The Economics, Politics, and Morality of Avoidance

3. The Economics, Politics, and Morality of Avoidance

Avoidance rests upon the choice or creation of transactions that are valid in formal legal terms. In pure liberal principle, this formal validity is sufficient: if the transactions chosen by taxpayers are valid but considered undesirable by the regulator, then the latter must seek legislative approval for a non­retrospective change in the rules. This formalistic approach can undermine legitimacy by reducing the system to a ritualistic game, in which the elaborate avoidance schemes of the taxpayer are countered by anti­avoidance measures. To satisfy the liberal requirement of certainty in the law, these should be specific counter­measures; but this results in complex and technical provisions which tax officials process through an uncomprehending legislature, producing `large bodies of complex, unsystematic and almost incomprehensible tax statutes ¶Rotterdam IFS 1979 p.346. The alternative is to adopt the `shotgun ¶ approach of broadly drafted anti­avoidance principles; but these give officials a wide discretion, and they may be interpreted narrowly or unpredictably by courts. Hence, broad anti­avoidance rules are often supplemented by informal or semi­formal guidelines. In practice, both these approaches usually involve processes of consultation and negotiation between state officials and specialist bodies and pressure­groups of professionals, mainly lawyers and accountants This negotiation of enforcement takes place within a structure of rules combining broad standards and specific guidelines; and the legal status of such rules not only differs between different political and social systems, but in each case is itself subject to some negotiation and change. The toleration of avoidance is criticised on the grounds that opportunities for avoidance are unequal, and the avoidanceanti­avoidance game is wasteful of resources Kay 1979. In reply, the classical liberal justification is based on the freedom of individuals to plan their affairs and dispose of their assets subject only to declared law. In the tax field, this has been expressed in well­known legal dicta, such as Lord Atkins statement in Inland Revenue Commissioners v. Duke of Westminster, the locus classicus of English law on tax avoidance schemes: I do not use the word device in any sinister sense; for it has to be recognised that the subject, whether poor and humble or wealthy and noble, has the legal right so to dispose of his capital and income as to attract upon himself the least amount of tax. The only function of a court of law is to determine the legal result of his dispositions so far as they affect tax. 1936 p.8. Fundamentalist economic liberals go further and proclaim tax avoidance to be not a vice but a virtue, a blow against the tyranny of egalitarianism Shenfield 1968, p.35, and a safety­valve which liberates wealth from unproductive state uses to productive private ones Bracewell­Milnes, in IEA 1979. This argument is taken even further, to demonstrate that measures against avoidance and even evasion may be against the economic interest of the fisc itself, by inhibiting economic activity, or diverting it from channels which generate fiscal benefits e.g.paid employment and the cash economy to others outside its net, such as the subsistence household economy Bracewell­Milnes 1980, Appendix. 3.a The Business Purpose Rule. The pure liberal approach may be modified to invalidate sham transactions. However, given that economic actors are free to choose the form of their transactions, there is no objective basis for categorising any particular form as a complete sham; although it may be done on the basis of an evaluation of the subjective factors of motive. Hence, the focus is normally on transactions which may be regarded as `artificial ¶ based on the criterion of legitimate business or economic purpose. This remains a modification rather than an abandonment of the liberal approach. Certainly, some have argued that the adoption of a substance­over­form approach undermines the requirements of certainty and predictability which are the basic requirements of a liberal system. However, this assumes that formal rules can be defined by reference to conditions which are entirely factual or objectively determinable. Even in the case of facilitative private law rules which regulate transactions between legal subjects inter se this is often impossible, and formally realizable rules are replaced or supplemented by less precise standards good faith, foreseeability, reasonableness etc.. 1 In the case of rules imposing burdens or granting benefits as a consequence of specified transactions normally the case with tax rules, the preference that legal subjects should