Filling the “tax gap”: complying with the spirit of the law

The National Fraud Authority’s recently published “Annual Fraud Indicator” included HMRC’s estimate that there is a £40 billion “tax gap”. The tax which is lost though various forms of tax fraud (evasion, criminal attacks etc) forms only part of the £40 billion. Almost half of the lost revenue is estimated by HMRC to be attributable to behaviour such as tax avoidance, failure to take reasonable care, and “legal interpretation”. Significantly, in calculating the lost tax, HMRC includes tax which is due “under either the letter or the spirit of the law” (italics added).

The current pressure to reduce the UK’s budget deficit is likely to manifest itself in increasing non-legislative pressure on taxpayers, particularly large corporates, to comply with the so-called “spirit of the law”.

There is, of course, little (if anything) which HMRC can do to enforce such an ill-defined obligation to refrain from tax planning (and other behaviour) which, though lawful, does not meet with the approval of HMRC. Any pressure to comply is likely to take a more subtle form - persuasion, possibly backed up by warnings of reduced co-operation from HMRC (eg, an increased “risk assessment” for large corporates) or increased use of HMRC’s powers of investigation and enquiry against taxpayers who are seen to be flouting what, in HMRC’s view, is the spirit of the law. There is a limit to which even these sanctions can be applied, as public authorities such as HMRC are bound to exercise their powers in accordance with principles of public law, such as the requirement to act reasonably.

If a taxpayer does take the view that there are benefits of being seen by HMRC to comply with the spirit of the law, this will require decision-makers outside the tax department, such as directors and in-house lawyers, to consider whether it is appropriate to engage in certain types of tax planning - the fact that a piece of tax planning is supported by a legal opinion may not necessarily be sufficient to insulate the organisation from criticism.

Codes of conduct – should you sign up, and what are the consequences?

The phrase “spirit of the law” is increasingly used in codes of conduct issued by businesses, or to which they are asked to sign-up. Recent examples include the UK’s Code of Practice on Taxation for Banks (the Banking Code), and UBS’s “Code of Business Conduct and Ethics of UBS”. The former states that the UK Government:

“expects that banking groups, their subsidiaries, and their branches operating in the UK, will comply with the spirit, as well as the letter, of tax law, discerning and following the intentions of Parliament.”,

whereas the UBS Code contains a more focused statement that “Our tax reporting complies with the spirit as well of the letter of any applicable laws, regulations or treaties and to accuracy in tax-related records”. While to date the focus has largely been on the banking industry, this development is an area of interest for most large corporates.

There are significant questions to be considered by any organisation before it signs up to such a code, such as whether it is consistent with the directors’ duty to maximise shareholder return. Such codes are usually voluntary, in the sense that there is no legal duty to sign up to them, and directors may be reluctant to tie their hands in advance. For those who sign up to such codes, there is a question as to how they are to be enforced, as the sanctions for non-compliance are unlikely to be tax litigation (where the courts are required to interpret the law itself, rather than the spirit of the law). Historically, HMRC has not met with much success in court cases where it has appealed to the spirit of the law, in order to defeat a particular piece of tax planning. As noted above, there are public law limits to HMRC’s ability to threaten to exercise its investigative/enquiry powers solely on the ground that a taxpayer has failed to comply with a set of principles which go beyond its statutory obligations.

Instead, the danger is of adverse media publicity and a greater workload for the group tax department, as a result of any increase in its “risk assessment”. Even though a group’s tax affairs are confidential, recent stories in the media demonstrate that information can make its way to the press, and the recent campaign by the Guardian newspaper seems to illustrate a greater appetite among the media to run critical stories about corporate tax planning. This publicity has helped to provoke a greater interest at boardroom level in tax matters and a concern as to whether it is appropriate to undertake a transaction which, whilst technically strong, could be the subject of (perhaps misplaced) criticism. The board has a duty to maximise returns for its shareholders, and a balance may have to be struck between a low effective rate of tax and entering transactions which could have an adverse effect on a corporate’s brand and reputation.

What is the “spirit” of the law?

Like other recent developments in tax (eg, the requirement for senior accounting officers to certify that the group has appropriate tax accounting arrangements in place), the emphasis on the “spirit of the law” is likely to raise new questions for organisations. Evaluating whether a particular transaction meets the “spirit of the law” test calls for new skills amongst the tax managers, in-house lawyers and directors who are called on decide whether that transaction should be undertaken.

The difficulty which such individuals will face is in determining the “spirit of the law”. One approach - that Parliament’s intention is discerned by the language it uses in the Finance Acts - is to equate the spirit with the letter of the law. Such an approach is appealing particularly to those trained in the legal profession, but is clearly not what HMRC envisages.

The Banking Code is helpful in this respect, as it elaborates on what is expected by HMRC of banks:

“[Complying with the spirit, as well as the letter, of tax law] means that banks should:

  • adopt adequate governance to control the type of transactions they enter into;
  • not undertake tax planning that aims to achieve a tax result that is contrary to the intentions of Parliament;
  • comply fully with all their tax obligations; and
  • maintain a transparent relationship with HM Revenue and Customs (HMRC)”

Although these four requirements are fleshed out in more detail, difficult judgment calls remain; eg, acceptable tax planning does not include promoting arrangements with a tax result which is “contrary to the intentions of Parliament”. Determining what the words used by Parliament mean is difficult enough, without having to then to identify an “intention” behind the words. Indeed, the highest courts have often rejected the notion that there is an intention of Parliament beyond the words used in legislation:

“The task of the court is often said to be to ascertain the intention of Parliament expressed in the language under consideration. This is correct and may be helpful, so long as it is remembered that the 'intention of Parliament' is an objective concept, not subjective. The phrase is a shorthand reference to the intention which the court reasonably imputes to Parliament in respect of the language used. It is not the subjective intention of the minister or other persons who promoted the legislation. Nor is it the subjective intention of the draftsman, or of individual members or even of a majority of individual members of either House. These individuals will often have widely varying intentions. Their understanding of the legislation and the words used may be impressively complete or woefully inadequate.” R v. Environment Secretary, ex parte Spath Holme Ltd [2001] 2 AC 349 at page 396F/G, per Lord Nicholls of Birkenhead (emphasis added).

This is an important point, particularly in relation to tax, because even within a single organisation people can have differing views as to where the boundary between tax planning and unacceptable tax avoidance lies, and some people in an organisation may even have a peculiar view of where the boundary between avoidance and evasion lies. This distinction - between tax planning, tax avoidance and tax evasion - brings to mind one of the more memorable quotes from the 1980’s TV series, Yes Minister:

“That's another of those irregular verbs, isn't it? I give confidential press briefings; you leak; he's being charged under section 2A of the Official Secrets Act.”

As this quote reminds us, such differences can often depend upon a person’s perspective: what is acceptable tax planning to one person, may be unacceptable to another, whether that person is a non-executive director in the organisation, a shareholder or a customer. It should be remembered that HMRC is not the judge of where the line between such behaviours lies. Accordingly, the challenge is to equip decision-makers in an organisation with the skills to form a reasoned decision as to whether any particular transaction is likely to be defensible not just in the tax tribunals, but also to its various stakeholders.