The way the EU is moving
The European Union lacks any new initiatives towards tax harmonisation. The “Verona Package” of 1997 envisaged a code of conduct, a royalty and interest directive and a directive on taxation of savings, but it has made no progress. Case law by the EC Court of Justice has nevertheless made some progress. The Commission has taken steps to reduce competition induced by subsidies and preferential tax regimes, but member states are nevertheless competing in the tax field. There are important differences in tax regimes of member states – credit v. exemption, commercial accounting v. tax accounting, deductibility of pension contributions, dependent states with special tax regimes. Unanimity is required for tax measures in the European Union, and member states have proved reluctant to divest themselves of legislative power in tax matters in favour of the EU.
The code of conduct for business taxation in the Package of Verona reflected the feeling of Finance Ministers that the tax revenue of member states should not be endangered by harmful tax competition through specific tax benefits. Some 300 provisions were considered, and of them 66 were identified as harmful. But progress is now at a standstill. The Commission approves of general tax competition, but believes that specific benefits are harmful: this does not seem altogether logical, but it is consistent with the Treaty of Rome.
The Amid case shows that neither the state of residence nor the state of the branch are permitted to place fiscal obstacles in the way of the establishment of a branch in another member state. The important consequence of the Saint-Gobain case is that all the tax treaties of member states have effectively been re-written, to equate the treatment of a local branch with that of a local company.
Art. 87 of the EC Treaty will be used by the Commission to challenge the preferential tax regimes identified by the Primarolo working party.
European tax policy is suffering from the absence of secondary legislation. The tax systems of the member states are broadly similar. But there are exceptions with some very peculiar measures, and the EU should have power to amend national systems to eliminate them. The Court is only a negative legislator; the member states need to take positive steps.
Jail for negligence?
New access to information
Litigation teaches that tax planning is full of pitfalls. The distinction between tax avoidance and evasion is well understood, though confusion often arises, and there are borderline cases – e.g. where the scheme operates to make liable an entity known to have no assets.
In Charlton, an elementary scheme was very badly implemented. The Revenue claimed that the invoices reflected fictitious transactions; the judge, counsel and jurors knew nothing about tax and the judge directed the jury that transactions designed simply to avoid tax were not “real”.
In Dimsey and Allen, Mr Chipping got Mr Dimsey to set up a Jersey company, to sell aeroplane parts to South Africa in breach of sanctions. It was held that the company was resident in the United Kingdom and therefore liable to tax. Mr Dimsey was convicted of conspiracy. to evade the tax. On appeal, it was claimed before the House of Lords that the liability to tax fell on Mr Chipping and not on the company. Technical arguments do not persuade, and may not even be understood by, a criminal court.
The accused in the Allen case claimed that everything was owned by a “red cross” trust. This was ridiculed by the judge – who was also suspicious of bearer bonds.
In the Stannard case, the accused bought companies with tax liabilities and somehow eliminated the liability with an interest charge. He was convicted. His co-defendant, Robert Nelson, was acquitted.
The first moral of these events is that any avoidance scheme must be technically sound and immaculately implemented. “Off the shelf” trusts or trusts drafted by someone who does not understand the tax implications are always a mistake. Documents need to be preserved; they must be capable of review at a later stage without invalidating the scheme. Professional advisors – accountants especially – have to remember that a document must bear the date on which it was executed. Where a clearance is applied for, all the relevant facts have to be disclosed.
The evading taxpayer who makes a full confession is generally not prosecuted. To pretend that a transaction was not done for tax avoidance – if it was – is a fraud. It is generally best to produce documents promptly. But litigation is always risky, and tribunals have a built-in prejudice against tax avoidance.
The new U.S. rules
Overview of the US tax system as regards non-resident aliens
Taxation of effectively connected income, not subject to withholding tax
Taxation of passive income not subject to withholding tax
Taxation of passive income which is subject to withholding tax
Application of withholding to US citizens and US residents, the “back-up” withholding tax regime
Abolition of “foreign address rule”: what were its defects?
The new withholding tax regime on payments to non-resident alien payees: what is the reason?
Identifying the beneficial owner, i.e. who is the taxpayer under US tax rules?
Entity classification issues: is the payee a corporation, a partnership, a grantor trust, a non-grantor trust, an individual?
