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Example Tax Dissertation

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Jess Morris

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The Philosophy of Tax

KPMG’s Tax Business School®

Victoria Heard

Abstract

This paper has been written to provide an overview of research relating to taxation
undertaken by academics in several different disciplines. Research from the disciplines of
philosophy, psychology, the law and economics has been included in this paper together with
other work by business commentators and social scientists. This summary hopes to provide a
platform from which further research can be commissioned within these differing disciplines
in order to gain more insight into how tax is perceived and how frustrations with the tax
system from taxpayers, tax gatherers and advisers that are currently gaining publicity could
be resolved. The paper begins with the identification of a number of topics where further
research would be valuable; also the concerns that business and the tax authorities are facing
in the current tax climate are highlighted. The main body of the paper then discusses in more
detail some of the themes alluded to in these dilemmas.

1. Introduction
1.1 Questions for further research
1.2 Dilemmas of the government and the tax authorities
1.3 Dilemmas facing businesses

2. Tackling avoidance
2.1 Introduction
2.2 The context
2.3 The existing legislative framework
2.4 The emergent frustrations
2.5 Legislative based solutions
2.6 The case for a social solution
2.7 Adapting an existing framework – the case for CSR
2.8 Tools to consider

3 Perceptions of tax and of the tax authorities

3.1 Introduction
3.2 Taxpayer behaviour
3.3 Using behavioural models to change behaviour
3.3.1 The Compliance Pyramid
3.3.2 Applications of the principles of the ATO compliance model
3.3.3 The compliance model and creative compliance
3.4 Regulation, self-regulation and the role of a code of conduct
3.5 How certain taxes are perceived
3.6 Providing incentives and disincentives

4 Conclusions and further research for academia

The aim of this paper is to bring together facets of tax research from fields such as philosophy,
psychology, law and economics to highlight some of the dilemmas facing the world of tax at present
and identify some paths toward resolving these issues by suggesting where further research could be
used to gain fuller understanding of how tax and tax behaviour is perceived by businesses, individuals
and the tax authorities. The paper begins with the identification of these potential research topics;
also the concerns that business and the tax authorities are facing in the current tax climate are
highlighted. The main body of the paper then discusses in more detail some of the themes alluded to
in these dilemmas. This begins with a discussion of the issue of tax avoidance and examines the
problem of defining and tackling tax avoidance and observes how the frustrations of the tax
authorities and the taxpayer are manifesting themselves. This section goes on to discuss some
potential solutions to the problem suggested by different disciplines. The third section of the paper is
concerned with how the perceptions of a tax system and those who administer it may affect the
appetite of taxpayers for compliance with the system. Finally, the paper goes on to look at how tax
policy is influenced by taxpayers’ perceptions of it and how incentives and dis-incentives are used to
shape the behaviour of these taxpayers.

1.1 Questions for further research

In light of the corporate philosophy debate more generally, should companies be required to give
regard to ideas of morality in respect of their tax affairs?

Can considerations of ethical theory assist in finding a resolution to the debate surrounding
“unacceptable” tax avoidance that is satisfactory to all sides?

Do the political beliefs of the boards of corporations influence the tax behaviour of the companies
they run?

Are companies who exhibit other “beyond compliant” activities such as ISO 9000 or ISO 14001
compliance, more likely to adopt a less aggressive tax stance?

Do companies consider tax when looking at their Corporate Social Responsibility (CSR) policies and
do companies with developed CSR policies have a more moderate tax planning attitude?

In light of the work that has been done in the field of psychology regarding how important a
taxpayer’s perception of the tax system is to voluntary compliance, it would be interesting to conduct
further research into how both individuals and representatives of businesses perceive the current tax
system and what changes they would recommend in order to enhance fairness.

Can the themes of evasion literature be applied to avoidance activities? Does the fact that the former
is illegal while the latter is legal change a taxpayer’s behaviour?

Is it possible to estimate the amount of tax lost to avoidance activities. What definition of avoidance
should be used for these purposes?

Research on individuals has moved away from the “rational actor” theory of tax behaviour. However,
intuitively it would seem that this is a more likely explanation for corporate behaviour. Is this the
case?

Is there any correlation between business environment and participation in tax avoidance schemes? If
companies operate in a field of higher than average regulation, such as banking, does this influence
their tax planning activities?

Is a legislative approach the best way to reduce the incidence of “unacceptable” tax avoidance?

How would a code of agreed conduct help to resolve the current frustrations? Could a non statutory
approach produce a better result than legislative approaches?

Is it the role of business or government to create a responsible working environment?

To what extent are tax reputational effects of concern to shareholders and institutional investors?

Could some of the experiments discussed in this paper be repeated in the UK with avoidance as their
focus?

How do reputational issues affect the share price of a company?

If tax policy could be designed with taxpayer behaviour in mind, might it help reduce problems with
avoidance?

There is a taxpaying attitude that Kristina Murphy, of the Centre for Tax System Integrity, calls
“game-playing”. Could further research into this attitude help to understand the behaviour of those
who undertake avoidance activities?

If further study of how businesses feel they are affected by different taxes was undertaken, could this
lead to the design of tax policies that were more acceptable to both businesses and the tax authorities?

1.2 Dilemmas of the government and the tax authorities

The role that the government plays in respect of tax is to balance the need to collect sufficient monies
to fund the social needs of the country with the requirement to create a competitive economy in which
business can flourish. The O’Donnell report (March 2004) entitled Financing Britain’s Future,
examines the best organisational arrangements for achieving the tax objectives set by the government
and it is this document that developed the issue of a merger between the Inland Revenue and Customs
and Excise. This proposal was accepted and HM Revenue and Customs (HMR&C) came into being
in April 2005. Other proposals were a more customer focused administration and increased analytical
resources for the Treasury. The report details how the government wish the UK to be a hub for global
business and also the aspects of a modern tax system to which the government aspires – namely
fairness, efficiency, minimisation of cost and impact of compliance administration and the need to
influence investment decisions and overall economic stability. The document sets out a blue print for
a modern tax administration focused on achieving a competitive tax system for a competitive
economy. To achieve this will require a commitment to the principles underlying that blueprint and
requires a response from all of those involved in the administration of the tax system – including
taxpayers, tax policy setters, tax administrators and tax advisers.

Some of the functions of taxation are to raise money to pay for government spending; to discourage
people from buying harmful goods; to influence the level of total demand in the economy and to
redistribute wealth. A government needs to raise revenue to fund the welfare state, whatever the level
of welfare provision their political philosophy deems to be required. One presumes that the
government is concerned that if it is possible for taxpayers to use complex arrangements created for
the specific purpose of avoiding tax, the tax take will drop significantly and reduce the ability of the
government to provide necessary services. In addition to tax avoidance, the UK tax system is under
pressure for two other reasons – international tax competition and the effect of recent decisions by the
European Court of Justice. These factors may both act to narrow the revenue raising powers of the
© 2005 KPMG LLP, the UK member firm of KPMG International, a Swiss cooperative. All rights reserved.
KPMG and the KPMG logo are registered trademarks of KPMG International.
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4
government. However, when entering into the European Union and adopting provisions of EU law,
parts of the UK tax law may no longer be valid and therefore steps need to be taken to rectify the
situation. Developments such as the new UK-UK transfer pricing legislation show how the UK
government are trying to tackle this situation – in this case by removing the exemption than was
previously enjoyed between two UK companies. Other countries have adopted different strategies for
dealing with this issue. For example, Spain dis-applied its versions of transfer pricing and CFC rules
for countries within the EU. Tax competition that arises from the lowering of tax rates across Europe
means that the government need to consider whether a lower rate of tax would attract investment and
wealth creation into the UK such that overall revenues did not diminish or indeed could increase. As
an aside, it has been suggested (e.g. by the Adam Smith Institute) that avoidance may be mitigated by
a reduction in effective tax rates. A further concern, the budget deficit, is discussed further on in this
paper.

Other worries to the tax authorities may include their defeat in tax planning cases in the courts
(Barclays Mercantile Business Finance Limited v Mawson which the Inland Revenue recently lost in
the House of Lords and Debenhams Retail Plc v C&E Commissioners, which Customs and Excise are
taking to the Court of Appeal), although the authorities have also had “wins” in cases such as Scottish
Provident Institution. With regard to the tax avoidance issues discussed later in this paper, specific
concerns to the tax authorities might be that they do not receive enough information to determine
which planning activities they should be investigating and which are innocuous, or that the
information they receive is deliberately vague. A report by the Taw Law Review Committee (1997)
suggested that participation in avoidance schemes might encourage taxpayers to be less than
completely honest because when the authorities obtain knowledge about the scheme in question they
may seek to render it ineffective with legislation. Any government also will be concerned that any
radical overhaul of the tax system might adversely affect its popularity. As tax is such a sensitive
subject for voters, there appears to be a lack of political will to initiate wide ranging change to the tax
system. Therefore one dilemma for the government and tax authorities would be whether the risk of
attempting to change the tax system or legislation in order to make it clearer and simpler can be
justified. The benefits of radical simplification appear to be a system that is administratively less
expensive to run and more certain for taxpayers and tax authorities alike. The drawbacks could be
major disruption and significant loss of revenue. It is a subject that would benefit from cross party
support.

1.3 Dilemmas facing businesses

Businesses also have a balancing act to perform. The board of a company needs to balance its
responsibility to its shareholders with other responsibilities to its employees, suppliers, customers and
communities. It needs to ensure that the company can be competitive in its market place; otherwise
the people to whom the company has responsibilities will suffer. Businesses need to try to innovate
and develop their products and services; they also need to ensure that they comply with the myriad of
regulations existing in the field in which they operate. The initial reaction of a business is to see tax
as just another cost (albeit a major one) which needs to be managed, and therefore any legitimate
means of reducing its tax costs are welcomed. As stated above, one of the roles of the government is
to create an environment in which businesses can grow, and although the tax rate of the UK has been
lowered over the last decade, the corporation tax take of the Exchequer has increased. The average
tax rate (excluding the UK) in the EU is 26.2 percent, although this does include all the new entrants
who have lower tax rates than the more long-standing EU member states.

When press attention is focussed on the amount of corporation tax paid by companies, they often
neglect the other taxes paid by companies – for example irrecoverable VAT, business rates,
employers NIC, customs duties and excise duties. A survey on this subject was undertaken recently
by PricewaterhouseCoopers and the results of this are summarised on its website. The PwC survey
showed that among 70 companies, 36 of which are quoted on the FTSE 100, 57 percent of
respondents estimated their total tax contribution was over 40 percent of profit, and 30 percent
estimated that it was over 50 percent of profit. This is a large amount of money for a company to
© 2005 KPMG LLP, the UK member firm of KPMG International, a Swiss cooperative. All rights reserved.
KPMG and the KPMG logo are registered trademarks of KPMG International.
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5
contribute to the Exchequer. There is also a compliance cost to companies, both in terms of its own
compliance but also in its unpaid job as tax collector for the government for PAYE and NIC. Also, a
company cannot affect tax policy in the same way as an individual – it cannot vote and therefore is
unable to directly shape the fiscal policies under whose remit it falls. Perhaps there should be a role
for business in helping to influence fiscal policy in a far wider way than it can now.

The spate of rises in the lesser taxes, such as stamp duty and national insurance will have hit many
businesses hard, especially smaller businesses, as these taxes are not proportional to profits.
Economically, tax has large cash flow implications for businesses in a way that other costs do not.
Businesses will also be concerned about the uncertainty resulting from rapidly changing legislation.
Companies may also feel unfairly treated by the recent press comments from those in opposition to
tax mitigation and worry that the company’s reputation is being damaged despite the fact that it is
operating wholly within the law. Because one function of tax laws is to encourage desired
investments, even the most conscientious taxpayer may have trouble deciding when legal strategies to
minimise taxes are appropriate responses to intentionally enacted tax incentives and when they merely
exploit loopholes. This is without taking into account the ethical judgement that some feel a taxpayer
should make in respect of whether to undertake planning that falls within the second category.

