Avoiding the issue: countering the termites in the Australian tax system

Chris Evans, Atax, The University of New South Wales

John Braithwaite Markets in Vice, Markets in Virtue Sydney, Federation Press, 2005 (252 pp). ISBN 1-86287-522-7 (paperback) RRP $49.50.

Reform of the personal income tax is currently attracting a great deal of media attention in Australia. Sadly, much of that attention focuses on just one small headline-grabbing aspect: the cutting of personal tax rates (particularly for those at the higher end of the tax scale). This focus has the potential to distract attention away from on-going and increasingly abusive tax avoidance and evasion that is undermining of the integrity of the tax system.

Tax avoidance and evasion are neither unique to Australia nor purely modern problems. Both have been around, in varying degrees, wherever taxes have been levied. But there is little doubt that the scale of tax avoidance activity, in particular, has grown significantly in Australia and elsewhere. An army of what Tanzi (2000) and Braithwaite (2005) refer to respectively as fiscal and moral ‘termites’ has been eating away at tax revenue bases throughout the world over the last thirty years.

The distinction between tax avoidance and tax evasion is well recognised. It is the difference between working within the law (though against its spirit) and working outside it (Woellner et al. 2005, p. 1615). Taxpayers have the right to arrange their financial affairs to minimise tax (tax planning), but it is not acceptable to do so by avoiding the intent of the law (tax avoidance) or by not following the law itself (tax evasion). The line between avoidance and evasion is reasonably clear; but the point at which (acceptable) tax planning slips over to (unacceptable) tax avoidance is not so obvious. The blurring of this line is reflected in the adoption, by the Australian Taxation Office (ATO), of the term ‘aggressive tax planning’ to refer to the activities it regards as tax avoidance and therefore unacceptable.

Tax avoidance and evasion are neither unique to Australia nor purely modern problems.

Australia experienced its first explosion of aggressive tax planning activity in the 1970s, in the form of ‘bottom of the harbour’ schemes, which involved, for example, simple asset strips aided and abetted by crude tactics such as deliberate bankruptcy to ensure tax rightfully due was never collected. Grabosky and Braithwaite (1986, p. 153) estimated that some 7,000 companies and over 30,000 taxpayers participated in the Australian tax avoidance schemes of the 1970s. Freiberg (1988, p. 137) identified several reasons for this explosion of avoidance (and sometimes blatant evasion) activity, including a staunchly pro-taxpayer High Court, led by Sir Garfield Barwick; a timid revenue authority; the existence of financial inducements (in the form of commissions) paid to the accountants and solicitors of clients induced into the schemes; and an increased willingness of taxpayers to participate in such schemes.

Many of these reasons have also been put forward to explain the re-emergence of aggressive tax planning in Australia in the 1990s. The more recent ‘boom’ of tax avoidance activity began as boutique schemes involving investments in a wide variety of primary production, film, franchise and research and development activities, and developed into a veritable deluge of mass marketed schemes by the middle of the decade. An ATO crackdown in the late 1990s and early 2000s curbed the flood, but only at the cost of tens of thousands of disaffected and often unsophisticated taxpayers who had bought into the schemes under the false premise that their ‘investments’ would provide them with legitimate tax deductions. A Senate Economics References Committee inquiry (2002, p. 4) identified that the amount of deductions disallowed by the ATO rose from a mere $54 million in both 1992–93 and 1993–94 to a phenomenal $1.1 billion in 1997–98 and $1.5 billion in 1998–99. By far the largest part of the knocked back deductions were claims arising under mass marketed schemes.

Many commentators have analysed aggressive tax planning over the years. For example, Nigel Tutt’s two books (1985; 1989) chart the growth of the tax avoidance industry in the United Kingcom in the 1970s and early 1980s, focusing upon the role of Ron Plummer’s Rossminster banking group, which financed many of the outrageous tax avoidance schemes devised by Roy Tucker in that era. More recently Doreen McBarnet and Chris Whelan (1999) and Judith Freedman (2004) have explored the topic in the United Kingdom. Respected academics such as Joel Slemrod (1985) and Joseph Bankman (1999) have analysed the problem in the United States.