Interaction with tax treaties
Who is a withholding agent liable for withholding? What income is subject to withholding?
The QI regime
Confidentiality of information provided to and by QIs and non-QIs
How to comply, how to fill out the new forms
What does it all mean, how does it affect your customers?
The “back-up” withholding tax regime identifies the recipient of income. It does not apply to corporations, non-resident aliens or foreign institutions. Non-resident aliens have separate filing obligations and the payor has to determine whether the payment is effectively connected with a business. A withholding regime applies to US passive income paid to a non-resident, though there are exceptions, including bank interest, portfolio interest, non-property capital gains and income of foreign governments and some pension funds and charities. Treaty relief has to be claimed, and is hedged about by various limitations. The cost of giving effect to these rules is enormous, and it seems that they will be imitated by other countries.
Everyone who handles US-source income is a withholding agent, bound to comply with these rules. Failure to withhold renders the agent liable for the tax, plus interest; over-withholding gives the payee no right against the agent. Sundry forms are required for sundry payments to non-US payees. Is the payee a US citizen? A corporation? The beneficial owner? The payor needs to know the complicated rules and how to apply them, and a multitude of records need to be kept and to be available for exchange of information.
A Qualified Intermediary (QI) signs an agreement with the IRS. A QI must be resident in an approved country. Payment to a WQI essentially relieves the payor from withholding obligations, but the IRS can always obtain from the QI information about the ultimate recipient. The NWQI has to satisfy the payor that payment should be made without withholding.
The QI must withhold unless it is satisfied that the recipient is entitled to the income free of withholding tax. We may expect to see the use of corporations to blunt disclosure, until further rules are made to pierce such screens.
The forms of privilege
What documents attract the protection of legal professional privilege
Is the rule procedural or substantive?
Privilege and statutory powers of investigation
The reasons for the rule about privilege
Developments in the United Kingdom may give some indication of likely developments elsewhere. The Morgan Grenfell case is going through the courts in the United Kingdom: the Revenue won in the Court of Appeal, but application has been made for permission to appeal to the House of Lords. This is likely to be granted.
Legal professional privilege is important in relation to the Revenue’s power to obtain documents in accordance with the provisions known as known as “Section 20″. The Revenue must have a reasonable belief that the document contains information relevant to a taxpayer’s tax liability. Where litigation is not contemplated, “advice privilege” protects communications between lawyer and client relating to the giving or taking of legal advice. Where litigation is contemplated, a document emanating from a third party may be privileged; documents intended to facilitate crime or fraud are not protected. The lawyer required to produce a privileged document will have a conflict of interest. Privilege applies only to lawyers – and not e.g. to accountants. It used to be regarded as a mere procedural rule; it is now understood to be a substantive right. It is much circumscribed by section 20 – see the Morgan Grenfell case, where the Court of Appeal said that privilege does not extend to a document not held by a lawyer, showing that the new statutory provisions have diluted the common law right.
In ex parte Daley, the House of Lords held that legal documents in a prisoner’s cell could only be examined in his absence if the officer was satisfied that it was necessary in the particular case to do so. Their Lordships demonstrated a refreshing lack of automatic belief in the rightness of official action. The Finance Act 2000 conferred on the taxpayer a new right to be heard on the question, whether a protection order should be made in the first place. In general, the law is moving away from an overall, blanket approach to a careful examination of the specific circumstances of the case.
The impact of the European Convention and the ICCPR
Human rights limit what governments can do which affects their citizens.
The Convention on Human Rights was adopted by the Council of Europe in 1950. The Strasbourg Organs have heard a large number of tax cases from taxpayers in the constituent 41 countries. Very similar protections exist in the UN International Covenant on Civil and Political Rights: a few tax cases have come before the Human Rights Committee.
The right to a fair trial is provided by both Conventions, both for civil rights and obligations and criminal charges: this right has been held not to apply to ordinary tax proceedings, but to apply only to serious penalties – where the proceedings are regarded as criminal. This doctrine is however under review in Strasbourg, in the Ferrazzini case. The rights include a right to a court, a right to an independent and impartial tribunal, a right to a determination within a reasonable time (held generally to be around five years) and a right to a public hearing. In criminal cases there is a presumption of innocence, a right to legal aid, a right of silence and the non-heritability of fines.