Companies are also affected by the uncertainty that the tax system can introduce into their finances.
Due in part to complex legislation, enquiries into tax returns can last for many years for large
companies and even if no adjustment is made to a tax return the company will incur costs in dealing
with these enquiries. Companies may suffer cash flow problems if repayments are delayed or they
may have to retain creditors on the balance sheet in case of any unexpected liabilities arising as a
result of the enquiries. These things also affect a company’s ability to attract investment. The
quarterly instalment payment system for large companies forces tax payments to be made before any
realistic estimate of the final liability, which means that the company risks punitive interest if it does
not pay enough tax or sub-optimal cash flow if it pays too much. In addition to this, as discussed
throughout this paper, some now argue that a company should adopt a moral approach to its tax
affairs, which could leave businesses without even the shaky certainty of the legislation to rely on.

Tax has been mentioned as a factor that could be included in corporate social performance
considerations. There are two main sides to the argument for a more socially responsible corporate
citizen. The first is that of “enlightened self interest”. This basically implies that in some cases it is
in a company’s best interests to undertake socially responsible behaviour. This can be due to
additional or more satisfied consumers, attractiveness to employees and voluntary actions that can
forestall restrictive legislation. Secondly, taking a more long term view, it has been argued that
making a more positive contribution to society might be a long term investment in that the existence
of a safer, better educated and more equitable society might create an improved and more stable
context in which the company can do business. It would appear more difficult to tie tax into these
economic arguments than it is the more traditional topics for CSR debate, such as supply chain rights
or the environment. However, it has been acknowledged that overly aggressive tax policies might
have a negative effect on the reputation of a company which could be to its detriment financially.
There is a definite balancing act to be performed here – pay too little tax and risk reputational risk
amongst investors and consumers, uncertainty over whether your planning will be accepted by the
authorities and a poor profile with HMR&C or pay too much and risk the wrath of your shareholders,
less cash to invest in your business and therefore potentially poorer financial performance.

Calls have been made, for example by the Tax Justice Network, to align tax regulation with corporate
governance legislation and guidance. This would increase burdens for businesses but might help the
transition of tax policy decisions from the tax function to the boardroom, ensuring that the company
has a clear decision making process laid out and that all planning undertaken has the unequivocal
support of the company’s leaders. However, arguably it is crucial that businesses and tax and
accounting bodies are involved in the development of any such regulation in order to help ensure a
fair and workable system that is not too burdensome to businesses.

2.1 Introduction

The first section of the paper looks at the issue of tax avoidance. Tax avoidance, by definition, is
legal but there has been increased scrutiny by the tax authorities of taxpayers who adopt tax planning
arrangements and recent condemnation of these taxpayers by Government officials. This section of
the paper first discusses the context of this debate, how legislation has been used in an attempt to
combat avoidance and the frustrations that have emerged on the part of the tax authorities and the
taxpayer. Ethics and morality are often mentioned in this context, so this paper has included a
discussion of some of the major schools of thought within the academic discipline of ethics to see if
this can help determine a solution. Corporate social responsibility is also discussed, as this can be
viewed as a framework within which companies are encouraged to adopt more socially beneficial
behaviour. Finally, there is an account of some of the tools that have been suggested to tackle the
problems facing the tax system together with some approaches used in different disciplines.

2.2 The context

The issue of taxation has once again been evident in the press in recent months and one of the topics
attracting the most passionate debate is tax avoidance. There are those who believe that it is our right
to organise tax affairs as we will, as long as we do not break the law. This concept was introduced
into law by Lord Tomlin in the case of IRC v Duke of Westminster 1936 – “Every man is entitled to
arrange his affairs so the tax attaching under the appropriate acts is less than it could be”. There are
others who think that those who employ tax planning to reduce their tax burden are effectively
robbing their communities and their country.

The idea of a moral attitude to tax has been spawned from the debate that has gone on for many years
regarding the difference between tax avoidance and tax evasion. This distinction appears to be
straightforward; the former being in agreement with the letter of the law and the latter, involving some
kind of dishonesty, being illegal – as Denis Healey (the former Chancellor of the Exchequer) said, the
difference between avoidance and evasion is “the thickness of a prison wall”. However, the new
frontier of this debate is wider ranging and questions where the line should be drawn between
acceptable tax mitigation and unacceptable “immoral” tax avoidance. There have been recent
instances of members of the government, such as the Chancellor and the Paymaster General,
criticising tax planning arrangements, those firms that sell them and the taxpayers that adopt them, but
without being able to draw a “bright line” between acceptable and unacceptable planning.

The increasing globalisation and sophistication of business has meant that wealth generating activities
can take place in multiple locations and can be moved more quickly. Intense competition has forced
businesses to constantly reduce costs and competition between countries for investment using tax as a
competitive lever forces tax onto the business agenda. This competitive environment may ultimately
be of benefit, but when looked at from a tax revenue perspective, it adds to the opportunities for tax
avoidance and results in advantages for multinational companies over domestic companies that may
have fewer opportunities to lower their tax bills.

A number of advocates of the application to tax of corporate social responsibility have pointed out
that developing countries may be harmed by some current tax practices for example because
companies operating in developing countries may use tax planning to take the profits earned in those
companies offshore. Also, multinationals impose a great deal of pressure on developing countries to
provide them with tax “breaks” (eg tax holidays for inward investment) and low corporation tax rates.
A study by Oxfam (2000) discusses how a survey of the corporation tax rates of developing nations
shows that these are generally much lower than the OECD average, few offering tax rates over 20
percent. With respect to tax havens, the UK government has estimated that 60 percent of international
trade consists of intra-group transactions and the value of assets held offshore in low-tax or no-tax
jurisdictions is estimated to be US$11 trillion (Oxfam 2000). This is one third of the world’s gross
© 2005 KPMG LLP, the UK member firm of KPMG International, a Swiss cooperative. All rights reserved.
KPMG and the KPMG logo are registered trademarks of KPMG International.
KPMG’s Tax Business School is a registered trademark of KPMG in the UK, a member firm of KPMG International.
7
domestic product. Data from the United Nations Conference on Trade and Development (UNCTAD)
has shown that in the early 1990’s there were 37,000 international companies with 175,000 overseas
subsidiaries. By 2003, there were about 64,000 such companies, with 870,000 subsidiaries.

A real concern for the government is balancing income and expenditure. The UK government was
warned by the Organisation for Economic Co-operation and Development (OECD) in January 2005
that the rising UK budget deficit might force the government to raise taxes or slow the rise in public
spending. In its 2004 Economic Survey of the United Kingdom, the OECD states that its projections
suggest "the need for further fiscal action" to avoid "diminishing the credibility of the fiscal
framework". The OECD also warned that "the jury is still out on whether the massive spending
increases will fully pay off in terms of improved service." In January 2005 the Institute for Fiscal
Studies estimated in its Green Budget that £11 billion is required in order for the UK government to
pay for its spending plans and put public finances back on track. The IFS also indicated that at the
end of this year, the government would be taking 2.1 percent more of national income in tax and other
receipts than the previous government in their last year in power. With these major concerns to
contend with it is understandable that the government are concentrating their efforts on trying to plug
the so-called tax gap. The tax gap is the difference between current tax revenues and what revenues
would be if there were no artificial avoidance schemes. It is a very difficult amount to estimate,
although an article by Prem Sikka in the online journal www.publicfinance.co.uk estimates the
amount to be £25-85 billion per annum. However, the impact of removing rights to undertake tax
mitigation activities is just as difficult to assess. As Barry Bracewell Milnes, a tax reform scholar said
“An economy breathes through its tax loopholes” – implying that excessively stringent enforcement
can reduce productivity, innovation, output and work incentives.

In addition, the taxpayer also has concerns - about the increasing burden of taxation that he bears and
the plethora of taxes that are used to try and raise revenue. Taxpayers are also concerned about the
use to which their money is put. A group of pacifists who opposed the war in Iraq and do not wish
their tax money to be used for military purposes is threatening to take the government to court under
the freedom of religion provisions of the Human Rights Act (Harding, March 2005). Stories of
government waste are in the newspapers every day; the James review (sponsored by the Conservative
party) uncovered several areas where government waste could be substantially reduced. It does not
seem altogether surprising that individuals and corporations are concerned about the fairness and
efficiency of the tax system and, as this paper goes on to discuss, moral objections and concerns about
waste are both factors that can have an effect on compliance with tax laws.

UK corporation tax revenues have fallen from 28.1 percent of total Inland Revenue income in 1989 to
19.4 percent in 2003 (although the absolute level of corporate tax revenue has increased). The
breadth of anti-avoidance legislation encompassing personal tax, employment taxes, VAT, stamp duty
and corporate taxes gives an indication of how the burden of all taxes are sought to be reduced by
planning from personal income tax through to corporate taxation. It is not surprising however that tax
planning is so pervasive as decisions by ordinary taxpayers and businesses are influenced by tax
incentives with consequent anomalies and inequities. Decisions to save; go to work; the form of pay
package; set up a business; finance a business; sell a business; share wealth or retire all require tax
decisions created by the use of tax incentives to influence behaviour.

2.3 The existing legislative framework

It could be argued that Parliament and the tax authorities should find it straightforward to direct
taxpayers regarding what tax planning should and should not be done. Initially, Parliament approves
the legislation. This should provide clear guidance as to what is and is not permitted. HMR&C then
have the opportunity of taking to court any taxpayers who implement schemes that they deem
unacceptable. If they lose the cases, they can then proceed through the appeals systems and if they
ultimately lose the final appeal, they can advise ministers to put legislation before Parliament to
ensure the tax planning cannot be repeated. Now, with the new disclosure rules introduced by
Finance Act 2004 promoters and users of tax planning arrangements have to inform HMR&C what
© 2005 KPMG LLP, the UK member firm of KPMG International, a Swiss cooperative. All rights reserved.
KPMG and the KPMG logo are registered trademarks of KPMG International.
KPMG’s Tax Business School is a registered trademark of KPMG in the UK, a member firm of KPMG International.
8
these plans are. Consequently, on coming across an arrangement that they disapprove of, the tax
authorities can announce that from that date, such arrangements will no longer be effective and that
the necessary legislation will be brought forward in the next Finance Bill. This has always been
within their power, but due to the disclosures rules the process will be accelerated.

The legislation itself already has specific anti-avoidance provisions, in some cases where clearance
applications can be made and in others where it cannot. There are sections of anti-avoidance
legislation such as s703 ICTA 1988 which applies to transactions in securities and s776 ICTA 1998
which applies to transactions in land. Clearance applications can be made to ascertain whether or not
HMR&C consider these anti-avoidance sections apply to the transaction in question. The clearance
operates in slightly different ways under each of these sections and if HMR&C are seeking to use
s776 in respect of land that is held to realise a gain of a capital nature from development; clearance
cannot be obtained. Also, many areas of the legislation in existence to date include their own specific
anti-avoidance clauses, for example Enterprise Investment Scheme (EIS) relief (s289(6) ICTA 1988) -
“An individual is not eligible for relief in respect of any shares unless the schemes are subscribed for,
and issued, for bona fide commercial purposes and not as part of a scheme or arrangement the main
purpose or one of the main purposes of which is the avoidance of tax”.

The 2005 budget initially suggested provisions in order to prevent avoidance of corporation tax
through schemes which create a tax advantage because different jurisdictions classify business entities
in different ways (“arbitrage schemes”). These provisions were removed from later versions of the
finance bill, but it is expected that they will be adopted in some format later in the year. If these
provisions were adopted in the same format in which they originally appeared in the draft finance bill;
then in a similar manner to the transactions in securities provisions the rules would only apply if
HMR&C issues a notice directing that this legislation will apply (the “direction”). There would be no
formal clearance mechanism, but the draft HMR&C guidance discusses the possibility of obtaining a
ruling on specific transactions under the usual Code of Practice 10 provisions. However, for the
purpose of this paper it is the uncertainty created for the taxpayer by these provisions that is of
relevance. If these provisions were to be introduced, a company would not know whether or not it is
caught by them until HMR&C informs it so. The provisions were also expected to apply to all
companies regardless of size, but the HMR&C guidance suggested that directions would only be
made where the tax at stake is in excess of £50,000. Therefore, the decision as to whether a direction
will be made might rest upon the HMR&C’s estimate of the tax that may be at stake if it could
subsequently be proven that the legislation did actually apply to the situation. It will be interesting to
chart the development of this potential legislation.

