Shelters in a shifting tax storm

Is it possible to feel sorry for the Big Four? If so, this might be the moment. The world's largest accountancy firms are getting thrashing after thrashing from regulators and legislators on both sides of the Atlantic.

Last week, a US judge ordered KPMG to betray clients by reporting their names. Nearly always the issue is the concocting of "unacceptable" tax shelters.

Some of the firms are fighting back, and it is not hard to understand why. They may have broken certain laws at certain points, but in many instances they were giving clients advice that both parties thought was legal at the time. And in Anglo-American tradition planning your life to reduce your tax bill generally has been legal. Such behaviour is called "tax avoidance". What has always been illegal, by contrast, is "tax evasion" - breaking the law to pay less tax.

In Britain, famous cases underscored the distinction. One was Bradford vs Pickles, in which Lord Halsbury urged everyone to stick to the letter of the law: "If it was a lawful act, however ill the motive might be, he had a right to do it." In the US, Judge Learned Hand determined specifically that "anyone may arrange his affairs that his taxes shall be as low as possible. He is not bound to choose the pattern which best pays the Treasury."

All this would seem to mark out an indisputable "bright line". Nonetheless, judges, members of parliament, congressmen or Treasury officials on both sides of the Atlantic have, over the years, fiddled with that line. There have been changes in statute, changes in interpretation and new precedents, but what they have in common is that nearly all have cut back the safe, legal ground and widened the definition of what might be considered illegal. On occasion, for example, authorities have relabelled what used to be "avoidance" as "evasion". Or they have created a new sub-category, "unacceptable avoidance". Yesterday's "tax shelters" become today's "generic abusive tax products" - the latter being the phrase the Internal Revenue Service in the US used to describe KPMG's advice.

The reasons for these shifts are obvious. Tax collectors and politicians both want revenue. Politicians want to stir class rage. Everyone wants a scapegoat, especially after a downturn or a scandal. Rarely, however, do we discuss what it is about a tax culture that gives the authorities licence to make such frequent - and at times retroactive - rule changes. In the US, they get away with it because rates are relatively high, especially the corporate tax rate, and because the tax code is so complicated. Or, to retrace the typical chain of events: Congress pushes up rates; high rates push up the demand for special exemptions and other tax breaks. Tax complexity also creates more grey areas - since few of us understand "Son of Boss" or "Blips", to mention two shelters currently in the news, few of us can say whether they are truly legal or not. What is clear is that the shelters are complicated enough to provide occasion for a good hearing and a chance to fiddle with the line. This is not new. During the first world war, lawmakers in the US pushed the top rate up to 77 per cent. Then they went to work writing the new exceptions.

Andrew Mellon, the steel magnate, did not care that these tax breaks were legal. He disliked them, for he happened to be the closest thing his era had to a flat-taxer. When he became Treasury secretary, he compiled lists of such exceptions, dubbing tax-free municipal bonds "involuntary subsidy" by Uncle Sam. Mellon knew about the shelters because he used them himself. He believed that by honestly pointing out the absurdity of tax breaks he could convince Congress to end them and lower rates.

This proved naive. For after Mellon left government, a new man at the Treasury, Henry Morgenthau, proved not to be interested in such nice distinctions. He wanted to string up plutocrats. Mellon found himself being hoist by his own tax petard. Intentionally conflating avoidance and evasion, Morgenthau went after Mellon's personal returns, including the shelters. John Morton Blum, the historian, reports that Morgenthau told the attorney prosecuting Mellon that "you can't be too tough in this trial to suit me". The secretary also said: "I consider that Mr Mellon is not on trial, but Democracy and the privileged rich, and I want to see who will win." In fact, Mellon did win, but prosecutions such as the one against him were a draught that chilled the nation's entrepreneurs.

Another such cycle came with the cold war, when lawmakers pulled the top rate up to 91 per cent. Again, the tax breaks proliferated. Among the most amusing was one that allowed citizens to save thousands by making their offspring their partners. In the late 1960s came the inevitable hearings, which uncovered the fact that 155 of America's wealthiest citizens, aided by the KPMGs of their day, paid no income tax. Lawmakers next passed the alternative minimum tax, a penalty tax to ensure the rich paid their share. In the end, as with the Mellon action, everyone paid, for today more and more families subject to the AMT are middle-class.

In recent years many American lawmakers have focused, to their credit, on bringing down tax rates. But neither party has thought seriously about the complexity problem. This is a shame, as much for civic reasons as for economic ones. After the Enron and WorldCom scandals, accounting firms have plenty to answer for. But so do the fiddlers.

© Copyright 2004 Financial Times

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