Studies in the History of Tax Law - Volume 5 9781474200752, 9781849462242

Citation preview

Preface

T

HESE ARE THE papers from the July 2010 Tax Law History Conference, held once more in the beautiful rooms and grounds of Lucy Cavendish College Cambridge and organised by the Cambridge University Law Faculty’s Centre for Tax Law. The following pages reflect the range and quality of our conference and reflect an ever widening range of topics. Apart from thanking all our speakers for their papers I wish also to record my thanks to all the participants, whether speakers or not, who have contributed to the quality and courtesy of the discussions, which, over the years, have come to mark this event. As ever, sincere thanks go to Christine Houghton and all the staff of Lucy Cavendish College who made us so welcome, which explains why the college enjoys so high a reputation in looking after its conference delegates. We are also grateful to the President and Fellow of the College for allowing us to invade their college during the July research period. Finally, we thank the Chartered Institute of Taxation whose continued support for the Centre is so much appreciated. John Tiley Cambridge October 2011

Book 1.indb v

12/2/2011 8:21:27 AM

Book 1.indb vi

12/2/2011 8:21:27 AM

Acknowledgement The Centre for Tax Law gratefully acknowledges the support of the Chartered Institute of Taxation in connection with the conference for which the papers in this volume were written.

Book 1.indb vii

12/2/2011 8:21:27 AM

Book 1.indb viii

12/2/2011 8:21:27 AM

List of Contributors Dr John Avery Jones CBE Retired Judge of the Upper Tribunal Tax and Chancery Chamber, former Visiting Professor, London School of Economics Cynthia Coleman Adjunct Associate Professor, Faculty of Law, University of Sydney Ann O’Connell Professor, Melbourne Law School, University of Melbourne; Senior Fellow, Taxation Law and Policy Research Institute, Monash University Malcolm Gammie CBE QC, Barrister at One Essex Court, Temple, and Research Director of the Tax Law Review Committee of the Institute for Fiscal Studies Michael Gousmett Founding Trustee, The New Zealand Third Sector Educational Trust, and Independent Researcher Jane Frecknall-Hughes Professor of Accounting, The Open University Business School, Milton Keynes Michael Littlewood Faculty of Law, University of Auckland, New Zealand Margaret McKerchar Professor of Taxation, School of Taxation and Business Law (Atax), Australian School of Business, The University of New South Wales Angharad Miller Senior Lecturer, Bournemouth University Ann Mumford Reader in Law, Queen Mary University of London John Pearce (ex HMRC) now University of Exeter John Snape Associate Professor of Law at the University of Warwick Chantal Stebbings Professor of Law and Legal History at the University of Exeter David Stopforth Professor of Revenue Law, Accounting and Finance, University of Stirling

Book 1.indb xi

12/2/2011 8:21:27 AM

xii List of Contributors C John Taylor Professor and Head of School, School of Taxation and Business Law, Australian School of Business, The University of New South Wales Richard Vann Challis Professor of Law at the University of Sydney Henk Vording Professor, University of Leyden, The Netherlands Onno Ydema Professor, University of Leyden, The Netherlands

Book 1.indb xii

12/2/2011 8:21:28 AM

1 Defining and Taxing Companies 1799 to 1965 JOHN F AVERY JONES CBE*

ABSTRACT

T

HE ORIGIN OF the provisions for taxing companies was Pitt’s 1799 Act which had separate machinery sections for partnerships and bodies of persons. Most bodies of persons were unincorporated bodies, incorporation requiring (for a trading entity) both an Act of Parliament and a Royal Charter, an expensive process. Unincorporated bodies of persons were effectively large partnerships in which the members could change without the consent of all the ‘partners’. They were in the form of a deed of settlement company, based on trust law in order to avoid the effect of what was later known as the Bubble Act which prohibited transferable securities in unincorporated companies. This had nothing to do with preventing a recurrence of the South Sea Bubble as it was in fact passed before the bubble burst and was the government’s attempt to stifle competition for funds for the South Sea Company that had just taken over the national debt. Pitt’s machinery sections remained the basis for their taxation throughout: joint assessment for partnerships, and a return by the chamberlain and assessment of the body for bodies of persons. While Pitt gave a deduction for dividends paid by a body of persons, thus separating the body from the members and treating the body as if it were incorporated, Addington’s 1803 Act taxed the body on its whole profits before dividends, but providing that the member ‘shall allow out of such Dividends a proportionate Deduction in respect of the Duty so charged’ [ie charged on the body, not the dividend]. This treated the body * I am most grateful to Richard Thomas for many helpful comments on the draft of this paper presented at the conference.

Book 1.indb 1

12/2/2011 8:21:28 AM

2

John F Avery Jones CBE

as transparent; there was no charging section for dividends. This deduction was different from the deduction of tax from charges on income: first, in being a deduction of tax charged on the body, not the dividend; and secondly, in not having any equivalent of what became rule 21 of the All Schedules Rules in the 1918 Act for charges not paid out of taxable income (applying from 1805 but then with assessment of the recipient; deduction and payment of tax to the Revenue by the payer started in 1888). This meant that, as with partnerships, if something other than the profit was distributed it was not taxable; it was effectively a payment to the member of what the member already owned. Income tax was reintroduced in 1842 just at the wrong time from the point of view of the development of company law. Two years later, Gladstone’s Joint Stock Companies Act 1844 provided for a simple method of incorporation of companies (meaning partnerships the shares in which were transferable without the consent of all the members, and partnerships with more than 25 members) by registration in the way we know it today. These companies were still unlimited; limited liability was not attained until 1855. They still had attributes of partnerships and trusts, for example that it was the deed of settlement that had to be filed whereas now that the company was incorporated there was no need for a trust. The Joint Stock Companies Act 1856 severed the connection with trusts and changed the documents to be filed from the deed of settlement to the memorandum and articles of association, thus changing to a constitution based on contract that we still have today. Effectively therefore this legislation must have been the end of the unincorporated body of persons for normal commercial bodies. These company law changes were ignored for tax law and with a proportional tax this made little difference. This changed with the introduction of graduated rates of tax and the concept of total income on the introduction of super-tax by the Finance (1909–10) Act 1910. Although bodies of persons, now effectively consisting of registered companies, started life as being transparent for tax there was no statutory provision saying that the timing of the member’s income was when the dividend is paid. This seems to have been an assumption made because companies had been incorporated since the 1850s and were not large partnerships any more; there was no statutory change. The absence of a charging provision for dividends was held not to be a problem as dividends formed part of total income for super-tax on ordinary principles. The 1918 Act changed the permissive deduction of tax from the ‘proportionate Deduction in respect of the Duty so charged’ [on the body] to ‘the tax appropriate thereto’ [to the dividend] in spite of its being a consolidation Act. Elements of transparency still remained: dividends paid otherwise than out of profits were not taxable, and the same applied to income that fell out of assessment, until this was reversed by statute in 1931. But this freedom from tax did not apply if the company distributed more than the current year’s income, nor to the distribution of the part of the rent in excess of the annual value which was held not to be taxable in Fry v Salisbury House. Capital dividends remained

Book 1.indb 2

12/2/2011 8:21:28 AM

Defining and Taxing Companies 1799 to 1965 3 tax-free until the apparent absence of logic for this was criticised by the 1955 Royal Commission; the position was finally changed on the introduction of corporation tax in 1965. Interestingly, the freedom from tax of capital dividends never applied to dividends paid by non-resident companies. Such companies were never transparent (because the Revenue could not find out about the source of their profits) and so the dividends were the source of income, a foreign possession, which was taxable on ordinary principles unless it represented the tree rather than the fruit. Since before 1914 foreign dividends were taxed on the remittance basis for everyone it was normally unnecessary to go behind the remittance. The Royal Commission used this different treatment of dividends from nonresident companies as an argument for changing the law for capital dividends by resident companies.

INTRODUCTION Mair [the Australian negotiator of the double taxation agreement] noted that Willis [the UK negotiator] ‘was experiencing difficulty in deciding what, under UK law, is a company. They use the term ‘body of persons’ in their Act. We eventually decided that it was unnecessary to include therein any reference to a company’.1

The quotation above, taken from a paper given at the previous History of Taxation conference in 2008, records a problem that arose in the course of the negotiation of the UK-Australia double taxation agreement of 1946. The context was a possible dual residence provision that would have differentiated between companies and others, for which a definition of ‘company’ was necessary. It seems extraordinary that in 1946 we were having difficulty in defining a company.2 This article first explores the nature of the problem and how we taxed bodies of persons, and concludes with how we dealt with defining company in other early tax treaties, and how bodies of persons are still referred to in modern tax treaties.

1 CJ Taylor ‘“I suppose I must have more discussion on this dreary subject”: The Negotiation and Drafting of the UK-Australia Double Taxation Treaty of 1946’ in Studies in the History of Tax Law, (Vol 4 ed John Tiley, Hart Publishing, Oxford, 2010) Ch 9, p 213 at 261–2. There is nothing about this point in the UK National Archives file except that the definition of company is crossed out in one of the early drafts. The UK negotiator was Robert Willis who later became Deputy Chairman of the Board of Inland Revenue. 2 This is more likely to have been an excuse for not agreeing to the Australian proposal because we managed to define company in all our other early tax treaties: see text at fn 173 (or perhaps it was an excuse by the Australian negotiator to the Commissioner for not achieving the dual residence provision).

Book 1.indb 3

12/2/2011 8:21:28 AM

4

John F Avery Jones CBE THE PROBLEM

Company Law We shall start with the state of company law in Pitt’s time. His 1799 Income Tax Act had separate provisions for partnerships3 and for ‘Bodies Politick or Corporate, Companies, Fraternities, or Societies of Persons, whether Corporate or not Corporate’,4 which will be referred to as ‘bodies of persons’.5 The normal form of unincorpoprated body of person used for commercial purposes at the time was a deed of settlement company. Gower describes it in this way: The company would be formed under a deed of settlement (approximating to a cross between modern articles of association and a debenture trust deed) under which the subscribers would agree to be associated in an enterprise with a prescribed joint stock6 divided into a specified number of shares; the provisions of the trust deed would be variable with the consent of a specified majority of the proprietors; management would be delegated to a committee of directors; and the property would be vested in a separate body of trustees, some of whom would often be directors also. Often it would be provided that these trustees should sue or be sued on behalf of the company, and although the legal efficacy of such a provision was by no means clear, suit by the trustees in a court of equity seems to have been generally permitted. As for the right to be sued, it will be appreciated that obscurity on this point was by no means an unmixed disadvantage from the point of view of the company.7

Thus a deed of settlement company8 had most of the attributes of an incorporated body but was constituted as a trust.9 Although dividends are not mentioned in 3 1799 (39 Geo.3 c.13) (‘1799’ or ‘Pitt’s Act’) ss 82, 83. The Act was amended and new Schedules substituted in the same year by 39 Geo.3 c.22. 4 1799 ss 87, 88, 89, 96, 98, 99, 100, 106, 110, 111. 5 They were so defined in ITA 1918 s 237; ITA 1952 s 526; TA 1970 s 526(5); TA 1988, s.832(1). 6 The stock in ‘joint stock’ is stock-in-trade. LCB Gower (The Principles of Modern Company Law, 6th ed (the historical section is not included in later editions), ed Paul L Davies, Stevens, 1997 (hereinafter ‘Gower’), at p 20) explains: ‘This process can be traced in the development of the famous East India Company, which received its first charter in 1600, granting it a monopoly of trade with the Indies. Originally any member could carry on that trade privately, although there also existed a joint stock to which members could, if they wished, subscribe varying amounts. At first this joint stock and the profits made from it were redivided among the subscribers after each voyage. From 1614 onwards, however, the joint stock was subscribed for a period of years, and this practice subsisted until 1653 when a permanent joint stock was introduced. It was not until 1692 that private trading was finally forbidden to members. Until this date, therefore, the constitution of the East India Co. represents a compromise between a regulated company, formed primarily for the government of a particular trade, and the more modern type of company, designed to trade for the profit of its members. This new type was called a joint stock company, a name which persists until the present day, although few of those who use it realise that it was adopted to distinguish the companies to which it relates from a once normal, but now obsolete, form’. 7 Gower (see fn 6) at pp 33–4 (the historical section is not included in editions after the 6th). 8 When companies first became incorporated by registration by the Joint Stock Companies Act 1844 (see the heading below The rise of incorporation and the abolition of the unincorporated body) one of the definitions in s 3 was: ‘The Word “Shareholder” to mean any Person entitled to a Share in a Company, and who has executed the Deed of Settlement’. The contents of the deed of

Book 1.indb 4

12/2/2011 8:21:28 AM

Defining and Taxing Companies 1799 to 1965 5 this quotation, they are in tax legislation10 and so we can assume that profits were divided in the sense of declaring dividends, although the profits must have been held in trust for the members before being distributed as dividends.11 In case it is objected that there should not have been any unincorporated companies in Pitt’s time because of the Act that became known as the Bubble Act 1720, it will be argued that this was irrelevant.12 The fact is that they must have existed otherwise there would not have been elaborate rules for taxing them. Apart from the small number of bodies incorporated by Act of Parliament or Royal Charter (often both),13 the rest were essentially large or small partnerships. This distinction between unincorporated bodies of persons14 and partnerships was not one of principle. There would usually be a larger number of members of a body of persons, there would be a separation of management and ownership, and shares would be transferable without the consent of all the members (which would be required in a partnership).15 Both were governed by partnership law, settlement are set out in s 7 and Sch A is headed: ‘List of Purposes for which Provision is required to be made by the Deed of Settlement of a Company before such Company can obtain a Certificate of complete Registration’. These references were replaced by the Memorandum and Articles of Association by the Joint Stock Companies Act 1856, which is in recognisably modern form. 9 A consequence was that if the company owned real property the shares in the company were to that extent real property, see the cases concerning the New River Company. The ‘Bubble Act’ (See the heading The irrelevance of the South Sea Bubble below) which incorporated the Royal Exchange Assurance Corporation and the London Assurance Company specifically provided in s 9 that their shares were personal property. 10 1799 s 88, see text at fn 65; 1803 (43 Geo 3 c 122) (‘1803’ or ‘Addington’s Act’) s 127 see text at fn 71. For an example of a deed of settlement company declaring dividends see The deed of settlement of the Society for Equitable Assurances on Lives and Survivorships with the bye-laws and orders William Morgan, London, 1833. The Equitable started as a company with shareholders and mutualised in the 19th century. 11 The term ‘dividends’ was also used in a different sense in Addington’s 1803 Act in Schedule C: ‘Dividends, or Shares of Annuities payable out of the publick Revenue’. Dowell’s Income Tax Laws (7th edn, 1913) at p 217 explains: ‘On the creation of the “consols” in 1752, of annuities “consolidated into one joint stock of annuities”, the annuities dealt with were made payable in halfyearly dividends on January 5th and July 5th, hence the word “dividends”, meaning these shares of the bank annuities’. This use was probably confusing even at the time. On 6 August 1842 the Solicitor’s Office advised against an argument put forward by Rothschilds that they were in receipt of interest and not dividends or annuities on a foreign loan on the basis that ‘there is no doubt that the term dividends is applicable to interest and is commonly used to designate it’. (The National Archives, Public Record Office (‘TNA’) file IR99/102 p 30). The expression was still causing problems as late as Esso Petroleum Co Ltd v Ministry of Defence [1989] STC 805 in which it was held to be limited to interest on securities and did not include interest on damages payable by the Crown. 12 See the heading The irrelevance of the South Sea Bubble below. 13 From the Bill of Rights 1688 the Crown did not grant a charter to trading companies unless Parliament sanctioned it, thus requiring both a charter and an Act. The Hudson’s Bay Company received its charter in 1670. 14 ‘In law these unincorporated companies were merely partnerships’. Gower (see fn 6) p 31. The provisions in Companies Act 1985, s 665 relating to the winding up of unregistered companies specifically included partnerships in the definition of unregistered company, thus showing that they were treated in the same way, which continued until its repeal by Insolvency Act 1985. 15 As evidence of the common law of partnership at the time, Adam Smith writing in 1776 said: ‘First, in a private copartnery, no partner, without the consent of the company, can transfer his share to another person, or introduce a new member into the company. Each member, however, may, upon

Book 1.indb 5

12/2/2011 8:21:28 AM

6

John F Avery Jones CBE

and there was no limit on the number of partners until 1844.16 Lindley describes the distinction in this way: The fundamental distinction between [unincorporated companies] and partnerships was that a partnership consisted of a few individuals known to each other, and bound together by the ties of friendship and mutual confidence, who, therefore, were not at liberty without the consent of all to retire from the firm and substitute other persons in their places; whilst a company consisted of a large number of individuals not necessarily nor indeed usually acquainted with each other at all, so that it was a matter of comparative indifference whether changes amongst them were effected or not. Nearly all the differences which existed between ordinary partnerships and unincorporated companies will be found traceable to the above distinction. Indeed it may be said that the law of unincorporated companies was composed of little else than the law of partnership modified and adapted to the wants of a large and fluctuating number of members.17

Commenting on the words ‘company, association or partnership’ in the Companies Act 186218 (with predecessors from 184419) preventing the formation of a new company, association or partnership with more than 20 partners, James LJ said: A company or association...is the result of an arrangement by which parties intend to form a partnership which is constantly changing, a partnership to-day consisting of certain members, and to-morrow consisting of some only of those members along with others who have come in, so that there will be a constant shifting of the partnership, a determination of the old and a creation of a new partnership, and with the intention that, so far as the partners can by agreement between themselves bring about such a result, the new partnership shall succeed to the assets and liabilities of the old partnership. This object as regards liabilities could not in point of law be attained by any arrangement between the persons themselves, unless the persons contracting with them authorised the change by a novation, or unless by special provisions in Acts of Parliament sanction was given to such arrangements.20

We therefore had a similar, though informal, distinction to the civil law one between a société de personnes in which the identity of the partners was proper warning, withdraw from the copartnery, and demand payment from them of his share of the common stock’. (Wealth of Nations, Book 5, Ch 1, Part 3, Art 1). 16 Except for banking partnerships, where the limit was 6 (Bank of England Act 1741 s 5) which was increased to 10 by Companies Act 1862 s 4. See also fn 106. 17 Lindley and Banks on Partnership, 18th edn p 22 §2–34. The Income Tax Codification Committee (Cmd 5131) 1936 (hereinafter ‘Codification Committee’) point out at para 98 of their Report that the first edition of Lindley on Companies (1860) was called ‘A Treatise on the Law of Companies considered as a branch of the Law of Partnership’. 18 S 4. 19 See text at fn 106. 20 Smith v Anderson (1880) 15 Ch.D 273, 273–4 deciding that an investment trust (established as a trust) was not within the legislation.

Book 1.indb 6

12/2/2011 8:21:28 AM

Defining and Taxing Companies 1799 to 1965 7 important and a société de capitaux where the identity of the members was not, with the word société comprising both of them.21 The distinction mentioned by Gower that unincorporated bodies could not sue in law was narrowed for a small class of unincorporated bodies by the Grants of Privileges to Companies Act 183422 which permitted grants by the Crown by Letters Patent of privileges that could be granted to a company incorporated by Royal Charter, particularly the right to sue in the name of an officer of an unincorporated company, thus largely removing the disadvantage of unincorporated bodies of persons where such right was granted. The Act provided: That it shall and may be lawful for His Majesty, His Heirs and Successors, by Letters Patent to be from Time to Time for that Purpose issued under the Great Seal of the United Kingdom of Great Britain and Ireland… to grant to any Company or Body of Persons associated together for any trading, charitable, literary, or other Purposes… although not incorporated by such Letters Patent, any Privilege or Privileges which, according to the Rules of the Common Law, or in pursuance of the said recited Act, it would be competent to His Majesty, His Heirs and Successors, to grant to any such Company or Body of Persons in and by any Charter of Incorporation, and especially the before-mentioned Privilege of maintaining and defending Actions, Suits, Prosecutions, and other Proceedings, both at Law and in Equity, in the Name or Names of any One or more of the principal Officers for the Time being of any such Associations respectively….

Judgment against an officer of such a body was treated as being against the members. The Act also provided for the names of the officers of such a body and a list of members to be available at the office of the Clerk of the Patents.23

The Irrelevance of the South Sea Bubble The provisions of Pitt’s Act for taxing bodies of persons, whether or not incorporated, shows that we can dismiss as irrelevant the attack on unincorporated companies in an Act passed in June 1720, which much later became known as the Bubble Act.24 This was not passed to prevent a recurrence of the South Sea Bubble but in advance of it. The Bill was introduced in February 172025 about six months before the collapse of the South Sea Bubble, and passed 21 To some extent in English company is the same as it can denote a partnership (as in ‘Smith & Company’) or a corporate body (as in ‘company law’), although in current usage a company normally means a corporate body. 22 (1834) c. 94 s 1. 23 ibid ss 2, 4. 24 (1719) 6 Geo 1 c 18. 25 Before the adoption of the Gregorian calendar in Britain in 1752 (by 24 Geo.2 c.23 and 25 Geo. 2 c.30), the year began on 25 March, and so the Bill was introduced in what was then called February 1719, but the current notation is used for clarity. The ending of the tax year on 5 April is the result of the government’s financial year ending on 29 September 1752 being extended to 10 October 1752

Book 1.indb 7

12/2/2011 8:21:28 AM

8

John F Avery Jones CBE

in June 1720 some two months before the collapse, which started in early August 1720.26 Far from being legislation against the South Sea Bubble, it was passed in support of the South Sea Company which had just taken over the national debt27 and it was in Parliament’s interest to stifle competition for capital in favour of the Company by preventing rival investment attractions.28 Somewhat incongruously provisions were also added to the Bill in May 1720 to incorporate, and grant a monopoly on marine insurance29 to, the Royal Exchange Assurance Corporation, and the London Assurance Company each of which had agreed to pay £300,000 to pay off George I’s civil list debt.30 The Act had a saving for pre-24 June 1718 (which seems to be an arbitrary date two years’ before the Act) undertakings, and provided:31 And whereas it is notorious, that several Undertakings or Projects of different Kinds have, at some Time or Times since the four and twentieth Day of June one thousand seven hundred and eighteen, been publickly contrived and practised, or attempted to be practised, within the City of London and other Parts of this Kingdom, as also in Ireland , and other his Majesty’s Dominions, which manifestly tend to the common Grievance, Prejudice and Inconvenience of great Numbers of your Majesty’s Subjects in their Trade or Commerce, and other their Affairs; and the Persons who contrive or attempt such dangerous and mischievous Undertakings or Projects, under false Pretences of publick Good, do presume, according to their own Devices and Schemes, to open Books for publick Subscriptions, and draw in many unwary Persons to subscribe therein towards raising great Sums of Money, whereupon the Subscribers or Claimants under them do pay small Proportions thereof, and such Proportions in the whole do amount to very large Sums;… And whereas in many Cases the said Undertakers or Subscribers have, since the said four and twentieth Day of June one thousand seven hundred and eighteen, presumed to act as if they were Corporate Bodies, and have pretended to make their Shares in Stocks transferrable or assignable, without any legal Authority, either by Act of Parliament, or by any Charter from the Crown for so doing;… And whereas it is become absolutely necessary, That all publick Undertakings and Attempts, tending to the common Grievance, Prejudice and Inconvenience of your

by the lost 11 days (the day after 2 September 1752 was 14 September 1752), and all dates for making payments were similarly extended. 5 April, as the end of the tax year, is the adjusted 25 March quarter day, not the adjusted 25 March start of the year, which the same Act moved to 1 January: see Simon’s Taxes A1.152 footnote 4, and correspondence with John Jeffrey-Cook (1985) BTR 56–7. 26 The share price was approximately (there being no reporting system) £128 in January 1720, £750 by early June, £1,050 by 25 June, £950–£1,000 in July, £800 by early August, £300 by the end of September and below £200 by the end of the year. 27 By 6 Geo 1 c 4. 28 See Ron Harris, ‘The Bubble Act: Its Passage and Its Effects on Business Organization’ The Journal of Economic History, Vol 54, No 3 (Sept, 1994), pp 610–627 for this convincing interpretation. 29 S 12. The monopoly was for marine insurance by corporations, bodies politic, societies and partnerships. This did not prevent underwriting of marine insurance by individuals in Lloyd’s Coffee House, or Lloyd’s as we now know it. 30 S 18. 31 S 22.

Book 1.indb 8

12/2/2011 8:21:29 AM

Defining and Taxing Companies 1799 to 1965 9 Majesty’s Subjects in general, or great Numbers of them, in their Trade, Commerce, or other lawful Affairs, be effectually suppressed and restrained for the future, by suitable and adequate Punishments for that Purpose to be ascertained and established: That from and after the four and twentieth Day of June one thousand seven hundred and twenty, all and every the Undertakings and Attempts described, as aforesaid, and all other publick Undertakings and Attempts, tending to the common Grievance, Prejudice and Inconvenience of his Majesty’s Subjects, or great Numbers of them, in their Trade, Commerce or other lawful Affairs, and all publick Subscriptions, Receipts, Payments , Assignments, Transfers, pretended Assignments and Transfers, and all other Matters and Things whatsoever, for furthering, countenancing or proceeding in any such Undertaking or Attempt, and more particularly the acting or presuming to act as a Corporate Body or Bodies, the raising or pretending to raise transferrable Stock or Stocks, the transferring or pretending to transfer or assign any Share or Shares in such Stock or Stocks, without legal Authority, either by Act of Parliament, or by any Charter from the Crown, to warrant such acting as a Body Corporate, or to raise such transferrable Stock or Stocks, or to transfer Shares therein,… shall (as to all or any such Acts, Matters and Things, as shall be acted, done, attempted, endeavoured or proceeded upon, after the said four and twentieth Day of June one thousand seven hundred and twenty) for ever be deemed to be illegal and void, and shall not be practised or in any wise put in execution.32

Not only was the Act not dealing with the mischief of the South Sea Company, which had not then occurred, but that Company was specifically excluded from its provisions: XXVII. Provided always, and be it further enacted by the Authority aforesaid, That nothing in this Act contained shall extend, or be construed to extend to… any Subscriptions made or to be made for enlarging the Capital Stock of the Governor and Company of Merchants of Great Britain trading to the South-Seas and other Parts of America, and for encouraging the Fishery (by or by Order of the General Court, or Court of Directors of the same Company) or to any Receipts made out and given, or to be made out or given, in respect of such Subscriptions, but that all such Subscriptions made and to be made, shall be firm and valid, and all Receipts made out and given, or to be made out or given, concerning the same, shall be assignable at Law by Endorsement made or to be made thereon; any Thing in this or in any other Act, or any Law, Usage or Custom to the contrary notwithstanding.

There was also a saving for traditional partnerships (although, as we have noted,33 there was then no limit in the number of partners): XXV. Provided always, That nothing in this Act shall extend, or be construed to extend to prohibit or restrain the carrying on of any home or foreign Trade in Partnership, in 32 S 18 (here and elsewhere I have split up the sentence into paragraphs for ease of reading). Breach of the Act carried the extreme penalty of praemunire in s 19, which is to be ‘put out of the King’s Protection, and their Lands and Tenements, Goods and Chattels, forfeit to our Lord the King’ (Statute of Praemunire 1392 (16 Ric 2 c 5)). The original purpose of that statute was to prevent any assertion of the supremacy of the Pope over the King. 33 See fn 16.

Book 1.indb 9

12/2/2011 8:21:29 AM

10

John F Avery Jones CBE such Manner as hath been hitherto usually, and may be legally done according to the Laws of this Realm now in Force…; any Thing in this Act to the contrary in any wise notwithstanding.34

According to the wording of the Act therefore, unless the body was incorporated by Act of Parliament or Royal Charter, raising capital by transferable stock was made void, and so the only way of trading was in partnership ‘in such Manner as hath been hitherto usually’, which meant that the partners’ interests were not transferable without the consent of all the partners;35 this would fit with the prohibition of transferable interests in unincorporated companies.36 That distinction would be the one made in Pitt’s Act in the machinery provisions for taxing partnerships and bodies of persons,37 except that on the basis of the Bubble Act the latter should not have existed. One can conclude that certainly by Pitt’s time the Bubble Act was a dead letter and not something that had stifled the progress of company law for a century;38 the deed of settlement company was no doubt invented to circumvent its provisions. The Act was ultimately repealed in 182539 during the interregnum of income tax between 1816 and 1842.

Tax Law Tax law made no distinction between incorporated and unincorporated bodies of persons; the distinction it made was between partnerships and bodies of persons. Contrary to accepted wisdom that Addington’s machinery provisions were always superior to Pitt’s, most of the machinery provisions for assessing partners on the one hand and bodies of persons on the other originated in Pitt’s 1799 Act and were only modified in minor ways in Addington’s 1803 Act and later Acts up to 1806,40 the 1806 Act being copied in this respect in the 1842 Act.41 The main distinction between Pitt’s and Addington’s Acts was over the tax base mainly because of Addington’s deduction of tax at source. (a) Partnerships For partnerships, Pitt’s Act provided that partnership profits may be charged jointly in the partnership name for persons engaged in partnership in any trade 34 ‘excepting only as to the insuring of Ships and Goods or Merchandizes at Sea, or going to Sea, and lending Money upon Bottomry’ for which Royal Exchange Assurance Corporation and the London Assurance Company were granted a monopoly (see fn 29). 35 See fn 15. 36 See fn 17. 37 See the next heading. 38 Although no doubt it caused problems of interpretation. 39 1825 6 Geo 4 c 91. 40 1805 (45 Geo 3 c 49) (‘1805’); 1806 (46 Geo 3 c 65) (‘1806’). 41 Income Tax Act 1842 (‘1842’).

Book 1.indb 10

12/2/2011 8:21:29 AM

Defining and Taxing Companies 1799 to 1965 11 or manufacture or any adventure or concern, and also provided for a return of profits by any one partner: LXXXII. Provided always, and be it further enacted, That any Persons engaged in any Trade or Manufacture, or in any Adventure or Concern, in Partnership together, may be jointly charged to the said Rates and Duties, in respect of their Joint Income arising from such Trade or Manufacture, or such Adventure or Concern, under the Firm or Description of their said Business, and that the Return of any one of the said Partners, on Behalf of himself and the others for that Purpose, shall be sufficient Authority for the said Commissioners to charge such Partners jointly in respect of their Income arising from such Trade or Manufacture, or such Adventure or Concern, but nevertheless wholly distinct from any Charge which may be made upon such Persons, or any of them, in respect: of any other Income belonging to them, or any of them.

Addington built on this while making a number of changes: (a) a joint return and assessment was the method having priority rather than being permissive as in Pitt’s Act, but partners were permitted to return their separate share of profits42 (and conversely partners were not required to return their share when there had been a joint return43); (b) the return was to be made by the partner with precedence, the origin of the familiar ‘precedent acting partner’, which was obviously more enforceable than Pitt’s Act leaving it to any of the partners to make the return; (c) applying also to professions; (d) dealing with the situation that no partner was resident, in which case the assessment (necessarily limited to the British44 profits) was made in the partnership name (presumably because the Revenue would have been unable to investigate the identity of the partners in a partnership with exclusively non-resident partners), thereby implying, contrary to Pitt’s Act, that assessment in the partnership name did not apply in other situations (assessment of UK resident partners by name would have been easier to enforce, and it suggests that partnerships were likely to have a small number of partners, although there was at the time no limit on the number of partners).45 These additions suggest that assessment of partnerships was important in practice and difficulties had arisen with partnerships under Pitt’s Act. Addington’s section was: XCV. And be it further enacted, That the Computation of the Duty to be charged in respect of any Profession, Trade, or Manufacture, or any Adventure or Concern, whether carried on by any Person singly, or by any one or more Persons jointly, shall be made exclusive of the Profits or Gains arising from Lands, Tenements, or

42 The form of return is in Sch G, No 7 for the joint return, and No 8 for partners wishing to be assessed separately. 43 They had to make a declaration in the form in Sch G No 9 giving the name of the firm and the place of business and the fact that the partners had been jointly assessed, but without giving any figures. 44 Income tax was not introduced in Ireland until 1853 when it became a United Kingdom tax. 45 Assessment in the partnership name generally was included in 1918 Sch D Cases I and II rule 10; 1952 s 144. The same applied to national defence contribution (later profits tax) in FA 1937 Sch 5 para 2.

Book 1.indb 11

12/2/2011 8:21:29 AM

12

John F Avery Jones CBE Hereditaments occupied by joint Partners for the Purpose of such Profession, Trade, or Manufacture;46 and the Computation of Duty arising in respect of any Trade or Manufacture carried on by two or more Persons jointly, shall be made and stated jointly, and in one Sum, and separately and distinctly from any other Duty chargeable on the same Persons, or either or any of them; and that the Return of the Partner who shall be first named in the Deed, Instrument, or other Agreement of Co-partnership (or where there shall be no such Deed, Instrument, or Agreement, then of the Partner who shall be named singly, or with Precedence to the other Partner or Partners in the usual Name, Style, or Firm of such Copartnership, or where such precedent Partner shall not be an acting Partner, then of the precedent acting Partner), and who shall be resident in Great Britain , and who is hereby required to make such Return on Behalf of himself and the other Partner or Partners, whose Names and Residences shall also be declared in such Return, shall be sufficient Authority to charge such Partners jointly: Provided always, that where no such Partner shall be resident in Great Britain, then the Statements shall be prepared and delivered by their Agent, Manager, or Factor, resident in Great Britain , jointly for such Partners, and such joint Assessments shall be made in the Partnership Name, Style, Firm, or Description: Provided also, that if the said Partners shall declare the Proportions of their respective Shares in such Profession or Concern, in order to a separate Assessment, it shall be lawful to charge them separately and respectively, at the Rate which such Proportions shall be chargeable with by virtue of this Act; but if no such Declaration be made, then such Assessment shall be made jointly, according to the Amount of the Profits and Gains of such Partnership: Provided also, that any joint Partner in such Profession or Concern, which shall have been already returned by such precedent Partner as aforesaid, may return his Name and Place of Abode, and that he is such Partner, without returning the Amount of Duty payable in respect thereof, unless the Commissioners respectively shall think proper to require further Returns; in which Case it shall be lawful for such Commissioners to require from every such Partner the like Returns, and the like Information and Evidence, as they are hereby entitled to require from the Partner making the Return of Duty.47

Pitt’s Act also provided that changes in the partnership were to be ignored unless the change was a specific cause of a diminution of the profits. This does not seem to indicate that the number of partners was likely to be large even though Pitt did provide for assessment in the partnership name, which Addington permitted only for partnerships with solely non-resident partners: LXXXIII. And be it further enacted, That if amongst any Persons engaged in Trade or Manufacture, in Partnership together, any Change shall take place in any such Partnership, either by Death or Dissolution of Partnership, as to all or any of the Partners, or by admitting any other Partner therein, within the Period when the

46 Partners could claim exemptions or abatements on Sch A income separately: 1803 s 202. ‘Publick Publick companies’ (incorporated companies) returned both land and trading profits together, see 1803 s 94. 47 See also 1805 s 104; 1806 s 112 (Sch D Case I Rules r 3); 1842 Sch D Cases I and II Rules r.3; 1918 Sch D Cases I and II Rules r 10; 1952 s 144.

Book 1.indb 12

12/2/2011 8:21:29 AM

Defining and Taxing Companies 1799 to 1965 13 Computation of Income ought to be made under this Act, or before the Time of making the Assessment under this Act, or if any Person shall have succeeded to any Trade or Manufacture, or any Adventure or Concern, within such respective Periods as aforesaid, it shall be lawful for the said respective Commissioners, and they, and also the Party or Parties interested, and every Officer acting in the Execution of this Act, shall compute and ascertain the Income of such Partnership, or any of such Partners, or any Person succeeding to such Trade or Manufacture, or Adventure or Concern, according to the Income derived during the respective Periods beforementioned, notwithstanding such Change therein or Succession to such Business as aforesaid, unless such Partners or Partner, or such Person succeeding to such Business as aforesaid, shall prove, to the Satisfaction of the said respective Commissioners, that the Income of such Person or Persons hath fallen short, or will fill short, for some specifick Cause to be alledged to them, since such Change or Succession took place, or by reason thereof.

This provision was adopted with minor variations in all the later Acts.48 (b) Bodies of Persons49 In contrast to partnerships, bodies of persons made returns and were assessed as a body, whether or not they were incorporated, although most of them would not have been incorporated because the only means of incorporation was by Act of Parliament or Royal Charter (often both were required50), which would have been an expensive procedure.51 Pitt’s Act imposed tax: upon all Income of every Person residing in Great Britain, and of every Body Politick or Corporate,52 or Company,53 Fraternity,54 or Society55 of Persons (whether Corporate or not Corporate) in Great Britain….56

48 1803 s 96; 1805 s 105; 1806 s 112 (Sch D Case I Rules r.4); 1842 Sch D Cases I and II Rules r 4; 1918 Sch D Cases I and II Rules r 11; 1952 s 145. 49 Much of the material on the meaning of body of persons has been previously published in the writer’s article ‘Bodies of Persons’ (1991) BTR 453. 50 See fn 13. 51 See text at fn 30. 52 Blackstone refers to incorporated bodies as artificial legal persons called bodies politic, bodies corporate or corporations: Vol 1, Ch 18. The 14th edn of 1803 is contemporary with this legislation. 53 ‘The word “company” has no strictly technical meaning. It involves, I think, two ideas namely, first that the association is of persons so numerous as not to be aptly described as a firm [partnership]; and secondly, that the consent of all the other members is not required to the transfer of a member’s interest’. In re Stanley (1906) 1 Ch 134 per Buckley J Blackstone mentions the Company of Surgeons in London in Vol 1, Ch 18. This had been incorporated by 18 Geo.2 c.15 on its separation from the Barber-Surgeons Company, and was reincorporated by Royal Charter as the Royal College of Surgeons of London in 1800, changing its name to the Royal College of Surgeons of England in 1843. 54 ‘A fraternity is some people of a place united together, in respect of a mystery and business, into a company…’ [mystery in this sense means a trade or calling, from the Latin misterium, meaning professional skill] Cuddon v Eastwick (1704) 1 Salk 192 which concerned ‘the company and fellowship of porters’ to whom the Common Council of the City of London had in a by-law given exclusive rights to load ships. It was objected that the City could not make a corporation, which is true as only the Crown can create a corporation, but it was held that the company and fellowship of porters was only

Book 1.indb 13

12/2/2011 8:21:29 AM

14

John F Avery Jones CBE

The assessment on the body was no doubt for convenience as the number of members could be large and was likely to fluctuate so that it would not have been practicable to assess the members jointly by name as partnerships. Pitt’s Act provided that the income was taxable in the hands of the body following a return by the chamberlain57 or other officer: LXXXVII. And be it further enacted, That where any Bodies Politick or Corporate, Companies, Fraternities, or Societies of Persons, whether Corporate or not Corporate, shall be entitled unto any Annual Income to the respective Amounts before specified, (other than and besides any Income applicable to charitable Purposes,) such Annual Income (not applicable to charitable Purposes only) shall be chargeable with such and the like Rates as any other Annual Income of the same Amount will, under and by virtue of this Act, be chargeable with. XC. And be it further enacted, That the Chamberlain, Treasurer, Clerk, or other Officer acting as Treasurer, Auditor, or Receiver, for the Time being, of every such Corporation, Company, Fraternity, or Society, shall, and he is hereby required, within twenty-eight Days after the Publication of such general Notice as herein mentioned, in the Parish or Place wherein the Office of such Chamberlain, Treasurer, Clerk, or other Officer, shall be situate, to make out and deliver to the Inspector or Surveyor a fraternity and not a corporation. The City livery companies were fraternities unless incorporated by Royal Charter, which many were. Chaucer’s Prologue mentions: An Haberdasser and a Carpenter A Webbe, a Deyer, and a Tapiser And they were clothed in o liveree, Of a solempne and greet fraternitee. The OED gives two relevant meanings: ‘...4. A body or order of men, organised for religious or devout purposes....5. A body of men associated by some common interest; a company, guild’. See Parish Fraternity Register of the fraternity of the Holy Trinity in the Parish of St Botolph without Aldersgate, London Record Society, 1982, which reproduces its records from its foundation in 1377 to about 1463. That fraternity was incorporated by letters patent of Henry VI in 1446. 55 A society seems not to have any definite meaning and could include both incorporated and unincorporated societies. Blackstone mentions the Royal Society and the Society of Antiquaries, and a statutory body, the Society of the British Fishery. The OED has the following relevant meanings: ‘... II.7. Partnership or combination in or with respect to business or some commercial transaction. III.1. A number of persons associated together by some common interest or purpose, united by a common vow, holding the same belief or opinion, following the same trade or profession, etc; an association...b. A corporate body of persons having a definite place of residence” (residence here means geographical place and not residence in the tax sense); a reference to the Society of the Middle Temple is cited in relation to this last meaning. Pitt’s Act and subsequent Acts contain an exemption from tax for friendly societies, indicating that they would otherwise have been included: 1799, s 5, referring to friendly societies established under 33 Geo.3 c.54 (friendly societies were unincorporated until the Friendly Societies Act 1992 permitted incorporation, which most of the larger ones did). See also 1803, s 67. Industrial & Provident Societies have been incorporated since 1862. 56 S 2. Addington’s Act, Schedule D Case I, Rule Second provided: ‘The said Duty shall extend to every Person or Persons, Bodies Politick or Corporate, Fraternities, Fellowships, Companies, or Societies, and to every Act, Mystery, Adventure, or Concern, carried on by them respectively in Great Britain or elsewhere as aforesaid’. 57 One of the OED meanings of chamberlain is ‘A steward; an officer who receives the rents and revenues of a corporation or public office’ with a cross-reference to one of the meanings of Chamber ‘The place where the funds of a government, corporation, etc are (or were) kept; chamberlain’s office; treasury 1632’.

Book 1.indb 14

12/2/2011 8:21:29 AM

Defining and Taxing Companies 1799 to 1965 15 duly authorized as aforesaid, a Statement of the Annual Income of such Corporation, Company, Fraternity, or Society, according to the Form specified in the Schedule to this Act annexed, marked (B)….58

Addington’s equivalent provision listed two additional bodies of persons (bodies collegiate59 and fellowships),60 combined Pitt’s two sections, and enlarged the chamberlain’s duties but without changing the essentials of Pitt’s mechanism: LXXXVIII. And be it further enacted, That all Bodies Politick, Corporate, or Collegiate, Companies, Fraternities, Fellowships, or Societies of Persons, whether Corporate or not Corporate, shall be chargeable with such and the like Duties as any Person or Persons will under and by virtue of this Act, be chargeable with; and that the Chamberlain or other Officer acting as Treasurer, Auditor, or Receiver, for the Time being, of every such Corporation, Company, Fraternity, Fellowship, or Society, shall be answerable for doing all such Acts, Matters, and Things, as shall be required to be done by virtue of this Act, in order to the assessing such Corporations, Companies, Fraternities, Fellowships, or Societies, to the Duties granted by this Act, and paying the same.61

Pitt’s Act provided that the chamberlain was entitled to pay the tax out of income coming into his hands and was indemnified by the body: XCI. And be it further enacted, That where any Person, being Trustee, Agent, or Receiver, Guardian, Tutor, Curator, or Committee, of or for any Person or Persons having any Income which shall be chargeable by virtue of this Act, or any Chamberlain, Treasurer, Clerk, or other Officer of any Corporation, Company, Fraternity, or Society, having any such Income as aforesaid, shall be assessed by virtue of this Act, to contribute any Sum or Sums in respect of such Income, then and in every such Case it shall be lawful for every such Person who shall be so assessed, by and out of such Annual Income as shall come to his or her Hands or Hand as such Trustee, Agent, or Receiver, Guardian, Tutor, Committee, or Curator as aforesaid, or as such Chamberlain, Treasurer, Clerk, or other Officer, to retain so much and such Part of such Annual Income as shall from Time to Time be sufficient to pay such Assessment; and every such Trustee, Agent, or Receiver, Guardian, Tutor, Committee, or Curator, Chamberlain, Treasurer, Clerk, or other Officer, shall be, and they are hereby respectively indemnified against all and every Person and Persons, Corporations, Companies, Fraternities, or Societies whatsoever, for all Payments which they shall respectively make out of such Income, in pursuance and by virtue of this Act. 58 The omitted part dealt with returning what proportion of the income was not chargeable and why, presumably referring to the charitable exemption; and for the surveyor transmitting the information to the clerks to the Commissioners. Addington’s and later Acts would not require the reference to exemption since this would require the reclaiming of tax deducted at source. 59 The list in ss 127 and 129 was ‘Corporation, Fellowship, Fraternity, Company, or Society’, thus using the word corporation. 60 The OED includes the following definition: 7 A guild, corporation, company;...an association of any kind 1541. 61 1803 s 88; 1805 s 98; 1806 s 53; 1842 s 44; 1918 s 106; 1952 s 362. The early Acts also contained similar provisions for assessing Schedule C income on bodies, see 1803 s 77; 1805 s 84. They became unnecessary when the 1806 Act provided for deduction of tax at source from Schedule C income (as Addington had always wanted but Pitt had prevented).

Book 1.indb 15

12/2/2011 8:21:29 AM

16

John F Avery Jones CBE

Later Acts all adopted this provision with minor modifications.62 The existence of the indemnity at the end of the quotation suggests that the chamberlain was personally liable for the tax, which is not unlikely for an unincorporated body, and this is accepted as being the law for trustees for whom the same provision applies. The Privy Council has, however, decided that he was not liable under a provision of the Jamaica tax legislation similar to Addington’s s 88.63 There was a similar indemnity in the Jamaican legislation but this is not mentioned in the decision, although it was referred to by the Court of Appeal of Jamaica.64 Where Addington differed fundamentally from Pitt was over the tax base, Addington taxing bodies before payment of dividends (with deduction and retention of tax from the dividend) while Pitt taxed them after deduction of dividends (and also interest). Pitt’s treatment of the members gave the body a greater degree of legal personality for tax. Pitt’s provision was: LXXXVIII. Provided always, and be it further enacted, That no such Bodies Politick or Corporate, Companies, Fraternities, or Societies aforesaid, shall be charged or chargeable, in respect of any Income, which, according to the Rules or Regulations of such Corporations, Companies, Fraternities, or Societies, shall be applicable to charitable Purposes, or to the Payment of any Annual Dividends or Interest to arise and become payable to any individual Members of such Corporations or Publick Companies, or to any other Persons or Publick Bodies, having any Share, Right, or Title of, in, or to any Capital Stock or other Property belonging to such Corporations or Publick Companies, nor in respect of which any Dividends or Interest shall, according to such Rules and Regulations, become payable; provided that such Person or Persons, Corporations, Companies, Fraternities, or Societies, to whom such Dividends or Interest shall be payable, shall be charged and chargeable in respect thereof, according, to the Amounts thereof, and the Rates before specified, as and when the same shall be received by them respectively, other than and except Dividends and Interest the Property of Persons not the Subjects of his Majesty, and not resident in this Kingdom, and that an Account of the Amount of such Dividends and Interest be delivered to such Inspector or Surveyor as shall be authorized for that Purpose under the Hands of three or more of the Commissioners for the Affairs of Taxes, upon Demand thereof, by the same Persons, and in the 62 1803 s 93; 1805 s 103; 1806 s 58; 1842 s 44; 1918 s 106(2); 1952 s 362(3). There was until 2010 a survivor of this principle in TA 1988 s 59(3) for profits of markets or fairs, or tolls, fisheries, or any other annual or casual profits not distrainable under which the owner or occupier or receiver of the profits is answerable for the tax so charged and may retain and deduct the same out of any such profits. The Rewrite proposed to repeal this, see Change 748 to the Taxation (International and Other Provisions) Bill, now enacted in 2010. This provision dates from 1806 s 85 with predecessors relating to land tax in 1763 4 Geo 3 c 2. Presumably the problem was that markets and fairs were of short duration which made taxing their profits difficult. 63 Income Tax Commissioner v Chatani [1983] STC 477. The indemnity provision is found in the Jamaican Income Tax Act s 56 64 (1980) 31 WIR 337. The PC said at p 479d that they did not find it necessary to refer to certain other provisions of the Act on which the Court of Appeal relied, but said that if support were needed for its conclusion it was obtained from another section that made the directors liable for tax deducted and not paid over.

Book 1.indb 16

12/2/2011 8:21:30 AM

Defining and Taxing Companies 1799 to 1965 17 same Manner, as the Statements of the Income of such Corporations, Companies, Fraternities, and Societies, are required to be delivered.65

Pitt therefore unambiguously treated all bodies of persons like incorporated ones with a complete separation of the body and the member, and only the body being taxed on undistributed income. It is not clear under what heading the member was assessed on dividends but the more likely heading seems to be trading income, which included other types of income of an uncertain annual amount,66 in which case the member’s income was of the same type as the body’s. In accordance with his principle of taxation at the source Addington taxed bodies on their profits before dividends with a proportionate deduction of the tax, which it will be suggested below was the tax charged on the body rather than the dividend. Both Pitt’s and Addington’s systems taxed the profits of the body and gave relief for dividends,67 but Addington’s taxation at the source was much more efficient as it avoided the need to assess the member as well as the body. The other differences were that Pitt also deducted annual interest but Addington dealt with this as a charge on income; and there was now no deduction for payments for charitable purposes.68 Addington’s Act also expressly stated that salaries of officers were in effect deductible, which may have designed to deal with payments to officers who were also members. Addington’s Act provided:

65 This section seems to imply that dividends would be distributed in the year the profits were made; see text around fn 86 in relation to the same assumption in Addington’s Act. 66 The possible headings were ‘income from any Trade, Profession, Office, Pension, Allowance, Stipend, Employment, or Vocation, being of uncertain Annual Amount’ (Case 15), or ‘income not falling under any of the foregoing Rules’ (Part IV). Case 16: ‘income from Offices, Pensions, Stipends, Annuities, Interest of Money, Rent Charge, or other Payments of the like Nature, being of certain Annual Amount’ does not seem to be applicable. The words ‘being of uncertain [Case 15] or certain [Case 16] annual amount’ were not in the original Act but were added in the schedule substituted by 39 Geo.3 c.22. 67 If the profits were 100 and the dividend 50 and if the tax rates under both had been 10%, Pitt would tax 50 on each of the body and the member, leaving each with 45 after tax; Addington taxed 100 on the body but allowed the body to retain the 5 tax deducted from the dividend, so that the body retained 100-10-50+5=45 (the same as in Pitt’s system) and the member received income of 45 net from which 5 had been deducted in tax. 68 Addington’s Act exempted wholly charitable bodies from tax under Sch A (IV Exemptions) applying to: (1) ‘The Scite of any College or Hall in any of the Universities of Great Britain, and all Offices, Gardens, Walks, and Grounds for Recreation, repaired and maintained by the Funds of such College or Hall’, (2) ‘The Scite of every Hospital or publick School, or Alms House, and all Offices, Gardens, Walks, and Grounds for Recreation of the Hospitallers, Scholars, and Almsmen, repaired and maintained by the Funds of such Hospital, School, or Alms House’ and (3) rents of ‘any Hospital or Alms House, on Proof before the respective Commissioners of the due Application of the said Rents and Profits to charitable Purposes only, and in so far as the same shall be applied to charitable Purposes only’ (item (3) was extended in 1805 to public schools and all land vested in trustees for charitable purposes); and from tax under Sch C (s 68) applying to: ‘Corporations, Companies, Fraternities, or Societies, or of any Trustee or Trustees, established by Act of Parliament, Charter, Decree, Deed of Trust, or Will’ (the Sch C exemption was extended to yearly interest and annual payments under Schedule D by 1842 s 105). For the history of the charitable exemptions see the writer’s ‘The Special Commissioners from Trafalgar to Waterloo’ in Studies in the History of Tax Law (vol 2, ed Tiley, Hart Publishing, 2007) (also published in [2005] BTR 40), and Michael Gousmett, ‘A Short History of the Charitable Purposes Exemption from Income Tax of 1799’ in ch 5 of this book.

