Capital in the Twenty First Century. And Tax.

Because something is happening here, but you don’t know what it is, do you, Mister Jones?

– Ballad of a Thin Man, Highway Revisited, 1965

Qui dit étude dit travail,

Qui dit taf te dit les thunes,

Qui dit argent dit dépenses,

Qui dit crédit dit créance,

Qui dit dette te dit huissier…

Alors on sort pour oublier tous les problèmes.

– Alors On Dance, 2010

The current dialogue on capital

A sign of the earnestness with which the issue of global concentration of wealth has now been recognized is the fact that the movement, which rose to headlines in the form of the Occupy protests in Zuccotti Park in 2011, has now culminated in a conference hosted and attended by the economic, political and business luminaries of the world. I am referring to the conference which was held in London in May 2014 by the Inclusive Capital Initiative, a non-profit organization. Keynote speakers included HRH Prince Charles, Christine Lagard and Bill Clinton. The ICI website states that Inclusive Capitalism is committed to fixing the ‘broken escalator’ in the economist Larry Katz’s metaphor. Larry Katz’s metaphor is as follows:

Think of the American economy as a large apartment block. A century ago – even 30 years ago – it was the object of envy. But in the last generation its character has changed. The penthouses at the top keep getting larger and larger. The apartments in the middle are feeling more and more squeezed and the basement has flooded. To round it off, the elevator is no longer working. That broken elevator is what gets people down the most.

The topic of the viability of capitalism has been on the agenda over the last few years. Waves in the publishing world were made recently and notably by the publication in English of the French economist, Thomas Piketty’s book, Capital in the Twenty First Century and its runaway success. Piketty researches the dynamics of capital and income, focusing mostly on historical data from Britain and France. Of particular interest to me were the chapters on the inefficacy of the tax codes in addressing this imbalance. Piketty’s theses resonated so much with me that they inspire this piece and undergird many of the points made here.

I write now with two audiences in mind and with the aspiration of bringing them together. First, I write with the view to bringing to the wider economic dialogue the perspective of someone who has practiced UK tax law for a period approaching 10 years. Journalists and economists – Piketty included – discuss tax primarily by reference to the headline grabbing rates and thresholds. The purpose of this article is to cast some sort of light upon the more impermeable recesses of the UK tax code and demonstrate how these contribute just as much to the phenomenon of Katz’s ‘broken elevator’ as do rates and thresholds. Second, as someone who in the course of his practice has often represented the interests of what is called ‘Middle England’, it appears to me that the ideas raised in Piketty’s book demand consideration by stakeholders in the tax field – the legislator of the UK tax code, tax practitioners and the wider public. The current debate on tax avoidance acquires an altogether different complexion when one takes into account the implications of the rising accumulation of capital in the hands of the top centile.

Any views expressed here are my own. Insofar as it might be relevant, I am only accidentally political, the accident being my vocation. Nor am I an economist. I am also aware of the detractors of Piketty’s book and other controversies. For instance, I note how Piketty himself has warned of the dangers to jobs of minimum wages being introduced in Seattle. Mervyn King objects to Piketty viewing the period from 1910 to 1970 as exceptional and not reflecting the evolution of wealth in a normal capitalist society. He also highlights that the share of the top one per cent is markedly lower than it was two hundred years ago (as Piketty accepts). Mervyn King notes how the risk premium, which constitutes a large part of the return on capital, reflects the uncertainty as to the recurrence of major shocks to which capital is vulnerable. By contrast, Piketty argues that the commonly used definition of growth rates do not account for capital depreciation and demographic factors such as increasing population. However, this ought not to detract from the book as much as it constitutes a snapshot of the current state of affairs. At the ICI conference, Christine Lagard gave the following statistic:

The 85 richest people in the world, who could fit into a single London double-decker, control as much wealth as the poorest half of the global population– that is 3.5 billion people.

Nor do they undermine my criticism of the particular central feature of our tax system which I highlight here.

Tax and capital: Imagine a Robin Hood who gives to the least well off – but only takes from the middle.

I only began to seriously think about the relationship between tax policy and capital a few months ago as I sat at the back of a taxi on the way home from dinner.

A member of a political party had that day made some comments in PMQs about the ‘Tories’ millionaires tax cuts’, referring to the reduction from the 50% to the 45% additional tax rate. I can’t remember how the driver and I jovially made the faux pas of getting on to this topic but I made comments to the effect that the tax reduction wasn’t a cut for millionaires. The driver didn’t agree – in his mind, the dichotomy was between people who earned in the tens of thousands and those who earned in the hundreds of thousands, with the latter category comprising ‘millionaires’. This came somewhat as a surprise to me, I had taken it for granted that everyone appreciated the difference between wealth and income. It appeared not to have occurred to my driver that to become a millionaire with earnings of £150,000 a year, one would have to work for more than 6 years, this assuming that one did not pay any taxes and saved the entirety of their income. To be fair, one cannot fault my cabbie – he was taking his cue from the political leadership.

