GAARding against tax avoidance

The country allegedly has a ‘tax gap’: the difference between the tax that we pay and the tax HMRC thinks we should pay. 

This has most recently been estimated at around £35 billion, although ‘estimated’ is probably too definite a word, given the amount of crystal ball gazing involved in making it up, but let’s go with it for now.

Somewhere around £6 billion of the alleged gap relates to tax evasion – fraud, in plain terms, such as not putting takings through the books – but the same amount again is said to stem from tax avoidance.  The press is full of stories about avoidance, which involves using entirely legal ideas and contrived arrangements to reduce tax bills.  Recently, both David Cameron and Nick Clegg promised a crackdown on avoidance, coincidentally not long after the publication of a report into the possible introduction of an overriding General Anti-Avoidance Rule, or GAAR.

What is GAAR likely to mean for the average taxpayer? 

• Can you still choose to pay dividends instead of taking a bonus out of your family company? 
• Can you still pay extra pension contributions to reduce your tax bill? 
• Can you transfer some assets to your spouse or adult children to make use of extra basic rate bands and annual allowances?

First of all, none of this is law yet, so you can do all of these, quite legitimately, and (provided you do it right) save some tax.  Even when it does appear in the next Finance Act, which now seems highly likely, all of these should still be OK.  So what is the GAAR all about?

The report sets it up, not as a rule against all tax ‘avoidance’, but as a rule against ‘abuse’ of the tax rules, which is subtly but crucially different.  Abuse of the tax rules is seen as using them to achieve a reduction in tax liabilities that Parliament never intended.  For example, a recent court case involved a taxpayer who bought and sold a second-hand insurance bond. The way in which it was done was legal, but it was contrived to create a wholly artificial loss that could be used to save tax on other income.  The taxpayer suffered no true loss in economic terms – he was actually out of pocket only to the tune of the fees he paid to the tax scheme provider – but he managed to persuade the courts that the tax rules, which were very prescriptive and specific, created a large tax loss.  This is the type of scheme against which the GAAR is set to be used.

HMRC will not be able to use it indiscriminately: the draft GAAR will not apply where the taxpayer’s actions can reasonably be seen as a reasonable exercise of choices offered by the law, and an advisory committee is to be set up (outside HMRC) to provide guidance on what is ‘reasonable’.  This safeguard means you can pay normal dividends or pension contributions and pass assets to others to save some tax, as these are perfectly reasonable and well-established methods of saving tax.

Taxpayers will also, theoretically, be able to escape the GAAR by showing that their motive was not tax avoidance, although proving a negative may be a challenge in practice. 

HMRC will also have to prove that any transactions are abnormal before the GAAR can apply – an attempt at a statutory ‘smell test’.  This will not be too difficult where the typical small company sets up an offshore trust that owns an offshore special purpose company to provide benefits to directors and employees by some unusual route: but HMRC will still have to prove the abnormality of it.

How do taxpayers guard against the GAAR?

The simple answer is don’t buy ‘dodgy’ schemes, because that’s the real target.  If the claimed tax saving from a scheme involves your doing something that you and your colleagues and competitors don’t normally do, stop and think.  Will you be able to demonstrate that you’re simply using a tax relief that is available to anyone, without contrivance?  Will you be able to demonstrate objectively that tax saving was not your design or intention?  Ask a straightforward question: is the promised tax saving too good to be true?

A client recently came in with a scheme he’d picked up at the golf club, involving setting up a new specially-designed holding company and having that company execute a declaration of trust over any dividends, for the benefit of the shareholders.  Existing tax anti-avoidance rules would treat any dividends as belonging to the company, which should make them tax-free, rather than taxable on the shareholders who actually receive the cash.  Would this scheme pass the GAAR test?  Would it pass for a reasonable choice of structure, or would it look very odd?  Have you seen or heard of that arrangement before?  It’s easy to see how HMRC will react: being practical and realistic, it’s hard to see that one sneaking past the GAARds.

David Heaton FCA CTA is a tax partner in Baker Tilly’s Leeds office and is currently chairman of the Tax Faculty at the Institute of Chartered Accountants in England & Wales.