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'I DO TAX planning, you do avoidance schemes, they evade taxes'. It all depends on your point of view. The difference between avoidance and evasion was memorably defined by Denis Healey as 'the thickness of a prison wall'; but what is the difference between acceptable tax planning and unacceptable tax avoidance? What is the borderline between avoidance that is sharp but legal and effective, where HMRC might need to legislate to stop it in future, and avoidance that can be shown in court to be an unsuccessful attempt to exploit the rules?
Acceptable?
The two most famous quotations about acceptable tax planning are surely from Lord President Clyde in Ayrshire Pullman Motor Services v Commissioners of Inland Revenue (1929) 14 TC 754 and Lord Tomlin in Duke of Westminster v CIR (1935) 19 TC 490. 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. The Inland Revenue is not slow — and quite rightly — to take every advantage which is open to it under the taxing statutes for the purpose of depleting the taxpayer's pocket. And the taxpayer is in like manner entitled to be astute to prevent, so far as he honestly can, the depletion of his means by the Revenue'. Lord Tomlin was briefer: 'Every man is entitled if he can to order his affairs so that the tax attaching under the appropriate Acts is less than it otherwise would be'.
I used to think the thing that made tax planning 'acceptable' could be expressed by adapting Lord Tomlin's comment: you had to start with some 'affairs' that you wanted to 'order' in a tax-efficient way, rather than starting with a tax bill and creating some 'affairs' that would not otherwise have existed to make the liability disappear. You have some cash to invest: you can put it in an individual savings account or a pension fund and enjoy the tax advantages. After all, the Government gives tax breaks to encourage you to do those things.
You want to run a business: it is acceptable to choose between operating as a sole trader or a limited company. There are more complicated issues here, because there are more rules to fall foul of but, if you tread carefully, it is surely also acceptable to choose to take your money out of the company as dividends rather than salary. There is nothing wrong with doing the calculations on the back of an envelope and realising that you get to spend rather more of the dividends.
The less acceptable end of tax avoidance would be, according to this analysis, a person with a large capital gain entering into a circular scheme which creates a matching allowable loss and exempt receipt, so there would be a tax deduction without a real cost (apart from the professional fees). The circular transactions would not have existed at all if it was not for the desire to avoid tax.
On a scale from one to ten …
The problem is telling the difference not only between what the taxpayer is 'entitled' to do, according to Lords Clyde and Tomlin, but what is effective in law and ineffective. My tax planning is always acceptable to me, because my tax liability is unreasonably high; your tax avoidance is a little dodgy; their wholly artificial scheme is on the borderlines of evasion, and they should not only pay the tax but be penalised for trying to get out of their civic responsibilities.
The danger in this self-assessment is that you will surely place yourself further up the 'good' end of the scale than HMRC would; at the point where they think you have turned to the Dark Side, you still think the Force Is With You. Where a judge will put you is another, and even more important, matter. Lords Clyde and Tomlin showed that HMRC do not always get it right. In recent years, senior HMRC officials and Government ministers have a dishonourable record of using the expression 'avoidance and evasion' as if they were similar (not even the thickness of a wall between them), and also 'avoidance and other non-compliant behaviour' as if using a legal tax planning device was similar to leaving income off a return.
This is probably not helpful. Blurring the distinction, and giving the impression that they regard the only good taxpayer as the one who not only opens his stores but meekly hands the shovel to HMRC, may encourage people to be less compliant. If you will be hanged for a sheep or a lamb, what will you steal? Now they have even got me doing it — if you are tax planning properly, you are not stealing at all.
Enter the Halifax
Suppose you are a bank, and you want to build a call centre to ring up people in the middle of dinner and sell them financial services. Many people would regard this as unacceptable behaviour in any case but, sticking with tax, there are several possible planning points. In general, such a building would not enjoy capital allowances for the bricks: but if the bank chose to locate it in an enterprise zone, it would. So it could, quite acceptably, reduce the tax cost of the project.
A major tax cost for financial institutions is irrecoverable VAT on expenditure. The Halifax would, in the normal run of business, recover only about 5% of the VAT on its overheads. So the directors decided to take the advice of experts on how to get some extra VAT on the call centre — just about 100%. Remember, they started with the real, commercial objective, i.e. to acquire a new call centre, and they are trying to minimise the tax attaching to it. That appears to be at the acceptable end of the scale. As the group financial director of the Halifax stated in a letter quoted in the tribunal:
'For the avoidance of any doubt, Halifax was driven by commercial imperative to expand its call centre facilities … Satisfying that commercial requirement is therefore the overriding objective of the transactions.'
The problem was that the 'affairs' that they needed to create to achieve the VAT objective looked very artificial. They had to interpose a series of transactions between the third party purchase (building services from a construction company) and the ultimate beneficiary (the Halifax, using the building for financial services). Three subsidiary companies were involved; there were invoices and payments carefully timed around 31 March 2000, the end of the companies' VAT years, to make sure that the mechanical operation of the standard partial exemption method would generate the required recovery. Quoting a little more of the letter from the financial director:
'Halifax plc therefore considered with its advisers how it might reduce or mitigate that cost. The transactions entered into were approved in outline by Halifax plc with that aim, and referred to the directors of LPDS and CWPI [two of the subsidiaries] to consider their implementation.'
VAT's different
A direct tax specialist might at this point reach for Furniss v Dawson [1984] STC 153 and think that this will be enough to knock the scheme on the head. There was a pre-ordained series of transactions, with steps that were inserted only to create a tax advantage. Surely Customs could simply ignore the chain and pretend that the builders had supplied services directly to Halifax, which was what was 'really' happening?