I began to ponder over this matter and the more I did so, it seemed to me that tax – or at least, the tax system that we have here in the UK – has the effect of pitting earners in one income tax bracket against others, but very little consideration is given to capital at all. As Piketty states:

If the capital-labor split gives rise to so many conflicts, it is due first and foremost to the extreme concentration of capital. Inequality of wealth – and of the consequent income from capital – is in fact always much greater than inequality of income from labour.

He maintains that the real disparities in society arise from differences in capital. I understand this not to be contentious.

At the same time, many in society – my cabbie and the said political leader among others – appear preoccupied with inequalities in earnings. In the case of the politician, to be fair, he was clearly in his speech employing a populist, if rebarbative, manner of attacking the tax cuts.

Moving away from public perceptions, I began to ask myself whether the legislator of the UK tax code demonstrates some cognizance of this economic truth. When one gets round to asking the question, the answer is one which comes readily to all tax practitioners. Ours is a system which is fixated on income. Indeed, if there is any tax with which the legislator is particularly interested, it is employment income. The particular code which governs the taxation of employment income (known as the ‘Income Tax Earnings and Pensions Act 2003’ or ITEPA) is the longest and most prescriptive of all. The legislator is extremely concerned to ensure that should one earn remuneration through their employment, then there ought not to be any benefit accruing to him at all which remains untaxed. This seems a highly reasonable aspiration at first glance. Though when the stringent manner of execution is considered and when a comparison is then made with the treatment of capital, a very different picture emerges.

How we treat our workers…

Whilst rates grab headlines, the challenges which our tax system poses to our workers are often found in those rules which receive lesser or no coverage in the press. I only here mention a few examples.

A few months ago I was consulted by trainee GPs who had been denied deductions for the cost of GP examinations. The cost of these examinations was in the region of £2,000 (around the monthly wage of trainee GPs) and most trainees had to sit them a couple of times before they passed, very much in the manner of the driving license tests. The reason the costs of the examinations were not deductible was because the particular statute allows only a deduction of those expenses which are ‘necessarily incurred in the performance of the duties’. Since the examinations were viewed simply as a prerequisite to there being any duties in the first place, any sums expended towards them were not deductible.

Another instance which comes to mind is the case of Mallelieu v Drummond 57 TC 330, a case from 1983 which remains legally binding to this day. The case involved a lady barrister who expended sums towards acquiring black dresses, suits, tights and shoes, and white shirts or blouses in accordance with Bar requirements. (More accurately, the sums were expended towards maintaining and replacing such clothes, as the initial cost, being a capital cost would not have qualified for a deduction in any event). HMRC, or the Inland Revenue as it then was, disallowed the deductions on the basis that these had not been incurred wholly and exclusively for the purposes of her profession. On appeal, the Tribunal agreed. It held that her purpose in making that expenditure was not only to enable her to earn profits in her profession but also to enable her to be properly clothed during the time she was on her way to Chambers or to court – or, as counsel for HMRC put it, for her ‘warmth and decency’. The High Court allowed the taxpayer’s appeal and the Court of Appeal agreed. However, when the matter eventually came before the House of Lords, it decided against deductions. Lord Brightman stated:

But she needed clothes to travel to work and clothes to wear at work, and I think it is inescapable that one object, though not a conscious motive, was the provision of the clothing that she needed as a human being…

I regret that their Lordships were not able to find more purposive a construction of the statutory rule. Could they not have taken it for a given – given the particular socio-cultural context in which the expenses were borne – that the taxpayer would have worn clothes for the purposes of warmth and decency and then arrived at the conclusion that the expenses borne in respect to these particular items of clothing were for the purposes of her profession? In our northerly jurisdiction, very little is done which does not involve considerations of warmth.

One cannot help but feel that whilst, when it comes to tackling tax avoidance, the emphasis remains at all times on overlooking the form of the transaction to arrive at the economic substance of it, when it comes to quotidian payments incurred by everyday people and which would be accepted by most economists as business expenses, an altogether different rule applies. One begins here to acquire a greater appreciation of Larry Katz’s ‘squeezed middle’.

For a much lesser known instance, I cite the decision in Flanagan v HMRC TC02161. An employee of a bank took out a mortgage from his employer. The rates of interest were commercial, those at which the bank would have lent to the public at large. There is a rule in the said ITEPA which stipulates that when an employee receives a loan from his employer and interest is paid at less than the prescribed HMRC official rates (as was the case here), then he is deemed to receive a benefit equal to that difference. Employment income tax is then levied on that benefit. The tribunal therefore held that the employee taxpayer was liable to tax on this basis. This even though the tribunal readily accepted that the stipulated official rates may be higher than the rates at which loans may be commercially available to the public at large.