Book 1.indb 17

12/2/2011 8:21:30 AM

18

John F Avery Jones CBE CXXVII. And be it further enacted, That every such Officer before described of any Corporation, Fraternity, Fellowship, Company, or Society, not otherwise to be charged as aforesaid,69 shall also within the like Period prepare and deliver in like Manner, a Statement of the Duty payable by such Corporation, Fraternity, Fellowship, Company, or Society, computed according to the Directions of this Act, together with such Declaration of the Manner of estimating the same as aforesaid; and such Estimate shall be made on the Amount of the annual Profits and Gains of such Corporation, Fraternity, Fellowship, Company, or Society, before any Dividend70 shall have been made thereof to any other Person or Persons, or publick Bodies having any Share, Right, or Title, in or to such Profits or Gains; and all such other Person or Persons, and publick Bodies, shall allow out of such Dividends a proportionate Deduction in respect of the Duty so charged; provided that nothing hereinbefore contained shall be construed to require in such Statement the Inclusion of Salaries, Wages, or Profits of any Officer of such Corporation, Fraternity, Fellowship, Company, or Society, otherwise chargeable under this Act.

Whether Addington treated all bodies of persons as incorporated or unincorporated for tax purposes is less clear than Pitt’s treatment of them as if incorporated. But it is interesting that from 1805 the profits of the three major incorporated bodies, the Bank of England, the East India Company and the South Sea Company were computed after dividends, as Pitt had done.71 There are more pointers to his treatment of all other bodies being transparent, ie as if the bodies were unincorporated, but the deduction of salaries to officers who are members points in the opposite direction, although such salaries would also have chargeable under Schedule D. As Malcolm Gammie has explained, the two possibilities are that the body is transparent or that distributions are a charge on income out of a mixed fund of income, which is a separate source.72 The most important pointer towards transparency is that dividends do not fall within any 69 This refers to assessment by referees by s 110 and following without naming the figure. The procedure was dropped in 1806 s 68 and these words were deleted. 70 See fn 11 for the then meaning of dividend. 71 1805 s 117: the statement of the duty payable in the section quoted above changed to the ‘amount of the balance of the annual profits or gains’; and an addition made: ‘Provided also, that the Statements of the several Companies of the Bank, East India and South Sea, shall be made exclusive of the Dividends and the Profits attached thereto, and to be divided amongst the Proprietors of the respective Stocks belonging to such Companies’, the profit thus being after dividends for these incorporated companies; 1806 s 68 (the words ‘balance of’ in the above substituted in 1805 were deleted; and a further addition made: ‘but the Statement of the East India Company shall include the Interest payable on any Bonds granted by the said Company, which shall become due after the Thirtieth Day of September One thousand eight hundred and six’); 1842 s 54; 1918 All Sched Rules r 20, see text at fn 128 for the differences in wording. 72 See ‘The Origins of Fiscal Transparency in UK Income Tax’ in Studies in the History of Tax Law, vol 4 Ch 2 p 33. Partnership interests and the interest of a beneficiary of a life interest trust are not recognised as a source of income in their own right but are transparent, unlike charges on income which are paid out of unidentified income and are treated as a separate source. I shall argue that bodies of persons started as transparent in Addington’s Act but later acquired some elements of opacity after the rise of incorporated companies and the abolition of unincorporated bodies that had existed in Addington’s time.

Book 1.indb 18

12/2/2011 8:21:30 AM

Defining and Taxing Companies 1799 to 1965 19 of Addington’s Schedules which it surely would have done if they were a separate source of income. As Lord Wright explained much later: ‘There is, in fact, only one profit, no new profit being created from the fact that the shareholder gets his share; the tax is a tax on the profits and not on the dividend’.73 The closest analogy seems to be that of an interest in possession trust which is transparent for tax purposes74 so that the beneficiary can apply assessment rules applicable to the type of underlying income. This is not surprising when unincorporated companies were formed as trusts by a deed of settlement. But if the income is received by the trustees rather than being paid directly to the beneficiary75 the trustees can be taxed on account of their receiving the income. It is still the beneficiary’s income but as a collection mechanism the trustees pay the tax. The difference is that the body of persons is always assessed as a body.76 With a partnership there is less separation of the person assessed and the person entitled. The treatment of dividends is different from that of charges on income,77 and the difference must have been intentional. As we have seen, for dividends the recipient had to allow a proportionate deduction of tax and dividends did not fall within any of the Schedules. Addington taxed annuities, yearly interest and annual payments78 under Schedule D, the case being unspecified until 1806 when it was specified as Case III.79 The first category of charges on income is those paid out of income brought into charge to tax: the payer was authorised to deduct tax from them and retain it. The second category is those charged on foreign property and therefore received without any deduction of tax, that is, 73

Neumann v IRC (1934) 18 TC 332 at 368. Archer-Shee v Baker (1927) 11 TC 749. The transparency of the trust meant that the income was from ‘securities, stocks, shares or rents’ which had ceased to be taxed on the remittance basis in 1914. It is at first sight strange that transparency applied to a trust with non-resident trustees (and foreign governing law, although in this case New York law was treated as being the same as English law; the result was different when New York law was taken into account in Garland v Archer-Shee (1930) 15 TC 693), but not to a non-resident company seemingly on the basis that the Revenue could not find out about the underlying income, see the heading Non-resident bodies below. The reason for the difference is that with a life interest trust the beneficiary has an entitlement to the whole income (subject to the trustees’ expenses), but with an incorporated company all that the shareholder is entitled to is the dividend when declared. 75 1799 s 43; 1803 s 92; 1805 s 102; 1806 s 57; 1842 s 42; 1918 s 103(3)(a); 1952 s 367. From 1803 these provide that a trustee who has authorised the receipt of the income by the beneficiary need only provide the Revenue with the name address of the beneficiary. The 1799 Act provided that the beneficiary and not the trustee is deemed to be in actual receipt of the income. 76 It is most unlikely that a body of persons would direct income to be paid to the members. 77 An expression that survived until the Corporation Tax Act 2010; they are now called ‘qualifying charitable donations’, being the only remaining heading. 78 The logic seems to be that these are personal obligations to be paid out of the generality of the payer’s income and so the source of that income was irrelevant. 79 Case III applied to ‘The Duty to be charged in respect of Profits an uncertain annual Value not charged in Schedule (A.)’. This charge was actually incorporated into Case III by ITA 1853 s 2 rather than charging it by reference. Strictly therefore before this the section may have been a separate charging provision (as Lord Macnaghten regarded it in Attorney-General v London County Council (1900) 4 TC 265, 207–8), but the distinction does not appear to make any difference. 74

Book 1.indb 19

12/2/2011 8:21:30 AM

20

John F Avery Jones CBE

that the payment was made before the income was remitted: the income was taxable on the recipient under Schedule D (Case III from 1806).80 This second category was extended in 1805 (by Pitt) to charges on income not paid out of taxed profits or gains (and also to short interest).81 The section is set out below in its 1806 (Lord Henry Petty) form with the additions made in 1805 in italic text and those in 1806 in italic bold text (but ignoring any changes in the rate of tax or differences in capitalisation): CXIV. And be it further enacted, That upon all Annuities yearly Interest of Money or other annual Payments, whether such Payments shall be payable, within or out of Great Britain, either as a Charge on any Property of the Person or Persons paying the same by virtue of any Deed or Will or otherwise or as a Reservation thereout, or as a Personal Debt or Obligation by virtue of any Contract, or whether the same shall be received and payable Half Yearly, or at any shorter or more distant Periods there shall be charged for every Twenty Shillings of the Annual Amount thereof the Sum of Two Shillings without Deduction according to and under and subject to the Provisions by which the Duty in the Third Case of Schedule (D.) may be charged; [1] provided that in every Case where the same shall be payable out of Profits or Gains brought into Charge by virtue of this Act, no Assessment shall be made upon the Person entitled to such Annuity Interest or other Annual Payment, but the Whole of such Profits or Gains shall be charged with Duty on the Person liable to such Annual Payment without distinguishing such Annual Payment, and the Person so liable to make such Annual Payment, whether out of the Profits or Gains charged with Duty, or out of any Annual Payment liable to Deduction, or from which a Deduction hath been made, shall be authorized to deduct out of such Annual Payment at the Rate of Two Shillings for every Twenty Shillings of the Amount thereof,…, and the Person or Persons to whom such Payments are to be made as are liable to Deduction… shall allow such Deduction, at the full Rate of Duty hereby directed to be charged, upon the Receipt of the Residue of such Money, and under the Penalty herein-after contained, and the Person charged to the said Duties, having made such Deduction, shall be acquitted and discharged of so much Money as such Deduction shall amount unto as if the Amount thereof had actually been paid unto the Person or Persons to whom, such Payment shall have been due and payable;… [2] but in every Case where any annual Payment as aforesaid shall, by reason of the same being charged on any Property or Security in Ireland, or in the British Plantations, or in any other of His Majesty’s Dominions, or on any Foreign Property or Foreign Security, or otherwise, be received or receivable without any such Deduction

80 The requirement on the payer to deduct and pay over the tax, instead of the recipient being assessed, was not introduced until C&IR Act 1888 s 24(3). In its amended form it became Rule 21 of the All Schedules Rules in the 1918 Act. 81 Meaning not taxed in the same year, see The Luipaard’s Vlei Estate and Gold Mining Co Ltd v IRC (1930) 15 TC 573 (Rowlatt J had suggested in Attorney-General v Metropolitan Water Board (1927) 13 TC 294, 301 that profits could be carried forward for this purpose, which he accepted was wrong in Luipaard’s Vlei). The fact that the courts later decided that for dividends the profits can have been charged to tax in any year, and so the rate at which they have been charged may be different from the current rate, will be suggested to be the result of the Revenue and the courts, and to some extent Parliament, later adapting the rules to fit incorporated bodies.

Book 1.indb 20

12/2/2011 8:21:30 AM

Defining and Taxing Companies 1799 to 1965 21 as aforesaid, and in every Case where any such Payment shall be made from Profits or Gains not charged by this Act, or where any Interest of Money shall not be reserved or charged or payable for the Period of One Year, then and in every such Case there shall be charged upon such Interest Annuity or other annual Payment as aforesaid, the Duty before mentioned, according to and under and subject to the several and respective Provisions by which the Duty in the Third Case of Schedule (D.) may be charged:…82

Although for the purposes of the charitable exemption,83 dividends were later treated as annual payments, they cannot have fallen within the charges on income section as annual payments because of the section dealing with the deduction of tax from dividends.84 There are some similarities between charges in category [1] (permissive deduction of tax for charges paid out of income brought into charge to tax) and dividends, when both are paid out of taxed income, but there are significant differences. The first difference is that for charges the rate of permissive deduction was the current rate of tax on the payment, and for dividends it was, on a literal reading, a proportionate deduction in respect of the tax ‘so charged’, that is charged on the body (not on the dividend),85 which points towards transparency. To repeat the relevant part of Addington’s section: such Estimate shall be made on the Amount of the annual Profits and Gains of such Corporation, Fraternity, Fellowship, Company, or Society, before any Dividend shall have been made thereof to any other Person or Persons, or publick Bodies having any Share, Right, or Title, in or to such Profits or Gains; and all such other Person or Persons, and publick Bodies, shall allow out of such Dividends a proportionate Deduction in respect of the Duty so charged;

Presumably the deduction is of a proportion corresponding to the proportion of the current year’s profit distributed as dividend. There was no need for a charging section for dividends because the body was transparent, as is implied by the reference to ‘share…in or to such profits or gains’. What was taxed was the underlying income of the body itself. That accounting86 was primitive at the 82 1803 s 208; 1805 s 192; 1806 s 114; 1842 s 102; 1918 All Schedules Rules, r 19, 21; 1952 ss 169, 170. I have added the numbering [1] and [2] for ease of reference to these parts. 83 ‘That any Corporation, Fraternity, or Society of Persons, and any Trustee for charitable Purposes only, shall be entitled to the same Exemption in respect of any yearly Interest or other annual Payment chargeable under Schedule (D.) of this Act, in so far as the same shall be applied to charitable Purposes only, as is herein-before granted to such Corporation, Fraternity, Society, and Trustee respectively in respect of any Stock or Dividends chargeable under Schedule (C.) of this Act, and applied to the like Purposes’: 1842 s 105 (this provision is not found in earlier Acts); 1918 s 37(1)(b); 1952 s 447(1)(b). If dividends were not annual payments there would have been no right for a charity to recover the tax deducted from them, see the Codification Committee (see fn 17) at para 101. 84 See text around fn 70. 85 The Codification Committee (see fn 17) at para 99 say that the words ‘may mean (especially the words in the Act of 1842) that the company may only deduct a proportionate amount of the tax borne by the company in the year in which he dividend is declared or paid…’. Deduction of tax on the body’s profit from the dividend was not such a burden when the tax rate was 5%. This interpretation was the taxpayer’s contention that was rejected (although on the basis of the different wording of the 1918 Act) in F H Hamilton v IRC (1931) 16 TC 213, which is considered below. 86 Pacioli wrote about double entry bookkeeping in 1494. The use of double entry bookkeeping in place of the charge and discharge bookkeeping in use for landed estates, seems to have been

Book 1.indb 21

12/2/2011 8:21:30 AM

22

John F Avery Jones CBE

time is shown by the items that it was necessary to state were not deductible, such as capital withdrawn, sums employed as capital, debts other than bad debts, and personal expenses.87 In any case there was no obligation even to keep accounts or to provide them to the Revenue unless there was an appeal and the General Commissioners issued a precept for a Schedule (in effect a profit and loss account).88 On the other hand, there were rules allowing returns for the date to which accounts are made up.89 developing in England about this time, having been in use for some centuries in mainland Europe and it was already in use in Scotland. See J R Edwards A History of Financial Accounting (Routledge, 1989; Accounting History from the Renaissance to the Present, a Remembrance of Luca Pacioli, ed T Lee, A C Bishop, and R H Parker, New York, Garland Pub, 1996); B S Yamey and R H Parker Accounting History: some British Contributions (Oxford, Clarendon, 1994); J R Edwards, G Dean, F Clarke Merchants’ accounts, performance assessment and decision making in mercantilist Britain (Accounting, Organisations and Society 34 (2009)) 551; and J R Edwards A business education for ‘the middling sort of people’ in mercantilist Britain, The British Accounting Review 41 (2009) 240 (I am grateful to Professor Jane Frecknall Hughes for bring these last two to my attention). I do not claim to have researched this aspect in any detail. My impression is that little is known about the accounting system used by small businesses in England at the time. 87 The 1806 Act prevented the deduction of the following items: (a) ‘Sums expended for Repairs of Premises occupied for the Purpose of such Trade Manufacture Adventure or Concern nor for any Sum expended by them for the Supply or Repairs or Alterations of any Implements or Utensils or Articles employed for the Purpose of such Trade Manufacture Adventure or Concern, beyond the Sum usually expended for such Purposes according to an Average of Three Years preceding the Year in which such Assessment shall be made; (b) sums ‘on Account of Loss not connected with or arising out of such Trade Manufacture Adventure or Concern’; (c) ‘any Capital withdrawn therefrom’; (d) ‘Sums employed or intended to be employed as Capital in such Trade Manufacture Adventure or Concern’; (e) ‘any Capital employed in Improvement of Premises occupied for the Purposes of such Trade Manufacture Adventure or Concern’; (f) ‘on Account or under Pretence of any Interest which might have been made on such Sums if laid out at Interest’; (g) ‘for any Debts, except such Debts, or such Parts thereof as shall be proved to the Satisfaction of the Commissioners respectively, to be irrecoverable and desperate’; (h) ‘for any Average Loss beyond the actual Amount of Loss after Adjustment’; (i) ‘for any Sum recoverable under an Insurance or Contract of Indemnity’ (Sch D Case I rules r.3); (j) ‘any Disbursements or Expences whatever, not being Money wholly and exclusively laid out or expended for the Purposes of such Trade Manufacture Adventure or Concern, or of such Profession Employment or Vocation’; (k) ‘any Disbursements or Expences of Maintenance of the Parties, their Families or Establishments’; (l) ‘for Rent or Value of any Dwelling-house or domestic Offices, or any Part of such Dwelling-house or domestic Offices, except such Part thereof as may be used for the Purposes of such Trade or Concern, not exceeding the Proportion of the said Rent or Value herein-after mentioned’; (m) ‘for any Sum expended in any other domestic or private Purposes, distinct from the Purposes of such Trade Manufacture Adventure or Concern, or of such Profession Employment or Vocation’ (Sch D Cases I and II rules r.1); (n) ‘any Deduction from the Profits or Gains arising from any Property herein described, or from any Office or Employment of Profit on account of Diminution of Capital employed, or of Loss sustained in any Trade Manufacture Adventure or Concern, or in any Profession Employment or Vocation’. (s 198). Items (c) to (e) in particular suggest that Adam Smith’s distinction between fixed and circulating capital (Wealth of Nations (1776) Book 2 Ch 1) had not been generally adopted in practice at the time. Items (k) to (m) were related to cases where the trade or profession was conducted from home. The 1799 Act 15th Case had a special deduction rule amounting to two-thirds of the rent for shops, innkeepers, and schoolmasters who took in 10 or more boarding pupils. 88 See the writer’s ‘The Special Commissioners after 1842: from Administrative to Judicial Tribunal’ (2005) BTR 80 at 88. The 1955 Royal Commission Cmd.9474 (hereinafter ‘1955 Royal Commission’) (para 1052) recommended a statutory requirement to keep accounts, which the Revenue opposed not having the resources to check them. By the time of the Keith Committee

Book 1.indb 22

12/2/2011 8:21:30 AM

Defining and Taxing Companies 1799 to 1965 23 The second and most important distinction between the treatment of charges and dividends is that there was no equivalent for dividends of category [2] of charges (taxation of the recipient; later, deduction of tax by the payer and payment over of the tax to the Revenue,90 when the payment is not made out of profits or gains brought into charge to tax). In the 1803 form of the charges on income section this may have been assumed to be unnecessary since foreign income would necessarily have been remitted91 before a dividend could be paid out of it. But this cannot explain why there was no equivalent for dividends of the 1805 version dealing with charges not made out of profits or gains brought into charge to tax. That possibility clearly existed for the distribution of capital gains on assets used in the trade, or the capital itself, which suggests that the difference must have been deliberate.92 If an annuity is paid out of capital it still has the character of income and should be taxed.93 One might say the same of a dividend, but the interest of a member of a body (like that of a partner) is not exclusively an entitlement to income similar to an annuity. If the body is treated as transparent and the proportionate deduction is that of the tax on the body there would obviously be no tax on the distribution of anything other than taxable profits.94 That is exactly what one would expect from treatment of the body as if they were unincorporated (as most of them were).95 If bodies had been taxed as if they were incorporated one would not expect this treatment of dividends paid out of profits that were not taxable, as is demonstrated by the treatment of dividends from non-resident companies where the courts, after the time when incorporation was usual, regarded as income anything distributed by the non-resident company, whether out of income or capital gains, so long as the share still remained intact.96 (1983, Cmnd.8822) the Revenue were in favour and the committee recommended it at para 3.2.17. It was eventually enacted by FA 1990 s 90. The writer has a recollection of the elderly AM Latter QC (1875–1961), who appeared in most revenue cases from 1912 to 1939, telling him that on principle he never provided accounts of his practice to the Revenue. 89

1803 Sch D Case I r. 1, 3, Case II r.1, Case III rule. See fn 80. 91 In Addington’s Act all foreign income was taxed on the remittance basis; Pitt had taxed what became Addington’s Case IV (the two categories of foreign income are Pitt’s) on an arising basis. 92 It is possible when the charges on income provision was amended to deal with this in 1805 a consequential change to the treatment of dividends was overlooked, but this seems unlikely to be the case. 93 As in Trustees of the Will of Brodie v IRC (1933) 17 TC 432, Lindus & Hortin (1933) 17 TC 442, and Cunard’s Trustees v IRC (1945) 27 TC 122. 94 As Viscount Simonds and Lord Reid pointed out in Cenlon Finance Co Ltd v Ellwood (1962) 40 TC 176, 202, 205–6 this exemption for dividends paid out of non-taxable income is nowhere stated. 95 There is no need for the tax treatment to follow this legal distinction; for example, today we have LLPs that are incorporated but normally taxed as partnerships, and unit trusts, which are not incorporated but are taxed as if they were. The transparency of a life interest trust for tax purposes is different from the position in trust law: see Donovan Waters ‘The Nature of the Trust Beneficiary’s Interest’ (1967) 45 Can Bar Rev 219. The reason for the difference is explained by Malcolm Gammie in the paper referred to in fn 72. 96 See the heading Non-resident bodies below. 90

Book 1.indb 23

12/2/2011 8:21:31 AM

24

John F Avery Jones CBE

The only difficulty over complete transparency is the reference to dividends in Addington’s provision,97 although, as we have seen, dividend was not a term of art. The reason may be no more than the change from Pitt’s system of taxing bodies on the post-dividend income required it to be put beyond doubt that it was now the pre-dividend income. Apart from that, the payment of a dividend was as irrelevant for tax as when partnership drawings were made. The permissive deduction of tax from the dividend may merely have been to prevent the member claiming that he was entitled, as he was under Pitt’s system, to a proportion of the profit before tax. If, on the other hand, the reference to dividends was a timing provision, that the income of the body is not that of the member until distributed as a dividend, this was inconsistent with full transparency.98 But that does not seem likely. If that were the intention, there would surely have been provisions about what tax to deduct from dividends paid in years later than that in which the profit was earned,99 and dividends would have be treated as charges on income as a separate source of income taxable under Schedule D. The conclusion is that transparency was assumed to apply to bodies of persons, just as it did for partnerships and trusts. Much later, Lord Phillimore in Bradbury v English Sewing Cotton100 correctly described the system applying to an incorporated body in this way: …the Act of 1842 has apparently proceeded on the idea that for revenue purposes a joint stock company should be treated as a large partnership, so that the payment of Income Tax by a company would discharge the quasi-partners. The reason for their discharge may be the avoidance of double taxation, or to speak accurately, the avoidance of increased taxation. But the law is not founded upon the introduction of some equitable principle as modifying the Statute; it is founded upon the provisions of the Statute itself; and the Statute carries the analogy of a partnership further, for it contemplates a company declaring a dividend on the gross gains, and then on the face of the dividend warrant making a proportionate deduction in respect of the duty, 97

See text at fn 70. Although Addington’s tax was at a flat rate the question whether the income of the body was the member’s income before distribution was important not only for persons whose income was below £150 pa, for which there were nine graduated rates of tax on income between £60 and £150 pa and no tax below £60 (1803 s 193; 1805 s 180), but also for the abatement of tax for those with more than two children which had four graduated abatements applying with no ceiling on the amount of income (1803 s 195; 1805 s 181). These were not continued in 1806 after which the tax became a fully proportional one. However, an exemption for incomes of less than £150 pa was re-introduced in 1842 (s 163) and reduced to £100 in 1853 (s 30) and so the issue was potentially relevant after 1842. 99 The 1955 Royal Commission said in para 50 that ‘Once large retentions become a permanent feature and the income tax becomes progressive, there is no theoretical justice in taxing undistributed profits at the standard rate’, thus suggesting that earlier there were originally no large retentions presumably because the tax rate was the same whether or not the profits were distributed and the shareholder expected distribution. 100 (1923) 8 TC 481, 519 (approved by Lord Atkin in Neumann v IRC (1934) 18 TC 332 at 359). See also ‘…so the Act of 1842 has, apparently, proceeded on the idea that for revenue purposes a joint stock company should be treated as a large partnership, so that the payment of income tax by a company would discharge the quasi-partners’. Neumann v IRC (1934) 18 TC 332 per Lord Tomlin at 359. 98

Book 1.indb 24

12/2/2011 8:21:31 AM

Defining and Taxing Companies 1799 to 1965 25 so that the shareholder whose total income is so small that he is exempt from Income Tax or pays at a lower rate, can get the Income Tax which has been deducted on the dividend warrant returned to him.

We had therefore reached the position that up to the abolition of income tax in 1816, the machinery provisions for returns and assessment treated all bodies of persons like incorporated ones, but in all other respects101 the treatment of bodies was transparent for tax purposes.

The Rise of Incorporation and the Abolition of the Unincorporated Body Income tax was reintroduced in 1842 just at the wrong time from the point of view of the development of company law. Two years later, Gladstone’s Joint Stock Companies Act 1844 provided for a simple method of incorporation of companies by registration in the way we know it today.102 These companies were still unlimited; limited liability was not attained for another 11 years.103 And companies still had attributes of partnerships and trusts, for example that it was the deed of settlement that had to be filed whereas now that the company was incorporated there was no need for a trust. The 1844 Act defined joint stock104 company established for any commercial purpose, or for any purpose of profit, to include: Every Partnership whereof the Capital is divided or agreed to be divided into Shares, and so as to be transferable without the express Consent of all the Copartners;105 and also,… Every Partnership which at its Formation, or by subsequent Admission (except any Admission subsequent on Devolution or other Act in Law), shall consist of more than Twenty-five Members.106 101 Except for the deduction of salaries paid to members, see the proviso in the text at fn 71 (and the possible exception for dividends). 102 It is interesting that the US introduced the ability to incorporate by registration earlier: New York in 1811, Massachusetts in 1830 and Connecticut in 1832: C A Cooke Corporation Trust and Company (Manchester University Press, 1950) at 134. He suggests that the US use of corporation as opposed to company was because they moved straight to the distinction between corporations and partnerships, whereas in the UK we developed the intermediate deed of settlement unincorporated company (at 94). In spite of this earlier incorporation, in the US all corporations were originally taxed as partnerships, initially with only distributed profits being taxed from 1862–64, and then as fully transparent entities from 1864 to 1909; a corporate excise tax on ‘every corporation, joint-stock company or association, and every insurance company’ was introduced in 1909 and, following the Sixteenth Amendment, from 1913 an income tax on such bodies: See Richard Winchester ‘Corporations That Weren’t: The Taxation of Firm Profits in Historical Perspective’, 19 Southern California Interdisciplinary Law Journal 501 (2010) (available at http@//ssrn.com/ abstract=1593806). In relation the origins of the US corporate tax, see Reuven S Avi-Yonah ‘Why was the US Corporate tax Enacted in 1909’ in J Tiley (ed), Studies in the History of Tax Law (Vol 2, Hart Publishing, 2007) Ch 14, p 377, and S A Bank ‘Entity Theory as Myth in the US Corporate Excise Tax of 1989’, ibid, Ch 15 p 393. 103 Limited Liability Act 1855. 104 See fn 6. 105 That is, unincorporated bodies of persons, see text at fn 17. 106 Joint Stock Companies Act 1844, s 2 (finally Companies Act 1985, s 716, repealed by Regulatory Reform (Removal of 20 Member Limit in Partnerships etc) Order 2002, SI 2002 No 3203). This

Book 1.indb 25

12/2/2011 8:21:31 AM

26

John F Avery Jones CBE

This meant that no new unincorporated bodies could be formed with more than 25 members, which limit was reduced to 20 from 1856.107 The 1844 Act did not apply to existing bodies: And that, except where the Provisions of this Act are expressly applied to Partnerships existing before the said First Day of November [1844], it shall be held to apply only to Partnerships the Formation of which shall be commenced after that Date…Provided also, that, except as herein-after is specially provided, this Act shall not extend to any Company incorporated or which may be hereafter incorporated by Statute or Charter, nor to any Company authorized or which may be hereafter authorized by Statute or Letters Patent to sue and be sued in the Name of some Officer or Person.108

The Joint Stock Companies Act 1856 had prevented existing partnerships with more than 20 members (that Act having reduced the number from 25) from carrying on a trade or business for gain unless they registered as companies.109 The penalty for non-compliance was that each partner was severally liable for the liabilities without a right of contribution from the other partners. However, this was modified in the 1857 Act so that such trading was not prohibited although the rule about liabilities still applied.110 This must have resulted in most existing bodies (technically partnerships) preferring to be registered under the 1844 Act to obtain the full effects of incorporation, which were considerable:111 XXV. And be it enacted, That on the complete112 Registration of any Company being certified by the Registrar of Joint Stock Companies such Company and the then Shareholders therein, and all the succeeding Shareholders, whilst Shareholders, shall be and are hereby incorporated as from the Date of such Certificate by the Name of the Company as set forth in the Deed of Settlement, and for the Purpose of carrying on the Trade or Business for which the Company was formed, but only according to the Provisions of this Act, and of such Deed as aforesaid, and for the Purpose of suing and being sued, and of taking and enjoying the Property and Effects of the said Company; …and such Company shall continue so incorporated until it shall be dissolved, and all its Affairs wound up; but so as not in anywise to restrict the Liability of any of the Shareholders of the Company, under any Judgment, Decree, or Order for the Payment of Money which shall be obtained against such Company, or any of the Members thereof, in any Action or Suit prosecuted by or against such Company in any Court of Law or Equity; but every such Shareholder shall, in respect of such definition shows the similarity between partnerships and incorporated bodies for which there were separate tax rules. 107

Joint Stock Companies Act 1856 s 4. S 2. The last phrase refers to the 1834 Act, see text at fn 22. 109 S 4. 110 S 3. 111 Note the declaration of dividends in No 9. 112 There existed an earlier state of provisional registration, with ‘provisionally’ added after the name. Complete registration required that the deed of settlement be subscribed (hence ‘subscriber’) in respect of three quarters of the shares. Following complete registration the subscribers became shareholders and ‘registered’ was added after the name. Provisional registration was abolished by the Joint Stock Companies Act 1856. 108

Book 1.indb 26

12/2/2011 8:21:31 AM

Defining and Taxing Companies 1799 to 1965 27 Monies, subject as after mentioned, be and continue liable as he would have been if the said Company had not been incorporated; and thereupon it shall be lawful for the said Company, and they are hereby empowered, as follows; that is to say, 1. To use the registered Name of the Company, adding thereto ‘Registered;’ and also, 2. To have a Common Seal (with Power to break, alter, and change the same from Time to Time), but on which must be inscribed the Name of the Company; and also, Powers and Privileges of Companies. — 3. To sue and be sued by their registered Name in respect of any Claim by or upon the Company upon or by any Person, whether a Member of the Company or not, so long as any such Claim may remain unsatisfied; and also, 4. To enter into Contracts for the Execution of the Works, and for the Supply of the Stores, or for any other necessary Purpose of the Company; and also, 5. To purchase and hold Lands, Tenements, and Hereditaments in the Name of the said Company, or of the Trustees or Trustee thereof, of the Purpose of occupying the same as a Place or Places of Business of the said Company, and also (but nevertheless with a Licence, general or special, for that Purpose, to be granted by the Committee of the Privy Council for Trade, first had and obtained,113) such other Lands, Tenements, and Hereditaments as the Nature of the Business of the Company may require; and also, 6. To issue Certificates of Shares; and also, 7. To receive Instalments from Subscribers in respect of the Amount of any Shares not paid up; and also, 8. To borrow or raise Money within the Limitations prescribed by any special Authority; and also, 9. To declare Dividends out of the Profits of the Concern;114 and also, 10. To hold General Meetings periodically, and extraordinary Meetings upon being duly summoned for that Purpose; and also, 11. To make from Time to Time, at some General Meeting of Shareholders specially summoned for the Purpose, Bye Laws for the Regulation of the Shareholders, Members, Directors, and Officers of the Company, such Bye Laws not being repugnant to or inconsistent with the Provisions of this Act or of the Deed of Settlement of the Company; and also, 12. To perform all other Acts necessary for carrying into effect the Purposes of such Company, and in all respects as other Partnerships are entitled to do: And the said Company are hereby empowered and required,— 13. To appoint from Time to Time, for the Conduct and Superintendence of the Execution of the Affairs of the Company, a Number of Directors, not less than Three, for a Period not greater than Five Years, with or without Eligibility to be re-elected at the Expiration of the Term, as may be prescribed by any Deed of Settlement or Bye Law; and also,

113 This refers to the necessity of obtaining a licence in mortmain, with the result that companies still did not have the right to acquire land. The requirement to obtain such a licence was abolished by the Joint Stock Companies Act 1856 for companies carrying on a trade or business for gain. 114 Concern is also used in ss 13, 24, 27 (‘To hold Meetings periodically and from Time to Time as the Concerns of the Company shall require’ and ‘ordinary Management of the Concerns of the Company’). These suggest that dividends might be paid out of the profits of separate businesses, each having their own joint stock. ‘Adventure or concern’ is also used in tax law, see the examples under the heading (a) Partnerships above.

Book 1.indb 27

12/2/2011 8:21:31 AM

28

John F Avery Jones CBE 14. To appoint and remove One or more Auditors, and such other Officers as the Deed of Settlement under which the Company shall be constituted may authorize.

In 1855 companies completely (as opposed to provisionally)115 registered under the 1844 Act could convert to limited liability by changing the name so that ‘limited’ was the last word, changing the deed of settlement to state that the company was formed with limited liability, and passing a resolution of threequarters of the shareholders and providing an audited certificate of solvency.116 The shareholders’ liability was limited to the amount unpaid on the shares. By 1856, 956 companies had completely registered under the 1844 Act.117 The 1856 Act more logically severed the connection with trusts and changed the documents to be filed from the deed of settlement to the memorandum and articles of association,118 thus changing to a constitution based on contract that we have today.119 Effectively therefore this legislation must have been the end of 115 See fn 112. There were about 4,000 provisional registrations during the same period, of which 1,600 were railway companies for which complete registration was optional as they incorporated by Act of Parliament (see fn 117). 116 Limited Liability Act 1855 s 2. It was a condition for a new company that 25 shareholders signed the deed of settlement and an existing company also had to satisfy this condition. This was therefore the minimum number of shareholders, which was reduced to 7 in the following year by the Joint Stock Companies Act 1856 s 3. 117 B C Hunt, The Development of the Business Corporation in England 1800–1867 (Harvard University Press, Cambridge, Massachusetts, 1936) p 114. Of these 47 were Irish companies. The largest categories were insurance 219, gas and water 211 (plus 28 Irish), markets and public halls 85 (plus 1 Irish), shipping 41, petty lending 41. He lists 947 (plus 47 Irish) companies in existence before the 1844 Act on p 88. On insurance companies, the following statistics were given for various periods by Mr Stephen Cave moving the Second Reading of the Life Assurance Bill (1870) (HC Deb 23 February 1870 vol 199 col 722): ‘We learn from Black’s Chart and White’s Insurance Register that before the year 1824, when offices were under charters and Acts of Parliament, thirty-nine were founded and only one ceased to exist; that from 1824 to 1843 inclusive, under deeds of settlement, 105 were established and thirty-eight ceased. From 1844 to 1868, under the registration system, 219 were founded and 170 ceased to exist… For three years, from 1853 to 1855 inclusive, sixty-two were founded and thirty ceased. In 1856 public attention was roused by a Return to this House of balancesheets under the Act of 1844, which displayed in thirty cases out of fifty-four, as analyzed by Christie, an expenditure in excess of premiums and interest received, and in six an expenditure, not only in excess of premiums and interest, but also of paid-up capital, without the smallest accumulation to meet ever-growing liabilities. The number founded was seven in that year, while the number of those which ceased was twenty. During the next five years, from 1857 to 1861 inclusive, three attempts at legislation were made, and fourteen offices only were founded, and no less than seventy-four ceased. But in 1863, possibly in consequence of facilities given by the Companies’ Act of 1862, the numbers began to show the other way’. 118 The Joint Stock Companies Act 1857 ss 27, 28 required companies registered under the 1844 Act to re-register under the 1856 Act or not be able to sue (although it could still be sued) or pay dividends. Between 1856 and 1859, 741 companies registered under the 1856 Act, and 834 between 1860 and 1862 (B C Hunt (see fn 117) at 144). 119 ‘The Memorandum of Association … shall, when registered bind the Company and the Shareholders therein to the same Extent as if each Shareholder had subscribed his Name and affixed his Seal thereto or otherwise duly executed the same, and there were in such Memorandum contained, on the Part of himself, his Heirs, Executors, and Administrators, a Covenant to conform to all the Regulations of such Memorandum, subject to the Provisions of this Act’ (s 7). See now Companies Act 2006 s 33: ‘The provisions of a company’s constitution bind the company and its members to the same extent as if there were covenants on the part of the company and of each member to observe those provisions’.

Book 1.indb 28

12/2/2011 8:21:31 AM

Defining and Taxing Companies 1799 to 1965 29 the unincorporated body of persons carrying on a commercial activity. While there may have been some remaining in transition, from then on, apart from the few incorporated by Royal Charter or Act of Parliament, bodies were either incorporated under this Act or, if below the (now) 20 partner limit, partnerships. Of course, many unincorporated bodies, such as friendly societies and industrial and provident societies, remained.

Tax Law from 1842 Onwards These major developments in company law were for a long time ignored by tax law, although it might be said that company law had now caught up with the distinction between partnerships and bodies (mostly now required to be incorporated) that had always been made in tax law. Rules that were made predominantly for unincorporated bodies, which had mainly ceased to exist, now had to be applied to incorporated ones. This does not seem to have caused any problems.120 But as income tax was charged at a proportional rate of tax this is to be expected; distributed and undistributed profits bore the same rate of tax.121 There are no reported cases of difficulty122 until the introduction of graduated rates of tax and the concept of total income123 with the introduction of supertax by the Finance (1909–10) Act 1910.124 By then companies incorporated by registration had existed for more than sixty years, and unincorporated bodies (other than partnerships with up to 20 partners, and bodies outside the normal commercial field like friendly societies and clubs) had not existed for the same period, so the circumstances existing in Addington’s time were forgotten and thinking was coloured by the fact that commercial bodies were incorporated. Companies were separate legal persons as a matter of company law, and issues arose of (a) whether payment of dividends now determined the timing of 120

Codification Committee (see fn 17) para 98. See 1955 Royal Commission, para 50. See fn 98 for exemptions for small incomes. One could mention Ashton Gas Company v Attorney-General [1906] 1 AC 10 on whether a maximum dividend of 10% was gross or net of tax; it being held to be gross because if it were net the dividend would exceed the maximum. It is clear that the tax was on the dividend. 123 See John Pearce ‘The Rise and Development of the Concept of ‘Total Income’ in United Kingdom Income Tax Law: 1842–1952’ in Studies in the History of Tax Law (ed John Tiley, Vol 2, Hart Publishing, Oxford, 2007) Ch 3, p 87. Strictly, as he points out, there was a concept of ‘total Income from every Source’ in 1853 s 28 in relation to the exemption for income under £100 pa and the abatement for income up to £150 pa; ‘total income from all sources’ was used in FA 1907 s 19(1) in relation to earned income relief, and in F (1909–19) A 1910 s 68(1) for child relief, as well as the same words for super-tax in s 66, in the last of which they were more important as it was a charging provision. 124 This had the effect that distributed profits were taxed at progressive rates, while undistributed profits were taxed at the standard rate. The difference was later increased since from 1947 profits tax, introduced as National Defence Contribution in 1939, taxed distributed profits at a higher rate than undistributed profits. Interestingly FA 1947 s 31 removed partnerships from profits tax by stipulating that the charge applied only to ‘a body corporate or by an unincorporated society or other body’. From 1922 the close company rules equalised the treatment of distributed and undistributed profits for super-tax and surtax purposes. 121 122

Book 1.indb 29

12/2/2011 8:21:31 AM

30

John F Avery Jones CBE

the member’s income for tax purposes, (b) if it did, how did this fit with the absence of any charging provision for dividends? (c) how to deal with dividends not paid out of the current year’s profits, and the interaction of this with the principle that dividends not paid out of taxable income were not taxable, and (d) in consequence, it was not possible to deduct the tax paid by the body on its current year’s profits from dividends any more because there might be no dividends. Nobody sat down and wrote a set of rules adapted to the new circumstances. The most fundamental of these items is (a) as it is determinative of transparency; this seems to have been decided by default based on the legal effect of incorporation.125 On (b) an attempt by a taxpayer to argue that in the absence of a charging provision dividends did not form part of total income was not accepted by the courts on the basis that total income did not depend on the schedules, and dividends were clearly income and were derived from property in the UK and thus within the territorial scope of Schedule D for a non-resident, which the cases happened to concern.126 On (c) whether a dividend was paid out of taxable income depended on whether the income had ever paid tax. This gave rise to problems over mismatches of the accounting and tax profit because of such matters as the three-year average and the low Schedule A charge compared to actual rents. On (d) the amount of tax to be deducted had to be the tax referable to the dividend, which was given statutory effect in the 1918 Act. Although a consolidation Act, the change in wording was highly significant:127 20. The profits or gains to be charged on any body of persons shall be computed in accordance with the provisions of this Act on the full amount of the same before any dividend thereof is made in respect of any share, right or title thereto, and the body of persons paying such dividend shall be entitled to deduct the tax appropriate thereto.128

Instead of a ‘proportionate Deduction in respect of the Duty so charged’ [on the body] we now had ‘the tax appropriate thereto’ [to the dividend]. Lord Wright in Neumann noted that the new wording was more appropriate to incorporated companies.129 In practice tax was always shown to be deducted at the current 125

See the quotation from the 1955 Royal Commission in the text around fn 156. Brooke v IRC (1917) 7 TC 261; Whitney v IRC (1925) 10 TC 88. But the same does not apply to previously undistributed profits on liquidation: IRC v Blott (1921) 8 TC 101, IRC v Burrell (1924) 9 TC 27. 127 In F H Hamilton v IRC (1931) 16 TC 213 at 228 Lord Hanworth MR said that one assumes that a change in wording was intended to have a different effect; Lawrence LJ comments on the change in wording at 233; and Romer LJ does so at 235 in relation to the Scottish Union case. In general, one interprets a consolidation Act by its language without reference to the former legislation: IRC v Joiner [1975] STC 657, 666 per Lord Diplock. 128 1918, All Schedules Rules r 20. 129 ‘In 1842 the modern development of limited companies was not in contemplation; ‘proportionate’ was an apt word for the simple cases of corporators where each year the corporators shared, in definite proportions, the available net income. ‘Appropriate’ tax, which is more precisely defined by the Finance Act of 1927 as being at the standard rate of the year of payment, is clearly a more apt term in connection with the dividends of a company’. Neumann v IRC (1934) 18 TC 332 at 369. 126

Book 1.indb 30

12/2/2011 8:21:31 AM

Defining and Taxing Companies 1799 to 1965 31 rate.130 Following a recommendation of the 1920 Royal Commission,131 a statutory provision required the body to show the rate of tax deducted and the gross and net amounts in a statement accompanying the dividend.132 On the introduction of surtax the concept of the standard rate133 was introduced, and section 39 of the Finance Act 1927 provided: (1) Such of the provisions of the Income Tax Acts as provide…that there may be deducted from any dividend the tax appropriate thereto…shall have effect as if they provided that tax may be deducted…at the standard rate for the year in which the amount payable becomes due.

The effect of these provisions on a dividend from an incorporated company were tested for super-tax for 1927–28 in Gimson v IRC134 in relation to a dividend out of income that had fallen out of assessment for various reasons: first, being paid out of discounts on government securities that had matured in earlier years but were not taxable because the basis of assessment was the income of the preceding year which was nil; secondly, out of foreign dividends paid in earlier years that were taxable on a three-year average but the company had no income from these sources in some of the three years after the foreign dividends was paid135 and so could not be assessed;136 and thirdly, out of capital profits (the distribution of which was conceded not to be liable to super-tax). The company had no taxable income in the year in which the dividend was paid. Rowlatt J held that the first two items were not liable to super-tax. He reasoned on the basis of the transparency of the company and tracing the income out of which the dividend was paid. If the recipient of the dividend had been in receipt of the underlying income he would not have been taxed, and the interposition of the company made no difference.

130 The Special Commissioners in Hamilton (at p 219) described this as ‘the almost universal practice’, with which the Court of Appeal agreed. Neumann v IRC (1934) 18 TC 332 at 360 per Lord Atkin. The requirement to show the rate of deduction was contained in FA 1924 s 33. FA 1927 s 39(2) ‘In estimating under the Income Tax Acts the total income of any person, any income which is chargeable with income tax by way of deduction at the standard rate in force for any year shall be deemed to be income of that year…’ may have been intended to specify that the deduction was to be at the current rate of tax for the year of payment (see Neumann at 361 per Lord Atkin) but this did not apply to dividends because they were not themselves ‘chargeable with income tax’. 131 Cmd 615, para 173. 132 FA 1924 s 33. 133 This was the ordinary rate of income tax on investment income (earned income was subject to a relief); rates of surtax were rates of tax in addition to the standard rate on the income liable to surtax, rather than as at present higher rates on the band of income. Unlike super-tax, which was a separate tax, surtax was part of income tax. 134 (1930) 15 TC 595. 135 As an example of the point, a foreign dividend paid in 1922–23 was taxed on one-third in 1923–24 but not taxed on the thirds due to be taxed in 1924–25 and 1925–26 because the company had no income from this source in those last two years. 136 On the basis of Whelan v Henning (1926) 10 TC 263 which decided that if there was no income from the particular shares in the year there was no liability to tax for the year, applying Brown v National Provident Institution (1921) 8 TC 57, which related to Case III, to Case V and applying it even though the source continued to be held in the year.

Book 1.indb 31

12/2/2011 8:21:32 AM

32

John F Avery Jones CBE …if this gentleman had received this money not from the company but direct, by holding the source of income himself and had been liable to Income Tax in nil because of the regulations affecting measurement, his income would not be subject-matter on which he could get back tax which was small or pay Super-tax in case it was big. So in the case of a company, although the Attorney-General very properly referred to what I said in Blott’s case137 which is a material case, although the case of a company is different, in essence it is the same; he can only get back tax which the money he received has suffered and he can only be liable to Super-tax in respect of a dividend which is taxable.

He rightly dismissed out of hand the Crown’s contention that the dividend was an annual payment made out of untaxed income and therefore taxable under Rule 21 of the All Schedules Rules in the 1918 Act (the successor to what we have called category [2] of charges on income138): ‘It is absolutely contrary to the idea one has ever held and it is in my experience entirely novel’.139 His decision was entirely in accordance with Addington’s principles. If the body were transparent these items would not have been taxable. In other words, transparency still applied to determine whether something was taxable even though the timing of the income was now clearly deferred until payment of the dividend. Allied to this was a debate on whether a company paid tax as agent for its members. Swinfen Eady LJ said in Brooke v IRC140 that: where the duty is paid by a firm or a partnership or a company in respect of the gains and profits upon which they are assessed, the company pays the Income Tax as agents for its shareholders, and in that way it is the shareholders, the persons beneficially concerned, who bear the burden of the tax.

On the basis of Addington’s principles applied to predominantly unincorporated bodies, this was correct. Viscount Cave disagreed, saying, ‘a company paying Income Tax on its profits, does not pay it as agent for its shareholders. …the payment by the company operates in relief of the shareholder. But no agency, properly so-called, is involved’.141 Properly so-called this is undoubtedly true but 137

See fn 141. See text at fn 81, following the amendment described in fn 80. 139 At p 601. The House of Lords confirmed this in Neumann v IRC (1934) 18 TC 332. 140 (1917) 7 TC 261, 272. 141 IRC v Blott (1921) 8 TC 101, 136. See also Neumann v IRC (1934) 18 TC 332, 368 in which Lord Wright said ‘The shareholder and the company are, no doubt, separate entities; the company is not an agent from the shareholder to pay tax on the dividend, nor is the company the collector for the Revenue to deduct tax from the dividend….What is essential to the requirements of the Inland Revenue is that all the profits of the company should be taxed and, if that is done, the Revenue is not concerned with what is done with these profits… There is, in fact, only one profit, no new profit being created from the fact that the shareholder gets his share; the tax is a tax on the profits and not on the dividend’. Also IRC v Cull (1939) 22 TC 603, 636 in which Lord Atkin said: ‘My Lords, it is now clearly established that in the case of a limited company the company itself is chargeable to tax on its profits, and that it pays tax in discharge of its own liability and not as agent for its shareholders. The latter are not chargeable with Income Tax on dividends, and they are not assessed in respect of them. The reason presumably is that the amount which is available to be distributed as dividend has already been diminished by tax on the company, and that it is thought inequitable 138

Book 1.indb 32

12/2/2011 8:21:32 AM

Defining and Taxing Companies 1799 to 1965 33 this is because Addington’s unincorporated companies were not legal persons and could not be an agent, and incorporated companies, which could be an agent, were treated in exactly the same way as unincorporated ones. Although both of them were speaking of the situation before 1918, Viscount Cave’s approach seems to be an example of thinking being coloured by bodies then being all incorporated. The taxpayer in F H Hamilton v IRC142 tried unsuccessfully to rely on Gimson claiming that where a company distributed more than its taxable income of the year his income for surtax could not exceed the taxable income of the company. Rowlatt J and the Court of Appeal rejected this on the basis of the plain words of the 1918 Act. I have argued that in Addington’s time this is what the legislation literally said and historically the taxpayer was right. But in the meantime the thinking had become coloured by companies being incorporated. It made no sense to look at one year’s income in isolation and so the only way to make the legislation work was to abandon the approach adopted for charges on income that one looked at only the current year to see whether income had been taxed.143 A passing remark of Rowlatt J144 is interesting in showing the problems the tax fraternity were having in adapting Addington’s system to incorporated companies: Now, as I said during the argument, I do not think anybody has ever sat down to really tackle exhaustively, so as to work out a complete system, the problems which arise in relating the taxpayer’s individual income to the income of the company. Those problems of course were very much in the background in 1842, but they came into some prominence as soon as you got the growth of the Joint Stock commercial companies, and their consideration has been one of the esoteric joys of the select company of Income Tax lawyers for a long time.

