Tax avoidance versus tax evasion versus tax mitigation

Al Capone was eventually done for tax evasion. If only he’d put his vice gains into a pension…

A lot of people confuse tax avoidance and tax evasion. It can be a dangerous mistake to make!

As the former British Chancellor of the Exchequer Denis Healey once said:

“The difference between tax avoidance and tax evasion is the thickness of a prison wall”.

Now as I always understood it, the two terms – and the actions each entailed – were definitely not the same thing.

I believed – and the 2009 version of this article stated – that:

  • Tax avoidance involves using whatever legal means you choose to reduce your current or future tax liabilities.
  • Tax evasion means doing illegal things to avoid paying taxes. It’s the Al Capone path to financial freedom.

And as best I can tell, it remains the case that tax avoidance is not illegal.

However the authorities have been taking an increasingly tough line in recent years – and the phrase ‘tax avoidance’ now potentially implies something worse than using an ISA.

Specifically, a General Anti-Abuse Rule (GAAR) was contained within the Finance Act 2013, which sought to counter ‘tax advantages arising from tax arrangements that are abusive’.

You will definitely want to delve into more detailed guidance on GAAR if you’re contemplating doing anything out of the ordinary.

But the most relevant point for our discussion of evasion versus avoidance is that according to the tax planning resource RossMartin.co.uk:

In addition to the legislation, HMRC published guidance in April 2013 which expressly states that the GAAR is an intended departure from the previous situation where routinely cited court decisions such as the judgment of Lord Clyde, ‘every man is entitled if he can to order his affairs so that the tax attracted under the appropriate act is less than it otherwise would be’ are now rejected.

The guidance sets out the Parliamentary intention that the statutory limit on reducing tax liabilities is reached when arrangements are put in place which go ‘beyond anything which could reasonably be regarded as a reasonable course of action’.

Tax avoidance may still not be a criminal act, but if you’re hit with an enormous bill and various penalties because the steps you took were deemed the unacceptable face of paying less tax – to be unreasonable, in other words – then you may well wonder what the practical difference is.

Please note I am NOT a tax expert. This article is simply the musings of a private investor trying to do the right thing! Please consult a specialist and/or HMRC if you want to know exactly where the law and you stand in respect to your taxes.

Tax avoidance used to be okay

So for any criminals who Googled ‘tax evasion’, I’m not about to give you a masterclass in laundering cash or doctoring a passport.

I’ve never evaded taxes, I don’t condone it, and I couldn’t tell you how it’s done.

Tax avoidance mitigation – as we should probably now call it – is another matter.

With taxes likely to rise in the UK over the next few decades to tackle public debt and pay for public services regardless of what party in power, it makes sense for investors to legally do what we reasonably can to reduce our tax burden, without overly compromising on other aspects of our lives.

And we probably need to be extra careful to follow the spirit as well as the letter of the law.

You see, when I first wrote about tax avoidance versus tax evasion back in 2009, it seemed a less contentious subject than today.

Of course, nobody liked a tax evader, then or now.

But over the past few years – perhaps spurred along by the backlash that followed in the wake of the financial crisis – politicians, the media, and the public has cast a harsher eye on tax avoidance, too.

I feel this has made the distinction between evasion and avoidance more difficult for the average person to be sure of than before.

Writing in the Financial Times in the wake of the controversial craze for tax inversions by US companies, John Kay noted that:

It is conventional to distinguish legal tax avoidance from illegal tax evasion. But the reality is that there is a spectrum.

The person who avoids the heavy taxation on cigarettes by giving them up wins our approval; the gangmaster who employs illegal workers off the radar screen of government authorities goes to prison when detected. But most cases lie in between.

The UK’s HM Revenue & Customs has issued big payments claims to people who invested in highly artificial film finance schemes that did not qualify for the allowances they claimed.

Were they avoiders or evaders? The line between avoidance and evasion would be clear only if the law were clear, and it is not.

Tax law is complex and the legality of particular actions can be firmly established only if there is a decision by a court on the facts of a particular case.

Since Kay wrote his piece, HMRC has continued to rule against the schemes, prompting suggestions that some of the 800 or so investors in the schemes – including various celebrities – face financial ruin. One of their advisors estimated 70% would go bankrupt. Some will reportedly see tax bills several times larger than their original investment.

A HMRC spokesperson was quoted as saying:

Avoidance schemes are often highly contrived and almost invariably fall flat when trying to deliver a tax advantage never intended by Parliament.

The fact is the majority of schemes simply don’t work and can put avoidance users in a significantly worse financial position than if they had never used the scheme in the first place.

Now, some MPs have pushed back on the film financing affair – or at least the penalties imposed in light of it.

In a letter to the chancellor Philip Hammond, Andrew Tyrie, chairman of the Treasury committee, agreed that Labour’s original film industry tax breaks were arguably “too generous and ill-defined.”

But with respect to rulings against schemes designed to exploit those breaks, he added:

An increasing number of representations have been made to me expressing concern that the outcomes are not always fair nor what anyone could have expected.

This has resulted in financial calamity for some of those involved and considerable difficulties for HMRC in bringing a large number of schemes to a close.

Many have said that, when these schemes were being sold, they were not considered to be aggressive avoidance but just a deferral of tax, and they were often marketed as routine tax management.

Whether or not these claims are valid, it does appear that many individuals are facing very severe financial distress as a consequence.

Some readers may have little sympathy with multi-millionaire celebrities apparently going out of their way to avoid paying more money to fund schools and hospitals and the rest of the laundry list.

And I am certainly not saying the schemes were legitimate. That’s outside of my wheelhouse.

However I do think there’s a bit of going somewhere but for the grace of God about this.