Flanagan leads me to the last of the points I would like to raise in the context of employment income planning, though it is a broad one. One might well understand how a government would wish to tax a benefit (such as a loan on beneficial terms) from an employer to an employee which constitutes remuneration to the employee for his services. However, in Flanagan, the taxpayer simply happened to be an employee of the bank, which provided loans to the public at large. The purported benefit was never intended to constitute remuneration to the employee for his services. The problem arose because ITEPA assumes that a loan made from an employer to an employee is always made in connection with the employment. The tax code is peppered with assumptions of causation such as this. These many legislative assumptions contained in ITEPA, made without any opportunity of rebuttal, bar the taxpayer from being able to demonstrate his facts and place reliance on them. So keen is the legislator to prevent any benefit from slipping through the tax net, that he appears not to care that the predicated facts on which the tax is charged bear little semblance to the truth.

One of the most egregious forms of legislative deeming at present occurs in the context of self-employed workers or contractors. ITEPA contains a raft of measures which deem contractors to be employees. The tax and National Insurance position of workers and of the persons who engage their services is beneficial where the worker is self-employed rather than employed. It follows therefore that the government is concerned to discourage parties from arranging their affairs so that there is no employment. What is neglected in the course of this deeming of contractors as employees, however, is that there is a fundamental difference – well recognised both as a matter of general law and economics – between employment and self-employment. A contractor is more akin to an entrepreneur, has a greater degree of freedom and, for instance, is often likely to have ownership of intellectual property developed by himself. On the other hand, he will have none of the security and concomitant rights (such as employment pension rights – an area which has seen major recent changes in favour of employees) that come with employment. What has been held to be especially objectionable about the law in this area is not only that it seeks to tax contractors as though they were employees, it refrains from going that one step further and deeming them to be employees for the purposes of general law and, in particular, employment law. So, a contractor is left both burdened with the detriments of employment as far as tax is concerned and exposed to the vagaries of self-employment in almost every other sense. This is unfair.

Equally objectionable is the fact that the law has been introduced in the name of ‘False Self-Employment’. This stigmatises self-employment and confuses the debate. As the test which has been set by the courts as to whether or not there is employment is comprehensive and substantive, there can be no such thing as ‘false employment’, a formal shift in the drafting of the contract itself does not preclude there from being employment.

And how we treat capital…

So far, I have solely discussed the tax treatment of earners. The position is aggravated when we stand back and consider the wider arena and, in particular, asking the question: what taxes are imposed by reference to the entirety of the capital of the taxpayer?

For most purposes – and, in particular, those of raising revenue – there is none.

The closest is IHT, which is sometimes described as a ‘voluntary’ tax. This view stems from the relatively low takings, which amount to only slightly over £3 billion. The truth is that the tax is better described as a manageable tax, which allows for planning under the auspices of the legislator, such as through lifetime giving. Piketty argues that lifetime giving is more commonplace than is thought. (During the period from 1820 to 1870, the total annual value of gifts was 30 to 40% of the annual value of inheritances – these gifts mostly taking the form of dowries and other gifts on marriage. In Britain lifetime gifts have remained stable at 10% of the inheritance since the 1970s whereas in France and Germany they have increased to 60% to 80% of the total. He concedes that there may be a statistical bias and for my part, I wonder whether forced heirship laws in certain countries have some effect here on the extent to which record-keeping extends to lifetime gifts in these countries). There are two points to be made here. First, the making of lifetime gifts is made easier the more capital one has. Second, the same is true for the obtaining of legal advice. Manageable taxes are especially resented by the wider public on account of their supposedly indirect regressive nature – as in the case of expense deductions, this too is something which is not discussed as much by economists. It is interesting to note that almost whenever participants in television and radio debates complain about tax avoidance, it is more to do with the fact that wealthier individuals have access to legal advisors. In other words, it is not so much the case that others are ‘avoiding’ tax, it is more the case that others are able to pursue a route which is not seen as open to them. In actuality, neither of these two hindrances ought to constitute a bar to effective tax planning. An advisor’s fees are unlikely to constitute more than a small fraction of the inheritance tax savings (even for the more average-sized estate). And the inheritance tax code contains various straightforward exemptions, such as the spouse exemption and the donor-donee cohabitation exemption, which ought to be as applicable to those who have only the one house in their estate as it is to the wealthier. Alongside this, one must also list the one factor which an economist is more likely to focus on – the ‘nil rate band’, the threshold which is protected from inheritance tax in all estate. Whilst this band has the effect of exempting most estates in the land, it provides little comfort to greater estates. In light of all this, it appears mysterious as to why the tax continues to be levied on smaller estates. It is more likely the case that people, as in the case of pensions, simply do not plan until too late. In any event, my purpose here is not so much to consider the effect of the taxes across different classes of estates but more to compare the taxation of capital with that of earned income. As between the classes, it appears to me that inheritance tax is equally manageable in practice.