The most recent Australian analysis of aggressive tax planning is provided by Professor John Braithwaite of the Australian National University in Markets in Vice: Markets in Virtue. The title, not obviously related to the topic of aggressive tax planning, reflects the author’s central thesis. He argues that in a globalised, deregulated, and competitive marketplace, vices such as paedophilia, pornography, drugs, corruption, problem gambling, and tax avoidance are able to flourish. In other words, the market can drive the production of social ‘bads’ just as it drives the production of social ‘goods’. But Braithwaite argues that it is possible to ‘flip’ markets in the grip of ‘bads’ such as tax avoidance into markets in the virtue of tax system integrity.

The market can drive the production of social ‘bads’ just as it drives the production of social ‘goods’.

Even if the title does not provide the reader with too many clues as to the book’s focus, tax avoidance is undoubtedly its central topic. Braithwaite provides a comprehensive and compelling review of aggressive tax planning in Australia since the 1970s, and produces fascinating insights into its causes, its different forms (including schemes that morph through initial endorsement by the ATO to boutique to mass marketed schemes—the equivalent of the hotel bell-hop receiving information about the latest hot share market tip), how regulatory agencies such as the ATO are countering aggressive tax planning, and possible additional means by which the war against this social vice can be waged.

Braithwaite positions his work squarely within a broader market context, noting that ‘[u]ltimately this is a book about competition policy, globalization and how national regulatory policies can respond to some of the problems that these create’ (p. xv). He shows how waves of aggressive tax planning in Australia (and elsewhere) have initially been supply driven. He contends that a relatively small group of promoters, including some acting out of major financial institutions and, more latterly, the (now) Big Four accounting firms, have been the driving force behind many of the schemes that have been adopted by taxpayers in Australia. This in turn has created a demand for aggressive tax planning opportunities from a much larger group of taxpayers, who feel that they should not miss out on what the ‘big end of town’ is able to enjoy. As Pederick has noted: ‘[c]ynicism grows apace and a race not to be left out of the tax minimisation derby, by hook or by crook, infects the body politic’ (1984, p. 575).

The market approach is one of the key strengths of Braithwaite’s book, permitting wide-ranging analysis of aggressive tax planning as a social phenomenon. All too often the literature in this area is dominated by a tight legal commentary on technicalities. While there is obviously a place for debate about whether a particular scheme crosses the line that takes it from legitimate tax planning to unacceptable tax avoidance (and such debate proliferates within the tax professional community), we sometimes need reminding that there is a world beyond statute, case law and legal interpretation. More importantly, tax professionals have an ethical and moral imperative to constantly re-evaluate their own roles in keeping in check the moral and fiscal termites prevalent in the tax system.

Braithwaite’s market analysis permits him to conclude that ‘reverse contagion’ is possible—that mechanisms and processes can be put in place to reverse the impact of the moral and fiscal termites so that the market can be flipped from vice to virtue. He identifies nine key strategies, including imposing heavy promoter penalties, using the techniques of restorative justice, targeting the clients of ‘A’ list promoters, banning contingency fees, instituting tax shelter disclosure rules, and educating investors to the risks of aggressive tax planning.

The market approach is one of the key strengths of Braithwaite’s book.

In isolation some of the strategies he suggests appear naïve. For example, he places great faith in the principles and practice of restorative justice, which is ‘a value-based approach to responding to wrong-doing and conflict, with a balanced focus on the person harmed, the person causing the harm and the affected community’ (Cavanagh 2005). Braithwaite sees restorative justice as a mechanism for ‘flipping this year’s ethical laggard into next year’s ethical leader, one who pulls the advice industry to a new level of best practice’ (p. 199). Bluntly—and as Braithwaite acknowledges—it is difficult to imagine the ATO and key partners of one of the Big Four firms of accountants sitting down in a cozy circle as one of the partners ‘pours their heart out about how he was just doing what the firm expected’ (p. 190). But, as Braithwaite points out, the mechanisms and processes he suggests should not be taken in isolation. None of the nine strategies on its own has any prospect of flipping markets in vice to markets in virtue. Each, he argues, is a web of influence, and while each might be weak, ‘together they might weave a fabric that effectively restrains vice’ (p. 205).