The Finance Act 1931 duly reversed Gimson in relation to the first and second items of income, restoring the generally accepted view and saving companies from always having to trace the income out of which the dividend was paid: 7.—(1) The provisions of Rule 20 of the General Rules, which authorise the deduction of the appropriate tax from any dividend paid by a body of persons, shall, in relation to a dividend paid by any body of persons, whether before or after the commencement of this Act, be construed as authorising the deduction of tax from the full amount paid out of profits and gains of the said body which have been charged to tax or which, under the provisions of the Income Tax Acts, would fall to be included in computing the liability of the said body to assessment to tax for any year if the said provisions required the computation to be made by reference to the profits and gains of that year and not by reference to those of any other year or period. to charge it again. At one time it was thought that the company, in paying tax, paid on behalf of the shareholder: but this theory is now exploded by decisions in this House, and the position of the share-holders as to tax is as I have stated it’. 142

(1931) 16 TC 213. This case also related to years before FA 1931 (see text at fn 146). See fn 81. 144 At 222–3. 143

Book 1.indb 33

12/2/2011 8:21:32 AM

34

John F Avery Jones CBE (2) Subject as hereinafter provided, a dividend paid by a body of persons, whether before or after the commencement of this Act, shall, to the extent to which it is paid out of such profits and gains as are mentioned in subsection (1) of this section, be deemed, for all the purposes of the Income Tax Acts, to represent income of such an amount as would, after such deduction of tax as is authorised by the provisions of the said Rule 20, be equal to the net amount received:145 Provided that the provisions of this subsection shall not apply to a preference dividend to which section twelve of the Finance Act, 1930, applies, and shall have effect subject to the provisions of subsection (3) of that section.146

By referring to dividends ‘paid out of profits and gains of the said body which have been charged to tax’ the section confirms the basis the decision in Gimson, reversing it only in relation to profits that would have been charged if they had been assessed on a current year basis. The dividend paid out of the first and second category of income in Gimson would then be taxable, apparently on a grossed-up basis, which was the issue to be decided in Neumann. But the third category remained exempt so that one aspect of the original transparency still remained. The section also added respectability to the concept of asking whether the income had been taxed in any year rather than in the current year. The next case, Neumann v IRC,147 dealt with the effect of Fry v Salisbury House148 on the shareholder. The House of Lords had decided in Fry that rent could be taxed only at the (much lower) annual value for Schedule A and that the excess over the annual value could not be taxed under Schedule D. The Salisbury House company then distributed as a dividend, without any deduction of tax, the excess amount that was found not to be taxable. In the light of Gimson the taxpayer in Neumann tried to apply the same principle to that dividend arguing that it was not taxable as it had been paid out of income that was not taxable. Initially Finlay J agreed but the Court of Appeal and the House of Lords did not. The House of Lords approved Gimson in spite of the Court of Appeal saying it was wrongly decided, but the facts were different. The rent had been taxed although on a different basis from the full amount, rather than part of the income not being taxable at all in the particular year. Accordingly the dividend had been paid out of profits or gains that had been taxed. Deduction of tax from the dividend was authorised, although the company had not actually 145

This subsection corrects the lacuna in FA 1927 s 39(2), see fn 130. FA 1931 s 7; 1952 s 184(2). The proviso refers to the deduction of tax pursuant to a resolution under the Provisional Collection of Taxes Act 1913. FA 1930 s 12(3) provided: ‘(3) Where on payment of a dividend (not being a preference dividend within the meaning of this section), income tax has, under Rule 20 of the General Rules, been deducted therefrom by reference to a standard rate of tax greater or less than the standard rate for the year in which the dividend became due, the net amount; received shall, for all the purposes of the Income Tax Acts, be deemed to represent income of such an amount as would, after deduction of tax by reference to the standard rate last-mentioned, be equal to the net amount received, and for the said purposes there shall in respect of that income be deemed to have been paid by deduction tax of such an amount as is equal to the amount of tax on that income computed by reference to the standard rate last-mentioned’. 147 (1934) 18 TC 332. 148 (1930) 15 TC 266. 146

Book 1.indb 34

12/2/2011 8:21:32 AM

Defining and Taxing Companies 1799 to 1965 35 deducted any tax, and the dividend was liable to surtax. In what seems to be an example of hard cases making bad law they held that section 7(2) of the Finance Act 1931 did not apply to gross-up the dividend even though it had been paid out of taxed income.149 If this were not the case the grossed-up amount would represent income to which the shareholder could never have become entitled. Lord Wright thought that the reference to ‘the net amount received’ implied that there had been a deduction of tax. The House of Lords later decided that this decision was of general application to all cases in which there had been no tax deduction in IRC v Cull150 in which the company had brought forward losses which meant that no tax was paid in the year the dividend was paid, and no tax was deducted from the dividend. As in Neumann it was held that the dividend should not be grossed-up. Cull was reversed by the following year’s Finance Act so that grossing-up applied.151 Thus rules designed and applying perfectly logically to unincorporated bodies in Addington’s time had by then been badly adapted to deal with incorporated companies resulting in the bizarre set of rules that Lord Wright described in Neumann:152 The scheme of these provisions as I understand them is to impose the tax on all the profits of the company at the source: if and so far as these profits have been so taxed, they are not liable to any further tax (other than surtax) in the hands of the shareholder receiving the dividend. The shareholder and the company are no doubt separate entities: the company is not an agent for the shareholder to pay tax on the dividend, nor is the company the collector for the Revenue to deduct the tax from the dividend. The company is the taxpayer. The shareholder has no right to any share in the profits till a dividend is declared: the company may use the profits in any way it pleases vis-a-vis any shareholder: it may put them to reserve or capitalize them or use them for extensions or improvements: the profits declared and paid as dividends in one year may have been made in previous years when the standard rate of tax was different: it is only very rarely and in exceptional cases that dividends are paid out of any particular source of profit: usually they are paid out of the general revenue fund of the company. What is essential to the requirements of the Inland Revenue is that all the profits of the company should be taxed and if that is done the Revenue is not concerned with what is done with these profits. The company is not bound but only authorized to deduct tax in paying dividends: whether it deducts or not is left to its discretion because the profits once having been taxed in the company’s hands, do not bear further tax (apart from surtax) in the shareholders’ hands. There is in fact only 149 So much so that the Codification Committee (see fn 17) at para 107–8 was unable to understand it and therefore to codify it. Their draft Bill (cl 42) equated dividends paid free of tax with those paid without deduction of tax. For example what if the company had paid a lower rate of tax in the past and now distributed it when the rate was higher, the grossed-up amount was equally fictitious. They also made the point that if the same facts had applied to a discretionary trust the income would be grossed-up, but this can be explained by the fact that the charges on income provision would have applied and dividends were different. 150 (1939) 22 TC 603. 151 FA 1940 s 20. 152 [1934] AC 215, 236; (1934) 18 TC 332, 368.

Book 1.indb 35

12/2/2011 8:21:32 AM

36

John F Avery Jones CBE one profit, no new profit being created from the fact that the shareholder gets his share: the tax is a tax on the profits and not on the dividend. But if tax is deducted from the dividend the Acts have provided that it is to be at the standard rate of tax of the year of the dividend, in order to avoid obvious difficulties which might arise because profits divided in one year may have been earned in other years.

The 1955 Royal Commission153 said of the exemption from tax of dividends paid out of capital profits: ‘We regarded this theory with misgiving and some surprise, for it seemed to us to rest upon a process of reasoning that had gone astray’.154 They pointed out the anomaly that a company with both taxable and untaxed profits could decide which to distribute first which had an important effect on the shareholders.155 They argued: 807….But from the tax point of view the exemption of such dividends from tax appears to depend on two quite simple propositions, with neither of which we agree. In the first place it may be said that profit that is a capital profit in respect of the company as taxpayer cannot be a profit in the way of income when it is transferred to a shareholder in the form of dividend. But the system of taxing company profits as the profits of the company and not of the shareholders denies the validity of this argument. If the company’s profits were merely the shareholders’ profits each shareholder’s income would include his proportionate share of the company’s profits as made. If shareholders are not taxed in this way—certainly to the benefit of some of them—it is not fair to claim that the capital profit of a company is necessarily a capital profit for the individual shareholder to whom it is distributed. In fact it is a familiar principle that what is capital in the hands of a payer may be income in the hands of the recipient.

Now that we had moved away from transparency on the timing of the shareholder’s income,156 the link between taxation of the company and that of the shareholder had been sufficiently broken. What is interesting is that there was no conscious decision in the legislation157 to break the timing connection; it just seems to have happened because of the change to incorporation of all bodies by company law. They continued: In the second place, it may be said that it is a fundamental rule of our tax system that a shareholder’s dividends are not assessable to income tax. There is no question but that, grossed up, they are, generally speaking, assessable income for the purposes of surtax. But, as we understand it, this rule does not arise from any mysterious sanctity attributable to the inherent nature of dividends. Its origin is simply that under the system to which we have alluded the company, though it pays income tax on its profits as an independent taxpayer, is treated as having paid that tax in the name and on behalf of its shareholders158 once the profits are transferred to them in the form of dividends. Whatever the difficulty of applying it consistently, that is the conception. 153

Cmd 9474. Para 804. 155 Para 806. 156 This was proposition (a) in the text at fn 125. 157 Unless it was the change made by the 1918 Act from ‘proportionate Deduction in respect of the Duty so charged’ [on the body] to ‘the tax appropriate thereto’ [to the dividend], see text at fn 128. 158 The agency argument was long outmoded by then, see fn 141. 154

Book 1.indb 36

12/2/2011 8:21:32 AM

Defining and Taxing Companies 1799 to 1965 37 Consequently the company’s payment of income tax, ‘franks’ the shareholder’s dividend for that tax on those profits; in that sense dividends are not assessable to income tax. But we see nothing in the logic of this principle that requires it to be said that if a company distributes by way of dividend a separate fund of profits on which no claim for income tax has arisen the tax cannot be assessed upon the shareholder in respect of his dividend. To argue this way would seem to stand the principle on its head; for it is to use the fact that there has been no payment of tax by the company which would otherwise have franked the tax on the dividend as itself the justification for claiming that the dividend should not be taxed. 808. Our view is that there is no sufficient ground for treating these ‘capital profit dividends’ as if their nature was different from that of other dividends. All represent benefits accruing from time to time upon the shares which are the source of the dividends. All arise while the company is a going concern: none involves any reduction of the capital paid up on the share. We recommend accordingly that they should be regarded as taxable income.

Treating the tax paid by the company as franking the dividends was merely a collection mechanism, from which it did not follow logically that if the company paid no tax on particular income then nor should the shareholder. Looked at from the shareholder’s point of view a dividend was a dividend whatever its source. Certainly when viewed without the benefit of history this follows. But it was a consequence of moving away from transparency that caused it to become merely a collection mechanism rather than an inevitable consequence of transparency. Professor Wheatcroft in his book published in 1962159 just before the abolition of these rules on the introduction of corporation tax, summarised them in this way: 1. In computing its tax liability the company is not entitled to any deduction for a dividend it has paid. 2. So far as it pays a dividend out of profits chargeable to tax (or which would have been chargeable on a current year basis) it may deduct and retain for itself tax at the standard rate in force for the year when the dividend was due. The right to deduct is permissive and not obligatory. 3. A dividend, other than a preference dividend,160 paid out of such profits is deemed to represent income of the recipient equal to the grossed up amount of the net sum received. 4. The dividend warrant must have annexed to it, or be accompanied by a statement as to the gross amount, the rate and amount of tax appropriate the net amount and, where appropriate, the net United Kingdom rate.161 5. A dividend paid without deduction of tax, when such deduction is authorised, is deemed to represent a net amount received in respect of its equivalent gross amount as if such a deduction had been made. 159 The Law of Income Tax, Surtax and Profits Tax (London, Sweet & Maxwell, 1962) paras 1–385 (footnotes omitted). 160 The provisions applying to preference dividends have not been reproduced. 161 The net UK rate was the rate that had actually paid UK tax rather than tax covered by double taxation relief and was the maximum that could be repaid.

Book 1.indb 37

12/2/2011 8:21:32 AM

38

John F Avery Jones CBE 6. A dividend other than a preference dividend from which tax has been deducted at the wrong standard rate is deemed to represent a net amount received in respect of the grossed up amount (at the current rate) of the actual net amount paid. Hence no adjustment is necessary when a dividend (other than a preference dividend) is paid at the beginning of a fiscal year subject to deduction at the old standard rate before a Ways and Means resolution alters the rate.

He comments, clearly correctly, that ‘These provisions were enacted originally in different Finance Acts and do not form a logical code’. All this came to an end with the introduction of corporation tax in 1965 which was designed for limited companies rather than transparent bodies of persons.162

Non-resident Bodies There was originally no recognition in the legislation of the existence of non-resident partnerships or bodies of persons, although the assessment of partnerships with only non-resident partners was, as we have seen, dealt with in relation to taxing its British profits.163 The charging provision for foreign income treated such income as a source of its own, income from a foreign possession, unrelated to the type of income (apart from interest on foreign securities).164 A membership interest, such as a share, in a non-resident body of persons was a foreign possession165 and so income from it was taxed under Case V necessarily by assessment on the recipient, and until 1914 on the remittance basis for everyone.166 It would not have made sense to apply transparency: ‘The officers of the Crown do not know and do not care what is the character of the sources from which the money comes’.167 The source of the income is therefore the dividend itself and on ordinary trust principles if the share remains intact, a dividend is income and is taxable whatever its underlying source. A dividend

162 The corporation tax definition was that ‘“company” means, subject to sections 66 [which exempts a local authority from corporation tax] and 67 [which treats an authorised unit trust as a company for corporation tax] of this Act, any body corporate or unincorporated association, but does not include a partnership’ FA 1965 s 46(5). Thus any remaining non-commercial unincorporated bodies, mainly clubs, were made liable to corporation tax. 163 See text at fn 47. 164 This approach lasted until the Tax Law Rewrite dealt with foreign income of a particular type, such as interest, at the same time as domestic income in Income Tax (Trading and Other Income) Act 2005. 165 Bartholomay Brewing Co v Wyatt (1893) 3 TC 213; Nobel Dynamite Trust v Wyatt (1893) 3 TC 224; Gramophone and Typewriter Co v Stanley (1908) 5 TC 358, Singer v Williams (1920) 7 TC 419. Because of the remittance basis the issue of whether the dividend fixed the timing of the income did not arise. 166 FA 1914 s 5 removed the remittance basis for income from foreign securities, stocks, shares and rents, except for non-UK domiciled persons and non-ordinarily resident British subjects. 167 Bradbury v English Sewing Cotton Co Ltd (1923) 8 TC 481, per Lord Phillimore at 519, quoted by Lord Simonds in Reid’s Trustees at 440. See fn 74 for the reason why the same was not the case for a life interest trust in Archer-Shee v Baker (1927) 11 TC 749.

Book 1.indb 38

12/2/2011 8:21:33 AM

Defining and Taxing Companies 1799 to 1965 39 paid by a non-resident body out of a capital gain is therefore taxable.168 The statutory provisions dealing with resident bodies are irrelevant because they proceed on the basis that the body is a transparent partnership, while the taxation of a foreign possession proceeds on the opposite basis. There was once a confusion of thought that treated a non-resident body as paying tax on behalf of its members, known as the rule in Gilbertson v Fergusson,169 which had the result that a resident shareholder could obtain credit for his proportion of tax paid by the non-resident company (or its subsidiary170) on its UK source income against the tax on the dividend. This was eventually overruled by the House of Lords171 on the basis of the changed understanding of whether a UK company paid tax as agent for its shareholders172 but the rule from the beginning should never have applied to non-resident companies because of the different approach to their taxation for which the statutory provisions we have been considering had no effect.

168 IRC v Reid’s Trustees (1949) 30 TC 431. For cases where the ‘tree’ remained intact, see Rae v Lazard (1963) 41 TC 1 (partial liquidation under Maryland law, likened to cutting the tree in two) and Courtaulds Investments Ltd v Fleming (1969) 46 TC 111 (Italian share premium reserve, the distribution of which was treated as a return of capital). The 1955 Royal Commission at para 809 used this difference as one of the advantages following from their recommendation of making capital dividends paid by resident companies taxable. For a recent decision that payment of dividends out of share premium account under Cayman Islands law were dividends in UK tax law, see First Nationwide v HMRC [2011] STC 1540. 169 (1881) 1 TC 501 concerning the (non-resident: see Attorney General v Alexander (1874) LR 10 Exch 20) Imperial Ottoman Bank that had a branch in London. The confusion was no doubt caused by the fact that the persons managing the branch were the same as the paying agents who deducted tax on dividends paid to UK residents which, if one considered that the company paid tax on behalf of its shareholders, appeared to be double taxation if the tax on one could not be credited against the other. See David Oliver ‘The Rule in Gilbertson v Fergusson: 140 Years of Relief for Underlying Tax’ in Studies in the History of Tax Law (vol 3, Hart Publishing, 2009) Ch 10 p 281. 170 Canadian Eagle Oil Co Ltd v The King (1945) 27 TC 205 is an example of the relief being applied to dividends from UK subsidiaries of a non-resident company. It concerned UK resident shareholders in a Canadian company holding three UK resident subsidiaries. The Gilbertson deduction had been given in 1929 to 1931 (and one suspects earlier) but had been refused by the Revenue for 1932 in respect of dividends on preference shares (rightly, as the House of Lords later decided in Barnes v Healy-Hutchinson 22 TC 655, in which the Revenue had not argued that Gilbertson was wrongly decided, see p 672) and in 1940 was restricted by the Revenue, in respect of the ordinary shares, to tax paid directly by the Canadian company and not on dividends from the subsidiaries, which gave rise to the case. But, as Lord Simonds pointed out in Canadian Eagle (p 262) if the rule applied it must apply to all classes of share. It appears from the claim in Canadian Eagle (see p 213) that the relief was by reference to the income that had paid UK tax as a proportion of the income that would have been charged to tax if the company had been resident. For the difficulties of the Singer family applying the rule, see David Parrott and the writer’s ‘Seven Appeals and an Acquittal: the Singer Family and their Tax Cases’ (2008) BTR 1. 171 The rule was reversed in Canadian Eagle (see fn 170) on the basis that it was inconsistent with later House of Lords cases that decided that the company paid tax on its own behalf and not on behalf of its shareholders (see text around fn 140 above). The Codification Committee (see fn 17) were right in para 110 to be confused by the rule in the final years before the House of Lords reversed it. 172 See text at fn 140.

Book 1.indb 39

12/2/2011 8:21:33 AM

40

John F Avery Jones CBE COMPANIES AND BODIES OF PERSONS IN TAX TREATIES

In the quotation with which we began ‘company’ may not have been defined in the first tax treaty with Australia but in all other early UK tax treaties it is defined as including any body corporate,173 which demonstrates that there was in fact no problem about defining a company.174 Bodies of persons still live on in tax treaties. The first tax treaty with Australia contained the following definition: In the present Agreement, unless the context otherwise requires…(e) the term ‘person’ includes any body of persons, corporate or unincorporate; This follows the Interpretation Act 1889 definition of person (which is repeated in the current 1978 Act): the expression ‘person’ shall, unless the contrary intention appears, include any body of persons corporate or unincorporate.175 The definition in other early tax treaties was slightly different: The term ‘person’ includes any body of persons, corporate or not corporate;

Did the draftsman copy the Interpretation Act but updating the English to say ‘not corporate’ rather than ‘unincorporate’? Or did he amend the definition of body of persons in the Income Tax Act 1918 Act that comprised Pitt’s and Addington’s list of bodies incorporated into a definition, by deleting the references to the historical bodies and making it into an inclusive definition as it was now a definition of person that had to include more than bodies of persons? The latter is quite possible as these are the only changes required to turn it into the definition in all early UK tax treaties:176 [The term] ‘body of persons’ means includes any body politic, corporate or collegiate, and any company, fraternity, fellowship and society of persons whether corporate or not corporate.

173 Later, as a result of the work of the OEEC (the predecessor of the OECD), this became an exhaustive definition with a second limb: ‘The term “company” means any body corporate or any entity which is treated as a body corporate for tax purposes’. The second limb had no meaning in the UK until corporation tax as we did not tax bodies corporate differently (except for profits tax). An example of the second limb is authorised unit trusts constituted as trusts which are not bodies corporate but are taxed as such. 174 The estate duty charge on benefits from companies under FA 1940 s 46 contained the following definition in s 59: ‘“Company” includes any body corporate, wheresoever incorporated’. Other tax provisions relating to companies had been limited to companies incorporated under the Companies Acts, such as the charge to super-tax on undistributed income of companies in FA 1922 s 21, and Adaptations of Income Tax Provisions as to Computation of Profits for Purpose of National Defence Contribution (which became profits tax) in FA 1937 Sch 4. 175 Interpretation Act 1889 s 19; Interpretation Act 1978 Sch 1. 176 A different definition is found only in the early treaties with France (1951): ‘The term “person” means: (i) any physical person; (ii) any unincorporated body of persons; and (iii) any body corporate’ (this is the only example of an exhaustive definition); and Switzerland (1955): ‘The term “person” includes any individual, company, unincorporated body of persons, and any other entity with or without juridical personality’.

Book 1.indb 40

12/2/2011 8:21:33 AM

Defining and Taxing Companies 1799 to 1965 41 Much later, the courts confirmed that the 1918 Act definition of body of persons was not itself intended to be incorporated into the treaty definition: If [the draftsman of the UK-Jersey Arrangement, ie the equivalent of a tax treaty] was assuming that the statutory definition of ‘body of persons’ would apply, I see no reason why he should have added the words ‘corporate or not corporate’. They form part of the [treaty] definition itself, and their inclusion had no purpose if the statutory definition applied. I do not think that they can be dismissed as mere tautology. On the face of the Arrangement, they are a specific part of what is intended to be a selfcontained definition for the purposes of the Arrangement. They are not, it seems to me, consistent with an intention on the part of the draftsman to utilise the statutory definition. They indicate a contrary intention.177

If that is the origin of the treaty definition of person there is a direct link from Pitt’s and Addington’s Acts to modern tax treaties.178

CONCLUSION

The history of taxing bodies of persons shows how tax law adapted to changes in company law with the minimum of legislative changes. Bodies were originally transparent in the same way as partnerships and merely had a different regime for their assessment because of the larger number of members. Shortly after income tax was reintroduced in 1842 changes in company law between 1844 and 1856 made it possible to incorporate companies easily with limited liability, but no change was made to tax law. Since income tax was charged at a proportional rate it made little difference whether companies were transparent or not. This changed when super-tax was introduced in 1910 by which time it seems to have been assumed that companies were non-transparent for tax purposes presumably on the basis that they had for some time been incorporated bodies. The taxation of the shareholder was assumed to be determined by the time of payment of dividends contrary to their original transparency. Although there was no charging provision for dividends this did not matter as they were clearly part of total income for super-tax. The 1918 Act changed the permissive deduction of tax on dividends from the ‘proportionate Deduction in respect of the Duty so charged’ [on the body] to ‘the tax appropriate thereto’ [to the dividend] in spite of being a consolidation Act. Other statutory provisions dealt with distributions out of profits that were not taxed because the income fell out of the rules for assessment because of the three-year average basis or differences between the amount of rent and the annual value. The last vestige of their transparent past remained that dividends paid by a resident company 177

Padmore v IRC [1989] STC 493 at 499a per Fox LJ. The definition in the current OECD Model Tax Convention is: ‘the term “person” includes an individual, a company and any other body of persons’. 178

Book 1.indb 41

12/2/2011 8:21:33 AM

42

John F Avery Jones CBE

otherwise than out of taxable profits were not taxable. This did not apply to non-resident companies that had never been transparent for tax purposes no doubt for practical reasons for which the courts determined taxability by analogy with fruit and trees. The distinction between resident and non-resident companies caused the 1955 Royal Commission to recommend that all dividends were taxable, which occurred on the introduction of corporation tax.

Book 1.indb 42

12/2/2011 8:21:33 AM

2 Public Health Imperatives and Taxation Policy: the Window Tax as an Early Paradigm in English Law1 CHANTAL STEBBINGS

ABSTRACT

T

HE WINDOW TAX had consequences which were unanticipated by the legislature when English society experienced rapid and intense industrialisation from the early nineteenth century. The appalling living conditions of the urban poor were exacerbated by the practice of blocking up windows to avoid the effects of the tax. Medical practitioners, supported by the miasmatic theory of the cause and spread of disease, maintained that a lack of ventilation was directly responsible for the high levels of illness and death among the urban poor. The public health arguments formed the basis of an intense campaign for the abolition of the tax lasting over twenty years until its repeal in 1851. This paper examines the interrelationship of the fiscal, political, legal, social, medical and scientific factors operating in the implementation and policy consideration of the window tax in the mid nineteenth century. It finds that while the tax was expressly repealed as a result of public health imperatives, fiscal considerations caused it to be maintained long after its wider dangers had become apparent, and only when the tax had become politically untenable was it finally abolished. The paper concludes that the window tax had a formative effect on modern fiscal policy, subjecting the role of tax in national life to a new intensity of scrutiny and criticism, and promoting an understanding that the interaction of tax with wider non-economic purposes was socially and politically essential. 1 The research on which this chapter is based was funded by a grant from the Wellcome Trust, which support is gratefully acknowledged.

Book 1.indb 43

12/2/2011 8:21:33 AM

44

Chantal Stebbings INTRODUCTION

The primary objective of taxation is to raise revenue for public purposes, notably for law, order and defence. Other traditional purposes are to regulate the economic life of the state, or to distribute its wealth equitably. Since the middle of the twentieth century, however, it has become a feature of fiscal law and policy for taxation to have a prominent and potentially powerful role to play in influencing social behaviour so as to promote public health. The indirect taxes on tobacco and spirits, dating from the seventeenth century, have come to acquire an objective beyond their original and explicit revenue-raising. As the consumption of both has been shown to be price-sensitive, so taxes are consciously imposed to control their use.2 Accordingly taxes have come to be levied on such commodities not only for their economic consequences, but for their wider impact. So when in 2009 over 10 per cent of the population of the United Kingdom were identified as drinking alcohol at hazardous levels3 with serious consequences for the public health, social order and, consequently, the wider economy, the raising of taxes on alcoholic drinks was promoted by most political parties and interest groups as being the most effective remedial measure.4 Today the imposition of taxation on substances shown by medical science to be injurious to the public health forms part of a deliberate and considered fiscal policy. It is accepted as part of the essential function of government that it must take measures to promote the health of the public. This is a modern phenomenon, an expression of contemporary fiscal thought. While the scale of such taxation today is unprecedented, its rationale is not, because when in 1735 the government could not ignore the social consequences of excessive and widespread gin drinking, it imposed a heavy duty on spirits.5 In all taxation, however, whether it is designed to promote the public health or is ostensibly unconnected with it, there lies the inherent danger of the unpredictability of its effects. Modern taxes on spirits and tobacco had unforeseen consequences with respect to social inequality, and revealed tensions between the government’s need for the significant public revenue that the taxes raised and their impact on the public health.6 Similarly, 2 See generally M Plant and M Plant, Binge Britain. Alcohol and the National Response (Oxford University Press, 2006) 142–46; V Berridge, ‘Militants, Manufacturers and Governments: Postwar Smoking Policy in the United Kingdom’ in E A Feldman and R Bayer (eds), Unfiltered. Conflicts over Tobacco Policy and Public Health (Harvard University Press, Cambridge, Mass. 2004) 114–137 at 130–31. 3 NHS Information Centre, Statistics on Alcohol: England, 2009 (http://www.ic.nhs.uk/pubs/ alcohol09); National Audit Office, Reducing Alcohol Harm: Health Services in England for Alcohol Misuse (The Stationery Office, 2008). 4 British Medical Association Board of Science, Alcohol Misuse: Tackling the UK Epidemic (British Medical Association, 2008). 5 The Spirit Duties Act 1735 (9 Geo II c 23) imposed a duty of 20 shillings per gallon on spirits, in addition to a licence duty on the retailer; Retailers of Spirits Act 1737 (11 Geo II c 26). 6 The debate on the effects of taxing tobacco was particularly active in the 1970s, and it was clear that a wide cost-benefit analysis was necessary to address the breadth of factors involved in this field: J A Kay and M A King, The British Tax System (2nd edn, Oxford University Press, 1980) 136–37.

Book 1.indb 44

12/2/2011 8:21:33 AM

Public Health Imperatives and Taxation Policy

45

the eighteenth century gin tax failed because such a penal tax was found to encourage smuggling and illicit distillers and thereby not only reduced the yield to the Treasury, but equally made cheap spirits widely accessible to consumers and even increased their use.7 Once the tax was lowered, the level of alcohol consumption returned to its former level, though it did not reduce further. But while governments were aware that addressing public health issues through the tax system was an unpredictable policy which required some flexibility of official response, their approach to general taxation which was shown to have detrimental effects on the public health was strikingly intransigent. In the case of the taxation of spirits, the imposition of duty was the apparent solution to a public health problem and consequently financial and public health imperatives converged. It was clearly politically easier for governments to address a public health issue by imposing a tax, for that both yielded revenue and justified the tax. It was more problematic where it was the existence of the tax itself which caused damage to the public health, for that raised a clear conflict of political priorities. That was the novel context of the window tax in nineteenth century England. The consequences of the window tax were unanticipated and unintended by the legislature, but they were evident and particularly unfortunate. The tax affected the behaviour and, as a result, the living conditions and ultimately the health, of the urban poor. The window tax had been imposed for reasons that reflected orthodox taxation theories of the seventeenth and eighteenth centuries – to fulfil the function of revenue-raising, and to do so in a form that was easy to collect and relatively un-inquisitorial. It was a tax suited to a pre-industrial, pre-urban society which, when implemented in an industrial urban context, became the first tax in English fiscal history that was found to be directly and unambiguously injurious to the public health. This paper examines the interrelationship of a web of complex factors operating in the implementation and policy consideration of the window tax in the mid nineteenth century, a period when the formation of tax policy was obscure. These factors were fiscal, economic, political, ideological, administrative, legal, social, medical and scientific in nature. It assesses the relative weight accorded to each by the executive, and specifically addresses the potency of fiscal imperatives in the face of public health imperatives supported by powerful medical and social evidence. It examines the influence of various organizations and professional and interest groups in their attempts, through reason and argument, to influence the fiscal policy of successive governments, and the official response to them in the political context of tax reform. It also investigates the extent to which fiscal policy was integrated into other areas of government activity. Finally the paper assesses the place of the window tax in the formative period of modern fiscal thought, and whether its effects have proved lasting so as to create a model for later taxation policy. 7 Six years later the government admitted defeat and the duty was reduced: Spirits Act 1742 (16 Geo II c 8). See too Seventh Report of the Commissioners of Excise Inquiry (British Spirits), House of Commons Parliamentary Papers (1834) (7) xxv 1 at 104.

Book 1.indb 45

12/2/2011 8:21:33 AM

46

Chantal Stebbings THE NATURE AND PERCEPTION OF THE TAX

The window tax was a direct tax introduced in 1695 and imposed on every inhabited dwelling house, originally as a charge supplementary to a house tax and then as a distinct charge on the windows themselves.8 The windows were charged on an ascending scale, and the rates varied throughout the eighteenth century, reaching their highest in 1808.9 At that time a house with not more than six windows was charged 6s 6d, and houses with 180 windows were charged £93 2s 6d. Each window above 180 was charged a further three shillings.10 By 1833 the charge was 16s 6d for a house with eight windows, £14 18s 9d for one with forty windows, and £29 8s 6d for one with a hundred windows.11 In the 1820s the tax raised some £2 million per annum.12 The legislation provided for a number of exemptions. It did not apply to public offices, farmhouses, dairies, churches, factories, shop windows, warehouses and counting houses.13 After considerable lobbying, the Irish were granted exemption, primarily on the grounds of their inability to pay. 14 The most notable of the exemptions, however, was that for all houses with fewer than seven15 windows, an exemption that was intended to relieve the poorest in society from the liability to the tax. As a tax, the window duty was attractive to the revenue authorities: it was easy and cheap to collect; it did not interfere materially with trade and industry; and any evasion was relatively easily addressed because it was obvious. To the taxpaying public, however, it was detestable. All taxes were unpopular, but the window tax was the subject of the most intense and enduring popular invective. It was described as ‘obnoxious’,16 ‘odious’,17 ‘capricious and pestilential’,18 ‘too oppressive to be endured’,19 ‘the foulest blot that ever disgraced the fiscal code of 8 7 & 8 Will III c 18. For a general history of the window tax, see S Dowell, A History of Taxation and Taxes in England (Longmans, Green & Co, London, 1884) vol iii, 193–203. 9 The principal Act in force in the first half of the nineteenth century was the House Tax Act 1808 (48 Geo III c 55). For the changes in the rates of the window tax, see Dowell, History of Taxation and Taxes, vol iii, 194–99. 10 48 Geo III c 55, Schedule A, (1808). For scale of charges in the 1840s, see G Daniell, Report of the Committee of Delegates Deputed by the Metropolitan Parishes to Collect Information on the Subject of the Window Duties: with a View to their Repeal (WM Davy and Son, London, 1845) 6. 11 Parliamentary Debates, series 3, vol 17, cols 806–09, 30 April 1833, (House of Commons) per Mr Spring Rice. 12 Return of Number of Dwelling Houses in England and Wales assessed to Window Tax, House of Commons Parliamentary Papers (1824) (166) xvii 463. 13 57 Geo III c 25 (1817); 4 & 5 Will IV c 73 (1834). 14 Parliamentary Debates, series 3, vol 110, col 72, 9 April 1850 (House of Commons) per Viscount Duncan. 15 32 Geo III c 2 (1792); 6 Geo IV c 7 (1825). 16 M Humberstone, The Absurdity and Injustice of the Window Tax: Considered with Especial Reference to the New Survey (W S Orr & Co, London, 1841), 6. 17 Parliamentary Debates, series 3, vol 17, col 765, 30 April 1833 (House of Commons) per Sir John Key. 18 Humberstone, The Absurdity and Injustice of the Window Tax, 21. 19 Parliamentary Debates, series 3, vol 18, col 15, 21 May 1833 (House of Commons) per Samuel Whalley.

Book 1.indb 46

12/2/2011 8:21:34 AM

Public Health Imperatives and Taxation Policy

47

any civilized nation’.20 A contemporary commentator called it ‘monstrous’ and ‘cruel’21 and the Health of Towns Association, a cross party political pressure group,22 condemned it as ‘a tax more vicious in principle and more injurious in practical consequences than a tax upon food’.23 The reasons for this were several, and of varying significance. The window tax was perceived as undermining most of the orthodox canons of taxation. It was inherent in eighteenth century fiscal thought that the necessities of life should not be taxed, that taxes should be essentially voluntary, that they should be locally administered, should not be inquisitorial and should be related to an individual’s ability to pay. 24 The assessed taxes, of which the window tax formed one, were charged primarily on luxury items of consumption. These had traditionally been justified on the basis of choice. Taxpayers could freely elect whether to purchase those articles or services within the charge, and therefore whether to pay the tax. Such voluntaryism was a powerful canon, reflecting as it did the fundamental constitutional principle of consent to taxation and contributed significantly to the public perception of a tax as fair. Where the article subject to tax was a necessity, however, it was perceived as negating the concept of a voluntary tax. The window tax was emotively called a tax on light and air, elements that were prerequisites to cleanliness, health and comfort, and indeed life itself.25 Taxpayers thus had no choice as to their consumption, and so the window tax lacked the essential constitutional element of consent and was, effectively, compulsory. As such the tax was ‘wicked and cruel, yet it was imperative and irresistible’.26 Light and air were in this sense not regarded as appropriate or legitimate objects of taxation. The right to light was a legal right in that it was protected by the law of nuisance,27 and as the editorial of the Provincial Medical and Surgical Journal observed in 1842, it was difficult to reconcile this with the enforcement of the window tax.28 But it was not the legal provenance of the right to light that fuelled the unpopularity of the tax on windows, but rather its perception as a sacred right. Religious analogy and imagery pervaded the debates on the tax, with frequent references to the ‘impious’ taxation of ‘the light of heaven’.29 ‘The cheering and invigorating light 20

ibid. Daniell, Report of the Committee of Delegates, 5. 22 See R G Paterson, ‘The Health of Towns Association in Great Britain 1844–1849’ (1948) 22 Bulletin of the History of Medicine, 373–402. 23 Health of Towns Association, Report of the Committee to the Members of the Association on Lord Lincoln’s Sewerage, Drainage, etc of Towns Bill (Charles Knight & Co., London, 1846), 109. 24 A Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, (R H Campbell, A S Skinner, W B Todd (eds), 2 vols (Oxford, Clarendon Press, 1976), vol ii, Book V Ch 2, 825–28. 25 Humberstone, The Absurdity and Injustice of the Window Tax, 8. 26 ‘The Queen’s Speech, an Insult, Without a Repeal of the Window Tax’ The York Herald and General Advertiser, 16 Feb 1850. 27 See generally M Sokol, ‘Bentham and Blackstone on Incorporeal Hereditaments’ (1994) 15 Journal of Legal History 287–305. 28 Provincial Medical and Surgical Journal, 19 Nov 1842, 153–54. 29 Humberstone, The Absurdity and Injustice of the Window Tax, 6. See too Daniell, Report of the Committee of Delegates, 5. 21

Book 1.indb 47

12/2/2011 8:21:34 AM

48

Chantal Stebbings

of the sun, and the pure and refreshing breeze of the morning’ were both ‘the free gifts of that all-wise and bountiful Creator, who saw that they were necessary for the preservation of the health and comfort of his creatures’.30 These ‘sacred laws can never be interfered with, by any earthly potentate, without the commission of an outrage against the authority of Heaven, and of a cruel invasion of the common rights of humanity’.31 To tax ‘the light of heaven’ was regarded as ‘monstrous’,32 an offence against natural law,33 ‘sacrilege’,34 and the clergy were urged to speak out against it.35 In 1848, the leading opponent of the tax, Lord Duncan, concluded his argument for its total repeal with an appeal to spare the light and air that Divine Providence provided, and paraphrasing Alexander Pope’s Iliad of Homer: ‘Dispel this cloud, the light of Heaven restore; Grant us to see, and England asks no more.’36 Though only mildly inquisitorial by the standards of the new income tax of 1842, since it could often be assessed entirely from the outside without having to enter the taxpayer’s house, the fact that the tax was assessed by a government official who had statutory authority to pass through the house to count the rear windows, made it objectionable on those grounds. The ‘arbitrary inquisitorial visits of window-peepers…so repugnant to English feeling’37 was a common theme. Similarly the tax undermined the canon of equality. The scale of rates meant that it was particularly burdensome to the poorer and middle classes, and less so when it affected the houses of the wealthy. In 1845 a house with eight windows paid 2s 3d per window; a house with nineteen windows paid 6s, one with thirty-nine paid 7s 8d. However, that was the top rate, and thereafter it declined. A house with 150 windows paid 5s 9d per window, and one with five hundred windows paid 2s 7d for each one.38 The houses of the aristocracy were therefore relatively untouched.39 Contemporary commentators demonstrated that the houses of the poor paid a far higher proportion of the rental value of their property in window tax than the wealthy. An inhabitant of a poor area of London paid some 20 per cent of his rental in tax, while the Duke of Beaufort, for example, paid just over 2 per cent.40 The tax was also recognised as unrealistic: its traditional rationale, namely that the outward signs of wealth 30 ‘The Queen’s Speech, an Insult, Without a Repeal of the Window Tax’ The York Herald and General Advertiser, 16 Feb 1850. 31 ibid. 32 Humberstone, The Absurdity and Injustice of the Window Tax, 6. 33 Manchester Financial and Parliamentary Reform Association, Financial Reform Tract No 20 (Manchester, 1850), 7. 34 ‘The Window Tax’, Daily News, 13 Dec 1850. 35 ibid. 36 Parliamentary Debates, series 3, vol 96, col 1268, 24 Feb 1848 (House of Commons) per Viscount Duncan. 37 ‘House and Window Duties’, The Times 23 Jan 1833. See too Parliamentary Debates, series 3, vol 110, col 75, 9 April 1850 (House of Commons) per Viscount Duncan. 38 Daniell, Report of the Committee of Delegates, 6. 39 Humberstone, The Absurdity and Injustice of the Window Tax, 6–7. 40 Daniell, Report of the Committee of Delegates, 8.

Book 1.indb 48

12/2/2011 8:21:34 AM

Public Health Imperatives and Taxation Policy

49

were an accurate indicator of an individual’s financial situation, had been discredited by the early decades of the nineteenth century, and it was widely understood that the number of windows in a house was no longer an accurate measure of an occupant’s wealth or indeed a fair criterion of the house’s value.41 As Lord Duncan observed, ‘[t]hey might as well take the buttons on his coat as a criterion of the value of what was in his pocket’.42 So not only was the window tax unjust, it fell most severely on those least able to bear it. This comprehensive undermining of the basic orthodox principles of taxation engendered a fundamental distrust and dislike of the window tax. This was compounded by the way in which the tax was interpreted and administered. As an assessed tax rather than an excise duty, the window tax was a direct tax administered by local lay commissioners. It was, however, under the supervision and control of the central Board of Stamps and Taxes.43 The arguments of the board’s officers found in the reports of appeals against the window tax reveal their intransigence in adopting and implementing a strict interpretation of the legislation. The unyielding interpretation of the legislative provisions was supported by the judiciary. The legislation was comprehensive, did not define the term ‘window’ and prescribed no minimum size. As a result, of all the assessed taxes, the window tax was subject to the greatest number of appeals to the local commissioners and then by case stated to the judges of the regular courts.44 It was said in Parliament that between 1830 and 1847 there were 620 assessed tax appeals to the judges, and of these 268 related to the window tax.45 It used a considerable amount of judicial time. The legislation included a detailed enumeration of openings which would be chargeable. All skylights, and any window in a staircase, garret, cellar, passage, kitchen, scullery, buttery, pantry, larder, washhouse, laundry, bakehouse, brewhouse or lodging room, whether attached to the dwelling house or not, was chargeable.46 Furthermore, two windows fixed in one frame would be charged as two windows if the partition was over 12” wide, and where a window lit more than one room, each room would be charged for a window.47 Where an opening was not expressly mentioned in the Act, and in the absence of any definition of the term window, the judges, adhering to the strict and literal rule of statutory interpretation favoured by the judiciary in the eighteenth and nineteenth centuries, adopted the dictionary meaning of the word. This was to the effect that the term meant any opening in a building which admitted light and air. The judges’ approach was 41

Humberstone, The Absurdity and Injustice of the Window Tax, 8. Parliamentary Debates, series 3, vol 96, col 1259, 24 Feb 1848 (House of Commons) per Viscount Duncan. 43 For the administration of the window taxes, see generally W R Ward, ‘The Administration of the Window and Assessed Taxes 1696–1798’ (1952) 67 English Historical Review 522–42. 44 21 Geo II c 10 s 10 (1747). 45 Parliamentary Debates, series 3, vol 96, col 1287, 24 Feb 1848 (House of Commons) per Captain Pechell. 46 21 Geo II c 10 (1747). 47 48 Geo III c 55 Schedule A ss 10,11 (1808). 42

Book 1.indb 49

12/2/2011 8:21:34 AM

50

Chantal Stebbings

strict to an extent that was striking even by the standards of nineteenth century statutory interpretation in the tax sphere, and a taxpayer ‘might find that he was called upon to pay for more windows than he ever knew he possessed’.48 The judges construed the legislation so as to bring into charge virtually any opening in a wall, even the smallest chink, if it admitted as much as a glimmer of light. An opening in a cellar to let out noxious air or admit coal deliveries was charged to the tax as a window even though a candle was needed to see,49 as was an unglazed window in a laundry to let out steam,50 a grating in a larder to keep food cool, and perforated zinc plates to ventilate a pantry.51 And however small the opening, it was legitimately charged the same as a window 12’ by 4’9”.52 Furthermore, the judges’ strict application of the legislation rendered it difficult and expensive for a taxpayer legitimately to avoid the tax. If a window was blocked up, this had to be done with the same material as the fabric of the house, otherwise it was still liable to the charge. So a window in a stone and mortar house which was blocked with loose stones and pasted paper, or even with lath and plaster, was held assessable.53 Though the local commissioners were often sympathetic to attempts to block up windows, their decisions were frequently overturned by the judges of the regular courts on appeal. Another reason for the tax’s unpopularity lay in concerns about its impact on the new domestic architecture of the country.54 Elegant houses in many old cities were spoiled by the blocking up of windows to reduce the burden of the tax. One resident of Bath observed that it was ‘melancholy’ to see every second window of fine houses in that city blocked up ‘and the artist called upon to do the duty of the architect’,55 and Stephen Dowell observed that in Edinburgh, a whole row of houses had been built without a single window in the bedrooms of any of them.56 It was pithily remarked in a public meeting that in this country ‘we build by act of Parliament. The dimensions of our architectural taste are 48 Parliamentary Debates, series 3, vol 96, col 1262, 24 Feb 1848 (House of Commons) per Viscount Duncan. 49 See Case 1546, Hundred of Appletree, County of Derby (1841) Assessed Taxes Cases, The National Archives (TNA) IR 12/2; Case 1298, Town of Cambridge (1839) Assessed Taxes Cases, TNA IR 12/2; Case 1444, Cambridgeshire (1840) Assessed Taxes Cases, TNA IR 12/2; Case 1479, County of Middlesex (1841) Assessed Taxes Cases, TNA IR 12/2. 50 Case 1513, County of Merioneth, Division of Estimanor (1841) Assessed Taxes Cases, TNA IR 12/2. 51 Case 1894, Cornwall, Kirrier Hundred, Eastern Division (1844) Assessed Taxes Cases, TNA IR 12/2. 52 48 Geo III c 55 Schedule A s 12 (1808). 53 Case 509, County of Somerset, Division of Frome (1831) Assessed Taxes Cases, TNA IR 12/1; Case 1552, Division of Talybont and Ardwyis, County of Merioneth (1841) Assessed Taxes Cases, TNA IR 12/2. 54 One commentator argued that the tax ‘interferes with architectural beauty’: W R Smee, The Income Tax, 2nd edn (Pelham Richardson, London, 1846) 14. See too The Times, 17 Jan 1850. 55 ‘Repeal of the Window Tax’ Daily News, 18 Jan 1848. The reference was to the practice of painting blocked out windows so as to make them appear to be real windows. They were known as ‘Pitt’s Paintings’, as Pitt’s increase in the rate of the window tax at the end of the eighteenth century had first given rise to the practice. 56 Dowell, History of Taxation and Taxes, vol iii, 203.

Book 1.indb 50

12/2/2011 8:21:34 AM

Public Health Imperatives and Taxation Policy

51

four feet nine’.57 Visitors to England remarked on the small back to back houses which stretched for miles around the major cities, deliberately constructed as individual houses with the minimum number of windows.58 Certainly the difference in building styles on the continent, where houses possessed a strikingly larger number of windows, was noticed by English visitors to France and Holland. In 1845 The Times was particularly critical: if it were desired to build a long transparent suite of rooms as was found in France, or a series of narrow windows in the Italian style, or again a series of small windows to light a gallery, ‘the tax gatherer forbids’. 59 The lancet windows and turret lights which were an integral feature of Gothic architecture were no longer affordable, and whereas it used to be that entrance halls were lit with two narrow windows on either side of the door, they were now lit from the landing window. Bay windows were no longer generally affordable, and were replaced by single large windows. ‘Taste and ingenuity [were] crippled in every direction’.60 Every building ‘bears the impress of the tax’.61 It bore it ‘on its front and on its back; from its cellars to its very roof; from its reception-rooms to its smallest offices, – from its general plan to its most casual appendages’.62 ‘[W]e have gone on for fifty years, said The Times, enduring the most slaving, annoying, and inconvenient limitations on our personal comfort and our architectural taste’.63 One specific event in 1840 compounded the intense dislike with which the window tax was regarded. In 1834 an Act was passed amending the law as to contracts of composition in relation to the assessed taxes. Lord Althorp, the Chancellor of the Exchequer, included a provision to the effect that occupiers could open as many new windows as they wished without incurring any extra duty.64 While in committee, it was suggested that this should apply to occupiers who had been ‘duly assessed’ to the tax in 1835. When in 1840 the government was in financial difficulties, the assessed taxes were increased and a re-assessment ordered. Despite the Board of Stamps and Taxes instructing its surveyors not to make any additional charges on parties who had increased the number of windows under Lord Althorp’s Act,65 it interpreted the words ‘duly assessed’ harshly so that the great majority of individuals were found not to have been duly assessed, and so were liable to pay the tax on the windows they had subsequently opened.66 Taxpayers were held liable even where a mistake 57

‘Repeal of the Window Tax’, Lloyd’s Weekly Newspaper, 16 Feb 1851 per Sir B Hall MP. ‘The Window Tax’, Daily News, 13 Dec 1850. 59 The Times, 20 March 1845. 60 ibid. 61 Editorial, The Times, 29 April 1850. 62 ibid. 63 ibid, Jan 17, 1851. 64 4 & 5 Will IV c 54 s 7 (1834). 65 Copy of Instructions issued by the Board of Stamps and Taxes to their Surveyors on the subject of a Survey of Windows, House of Commons Parliamentary Papers 1840 (71) xxviii 647 at 648. 66 First Report of the Royal Commission for Inquiring into the State of Large Towns and Populous Districts, House of Commons Parliamentary Papers (1844) (572) xvii 1 qq 6172–73 per 58

Book 1.indb 51

12/2/2011 8:21:34 AM

52

Chantal Stebbings

had been made in the assessment of 1835 by the tax authorities themselves, where the surveyor had entered a taxpayer’s name wrongly in the assessment book,67 and again where a taxpayer had reopened some windows which she had blocked off with the wrong materials, and as she could not have been duly assessed for windows illegally blocked, she was held liable to pay the tax on the reopened windows.68 The reassessment brought over 50,000 extra houses into charge, paying an additional tax of nearly £300,000.69 It was condemned as oppressive,70 a ‘violation of public faith’71 and of Lord Althorp’s Act,72 a ‘trap’ by the government.73 The Health of Towns Association implied that the judges were not entirely impartial in their interpretation of the Act,74 reducing it to ‘a mockery and a snare’ rather than the relief it was intended.75 Indeed the Association maintained that the clear intention of Lord Althorp’s Act had been ‘deliberately evaded for the sake of revenue’.76 This widespread discontent was expressed in a large number of pamphlets, tracts77 and semi-official reports, 78 and the tax authorities were criticised for an ‘asperity and rigour’ which went beyond the intention of the legislature.79 These factors alone – the undermining of the accepted principles of taxation, the effect on the country’s architecture and the final insult and injury of the reassessment of 1840 – sufficed to render the window tax one of the most unpopular taxes of the early nineteenth century. Dowell observed that its unpopularity ‘exceeded the average’.80 But the resentment resulting from these factors was essentially personal in nature, an antipathy that existed to varying degrees in relation to all taxes. It was an objection motivated by a resentment of a personal liability to tax rather than by any altruistic motive. The widespread and intense objection to the window tax possessed a dimension which was not WE Hickson. See the account in Health of Towns Association, Report of the Committee on Lord Lincoln’s Bill, 115–16; Anon, The Case to the Window Duties (Samuel Clarke, London, 1844) 12. 67

Case 1481, County of Lancaster, Borough of Wigan (1841), Assessed Taxes Cases, TNA IR

12/2. 68 Case 1485, County of Surrey, Hundred of Wotton (1841), Assessed Taxes Cases, TNA IR 12/2; Case 1490, County of Middlesex, Tower Division (1841), Assessed Taxes Cases, TNA IR 12/2. 69 Parliamentary Debates, series 3, vol 96, col 1258, 24 Feb 1848 (House of Commons) per Viscount Duncan. 70 ibid, series 3, vol 110, col 75, 9 April 1850 (House of Commons) per Viscount Duncan. 71 ibid. 72 ibid, series 3, vol 96, col 1257, 24 Feb 1848 (House of Commons) per Viscount Duncan. See too Daniell, Report of the Committee of Delegates, 14. 73 First Report of the Royal Commission for Inquiring into the State of Large Towns and Populous Districts, House of Commons Parliamentary Papers (1844) (572) xvii 1 q. 6173 per W.E. Hickson. 74 Health of Towns Association, Report of the Committee on Lord Lincoln’s Bill, 115. 75 ibid, 116. 76 ibid, 115. 77 For example, Humberstone, The Absurdity and Injustice of the Window Tax; Anon., Case to the Window Duties. 78 See for example the Daniell, Report of the Committee of Delegates, 14–15. 79 Humberstone, The Absurdity and Injustice of the Window Tax, iii. 80 Dowell, History of Taxation and Taxes, vol iii, 200.