SDLT and the new ATED are not latched to wealth – even as glimpsed through the ownership of one property. They do not even take into account the extent to which the particular purchase (or ownership) has been affected through financing. In other words, the fact that I buy a house with a 90% mortgage or with no mortgage at all has no bearing on the amount of SDLT payable. Rather mysteriously, there is no principal private property relief for buyers as there is in the context of capital gains tax. This seems strange when considered alongside the ‘help to buy scheme’ and the policy objectives which must have propelled its implementation.

Capital gains tax is levied on gains alone. The tax applies asset-by-asset and that too on disposals, the timing of which the taxpayer has control over. As with the other taxes, the rates are not affected by reference to the overall capital of the person making the disposal. Furthermore, to the extent that capital is tied in the principal private residence, a disposal of the asset escapes this tax. Perhaps some indication of the regressive nature of this tax can be gleaned from the way in which the private principal property relief is defined:

222 Relief on disposal of private residence

(1) This section applies to a gain accruing to an individual so far as attributable to the disposal of, or of an interest in—

(a) a dwelling-house or part of a dwelling-house which is, or has at any time in his period of ownership been, his only or main residence, or

(b) land which he has for his own occupation and enjoyment with that residence as its garden or grounds up to the permitted area.

(2) In this section “the permitted area” means, subject to subsections (3) and (4) below, an area (inclusive of the site of the dwelling-house) of 0.5 of a hectare.

(3) Where the area required for the reasonable enjoyment of the dwelling-house (or of the part in question) as a residence, having regard to the size and character of the dwelling-house, is larger than 0.5 of a hectare, that larger area shall be the permitted area.

The subsections above define the scope of the land which qualifies for relief. What I find telling is subsection (3). If one has a small house, then the surrounding land which is also eligible for relief is limited to 0.5 hectares. On the other hand, if one has a mansion, then the prescribed upper limit is explicitly occluded.

The combined effect of these taxes is that whilst benefits are conferred to those already in the ‘real estate’ club (in the form of capital gains tax exemptions), hurdles are posed to those outside (in the form of SDLT). Of course, in this piece I am only discussing how tax contributes to growing inequality. The stretching out of society is, of course, exacerbated by the poisoned chalice of rising house prices and even without tax considerations. Rising house prices in London have made all home-owners wealthier in absolute terms and their position, relative to each other, also remains the same. The problem, of course, is that the difference between those occupying the upper echelons and those at the middle rises in absolute terms, a difference so great that normal earnings alone are unlikely to compensate for it in the future. This is a vast topic and the tax strategy to adopt in light of it ought to make up for a separate piece.

As far as the taxation of capital income is concerned, the rate on savings and on dividends is generally lower. A very curious feature of the tax code is that the exact rates here hinge on the total amounts of income – so that if I work and have greater earned income, then I may end up paying more tax on my savings and dividends income. Surely, a fairer system would ring-fence earned income so that our workers were not penalised for their industry by bearing a greater burden on unconnected income (and capital gains, which is also top-sliced). Another anomaly is that the taxation of distributions does not discriminate between distributions which have in a sense been earned and those which arise from passive investments. Indeed, cases such as PA Holdings highlight that if we earn our dividends, then we are to be treated worse off than if they were simply passive investments. One would have thought that this is just the sort of dividend which we would wish to encourage.

All this forms part of the very same UK tax code which denies trainee GPs deductions for exam expenses. Cases like Mallelieu and Flanagan may seem petty to us, but that may be part of the problem. I suspect that their implications loom far larger in the minds of the many thousands of people whom they affect than they do in the minds of our luminaries, politicians and the media.

Concluding Thoughts

It appears to me that there are various counter-intuitive dynamics at play here. Primarily, the notion that the same income tax rates apply to all individuals (subject only to the various thresholds) appears fair at first glance. However, as seen, even the income tax rates actually favour Balzac’s ‘rentiers’ or Aldous Huxley’s Tantamounts.

