Analysis of UK Income Tax Provisions - Essay Example

? Analysis of UK’s Income Tax Provisions Relating to Anti-avoidance, Tax Planning and Tax Avoidance Part A “Opposite Concepts of Taxation” Regressivetax and progressive tax fundamentally symbolises two opposite ideas in taxation. Progressive taxation implies that the amount of taxes one pay increases when the quantum of income increases. For instance, an assessee has to pay 10% tax when his income is ?100,000, and he is required to pay 30% tax if his income is ?300,000. Majority of the countries around the world follows the progressive taxation as they conceive the same as more fair. Under progressive taxation, the difference between the distribution of income before the taxation and the distribution of income after the taxation is of great importance. The Progressive taxation is said to minimise inequalities in the society as wealthier people has to pay more taxes as compared to less income group thereby offers some aid from the inadequate demand for consumption in capitalist’s economies. As per Keynes, progressive taxation helps to alleviate unemployment. For reaping the greatest benefits, the whole tax system of a nation should follow the progressive taxation system. USA is having highest progressive individual taxes like the federal income tax and death or estate duty .Besides; it is also having a number of regressive taxes like sales taxes levied by the majority of the states and excise duties imposed by the federal government1. A progressive tax system is a system where the average rate of tax increases as income soars. Thus, rich people have to pay heavy taxes whereas poor people have to pay less tax. The ability to pay is the main theme behind the progressive taxation. Thus, rich people are expected to contribute more to the national chequer for public spending. The ardent supporters of progressive taxation are of the view that such a tax system is equitable, and that helps to redistribute the income among the society to maintain the equilibrium. Lorenz was the first economist who found that there is a relationship between the cumulative size of income and cumulative size of income receiving components when they are organised in the ascending order of their income as early in 1905. This has been popularly known as the Lorenz curve which is being extensively employed to calculate inequalities of wealth and income in many nations around the world. Lorenz curve is being employed extensively for formulation of public policy. For instance, it can be demonstrated from the scrutiny of Lorenz curve that post-tax income is evenly allocated than that of pre-tax income if the mean rate of taxes soars with the level of income. Moreover, if the tax-income ratio stays constant, inflation does not alter the distribution of post-tax revenue even if the tax function is altered or shifted every fiscal year. Lorenz curve is also being employed widely to assess poverty2. Progressive tax system also produces fiscal drag impacts and when a nation’s economy is developing rapidly and there are more citizens in work thereby earning salaries and wages and incomes seem to increase faster than prices of commodities thereby pushing citizens into the higher income-tax range and thereby enhancing the aggregate flow of tax income into government exchequers account. This can be explained as a partial automatic stabiliser for the economy as increasing tax receipts is being contributed from citizen’s disposal income. From the table given below, one can understand under the progressive tax system, the less income groups have contributed just ? 263 million by 2460 taxpayers whereas high-income group of just 8 people contributed ? 6,370 million to the UK’s exchequer. “Regressive Tax System” In the regressive tax system, the higher-income group of a country contributes the lesser share of taxes to the government and whereas poor people of a nation is taxed heavily at higher rates as compared to the higher-income group. Thus, regressive tax system can be said to be just contrary to the progressive tax system. Under the regressive tax system, the rate of tax decreases when the level of income increases. Since, regressive tax system is not an equitable or just, majority of the nations have discarded it. However, regressive tax limits the usage of intoxicants. Thus, regressive tax can able to increase the welfare of the society by levying higher taxes on liquors, opium, wine, bhang and beverages so as to minimise the consumption of alcohol. Regressive tax can be employed to levy higher taxes on luxury products and alcoholic liquors to minimise their consumption. Regressive tax system has been criticised as uneconomic and non-productive as the cost surpasses the revenue. It is also being criticised that it axes the poor more than that of rich people3 . “Opposite Circumstances in Taxation” Tax avoidance is circumventing the tax rules to derive a benefit from the tax advantage that rule makers never meant for. Tax avoidance divests the UK government the fund it requires to finance public expenses and weakens the confidence reposed by the public in the equity of the UK tax system. At present, it is estimated that UK is facing a tax gap of ?35 billion or 8% of the tax to be collected. About 14% of the tax gap is comprised of tax avoidance, which works about ? 