Book 1.indb 52

12/2/2011 8:21:34 AM

Public Health Imperatives and Taxation Policy

53

present in the extensive antipathy to taxation in the nineteenth century and which transcended the general objection to paying taxes and any theoretical inequality in their incidence. That was its very direct and visible impact on the public health, a feature that brought the tax out of the purely fiscal sphere of revenue-raising and into that of social welfare and humanitarian concern. The tax was understood materially to contribute to the appalling living conditions endured by the urban poor.

THE EFFECT OF THE TAX ON THE LIVING CONDITIONS OF THE URBAN POOR

In the context of a considerable increase in the population and the concentration of industry in the towns and cities, the urban poor formed a new and rapidly growing class in the first half of the nineteenth century. Landowners, architects and builders were united in wanting to secure the highest financial return on their properties,81 the outcome of which was the proliferation of cramped and cheaply erected accommodation for the urban poor, built on every available block of ground in the towns and cities. This slum housing was crowded and insanitary, and was prone to devastating epidemics of typhus, smallpox and cholera. Mortality rates were shockingly high, and life expectancy shockingly low.82 In 1838 some 20% of deaths from specified causes83 in England and Wales were caused by epidemic, endemic and contagious diseases, including fever, typhus, and scarlatina. This amounted to some 56,000, the equivalent of the entire population of Westmoreland or Huntingdonshire.84 The numbers of deaths did not reflect the number who had become ill, for while 16,000 died from types of typhus in 1838, some 80,000 had suffered from the illness.85 This state of affairs was first exposed by the reports of the Poor Law Commissioners in the 1830s. The devastating cholera epidemic of 1832 caused an immediate concern with the sanitary conditions in the country.86 A number of local investigations were commissioned, and these ultimately resulted in Edwin Chadwick’s 81 One builder in Birkenhead erecting houses which incorporated sanitary improvements made a return of some 4.5% as opposed to a return of 10% on unsanitary back to back houses with fewer than eight windows: D D Jones, ‘Edwin Chadwick and the Early Public Health Movement in England’ (1931) 9 University of Iowa Studies in the Social Sciences, 1–160, 38–9. 82 The average age of those dying in South Shields in 1843 was reported as just over 26 years: Second Report from Commissioners Inquiring into the State of Large Towns and Populous Districts, House of Commons Parliamentary Papers (1845) (602) xviii 1 at p. 538. See generally R Woods and J Woodward (eds) Urban Disease and Mortality in Nineteenth-Century England (BT Batsford, London, 1984). 83 Excluding deaths from violence or old age. 84 Report of the Commissioners on the Sanatory Condition of the Labouring Population of England, House of Commons Parliamentary Papers (1842) (006) xxvi 1 at 35. 85 ibid, 36. See too Repeal of the Window Tax’, The York Herald and General Advertiser, 25 Jan 1851 per Dr Adolphus Barnett. 86 H Jephson, The Sanitary Evolution of London (T Fisher Unwin, London, 1907) 2–6.

Book 1.indb 53

12/2/2011 8:21:35 AM

54

Chantal Stebbings

landmark report on the Sanitary Condition of the Labouring Population in 1842.87 Subsequent investigations in the mid 1840s into the health of towns revealed the appalling sanitary conditions in which the working poor lived in districts such as Whitechapel, Holborn and Lambeth in London and in the other industrial cities, notably Liverpool, Preston, Nottingham, Leicester, York and Huddersfield. 88 It was a national disgrace. An inadequate supply of fresh clean water, filthy unpaved streets, no drainage or sewerage and, inside the dwellings themselves, unspeakable dirt was commonplace. There was chronic and severe overcrowding with large families of seven or more often living in one or two small rooms, in which they slept, cooked, washed, ate and sometimes worked.89 In 1847 the Statistical Society of London conducted an investigation into the housing of the inhabitants of a particular street in St Giles, a notoriously poor area of the capital. The one hundred families in the street lived in the thirty houses, with an average of five to a bed, and many rooms were inhabited by as many as twenty-two individuals, without water, drainage or privies. It was a picture of ‘human wretchedness, filth, and brutal degradation’.90 Adults and children of both sexes, the healthy, the sick, the dying and the dead existed together in intolerably cramped and insanitary conditions. It was on the conditions within the homes of the poor that the window tax had a severe impact. The exemption for cottages with seven or fewer windows was intended to exempt windows necessary for life, and to relieve the poor from liability to the tax. It was assumed that only the poor inhabited dwellings with the minimum number of windows, and so relief from the tax would be appropriately directed where it was most needed. While this exemption was effective in the homes of the rural poor, who generally lived in distinct cottages with fewer than seven windows and who anyway benefited in this respect from natural ventilation through poor construction, the exemption was ineffective in relation to the urban poor. In towns and cities, with constraints of space and money, the poor rarely lived in individual houses, but increasingly in large tenement blocks, many of which were originally the large houses of the wealthy converted into a number of ‘nests of paupers’.91 The occupiers of 87 Report of the Commissioners on the Sanatory Condition of the Labouring Population of England, House of Commons Parliamentary Papers (1842) (006) xxvi 1. 88 See First Report of the Commissioners Inquiring into the State of Large Towns and Populous Districts, House of Commons Parliamentary Papers (1844) (572) xvii 1; Reports from Commissioners Inquiring into the State of Large Towns and Populous Districts, House of Commons Parliamentary Papers (1845) (602) (610) xviii 1, 299. 89 First Report of the Royal Commission for Inquiring into the State of Large Towns and Populous Districts, House of Commons Parliamentary Papers (1844) (572) xvii 1, q 1498 per Hugh Biers, builder. 90 WH Sykes, ‘Statistical Account of the Labouring Population Inhabiting the Buildings of St Pancras, erected by the Metropolitan Society for Improving the Dwellings of the Poor’, (1850) 14 Journal of the Statistical Society of London, 46–61 at 57. See Report of the Commissioners on the Sanatory Condition of the Labouring Population of England, House of Commons Parliamentary Papers (1842) (006) xxvi 1, 153–59. See too C Cochrane, How to Improve the Homes of the People: Address (WS Johnson, London, 1849). 91 The Times, 20 March 1845.

Book 1.indb 54

12/2/2011 8:21:35 AM

Public Health Imperatives and Taxation Policy

55

apartments in tenements were unable to take advantage of a legislative provision allowing apartments in certain establishments, notably in the Inns of Court, the universities and public hospitals, to be charged as separate dwelling houses and thereby attracting a lower rate of tax if they each had fewer than seven windows.92 And so, although each apartment in the tenement would have four or so windows, it bore the full tax of the whole building. So while three sets of chambers in the universities and inns of court, each with seven windows, were not chargeable at all, a house inhabited by three families where each apartment had seven windows would bear a considerably heavier charge, for each family would be charged for twenty-one windows.93 Whether they paid directly as occupiers or through an increased rent to the landlord,94 the tax constituted a heavy financial burden on poor families. As a result, the evasion of the window tax by blocking up windows had been a common practice since the tax’s inception. Initially occupiers blocked up some windows before the surveyor’s visit, and then opened them once he had made his survey, though this practice was eventually prohibited under penalty, with a requirement that notice of any re-opening had to be given to the surveyor. The practice thereafter was towards the permanent blocking up of windows. Whereas the wealthy were able to avoid the tax by building new houses with few windows of the largest permissible size, namely 12’ by 4’9”, the poor had no option but to adopt the practice of blocking up as many windows as they could. One builder observed that he had been employed in nearly every house in Compton Street, Soho, in order to reduce the number of windows95 and when a committee of the Metropolitan parishes inquired into the window tax in 1845, it found that thousands of windows had been blocked up in the large houses converted into sets of dwellings for the poor.96 The situation was repeated in many provincial towns and cities.97 As a result of these practices, and the narrowing of streets to mere alleys and courtyards caused by building over every available space, both external and internal ventilation was reduced to a minimum. The Health of Towns Commissioners investigating the living conditions in a number of towns and 92 The charge was 3s 6d for every window, as long as the apartment did not contain more than seven windows: 48 Geo III c 55, Schedule A, s 8 (1808). 93 Case 2126, County of Chester (1849) Assessed Taxes Cases, TNA IR 12/3. However some purpose built lodging houses were successfully assessed as separate dwellings: see Case 2207, Middlesex Division of St Giles in the Fields and St George Bloomsbury (1851) Assessed Taxes Cases, TNA IR 12/3. 94 The tax was legally a burden on the occupier, not the proprietor, though a landlord might bargain with a tenant to relieve him of the window tax if the tenant paid an increased rent: Report from the Select Committee on Burdens Affecting Real Property, House of Commons Parliamentary Papers (1846) (411) vi 1 qq 4303–06 per RH Grey. 95 Parliamentary Debates, series 3, vol 96, cols 1255–56, 24 Feb 1848 (House of Commons) per Viscount Duncan. 96 Daniell, Report of the Committee of Delegates, 11. 97 As in Newcastle upon Tyne: Report of the Commissioners on the Sanatory Condition of the Labouring Population of England, House of Commons Parliamentary Papers (1842) (007) xxvii 1, 438–41.

Book 1.indb 55

12/2/2011 8:21:35 AM

56

Chantal Stebbings

cities paid particular attention to what they believed was the neglected issue of ventilation, 98 and exposed the problem starkly. The closed courts of Liverpool and the back to back houses of Birmingham were notable in this respect.99 The blocking up of every possible window resulted in dwellings becoming almost unbearably malodorous and polluted.100 This was compounded by the common and natural habit of sealing every opening or crevice, and curtaining beds, to keep out the cold and the smoke pollution of the streets. Workers who operated machinery in a warm and damp atmosphere all day were particularly susceptible to cold when they returned to their homes.101 The air in living rooms became hot, damp and stagnant, a state contemporaries called ‘vitiated’.102 Moisture, heat and pollution came from the breath and bodies of the crowded inhabitants, the damp from washing and cooking, and heat from the burning of fires, lamps or candles. At night the problem was exacerbated, for when the house was entirely closed up, and fires lit in every room, the chimney shaft which provided the sole source of ventilation would draw the air from the house, resulting in the rooms being fed with the air of the basement and the other occupied rooms. Since the window tax was imposed on the smallest opening, including air holes and gratings, unoccupied rooms such as cellars and larders became damp and riddled with mould. Not only did the window tax result in inadequate ventilation in existing dwellings, it also seriously undermined the construction of new healthy houses for the urban poor, and this was the tax’s ‘one great and fatal fault’.103 As The Times observed in 1850, ‘in relation to the window tax there exists a sort of race of ingenuity between the architect who aims to conceal and the official who rejoices to detect’.104 The tax was said to operate as ‘a premium upon defective construction’,105 for commercial imperatives led builders and architects to construct new houses with as few windows as possible and accordingly ventilation openings, such as those under steps and in larders, privies, closets and outbuildings were greatly reduced in number.106 Lodging houses had been identified by the Poor Law Commissioners’ investigations as particularly appalling, in part because the standards of 98 Second Report from Commissioners Inquiring into the State of Large Towns and Populous Districts, House of Commons Parliamentary Papers (1845) (602) xviii 1, 69–71. 99 Report from the Select Committee on the Health of Towns, House of Commons Parliamentary Papers (1840) (384) xi 277 q 2382 per W H Duncan and q 2972 per Joseph Hodgson, medical practitioners. 100 See for example Second Annual Report of the Poor Law Commissioners for England and Wales, House of Commons Parliamentary Papers (1836) (595) xxi 1, 447 per Neil Arnott MD. 101 Report from the Select Committee on the Health of Towns, House of Commons Parliamentary Papers (1840) (384) xi 277 qq 1160–67 per JC Symons. 102 Health of Towns Association, Report of the Committee on Lord Lincoln’s Bill, 74–5. 103 ‘The Window Tax or a House Duty?’, The Bradford Observer, 18 April 1850. 104 The Times, 17 May 1850. 105 First Report of the Commissioners Inquiring into the State of Large Towns and Populous Districts, House of Commons Parliamentary Papers (1844) (572) xvii 1, q 6172 per WE Hickson. 106 This was the case even in wealthier homes: ibid, q 1501 per Hugh Biers, builder.

Book 1.indb 56

12/2/2011 8:21:35 AM

Public Health Imperatives and Taxation Policy

57

building were so low and they were constructed with the minimum number of windows.107 However, reformers pressing for the building of experimental model lodging houses for the working poor, with improved ventilation and ample light, 108 were utterly undermined by the window tax.109 Any economies of scale to provide better facilities and greater comfort were effectively prohibited by the tax because the denial of any exemption to inhabitants of such apartments meant the tax burden on them would be prohibitive. 110 The ‘nests of lodgings’ on the model of colleges and offices, which were so common in the rest of Europe, were precluded by the window tax legislation,111 and instead each family was forced to have its own small and separate dwelling house. Not only did this mark the physical landscape of the country, it reinforced a residential habit which is still evident in Britain today. In the absence of dedicated apartment blocks in nineteenth century cities, families who could not afford their own separate house were forced into communal living in converted old mansions, often themselves abandoned due to the pressure of the window tax. As these old houses were liable to high taxation, the inhabitants blocked up every possible window, and the cycle of insanitary living conditions remained unbroken.

MEDICAL SCIENCE

Contemporary social observers directly linked the degradation caused by living in darkness, poverty and filth to moral degeneration. Light and fresh air led to cleanliness, cleanliness to education, and education to morality.112 Inadequate ventilation was believed to induce nervous depression and lethargy, which in turn drove the otherwise healthy to alcoholic drink. That in turn gave rise to intemperance, and ultimately to violence, crime and vice. Poor ventilation was thus regarded as a cause of many of society’s ills.113 With equal certainty they made the connection between the living conditions of the urban poor and the fevers and epidemics which were common in the first half of the nineteenth century. It had been observed that bad ventilation had caused fever and deaths in crowded and insanitary ships, hospitals and prisons,114 and when Britain experienced devastating cholera epidemics in 1831–32, and again in 1848–49, statistics showed that the mortality rates were significantly higher 107

See too ‘Abolition of the Window Tax’, The Bristol Mercury, 8 Feb 1851. Sykes, ‘Statistical Account of the Labouring Population’, 46–52. 109 For example, the Metropolitan Association for Establishing Model Lodgings and the Society for the Improvement of the Conditions of the Labouring Classes. 110 Sykes, ‘Statistical Account of the Labouring Population’, 52. 111 The Times, 9 April 1851. 112 Manchester Financial and Parliamentary Reform Association, ‘Financial Reform Tract No. 20’ (Manchester, 1850) 7. 113 Daniell, Report of the Committee of Delegates, 5. 114 Second Annual Report of the Poor Law Commissioners for England and Wales, House of Commons Parliamentary Papers (1836) (595) xxi 1, 447 per Neil Arnott MD. 108

Book 1.indb 57

12/2/2011 8:21:35 AM

58

Chantal Stebbings

in poor crowded urban areas than in areas where the population was not so dense.115 From their experience in the field, physicians affirmed that insanitary conditions and disease were intimately connected.116 They observed that it was the inhabitants of unventilated houses, particularly women and children, who suffered most from typhus, typhoid, malaria, smallpox, whooping cough and scarlet fever, and from other conditions such as tuberculosis, stunted growth and nervous depression. Although the observation that the incidence of disease was greater among the poor did not establish any causal link between unhealthy living conditions and disease, by the end of the 1840s, expert and informed medical opinion was unanimous that the window tax was a major cause of inadequately ventilated and lit houses and that this was seriously injurious to the health of the urban poor. 117 Medical science in this period supported the view that a deprivation of fresh air and light was injurious to health. It had been observed in the late eighteenth century that just as plants deprived of light became pallid, so individuals confined in prison and deprived of light were pale and sickly, as were inhabitants of houses darkened through the closing up of windows and servants housed in ill-lit attics. Light, it was said, ‘was one of the most exhilarating cordials in nature’ and was necessary for the maintenance of good health.118 Therefore the concerns in the early nineteenth century as to light deprivation were directed towards the stunting of physical development,119 the connection between darkness and dirt,120 and the very real problem of accidents in dark passages, stairways and cellars. However it was with respect to the deprivation of fresh air that medical concerns were most keenly expressed. The amount of air necessary for optimum respiration had been scientifically established,121 and medical practitioners had no doubt at all that poor ventilation prevented the effective treatment of disease. The recognition that ventilation was essential to the control of fever122 and contagion in hospitals had been expressed from the eighteenth century,123 and medical practitioners with particular expertise in fevers in the middle decades 115

Sykes, ‘Statistical Account of the Labouring Population’, 60. See B Keith-Lucas, ‘Some Influences Affecting the Development of Sanitary Legislation in England’, (1954) 6 The Economic History Review NS, 290–96. 117 See the evidence in Second Report from Commissioners Inquiring into the State of Large Towns and Populous Districts, House of Commons Parliamentary Papers (1845) (602) xviii 1, 533, 555 per DB Reid MD; ibid, 663 per J R Martin. 118 RJ Thornton, The Philosophy of Medicine, vol iii, 4th edn (London, 1800) 73. 119 Anon., Case to the Window Duties; ‘The Window Tax’, The Huddersfield Chronicle and West Yorkshire Advertiser, 13 April 1850. 120 Manchester Financial and Parliamentary Reform Association, ‘Financial Reform Tract No. 20’ (Manchester, 1850), 7. 121 Health of Towns Association, Report of the Committee on Lord Lincoln’s Bill, 72–73. 122 In the early nineteenth century ‘fever’ included a number of different conditions, including typhus and typhoid. 123 JV Pickstone and SVF Butler, ‘The Politics of Medicine in Manchester, 1788–1792: Hospital Reform and Public Health Services in the Early Industrial City, (1984) 28 Medical History, 227–49, 230. 116

Book 1.indb 58

12/2/2011 8:21:35 AM

Public Health Imperatives and Taxation Policy

59

of the nineteenth century were convinced that a constant supply of fresh air to the patient was crucial to the effective treatment of fevers. It was observed that patients suffering from typhus began to recover when they were removed from the ‘foul atmosphere’ of their own houses, because the fever was caused by a condition of the blood produced by continued breathing of a contaminated or poisoned atmosphere, which fresh cool air in the sick room could eliminate.124 But orthodox medical thinking, epitomised by Dr Thomas Southwood Smith in his Treatise on Fever, attributed much more than just therapeutic damage to poor ventilation.125 It asserted that it predisposed individuals to certain diseases, and actually caused and aggravated others. It maintained that there were various forms of epidemic, endemic and other diseases caused, aggravated, or propagated chiefly amongst the poor by atmospheric impurities or ‘miasma’.126 This was produced by decomposing animal and vegetable substances, by damp and filth. It was present in close and overcrowded dwellings, for where whole families lived in one room with closed up windows, the breathing in and out of a limited air supply caused the air to become putrid. In particular, the ‘mephitic vapours’ would collect in unventilated passages, closets, cellars, roofs, staircases and privies.127 The inhalation of this miasma both caused disease and was responsible for spreading infection. ‘Life or death’, it was believed, ‘may be inhaled by the lungs, according to the properties of the gases present in the atmosphere, or the minute morbid particles held in suspension at the time of inspiration’.128 ‘[E]very breath’, it was said, ‘carries with it the seeds of disease’.129 Scrofulous diseases130 were caused directly by a lack of pure air, and accordingly it was the inhabitants of unventilated dwellings who suffered most.131 Joseph Toynbee, a London surgeon who had investigated the causes of the disease among his patients, was convinced that the main cause was the repeated respiration of the same air in closed and crowded rooms. Although scrofulous diseases were not fatal, they were of long duration and as such were 124 Dr Herbert Barker, ‘The Treatment of Fevers: with Special Reference to Ventilation’ Association Medical Journal, 8 Nov 1856, 955–57, 957. 125 Thomas Southwood Smith, A Treatise on Fever (Longman, Rees, Orme, Brown and Green, London, 1830) 348–49. 126 From the Greek, meaning to contaminate or pollute. It was another name for aerial poison: George Gwynne Bird MD, Observations on Civic Malaria and the Health of Towns (William Wood, London, 1848) 6; Health of Towns Association, Report of the Committee on Lord Lincoln’s Bill, 73. See generally C Hamlin, Public Health and Social Justice in the Age of Chadwick (Cambridge University Press, 1998) 110–20; WM Frazer, A History of English Public Health 1834–1939 (Baillière, Tindall and Cox, London, 1950) 69–70. 127 First Report of the Commissioners Inquiring into the State of Large Towns and Populous Districts, House of Commons Parliamentary Papers (1844) (572) xvii 1, q 6172 per WE Hickson; Jephson, Sanitary Evolution of London, 26. 128 Anon., Case to the Window Duties, 6. 129 ibid, 7. 130 Scrofula was the contemporary term for a number of skin diseases, notably tuberculosis of the lymph glands in the neck and affecting children in particular. It was found to be spread by bacterium in unpasteurised milk from infected cows. 131 ‘Deputation to the Chancellor of the Exchequer on the Window Tax’, Daily News, 30 May 1850 per Hector Gavin MD.

Book 1.indb 59

12/2/2011 8:21:35 AM

60

Chantal Stebbings

among the greatest of the ‘pauperising diseases’.132 It was also believed that tuberculosis, smallpox, whooping cough and malaria were spread through the air in the same way.133 Dr Neil Arnott MD, reporting on the Metropolitan houses for the reception of pauper children in 1836, observed that it was now known that factory workers became ill and scrofulous as a result of working in conditions where ventilation had deliberately been reduced for warmth and for the manufacturing process. The workers were constantly breathing noxious air, and only when fans were introduced into factories did their health improve.134 In the case of severe accidents, infected air was believed to cause erysipelas, an acute bacterial infection of the skin, and fever.135 Medical practitioners in the mid nineteenth century observed and reported cases of illness they believed were caused by miasma. One physician in 1844 reported several cases of illness in one household, brought on by the miasma created from decomposing vegetable matter near the house, and attributed several miscarriages to the same cause.136 This miasmatic theory prevailed for the first half of the nineteenth century and underpinned the campaign for the repeal of the window tax. It was the official doctrine, and was upheld by Sir John Simon,137 Thomas Southwood Smith,138 and other leading public health reformers including Edwin Chadwick himself in his seminal report of 1842,139 by the General Board of Health and the Privy Council.140 Although it was vague and undefined, it was thought completely and satisfactorily to explain infectious disease,141 and it was difficult to disprove. By the middle of the century, however, some observers believed that a further agent was present in the cause and spread of infectious disease, and ultimately scientific advancement developed the theory of specific contagia and the science of bacteriology was born.142 By the 1850s, a combination of statistical inquiry 132 ibid. See Toynbee’s evidence in First Report of the Royal Commission for Inquiring into the State of Large Towns and Populous Districts, House of Commons Parliamentary Papers 1844 (572) xvii 1, q 5526. 133 Fourth Annual Report of the Poor Law Commissioners for England and Wales, House of Commons Parliamentary Papers (1837–8) (147) xxviii 145, 216 per Neil Arnott MD and James Kay MD. 134 Second Annual Report of the Poor Law Commissioners for England and Wales, House of Commons Parliamentary Papers (1836) (595) xxi 1, 445. 135 The Evil Effects of the Window Tax’, 57 The Lancet, 312–3 (15 March 1851). 136 J C Smart MD, ‘Effects of Miasma’ 8 Provincial Medical and Surgical Journal 559–60, (December 1844). 137 See John Simon, Report on the Sanitary Condition of the City of London for the year 1848–9 (Brewster & West, printers, London, 1849). 138 Southwood Smith, Treatise on Fever, 348–49. 139 Report of the Commissioners on the Sanatory Condition of the Labouring Population of England, House of Commons Parliamentary Papers (1842) (006) xxvi 1, 427. 140 See generally Frazer, History of English Public Health, 38–39. 141 Although some medical practitioners were aware that little was known as to the precise scientific nature of miasma, as no difference had been observed between the air of infected districts and that of areas where the disease was absent: George Gwynne Bird MD, Observations on Civic Malaria and the Health of Towns (William Wood, London, 1848), 6. 142 See L N Mager, A History of Infectious Diseases and the Microbial World (Praeger, Westport, Connecticut USA, 2009) pp 19–47; Frazer, History of English Public Health, 69–70. See generally

Book 1.indb 60

12/2/2011 8:21:35 AM

Public Health Imperatives and Taxation Policy

61

and the medical observations of Dr John Snow confirmed that cholera was spread by infected water.143 This advance in the aetiology of cholera was the developing contagion theory which evolved into the germ theory later in the century, and it proved a mortal challenge to the miasmatic theory of the origin of infectious disease.144 However the latter dominated scientific and official thinking for the first half of the nineteenth century and, significantly, during the agitation against the window tax on public health grounds. 145

THE MOVEMENT FOR REFORM OF THE WINDOW TAX

The combined effect of extensive social investigations and informed medical opinion resulted in the window tax being regarded as one of the greatest sanitary and social evils of the 1830s and 1840s and as such gave rise to an intensive movement for reform lasting some twenty years. Ancient and progressive, the tax was insidious in its effects and had become a ‘chronic evil’.146 Agitation for the abolition of this ‘typhus-fostering impost’147 was led by medical practitioners, supported by humanitarians and the more enlightened sectors of the building industry, 148 and promoted by politicians in Parliament. Justified in their opposition by the miasmatic theory of airborne epidemic disease, medical practitioners promoted the necessity for good ventilation in dwelling houses and called for an immediate repeal of the window tax. The medical press unambiguously called the window tax a ‘tax on health’ and maintained that it was materially responsible for the frequent lack of natural light and ventilation which reduced the quality and length of life.149 Dr Southwood Smith said ‘Give me light and air, and I will eradicate typhus’150 and Thomas Wakley, a Radical reformer, medical journalist and founder of The Lancet, strongly promoted the medical campaign for the repeal of the tax in his publication.151 M Worboys, Spreading Germs. Disease Theories and Medical Practice in Britain 1865–1900 (Cambridge University Press, 2000). 143

See Frazer, History of English Public Health, 63–67. T Maclagan, The Germ Theory applied to the Explanation of the Phenomenon of Disease (Macmillan & Co., London, 1876) 1–37. 145 Despite the scientific knowledge of the sanitary reformers of the early nineteenth century beings flawed, their solutions to the problems of disease and public health were correct: see generally Frazer, History of English Public Health, 40. 146 Parliamentary Debates, series 3, vol 17, col 766, 30 April 1833 (House of Commons) per Sir John Key. 147 ‘The Window Tax’, The Leicester Chronicle, 18 Jan 1851. 148 First Report of the Commissioners Inquiring into the State of Large Towns and Populous Districts, House of Commons Parliamentary Papers (1844) (572) xvii 1, q 1502 per Hugh Biers, builder; Report from the Select Committee on the Health of Towns, House of Commons Parliamentary Papers (1840) (384) xi 277, qq 2640–41 per George Smith, architect. 149 45 The Lancet, 196–7, 197 (15 Feb 1845). 150 Reported in ‘Repeal of the Window Tax’, Daily News, 17 Jan 1851. 151 See for example ‘The Evil Effects of the Window Tax’, 57 The Lancet, 312–3 (15 March 1851). See too Parliamentary Debates, series 3, vol 96, col 1279, 24 Feb 1848 (House of Commons) per Thomas Wakley. 144

Book 1.indb 61

12/2/2011 8:21:36 AM

62

Chantal Stebbings

The first successful campaign against the window tax on the grounds of public health had been promoted by the Irish. As early as 1818 the inhabitants of Kilkenny petitioned the House of Commons for relief from their tax burden, and argued that the window tax rendered their houses ‘damp and unwholesome’ and that the ‘pestilential disease’ which had struck the city had been greatly aggravated, if not caused, by the absence of free ventilation.152 In 1819 the inhabitants of Dublin begged for relief on the same grounds,153 and in the same year the inhabitants of Limerick implored the House of Commons for the total abolition of the tax to which ‘they must in a great measure attribute the continued and destructive pestilence which had crowded their hospitals and wasted their population’.154 In these extreme cases the tax authorities responded, ordering that windows which had been closed up could be opened ‘on proof adduced of the Contagious Fever prevailing in such House’.155 In England, however, the movement for the abolition of the window tax was at its height in the 1830s and 1840s.156 At first the repeal of the tax was demanded entirely on the grounds of its inherent unfairness, its unequal financial incidence, its effect on trade and its inquisitorial nature157 rather than its effect on the public health. Because the latter was in its initial stages of proof through statistical evidence, scientific knowledge and medical observation, public health arguments were initially few and muted.158 As the investigations of the poor law commissioners and the commissioners for the improvement of towns yielded full evidence as to the injurious effects of inadequate ventilation, and that evidence became increasingly extensive and endorsed by the medical and scientific communities, so it was adopted as the principal and most compelling reason for the repeal of the tax.159 It was only to be expected that personal objections to paying the tax should be presented in the guise of philanthropy,160 but nevertheless the public health argument was persuasive and the coincidence of the re-assessment of 1840 with a period of epidemic was described as ‘a national calamity’161 and it considerably fuelled the public health arguments. The inhabitants of urban areas, particularly in London, began to include the 152

Journals of the House of Commons 1688–1834, vol 73, 242, 14 April 1818. ibid, vol 74, 149, 22 Feb 1819. 154 ibid, 155, 23 Feb 1819. 155 ibid, vol 73, 241, 14 April 1818. 156 Most of the principal towns and cities in England presented petitions for the repeal of the window tax as early as the 1820s. See, for example, Oxford, Greenwich Reading and Westminster in 1825: ibid, vol 80, 133, 28 Feb 1825; ibid, 427, 17 May 1825. 157 See for example Parliamentary Debates, series 3, vol 15, cols 560–61, 12 Feb 1833 (House of Commons); ibid, vol 17, col 538, 24 April 1833; ibid, cols 758–65, 30 April 1833 per Sir John Key. See too ‘Repeal of the House and Window Tax’, The Morning Chronicle, 29 Nov 1832; Letters to the Editor, The Times 24 Feb 1830; 22 March 1830; 17 Nov 1832; ‘The House and Window Tax’ The Times, 29 Nov 1832. 158 See for example the editor’s report of the public meeting in The Times, 23 Jan 1833. 159 ‘Repeal of the Window Tax’, The Morning Chronicle, 11 Feb 1848. 160 See for example 45 The Lancet, 196–7, 197 (15 Feb 1845). 161 Humberstone, The Absurdity and Injustice of the Window Tax, 10. 153

Book 1.indb 62

12/2/2011 8:21:36 AM

Public Health Imperatives and Taxation Policy

63

public health argument in their petitions to Parliament,162 and as early as 1832 public meetings were called to press for the repeal.163 In 1833 Sir John Key added the public health concerns to more traditional objections in his speech against the window tax.164 The cholera epidemic of 1832–3 added considerable force to this first wave of protest against the tax and from then abolition associations,165 petitions to the House of Commons, deputations to the Chancellor of the Exchequer, and a popular movement of public meetings and pamphlet agitation demanded the repeal of the tax. Though the deputation in 1834 to a sympathetic Lord Althorp resulted in the passing of the Act permitting new windows to be opened free of duty,166 the deputations in 1844 to Henry Goulburn, Conservative Chancellor in Robert Peel’s administration were singularly unsuccessful. Goulburn politely received a strong group of representatives from the Metropolitan Improvement Society, led by Dr Southwood Smith, but intimated ‘his entire disbelief’ in its statements.167 Scrofula, he observed, existed in the rural cottages of the poor, who were exempt from the window tax.168 When the Master Carpenters’ Society of London proposed that all unglazed openings in basements and closets should be free of tax, the Chancellor answered that if they could propose a hole that would admit air but not light, it would not be chargeable as a window.169 Such dismissive and somewhat sarcastic responses were supported by subsequent correspondence between the Society and the Board of Stamps and Taxes.170 It appears that the chairman mistakenly stated that houses could be ventilated by perforated zinc plates free of duty,171 ‘a hasty and…unwarranted assertion’ made simply to extract the Chancellor of the Exchequer out of a difficult situation.172 The judges had held otherwise, and the board confirmed in private correspondence that such ventilation plates would be chargeable if they admitted any light.173 Not only did Goulburn refuse to 162 City of London: Journals of the House of Commons 1688–1834, vol 88, 217, 26 March 1833. See too Parliamentary Debates, series 3, vol 15, col 617, 13 Feb 1833 (House of Commons). 163 See for example ‘House and Window-Tax’, The Times, 5 Feb 1833. 164 Parliamentary Debates, series 3, vol 17, cols 758–66, 30 April 1833 (House of Commons) per Sir John Key. 165 See for example ‘Window Tax Repeal Association’, Daily News, 27 Feb 1849; ‘Repeal of the Window Tax’, Daily News, 18 Jan 1848. 166 4 & 5 Will IV c 54. The benefit of this legislation was, however, was entirely undermined by the insertion of the phrase ‘duly assessed’ into the Act, and its subsequent strict interpretation by the tax authorities and the judges. 167 Anon, Case to the Window Duties, 7. 168 ‘Proposed Modification of the Window Duties’, Morning Chronicle, 2 May 1844. 169 Parliamentary Debates, series 3, vol 120, col 78, 9 April 1850 (House of Commons) per Viscount Duncan. 170 The correspondence is quoted at ibid, col 79. 171 Anon, Case to the Window Duties, 7. 172 ibid. The judges had held otherwise. 173 ibid. See too the suggestion of one witness to the Royal Commission on the State of Large Towns and Populous Districts in 1844, who proposed that all new houses should be assessed on the basis that each house required a certain number of openings for light and air in proportion to its cubic size, and that these should be charged to tax whether or not they were in fact built into the house. Thereby any temptation to builders to build houses below that standard would be removed.

Book 1.indb 63

12/2/2011 8:21:36 AM

64

Chantal Stebbings

entertain even practical and feasible suggestions for the mitigation of the tax in such a way that the revenue was not diminished,174 the deputations did not convince him that the subject ‘was one of the slightest moment’.175 A further deputation of the Metropolitan Improvement Society to Goulburn’s successor, Sir Charles Wood, in 1847 received an equally unsympathetic reception. The Society was told that if it could submit a clause which would give their tenants the relief they desired, and at the same time protect the public revenue from loss through its exploitation by landlords, it would receive the government’s consideration.176 The Society was persistent, and made representations four times to the government, but failed to obtain a remission of the tax. On the final occasion in 1850 the Chancellor of the Exchequer said ‘he could not enter upon any medical consideration, or doctrines involving opinions’.177 A deputation from the Metropolitan parishes, accompanied by twelve Members of Parliament, fared little better.178 An observation that a verdict of wilful murder would be returned against the Chancellor in the event of a coroner’s inquest being held on a victim of inadequate ventilation left him unmoved. 179 Accompanying the medical and popular movements for repeal was a vigorous parliamentary campaign led by Lord Duncan. He put motions for the tax’s repeal to Parliament in 1845, 1848 and 1850, on each occasion making the case for abolition forcibly and convincingly. Not only did he personally raise public awareness of the tax and kept it in the parliamentary eye, his eloquence, energy and well informed arguments forced the government to pay attention to it.180 His speeches were widely praised181 and his ‘manly spirit’ was admired by The Times.182 His struggle for repeal was considerable: though in 1845 Sir Robert Peel promised he would consider repeal, nothing came of it, and in 1848, Lord John Russell, while admitting that Lord Duncan’s arguments had force, refused to repeal it. In 1850, however, though the motion was again lost, the arguments for the tax’s repeal were so convincing that the government prevailed by just three votes.183 Never, said The Times, was ‘a stronger case made out upon a financial Thereafter, as many windows as desired could be opened, without further charge. This would cause the revenue no loss and would immeasurably promote the public health ‘by the stroke of a pen’: First Report of the Royal Commission for Inquiring into the State of Large Towns and Populous Districts, House of Commons Parliamentary Papers (1844) (572) xvii 1, qq 6174, 6176 per WE Hickson. 174 Anon., Case to the Window Duties, 8–9. One suggestion was the windows charged should be in proportion to the space enclosed or the number of rooms. 175 ibid, 4. 176 Sykes, ‘Statistical Account of the Labouring Population’, 53. 177 ‘Repeal of the Window Tax’, The York Herald and General Advertiser, 25 Jan 1851. 178 ‘Repeal of the Window Tax’, The Morning Chronicle, 11 Feb 1848. 179 ‘Repeal of the Window Tax – Deputation to the Chancellor of the Exchequer’, Daily News, 11 Feb 1848. 180 ‘Repeal of the Window Tax’, Lloyd’s Weekly Newspaper, 18 Feb 1849. 181 Daniell, Report of the Committee of Delegates, 5. 182 The Times, 20 March 1845. He was elected a freeman of Dundee in 1851 in recognition of his successful opposition to the window tax. 183 Parliamentary Debates, series 3, vol 110, col 99, 9 April 1850 (House of Commons) per Viscount Duncan.

Book 1.indb 64

12/2/2011 8:21:36 AM

Public Health Imperatives and Taxation Policy

65

question’ and ‘it was impossible to resist conviction’.184 The narrowness of the margin was, in effect, a defeat which the Treasury well deserved,185 and Dowell described it as ‘a practical victory’.186 So when in 1850 the Queen’s Speech made no mention of the repeal of the window tax there was widespread outrage, and in a public letter Joseph Hume condemned it as ‘a mere mockery and insult’.187 Hopes were raised once more in 1851 when the revenue returns indicated the country would be in surplus, but yet again the government was intransigent. It maintained that it was unable to forgo the revenue, even in the context of the substantial surplus, the highly visible impact of the building of the Crystal Palace in glass for the Great Exhibition188 and the recent devastation of the second cholera epidemic.189 Even The Times, an admirer of Lord Duncan’s campaign, believed the public revenue could not afford to forgo the £2 million the tax raised annually.190 Rumours began that if the window tax were repealed, it would be replaced by a new house duty. Organised agitation reached new levels of intensity, with public meetings held in London, Liverpool, Hull, Plymouth and Bristol, and most large towns in England. The delegates of the Metropolitan parishes determined to send a deputation to the Chancellor of the Exchequer, in carriages with placards demanding ‘Unconditional Repeal of the Window Duties’.191 Others suggested they should stand outside the Houses of Parliament with placards stating “No Window Tax – No House Tax”’.192 Ultimately the Chancellor of the Exchequer, unable to resist the compelling arguments for the tax’s repeal and acknowledging there was ‘some weight’ in them, bowed to the inevitable and repealed the tax in 1851. However, as many had feared and predicted, it was replaced by a new house duty,193 though one with a more rational basis of charge.194

CONCLUSION

The importance of the window tax, in terms of its nature, effect and its difficult passage to abolition, lay in the fact that it was the first time that public health 184

The Times, 10 April 1850. The Times, 11 April 1850. Dowell, History of Taxation and Taxes, vol ii, 315. See contemporary press reaction in ‘The Window Tax’, Hampshire Telegraph and Sussex Chronicle, 13 April 1850. 187 ‘The Queen’s Speech, an Insult, Without a Repeal of the Window Tax’, The York Herald and General Advertiser, 16 Feb 1850. 188 ‘Repeal of the Window Tax’, Daily News, 8 Jan 1851 per Mr J Wyld MP. 189 Parliamentary Debates, series 3, vol 96, cols 1272–75, 24 Feb 1848 (House of Commons) per Chancellor of the Exchequer, Sir Charles Wood (Viscount Halifax). 190 The Times, 20 March 1845. 191 ‘Repeal of the Window Tax’, Reynolds’ Weekly News, 9 Feb 1851. 192 ‘Repeal of the Window Tax’, Daily News, 31 Jan 1851. See too ibid, 21 Jan 1851, 20 Feb 1851. For examples of the widespread popular objections to the house duty, see Letters to the Editor, The Times, 20 Feb 1851. 193 Parliamentary Debates, series 3, vol 110, col 91, 9 April 1850 (House of Commons) per Chancellor of the Exchequer. 194 14 & 15 Vict c 36, preamble, s 1. The basis of charge was the annual value. 185 186

Book 1.indb 65

12/2/2011 8:21:36 AM

66

Chantal Stebbings

imperatives conflicted so directly and manifestly with the fiscal interests of the state. The way in which this unique juxtaposition of two distinct public exigencies was addressed is revealing of the dynamics of Victorian government, politics and society. It also formed the factors and considerations that were to endure into the modern age of taxation policy. The window tax was ultimately repealed as a result of intense pressure from public health activists and medical practitioners, and the compelling nature of the social, medical and scientific evidence they adduced as to the effects of inadequate ventilation. The repeal was a triumph for those fighting for better housing for the poor, and a beneficial reform as potent as the repeal of the corn laws. The window tax therefore appears to be the earliest paradigm in English law of the viability of a tax being dictated by non-fiscal public health needs. However, the evidence suggests that the public health arguments as such were effective not because of their intrinsic merits but because of their political effects. While public health considerations appeared to prevail in that the tax was repealed expressly on those grounds, the fiscal demands sustained it for twenty years after the damage it caused to the public health was recognised, and only when the tax had become politically untenable was it repealed. The evidence affirms the intense potency of fiscal requirements and their dominance over wider policy considerations. The public health concerns that formed the basis of the abolition campaigns left successive chancellors unmoved, and financial imperatives, iterated by the Treasury and the revenue boards, prevailed. They constituted the express reason for the Treasury’s uncompromising refusal to contemplate repealing the tax throughout the 1830s and 1840s, and indeed, the fiscal needs were unambiguously asserted even when the window tax was repealed, in that it was immediately replaced by a new inhabited house duty estimated to raise £720,000.195 The revenue demands of the government were thereby safeguarded to some degree. These demands, however, were based not on true financial necessity but on politico-fiscal considerations. The window tax was not essential to the national finances; the amount it raised was relatively small and continually declining due to exemptions and avoidance. In 1833 the gross receipt of ordinary revenues was over £52 million, of which £37 million came from customs and excise duties, and the window tax rarely yielded more than £2 million,196 and even Lord Althorp admitted that it was ‘so small and object’.197 Furthermore, in 1850 the national finances were in surplus. The government’s refusal either to amend or repeal the tax in this context bemused contemporaries, but was the outcome of two principal factors. First, the government was concerned as to the political signals any repeal would send. The power to levy taxes constituted a potent characteristic of sovereignty and one of the most important functions of government. Successive 195 Parliamentary Debates, series 3, vol 116, col 168, 14 April 1851 (House of Commons) per Chancellor of the Exchequer. 196 The accounts for 1833 are printed as an appendix to Parliamentary Debates, series 3, vol 25. 197 Parliamentary Debates, series 3, vol 24, col 882, 26 June 1834 (House of Commons).

Book 1.indb 66

12/2/2011 8:21:36 AM

Public Health Imperatives and Taxation Policy

67

administrations would not condone a social expectation in which extensive lobbying of government ministers, however well founded the arguments, directly resulted in the repeal of a national tax. It would set an unacceptable precedent. Any such decision was regarded as properly within the responsibility of the Treasury, dictated by the requirements of the government and not as a result of popular pressure. Secondly, the Treasury in its fiscal rather than its political capacity was reluctant to abolish any impost that produced a net gain, however small. In this the Treasury was supported and influenced by the ethos of the revenue boards. Their statutory function was the care and management of all the taxes, and their overriding objective was to safeguard the national revenue. They saw this in entirely financial terms, namely the quantum of tax. This dominant ethos was expressed through a strong innate and pervasive conservatism. It predisposed the tax bureaucracy against any change in either the substance or the administration of taxes. This ethos developed and intensified throughout the nineteenth century in line with the bureaucratisation of the state, the growth in the importance of the direct taxes in the national revenue, and the increasing reach of the liability to taxation as the growth in individual wealth brought more and more individuals into charge. Although it was said that in the 1840s the Board of Stamps and Taxes had considered various schemes to improve the method of rating to the window tax198 no evidence of these has come to light and, in relation to the tax, the evidence suggests that the revenue boards unambiguously acted to block any change in the substance of the law, even to the extent of providing incorrect advice to the Chancellor of the Exchequer. The Treasury, Chancellor and revenue boards were not prepared to sacrifice any public revenue, and certainly not for reasons which were not fiscal in nature. The refusal to permit any non fiscal policy considerations to impinge on the tax framework was promoted by the strict legalistic interpretation of the window tax legislation by the judges. In accordance with the judicial orthodoxy of the nineteenth century and the constitutional nature of taxation, the judges maintained the literal rule of statutory interpretation, whereby they interpreted the words of the statutes before them and only exceptionally could take into account the wider purposes of the legislation before them.199 As a result policy arguments as to the necessity of healthy ventilation were never raised in argument before the judges in window tax appeals. Vested interests in Parliament also played their part in subordinating non fiscal considerations to fiscal ones. While such influence was not overt, it was nevertheless material, and operated to delay the repeal of the tax. Parliament was dominated by the landed classes owning rural estates with farms and cottages. Other than the tax applicable to their personal residences, which in any event 198 Parliamentary Debates, series 3, vol 96, col 1275, 24 Feb 1848 (House of Commons) per Chancellor of the Exchequer, though it appears that no evidence of these survives. 199 See generally C Stebbings, The Victorian Taxpayer and the Law. A Study in Constitutional Conflict (Cambridge, 2009), 30–33, 111–22.