And when one takes into account capital as well as income, then the counterintuitive truth which emerges is that a parity of rates actually results in a more disparate society. The greater the capital, the smaller a proportion the income bears to one’s overall wealth. The disconnect between capital and income is most significant in the case of earned income, where the income far more often than not constitutes a greater proportion of the individual’s wealth. A taxation of this income therefore constitutes a greater detriment to a worker’s wealth and especially so when one considers the proportion of this income which must be expended towards subsistence. On the other hand, a capitalist will normally expect a yield of 5% on his capital (this usual rate of return has apparently remained constant since 1700). So, even assuming a tax of 50% on his return, one is only taxing 2.5% of his original capital (and even less of his accumulated capital), ignoring any appreciation in the course of the year.

And what can be said of rates, can be said of the wider manner in which tax is implemented. Judges are often concerned that the principle espoused in one case might result in taxpayer abuses in others. This often restricts their responsiveness to the particulars of the case before them. (For instance, in Mackinlay v Arthur Young, the House of Lords disagreed with how the lower court had factored in the large size of the firm before allowing partnership expenses. Though, as I discuss in my TAA piece, the judges are not always concerned that principles espoused by them might result in abuses in other cases by HMRC). The idea that everything and everyone should be governed by a set of uniform principles of course represents the best of British values. But could it be that we might actually wish to treat some individuals more leniently than others? Can one imagine another jurisdiction (Spain, Italy, further afield?) where a judge posed with the problem in Mallelieu v Drummond would have said, ‘You are a young barrister, a worker and have taken certain risks to secure yourself a career which is itself fraught with uncertainties….I will allow you these expenses, though I cannot promise that the same approach would be taken if you were a company laying pipelines in the North Sea.’

Why is there no reverse-Ramsay? And where are the Lord Dennings?

A cynic might even conclude that the purpose of taxation, as it presently is, quite far from being redistributive, is actually the opposite – as it preserves capital accumulated by the ‘landed gentry’ and prevents accumulation by newcomers. That this verity is somehow intuited by the young people of the land can be seen from the rise of celebrity culture – the number of those who aim to become actors, singers, footballers and the like appears to far eclipse those who aspire to join the middle classes. Admittance to a class which does not promise even a footing on the housing ladder does not appeal. The motto of the day is very much ‘All or Nothing.’ I note that Mervyn King uses ‘Winner Takes All’ in his piece.

Peripheral Thoughts

I have wondered why it is the case that things are this way and, also, why it is not discussed more among practitioners.

As to the former, it may simply be that there have been historical reasons for this – most of the European (rated) income tax codes were set up hastily in anticipation of war. In his book, Black Swan, Nassim Nicholas Taleb argues that so taken is the system by the statistically small likelihood of certain occurrences taking place (in this context, a massive accumulation of capital), that it fails to address the contingency of them actually occurring. There is also in our system, at first glance, a very proper reluctance to subject to taxation that which has already been taxed. In other words, once something has been processed through the system, the taxpayer ought to be left in peace to enjoy the remainder. The view might be taken that to tax capital which has already been subject to income or inheritance tax is unfair. However, it appears to me that under the present system, it already is the case that, when one looks across various taxes, the same property may be subject to multiple taxes to the detriment of the same individual. For instance, a middle class earner may pay up to 45% of income tax on his earnings and his estate might then suffer a 40% charge to inheritance tax on the remainder when he dies.

As to the silence of practitioners, my brethren in the tax industry may well be wondering why I am arguing in favour of the tax net being cast even wider. Over the course of my career, I have encountered a range of moral attitudes espoused by practitioners. On the right, there are those who have a principled objection to the state’s encroachment over private property. In general terms, when one appreciates how hard it is for most earners to earn a living, one certainly has some sympathy with this diametrical reaction to the nonchalance with which people in television debates say, ‘Tax this or that person’s income….’. However, so absolute a response will not succeed in the real world. Others choose to remain silent in the name of professionalism, the idea being that it is one’s job to comment on the law as it is, not as it is meant to be. The reasoning, however, is not without conceptual problems – because of the purposive nature of interpretation, the law is at least sometimes what it is meant to be. In any event, the problem with silence is that there is a danger that moderates and well-meaning individuals are mistaken for unprincipled easy-riders.

I began with Capital in the Twenty First Century and ought to end with it. The book makes a case for a small capital tax on net wealth. This because whilst net public wealth in the richer countries is pretty much nil, net private wealth is greater than it has been for centuries. But the book also acknowledges that the time is not yet right for the imposition of such a tax. This is primarily because of the amount of global co-ordination which would be needed if such a tax were to be effective. Failed instances of such a taxation being attempted in Spain, Italy and Cyprus are cited. I would agree with the administrative objections and also have concerns that such an infrastructure, once set up, might become an instrument for populist pillaging by governments of the future. I have other problems with the book. For instance, Piketty does not ask the question as to what end tax revenues ought to be devoted to (his arguments for taxation are primarily redistributive). Also, he does not really address the question as to what steps individuals might take to better their position relative to the rich. The book makes the point that mass education is not a solution as this has the effect of turning a diploma into the high school education and simply defers competition. I query whether this is true – or, rather, whether it has to be true – in a time of globalisation. However, it is hard to take exception to a book which is expressly written with the view to encouraging debate. And in light of the extreme amounts of concentration which are the real subject of his book, it is questionable whether there is anything which could be achieved other than through taxation or central banks (in the form of inflation).

