Jonathan Crowther sets out the six generic strategies for structured tax and estate planning and the Government's anti-avoidance responses to each
Any structured tax and estate planning solution must steer clear of being categorised as a sham or construed as tax evasion and generally a solution should be at the 'cool' end of the tax avoidance spectrum so it is viewed as acceptable tax planning rather than unacceptable tax avoidance.
Tax and estate planning employ a number of generic strategies, which have in turn evoked generic anti-avoidance responses. The key to successful tax and estate planning for taxpayers is to take full advantage of a strategy while remaining outside of anti-avoidance rules. For a government, the key to influencing desired economic behaviour through tax is to allow these strategies to be successful without opening the door to significant leakage to the tax base.
strategies of planning
The first strategy is privileging certain assets or transactions to encourage or reward certain desired behaviours such as savings (Isas or pensions), risk-taking (venture capital trusts and enterprise investment schemes), employee participation (employee share save schemes), enterprise (enhanced taper relief for business assets) or investment in certain types of property (principal private residence relief for capital gains tax (CGT) and business and agricultural property relief for inheritance tax (IHT)).
The legislation privileging these assets and transactions will be hedged round with conditions for qualification and a suite of anti-avoidance measures to prevent abuse. Nevertheless, tax breaks for personal equity plans (Peps) and profit-related pay were withdrawn in the UK because of widespread abuse that was thought uncounterable by anti-avoidance legislation.
The impact of tax on investment product design is huge. The Sandler Review of medium and long-term savings in the UK found that "where government provides tax advantages for certain types of products, its impact can be extremely powerful".
The danger is that the investment is made purely for tax purposes without appreciating the underlying investment and pricing issues and Sandler also recognised this. He said: "It has been suggested advisers tend to concentrate on issues of product design, such as tax treatment, and they do not have a comparable level of expertise in investment issues." An extreme case was when individuals of limited wealth became Lloyd's Names for tax purposes without appreciating the economic jeopardy of unlimited liability.
The second strategy is disconnection of the asset from the individual. The techniques of disconnection have been discussed at length in The easy guide to....articles and involve the use of an adviser holding vehicle or wrapper, such as a collective investment scheme, as well as a portfolio investment bond or a trust.
The anti-avoidance responses to disconnection include looking through and deemed income charges. The 2006 Budget attack on the use of trusts requires no further comment.
The third strategy is reclassification. A typical example is reclassifying income as gains or vice versa, depending on which is the most tax efficient at the time. The anti-avoidance response is to set aside the reclassification. A classic reclassification strategy is 'bond washing' whereby a bond is sold cum-div so that the accrued income is treated as a capital gain.
The UK response was the introduction of the accrued income scheme whereby the accrued interest is taxed as income on sale of the bond.
The fourth strategy is deferral. HMRC's view is that deferral is tax avoidance and should be countered, and certainly not condoned, by the tax system. There are two generic methods for countering deferral, either by levying an annual charge or a penalty on realisation.
The problem with the first method is that on realisation there may be a loss and therefore complicated loss carry back rules would be required.
The problem with the second method is that the taxpayer may be out of charge at the time of realisation. Certainly the investment industry believes that tax deferral is legitimate tax planning and that income and gains should only be taxed on realisation or withdrawal without the application of a penalty.
In consultation discussions with HMRC on the reform of the taxation of offshore funds, it quickly became apparent that the principal evil of offshore funds was the possibility of tax deferral within a roll-up fund.
The proposed solution was to categorise funds as qualifying and non-qualifying. Qualifying funds, whether issuing distributing or accumulation shares or units, would issue an annual income voucher, which looked through the fund to its underlying net income. The problem came with the anti-avoidance response to non-qualifying funds. There were three possible solutions:
(1) Tax as income on the actual mark-to-market gains on the net asset value of the fund,
(2) Tax as income on a deemed gain based on the initial investment in the fund, or
(3) Charge a penalty on the actual gain when realised.
The first response would follow the existing loan relationships rules, the second the existing personal portfolio bond rules and the third the existing offshore trust rules.
While insurance products and UK savings products were initially out of the scope of the review, it became apparent that it would not be feasible to revise the rules for offshore funds without also addressing the use of insurance products where these are used as investment wrappers (as opposed to with-profits policies) and the regime applying to UK savings products.
Other than some beneficial changes to the offshore funds rules nothing has yet come of this review.
The damage of deferral comes when the taxpayer becomes non-resident and so avoids tax altogether on the rolled up income and gains. With a recent poll suggesting 50% of Britons would like to live abroad, continued opportunities for deferral could result in significant tax leakage if a significant proportion of Britons move abroad over the next 10 to 20 years.
The main victim of a mark-to-market regime was quickly identified as hedge funds since they could not produce the required income voucher. Given moves to introduce hedge funds in the UK, applying a penal tax regime could strangle this fledgling industry at birth, which points to the need for a consistent tax regime between onshore and offshore savings and investment products.
The fifth strategy is situs and domicile shifting, either by disconnecting the asset/transaction from the jurisdiction or the owner from the jurisdiction. The anti-avoidance responses are either to apply exit/re-entry charges or to deem connections. Different countries apply different responses and a country may apply different responses to different types of transactions. In the UK there is a capital gains tax (CGT) export charge for an emigrating trust but not for an emigrating individual. There is a deemed domicile rule for IHT but not for income tax or CGT.
All of the above strategies can be countered through specific anti-avoidance legislation with varying degrees of success. And just as a taxpayer needs to carefully select a tax planning solution, a tax authority needs to carefully draw its anti-avoidance responses.
The need for consensus
What is important is that both taxpayer and tax authority accept the legitimacy of tax and estate planning and, through a process of consultation, reach a consensus as to what is acceptable both in terms of planning strategies and anti-avoidance responses.
The position is not so simple with the sixth strategy, which involves the use of artificial transactions or arrangements, which are invariably viewed with suspicion and hostility by tax authorities. The classic legislative approach to this strategy is a general anti-avoidance rule (GAAR), which certain countries have adopted with varying degrees of success.
The UK has looked at introducing a GAAR (the last time it was to be limited to company taxation) but has always backed off. The problem with a GAAR is that it requires the tax authority to give pre-transaction rulings otherwise it is unworkable. If a GAAR is not in place then the attack on such schemes takes place in the Courts and the UK Courts have developed the 'Ramsay doctrine' to test the tax efficiency of artificial transactions, which will be looked at in the next issue.
Investors should be careful not to overstep barrier to tax evasion
Generic strategies available to avoid this
HMRC to continue to look at tax deferral on offshore funds
EIS and Seed EIS sectors
'Truly making a difference'
Avoidance, evasion and non-compliance
From 6 April 2019