The Coalition Government and sections of the media are blurring the distinction between legal tax avoidance and illegal tax evasion. Prime Minister David Cameron wants an end to “that sort of thing”, and Chancellor George Osborne has even said he finds tax avoidance “morally repugnant”. But taxpayers should only pay the tax required by law, argues David Colom, managing director of D J Colom & Co. And in this article for ContractorCalculator he writes that if there is no law against the creation and implementation of tax mitigation strategies, all taxpayers are entitle to benefit from them.
There is an ongoing arms race of creative tax advisors developing tax mitigation strategies, only for HMRC and the Treasury to impose new laws to negate them. And it is only because avoidance schemes must be registered that HMRC identifies and stamps out so many of them. This has led to a cycle of developing tax mitigation strategies, taxpayers benefiting from legitimate tax avoidance and then disclosure often leading to scheme closures.
Tackling tax avoidance was not something new dreamt up by the last Labour administration. Nor is it a Coalition Government initiative devised to combat the structural deficit. In fact, English tax avoidance goes at least as far back as 1696, when householders bricked-up openings to avoid the window tax, and probably much further.
But what recent governments have in common is their demonisation of tax avoidance and their attempts to cloud the distinction between illegal tax evasion and legal tax avoidance. Former Labour Chancellor Denis Healey’s once said, “the difference between tax avoidance and tax evasion is the thickness of a prison wall”. Clearly a prison wall is no longer a sufficient barrier between illegal evasion and legal avoidance.
If there’s no law against it, it’s legal
The legitimacy of many tax mitigation strategies devised by tax planners is highlighted by the requirement to outlaw them to prevent taxpayers from benefiting from tax savings. If they were not legal, they would not require new laws to render them impotent. Traditionally, a scheme was devised and taxpayers joined. At some point, HMRC became alerted to the scheme’s existence and introduced new legislation in the Finance Act to close the legal tax loophole that had been exposed, by making it illegal. Then new schemes would be devised and the cycle would continue.
But two key factors have hugely accelerated this arms race between tax advisers and HMRC: ‘DOTAS’ and the internet. In 2006, the Disclosure of Tax Avoidance Schemes, or DOTAS, legislation was introduced, requiring all tax avoidance scheme promoters to register their schemes with HMRC and provide details of how they work.
This meant that HMRC became immediately aware of new schemes and, because the provider is required to describe its tax mitigation strategy, could instantly implement so-called ‘anti-forestalling’ measures to effectively shut down schemes immediately, and subsequently update the law in the next Finance Act.
HMRC also finds out about older schemes in place before DOTAS, and brand new schemes not yet launched, via ‘aggressive’ online marketing by the scheme providers. On discovering a scheme online, HMRC can take similar forestalling actions, and then legislate. This was the fate of the Managed Service Company (MSC) scheme concept, which was perfectly legitimate until some providers over-marketed MSCs and HMRC was forced to act.
Sometimes scheme participants may only have a matter of days or hours to participate before HMRC shut them down. But if the sums involved are significant, the tax savings can still be large.
Governments draw the line at retrospective tax legislation. So far.
Historical precedent shows us that governments can legislate at will and there is little taxpayers can do about it. In theory, the Treasury could decide that all income splitting by married couples is unacceptable and, via parliament, force through legislation saying that the settlements legislation does apply to spouses and civil partners who should all now pay taxes, penalties and interest going back six years.
It would be like the government deciding that, as of a month ago, the speed limit on the motorways was 60 miles per hour (mph), and then prosecuting everyone ‘caught’ going over 60 by a speed camera in the last 31 days.
Fortunately, in the interests of a stable tax regime with mostly compliant taxpayers, even the most overzealous Chancellor has yet to impose genuinely retrospective tax legislation.
So, in the arms race which is the tax avoidance industry, the Treasury can only prevent taxpayers from benefitting going forward, and cannot go back in time. This also means that contractors joining schemes that are legal at the point of joining, and leaving when the scheme is closed down, do not have to fear retrospective taxation.
Some avoidance is legal and simply can’t be legislated against
The quality and robustness of new tax mitigation strategies varies, but the best of them are created by highly experienced teams of specialist tax advisers and are examined by eminent barristers before they are launched. Quite often, teams of tax counsel, specialist tax accountants and former tax inspectors will extensively examine each and every aspect of the strategy before it is launched. Strategies that fail this extensive process never make it onto the market.
Contractors, like all taxpayers, should only be obliged to pay as much tax as they are legally required to do and not a penny more
David Colom, D J Colom & Co.
