Beyond the blunt power of of tax legislation

Tax avoidance has become a much maligned term over recent weeks. The revelations that global companies with enormous turnovers in the UK have been paying little or no corporation tax have engendered emotions of rage and frustration among members of the public and politicians of all persuasions.

Margaret Hodge MP, chair of the Public Accounts Committee, is reported as describing tax avoidance schemes as “completely and utterly and totally immoral”. Starbucks, the international coffee chain, has been subjected to protests and demonstrations. As a result it has said that it is now willing to pay £20m in corporation tax to avoid consumer boycotts.

Campaign group UK Uncut commented that Starbucks’ announcement was “a blatant admission of guilt” that the coffee chain had intentionally avoided tax.

However, tax avoidance or tax mitigation schemes have a long tradition with UK taxpayers, whether individuals or companies.

Long tradition

In 1935 the House of Lords considered a scheme set up by the then Duke of Westminster (IRC v Duke of Westminster [1936] 1 AC 1) intended to reduce his surtax income. The Lords found in the Duke’s favour. In his judgment, Lord Tomlin explained in terms that have been much quoted and misquoted ever since: “Every man is entitled if he can to order his affairs so that the tax attaching under the appropriate Acts is less than it otherwise would be. If he succeeds in ordering them so as to secure this result, then, however unappreciative the Commissioners of Inland Revenue or his fellow tax-payers may be of his ingenuity, he cannot be compelled to pay an increased tax.”

Britain is not alone. Just a year earlier in the United States Justice Learned Hand, giving the judgment of the United States Second Circuit Court of Appeals in Helvering v Gregory (1934) 69 F 2d 809, had said the same thing in different words: “Anyone may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury.”

But the judicial attitude to tax avoidance has changed. In the 1980s the House of Lords began to develop a new judicial approach to tax avoidance. In 1984 in Furniss v Dawson [1984] 1 All ER 530 Lord Scarman commented (at 533): “The law will develop from case to case… What has been established with certainty by the House … is that the determination of what does, and what does not, constitute unacceptable tax evasion is a subject suited to development by judicial process.[…] Difficult though the task may be for judges, it is one which is beyond the power of the blunt instrument of legislation. Whatever a statute may provide, it has to be interpreted and applied by the courts; and ultimately it will prove to be in this area of judge-made law that our elusive journey’s end will be found.”

Directors’ duties

If it is immoral to avoid tax, are directors justified in minimising their company’s tax liability? Or should they operate the company in a tax-inefficient manner in order to pay more corporation tax? If they do, what will the shareholders have to say?

Directors owe fiduciary duties to their company, which are now set out in statutory form in chapter 2 of part 10 of the Companies Act 2006. Two of those sections are particularly relevant.

A director must act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole (section 172) and he must exercise reasonable care, skill and diligence (section 174). If he fails to do so, then he will be liable to the company for any loss incurred as a result of such breach.

This presents difficulties for directors who wish to adopt a more ethical approach to the way in which the company’s tax affairs are structured. Generally, a director who is responsible for promoting the success of his company must put to one side his own moral predilections (see the judgment of Megarry V-C in Cowan v Scargill [1984] 2 All ER 750 at 761). If the company were to suffer a loss by way of an increased tax bill as a result of the director’s decisions, then he might be liable to compensate the company for his breach of duty.

Prudence or avoidance

Does this mean that the directors are bound to adopt an aggressive approach to tax planning? Or does it depend on what we mean by tax avoidance? Clearly, there is a difference between prudent tax planning and tax avoidance.

What does tax avoidance involve in a legal sense? There is no complete answer, but, generally, it involves “a pre-ordained series of transactions (whether or not they include the achievement of a legitimate commercial end) into which there are inserted steps that have no commercial purpose apart from the avoidance of a liability to tax which, in the absence of those particular steps, would have been payable” (per Lord Diplock at 32 in IRC v Burmah Oil Co Ltd [1982] STC 30). Therefore, the use of reliefs made available by the tax legislation should be unexceptional; for example, claiming capital allowances or roll-over relief for the replacement of business assets. Tax planning becomes tax avoidance when loopholes in tax law are exploited or reliefs are used for purposes not intended by parliament.

What factors ought directors take into account in considering what should be the company’s approach to tax planning? Section 172 (1) sets out some factors that are relevant in this context:

“(a) the likely consequences of any decision in the long term,

(c) the need to foster the company’s business relationships with suppliers, customers and others,

(d) the impact of the company’s operations on the community and the environment,

(e) the desirability of the company maintaining a reputation for high standards of business conduct”.

Public eye

High profile companies, which receive much press and media attention, will be more sensitive to the effect of adverse publicity and hostile public comments. Starbucks is an example of a company that has responded to the public’s reaction to its tax arrangements by offering to pay more tax. The directors should be able to justify that to shareholders by saying that revenues will be severely affected and, hence, profits; in other words, the likely consequences in the short to medium term.

However, it may be a very different story for private companies that will not be directly subjected to the same media hype. Most private companies have a relatively small number of shareholders, some of whom, if not all, will also be directors. Therefore, to that extent, what they decide as directors they are effectively agreeing to as shareholders.

Generally, it will be a breach of duty if the directors give away the company’s money. Charity does not sit at the board of directors (as per Bowen LJ in Hutton v West Cork Rly Co [1883] 23 Ch D 654), but acting responsibly in relation to paying tax may make sound commercial sense if public outrage leads to a boycott of the company’s goods or services. However, that sort of public exposure is unlikely to affect the vast majority of private companies. Therefore, there is unlikely to be the same sort of business justification for voluntarily paying more tax than is chargeable. Similarly, failing to adopt a prudent tax-efficient policy is less likely to be justifiable for a company not adversely affected by media attention.

If the directors wish to adopt a more ethical approach to tax planning, then, as directors, they will need to consider carefully the commercial justification for that approach and document it in the board minutes. Even so, it would be wise to have such an approach formally approved by the shareholders by an ordinary resolution. Then, if the company were subsequently to be sold, the new owners would not be able, acting through the company, to claim that the former directors were in breach of duty to the company.