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Tax gap debate: Measuring the cost of avoidance

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The public will not wear the ‘overly aggressive pursuit of lower tax bills’, David Gauke told the Hundred Group of finance directors in a recent speech. But it is ‘equally unhelpful’, he said, to ‘try to exaggerate the scale of the problem’.

The Exchequer Secretary to the Treasury has accused some campaigners of ‘choosing to stoke the fires of public opinion’. Legitimate behaviour is classified as avoidance, he claimed. He pointed out that Richard Murphy, director of Tax Research and a senior adviser to the Tax Justice Network, acknowledges the use of allowances and reliefs within his calculations of the tax gap.

Clearly, Gauke does not believe that Murphy, who has estimated the UK tax gap at £120bn including avoidance of £25bn, can be ignored. Murphy’s estimates are often cited by the TUC and unions including the Public and Commercial Services Union, whose members include HMRC staff.

They have also been widely used by pressure groups and charities. In recent weeks supporters of the protest group UK Uncut have quoted the estimates in several TV news reports and documentaries.

Gauke told MPs debating tax avoidance last summer that avoidance was estimated to contribute around £7bn of a total tax gap estimated at £40bn.

He quoted Murphy’s report ‘The Missing Billions’, produced in 2008 for the TUC. After setting out a series of numbers leading towards the estimate for corporation tax avoidance, Gauke said, that report stated: ‘Much may be due to legitimate tax planning, but by no means all is. Some, undoubtedly, is due to tax avoidance.’

‘Tax avoidance is generally regarded as the use of legal structures and allowances to reduce tax bills in manners not intended by Parliament when enacting the legislation,’ Gauke said.

‘It is simply nonsense to categorise as tax avoidance the use of allowances for purposes intended by Parliament.’

Gauke argued that organisations outside government have access to much less data than HMRC, so the types of methodology available to them are restricted.

‘It is reasonable to assume that HMRC is clearly in a better position to make an assessment, but there is no reason why outside bodies should not contribute to the debate. However, having considered the methodology used to produce the figure of £120bn, even a brief analysis reveals that it is deeply and systematically flawed,’ he said.

Corporation tax avoidance
HMRC’s latest published estimates put the total tax gap at £42bn, including corporation tax avoidance in the region of £4bn. Murphy’s estimate for corporate tax avoidance is £12bn.

Part of what Gauke calls ‘exaggeration’ appears to reflect the fact that some campaigners, including Murphy, regard as avoidance some arrangements that use corporate tax reliefs which they believe to be over-generous, such as relief for interest paid.

But as the analysis below illustrates – and Murphy accepts – his methodology in relation to corporate tax avoidance produces an estimate which inevitably includes an element of ‘legitimate’ tax planning.

On the other hand, HMRC accepted that they may not be identifying all ‘tax risks’, suggesting that the two sides may not be as far apart as the headline figures suggest.

HMRC told Tax Journal that the £42bn estimate for 2008/09 represented around 9% of total tax liabilities. That estimate will be updated in Autumn 2011.

‘This is a significant amount of money and it is one of HMRC’s key objectives to reduce it.  Nevertheless, HMRC already collect over 90% of the tax that is due,’ a spokesman said.

HMRC: ‘Measuring Tax Gaps’
Measuring Tax Gaps 2010’, published last September, reported a corporation tax gap of £6.9bn comprising:

  • £3.1bn for businesses managed by the Large Business Service – £2.9bn  for ‘avoidance’ and £0.2bn for ‘technical issues’;
  • £1.2bn for ‘large and complex’ (L&C – relatively smaller) businesses; and
  • £2.6bn for small and medium-sized businesses.

Where LBS officers identify tax ‘risks’, an initial estimate of the associated tax is recorded as ‘tax under consideration’, the report said. The tax gap estimate is the tax under consideration less the expected compliance yield after intervention. No tax gap is assumed where a risk is settled by agreement.

Risks are categorised as avoidance or technical issues. ‘Avoidance’ relates to ‘the use of disclosed avoidance schemes or other suspected avoidance, while ‘technical’ covers a wide range of issues, including genuine uncertainty about the correct tax treatment, mistakes and culpable errors in the return.

HMRC accept that the main source of error in these estimates is that HMRC may not identify all risks. Estimates are provisional ‘until every risk is closed’.

For L&C businesses, HMRC assume that the tax at risk represents a similar proportion of liabilities to that reported for businesses managed by the LBS. Using information held on avoidance schemes, and the methodology applied in estimating the income tax gap, HMRC estimate that £0.7bn of the £1.2bn total tax gap for L&C businesses is due to corporation tax avoidance.

The £2.6bn estimate for small and medium-sized businesses is taken from the CTSA random enquiry programme and non-payment data. HMRC have not separately calculated an estimate of the corporation tax avoidance element here. If, for the sake of argument, that element was £0.4bn, corporation tax avoidance for all three categories would amount to £4bn.

Richard Murphy: ‘The Missing Billions’
In ‘The Missing Billions’, Murphy estimated the cost of tax avoidance by UK companies at £12bn.

He addressed the ‘expectation gap’, a measure of the difference between the contribution that society might reasonably expect businesses to make by way of tax paid, and what is actually paid. The accounts of the 50 largest FTSE 100 companies covering the seven years from 2000 to 2006 were reviewed.

The ‘conventional profit and loss ratios of tax paid’ were adjusted to eliminate deferred tax charges (there being ‘no certainty as to when, if, or ever that tax might be paid); to add back charges in respect of goodwill (on the basis that they are not allowable for tax purposes); and to eliminate ‘statistically outlying data that distorts the underlying trend’.

Where a company has acquired goodwill since April 2002, corporation tax relief is generally available.

Murphy identified ‘a clear trend’ of effective tax rates falling over the period, and found that ‘declared tax rates in the UK are on average a consistent 5% higher than current tax rates’.

He estimated that the 50 companies had an expectation tax gap of almost £13bn by 2006, based on ‘pre-goodwill’ profits of £173bn and a ‘tax gap percentage’ in 2006 (based on the declared, current tax rate as a percentage of pre-goodwill profit being 22.5% while the headline rate was 30%) of 7.5%.

But the situation was more complicated than this, Murphy accepted. First, he estimated that that about 44% of the profits of the companies surveyed should be subject to UK tax, giving an adjusted expectation tax gap of £5.7bn.

That figure, however, had to be extrapolated for all other UK companies. Small companies were unlikely to have the same opportunities for tax planning as larger ones, but extrapolation across all large companies was possible.

‘In 2006/07, HMRC raised £44.3bn in corporation tax, of which £23.8bn came from those businesses within the Large Business Service,’ the report continued. ‘In 2006 the companies in this survey declared UK current tax liabilities of £11.5bn, or just under half the total tax managed by this unit. If the estimated loss is extrapolated across all of these 700 companies then the total corporation tax expectation gap might be some £11.8bn.’

Murphy added: ‘As a proportion this may be the highest gap of all. Much may be due to legitimate tax planning, but by no means all is. Some, undoubtedly, is due to tax avoidance.’

In October 2010 he warned, in a report titled ‘The Corporate Tax Gap’, that many of the companies whose accounts informed his earlier work had ‘ceased to publish any data on their UK trading, profits or tax liabilities’. A ‘downward trend’ in the effective tax rates of the UK’s largest companies appeared to be continuing, he said.

He also noted that banks appeared to have accumulated since 2008 tax losses having a ‘cash value’ of around £19bn. But overall, he said, there was ‘no basis to change the estimate for tax avoidance offered in "The Missing Billions"’.

What do you think? What do you think the government should do tackle the ‘tax gap’?