Those that do are compliant and legal according to the current legislation, and HMRC and the Treasury then have to create new laws to close some schemes. But there are schemes that have been so thoroughly road-tested that they remain legal no matter what legislative changes are made. And if HMRC test the legality of such schemes through the courts, it frequently loses, because our judiciary remains independent of government to fairly rule on the application of our laws. Salary packaging is one such example familiar to some contractors, where HMRC challenged certain aspects of the legitimacy of the strategy, but it was held in court that the strategy was compliant according to the legislation in force at that time.
On frequent occasions HMRC has been forced to abandon attempts to outlaw some tax mitigation strategies because, in order to outlaw a particular activity offering a tax benefit to a tiny minority, the new legislation would impact negatively on a huge number of unrelated stakeholders. Had HMRC persisted in its attempts to introduce new legislation to prevent income splitting, as it intended in 2009, the impact on the wider business community would have been potentially devastating. Ultimately, if an activity is legal and widely practiced, it can be very difficult to legislate against.
Choose schemes wisely
But not all schemes are robust and defensible. In fact, many are poorly thought through, badly implemented and bordering on illegality even before HMRC get to work. That’s why contractors considering legal tax avoidance should always look into a scheme’s creation, implementation and defence, or ‘CID’:
Creation: who created the scheme? Are they among the very best tax planners with decades of successful scheme creation and access to the best tax counsel, tax advisors and accountants?
Implementation: If there is a flaw in the paper trail of a scheme’s creation and management, HMRC will find it and exploit it. Does the organisation implementing a scheme have a strong track record of successful implementation and management?
Defence: The best scheme creators and implementors not only expect investigations by HMRC, but welcome them. That’s because the team creating and implementing the scheme will have attacked it from all directions long before its launch. So, any attempts by HMRC to find its own loophole to exploit are likely to be doomed from the outset. And a good scheme manager will have a fighting fund to cover the costs of a robust defence, and stand by its members.
When the Treasury announced its disguised remuneration legislation on 10th December 2010 and shut down employee benefit trusts (EBTs) overnight, many scheme providers went in two directions. Those falling short of the ‘CID’ criteria opted to launch ‘self-employment’ salary packaging schemes because they were easy, although brought risks to contractors joining them.
But the best scheme providers spent months devising employment-based salary packaging schemes that are based on established legal precedents and can be robustly defended against investigations by HMRC.
Risk appetite depends on your definition of risk
Tax mitigation strategies do not have to be risky. Is channelling fee income into a company pension scheme risky? Is income splitting by sharing company ownership with a spouse or civil partner perceived to be a high risk avoidance strategy? These are generally recognised as being ‘legal’ and ‘safe’, but are tax avoidance nonetheless.
And, as has been seen with changes to pension rules and the attempts to widen the scope of the settlements legislation that resulted in the Arctic Systems case, these ‘safe’ tax avoidance strategies can suddenly attract an element of risk. Furthermore, many contractors operating their own one-person companies are taking significant risks by ignoring or only paying the most limited attention to the IR35 legislation. That is perhaps the most dangerous form of ‘tax avoidance’: wishful thinking that existing legislation will not be applied to them because, hopefully, HMRC will not get around to inspecting them.
So, if you have conducted due diligence on, say, the providers of an employment-based salary packaging scheme using the CID principles and determined that what is proposed is legal according to current legislation, as are pension contributions and income splitting, what’s the risk? HMRC may create legislation that renders a scheme unworkable, but from that point on members can stop using the scheme so are not at risk of any additional tax liability. And so the avoidance arms race begins again with a new scheme.
Contractors, like all taxpayers, should only be obliged to pay as much tax as they are legally required to do and not a penny more. If some contractors choose legal tax mitigation strategies that net them 83% of their income or more, then that is their valid choice, and in a free society people should be allowed to make such choices, regardless of what the Chancellor may consider "morally repugnant”. If government does not like people's valid choices, then they are always at liberty to introduce new legislation.
Tax evasion is unquestionably illegal, as it should be in any civilised society. But it is completely different to legally compliant tax avoidance, which government may not like because it is not in its tax-collecting interests. But tax avoidance generally has always had its place in everyday business plans, be it through the formation of a limited company to mitigate National Insurance Contributions (NICs) by paying dividends, paying into a pension plan to reduce corporation tax liabilities and income tax, or choosing an alternative strategy, not involving a limited company, to reduce tax liabilities.