Book 1.indb 67

12/2/2011 8:21:36 AM

68

Chantal Stebbings

benefited from the inherent inequality of the charge, such landowners were relatively untouched due to the application of express statutory exemptions for farms and rural cottages which protected their interests.200 While this did not lead to an active resistance to abolition, such members of Parliament were indifferent, and this apathy hindered the passage of the tax’s repeal through Parliament and allowed official fiscal arguments to prevail. From the perspective of property owners in general, however, vested interests provided a significant check on the repeal of the tax. An insistence on the repeal of the window tax demanded an engagement with, and support for, the public health movement as a whole. That necessarily brought with it an acceptance of the need for compulsory action – the building of drains and sewers, the provision of fresh water, the relocation of some trades from town centres and the regulation of others. It could even bring a requirement for greater ventilation provision in private dwellings. All these were regarded as unacceptable interferences with private property interests. The public health legislation faced enormous resistance as a result of such vested interests,201 combined with the influence of laissez faire, an ideology still sufficiently powerful not only to excite popular opposition to the reforms, but also to ensure that governments were reluctant to implement certain reforms and to explain the absence of public health regulation in the early nineteenth century and its limitation in the later years of the century. For example, while the Royal Commission for Inquiring into the State of Large Towns and Populous Districts recommended the promotion of ventilation systems in public buildings such as schools, it stopped short of introducing compulsory provisions for ventilating private homes, believing this would be too great an invasion of privacy, and urged instead better education of the public as to the benefits of fresh air.202 Since the window tax was retained as a result of politico-fiscal imperatives, it was but a short step to its repeal if its political position became untenable and its fiscal benefit could be secured by other means. By 1850, two factors had combined with the increasingly powerful popular movement for reform to bring about the final political collapse of the tax. The first was that it was manifestly clear that there was a conflict between a fiscal policy which retained the window tax as an instrument of public revenue, and the government’s programme of sanitary reform.203 It was certainly the case that sanitation, namely drainage, sewerage and fresh water supply, was the first 200

Daniell, Report of the Committee of Delegates, 10. See Parliamentary Debates, series 3, vol 26, cols 1480–88, 26 July 1844 (House of Lords) per the Duke of Buccleuch and the Duke of Wellington. 202 Second Report from Commissioners Inquiring into the State of Large Towns and Populous Districts, House of Commons Parliamentary Papers (1845) (602) xviii 1, 71. 203 There exists a vast body of scholarship on the public health movement in the nineteenth century. See generally D Porter, Health, Civilisation and the State (Routledge, London, 1999), 110–46; Anthony S Wohl, Endangered Lives, Public Health in Victorian Britain (JM Dent & Sons Ltd, London, 1983; MC Buer, Health, Wealth and Population in the Early Days of the Industrial Revolution (George Routledge & Sons Ltd, London 1926); Frazer, A History of English Public, 61–70. 201

Book 1.indb 68

12/2/2011 8:21:36 AM

Public Health Imperatives and Taxation Policy

69

concern of all reformers and indeed of public health legislation. The primary absolute necessity was to clean up the cities, to remove the human and animal waste and refuse which polluted the water supply and accumulated around the dwellings of the urban poor. Burial grounds and slaughterhouses had to be regulated to this end then open drains and cesspools had to be eliminated and replaced with closed functional sewers. Thereafter, a fresh and constant water supply had to be engineered. But it was evident to most public health activists and to the general public that the continuance of the window tax materially undermined the efforts of sanitary reformers.204 Lord Ashley, speaking in the debate on the repeal of the tax in 1848, believed that ‘it was impossible to exaggerate the mischief’ which the window tax caused in terms of sanitary health.205 Quite apart from the damage that avoidance of the window tax inflicted on the health of the people, other legislation appeared either unaware of the fiscal consequences of its provisions, as where the Metropolitan Building Act 1844206 laid down new specific requirements for light and ventilation and provided that proceedings were to be taken against anyone who did not comply with them, or ignored the public health consequences of the tax entirely by not referring to it. Neither Lord Lincoln’s Sewerage, Drainage etc of Towns Bill of 1846, the starting point of sanitary legislation, nor Lord Morpeth’s Public Health Bill of 1848207 made any mention of the window tax, and were heavily criticised for the omission.208 For political and constitutional reasons there was a deep seated reluctance both to challenge the Treasury and for non fiscal legislation to address any fiscal issue, even obliquely. It was said that when the New Building Act was being discussed, Lord Lincoln rejected a suggestion that windows should be charged in proportion to the space enclosed or the number of rooms, because he ‘declined to interfere with the province of the Chancellor of the Exchequer’.209 For the government to implement reforms addressing drains and sewers without ameliorating ventilation by repealing the window tax was a hypocrisy that could not be denied.210 It was described as ‘a farce’,211 rendering the Whigs’ sanitary reforms ‘as shams, feigned for popularity’s sake’.212 To spend the public revenue 204 Parliamentary Debates, series 3, vol 96, col 1255, 24 Feb 1848 (House of Commons) per Viscount Duncan. See too WT Gairdner, Public Health in Relation to Air and Water (Edmonston & Douglas, Edinburgh, 1862), 263. 205 Parliamentary Debates, series 3, vol 96, col 1288, 24 Feb 1848 (House of Commons) per Lord Ashley, later Earl of Shaftesbury. 206 7 & 8 Vict c 84. 207 See Frazer, History of English Public Health, 45–46. The bill got through after considerable opposition, and created the General Board of Health. 208 By Lord Duncan: The Times, 11 Feb 1848 and by the Health of Towns Association: Health of Towns Association, Report of the Committee on Lord Lincoln’s Bill. 209 Health of Towns Association, Report of the Committee on Lord Lincoln’s Bill, 114; Anon., Case to the Window Duties, 4. 210 J L Hammond and Barbara Hammond, Lord Shaftesbury (4th edn, Longmans, Green and Co, London, 1936), 162. 211 ‘Repeal of the Window Tax’, Lloyd’s Weekly Newspaper, 18 Feb 1849. 212 ‘The Window Tax’, The Hull Packet and East Riding Times, 12 April 1850.

Book 1.indb 69

12/2/2011 8:21:37 AM

70

Chantal Stebbings

on building sewers and drains and improving the air of the streets, and raising the same sum from a tax that directly prevented the ventilation of houses was nothing less than ‘a monstrous humbug’213 ‘a pretence and a delusion’.214 This failure to integrate fiscal policy into the political landscape, indeed to allow such a degree of dislocation between tax policy and social welfare policy, revealed a government lacking in coherence, a perception which was politically dangerous. The second factor that was responsible for the political collapse of the tax was that the campaign for abolition provoked reflection and debate as to the fundamental purposes of taxation. In a penetrating leader in 1848 The Times addressed the policy of taxation. It concluded that a tax was introduced, or remained in force, because it was easy in terms of assessment and collection, or because its yield was high, or because taxpayers were not able to make any effective resistance. ‘The social effects of the tax,’ observed the editor, ‘are comparatively put out of the question’.215 Although the piece showed that traditional fiscal imperatives remained important, and in the case of the window tax in practice dominated over public health concerns, its significance is that the social effects of a tax are being discussed in an open forum at all. Contemporary commentators urged that no tax should be sustained entirely for the purposes of the revenue it raised, if it caused harm to the public good. The fiscal imperative could not be allowed to prevail, and taxes had to be looked at in the context of the wider public interest.216 It was appreciated that the considerations that sustained a tax were not purely financial: the fiscal discourse predominated, but the social and medical discourses played a material role. As such, the window tax signalled the beginning of a period where the purposes of taxation and its role in national life were subjected to a new intensity of scrutiny and criticism. This new perspective on tax marked a point where tax was moving out of a purely inward looking fiscal sphere where its revenue raising objectives prevailed above any other, into a new climate where its interaction with wider non-economic purposes was becoming understood. The official acceptance of the interaction of fiscal and public health imperatives, albeit only to the extent of acknowledging the need to balance the two requirements, is the window tax’s most lasting influence. The window tax unequivocally raised the awareness of the potential connection between fiscal policy and public health, and constituted an example of a tax where the public health impact demanded some action on the part of the Treasury.217 The health of the population was accepted as a serious and important concern, for the happiness of the individual 213

‘The Window Tax’, Hampshire Telegraph and Sussex Chronicle, 13 April 1850. Parliamentary Debates, series 3, vol 110, col 81, 9 April 1850 (House of Commons) per Viscount Duncan. See too Humberstone, The Absurdity and Injustice of the Window Tax, 11. 215 The Times, 12 Feb 1848. 216 ‘Repeal of the Window Tax’, Daily News, 18 Jan 1848. 217 But see The Independent, 7 July 2007, where a leading manufacturer of fresh fruit drinks launched an unsuccessful campaign to persuade HMRC to exempt its products from VAT. The debate raised traditional arguments as to the acceptability of taxing essential or luxury articles of consumption. 214

Book 1.indb 70

12/2/2011 8:21:37 AM

Public Health Imperatives and Taxation Policy

71

and the economic strength of the country depended on it. ‘Health’, observed a medical practitioner in 1850, ‘is the capital of the working classes of society, and all legislative enactments should in their design contemplate the preserving of the health, and therefore the wealth of these classes’.218 In this context, the window tax had a lasting effect. This connection was thereafter accepted as a factor in tax policy, a factor that could be a major one, and one that could never be ignored and indeed had to be consciously addressed. Although as late as the 1970s, in relation to tobacco, expert analysis of the factors involved in raising or lowering the duty and the wider consequences of lowering the consumption, were found not to have affected government policy,219 the connection highlighted by the window tax in the mid nineteenth century has been taken to a stage beyond any negative impact of a tax on public health, and is now used in a positive sense, in that taxes on alcohol and tobacco are deliberately and expressly imposed in order to form social behaviour with public health objectives. The window tax thus had a formative role in the public perception of the role of tax, and in the shape and pattern of modern fiscal policy and its embodying legislation.

218 ‘Deputation to the Chancellor of the Exchequer on the Window Tax’, Daily News, 30 May 1850 per Hector Gavin MD. 219 Kay and King, British Tax System, 136–37.

Book 1.indb 71

12/2/2011 8:21:37 AM

Book 1.indb 72

12/2/2011 8:21:37 AM

3 Montesquieu – ‘The Lively President’ and the English Way of Taxation* JOHN SNAPE

ABSTRACT

T

HIS CHAPTER ANALYSES how Montesquieu’s ideas on the design of taxes informed Scottish Enlightenment thinkers, and, through these, shaped English ideas on the political economy of taxation. Even today, questions about the feasibility of various taxation policies in England echo those that Montesquieu first raised in L’Esprit des lois, of 1748. The relative perspective that he brought to the analysis of law and of legal systems, by asking why measures effective in the government of one state, might nonetheless not work in others, was quickly assimilated to English modes of thought. Montesquieu therefore effected a cultural, critical, appraisal of tax policies and of the institutions that devised and implemented them. This is what commended him to thinkers such as Lord Kames, in his Sketches of the History of Man, of 1774, and to Adam Smith, whose maxims of taxation, in The Wealth of Nations, of 1776, drew their inspiration from Montesquieu’s analysis of taxation principles in L’Esprit des lois. The chapter thus seeks to illustrate the ways in which Montesquieu’s ideas on taxation have been transferred to, and legitimised in, English ways of thinking about tax policy.

I. INTRODUCTION

The purpose of this chapter is to examine an instance of what Sir Isaiah Berlin called ‘the ... models that dominate and penetrate ... [people’s] thought and * I would like to thank for their comments participants at the seminars in Cambridge, Warwick and Limerick, in the summer of 2010, at which I presented the paper on which the chapter is based.

Book 1.indb 73

12/2/2011 8:21:37 AM

74

John Snape

action’1 in a particular field of human endeavour. That field of endeavour is legislation: the promulgation of enlightened laws, in Georgian England,2 certainly, but in our own time, too. For students of eighteenth-century thought, I want to highlight a specific ‘transfer of ideas’ in the ‘science of politics’. The ‘originator’ of these ideas was Charles-Louis de Secondat, Baron de Montesquieu (1689– 1755), the French political philosopher, who was writing in the middle years of the eighteenth century. The thinker who further developed them was Adam Smith (1723–1790), the Scottish political economist and moral philosopher, whose thoughts on legislation developed over a 20-odd year period, from the 1750s onwards. For those interested in the study of contemporary public policy, I would like to demonstrate how this transfer of ideas, between Montesquieu and Smith, shows that some of the most dearly-held assumptions of modern policymakers, are the attenuated, yet stubborn, results of an interplay of ideas between France and England in the middle years of the eighteenth century. Taxation is a rewarding focus of inquiry, since tax policy questions, although not necessarily the answers offered to them, tend to recur. As a tax lawyer, one with a fascination for eighteenth century modes of thought, I wanted to attempt an exercise with two interwoven strands: to highlight Montesquieu’s ideas on taxation in relation to those of Smith; and to show how, although viewed in a Smithian prism, Montesquieu’s ideas continue to inform tax policy choices even today. My discussion of Montesquieu’s fascination, not only for us, but for the eighteenth-century Scottish philosophers, unfolds in three stages. I begin by establishing a context: a certain communality of concerns, between Montesquieu and Smith, in their days, and between them and the makers of tax policy in ours. My preoccupation here is to delineate the modernity of Montesquieu’s thought, to show how certain policy assumptions that might seem to us axiomatic, were to him an innovation. I then locate within this context the nature and purpose of the philosopher’s discussion of taxes, thereby highlighting those aspects of his thought picked up by Smith. This stage of the discussion is, in part, about those modes of thought dominant in Montesquieu’s mind, and in part about those that rule ours.3 It is also about uncovering an understanding of tax policy in terms of the modern natural law theory that Montesquieu is credited with having created. Finally, I spend some time touching on four specific features of Montesquieu’s discussion of taxes: the limited scope for tax fairness; the portability of capital as a constraint on tax policy; the desirability of indirect taxes – taxes on commodities, in other words – as against direct (‘capitation’) taxes; and – somewhat topically – the role of taxes in a time of fiscal crisis. This final part of the chap1 I Berlin, ‘Does Political Theory Still Exist?’ in H Hardy (ed), Concepts and Categories: Philosophical Essays (London, Hogarth Press, 1978) p 143, 159. See Loughlin, n 12. 2 On the use of ‘ England’, rather than ‘Britain’, see U Haskins Gonthier, Montesquieu and England: Enlightened Exchanges, 1689–1755 (London, Pickering and Chatto, 2010) p 177: ‘ ... Montesquieu uses the term “Angleterre” ... to refer collectively to the nations of Great Britain governed from London under one constitution following the Act of Union in 1707’. With Haskins Gonthier, I follow Montesquieu in using the term ‘England’ in this way. 3 Berlin, n 1; Loughlin, n 12.

Book 1.indb 74

12/2/2011 8:21:37 AM

Montesquieu – ‘The Lively President’ and the English Way of Taxation 75 ter highlights a significant legacy of Montesquieu’s thought. Knowing what is known, about the nature and ends of law, how is the legislator to choose between tax policy alternatives? Throughout the chapter, I seek to emphasise how elements of Montesquieu’s analysis are still present in the assumptions of today’s policy-makers, even though time has obscured their source. Their assumptions are at work, of course, in a context that neither Montesquieu, urbane former Président à Mortier of the Bordeaux Parlement, nor Smith, the reclusive academic, could have envisaged: an open, large, post-industrial economy.

II. SOME COMMON PREOCCUPATIONS

Anyone who picks up a copy of one of the ‘broadsheet’ newspapers in England, especially around Budget time, will quickly become aware of certain widelyheld beliefs about the English tax system: it is too complex, too ‘unstable’, too obsessed with tax avoidance, and so on. This type of criticism tends to come from business groups, and it masks much more fundamental worries: that, for instance, the tax system produces unacceptable economic inequalities; or that its faults are such as to discourage that inward investment by multinational corporations which is considered so necessary to economic wellbeing. My principal contention, in this chapter, is that the positions taken in these debates embody a view of policy and of legislation, which is traceable to questions first raised, in acute form, by Montesquieu, in L’Esprit des lois of 1748.4 This imposing volume, originally published in Geneva,5 and characterised by Jean-Pierre Gross as, with Dacier’s 1721 French translation of Plutarch’s Lives, one of the two ‘most influential book[s] of the [eighteenth] century’,6 has been characterised in many different ways. On one level, it is a scientific guide for the legislator, albeit a diffuse and often evasive one. On another, it is a groundbreaking work of comparative political analysis, a work of sociology almost. It develops and incorporates a lifetime of philosophical reflection, some of it, such as his reflections on luxury, dating back at least to Montesquieu’s early, satirical, epistolary novel, Lettres persanes.7 Reading L’Esprit des lois today, much is still to be learned, I believe, from Thomas Pangle’s delicate analysis, originally published in 1973.8 Without 4 ‘De L’Esprit des lois’ [1748] in Montesquieu, Œuvres completes (R Caillois (ed)), 2 vols (Paris, Gallimard (Bibliothèque de la Pléiade), 1951) II p 225. 5 R Shackleton, Montesquieu: A Critical Biography (Oxford, Oxford University Press, 1961) p 241. 6 J-P Gross, ‘Progressive taxation and social justice in eighteenth-century France’ (1993) 140 Past and Present 79, 90. 7 ‘Lettres persanes’ [1721] in Montesquieu, Œuvres completes (R Caillois (ed)), 2 vols (Paris, Gallimard (Bibliothèque de la Pléiade), 1951) I p 129, 153; M Sonenscher, Before the Deluge: Public debt, inequality, and the intellectual origins of the French revolution (Princeton, Princeton University Press, 2007) pp 98–99. 8 TL Pangle, Montesquieu’s Philosophy of Liberalism: A Commentary on The Spirit of the Laws (Chicago, University of Chicago Press, 1973).

Book 1.indb 75

12/2/2011 8:21:37 AM

76

John Snape

imposing an artificial unity on the work, Pangle persuasively dissolves its argument into five successive, yet interrelated, inquiries: (1) the natural human need for security, which the philosopher identifies with liberty, and which led human beings out of their original state of vulnerability in the wilderness; (2) the form of government that best meets that need for security, which is to be found in England, a ‘liberal republic’ though disguised as a monarchy;9 (3) how, though climate or terrain may restrict the choice of government and of legislation, commerce may yet compensate, as in England itself, where the climate is terrible;10 (4) the legislator’s need for historical awareness, as an aid to that crucial aspect of legislative science, the exercise of political prudence; and, finally, (5) the use of that prudence to further the goal of security, by promoting commerce, where climate, terrain and tradition so permit. Montesquieu’s discussion of taxation forms part of his analysis, not of commerce as such, but of liberty and security; tax, like criminal law, requires the deployment of a ‘modern knowledge’ lacking in the ancients.11 My use of Isaiah Berlin’s methodology, in approaching Montesquieu’s discussion of taxes, follows Martin Loughlin’s recommendations for the ‘functional’ analysis of public law,12 that is, the law of the state and the individual in general. By using Berlin’s approach to the history of ideas, Loughlin tells us, we can both uncover the suppositions at work in the minds of the architects of public law concepts, and also question our own assumptions as to what is axiomatic in the public law issues of today.13 Precisely this task, has not, so far as I know, been undertaken for the philosophical analysis of tax law and policy, although there is increasing enthusiasm for mapping the links between Montesquieu’s and Smith’s ideas more generally,14 and the later years of Gordon Brown’s chancellorship saw controversial invocations of Smith in the formulation of Labour party policy.15 What seems to be at play here is the ‘commerce’ of ideas,16 between Montesquieu and his contemporaries, to be sure, but also between them, and the policy-makers of our own day. Indeed, this commerce of ideas provides some striking parallels. For example, speaking of stamp taxes, Montesquieu comments: 9 PA Rahe, ‘Forms of Government: Structure, Principle, Object, and Aim’ in Carrithers, Mosher and Rahe (eds), Montesquieu’s Science of Politics: Essays on The Spirit of Laws (Lanham and elsewhere, Rowman and Littlefield, 2001) p 84. 10 Shackleton, n 5 p 312. 11 Pangle, n 8 pp 90, 139. 12 M Loughlin, Public Law and Political Theory (Oxford, Clarendon Press, 1992) pp 34–36. For the importance of Loughlin’s public law theory to the analysis of tax law and policy, see J Snape, The Political Economy of Corporation Tax: Theory, Values and Law Reform (Oxford, Hart Publishing, 2011) p 10. 13 Loughlin, n 12. 14 eg, HC Clark, ‘Montesquieu in Smith’s method of “theory and history”’ (2008) 4 Adam Smith Review 132. 15 eg, I McLean’s, Adam Smith, Radical and Egalitarian: An Interpretation for the Twenty-First Century (Edinburgh, Edinburgh University Press, 2006). 16 C Larrère, ‘Montesquieu on Economics and Commerce’ in Carrithers, Mosher and Rahe (eds), n 9, p 346.

Book 1.indb 76

12/2/2011 8:21:37 AM

Montesquieu – ‘The Lively President’ and the English Way of Taxation 77 Il faut, pour se défendre du traitant, de grandes connoissances, ces choses étant sujettes à des discussions subtiles. Pour lors le traitant, interprète des règlements du prince, exerce un pouvoir arbitraire sur les fortunes. L’expérience a fait voir qu’un impôt sur le papier sur lequel le contrat doit s’écrire, vaudroit beaucoup mieux.17

This idea resonates clearly with the comments of the early nineteenth-century English judge, Sir William Taunton (1773–1835), who, in 1834, remarked that stamp duties were entirely a matter of positive law, involving ‘nothing of principle or reason’, and inexplicable except in their own terms.18 What we have in this brief quotation from L’Esprit des lois is a similar indication (perhaps even one with which Taunton J was familiar), that such taxes are contrary to liberty, because invasive of the security of property. No-one who has followed the tortured recent history of stamp taxes in England can fail to appreciate the issues at stake here. Although people today would not perhaps express the points in the same way, the underlying issue is the same now as it was then. Given the size and scope of L’Esprit des lois, I concentrate on the taxation discussion contained in the 20 brief chapters of Book XIII,19 but I occasionally draw on relevant elements from elsewhere, and I read all of these materials in the light of Book Five of The Wealth of Nations, of 1776.20 Book XIII of L’Esprit des lois is not, of course, the only place in which Montesquieu writes about taxation. For example, as a young advocate, though not yet a judge – that is, a Président – of the fearsome Parlement of Bordeaux,21 Montesquieu had offered suggestions to the Regent of France, in his Mémoire sur les dettes de l’état (1715),22 as to how to eliminate the enormous public debt incurred in Louis XIV’s wars. Some of Montesquieu’s ideas on taxes, as expressed in the Mémoire, resurfaced in Book XIII of L’Esprit des Lois, when, over three decades on, and nearly blind, he was dictating his masterpiece to one or other of his ubiquitous priestly scribes.23 By the same token, Book Five of the Wealth of Nations is not the only place in which Adam Smith writes about taxation. It is, however, as with Montesquieu’s Book XIII, the place where the author makes his central points. Reading the taxation discussion of L’Esprit des lois in the context of The Wealth of Nations should take my analysis a considerable way, but it is possible 17

Montesquieu, n 4, p 464 (Book XIII, ch 9). Morley v Hall (1834) 2 Dowl 494, 497, quoted in BJ Sims and JFW Hinson (eds), Sergeant and Sims on Stamp Duties and Capital Duty and Stamp Duty Reserve Tax, 9th edn (London, Butterworths, 1988) p 18. 19 Montesquieu, n 4, p 458. 20 A Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (RH Campbell, AS Skinner and WB Todd (eds)) 2 vols [1776] (Indianapolis, Liberty Fund, 1979) II esp pp 825–828 (Book Five, ch II). 21 J Shklar, Montesquieu (Oxford, Oxford University Press, 1987) p 5. 22 ‘Mémoire sur les dettes de l’état’ [1715] in Montesquieu, Œuvres completes (R Caillois (ed)), 2 vols (Paris, Gallimard (Bibliothèque de la Pléiade), 1951) I p 66. 23 Shackleton, n 5 p 233. 18

Book 1.indb 77

12/2/2011 8:21:38 AM

78

John Snape

to go further still. So I would like to refer briefly to Book II of Lord Kames’s Sketches of the History of Man,24 of 1774, to illuminate certain points, as well as to David Hume’s essay, ‘Of taxes’, first published in 1752,25 to indicate the critical reaction to Montesquieu, as well as to sketch the context of Smith’s own contribution. Lord Kames, in James Buchan’s words, was ‘an energetic, clever, coarse, domineering lawyer’,26 and, as a judge of Session and a landowner, he was closer perhaps in social status and in occupation to Montesquieu than was Smith. David Hume, ‘fat, good-natured, a decent cook and a better eater’,27 needs no introduction. Thought by AJ Ayer to be ‘the greatest of all British philosophers’,28 Hume was also well received in France, a country ‘... whose public mind ... had been opened for novel doctrines by the bold appeal of Vauban, and by the curious and original enquiries of Montesquieu’.29 It will be inferred from what I have said so far that Smith’s discussion of taxation, in Book Five of the Wealth of Nations, might owe more than a little to its illustrious predecessor. In fact, Smith’s apparent indebtedness to Montesquieu was first anatomised in the 1930s, by FTH Fletcher,30 and I make no claim to originality on that score, but I would like to use the similarities that Fletcher identified to elaborate the issues that I have already outlined. Nor am I saying that Montesquieu was the only influence on Smith, or on Kames, or that he was such in a pure form. It is possible, for instance, that they had also read and digested French translations of the work of the German Cameralist writers, especially that of the most distinguished member of that long-dead school, Johann Heinrich Gottlob von Justi (1720–1771).31 Von Justi, too, published advice to princes on taxation, but he did so as a professed admirer, albeit a critical one, of L’Esprit des lois. As Albion Small wrote in 1909, ‘Justi was exceptionally unwilling to give other writers their due unless they were safely dead. Montesquieu is the only author whom he frequently mentions by name’.32 The possible late Cameralist influence on Smith has been noted 24 H Home, Lord Kames, Sketches of the History of Man (JA Harris (ed)) 3 vols [1774] (Indianapolis, Liberty Fund, 2007) II pp 432–485 (Sketch VIII). The Liberty Fund edn follows the text of the 1788 (third, posthumous) edn, indicating some variant readings from the 1774 edition. See Smith, n 20 p 827n. 25 D Hume, Essays Moral, Political, and Literary, rev edn (E F Miller (ed)) [1758] (Indianapolis, Liberty Fund, 1987) p 342. ‘Of Taxes’ originally formed Essay VIII of Part II of Hume’s Essays, published in 1752 (see Essays Moral, Political, and Literary. By David Hume (TH Green and TH Grose (eds)) [1882] (Darmstadt, Scienta Verlag Aalen, 1964) pp 56, 285). 26 J Buchan, The Authentic Adam Smith: His Life and Ideas (New York, WW Norton, 2006) p 30. 27 ibid, p 37. 28 AJ Ayer, Hume: A Very Short Introduction (Oxford, Oxford University Press, 2000) p 1. 29 Hume, n 25 p 56. 30 FTH Fletcher, Montesquieu and English Politics (1750–1800) [1939] (Philadelphia, Porcupine Press, 1980) pp 63–68. 31 U Adam, ‘Justi and the Post-Montesquieu French Debate on Commercial Nobility in 1756’ in The Beginnings of Political Economy (JG Backhaus (ed)) (New York, Springer, 2009) 91. 32 AW Small, The Cameralists: The Pioneers of German Social Polity [1909] (New York, Burt Franklin, 1969) p 393 (and see, ibid, p 382, for the similarity between Smith’s ‘maxims’ of taxation and von Justi’s ‘rules’).

Book 1.indb 78

12/2/2011 8:21:38 AM

Montesquieu – ‘The Lively President’ and the English Way of Taxation 79 more than once,33 but less often remarked has been von Justi’s own reading of Montesquieu.34 Finally, I am also aware that, as James Moore has shown,35 many more Scottish Enlightenment thinkers even than Kames, Hume and Smith, read Montesquieu. Indeed, Montesquieu’s devotees included the much younger Edmund Burke, as early as 1754.36 With the Scots, though, there is a direct literary interaction, rather than an intellectual transfer in some broader sense. Hume was one of the first readers of L’Esprit des lois, in 1749, and wrote to Montesquieu, among other things, about the latter’s discussion of taxation.37 Kames, Hume’s cousin, and Smith’s patron, made specific reference to Montesquieu’s volume, and Smith’s library contained at least one French edition of the work.38

III. MONTESQUIEU AND SMITH ON TAXATION

Overall, Montesquieu’s great work is similar to, yet significantly different from, that of Adam Smith. I am thinking here of the intellectual framework, so to speak, within which their respective discussions of taxation are cradled. I would like to discuss this framework in more detail, since it profoundly affects how we read the taxation points that appear in Book XIII of L’Esprit des lois. They are not, in the manner of Smith, laid out in a schematic and bold plan, but instead are to be garnered from the brief chapters of which the Book consists. Thomas Pangle’s analysis, already referred to, reduces Montesquieu’s fundamental points to two: the greater the liberty of a state, the more the taxes may be increased; and, – against encouraging a view of taxes as a sacrifice of property ‘for the common good’ – it is actually better for people not even to be aware that they are being taxed, as in England.39 Cecil Courtney, taking a broad view of the whole work, encapsulates the central ideas of L’Esprit des lois in two propositions.40 Montesquieu, he says, seeks to do for the positive laws of political societies what Hugo Grotius has 33 AT Peacock, ‘The Treatment of the Principles of Public Finance in The Wealth of Nations’ in Essays on Adam Smith (AS Skinner and T Wilson (eds)) (Oxford, Clarendon Press, 1975) pp 553–567, 563. 34 K Tribe, ‘Cameralism and the Sciences of the State’ in The Cambridge History of EighteenthCentury Political Thought (M Goldie and R Wokler (eds)) (Cambridge, Cambridge University Press, 2006) pp 525–546, 538. The second edition of Justi’s Staatswirthschaft was published in 1758, having originally been published in 1755. 35 J Moore, ‘Montesquieu and the Scottish Enlightenment’ in Montesquieu and his Legacy (RE Kingston (ed)) (Albany, State University of New York Press, 2009) pp 179–195. 36 CP Courtney, Montesquieu and Burke (Oxford, Basil Blackwell, 1963) p 30. 37 Moore, n 35 p 181; ‘To President de Montesquieu’ in The Letters of David Hume (JYT Greig (ed)), 2 vols (Oxford, Clarendon Press, 1932) I p 133, 136; Shackleton, n 5, p 388. 38 eg Smith, n 20 II p 775; H Home, Lord Kames, n 24 II p 445; Adam Smith’s Library: A Catalogue (H Mizuta (ed)) (Oxford, Clarendon Press, 2000) p 175. 39 Pangle, n 8 p 145. 40 CP Courtney, ‘Montesquieu and Natural Law’ in Carrithers, Mosher and Rahe (eds), n 9, p 41.

Book 1.indb 79

12/2/2011 8:21:38 AM

80

John Snape

done for natural law.41 Positive laws, in other words, can ‘be deduced from “the nature of things”, that is to say, from the constitution of human nature’.42 What rules people’s behaviour is not ‘reason’ as such – as on the plane of Grotian natural law – but whatever ‘principle’ sets in motion the society in which they live.43 It might be fear, or virtue, or honour, or – as in England – ‘political vigilance’.44 The ‘spirit of the laws’, as Pangle points out, is ‘this relation between the universal principles of human nature understood by reason and the particular sociopolitical environment to which this reason is ... applied in the form of laws’.45 Since Montesquieu is concerned with discovering what, in fact, makes the English polity ‘tick’, he is engaged in an enterprise similar to that of Adam Smith. But Smith wants to uncover something wider and deeper still: the self-interest that drives people on from cradle to grave,46 and before which all the passions flee.47 To put these ideas in Berlin’s terms, ‘the model’ that ‘dominates’ Montesquieu’s thought is Grotian, while Montesquieu’s thought is what dominates Smith. What I want to argue is that, at some level, a ‘scientistic’ ‘model’ of human nature, with elements of Smith, certainly, but crucially too, of Montesquieu, dominates the consciousness of present-day taxation legislators. Moreover, there is rather more to Courtney’s characterisation of L’Esprit des lois than meets the eye, especially when read alongside Pangle. The latter, working under the supervision of the conservative theorist, Joseph Cropsey, did not portray Montesquieu as a proto-sociologist,48 but as an innovative natural lawyer: not just a describer, but a discreet prescriber, too. Beyond the Grotian model identified by Courtney is the shade of Thomas Hobbes,49 and Montesquieu’s innovation is the idea that the only meaningful precept of natural law is this basic human need for security.50 Interestingly, that interpretation accords closely with Judith Shklar’s portrait of the idea of the rule of law in Montesquieu’s thought as primarily about ‘freedom from fear’,51 and it enables me to make a point of some significance. True it is that Montesquieu is offering an explanation of positive laws in different states, but he is, too, making a veiled suggestion to guide legislators of the future. If the only precept of natural law is an imperative of security, the rest of the science of legislation is a matter

41

ibid, pp 61–62. ibid, p 44. 43 Montesquieu, n 4, p 250 (Book III, ch 1). 44 Rahe, n 9, p 90. 45 Pangle, n 8, pp 43–44 (quoting Montesquieu, n 4, pp 237–238), 156–159. Thanks to John Pearce for prompting me to think about this. 46 Smith, n 20, I p 343; II p 674. 47 AO Hirschman, The Passions and the Interests: Political Arguments for Capitalism before Its Triumph, 2nd edn (Princeton, Princeton University Press, 1997) pp 110–111. 48 Pangle, n 8, p 45. 49 ibid, p 33. 50 ibid, pp 29, 49. 51 JN Shklar, ‘Political Theory and The Rule of Law’ in AC Hutchinson and P Monahan (eds), The Rule of Law: Ideal or Ideology (Toronto, Carswell, 1987) pp 1, 4. 42

Book 1.indb 80

12/2/2011 8:21:38 AM

Montesquieu – ‘The Lively President’ and the English Way of Taxation 81 of political prudence.52 Indeed, it is the residue of the legislator’s activities, in different political societies, over many years, which enables Montesquieu to account for the divergences in their positive laws. Taxes, penal statutes, etc, all are directed at security, or liberty, albeit with varying degrees of success. So, whilst Montesquieu’s discussion of taxes does have its antecedents,53 he is right to see himself as the creator of something original: ‘prolem sine matre creatam’.54 If there are both descriptive and delicately prescriptive elements to Montesquieu’s work, and if Smith is indeed pursuing to its ‘final cause’, namely self-interest, a model of human behaviour that Montesquieu accepts as attributable instead to variations in the principles of societies, then the divergence has important consequences. What each of Smith’s and Montesquieu’s systems has in common is an insistence that, to rule effectively, the legislator must be realistic about how people will respond to the legislation promulgated. This is political prudence in action. Exactly how different Montesquieu is from Smith, says Courtney, appears from the following passage, from Smith: Every system of positive law may be regarded as a more or less imperfect attempt towards a system of natural jurisprudence, or towards an enumeration of the particular rules of justice.55

So the ‘terrifying logic’ of a society whose principle is fear – namely, a despotism – is that it is ‘an attempt toward a system of the unnatural’. Montesquieu, as a scientist of human nature, and with a particular view of prudence, is not prepared to go quite so far.56 With Montesquieu, as Eric Voegelin avers, the ‘prevailing sentiment is that of a profound respect for variety and the feeling that it should be left alone’.57 His ‘pluralism’ is, as Berlin might have said,58 as characteristic of Montesquieu as a certain ‘monism’ is characteristic of Smith. For Smith, Roman Stoicism had much to teach about the nature of mankind, and the legislator should heed it when framing his laws.59 Montesquieu, though he admired the Stoics,60 did not feel that other people need necessarily model their behaviour on them, and prudence was rather a matter of deference to history, to climate, to tradition. While Montesquieu differentiates between the effectiveness 52

Pangle, n 8, ch 9. See, eg, R Bonney, ‘Early Modern Theories of State Finance’ in R Bonney (ed), Economic Systems and State Finance (Oxford, Clarendon Press, 1995) p 163, 192. 54 Montesquieu, n 4, p 227. 55 A Smith, The Theory of Moral Sentiments (DD Raphael and AL Macfie (eds)) [1759] (Indianapolis, Liberty Fund, 1982) p 340. 56 Courtney, n 40, p 56. 57 E Voegelin, The New Order and Last Orientation (J Gebhardt and TA Hollweck (eds)) (Columbia, University of Missouri Press, 1999) p 167. 58 I Berlin, ‘Montesquieu’ in H Hardy (ed), Against the Current: Essays in the History of Ideas (London, Hogarth Press, 1979) p 130, 157. 59 A Fitzgibbons, Adam Smith’s System of Liberty, Wealth, and Virtue: The Moral and Political Foundations of The Wealth of Nations (Oxford, Clarendon Press, 1995) p 74. 60 Shackleton, n 5, p 74. 53

Book 1.indb 81

12/2/2011 8:21:38 AM

82

John Snape

of different taxes under various governments, Smith’s tax prescriptions are of universal application.61 There is a ‘good life’ in Smith, and it is to work hard in a political society where taxes are light.62 With Montesquieu – well, it all depends. Modern tax legislators accept that Smith says useful things about taxation,63 but they recognise, too, that his prescriptions cannot be regarded as universal. I want to argue that they owe this relativistic insight, ultimately, to Montesquieu. Montesquieu’s legislator, then, has a task similar to, yet crucially different from, Smith’s. Contemporary tax legislators accept Smith’s monism, indeed some have assimilated it to public choice theory,64 but, significantly, they lean towards Montesquieu in matching the theory to the pluralistic reality, for instance in regard to the views they take of the tax systems of developing countries, and also in their rather more mundane acceptance that, whilst certain tax policy arguments might work elsewhere in Europe, they will not do so in England.65 This contrast leads me to speculate on why Montesquieu’s great work might seem to leave open political questions to which Smith offers clear solutions. Evidently, both men envisage that their arguments inhabit a space in which, as Ursula Haskins Gonthier reminds us,66 ‘public reason’, namely, the justification of public policy in critical and rational debate, is becoming crucially important. Notable among the writers that she surveys are Jürgen Habermas67 and Jonathan Israel,68 each of whom considers the elevation of public reason, as the basis for government action, to be the greatest innovation of eighteenth century life. Smith, in the Scotland of the 1770s, was arguably freer to engage directly in this debate than was Montesquieu, in France, three decades earlier. Montesquieu’s conclusions are often coded, evasive: he writes for the trusted reader.69 He wants, not to erect a new political society, but, as Robert Wokler says,70 to point out the means by which the existing social and political orders may be maintained. If Montesquieu 61

Fitzgibbons, n 59, p 101. D Stewart, ‘Account of the Life and Writings of Adam Smith, LL.D.’, in A Smith, Essays on Philosophical Subjects (IS Ross, DD Raphael and AS Skinner (eds)) [1793] (Indianapolis, Liberty Fund, 1982) p 269, 322. 63 ‘Address: Rt. Hon. Gordon Brown MP, Chancellor of the Exchequer’, in enlightenment lectures 2002: A series of lectures held at the University of Edinburgh between February and April 2002 (B Shimshon (ed)) (London, Smith Institute, 2005) p 98; G Osborne (now Chancellor of the Exchequer), ‘Principles of tax reform’, speech to the think-tank, Policy Exchange, 15 February 2008 (available from http://www.policyexchange.org.uk). 64 McLean, n 15, pp 77–80. 65 A fairly recent example would be the UK’s drawn-out negotiations over the tax treatment of interest paid on quoted Eurobonds. 66 Haskins Gonthier, n 2, pp 3–4. 67 J Habermas, The Structural Transformation of the Public Sphere: An Inquiry into a Category of Bourgeois Society (T Burger and F Lawrence (trans)) (Cambridge, Polity, 1992) ch 3. 68 J Israel, Enlightenment Contested: Philosophy, Modernity, and the Emancipation of Man 1670–1752 (Oxford, Oxford University Press, 2006) ch 2. 69 DW Carrithers, ‘Introduction: An Appreciation of The Spirit of Laws’ in Carrithers, Mosher and Rahe (eds), n 9, p 18. 70 R Wokler, ‘The Enlightenment Science of Politics’ in C Fox, R Porter and R Wokler (eds), Inventing Human Science: Eighteenth-Century Domains (London and elsewhere, University of California Press, 1995) p 323, 325–327. 62

Book 1.indb 82

12/2/2011 8:21:38 AM

Montesquieu – ‘The Lively President’ and the English Way of Taxation 83 does have a preference, it might be – as Céline Spector convincingly contends – for a moderate commercial society, whose actuating principle is honour.71 But he whispers this point softly, almost anxiously. Smith is less evasive, his aim more ambitious. He speaks directly, since, as Athol Fitzgibbons argues, Smith sees himself as nothing less than ‘a legislator in the ancient sense’.72 England is on the road to industrial expansion, and Smith is providing its moral constitution.73 France is on the road to who knows where.74 Tax policy debate in our own time is the epitome of public reason in action, though not all may engage on the terms that Habermas would regard as appropriate.75 The ideas that Montesquieu advances on taxation, in common with his system as a whole, are thus analytical, pluralistic, prudential, evasive. Yet his masterpiece proclaims ‘a stupendous discovery’76 about the nature of people, and of the laws under which they live.77 Montesquieu may well have thought that he had discovered that (Isaiah Berlin, again), far from being ‘the happy hunting ground of bigots and charlatans and their dupes and slaves’,78 the discussion of the ways of men and women could be systemised, like the laws of Newtonian natural philosophy. But he realised, too, that prudence must have a role, since not everything is knowable beforehand. This dominant, ambitious, and flexible, idea of law was subsequently lost to lawyers, but its vestiges still cling to others involved in public policy debate, especially to economists. Robert Shackleton, though not a lawyer, when writing about Montesquieu in 1950s Oxford, was so accustomed to the hegemonic self-contained ‘analytical jurisprudence’ of his time, that he had difficulty understanding the famous definition of laws with which Montesquieu begins:79 ‘ … les rapports nécessaires qui dérivent de la nature des choses ...’.80 Hume had done so, however, which was why, although professing to admire Montesquieu’s work, he remained uneasy about its Grotian implications.81 That this deracination had not affected other policy disciplines related to law, and still reliant on natural law premises, was illustrated by Gunnar Myrdal, also in the 1950s, but for economics, which he thought of as essentially remaining a natural law discipline.82 71 C Spector, ‘Honor, Interest, Virtue: The Affective Foundations of the Political in The Spirit of Laws’ in Kingston (ed), n 35, p 49, 60, 67. 72 Fitzgibbons, n 59, p 1. 73 ibid, ch 2. 74 Sonenscher, n 7. 75 W Outhwaite, Habermas: A Critical Introduction (Cambridge, Polity, 1994) ch 3. 76 Berlin, n 58, p 133. 77 ibid. 78 ibid. 79 Courtney, n 40, p 64. 80 Montesquieu, n 4, p 232 (Book I, ch 1). 81 D Hume, ‘An Enquiry concerning the Principles of Morals’ in Enquiries Concerning Human Understanding and Concerning the Principles of Morals. By David Hume (LA Selby-Bigge and PH Nidditch (eds)), 3rd edn [1751] (Oxford, Clarendon Press, 1975) p 169, 197n, quoted in Shackleton, n 5 p 245. 82 G Myrdal, The Political Element in the Development of Economic Theory (P Streeten (trans)) (London, Routledge and Kegan Paul, 1953) ch 7.

Book 1.indb 83

12/2/2011 8:21:38 AM

84

John Snape

The context of Montesquieu’s tax disquisition, as already mentioned, was France’s experience as a state desperate for tax revenues, yet unable to raise them effectively. He seems simultaneously to present to the reader both an explanation of why the tax laws of different countries vary, and behind this, sotto voce, one might say, a guide to the prudential exercise of the tax legislator’s powers. L’Esprit des lois is, as Pangle points out, unmistakeably, a founding political treatise of modernity, with man, not God, at its centre.83 No longer, as with the ancients, is the search for the good at the centre of political thought, but a quest for what is the least bad. Least bad, says Montesquieu, is the liberal republic of England, and at least some of its tax laws, which operate in conjunction with England’s ‘spirit of commerce’. It was Pangle who first uncovered the importance that commerce has in Montesquieu’s work, something which generations of scholars before him, blinded by a Madisonian preoccupation with the separation of powers,84 had failed to recognise. What my discussion has sought to do is to highlight Montesquieu’s argument about the significance of taxes as constitutive of liberty. It is with these points in mind that I would like to touch, finally, on four specific aspects of Montesquieu’s taxation discussion: the prudential scope for ‘tax fairness’; the role of prudent taxation policy in preventing ‘capital flight’; the benefits of indirect taxes, as against direct ones; and (somewhat topically), the role of taxation in dealing with a public finance deficit. None of these points is offered in the naive belief that Montesquieu’s ideas can offer us much present comfort. Instead, I put each one forward to demonstrate how, when reasoning about these issues, we may unconsciously be using Montesquieu’s modes of thought. More importantly, however, I would like to suggest that the elements of Montesquieu’s thought we thereby elide nonetheless still have the capacity to illuminate. Before embarking on this final part of the discussion, however, I would like to lay out some of the points of comparison with Smith, Kames and Hume, again to show how novel Montesquieu’s ideas would once have appeared.

IV. MONTESQUIEU AND SMITH ON TAX POLICY CHOICES

Faced with the iron rule of nature,85 namely the need for security, tax legislation requires more prudence and wisdom than any other aspect of government. Taxation is the: ‘portion que chaque citoyen donne de son bien, pour avoir la sûreté de l’autre, ou pour en jouir agréablement’.86 Some have seen in this an affinity with John Locke,87 and it is certainly the case that Montesquieu’s 83

Pangle, n 8, p 25. Shackleton, n 5, pp 298–301; Shklar, n 21 pp 121, 124. 85 Montesquieu, n 4, p 405 (Book XI, ch 6) (see Pangle, n 8 p 143). 86 Montesquieu, n 4, p 458 (Book XIII, ch 1). 87 J Dedieu, Montesquieu et la Tradition Politique Anglaise en France: Les Sources Anglaises de l’Esprit des lois (Paris, Victor Lecoffre, 1909) ch 6. Thanks to Jane Frecknall-Hughes for prompting me to investigate this further. 84

Book 1.indb 84

12/2/2011 8:21:39 AM

Montesquieu – ‘The Lively President’ and the English Way of Taxation 85 thought in general has affinities with Locke’s.88 But, again, as Pangle has shown, there is too something radically different at work,89 not least because Montesquieu does not emphasise the idea of a ‘social contract’.90 Moreover, the statement just quoted precedes Montesquieu’s equally famous pronouncement that: ‘Il ne faut point prendre au peuple sur ses besoins réels, pour des besoins de l’État imaginaires’.91 These words were obviously coined with the parlous state of the French finances in mind,92 but they underline, too, the importance of moderation in the prudential exercise of legislative powers.93 Lord Kames, unlike Montesquieu, is free in the Scotland of 1774 to nominate some specific contemporary examples of taxation imprudence. He identifies Spain, which, he says, ‘hath been wrecked’ by bad taxes,94 as well as – presciently – France, whose taxes, notably the detested gabelle – the salt tax – are a peril to its political stability.95 When laying a tax upon a people, says Montesquieu, prudence dictates matching the tax to the form of government under which they live. What Smith will later call ‘direct taxes’96 – those that Montesquieu classes as capitation taxes97 – work best in a despotism, while indirect taxes are most effective in moderate governments.98 Robert Nozick took up the former contention when, famously, he compared income tax to ‘forced labor’,99 and both Kames and Smith echoed the latter point nearer to Montesquieu’s own day. Heavy taxes, says Montesquieu – here writing against the mercantilists – are unlikely to make people work harder.100 Reacting to this, in his 1752 essay, ‘On taxes’, Hume agrees with Montesquieu, and it is in this context that Smith argues against heavy taxes as contrary to ‘the natural system of perfect liberty’.101 Smith lays down his famous four maxims, of ‘equality’ in taxing (what we would call ‘fairness’), of ‘certainty’ of the amount to be paid, of convenience in the paying and of cost-effectiveness in the levying, as best under all circumstances.102 Montesquieu, by contrast, relies on an idea of what is natural to each type of state, in emphasising ‘the necessity for prudent attention 88

Pangle, n 8, pp 4, 35, 162. Shackleton, n 5, pp 135, 163, 167. 90 Pangle, n 8, p 41. 91 Montesquieu, n 4, p 458 (Book XIII, ch 1); Shklar, n 21, p 92. 92 DW Carrithers, ‘Montesquieu and the Spirit of French Finance: an analysis of his Mémoire sur les dettes de l’état (1715)’ in DW Carrithers and P Coleman (eds), SVEC 2002:09, Montesquieu and the Spirit of Modernity (Oxford, Voltaire Foundation, 2002) p 159. 93 Rahe, n 9, p 81. 94 H Home, Lord Kames, n 24 II, p 479. 95 ibid, p 443. 96 Smith, n 20 II, pp 848, 864. 97 The expression ‘La régie’, sometimes translated as ‘direct taxes’, is used by Montesquieu by way of distinction with taxes that are farmed (‘la Ferme’). ‘Capitation taxes’ are defined by Kames as ‘a tax laid on a man personally, for himself and family’ (H Home, Lord Kames, n 24, II p 440). 98 Montesquieu, n 4 pp 461–463 and 467–468 (Book XIII, chs 7 and 14). 99 R Nozick, Anarchy, State, and Utopia [1974] (Oxford, Blackwell Publishing, 2008) p 169. 100 Montesquieu, n 4, pp 431–432 (Book XIII, ch 2). 101 Smith, n 20, II p 606. 102 ibid, pp 827–828. 89

Book 1.indb 85

12/2/2011 8:21:39 AM

86

John Snape

to the particular character of each nation’.103 In moderate states, heavy taxes are the price of liberty,104 so they can be increased more easily than in states that are not moderate.105 Montesquieu is pluralistic to the extent that, unlike Smith, he posits the appropriateness of different taxes to different political orders. Yet, as Catherine Larrère explains, Montesquieu is writing against the dominant ‘absolutist’ theory of taxation,106 Cardinal Richelieu’s idea that heavy taxes make the poor industrious and remind them of their true duty.107 This last provides a highly tangible point of contact between Montesquieu’s and Smith’s systems: the corollary of cost-effectiveness, later adopted by Smith, that the fewer visits the tax authority makes to the tax payer, frankly, the better. Attuning taxes to different political orders means, first, according some role to what, in liberal discourse, is referred to as tax fairness.108 As I have noted, Smith’s first, rather ambiguous, maxim, speaks only of ‘equality’. Montesquieu, by contrast, thinks that taxes should play a role in curtailing luxury, and invokes the sumptuary laws of various ancient and modern states in support of this argument. Familiar to Jansenist and Jesuit alike, sumptuary laws were designed ‘to suppress luxury and achieve as equal a distribution as possible of basic commodities and benefits’.109 As Gross says, pervading L’Esprit des lois ‘is the leitmotiv of the frugal imperative and the fiscal challenge this presents to the legislator’.110 In one of the democratic republics of antiquity, this meant that citizens would actually volunteer to pay taxes.111 Whilst there is no chance of that happening in England’s liberal republic, it might nonetheless be possible in ‘despotic’ France: Had not Nicolas Poussin in 1648 composed one of his finest paintings around the theme of Diogenes the Cynic throwing away his bowl on seeing a shepherd-boy drinking from a stream with cupped hands? And did not Fénelon develop this idea into a system of government in his mythical picture of Crete and Ithaca, whose inhabitants make do with only those commodities ‘truly necessary to life’?112

Montesquieu is himself very keen on this idea of using taxes to prevent the rich being too rich. In this respect is he part of an eighteenth century discourse on luxury that Smith will later reject. What it reminds us, is that, even if a tax 103

Pangle, n 8, p 16. Montesquieu, n 4, pp 442–443 (Book XIII, ch 12). 105 ibid, pp 443–444 (Book XIII, ch 13). 106 Larrère, n 16, p 340. 107 Cardinal de Richelieu, Testament Politique (L André and L Noël (eds)) [1688] (Paris, Robert Laffont, 1947) p 253 (Part 1, ch 4, section 5): ‘Tous les politiques sont d’accord que, si les peuples étoient trop à leur aise, il seroit impossible de les contenir dans les règles de leur devoir’. (Quoted in English by Larrère, n 16, p 340.) 108 But see L Murphy and T Nagel, The Myth of Ownership: Taxes and Justice (Oxford, Oxford University Press, 2002) p 38. 109 Gross, n 6, p 91. 110 ibid, p 90. 111 Spector, n 71, p 53. 112 Gross, n 6, pp 88–89. 104

Book 1.indb 86

12/2/2011 8:21:39 AM

Montesquieu – ‘The Lively President’ and the English Way of Taxation 87 system can ensure a level of subsistence for the poor, the existence of ‘the gap between rich and poor’ may itself be such as to be politically imprudent. One only has to read a report from the Institute for Fiscal Studies, or the references in the Financial Times to ‘Ken’s sumptuary tax’ on ‘Chelsea tractors’, in the context of the London congestion charge, to realise how important a factor in political judgment these disparities may be. Pangle draws out the point that Montesquieu believes that, perhaps especially in England’s liberal republic, this disparity will need to be addressed.113 Smith’s rather minimalist formulation of taxation ‘equality’ specifically departs from this sumptuary discourse. His famous comment about it being, in effect reasonable enough to ask the rich to pay proportionately more tax,114 seems to me at least to lack much conviction. Montesquieu’s elusive exegesis on taxation has a second major implication, one which is to be found in Smith also. This is the potential flight of capital as a deterrent to the governmental infringement of scientific taxation principles.115 This idea, that, where tax laws compare unfavourably with those in other countries, capital will ‘fly away’, is at the heart of our contemporary obsession about tax competition between states.116 The new coalition government in Britain was quick to reassure transnational business that it understood this principle very well.117 It is a commonplace of international tax law discourse, as well as of globalisation literature more generally. Yet the penetration of Montesquieu’s ideas on ‘capital flight’ are deeper, perhaps, than might be imagined. Smith simply represents the portability of capital as a fact of life. Merchants have no loyalty towards states, he says, because, if they fear the form of government in one state, they simply move to another one.118 What Montesquieu says, as Albert Hirschman pointed out,119 but in a broader policy context, is something rather more profound, and, as a reflection of its profundity, rather more deeply felt, even today. This is the idea that princes, governments, in our terms, are actually restrained from les grands coups d’autorité (imprudent, capricious, policy action)120 by the presence of commerce in their borders, or, more specifically, by the effect of imprudent governmental action on foreign exchange markets. Only the briefest of reflections tells us how deeply felt this idea is in contemporary tax 113 Pangle, n 8, p 150 (ref Montesquieu, n 4, p 280 (Book V, ch 6)); but see Sonenscher, n 7, pp 166–172, for a different interpretation. 114 Smith, n 20, II p 842. 115 Montesquieu, n 4, p 461 (Book XIII, ch 5) pp 639–641 (Book XXI, ch 20); Smith, n 20, I p 364; II pp 848–849, 906, 927–928. 116 See, eg, J Eaglesham, ‘Treasury pledges corporate levy reform “road map”’ Financial Times, June 9, 2010 p 4; V Houlder, ‘Competitiveness policy needs clarity, says study’ Financial Times, June 22, 2010 p 2. 117 ibid; see also, eg, J Eaglesham, ‘Cable vows fight for industry on corporation tax’ Financial Times, May 15–16, 2010 p 3; B Groom, ‘Osborne promises to protect industry’ Financial Times, May 20, 2010 p 3. 118 Smith, n 115, refs passim. 119 Hirschman, n 115, pp 70–81; AO Hirschman, ‘Exit, voice, and the state’ in Essays in Trespassing: Economics to Politics and Beyond (Cambridge, Cambridge University Press, 1981) p 246, 253–258. 120 Montesquieu, n 4, pp 639–641 (Book XXI, ch 20).