5 billion. As UK tax payers are more concerned with the payment of taxes, as per the international findings, UK is having the lowest tax gaps in the globe. Tax avoidance involves artificial, unnatural transactions that result in a tax advantage. Though, tax avoidance is a scheme which is well within the letter of the UK tax laws but does not fall within the spirit of the law. Tax avoidance is divergent from that of tax planning. For instance, for capital investment, tax relief can be availed by investing pension scheme or in a tax –exempt ISA which is a legitimate guise of tax planning. The best method to put a full stop to tax avoidance is to prevent it by framing the tax laws effectively without any loopholes. One of the anti-avoidance strategies of tax avoidance is the Disclosure of Tax Avoidance Scheme (DOTAS) which helps the whistle blowers to bring any tax avoidance to the attention of the HRMC in UK. Under DOTAS, more than 2000 schemes have been recognised as of March 2012. These disclosures have helped to UK government to make about 60 changes in the existing tax laws which have closed about ? 12.5 billion in tax avoidance opportunities. UK government introduced GAAR, which will function as a restraint to those who indulged in abusive and artificial avoidance schemes. It is alleged that wealthy individuals and large business groups have indulged in tax avoidance schemes. In one recent tax avoidance schemes namely The Tower MCashback scheme4, UK government gained tax revenue of ? 1.8 billion in the UK Supreme Court. Under this scheme, one can claim capital allowance on software funded by finance from banks on artificial terms. Thus, the borrowed funds were utilised to claim tax relief, which is higher than their original investment5. “Answer to B” Graham would be paid by the National Chain a large amount as non-compete fees. This may be construed as non-compete fees paid to Graham for not competing with the business for five years. Under present employment laws, non-compete contracts are the most complicated contractual provisions as of date. Non-compete agreement tries to eschew to solicit the customers or to engage in competition and is running the risk of breaching the fundamental rights of an employee to exercise professional freedom. Under UK laws, it is possible to draft non-compete commitments on key employees which prolong after the termination of the employment contract. However, such bar will be implementable only to the magnitude that they are rational by giving adequate consideration to the period for which it is imposed, the scope of the restraint, and its geographical relevance. The majority of the employment contracts will have a provision that bars the competing by an employee after the termination of the employment agreement which is known as “restraint of trade’ provisions. The common restraint that an employer may impose the time-limits within which the ex-employee may take up further activities and geographical restrictions on markets on which an employee can perform. Thus, non-compete provisions bars the employees from vying with his former employer and restrains the employee from divulging confidential information, client information and tools of their erstwhile employers. Under normal circumstances , non-compete provisions will be not valid, unless they are deemed to be essential to bar dissemination of trade secrets or employing the connection made while in employment with the employer6. As per the Income Tax (Earnings and Pensions) Act 2003 (ITEPA 2003), sections 401 and 403 stipulates that any terminal payment made to an employee as regards to termination of his employment contract is liable to be taxed under UK’s Income-tax provisions . Thus, in calculating the tax burden on such employee terminal payments, the first ?30,000 will be excluded from the tax. Thus, any amount received in excess of ?30,000 will be liable for income-tax. In 7Obihara v HRMC, where there were question about the tax deductibility on termination benefits, which included both compensation of termination of employment and compensations of discrimination8. In this case, it has been held that the proper starting event is to recognise the amount for termination of employment which is a taxable one and balance amount can be treated as compensation for harassment, which is free of tax. Further, in9”Norman v. Yellow Pages Sales Ltd10”, it has been held that there exists no implied duty on the part of the employer to divide the termination fees between non-taxable and taxable portions. Thus, the employer is required to deduct the tax on the whole amount in excess of ?30,000. If the employee wants to raise any dispute over the same, he has to raise the same with HMRC separately. To arrive at the financial loss incurred due to termination from employment, it is not wise to restrict the loss with 3 months notice period. It would be rational to think how Graham would be without employment within the radius of twenty miles from Tom's business premises for a period of five years. In other words, Graham has to be without job or earnings for the period of sixty months. Hence, the HRMC should take into account the Graham compensation which includes salary, bonus and benefits in kind for 5 years as Graham would be out of job for five years due to non-competent agreement entered with the national agency.11. Payment of non-compete fees is governed by the HMRC guidance notes CG68060. As per this guide note, any lump sum amount received due to a contract that bars the style in which an individual can enter into an employment contract or to carry on business or trade. These types of covenants can take the guise of non-competition agreements ?exclusivity