"Settling large tax disputes" report - anyone want to chew the cud?

[CinnabarRed]

Last Autumn the Public Accounts Committee challenged whether HMRC was too cosy with large business and had settled enquiries too cheaply. The National Audit Office thus engaged former High Court judge Sir Andrew Park to review in detail five cases where the NAO had found HMRC had not complied fully with its own procedures in settling the cases. Two of the cases are public: Vodafone and Goldman Sachs.

The four corporate tax cases essentially covered transfer pricing and Controlled Foreign Companies issues [happy to explain what CFCs are if anyone wants]and ? in all cases ? Sir Andrew found that the settlements were reasonable (and one probably favourable to the Exchequer). HMRC had conducted thorough examinations of the issues and had taken legal advice where appropriate. The only real issue was that there hadn?t been the level of independent review that there should have been ? but that was because there were no other Commissioners with appropriate tax knowledge.

The fifth case concerned NIC. The NAO report makes it clear that there were quite a few procedural errors in that case ? and it?s probably fair to say that HMRC doesn?t come out especially well. However, there were six separate technical issues included in the Goldman Sachs settlement ? not just the NIC and interest on it. The overall agreement covered all six ? and in that context Sir Andrew considered the settlement was reasonable. After the settlement was reached, the matter was taken to the Programme Review Board, which initially refused to agree it since interest hadn?t been charged. Legal advice was then taken and the Board then agreed it was not in HMRC?s interests to reopen the matter. Indeed, Sir Andrew considered that HMRC couldn?t have reopened it, since the original agreement with the bank was legally binding.

Meanwhile, UKUncut have persuaded the High Court that they have an arguable case to challenge the legality of HMRC?s settlement in the Goldman Sachs case. The judicial review will be heard in October.

So, in a nutshell, all those bleating about evil corporations such as Vodafone, Amazon and Goldman Sachs evading UK tax were wrong and have libelled some perfectly law abiding companies.

I look forward to hearing their apologies expressed as fervently as their accusations.

i'm not sure i totally follow, but i read this as: HMRC didn't follow their own procedures properly. it became too expensive to pursue (cost v. benefit) and the regulations seem to favour businesses and clever accountants, therefore a smaller settlement was agreed that left HMRC £20 million short.

so, should the judicial review be examining this? well, yes i think so. our tax system is ludicrously over-complicated and therefore there are multiple loopholes that can be and are being exploited by teams of lawyers and accountants in big companies that can afford it.

I think that it will always be the case that clever accountants will find tax avoidance loopholes faster than governments can legislate to close them. As there is a huge incentive for companies to find these legal loopholes they will continue to do so. I have heard it said that the UK tax code extends to some 11,000 pages whereas our EU competitors? codes are a fraction of this - can CinnabarRed confirm this? If this is true, then simplification would seem to be a matter of some urgency.

I find it difficult to comprehend that even the National Audit Office can scrutinise these accounts and be unable to come up with an accurate figure and TheMysteryCat, I?m not sure I totally follow either but I read it as all five companies have paid broadly the right amount of tax, except one, which has overpaid and is presumably, due a rebate!

11,000! Oh my! no wonder it's all such a mess. agreed that simplification is very urgent.

I think that NAO still not being able to understand underlines just how ridiculous a mess it all is.

I often wonder why the UK doesn't have the same basic premise for a company operating in its country as the US. You pay tax where you work, not where you push the money off to?

OK, a few points here.

Vodafone, Amazon, Goldman Sachs, etc - none of them have ever been accused by anyone halfway sensible of evading tax.

Tax evasion is illegal. They haven't done it.

Tax evasion is almost exclusively the preserve of sole traders and microbusinesses. According to HMRC there are a small handful of medium sized businesses that might consider tax evasion, and some that even do it, although I've never come across any.

They have accused them of tax avoidance. Tax avoidance isn't illegal although many find it immoral.

In fact, in my view, of the 5 companies reviewed in the report, only one was involved in out-and-out tax avoidance, and that was Goldman Sachs (strictly it was seeking to avoid NIC which is a levy not a tax, but let's not quibble).

All of the others were involved in commercial transactions where the tax treatment was uncertain, and the companies, naturally, tried to argue positions which minimised their tax bills. HMRC took counter positions.

