The morality of tax avoidance. A cautionary tale.

“Tax avoidance rocketed in the late 1990s,” according to an unnamed senior HMRC expert. And the question ‘Why?’ engaged a number of technical commentators this morning. 

There is a very strong candidate explanation as to why. And, of course, if you’re engaged in making tax policy, you’re keenly interested in what it was that happened at that particular moment in time. Knowing the answer to that question might help you damp the fuse of any future rocket. But I’m not interested in the explanation so much as what an account of the increase in tax avoidance might tell us about why people seek to avoid tax – and the morality of doing so. But the two tales are intertwined.

First, I need to start with a key distinction. Not all tax avoidance is ‘bad’. If I choose to pay money from my earnings into my pension scheme, I will not be taxed on those earnings: the tax code encourages me to make payments into my pension scheme by enabling me to do so out of untaxed income. So I will have arranged my affairs so that I pay less tax and I will have avoided tax – but few would regard this as objectionable. If the tax code offers me a reward for behaving in a certain way – because it serves some broader societal purpose such as encouraging people to save for their old age – and I behave in that way, why should I not enjoy the reward?

However, if, for example, I could contribute money into my pension scheme, get the tax relief, and then borrow it back from my pension fund at a zero-rate of interest, that would be anti-purposive. I would be getting to the other side without having to pay the ferryman. The money would not be there for me to spend in my old age. 

So, pro-purposive good. Anti-purposive bad.

This is all, now, pretty much agreed across the spectrum of commentators. People might disagree about whether Government should offer a particular relief but if Government does then there’s nothing immoral in you availing yourself of it in the way in which Parliament intended. The Fair Tax Mark is seeking investment and offering a relief (Enterprise Investment Scheme relief) which its Technical Director thinks should not exist. But it would say, if the relief exists there’s nothing wrong with people accessing it.

Working out whether the use of a relief is pro-purposive or anti-purposive? Less easy. But more on that later.

In 1992, Government decided it wanted to encourage investment in British films. So it introduced a new relief: if you used 100 to purchase a film, you could, in effect, set 33 off against your other income in each of tax year one, year two and year three. If you were a 40% taxpayer, you would (in effect) get a tax credit worth 13.3 in each of those years. This might not be enough to tempt you to invest in films – they are inherently very risky. So Government also said that the film company could sell you the film for 100 and then rent it back from you for a guaranteed stream of income worth, say, 92. That way, the film company would get 8 to put towards the cost of making the film. And you would get three tax credits of 13.3, plus income worth 92 for your 100. 

Now that’s not quite as good a deal as it looks, because that 92 of income is taxable so its net value in your hands is 92 – (40%) = 55. So you’re still down 5 (100-55+13.3+13.3+13.3) plus you only get the second and third 13.3s in the second and third years.

So in 1997, (under a Labour administration by the way) the Government announced you could get all of those 13.3s in your first year. And this was enough to tip the balance. You could borrow, say, 80 and put up 20 of your own money. You’d get a tax credit of 40 in your first year so you’d be 20 up in that year alone. You’d get taxed on 92 as it came back to you (so it would be worth 55) but you’d invest the 20 you were up and make up the extra 5 and then some. You wouldn’t need to worry about repaying the borrowing – this would be done from the rental stream of 92 which the film-maker would pay a bank to guarantee.

Now, so far so good. In published documents – I have them and I am perfectly happy to post them on line if anyone wants them – Government through HMRC encouraged this investment. In exactly the form I have described (the numbers are slightly different but the principle absolutely as stated). And the British Film Commission went out and encouraged foreign film makers to make their films in the UK on the back of the fact that they could make a 100 film here for only 92.

Just pause there. This was pro-purposive investment in films. Encouraged by the Government. And the result was that this sort of arrangement became respectable. Analytically, in tax terms, it was no different from putting money into your pension.

The result was that an enormous tidal wave of money came into British films. Because of the way in which the reliefs were structured, investors were, in effect, financially indifferent to the quality of films that were made. They made money from the arrangements irrespective of whether the films flew or bombed at the box office. 

Now several billions of pounds later, Government worked out that the reliefs weren’t really operating as they had intended. They were badly designed and too expensive. And the wholly unsurprising consequence of indifference to quality was the production of turkeys: remember Sex Lives of The Potato Men? I thought not – and that was, relatively speaking, one of the better ones: it at least got made and got a cinema release. So over a period of about a decade, Government slowly rowed back from what it had started in 1997. 

But it was difficult. You had a whole class of Film Investment companies which had grown up to put these deals together (the big ones generally founded around the late 1990s). You had IFAs who had made a lot of money introducing their clients to these deals. And you had a class of perfectly respectable, moral, law abiding individuals who had grown accustomed to arrangements of this nature.

Arrangement of this nature. Geared investments? encouraged by Government. Guaranteed income streams? encouraged by Government. Indifferent to the performance of the film because protected by the tax relief? encouraged by the structure of the tax relief. All of these features perfectly respectable – both legally and morally – at the time.

Like the launch of the reliefs in the first place, the process of rowing back from them was equally flawed. It left many of those moral and law abiding citizens genuinely in the dark about whether they were participating in pro- or anti- purposive arrangements. But subtle nuances – even important ones – don’t play well with an audience in the mood for blood. 

But the story of the trip back is for another day.

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  1. Pingback: Snake Hall II (or) Tax Avoidance and the Sex Lives of the Potato Men | Lawyer Watch

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