How the Inland Revenue helps corporations avoid tax

The Guardian, July 23 2002

Imagine a gamekeeper sending a letter to the local poachers, telling them that, in future, he would like to support their activities: he would trust them not to shoot the pheasants and he would invite them to regular meetings so that he could take their advice on how he should handle them and, in the meantime, he would ask his staff to consider the genuine needs of poachers alongside those of the landlord. Imagine the gamekeeper declaring finally that his ambition was to become the poachers’ champion.

Now look at the Inland Revenue’s recent ‘Hartnett Review’ in which the Revenue’s director of policy, Dave Hartnett, and the most senior officials responsible for the taxing of multinational corporations explain that in future they want to be ‘supportive of business’, that they hope they will work with the corporations in ‘a relationship of mutual trust’, that they would like corporate executives to come to regular meetings as ‘an open channel… to influence operational policy’ and, in the meantime, they want ‘new service targets which balance Exchequer risk with the genuine needs of business’. The specialist section of the Revenue should act, the document suggests, as ‘a champion for business’.

The Hartnett Review is aimed at the 2,000 largest commercial organisations in Britain – the banks and insurance companies and multinational corporations who between them last year were caught failing to declare to the Inland Revenue more than £20 billion of tax; the same organisations who each year collectively spend millions of pounds on tax avoidance schemes which are designed to frustrate the will of Parliament; the same corporations who provide the bulk of the United Kingdom’s contribution to the estimated £3,000 billion of global wealth which now sits in the secret accounts of the world’s booming off-shore havens.

This is the story of an extraordinary transformation. It has taken place without public debate or parliamentary approval. It involves a government department being encouraged by ministers to cut corners in the law and to compromise its own function.

And it reflects the emerging weakness of all governments in the globalised economy, that they lack the muscle to challenge the giant corporations upon whose investment they rely. “There is a kind of turning the blind eye to make life easier for enterprise,” according to one specialist.

According to multiple expert estimates, big corporates who trade in the UK are responsible for avoiding the payment of some £20bn in UK tax each year. For years, the Revenue has uncovered only a tenth of this. In the past, its problems have been practical – too few experienced inspectors, too little power in offshore havens, too few lawyers to fight its corner in court. Now, the Revenue’s inspectors also face a political problem – that, in a globalised economy, where big corporations are free to invest where they will, the Treasury is frightened to tax the hand that feeds the UK economy with capital.

At the heart of this contradiction is the Revenue’s Large Business Office, whose job is to uncover undeclared tax from the UK’s 2,000 largest corporations. Acting on the principles outlined in the Hartnett Review, LBO officials have made a series of crucial concessions during meetings with executives from companies including British American Tobacco, General Motors, ICI, Rolls Royce, SmithKline Beecham and Unilever. In some cases, according to minutes of these meetings, Revenue officials have agreed to cut corners in the law.

For example, since July 1999 UK tax law has required all companies to pay their corporation tax in quarterly instalments, but the big corporates complained, and so LBO officials offered them a blind eye, assuring them at a meeting on January 18 2000, that they “did not intend to examine the figures in any detail”.

When the corporates went on to complain that they if they paid too little in any quarter, they would be charged interest on the underpayment (like any other taxpayer), the officials arranged for their rate of interest to be cut by 1%, so that the 2,000 biggest corporations would be charged less interest than smaller companies and individuals who failed to pay their tax bills on time.

In what appears to be an even more sweeping disregard for the law, the Large Business Office has undertaken not to impose penalties on large corporations except in the most serious of cases. The law allows that all taxpayers can be charged penalties of up to £1 for every £1 of undeclared tax where there is evidence of fraud or negligence. Small companies and individuals are routinely penalised but corporate tax advisers say that big corporations are frequently escaping without penalty.

The Inland Revenue deny this. The deputy chair, Ann Chant, told the Guardian in writing: “Just like all other taxpayers, companies dealt with by our Large Business Office are subject to statutory penalties if they submit fraudulent or negligent tax returns or, for that matter, if they send in returns late.” However, the Hartnett Review refers quite clearly to “the general reassurance which has been given that penalties will be reserved for the most serious cases”.

Echoing this, the deputy president of the chartered institute of taxation, Heather Self, writing in this month’s (July 2002) Tax Journal, reports that “The Revenue has gone out of its way to reassure businesses and continues to emphasise that the imposition of penalties is expected to be a rare event.” No other group of taxpayers has been given such a concession.

In an attempt to confirm the truth, we asked the Inland Revenue how much penalty the LBO collected last year. The Revenue’s annual report credits the LBO with finding £2,142 million which it explicitly describes as “tax, interest and penalties” but, confronted with our criticism, the Revenue claimed to have no idea how much of this was penalty.