be free to choose the form of their transactions contradicts the priority of formalism. Indeed, a tax code which attempts to rely only on specific and formal rules is likely to be so often amended as to become a minefield rather than a field of fair play for taxpayers and the fisc. Hence, the business purpose rule has been defended on the grounds that with such a general backstop `statutory safeguards need not be provided every time an ingenious taxpayer or his adviser thinks he sees a way to manipulate statutory language in a manner foreign to the purpose of the provision ¶ Surrey 1969, p 694. In fact, the modification introduced by a business purpose requirement may be hard 1 For a fuller discussion see D. Kennedy 1976, M. Kelman 1987, Chapter 1. Kennedys argument links the choice between broad standards and specific rules to a broad difference in political vision between altruism =standards and individualism =rules. Kelman prefers to regard this as a general cultural connection rather than a predictive or causal link, and stresses that in specific controversies both these DSSURDFKHVDVZHOODVLQWHUPHGLDU\SRVLWLRQVCXQFRPIRUWDEO\FRH[LVW¶DOWKRXJKKHH[SORUHVWKHLU interaction, he still seems to agree broadly with Kennedys view that they express competing visions. In my view, it is necessary to go further and explore the interaction of rules and standards, which generally exist in combination in the regulatory systems of advanced capitalist society, although their different combinations in different societies and contexts reflect differences in political culture and social relations more generally. to spot. For example, a dictum which is quoted even more often than that of Lord Atkin above, is the statement of Lord Clyde: 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 ¶Ayrshire Pullman Motor Services Ritchie v I.R.C. 1929, p.763. At about the same time, an even more famous American judge, Learned Hand, made an apparently very similar statement: Anyone may so arrange his affairs that his taxes will be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase ones taxes Helvering v Gregory 1934, p. 810. Indeed, statements to this effect proliferate in tax court decisions everywhere. However, Learned Hands dictum in Gregory was part of a seminal judgment which established the `business purpose ¶ rule in American law. In his view, the `choice¶ which was permitted was between transactions which each have a business or economic purpose; given such a choice, it is legitimate to select the most tax­efficient one. This draws a distinction between transactions which have a valid business purpose, and those which are artificially designed merely to avoid tax; or, even more extreme, purely sham transactions. This introduction of a business purpose criterion was not clarified until much later in British law. British judges have been reluctant to develop a general business purpose rule, but they have been more willing to try to develop criteria to single out the `unacceptable ¶tax planning industry. It took indeed more than half a century for a general rule similar to that in Helvering v. Gregory to be approved in Britain, in Ramsay v IRC 1982, and Furniss v Dawson 1984; see Millett 1986; Tiley 1987, 1988. The court decisions were the final battle in a protracted war initiated by the Revenue against the sale of off­the­peg tax schemes in the 1970s, especially through the Rossminster group Tutt 1985. These decisions caused a considerable stir; but in the event it seems to have been limited to the `step­transaction ¶ rule. This is that intermediate steps in a chain of preordained transactions may be disregarded, or the entire chain treated as a single act, if the steps were evidently designed to produce a result which if directly carried out would have attracted tax. 1 On the other hand, the US courts have gone beyond the business purpose rule and adopted a more general substance­over­form approach. However, the difference in approach can be traced to differences in the role of courts and their relationship to the legislature, as well as to wider political and social factors see Tiley 1987, 1988. In particular, under the British parliamentary system the Inland Revenue can normally 1 Craven v White, IRC v Bowater Property, Baylis v. Gregory 1989; there remains some GLVDJUHHPHQWDPRQJWKHMXGJHVDVWRZKDWFRQVWLWXWHVDCSUHRUGDLQHG¶series of transactions. be sure that its proposals will be enacted, provided it can satisfy the Treasury and the Chancellor of the need to block a loophole Stopforth 1987, as well as overcoming the technical and political arguments put up by tax specialists during the pre­ legislative consultation process, which has become increasingly important. This leads to more specific and statute­based anti­avoidance rules. Thus, a more specific business purpose rule has been embodied in a number of legislative anti­avoidance provisions, where tax consequences are deemed to flow from certain artificial transactions unless the taxpayer can show a valid business purpose other than reduction of tax liability. This is the principle used for example in the provisions against the use of overseas trusts or companies to shelter private income now s.739 ICTA 1988; see Chapter 5 below. 