The purpose of this piece is more to highlight the issue than to provide answers. In general, it appears to me that the exemptions, reliefs and thresholds (such as the CGT residence relief discussed above or even those that might be said to emasculate IHT in many respects) are in fact undergirded by sound policy considerations, at least when applied to the wider public. What is needed is a greater, albeit measuredly gentle, articulation of the rules towards the tail end of the Bell curve which represents the spread of capital in the UK. And, equally, a reciprocal relaxation of the rules in favour of workers.

July 2014

Mixed Partnerships: Communique

Schedule 13 of the Finance Act 2014 will introduce a raft of rules pertaining to partnerships. The ‘salaried members’ and ‘mixed partnership’ rules are the most far-reaching of these (but by no means the only!). The salaried members rules are domestic in scope, whereas the mixed partnership rules can apply to offshore entities too.

My concern is that many parties appear to be reacting in knee-jerk style by unravelling existing mixed structures. There are two primary reasons why this ought not to be done without careful deliberation.

First, because the new rules are not as draconian as might first appear. Through Conditions X and Y, the legislator is essentially attempting to provide a barometer through which he assesses whether the profits accruing to the corporate member are such as one might expect in circumstances where the parties are acting at arm’s length terms. To the extent that these conditions are not satisfied,  profits arising to the corporate member are relocated to individual members. Whilst Conditions X and Y appear to me to provide a sufficient measure of leeway to allow for real-world practices, the Examples provided by HMRC in the concomitant guidance indicate (in my opinion, misleadingly) that the rules are far stricter than they in fact are. (Examples in executive Guidance perhaps not surprisingly tend to present a stricter view of legislation and a ready example which comes to mind is the admission in the GAAR Part D Guidance that the use of ISAs would not be viewed as an unreasonable course of action!)

Second, because to unravel existing structures with a view to addressing the mixed partnership provisions would result in an irrevocable, complete and possibly negligent forfeiture of the valuable pre-commencement GAAR protection.

There are other points arising too – those pertaining to construction and others pertaining to facts which might very reasonably be taken to preclude an application of these rules. In light of all these, I would recommend a fine-tuning of the arrangements rather than a re-structuring where possible.

April 2014

TAA and the Overkill Defence

TAA and the Overkill Defence

Best to be prudent and kill them all, God will know his own kind!

– The Bishop at the gates of Beziers

First, A Past Instance of Overkill

Sometimes in the course of his or her submissions, a barrister will employ the technique of reductio ad absurdum, such as that employed by Euclid in his proof that there are an infinite number of prime numbers. Sadly, one finds that the judges are sometimes skeptical of such techniques, viewing them as a rouse to obfuscate the analysis of the case at hand through the introduction of far-fetched hypothetical instances. However, a decision-maker would do well to remember the salutary lessons from Congreve, where a body no less distinguished than the supreme court of the land failed to take into account the wider ramifications of interpreting the law as it did. When presented with the deeply unjust but inevitable consequences of its decision in the case of Vestey thirty years later, the court had no choice but to depart from its previous decision, expressly conceding as it did so that a whole range of cases had been decided erroneously in the interim and that many hundreds of cases would have been wrongly settled without resistance.

There are two questions which had dogged the area of TAA for a number of years. First, the question as to who was liable under these provisions and, in particular, whether a non-transferor could be liable.  Second, what the amount of liability is to be (assuming that the person is in fact liable). The case of Congreve required the answering of both these questions. Mrs. Congreve’s father had 93,000 of 1000,000 shares in Company A. He transferred 60,000 of these to International Gas Processes Corporation in return for shares in the latter. He then gifted these shares to Mrs. Congreve along with 5,000 shares in Company A. Company B was incorporated in Canada. It purchased shares from International Gas in Company A in return for 995 of its 1,000 shares. International Gas was then liquidated, so that the shares in Company B were distributed as dividends in specie to Mrs. Congreve. Company B then bought 5,000 shares in Company A from Mrs. Congreve and the father’s remaining shares in that company from him. So, Mrs. Congreve ended up owning the entirety of the share capital in Company B, which in turn owned the bulk of the share capital in Company A.

