Line between aggressive tax structures and efficient tax planning still unclear for UK M&A

Interview by Katherine Steiner-Dicks

Provisional GAAR regulation in the UK is likely to target artificial and abusive tax schemes by next year. However, in the context of commercial transactions, especially those with a cross-border element, a provisional GAAR could generate additional tax uncertainty.

Various jurisdictions have had tax systems with general anti-abuse rules (or “GAARs”). If the rules are clearly set out, then companies can plan their tax affairs accordingly. But when rules are left open for broad interpretation, a lack of clarity sets in. Many investors, corporate and private equity alike, could be concerned that future overarching, yet sometimes vague, tax laws or in this case, principles, could bring retrospective penalties, which carries unwanted risk.

The debate is still open as to whether the UK tax system needs a general anti-abuse rule. There are, however, strong indicators from the Chancellor’s recent Budget announcements that the UK tax system will in all likelihood introduce a GAAR next year.

Being aware of the potential implications for corporations and private equity clients, Simon Tesselment, Head of Transactional Liability Europe for Aon, sought the views of Stuart Sinclair, a UK tax partner at US law firm Bingham McCutchen in London to get a better understanding of what the new rules could mean and how clients could be exposed to UK-based GAAR related risks within their core business, portfolio company or future acquisition target. Sinclair has extensive experience of corporate tax and in particular, where tax insurance can be an effective route to removing tax risk for clients.

The understanding, according to Sinclair, is that the UK GAAR would, in principle, be targeted at “artificial and abusive tax avoidance schemes”, but the key question will be where, and how, to draw the line between unacceptable abuse of tax law and acceptable tax planning, particularly in the context of wider commercial transactions where a GAAR could generate additional tax uncertainty.

Those drafting the regulation will be considering all angles so that any room for blatant tax avoidance is eliminated by using overarching principles. They will also likely look to other markets for guidance on what and what not to do.

Markets that do have GAARs in place include Germany, Canada, Australia and India, the latter of which has created immediate economic impacts. In recent weeks India’s finance minister Pranab Mukherjee introduced the GAAR in the March 16 Budget, which gave the tax department the power to deny double taxation treaty benefits to foreign institutions routing their money through Mauritius. The immediate reaction saw shares of two-thirds of the companies, in which these funds have sizeable stakes, drop more than the benchmark indices.

For Mauritius-based investors, it currently appears that they will not be in a position to gain from this exemption and will eventuality have to sell Indian shares.

Equities specialists are saying that standalone foreign institutional investors (FIIs), which have no permanent establishment in Mauritius, will be taxed as of 1 April, which could unwind their positions.

Foreign institutions will then have to prove that their structures were not solely set up for tax benefits, despite the fact that there may have been no law in place discouraging them from doing otherwise. The risk lies in the fact that they may or may not have to pay capital gains tax of 15 per cent. Many may have taken a view to unwind their positions before 31 March to avoid future unknown risk cum penalties as tax in the new financial year is not clear.

Other markets, such as Germany, have had a statutory abuse of law rule in place for some time, which can often be raised by the German tax authorities during audit, says Sinclair. “However, its effectiveness is open to question as the German courts have largely appeared reluctant to confirm its application. It is understood that the German tax authorities seem keen to examine an extension of more targeted anti-avoidance rules due perhaps to difficulties with the GAAR.

“Canada and Australia, for example, introduced GAARs against the backdrop of a literal approach to construing tax statutes. However, given the different environment in the UK, which has a purposive approach to statutory interpretation and a wealth of targeted tax avoidance rules, it is not clear whether conclusions as to how a UK GAAR will work in practice can readily be drawn from experiences in those other jurisdictions,” says Sinclair.

“If GAAR produces a greater climate of uncertainty, tax insurance may be a useful tool to investigate”.

There have been some retrospective penalties for private investment tax schemes in the UK and some of which are currently being contested by HMRC, namely film funds. When the goal posts are moved, investors should do their best to be aware of pending tax legislation and reassess their appetite for risk in the eventuality that their existing structures could be considered tax abusive.