The European Convention provides for protection of property. Taxation is a prima facie interference with this right: this exception is open to scrutiny – e.g. on the grounds that the tax rules are not subject to the conditions provided by law. Taxpayers have had some success in relation to procedural rules.
The Conventions prohibit discrimination: the taxpayer in the Van Raalte case successfully challenged the discrimination against men in the Netherlands system.
Article 8 of the European Convention guarantees the right to privacy. In the Hardy-Spirlet case, the Court said that the state can justify collection of information if it is in accordance with law and not disproportionate.
There are articles which taxpayers have thought to be of importance – the right to life, the prohibition of torture, prohibition of slavery and forced labour, freedom of though, conscience and religion and freedom of expression.
Its meaning and purpose
In 1996 the OECD Council requested a study of “harmful tax competition” from the Committee of Fiscal Affairs, which resulted in the Report of 1998, Luxembourg and Switzerland abstaining from endorsement of the Report. A Forum was established to open dialogue with members and non-members. In 2000 a further Report listed “harmful preferential tax regimes” (HPTR’s), and tax havens. In November 2000 the OECD established a simplified procedure to avoid getting on the blacklist. Non-member countries prefer bilateral agreements; member countries prefer multilateral agreements. If the United States withdraws its support, the project will slow down.
The Reports dealt only with geographically mobile activities. Taxes on labour and indirect taxes are increased if tax bases on mobile activities are eroded; the OECD recommends that high-tax countries have CFC/IFC legislation. Other methods such as prohibition on deduction of payments to tax havens or HPTR’s are not mentioned. The criteria of the 1998 Report for tax havens were – no or low taxation (a relative concept), no access to or exchange of information (the opposite needing to be encouraged), absence of transparency (which is not good for honest business), absence of substantial activities (a criterion the speaker does not support – especially since more can often be achieved by one person and a telephone than by a whole factory full of workers). For HPTR’s, the fourth criterion is ring fencing. Paragraph 30 of the Report sets out the perceived harmful effects of tax competition, but most of the evils that can be attributed to bad tax competition can be said about tax itself.
However, the recommendations have had their effect: the Netherlands has made changes in its ruling practice. The member states are encouraged to protect their tax base – including the introduction of CFC rules, which penalise smaller and less powerful countries. Strangely, the OECD wants members to have no treaties with tax havens. The Organisation has been accused of being a cartel. But its main purposes are to be applauded – access to information especially; member countries should not be punishing tax havens but should be encouraging them to be more transparent. Dialogue is important to all parties.
Its influence on European taxation
The European Court of Justice is based in Luxembourg. It is responsible for interpretation of European law, and the main vehicle through which it does that is the preliminary ruling procedure. There have been more than 1000 in the taxation area, including rulings on discrimination against imports, on VAT, on fiscal restrictions on Community freedoms. EC law takes precedence over national laws. There are four fundamental freedoms – of goods, of persons (including establishment), of provision of services and movement of capital. They prohibit discrimination, direct or indirect – e.g. on grounds of nationality or residence or other unjustified obstacles to cross-border activity. The Court has dismissed a number of excuses which have been presented by member states as justification, but the Court has acknowledged the right of member states to take account of the different situations of taxpayers, provided that the treatment is proportionate to the circumstance. For example, it allowed a member state of a permanent establishment to limit loss relief to losses occurring in its territory. It has also recognised the need to safeguard the fiscal coherence of the tax system.
In the Saint-Gobain case, a German branch of a French company was denied the treaty relief available to a German company. This was held to be discriminatory. In the Eurowings case, the German company leased an aeroplane from an Irish company not subject to German trade tax; in computing its profits for German tax half the rental payment had to be added back – which would not be required if the lessor were a German company. The Court found this discriminatory.
In the Verkooijen case, a Dutch investor suffered a more onerous tax liability by investing in a Belgian company than he would have done if he had invested in a Netherlands company. The Court ruled against this – a decision which may have very wide implications.
There are several unresolved issues – in tax systems, CFC legislation, cross-border restructuring charges, double taxation, thin capitalisation and transfer pricing, most favoured nation provisions and limitation on benefits, and in practice there are many circumstances likely to give rise to disputes.
Exchange of information – what it actually means
Global tax rules – hypocrisy or reality?