It would seem, not surprisingly, that there are two conflicting objectives regarding tax planning. The
government would prefer that no taxpayer pays less than expected by Parliament, whereas taxpayers
will rarely seek to pay more than required by the law. Also, from a legal perspective, it is important to
note that taxpayers can only be taxed on what the legislation says. Many members of the judiciary
have opined eloquently on this subject, but perhaps the neatest summary is from a non-tax case
(Black-Clawson v Papierwerke 1975), where Lord Reid said “We are seeking, not what Parliament
meant, but the true meaning of what they said”.

Case law throughout the decades has developed the concept of acceptable and unacceptable planning
with the cases from Ramsay v IRC through Furniss v Dawson, Macniven v Westmoreland Investments
Limited and most recently Barclays Mercantile Business Finance Limited v Mawson. However, the
judiciary appear reluctant to be too prescriptive when dealing with tax cases – indeed in Macniven v
Westmoreland, Lord Hoffman noted that creating an overlying principle that would guide tax
behaviour was beyond the constitutional authority of the courts. In the past the idea of a “substance
over form” approach has been suggested, in that the overall aim of the transaction should be
considered, as well as its actual legal form. However, the recent cases of Barclays Mercantile and
Scottish Provident Institution seem to have simplified the issue by showing that what is required is the
application of the words of the legislation to all the facts of the case. Where this leads to ambiguity, a

Anti-avoidance questions have reached the European courts too. The Advocate General (AG) gave
his Opinion in the joined cases of Halifax, the University of Huddersfield, and BUPA on 7 April 2005
each of which have been referred to the European Court of Justice (ECJ). The cases concern whether
there is any rule in EU law that prevents transactions carried out by a taxpayer for the purpose of
avoidance of VAT from having the effect intended by the taxpayer. If the ECJ follows the AG’s
opinion, taxpayers will not be prevented from structuring their businesses in a tax efficient manner.
However, tax avoidance structures which aggressively seek to undermine the fundamental principles
of VAT neutrality may fall foul of the principle of abuse. This appears to provide some clarification
as to how anti-avoidance, at least in the case of VAT, will be treated in the European courts and give a
little more guidance to taxpayers when structuring transactions.

Overall therefore, there is a legal process to determine the amount of tax that a taxpayer is required to
pay and that legal process can be used as policy objectives change or taxpayer behaviour does not
produce the expected tax revenues. It would seem, however, that this process is not working
satisfactorily.

2.4 The emergent frustrations

The HMR&C, the Chancellor and other Treasury officials have begun to be more and more vocal in
condemning those who use tax avoidance to legally ensure that they pay as little tax as possible. For
example when announcing the creation of an international tax force to counter tax avoidance on 23
April 2004, John Healey, Economic Secretary to the Treasury, stated: “Tax avoidance and the
industry that drives it are increasingly an international phenomenon and it is vital that we have
effective international co-operation to tackle it, as we do for tackling terrorism, organised crime,
money laundering and fraud.”

However, it must be pointed out that tax avoidance is currently legal and it would seem somewhat
inflammatory to compare it with terrorism and money laundering, which clearly are not. It is
acknowledged that there is a point of view that any tax avoidance arrangements which obey the letter
of the law but not its spirit are unacceptable, but provocative statements such as these may damage the
cause of those who believe this. On the same occasion, Paymaster General, Dawn Primarolo, a vocal
critic of tax planning, says: “Tax avoidance works to the detriment of everyone who pays their fair
share and robs our public services of billions of pounds”.

This of course begs the question – what is a “fair” share? What is unfair about using the legislation to
one’s best advantage? Further research is needed in order to estimate accurately the tax lost due to tax
avoidance, although it is acknowledged that this is a difficult task. As noted earlier, estimates that
have been made range between £25 billion and £85 billion. It has been argued (e.g Avery Jones 1996)
that it is the complicated tax legislation that adds to the problem of tax avoidance, and that the
increasing instances of laws being rushed through Parliament without the level of necessary review
and consultation only compound the effect. Several academic studies have made the point that the
more complex and rigidly rule based tax systems are, the more opportunities for tax avoidance abound
(e.g McBarnet 2002).

A further concern is that the government is able to announce that certain arrangements will be
unacceptable from a certain date, with no draft legislation available to allow the taxpayer to know
exactly what is contrary to the legislation and what is not. Is this a fair way to ensure that people are
taxed correctly? It would appear to allow a taxpayer to be penalised for doing something that at the
time he had no way of knowing was incorrect. This approach may leave the government open to
litigation under human rights legislation, although this view is not shared by all. An article in the
British Tax Review by Philip Baker QC provides an insight into this issue (Baker 2005). The new
approach by HMR&C to combating arrangements they deem unacceptable is clear. “We will be
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10
aggressive” said Chris Tailby, head of HMR&C’s new anti-avoidance group when describing their
plans to bring finance directors into the courts to explain their involvement in tax planning
arrangements (Rae 24/02/2005). HMR&C also intend to report accountancy firms to their
professional bodies where they feel that these firms have been aggressively pursuing tax mitigation
and where HMR&C consider them to be acting unethically.

Again it should be pointed out that tax avoidance activities are legal and what may or may not be
unethical is far from defined. Is a grey area of the law made black and white just because HMR&C
want it to be? On the other hand, it might be argued that the law is indeed black and white, and what
it states is that tax avoidance is by definition legal. Perhaps it is the tax authorities who are trying to
introduce grey areas by adding considerations of morality to the debate. For all the heated argument,
there does not appear to have been a suggestion (that would be acceptable to all sides of the argument)
of what to do about the fact that taxpayers are permitted to undertake tax avoidance activities by the
law. Inland Revenue figures show corporation tax receipts of £28.1 billion for the tax year
2003/2004. This is only the tip of the iceberg where the tax contributions of companies are concerned
and if the other taxes that companies pay were included, the amount contributed would be far higher.
The above quotations show the level of emotion surrounding this subject, but it is not law that a
taxpayer must not do something because HMR&C do not want him too.

Tax avoidance is not illegal, but outside the tax world there are many instances where the law and
morality do not stand on the same line. For example, most people would consider infidelity to their
spouses immoral. Yet, it is not illegal. On the other hand, speeding is against the law yet if the
opinions of motorists were canvassed, a spectrum of differing beliefs as to whether or not it is
acceptable behaviour would be obtained. Obviously the key problem is that morality is difficult to
define. Something that is anathema to one person may be considered perfectly acceptable by another.
What seems clear however is that a long term solution to the issues raised by the tax avoidance debate
needs to be found.

2.5 Legislative based solutions

The idea of an overlaying principle or rule has been mooted to a certain degree in the form of a
general anti-avoidance rule (GAAR). It is possible that this former would act to impose a further
layer of rules onto the already extremely complicated legislation. The general anti-avoidance rule has
been rejected so far in the UK on the basis that it would not provide the certainty required by
taxpayers and that it is difficult to define a general rule that does not impact genuine business
transactions. Advance clearance mechanisms have been proposed; however this would be labour
intensive for HMR&C and would increase the cost of collection for the tax in question. Every
genuine commercial transaction found to have a tax consequence would need advance clearance if
those carrying it out were to have certainty about its effect. The resulting flood of applications for
clearance could swamp HMR&C and potentially introduce delays of many months into the process.

A further disadvantage of clearance applications under the GAAR is that it could empower HMR&C
to decide (at least in the first instance) what is and is not an acceptable interpretation of the tax
legislation. The taxpayer would still have the option of taking the matter through the courts, but
would naturally be discouraged from doing so by HMR&C’s refusal to give clearance. It is for the
courts to hand down binding interpretations of legislation, not civil servants at the HMR&C. A
further criticism of the clearance procedure is that it would only apply if the transaction was carried
out precisely as described in the clearance applications. As anyone involved in commercial
transactions will be aware, the nature of a commercial scheme can change from day to day, even hour
to hour. Would advance clearance need repeated applications?

Some nations around the world have introduced general anti-avoidance rules, notably New Zealand,
Australia and Canada. Canadian tax law has contained a general anti-avoidance rule since 1988. The
governments view is that the GAAR is intended to prevent abusive or artificial avoidance schemes,
without interfering with legitimate commercial transactions. It does so by giving the Canadian tax
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11
authorities the ability to deny any tax benefit obtained as a result of the particular offensive avoidance
transaction, or series of transactions. The key tests are whether there has been a misuse or abuse of a
provision of the Act and whether the primary purpose of the plan is to obtain a tax benefit. Therefore
as a result of the latter condition, as long as a taxpayer can justify the transactions from a business
perspective, they should not be at risk from the GAAR. In general, Canadian courts have used the
GAAR restrictively, imposing a high threshold on the tax authorities to show there has been a misuse
or abuse of the Canadian tax legislation. In applying the GAAR, Canadian courts still generally look
to the legal form of a transaction as opposed to its economic substance.

A second anti-avoidance provision has been suggested (Freedman 2004) – the general anti-avoidance
principle (GANTIP). This might be preferable as it would not attempt to define in detail the type of
planning or transaction that would be halted. In acting upon such a principle, anybody whose goal
was to comply with the law would be better able to understand what was required by Parliament. It
would also give the company director protection and guidance on how to balance his duties to
shareholders and the company’s duty to pay tax. Freedman’s paper suggests that the GANTIP could
be a statutory provision entitling the courts to go beyond the ordinary rules of statutory construction
and potentially negate artificial avoidance schemes which abused the wording of the legislation. In
effect this could create the overlying principle guiding taxpayer behaviour that Lord Hoffman noted
was beyond the constitutional authority of the courts. Once the statutory provision had been enacted,
it would provide a legitimate framework in which the courts could operate to work out what
Parliament would have intended. This would allow HMR&C to concentrate on the extreme cases of
avoidance, while the majority complied voluntarily with the principles. The GANTIP could give rise
to a debate around the meaning of avoidance which could be held between the taxpaying community
and the revenue authorities in agreeing the guidelines, although some have argued that the
development of the GANTIP should be a matter for the courts. Again, there is a lack of certainty for
the taxpayer and the tax gatherer, however as discussed further on in the paper, certainty may not
assist in the fight against tax avoidance.

A legislative solution to the issues at stake might therefore be a useful one, but if too prescriptive it
could add further complexity to the legislation. Also as with the tax cases that have come to the
courts in the UK to date, the severity and usefulness of a GAAR would depend on test cases that came
before the judges and it would take some time before the boundaries of such legislation could be
established. A principle, whether created in the legislation (such as the GANTIP) or whether as a
code incorporated into corporate governance might be of more assistance in that it could provide
guidance to the taxpayer when navigating the complicated tax system. Whilst both provide a clearer
statement of intent, both leave areas of uncertainty; perhaps this should be accepted as inevitable - the
objective may simply be to reduce the areas of uncertainty.

2.6 The case for a social solution

As discussed above, the ambiguities that can be found in the legislation make it difficult for the law to
arrive at a solution to the emerging problems. Can considerations of ethics help? The word “ethics”
has been much quoted in the press, but what could those who are involved in the academic study of
ethics contribute to the debate? In short, who decides what the correct ethical stance to take is? The
information contained within this section will no doubt appear rudimentary to a scholar of philosophy,
but a brief summary of some of the different perspectives of the differing schools of philosophy, along
with the author’s thoughts as to how these might apply to the tax avoidance debate, might be of
interest to the non-specialist reader. This is by no means an exhaustive review of all schools of
philosophy, but rather a general discussion about some of the more major principles. Fisher and
Lovell (2003) and Crane and Matten (2004) provide further insight into the schools discussed here.

An article by John Sartoris in the Philosophy for Business online journal (2/11/2003) provides an
interesting discussion of the issues to be considered here. The argument has been raised that tax
avoidance is unethical because if some people avoid their taxes, then others will have to bear an
increased burden. This implies that if avoidance was to cease completely and the tax revenue to the
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12
government to increase, the government would reduce the tax rates. This appears to be a fair solution,
although it may be an unlikely one. It is equally probable that the government would identify
something else to spend the money on and it is possible that this additional spending would increase
the level of public services, which would also be a beneficial outcome.