Book 1.indb 87

12/2/2011 8:21:39 AM

88

John Snape

policy debate. What is interesting is that some, for instance Robert Skidelsky, writing in the Financial Times about government by financial markets,121 regard it as a wholly bad thing. Montesquieu himself would have regarded it, as Hirschman so elegantly explains, as an unqualified good in a moderate people. A third notion, one adopted by both Kames and by Smith, is that, given people’s ways, what makes them ‘tick’ in other words, then at least in a monarchy, there is a presumption in favour of indirect, as against direct, taxes.122 Indirect taxes, because of their regressive nature, are closely linked in our mind to questions of tax equality. Moreover, the idea that, being generally less visible, indirect taxes are more suitable as ‘stealth taxes’, is a familiar one us also. In fact, as will be conjectured, the mention in that formulation of ‘stealth taxes’ is something of an extrapolation in the terms of our contemporary tax policy debate. What Montesquieu and, so to speak, his loyal Scottish disciples actually say, is that indirect taxes, taxes on commodities, used prudently, are better than capitation taxes.123 Again, in our own time, this is a powerful idea, but, again, we need to strip away its layers of significance with some care. Both Smith and Kames approve of taxes on commodities, provided they do not rise too high, because the customer confounds them with the price. People buy their candles, their salt, their ale, their electronic technology, and they do not realise how much of the price of the goods consists of taxes. Montesquieu likes this idea too, indeed, it is he who has sown it in the minds of Kames and of Smith, in the first place. And, after all, in their lexicon, capitation taxes do not yet include anything quite so subtle as an assessed tax on income, not introduced in England until 1799.124 Contemporary tax policy makers regard indirect taxes with deep suspicion, a fact exploited recently by both the British Retail Consortium125 and by the Trades Union Congress126 in their representations on Budget proposals to increase the rates of VAT, the main European indirect tax in England. What Montesquieu captures, absent from Smith’s system, is what both Sainsbury’s and the TUC represent: that ‘political vigilance’,127 that anxious principle, fuelled by inquiétude,128 which animates the English state. There, says Montesquieu, in his pluralistic mode, the usual tenets of what Smith was to call ‘the man of system’,129 may not apply. Finally, I would like to draw attention to a fourth aspect of prudent tax policy, namely, Montesquieu’s reference in L’Esprit des lois to the use of taxes to service public borrowing. David Carrithers drew attention to this point in 2002,130 121

R Skidelsky, ‘Once again we must ask: “Who governs?”’ Financial Times, June 17, 2010, p 13. Montesquieu, n 4, pp 467–468 (Book XIII, ch 14); Smith, n 20, II p 826. 123 Smith, n 20, II pp 826, 869; H Home, Lord Kames, n 24, II pp 443–444; Hume, n 25, p 345. 124 eg, M Emory, ‘The Early English Income Tax: A Heritage for the Contemporary’ (1965) 9 American Journal of Legal History 286. 125 E Rigby, ‘Retailers warn over VAT rise impact’ Financial Times, June 7, 2010 p 4. 126 L Shannon, ‘Rise in VAT “would cost households £425 a year”’ Metro, June 14, 2010 p 43. 127 Rahe, n 9, p 90. 128 ibid, p 88. 129 Smith, n 55, p 233. 130 Carrithers, n 92, p 186. 122

Book 1.indb 88

12/2/2011 8:21:39 AM

Montesquieu – ‘The Lively President’ and the English Way of Taxation 89 although its strident relevance is perhaps only now becoming apparent. Of public debt, says the philosopher, ‘je n’en connois point les avantages’.131 ‘L’impôt levé pour le paiement des interest de la dette, fait tort aux manufactures, en rendant la main de l’ouvrier plus chère’.132 This recalls Montesquieu’s 1715 advice to the Regent,133 in which, rather than advising the raising of taxes to service the state’s indebtedness, Montesquieu recommended that the debt be repudiated ‘proportionately in such a way that every bond-holder would remain in exactly the same position relative to all the others as before’.134 Such an overtly political attitude to property rights is unlikely to commend itself today, at least in this particular political society. Nonetheless, it points to Montesquieu’s public law conception of public finance, and this is useful in reflecting on his comments on the nature of tax law. The currency of all four of these ideas in our public policy discourse needs hardly to be emphasised, and it underlines the point that taxation law, as public law, is a form of ‘political jurisprudence’,135 or ‘political law’. Montesquieu would, as David Lowenthal implies, have regarded this as axiomatic,136 though with the important proviso that, as such, taxation law both assists in the formation of the state and sustains it once it is so formed. The former point was underlined by Montesquieu, in drawing attention to the necessity in England for taxation legislation to be approved by the Crown in Parliament.137 In the latter, he would have detected a painful dilemma as to the scope of political, as against ‘civil’ jurisprudence,138 something reflected in his comments on public debts. Our contemporary policy makers might do well to remember these points. Probably, though, they do, but without realising their source.

V. SOME CONCLUSIONS

It was Lord Macaulay who described Montesquieu as ‘the lively President’,139 clever but flawed. Macaulay did so, of course, very much in Adam Smith’s long shadow. Reading Montesquieu today, we may share that view, but we must, too, acknowledge the continuing power of his thought to illuminate our continuing assumptions about the way we should live. That he shaped the taxation ideas of Scottish philosophers seems beyond doubt. Of Smith, especially, it can be 131

Montesquieu, n 4, p 673 (Book XXII, ch 17). ibid. 133 Montesquieu, n 22. 134 Shklar, n 21, p 18. 135 M Loughlin, The Idea of Public Law (Oxford, Oxford University Press, 2003) p 134. 136 D Lowenthal, ‘Montesquieu 1689–1755’ in History of Political Philosophy (L Strauss and J Cropsey (eds)), 2nd edn (Chicago, Rand McNally, 1972) p 487. 137 Haskins-Gonthier, n 2, p 120. 138 Pangle, n 8, pp 89–90. 139 TB Macaulay, ‘Machiavelli’ [1827] in Lord Macaulay’s Essays and Lays of Ancient Rome (London, Longmans Green, 1886) p 28, 48. 132

Book 1.indb 89

12/2/2011 8:21:39 AM

90

John Snape

said that, despite his own stature, the novelty of what he had to say about taxes was far less than commonly supposed. The physiocrats, and especially Quesnay, shaped Smith’s economic theory generally, but it was Montesquieu who was the basis of Smith’s thoughts on taxation. Fletcher, writing in the 1930s, painstakingly set out the correspondence of Smith’s taxation maxims with Montesquieu’s discussion of taxes.140 To Fletcher, what Smith had done looked almost like plagiarism.141 It is certainly true that Smith was not, as has already been observed, open-handed in acknowledging his sources, yet there might, I would suggest, be another consideration at work here. Equipped, as we are, with a better understanding of the eighteenth-century ‘international republic of letters’,142 we might instead think of the similarities as indicating commonplaces of eighteenth-century discourse. Like it or not, in Berlin’s terms, these models still dominate our political thought. What I hope to have shown, in this chapter, is that Montesquieu does indeed speak to us about tax law and policy. To the extent that we can gather from L’Esprit des lois a sense of where we are in the history of taxation ideas; of the nature of taxation in the political societies of which we are part; and of the kinds of difficult political judgments that tax policy implies, no less than their very contingency, we can still read him with so much profit. Not, perhaps, in terms of what we might put in place of the existing system, but of the modes of thought that tell us how we came to be here. As the philosopher himself says: ‘Il ne s’agit pas de faire lire, mais de faire penser’.143

140

Fletcher, n 30, p 55–57, 61, 63–65. ibid, pp 61, 63. 142 See P Casanova, La république mondiale des lettres, 2nd edn (Paris, Éditions du Seuil, 2008) pp 17–23. 143 Montesquieu, n 4, p 430 (Book XI, ch 20). 141

Book 1.indb 90

12/2/2011 8:21:39 AM

4 Charitable Treatment?—A Short History of the Taxation of Charities in Australia ANN O’CONNELL

ABSTRACT

T

HE TAXATION OF charities and other not-for-profits has been the subject of review in Australia recently. A consideration of the history of taxation of charities demonstrates that the issue has always been politically contentious. This chapter considers the development of the income tax exemption for charities and related bodies; the gift deduction for gifts to public benevolent institutions and the more recent concessions in the fringe benefits tax and GST legislation. That history reveals a rather haphazard development – it shows the legacy of British law as well as the signal influence of key individuals and the development of a distinctive Australian taxation law. The historical development also shows that once introduced tax concessions are very difficult to remove.

INTRODUCTION

In the past decade or so, the taxation of charities and other not-for-profit organisations (NFPs) has been a part of the Australian political agenda. Most recently, the issue was considered in 2010 in a comprehensive review of taxation, known as the Henry Review, which was conducted by a committee chaired by the Secretary to the Australian Treasury.1 1 Australia’s Future Tax System Review Panel, Australia’s Future Tax System–Final Report (2010), available at http://taxreview.treasury.gov.au/.

Book 1.indb 91

12/2/2011 8:21:39 AM

92

Ann O’Connell

The Review made four recommendations in respect of NFPs, two of which—the establishment of a national charities commission, and retention of existing income tax and GST concessions2—are relatively uncontroversial. It recommended new rules for clubs with considerable gaming, hospitality and entertainment activities, such as a concessional rate of tax at a particular threshold.3 Most controversially, it recommended phasing out concessions for fringe benefits tax and replacing this with government funding.4 The thengovernment, facing an election, responded to rumblings of discontent by swiftly ruling out ‘any changes to the tax system that harm the not-for-profit sector’, including removing tax concessions, raising the threshold for gift deductions or changing income tax arrangements for clubs.5 This latest episode repeats a familiar pattern. Proposals for reform in this area have come and gone, leaving little trace on a structure of taxation that has developed fitfully and casually, yet which remains remarkably intractable. The most outstanding feature of this structure is its complexity, with 40 different statutes—Commonwealth, state and territory—providing for taxation or revenue concessions for non-profit organisations.6 The most practically important of these are contained in the Commonwealth Income Tax Assessment Act 1997 (Cth). It is this Act which exempts charities from income tax, and also governs which gifts to charities may be deducted from the assessable income of taxpayers. Charities also receive preferential treatment under the Fringe Benefits Tax Assessment Act 1986 (Cth),7 and federal legislation imposing a goods and services tax.8 While similar concessions extend to other non-profit organisations, including friendly societies, building societies, and co-operatives—all of which have their own fascinating history—these are not examined here. This chapter traces the early history of these three concessions—the income tax exemption, the tax deduction for gifts to charities, and (to a lesser extent) the fringe benefits tax exemptions and rebates—in legislation, parliamentary debates and case law. In particular, it focuses on the debates about which charities ought 2

Recs 41–42. Rec 44. 4 Rec 43. 5 Prime Minister and Treasurer of Australia, Stronger, Fairer, Simpler: A Tax Plan for Our Future (Press Release, 2 May 2010). The issue may, however, surface in a tax summit that has been promised on the Henry Review in the next parliamentary term. 6 National Roundtable of Non-profit Organisations, The Assessment of Charitable Status in Australia: Current Practice and Recommendations For Improvement (2007), 5 (http://www.aph.gov. au/Senate/Committee/economics_ctte/charities_08/submissions/sub170c.pdf at 19 May 2010). 7 See ss 57A (exempt benefits); 58G(2) (exempt car parking benefits); 65J (rebates for certain nonprofit employers). 8 A New Tax System (Goods and Services Tax) Act 1999 (Cth), Ch 3, esp Subdivision 38-G (dealing with supplies to charitable institutions); Div 49 (dealing with religious groups); Div 50 (dealing with religious practitioners); Div 63 (dealing with non-profit sub-entities); s 111.18 (dealing with reimbursement of volunteers); ss 157.5, 157.10 (dealing with charities accounting on a cash basis); s 129.45 (dealing with gifts to charities). 3

Book 1.indb 92

12/2/2011 8:21:40 AM

A Short History of the Taxation of Charities in Australia

93

to qualify for tax concessions; and on the development of the legislative regime for tax deductions for gifts to charities. This chapter adopts a chronological approach, beginning by looking briefly at the British legacy of taxation provisions for charities. It then turns to examine the provisions exempting charities in colonial legislation imposing direct taxation, the predecessors of the Commonwealth Income Tax Assessment Act, and the introduction of the tax deduction for gifts to charities. The influence of this legislation is traced in the introduction of early Commonwealth tax legislation, and in the battles between Australian and imperial courts in the early part of the twentieth century. The incremental growth of the scope of the concessions is briefly discussed, before finally turning to the influence of the Income Tax Assessment Act in the introduction of fringe benefits tax, and goods and services tax. What does this history reveal? Perhaps most obviously, it reveals historical changes both in the nature of the charitable and non-profit sector, and in the perception of the sector. It also tracks both the long legacy of British law as well as the development of a distinctive Australian taxation law. Interestingly, it reveals the signal influence of key individuals—quite often politicians in opposition— at important junctures of its development. Perhaps most surprisingly, it reveals the Australian origins and near-death experiences of the provisions allowing tax deductions for gifts, and its continued influence in later tax concessions. This history also helps establish a case for reform, while at the same time undermining any optimism about the success of such reform. For the history reveals the almost accidental nature of the taxation concessions, their obscure origins and their meagre examination. At the same time, however, the history also reveals that, once a concession is introduced, it is very difficult to remove or even confine it.

THE BRITISH LEGACY

The tradition of favourable tax treatment for charities and other non-profit organisations is one of ancient origin in British law. For example, s 5 of the Taxation Act 1692,9 exempted specified non-profit organisations including: universities, colleges and schools; charities for the relief of the poor; and hospitals and almshouses. These three sectors—educational institutions, charities in what might be called the ‘narrow’ sense, and hospitals—have remained at the core of tax concessions for non-profit organisations. In the very first British income tax legislation, the Duties on Income Tax Act 1799,10 there was an exemption for ‘any Corporation, Fraternity, or Society of Persons established for charitable Purposes only’.11 In the Income Tax 9

4 Will & Mar c 1 39 Geo 3, c 13. 11 S 4. 10

Book 1.indb 93

12/2/2011 8:21:40 AM

94

Ann O’Connell

Act 1803,12 a distinction was clearly drawn between exemptions for land tax and taxes on annuities, shares and dividends. The land tax exemptions were narrower, exempting the sites of universities, colleges and schools, hospitals and almshouses, as well as the rents and profits from hospitals or almshouses which were applied for charitable purposes.13 On the other hand, the exemptions for tax on annuities, shares and dividends applied to charities and any funds required to be applied for charitable purposes.14 The Income Tax Act 1842,15 which was the British legislation in force when the first colonial income taxes were introduced, enlarged this tradition slightly. The land tax exemptions extended to ‘literary and scientific institutions’, while the exemptions for rents and profits from land extended to public schools and trusts established for charitable purposes, to the extent funds were applied for such purposes.16 There were exemptions from duties on annuities, dividends, and shares of annuities for organisations and trusts established for, or required to apply the income for, charitable purposes only, as well as for trusts for repairs to religious buildings.17 Finally, there were exemptions for charitable institutions from income tax and interest.18

TAXATION OF CHARITIES IN THE AUSTRALIAN COLONIES

This tradition of exempting charities was continued in some of the early colonial statutes providing for council rates and death duties. The first NSW legislation providing for death duties, for example, exempted charities.19 More significantly, the Municipalities Act 1867 (NSW) exempted: hospitals, benevolent institutions, and buildings used exclusively for public charitable purposes; churches, chapels, and other buildings used exclusively for public worship; and all public schools, colleges and universities. This legislation appears to have introduced the language of ‘benevolent institutions’ and ‘public charitable purposes’, which did not derive from British legislation. The great debates about direct taxation in the United Kingdom in the mid19th century did not have immediate impact upon the Australian colonies. The colonies were then reliant upon customs and excise duties, the sale of public land, and borrowing from the London markets. Direct taxation was delayed in Australia because it was impractical to administer; because the need for this 12

43 Geo 3, c 122. Sch A, no 4. 14 Sch C, 68. 15 5 & 6 Vict, c 35. 16 See Sch A, no 6. 17 See Sch C, first and third exemptions. 18 See s 105. 19 Stamp Duties Act 1865 (NSW) Sch 3, Sch 4. Not all of the early death duties legislation, however, included such exemptions when they were introduced: see, eg, Duties on Estates of Deceased Persons Act 1870 (Vic); Duties on Deceased Persons’ Estate Act 1895 (WA). 13

Book 1.indb 94

12/2/2011 8:21:40 AM

A Short History of the Taxation of Charities in Australia

95

revenue had not yet been demonstrated; and because it would adversely affect the interests of the colonial elites, the landowners and the wealthy, who still wielded tremendous political influence.20 This last factor was largely responsible for the repeated failures of colonial governments to pass bills imposing land and income taxation in the latter half of the 19th century. The balance began tipping in favour of direct taxation first in the smaller colonies of Tasmania and South Australia, which were less able to raise money by the sale of public land and borrowing. After a brief foray by the NSW legislature,21 Tasmania led the way, even though its first attempt at imposing income tax (along the lines of the British income tax legislation) in 1866 led directly to the end of that Government.22 Despite this, the Tasmanian Government tried and failed again in 1873,23 1878,24 and 1879.25 The Victorian Government was the first to succeed in introducing direct taxation—in the form of a limited land tax targeting large parcels of land— in 1877, after a previous government had been forced to withdraw a land and income tax bill in 1876.26 This legislation did not, however, provide exemptions for charities. It was ultimately New Zealand that paved the way, introducing land and property taxes in 1878 and 1879 respectively. These Acts did not pass uneventfully, however, occasioning a ministerial crisis.27 In 1879, an income tax bill was also proposed in New Zealand, but was not even released before a vote of no confidence was passed.28 Significantly, the land tax legislation departed from both the Victorian and British models of land tax by being based on the selling value of land, net of improvements—a model that became a distinguishing characteristic of the early land taxes of the Australasian colonies.29 The Property Assessment Act 1879 (NZ) exempted, in addition to the usual exemptions for places for public worship, the broader category of property vested in ‘any public body society or persons for public charitable or public educational purposes’. It also exempted any organisation ‘not formed wholly or mainly for the purpose of gain or profit’.30 This New Zealand Act therefore 20 See generally J Smith, Taxing Popularity: The Story of Taxation in Australia (Rev edn, 2004); P A Harris, Metamorphosis of the Australasian Income Tax: 1866 to 1922 (2002). 21 The Land Tax Bill 1860 (NSW) was proposed ‘as a supplement to legislation regulating the sale of public lands’, and its ‘revenue raising capacity was only secondary’: Harris, above n 20, 25. 22 ibid, 27–33. 23 ibid, 37. 24 ibid, 56–58, discussing the Land, Dividend and Mortgage Tax Bill 1878, which was adjourned during the House Committee on the Bill, and which resulted in the government falling with the passing of a motion of no confidence. 25 ibid, 59–63, discussing the Income and Property Tax Bill 1878 (Tas). This lapsed after the Legislative Council resolved to read the Bill a second time in six months. 26 ibid, 38–46. 27 The New Zealand land tax bill was accompanied by a Joint Stock Companies Duty Bill and a beer tax bill, but the last two bills were withdrawn to resolve a ministerial crisis: ibid, 46–50. 28 ibid, 50–51. 29 Land-Tax Act 1878 (NZ) s 4. See generally Smith, ‘Taxing Popularity,’ above n 20, 18–24. 30 S 26.

Book 1.indb 95

12/2/2011 8:21:40 AM

96

Ann O’Connell

introduced the language of ‘public educational purposes’, and was the first to introduce an exemption for all non-profit societies, without reference to ‘charitable purposes’.31 In 1880, the Tasmanian Government finally succeeded in passing a limited land and income tax bill, the first Australasian colony to pass an income tax bill.32 More importantly, however, a few years later the South Australian Government finally succeeded in passing the first broad-based income tax in the Taxation Act 1884 (SA),33 following failed attempts in 1878, 1879, and twice in 1883.34 Section 9 of the Taxation Act 1884 (SA) carried on the New Zealand tradition of exempting all non-profit organisations from income tax, exempting ‘all Companies, Public Bodies, and Societies not carrying on any business for the purpose of gain’. As well, the South Australian legislation introduced a clear distinction between exemptions for land tax, and income tax. Section 8 of the Act provided for exemptions from land tax for, inter alia, ‘land used solely for religious or charitable purposes’.35 The model of more restrictive exemptions for land tax, and more generous exemptions for income tax, was continued in subsequent colonial legislation. The next significant step was the relatively smooth passage of the Land and Income Assessment Act 1891 (NZ), which replaced the unpopular property tax in New Zealand.36 This formed the basis of most subsequent Australian legislation, and (after its consolidation in 1900 and 1908) was the primary model for the first Commonwealth tax legislation.37 The exemptions in the 1891 Act were drawn from the earlier Property Assessment Act 1879 (NZ).38 Like the South Australian model, there was a clear distinction between the exemptions for land tax and income tax. The New Zealand Act exempted from land tax, inter alia: places of worship and residences of clergy and ministers; public schools and other schools not carried on exclusively for pecuniary gain or profit;39 universities and colleges; and public libraries, athenaeums, mechanics’ institutes, and public museums.40 The exemptions for income taxes, as before, extended to ‘all public bodies and societies not carrying on any business or not being engaged in any trade, 31

This innovation was not, however, examined in the parliamentary debates. Real and Personal Estates Duties Act 1880 (Tas). 33 Harris, above n 20, 85–93. 34 ibid, Ch 4. This discusses the Land and Property Tax Bill 1878 (SA), which was rejected by the Legislative Council by deferring the second reading; the Property Tax Bill 1879, which precipitated an election after it failed to pass the House Committee; the Property Tax Bill 1883 (SA), when the bill was defeated before even being considered for a second reading; and the Land and Income Tax Bill 1883 (SA), which lapsed after the Legislative Council deferred the second reading by six months. 35 It also exempted institutes formed for the ‘promotion of useful knowledge and rational mental recreation’ under the Suburban and Country Institutes Act 1874 (SA). 36 Harris, above n 20, 108. 37 ibid, 171. 38 New Zealand, Parliamentary Debates, House of Representatives, 4 August 1891, 97. 39 Subject to a limit of 15 acres. 40 S 16(1). 32

Book 1.indb 96

12/2/2011 8:21:40 AM

A Short History of the Taxation of Charities in Australia

97

adventure, or concern for the public purposes of gain’.41 These exemptions were gradually added to, with the important addition in 1892 of exemptions for mortgages and income ‘by or on behalf of any public charitable institution, whether formed under the Hospitals and Charitable Institutions Act 1885, or any other Act …, or howsoever formed, if carried on for public charitable purposes and not for gain or profit.’42 1891 was also the year that the House of Lords handed down its judgment in Pemsel’s case,43 affirming a decision of the English Court of Appeal in 1888.44 This case famously applied the broad technical definition of ‘charity’ applied in equity, derived from the Preamble of the Statute of Elizabeth,45 in the context of the British Income Tax Act 1842. As commentators have pointed out, the line between the Statute of Elizabeth and Pemsel’s case is less straightforward than it appears.46 The Statute of Elizabeth needs to be read in the context of the Reformation, and the establishment of the Church of England: Elizabeth I recognized the need to attract religious money for secular purposes. In a society which did not offer fiscal and tax benefits to donors, religion was an important factor motivating charitable gifts. The citizens with new wealth spurned her state church. Understanding the attitude of the rich Puritan merchants to both the Established Church and the Crown’s history of appropriating religious endowments, Elizabeth I enacted the Statute of Elizabeth 1601.47

Even more importantly, between 1736 to 1891, mortmain legislation meant that ‘the most common way of denying a gift to charity was to have that gift declared charitable’.48 Under the Mortmain Act 1736,49 all testamentary gifts for charitable purposes were rendered void and reverted to the testator’s heirat-law.50 The legislation was enacted during ‘the climax of an anti-clerical movement’ which feared the wealth of the great ecclesiastical charities.51 The parliamentary debates of the time express this fear eloquently: I am very far, my Lords, from disapproving of all charitable foundations, or of all donations to charitable uses … but I am convinced that our charitable foundations may become too numerous, and that some of those we have already established, 41

S 16(2). Land and Income Assessment Amendment Act 1892 (NZ) s 3(4). Land and Income Assessment Acts Amendment Act 1895 (NZ) s 6 also added exemptions for land and mortgages used by religious bodies for the purposes of supporting elderly ministers, and the widows and orphans of ministers. 43 Special Commissioners of Income Tax v Pemsel [1891] AC 531. 44 Special Commissioners of Income Tax v Pemsel (1889) 22 QBD 296. 45 Charitable Uses Act 1601, 43 Eliz 1, c 4. 46 B Bromley & K Bromley, ‘John Pemsel Goes to the Supreme Court of Canada in 2001: The Historical Context in England’ (1999) 6(2) Charity Law and Practice Review 115, 120. 47 ibid, 123–124. 48 ibid, 124. 49 9 Geo 2, c 36. 50 Exemptions were subsequently granted to specified universities, colleges and schools, but other petitions for exemption were resisted: see Gareth Jones, History of the Law of Charity, 1532–1827 (1969), 111–112. 51 ibid, 109. 42

Book 1.indb 97

12/2/2011 8:21:40 AM

98

Ann O’Connell may become too rich and extensive … for, by the specious pretence of charity, the solicitations of those who are interested in charitable foundations, and the pride and vanity of donors, it is to me highly probable, that too great a part of the lands in this kingdom may soon come to be in Mortmain, to the prejudice of the nation in general, and to the ruin or unjust disappointment of many a man’s poor relations … The giving to any such charity I shall always look on rather as an act of injustice towards the heirat-law, than as an act of charity in the donor …52

The extremely broad definition of ‘charity’ developed in equity during this period reflected a desire not to assist charities, therefore, but rather to deny gifts to charities.53 Further, the Statute of Elizabeth, far from being ‘the classic starting point and quintessential statement of the law of charity’, marks ‘the beginning of the legal secularisation of charity’.54 The significance of the preamble for charities, however, was a later development. According to Gareth Jones, it was not until the 1805 decision in Morice v Bishop of Durham55 that the preamble to the Statute of Elizabeth was enshrined as ‘the fons et origo of all charity’.56 This case deserves some comment in light of the later developments of Australian tax law. In that case, the testator made provision ‘for such objects of benevolence and liberality’ as the executor, the Bishop of Durham, ‘in his own discretion should most approve of’.57 Although neither counsel cited the preamble before the Master of the Rolls, the Master relied upon the preamble in holding the trust void for uncertainty.58 On appeal, it was Sir Samuel Romilly, counsel for the next-of-kin, who formulated the four ‘heads of charity’ later made famous by Lord McNaghten in Pemsel’s case.59 Interestingly, Romilly argued that although ‘benevolence’ might be synonymous with ‘charity’ in some contexts, it assumed a wider meaning when coupled with ‘liberality’ and the objects of the trust were therefore too vague to be enforced. Lord Eldon, relying upon the preamble, agreed that benevolent and liberal objects were ‘neither within the letter nor equity of the preamble: therefore they were not charitable objects’, and the trust failed.60 Embedded within the decision in Pemsel’s case, therefore, is the turbulent history of the Reformation. The decision in Pemsel’s case itself was far from foregone, as the dissents of Lords Halsbury and Bramwell show. Lord Halsbury, protesting against the distinction between a ‘popular’ and ‘technical’ sense of the term charity, considered that ‘charitable’ did not have a technical meaning, though he ‘did not deny that the old Court of Chancery … included in that 52

ibid, 110–111, citing Cobbett, Parliamentary History, IX, 1122, 1125–1126, 1144–1145. Bromley and Bromley, above n 46, 123–124. 54 ibid, 129. 55 (1804) 9 Ves 399; (1805) 10 Ves 522. 56 Jones, above n 50, 122. 57 ibid. 58 ibid, 123–124. 59 ibid, 124–125. Jones notes that this description was adopted and adapted without attribution in Pemsel’s case. 60 ibid, 126. 53

Book 1.indb 98

12/2/2011 8:21:40 AM

A Short History of the Taxation of Charities in Australia

99

phrase a number of subjects which undoubtedly no one outside the Court of Chancery would have supposed to be comprehended within that term’.61 At this time, most Australian colonies had passed legislation regulating charitable institutions. These statutes universally confined the scope of their legislation to what might be called the ‘popular’ meaning of charity, namely to the relief of persons in ‘necessitous circumstances’, as the Australian taxation legislation later put it. Section 1 of the Public Charities Act 1875 (SA), for example, defined the phrase ‘public charitable institution’ as meaning ‘public hospitals, destitute and lunatic asylums, orphanages, reformatories, and other institutions of the like nature’. Similar language can be found in the Queensland and New Zealand Acts of 1885,62 the Tasmanian Act of 1888,63 and the Victorian Act of 1890.64 Perhaps most clearly, the Victorian Act distinguished between ‘charitable’ and ‘philanthropic’ institutions, the latter of which were directed to objects including ‘the saving of human life, the promotion of health temperance or morality, the prevention of cruelty or vice, or other cognate objects of a philanthropic or humane nature’.65 The need for charities doubtless became all too apparent in the 1890s, when the Australian colonies experienced depression. The depression prompted Australian legislatures to push, once again, for direct taxation. New South Wales had proposed direct taxation in 1886 and 1888.66 The real push came, 61 Commissioners for Special Purposes of Income Tax v Pemsel [1891] 1 AC, 542. Lord Halsbury also argued that it would be unfair to apply the English ‘technical’ term to the Scottish, which were also governed by the Income Tax Act 1842, which had not adopted such a meaning. 62 Section 2 of the Charitable Institutions Management Act 1885 (Qld) defined ‘public charitable institutions’ as public institutions ‘for the reception, maintenance and care of indigent persons, or other persons requiring medical or other aid or comfort’, but excluding hospitals for the insane or established under statute, or orphanages. Section 4 of the Hospitals and Charitable Institutions Act 1885 (NZ) defined the word ‘Institution’ as ‘any hospital institute for the reception, relief, treatment, and cure of disease, and includes any public establishment instituted for the reception or relief of orphans, aged, infirm, incurable, or destitute persons, or established for any one or more of such objects, or the administration by any body or association of persons of charitable aid’. 63 Section 2 of the Charitable Institutions Act 1888 (Tas) defined a ‘charitable institution’ as ‘any hospital established for the treatment of the sick; any home or refuge for destitute or unfortunate persons; any institution for the gratuitous education or gratuitous maintenance and education of children; any society or association of persons established or associated for the purpose of raising and disbursing moneys for the relief or maintenance of indigent persons; and any other institution which the Attorney-General may certify as a fit and proper institution to be registered under this Act ...’. 64 Section 3 of the Hospitals and Charities Act 1890 (Vic), a consolidating Act, defined a hospital or charitable institution as: ‘any institution established for the cure of disease or for the relief of diseased aged incurable or destitute persons, and supported in whole or in part by the voluntary contributions of not less than fifty persons, each of whom shall have paid not less than One pound per annum or Twenty pounds in one donation’. 65 ibid, s 19. 66 Harris, above n 20, Ch 5. This discusses a proposal for a land tax in 1885, which ultimately led to the downfall of that government; a Land Tax Bill, Land Tax (No. 2) Bill and Income Tax Bill in 1886, the income tax bill being defeated in the House of Assembly Committee and the land tax bill defeated by the Legislative Council; a Land Tax Bill 1888 and Property Tax Bill 1888, which both lapsed when Parliament was prorogued.

Book 1.indb 99

12/2/2011 8:21:40 AM

100

Ann O’Connell

however, between 1893 and 1895. In 1893, the Tasmanian,67 Victorian68 and New South Wales69 governments proposed direct taxation, only to be defeated in all cases. The Tasmanian government succeeded the following year in passing an Income Tax Act, while continued attempts by the Victorian and New South Wales government in 1894 pushed both colonies close to constitutional crisis,70 before eventual success in both Victoria and New South Wales in 1895. Queensland and Western Australia survived until federation with more limited direct taxes, in the form of a dividend duty and a corporate income tax, respectively.71 The New South Wales Land and Income Assessment Act 1895 continued to use the language of ‘public charitable purposes’ and ‘benevolent institutions’, as used in its Municipalities Act 1867. It exempted from land tax both ‘benevolent institutions’ and lands occupied for ‘public charitable purposes’. Section 11(vi) also extended exemptions from land tax for ‘lands dedicated or vested in trustees’ used for ‘zoological, agricultural, pastoral or horticultural show[s]’, and ‘other public or scientific purposes.’ Like the South Australian and New Zealand model, it provided an exemption from income tax for, inter alia, all ‘companies or societies not carrying on business for the purpose of profit or gain’, as well as ‘ecclesiastical, charitable and educational institutions of a public character’. The concept of ‘public’ was therefore strongly emphasised in this legislation. The Western Australian Land and Income Tax Assessment Act 1907 drew largely upon the wording in NSW, although it also clarified the term public by the following phrase: ‘ecclesiastical, charitable, and educational institutions of a public character, whether supported wholly or partly, or not at all, by grants from the Consolidated Revenue Fund’.72 Section 7 of the Victorian Income Tax Act 1895 similarly exempted all ‘trusts societies associations institutions and public bodies not carrying on any trade or not being engaged in any trade for the purposes of gain’. Its exemption for educational institutions was restricted to a specified catalogue of institutions, rather than using the concept of a ‘public character’, and it exempted all bodies ‘formed solely for the promotion of religion’, without requiring that these be of a ‘public’ character.

67 ibid, 127–130. This discusses the Income Tax Bill 1893, in respect of which the Legislative Council refused to give a second reading. 68 ibid, 121–127, 133–141. This discusses the Income Tax Bill 1893, which was withdrawn before a second reading; and the Land and Income Tax Bill 1894, which was rejected by the Legislative Council. 69 ibid, Ch 5. This discusses the Income Tax Assessment Bill 1893 and Income Tax Assessment Bill (No. 2) Bill 1893, which was rejected by the Legislative Council. 70 ibid. This discusses the Land and Income Tax Assessment Bill 1894 (NSW), which was also rejected by the Legislative Council. 71 Dividend Duty Act 1890 (Qld); Companies Duty Act 1899 (WA). 72 S 19(6), relating to income tax exemptions.

Book 1.indb 100

12/2/2011 8:21:41 AM

A Short History of the Taxation of Charities in Australia

101

The federation of Australia in 1901 changed the landscape of taxation again. Under ss 86 and 90 of the Australian Constitution, the Commonwealth was given exclusive power to levy customs and excise duties—still by far the largest stream of colonial taxation—and was also given concurrent power to levy other taxes.73 This finally prompted Queensland and Western Australia to introduce direct taxation, in the form of the Income Tax Act 1902 (Qld),74 and the Land and Income Tax Assessment Act 1907 (WA).

The Emergence of the Gift Deduction While depression prompted the push for direct taxation, it was the return to a time of plenty in Victoria that was responsible for the innovation of allowing tax deductions for gifts to charities, under the government of Sir Thomas Bent. Sir Thomas Bent had come to power in Victoria in 1904. In 1907, Bent had championed the raising of money from an entertainments tax for the purpose of funding charities,75 a proposal that had been made by a Victorian Royal Commission on Charitable Institutions in 1891.76 However, although the bill was introduced into Parliament, it was discharged from the notice paper because of demands on legislative time and the opposition of the racing and theatrical industries.77 When Bent moved to discharge the bill, he noted that he ‘regretted this more than any other Bill which he had moved to be removed from the notice-paper’.78 Two months earlier, however, the Victorian legislature reduced its income tax by 20 per cent in the Income Tax Act 1907 (Vic). The resolution to introduce the bill, moved by Bent, included the following proviso (to become s 3 of the Act): Provided further that there shall be deducted from the gross amount of each taxpayer’s income any gift of any sum over 20 pounds paid by him during the year to or for any free public library or any free public museum or any public institution for the promotion of science and art (including working men’s colleges and schools of mines), or any public university or any public hospital or public benevolent asylum or public dispensary, whether any such library or other institution is or is not in existence at the time of the gift.79

73

Australian Constitution s 51(ii). This legislation provided for income tax exemptions for ‘societies and institutions not carrying on business for purposes of profit and gain’, as well as ‘religious, charitable and educational institutions of a public character’: s 12(iv), (vi). 75 ‘In the Name of Charity—Mr Bent’s New Taxation Scheme’, The Advertiser (Adelaide), 16 October 1907, 6. 76 See ‘The Charities Commission—Supplementary Report—Tax on Sports Advocated’, The Argus (Melbourne), 20 August 1895, 7. 77 Victoria, Parliamentary Debates, Legislative Assembly, 27 November 1907, 2638. 78 ibid, 2639. 79 Victoria, Parliamentary Debates, Legislative Assembly, 18 September 1907, 1214. 74

Book 1.indb 101

12/2/2011 8:21:41 AM

102

Ann O’Connell

According to the Premier, this ‘had never been done before’.80 He explained that he had included this proviso because he had found that in one or two cases, gentlemen had stated that they would not give to charities the large amounts they otherwise would give because the Government were charging income tax upon them. Therefore, he thought it only fair that any one giving over £20 should not be charged income tax upon the amount.81

Introducing the bill to the Legislative Council, the Honourable JM Davies explained it thus: [I]f in the past there had been a similar provision in connexion with the probate duties, testators would probably have given more in their wills to charitable institutions than they had done. … Thus, although the State would lose revenue in one direction the encouragement afforded to charitable giving would probably make up the loss.82

The Victorian Legislative Assembly was gratified by this innovation, and even William Watt, a long-time enemy of Bent (and a later Premier), called it ‘a splendid thing’.83 Indeed, the momentum was entirely in the direction of expansion of this concession, and foreshadowed similar debates in the federal sphere. George Prendergast, also a subsequent Labor Premier of Victoria, asked why the man who contributed £1 should not also have a deduction, since ‘[s]urely the object was to encourage everyone to subscribe according to his means. If a man could afford to subscribe £20 it meant that he could very well afford to pay income tax upon that amount’.84 He thought that since ‘the number of people who subscribed liberally to charities was not very large’, the loss of revenue by adopting his suggestion would ‘not be very considerable’.85 James Farrer was of a similar view, although he proposed the threshold be £5. When Bent replied that, if this proposal were adopted, ‘the bookkeeping would cost more than the revenue’, Farrer pointed out that it was ‘the taxpayer [who] would have to do the bookkeeping.’86 The following day, Bent explained his intention was for the concession ‘to apply to any one giving to the ordinary institutions a sum equal to that required for life governors’.87 Watt thought the concession ought to be expanded in relation to the institutions included in the concession. In his view:

80

ibid, 1215. ibid, 1214. 82 Victoria, Parliamentary Debates, Legislative Council, 2 October 1907, 1356–1357. 83 Victoria, Parliamentary Debates, Legislative Assembly, 18 September 1907, 1233 (William Watt). According to (Sir) Frederic Eggleston: ‘The history of the Bent Ministry is a duel between Bent and Watt’: Australian Dictionary of Biography Online Edition, http://adbonline.anu.edu.au/ biogs/A120459b.htm. 84 Victoria, Parliamentary Debates, Legislative Assembly, 18 September 1907, 1215. 85 ibid. 86 ibid, 1221. 87 ibid, 1273. 81

Book 1.indb 102

12/2/2011 8:21:41 AM

A Short History of the Taxation of Charities in Australia

103

The institutions mentioned in the clause were altogether inadequate. The operation of the clause was confined to too few institutions. It dealt with seven classes of institutions ... and the only really charitable one amongst them was the benevolent asylum. … If the Premier did not wish to dry up the streams of private charity, he should open a wider gate in connexion with this clause. There were institutions such as refuges that deserved consideration, and notably the women’s refuge in Carlton, which was a splendid institution. If a man gave £50 to that institution, it was more meritorious than a gift to the Ballarat School of Mines.88

Bent replied that he intended originally to put the whole lot in, but he found there were something like 150, and it was a question of what could be done. However, he was prepared to adopt any suggestion that would have the effect of relieving those who gave to charities, and of encouraging them in every possible way.89

He suggested that Watt prepare a list of further institutions for consideration upon recommittal of the bill, and these suggestions—women’s refuges, ladies’ benevolent societies, and miners’ benevolent funds—were adopted the following day.90 At the same time, a proviso that the institution should be situated in Victoria was moved by Bent, and accepted.91 Prendergast raised a further objection, namely to the form of the concession. Rather than naming individual organizations, he thought it would be better to include ‘or such other organization existing for the purpose of giving charity as may be determined by the Governor in Council.’ In his view: It would be better to have the discretion in the hands of the Governor in Council. Even if it were provided that all societies affiliated with the Charity Organization Society were included that would considerably enlarge the scope of the clause. If certain organizations were mentioned it might mislead, and some people would say that it was done purposely.92

William Beazley echoed this sentiment, saying the only fear he had ... [was that the clause] would have the effect of directing the attention of benefactors to particular institutions. ... It should be provided that the clause should apply to any charitable institution without distinction.93

The sentiment did not find favour, however, and the bill passed without further discussion in the Council.

88

Victoria, Parliamentary Debates, Legislative Assembly, 18 September 1907, 1233. ibid, 1234. 90 Victoria, Parliamentary Debates, Legislative Assembly, 19 September 1907, 1272–1273. 91 ibid. A suggestion that infant asylums be included was rejected, for in the view of Bent and Watt this would ‘open up the denominational question’ with claims being pressed for the ‘Orange lodge and the Roman Catholic lodge’, and in any event infant asylums did not tend to receive sums over £20: ibid. 92 ibid, 1273. 93 ibid. 89

Book 1.indb 103

12/2/2011 8:21:41 AM

104

Ann O’Connell

At the same time, the Victorian legislature similarly exempted from administration and probate duty bequests and settlements to the same list of institutions by s 3(2) of the Administration and Probate Act 1907 (Vic). This was the only new clause in the bill, and the only comment made in Parliament was that it might have been ‘enlarged somewhat’.94 Significantly, the legislation used the phrase ‘public charitable’ bequest or settlement, language that would later be picked up by the federal government. The following year, Bent was knighted, but in 1909, he lost government and, under the strain of allegations of corruption, the 71-year-old died of influenza.95 Bent’s gift, however, would long outlive him.

THE FORMATION OF THE COMMONWEALTH

Tax Exemptions At federation, it was anticipated that the customs and excise revenue would be more than sufficient to sustain a relatively small Commonwealth Government.96 Nevertheless, the promise of a national old-age pension, a push to attract immigrants, and the rise of the Labour Party led to a graduated federal land tax in 1910 in the Land Tax Assessment Act 1910 (Cth), which was largely based on the 1908 NZ Act.97 The era of competition between the Commonwealth and the States in taxation had begun. The man who was to preside over the early federal taxation legislation, William Morris Hughes, popularly known as Billy, is one of the great figures of Australian political history. An influential figure in the early Labour years, he was colourful and controversial. Between 1910 and 1915, as Attorney-General, Hughes shepherded three important pieces of taxation legislation through the Parliament.98 A prominent unionist and a widely read newspaper columnist, he became Prime Minister midway through World War I and was spectacularly expelled from the Labour Party after losing a referendum on conscription.99 Hughes was responsible for the land tax legislation in 1910. Clause 12 of the Land Tax Assessment Bill included an exemption for all land owned by ‘public charitable’ and ‘public educational’ institutions which were carried on ‘not for pecuniary profit’, along the lines of the New Zealand and New South Wales terminology. It also included an additional exemption for all land used and

94

Victoria, Parliamentary Debates, Legislative Council, 2 October 1907, 1354 (Arthur Sachse). Australian Dictionary of Biography Online Edition, http://adbonline.anu.edu.au/biogs/ A030137b.htm; ‘Obituary’, The Mercury (Hobart), 18 September 1909, 6. 96 Smith, above n 20, 40–41. 97 ibid, 42–43; Harris, above n 20, 167. 98 Hughes was Attorney-General under Andrew Fisher from 29 April 1910 to 24 June 1913, and again from 17 September 1914 to 27 October 1915, after which he was Prime Minister until 1923. 99 Australian Dictionary of Biography Online Edition, http://adbonline.anu.edu.au/biogs/ A090395b.htm. 95

Book 1.indb 104

12/2/2011 8:21:41 AM

A Short History of the Taxation of Charities in Australia

105

occupied solely as a site for ‘a charitable or educational institution not carried on for pecuniary profit’. The parliamentary debates on this clause were, in contrast to that in the colonial legislatures, surprisingly spirited, and the concerns raised in those debates foreshadowed long and, in some cases, continuing controversies. For example, notwithstanding the long history of this type of provision, Ernest Alfred Roberts, a South Australian Labor Party member, questioned its desirability, on the basis that some societies used the major portion of revenues to meet expenses for management—a forerunner of the vexed debate over the size of overheads in charitable organisations.100 This debate was revived in 1916, on the introduction of the federal Entertainments Tax Bill, when there was considerable debate about the value of exempting charitable entertainments which were largely eaten up by expenses.101 The most spirited debate, however, in the House committee concerned the use of the word ‘public’. Three members urged its omission, on two bases: first, that it was ‘very difficult to obtain a satisfactory definition of the word’,102 and secondly, because the word ‘public’ could be construed to mean ‘in the sense of being controlled or supported by the State’103 and would exclude, for example, a number of privately endowed institutions or educational institutions that charged fees.104 Littleton Ernest Groom (a barrister and later a Commonwealth Attorney-General) considered that the purpose was surely to preserve from taxation all charitable and educational institutions that are substantially intended for the benefit of the community generally … provided they are not carried on by some individual for his own or personal gain.105

Hughes conceded that the words ‘public charitable or public educational institution’ were ‘by no means unambiguous’, and were not clarified by decisions under the NSW legislation which dealt with the term ‘public charitable purposes’. Nevertheless, he submitted, there was no necessity to leave out the word ‘public’, because in his view the word ‘public’ referred to the ‘public purpose’ behind a charity, which need ‘not be a public purpose in which the whole community share, and its benefits may be restricted to a comparatively small proportion of the community’. He doubted ‘very much whether anything could be construed 100

Commonwealth, Parliamentary Debates, House of Representatives, 28 September 1910, 3870. Commonwealth, Parliamentary Debates, House of Representatives, 18 December 1916, 10228 (Alexander Poynton—Treasurer). Clause 13 of that bill also enabled a rebate to be paid if the expenses amounted to less than 20 per cent. When this percentage was queried, one member noted that attempts to increase this percentage might ‘go too far’, noting an educational lecture which had been held of which only two out of nearly 30 pounds had been available for the patriotic purposes advertised. The threshold was, however, increased to 50 per cent, bearing in mind the cost of renting large venues, and a further proviso enabling a rebate in the case of adverse climatic conditions rendering the expenses greater than this percentage was also included. 102 Commonwealth, Parliamentary Debates, House of Representatives, 28 September 1910, 3872 (Littleton Ernest Groom). 103 ibid, 3870 (Patrick Glynn). Glynn had been the previous Attorney-General. 104 ibid, 3871–3872. 105 ibid, 3872. 101

Book 1.indb 105

12/2/2011 8:21:41 AM

106

Ann O’Connell

to be a charity that did not effect a public purpose’, but promised to reconsider the matter on recommittal of the legislation.106 On recommittal, Hughes moved that the word ‘public’ be removed from the clause, which was agreed to.107 In doing so, Hughes clearly indicated that fee-charging educational institutions would not be excluded by the phrase ‘not carried on for pecuniary profit’. It is unclear from the debates exactly what was intended by the scope of the word ‘charitable’. Hughes alluded to Pemsel’s case, noting that the ‘technical legal meaning’ ‘covers a very wide field, and would not appear to be at all limited by the popular meaning of the term’.108 However, he also noted that the NSW courts had construed the words ‘public charitable purposes’ as having a ‘special and more limited meaning, and are not to be construed in their technical, acquired, and legal sense’.109 Did he intend, by adopting the phrase ‘public charitable’ institution, to favour the narrower, popular, meaning? The debate was revisited again when, with the greater need for revenue occasioned by World War I, the Commonwealth imposed three new taxes—an estates duty tax, an income tax, and an entertainments tax—in 1914, 1915 and 1916 respectively. Once again, Billy Hughes as Attorney-General introduced the Estate Duty Assessment Bill 1914 (Cth), largely based on the Finance Act 1842 (UK).110 This bill did not originally contain an exemption for charities. However, when Littleton Groom proposed an amendment exempting from duty ‘so much of the estate as is devised or bequeathed for religious, charitable, scientific or educational purposes’, the government agreed to adopt the amendment by exempting ‘so much of the estate as is devised or bequeathed or passes by gift inter vivos, or settlement for religious, scientific, public charitable, or public educational purposes’. As noted earlier, the inclusion of the word ‘public’ before charitable and education was drawn from the Victorian Administration and Probate Duties Act 1907,111 although the federal exemption was more generous as it applied to all estates.112 More importantly, as Glynn pointed out, the Victorian Act went on to expressly define which institutions were covered by the provision, unlike in the federal bill.113 As Glynn also noted, the Victorian definition was quite narrow, and would exclude ‘a great many charities’ including, for example, the Salvation Army and Barnardo’s. Glynn’s other objection to the word ‘public’ was that, as previously discussed, it would create uncertainty. Noting Pemsel’s case, he 106

ibid, 3873 (William Hughes—Attorney-General). Commonwealth, Parliamentary Debates, House of Representatives, 7 October 1910, 4293. 108 Commonwealth, Parliamentary Debates, House of Representatives, 28 September 1910, 3873 (William Hughes—Attorney-General). 109 ibid. 110 Commonwealth, Royal Commission on Taxation, Third Report (1934), 176. 111 Commonwealth, Parliamentary Debates, House of Representatives, 15 December 1914, 2028 (William Hughes—Attorney-General). The Victorian Act applied only to estates of £20,000 or upwards. Hughes estimated that this concession would reduce the total revenue of the estate duty by one-third. 112 ibid, 2027–2028. 113 ibid, 2032. 107

Book 1.indb 106

12/2/2011 8:21:41 AM

A Short History of the Taxation of Charities in Australia

107

argued that the ‘greatest confusion has always been introduced by qualifying the private character of charitable institutions’.114 As Sir William Irvine succinctly put it, while the term ‘charitable purposes’ ‘has a perfectly defined meaning in law’, the use of the word public ‘before it may give some undefined limitation’.115 Hughes, on his part, thought the term ‘public charitable purposes’ was ‘very wide’ and to ‘what extent it is narrower than “charitable purposes”’ he could not say. He was tempted to strike the word out before ‘educational’ rather ‘than have any more bother about the matter’, although he could ‘hardly conceive of any educational purpose which would not be public. The word ‘public’, as used here, does not mean ‘State’ or ‘National’ … but has a very wide significance’.116 The word ‘public’ was then struck out before ‘charitable’, but not before ‘educational’. As debate continued on the use of the term ‘public educational’, Hughes’ resistance stiffened. In his view, the members were ‘creating difficulties, and are arguing about words rather than principles’.117 He cited the definition of ‘public institution’, ‘public charity’, and ‘public education’ in Stroud’s Judicial Dictionary, the last of which specified that it included education ‘provided in return for periodical payments’ and that it was ‘not material that such education should be controlled by the State’. He insisted that ‘public educational’ was the ‘proper term to use’ because if a ‘testator devised his estate to be used for the purpose of educating his own family’,118 that would come within the phrase ‘educational institution’—and, presumably, was not worthy of exemption. Hughes stated his ‘idea is to express what ‘public’ connotes generally, and not what it connotes technically—that is, a public institution is one which is open to a considerable body of persons, and used for educational purposes’.119 While Hughes promised to consider the matter again and, if necessary, amend it in the Senate, the matter was not raised again. Thus, the Estate Duty Assessment Act 1914 (Cth) exempted from duty bequests, settlements, and gifts inter vivos for ‘religious, scientific, charitable or public educational purposes.’ The following year, the first federal income tax legislation, the Income Tax Assessment Bill 1915 (Cth), was introduced. The bill provided inter alia for exemptions for friendly societies, trade unions, and ‘religious, scientific, charitable or public educational institutions’—namely, the phrase taken from the estate tax legislation of the previous year. This time, there was no debate about the word ‘public’. Rather, the debate was about whether the exemption was sufficiently wide. As noted earlier, the legislation of the States generally provided for a broader income tax exemption for all organizations not carried on for the purpose of profit, in contrast to the 114

ibid. ibid. 116 ibid, 2033. 117 ibid, 2034. 118 ibid. 119 ibid, 2035. 115

Book 1.indb 107

12/2/2011 8:21:41 AM

108

Ann O’Connell

narrower exemptions for land tax. When Hughes—still the Attorney-General— was questioned on this, he replied (incorrectly) that while some exemptions in colonial legislation went further, most did not go quite so far, and he was not inclined to extend it further, although he would think it over.120 He also rejected a proposal that the exemption extend to temperance societies, on the basis it was difficult to distinguish between this and a ‘political organization’.121 This may be considered a forerunner to the continuing debate about tax exemptions for organizations involved in political activism, as discussed later.