The function of offshore tax centres – necessary evil or essential safety valve?
Are the tax havens nimble operations essential to the developed world or parasites undermining the world economy? Taxable capacity has become scarce: public services and infrastructure expenditure are ever more demanding.
The features of the offshore centres are (1) low taxes – with efficient private investment vehicles, transparent and neutral investment vehicles and location of mobile activities, (2) confidentiality – with protection of privacy, especially for people from politically unstable countries and (3) a light regulatory regime.
Low taxes give rise to “avoidance” and “erosion of tax base”, poaching of business and distortion of trade and investment. Confidentiality can encourage tax evasion and money laundering.
The 1998 Report failed to make any distinction between the proper operations of multi-nationals and the evasive operations of individuals. The OECD has (commendably) revised its views. Tax avoidance is hard to define: it is not enough to say that it consists in paying less tax than the legislation intended. Transfer pricing and CFC rules are there to preserve residence-based taxation – which may no longer be appropriate. Unfortunately, the very OECD countries which condemn offshore jurisdictions for offering tax breaks are doing the same thing themselves. Financial activities are inherently mobile: companies will try to relocate their mobile activities in a more favourable tax environment. This is an inevitable consequence of globalisation and greater mobility of capital.
“Tax poaching” functions as a safety valve. The OECD has confused issues relating to avoidance and those relating to evasion. But there are real problems here. In the United Kingdom, the treatment of trusts has always puzzled legislators, though the rules relating offshore trusts have been much tightened up. A similar confusion in the treatment of private investment companies and funds has reflected itself in a similar confusion in the treatment of offshore vehicles.
A certain amount of evasion has to be tolerated, as a price of allowing a proper measure of confidentiality. Acknowledgement of this is hard for governments. Dealing with it is even harder.
The OECD has had success in moving the debate over tax havens towards exchange of information. The havens have had success in persuading the OECD countries that they should impose the same standards on themselves. The Organisation seems to have abandoned its opposition to ring fencing and is avoiding sanctions. But the OECD still needs to get to grips with the boundary between confidentiality and concealment, the tension between public and private interest, the availability of resources and the right of national sovereignty: it is the voice of the rich countries, whose influence is going to be felt, whether the rest of the world likes it or not. The OECD countries must exercise that influence responsibly. The offshore centres must recognise that they too are part of the world economy and must work to ensure that these problems are addressed and resolved.
A view from the outside
The OECD is concerned with tax systems it regards as not meeting international standards. Since 1998, when the Report was published, the OECD has been in a process of continual change, to improve its processes for carrying out this work. There was a meeting in Paris last week, following upon the mid-May apparent change of policy by the United States.
The mission of the OECD is expressed to be in favour of developing countries; in fact it represents the interests of the rich countries. Its decisions are non-binding and require unanimity. The transfer pricing guidelines of 1995 led the Organisation to develop into more of a policy forum in the field of taxation: the guidelines offered businesses a degree of certainty.
The tax haven project is very different from the EU concept of tax competition: it focuses on preferential rates and on exchange of information and transparency. The initiative was begun by Japan, it was endorsed by finance ministers in 1996. The report of 1998 added the tax haven section almost as an afterthought, and the Organisation was surprised by the opposition it stimulated. The emphasis was originally on shell companies; mistakenly, emphasis was shifted to ring fencing.
Tax havens are not members of OECD. They questioned the right of the OECD to interfere with them, but there were many hours of dialogue, and the project was constantly modified – a process for which the OECD has not generally been given credit. A mere commitment took jurisdictions off the list.
Barbados launched a campaign objecting to the process, and its voice was joined by the right wing of the Republican party – with objections on the grounds that the initiative was hostile to US interests. The Congressional Black Caucus also objected to the initiative on the grounds of lack of dialogue. These events have shown the OECD to be heavily influenced by the exercise of political power by the United States. The Organisation has also been criticised as a “rich man’s club”, which needs to bring the developing countries to the table with an agenda which the developing countries play a role in developing.
Perhaps the question of taxation and international taxation will be more effectively pursued by the United Nations. The developing countries have an interest in revisiting the CFC rules and the residence basis of tax and in encouraging investment in their own countries. It seems that the United States was doing some back-pedalling in Paris, but no press statement has been issued.