I The Legal Regulation of Economic Relations

4. I

NTERNATIONAL T AX A VOIDANCE The first three chapters of this book focussed on the way that the international tax system developed as a result of multiple, related policy initiatives by different national states, as well as international negotiation and compromise between states. It is crucial to recognise, however, that an important part was also played by initiatives taken by taxpayers themselves, in particular the major international corporations and their advisors. Indeed, as has already been pointed out Chapter 3 section 1 above, the emergence of international tax planning attempted to resolve some of the problems caused by the failure to agree international principles of tax equity or effective arrangements for the allocation of tax jurisdiction. International tax planning emerged within a process of bargaining and negotiation between specialist consultants and the tax officials of the main capitalist countries, and this process has essentially reinforced the international tax arrangements, based largely on national equity and bilateral treaties, to which both private consultants and government officials have become increasingly committed. However, the increasingly widespread availability of access to the mechanisms of international tax avoidance, as well as the increasing complexity of the arrangements for allocating international income and expense in the absence of internationally­agreed principles and criteria, have put the international tax system under increasing strain. This will be discussed in detail in the following chapters. A necessary first step, taken in this chapter, is the analysis of the dynamics of taxation as a process of economic regulation, focussing on the problem of avoidance.

1. The Legal Regulation of Economic Relations

Taxation, like any type of economic regulation, must be seen not merely as a series of more or less functional decisions by the state and its officials, but as a dynamic and in many ways contradictory process. Business taxation, in particular, is a process primarily of negotiation between tax officials and corporate managers and advisors. The officials, usually structured in a hierarchic bureaucracy, have the important advantage of access to state power: they can order an audit, issue an assessment to tax, publish regulations and statements of practice, or resort to the courts or legislature to clarify or amend the law. Recourse either to legal adjudication or legislative intervention depends not only on technical legal issues such as the interpretation of statute or the logic of case­law, but a variety of other factors. These, which may be referred to as the cultural elements in a legaladministrative process, include the social backgrounds and relationships of the actors, general social attitudes including moral and political considerations, as well as more immediate questions such as the resources of time, people and skills which the parties might reasonably make available. The greater resources which they can apply give businesses, especially the largest corporations, a considerable advantage over state administrators: not only can they devote more people and time to tax planning, they can also pay salaries which in most countries ensure that the best tax inspectors often become corporate tax consultants. Most important, tax planning gives the business taxpayer a power of initiative which means that the tax gatherer is responding after the event. On the other hand, tax officials generally have very broad powers to disallow claims which can reverse these advantages by putting the taxpayer very much on the defensive. Not all taxpayers are able or willing to divert substantial resources from their actual business to tax planning; and a system that allows too free a rein to such planning undermines equity as well as wasting resources. Studies of the process of legal regulation tend to separate consideration of the social factors or `context ¶from any analysis of the legal concepts or rules themselves. Thus, `socio­legal studies ¶ focus on the extra­legal factors, the relations of economic or social power that influence the way in which the legal process `really ¶works law­in­ action as against the law­in­the­books; while the economic analysis of law applies techniques of neo­classical economics to evaluate the efficiency of legal rules. For these approaches, the legal rules themselves are a given, and the nature of legal reasoning is an external and normally unproblematic question. On the other hand, jurists who focus on the legal rules tend to adopt a functionalist view of legal reasoning, which may be rationalist or anti­rationalist. Rationalism is the stance of legal positivism. In traditional positivism, legal reasoning is accepted as a process of inductive­deductive logic, consisting of applying rules to `facts ¶ thus combining legal with sociological positivism; the same fact­value dichotomy holds where, especially in common­law systems, rules are not only formulated by statute or code but also emerge inductively, by comparing and distinguishing decisions in previous similar fact­situations. In more modern versions of legal positivism, legal reasoning and the development of legal principles are celebrated as a self­reproducing system, whose character and links with the social system result from historical constitutive moments; this allows for a more elaborate historical explanation of the social origins of law, but the sphere of the social and the sphere of law are still seen as essentially separate and autonomous. Positivism is rationalist, in that it emphasises the inner logic of the rules and concepts themselves: legal reasoning is a craft, consisting either of choosing, applying and adapting rules that best fit the `facts ¶in the blunt pragmatism especially of British legal positivism, or teasing out and fashioning principles that can make an elegant or functional system. Equally functionalist are the various perspectives that emphasise that the process of application, interpretation and development of rules is not driven by the inner logic of the rules themselves, but by `external ¶ social factors. These include many types of legal realism, policy­oriented functionalism, and structuralist Marxism. In reaction to rationalism, postmodern approaches seek to deconstruct the concepts wielded by lawyers, as essentially ideological constructs; but seeking to avoid functionalism they fall into an anti­rationalist view that stresses the radical indeterminacy of rules. What is needed is a social theory of law itself, which can theorise the historical development of forms of regulation, including specific legal principles and their application, as a social process. This section deals briefly with the contradictions and dynamics of taxation as a mode of economic regulation in capitalist or market­ economy societies, before going on to consider tax avoidance, and specifically its international dimension. 