The question arose as to whether Mrs. Congreve could be assessed under the TAA provisions on the basis that her rights did not ‘wholly or mainly spring from a transfer of assets affected by her’ – it was not of course disputed that there had been a transfer by her at all. It was held by the House of Lords that there could be no objection to her being so assessed. Indeed, their Lordships went further and held that she could have been so assessed even if no transfer had been affected by her at all. Finally, they also held that Mrs. Congreve could be assessed on the entirety of the income of Company B. This was in 1948.

In 1980, the House of Lords was faced with an extraordinary set of facts in the form of Vestey. Two settlors had made a trust in 1942. Certain payments were made to discretionary beneficiaries from 1962 to 1966. HMRC assessed the recipients to income tax on the distributions under the TAA provisions. HMRC then did something remarkable. It went back six years and assessed these beneficiaries to tax on a proportion of the entirety of the income of trust in each of those six years, irrespective of the fact that the beneficiary had not received a payment in that particular year and irrespective of the fact that there was no correlation between the income arising to the trustee and the distribution to the beneficiaries (the exact basis adopted by them was the proportion which the distribution of a particular beneficiary bore to the income of the trustees in each year). One beneficiary was called Mrs. Baddeley. She received a distribution in 1966-67 of £100,000. HMRC went back each of the six years and assessed her (or rather, her husband) to £270,000. The Commissioners did not see any problem with this and insisted that Mr. Baddeley could in fact have been assessed many times this amount. The House of Lords could not allow this. But nor could they allow the particular get-out which HMRC put forward, which was for allocations to be made among the various beneficiaries on an extra-statutory basis. As per Lord Wilberforce (citing the judge in the court below him):

One should be taxed by law, and not be untaxed by concession.

(Though for a subsequent acceptance of concessions, see ex-parte Fulford Dobson). Their Lordships ultimately decided that the decision arrived at in Congreve had to be departed from, so that the various recipients in this case, being non-transferors, could not be assessed at all. In doing so, they acknowledged the huge cost which the taxpayer would have unjustly borne over the preceding thirty years by reason of that court’s earlier reluctance to consider the reductio ad absurdum argument and to interpret the legislation as a comprehensive matrix which would cater robustly to circumstances which were, after all, not that unforseeable. As per Lord Wilberforce:

 We now have to face the fact that this House decided otherwise, unanimously, and affirming the Court of Appeal. That was 30 years ago, the decision has been followed in reported cases (Bambridge v. Inland Revenue Commissioners [1955] 1 W.L.R. 1329, Philippi v. Inland Revenue Commissioners [1971] 1 W.L.R. 1272) and no doubt many persons have been taxed on the basis of it, without resistance.

The exact number of victims may never be known.

However, my objective here is not to remonstrate – for just one instance among many in which legislative overkill has been adroitly tackled by the courts, one has to consider only the settlements code. It just so happened that in the case of Congreve the courts were fettered to largely unwieldy language. The question which interests me now is this: What was it about the HMRC assessments in Vestey which their Lordships found so objectionable? Was it the mere fact that non-transferors were being assessed? Or was it the fact that non-transferors were being assessed on income they had never received? In other words, was it the incidence of liability or was it more the unfettered extent of it? The question is relevant today because it might cast some light on how the courts would react to another instance in the tax system of ‘overkill’. The particular instance I have in mind is also within the context of TAA – and I discuss it below.

For Lord Wilberforce, it was more the question of incidence. He accepts that the TAA rules might be viewed as penal provisions as was held in Howard de Walden. However, this does not mean that they are intended to penalize non-transferors (including persons who may never in fact benefit from the income arising to the person abroad). In his words, ‘to visit the sins of the transferor on future generations’ was not permissible.  For Viscount Dilhorne, the objection lay more on the unfettered liability that HMRC’s approach gave rise to. At page 1184:

I share Walton J.’s view that Parliament cannot have intended that a person, it might be unborn at the time of the transfer of assets, should be chargeable to tax on the whole of the income of the foreigner if he acquired rights giving him power to enjoy part of that income or received or was entitled to receive a capital sum coming within subsection (2) and without limit of time or that the revenue should be able to recover multiple tax if there were a number of such individuals.

(His Lordship goes one further and seems to discount the application of TAA contemporaneously to multiple persons in respect of the same income – something which Congreve or Vestey were not strictly concerned with). Lord Edmund-Davies was much influenced by the scope of the potential charge to which the beneficiaries would be exposed and so was Lord Keith of Kinkel. Their Lordships also took into account the textual argument which had been put forward on behalf of the taxpayers, though it appears to me that it was the policy consideration which was really determinative. The important point which emerges from all this is that even though in Vestey the court restricted the scope of the legislation on the basis of the fact that the assessed individuals were not transferors, what really riled them was the extent and number of the assessments which might be potentially unleashed should that bar not be raised. The overkill was, for them, over the top.

