Thinking Fast, and Slow……About Tax.


“You know, ‘Why? Why?’ and that was a very (again, in my way of seeing America) a very American finger-snapping question. I did something magnificent and mysterious and I got a practical ‘Why?’ And the beauty of it is that I didn’t have any ‘why’.”
– Philippe Petit, Man on Wire (2008)

There is a scene in the film A Bronx Tale (1993) – which Roger Ebert rightly awarded 4 stars to – where the frustrated young protagonist Calogero is chasing an elusive acquaintance who owes him twenty dollars. He is spotted by his mentor, Sonny, who waves him over. When explained the situation, Sonny laughs and advises Calogero to forget about the loan. The way Sonny sees things is that Calogero has paid a mere twenty dollars for the privilege of not ever having to see that person again – a bargain. It is a brief exchange in a classic film which has stayed with me. So much in life depends on how we see things and we each have a slightly different way of doing so. The viewing of a transaction, such as the release of the loan, will be through the prism of motivation and this is something which the Alexanders and Parmenions of the world may not agree on.

It is strange, given just how widely accepted it is that the tax should follow the economic substance of a transaction, how little formal thought is in fact given to economics by lawyers, judges and legislators. The presumption appears to be that once the facts are established, one is drawn irresistibly to the economic substance. But this is to gainsay the notion, commonly held among economists, that theirs is a field which especially lends itself to the accommodation of hugely divergent views. The old joke being that one can have six economists in a room and seven opinions. In Capital in the Twenty First Century (which I reference in another of my pieces), the author Thomas Piketty reiterates how economics is more an art than it is a science. He says:

To put it bluntly, the discipline of economics has yet to get over its childish passion for mathematics and for purely theoretical and often highly ideological speculation, at the expense of historical research and collaboration with the other social sciences….The truth is that economics should never have sought to divorce itself from the other social sciences and can advance only in conjunction with them….

Of course, one should be weary of being flattered by highly readable economists like Piketty – or Daniel Kahneman, whose book forms the subject of this piece – into thinking that one has acquired, from a reading of them, a license to comment on their fields with some Savonarola-like authority. For instance, Piketty himself is mostly diffident about his own predictions. The real lesson to be had from their writings is that the truth remains elusive to us all and empowerment, if any, comes from the realization that we are all equally in the Garden of Tantalus when it comes to certainty on economics.

In Citizens, which I happen to be reading at the time of writing, Simon Schama states:

Public bankruptcies are a state of mind. The exact point at which a government decides that is has exhausted resources so completely that it can no longer fulfill its most basic function, the protection of sovereignty, is quite arbitrary. For great powers never go into receivership. However dreadful a financial situation they may get into, there generally will be moneymen lurking in the wings prepared to set them on their feet – at a price….

That macro-economics is rife with uncertainty was something we had all known long before the recent crisis. However, it was not until I read Daniel Kahneman’s Thinking Fast, and Slow that I fully realized that there was another branch of economics – behavioral economics – which is far more pervasive. Not only does it pervade aspects of our lives well beyond our commercial operations but it does so without our even realizing it. Just as Capital in the Twenty First Century is likely to be the dominant influence when it comes to my arguments on policy, Kahneman’s book ought to be a steady beacon in the future when it comes to practice.

The tenor of the book is best illustrated through the following puzzle. There is a woman called Linda. She likes writing about women’s rights and she doesn’t like warfare. Which of the following careers is she most likely to be pursuing?

(a) Military;

(b) Writing;

(c) Writing about women’s rights.

Choose an option before you continue. Now: Kahneman polled people along similar lines. A very significant proportion of individuals gravitated towards (c). They did not consider that the set of (c) formed a subset of (b) – so the likelihood of one falling within (b) was, a priori, greater than falling within (c). Had no background information been proffered at all, then it is likely that they would not have made that mistake. However, the pithy introduction to Linda ‘anchored’ their minds to wrong answer. The book gives several other instances of anchoring. If you ask someone whether Gandhi was 110 years old when he died and, having received a negative response, then ask them whether he was 80 or 90 when he died, you are more likely to get 90 as a reply.

Kahneman (who was awarded the Nobel Prize in 2002) and his colleague, Amos Tversky (who died before he could be awarded it) developed the cognitive basis for biases. Before their work, the often accepted position had been that people were rational unless they were overcome by emotions. However, as the examples above indicate, heuristics can be equally detrimental to clear thinking. In his book, Kahneman settles (at least for me) the perennial question as to whether we ought to be guided in our choices by our intuition. He states that intuition is nothing other than memory. When a new person (say X) walks through a door and reminds us of another, Y, for some reason or another, then we will make a decision about X on the basis of our experience of Y. We may attribute this to ‘intuition’ – but it is (really) our minds reaching through our memories to find a match with X so that we might then make a snapshot decision about him or her. A good decision-maker uses his intuition – but also trains it, so that he factors in only information about Y which might be useful in making a determination about X.