1.a Liberal Forms and their Limits The form of state regulation which most closely corresponds to a fully developed market­economy society is liberal regulation. Liberal forms of regulation require the maximum freedom for social actors to engage in economic transactions, within a framework of fixed and settled laws which enable them to choose and plan their transactions. Law enforcement is indirect, relying primarily on voluntary compliance, supplemented by inducements, or post facto sanctions on detected lawbreaking. Pure liberalism requires a radical separation of legal form and economic substance. Laws must be addressed to the generality of legal subjects, without distinction as to their social or economic position. The processes of legal regulation of economic relations are therefore essentially structured by markets and competition. The regulators, on behalf of the state, enforce the laws and seek to implement and develop policy, while the economic actors whose activities are regulated are free to choose and adapt their transactions. They may comply with or breach the law. More importantly, their actions may influence the patterns of development of legal relations as much as do the measures taken by regulators. The ways in which they modify the legal form or economic substance of their transactions might clearly frustrate the spirit of the law or the intentions of the legislators, and so lead to retaliation. Not uncommonly however, a whole new legal­economic landscape might be opened up, posing new problems for the regulator and the legislator. It was not envisaged, for example, by Senator Sherman, when steering the Anti­Trust legislation through Congress in 1890 to outlaw agreements restricting competition, that it might be a contributory factor in the great merger movement from 1897 see Lamoreaux 1985. Nor did the drafters of the English companies legislation of 1844­62 envisage that the protection of limited liability would be used extensively by private companies or even sole traders: and it was after this had become a widespread practice, and against significant judicial opposition, that the House of Lords sanctioned the sole­trader company in the famous Salomon case Ireland 1984. Thus, the legal forms devised by professionals for economic actors, using the facilitative structures of private law, make a significant contribution to the dynamics of a regulatory system McBarnet 1984. However, liberal forms have never and could never exist in a pure form. First, some element of public regulation is needed to create, establish and maintain the terms of trading on markets. Markets cannot exist without state regulation, since the state is essential to the creation and guaranteeing of the property rights that are traded. The creation of property rights is another way of saying that social relations are structured so that they are mediated by commodity exchange. Since it is the state, or public bodies generally, that govern those social relationships, state action crucially determines the terms of trading on markets. In that sense markets are never `free ¶and state regulation, including taxation, cannot be purely `neutral ¶ Hence, state intervention is essential, both historically and continually, in order to help define and delimit legitimate property rights: from the enclosures of common land to the compulsory purchase of land for roads, the granting of oil prospecting or land development rights, or the outlawing of the use of confidential price­sensitive information when trading in securities. The sale of property rights or economic privileges was historically an important source of state revenues, and continues to be so today to varying extents, quite importantly for example in oil­producing states. Such state action can create wealth for specific individuals or groups, or deprive them of it, so it is frequently discriminatory. The easiest category to discriminate against is the foreigner, and the characteristic of the mercantile state, in which state revenue is raised mainly by charging for economic privileges, is the use of tariffs or duties especially on imports. Secondly, liberal forms are continually undermined by the operation of markets and competition. They seek generally to maintain equality in the conditions of competition, and this is in the general interest of all economic actors. However, the pressures of competition continually drive those actors to seek advantage over their competitors. Indeed, competition is best thought of not as a state of equal conditions between economic rivals, but a process of equalization which creates differentiation due to the continual pressures on each actor to seek out and defend special advantages. In the economic arena, this drives firms to seek production, marketing or managerial advantages. In the political­legal arena, they seek regulatory advantages: finding and exploiting loopholes in the regulations, obtaining special treatment by the regulators, or modifying transactions to bypass the regulations. Since the process of competition itself leads to economic inequalities, it also creates political demands for state intervention to redress inequality, as well as undermining the general and nondiscriminatory characteristics of liberal forms. It becomes impractical as well as politically difficult or unethical to enforce the same laws in the same way in relation to small and big business, or the ordinary wage­earner and the very rich. Even in relation to the social treatment of individuals, laws are introduced to bring about and maintain equal treatment: politically­motivated and often contradictory attempts to use discrimination to secure substantive equal treatment. To resolve these problems, pure liberalism gives way to welfare liberalism. This entails a limited movement away from pure legal formalism, and even accepts an element of discrimination, on political or social grounds, to re­establish an adequate substantive social basis for formal equality to operate. However, the