3.b General Statutory Anti­Avoidance Rules Other common­law countries have longer involvement with general anti­avoidance rules, notably Australia and New Zealand, which have also given British judges hearing cases on appeal to the Privy Council some experience of their interpretation. The original very broad provisions 1 merely laid down that any contract, agreement or arrangement should be `absolutely void ¶in so far as it had the `purpose or effect ¶of in any way directly or indirectly altering, relieving or defeating any income tax liability or preventing the operation of the statute in any respect. Not surprisingly, the criterion of the `purpose or effect ¶of the arrangement was held to be not the subjective motive of the taxpayer but an objective `predicate ¶test: [Y]ou ..must be able to predicate ­ by looking at the overt acts by which it was implemented ­ that it was implemented in that particular way so as to avoid tax. If you cannot so predicate but have to acknowledge that the transactions are capable of explanation by reference to ordinary business or family dealing without necessarily being labelled as a means to avoid tax then the arrangement does not come within the section. Lord Denning in Newton v. Commr. of Taxation [1958] 2 All E.R. 759 P.C., at p.765. The importance of the word `necessarily ¶was emphasised in a later case: If a bona fide transaction can be carried through in two ways, one involving less liability to tax than the other, the ... transaction [cannot be declared] wholly or partly void merely because the way involving less tax is chosen ¶ Lord Donovan, in Mangin v. IRC 1971, p.751. Indeed, in C.I.R. v Challenge Corp., Lord Templeman went even further and, citing the Duke of Westminster case with approval, argued that there is no avoidance in the 1 For a history of the provisions, originating in New Zealands Land Tax Act 1878 and included in its first income tax statute of 1891, see Mangin v. Inland Revenue Commr. 1971; the most recent versions were, in Australia s.260 of the Income Tax Assessment Act 1936, replaced by Part IVA of the Income Tax Assessment Act in effect from 28 May 1981; and in New Zealand s.108 of the Land and Income Tax Act of 1954, replaced by s.99 of the Income Tax Act 1976. case of tax `mitigation ¶ that is to say where the tax advantage comes from a reduction of income or the incurring of an expenditure 1987, p.167; but it is not yet clear whether this view will gain more general acceptance. 1 The later versions of these provisions laid down that the section applied even if there is a valid business purpose, provided the tax avoidance purpose is more than merely incidental. Also, quite importantly, they empowered the Commissioner to intervene to restructure the transaction so as to counteract the tax advantage. This meant both that an invalid transaction is not necessarily `annihilated ¶which might have equally bad consequences for the revenue; but also that, unless the tax authorities do invoke the section, the transactions will be undisturbed. 2 Hence, a general statutory anti­ avoidance provision of the shotgun or blunderbuss type also operates mainly as as a threat to wholesale or unwary avoidance, but will not pose any real danger to careful tax planning. Where the tax authorities are given powers to restructure transactions which might be considered artificial, they are given a basis for negotiation with the taxpayers advisers, which helps to entrench the function of tax planning, although within the limits of acceptability set by the negotiations with state officials. 3.c Abuse of Legal Forms In civil law systems systems, there is the same ambivalence. Most have a concept of `abuse of rights ¶ in private law, either embodied in the Civil Code or developed jurisprudentially. However, there has been some reluctance to apply the doctrine in relation to taxation, although this has occurred in some countries in the modified form of `fraude a la loi ¶ either jurisprudentially or in the Tax Code. The taxpayer is considered to have the right to arrange her affairs in the way that is most advantageous to her, but this right must not be `abused ¶by the concealment of the economic reality of a transaction by use of legal forms. Thus, in France the principle of abuse of rights has been explicitly enacted in the