Gift Deductions The debates of the Income Tax Assessment Act 1915 (Cth) are, however, more illuminating in respect of tax deductions for gifts to charities. The original bill did not include any such provision, although the Attorney-General had discussed the matter ‘at length’ with the Tax Commissioner.122 It was wartime, however, so the Commonwealth saw fit to allow tax deductions in respect of contributions to the war of £5 or more. The proposal for a tax deduction for gifts to charities was, instead, picked up by a Victorian pastoralist, James Chester Manifold. Manifold was one of a family of noted philanthropists. His father, William Thompson Manifold, donated to the Church of England cathedral, Queen’s College, and Ballarat Grammar School; endowed scholarships and superannuation funds; and gave a large bequest of £280,000 to a college at the University of Melbourne.123 James Chester Manifold also gave generous benefactions to ‘to his country, Church and district’.124 It was Manifold who suggested including tax deductions for gifts to charitable institutions on the basis that they were ‘likely to experience a very bad time in the next two or three years’, and deductions might induce the public ‘to render very necessary assistance’.125 He suggested the phrase ‘public charitable institutions’, noting that this phrase ‘was defined in most State Acts’. Hughes replied that it would cover a very wide field, but he would consider what could be done.126 The Attorney-General must have had a change of heart, for when the bill was introduced in the Senate on 9 September 1915, clause 18 allowed for tax deductions of donations exceeding £20—the same threshold as set by the Victorian legislation. This was likely only the second Australian income tax 120 Commonwealth, Parliamentary Debates, House of Representatives, 1 September 1915, 6541 (William Hughes—Attorney-General). 121 ibid. 122 ibid, 6608 (William Hughes—Attorney-General). 123 Australian Dictionary of Biography Online Edition, http://www.adb.online.anu.edu.au/biogs/ A100694b.htm.htm. 124 ibid. 125 Commonwealth, Parliamentary Debates, House of Representatives, 1 September 1915, 6608. 126 ibid (William Hughes—Attorney-General).

Book 1.indb 108

12/2/2011 8:21:42 AM

A Short History of the Taxation of Charities in Australia

109

legislation to include such a provision.127 Crucially, the form of the amendment was to insert before the provision enabling deductions for war funds the phrase ‘gifts exceeding Twenty pounds each to public charitable institutions’. The term ‘public charitable institutions’ was not discussed in Parliament, although Hughes no doubt remembered the earlier debates about the use of the word ‘public’. Rather, the major debate about this clause concerned the threshold of £20 for charitable institutions, compared to the threshold of £5 for contributions to the war. Echoing Bent in 1907, Senator Russell stated that the threshold had been set because a sum of less than £20 was ‘a little too small to bother about’,128 and again the reply came that receipts could be demanded.129 The following year, the Entertainments Tax Assessment Act 1916 (Cth) was passed. This legislation used slightly different terminology to the earlier Acts. Section 17 exempted entertainments where all of the takings were wholly devoted to ‘public, patriotic, philanthropic, religious or charitable purposes’, or where ‘the entertainment is of a wholly educational character’, or ‘the entertainment is of a partly educational or partly scientific character conducted by a society, institution or committee not established or carried on for profit’. Section 18 of the Act provided a rebate where the net proceeds were devoted to public, patriotic, philanthropic, religious or charitable purposes, and the expenses did not exceed 50 per cent of the receipts. The debates on this bill, however, did not discuss these phrases. In contrast to the relatively uncontested income tax exemptions for charities, the tax deductions for gifts to charities have had a rather more turbulent history. At the end of the war, indeed, the provision came perilously close to extinction. The competition between the Commonwealth and the States in the arena of taxation had led to a series of inter-colonial conferences. The Income Tax Assessment Act 1918 (Cth) was enacted primarily to adopt agreements made at such a conference in 1917. The original bill also included a remodelling of the provision enabling deductions for gifts to charitable institutions, primarily providing that in ‘future all cash contributions to patriotic funds will be deductible irrespective of amount’.130 The bill also enabled a tax deduction to be claimed where a total of £20 was given to charity, instead of £20 to each charity as originally provided.131 The bill was introduced by then Commonwealth Treasurer and Acting Prime Minister William Watt, formerly of the Victorian Legislative Assembly, who (as noted earlier) had called the Victorian innovation in 1907 a ‘splendid thing’. 127 By 1922, only the Victorian and Queensland income tax legislation included such a provision: Commonwealth, Royal Commission on Taxation, Third Report (1922), 163. Queensland had not introduced such a provision by 1911. (The subsequent volumes of legislation are missing from the University library.) 128 Commonwealth, Parliamentary Debates, Senate, 9 September 1915, 6745. 129 ibid (Sir Albert Gould). 130 Commonwealth, Parliamentary Debates, House of Representatives, 1 May 1918, 4257 (William Watt—Acting Prime Minister and Treasurer). 131 ibid, 4686 (Patrick Glynn).

Book 1.indb 109

12/2/2011 8:21:42 AM

110

Ann O’Connell

Under his stewardship, the federal equivalent was nearly blown away by a side-wind. Having attracted no comment in committee originally, when it was recommitted on 15 May 1918, there were multiple objections, which echoed earlier debates. Henry Piggott moved an amendment removing the threshold of £20, on the basis that it was ‘not democratic to discriminate between a man who gives £20 to a public charity and a man who gives his £1’.132 Another member suggested deleting the word ‘public’.133 Patrick Glynn, then Minister for Home and Territories, objected that, while an exception to the threshold was made for patriotic funds, ‘this is general legislation with which we are dealing, in connexion with public charities that will outlast the duration of the war’, and that removing the threshold would result in a loss of at least £50,000 a year in revenue.134 At this point, the debate swung the other way. Austin Chapman, with whom Edmund Jowett agreed, thought it would be better to remove the exemption altogether rather than include an exemption that discriminated against the poor, when ‘we all know that it is the poor man who gives the best’.135 William Finlayson, echoing Manifold, argued that the war had had a terrible effect on charities as money was diverted to patriotic funds.136 Then Bernard Corser intervened, rejecting the exemption altogether on the basis that donors have no idea of receiving in return any direct advantage. My own belief is that 95 per cent of those who contribute to patriotic funds do not desire any exemption on that account. If the exemption were abolished, I do not think it would in the slightest degree reduce the amounts contributed for either charitable or patriotic purposes.137

This sentiment against the tax deduction would be reiterated by members of Parliament for years to come. The debate concluded rather surprisingly when Glynn suggested it was more logical to abolish the exemption, and Piggott, who had moved the original amendment removing the threshold, agreed. By this turn of events, the House of Representatives agreed to strike out the provision altogether.138 On 29 May 1918, however, Senator Fairbairn successfully moved to restore the provision.139 In contrast to the debate in the House, the debate in the Senate concerned only the appropriate threshold. Fairbairn originally proposed a 132

ibid, 4685 (Henry Piggott). ibid, 4685 (John Lynch). 134 ibid, 4686. 135 ibid, 4687. 136 ibid, 4687–4688. 137 ibid, 4688. 138 The action of the House of Representatives was protested against by the Secretary of the Charity Organisation, which noted that the US Senate had the previous year considered favourably a deduction for charitable, educational and religious purposes. The Secretary observed that the ‘Government can well afford such an investment of whatever it would lose in taxes thereby, and can easily recoup its losses’ by other taxes: S Greig Smith, Letter to the Editor, ‘Charities and Income Tax’, The Argus (Melbourne), 28 May 1918, 5. 139 Commonwealth, Parliamentary Debates, Senate, 9 May 1918, 5180–5182. 133

Book 1.indb 110

12/2/2011 8:21:42 AM

A Short History of the Taxation of Charities in Australia

111

threshold of £1, but to the dismay of other Senators restored it to £20 when the same objection was made by the government. The Senate’s request was duly reported to the House, where the matter was reconsidered on 7 June. Watt urged adoption of this request, with a limit of £5.140 This time, the voices speaking against the deductions were even stronger. For example, William Higgs was very sorry that it is proposed to provide for any deduction at all in respect of these gifts to patriotic funds ... Personally, I believe that the prospect of an exemption from income tax in respect of a gift to one of these funds does not weigh at all with the average contributor. When a man is asked to subscribe to a fund ... it does not occur, I believe, to one in a thousand that by making the contribution he will secure a deduction[.]141

Watt noted that while, previously, some members had objected on the basis that there should be no discrimination between gifts to charities and patriotic funds, and others on the basis that it was too difficult to verify donations, there was now ‘quite a new school of thought within this chamber. I refer to those honorable members who say, “Why grant any remission of income taxation at all?”’142 Provoked, Watt rose to the defence of the deduction, speaking from his experience of the original Victorian experience. In 1907, he noted, the Crown took the attitude that in granting deductions for donations of that kind it could afford to lose the revenue providing that the destination of the money was the coffers of the charitable institutions of the State. If that held good at that time, it is even more emphasized to-day. ... From the stand-point of expediency it has been found advisable, because it has acted as an incentive, inducing people to give more generously to charitable institutions.143

Arthur Rodgers, too, argued that in his experience, he had found the tax deduction a ‘great incentive’ when fundraising.144 In his view, such a deduction could also serve to ‘influence, if possible, the man who is not in the habit of making contributions.’145 John Lynch, still objecting on principle to the deduction, observed of Watt’s argument that he hoped the ‘chastening effects of war ... will evolve a higher standard among Victorian taxpayers’.146 The deduction was saved, but the debate had not yet died. The tax deductions came under threat once again in 1922, when the third report of the Royal Commission on Taxation was published. The report noted that the views of witnesses varied greatly, with some advocating the abolition of 140

Commonwealth, Parliamentary Debates, House of Representatives, 7 June 1918, 5671. ibid, 5668–5669. 142 ibid, 5673. 143 ibid. 144 ibid, 5674. 145 ibid. 146 ibid, 5675. 141

Book 1.indb 111

12/2/2011 8:21:42 AM

112

Ann O’Connell

the clause, and some arguing for amendment of the threshold, ‘whether above or below’.147 The Royal Commission’s view clearly put the case against: A strong objection to a provision of this character is that it affords a concession to the taxpayer, varying in value according to his position upon the scale of graduated rates, but whatever that position may be, the effect of the sub-section is to make the general body of taxpayers contributors of a proportion of the individual’s charitable gift. ... [The] extreme differences in effect of the provision as between one taxpayer and another, and the doubt we entertain that the concession has had any appreciable effect in stimulating private benevolence, lead us to the conclusion that it is not in the general interest of the public that the provision be retained. We therefore suggest its omission from the Act.148

Despite this clarion call, the Income Tax Assessment Act 1922 (Cth), which consolidated the earlier legislation and gave effect to the recommendations of the Royal Commission, did not repeal the provision.149 Stanley Bruce—due to become Prime Minister the following year—objected to its inclusion, noting that the provision had been introduced hastily in a time of war. In his view: When people have spent their income in a particular way, which I trust gives them every satisfaction, as it is should, if it is in the direction of generous gifts to charitable causes, they are a little too inclined to think that the State should subsidise him for so doing.150

Matthew Charlton agreed. In his view, it was unlikely such a provision would have been inserted except for the war, and it was time to strike it out.151 This proposed amendment, however, was negatived. Similar objections were raised in 1927,152 when Bruce was in power under a coalition government. Somewhat surprisingly, given Bruce’s previous opposition, the deduction was widened to include gifts to universities and colleges and gifts in kind. While a push to expand the concession to other educational and research institutions was defeated,153 the Treasurer agreed to lower the threshold to £1, ending once and for all that particular debate.154 In contrast to the first Royal Commission on Taxation, a second Royal Commission on Taxation—which succeeded finally in imposing a degree of uniformity between Commonwealth and state legislation—did not even consider the merits of the provision. Instead, it was primarily concerned with the

147

Commonwealth, Royal Commission on Taxation, Third Report (1922), 162. ibid, 162–163. 149 Commonwealth, Parliamentary Debates, House of Representatives, 10 October 1922, 3481. 150 ibid, 3484. 151 ibid. 152 Commonwealth, Parliamentary Debates, House of Representatives, 29 November 1927, 2159, 2168. 153 ibid, 2160. 154 Commonwealth, Parliamentary Debates, House of Representatives, 15 November 1927, 2160. The current threshold is $A2: Income Tax Assessment Act 1997 s 30–15. 148

Book 1.indb 112

12/2/2011 8:21:42 AM

A Short History of the Taxation of Charities in Australia

113

technical limits of the concession.155 The Royal Commission also recommended harmonising the various exemptions in state and Commonwealth Acts imposing death duties,156 and the removal of some anomalies in the Commonwealth exemptions in relation to land taxes.157 As a result, the state legislation was largely amended in line with the Commonwealth provisions.158 The generosity of this Royal Commission stood in greatest contrast to the previous Royal Commission when it considered whether donations to research should also be allowed as a tax deduction. The Commission noted that only Western Australia at that time specifically allowed such a deduction, and ‘no general request’ had been made for such a deduction by witnesses to the Commission. Nevertheless, it recommended that, ‘having regard to the social value of such contributions’, they be allowed as a deduction by all governments.159 This was not the end, however, of the controversy. In 1944, the Government announced a review of the tax deductibility of such gifts on the basis that some citizens appeared to be using them to evade tax.160 More significantly, when the Commonwealth Committee on Taxation was established to consider a wide range of taxation matters in the 1950s, the tax deductions were criticised once again. In the Committee’s view, these allowances were a matter of Government policy. It can see no reason in principle why gifts should be allowed as a deduction in ascertaining a taxpayer’s taxable income. In the opinion of the Committee, such an allowance must be nothing more than a means of indirectly granting assistance to the institutions and funds by employing the income tax concession as a means of encouraging generosity. The Committee does not therefore favour the principle of the allowance of deductions for gifts to approved funds and institutions, but considers that if assistance is warranted, it should be granted directly, and not indirectly by means of an income tax concession granted to the donor of money or property.161

155 These included: amending the provision so that gifts need not be made out of ‘assessable income; whether deduction of gifts in kind should be limited to those purchased in the assessable income of the year made, and thirdly whether the concession should be restricted to charitable institutions carrying on their functions within the jurisdiction of the taxing authority. 156 Commonwealth, Royal Commission on Taxation, Third Report (1934), 202–203. 157 These anomalies were that the provision exempted land if it was owned by certain institutions, without restriction on the use of the land for certain purposes; and that in other parts of the section the institution could only be exempt if the land was used solely for those purposes. 158 See, eg, Income Tax Assessment Act 1936 (Qld) ss 13, 29(22). 159 Commonwealth, Royal Commission on Taxation, Third Report (1934), 107. 160 See ‘Charities deplore tax evasion charge’, The Canberra Times (2 February 1944), 3, and ‘Tax deductions for charity’, The Canberra Times (4 February 1944), 2. It appears this review came to nothing. 161 Commonwealth Committee on Taxation, Report on Income Tax-Concessional Allowances in respect of Gifts to Certain Funds and Institutions in Australia (Reference No 12), Parl Paper No 50 (1951), 3. The Committee also noted in relation to exemptions for charities in relation to pay-roll tax that most submissions had argued for their abolition, but this was not within its terms of reference: Commonwealth Committee on Taxation, Report on Pay-roll Tax: Exemptions and Anomalies (Reference No 52), Parl Paper No 216 (1953), 3.

Book 1.indb 113

12/2/2011 8:21:42 AM

114

Ann O’Connell

As a result, if the concessions remained, the Committee considered the scope of the concessions should not be extended further, but rather limited by analogy with the existing institutions. Using that principle, it considered that nonprofit hospitals should also be granted this concession, although it rejected its extension to educational institutions of other kinds.162 Rather than repealing the concession, the government responded to this report by extending the scope of the concession to non-profit hospitals.163

CASE LAW ON THE MEANING OF CHARITY AND CHARITABLE PURPOSES

If Billy Hughes was the presiding spirit of the first federal taxation legislation, it was Isaacs J who was instrumental in the story of the taxation of charities in the next decade. Isaacs J, like many of the early Justices of the High Court, had been a prominent politician—acting Premier of Victoria, a delegate to the federation conventions, a founding member of the Commonwealth Parliament, and Attorney-General in 1905 prior to his appointment to the High Court in 1906. He was to later be the first Australian-born Governor-General. A fervent nationalist and a passionate social reformer, he steered the High Court to an expansive view of Commonwealth power.164 In 1920, not long after the near-death of the tax deduction for gifts to charities in 1918, the High Court had to consider the meaning of the phrase ‘public charitable institutions’ in that paragraph in Swinburne v Federal Commissioner of Taxation.165 The question concerned whether an educational college fell within that description. Isaacs J, giving judgment together with Gavan Duffy, Rich and Starke, JJ, rejected the argument that the phrase should be interpreted in the technical legal sense of ‘charitable purposes’ as discussed in Pemsel. In their view: no technical signification has attached itself, at all events in Australia, to the expression ‘public charitable institution’. We are not to pull the phrase to pieces and consider the various meanings of its component parts, but we have to read the composite expression as written … Now, in Australia (and the Act we are considering is directed to Australians) the expression ‘public charitable institution’, so far from having the technical meaning coextensive with the Elizabethan Statute, is used both popularly and officially as denoting an institution which—assuming its ‘public’ character … —is ‘charitable’ in the sense of affording relief to persons in necessitous or helpless circumstances, and in most instances, at all events if required, gratuitously. That that is the popular understanding of the phrase is a matter of common knowledge, and so within our judicial cognizance.166 162

Commonwealth Committee on Taxation, Report on Gift Deductions, above n 161, 4. Income Tax and Social Services Contribution Assessment Act 1951 (Cth) s 14. 164 Zelman Cowen, ‘Isaacs, Isaac Alfred’, Oxford Companion to the High Court of Australia Online Edition (2007). 165 (1920) 27 CLR 377. 166 ibid, 384. 163

Book 1.indb 114

12/2/2011 8:21:42 AM

A Short History of the Taxation of Charities in Australia

115

In doing so, the Court referred to the series of State Acts passed in the 19th century governing charitable institutions, discussed earlier. Manifold had, of course, referred to these definitions when proposing this language in 1915. Knox CJ, concurring separately, confessed he still felt ‘some doubt’ whether the phrase was intended in its technical legal sense, but considered that the rule of statutory construction which required strict construction of tax exemptions applied.167 Soon after, in 1925, another case—Chesterman’s case—arose before the High Court considering the term ‘charitable’ in the Estate Duty Assessment Act 1914 (Cth), in the context of ‘religious, scientific, charitable or public educational purposes.’ As noted above, the term ‘public’ had been struck out before the word ‘charitable’, so the phrase was the classic ‘charitable purposes’, rather than ‘public charitable institutions’. Again, Isaacs J led the majority, with Knox CJ and Higgins J dissenting. Not surprisingly, the majority construed the term ‘charitable’ in this statute along the lines of the construction in Swinburne—namely, that the term was meant in its popular rather than legal sense. Pemsel’s case was distinguished on the basis that the collocation of the terms ‘religious, scientific, charitable or public educational purposes’ indicated that ‘charitable’ was not meant in the broader legal sense, which would encompass most religious, scientific and educational purposes. In this case, as in Swinburne, it was clear that Isaacs J considered that the broader legal definition was far too wide: If the word ‘charitable’ were there to receive its ‘curiously technical meaning’, there are decisions which show how far it would extend to relieve estates from the common contribution to taxation. For instance, the following have been held to be ‘charitable’ in that sense: ‘Home for starving and forsaken cats’ …; the promotion of vegetarianism …; for ‘the promulgation of ... Conservative principles combined with mental and moral improvement, Socialism, anti-vivisection principles.’ … That would be a strange intention to impute to the Federal Legislature.168

In doing so, however, Isaacs J was at pains to emphasise the popular meaning of ‘charitable’ was far from ‘narrow’, embracing ‘the relief of any form of necessity, destitution, or helplessness which excites the compassion or sympathy of men, and so appeals to their benevolence for relief’, as well as ‘benevolent assistance in aid of physical, mental, and even spiritual, progress for the benefit of those whose means are otherwise insufficient for the purpose’.169 This interpretation was, however, overturned by the Privy Council on appeal in 1925. (By then, Isaacs J himself was a member of the Judicial Committee of the Privy Council.)170 The Privy Council agreed with Higgins J that, while the legal sense of the word charitable ‘is larger and more comprehensive than the 167

ibid, 382. Chesterman v Federal Commissioner of Taxation (1923) 32 CLR 362, 383. ibid, 384–385. 170 Australian Dictionary of Biography Online Edition, http://adbonline.anu.edu.au/biogs/ A090439b.htm. 168 169

Book 1.indb 115

12/2/2011 8:21:42 AM

116

Ann O’Connell

other words’, not everything that was religious (for example) was charitable and the word ‘charitable’ therefore ‘adds something to those words’.171 Mere months later, the High Court heard yet another case relating to the term ‘charitable institution’ under the tax exemption in the Income Tax Assessment Act 1914 (Cth), Young Men’s Christian Association of Melbourne v Federal Commissioner of Taxation.172 In that case, the Court held that the Association was clearly a ‘religious institution’ for the purpose of the tax exemption, and therefore it was unnecessary to decide whether it was also a ‘charitable institution’ under that section. Nevertheless, Isaacs J took the opportunity to urge the Parliament to clarify the matter—not surprisingly, in favour of the popular term: But for the sake of all concerned it is right to advert to the state of doubt and confusion that exists with regard to this branch of the subject. As is well known to lawyers— though few others of the six million inhabitants of the Commonwealth suspect it—the word “charitable” has in some collocations a technical meaning of a singular nature.173

His Honour noted, once again, the application of the term ‘charitable’ to objects such as cats’ homes and trusts for the promotion of vegetarianism, and observed that the different terms ‘charitable purposes’ and ‘charitable institutions’ were used in the Income Tax Assessment Act, the Estate Duty Assessment Act and the Land Tax Assessment Act. Noting the disparity between the Privy Council’s holding in Chesterman’s Case and Swinburne, he concluded with a ringing call for legislative reform: It is obvious to me that in the interests of all concerned the meaning of Parliament should be legislatively declared beyond doubt. Besides the rights of the Public Treasury, in the first instance, and the possibility of refunds, as well as the administration of the Taxing Branch, which must be seriously hampered by the diversity of expressions and of decisions, the parties immediately concerned as possible taxpayers should be definitely informed, without the necessity of further costly legal proceedings, as to their liability or non-liability, and the general public ought also to know what clear exemptions are intended which cast a heavier burden on the rest of the community. Litigation, perhaps protracted and expensive, is inevitable unless Parliament by a few words declares whether by “charitable” it means to use that word in its ordinary modern sense, or in the technical Elizabethan sense that some quaint Chancery decisions in connection with trusts have affixed to it as its primary legal meaning, extending to objects which include, as I have said, purposes quite outside what any ordinary person would understand by charitable.174

The Parliament proved quickly, but partially, responsive to this call. The following year, Bruce’s coalition government introduced the Income Tax 171

Chesterman v Federal Commissioner of Taxation (1925) 37 CLR 317, 320. (1926) 37 CLR 351. 173 ibid, 358. 174 ibid 359. This statement was reported widely: see ‘A Tax Appeal—’Charitable Institution’— Mr. Justice Isaac’s Interesting Views’, The Brisbane Courier (Brisbane), 19 March 1926, 13. 172

Book 1.indb 116

12/2/2011 8:21:43 AM

A Short History of the Taxation of Charities in Australia

117

Assessment Bill 1927, which included a statutory definition of the term ‘public charitable institution’ in the context of tax deductions for gifts to such institutions.175 This term was defined as meaning ‘a public hospital, a public benevolent institution and includes a public fund established and maintained for the purpose of providing money for such institutions or for the relief of persons in necessitous circumstances.’ This definition was not debated in Parliament, although as noted above the term ‘public benevolent institution’ appears in earlier NSW legislation. Curiously, this Act did not, however, apply this definition to ‘charitable purposes’ in the context of exemptions from income tax, which remained unchanged. The Estate Duty Assessment Act 1914 (Cth) was similarly amended the following year. The Privy Council, however, struck back. In 1928, it handed down its decision in Adamson v Melbourne and Metropolitan Board of Works,176 on the definition of ‘any public hospital or charitable institutions’ in Melbourne and Metropolitan Board of Works Act 1915 (Vic). In doing so, the Privy Council held that the words ‘charitable institution’ in any legislative Act should be given their technical legal sense, unless a contrary intention appears from the context, and held that Swinburne had been implicitly overruled by Chesterman.177 As a result, the phrase ‘religious, scientific, charitable or public educational institutions’ in the Income Tax Assessment Act—left undefined by the 1927 Act—were henceforth to be interpreted with reference to the technical legal meaning.178 The statutory definition of the term ‘public charitable institution’ in relation to gift deductions, however, had its intended effect. In 1931, the High Court considered the term ‘public benevolent institution’ in Perpetual Trustees Co Ltd v Federal Commissioner of Taxation, noting it had no technical legal sense and was not further defined.179 The Court unanimously held that the term was (largely) restricted to ‘an institution organized for the relief of poverty, sickness, destitution, or helplessness’,180 primarily on the basis that it had been inserted after Chesterman’s Case. This definition has continued to govern the tax deduction provision ever since.

175 The then Treasurer explained this clause as being introduced ‘in order to remove any possible difficulty which might arise in litigation through what is apparently regarded by the court as a somewhat obscure provision’: Commonwealth, Parliamentary Debates, House of Representatives, 15 November 1927, 1392 (Dr Earle Page—Treasurer). See also Commonwealth, Parliamentary Debates, Senate, 7 December 1927, 2713 (Sir George Pearce). The legislation also extended the deduction to gifts in kind. 176 [1929] AC 142. 177 ibid, 147. The Privy Council expressly disapproved the use of definitions in other state legislation in statutory interpretation. In the case before it, however, the Privy Council held the statute showed it was intended to apply only in the case of municipally owned or conducted institutions. 178 Hobart Savings Bank v Launceston Bank for Savings (1930) 43 CLR 364. 179 (1931) 45 CLR 224. 180 ibid 232. (per Starke J).

Book 1.indb 117

12/2/2011 8:21:43 AM

118

Ann O’Connell THE CHANGING NATURE OF THE NOT-FOR-PROFIT SECTOR

Gradually, over the 20th century, the provisions for both exemptions and tax deductions in the Income Tax Assessment Act 1936 (Cth) grew, reflecting in part the growth of the non-profit sector and the perception of its importance, and the changing role of the State. The income tax exemptions were extended to charitable trusts and bequests (1916);181 non-profit societies or associations for various agricultural and industrial purposes (1918);182 and non-profit societies or associations for various artistic and scientific purposes (1922).183 The next additions reflected expanded government involvement in education and health, with additions for scientific research in 1932,184 educational scholarships in 1951,185 public and non-profit hospitals in 1952,186 and in 1956 non-profit medical benefits organization or hospital benefits organizations for the purposes under the newly introduced National Health Act 1953 (Cth).187 Perhaps the most contested category of exemption has been in relation to sporting associations. From the beginning, claims were made for such associations and rejected. When the first federal income tax legislation was before the Senate in 1915, an amendment was moved to exempt all non-profit organisations, with specific reference to sporting clubs.188 Senator Russell rejected this, on the basis that it only exempted racing clubs and large sporting organizations, and most smaller sporting clubs didn’t make any profit.189 The Royal Commission on Taxation in 1922 similarly rejected the representations of the NSW Cricket Association, on the basis that these associations were of insufficient national importance190—a view shared by the then Treasurer, Stanley Bruce, when the issue was raised that year in Parliament.191 It was not until 1952, after the Commonwealth Committee of Taxation had recommended the inclusion of athletic sports or games involving only humans,192 that these were finally exempted.193

181

Income Tax Assessment (No 2) Act 1916 (Cth) s 4. Income Tax Assessment Act 1918 (Cth) s 6. In 1930, this exemption was extended to the promotion of aviation: Income Tax Assessment Act 1930 (Cth) s 5. 183 Income Tax Assessment Act 1922 (Cth) s 14. 184 Income Tax Assessment Act 1932 (Cth) s 5. 185 Income Tax and Social Services Contribution Assessment Act 1951 (Cth) s 5. 186 Income Tax and Social Services Contribution Assessment Act (No.3) 1952 (Cth) s 4 (following the report of the Commonwealth Committee of Taxation, as noted above). 187 Income Tax and Social Services Contribution Assessment Act (No. 3) 1956 (Cth) s 4(1). 188 Commonwealth, Parliamentary Debates, Senate, 9 September 1915, 6741 (Sir Albert Gould). 189 ibid. 190 Commonwealth, Royal Commission on Taxation, Third Report (1922), 149. 191 Commonwealth, Parliamentary Debates, House of Representatives, 2 October 1922, 3442. 192 Commonwealth Committee on Taxation, Report on Exemption of Income of Certain Bodies and Funds (Reference No 25) Parl Paper No 136 (1952), 5. The Committee noted there was precedent for this in the Entertainments Tax Act 1942 (Cth) s 5(6), which applied (along with a range of other artistic and educational entertainments) a lower rate of tax to sporting activities that were not conducted for profit. This was added by s 3 of the Entertainments Tax Act 1949. 193 The only comment on this inclusion was complimentary, with one member noting that the Olympic Games were to be held in Melbourne in 1956: Commonwealth, Parliamentary Debates, House of Representatives, 24 September 1952, 2019 (Winton Turnbull). 182

Book 1.indb 118

12/2/2011 8:21:43 AM

A Short History of the Taxation of Charities in Australia

119

The list for tax deductions grew in a similar way to that of exemptions. Research into disease received recognition in 1924,194 and in 1946 special provision was made for scientific research, broadly defined.195 A range of deductions for war and military-related purposes were also added to the list.196 The greatest growth was through the addition of specific organisations, which also reflected changing times. For example, the inclusion of the United Nations Appeal for Children in 1948 marked the recent birth of the United Nations.197 The Queen’s visit to Australia in 1954, a golden moment of imperial unity, prompted the establishment (and inclusion) of the Queen Elizabeth II Coronation Gift Fund, the Australian Elizabethan Theatre Trust, and the Australian Academy of Science,198 reflecting the growth of an Australian arts and scientific community. This was further emphasised by the subsequent inclusion in the 1950s and 1960s of the Australian and New Zealand Association for the Advancement of Science, various medical colleges and scientific foundations.199 The growth of the community sector—in the cultural and humanitarian fields especially—marked the list too. In the late 1950s, bodies such as the National Trust of Australia, The Sydney Opera House Appeal Fund, the Sydney Myer Music Bowl, and the Art Gallery Society of NSW were included.200 Two notable humanitarian organisations—the Australian National Committee for World Refugee Year and the Australian National Committee for the Freedom from Hunger Campaign—also made the list.201 The list of tax deductible gift recipients eventually expanded to such a length that, in the tax simplification project begun in 1993, the recipients were divided 194 Income Tax Assessment Act 1924 (Cth) s 8, which included donations for research into the ‘causes, prevention or cure of disease in human beings, animals or plants’ conducted by a public university or hospital. 195 Income Tax Assessment Act 1946 (Cth) ss 11, 12, and 17. Scientific research was defined as ‘any activities in the fields of natural or applied science for the extension of knowledge’, including research improving the technical efficiency of businesses or the welfare of workers. 196 Income Tax Assessment Act 1927 (Cth) s 14 (war memorials); Income Tax Assessment Act 1940 (Cth) s 6 (institutions for the recreation or welfare of members of the armed forces and gifts to the Commonwealth for the purposes of defence). 197 Income Tax Assessment Act 1948 (Cth) s 8. 198 Income Tax and Social Services Contribution Assessment Act (No 2) 1953 (Cth) s 7; Income Tax and Social Services Contribution Assessment Act 1954 (No 43) (Cth) s 8. See ‘Appeal launched for Fund to Queen’, The Canberra Times (Canberra), 6 July 1953, 4. The Prime Minister of the time launched this fund established for the welfare of mothers and their children, stating that contributions would ‘emphasise our admiration for our young Queen not merely in her onerous role as Royal symbol of unity of the British Commonwealth, but also in her intensely human role as a Royal mother’. See also ‘Royal Charter for Scientists’, The Sydney Morning Herald (Sydney), 17 February 1954, 7, on the establishment of the Australian Academy of Science. 199 Income Tax and Social Services Contribution Assessment 1955 (Cth) s 8; Income Tax and Social Services Contribution Assessment Act 1957 (Cth) s 17; Income Tax and Social Services Contribution Assessment Act (No 2) 1960 (Cth) s 6; Income Tax and Social Services Contribution Assessment Act (No. 3) 1961 (Cth) s 10. 200 Income Tax and Social Services Contribution Assessment Act 1957 (Cth) s 17; Income Tax and Social Services Contribution Assessment Act (No 2) 1960 (Cth) s 6. 201 Income Tax and Social Services Contribution Assessment Act (No 2) 1959 (Cth) s 9; Income Tax and Social Services Contribution Assessment Act 1962 (No 39) (Cth) s 9.

Book 1.indb 119

12/2/2011 8:21:43 AM

120

Ann O’Connell

into different ‘registers’ according to category.202 However, the language of the original statute was preserved, so that—for example—the category of ‘public benevolent institution’ was retained, in addition to the specifically named organisations in the registers. These lists have since been moved to the Income Tax Assessment Act 1997 (Cth), in what is now Subdivision 30-B. These registers indicate the growth of the non-profit sector in the intervening years, with (for example) 41 specifically named ‘welfare and rights’ organisations,203 a category for the environment,204 international affairs,205 and fire and emergency services.206

THE FRINGE BENEFITS TAX EXEMPTION

The term ‘public benevolent institution’, so redolent of that early age of the relief of the poor, surprisingly continued to have a strong shelf life. In 1986, when an Australian fringe benefits tax was introduced, the opposition parties in the Senate sought tax relief for charities. The Liberals borrowed the language of the exemption in the Income Tax Assessment Act 1936 (Cth), but their proposal to exempt ‘employees of scientific, charitable or public educational institutions’ was rejected.207 The Australian Democrats, a minor party, proposed instead an amendment using the phrase ‘public benevolent institutions’.208 Senator Haines explained this decision as follows: To the lay person reading [the provision for income tax exemptions] and seeing the mention of charities and charitable organisations it would appear as if that was a perfectly appropriate lynchpin on which to hang an amendment to exempt those particular charitable organisations from this fringe benefits tax. Unfortunately … we entirely overlooked the tortuous minds of some members of the legal profession and some of the issues that from time to time over the years they have picked up and classified as being related to charitable organisations. In fact, the word `charitable’ has a technical legal meaning which is completely different from the meaning that most people in the general public and I suggest most honourable senators have. Various Privy Council decisions and other legal decisions have led to some fairly extraordinary cases being picked up as charitable organisations which we in this place would not wish to be classified as such.209

Echoing Isaacs J, she continued: Included, I might add, in this list of extraordinary things which are qualified as charitable organisations by the courts has been the reduction of the national debt.

202

Taxation Laws Amendment Act (No 2) 1993 (Cth) s 8. S 30.45. 204 S 30.55. 205 S 30.80. 206 S 30.102. 207 The Australian Democrats objected on the basis that this would exempt wealthy private schools: ibid, 3315 (Janine Haines). 208 Commonwealth, Parliamentary Debates, Senate, 3 June 1986, 3760 (Peter Baume). 209 ibid, 3761 (Janine Haines). 203

Book 1.indb 120

12/2/2011 8:21:43 AM

A Short History of the Taxation of Charities in Australia

121

I do not know exactly how the Government could use that to its own deficit benefit, but maybe it could well do so. Having been met with that extraordinary list of things that were likely to be suddenly exempt from fringe benefits tax … we then went looking amongst the murky depths of legal history for something that defines public benevolent institutions. … Quite clearly that definition of what is legally known as a public benevolent institution is the word that we, in this place, and most people in the community would regard as applying to what we would normally call a charitable organisation.210

Reflecting the pattern of successful opposition in the arena of tax concessions, the Government gave in on this amendment, although not with good grace: Arrangements could be made, and I predict would be made, whereby through a socalled benevolent institution a person could provide individuals in the community with cars … 24 hours a day, seven days a week for his own personal use and that would be okay. … As I said earlier, we will probably come back in a year or two years and have a look at this amendment. We do not oppose it. Honorable senators opposite have all done the right thing. They have all made themselves big people in the eyes of what they see as charitable or benevolent organisations, but they have left a hole big enough for a Mack truck to drive through. We will close it later.211

THE GOODS AND SERVICES TAX CONCESSIONS

In 1999, the Liberal Government controversially proposed a goods and services tax, which was passed with the agreement of the Australian Democrats, who held the balance of power in the Senate. Protests by Senators in support of concessions for charities were plentiful and vociferous, and significant concessions were won for charities as a result. Of particular interest for this paper, however, was the stance of the Australian Green Party, another minor party in the Senate. The Australian Greens pushed for a much broader definition of the third sector, moving an amendment to substitute the word ‘eligible non-profit organisation’ instead of ‘charitable institution’. Senator Margetts explained their view as follows: We think it is important to remember that the third sector goes far beyond charitable institutions and gift deductible entities. Community organisations are the backbone of society. They play a huge role in supporting and enhancing our communities. … These include a myriad of groups playing a role in welfare, health, education, sport, recreation, child care, entertainment, finance, overseas aid, environmental protection, Aboriginal affairs, emergency services and the organised representation of interests or lobby groups.212

210 211 212

Book 1.indb 121

ibid. ibid, 3297–3298 (Donald Grimes). Commonwealth, Parliamentary Debates, Senate, 30 April 1999, 4670 (Diane Margetts).

12/2/2011 8:21:43 AM

122

Ann O’Connell

Senator Brown, the Greens’ leader, subsequently moved a (doomed) amendment defining this phrase to mean ‘a non-profit organisation whose objects or purposes include activities in the public interest, but does not include a nonprofit organisation that benefits only its own members’. This language echoes that of the income tax exemptions in colonial legislation, with the addition of a test of ‘public interest’. The amendment included an illustrative list of examples, which included providers of welfare services; recreational, arts or entertainment organisations; organisations assisting the community through activities such as research, lobbying, and the provision of information; environment, overseas aid, and indigenous organisations; community information and communication services; and sporting and parents’ organisations.213 Senator Kemp, a government Senator, expressed for the government its concern that this amendment would be ‘very substantial’, noting that it would include, for example, wealthy sporting clubs such as the Collingwood Football Club and political parties.214 The echoes of the first federal debate could be heard loudly and clearly. Ironically, in this debate the Australian Democrats expressly relied upon the common law definition of ‘charitable institution’ which they had rejected as being too broad in 1986.215 Shortly afterwards, fulfilling the Labor government’s prophecy on fringe benefits tax, the Liberal Government proposed to stop the alleged rorting of fringe benefit tax by non-profit organisations—an issue that was agitating Australian non-profits again recently.216 The reopening of the debate resulted in the Australian Democrats pressuring the government for a ‘two stage inquiry into the tax treatment of charities … commencing with a review of the legal definition of ‘charities’ by the Australian Law Reform Commission.’217 In the end, an ad hoc inquiry was constituted on the definition of charities on 18 September 2000, chaired by the former judge I F Sheppard AO QC.218 The Inquiry recommended a statutory definition of ‘charitable purpose’, extending the common law definition by including the advancement of social and community welfare,219 culture, and the natural environment; and specifically including the promotion and protection of civil and human rights, and the prevention and relief of suffering of animals.

213

Commonwealth, Parliamentary Debates, Senate, 9 December 1999, 11658. Commonwealth, Parliamentary Debates, Senate, 30 April 1999, 4671 (Rod Kemp). 215 ibid, 6376 (Andrew Murray). 216 ABC/AAP, ‘Charities fear loss of millions over tax review’, (2010) ABC News at 30 April 2010. This anxiety was in anticipation of the independent review of the taxation system by Ken Henry, but the federal government has promised not to implement the recommendations concerning charities. 217 Commonwealth, Parliamentary Debates, Senate, 9 December 1999, 11645 (John Woodley). 218 Commonwealth, Parliamentary Debates, Senate, 10 May 2000, 14270 (Chris Evans). 219 Illustrative examples included the care, support and protection of the aged, disabled, children and young people, and members and former members of the military, as well as the promotion of community development to enhance social and economic participation. 214

Book 1.indb 122

12/2/2011 8:21:43 AM

A Short History of the Taxation of Charities in Australia

123

The initial Government response, an exposure draft Charities Bill belatedly released in 2003, adopted a number of recommendations but, controversially, disqualified from the status of charity organisations that had ‘the purpose of attempting to change the law or government policy’. This was directly in conflict with the recommendation of the Inquiry, which had concluded that ‘charities should be permitted to engage in advocacy on behalf of those they benefit’ and this type of conduct ‘should not deny them charitable status’.220 Ironically, by this point, the Democrats had turned full circle on the phrase ‘public benevolent institutions’: The problem is that most of the tax concessions associated with charities are only associated with a very narrow category of charities called `public benevolent institutions’, which was a result of the response of the Bruce-Page government in 1927 to a Privy Council decision. That particular definition has been found to be more and more narrow by the various courts. In fact, the key decision that defined a public benevolent institution goes back to 1931. … In other words, the common law has atrophied in the area of the most important issue for charities, which is access to PBI status. That is why the Charities Definition Inquiry said that we need to get rid of this definition. We need to update it, improve it, make it more comprehensive, make it more modern and make it more readable.221

After further inquiry, the Government chose not to proceed with the draft bill, and instead enacted a much more limited measure, the Extension of Charitable Purposes Act 2004— what was called the ‘fag end’ of an important reform by the Democrats.222 The 2004 Act merely extended the definition to include nonprofit childcare centres, self-help groups, and closed or contemplative religious orders. Since then, there has been no further action, although in 2009 the Productivity Commission called once again for modernisation of the definition of charities.223

CONCLUSION

A number of themes run through this history of taxation of charities. Perhaps most surprisingly, the exact nature and scope of the income tax exemptions, and the very existence of the tax deductions, are largely creatures of accident and fitful attention by the legislature—indeed, very often by individual opposition members of the legislature. Individuals such as Bent, Manifold, Isaacs and Hughes have had great influence on the eventual outcome, as have minor parties such as the Democrats and Greens. The overseas influence of the United Kingdom—both in terms of its imperial legacy and through the

220

Report of the Inquiry into the Definition of Charities and Related Organisations (2001). Commonwealth, Parliamentary Debates, Senate, 12 August 2003, 13322 (John Woodley). 222 Commonwealth, Parliamentary Debates, Senate, 23 June 2004, 24644 (John Woodley). 223 Productivity Commission, Contribution of the Not-for-Profit Sector (2010), 164. 221

Book 1.indb 123

12/2/2011 8:21:44 AM

124

Ann O’Connell

Privy Council—and that of New Zealand have been profound, although in the end the Australian colonies charted their own distinctive course. The eventual supremacy of the Commonwealth in income taxation led to a restriction of income tax exemptions—away from all non-profit organisations and all charitable endeavours—and the entrenchment of an Australian novelty, the tax deduction. What is also striking is that reform of these concessions has often been stymied. Once introduced, taxation concessions are difficult to remove, and their influence multiplies across taxation regimes. Governments have repeatedly ignored the recommendations of Royal Commissions, Committees, and inquiries, daunted no doubt by the opposition of charities themselves and fear of being seen to harm that ultimate symbol of the virtuous public good, the charity. Perhaps the near-death of gift deductions provides an apt symbol of this history—in the end, a partial and inadequate concession will almost always win the day over logic.