The proposed Tax Laws Amendment (2005 Measures No. 6) Bill 2005 (Cth) seeks to impose severe penalties on promoters and implementers of what are termed ‘tax exploitation schemes’, and so picks up on one of Braithwaite’s nine strategies. The provisions are designed to introduce a range of measures—civil penalties (of up to the greater of $550,000 or twice the amount gleaned by the promoter from the scheme), statutory injunctions, and voluntary undertakings—aimed at deterring the promotion of schemes that exploit the tax system and the tax laws by avoidance or evasion. The legislative provisions now published result from a recommendation of the final report of the Senate Economics Reference Committee (2002). In December 2003, the government announced that it would introduce measures, including a new civil penalty regime, to deter the promotion of tax exploitation schemes. Somewhat surprisingly Braithwaite’s book does not deal in any detail with the genesis or later history of the scheme promoter legislation, although much of it would have occurred before the publication of the book.

Braithwaite’s work, largely through the ANU’s Centre for Tax System Integrity, has clearly influenced how the ATO has tackled tax avoidance in recent years. As he notes, the ATO’s response to aggressive tax planning has moved beyond the ‘command and control’ framework that typified the 1970s and 1980s to one of ‘responsive regulation’ and ‘meta risk management’ from the 1990s onwards. Braithwaite explains that under the command and control approach ‘[t]axpayers lodged their returns, the ATO assessed them and decided how much tax was due. Audits were conducted to detect the provision of false information on returns, which, when detected, typically resulted in the imposition of modest penalties’ (p. 68). That command and control mentality involved the seesaw of ‘carrot and stick’ approaches (oscillating between a customer service focus and one which relied on punitive legal action, depending on whichever philosophy happened to be in the ascendant at a particular time within the organisation).

Braithwaite’s work has clearly influenced how the ATO has tackled tax avoidance in recent years.

Responsive regulation involves an enforcement pyramid (now encapsulated in the ATO’s Compliance Model) in which the bulk of taxpayers engaged in co-operative compliance sit at the base of the pyramid, while a small hard-core of recalcitrant offenders are at the apex. Little enforcement activity is required for those at the base of the pyramid; essentially they require only positive encouragement to comply. On the other hand the revenue authority possesses a credible capacity to escalate up the pyramid to progressively more severe sanctions in the face of persistently aggressive non-compliance. In Braithwaite’s terms, responsive regulation involves ‘sending clear signals through concrete enforcement actions that the agency is willing to escalate in order to create a culture where systemic preventive solutions and good relationships with taxpayers will do most of the compliance work’ (p. 178). As part of this responsive regulation, meta risk management simply refers to the ‘risk management of risk management’ (p. 85). It entails the ATO monitoring the tax community’s self monitoring and self regulation.

Braithwaite’s book has great strengths. It also has a few weaknesses. For example, it suggests that it is largely a comparative study, with a focus on comparing the tax advice markets in the United States and in Australia. Unfortunately the US research was severely disrupted by the events of September 2001, which significantly impacted upon the breadth and depth of the US content. As a result there is a lack of substance to the principal comparative elements, and the US fieldwork is covered in less than one sixth of the book. Despite this, the author concludes that the US market for aggressive tax planning advice is cyclically ahead of that in Australia, and warns that a new wave of aggressive tax planning activity, with a focus on major corporate tax shelters and driven by the Big Four accounting firms, is likely to hit Australia in the coming years. It remains to be seen whether this prediction will hold true, particularly in the light of KPMG having very recently entered into a very large and punitive settlement with the Internal Revenue Service (IRS) in the United States as a result of KPMG’s aggressive marketing of tax shelters in that country. The IRS has clearly put the Big Four on notice, and their accounting counterparts in Australia may be loathe to expose themselves in a similar fashion.

More importantly, the book desperately needs a broader international comparative element. There is very little in the book about how other comparable tax jurisdictions are attempting to counter the culture of avoidance. Tax avoidance is a global tax problem, and most aggressive tax planning involves cross border activity. Australian companies have not been shy about using offshore tax havens to route income and expenditure flows in a tax-advantageous fashion. The Spotless case heard by the High Court in the mid 1990s (FCT v Spotless Services Ltd & Anor 96 ATC 5201) illustrates the very simple use of the Cook Islands in an attempt to obtain a major tax advantage for the company (subsequently knocked back by the High Court). In the context of globalisation and international tax arbitrage, some greater sense of how other tax regimes are coping with aggressive tax planning would have been very welcome.