political system can become overloaded by claims for special treatment by special­interest groups. As liberal forms of regulation become undermined, they are supplemented by more direct, selective and interventionist forms. Thus, for example, the need for generally­ applicable rules for widely diverse legal subjects and social situations can lead to vagueness and lack of specificity, and can undermine fairness and predictability: this may be referred to as the problem of indeterminacy. Thus, general rules operated within a liberal­legal framework tend to be supplemented or replaced by administrative regulation by bureaucracies. These characteristically entail powers for officials to take administrative decisions on a selective basis; frequently, this is done on the basis of much more specific and detailed rule­systems. Such detailed rules may be formalised as subsidiary legislation or regulations; or, frequently, they may remain informal, either as administrative guidelines or even more informal rules of practice. In particular, in relation to economic and business regulation, the emergence of the large corporation leads to an important role for bureaucratic­ administrative negotiation and bargaining, since the size and the frequent diversity of the corporations assets and investments makes its decisions directly social ones. Bureaucratic­administrative regulation does not supplant, but significantly modifies liberal regulation. While it is more explicit about the substantive content of rules than liberal forms which strive for neutrality, it raises new problems of fairness and the control of discretion. 1.b Fairness, Efficiency and Legitimacy in Taxation State taxation begins from the primary purpose of raising money for the treasury. In that sense, it always involves a political choice which affects differently specific individuals or groups, i.e. a collective decision to deprive some of wealth for the benefit of others or for the common good. However, in a society where market relations are dominant, the dominant considerations are those of liberalism: that the tax burden should fall equally on all and that its enforcement should interfere as little as possible with private economic activity. These were classically expressed in Adam Smiths four canons of taxation: equality, certainty, convenience and economy. 1 The very notion of equality, however, is clearly problematic, since it involves attempting to treat as equal legal subjects social actors who may be economically quite unequal. Smiths general notion was that citizens should contribute to the treasury in proportion to the revenues they enjoy under the protection of the state. His principle therefore favoured the direct taxation of the incomes of all citizens, rather than specific levies such as stamp duties or window­tax, which were unrelated to ability to pay. Yet even the single uniform rate of income­tax which applied in Britain during the 19th century although only to a relatively small minority was much resented and evaded. As the scope of the income tax grew in the 20th century, the question of proportionality came to the fore. The principle of equality gave no clear guidance in relation to the two main issues which arose as the income tax became a mass tax: the threshold of taxable income, and the progressivity of tax rates. The principle of ability to pay and the view that a uniform rate bears unfairly on those with middle and low incomes justifies progressively higher rates on higher bands of income, sometimes referred to as `v HUWLFDO¶ DV DJDLQVW CKRUL]RQWDO¶ equity; those favouring the `free ¶ operation of markets prefer a uniform percentage rate on incomes. 2 The introduction of progressive rates has resulted historically from fierce political debates and, usually, wartime emergency; and high rates on high wealth have been denounced as confiscatory. Most recently, in the 1980s, high marginal rates have been attacked as a major cause of tax avoidance and evasion IEA 1979. Meanwhile, the acceptance of income tax as a mass tax has turned debate about the threshold to one about the `poverty trap ¶ The question of equal treatment, or equity, also arises in relation to the economic efficiency of taxation. In principle, efficiency requires the optimal allocation of resources, and therefore tax neutrality ­ the incidence of taxation should as far as possible be equal in relation to the alternative choices available to economic actors. For some, this can justify the use of taxes by the state for raising finance for general 1 Wealth of Nations, Book IV, Ch.II, Part II. 2 Musgrave Musgrave 1984 Chapter 11 discuss the various views of political philosophers and economists. social purposes and redistribution. For others, efficiency can only be assured by the private transactions of economic actors through the market, hence the state is always an obstacle. Whether from the perspective of fairness or efficiency, the major difficulty in ensuring the equal incidence of income taxation is the treatment of income from different sources. Should the same rates apply to the wage­earner and the rentier? Should business or corporate profits be treated as income and taxed on the same principles as individual income, so that the sole trader, the partnership and the company are taxed in the same way? Is there a clear and valid distinction between income and capital gain? Underlying all these questions is the definition of income itself, the tax base, which is at the heart of the operation of direct taxes. It is also at the heart of the problem of avoidance. Taxation is not an abstract exercise in political or economic philosophy, but a practical matter of raising state finance for the public good. The overriding aim is therefore effectiveness, which must be predicted, based on estimations of the patterns of compliance, non­compliance and avoidance. It is in this sense that the question of legitimacy is central to the evaluation of taxation, as well as other types of legal regulation of economic activity. Legitimacy in this sense combines the interrelated issues of equity and effectiveness. To the extent that a regulatory system lacks fairness it fails in political acceptability, and will also tend to fail in effectiveness as enforcement becomes difficult and noncompliance grows. Equally, a system which has problems of enforceability and therefore of effectiveness will tend to lose political acceptability.

2. Taxation of Revenues and Opportunities for Avoidance