Tax planning: What is legally acceptable?
David Small of Arnot Manderson Advocates looks at current legislation and distinguishes between tax mitigation and tax avoidance.
Tax planning is a spectrum.
At one end of the spectrum there are completely blameless activities that we all engage in, while at the other end are complex schemes and contrivances, used by wealthy celebrities among others, which provoke passionate disapproval among the public when they come to light.
But, putting passion to one side, is there a rational basis for distinguishing acceptable from unacceptable planning?
I will concentrate on what is legally acceptable. That is partly because I am a lawyer and like to talk about what I am familiar with, but also because I believe that there is no moral duty to pay more tax than the law requires.
Of course, there is a forest of anti-avoidance legislation on the statute book. But if you can find your way through that and reduce your tax bill by legal means, I do not see that you are doing anything morally wrong. In my view, the legal and the moral limits to acceptable tax planning coincide.
If that view seems naïve, let me qualify it in two respects.
Firstly, I am not talking about tax evasion; evasion involves deceit, which is always morally wrong.
Secondly, if you use tax planning which fails – i.e. the courts find that it does not work – that is not reducing your tax bill by legal means. In my view, failed tax planning is morally wrong.
When you plan to reduce your taxes you must have an honest and responsible belief that what you are doing is legally sound; you should not regard filling in your tax return as a game of poker in which it does not matter if HM Revenue & Customs calls your bluff.
So, what kind of planning is legally acceptable? We need to distinguish between tax mitigation, which is always acceptable, and tax avoidance, which is rarely (indeed, nowadays, hardly ever) acceptable.
What is tax mitigation?
In some legal cases, judges have suggested that there are three "badges" of mitigation:
- Parliament has enacted a specific tax relief.
- Which furthers a socially desirable objective.
- The taxpayer incurs the economic consequences that Parliament intended should be borne by those claiming the relief.
It is easy to give examples of "three badge" tax mitigation. For example, Parliament has legislated to provide tax relief on pension contributions to encourage saving for retirement, and a taxpayer who makes contributions has to accept restrictions on what can be done with the money once it is in his/her fund. ISAs and capital allowances are other examples. All are standard agenda items for year-end planning meetings with clients and all are clearly acceptable.
"You should not regard filling in your tax return as a game of poker in which it does not matter if HM Revenue & Customs calls your bluff"
However, quite a lot of planning is clearly acceptable but does not exhibit all three "badges" of mitigation. For example, a client may be advised to take dividends from his company instead of director's remuneration. The Taxes Acts prescribe a lower rate of tax for dividends than for earned income, but I don't think one can really say that there is a specific relief for dividends; nor can one easily point to a socially desirable objective which the tax system is pursuing in encouraging the owners of small companies to pay themselves dividends rather than remuneration.
The use of non-residence
Another similar, although rather more extreme, example is the use of non-residence. The Finance Act 2013 contains a detailed statutory residence test. From this it is possible to infer how to become non-resident and escape UK tax on, for example, the disposal of a valuable asset. Becoming truly non- resident is not easy and will involve a substantial upheaval in any taxpayer's life, even if it is not necessary to leave the UK forever.
I would see nothing wrong in advising a client on how to achieve this. But one could hardly say that the Finance Act 2013 contains a specific relief from tax, or that becoming non-resident achieves a socially desirable objective.
Two tests for acceptable mitigation
There are in fact only two tests that I think must be satisfied if tax planning is to qualify as acceptable mitigation rather than unacceptable avoidance. These are:
- The Taxes Acts allow it (or do not prohibit it); and
- The taxpayer incurs the economic or lifestyle consequences consistent with the results of the planning.
One can say that tax mitigation "goes with the grain" of the legislation. If mitigation goes with the grain of the legislation, tax avoidance goes directly against it. A hallmark of tax avoidance is a taxpayer trying to benefit from a tax loss without having suffered an economic loss – in other words, the reverse of test 2 above.
When faced with such schemes the courts have, in the last 40 years or so, made increasingly determined and successful efforts to block them by interpreting the Taxes Acts in HMRC's favour. However, until recently, the courts reluctantly had to let a handful of schemes succeed, on the grounds that only new, reworded legislation could stop them.
The 'General-Anti-Abuse Rule'
That gap has now been plugged by the General Anti-Abuse Rule ("GAAR"), which was enacted in the Finance Act 2013. The GAAR is aimed at schemes that comply with the literal wording of the Taxes Acts, but which give rise to wholly unreasonable results, such as a tax loss without an economic loss.
An independent panel of experts has been set up to advise on the reasonableness of schemes, although the courts still have the final decision. The GAAR applies to most of the major taxes that are the responsibility of the UK Government (although not to VAT, which has its own anti-abuse rule deriving from the law of the European Union).
The Finance Act 2013 GAAR seems to me to leave us more or less in the right place. Most tax planning, in the form of tax mitigation, continues to be acceptable while the extreme fringes have been curtailed. There is also a Scottish General Anti-Avoidance Rule (in the Revenue Scotland and Tax Powers Act 2014).
"Most tax planning, in the form of tax mitigation, continues to be acceptable while the extreme fringes have been curtailed"
At present it only applies to land and buildings transaction tax and Scottish landfill tax, although it may come to apply to other taxes as fiscal devolution proceeds. As its name suggests, the scope of the Scottish GAAR is potentially wider than that of its UK equivalent, although it remains to be seen whether, in practice, this will result in a different balance between mitigation and avoidance to that which prevails in the rest of the UK.
A reasonable balance?
Overall, I think that we now have a reasonable balance between the acceptable and the unacceptable in
tax planning. I would like to conclude with a plea for action in another direction.
It is all very well to have a GAAR that enables HMRC to block unreasonable avoidance schemes, which the literal words of the Taxes Acts let through. But the reverse of that situation is the innocent taxpayers who blunder into tax charges which were not intended to apply to them and which are clearly unreasonable in their circumstances.
If the literal words of the Taxes Acts cannot be interpreted to release the taxpayer, at present there seems to be no way out of the trap. In the interests of even-handedness between HMRC and taxpayers, I would like to see a statutory procedure for dealing with these hard cases – perhaps an independent, expert panel which, in the right cases, could advise HMRC to waive the tax.
This article is based on a talk by David Small at the ICAS Tax conference, "The Challenge of Change", In Edinburgh on 21 May 2015, which is available to watch now.
David Small is an advocate at the Scottish Bar with Arnot Manderson Advocates, specialising in taxation. This article will appear in the September 2015 edition of The CA magazine.