As an aside, most people assume that all tax disagreements have a binary answer, but in reality this is almost never the case.

HMRC followed most of their own procedures correctly. In 4 of the cases they followed procedure, although Park identified instances where the procedures themselves were creaking to manage such large settlements.

In the 5th case, Goldman Sachs again, they didn't follow procedure and received some duff advice which made the situation worse.

In all 5 cases, Park concluded that the settlement negotiated by HMRC was a good deal for HMRC. Remember, these are grey areas where it's far from clear what the right answer is (or even if there is a right answer).

I'll post separately to give you an example of a tax disagreement that doesn't have a "right" answer.

Park is a former judge, and knows his onions.

Yes, our legislation runs to well over 11,000 pages. It's the longest in the World.

The US tax system is a nightmare! It starts with the basic premise that everyone, everywhere in the World is subject to US tax, and then carves out exemptions.

In theory, anyone who holds or is entited to hold a US passport should file a US tax return. That includes my brother, who was born prematurely while my parents were on holiday in the US and therefore has the right to US citizenship. Despite both my parents being Brits, my brother being a Brit and my brother never going back to the USA since he left aged less than 2 months old!

Just a point on the legislation. Most of it is anti avoidance in some way.

I thought the US had a more wordy legislation Cinnabar due to their's being a "cover every eventuality" type of legislation?

Simple legislation is fine in theory, however leads itself open to large amounts of avoidance and abuse.

You do pay tax where you work, so if you gain income in the UK you will pay tax (and in some instances NIC) on your UK income. However if you are not UK resident you will not pay tax on your worldwide income.

That is very simplistic but basically correct.

"as of 2010, means that the U.S. tax code has ballooned to be 71,684 pages in length" (from a political blog)

The US try and prevent any type of avoidance - if it isn't covered in the federal tax code you don't get it.

The bit of the american system i do think is reasonable is that you pay tax on your worldwide income to the country you live in.

this is probably tax 101, but why is anyone allowed to use a tax haven, in order to avoid tax in their home country?

You will pay tax on your worldwide earnings if you are a UK resident Cat. If you are not you will pay tax on your UK earnings.

A tax haven is usually a tax avoidance device, but the UK profits should still be taxed. However companies can do funny things with transfer pricing, losses, capital assets etc to move money abroad.

If it is legal it is tax avoidance - some of these work and some don't and HMRC should be policing that. If it is clearly illegal then it is evasion. Although sometimes the line can become very blurred.

CR Post the "no right answer" example (can't believe I'm getting excited about a tax conundrum but that's the kind of geek I am).

I agree though that it is a myth that tax and accounting rules are black and white. I once sat in a 4 hr meeting arguing about whether coking coal is a cash equivalent (as gold is generally agreed to be).

the mystery - Americans have to pay US tax on their worldwide earnings, even if they dont live in the US, (to the extent that US taxes are higher- can deduct tax paid elsewhere) which is not the case of almost any other type of citizenship. There are currently a lot of Americans renouncing their citizenship as they dont intend to live in the US again and dont want to pay US taxes when they live in (eg) Asia. If you renounce, you just pay a one-off "capital gains" type tax. Apparently, if you want to renounce US citizenship in HK, there is a 4 month wait list.

Loopholes are always hard to close because, contrary to the belief that they are deliberately left there by the Tories to help big business, they exist because they are the 1% exception to a 99% rule. In closing them, the government has to make sure that it doesnt make the system unfair to the 99%, and, as has been pointed out above, can result in the guidance becoming really complicated and expensive to administer.

Most people I know in the UK (employees) can do their own tax return no probs, even if they have reasonably sophisticated personal finances (options, share schemes, directorships etc). Nearly all the Americans I know have to use an advisor in the same situation. That's kind of ridiculous just for personal taxation.

Love Cinnabar's tax threads!

they are deliberately left there by the Tories to help big business,

What tripe. Loopholes have existed for as long as anyone can remember. This is not a party political issue.

Yeah, that's what I'm saying- it's not true, but a lot of people make out that the loopholes are some sort of sinister plot between Cameron and Vodafone, whereas in reality, they are generally sensible bits of guidance that occasionally lead to situations which are not really intended.

OK, here are typical examples of 'no right answer' tax issues.