Tax advisers described the idea that the Revenue did not know the origin of £2.1 billion of its own income as ‘incomprehensible’ and ‘complete rubbish’. Professor David Heald, who has acted as adviser on public accounting for the Treasury Select Committee, told us: “As a matter of good practice, I would have expected them to distinguish between tax, interest and penalty. It would be very surprising if the guidelines for preparing the national accounts do not make a distinction.”

Faced with this criticism, the Revenue changed its line, saying that they did, in fact, know how much penalty the LBO had collected in each settlement, but it would cost them too much to collate it into one total.

The law also appears to have been bent in a series of tailor-made tax deals which have been negotiated over the years with individual corporations. Minutes for a meeting on June 28 2000 record the corporates worrying that the new regime of self-assessment might undermine “agreements between a company and the Revenue to complete its returns in a way that was non-statutory but which was convenient to both sides.”

For example, if a UK company wants to cut its taxable income by saying it has spent £1 million on ‘marketing and promotion’, the taxman ought to find out how much of that money was spent on entertaining, which is not tax deductible. Instead, the Revenue will strike a deal to treat, say, 10% of the spending as entertaining, regardless of the reality.

Dealing with companies who have off-shore subsidiaries, multiple millions of tax are decided by striking fixed deals to treat only an agreed percentage of multinational profit as being taxable in the UK, while the rest is allowed to disappear into a no-tax haven, again regardless of the reality.

LBO officials acknowledged that “many of these agreements did not comply with the Revenue’s published policy” and yet, having reviewed them, they agreed at a meeting on October 31 2000 that “there is no reason in principle why practices cannot continue if the relevant facts and law remain the same and the practical results give a close approximation to the statutory treatment.”

This concession has become particularly controversial since the High Court in June rejected a series of non-statutory deals between the Inland Revenue and very rich individuals, who had been given ‘forward contracts’ allowing them to pay fixed sums of tax without filing full tax returns. The most senior judge in Scotland, Lord Gill, said the Inland Revenue had no right to ‘step outside’ its statutory duty to collect tax according to the law. It is not clear whether these non-statutory corporate deals will survive Lord Gill’s judgement.

The new strategy goes to the heart of the Inland Revenue’s supposed role in tackling tax avoidance. The minutes appear to show the Large Business Office making concessions on the policing of ‘transfer pricing’, which allows multinationals to avoid tax by abusing the transfer of goods or services between their own subsidiaries. All multinationals oversee trade between subsidiaries in different countries: a Korean subsidiary may produce shirts for sale by a UK subsidiary, and the multinational can set the price at which the Korean company transfers the shirts to the UK. It can set the price legitimately, or it can fix it to avoid tax: the Korean company, for example, might sell the shirts cheap to a third subsidiary, in the Cayman Islands, thus making no taxable profit in Korea; the Caymans company can then add a huge mark-up, knowing that its profit will attract zero tax; leaving the UK company to buy the shirts from its own subsidiary at such a high price that the sales will make no taxable profit in the UK either.

The OECD estimates that 60% of world trade consists of transfers made within multinationals. There are oil companies in the Cayman Islands, where there is no oil; car companies in Liechtenstein, where they don’t build cars; all kinds of electronic goods being sold out of countries which have no factories. But UK corporate executives were furious when the 1998 Finance Act required them to be able to prove that all their foreign transactions were ‘at arm’s length’ – ie on normal commercial terms – and not for tax avoidance. They complained that this meant they would have to keep paperwork to justify any transaction which might be queried and, in meetings with the LBO, they pushed for corners to be cut in the new law.

At first, the Inland Revenue stood its ground. According to minutes of a meeting on January 18 2000, the corporates lobbied to be given ‘record-retention agreements’ which would narrow the scope of the new law; and to be completely exempt from keeping any records with particular countries. Revenue officials replied that this was ‘not appropriate or feasible’. The corporates went on to ask for a ‘blanket clearance’ to keep no records at all on joint ventures between themselves and offshore companies. The Revenue pointed out that it was these joint ventures which had provoked the legislation in the first place. “It was felt to be too early to think about changing the record-keeping regime,” the minutes concluded.

And yet, only six months later, minutes of a meeting on June 28 2000 recorded Revenue officials telling the corporates that they understood their problem and – in an apparent reversal of their earlier position – pledging that there was no prospect of tax inspectors asking for all of the paperwork for such transactions. They agreed to adopt ‘a reasonable, practical, pragmatic approach’. Beyond that, the officials reassured the corporates that they would not be making too many inquiries into transfer pricing.

This was a particularly surprising concession. Just as the Inland Revenue were holding these meetings, senior officials obtained a copy of a private survey of major corporations conducted privately by one of the UK’s then ‘big five’ tax advisers, Deloitte and Touche. The Guardian has seen a copy of the survey which found that transfer pricing was seen by multinationals as a particularly high risk area in dealing with the Inland Revenue. Beyond that, it found that more than 70% of the companies who said it was their highest risk, reported that their tax affairs had not been investigated at all in the previous three years.