Overkill today

Under the TAA provisions as they are now, there appears to be a clear dichotomy between the original provisions which are accepted as applying to transferors and the subsequently added provisions which apply to non-transferors. The question of incidence has thus been made relatively clear (though as to who constitutes a transferor or a quasi-transferor still continues to involve a value judgment). However, the question of what the extent of liability of a transferor is still appears to be capable of causing confusion and raising dispute.

Let us take the case where (say) a hundred individuals pay £100 to a trust with non-resident trustees of a discretionary trust with a view to avoiding tax which be payable by him on the interest. The income of the trust is £10,000 arising from these contributions. The transferors are beneficiaries of the trust. In such circumstances, the apportionment provision at section 743 requires for an apportionment of the £10,000 on a just and reasonable basis. The provisions thus go some way towards addressing the problems which may arise where there are multiple transferors, as in the instance above, even though the HMRC official would have some discretion in the matter.

However, what the provisions do not appear to me to yet take into account is the circumstance where the person abroad has income arising from unrelated sources. The recent introduction of section 721(3B) ITA by FA 2013 provides:

(3B) The amount of the income treated as arising under subsection (1) is equal to the amount of the income of the person abroad (subject to sections 724 and 725).

Take the facts of Congreve for instance, where the taxpayer transferred shares to a person abroad who had income other than that arising from those shares. (Such an occurrence was in fact forseen by Lord Greene MR in Howard de Walden). In such circumstances, HMRC might argue that it is the entirety of the income of the person abroad which would be allocated to the transferor, notwithstanding the overkill. If a succession of such cases were to arise then it is possible that history would repeat itself, with HMRC first bringing a case which would illicit the sympathy of the courts and secure for them a precedent (as in Congreve) and then a taxpayer would appeal in a more unjust case and in which he may well persuade the courts to bless a get-out from the charge (as in Vestey).

In the event of an appeal being made by a taxpayer in such circumstances, it would at the very least be arguable that the legislation was not ‘punitive’. Indeed, it would appear to me, as it did to Walton J in Vestey, to be strange if the penalty were somehow contingent upon the extent of the income arising to the person abroad as there would, of course, be no correlation between the penalty and the particular ‘crime’ (to use the word of Walton J in Vestey). In my view, the rule is perhaps better described as ‘preventative’ or ‘restorative’, having as it does an intention to restore the position to what it would have been had the transfer not been made and, in doing so, to provide a disincentive in making such transfers in the first place. Rather fortuitously, the provisions themselves provide some insight into the objectives of the legislator:

(1)  The charge under this section applies for the purpose of preventing the avoiding of liability to income tax by individuals who are . . . UK resident by means of relevant transfers.

Finally, the inclusion of the apportionment provisions at section 743 ITA in the case of multiple transferors indicates to me that even to the extent that the provisions may at some time have been punitive, they are no longer intended to be so. There can be no reason for relieving, in the case of multiple transferors, one transferor from tax on the income from transfers made by other transferors and, at the same time, charging a single transferor on unrelated income arising to the person abroad.

In addition to policy considerations, it would, but of course, be necessary for the courts to have some literal basis on which to provide a get-out. In Vestey, as seen above, the get-out came in the form of restricting the person liable to the transferor and there was indeed sufficient basis in the language on which this view might be founded. In the case of section 721(3B), the argument would have to lie in restricting the definition of ‘the income of the person abroad’. The approach would not be to restrict this expression by reference to the transferor’s power to enjoy (as was unsuccessfully attempted in Howard de Walden) but instead by reference to income which can be traced back to the transferred asset (such an approach was by no means ruled out in Howard de Walden – it just so happened that in that case all the income of the person abroad could in fact be traced back to the transferor’s assets – and the same is true of Lord Simonds leading speech in Congreve). It is at least arguable that section 721(3B) is amenable to such an interpretation – as the expression ‘the income’ there could be referred back to ‘relevant transfer’ and the income mentioned therein. Another opening in the text might be found in cases involving multiple transferors. In such circumstances, section 743 would give leeway not only as to who is to be charged but also the extent to which he is to be charged.

Conclusion

It is desirable that legislation is interpreted in a way which not only answers to the fact of the case at hand but goes further and provides a comprehensive matrix which caters to all forseeable scenarios and the possibility of gross overkill. The failure to do so in Congreve lead to the courts having to back-track thirty years later, with dire consequences for many hundreds of taxpayers in the interim.

Even today, the TAA legislation has facets which might result in reckless assessments. If such assessments were to be made, it is not inconceivable that further restrictions (or, depending on how one views it, clarifications) may be necessitated. In the meantime, in cases where a liability to the transferor may arise under TAA, it would be desirable to ensure that the person abroad did not have any other income arising to him from unrelated sources (unless that income is attributable to transfers made by other transferors).