That people are impressionable or muddled in their motivations is not a revelation. However, the value of books such as Kahneman’s and Piketty’s lies in how they refocus the mind and bring their themes to the forefront of the consciousness. On reflection, the ways in which anchoring affects tax in practice are both many and diverse. I discuss only some examples here.

Consider the HMRC & other executive Manuals. A curious realization that emerges as one goes through the manuals is that these might be misleading even where the statement within is completely true. For instance, the Manual on GAAR states:

B4 What the GAAR is not targeted at
B4.4 Similarly, decisions to invest in an ISA in order to take advantage of the income tax relief which such investments carry, or to give away assets to a son or daughter without retaining a benefit in the gifted asset, with a view to reducing the amount of inheritance tax payable on the transferor’s death, clearly fall outside the target area of the GAAR. Using statutory incentives and reliefs to support business activity and investment in a straightforward way (for example business property relief, EIS, capital allowances, patent box) are also not caught by the GAAR. However, experience has shown that incentives and reliefs can be abused. Where taxpayers set out to exploit some loophole in the tax laws e.g. by entering into contrived arrangements to obtain a relief but incurring no equivalent economic risk then they will bring themselves into the target area of the GAAR.

When viewed in isolation, there is nothing wrong with the italicised paragraph. However, it is potentially misleading in the sense that it anchors the mind to the notion that the GAAR threshold is lower than it in fact is – the test under GAAR is, of course, reasonableness. An especially cautious taxpayer or his advisor might read this paragraph with trepidation and come to the view that a form of reasonable planning – such as, say, a non-domiciliary expatriating funds – is problematic.

The Guidance on the Mixed Partnership rules provides another instance which comes to mind. The purpose of these new rules, in brief, is to ensure that where a company and individual enter into a partnership, then the profits accruing to the company from the partnership are such as would be expected. This is achieved through the concept of ‘appropriate notional return’:

Example 21:
B Ltd has invested £10,000 in the ABC LLP. It receives no return on this other than its profit share.
ABC LLP is paying 2% on loans on the commercial market, reflecting its good credit rating. This represents a commercial rate, so B Ltd has an appropriate notional return on capital of £200.

HMRC appear to believe that the rate of return on an investment should hinge only on the creditworthiness of the borrower. According to them, the nature of the venture, the competitiveness of the market and the strength of the wider economy appear not to have any bearing – so that a return of anything more than £200 on £10,000 is completely inappropriate. Now, if one were inclined to attribute a greater measure of business acumen to HMRC than is perhaps evinced in this Guidance, it could be argued that the Guidance here is suggesting that the £200 falls within the concept of ‘appropriate notional return’ – but, also, that there may be more as well. However, if this were the case, then one would have expected the Guidance to state that the £200 constitutes B Ltd’s appropriate notional return rather than it saying that B Ltd has an appropriate notional return of £200, which suggests something rather different. That the power of suggestion is being consciously employed here is further corroborated by the choice of the hypothetical rate of interest at a low 2%.

Turning away from Manuals and Guidance, I consider the execution of tax law itself. When reference is made to the ‘economic substance’ of a transaction, this ought to encompass two separate limbs – first, what value is being transferred from one party to another and second, why this is being done. Without knowing the psychology that undergirds a transaction, then, in the absence of there being some deeming provision, there cannot, of course, be any remuneration, any consideration, any gift, any trading receipts, any trade, any expenditure wholly and exclusively for the purposes of the trade, any view to earmarking, any distribution, any associated operation and so on. But if inferring or establishing purpose is already contentious under the apparently extant presumption of rationality, then how much more uncertain are made things when one factors into the equation the fact that individuals may not even know why they are doing what they are doing.

This may seem academic at first glance. But that questions such as these arise in practice is made palpably clear from the cases themselves. In Mallelieu v Drummond (my least favoured decision of all time), the House of Lords had to decide whether the expenses were incurred wholly or inclusively for the purposes of trade. It was accepted that the test was subjective. So, in other words, their Lordships were acting on their understanding of psychology. The chequered route which the case took on its way through the courts suggests how uncertain the position was. The House of Lords came to the view that since the individual would have needed the clothes for some reason or another, it was not open to them to hold that the taxpayer’s purpose was wholly and exclusively for the purposes of her trade. The easy riposte to this reasoning is, as I have suggested elsewhere, to say that the taxpayer would have had other clothes, so the purpose for the expenditure in respect to these particular items was the trade carried out by her. However, the object of this piece is not to replicate points made elsewhere and the concern at present is psychology. Lord Brightman considered that the taxpayer would inevitably have had the additional benefits in mind – even though there was nothing in the taxpayer’s testimony to suggest that she had and her credibility was not in question in any way. Could it not be the case that the taxpayer may simply not have considered the additional benefits, no matter how obvious those benefits may have appeared to the judges? Is it right to attribute rationality when psychologists like Kahneman argue the opposite?

