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Personal Tax Review


By Tax-News.com Editorial
June 18, 2013


While we have been hearing a lot of talk within and between Governments about how multinational corporations must be stopped from employing tax minimization strategies, individual taxpayers have by no means been let off the hook either, and this feature looks at how opportunities to shelter income from are being increasingly attacked.


Introduction

The majority of taxpayers have very little say over the amount of tax they pay. Chances are, if you are a salaried individual working for an employer, income tax and social security contributions will be taken out of your wages and sent to the taxman before you even see the money. There are ways for individuals to legitimately reduce their exposure to tax, and in many cases these actions are positively encouraged by Governments e.g. by transferring money into tax-privileged savings accounts, or by saving into a pension scheme (although tax relief associated with pension contributions is being eroded in many countries).

Those on high incomes, who in Europe and other developed parts of the world may face income tax rates of up to 50% – or even higher in some cases – have more scope (and motivation) to reduce the amount of tax they pay, as do the self-employed and people who run their own businesses. Broadly speaking, they may do this by converting pay into other forms of income which are taxed at lower rates.

Revenue-hungry Governments are intensifying their attacks on the more aggressive, often marketed, tax minimization schemes. However, as the line between “acceptable” and “unacceptable” tax avoidance is becoming increasingly blurred, individual taxpayers in many countries now need to tread very carefully when putting together structures designed to reduce liability to tax, for even if these maybe legitimate under the laws at the time, they could attract the unwelcome attention of the tax authority, or be legislated away by new anti-avoidance measures, which are increasing in frequency.

This feature summarizes some key initiatives by Governments to limit opportunities for personal tax planning, particularly by wealthy individuals.


High Income And High Net Worth Tax Units

National tax authorities often complain of being under-staffed and under-resourced, and given the complexity of most tax codes this is probably true. Therefore, they now tend to concentrate these scarce resources into “high risk” areas of tax compliance, and for the most part this means small businesses, those with dealings offshore, and high-income or high net worth individuals.

Recently, tax authorities have formed dedicated offices within their organizations which deal solely with tax affairs of the affluent. The United States Internal Revenue Service (IRS) and HM Revenue and Customs (HMRC) in the United Kingdom are but two examples.

The IRS announced the creation of a dedicated team of enforcement and investigation officers to chase up wealthy individuals with complex, often offshore-based, financial arrangements in 2009. The new unit is to be attached to the IRS’s Large and Mid-Sized Business Division, which has extensive experience in scrutinizing complex international corporate tax arrangements and is therefore thought to be the most suitable division to oversee the global high-wealth task force.

This task force centralises high-net-worth individual compliance in one place. Previously, this was spread across other divisions of the agency with little know-how when it comes to international tax issues.

Intensifying oversight of wealthy individuals’ tax affairs has become an increasing preoccupation of the Obama Administration, and the President’s budget proposals for the 2014 fiscal year included a further USD34m in funding for the high-wealth compliance unit, an investment which is projected to yield additional enforcement revenue of USD370m annually once new staff have been fully trained in the 2016 fiscal year.

“This initiative will continue the IRS’s efforts to focus on high-wealth taxpayers by increasing risk identification, case building, and examination capabilities,” says the US Treasury. “High-wealth individuals frequently operate complex enterprises consisting of multiple, interrelated businesses and flow-through entities that often have international components. The IRS takes a unified look at the entire web of business entities controlled by high-wealth individuals to better assess the risks of noncompliance.”

Across the pond, HMRC confirmed plans in January this year to recruit 100 extra inspectors to concentrate on the tax affairs of those classed as affluent, and these were expected to be in place by April 2013.

The new inspectors are attached to HMRC's Affluent Compliance Team, which was set up in October 2011 with a view to raising an extra GBP586m (USD917m) by the end of 2015. According to HMRC, the team currently has staff in six locations across the UK, and its remit has been expanded from taxpayers with an annual income of more than GBP150,000 and wealth of between GBP2.5m and GBP20m, to include those with wealth ranging from between GBP1m and GBP2.5m.

The team focuses in particular on wealthy individuals who habitually use avoidance schemes; have a low effective rate of tax across their total income; have bank accounts in Switzerland and appear to be understating their tax liability; fail to file their Self-Assessment return on time; avoid or evade Stamp Duty on property purchases; or who have UK and offshore property portfolios.

According to HM Treasury, the new team had brought in an extra GBP75 by the time of January’s announcement.


Anti-Avoidance Laws

There is not enough space in this feature to detail every anti-avoidance law proposed or introduced around the world over the course of the last few months – as well as providing a remedy for insomnia, this would end up filling many encyclopaedia-sized volumes – but a snapshot of recent budget announcements points to a clear trend towards governments prioritizing the need to tackle tax shelters and close “loopholes.”


