Tax avoidance and the problem of establishing purposes

Tax avoidance is the reduction of tax liabilities by the use of contrived schemes, which are such that when the law is applied to them, the resulting tax liabilities are less than one might have expected. It differs from tax evasion, which is the reduction of tax liabilities by not disclosing the full facts, or by misrepresenting the facts.

The tax code of the UK is likely to have a general anti-avoidance rule, alternatively known as a general anti-abuse rule, or a GAAR, in the near future. The Government proposes to introduce one in 2013. Its consultation document on the proposal, published on 12 June 2012, and related documents, are available here:

http://www.hm-treasury.gov.uk/tax_avoidance_gaar.htm

(The link to the June 2012 document is about half way down the page, following the heading "GAAR consultation".)

The purpose of a GAAR is to remove the tax advantages that would be obtained by the use of contrived tax avoidance schemes,when the schemes are not defeated by specific provisions (for example, a specific provision that says that when an asset is sold between connected parties for less than its market value, the transaction is to be treated as taking place at market value). Governments are interested in GAARs because the counteraction of avoidance by specific provisions is an endless game of cat and mouse. Each year, new provisions are introduced to defeat known schemes. And each year, new schemes are devised to get round the existing specific provisions.

I shall not discuss the merits of GAARs here. Instead, I shall set out how some problems concerning the identification of the purposes of arrangements that have been devised by human beings arise in the context of GAARs.

It is common for anti-avoidance legislation to include a purpose test of some sort. The legislation may, for example, only take effect if a reduction in tax is one of the main purposes of the arrangements that the taxpayer has chosen. "One of the main purposes" is likely to be the phrase, rather than "the main purpose", so as to catch schemes in which tax avoidance is a significant purpose, but there is some greater commercial purpose that has nothing to do with reducing tax liabilities. For example, clause 2(1) of the proposed GAAR, discussed on page 13 of the June 2012 document, reads:

'Arrangements are "tax arrangements" if, having regard to all the circumstances, it would be reasonable to conclude that the obtaining of a tax advantage was the main purpose, or one of the main purposes, of the arrangements.'

The problem is this: how should we determine whether obtaining a tax advantage was a main purpose of some given arrangements?

The first point to make is that the challenge is not to find a way to look inside the actual taxpayer's head, and establish his or her subjective motives. The question is, "What is the point of these arrangements?", not "What was this taxpayer trying to achieve?". Some of the points that follow would have parallels in a discussion of the problem of establishing motives, but that is not the topic here.

Having said that, we cannot ignore the human element. Purposes are purposes of creatures that have goals. We can reconcile this point with the irrelevance of the motives of the particular taxpayer who in fact entered into the arrangements, by regarding the purposes in question as those of a hypothetical rational taxpayer who entered into the arrangements. Abstracting from the actual taxpayer's psychology, what would we say was going on, if all we knew was that some taxpayer had entered into the arrangements, and we were told nothing more about the taxpayer apart from his or her income, assets, and existing family or financial links to other people who were affected financially, along with any other facts that we would need to know in order to understand his or her tax affairs?

It is not enough for arrangements to be such that tax liabilities are lower than one would expect, for example when a profit is made, but no tax arises on it, nor will arise in the future. That is not enough because the lack of tax might be a pure accident. While the motives of the actual taxpayer may be irrelevant, the achievement of accidental consequences could not be seen as a purpose at all, not even a purpose of a hypothetical taxpayer, about whom nothing psychological was known. It is, however, most unlikely that such accidents would occur. Their occurrence would indicate that the tax system had been very badly designed.

It seems that we must look for indications that tax-saving features were included in the arrangements by design. One sign would be that a feature took some work to include, but that the other likely purposes of the arrangements (such as the transfer of an asset from grandparent to grandchild, or the purchase of some land followed by its sale at a profit) would have been achieved just as well without the feature, and without its replacement by another feature that would have taken a comparable amount of work to include.

This does seem to be the appropriate sort of way to proceed, if we are to abstract from the psychology of the actual taxpayer. We should compare what happened with other things that might have happened. The basis on which we would establish purposes could then be a principle of sufficient reason, something like this, where B is what the taxpayer actually did:

'If some commercial result was achieved by doing B rather than C or D, where all of B, C and D were possible, take it that the purposes of the agent must include enough purposes to explain the preference for B over C, and the preference for B over D, and identify enough purposes accordingly.'

Three problems with this principle as it stands are immediately apparent.

First, the purposes that would explain the preference for B over C might be incompatible with the purposes that would explain the preference for B over D. That would not, however, affect the workability of a GAAR, so long as the purpose of achieving a reduction in tax featured in both sets of purposes. We can imagine one hypothetical taxpayer preferring B to C, and another one preferring B to D.

Second, there might be some differences between B and C, or between B and D, about which the hypothetical taxpayer would be indifferent, making it inappropriate to seek explanatory purposes. If there were other differences which meant that the preference for B could only reasonably be explained by a purpose of achieving a reduction in tax, that would not affect the workability of a GAAR. But if all of the differences were ones about which the hypothetical taxpayer would be indifferent, while B was nonetheless the choice that happened to reduce tax, legislation which ensured that a GAAR still applied would have the same effect as legislation that required people deliberately to arrange their affairs so as not to make tax savings. Such legislation could reasonably be argued to be excessive.

Third, the principle would not always be enough to allow us to work out whether a GAAR should apply to take away a particular tax advantage. There might be a range of possible sets of purposes to impute to our hypothetical taxpayer. Each set would be sufficient to explain his or her preference for B, but some sets would include a purpose of achieving a reduction in tax, and others would not include such a purpose. This problem would become more acute if we were required to determine, not only what the hypothetical taxpayer's purposes were, but which ones were main purposes.

These difficulties may not be insuperable. But if they are not addressed explicitly in the guidance that we are promised will accompany the UK's forthcoming GAAR, it may not be easy to discern a consistent line of thought behind the decisions that judges will make, once cases start to be litigated.