In Postlethwaite’s Executors v Revenue and Customs Commissioners [2007] STC (SCD) 83, the question arose as to whether, in transferring funds from a close company to a retirement benefit scheme, there was an intention on the part of the participator of that company to confer a gratuitous benefit upon another person. The beneficiary of the retirement scheme included, apart from the participator himself, his wife. It was held that there was no intention to confer a gratuitous benefit – as the participator was only 49:

Paragraph 95: The normal life expectation of a man in England aged 50 given in Whitaker’s Almanack (1993) was over 25 years. It was clearly unlikely that Dr Postlethwaite would die before receiving benefits even taking account of the preservation of benefits under cl 5.6 and it follows that it was unlikely that any death benefits would become payable under cl 6. While we accept that Dr Postlethwaite clearly did wish to protect his widow in the event of his early death, it seems clear that his primary intention was to be able to provide for her during his life. We do not consider such intention to be an intention to confer a gratuitous benefit on her because primarily it was to provide for himself. The element of benefit intended to be directly conferred upon her was de minimis.

The section 10 IHTA test here requires exclusivity just as much as the test in Mallelieu. However, even though some intended benefit to the wife was found here, it was overlooked. In Mallelieu, though no subjective intention other than those related to trade was found, the test was failed. I submit that the Postlethwaite approach, with an emphasis on the conscious purpose, is to be preferred. Individuals are more often than not governed by what Kahneman and others refer to the limbic part of the brain and, moving away from neurology and the opportunities of comicality it presents in its introduction here, the point being made – put more simply – is that people do make snapshot decisions on the basis of a reduced understanding of the facts. In fact, they do it all the time.

Another question which arises all the time, as I say, is what the payment is for. Whilst not so obviously expressed, this also requires a consideration of what the purpose of the payments is. Not all payments from my employer to me will be in recognition of my past services. For instance, it may be to incentivize me in the future. It may a gift (i.e. a payment which the employer would have made to me had I never been employed by him in the first place – an aspect which is considered in the context of ‘tips’). It may be for consideration provided by me under a collateral contract or to wrinkle out a problem which has arisen in the past. According to Kahneman, it may, in an economic sense, be for nothing at all:

Some years ago I had an unusual opportunity to examine the illusion of financial skill up close. I had been invited to speak to a group of investment advisers in a firm that provided financial services and other services to very wealthy clients. I asked for some data to prepare my presentation and was granted a small treasure….It was a simple matter to rank the adviser by their performance in each year and to determine whether there were persistent differences in skill among them and whether the advisers consistently achieved better returns for their clients year after year…The results resembled what you would expect from a dice-rolling contest, not a game of skill.

There may be a silver-lining to this finding. The conceptual difference between a bet and a bonus is that the latter involves the counterparty influencing the outcome. But if there is not to be any influencing in actuality and the services provided by an employee are mostly mechanistic, then the employee is better off receiving a salary for those mechanistic services and then taking an independent bet as opposed to a bonus. The winnings would not have been ‘earned’ or produced by him in an economic sense. The legal position would be complex and may well depart from the economic substance – for instance, where the bet takes the form of employment related shares, then Part 7 ITEPA would apply. If the UK tax code were really committed to tracing the economic substance of a transaction, then there would not be posited in it so many unfair deeming provisions, which provide no opportunity for rebuttal on the basis of the facts. This appears not to make the blood boil.


It sometimes appears to me that tax law is one half art, one half science. And one half distortion.

On reflection, it cannot help but be so – as it involves the coming together and meshing of so many soft disciplines – language, economics and psychology. The dicta in Barclays Mercantile is that a purposive interpretation of the law must be married to a realistic interpretation of the facts. But a realistic interpretation of the purpose of the taxpayer (which tends to be one of the facts to be established) requires a more sympathetic take on the many fallibilities of human reasoning, as demonstrated in Thinking Fast, and Slow.

On the other hand, practitioners of tax should be aware of the role ‘which anchoring’ plays in HMRC Guidance – there and also in the use of titles such as ‘Disguised Remuneration’ and ‘False Self Employment’, which have the effect of unfairly stigmatizing what are often normal commercial transactions.

In this article, I have simply highlighted how these aspects may impact the administration of tax laws. The effect of anchoring is in fact far more widespread than that of course. In “Capital in the Twenty First Century, And Tax.” I consider why it is the case that discussion on inequality hinges so much on differences on income rather than overall wealth. A significant part of the blame must lie with the media. How often is it that one reads in the media that ‘Sam Smith, who earns £80k a year…’ has violated this rule or another? This has the effect of exaggerating the differences between those of us in the lower centiles. The wealth of the proprietors of these newspapers remains undisclosed.

August 2014

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