Senior officials are said to have been ‘appalled’ at the survey’s findings. At the meeting in January 2000, the minutes noted ‘the potential for substantial amounts of new transfer pricing work’. And yet in June 2000, the Revenue officials told their corporate counterparts that they “expected the amount of transfer pricing work done to be similar to that at present.” Indeed, the minutes noted, “the focus on best use of resources… had led to reductions in the number of new issues being taken up – particularly resource-intensive issues like transfer pricing.” The minutes recorded that the corporate members welcomed this.

From the same private survey, Revenue officials also found that the other main tax risk for multinational companies was the use of tailor-made tax avoidance schemes. Specialist tax advisers and lawyers earn huge fees by marketing such schemes, which use self-canceling payments and off-shore partners and book-keeping devices to divert millions of pounds in potential tax. “In common language, they are scams,” according to one corporate tax specialist.

The world’s largest accounting firm, PricewaterhouseCoopers, has just agreed to pay ‘a substantial sum’ to settle an investigation by the US Internal Revenue Service into tax-shelter schemes it has been using since 1995. KPMG are being taken to court by the IRS to force them to disclose the names of clients who have used what the IRS call ‘dozens of possibly abusive tax shelters’.

The results of the survey confirmed what Revenue officials already knew – that UK companies were using similar scams and getting away with it. The survey found that 52% of multinationals used “novel tax planning ideas which they would expect the Revenue to challenge and/or test in the courts” – but only half of those companies had had even one of their schemes investigated in the previous three years. Those whose schemes were investigated had to make settlements averaging £2 million; the rest escaped scrutiny.

Indeed, 85% of the companies in the survey reported that they had used avoidance schemes which they had expected to be challenged, without the Revenue ever investigating them. Now, following the terms of the Hartnett Review and in sharp contrast to the aggressive action of the US tax authorities, minutes show that the Inland Revenue’s Special Investigation Section, which targets these schemes, has been told to abandon investigations into specific cases in favour simply of making ‘generic inquiries’.

Beyond these specific agreements, Revenue officials have made a series of underlying procedural concessions to the multinationals. They have given them a new complaints procedure, they are planning a system of peer review which would allow companies to query decisions by tax inspectors and they have even offered to run customer-satisfaction surveys. More than that, they have invited the companies to help them to form new policy.

The Revenue is setting up a new Business Tax Forum with the role of ‘giving business a proactive input into the policy process’ and, even more controversial, it has invited them to join its Regulatory Impact Unit, which assesses how new tax law should be put into practice. When the corporates were first invited to join this unit, at a meeting on March 12 of this year, they said they could see no point since the law had already been decided. Revenue officials reassured them that “a lot of the impact depended on the details and on how the measure was implemented”.

Those who defend the Hartnett Review say it is an attempt to streamline the investigation of multinationals so that LBO inquiries are less common but more thorough. Hartnett suggests that most corporates do not want to avoid tax and invites them to work openly with the LBO, meeting inspectors to discuss problems in their accounts so that they can highlight their tax worries before they file their annual tax return. In return for this openness, the LBO will agree to pursue only a limited shortlist of queries, thus cutting down the time which each side has to spend on the return.

But insiders quarrel with Hartnett’s core finding, that “corporates want mutual trust with the LBO” and will work openly with inspectors. Hartnett, for example, wanted the Revenue and accounting firms to swap some staff on secondment: the Revenue allowed 20 outside accountants to work in its office; but the accountants allowed only one inspector to work with them. When Hartnett pushed for corporates to allow Revenue inspectors to work temporarily in their tax departments, the minutes recorded the corporates were happy to send their people into the LBO, but “the secondment of inspectors to industry would not work unless they could understand the concept of materiality – otherwise, they would return to the Revenue armed with detailed knowledge with which to conduct witchhunts.”

Apparently undisturbed by this lack of mutual trust, Dave Hartnett, according to the minutes, “said it would clearly be necessary to agree safeguards. For example, it was certainly not the idea that the secondee should have prior knowledge of the business concerned; and when they came back, they would not work on the tax affairs of that company.”

In the same way, the minutes show that the corporates who are supposed to be interested in mutual trust, were not so sure. One corporate considered Hartnett’s plea for openness and “saw a danger that it could encourage some inspectors to go on digging beyond what was reasonable and to counter any protests by pointing to the requirement for openness.”

The minutes also recorded, apparently without irony, that when the corporates considered the possibility of co-operating on inquiries into their transfer pricing, “one comment was that it was hoped that inspectors would not do so by digging down from one document to the next.”