Ethical theories can be roughly split into two camps – non-consequentialist and consequentialist. The
first considers ethics to be a set of principles that apply regardless of the consequences of the actions.
The second considers an action to be more ethical if it brings a person closer to a desired ethical state
– i.e. that it is the result of the action that is important. Examples of non-consequentialist theories are
virtue ethics and deontological ethics, and examples of consequentialist theories are ethical learning
and growth, and teleological ethics.

Teleological ethics argues that the “rightness” of an action is not inherent in that action, but is judged
by its consequences. Utilitarianism theory, a subset of teleological ethics, accepts utility, or the
greatest happiness theory as the foundation of morals. As Jeremy Bentham, the 18th century
philosopher said: “the greatest happiness of the greatest number is the foundation of morals and
legislation” (Bentham 1982).

It has been claimed that tax avoidance is unethical on utilitarian grounds because it damages the
general economy and therefore does not increase “the greatest happiness of the greatest numbers”.
However, economics needs to play its part here and it is far from certain that tax avoidance causes the
economy to suffer; in fact there is an school of economic thought that would argue that a lower tax
burden encourages innovation. Perhaps if it does not cause the economy to suffer, tax avoidance
cannot be said to be reducing the level of happiness. Utilitarianism can perhaps be thought to be a
calculating approach to ethics and it assumes that it is possible to measure both the quantity and
quality of happiness. However, when assessing considerations of happiness it is necessary to consider
whether the happiness that has been achieved has been at the cost of greater pain to other people.
When thinking about what actions lead toward the greatest happiness, it is important to consider
whether a good is being maximised rather than the good – whether the greatest happiness of some is
being obtained rather than the greatest happiness of all. It could be postulated therefore that if tax
avoidance ceased completely, the revenues of the government would be maximised. However, this
could be at the cost of damage to innovation and the economy, in which case the overall good might
not have been maximised. Also, utilitarianism may fail to work as a method of assessment if people
are unable to make accurate predictions about the consequences of their actions (as may well be the
case for the tax debate), as there is little point in weighing up the greatest happiness from a set of
actions if the actual consequences of the actions have been misinterpreted.

Another subset of teleological ethics is discourse ethics. This approach deals with the proper process
of rational debate. It is a concept of self-reflection that requires those involved in the debate to
challenge their own arguments. Contributors to this school of ethics have looked at advice given in
popular books on the skill of debate and considered whether some of these could be considered unfair
“tricks” of presentation. This leads to some tests that people should consider when assessing their
own arguments. The first is called formal validity and considers whether arguments are logically
rigorous or not. Has the proponent only used cases that support his point of view and discounted all
others? The second is sincerity/truth – are the arguments intentionally misleading, incoherent or
incompatible with the truth? Is the proponent misrepresenting the position of his opponent or
exaggerating points? The third is content justice. This includes arguments where the opponent is
attacked, rather than his arguments criticised. The final one is procedural justice which would counter
techniques preventing an opponent from fully participating in the debate – for example the use of
unnecessary jargon. It is also an important ethical consideration to determine who should have a
voice in the debate. This point has been used to underline the fact that including the opinions of
stakeholders in the running of a company can help to include consideration of the impact of a decision
on workforces, communities and the government. If only the point of view of the directors were
included, only bottom line profit might be considered, as it is the job of this group to maximise
shareholder profit. On this basis, a fair debate on tax avoidance would presumably need to include the
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13
views of the tax authorities, government, tax practitioners and representatives of all categories of
taxpayer. It would be ironic to conclude that the current method and tone of the debate of ethics and
tax was itself unethical!

Deontological ethics is from the non-consequentialist school. One subset of this is Kantian ethics,
which seems to argue that knowing what action to take in a situation will be determined by a set of
pre-determined principles that are completely independent of the situation at hand. According to
Kant’s principles, this applies to such an extent that if lying is considered to be wrong, then no-one
should lie under any circumstances, not even if such a lie could save an innocent human life. The
framework that Kant developed was called the categorical imperative and it has three parts (De
George 1999):

• Act only according to that maxim by which you can at the same time will that it
should become a universal law.
• Act so that you treat humanity, whether in your own person or another, always as an
end and never as a means only.
• Act only so that the will through its maxims could regard itself at the same time as
universally lawgiving.

If an action is to be viewed as morally right, it must “pass” all three tests. The first maxim checks for
consistency – an action can only be right if everyone could follow the same underlying principle. The
second maxim focuses on the idea of human dignity – that no-one should ever treat another person
solely as a means to achieve what he wants and forget about that individual’s needs in life. The third
maxim tries to overcome the subjectivity that is inherent in a person’s analysis of his own behaviour
as it stipulates that a person should consider whether other rational actors would endorse his
judgement of a certain situation. This can be compared with the Texas Instruments ethics test
discussed below – how would you feel if your actions were published in the papers? If the answer to
this question is not positive, it is likely that from a Kantian standpoint your actions cannot be
considered ethical. It would be interesting for a philosopher to apply Kant’s theories to the tax
avoidance debate.

This third maxim was expanded on by Rawls (Rawls 1971), who theorised that in order to arrive at a
blueprint for a just society it must be discussed by people who are in ignorance of where they might
fit into that society. For example from a tax perspective, perhaps a group of people could discuss an
ideal tax policy without knowing whether, when put into this society, they would be an unemployed
person relying on state benefits, someone reliant on lifesaving drugs from the NHS, an extremely rich
person, a chancellor seeking to maximise revenue, or one of the millions of “ordinary” people who
fall somewhere in between these extremes. Rawls argues that in adopting this approach a person will
take a risk-averse approach and analyse all the worst case scenarios she can think of before selecting
the one that is “least worse”. In theory, this leads to the policy that is beneficial to the most people.

The Libertarian school of philosophy (another subset of deontological ethics) can also be applied to
the tax debate. The Libertarian school holds that differences in personal wealth, talent, intelligence are
seen as being natural in that their ownership owes nothing to political or social institutions.
Differences to the opportunities in life of individuals owing to the possession or otherwise of these
characteristics do not justify the intervention of the government to redistribute some of the associated
benefits. The school therefore holds the view that individuals have a fundamental right to own and
keep their property, including the wages they earn. It accepts that tax should be paid, but holds that
taxpayers must give voluntary consent to the state taking away what belongs to them. This school
rejects that the state has a general right to tax or a moral right to a fair share of the wealth or the
income of the nation, and opines that any prior consent given applies only to the circumstances set out
in the legislation specifically consented to. This would imply that if the circumstances of the taxpayer
change or the taxation environment changes, the consent previously given is withdrawn and tax is no
longer due as prior consent has not been given to taxation in the new circumstances. Robert Nozick
was a leading advocate of the libertarian position on justice and rights. He arrived at the term
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14
“entitlement theory” to demonstrate his opinion that what has been acquired legally and fairly cannot
be taken away within the libertarian notion of justice (Nozick 1974).

An alternative perspective that branches off the main libertarian philosophy is liberalism, which
appears to take the freedom advocated in libertarianism, and add a more socialist element. This
school of thought believes that the state can be used to achieve social justices and therefore a liberal
view of tax might be that part of the wealth or the income of the population belongs to the state and
even without consent it is possible for it to redistribute wealth and income as it sees fit. This is on the
grounds that wealth would not be able to be earned were it not for the state.

Virtue ethics takes the point of view that virtues are not ends but means, and these characteristics
provide the basis for individuals to lead a good and noble life. For Aristotle, one of the original
proponents of virtue ethics, the notion of a good life meant a complete life and assumes that happiness
comes from behaving well in addition to faring well. Virtue ethics can be defined as the belief that
there is a set of personal characteristics that if practised will ensure that an individual is likely to make
the right choices. Therefore when confronted with a dilemma, one should ask – what would a
virtuous person do in this situation? However, one important thing to note about this ethical school is
that the notion of the individual is seen as an individual as part of a wider society. Therefore it is the
perception of others that determines where on the scale of values one fits. The scale of values starts
with the virtue itself (e.g courage) and goes on to describe the vice of deficiency (cowardice) or the
vice of excess (recklessness). This balance can be shown in the Aristotelian perspective of justice “to
do injustice is to have more than one ought and to suffer it is to have less than one ought and justice is
the mean between doing injustice and suffering it.”

Over the years philosophers have added to Aristotle’s concepts and developed the idea that sometimes
wisdom is needed to temper justice. This leads to the idea of “care” as a virtue – this has formed a
school that is sometimes called feminist ethics. This is an approach that seeks to find a way forward
that not only provides some form of equitable resolution to a conflict, but also holds out the
possibility for maintaining a working relationship between the parties so that future co-operation
might be possible. One can imagine that this could be put to good use in the debate between the
taxpayer and the tax authorities. Philosophers within the school based on Aristotle’s teaching have
also debated whether a good outcome is a virtuous one even if the deed was set about with bad
motives, or if the achievement of socially desirable ends can justify less than acceptable means.

A further school of thought, ethical learning, develops the idea that policy ends should be the
yardsticks against which the morality of actions should be judged and they can only be achieved
indirectly. This means that the end has to be approached indirectly by encouraging processes of
learning that enable people to decide for themselves to act ethically. This is one element of
philosophy that has definitely been used in our modern world and the concepts of individual growth
and organisational learning are frequently used in business. The reasoning behind this is that
individual learning is necessary for the growth of an organisation and it is only organisations that
learn and grow that will be successful. Learning is considered to be an ethical end in itself. Therefore
in trying to learn or develop knowledge about a particular issue, a person is achieving an ethical goal.

Ethical egoism, a school of consequentialist ethics, states that an individual should pursue his own
interests by applying his own reason to the task of identifying and achieving his own best interests – a
person’s actions would be morally right if he freely decided to pursue either his short term desires or
long term interests. The ethical position of these theories, one of which is objectivism proposed by
Ayn Rand, is that each independent individual should seek his own happiness through a productive
independent life in which his own rational judgement is his only guide. Rand said “my philosophy,
in essence, is the concept of man as a heroic being, with his own happiness as the moral purpose of
his life, with productive achievement as his noblest activity, and reason as his only absolute” (Rand,
1964). Ethical egoism school encourages a robust belief in self-help and concludes that people who
will not take responsibility for themselves will have to bear the consequences and cannot expect
society to help them out. However, egoism appears to be different from selfishness. An egoist might
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15
be moved to help others by seeking to remove his own distress at their plight, whereas a selfish person
would be entirely indifferent to the plight of others. It appears straightforward to apply this theory to
tax behaviour – as long as the law is adhered to a person should just use their own reason to determine
whether or not they should adopt tax minimisation strategies that can lower their liabilities.

While ethics can provide some guidance and a basis for discussion of modern day problems,
obviously it is probably not capable of providing “answers” to the problems currently facing tax
authorities, tax practitioners and taxpayers. However, it would be of great interest for a philosopher to
apply their work to tax issues in the current environment and for philosophy’s contribution to the
debate to be heard.

2.7 Adapting an existing framework – the case for CSR

The idea of ethical tax governance has also come to the forefront as part of the debate on corporate
social responsibility (CSR). Should companies try to make sure they pay the absolute minimum in
tax? Should companies recognise a responsibility to the community that they operate in and ensure
that they make a fair contribution? Has less tax being payable encouraged innovation and growth,
thus leading to benefits such as increased employment? Do companies ever truly bear the burden of
tax? Or do they pass the cost on to their customers as they would any other cost of doing business?
As Holman W Jenkins Jr stated: “A business is nothing more than a conduit for passing along costs to
its customers. Taxes are a cost, so tax avoidance is part and parcel of competition to bring consumers
better stuff at lower cost”.

Perhaps it is worth mentioning here Milton Friedman’s objections to the idea of a corporation as an
entity with responsibilities (Friedman 1970). The first objection is an economic criticism that states
that the engagement of companies in philanthropic activities distorts allocative efficiency. He opined
that a corporation’s only responsibility was to use shareholder’s funds in a profitable way. He only
accepted that spending on socially responsible activities could be a company’s goal if it improved the
company’s profits more than other ways of spending that money. His second point was: “How can it
be ethical that a corporation should act first as an unpaid tax collector and then as an unaccountable
benefactor?” In his opinion, it was up to publicly elected representatives to provide finance for public
services and up to individuals to donate to charity. Finally he stated that companies cannot possess
responsibilities – only individuals can do so. Companies are social constructs set up by the law and as
such are unable to have responsibilities – a subject that has been the focus of much philosophical
debate.

