Walking a Tight Rope: Thin Line Between Tax Planning and Tax Abuse

By Walter Amoko | Lena Onchwari

Share this article

Globalization has had its bright side. Liberalization of domestic markets as well as the feeble returns in most Western markets has resulted in dramatic growth in foreign direct investment by multinational companies especially across the globe with developing countries receiving a substantial share. This has been of great benefit to developing countries spurring economic growth. Their tax authorities should also be smiling as growth results in more tax revenue. However, this is not guaranteed as tax efficient multi-nationals are astute at avoiding taxes. Consequently, developing countries have seen the need to drastically amend and enact tax laws that will give them a wider tax base, curb tax evasion and mitigate against tax avoidance.

It is noteworthy that despite the statutory obligation to pay taxes, a taxpayer is allowed under law to so arrange its affairs to mitigate its tax liability. This is encapsulated in the statement of Lord Clyde, in the case of Ayrshire Pullman Motor Services & Ritchie v Inland Revenue Commissioners where he stated that; “….No man…. is under the smallest obligation, moral or other, so to arrange his legal relations to his business or to his property as to enable the Revenue [authority] to put the largest possible shovel in to his stores. The Revenue [authority] is not slow – and quite rightly – to take every advantage which is open to it under the taxing  statutes for  depleting the taxpayer’s pocket. And the taxpayer is, in like manner, entitled to be astute to prevent, so far as he honestly can, the depletion of his means by the Revenue [authority]….” This passage recognizes the inevitable game of cat and mouse where the tax authorities seek to legally maximize tax collection while the tax payer seeks to legally reduce his/her tax obligations, with the Courts determining the legality of the transaction or structure when confronted with such matters.

The increased sophistication of financial arrangements to minimize tax obligations and the advancement of tax law to address this has occasioned numerous court decisions on tax planning. The Courts have become more sagacious and have moved away from solely looking at the legality of the transactions on the face of it as they have deemed that approach insufficient, the Courts now also examine the underlying commercial rationale of a scheme to determine whether it amounts to an abuse of law.

In the landmark case of Halifax plc v C & E Commrs (and related appeals), the Court  stated  that ‘…the   application of Community legislation cannot be extended to cover abusive  practices by  economic  operators,  that  is  to say  transactions  carried  out  not   in the context of normal commercial operations, but solely for the purpose of wrongfully obtaining advantages provided  for  by   Community   law. That principle of prohibiting abusive practices also applies to the sphere of VAT….’ The judgment of the court in this case could not be more discerning. The Court opined that  despite  the  legality of a tax planning scheme, the tax payer cannot employ the same without an accompanying commercial purpose as that would be tantamount to an abusive practice. It is therefore pertinent  for the tax payer when formulating a tax planning structure, to take cognizance of the developments in both statutory and juridical law to ensure that the structure will not be deemed to be an abuse of law.

That said, tax planning can be approached from three different angles namely legal, financial and operational.

Legal Structure

A company’s legal structure relates to its ownership or share holding. This is especially important when it comes to withholding taxes on dividends  and most importantly in the  eventuality  of an exit from a country. In the Chinese Chongqing case (State Tax Bureau, 27 November 2008) a Singapore parent company sold to a Chinese buyer its Singapore subsidiary, which was a SPV(special purpose vehicle) that held a subsidiary in China. The Chongqing tax bureau disregarded the Singapore subsidiary and treated the  transaction as a sale by the Singapore parent of the Chinese subsidiary. Consequently, the Singapore parent  company  had to pay income tax in China at a 10% rate on the capital gain from the sale, as if it had sold the Chinese subsidiary directly. The tax bureau was of the view that the Singapore subsidiary had a very small amount of capital and also did not carry on any business activity other than owning the shares of the China subsidiary. Hence, the Singapore subsidiary lacked economic substance.

Financing Structure

Companies finance their operations in two major ways,  intercompany  loans or loans from third party financial institutions. However the  deductibility of the relevant interest expense is governed by certain specific and general anti-avoidance rules.

As already stated above, the Courts expect financing arrangements between companies to be driven by an economic goal. This was reflected in the recent judgment of the Supreme Court of Netherlands dated 5th June 2015  in a case that involved a listed parent company of a South African media group. The parent company issued shares of which approximately 60% of the proceeds were  directly  wired  to its Dutch third-tier subsidiary. From a legal perspective, the proceeds were contributed as capital to a second-tier Mauritian company, which in turn granted an interest free loan to its 100% owned Mauritian subsidiary, the group’s internal financing (low-substance) company. This company lent the proceeds to the Dutch holding company through an interest bearing loan. The Dutch holding company used the proceeds to acquire other companies and claimed interest deduction on the Mauritian Debt. The Supreme Court denied the claim for interest deduction and consequently referred the matter back to a lower Court to determine whether commercial reasons had duly motivated the funding provided by the holding company.

Operational Structure

It is common practice for companies in a group to offer other sister companies services at a cost. These services include management and professional services, marketing services, intellectual property leasing   among   others.   Payments for such services will be allowable deductions in one company  and  may be subject to  taxation  in  another.  It is however prudent to note that the transfer pricing guidelines will apply in such transactions.

The  spaghetti  plate  of  divergent views on  tax  planning  is  not  only  of a legal nature, but also of a moral, economic and political nature. As already discussed above, tax planning or avoidance is not illegal but it may be deemed by the Courts and the revenue authorities to be an abuse of law, in which case the tax payer may be denied the tax advantage they sought to enjoy.

There are proponents, especially the civil society, who consider tax planning to be outright immoral. Such a stance may adversely affect a company’s reputation, especially in cases where there is public outcry. However, such reputational risks can be allayed by putting in place certain measures which among others include intense lobbying and engagement with the government and tax authorities.

Flowing from the above, it is noteworthy that the Courts look at a number of factors in  order  to  determine  whether a company’s tax planning activities amount to an abuse of law. It was the trend that Courts mainly considered whether the structure was highly motivated by a commercial or economic benefit to the company. However a recent judgment of the UK Supreme Court in the case of HMRC V Pedragon plc & 5 others (2015) UKSC added a new twist to this. In the case the court held that it is not sufficient that a transaction has a commercial benefit, this will be open to challenge if the  accrual  of  a tax advantage is established to be the principal aim of the transaction.

In essence, while determining whether a tax planning structure amounts to an abuse of law or not, the Court will now consider two key factors; whether a company wished to obtain a tax advantage and whether the tax planning structure was driven by a commercial benefit. This decision of the Court is mirrored in the recent development of tax legislation in developing countries. For instance the Tax Procedures Bill in Kenya intends to look beyond the legality of the structure or transaction; it seeks to determine the commercial purpose of the same. It essentially lays the burden upon the tax payer to demonstrate the commercial purpose of certain transactions, failure of which the tax payer may be subjected to paying double the tax avoided as a penalty.

Therefore a tax payer should ensure that they structure their affairs in such a way that on one hand they are able to achieve their commercial or economic goals and on the other hand they get to optimally benefit from tax advantages brought about by the structure, without abusing the law.