Tax high on government agenda

“It is high on government agendas around the world to take a closer look at highly aggressive schemes in an effort to find new ways to generate new tax income and shut some of those schemes down,” says Tesselment. “The intent,” he says, “is that the UK should have the general provision, but it should only be targeted at the highly abusive and artificial schemes. The schemes likely to be hit are those established by those who are willing to take a high risk approach and who are prepared to run the risk in the event that they are not successful in achieving the tax savings they seek. This type of planning would in any event be unlikely to be insurable for obvious reasons, and insurers would not want to support this type of approach. However they are willing to look at tax positions where there remains uncertainty and where clients have a compelling need to be clear as to the ultimate outcome. If the GAAR produces a greater climate of uncertainty, tax insurance may well be a useful tool to investigate.”

Tesselment says the line drawn between abusive and less aggressive schemes could prove hard to define: “While the target on abusive tax schemes is sensible in principle, when it comes to be applied there has to be a line drawn somewhere. Will this then catch perfectly proper tax planning because there is a balance that has to be struck as companies and people should be able to plan their tax affairs efficiently and take advantage of the law as it stands? Even if the GAAR does not intend to catch less aggressive schemes it could end up doing that. While the GAAR’s intention is to create less uncertainty it may well cause more. This is where insurance could have a greater role to play.”

The existing court system in the UK can even now introduce an uncertain outcome for the UK taxpayer, as Tesselment’s colleague Anka Taylor, Director of Transactional Liability Europe Taylor, highlights: “There has been a history of case law where the court has unravelled some artificial structures which have no commercial purpose other than to avoid tax. In instances like these, the court has looked at the purpose of the underlying legislation and applied that as a principle in order to say a structure doesn’t work. So the existing position has large elements of uncertainty already.”

Taylor confirms that offering specific examples of how a company or individual may be caught out by the pending principles is practically impossible until the recommendations are set in place. “However it may well be true to say that having overriding principles enshrined in legislation is a better outcome than the potential vagaries of the court system.”

GAAR: snapshot history

References to GAARs have come to encompass a variety of legislative measures in various jurisdictions which, broadly, seek to counteract, and in some circumstances penalise, tax-motivated arrangements.

Historically, says Sinclair, the UK has been reluctant to introduce a statutory GAAR. It is understood that previous proposals over the years for introducing a GAAR into the UK tax system have been rejected due to concerns from business that such a rule would be ineffective in countering the tax avoidance at which it is aimed (based on experience in other jurisdictions) and that it would create more uncertainty and increase administrative burdens and compliance costs for UK business.

“Instead, the UK’s approach to dealing with tax avoidance has involved a combination of targeted anti-avoidance rules, a principles-based approach to drafting new legislation, the Disclosure of Tax Avoidance Schemes rules and the trend of the courts towards the modern doctrine of applying the relevant statutory tax provisions, construed purposively, to the facts of a case, viewed realistically,” says Sinclair.

It was however announced in Budget 2010 that there would be another examination of the need for a statutory GAAR in the UK. This led to the appointment in December 2010 of an independent study group led by Graham Aaronson QC, a leading UK tax barrister specialising in commercial taxation, which was asked to consider whether the introduction of a GAAR would be beneficial for the UK tax system.

The group published its final report in November 2011, concluding that a “broad spectrum general anti-avoidance rule would not be beneficial for the UK tax system” as it would “carry a real risk of undermining the ability of business and individuals to carry out sensible and responsible tax planning” which was “an entirely appropriate response to the complexities of a tax system such as the UK’s”. The group did however recommend the introduction of a “specifically targeted anti-abuse rule” aimed at egregious and artificial schemes, but which sought to exclude reasonable tax planning.

In Budget 2012, the Government announced that a formal consultation process will commence this summer into the introduction a UK GAAR (which will be based on the recommendations of the study group) with a view to legislation being included in the Finance Bill 2013.

The potential scope of a GAAR

“Until the UK’s draft legislation is published for consultation, we will not know how the Government proposes to frame the GAAR. As the draft legislation will be based on the recommendation of the Aaronson study group, it will perhaps not replicate exactly the illustrative legislation suggested by the study group itself,” says Sinclair. “However, there are some key principles which can be gleaned from the Government’s comments on the study group’s report.”

To which taxes would the GAAR apply? The report suggested that it should apply for the purposes of income tax, corporation tax, capital gains tax and petroleum revenue tax. To that list, the Government has added stamp duty land tax (which is perhaps unsurprising given the other measures announced in the Budget on stamp duty land tax avoidance schemes). Sinclair says that it is not currently intended that the GAAR would apply to value added tax, which has its own anti-abuse principles derived from EU law.