There are significant obstacles facing companies that wish to undertake socially responsible activities.
For example, if they incur costs that their competitors do not, they put themselves at risk of erosion of
their competitive position. Also, drawing on regulatory themes, if they invite government attention,
they may be hampered by regulations that impose costs without generating meaningful societal
benefits in return (such as environmental taxes criticised by the CBI for imposing burdens on
businesses without providing much benefit to the environment). Could academic study apply the
principles facing companies in the broader field of socially responsible behaviour to the specific
issues of the ethics surrounding tax planning?

The legal structures of corporations owned by shareholders impose certain priorities on their leaders.
If leaders fail to maximise shareholder value, they risk removal by equity holders and they put the
company at risk of being acquired by a stronger company. This would seem to imply that self
preservation would dictate that no rational executive would engage in any activities which do not have
as their primary purpose the increase of shareholder value. The fact that the directors of a company
have a fiduciary duty to protect the investment of the shareholders is of key importance. In some
states in the USA, shareholders are able to sue a company if they believe that actions are being taken
that are not in their best interests. A situation can be conceived whereby a company could be sued for
being overly philanthropic with money that the shareholders believe should be put to work to improve
their investments. Tax can be a very large number in the profit and loss account of a company’s
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16
financial statements and if a company were to make no attempt to arrange its tax affairs to mitigate
these liabilities it is logical that this will be to the detriment of the business and potentially all the
stakeholders, not just the shareholders.

However, it is true to say that corporations do not exist in a world that is made up solely of
shareholders. They are also subject to pressures from other stakeholders and it is important to note
that stakeholders are not mutually exclusive of each other. A person could be a shareholder and a
consumer for example. As discussed further on in this paper, pressure from certain sections of society
can drive improvements in one company or industry that can become normal practice through the
expectations of society in general, which can then be introduced into legislation or regulation to
ensure a minimum standard of behaviour for all firms. In this way, there can be a continual cycle of
improvement of corporate behaviour.

The large amount of tax that corporations pay, together with their broader contribution to the
economy, makes them key stakeholders in the nation and arguably should give them a greater
influence than they currently have on the setting of fiscal policies. This would also mean that
companies could use their business skills and financial expertise in a socially responsible way in order
to help the government to develop fiscal policy that is beneficial to all. There are many examples in
practice of where the most effective type of socially responsible behaviour is using a company’s
particular capabilities to address a problem faced by groups in society. For example, Procter and
Gamble used their own expertise in order to develop a technology that allows people in the
developing world to disinfect water in their own homes at very low cost (Martin 2002).

Another point that has been made by supporters of the CSR debate is that surely an aim of corporate
social responsibility is to give a company an ethical approach to doing business. Is it possible to be
ethical in one area of the business and not in others and yet still be socially responsible? If one
assumes the point of view that aggressive tax planning is not ethical, then one can imagine a situation
where a company makes a contribution of, say, £100,000 to a children’s ward of a hospital for vital
equipment, but undertakes a tax planning scheme that allows them not to pay £1,000,000 of tax,
which potentially would go to the NHS. There must be many examples of this in practice. Does this
show a disconnection in the values of the company? If one accepts that a company should try to be
socially responsible it would appear that its tax policy should be in line with its other CSR policies.

2.8 Tools to consider

A tool has been developed by Texas Instruments in order to help people consider the relevant issues
when making ethical decisions (http://www.ti.com/corp/docs/company/citizen/ethics/quicktest.shtml).
The Texas Instruments ethics test uses a series of questions to help a person to decide whether
something is ethical or not, although it is worth noting again that the answers will be subjective and
wide-ranging from individual to individual. These are:

Is it legal?
Does it comply with our values?
If you do it, will you feel bad?
How will it look in the newspapers?

This looks at ethics from a point of view of social responsibility rather than a pure philosophical
outlook, but these questions are very interesting when applied to tax from a perspective of corporate
social responsibility and linked to a company’s own CSR agenda. Arguably most companies would
only undertake legal tax planning activities, but how do tax directors feel about the arrangements they
implement? Would companies want the intricate details of their tax planning published on the front
pages of the Financial Times? If a specific consequence of the non-payment of tax could be
identified, might their responses be different? Do companies consider tax when designing their CSR
policies?

If your group is consistently reporting losses, are these real economic losses and can
they be satisfactorily explained in terms of the group’s overall performance?

If the structure for your group’s business or a major transaction is complicated, is this
because the business issues are complicated? Or are there additional steps designed
to reduce the taxes that would ordinarily be payable?

The ATO intend these questions to help board members determine whether there are any governance
issues associated with the group’s tax responsibilities and whether there are any tax issues within the
group that might attract ATO attention. Even if the company still fully intends to undertake tax
mitigation, it can only be helpful that the board is fully informed and involved in these decisions and
the above questions allow those at the company to evaluate the ATO’s likely response to their actions.
This way any consequences of tax planning and policy can be anticipated and tax risks managed.
Here in the UK, now that several non-financial considerations have been assigned to tax, such as
reputational risk, reporting decisions and governance issues, it is important that decisions regarding
tax also reach non-financial directors, in order that the tax function is managed to the best advantage
of the company.

On a more fundamental level, Roger L Martin, in an article in the Harvard Business Review,
introduces us to a concept called the Virtue Matrix, which he designed in order to assist executives to
think about the issues of corporate responsibility. He split the types of activity that a company can
undertake into four sections of a matrix, each governed by their effect on shareholder behaviour. His
theory discussed four sections of a matrix with the structural frontier at the top right; the strategic
frontier at the top left; the choice section of the civil foundation at the bottom left and the compliance
section of the civil foundation at the bottom right. These terms are explained below:

Frontier – structural

This part of the matrix again represents a course of action that is undertaken because it is the right
thing to do, but that is clearly contrary to the interests of shareholders. These activities are unlikely to
become the norm in the corporate field. The example that Roger Martin gives to illustrate this is that
of Aaron Feuerstein’s decisions at Malden Mills (see below).

Frontier – strategic

This part of the matrix represents a course of action that is undertaken because it is the right thing
to do. This is a risk, but it may add to shareholder value by generating positive reactions from
customers, employees or authorities. A real life example of this is the introduction by Prudential
Insurance of viatical settlements that allowed people suffering from AIDS to use the death benefits
of their life insurance policies to pay for medical expenses. This was groundbreaking at the time,
but swiftly became commonplace due to the goodwill it created. This is also a good example of
how socially responsible corporate practices can move from the strategic frontier as other
companies adopt the practice until it becomes the norm.

Civil foundation – choice

This part of the matrix represents activities that a company chooses to undertake that have the dual
aim of enhancing shareholder value and meeting the social requirements of the broader
community. For example a company might provide kit, equipment and improved facilities for a

Civil foundation – compliance

This part of the matrix represents activities that explicitly serve the purpose of enhancing
shareholder value, but this time it creates shareholder wealth by ensuring that a business stays on
the right side of the law. For example, a company ensuring that it does not exceed its limits on
carbon emission. This safeguards shareholders by ensuring a company does not attract legal
sanctions or reputation-damaging publicity.

The Malden Mills example mentioned above is an interesting one. On December 11, 1995 a fire burnt
most of Malden Mills to the ground and put 3,000 people out of work. Rather than taking the
compensation money and moving the factory to a less economically depressed part of the US, Aaron
Feuerstein continued to pay all the staff who had worked in the factory on full benefits while the
factory was being rebuilt. He said: “I have an equal responsibility to the community. It would have
been unconscionable to put 3,000 people on the streets and deliver a death blow to the cities of
Lawrence and Methuen. Maybe on paper our company is worth less to Wall Street, but I can tell you
it is worth more.” Despite the fact that his actions were not beneficial to the shareholders (most of
whom were admittedly members of his family) he went ahead and paid the workers and rebuilt in the
same location as he thought that was the ethical thing to do. Unfortunately, the company eventually
went into liquidation.

How would these definitions affect the current debate on ethical tax behaviour? What are the benefits
or disadvantages to shareholders of the company ceasing to use tax planning arrangements? If the
company pays out more tax, this will decrease the returns made to the shareholder, thus diminishing
the value of his investment. If the company was the only one in its field to cease tax planning, the
extra costs that it incurred might reduce its ability to be competitive in the market place. It might also
give the company cash flow problems. None of these effects are beneficial to the shareholder.
However, it is possible that the effect of being seen to be a socially responsible company paying its
fair share of tax might be to enhance the reputation of the company and therefore its shareholder
value. Arguably these considerations put a conservative tax policy on the strategic frontier, although
arguments could be made for its presence on the structural frontier.

In any case, it would seem that any policy on what constitutes acceptable tax planning would need to
be made on behalf of corporate groups as a whole, as the risk for one company acting alone would
outweigh the benefits. This situation can be compared with the emission of greenhouse gases. Were
one company to undertake to drastically reduce its emissions, it would be at considerable risk to its
own market position, and without much overall reduction in the emission of gases by society as a
whole. On the other hand, if emitting companies were to act together to agree a suitable policy for
reducing emissions and stick to it, this would significantly cut both gas emissions and the risks posed
to each firm individually. Equally, for example, were one company to resolve not to use tax havens
and to pay tax in the location where its profits were earned, it would not increase the tax take of that
locale significantly, but the company would put itself at a distinct disadvantage in the market place. If
all firms operating in that location were to make the same agreement, the tax revenue would rise
substantially, again with reduced risks to each individual company. However, the advantage of this to
the shareholders of the companies is unclear.

An article in the Harvard Business Review by Simon Zadek (December 2004) documents the power
of stakeholders in businesses to achieve socially beneficial outcomes, taking the reader through the
stages of learning that companies such as Nike (the focus of the article) go through when developing
socially responsible behaviour. It is interesting to see if these stages can be applied to tax
responsibility.

The second stage is the compliance stage. At this stage it is clear that a corporate policy is required
and that it can be demonstrated to the company’s critics that it is working. Companies can understand
compliance – it protects the company’s reputation and reduces the risk of litigation.

The third stage is the managerial stage. This is where the company realises that it is facing a problem
that is not short term and will not go away and that someone in the company needs to take
responsibility for solving the problem. Arguably this is the stage that tax directors of large companies
are currently at in respect to tax ethics. Some companies are learning the importance of taking tax
into the boardroom and thinking about developing internal tax policies that will impose accountability
on the tax department and require board approval (or otherwise) of tax planning arrangements.

The fourth stage is the strategic stage. This is where the company learns how developing responsible
business practices can give it a competitive edge and help contribute to the organisation’s success.
This could be the application of the internal tax policies mentioned above, although more research is
required as to the effect that tax reputation issues actually have on share price. One study based in
Israel (Harony and Aviva 2003) showed that there was no statistically significant effect on the share
price of a company for the period of time during which its CEO was being prosecuted for tax evasion.
However, this does not mean that if there are no reputational effects, companies should be able to
behave as they wish. The campaign against Nike, which was so well documented in the media did not
appear to produce any real damage to its share price and this could have been due to the fact that Nike
was willing to address its problems and take innovative steps to change the ethos of the way that it
managed its supply chains. This process may have been kick-started by the negative publicity, but it
also appeared that Nike wished to address the issues discussed in Zadek’s article because of a genuine
desire to improve its way of doing business.

The final stage is the civil stage. In this stage, companies promote collective action to address
society’s concerns. This might be the encouragement of all companies to adopt acceptable tax
practices and agreement with HMR&C that certain standards will be adhered to.

Perceptions of tax and of the tax authorities

3.1 Introduction

Much research has been undertaken in respect of the economic psychology of how individuals decide
whether to comply with tax regulations or whether to attempt to reduce their tax liability. This
approach has been developed into methods that tax authorities can use in order to encourage
compliance amongst taxpayers and seek to ensure that the relationship between taxpayers and tax
authorities encourages maximum voluntary compliance possible. Tax evasion is of course illegal and
therefore not acceptable under any circumstances but perhaps the lessons learned from studies of
evaders (the literature on which is more prevalent) can be helpful in assessing the attitude of people
and corporations toward tax avoidance. It is also possible that in the field of psychology, the
distinction between avoidance and evasion is not as critical as it is to the legal profession as both start
with the premise of trying to reduce one’s tax bill – this would be an interesting preliminary question
that psychologists might need to research before undertaking more detailed work into tax avoidance
behaviour.

