“Tax is too difficult for a mathematician, it needs a philosopher” – Albert Einstein
By some distance my favourite tax quote, from a man who once stood in line for hours to pay his tax, pondering a complex question of physics, to such an extent that when he reached the front of the queue he forgot his name and had to start again. I can sympathise with that!
Tax is very much a political as well as a fund raising mechanism, which makes it a fascinating topic to study in a historical context. So what are the forces that have shaped the modern tax system, and in particular how have attitudes to paying tax and the lengths to which it is legitimate to go to avoid it changed with the times, and what are those attitudes now?
Income tax was initially an emergency measure to fund the Napoleonic wars, and was actually briefly abolished once those wars were over. Government spending, certainly in peacetime, was not a major issue until the advent of the early 20th century Liberal Government, and in particular of David Lloyd George as Chancellor.
A complex character, capable of dreadful acts of political misjudgement (some would say corruption), but a magnificent speaker and a radical reformer, Lloyd George introduced the revolutionary concept of the state pension, the first foundations of what would become in the 1940s the Welfare State. To pay for this, not to mention the building of dreadnoughts in anticipation of the impending World War, he increased income tax on the rich and introduced death duties on their estates.
Never before had the incidence of taxation on the landed interest been so severe, and they did not react well; indeed it was necessary to pass an Act of Parliament, still effective to this day, denying the House of Lords the right to reject, or even delay, a Finance Bill, in order to get one of Lloyd George’s Budgets through the upper chamber. Lloyd George’s description of the House of Lords as:
“Five hundred men, chosen by accident from among the ranks of the unemployed”
gives a good flavour of the political storm generated by this first great modern political confrontation over the issue of direct taxation (as opposed to customs duties etc, which had been the subject of previous Parliamentary, and indeed party, bust-ups).
Tax then went relatively quiet until the 1940s, when the massive cost of World War 2 and the advent of the full apparatus of the Welfare State again required an increase in levels of taxation. It was at this point that the concept of tax avoidance first assumed significant prominence, although the Duke of Westminster case in the 1930s had already established that tax avoidance was a legitimate undertaking for a taxpayer.
Early tax avoidance was very much focused on generating capital gains as an alternative to income, on the basis that income was taxed and capital gains were not, at least until 1965. Nor indeed were lifetime transfers of property subject to death duties until the advent of capital transfer tax in the same year, so some tax planning was not too difficult, with deathbed transfers of property very much the order of the day. Thus the tax cases of the 1930s to 1960s are largely based on the distinction between income and capital, as are the first examples of anti-avoidance legislation, which sought (and still seeks) to combat the artificial conversion of income into capital for tax purposes.
The tax innovations of the Labour government of the mid-1960s, some mentioned above and also including corporation tax (companies had previously paid income tax), were followed by an explosion of tax avoidance activity, some of it (notably the infamous Rossminster case) bordering on tax evasion. This was only encouraged by the financial crises of the 1970s, which led to the top rate of income tax peaking at 98%, which was getting dangerously close to confiscation as opposed to taxation.
My arrival in the world of tax in the early 1980s coincided with a reduction in the burden of taxation under the Thatcher governments, although rates were still very high compared to today. 1980s avoidance activity tended to centre on national insurance, as benefits-in-kind did not then attract NI. Here, perhaps for the first time, tax avoidance began to bring the accountancy and tax advice professions as a whole into disrepute.
The process was that a particular form of non-cash remuneration would be identified and adopted as the latest ‘in thing’ for national insurance avoidance, the Government would belatedly identify this and block the planning with legislation, at which point another form of non-cash remuneration which was not yet blocked would be adopted by the profession, and the cycle would begin again. Eventually the Government introduced employers’ national insurance on all benefits-in-kind, and avoidance activity in this area became less worthwhile.
Two things occur to me with the benefit of hindsight and perspective. Firstly, as a twenty-something tax manager in a medium-sized provincial firm, adopting these schemes on behalf of clients, I felt no qualms whatsoever about what we were doing. Looking back, that seems very naïve and immature to me. As a tax adviser one is required to give one’s clients best advice, but I should have thought and worried more about the moral implications of what we were doing.
Secondly, this was the point at which governments began to impose very widely drawn anti-avoidance legislation, whose impact was far wider than blocking the specific abuse it was designed to combat. Having spent many years complaining about this tendency, it does now occur to me that it was hardly surprising that governments took this tack, given the perpetual cat and mouse game that the tax profession insisted on playing in the 1980s with national insurance schemes.
It is after all far easier to draw up very wide legislation to block not only what has been done in the past but also what might be done in the future, rather than perpetually laying catch up in such a soul-destroying manner. So we clearly reaped what we had sown in that respect.