agreements, restrictive covenants or golden handcuff agreements and so on. The distinctive characteristics of the scheme are that in return for the fiscal incentives, an individual will limit his trade, business, employment or professional services in some way. In deciding the taxability of the non-compete fees received, one has to give consideration to whether the whole amount or part of it is to be treated as income receipt or whether it has to be taken as income profits ,losses or gains of the recipient. In accordance with the TCGA92/S37(1), the quantum that is chargeable as income shall be treated as profits, losses or gains and the same should be excluded from the amount which is to be taken as capital gains purposes . Non-compete compensation so received, for the purpose of tax treatment, will foot upon the facts of each and every case and especially the purpose for which it is made. Hence, it is crucial to read the exact terms of the contract and the background of the each case. Thus, in some case, it may be essential to divide the sum so received under a complex agreement between revenue and capital receipts and between numerous capital assets. Further, as per the guidance note TCGA92/S52, such division should be “reasonable and just.” Section 52(4) permits any “necessary” apportionment, which is to be made on a reasonable and just basis. Now, an assessee can determine the method of apportionment under the Self Assessment scheme. It is to be noted that if the non-compete fees received from a capital asset, then it will be capital or if it from revenue, then it will be regarded as revenue. In the Glenboig Union Fireclay Co Ltd v CIT12 , the amount paid by a railway company to safeguard its tract to sterilise that specific property amounts to capital account. In Johnson v W S Try Ltd13 , receipt of money to stop the ribbon development was a revenue receipt. If non-compete fee is received for a partial or temporary cessation of a trade or employment, then such receipt will be revenue in nature. An individual may be paid non-compete fees for the restriction placed to involve in similar employment will be regarded as an employment income. For example, non-compete fees received due to restrictive covenants that result in the overall termination of a trade is likely to be a capital receipt. To decide whether the lump sum fee received due to a non-compete clause, we have to see whether it is chargeable to corporation tax or capital gains on chargeable gains. If non-compete clause prohibit the owners’ freedom to exploit the goodwill of his business, then it will be regarded as a capital receipt. In Kirby v Thorn EMI Plc, it was held that if an individual’s liberty to trade is not an asset. If a company derived a capital receipt from its goodwill, it will be a capital receipt. In the problem, it has not been clearly mentioned that in which tax court Graham’s tax advisor has filed his contention. In the absence of specific information regarding this, it has been assumed that the first verdict relating to Graham’s tax matter was made by Her Majesty’s Revenue and Customs (HMRC). In such case, Graham can appeal to First–tier Tribunal (Tax). Graham can appeal to the Upper Tribunal against a verdict made by the First-Tier Tribunal if he thinks it is bad in law and against any verdict of an upper tribunal in the tax courts. In this case, no mention is made about the quantum of the amount received from the National Chain by Graham. If Graham has received less than ? 30,000 as non-compete fees, there is no need to pay any taxes on the same, as there is no tax payable if the income is less than ? 30000. Further ?as per UK income tax laws, it is the duty the national chain to deduct tax when it is paying Graham the lump sum fee for non-compete. In this case, it has not deducted tax out of the lump sum fees paid to Graham. HMRC can take action for not deducting tax at source on the national chain. If Graham wants to raise any dispute over the same, he has to raise the same with HMRC separately. In this case, the tax advisor should take into account that Graham had left Tom's business without any compensation from Tom, and Tom sold his business to the national chain; and the national chain paid Graham quite a large amount of money not to work on his own within a radius of twenty miles from Tom's business premises for a period of five years. The tax advisor should consider the same as capital receipts. Applying the principles laid down in the Glenboig Union Fireclay Co Ltd v CIT and due to the fact that non-compete fees received due to restrictive covenants that result in the overall termination of a trade are likely to be a capital receipt, the tax advisor should appeal to the first-tier First–tier Tribunal (Tax) against the verdict given by the tax court as the Revenue had not characterised the receipt. The tax advisor in the appeal should state that it is a capital receipt as Graham had been stripped out of job for five years and as such the termination of his association with Tom had put a full stop to his earnings and cessation of trade and hence exempted from the payment of income-tax in UK. “Answer to Question C” HMRC approach to confront the commercially planned transactions which are aimed at tax planning is being condemned by businesses in UK. The present tax legislations are short of appreciating the legally permitted tax planning and hence there is an urgent need to revamp the tax code. Unless the present strategy of HMRC of questioning the commercially driven events, very