Perhaps the book’s greatest potential weakness is its firm conclusion that aggressive tax planning is driven primarily by the supply side of the market. As a result, Braithwaite’s strategies for transforming a market in vice to a market in virtue are skewed towards hitting the supply side—the promoters and the products—rather than tackling taxpayers’ willingness to engage in aggressive tax planning.

The cure does not lie entirely in cutting off the supply of aggressive tax planning opportunities.

I accept that Braithwaite does not ignore the demand side. Some of the strategies he proposes for countering the culture of avoidance seek to promote less engagement by taxpayers in avoidance activity. But the balance he proposes may not be right. Ultimately, if the large bulk of taxpayers perceive that the tax system is inequitable, as many currently do, and that it is far too complex—again a common complaint—there is little doubt that they will engage in activities designed to reduce their tax liabilities. The biggest danger is that if the supply of aggressive tax planning products is killed off, just as with other ‘bads’ such as drugs, taxpayers may look elsewhere for their ‘fix’, shifting from tax avoidance to tax evasion.

The cure does not lie entirely or principally in cutting off the supply of aggressive tax planning opportunities, though that should help. It also lies in ensuring that Australia creates a tax system that is as administratively simple, as efficient, and as equitable as it is possible to be. That tax system must also enjoy community acceptance and confidence, in that it is perceived to be equitable. This is clearly not the case at the moment. Until we broaden the tax base to remove concessions such as negative gearing and reduced rates of capital gains taxation, flatten the income tax rates to iron out the ridiculously high effective marginal tax rates encountered by many taxpayers on low and middle incomes, and provide an administrative model that removes the very high compliance burden imposed on most taxpayers, we will not be in a position to prevent taxpayers from seeking to engage in aggressive tax planning. Tax reform is possible, but there is still a long way to go.

In short, the erection of termite barriers and a liberal dosage of termiticides (as Braithwaite implicitly suggests in his book) may be a sensible response to the fiscal and moral termites currently undermining the integrity of the Australian tax system. But the damage that has already been caused may also require more fundamental reconstruction of the foundations of the system. A challenging prospect indeed.

REFERENCES

Bankman, J. 1999, ‘The new corporate tax shelters market’, Tax Notes, vol. 83, p. 1775.

Cavanagh, T. 2005, Restorative justice, healing the effects of crime [Online], Available: http://www.restorativejustice.com/ [2005, Sep 5].

Freedman, J. 2004, ‘Defining taxpayer responsibility: In support of a general anti-avoidance principle’, British Tax Review, vol. 4, pp. 332–357.

Freiberg, A. 1988, ‘Ripples from the bottom of the harbour: some social ramifications of taxation fraud’, Criminal Law Journal, vol. 12, pp. 136–192.

Grabosky, P. & Braithwaite, J. 1986, Of Manners Gentle: Enforcement Strategies of Australian Business Regulatory Agencies, Oxford University Press, Melbourne.

McBarnet, J. & Whelan, C. 1999, Creative Accounting and the Cross-Eyed Javelin Thrower, John Wiley, Chichester.

Pederick, W. 1984, ‘Fair and square taxation for Australia’, Taxation in Australia, vol. 19, no. 6, pp. 575–581.

Senate Economics References Committee 2002, Inquiry into Mass Marketed Tax Investment Schemes and Investor Protection, Final Report, Commonwealth of Australia, Canberra, February.

Slemrod, J. 1985, ‘An empirical test for tax evasion’, Review of Economics and Statistics, vol. 67, pp. 232–238.

Tanzi, V. 2000, Globalization Technological Developments and the Work of Fiscal Termites, International Monetary Fund WP/00/181, Washington DC.

Tutt, N. 1985, The Tax Raiders: The Rossminster Affair, Financial Training, London.

Tutt, N. 1985, The History of Tax Avoidance, Wisedene, London.

Woellner, R., Barkoczy, S., Murphy, S. & Evans, C. 2005, Australian Taxation Law, (15th Edition), CCH, Sydney.

Chris Evans is Professor of Taxation and Director of Atax, Faculty of Law, The University of New South Wales.