Secondly, which arrangements would be caught by the GAAR? The study group describes an “overarching principle” that the GAAR should target only “highly abusive contrived and artificial schemes which are widely regarded as intolerable” but warned that it “should not affect the large centre ground of responsible tax planning”. This is the crux of the matter, urges Sinclair.

The study group attempted to reflect its overarching principle and protect this centre ground by several statutory mechanisms, the most important of which being an exclusion for arrangements which “can reasonably be regarded as a reasonable exercise of choices of conduct afforded by the provisions of the [taxing] Acts”, which could place a lot of weight on an undefined standard of reasonableness. Another suggested safeguard is the establishment of an independent panel to advise on whether there are reasonable grounds for invoking the GAAR in a particular case.

“There are concerns as to the uncertainty that a GAAR is likely to bring into normal commercial transactions which have any tax-planning features. Whether the proposed safeguards, or others introduced and debated as part of the consultation in the summer, will be sufficient to allay those concerns remains to be seen,” says Sinclair.

“Any client who has a tax profile with HMRC will potentially be impacted, whether a corporate or private equity firm”.

The UK currently has a vast number of “targeted anti-avoidance rules” (TAARs): measures which apply to specific areas of the UK tax code and which aim to counteract tax advantages on particular arrangements. One of the concerns of a GAAR is that unless its introduction is coupled with a simultaneous repeal of TAARs (which is highly unlikely) there will be a period when a GAAR and the TAARs will co-exist, adding to the already bewildering array of UK tax legislation and, as a result, increasing complexity in the system.

It is often suggested that one way of resolving any uncertainty in a GAAR is to provide taxpayers with a statutory pre-transaction clearance system, with a fee-based system to counter concerns about the strain on resources which could be placed upon HMRC. However, the study group was clearly averse to a clearance system, citing (aside from resources) a concern that it could result in an allocation of “discretionary power to HMRC who would effectively become the arbiter of limits of responsible tax planning”. “From practical experience with current statutory clearance procedures”, says Sinclair, “a GAAR clearance system might not be a panacea to address the uncertainty which a GAAR could create.”

Retrospective regulation, greater risk?

Indirectly linked to the UK GAAR, is the issue of retrospective UK tax legislation, which recently came into sharper focus when, in February 2012, the UK Government enacted new laws retrospectively taxing certain debt buy-back transactions entered into at the end of 2011.

Taylor says that if the new anti-abuse GAAR rules are put in place next year, it is felt unlikely that they would have a retrospective effect as has been seen in the recent example of India.

The Government’s stated view is that retrospective tax legislation will be appropriate only in “wholly exceptional” cases, although the Chancellor’s Budget announcements reaffirmed its potential role in the future to defeating tax schemes which the Government views as unacceptable.

Indeed, it has been questioned whether a GAAR is necessary when the Government feels it can undo arrangements which it views as unacceptable tax avoidance simply by legislating with retrospective effect after the event. As a general observation, however, whenever retrospective legislation is introduced it will inevitably serve to increase tax uncertainty and affect stability, which has been the case in other markets.

Protection against potential tax liabilities

“Concepts such as the GAAR and retrospective legislation, while seemingly aimed at one end of the spectrum of tax avoidance, will inevitably create problems of definition and, as a result, increase tax uncertainty. Where those uncertainties arise in a wider commercial context, insurers and other providers of contingent liability cover may well find that UK taxpayers have an increased appetite for protection against potential tax liabilities,” says Sinclair.

Taylor reiterates this point: “Any client who has a tax profile with HMRC will potentially be impacted, whether a corporate or private equity firm. And each client will have a different tax profile and a different risk appetite for tax planning.”

But how can one cover any level of uncertainty? She uses an example to put things into perspective: “If for example, you are doing a piece of restructuring and the tax advisers can never guarantee 100 per cent that the structure will not incur a charge to capital gains tax, an insurance policy can eliminate this level of uncertainty. If the tax liability does eventually crystallise and the tax authorities are able to succeed in issuing an assessment for tax, your tax policy will cover the tax liability itself, plus interest and defence costs on appeal.,” she explains.

Sinclair concludes: “It seems that now and in the future, whether in relation to business arrangements with tax features or warranty and indemnity protection on M&A transactions involving target groups with potential latent tax exposures, the potential impact of both retrospective legislation and a GAAR will often need to be considered.”

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