The other interesting development of the 1970s and 1980s was the rise and partial fall of what became known as the Ramsay principle, on the basis of the leading case in that area. The obscenely high tax rates of the mid to late 1970s had inspired an explosion of tax avoidance activity, and in particular the advent of highly artificial planning schemes, designed to exploit ‘loopholes’ in the tax legislation to achieve a tax result far more favourable than the true commercial outcome of the transactions justified.
A feature of many of these schemes was the inclusion of one or more ‘steps’ that had no commercial justification or effect other than to confer a tax advantage on the taxpayer. The Ramsey principle was established by the House of Lords in its judicial capacity (perhaps belated redemption for its attitude to Lloyd George’s Budgets?), and was in essence that it was open to HMRC (then the Inland Revenue) and the Courts to ignore steps inserted into a series of transactions for no commercial purpose other than tax avoidance in determining the tax consequences of those transactions. It was a principle that had its limits, but it was effective in blocking a number of particularly abusive and artificial schemes of no commercial merit whatsoever.
The 1990s featured the rise of the Employee Benefit Trust (“EBT”), designed to provide tax-efficient remuneration for senior personnel, often in the form of loans as opposed to salary in order to avoid income tax and national insurance. Partly because I was by now a tax partner, and thus in a better position to enforce my moral judgements on the policy of my firms, partly because the moral aspect of what was going on had started to impinge upon my conscience and partly because I wasn’t convinced that EBT’s were actually effective in achieving what they purported to, I steered my clients clear of them. This is a rare example of a decision that I look back on in retrospect with total approval, not to say relief, along with getting married, having children, specialising in tax and joining Frenkels chartered accountants.
This is because, after a series of complex and long-running tax cases, a number of EBT’s were found to be ineffective in achieving some of the tax advantages they were promoted as conferring, and because some more wide-ranging anti avoidance legislation was introduced to block those tax advantages that they did successfully achieve. The EBT saga showed that HMRC had increasingly adopted the approach of challenging tax schemes not on the basis of their principles, but on the basis of their implementation. This was sound thinking, as often the practical implementation of theoretically sound (if morally less so) schemes did not match the intellectual rigour applied to their creation.
The new Millennium dawned with the advent of a rash of inheritance tax planning schemes centred around the family home, fuelled by the failure of the inheritance tax nil rate band to keep pace with the explosion in house prices. Most notable among these was the so-called ‘Eversden’ scheme (named after the taxpayer who featured in the leading case). Once again the beginnings of a pattern repeating that of the 1980s could be discerned, as legislation was introduced to block one scheme only for another slightly different version to spring up. However, HMRC and the Treasury had two new pieces of weaponry up their collective sleeve.
The first of these was a bizarre concept, aimed at applying an income tax charge in situations where the inheritance tax gifts with reservation legislation failed to catch tax planning schemes, usually involving the family home. The Pre-Owned Assets Charge, also fondly known in tax circles as “The Tax No-One Ever Paid”, remains on the statute book, and remains I believe unique in being a tax introduced with retrospective effect (or retroactive, as the government insisted at the time) with the prime intention of discouraging particular taxpayer behaviour in the future rather than taxing what taxpayers had actually done. Quite simply the oddest piece of anti-avoidance legislation ever introduced, whose impact remains impossible to measure, because of its unique objective.
The second appeared mush more rational and potentially effective, although in retrospect I have come to doubt to some extent the latter impression. This was the Disclosure of Anti Avoidance Schemes (“DOTAS”) regime, whereby those who commercially market tax avoidance schemes for general taxpayer use are obliged to disclose those schemes in advance to HMRC. This was very much designed as an ‘early warning’ system for HMRC, to enable them to identify, evaluate and block potentially effective and popular schemes at a much earlier stage in their existence.
DOTAS is a fundamentally good idea that suffers from one practical and one theoretical flaw. The practical flaw is the sheer number of schemes submitted to HMRC under DOTAS, given the limited resources that HMRC is able to devote to administering the scheme. Far be it from me to suggest that tax boutiques would submit large numbers of schemes that they never intended to commercially exploit in order to clog up the system, but it must at least be a temptation. The result is that, although HMRC reaction time in blocking schemes has improved to some extent, it is far from being the almost ‘real time’ system that I suspect was envisaged on introduction.
The theoretical flaw is that the legislation applies to commercially marketed schemes, and not to the bespoke variety. Thus the very largest taxpayers (Vodafone, Goodman Sachs, most of the UK clearing banks among them) could either devise in-house, or pay their tax advisers to devise solely for them, one-off schemes that avoided very large amounts of tax indeed. These schemes were not subject to disclosure under DOTAS, and thus escaped advance HMRC scrutiny, often at significant cost to the taxpayer.
Alostby way of a sideshow, but one of great importance nonetheless, HMRC set out on what proved to be a wild goose chase to challenge the division of trading income between spouses in the long running Arctic Systems case. This was a move into what HMRC itself now refers to as “the centre ground of tax planning”, and as such a move calculated to incur the wrath of the centre ground of tax planners, including the writer. At times HMRC and the government appeared blind to commercial and economic realities in pursuing this case, which is in the end largely why they lost it.