Tax Code Art. L64 of the Book of Fiscal Procedures, but it does not prevent the taxpayer from choosing an optimal tax route from among alternative legal forms for a transaction, and the administration must prove both the intention to avoid tax and the artificiality of the form chosen Tixier and Gest 1985, p.414. In Belgium, the courts have refused to apply the doctrine to taxation, but have more recently been willing on occasion to disregard CVKDP¶ transactions used for tax avoidance. Sweden has not applied the abuse of rights principle, but enacted a statutory anti­avoidance provision in 1981. On the other hand, Switzerland has both a well developed general principle authorising an economic approach, as well as specific legislative provisions, in particular a 1962 decree against the improper use of tax treaties. Substantially similar 1 New Zealands Commissioner of Inland Revenue issued a statement to clarify enforcement of s.99 following the Challenge decision: see 1990 44 Bulletin of International Fiscal Documentation 288 and A.M.C. Smith 1991. 2 For a comparison of the New Zealand and Australian provisions with the rule newly enacted in Singapore, as well as the Hong Kong provisions, see Liang 1989. are the Dutch principle of `fraus legis ¶, and the German rule on `abuse of forms and VWUXFWXUHVRIWKHFLYLOODZ¶ 1 3.d Tax Planning In effect, while the `business purpose ¶ rule combats crude artificial avoidance schemes, it authorises tax planning. Professional tax planning is generally able to establish a pattern of legitimate business activity which optimises tax payments from the taxpayers viewpoint. If a companys new investment may be financed in a number of different ways, is it not reasonable to choose the most tax­efficient? And how can the relative importance of the tax factor be judged? If the criterion of `purpose ¶ slides into the subjectivity of `motive¶, legitimacy is threatened: the validity of a transaction cannot depend on the state of mind of the citizen. 2 Hence, the business purpose test tends to outlaw only the most `weird and wonderful ¶schemes, which might not even stand up to rigorous technical scrutiny Millett 1986. Nevertheless, it introduces into the law a terrain that must be contested, since a transaction might be required to have a demonstrably valid purpose, beyond its purely formal legal validity. This contest is in terms of the interrelated elements of economics, politics, and morality. These factors are not normally directly invoked, but are embedded in the process of legal reasoning, the application of the general principles of law to the `facts ¶of a case, whether this is done by legal advisers evaluating the validity of a proposed strategy, or by an adjudicating tribunal. It is by this process that the formal requirements of abstract legal principles are applied to the substance of actual social and economic transactions to determine their acceptability Tiley 1988. 3 1 Section 6 of the Steueranpassungsgesetz, later modified in section 42 of the 1977 Abgabenordnung. See generally Avery Jones 1974; International Fiscal Association 1983; Rotterdam IFS 1979; Ward et al 1985. 2 7KXVWKHULWLVKRXUWRISSHDOKDVUHFHQWO\UHFRPPHQGHGDCEDODQFLQJWHVW¶WRGHFLGHZKHWKHUWKH transaction was a commercial one in a fiscally advantageous form, or was entered into essentially for fiscal purposes but under the guise of a commercial transaction; the test should be an objective one, but subjective evidence of motive might be relevant: Stokes v. Ensign Tankers Leasing Ltd. 1991. 3 It should be clear from my argument that I do not consider that law is a self­contained and self­ referential body of rules, as claimed by the traditional positivists such as Austin and Hart, or, subject apparently to more complex mediations, by the newer ones such as Luhmann and Teubner. This does not mean, however, that it is either a mechanism manipulated in class interests, as suggested by some crude versions of Marxism, or consisting of radically indeterminate concepts which leave scope for arbitrary interpretation, as suggested by some critical legal scholars see the survey and critique by Kelman 1987. My stance is that the forms taken by legal rules result from the more general forms of social relations, autonomized by a historical process of abstraction; in particular, in capitalist societies based on generalised commodity production and market relations, law mediates the relationships of economic subjects, subject to the permeating authority of the state: see Picciotto 1979. The interpretation and application of legal concepts is, therefore, also a social process, institutionally autonomized, but also part of the social whole, and in which economic and political ideologies play a part. Nevertheless, this normally takes place