fewer businesses could be established in the UK in the near future which may result in the reduction in the tax revenues which may result in reduction in both income tax and corporation tax revenues? If much clarification is enshrined in the tax codes about the permissible tax planning, it would save time and money to both UK businesses and HMRC. As per recent research study , about 66% of businesses in UK are of the opinion that the present tax structure in UK is so complicated that they are unclear about what is legitimate tax planning and whether they could be blamed of indulging in tax avoidance. Further, 30% of UK businesses feel that HMRC conceives them as illegitimate tax planning and whether they could be blamed of indulging in tax avoidance. Further, 30% of UK businesses feel that HMRC conceive them as guilty until their innocence is established. UK businesses are of the view that due to intricate tax structure, which is aggravated by a lack of commercial comprehension by HRMC. About 44% respondents are of the view that HMRC staff has poor or insufficient commercial awareness and knowledge on taxation issues. About 56% of the businessmen are of the view that questions posed by HMRC officials to assessee on tax liability are excessive in nature. About 62% of the interviewees are of the opinion that HMRC should earmark more time in investing or detecting tax avoidance, which has been artificially designed instead of harassing reasonable tax planners14. Under IR35, a one-man service company can be formed, and such company can render services to a client and earn income. The whole of the revenue received by such one man-company can be paid back to the service provider who is the single member / director of such one man company by way of salary, PAYE income tax can be paid and also contribution to employee’s National Insurance Contribution (NICs) and the one-man service company would be paying employer’s contribution to NIC. The balance revenue can be dealt with many ways : like paying expenses which include training cost , professional fees for the service provider (the owner of the one-man company) ?salary can be paid to spouse and dividend out of profit can be declared to the service contractor as such dividend payment will not attract NICs . Further, income tax shall have to be paid only when there is a declaration of dividend. Further, one-man service company can retain the profit which is liable to corporation tax but at the special low rate applicable to small companies and will be considerably low as compared to personal income tax rates. The one-man company which is legally permitted under IR35 of UK has many advantages. In such company, the service contractor (the owner) can decide the quantum of the amount that can be taken as salary and income tax on such salary payments can be paid by the company and payments to NICs. Further , he can plan in such a way that he retains the earnings in the company itself so that he can take it out by way of dividends later as no NIC is payable on it15. Tax avoidance unlike tax evasion is legally permissible under the English law, and hence it is up to the government to plug the loopholes to make those who indulge in tax avoidance to pay more in taxes. Those who are having surplus income can invest in Enterprise Investment Schemes (EIS) which are intended to invest in new business ventures with novel ideas but have great risks as these schemes offer large tax relief. Further, investors need not to pay any tax on returns received from these businesses once business becomes successful. Some cap has been fixed for making investment in these schemes to qualify for tax exemption16. It is suggested that Graham should form a one-man company just before he receives the compensation from national agency. Applying the principles laid down in the Glenboig Union Fireclay Co Ltd v CIT and due to the fact that non-compete fees received due to restrictive covenants that result in the overall termination of a trade are likely to be a capital receipt. Hence, non-compete fees will be regarded as a capital receipt in the hands of the one-man company of Graham. Further, he has to remain without a job for the remaining 5 years as per the covenants entered already, he may use the capital receipts in his company to take salary and other perquisites and even declare dividends to him, he can pay salary or consultation fees to his wife, meet the various expenses from the company thereby reducing the taxable income of the one-man company. Further, the taxable income in the one-man company is subject to minimal corporate taxation as compared to personal taxation in UK. This is one of the benefits of tax planning, which is legally available to Graham under UK taxation law. Further, if Graham wants to carry out his profession in the name of the company, he can carry out his profession in the place situated beyond the radius 20 miles. By entering into non-compete agreement, it is to be noted that Graham has been denied to carryon his profession for five years. To survive for five years, he has to use the funds which he received from the national agency .Hence, it is suggested that in the absence of any revenue or income in the coming years, Graham has to wholly depend upon the non-compete fees received and hence, it is suggested to show it as capital receipt and to draw the salary in his one ­man company so that tax incidence is minimised within the available legal framework in UK. 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