Customs' problem was that this principle has been held to hold for every other major UK tax, but not for VAT. The House of Lords specifically rejected its application in Robert Gordon's College v CCE [1995] STC 1093. VAT depends on the objective analysis of individual transactions, and it is not proper to look at 'the big picture' or the motives of the taxpayers. You do not have to be short-sighted to be a VAT specialist, but it helps.
That gave the Halifax and its advisers the confidence to go happily into the tribunal, acknowledging that the transactions were purely carried out to mitigate the tax liability. There was an underlying commercial purpose for the whole arrangement, but the predetermined chain was a tax scheme. They had no reason to try to disguise it, always a risky business, verging on the untruthful, because they did not think the motive was relevant.
Legal ping-pong
The senior tribunal chairman, Stephen Oliver QC, decided against the taxpayer (decision no 17,124, February 2001). He took the view that the avoidance of VAT was not a proper business purpose, so transactions with that sole motive were not 'economic activity' within the meaning of the Sixth Directive or 'business' under the VAT Act. They did not carry a right of input tax recovery. Once the 'unreal' transactions were stripped away, all that was left was the builder and the bank. This was Ramsay applied to VAT by other means.
In December 2001, the High Court judge sent the case back. He said that the tribunal might or might not be correct about the 'economic activity' principle, but it appeared that the chairman had only considered the motives of the directors of the Halifax. If the intermediate companies were claiming input tax, it was their motives that needed to be examined. At the very least, the tribunal's decision should declare a finding about them.
The first tribunal report does contain some comments about the subsidiaries' decisions: they were made after 'due and careful consideration' of between two and three minutes. It is clear that the chairman regarded them as simply doing what they were told. When he heard the remitted case (decision no 17,721, April 2002), he made explicit findings that the purposes of the subsidiary directors were the same as those of the holding company, and that the result of the scheme would be to distort competition (which is against the fundamental principles of VAT).
However, in view of the controversy that the case was causing, he decided to refer questions to the European Court of Justice. There were fundamental issues which were unlikely to be settled beyond doubt in a British court.
The ECJ
It has taken a long time for Case C-255/02 to come to a conclusion: the judgment was at last released on 21 February 2006. If you are not used to VAT or the workings of the European Court of Justice, it may be a little hard to understand the apparently contradictory points that the judges are making.
They roundly reject the reason for which the chairman found initially for Customs: 'the question whether a given transaction is carried out for the sole purpose of obtaining a tax advantage is entirely irrelevant in determining whether it constitutes a supply of goods or services and an economic activity'. One-nil to the Halifax.
However, there was a second question: does the European case-law concept of 'abuse of rights' apply to VAT, and in particular to this situation? If someone acts in an abusive way to exploit legal rights that they ought not properly to enjoy, the European Court has held in the past that they will still not benefit. It is the mirror-image of the UK concept of equity, which gives you rights that you deserve even though you are not entitled according to the letter of the law.
The judgment states that the principle does apply to VAT, and then gives two critical conditions which must exist before it will be held against a particular taxpayer. First, the transactions must 'result in the accrual of a tax advantage the grant of which would be contrary to the purpose of [the legal provisions]'. Second, 'it must also be apparent from a number of objective factors that the essential aim of the transactions concerned is to obtain a tax advantage … the prohibition of abuse is not relevant where the economic activity carried out may have some explanation other than the mere attainment of tax advantages'.
It is for the national court to decide whether these conditions are present. That assumes that it is possible to determine 'the purpose of the law'. Here, it seems that the law is intended to deny banks input tax credit, so engineering 100% recovery 'must be wrong'. Although there are a number of general principles of VAT e.g. the prevention of distortion of competition, the application of the law consistently to like transactions, it is not always possible to divine a clear intention. The law is just the law: you do what it says without asking why (am I sounding like a planner or an avoider?).
The big problem for the Halifax is that they effectively admitted the second condition, at least insofar as the holding company was concerned, because they did not think it mattered. The batting of the case between the Tribunal and the High Court led to a very clear finding of fact that all the companies entered into all the transactions for tax avoidance reasons and no others. In many situations it will be less clear, or harder for the authorities to prove if the taxpayer is less inclined to admit it (being forewarned and forearmed).
There is one small crumb of comfort in the decision: 'it must also be borne in mind that a finding of abusive practice must not lead to a penalty, for which a clear and unambiguous legal basis would be necessary, but rather to an obligation to repay, simply as a consequence of that finding, which rendered undue all or part of the deductions of input VAT'. So trying to exploit the rules is not so naughty that it deserves a penalty: it will simply be rendered ineffective. It is tax avoidance that is sufficiently unacceptable to be ineffective, but not so unacceptable that it gets punished.
Where now?
Presumably HMRC are preparing a celebratory announcement that may give some clues as to where and how they will use their new 'toy'. It has certainly given them justification for shifting all taxpayer behaviour towards the bad end of the scale: what was tax planning to mitigate the cost of a commercial project has become 'an abusive practice'. Any VAT planning which depends on interposing transactions in a supply chain must
now be suspect, even if some such arrangements have been operated happily for years without objection from Customs.
As 'abuse of rights' is a European law concept, it has no obvious or immediate application to direct taxes. However, the merged department will surely be sharing ideas on legal arguments to defeat the evil tax avoiders, and some of the concepts of the VAT approach may be interesting to the direct tax side.
Still, I am not worried, because I do not do tax avoidance. I only do tax planning. That is all right, isn't it?
Mike Thexton is director of Thexton Training Ltd.
HMRC have issued Business Brief 02/06 in response to the Halifax decision. It states that 175 appeals have been held over pending this judgment, and they have been held over for a further 60 days from the date of the decision (i.e. to 22 April) while HMRC consider the implications for each case individually. It is clear that HMRC believe that they are unlikely to have to withdraw many disputed assessments as a result of the decision.