There appears to be a lack of academic research undertaken to date about people’s attitudes to various
different taxes and the extent to which people think that it is appropriate to attempt to avoid these
taxes. Also, the research that has been done is mainly concentrated on individuals rather than
corporations, so further studies about the decision making process behind a corporation’s tax planning
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20
would be of great interest. Further empirical research done in these areas could do much to add to the
debate on tax behaviour and tax policy. Due to an apparent lack of relevant tax research undertaken
in the UK, many of the papers discussed here are from the United States or Australia. This section is
by no means intended to be an exhaustive review of the literature published on the topics of taxation
and psychology. Rather, the intention here is to highlight thought provoking pieces of research which
pose interesting questions for additional research activities.

A vast amount of research has been done on the subject of tax policy and the drivers behind it and it is
not proposed to attempt to summarise all of this research in this paper. Section 3.6 of the paper
discusses how the concepts of incentivisation could be applied to the tax avoidance debate. Tax
policy is of also interest due to the fact that the drivers of tax policy can be influenced by how these
policies are perceived by taxpayers and therefore if tax policy could be designed with taxpayer
behaviour in mind, it may help to reduce problems associated with avoidance and evasion. It would
be very interesting for academics who study taxpayer behaviour to look at UK tax policy in this light.

3.2 Taxpayer behaviour

Academic research has studied the decision making processes that individuals undergo when deciding
what amount of tax to pay. The starting point of these theories is the consideration that the taxpayer
has solely self interest in mind and therefore considers the probability of being caught and the fine he
will need to pay if he is caught, and then compares this with the amount that he will save if he does
not pay his taxes and does not get caught (the so-called rational actor theory). This approach implies
that high penalties and high probabilities of audit are needed to ensure maximum compliance.
However, this approach cannot explain the generally high levels of compliance that have been
observed, where the majority of taxpayers complete their tax returns in agreement with the law. For
example, in the US, in 1990 only 0.8 percent of individual tax returns were audited and in 1995 only
4.1 percent of taxpayers who were audited and who were reassessed as a result of the audit had any
penalty at all (Wintrobe 2001). Yet the IRS estimates that, for example in 1992, 91.7 percent of
income that should have been reported was reported. As discussed earlier in this paper, it is clear that
for some people paying tax is a moral obligation, but there are also other psychological factors
explaining the departure from pure self-interest that have been studied in the literature and that need
to be taken into account.

Some studies of individual taxpayer compliance look at the “public choice” approach to the issue.
This hypothesises that citizens of democratic political jurisdictions perceive a connection between the
taxes they pay and the government services they receive and implies that taxpayers are aware that
taxes are the price they pay for public services. This therefore forms part of an implicit contract with
other taxpayers and the government. A paper by Ronald Wintrobe (2001) discusses this concept in
terms of the relationship of exchange between the government and the taxpayer. The results of his
research led him to make some suggestions that could be used to reduce tax evasion and these may
also be useful when considering what taxpayers may think about when intending to avoid taxes. The
first is that as long as taxpayers (individuals and corporations) do not think that the government is
responsive to their wishes, they may attempt to evade their taxes. This implies that it is important for
the government to know what taxpayers are happy for their money to be spent on and to be motivated
to do this. Secondly, if taxpayers do not trust the government they are unlikely to comply voluntarily
with the tax laws. The example shown here is that of Russia, which in the past had strong
authoritarian governments that were not trusted by taxpayers and which attempted to uphold the law
with a punitive regime. This can go part way to explaining Russia’s past problems with large scale
tax evasion. Thirdly, and possibly most importantly when trying to explain tax avoidance behaviour,
people are more willing to pay their taxes where they believe the tax code is fair. It would appear not
to take much motivation for a taxpayer to use legal tax mitigation where he think the tax law is unfair
and he should not be subject to those taxes/that amount of tax he seeks to avoid. Finally, the point is
made that as long as people believe that others are evading tax, they will seek to do the same. Again
this psychology can be applied to those looking to avoid their taxes – if everyone else is doing it, and
it is legal, why shouldn’t they? Also, for corporations, if others are able to avoid paying tax and they
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21
cannot or do not; then economically they are placing themselves at a competitive disadvantage.
However, if reputational effects are important, and the public would prefer to purchase goods from a
company that did not use tax reduction strategies, the company may not be disadvantaged.

A paper by H Elffers and DJ Hessing (1997) uses knowledge of psychology to suggest methods of
preventing tax evasion in the United States. They postulate a theory that states that if a person is
expecting to gain from a situation, they adopt risk avoiding behaviour, whereas if the taxpayer is
expecting to lose out in a situation, they will adopt more risky behaviour. For example, if a taxpayer
fills in his tax return and discovers that the IRS will be paying him back some tax, he will simply file
his return. Whereas if the taxpayer fills in his return and discovers that he owes some tax to the IRS,
he is more likely to re-examine his form to see where he can rectify this situation – potentially a more
risky approach if his examinations and subsequent amendments take him the wrong side of the law.
This approach appears to be supported by a study by Cox and Plumley (1988) which shows that the
percentage of tax returns needing correction increases consistently and considerably as a function of
the amount of supplementary payments that the taxpayers need to pay.

Their second suggestion involves taxpayers choosing whether to forgo the claim for tax deductible
items on their tax return in exchange for the right to a standard deduction. This approach highlights
problems in theories proposing that human behaviour is governed by rational choices, which would
assume that taxpayers would calculate their tax liabilities under both methods and then pick the one
which is lower. The paper postulates that in actual fact the taxpayer may instead make a rough
estimate of what his deductions are and compare this with the situation under the standard deduction
and then decide whether or not to make the effort and do a full calculation. The paper also argues
that there is also a psychological advantage to the standard deduction in that the taxpayer can be
certain of the tax liability on his return. He does not need to worry about whether he has interpreted
the tax legislation correctly and claimed only the permissible deductions or whether he has made
errors which will be challenged or rejected by the Inspectors. These psychological advantages may
improve compliance, but clearly these considerations could only work in a system where the majority
of taxpayers complete a tax return annually.

Lars P Feld and Bruno S Frey (2002) looked at how the constitutional differences of Swiss cantons
affected the likelihood of evasion. Previous studies (such as Pommerehne and Frey (1992)) have
concluded that the more directly democratic the political decision making procedures of a canton are,
the lower the incidence of tax evasion. In the cantons of Switzerland, the taxpayer can change tax
laws in the political process (via referenda) and the tax authorities are aware of this; therefore citizens
have much better ways of expressing their discontent with tax policy than by breach of the
psychological contract with the tax authorities. Even if groups of voters do not win in a referendum,
they are aware that the political process is fair and therefore will comply with tax laws. This paper
seems to imply that were taxpayers to be more involved in setting the tax rules, they would be more
likely to abide by them and not seek creative ways in which to reduce their tax bills. If taxpayers
could participate in the creation of a code of agreed conduct, they might well be more likely to
perceive the system as fair and to co-operate with the agreed practices.

Is it possible that all the theories about why a taxpayer, whether individual or corporate, might attempt
to evade his taxes could also be applied to why a taxpayer might use tax mitigating arrangements to
avoid paying taxes? It may be possible that due to the obvious distinction that the risk is lessened as
avoidance is legal, the motivation to use mitigating arrangements may be higher than any motivation
to evade taxes. Most of the literature on avoidance or evasion is concentrated on individuals rather
than corporations, but it could be argued that the opportunities and rewards for a company to
minimise its tax liability are higher and the risks are lower. There can be a subtle distinction between
ways of looking at tax minimisation. For example, sale and leaseback is both a means of raising
finance for a company and a technique for obtaining a favourable tax treatment for leasing. Whether
the primary reason for implementing the scheme is to raise finance or to obtain tax relief, the results
are the same and both are achieved. Is a corporation’s propensity to implement such schemes likely to

3.3 Using behavioural models to change behaviour

3.3.1 The Compliance Pyramid

In 1998 the Australian Tax Office (ATO) introduced a new regulatory model in order to improve their
long-term compliance enforcement strategies (see Taxing Democracy, Ashgate Publishing
International for a full description). This model was introduced because of regular media reports
about poor ATO practices, bullying tactics and unfair use of their powers. This model proposes that
as taxation is continuous and fundamental to the long-term health of the community, the goal of the
tax authorities should not be to punish, but rather to secure long term voluntary compliance. When
punishment, rather than co-operation, is the premise of a regulatory encounter it is basic to human
psychology that people will feel humiliated and their response may well be weakened respect for
compliance with the law. Also, individuals and firms are more likely to regard enforcement action as
fair if persuasion has been attempted first.

A study was undertaken so that the regulators could understand why a person has a certain attitude
towards paying tax. An article by Kristina Murphy in the British Tax Review discussed the five terms
that were adopted to describe the attitudes of taxpayers to compliance. These are commitment,
capture, resistance, disengagement and game-playing. The idea behind the compliance model was that
by tailoring the ATO’s approach, it could select the correct response to the attitude presented by the
taxpayer and then attempt to encourage taxpayers toward the more desirable attitudes. Perhaps it is
the category of taxpayers who are game-players that are of the most interest in light of the subject
matter of this paper. They enjoy the challenge of unearthing grey areas of tax law and the test of
minimising their tax liabilities and generally believe that they are fulfilling their obligations under the
law. Murphy mentions that it would be interesting for more research to be undertaken regarding the
behaviour of this type of taxpayer, as they are those who would adopt and use tax avoidance schemes.

The approach adopted by the ATO was designed to be a balance between deterrence and persuasion
as there are significant disadvantages to adopting one approach absolutely over the other. The
problem of a punishment-based policy is that it can inadvertently cause resistance to regulation
reducing the likelihood of compliance amongst individuals who always intend to do the right thing.
For example, if a taxpayer makes an inadvertent error due to the complexities and ambiguities of the
tax system, she is likely to believe that any punishment she receives is unfair and unreasonable. Also,
deterrence can be expensive and time-consuming. However, a solely persuasive approach could be
viewed as naïve. The regulatory approach adopted at the ATO therefore considers when to punish
taxpayers and when to persuade them. The model used is called the Compliance Pyramid and it starts
with a persuasive approach and graduates through warning letters and civil then criminal penalties to
the most severe sanctions that the ATO is allowed to impose. The idea is that in starting with a
gentler and more persuasive response, the taxpayer is given every opportunity to correct his behaviour
and assistance can be given if the errors made have come from a lack of tax or business knowledge.
This means that relationships can be built up, the taxpayer can be educated about the tax system and
the message that it is the taxpayer’s responsibility to comply with the rules can be reinforced. The
level of punishment then increases if taxpayers continue to resist the authority’s attempts to encourage
compliance, but all the while at the discretion of the tax authorities, in order that they can attempt to
select the correct response to the taxpayer’s attitude.

This is interesting to apply to the Inland Revenue, who promote the use of a model similar to that of
the ATO. There are many approaches that the Inland Revenue have put in place in order to improve
their relationship with taxpayers and it will be interesting to see how they continue to do this as part of
HMR&C. However, in practice, it would appear that in some cases the authorities are formalising
their approach to certain taxpayers. It has come to the attention of the accounting firms that Large
Business Office inspectors have been instructed rigorously to apply paragraph 27 Sch18 FA1998, one
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23
of their main investigatory powers, from 1 May 2005. The impact that inspection style can have on
regulation is discussed further on in the paper in section 3.4, where a paper by May (2004) regarding
compliance with building codes in the USA concluded that inspector behaviour can affect the
dispositions of regulatees to comply with regulations and that inspectors can play an important role in
shaping a sense of obligation to comply that is fundamental to the regulatory social contract. The
paper also suggests that once an inspector “gets tough”, any later attempts at facilitation will backfire
– there is no going back and they will be seen more as a “cop than a consultant”!