The government’s knee-jerk reaction to the House of Lords’ decision in favour of the taxpayer, delivered by one of my old school mates the Eagle twins, brought it into disrepute, as did its abandonment of its proposed counter-measures, which I strongly suspect was precipitated by a belated realisation of just how widespread this type of planning is, among people who would be voting in what was clearly going to be the very close 2010 General Election.
Into this landscape came the financial crisis of 2007/2008, precipitated by those same banks that had almost routinely avoided theirUKtax obligations, and requiring the expenditure of vast sums of money that would ultimately need to be funded by increased taxation. I chair a twice-yearly discussion group at the Chartered Institute of Taxation Residential Conference, and a fundamental shift in sentiment among those who attend the conference, mainly representative of small and medium sized firms of tax advisers and accountants, swiftly became apparent.
I believe that previously the tax profession had, by and large, looked at avoidance activity on the grand scale and of an artificial nature as being something we would never get involved in for practical reasons, but something that was broadly morally neutral. In the light of the long-term financial commitment we would as a nation clearly have to undertake to extract the UKfrom a deep financial hole, this attitude of moral neutrality changed dramatically. The activities of the large corporations and the tax boutiques marketing artificial avoidance schemes had become morally unacceptable in the 21st century financial climate.
I suspect that the bulk of the tax profession was ahead of the general public on this (which these days tends to mean ahead of the media), not because of any great moral superiority, but because we had slightly more idea of what was going on in the tax system. However, this left us with a huge moral dilemma. Tax advisers have a professional responsibility to give their clients best advice, and can be sued if they fail to do so. Thus it was incumbent upon us as professionals to give our clients the full range of potential options in terms of tax planning, morally repugnant to us or not.
There was no comfortable answer to this dilemma, and I suspect we all dealt with it in our own way. Mine was to identify the most ethically responsible tax boutique I could find, which was honest with clients about the risks and costs associated with their schemes and which marketed schemes that had at least some commercial justification. I would then point the relevant scheme out as a possibility, emphasising the risks associated and the moral aspect of choosing to adopt such a scheme.
The vast majority of our clients shared my views and went nowhere near, a few entered into discussions, but none entered into schemes. This saved us from the ultimate moral dilemma, of being offered commission for referring a client into a scheme.
I should say that I have never accepted referral fees in other contexts, much less morally compromised, on the grounds that I refer people because they are good at what they do, not because they pay me. However, there is the world of difference between asking someone to donate your small commission for referring a will writer to your chosen charity and being offered a four-figure commission in respect of a tax scheme. Perhaps the fact that I am glad the situation never arose suggests what my personal answer would have been, but I freely confess it would have been a difficult decision.
It will no doubt surprise the lay reader to learn that, in this taxation moral maze, the proposed introduction of the General Anti-Abuse Rule (“GAAR”) was welcome news indeed for the general run of tax advisers. At a stroke it gives us a valid reason to deter our clients from undertaking artificial tax schemes, reassurance that our own less controversial tax planning lies at the ‘centre ground of tax planning’ and the potential competitive advantage that in future our more modest tax planning efforts will not be outgunned by artificial schemes offering very large savings.
So there is self-interest there as well as a moral imperative, but in my view the fact remains that the introduction of the GAAR is the most positive step forward in the UK tax system in my almost 30-year professional career in tax, and indeed for some considerable time before that. Perhaps, arguably, the most importantUKlegislative tax development ever.
Media and public concern about abusive tax avoidance activity may have been slower to come to fruition than concern within the mainstream tax profession, but it has certainly caught up and may well have further to go. In his thoughtful and thought-provoking response to my post about the whereabouts of the centre ground of tax planning (an easy thing to say but a hard one to define), “Lemexie’s” response to my six examples of planning that I would personally recommend to clients was:
“All fail the higher standard of morals/ethics being expressed in the media. This standard has never applied to HMRC rules.”
So before the majority of the tax profession becomes too self-congratulatory about the introduction of the GAAR and the more level tax playing field that it promises, and the reassurance that the GAAR Consultation Document appears to offer with its comfortingly extreme examples of schemes to which it would apply and its non-application to ‘the centre ground of tax planning’, we should perhaps consider that even to the extent that this centre ground has any real meaning, its whereabouts is quite rightly determined by the opinion of those who pay their taxes and elect our government.
And if they decide that the centre ground is somewhere other than where we would like it to be, who are we to argue? So my philosophy for tax advisers in the 21st century is to be flexible, and to be prepared to take guidance from public opinion as to what is and is not acceptable in terms of tax planning. Because I suspect this will increasingly be a moving target as the century progresses.