There are four separate ways of classifying a transaction and it pays to know them all if clients are to avoid problems with the HM Revenue & Customs
The era of self-assessment and exchange of information coupled with criminal penalties for tax evasion requires most people to understand the fundamental tax planning concepts determining the scope of what is legally acceptable in the area of tax planning.
Lord Templeman provided a concise summary of these concepts in the Privy Council case of Challenge Corporation Ltd. He said: "There are discernible distinctions between a transaction that is a sham, a transaction that effects the evasion of tax, a transaction that mitigates tax and a transaction that avoids tax."
Transaction here is an all-encompassing term for legal acts that potentially have a financial effect. So, taking an investment, the creation of a trust and the sale of a business would all be deemed transactions.
A sham is a transaction structured to create a false impression in the eyes of the tax authority. Lord Diplock in Snook vs London and West Riding Investments Ltd (1967), described a sham as: "Acts done or documents executed by the parties to the sham, which are intended by them to give to third parties or to the Court, the appearance of creating between the parties legal rights and obligations different from the actual legal rights and obligations (if any) which the parties intend to create.
"For acts or documents to be a sham, with whatever legal consequences follow from this, all the parties there to must have a common intention that the acts or documents are not to create the legal rights and obligations which they give the appearance of creating."
In the case of Abdel Rahman vs Chase Bank (CI) Trust Co Ltd (1991), the Jersey Court considered a trust created by Abdel Rahman, a Lebanese national, was a sham.
It said: "Having taken into consideration evidence and documentation, we reached a single unanimous conclusion. Rahman retained dominion and control over the trust fund throughout his lifetime. The settlement was a sham in the sense that it was made to appear what it was not - the trustee was never made the master of the assets.
"Rahman intended to and in fact retained control of the capital and the income of the trust fund throughout his lifetime and his advisers and the trustee lent their services to the attainment of his wishes."
Rahman was seeking to favour certain members of his family at the expense of others by using a Jersey trust contrary to Shariah inheritance laws. On his death his widow challenged the trust and the Jersey Court decided the trust was a sham because of the way it had been run. For example, the trustees had not taken control of the trust assets.
The Jersey Court did comment that had the trust been structured differently from the beginning it may well not have taken the view that the trust was a sham. It is therefore essential when structuring a transaction to ensure it reflects the realities of the situation.
Evasion and mitigation
Lord Templeman said evasion is when not all the facts relevant to tax assessment are declared.
The question of what evasion is has become very important under the new UK self-assessment regime. How can a taxpayer be sure he has informed the Revenue of all the facts?
Lord Templeman then identifies the acceptable face of tax planning. He said: "Income tax is mitigated by a taxpayer who reduces his income or incurs expenditure in circumstances which reduce his assessable income or entitle him to a reduction in his tax liability."
When a taxpayer makes a trust, he deprives himself of the capital, which is a source of income, and thereby reduces his income. If the trust is irrevocable and satisfies certain other conditions, the reduction in income reduces the assessable income of the taxpayer. The tax advantage results from the reduction of income.
Where a taxpayer pays a premium on a qualifying insurance policy, he incurs expenditure. The tax statute entitles the taxpayer to reduction of tax liability. The tax advantage results from the expenditure on the premium.
Clearly, in the Rahman case the settlor had not deprived himself of the capital, or at least he had not as far as the Jersey Court was concerned, and so the trust would not have been effective for tax purposes if tax mitigation had been in point.
Having succinctly dealt with the concepts of evasion and mitigation, Lord Templeman turns his attention to the more problematic tax avoidance.
He said "Income tax is avoided and tax advantage derived from an arrangement when the taxpayer reduces his liability to tax without involving him in the loss or expenditure that entitles him to that reduction. The taxpayer involved in tax avoidance does not reduce his income or suffer a loss or incur expenditure but nevertheless obtains a reduction in his liability to tax as if he had.
"In an arrangement of tax avoidance, the financial position of the taxpayer is unaffected, (bar costs of devising and implementing the arrangement). The taxpayer has sought to obtain tax advantage without the reduced income, loss or expenditure that Parliament intended to be suffered by taxpayers qualifying for a reduction in their tax liability. Most tax avoidance involves pretence."
Tax avoidance is here distinguished as being 'unacceptable' as opposed to tax mitigation which is 'acceptable'. This may come as a surprise to many who were under the impression tax evasion was unacceptable compared to tax avoidance, which was acceptable.
The word 'real' is often invoked at this point to distinguish avoidance from mitigation. Tax mitigation is based on real transactions whereas tax avoidance involves 'artificial' transactions. The method of distinguishing the real from the artificial is to analyse the transaction to determine whether a reduction in income, loss or expenditure is really to be found or whether the transaction only involves a pretence.
This reality test assesses whether the transaction is natural and/or commercial. For example, the statutory defences against the anti-avoidance rule targeting transfers of assets abroad by UK residents is to show the purpose, or one of the purposes, of the transfer was not to avoid a liability to (UK) taxation or that the transfer was a bona fide commercial transaction. It could be said that any attention to UK tax planning would fall foul of the first condition - the only practical defence therefore is to demonstrate the naturalness or commerciality of the transaction.
Transactions must be structured in some way, and it is acceptable that it is such a way to minimise or eliminate the associated tax liability; as Lord Upjohn says in IRC vs Brebner (1967).
Upjohn said: "When the question of carrying out a genuine commercial transaction, as this was, is reviewed, the fact there are two ways of carrying it out - one by paying the maximum amount of tax, the other by paying no, or much less, tax - it would be quite wrong, as a necessary consequence, to draw the inference that, in adopting the latter course, one of the main objects is the avoidance of tax. No commercial man in his senses is going to carry out a commercial transaction except upon the footing of paying the smallest amount of tax that he can."
For tax planning to remain under the concept of tax mitigation rather than that of tax avoidance, it must be demonstrable that the steps taken are natural and/or commercial transactions.
If a parent wishes to provide for his children's education and future maintenance then his tax adviser should point him the direction of an accumulation and maintenance trust specifically blessed by statute with a variety of tax advantages.
These tax advantages can be enhanced by placing it in an offshore trust, which will not be subject to UK income tax.
Tax deferral and tax saving
The UK Courts take the view that the deferral of tax is the avoidance of tax and so both tax deferral and tax saving must be analysed using the fundamental tax concepts.
Readers of International Investment will appreciate that bank accounts, collective investment schemes, insurance policies and trusts can be used for both tax deferral and tax saving. Whenever they are, investors should consider whether the transactions involved constitute a sham, evasion, avoidance or mitigation.
A sham is a transaction structured to create a false impression for the tax authority
Evasion occurs when not all relevant tax assessment facts are declared
Avoidance is when tax payer reduces his liability to tax without the reduction in income that entitles him to that reduction
Mitigation is when the taxpayer reduces his income and hence the tax liability
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