DOTAS: Houdini’s Escape?
Houdini was a masterful illusionist famed for his escapology. The recent judgment given by the Upper Tribunal in The First De Sales Limited and Ors -v- The Commissioners for HM Revenue and Customs [2018] UKUT 396 (TCC) confirmed that the Disclosure of Tax Avoidance Scheme (“DOTAS”) that was struck out by the FTT on application by HMRC provided the taxpayer – unlike Houdini – with no reasonable prospect of escaping from the manacles of tax.
Brief Facts
The Appellants were a combination of limited liability partnerships and limited companies carrying on a creative writing profession for which they derived modest income. Founder members of the Appellants sought further partners or members and those partners or members made capital contributions to the Appellants. The Appellants then employed people who were Non-UK Resident to undertake administrative tasks and manage the estates which were based in the United Kingdom. Shortly after the employees commenced working at the Appellants they were invited to enter into Deeds of Restrictive Undertakings under which the Appellant agreed to pay huge sums (£970M in aggregate) “solely in consideration of [the employee] giving the restrictive undertakings”. This amount was then claimed as a deduction in calculating its business profits for the tax year it was paid. The loss generated by the deduction was then allocated to the Appellants’ partners and members who sought sideways relief in respect of their share of the allocated losses.
Importantly the information memoranda for the Appellants (which was materially similar between each) stated that they were exploiting a “gap” or “loophole” in the respective pieces of legislation (Income Tax (Trading and Other Income) Act 2005 and Corporation Tax Act 2009). The “gap” that they were said to be exploiting was that the employees lived in Jersey. The premise therefore was that the employee, as a non-UK resident, cannot be taxed on the payment; that being the payment to the employee.
The parties accepted that there had been a “restrictive undertaking” given by the employees to which ss225(1)(a) of the Income Tax (Earnings and Pensions) Act 2003 (not a 2005 statute as erroneously appears in the judgment).
The Issue before the Upper Tribunal
The Upper Tribunal observed that the issue in the strike out application was whether the Appellants had made a payment, in whole or in part, “in respect of the giving of the undertaking”. The First-tier Tribunal had concluded that the issue was whether there was a realistic prospect of establishing that at least part of the sums paid pursuant to the Deeds of Restrictive Undertakings were deductible under the legislation.
The Test for Strike- Out Revisited?
The Upper Tribunal commenced by considering the decision of HMRC -v- Fairford Group plc and Anor [2014] UKUT 329 which is the leading authority on strike out pursuant to rule 8(3)(c) of the Rules. The Upper Tribunal noted that whilst the summary of authorities in Fairford was “very useful” it preferred to use the more detailed statement of principle given by Lewison J (as he was) in Easyair Ltd (t/a Openair) -v- Opal Telecom Ltd [2009] EWHC 339 (Ch) and which was approved by the Court of Appeal in AC Ward & Sons -v- Caitlin Five Limited [2009] EWCA Civ 1098.
The Easyair judgment lists 7 factors relevant to consideration on strike out as follows:
- Is there a “realistic” as opposed to fanciful prospect of success;
- A “realistic” prospect is one that carries some degree of conviction (i.e. more than merely arguable);
- The Court must not conduct a mini-trial;
- Analysis can be undertaken about what is said in statements;
- The Court must take account not only of what is in front of it, but what could reasonably be expected to be placed before it;
- A court should be slow to make a final decision without a trial where reasonable grounds exist for believing that a fuller investigation into the facts of the case would add to or alter the evidence available at trial; and
- Equally if it is a short point and there if all necessary evidence before the Court to decide the issue then it should grasp the nettle and decide it.
Statutory Construction?
The Upper Tribunal also reviewed the authorities on the proper construction of taxing statutes. It noted that the correct approach was that stated in WT Ramsay Ltd -v- Inland Revenue Commissioners [1979] 1 WLR 974 and specifically that a “purposive approach” is required. The Upper Tribunal also examined UBS -v- HMRC and DB Group Services UK Ltd -v- HMRC [2016] UKSC 13 where it was noted that the essential nature of taxing statutes is that they operate in the real world.