United Kingdom

Again, the UK has been particularly active on this front, and earlier this year UK Chancellor George Osborne unveiled what he called "one of the largest ever packages of tax avoidance and evasion measures presented at a Budget." 

The Budget document, known as the Red Book, provides greater detail on the changes sketched by Osborne in his March 20 Budget speech. The Red Book sets out four key areas in which the Budget represents a crack-down, focusing on offshore tax evasion, the avoidance of employment taxes, tax avoidance schemes, and corporation tax. It is estimated that collectively Osborne's measures will raise over GBP4.6bn (USD7.2bn) in new revenue over the next five years. The immediate closure of ten loopholes will also protect against the loss of billions in revenue, the Treasury calculates.

Also confirmed in the Budget are proposals to target the promoters of tax avoidance schemes, and the aim here is "to tackle both the supply and demand of these schemes." The Budget builds on an announcement made in February that companies and individuals found to have been involved in failed tax avoidance schemes may be disqualified from receiving Government contracts. Potential suppliers will be obliged to declare whether they have had an "occasion of non-compliance" in recent years. The Red Book adds that the Government will review the policy's effectiveness within the next year, and will amend the rules if necessary.

Research by international law firm Pinsent Masons found that the UK's revenue agency is becoming more aggressive towards those it suspects of having evaded tax, and it launched 53% more tax fraud-related prosecutions in 2012 than the year before. Case numbers leapt from 157 to 240, while the number of arrests made rose by 7%. Convictions increased by 4% to 154.

According to Jason Collins, Head of Tax at Pinsent Masons, HMRC is now "much more willing to opt for the criminal - as opposed to civil - investigative weapons in its arsenal."


Canada

Canadian Finance Minister Jim Flaherty's 2013 Budget reaffirmed his commitment to ensure that "everyone pays their fair share" of tax.

When Flaherty launched consultations on this year's Budget, he made clear that the tax burden would not be increased. His Budget speech accordingly reiterated this message, instead focusing largely on the issue of tax fairness, which he described as being "important to ordinary hard-working Canadians." Flaherty announced that the Government is taking action to close a number of tax loopholes which can result in the type of "complex structured transactions that have allowed a select few to avoid paying their fair share of taxes."

In particular, the rules around tax planning are to be tightened, and a harder line will be taken in instances of evasion and avoidance. New monetary penalties and criminal offences will be introduced to deter the use, possession, sale and development of electronic suppression of sales software that is designed to falsify records for the purpose of tax evasion. The reassessment period will be extended for reportable tax avoidance transactions and tax shelters when information returns are not filed properly or on time. The application of the thin capitalization rules will also be further extended to Canadian resident trusts and non-resident entities, and unintended tax benefits relating to leveraged insured annuities and leveraged life insurance arrangements will be eliminated. In addition, the Canada Revenue Agency (CRA) will be permitted to collect up to 50% of amounts in dispute in respect of tax shelter claims that involve a charitable donation. 

On the international front, the CRA will be able to make use of a new Stop International Tax Evasion Program, giving it major new powers of oversight and information collection. It will be enabled to pay individuals with knowledge of major international tax non-compliance a percentage of tax collected as a result of information provided. Certain financial intermediaries, including banks, will be required to report their client's international electronic funds transfers of CAD10,000 or more to the CRA. The CRA's process for obtaining information concerning unnamed persons from third parties, such as banks, will also be streamlined.

In a more explicitly administrative vein, the Foreign Income Verification Statement will be revised to require reporting of more detailed information, and the reassessment period for taxpayers who have failed to report income from a specified foreign property on their annual income tax return, and failed to properly file their Statement, will be extended.

In May, the federal Government confirmed that the CRA will benefit from an additional CAD30m in funding over the next five years. The money will be used as part of the CRA's crack down on international tax evasion and "aggressive" tax avoidance practices.

A dedicated team of CRA experts will be responsible for implementing Budget changes. According to the Finance Department, the team "will ensure that the full force of the agency's international compliance and auditing resources are brought to bear on individuals or businesses seeking to hide money or assets offshore."


South Africa

Various new measures were proposed in the 2013 Budget to protect South Africa’s tax base and limit the scope for tax avoidance. For example, the taxation of trusts will come under review to control abuse; modifications are proposed to the tax treatment of employment share schemes and disability or income-protection policies; and outstanding difficulties in the distinction between debt and equity will be addressed.

With regard to share incentive schemes for employees, the Government still appears to be concerned that some staff equity schemes are being used to lower overall tax rates for high-income earners, and it can be expected that the relevant legislation will be modified.

In their parliamentary speeches regarding the vote on South Africa's 2013 Budget, both Finance Minister Pravin Gordhan and Deputy Finance Minister Nhlanhla Nene stressed the priority the National Treasury is giving to an improvement of tax administration and compliance.

