 of company profits. This was trumpeted, quite rightly, as both a tax reduction and a tax simplification measure, but it was a fairly clear invitation to tax mitigation, which the tax profession accepted. Huge numbers of small sole trader businesses which had never previously even considered operating as companies were advised by their accountants to incorporate to take advantage of the nil rate band, and did so.
In autumn 2005, the self-same Chancellor announced that he was closing a widely exploited tax avoidance loophole by abolishing the zero-rate of corporation tax. Given that he himself had introduced it 4 years earlier, this took a bit of swallowing, and to my mind represents the classic example of confusion between mitigation and avoidance.
2. Flipping homes
The media had similar difficulties during the MP’s expenses scandal with the concept that became known as ‘flipping’. There is a long-standing ability under the capital gains tax legislation to elect as to which of two or more properties, each occupied as the taxpayer’s main residence, is to be regarded as the taxpayer’s exempt main residence for capital gains tax purposes. Once again, in order to avoid being negligent, a tax adviser needs to advise his client how best to use such an election to minimise capital gains tax liabilities.
Of course, the majority of MPs for constituencies outside the South East of England quite legitimately need a London home as well as a constituency home, and are no doubt routinely advised by their accountants as to how best to strcuture this arrangement to minimise capital gains tax. However, in the hands of the media this became the despicable practice of ‘flipping’, and Hazel Blears, MP for Salford, was among others in being pilloried for this practice. Again to my mind this confused mitigation with avoidance. However, in this case it may also reflect a genuine public concern that the tax legislation should not be designed to favour those fortunate enough to be able to afford more than one residence. I will leave that for the reader to decide.
Which brings us back to the use of service companies. I have always seen this as mitigation; the government sets corporation tax, income tax and national insurance rates and determines how those taxes interact and apply to particular forms of income. If the government chooses to implement a tax regime that significantly favours trading through a limited company, and has done so for many years, the tax profession can only assume that there are sound policy reasons for so doing. For example:
1. Encouraging businesses to accept greater levels of risk by offering limited liability to their owners.
2. Keeping greater control over business accounting and record keeping by encouraging the use of an entity that is required to file publicly annual accounts.
However, the past few weeks have seen a great deal of media interest in the subject of service companies, when used by national or local government consultants or former, and indeed aspirant, London mayors. Two questions arise from this. Firstly, does this reflect widespread public concern about the issue, or is the fascination limited to the media itself? And secondly, has the publicity been sufficient to encourage the Chancellor to legislate to reduce or remove the tax advantages of operating a business through a limited company in his forthcoming Budget?
In practice I very much doubt the latter. The Chancellor’s instincts are clearly to cut corporation tax rather than increase it, an significant part of the voting public actually trades through companies, and anything that serves to further depress the economy at this point, as such a change would, is unlikely to commend itself to Mr Osborne. Nonetheless, it does reflect the fact that today’s legitimate tax mitigation can easily become tomorrow’s abusive tax avoidance, and it behoves us as tax practitioners to keep a weather eye on public opinion in this respect.