As a small aside, it may be worth noting that the population of Switzerland is around 7.4 million and
the population of Australia is approximately 20 million, whereas the population of the UK is roughly
60 million. Therefore, where this paper discusses approaches that have been used in these two
countries to improve their tax system, it could be argued that it is easier for these smaller countries to
adopt a more personal approach from the tax authorities that it would be in the UK. Also any changes
to the tax system or approaches to the taxpayer in these countries would be easier and cheaper to
implement.

3.3.2 Applications of the principles of the ATO compliance model

A further paper by John Braithwaite (2003) describes how the risk management by the ATO of risk
management systems of corporations (“meta risk management”) can be a cost-effective and
responsive regulatory strategy. He makes the point that while globalisation and the creation of
purpose-built financial products makes the risk faced by tax authorities more complex, new
information technologies also make possible more sophisticated monitoring of these risks. Once
example of this is the meta-risk management system the ATO have in place for transfer pricing. In
this way they show business that if corporations manage their risks of breaching the arm’s length
principle in ways the ATO specifies or approves, then they will not be subject to time-consuming and
costly reviews. Here, the ATO selected 190 large companies for the Transfer Pricing Record Review
(TPRR) and Improvement Project. ATO staff visited the companies to conduct a review of their
transfer pricing procedures and then sent each company a letter advising them of a quality assessment
between high and low given to their transfer pricing policies and documentation and different
strategies adopted accordingly. The companies on the top three tiers of the risk assessment were
given the option of changing their transfer pricing policies to those of an Advance Pricing
Arrangement (APA). This approach is interesting to compare with the theory noted above of standard
deductions for individual taxpayers. The APA is an arrangement negotiated between the company
and ATO on the transfer pricing policies that will be used. If the company sticks to this, it has
certainty over its tax returns and far less involvement from the ATO. For the ATO, the company is
effectively doing the ATO’s risk management for it. The amount of tax paid in the year of the review
increased by 26 percent despite the fact that the income of the companies fell by 5 percent. This
increase in tax revenue (almost 18 million Australian dollars) cost the ATO less than half a million
Australian dollars in tax office resources. There were increased tax revenues in the years following
the survey also. This approach is also interesting in that the TPRR was a collaborative exercise with
major accounting firms and corporate clients and the project was designed to build trust. As well as
being an area where tax avoidance can be used, transfer pricing is a very difficult thing to get right
and therefore in starting with an approach to help corporations improve their transfer pricing, trust
began to be built.

It would be interesting for further independent research to be carried out to determine how well the
theoretical approaches of the ATO discussed in this paper are actually working in practice. Research
could also be performed in the same manner around HMR&C in the UK. This would allow policies
to be more widely publicised and increased trust to be built up between the taxpayer, the tax
practitioner and the tax authorities.

3.3.3 The compliance model and creative compliance.

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24
A further paper produced in Australia discusses the issue of creative compliance (McBarnet (2002)).
This paper defines “creative compliance” as finding ways to accomplish compliance with the letter of
the law, while undermining the policy behind the words. The paper mentions that one factor that
contributes to creative compliance is the nature of the law itself, in that it is open to different
interpretations and that drafting of the law is not infallible. Some aspects of regulation theory are
discussed below, but it would be interesting to study other fields where arrangements can be used to
avoid the full weight of legislation and the reasons why firms and individuals might seek to do this.
This might also help by removing some of the emotion that is evident in the debate surrounding tax
avoidance. McBarnet believes that another factor influencing tax avoidance is a particular attitude
toward the law – the attitude that sees the law as “a material to be worked on, to be tailored,
regardless of the policy behind it, to one’s own interests”.

Her main argument is that regulators are often concerned about uncertainties in the law being
exploited, whereas in fact creative compliance can operate particularly effectively in rule-bound
systems. The paper also points out that as case law is built up around avoidance (or on the GAAR in
Australia) potential new opportunities for avoidance are produced because the system determines
specific responses to specific situations rather than just relying on a principle of good behaviour. Any
power based on legal proceedings, such as the GAAR, that involves the courts can only be as
powerful as those who are interpreting it will allow. The paper concludes by suggesting that changes
in law, however wide ranging, are unlikely to eliminate creative compliance and it is attitudes that
need to be changed. Perhaps this is the aim of the authorities when pushing an “ethical dimension”
for tax onto centre stage. Might this mean adapting the tax law from a body of legislation that
taxpayers are happy to comply with creatively but are not committed to, to include a code of
principles behind the legislation with the spirit of which taxpayers were happy to comply?

3.4 Regulation, self-regulation and the role of a code of conduct

The previous section shows how the approach of the authorities to regulation can influence the
behaviour of those that they seek to regulate but, looking outside the area of taxation, to what extent is
regulation important in shaping corporate behaviour? A paper by Kagan, Thornton and Gunningham
(2003) notes that some regulatory strategies, in focusing on compliance, fail to facilitate or encourage
“beyond compliance” behaviour. They may even inadvertently discourage it. However, others argue
that government-mandated self-regulation is the key to progress. Kagan’s paper looks at how firms in
America and Canada have responded in the area of environmental regulation by studying the
environmental performance of fourteen pulp and paper mills in various countries. They found that
over the last three decades the increase in regulatory requirements and political pressures have caused
an improvement in the environmental performance of the mills and that many of them have gone
beyond compliance in many ways. However, regulation does not account for the differences in
environmental performance that remain. Rather, pressure from their local communities and
environmental activists encourages some firms toward better environmental compliance than others.
Also, the style of the management of the firms has a large part to play. On the other hand, economic
considerations impose limits on the extent to which the companies can take their environmental
performance further no matter how committed they are to doing so. The paper concludes that
regulation is important in producing large improvements in environmental performance, but not as a
system of rigidly enforced rules, rather as a “co-ordinate mechanism, routinely interacting with
market pressures, local and national environmental activists and the culture of corporate
management in generating environmental improvement while narrowing the spread between
corporate leaders and laggards.”

If regulation is less important than these other pressures in ensuring that firms continuously seek to
improve their environmental performance, an efficient regulatory system will nevertheless encourage
progress by reassuring the leaders that their less committed competitors will also be compelled to
spend money to achieve the same levels of environmental performance as the leaders have shown is
possible. This means that pressures on one firm (the leader) and its environmental style of
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25
management can be used in order to develop the regulatory system and improve performance across
the population.

It would appear that there are important parallels that can be drawn between environmental regulation
and performance and the tax avoidance issue. Firstly, the improvement of environmental performance
and of tax policies are both generally accepted to give desirable social consequences. Secondly, both
issues cause firms to face adverse publicity from those who are unhappy with their behaviour.
Thirdly, if a company has a desire to go beyond compliance, it has to temper this with responsibilities
to its shareholders, employees and customers. Finally in both of these cases, companies take as their
basic starting point compliance with the law. It is then up to them whether they wish to just stick to
the law, or go beyond this in developing their own “code” of environmental standards or tax
standards. How can the regulatory environment encourage these desirable outcomes? Interestingly, in
comparison with the managerial style that was noted as important to environmental performance in
the paper discussed above, tax research in the United States has shown that small companies that are
non-compliant in their corporate income taxes are three times more likely to be managed by
executives who have understated personal taxes (Joulfaian 2000). This suggest that at least for small
companies managerial styles play an important role in determining the level of tax compliance
(Slemrod 2004). Intuitively it would appear likely that the attitude of corporate tax staff toward tax
risk would affect the type of tax planning undertaken by that company, therefore this might be an
interesting area for further research.

Sometimes, it is possible for strategic self-regulation to pre-empt political action. Also, self-
regulation may increase consumer demand by reducing uncertainty about quality of products or
ensuring the inter-operability of the products of different firms. It may enhance employee retention
by improving workplace safety. It can also serve a more strategic purpose by softening competition
or pre-empting stricter government regulation. If self-regulation is more cost effective than
government regulation, it is more sensible for companies to self regulate even if they do not face a
greater level of restraint from the government. Reports by Rice (Rice 1992) using the US Taxpayer
Compliance Measurement Program also concluded that compliance (i.e. the absence of evasion)
among US companies was highest amongst publicly traded companies and those in highly regulated
areas such as banking and insurance. This suggests that factors encouraging transparency and
disclosure also foster compliance. However, it would be interesting to know whether a relationship
can be drawn between a firm’s propensity to engage in tax planning activities and its regulatory
environment.

PJ May (May, 2004) undertook a study of the regulation of the homebuilding sector in the United
States. This sector seems to provide an ideal case study for responsive regulation practices as the
primary mechanism for ensuring compliance with building code are safety inspections by local
building inspectors and inspections occur multiple times at different stages of the building project. As
inspection is certain, compliance is ensured through detection and correction of violations. However,
as the homebuilders have more at stake than just the avoidance of penalties (namely the maintenance
of reputation and the fact that build quality will be a key factor in the sale of their properties) the
inspection is not the sole reason why they comply. According to May’s research, two reasons why
people might comply with regulations are because they fear detection and punishment (a negative
base) and because they feel a duty to comply (an affirmative base). He argues that in order for
regulation to be treated as a social contract, there must be affirmative reasons for adhering to the
contract. If it is presumed that regulatees will not comply with regulations voluntarily, and must be
compelled to do so, greater compliance will be obtained by reinforcing the fears that create the
negative set of compliance motivations. For example, if people are motivated to pay tax by a fear of
getting caught, then reinforcing these fears with increased audit probabilities and strict penalties will
increase compliance. However, if this presumption is incorrect, it may be that affirmative motivations
are undermined. This balance between affirmative and negative motivations can be compared with the
ATO compliance pyramids balance between persuasive and deterrent regulation.

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26
The paper studied the enforcement style of building inspectors and expected it to be a greater factor in
influencing affirmative motivations than just the actions of the inspector. The paper looked at the
facilitation style of the building inspectors, ranging from helpful and friendly to un-cooperative and
threatening and also the formalism of the inspectors ranging from flexible to rigid and easy-going to
fastidious. Taking one of these as an example, increased facilitation was thought to foster affirmative
motivations while detracting from negative motivations, because it leads to greater understanding of
the basis of the regulations and of the means of complying with them. However, by demystifying the
means of compliance and the basis for applying sanctions, facilitation undermines the fear that is the
basis of negative motivations. It may be that if cost of compliance is high and the benefit to those
regulated is low, deterrent actions are more important, whereas if the cost of compliance is low and
the benefit to those regulated is higher, then affirmative motivations are more important. Lowering
the cost of tax compliance and increasing the benefits to regulatees might yield long term affirmative
results.

Codes of practice are the most common form of self-regulation. The advantage of these voluntary
codes is that they can be implemented quickly and inexpensively as they do not require time-
consuming parliamentary processes. Also, the industry designs, implements and enforces the code.
This has two advantages, the first being that it is likely to be set up in a way that does not place too
high an administrative burden on its members and secondly; it does not involve the additional costs to
society that arise when a code is set up and policed within the public sector. However, a voluntary
code may be less effective than classic regulation depending on which firms/industries it covers, and
may be subject to undue influence by larger companies. The use of both industry-generated codes of
conduct and externally imposed codes has grown over recent years. Regulatory codes imposed
additional burdens on businesses and this means that careful consideration needs to be given to this
when new codes are created. However, the fact that industries can be seen to react to the possibility
of government intervention by designing their own regulation suggests that business can see the
advantage in this type of regulation over a more strictly imposed classic style of regulation.
Sometimes voluntary codes of practice are subject to significant government intervention before they
reach their final form and statutory backing can give voluntary codes added credibility.

Companies often also adopt internal codes of conduct, covering issues such as equal opportunities and
good working practices. A study (Doig and Wilson 1998) of the content of company codes of
conduct found that the more discrete the issue or the more the issue had legal implications, the more
likely it was to be included in the code. Codes of corporate governance are used to ensure that listed
companies govern themselves in an appropriate manner and some of these codes consist of
recommendations rather than rigid rules, requiring companies to state whether they have adopted
them and, if not, why they have not done so. Perhaps one step in the direction of improving the
current situation between corporate taxpayers and the tax authorities would be such a code. This code
could be determined by collaboration between these parties and companies that wished to sign up to
the code could do so. There are many forms that this code could take. It could be a statement of
principle; for example, not to undertake tax planning activities that are designed solely for the purpose
of avoiding tax, or not to undertake activities that give a tax advantage without the company
undergoing the other economic consequences that were intended by the relevant legislation.
Alternatively, it could be a more structured set of rules that states that the company has agreed not to
undertake certain specified activities. This code could be made part of corporate governance, by
requiring that companies declare in their financial statements whether or not they had adopted it. The
important thing would be that for this code to be effective it would have to be arrived at as a
partnership between those who are bound by it.