In reply to a question in the National Assembly last year, South Africa’s Finance Minister Pravin Gordhan confirmed that the South African Revenue Service (SARS) has taken steps to improve compliance among HNWIs, including the establishment of a dedicated unit to handle the tax affairs of HNWIs and, as announced in the 2012 Budget Review, improvements in compliance with the tax laws would be a focus area for SARS in future.

SARS is also using its own data and data from third parties to identify failure to register as a taxpayer or declare income and a variety of other forms of noncompliance; and has commenced audits and investigations on a number of HNWIs and their associated entities, such as trusts and companies.


New Zealand

Finance Minister Bill English announced in his 2013 Budget speech the provision of an extra NZD6.65m in funding per year for the Inland Revenue Department (IRD) to "better pursue tax compliance in the area of property investments." Since 2010, NZD110m has been raised from additional property audit funding, representing a return of NZD6.60 for every dollar invested. English expects this latest investment to return roughly NZD45m a year in revenue. An officials' issues paper, released alongside the Budget, aims to clarify issues regarding the acquisition of land. A consultation on the paper will close on June 28.

New Zealand's Inland Revenue has clawed back nearly NZD200m (USD169.4m) through the pursuit of allegedly evaded taxes in the past two years.

Newly released figures show that in the two years to June, 2012, Inland Revenue concluded 1,170 evasion cases. In the twelve months to June, 2011, NZD115.4m in undeclared taxes was recouped, with 657 cases resolved. In the second half of the period, 513 cases were successfully dealt with, generating an additional NZD82.6m in revenue.


United States

At the heart of President Obama’s 2014 Budget are measures to close "tax loopholes" for the wealthiest. As he has proposed before, the President would limit the value of itemized deductions for high-income households and introduce a "Buffett Rule."

The so-called "Buffett Rule" would impose a new "Fair Share Tax" (FST) on high-income taxpayers. The FST is designed to claw back revenue from high income investors who are able to reduce their overall liability to tax by taking advantage of deductions and the lower tax rates in place for capital gains and dividends. The FST would equal 30% of adjusted gross income less a credit for charitable contributions. The charitable credit would equal 28% of itemized charitable contributions allowed after the overall limitation on itemized deductions (so called Pease limitation).

The Budget would also reduce the value of certain tax breaks for affluent taxpayers by capping itemized deductions and certain other deductions and income exclusions. This limitation would reduce the value to 28% of the specified exclusions and deductions that would otherwise reduce taxable income in the 33%, 35%, or 39.6% tax brackets. A similar limitation also would apply under the alternative minimum tax.

Just ahead of the April 15 tax filing deadline this year, the US Justice Department highlighted the work it had done in the past fiscal year to defend and enforce the nation's tax laws, while working closely together with the IRS.

The Tax Division works with the IRS to carry out their combined tax enforcement missions in several critical areas, including prosecuting tax fraud and evasion, halting the spread of abusive tax shelters, tracking down the use of offshore accounts, and combating stolen identity refund fraud. Previously, the Division also announced that it has shut down more than 30 fraudulent tax preparers over the past six months.

Some of the Division's accomplishments from the 2012 fiscal year include the favorable outcomes achieved in over 95% of all civil and criminal cases litigated; the authorization of 938 grand jury investigations and 1,751 prosecutions of individual defendants; the obtaining of 127 indictments and 137 convictions (not including the US Attorney's Offices' additional criminal tax prosecutions); the collection of over USD290m through affirmative civil litigation and the retention of over USD1.1bn through defensive tax refund and other litigation. Previously, the Division had also announced that it has shut down more than 30 fraudulent tax preparers over the past six months.

It was also noted in particular that the Division plays a significant role in the government's efforts to combat abusive tax shelters. These cases involve more than USD1bn in tax revenue, and affect billions more owed by other taxpayers. In recent years, civil litigators at both the trial and appellate levels have won important victories in cases involving tax shelters with names such as Son of BOSS, BLIPS, CARDS, DAD and SILO/LILO.


General Anti-Avoidance Rules (GAARs)

Another legislative weapon that some Governments have in their anti-avoidance armoury is the general anti-avoidance rule (GAAR). Although the technicalities of these rules will vary from one jurisdiction to another, essentially the objective of all GAARs is the same: to subject all questionable tax avoidance schemes to a standard test to establish whether they fall within the law or not. Usually, tax avoidance schemes will have to follow the spirit, as well as the letter of the law, to be deemed acceptable and legal under a GAAR. An economic substance doctrine is often employed, such that if a transaction (or series of transactions) is adjudged to have been structured with the sole intention of avoiding tax, it is illegal.