The celebrity investors were presumably advised by specialists, and I suppose most thought the schemes were above board.

After all, there’s been a long-running court case to prove they weren’t actually above board. So how was a footballer or a pop star supposed to be able to assess this at the offset, when presented with the scheme by a knowledgeable person in a suit?

Consider, by way of comparison, Payment Protection Insurance. So far the banks have paid out £27 billion in compensation to an estimated 7.5 million people deemed to have been mis-sold PPI. For these ‘victims’, caveat emptor didn’t apply, and they’ve got their money back. But for the would-be tax avoiding film financiers, caveat emptor has bitten them in the bottom line.

How would we feel if were to discover that hitherto commonplace practices such as pension recycling or bed and ISA-ing were suddenly deemed too aggressive, and we were hit with a retrospective tax bill?

Exactly!

I am just musing aloud here. I am far from an expert on tax matters. We never give personal advice on Monevator, for both practical and regulatory reasons, but I’m always extra wary of even answering general queries when it comes to tax.

The fact is tax is often complicated, and always very dependent on your personal situation.

The letter of the law

Interestingly, in the original version of this article posted in 2009, I quoted evidence of an emerging debate about the terminology as then covered on Wikipedia.

At the time the phrase ‘tax avoidance’ was apparently in dispute in the UK, with ‘tax mitigation’ being suggested as a better term for legal tax reduction.

The Wikipedia article noted, in paragraphs since removed, that:

The United Kingdom and jurisdictions following the UK approach (such as New Zealand) have recently adopted the evasion/avoidance terminology as used in the United States: evasion is a criminal attempt to avoid paying tax owed while avoidance is an attempt to use the law to reduce taxes owed.

There is, however, a further distinction drawn between tax avoidance and tax mitigation.

Tax avoidance is a course of action designed to conflict with or defeat the evident intention of Parliament.

Tax mitigation is conduct which reduces tax liabilities without “tax avoidance” (not contrary to the intention of Parliament), for instance, by gifts to charity or investments in certain assets which qualify for tax relief. This is important for tax provisions which apply in cases of “avoidance”: they are held not to apply in cases of mitigation.

I wrote at the time that: “I suspect this is largely a courtroom debate, caused by the Revenue looking to close down schemes of dubious legality created by planners for wealthy individuals.”

And indeed, that does seem to have been the direction of travel in this area, given that later ruling in the 2013 Finance Act.

Avoid being deemed an overt avoider

So where does this all leave us?

As I say I’m no legal expert nor a tax planner – I’m just an everyday bloke who enjoys investing.

So to be absolutely clear, whenever I’m talking about reducing taxes on your investments, I mean by using legal and strictly above board means. Never the dodgy stuff.

But perhaps this isn’t enough anymore? Maybe we now need to apply the ‘front of the local newspaper’ test to any decisions we make about trying to reduce our taxes?

In other words, how would you feel if whatever tax mitigation decision you made was splashed on the cover of your local newspaper for all your neighbours to read?

Saving into a pension? Putting money in an ISA? Making use of capital losses by setting them against capital gains to reduce your total taxable gain?

Very, very safe.

What about defusing capital gains over the years by making sure you use your capital gains allowance? Or incorporating to reduce your income tax bill and national insurance liabilities?

Already in the current climate we can see they seem a bit less safe, though I think still firmly on the right side of the spirit and reality of the law, if not always the court of public opinion.

What about offshore vehicles? Or moving back into a rental property or second home for a period so you can benefit from principle place of residence relief?1

Hmm.

A HMRC spokesman told the BBC in an article from 2014 on tax avoidance that:

“Tax avoidance is bending the rules of the tax system to gain a tax advantage that Parliament never intended.

“It often involves contrived, artificial transactions that serve little or no purpose other than to produce a tax advantage. It involves operating within the letter – but not the spirit – of the law.”

The official Government website confirms the exact statement.

Now you know!

How to spot avoidance in action

It seems ‘avoidance’ has become a dirty word. We will probably be better off talking about tax mitigation in the future.

More official advice from HMRC:

How to identify tax avoidance schemes

Here are some of the warning signs that you might be in a tax avoidance scheme or that you are being offered to join one.

It sounds too good to be true
It probably is. Some schemes promise to lower your tax bill for little or no real cost. They will say you do not have to do much more than pay the scheme promoter and sign some papers.

Pay in the form of loans
Some schemes designed for contractors involve giving you some or all of your payment in the form of a loan that you’re not expected to pay back. It’s diverted through a chain of companies, trusts or partnerships and you’ll be told this is to save you tax.

Huge benefits
The benefits of the scheme seem out of proportion to the money being generated or the cost of the scheme to you. The scheme promoter will claim there’s very little risk to your investment.

Round in circles
The scheme involves money going around in a circle back to where it started, or some similar artificial arrangement.

HMRC has given it a Scheme Reference Number (SRN)
This is where HMRC has identified the arrangement as having the hallmarks of tax avoidance and are investigating it. You will have been given an SRN by your promoter and will have included it on your tax return. Having an SRN doesn’t mean that HMRC has ‘approved’ the scheme. HMRC does not approve any tax avoidance schemes.

Schemes HMRC has concerns about
You can find examples of tax avoidance schemes HMRC is looking at closely. Even if a scheme is not mentioned, it will still be challenged by HMRC.

Well, there you have it. I know I haven’t done anything dodgy (my affairs are far too boring for that) and I hope you haven’t either. But the example of the film financing scheme shows how careful we all need to be.

Thoughts and corrections from experts especially welcome.

  1. Being a property-less peasant, I’ve never been fully up-to-speed as to how this works exactly, and I believe the rules did change in recent years. Follow the link for more details of one suggestion.

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