In many countries efforts have been made to align tax regulation with corporate governance
legislation and guidance, however, an agenda set solely by the tax authorities runs the risk of being
too prescriptive and lacking the flexibility required by businesses. There are also issues in general
with requiring additional disclosure by companies. For example, for many years Nike resisted the
publication of details of its supply chains. This was bemoaned by CSR advocates, who wanted to
monitor the supply chains in order to ensure that Nike was actually making the improvements to
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27
working conditions that it had publicised (Crane and Matten; Chapter 2). However, Nike argued that
details surrounding its supply chain were of a sensitive nature and if they were to publish these
details, they would be losing their competitive advantage. Also, additional governance regulations
raise costs for a company. If disclosure of tax payments, tax planning arrangements or tax policies
were to become a requirement in financial statements of the future, this would allow investors and the
general public to be aware of how a company runs its tax function. On one hand, this would increase
burdens for businesses and might require a company to disclose sensitive information about its tax
payments. However, on the other hand it might help the transition of tax policy decisions from the tax
function to the boardroom, ensuring that the company has a clear decision-making process laid out
and that all planning undertaken has the unequivocal support of the company’s leaders. However,
arguably it is crucial that businesses and tax and accounting bodies are involved in the development of
any such regulation in order to ensure a fair and workable system that is not too burdensome to
businesses.

3.5 How certain taxes are perceived

This section looks at some of the research concerning how taxpayers perceive taxes. Again, this is not
an exhaustive study of all relevant literature, but a discussion of a few pieces of work that pave the
way for further research in this area. A survey done by Kirchler, Maciejovsky and Schneider (2003)
for the Johannes Kepler University of Linz concerning people’s perceptions of tax avoidance, tax
evasion and what the author calls tax flight (relocation of business in order to achieve a favourable tax
treatment) makes interesting reading. The author asked those he surveyed to “free associate” words
that they thought described each of these three concepts. With respect to tax evasion, people chose
illegal; fraud; risk, punishable and tax saving. Tax flight was associated with the intention to save
taxes and the impression that taxes are lower abroad. However, when tax avoidance was discussed,
people thought that it was legal; cost saving; clever and a good idea. The author also used techniques
to measure where on a scale of legality and morality each of the three tax behaviours fitted. This
gave the following results:

Tax evasion Tax avoidance Tax flight

Illegal Legal Legal

Immoral Moral Immoral

It would be interesting to repeat such a study in the UK, as the popular press seems to suggest that tax
avoidance is not seen as fair by the general public.

Literature also suggests that perceptions of payment may be important. In a study done by Adams
and Webley (2001), people who thought of VAT payments as depleting their business funds were
more likely to seek to reduce their payments than those who saw the VAT payments as belonging to
C&E in the first place. Also it would seem intuitive that people object more to the paying of taxes
that appear to reduce profits that they have made, for example capital gains tax or income tax on
business profits, where they see their potential additional cash being reduced by the amount of tax
they have to pay at a later date. This can be contrasted with the deductions at source via PAYE and
NIC, where an individual is likely only to note her net income, rather than the gross amount and the
tax payment. This appears to encourage the notion that this amount of tax always belonged to the
government. Therefore, as well as the opportunity factor that is important in governing what taxes
people seek to avoid, the method of payment may also be important.

Research by Prof Norman Gemmell, Prof Oliver Morrissey and Dr Abuzer Pinar (2004) drew some
conclusions from the British Social Attitudes Survey (BSAS), which looked at how accurately people
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28
assess the effect on them of increases in tax rates and whether this affects their preferences as to
which taxes the Chancellor raised. They found that people are more likely to overestimate how much
an increase in tax will cost them than they are to underestimate the cost. For example, more than 40
percent of people are able to estimate accurately how much an increase in income tax might cost
them. Again, however, 40 percent overestimate the cost and only 15 percent underestimate the cost.
Also the survey showed that given the choice between a 1 percent rise in VAT, 1p on the basic rate of
income tax or 5p on the top rate of income tax, 59 percent chose the last option, with 10 percent
choosing the VAT increase and 30 percent choosing the basic rate increase. The survey indicates that
in general, people prefer increases in those taxes they do not pay or in those taxes that are less costly
to them. Does this indicate that people are so worried about the prospects of further tax rises, that
they inflate the amount they think it will cost them in their minds?

A research review by MORI using data from its own polls and again from BSAS, concluded that the
public’s tolerance on taxation is very dependent on their recognising the need for it and whether they
believe that the money raised will be properly and efficiently used. People also seem to distinguish
between different types of taxation, with 73 percent of people thinking that the government could
afford to cut excise duty on petrol and still retain adequate funding for schools and hospitals, yet
simultaneously supporting the raising of national insurance to fund the NHS. More generally this
survey showed that people appeared to be tolerant of the burden of tax placed on them at present, as
long as this manifested itself in improved public services. A study carried out in the USA (Barron
and McCaffrey) makes the point that taxes might be more acceptable to the general public if it could
link them more directly to the benefits it receives. For example, social security and medicare taxes in
the USA are the largest taxes for most Americans but these taxes are seldom cut. Also, people’s
approaches to taxes are governed by self interest. This would appear to link back to Rawls justice
theory discussed in section 2.6, which discussed how the development of an ideal society requires
personal considerations to be set aside.

Moving on to the perceptions of the business community, a survey carried out in November 2002 by
the CBI undertook 256 interviews with senior executives from CBI member companies various
questions to assess whether they thought the UK was a good place to do business. 13 percent of those
questioned thought that the UK was not an attractive place to do business due to its high corporation
tax rate. 50 percent of those questioned thought that business taxation levels were very influential in
their choice of country to invest in. Even more significantly, 76 percent thought that the total amount
of tax paid by their company as a percentage of turnover had increased over the last five years. 17
percent thought that taxation had a very negative impact on the competitiveness of their business and
55 percent thought that it had had a fairly negative impact. Of those who thought that tax was the
reason that they were non-competitive, difficulty with taxation and tax credits, the level of national
insurance contributions and rising cost were listed as the reasons. A list of tax changes introduced by
the government was read to the executives and they were required to state the extent to which they
had affected their business. The full survey makes interesting reading - for example, 54 percent of
businesses surveyed thought that the R&D tax credits have had no impact on their business. This may
be because they do not apply to these companies, but it may also be that the scheme is not widely
enough publicised or understood. Also National Insurance contributions appeared to concern the
majority of companies surveyed. Perhaps more study of how business feels that it is affected by
certain taxes might help the government develop more efficient tax policy. Incentives can only be
useful if companies are aware of them and equally, unintentionally damaging provisions could be
removed from legislation.

The public’s perception of inheritance tax has also been well publicised in recent years, because of the
failure of the nil rate band to keep up with inflation and also because of the huge growth in house
prices has brought many people into its ambit. A recent survey on the Daily Telegraph website
revealed strong opinions on the subject, with almost every person whose opinions were displayed
speaking out in favour of reform or removal of this tax. The two most common themes were the
disincentive to save for old age, as anything that remained on death would be subject to tax, and the
point that wealth accumulated during life had already been taxed during life and therefore it was
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29
unjust to tax it again on death. Also mentioned was the fact that children who still live in the family
home left to them by their parents will have to sell up to pay the inheritance tax on the property. This
was seen as unfair by the public. Also, the tax has to be calculated and paid at a time of distress for a
grieving family, which adds to its unpopularity. Even given this, however, only a small percentage of
estates (estimated to be around 6 per cent in the recent Budget speech) actually pay inheritance tax
and its emotional unpopularity and the perception of its inequity may be outweighing this fact in the
minds of the public.

3.6 Providing incentives and disincentives

One of the functions of the tax system is to encourage desirable investments by providing tax
incentives and to discourage undesirable behaviour by providing tax disincentives. Examples of the
former would be the research and development tax reliefs, 100 percent capital allowances for energy-
saving equipment and tax relief on pension contributions. Examples of the latter are the duties on
petrol, alcohol and tobacco. Tax can be an effective form of regulation as it keeps choice regarding
individual or corporate behaviour in the hands of the individual or company, whilst ensuring that,
through tax, they literally pay for undertaking actions that the government has decided are bad.
However, it is acknowledged that this incentivisation can be very difficult to achieve. For example,
while duties on alcohol and tobacco raise revenue for the government which can help pay for the
harmful effects of overuse of these drugs, they do not seem to have a large effect on people’s
consumption. Also, they help to increase illegal smuggling. However, in certain circumstances they
can be effective as additional taxes do hit those who are more price-constrained, such as young
people. Taxes on petrol do not in general reduce people’s propensity to use their cars and can be seen
to be unfair to those in rural areas where there is little public transport. In 1999, motorists
contributed £36bn to the Treasury, so even if the tax does not succeed in changing people’s driving
habits, it certainly raises tax revenue.

When financial directors are deciding on how to approach their tax planning, there are several things
to be taken into account. The disincentives to undertake tax planning seem fairly clear. Even those
tax planning arrangements that are not contested by the authorities cost money to implement and
involve additional work for the tax and accounting staff at the company. With arrangements that are
open to challenge, there is the cost and additional work of responding to HMR&C enquiries, and the
risks of court proceedings. If the taxpayer loses the court case, she will have to pay the tax, interest
on that tax and potentially penalties also. The new disclosure legislation adds a further level of
administrative burden to the company (through their advisors) when undertaking tax planning. There
may be reputational damage to any company that is not aware of these risks. Yet the benefits to the
company of reducing its tax bill can be large enough that these risks are worthwhile. At present, there
appear to be no incentives for a company to adopt a strategy toward its tax planning that is more in
line with what the government intends.

One possible avenue that the government could explore in order to encourage the behaviour that they
would like companies to adopt in relation to tax mitigation activities is the introduction of incentives
for companies not to adopt arrangements that the government deems unacceptable. In light of the
research summarised above about the attitudes of tax authorities and taxpayers that encourage
voluntary compliance, further research could determine whether incentives such as tax credits for
companies who adhere to a code of conduct for a set number of tax accounting periods might reduce
unacceptable avoidance in a way that is initially beneficial to both parties. Tax avoidance
arrangements that are legal, even if unacceptable to the government, can always succeed in saving tax
for companies before the law is changed. If companies could be encouraged not to adopt the “worst”
avoidance schemes, rather than penalised for adopting them, a system of co-operation could be
fostered. There would be appear to be a psychological difference between, on one hand companies
receiving a benefit for choosing not to do something that, while they are entitled to do so by the law,
the government would prefer that they did not, and on the other hand, to the government attempting to
penalise them with “reputational shaming” for something that they are entitled to do by law.
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30
One example of an incentive to comply with the tax system that has been used in countries such as
Ireland, Italy and in certain states within the USA is tax amnesties. These take many different forms,
but basically involve a declaration by the tax authorities that if a taxpayer approaches them with the
intention of bringing their tax affairs up to date, they will not face penalties for their past non-
compliance. It would be interesting to see if the lessons learned from studies of tax amnesties might
contribute to resolving the issue of long-term tax avoidance.

4 Conclusions and further research for academia

In conclusion, it can be seen that the tax system can lead to complex dilemmas for all those involved
in it and this paper has tried to outline what some of these dilemmas are. Taxpayers and tax
authorities alike desire certainty in the tax system in order that they can manage their tax payments or
revenue streams. However if the views of society as to what is acceptable behaviour in this field are
changing, taxpayers, and corporate taxpayers in particular, may need to consider their actions more
carefully in order to avoid the risk to their reputations and the risk of increased tax authority focus.
The tax authorities also may need to consider their actions and policies more carefully in light of the
impact these can have on voluntary compliance. It would be very interesting for scholars to take
forward some of the themes of this paper and undertake their own independent research in this area,
as it appears that further study could add much to the debate.

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