The Upper Tribunal’s Conclusions
In deciding whether there was a real prospect of success the Upper Tribunal identified two questions:
- Did the FTT err in its construction of s225 ITEPA 2003; and
- Did the FTT wrongly conclude on the evidence available that the Appellant had no reasonable prospect of establishing that the payments are deductible in whole or in part.
On the first issue the Upper Tribunal found that the key propositions for consideration were:
- Was the payment made “in respect of” or “for” the giving of the restrictive undertaking;
- This required the Court to consider the “real reason” for the payment; and
- This question cannot be approached as one purely of construction of the deed. The critical question is: “What is the reality?”, and not simply, “What does the deed say?”
Accordingly, it found that the First-tier Tribunal had been correct to apply the Ramsay principle of statutory construction and consider whether the enormous payments to administrators demonstrated a commercial transaction.
On the second issue the Upper Tribunal found that the First-tier Tribunal had been correct to find that there was no real reason for any part of the payments being in respect of the restrictive undertaking. It noted that there was ample evidence to support this conclusion including the amount of consideration paid for the undertakings was noncommercial and grossly disproportionate, the employees had limited or no prior experience of the Appellants’ activities and in any event were in administrative roles so their ability to influence the commercial success one way or the other was limited. In those circumstances the Upper Tribunal concluded that the First-tier Tribunal had been correct to find that the payments were not in respect of the restrictive undertakings and were, instead, in respect of a tax avoidance arrangement.
General Discussion
The Upper Tribunal, almost as a post script to the judgment pertinently observed:
“72. Lord Reed’s judgment in UBS begins with the following, now well-known, observation:
“In our society, a great deal of intellectual effort is devoted to tax avoidance. The most sophisticated attempts of the Houdini taxpayer to escape from the manacles of tax (to borrow a phrase from the judgment of Templeman LJ in W T Ramsay Ltd v Inland Revenue Comrs [1979] 1 WLR 974, 979) generally take the form described in Barclays Mercantile Business Finance Ltd v Mawson [2004] UKHL 51; [2005] 1 AC 684, para 34:
“…structuring transactions in a form which will have the same or nearly the same economic effect as a taxable transaction but which it is hoped will fall outside the terms of the taxing statute. It is characteristic of these composite transactions that they will include elements which have been inserted without any business or commercial purpose but are intended to have the effect of removing the transaction from the scope of the charge.”
- That paragraph is apt to describe the schemes which are the subject of this appeal, save in one respect. Houdini always allowed himself a reasonable prospect of escape from the handcuffs in which he was bound. These schemes do not have any reasonable prospect of enabling taxpayers who invested in them to escape from the manacles of tax.”
It is uncertain bearing in mind the arguments advanced why it was thought that there was a “reasonable prospect of success” in this case. An express concession was made by the Appellants in the Upper Tribunal [at 41] that the amount of the consideration paid for those undertakings was noncommercial and that payments were “grossly disproportionate to the value of the restrictive undertakings.” If that is right, it is unclear why the Appellants thought they could succeed on the case where it would centre around a consideration of “commercial reality”. True it is that the statute does not give any indication that payments ought only be made for an equivalent value of the undertaking. However, that presupposes that Parliament would have intended to artificially limit or prescribe the worth or value of an undertaking in a vacuum. This would be counter-intuitive and unhelpful because Parliament would not possibly be able to identify every different factual matrix to which the legislation may apply.
We suggest that this is precisely why the commercial reality test is the most appropriate and helpful. It allows flexibility to a business which might properly enter into an arrangement that does have a commercial purpose or proper economic reality.
As the Upper Tribunal observed, Houdini gave himself a chance of escape. Moving forwards, before entering into these types of arrangements a prudent business would be well advised to take specialist advice early to give themselves the same chance.
Leon Kazakos and Joshua Carey are specialist tax barristers who litigate for and against the Revenue in both direct and indirect tax matters. They are available for instructions across the full spectrum of taxes including matters subject to DOTAS considerations.
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