Suppose that a group of companies manufactures and sells widgets. The widgets are manufactured by a group company in Germany. There is a UK company which is responsible for selling widgets to customers in the UK and Ireland. How much should the UK company pay the German company for each widget it sells?

UK tax law doesn't care what price is actually agreed between the UK company and the German company. It simply says that for tax purposes the price should be the price that would have been charged between unrelated parties (that is, a selller and a buyer who are not under common control). This is often called the "arm's length price". If HMRC argues successfully that the price charged was not at arm's length then it can replaces the actual price with the arm's length price - for tax purposes only.

If the German company happens to also manufacture exactly the same type of widgets for sale to unrelated customers of its own then the arm's length price is relatively easy to determine - Germany should sell the widgets to its UK sister company at the same price as it sells them to its own customers (there are, actually, reasons why the sales price might differ, such as bulk purchase discounts, but let's keep it straightforward for now).

But in reality it's extremely unusual for the German company to also sell direct to third party customers. So the obvious answer isn't available. What happens next?

The OECD says that the next best thing is to use statistical analysis of published economic data for millions of sales transactions to calculate what the arm's length price. And economists have done enormous statistical studies attempting to do just that. It's an absolute balls ache to grind through the numbers, and it's far from easy to agree which transactions are even sufficiently comparable that they should be included in the number-crunching to start with. But the consensus is that there is a very strong link between the costs that manufacturing companies incur and the prices that they charge.

So the price the German company should charge the UK company should be based on its costs plus a mark up for its profits. In other words, if it incurs costs of 100 to manufacture each widget then it should charge 100 plus a profit margin.

(Note here that the price that the widgets are to be sold by Germany to the UK is entirely dependent on the costs incurred in Germany. There is no allowance to be made for the price that the UK company can sell the widgets on to its customers.)

Ah, but what should the profit margin be?

It depends on the risks that the German company takes on to operate its business. The more risks it takes, the more profit it should make.

The group as a whole can decide which risks will be borne by the German company and which by the UK company. Let me give you some examples:

1. Who will decide how many widgets the factory will manufacture each month? If the German factory can be left with unsold widgets at the end of the month then it's bearing more risk than if the UK company is obliged to buy all the widgets as a matter of course.

1. Who decides where the factory gets its raw materials? Often, a central purchasing team will negotiate global contracts for raw materials, in which case the German company doesn't have to worry about suppliers going bust or trying to renegotiate prices.

1. Who owns the patents for the technology which the German company uses to make its widgets? Again, it's common for groups to have a centralised R&D team that come up with all of the clever technology, so the German company doesn't need to.

1. What happens if a UK customer makes a complaint about a widget? Does the UK company have automatic right of recourse against Germany or not?

1. Who has to insure the widgets when they're shipped from Germany to the UK?

1. Will Germany sell its widgets to the UK in Euros, or pounds Sterling? That will determine which of the two bears foreign exchange risk.

So once all the risks have been allocated out, the group will try and calculate what the German company's profit margin should be. A low-tech low risk factory might only earn a profit margin of, say, 5%. (That is, if it incurs costs of 100 it will sell its widgets to the UK company at a price of 105.) A high-tech high risk factory might ean a profit margin of, say 25%.

So now imagine that the group does all of the statistical and risk analysis, and concludes that the price that Germany should charge the UK is cost + 10%.

HMRC does not agree. It says the price is too high and should only have been cost + 8%.

The German tax authorities also disagree. They think the price was too low, and should have been cost + 12%.

Who is right? Nobody knows. Everyone has to argue the toss between them and try to find a solution that they can all live with.

Now imagine that R&D centres are in the US and Asia-Pac, the raw materials suppliers are also group companies, that the widgets manufactured in Germany have to be packaged in each sales jurisdiction to meet marketing authorisation requirements, the group operating its back office functions out of a data centre in Belgium, and its distribution functions out of a warehouse in the Netherlands. Imagine the complexity then

Welcome to the wonderful world of transfer pricing....

I agree entirely about loopholes - they're definitely not intended.

BBB - I think the 71,000 page quote for US tax legislation includes state taxes as well as federal taxes, but I've asked a colleague in the US to confirm.

I can give you non-transfer pricing examples where there isn't a 'right' tax outcome if anyone wants...

Thank you SweetTheSting

Sorry richman...i misread your sentence.