within the same broadly liberal assumptions embedded in legal formalism. In evaluating the economic value of a transaction in liberal terms, the question is whether the economic transaction in the form chosen by the taxpayer is a `normal ¶ one, since the business purpose rule assumes that a transaction which could take place by a `normal ¶ route is diverted to an artificial one. However, strict limits can be imposed on this by the pure liberal argument that it is more beneficial to allow a transaction to take place even in a form which avoids tax, if the alternative is that it might not take place at all. This assumes that economic actors may be seen as having a range of possibilities open to them, including refraining from activity, or choosing to undertake such activity in a sphere beyond the reach of the fisc such as the household economy, or a foreign jurisdiction. If the decision to undertake the activity is based on a calculation which assumes a tax­efficient route, it is difficult to conclude that tax­avoidance is the dominant or exclusive purpose. This argument can be taken further in the fundamentalist liberal direction mentioned earlier. This denies the right of the state to challenge the economic actors choice of transactions. High rates of tax, in particular, can be said to inhibit activity which could generate a larger tax base; and it has even been argued that, paradoxically, measures against both evasion and avoidance can result in a reduction of state revenues Bracewell­Milnes 1980. This perspective essentially assumes that private transactions are more beneficial to the economy as a whole than activities funded, organised or stimulated by state finance. However, not all adjudicators accept this view of the economic desirability of private transactions. The political validity of a tax avoidance transaction is normally expressed as depending on whether it conforms to the spirit of the law. Hence, it is not only the intention of the taxpayer, but also that of the legislator which is relevant. This is the problem of `loopholes ¶in the law. To the tax official, the taxpayer may only validly make a choice which reduces tax liability if the legislator intended to allow that choice. In this view, tax reduction is limited to explicit tax incentives or disincentives ­ for example, choosing not to smoke cigarettes, or deciding to invest in a development area for which a tax incentive has been provided. As the OECDs Fiscal Committee rather frankly put it: `governments tend to take an operational approach towards tax avoidance to cover those forms of tax minimization which are unacceptable to governments ¶OECD 1987A­I, p.8. This can clearly be criticised as `Tax avoidance is what the fisc says it is, without WKH DSSOLFDWLRQ RI OHJDO WHVWV¶ Bracewell­Milnes 1980, p.18. However, the regulatory net cannot be infinitely stretched ­ or again legitimacy would be threatened. The law enforcer must consider, first whether a new pattern of activity may be tolerated; this is frequently the subject of negotiation, which might result in adaptation or modification. If the activity is considered unacceptable, a decision must be made whether to proceed against it under existing legal provisions, or to seek approval for legislative amendments. 1 The morality of transactions is often ringingly said to be quite irrelevant to their legal validity. In practice, however, the impossibility of deciding these issues of validity in purely formal legal terms inevitably raises ethical or moral issues. Most commonly, the form it takes is the requirement of openness or frankness. The taxpayer who has laid out the transactions without secrecy or any element of deceit is more likely to gain the approval both of the official and the judge. Since tax planning strategies are developed in consultation between the managers of a business and its professional advisers, considerations of professional ethics in the giving of advice also play an important part. These entail balancing the professionals duty to produce the most economical result for the client against the more general obligation to ensure that accounting and taxation regulatory systems operate fairly for all, and perhaps even in the interests of society. 2 In broad terms, therefore, the three principles on which the validity of tax avoidance rests may be summarised as follows: i the existence of a valid economic or business purpose; ii compliance with both the letter and, broadly speaking, the spirit of the law; iii openness, or at least lack of excessive secrecy. These criteria may be identified both in the advice of tax planners see e.g. Freeman and Kirchner 1945, as well as statements by officials or policy­makers see e.g. OECD 1987­A, p.9.

4. International Investment and Tax Avoidance.