It can be difficult to establish where the boundaries of a GAAR should end however. Too narrow and the GAAR becomes almost pointless. Too wide and the GAAR has the potential to disrupt perfectly legitimate individual and business transactions and cause huge uncertainty. This is a problem that is  being experienced in the countries which are currently in the process of adopting GAARs, and India is a prime example of where the GAAR margins were originally drawn too wide. As originally drafted India’s GAAR puts the onus on the taxpayer to prove that a transaction has commercial substance, wording that goes directly against the recommendations of the Standing Committee on Finance’s proposal that the burden of proof should fall on the tax authority, to ensure that the government does not abuse its power. The combination of this and a series of other concerns surrounding the proposed GAAR resulted in India’s Finance Minister announcing in January that the new law would not be implemented until 2016 (it was originally supposed to be in place in 2012) giving time for the legislative text to be redrafted.

Similar concerns have been heard from tax experts in the UK, which is also attempting to bring in a GAAR. In 2010 the Government commissioned tax barrister Graham Aaronson QC to lead a study that would consider the merits of a GAAR. However, it has deviated from some of Aaronson’s key recommendations. One particular point of controversy is the government's "main purpose" test used to define a "tax arrangement." This clause would ensnare an arrangement if, having regard to all the circumstances, it would be reasonable to conclude that the obtaining of a tax advantage was the main purpose, or one of the main purposes, of the arrangement. Suggestions by respondents that a more narrowly-targeted test, such as a "sole," "dominant" or "primary" purpose test would be preferable to a main purpose rule, so as to provide greater assurance to taxpayers that "centre ground planning" would not be caught, were rejected by the government. Another bone of contention is the so-called "double reasonableness test," which is the proposed means to ascertain whether a tax arrangement is "abusive." Under this rule, tax arrangements are "abusive" if they are arrangements "the entering into or carrying out of which cannot reasonably be regarded as a reasonable course of action, having regard to all the circumstances." This is a much wider test than that proposed by Aaronson, whose report stated that the GAAR's main test should only target "those highly abusive contrived and artificial schemes which are widely regarded as intolerable."

In countries with well-established statutory GAAR rules, these lines are often subject to the court’s interpretation, and this fact is somewhat ironic given that GAARs are supposed to limit the need for litigation between taxpayers and tax authorities. In one example, the Canadian Supreme Court struck a blow against the government's GAAR by ruling in 2005 that transactions structured to legitimately minimise tax payments do not constitute a breach of the law. The transaction at issue was a leveraged sale-leaseback which resulted in the taxpayer having minimal economic risk. However, finding in favour of the taxpayer, the Supreme Court decided that the transaction in question was not structured illegally and, therefore, rules that it did not fall outside the "object, spirit or purpose" of the capital cost allowance provisions of the Tax Act. Crucially, the Court also stated that the Tax Act continues to "permit legitimate tax minimization." 

The United States doesn’t have a GAAR law as such, but the economic substance test was recently codified under President Obama’s healthcare legislation.

The economic substance test is a judicial doctrine that has been used by judges to deny tax shelters when the transaction generating these tax benefits lacks an underlying economic purpose. However, the courts have not applied the doctrine uniformly, and the health reform legislation clarifies the manner in which the principle should be applied by the courts. Under the provision, the economic substance doctrine would be satisfied only if: the transaction changes in a meaningful way (apart from federal income tax consequences) the taxpayer’s economic position, and the taxpayer has a substantial non-federal tax purpose for entering into such transaction. The provision also imposes a 20% penalty on understatements attributable to a transaction lacking economic substance. This penalty increases to 40% in the case of transactions in which the relevant facts affecting the tax treatment of the transaction are not adequately disclosed.

Other jurisdictions which have GAARs include Australia, New Zealand, South Africa and Hong Kong.


Conclusion

Despite the words and actions of Governments in recent months, tax avoidance is still acceptable if the right side of the law stuck to. Indeed, as stated above, Governments induce us into certain behaviours by offering tax breaks, for example in area of savings and long-term investments, or to encourage more environmentally responsible behaviour, and they will likely continue to do so. However, the picture is more uncertain for taxpayers on high incomes, or with a high net worth, and it is these groups of taxpayers above all others that revenue authorities are keen to ensnare. Wealthier individuals are more likely to explore tax minimization schemes than taxpayers on low- to middle-incomes, but it is exactly these sorts of marketed schemes that are attracting so much attention at the moment, not only in the media, but also from the taxman. On the other hand, the boundaries between “acceptable” and “unacceptable” tax avoidance are being increasingly blurred within the tax avoidance debate, and this is a cause for much uncertainty for individuals and companies when planning their tax affairs. What is more certain though is that Governments are not going to let this issue drop, and it can be expected that the boundary between the “acceptable” and the “unacceptable” in the area of tax planning will continue to be redefined.


 

Tags: tax | law | individuals | tax avoidance | compliance | Finance | business | offshore | South Africa | India | Canada | investment | legislation | court | New Zealand | trusts | United States | tax planning | tax rates | enforcement | audit

 

 

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