1

Book 1.indb 124

12/2/2011 8:21:44 AM

5 A Short History of the Charitable Purposes Exemption from Income Tax of 1799 MICHAEL GOUSMETT1

PREAMBLE – PITT TO PEMSEL: 1798–1891

I

T WAS AS a consequence of the Income Tax Act of 18422 that, in 1888, the Moravians challenged the decision of the Special Commissioners to deny them a refund of Income Tax of £73 8s 3d for the year ending 5 April 1886, which in previous years had been approved. While the grounds for the refund was based on the charitable purposes exemption from Income Tax in the Income Tax Act 1842, the origins of that statutory provision can be found four decades earlier, in the taxing Acts of 17983 and 1799.4 While the ‘War Tax’ Act of 1799 was intended to be a temporary measure, and had by 1816 been repealed, on its reintroduction in 1842 the Income Tax Act was based on the Act of 1806,5 complete with the

1 M J Gousmett, The Charitable Purposes Exemption from Income Tax: Pitt to Pemsel 1798– 1891 (unpublished Doctoral Thesis, University of Canterbury, 2009) available at http://ir.canterbury. ac.nz/handle/10092/3448. 2 An Act for granting to Her Majesty Duties on profits arising from property, professions, trades, and offices, until the sixth day of April [1845] 5 & 6 Vict. c. 35 [22 June 1842] s. 61 No. VI Schedule A. 3 An Act for granting to His Majesty an aid and contribution for the prosecution of the war 38 Geo. III c. 16 [12 January 1798]. 4 An Act to repeal the Duties imposed by an Act, made in the last session of Parliament, for granting an aid and contribution for the prosecution of the war; and to make more effectual provision for the like purpose, by granting certain Duties upon Income, in lieu of the said Duties 39 Geo. III c. 13 [9 January 1799]. 5 An Act for granting to His Majesty, during the present war, and until the sixth day of April next after the ratification of a definitive Treaty of Peace, further additional Rates and Duties in Great Britain (on the Rates and Duties on profits – query on the profits [sic]) arising from property professions trades and offices; for repealing an Act passed in the forty-fifth year of His present

Book 1.indb 125

12/2/2011 8:21:44 AM

126

Michael Gousmett

charitable purposes exemption of 1799 but subsequently modified. However, the concept of charitable purposes not having been defined in the taxing statutes, first the Commissioners dealing with claims for refunds of Income Tax, then the Special Commissioners,6 had no guiding light by which to make decisions regarding refunds, the tax having been deducted at source following Addington’s introduction of the concept in 1803.7 By 1865,8 then again in 1888,9 questions were being asked in the House of Commons about such claims, Parliament having neglected to address the issue, in spite of being encouraged to do so by the Lords of the Treasury in 1863.10 It was not Parliament that ultimately resolved the issue, but Lord Macnaghten in the House of Lords in 1891, when he laid down the four principle divisions of charity which in the twenty-first century continue to be a guiding influence in common law countries across the globe.11

PART I: INTRODUCTION

On 18 March 2010 Ronald Young J handed down his judgment in Canterbury Development Corporation v Charities Commission (CDC).12 In his discussion on the Charities Act 2005 (CA 2005),13 with respect to the meaning of charitable purposes as defined in s 5 of the CA 2005, Young J did so with respect to ‘relief of poverty’,14 education purposes’,15 ‘purposes beneficial to the community: economic development’,16 and ‘public benefit’.17 At no point in his judgment did Majesty, for repealing certain parts of an Act made in the forty-third year of His present Majesty, for granting a contribution on the profits arising from property professions trades and offices; and to consolidate and render more effectual the provisions for collecting the said Duties 46 Geo III c 65 [13 June 1806]. 6 See John F. Avery Jones, ‘The Special Commissioners from Trafalgar to Waterloo’ (2005) 1 British Tax Review 40. 7 See BEV Sabine, A History of Income Tax (1966) 37 and E. Piroska Soos, ‘The origins of taxation at source’, in Simon James (ed), Taxation Critical perspectives on the world economy (2002). 8 See Gousmett, above n 1, Ch 6. 9 See Gousmett, above n 1, Ch 7. 10 See Gousmett, above n 1, Ch 7. 11 Commissioners for Special Purposes of the Income Tax v Pemsel (1891) AC 531. 12 Canterbury Development Corporation v Charities Commission HC WN CIV 2009-485-2133 (18 March 2010) (CDC). The case was an appeal by Canterbury Development Corporation (CDC) (incorporated in the NZ Companies Office as a company on 5 December 1983), the Canterbury Development Corporation Trust (CDCT) (incorporated in the NZ Companies Office as a charitable trust on 22 August 1995), and the Canterbury Economic Development Fund (CEDF) (incorporated in the NZ Companies Office as a company on 9 October 2008) against the decision of the Charities Commission to register those entities as tax charities under the Charities Act 2005. The Charities Act 2005 provides for the right of appeal at s 59. The 16 shares in CDC (registered 1983) are held by CDCT (registered 1995). 13 Charities Act 2005 No.39 (20 April 2005). 14 CDC, above n 12, 25. 15 CDC, above n 12, 32. 16 CDC, above n 12, 34. 17 CDC, above n 12, 45.

Book 1.indb 126

12/2/2011 8:21:44 AM

The Charitable Purposes Exemption from Income Tax of 1799 127 Young J, nor any other party to the appeal, make any reference to the origins of those concepts in charity law which were enunciated in 1891 by Lord Macnaghten in Commissioners for Special Purposes of the Income Tax v Pemsel.18 While Young J referred to some of the charity law cases from jurisdictions in the UK, Australia, and New Zealand which had, over time, followed Pemsel, he did so without one word about Pemsel itself. However, the long history of charity law is evident in CDC in the citation by Young J in his judgment in which mention is made to ‘the spirit and intendment of the Preamble [of the Statute of Elizabeth] [sic]’.19 That is, since Pemsel, the courts have accepted that if an entity’s charitable purposes are consistent with the four principal divisions of charity as laid down by Lord Macnaghten,20 ergo the charitable purposes exemption from Income Tax follows. There is no need for a judge to consider the elements that comprise the charitable purposes exemption from Income Tax; there is no need to re-litigate Pemsel. The outcome, provided the charitable purposes test is met, is a forgone conclusion. Similarly, should the charitable purposes test not be met. However, the charitable purposes test is one of law, not fiscal policy. Lord Macnaghten explained this indifference when he stated unequivocally ‘[w]ith the policy of taxing charities, I have nothing to do. It may be right, or it may be wrong …’.21

Rationale for Research It was the issue of the fiscal policy underlying the charitable purposes exemption from Income Tax that was to lead the author on a seven-year journey to research that concept.22 However, it was not so much Lord Macnaghten’s comment about fiscal policy that was the motivating factor for the study. Instead, apart from being curious about the origins of the charitable purposes exemption, it was a statement by Owen that the author wished to challenge. Owen had written that 18

Pemsel, above n 11. CDC citing Crystal Palace Trustees v Minister of Town and Country Planning [1951] 1 CH 132, IRC v White (1980) 55 TC 651; Laws of New Zealand Charities at 13: ‘… such other purposes may be charitable because they are prima facie beneficial to the public and there is no ground for holding them outside the spirit and intendment of the Preamble [of the Statute of Elizabeth]’. The appellant claimed that ‘CDC’s constitution comes within the fourth category of charitable purposes, given its promotion of economic development in Canterbury’. CDC, above n 12, 34. 20 ‘“Charity” in its legal sense comprise four principal divisions: trusts for the relief of poverty; trusts for the advancement of education; trusts for the advancement of religion; and trusts for other purposes beneficial to the community, not falling under any of the preceding heads. The trusts last referred to are not the less charitable in the eye of the law, because incidentally they benefit the rich as well as the poor, as indeed, every charity that deserves the name must do so either directly or indirectly’. Pemsel, above n 11, 583. 21 Pemsel, above n 11, 591. Lord Macnaghten also stated that ‘[i]f a gentleman of education, without legal training, were asked what is the meaning of a ‘trust for charitable purposes, I think that he would most probably reply, ‘[t]hat sounds like a legal phrase. You had better ask a lawyer’.’ Pemsel, above n 11, 584. 22 The author was the General Manager, Pacific Leprosy Foundation, a charitable trust with international purposes, from 1989 to 2007. 19

Book 1.indb 127

12/2/2011 8:21:44 AM

128

Michael Gousmett

[t]he exemption of British charities from the Income Tax dated from its inception. We can only guess as to the motives that inspired Pitt to include in his Income Tax Act of 1799 a clause exempting charitable organizations, but it was a natural enough decision.23

Owen argued, by way of example, that as grammar and free schools at that time were carrying the entire burden of popular education and thus performed a public function of incontestable value, [i]t would have been preposterous to tax the income of such quasi-public agencies.24

That may have been so, and the author does not disagree. However, indignation is no substitute for fiscal policy, and thus the author’s search began.

The Early History of Exempting Charitable Institutions from Taxation The exemption of institutions which, subsequent to Pemsel, might be considered charitable, has a history which can be traced back many centuries. The seminal works by Lunt provide a fascinating picture of papal taxation in England, beginning with the first tax on the income of the clergy in 1199 for the support of the papacy.25 An exemption from papal taxation appears to have been provided, in 1274, to hospitals established for the treatment of leprosy patients.26 Adler’s work in 1922 also explored the historical origin of the exemption from taxation of charitable institutions, in a chapter of the same name.27 In answering his own question, ‘[w]hat was the cause of the injection into the Taxation Acts [of the nineteenth century] of this clause exempting educational and charitable institutions?’ Adler explained that: the moving cause of this phenomenon was the fact that beginning with the fifteenth century the State, in most cases the municipalities, took over the function of administering charity, and that consequently it was thought that property devoted to a public use should be freed from the burden of taxation. (Emphasis added.)28

Adler does not suggest or explain by whom ‘it was thought that property devoted to a public use’ should be exempt from taxation.29 This was to become an issue during the nineteenth century, due to the manner in which Poor Rates were 23

D E Owen, English Philanthropy (1965) 330. Owen, above n 23, 330. 25 WE Lunt, ‘Papal Taxation in England in the Reign of Edward I’ (1915) 30 (119) English Historical Review 398–417, 398. 26 WE Lunt, ‘A Papal Tenth Levied in the British Isles from 1274 to 1280’ (1917) 32 (125) English Historical Review 49–89, 86. 27 P Adler, Historical Origin of the Exemption from Taxation of Charitable Institutions Part I in The Westchester County Chamber of Commerce (ed), Tax Exemptions on Real Estate An Increasing Menace: A Study by the Westchester County Chamber of Commerce (1922). 28 Adler, above n 27, 54. 29 Adler, above n 27, 54. 24

Book 1.indb 128

12/2/2011 8:21:44 AM

The Charitable Purposes Exemption from Income Tax of 1799 129 levied.30 If there was, for example, a strong government presence in a rateable area, the burden of the rates increased as a consequence of government property being exempted. There was no consideration of ability to pay. A rate was levied and it was to be paid irrespective of the financial burdens it imposed. The Poor Rate, ‘[being] local in incidence, was unequal geographically as well as socially’, with the landed gentry as well as tenants carrying the burden.31 According to Adler, long usage as evidenced in history, ‘is ample historical justification for the exemption from taxation of charitable institutions which perform without compensation a function which the State has, from Tudor times in England … avowedly undertaken to perform …’.32 Instead of ‘open, direct bounty’ from government, charities are the recipients of public aid through being granted ‘the privilege of exemption from [Income Tax]’.33 Public debate on the exemption of charitable institutions from Income Tax did not emerge until the nineteenth century when, in 1863, Gladstone attempted unsuccessfully to remove the charitable purposes exemption from the statute books. It is as a consequence of Gladstone’s threat that a rationale was provided, for the first time since the introduction of the Income Tax by Pitt in 1799, which argued the case for the exemption of charitable institutions from Income Tax, and in a most unlikely place. The document in question was not published in the various Parliamentary papers of the day but instead was published in at least two newspapers, The Times of London of 4 May 1863,34 and the Liverpool Mercury of 6 May 1863.35 Other than those two newspapers, nowhere else is such a document to be found. The deputation which paid a visit to Gladstone, the Chancellor of the Exchequer, at 3 o’clock on the afternoon of 4 May 1863, had been at work for quite some time before the meeting. The advance notice of the deputation which was published in The Times of 4 May is dated 2 May 1863.36 No doubt Gladstone had read the morning papers of 4 May, and was well aware of what he was to be confronted with, in the knowledge that he stood alone without the support of the House of Commons. The notice in The Times contained a list, under the heading ‘Extension of Income Tax to Charities’, of 11 ‘Reasons against the measure’.37 Those reasons were founded, not in fiscal policy, but in social policy. There were no maxims akin to those of Adam Smith, concerning equity, fairness, and ability to pay.38 The notice summed up the 11 reasons by arguing that:

30

See Gousmett, above n 1, Ch 2. See JR Poynter, Society and Pauperism: English Ideas on Poor Relief, 1795–1834 (1969) 62–76 for a detailed discussion of William Pitt the Younger’s Poor Law Bill. 32 Adler, above n 27, 80. 33 Adler, above n 27, 63. 34 ‘Taxation of charities – A Deputation’, The Times (London), 4 May 1863, 5. 35 ‘The argument for taxing charities’, Liverpool Mercury (Liverpool), 6 May 1863, Issue 4754. 36 ‘Taxation of charities – A Deputation’, above n 34. 37 ibid. 31

Book 1.indb 129

12/2/2011 8:21:44 AM

130

Michael Gousmett

… the exemption contended for is founded on principles of humanity and policy, which the very Bill by which it is proposed to be taken away emphatically maintains. It is sanctioned by long usage and by the authority of the most distinguished statesmen. Its withdrawal is required by no State necessity, and is not demanded by the voice of public opinion. It cannot be carried out under the existing Bill without a manifest and cruel inconsistency, and, whilst causing a large amount of individual suffering, it will bring an insignificant gain to the national treasury. (Emphasis added.)39

The Taxation of Charitable Institutions in the Eighteenth Century In spite of the lack of debate prior to 1863 concerning the taxation of charities there was, in the late eighteenth century, a lone voice in the form of Anthony Highmore (1758/9–1829) who, in 1785, was a junior Attorney at Law, Secretary, and Receiver.40 Highmore, a grandson of Joseph Highmore, the painter,41 was a prolific author of legal texts as well as being a frequent contributor to The Gentleman’s Magazine, of which the theme of many of his works concerned charitable institutions.42 It was in one of Highmore’s texts that a solitary comment concerning the taxation of charities in the late eighteenth and nineteenth centuries is to be found.43 Highmore’s claim, the one and only such comment that the author found from that era relating to the exemption of charitable institutions from taxation, was that: [i]n the year 1786, I submitted to [the Smallpox Hospital] and other charities, and finally to some of the members of the administration, a plan for the total exemption of all institutions of charity from taxes, by one general Act; but, notwithstanding many interviews, and a tolerable concurrence in the principle, the reduction of the revenue was an obstacle too powerful to be subdued. (Emphasis added.)44

However, discovering Highmore’s plan appeared to be, at first, an impossible task. It was only as a consequence of being curious about a legal text on Mortmain by Highmore that I found what I believe to be is the basis of Highmore’s plan. Highmore wrote two texts on Mortmain, first in 178745 and then an updated 38

See A Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (1776). ‘Taxation of charities – A Deputation’, above n 34. 40 ‘Advertisements’, The Times (London), 26 February 1785, 1. Oxford Dictionary of National Biography (ODNB) 27 (2004) 81. 41 Joseph Highmore (1692–1780), had also trained as a lawyer, but art was his real interest, having been influenced by his uncle, Thomas Highmore, the serjeant-painter. On presenting his painting of Hagar and Ishmael to the Foundling Hospital in 1746, Joseph Highmore was made a governor. Did this also inspire his grandson, Anthony, to involve himself with charitable institutions? See H.C.G. Matthew and Brian Harrison (eds), Oxford Dictionary of National Biography (ODNB) 27 (2004) 82. 42 See Gousmett, above n 1, 84 and 85. 43 The author made this serendipitous discovery at the British Library on the last evening of a very full two-week research visit to London in 2005. 44 A Highmore, Pietas Londinensis (1810) 291. 45 A Highmore, A Succinct View of the History of Mortmain (1787). 39

Book 1.indb 130

12/2/2011 8:21:44 AM

The Charitable Purposes Exemption from Income Tax of 1799 131 version in 1809.46 Both of these texts contain a chapter entitled ‘Of taxes, and of exemption from them’, with the later chapter being considerably longer in length.47 With a period of 22 years between publication dates, one supposes that Highmore had gained considerably more knowledge and experience of taxation issues relating to charities during that time. The value of Highmore’s work towards an understanding of the taxation of charities, or their exemption from taxation, lies in his detailed analysis of legislation and case law on the subject in his two texts on Mortmain.48 Highmore’s contribution, although dated by the passage of time, has until now gone unnoticed and unrecognised. The significance of Highmore’s contribution lies in the fact that there is no other work on the subject from that period in history, when England was at war with France and the Pitt and Addington governments of the time were desperately short of finances, a shortfall which was ultimately met by the introduction of Income Tax in 1799, with all its shortcomings as a consequence of evasion and administrative failings.49 However, while Highmore claimed that he had, in 1786, argued for the exemption of charitable institutions from all forms of taxation,50 the author has not been able to locate any petitions from charitable institutions to Pitt during December 1798 and January 1799, when Pitt’s Duties upon Income Bill was before the House of Commons.51 Given Highmore’s involvement with a number of London charities, (being ‘a devout Christian [who] devoted much of his spare time to the management of charitable concerns and served as secretary to the London Lying-In Hospital’,52 as well as the Smallpox Hospital, a point which is overlooked by the ODNB,) the author had high expectations of finding petitions from Highmore to Pitt arguing the case against taxing the income of England’s charitable institutions.53 46

A Highmore, A Succinct View of the History of Mortmain (1809). The chapter as contained in the 1787 text was 10 pages long, whereas the chapter in the 1809 edition comprises 27 pages. See Gousmett, above 1, for a comparison of the contents of the two chapters at Appendix 547. 48 Highmore, above n 45 and 46. 49 See PK O’Brien, Government Revenue 1793–1815 – A Study in Fiscal and Financial Policy in the Wars against France (Unpublished Doctoral Thesis, University of Oxford, 1967) for an excellent exposition of that subject; Sabine, above n 7. While Sabine’s work discusses exemptions extensively, he referred only to Gladstone’s challenge to the exemption of charitable institutions from Income Tax in 1863 at 272. The charitable purposes exemption was not considered significant enough to index, either under ‘charitable’, ‘Gladstone’, or ‘exemption’. Omission of a discussion of the charitable purposes exemption from Income Tax is indicative of how tax historians have treated the exemption, yet the exemption is arguably one of the most valuable contributions governments have made towards the achievement of social policies and the development of civil society. 50 Highmore, above n 44, 291. 51 Ultimately An Act to repeal the Duties imposed by an Act, made in the last session of Parliament, for granting an aid and contribution for the prosecution of the war; and to make more effectual provision for the like purpose, by granting certain Duties upon Income, in lieu of the said Duties 39 Geo. III c. 13 [9 January 1799]. 52 ODNB, above n 41, 81. Highmore was also involved with the School for the Indigent Blind. See ‘Advertisements’, The Times (London), 16 January 1800, 2. 53 This is not to say that they do not exist, and I invite UK researchers to consider taking up this matter on my behalf. 47

Book 1.indb 131

12/2/2011 8:21:45 AM

132

Michael Gousmett

However, on 5 December 1798, two days after Pitt had introduced his Duties upon Income Bill into the House of Commons, Highmore wrote to Pitt ‘with the utmost deference … to offer suggestions to [his] capacious mind’, with respect to Pitt’s ‘new mode of taxation on income’.54 Highmore’s letter discussed the rates of tax applicable at various levels of income, and what he considered to be the inequality of Pitt’s proposal, but at no point did Highmore make any comment on the effect of the Duties upon Income on charitable institutions.55 Highmore was also concerned about how Commissioners were to be appointed, especially where a person under examination by a Commissioner might be in a financial relationship with that Commissioner.56 Highmore’s letter contains a curiosity that indicates that Pitt’s plans might have been the worst kept secret of the times. In his letter, Highmore mentioned an amount of tax, £10 0s 6d, yet neither The Times, nor the parliamentary report of the debate on 3 December, made any mention of that particular amount.57 Highmore’s letter was one of only three that were written to members of Parliament about the impact of Pitt’s proposed Duties upon Income Bill on charitable institutions, and which are contained in the PRO records. The second letter, dated 10 December 1798, was written by the Rev. Dr George Hill, of St Mary’s College, to the Right Honourable Henry Dundas.58 Dr Hill was concerned that ‘if the common fund [of the College] is taxed as belonging to the corporation and the individuals are also required to assess themselves according to their income [from the common fund], the same property is taxed twice’.59 The Income Tax would also reduce the common fund, declared Dr Hill, therefore ‘it will not afford the Bursars their present allowance without a considerable encroachment upon the incomes of the professors’.60 Dr Hill also argued that: [t]he hardship would fall with peculiar severity upon [St Mary’s College] which is appropriated to the study of Divinity, both because the number of bursars bears a large proportion to the extent of the funds; and because students of Divinity pay no fees to the masters.61

A third undated and unsigned letter in the Public Record Office appears to have been written in December 1798, due to similarities in the contents of the letter and Pitt’s Duties upon Income Bill.62 The anonymous author argued that as the 54

Anthony Highmore, PRO 30/8/267 Part I (93-94). Highmore, above n 54. 56 Highmore, above n 54. The Commissioners for Special Purposes of the Income Tax were, in 1798, some years away from being created by Pitt. 57 Parliamentary Intelligence, The Times (London), 4 December 1798, 2; Hansard, Parliamentary History (1819) vol 34 17. ‘ … a tax of 10 per cent …’, said Pitt. 58 PRO 30/8/145/1/11–12. 59 PRO, above n 58. 60 PRO, above n 58. 61 PRO, above n 58. 62 PRO 30/8/311/1/35. 55

Book 1.indb 132

12/2/2011 8:21:45 AM

The Charitable Purposes Exemption from Income Tax of 1799 133 entire revenue of Sutton’s Hospital was, and would continue to be ‘expended in the necessary purposes of the hospital’ and, as many of the hospital’s items of expenditure did not appear to be considered charitable under Pitt’s proposal, both the income of the hospital and that of its employees would be taxed twice over.63 The similarity of the arguments by Dr Hill and the anonymous author concerning double taxation are of interest; however, Pitt does not appear to have written in response to these concerns.

Highmore’s Mortmain Highmore’s Mortmain of 178764 may have been a development of his thoughts when, in 1786, he had argued for ‘the total exemption of all institutions of charity from taxation, by one general Act’.65 Highmore’s 1809 edition of Mortmain contains a more comprehensive development of the issue of charitable institutions and taxation than that of 1787, including a number of cases concerning hospitals.66 The role of hospitals which, at that time, were ‘erected and maintained for the relief of the poor and afflicted’,67 were considered by Highmore to be ‘a work of mercy’.68 In spite of the difficulties of those days, Highmore observed that: the liberality of the opulent is a monument of wonder to ourselves and to surrounding nations: however pressing may have been the demands of the state, however excessive may have been the luxuries and extravagance of the people in an age refined and polished as the present, still our charitable institutions have continually increased in number, in extent, and in wealth.69

However, in order for these institutions to become less reliant on annual donations, ‘a large capital is necessary to be laid up, even before a moderate income can be secured’.70 Given the need for large sums of capital in order to provide sufficient income for the purposes of the hospitals, Highmore considered that ‘it should seem extraordinary that any taxes should ever have been levied upon charities’.71 It was, declared Highmore, ‘a seeming injustice to charge the revenues of the institution, with a tax upon those apartments where the officers and servants are lodged’ (emphasis added).72 ‘The servants of an hospital’, 63

PRO 30/8/311/1/35. Highmore, above n 45. 65 Highmore, above n 44, 291. 66 Highmore, above n 46. 67 Highmore, above n 46, 478. 68 Highmore, above n 46, 478. 69 Highmore, above n 46, 478. 70 Highmore, above n 46, 478. 71 Highmore, above n 46, 478. 72 Highmore, above n 46, 478. 64

Book 1.indb 133

12/2/2011 8:21:45 AM

134

Michael Gousmett

argued Highmore, ‘are as essential to it, as any other part of its administration; and the directors would, for their own sakes, and the sake of its revenues, never employ one more than the immediate necessity of the case required’.73 In his opinion, the tax on charitable institutions was so insignificant in relation to the government’s total tax revenue that if they were abolished ‘would not be felt by the state’.74 Highmore also argued that any taxes paid by a charitable institution ‘very considerably reduces its revenue, and abridges and restrains the benevolent designs of its institution’.75 ‘For these reasons’, Highmore pleaded, ‘it is humbly recommended to the consideration of the Board of Treasury, and, finally, to the legislature, to pass a general Act of exemption of all charitable institutions from all taxes and assessments’.76

The Eighteenth Century Taxation of Charities The government levied a variety of taxes on eighteenth century charitable institutions, including hospitals. The Poor’s Rate was one such tax, and why hospitals were also levied can be seen in the judgment of Holt CJ who declared that: [a]ll lands within a parish are to be assessed to the Poor’s Rate. Hospital lands are chargeable to the poor as well as others; for no man, by appropriating his lands to an hospital, can discharge or exempt them from taxes to which they were subject before, and throw a great burden upon their neighbours. (Emphasis added.)77

Lord Mansfield, however, considered that St Luke’s Hospital, a hospital for lunatics, ‘was not chargeable to the parish rates, and that in general no hospital is so’.78 Lord Mansfield’s rationale was that ‘there was no person who could said to be an occupier [of St Luke’s Hospital]’.79 That is, with the exception of those parts of the hospital ‘which are inhabited by the officers belonging to the hospital, as the chaplain, and physician … these apartments are to be rated as single tenements, of which the officers are the occupiers. … It would be absurd to call the poor objects [occupiers]. ‘80 The decision in the St Luke’s Hospital case had ramifications for the Smallpox Hospital, as the House Duty 73

Highmore, above n 46, 478. Highmore, above n 46, 479. 75 Highmore, above n 46, 479. 76 Highmore, above n 46, 479. 77 Highmore, above n 46, 483 citing ‘Anonymous’, Pasch. 1 Ann. B.R., 2 Salk 527. This case can be found in The English Reports vol XCI KB Division XX 448. Highmore tended to cite the bare minimum of detail regarding cases he referred to, for example 2 Salk 527 with respect to this case. 78 Highmore, above n 46, 483 citing Rex v Occupiers of St Luke’s Hospital Burr. 1053; 2 Burn. Eccl. Law 286. 79 Highmore, above n 46, 483 citing Rex v Occupiers of St Luke’s Hospital Burr. 1053; 2 Burn. Eccl. Law 286. 80 Highmore, above n 46, 483 citing Rex v Occupiers of St Luke’s Hospital Burr. 1053; 2 Burn. Eccl. Law 286. 74

Book 1.indb 134

12/2/2011 8:21:45 AM

The Charitable Purposes Exemption from Income Tax of 1799 135 Act 1777–78, at s 35, provided an exemption for which the hospital qualified.81 Highmore explained that: [i]t is upon the equity of the decision on St. Luke’s Hospital, that the assessors usually levied only upon officers’ apartments in all the taxes charged upon the hospitals. But in the original Act for levying a duty on inhabited houses, called the House Tax, there was a clause of exemption without this reserve; and on that ground the Smallpox Hospital was relieved in toto, on appeal to the Commissioners in 1807.82

The House Tax to which Highmore referred was one of a group of taxes known collectively as the Assessed Taxes. The Times of 1 December 1797 provided a table of the revenue collected from the Assessed Taxes of 1797, as well details of the various statues under which those taxes were collected. One might say, somewhat flippantly perhaps, that everything that moved was taxed, and then also things that did not move.83 However, the Report provides an insight into the extent of the Assessed Taxes as is apparent from Table 1 Assessed Taxes 1797:84 Table 1 Assessed Taxes 1797 Tax

Statute

Inhabited Houses

24 Geo. III

£ 532,230

Houses and Windows

6 Geo. III

379,196

Inhabited Houses

19 Geo. III

164,084

Male Servants

25 Geo. III

94,516

Horses

25 Geo. III

89,344

Additional Horses

29 Geo. III

16,450

Further additional horses

36 Geo. III

105,795

Horses and Mules

36 Geo. III

90,751

Dogs

36 Geo. III

68,456

Four Wheel Carriages

25 Geo. III

133,499

Additional Four Wheel Carriages

29 Geo. III

18,783

Two Wheel Carriages and Carts

25 & 35 Geo. III

51,048

10 Per Cent.

31 Geo. III

94,501

10 Per Cent.

36 Geo III

137,122

[Rounding] Total Assessed Taxes

8 £1,975,783

81

Highmore, above n 46, 493. House Duty 18 Geo. III c. 26 [1777–78]. Highmore, above n 46, 493. 83 My inspiration comes from the Army saying that my late father told me: ‘If it moves, salute it. If it doesn’t, paint it’. 84 ‘Offices for Taxes’, The Times (London), 2 December 1797, 3. (£’s only.) The author undertook a considerable amount of research into the Assessed Taxes but, on the advice of his Doctoral supervisors, it was decided to omit this chapter, and a chapter on the Land Taxes, from the Doctoral Thesis. 82

Book 1.indb 135

12/2/2011 8:21:45 AM

136

Michael Gousmett

Highmore commented that the Assessed Taxes Act of 1808,85 in the form of those Acts which were applicable to charitable institutions, such as the Duty on Windows and on Inhabited Houses ‘is excepted as to any hospital, charityschool, or house provided for the reception or relief of poor persons; except such apartments therein as are occupied by the officers or servants thereof’.86 The Royal Hospitals of Christ, St. Bartholomew, Bridewell, Bethlem, St. Thomas, as well as Guy’s Hospital and the Foundling Hospital, were also exempt from the Assessed Taxes.87 However, the attitude of the courts was changing as it was eventually decided that ‘[s]ervants attending an hospital, and resident there, are not such occupiers as are intended by the statute, which renders a house or property rateable’.88 While Highmore discussed cases at length concerning the Assessed Taxes, he made no mention of the Duties upon Income Act of 1799. The only reference to the Duties upon Income that Highmore made was to observe that ‘[i]n the statute of 1803, for levying duty on property, the revenue and income of lands and funds of charitable institutions were exempted’.89 Highmore then noted that ‘[t]his Act was repealed by 46 Geo. III c. 65 [in] 1806’.90 Clearly Highmore saw the Duties upon Income as being of no significance, given that it contained an exemption for charitable institutions. Highmore’s preoccupation was with the Assessed Taxes, which were not finally abolished until 1924, when the last of the Assessed Taxes, the Inhabited House Duty, was repealed.91

PART II: PITT’S DUTIES UPON INCOME ACT OF 1799 The Orlemma of Lord Chancellor Maten [sic] Chancellor Maten, in issuing his orders respecting the levying of a tax under Henry VII,92 said that if a person was frugal, he could afford to pay it out of his savings, and if he was prodigal, it was proof of his being rich. Tierney, ‘Parliamentary Intelligence’, The Times (London), 1 January 1799, 4.

85 An Act for repealing the Duties of Assessed Taxes, and granting new Duties in lieu thereof … 48 Geo. III c. 55 [1 June 1808]. 86 Highmore, above n 46, 493. 87 ibid. 88 Highmore, above n 46, 494 citing Rex v St. Luke’s Hospital 2 Bur. 1053 1 Bot. 123 1 Nolan 110 A[?] v Smallpiece 1 Bot. 12 1 Nolan 111. 89 Highmore, above n 46, 500. An Act for granting to His Majesty, until the sixth day of May next after the Ratification of a definitive Treaty of Peace, a contribution on the profits arising from property, professions, trades, and offices 43 Geo III c 122 [11 August 1803]. 90 Highmore, above n 46, 500. An Act … , above n 5. 91 ‘The Budget’, The Times (London), 30 April 1924, 14. 92 ‘Henry VII, 1457–1509’, Oxford Dictionary of National Biography (2004) vol 26 510. The reference to ‘Lord Maten’ is incorrect. In March 1487 John Morton, archbishop of Canterbury 1486–1500, was appointed as chancellor. JD Mackie, The earlier Tudors 1485–1558 (1952) 56 and 684. Morton’s statement became known as ‘Morton’s Fork’, for the fact that no-one was exempt from its two distinctions. See ‘John Morton’, http://en.wikipedia.org at 12 September 2009.

Book 1.indb 136

12/2/2011 8:21:45 AM

The Charitable Purposes Exemption from Income Tax of 1799 137 It is interesting to observe the parallel between fiscal policy in England of the eighteenth century and New Zealand (NZ) in the twenty-first century, where the NZ government Budget for 2010–2011 has proposed an increase in consumption taxation from 12.5 per cent to 15 per cent, coupled with reductions in personal rates of Income Tax.93 Taxing consumption implies an element of choice,94 in contrast to the taxation of wages and salaries, in which an individual has little choice regarding the amount of Income Tax deducted at source. Ehrman has observed that: [t]theories of taxation in the middle and later eighteenth century were in something of the same position as theories of politics. … No man, it was argued, should be exempt from liability for tax, in return for the protection afforded the state; but taxes should fall as lightly as possible on the poor, for the sake of social justice (and indeed of social quiet) … taxes should fall on consumption … Indirect taxation in fact was the staple of revenue in quiet times. … In times of greater expense direct taxes also had to be levied; and these, once imposed, seldom entirely disappeared. (Emphasis added.)95

Since 1787, the British public had generally believed that war with France was inevitable.96 Following the fall of the Bastille in 1789,97 in early 1790 the defence estimates became the subject of debate in the House of Commons.98 The Opposition considered that there was no longer any need for ‘such high defence expenditure now that French absolutism, the traditional danger against which free-born Britons had had to arm themselves, was at an end’.99 On 2 February 1793, with Britain having declared war on France, George III wrote that ‘[his] natural sentiments were strong for peace [even though] duty as well as interest calls on us to join against the most savage as well as unprincipled nation’.100 Having been embroiled since 1793 in what later became known as the Napoleonic Wars, by 1797 Pitt had all but exhausted the ability of the nation to advance funds by way of loan, leaving him no option but to resort to ‘means … more radical than anything [he] had before attempted in the realm of taxation’.101 The process that Pitt employed to achieve his financial targets was described by Duffy who explained that: Pitt gestated major financial legislation … in the autumn of 1797 … [when] he decided to make a fundamental change in his methods of financing the war – including what was effectively a switch towards an Income Tax through a graduated increase in the Assessed Taxes on property.102 93

Taxation (Budget Measures) Bill, available at www.parliament.nz/en-NZ/PB/Legislation/Bills. ‘Taxes upon … consumable goods as are articles of luxury, are all finally paid by the consumer … he is at liberty too, either to buy or not to buy, as he pleases …’. Smith, above n 38, vol II 473. 95 John Ehrman, The Younger Pitt: The Years of Acclaim (1969) 248. 96 Derek Jarrett, Pitt the Younger (1974) 150. 97 Jarrett, above n 96, 151. 98 ibid, 153. 99 ibid, 153. 100 ibid, 160. 101 Richard Cooper, ‘William Pitt, Taxation, and the Needs of War’ (1982) 22 (1) The Journal of British Studies 94, 100. 102 Michael Duffy, The Younger Pitt (2000) 77. 94

Book 1.indb 137

12/2/2011 8:21:45 AM

138

Michael Gousmett

Thus it was that the Triple Assessment of January 1798 came into being.103 However, the description as a ‘triple’ assessment is a misnomer: it was, as noted by Rose, ‘a rather cumbrous form of graduated Income Tax’.104 Regardless, the yield was less than Pitt had budgeted for, leading Pitt to seek further means to raise much-needed funds, as in 1798 Great Britain was threatened by French invasion and faced the prospect of a long-continued war with a country which was considered to be ‘Britain’s most dangerous enemy [whose] appetite for revenge had by no means been satisfied by her apparent victory in the War of the American Independence’.105 Pitt tried a number of different financial techniques before settling on his Duties upon Income. ‘In the Parliamentary session of 1797–8’, Duffy explained, Pitt ‘[had] selected payment of the Assessed Taxes as an indicator of personal property, and increased their rates on a graduated scale according to past payment’.106 This was followed, in 1798: with a plan to allow those paying the Land Tax to buy themselves out of it over five years through buying back National debt stock, the interest on which would be sufficient to replace their Land Tax dues, while the capital of the debt would thus be diminished.107

Lord Rosebery has described how Pitt, as War Minister: explored and attempted every source of taxation. He added repeatedly to existing taxes. He even appealed to voluntary contribution; by which he obtained more than two millions sterling in 1798, and a further sum in 1799. He introduced such fertile expedients as the legacy duty, which he borrowed from Holland in 1796. In 1796 [sic – 1798] he took the desperate measure of trebling the Assessed Taxes … ; and when this impost fell short of expectations, finding that ‘the resources of taxation were failing under him’, he boldly carried through an Income Tax of minute and complicated graduation in an oration ‘which’, said a competent French writer, Mallet du Pan, who heard it, ‘is not a speech spoken by the minister; it is a complete course of public economy; a work, and one of the finest works, upon practical and theoretical finance that ever distinguished the pen of a philosopher and statesman’. … It was only when the trebling of the Assessed Taxes had failed, that [Pitt] determined to attain, by a direct impost, his avowed object, of taking a tenth of the income of the country. The net of the tax was extremely wide, and the mesh extremely small. … The imposition and acceptance of a tithe so novel and exasperating shows sufficiently that all that 103 Cooper explains that ‘the innovative nature of the triple assessment has been little understood. [It was not a trebling of the Assessed Taxes.] Rather, [Pitt] devised a kind of jury-rigged Income Tax based on past payment of Assessed Taxes’. Cooper, above n 101, 100. 104 John Holland Rose, A Short Life of William Pitt (1925) 149, as cited by Cooper, above n 101, 101. 105 Jarrett, above n 96, 146. 106 Duffy, above n 102, 94. 107 Duffy, above n 102, 94. The author also researched the Land Tax for his Doctoral Thesis, but the chapter was not included in the thesis as presented for examination. It is intended that a paper on the Land Tax and charitable institutions will be submitted to the British Tax Review for consideration in due course.

Book 1.indb 138

12/2/2011 8:21:45 AM

The Charitable Purposes Exemption from Income Tax of 1799 139 taxation could do was done, as well as the anxiety of Pitt and his generation to bear the fullest possible proportion of the burden of the war. (Emphasis added.)108

Pitt had no choice but to find alternative means of funding the nation’s defences against the threat posed by France. Thus the necessity of the Income Tax was, according to Tayler, a consequence of: the utter hopelessness of successfully meeting the claims occasioned by war, which induced the laying [of] a tax upon incomes; a tax, in its then origin, and always afterwards, until its memorable infliction in time of peace by Sir Robert Peel, [was] emphatically designated and considered a war tax [sic].109

Thus it was that, having failed to achieve his financial targets, and not wanting to further burden the nation with debt, Pitt: in the session of 1798–99, taking advantage of the new patriotic upsurge, … at last went the whole way and produced his famous direct tax on incomes, completing the switch to a principle which, he told the Commons in November 1797 [sic], was ‘new in the financial operations of this country, at least for more than a century’.110

In spite of the contempt in which taxes were held, Jarrett noted that Pitt’s power and influence was clearly evident as, ‘[i]n 1799 Pitt had even managed to get the British Parliament to accept an Income Tax’.111 However, that was not achieved ‘without strong opposition to his unpopular proposal’.112 Neither of the tax Bills of 1797 and 1798 had passed easily as, in order to ‘still objections’, 113 Pitt of necessity had to amend both the Assessed Taxes Bill of November 1797 and the Duties upon Income Bill of December 1798. Even so, Pitt’s Duties upon Income Act of 9 January 1799, ‘a very formidable document containing 124 sections covering 152 pages’,114 was not without its problems, ‘as only three months later, an amending Act [39 Geo. III c. 22] was passed’,115 the purpose of the amending Act being to extend the time allowed for submitting Returns.

The Requirement to Claim Exemptions and Abatements In what appears to have been an attempt to minimise evasion Pitt had, in his Plan of Finance for 1798 (that is, the Triple Assessment of 1798), decided that ‘[t]hose who wished to claim exemptions and abatements had to disclose their incomes and the Tax Office issued very careful instructions as to how their 108

Lord Rosebery, Pitt (1891) 153. William Tayler, The History of the Taxation of England (1853) 52. 110 Duffy, above n 102, 95. Duffy does not states precisely where the source for the quote from Pitt is to be found. 111 Jarrett, above n 96, 189. 112 Michael J Turner, Pitt the Younger: A Life (2003) 184. 113 Duffy, above n 102, 125. 114 A Farnsworth, Addington: Author of the Modern Income Tax (1951) 15. 115 Farnsworth, above n 114, 16. 109

Book 1.indb 139

12/2/2011 8:21:46 AM

140

Michael Gousmett

circumstances might be investigated’.116 Section LXIV of the Assessed Taxes Act 1798 appeared to reflect that intent, the section having provided: [t]hat if any person shall, on account of his or her income, claim to be exempted from the additional rate or duty which shall be assessed by virtue of this Act, or to be entitled to any abatement thereof … it shall be lawful for him or her to appeal to the Assistant Commissioners … .117

Addington included a similar section in his Income Tax Act 1803.118 However, Addington also included a specific requirement for the income of hospitals and alms-houses applicable to ‘charitable purposes only’, to be claimed in accordance with sections 197, 198 and 199 of his Income Tax Act of 1803.119 This raises the question that as Pitt, in the Assessed Taxes Act 1798, had required exemptions to be claimed by way of appeal, why did he not apply this concept to the exemption for charitable purposes in the Duties upon Income Act of 1799? The answer is that Pitt, unlike Addington, had not provided for the Income Tax to be deducted at source, hence the need to submit a claim in order for the deduction under Addington’s Act to be refunded.120

The Duties upon Income Bill of 1798–9: The Charitable Purposes Exemption Clause A copy of the first Duties upon Income Bill, as promoted by Pitt in the House of Commons on 3 December 1798, does not appear to exist, as no such copy is listed in Lambert’s compilation of the House of Commons Sessional Papers (hereafter ‘Sessional Papers’.)121 The first listing of Pitt’s Duties upon Income Bill in the Sessional Papers is for: [a] Bill (as amended by the Committee) to repeal the duties imposed by an Act [38 Geo. III c. 16 1798] … ; and to make more effectual provision for like purpose, by granting certain Duties upon Income, in lieu of the said duties. Presented by Hon. William Pitt, 1a 5 December, [ordered to be printed] as amended 8 December 1798 Enacted 39 Geo. III c. 13 [5 January 1799].122

A notation to the Duties upon Income Bill (as amended by the Committee), which was printed on 8 December 1798, recorded that ‘[t]he Clauses marked 116

Plan of Finance for 1798, Pitt Papers vol. 273 cited by O’Brien, above n 49, 401. An Act for granting to His Majesty an aid and contribution for the prosecution of the war 38 Geo. III c. 16 [12 January 1798] s. LXIV. 118 An Act … , above n 89, ss. CXCVI and CXCIX. 119 An Act … , above n 89, Rules attached to Schedule A; Rule No. IV. 120 Addington had a deep knowledge of the history of taxation, and ‘[t]he principal of deduction of taxation at source would therefore, be familiar to him’. The earliest that deduction at source had appeared was in 1657, in an Act of that year, in which ‘certain tenants were allowed to deduct tax from their rents’, the Act being to raise ‘a Monthly Assessment of £60,000’. Sabine, above n 7, 37. 121 Sheila Lambert (ed), House of Commons Sessional Papers of the Eighteenth Century (1975) vol 120 George III Bills 1798–99. 122 A Bill as amended by the Committee, Lambert, above n 121, v. 117

Book 1.indb 140

12/2/2011 8:21:46 AM

The Charitable Purposes Exemption from Income Tax of 1799 141 (A,) (B,) (C,) and (D,) were added by the Committee’.123 However, none of those clauses related to the charitable purposes exemption. The Duties upon Income Bill (as amended by the Committee), the clauses of which were not otherwise numbered alphabetically or numerically, provided (with the exception of those above) at the third clause for the duties which were to be levied to include that ‘of every body politic or corporate, or company, fraternity, or society of persons, (whether corporate or not corporate) in Great Britain’.124 It is not until the forty-fifth clause of the Duties upon Income Bill (as amended by the Committee) that the charitable purposes exemption, of 79 words, is to be found and which provided: [t]hat where any bodies politic or corporate, companies, fraternities, or societies of persons, whether corporate or not corporate, shall be entitled unto any annual income, to the respective amounts before specified, other than and besides any income applicable to charitable purposes, such annual income not applicable to charitable purposes only shall be chargeable with such and the like rates as any other annual income of the same amount will, under and by virtue of this Act, be chargeable with. (Emphasis added.)125

At that stage of the Duties upon Income Bill, the clauses of the Bill had not being numbered sequentially. Instead, approximately every twelfth row of print was numbered, with the above clause commencing at line 102 of the Bill.126 The charitable institutions exemption clause was the forty-fifth clause in the Duties upon Income Bill, yet in the final Duties upon Income Act the exemption was placed at section 87.127 How and why the charitable purposes exemption was relocated has yet to be explained. The second listing of the Duties upon Income Bill in the Sessional Papers is that of the Duties upon Income Bill (as amended on recommitment), which was printed on 22 December 1798.128 The ‘income applicable to charitable purposes’ exemption clause reappeared as the seventy-sixth clause in the Duties upon Income Bill (as amended on recommitment), the only amendments made having been to insert round brackets as follows: ‘(other than and besides any income applicable to charitable purposes)’ and ‘(not applicable to charitable purposes only)’.129 This clause ultimately appeared in the Duties upon Income Act 1799 as s 87. 123

A Bill as amended by the Committee, Lambert, above n 121, [1]. ibid, [2]. 125 A Bill as amended by the Committee, Lambert, above n 121, [28]. A Bill [As amended by the Committee] to repeal the Duties imposed by an Act, made in the last Session of Parliament, for granting an aid and contribution for the prosecution of the war; and to make more effectual provision for the like purpose, by granting certain Duties upon Income, in lieu of the said Duties (8 December 1798). An issue arising from this clause may well have been how to apportion income between that applied to charitable purposes and that which had not been so applied. 126 Some numbers were entered at every tenth line of print. 127 An Act … [9 January 1799], above n 4, s. LXXXVII. 128 A Bill as amended on Re-Commitment, Lambert, above n 121. 129 ibid. 124

Book 1.indb 141

12/2/2011 8:21:46 AM

142

Michael Gousmett

There is a significant difference between the forty-sixth clause of the Duties upon Income Bill (as amended by the Committee) and its counterpart, section 88, in the Duties upon Income Bill (as amended on re-commitment). This particular clause in the Duties upon Income Bill (as amended by the Committee) declared: [t]hat no such bodies politic or corporate, companies, fraternities, or societies aforesaid, shall be charged or chargeable, in respect of any income which, according to the Rules or Regulations of such corporations, companies, fraternities, or societies, shall be applicable to the payment of any annual dividends or interest to arise and become payable to any individual members of such corporations or public companies … .130

The reason for such a clause is quite clear – to avoid double taxation. However, a direct reference to charitable purposes was inserted into the seventy-seventh clause of the Duties upon Income Bill (as amended on re-commitment) which now read: [t]hat no such bodies politic or corporate, companies, fraternities, or societies aforesaid, shall be charged or chargeable, in respect of any income which, according to the Rules or Regulations of such corporations, companies, fraternities, or societies, shall be applicable to charitable purposes or to the payment of any annual dividends or interest to arise and become payable to any individual members of such corporations or public companies …. (Emphasis added).131

This clause ultimately appeared in the Duties upon Income Act 1799 in s. 88.132 The Duties upon Income Bill (as amended by the Committee) contained yet another clause of which, while not specifically targeting entities with charitable purposes, the intention is nevertheless quite clear. The forty-seventh clause required a ‘Statement’ to be delivered to the Assessors, being a statement: of the annual income of such corporation, company, fraternity, or society, … [specifying] how much and what proportion of such annual income is not chargeable by virtue of this Act upon such corporation, company, fraternity, or society, and for what purposes the income, not chargeable as aforesaid, is or shall be applicable. (Emphasis added.)133

This clause also appeared, at the seventy-eighth clause, in the Duties upon Income Bill (as amended on re-commitment),134 and in the Duties upon Income Act 1799 in s. 90.135 There is yet another section in the Duties upon Income Act 1799 concerning the charitable purposes exemption, but this section was not 130

A Bill as amended by the Committee, Lambert above n 121, [29]. ibid, [42]. 132 An Act… , above n 4, s 88. 133 A Bill as amended by the Committee, Lambert, above n 121, [29]. 134 ibid, [43]. 135 Section 89 of the Duties upon Income Act 1799 provided that ‘no corporate city, &c. shall be charged for income appropriated to the expences [sic] of its government, nor collegiate bodies, &c for income applied to the maintenance of Fellows, &c’. 131

Book 1.indb 142

12/2/2011 8:21:46 AM

The Charitable Purposes Exemption from Income Tax of 1799 143 contained in either of the Duties upon Income Bills. The mystery is how did this particular charitable purposes exemption clause come to be included at section 5 of the Duties upon Income Act 1799. Section 5 simply stated: [t]hat no corporation, fraternity, or society of persons established for charitable purposes only, shall be chargeable under this Act, in respect of the income of such corporation, fraternity, or society.136

It is also interesting why this section was needed at all, given that sections 87 and 88 of the Duties upon Income Act 1799 made it quite clear that income applicable to charitable purposes was exempt from duties upon income. The only difference between section 5 and sections 87 and 88 is that whereas section 5 uses the phrase ‘charitable purposes only’, sections 87 and 88 both refer to ‘charitable purposes’. The distinction may well be in the nature of trusts for charitable purposes in that there were those established solely for that purpose, whereas other entities, such as the Guilds of London, had income some of which was applicable to charitable purposes, and some not applicable. Hence the requirement for the Statement declaring what income was not chargeable and for what purposes it was intended to be used. This alone raises another issue. Were such Statements filed, and if so, were inquiries made to ensure that income applicable to charitable purposes had been so applied, to ascertain that evasion or avoidance was not being practiced? While Duke had written extensively on the law of charitable uses as long ago as 1676,137 the concept of charitable purpose with respect to Income Tax was not refined in charity case law until the Pemsel case of 1891 when the nexus between ‘charitable purpose’ and the exemption from Income Tax was definitively resolved.138

A Comparison of the Duties upon Income Act 1799 and the Assessed Taxes Act 1798 The wording of the charitable purposes exemption at section 5 of the Duties upon Income Act 1799 differs significantly from the charitable purposes exemption clause in the Assessed Taxes Act 1798, An Act for granting to His Majesty an aid and contribution for the prosecution of the war. The Assessed Taxes Act 1798 provided, in section XIX: [t]hat nothing herein contained shall be construed to extend to charge the said additional rate or duty on the amount of the Duties payable on houses, windows, 136

An Act… , above n 4, s. V. George Duke, The Law of Charitable Uses … whereunto is now added, the Learned Reading of Sr. Francis Moor [sic] (1676). The first chapter recites 43 Eliz. c. 4, upon which Duke elucidates. The second chapter, ‘Commission’, gives the date of 43 Eliz. c. 4 as having been ‘made in the High Court of Parliament, holden the seven and twentieth day of October, the three and fortieth year of the reign of the late Queen Elizabeth …’. 138 Pemsel, above n 11. 137

Book 1.indb 143

12/2/2011 8:21:46 AM

144

Michael Gousmett

or lights, in respect of any of the Royal or public hospitals, or any chambers or apartments therein used or occupied for charitable purposes. (Emphasis added.)139

Historical precedent for the exemption of hospitals from Imperial taxation is found in the Duties upon Inhabited Houses Act 1778 in which section XXXV provided: [t]hat nothing therein contained shall extend, or be construed to extend, to charge or make liable any hospital, or house provided for the reception and relief of poor persons, to the payment of the rate or duty to be laid by virtue of this Act.140

The Duties upon Inhabited House Act 1778 is the first such Act to include an exemption for hospitals, and indeed for a charitable activity, in the legislation providing for Duties upon Inhabited Houses. While the exemption was later applied to Royal and public hospitals in the Assessed Taxes Act 1798, it is interesting that houses for the reception of ‘lunatics’ [sic] in the 1798 Act were not seen in the same light as houses for the reception and relief of poor persons in the 1778 Act. In the Assessed Taxes Act 1798, houses kept for the reception of lunatics, an activity that one might today consider to be charitable in nature, did not benefit from an exemption to the same extent as that provided for Royal and public hospitals (see section XIX above of the Assessed Taxes Act 1798). This can be seen in section XX of the Assessed Taxes Act 1798 which provided: [t]hat no person who is or shall be duly licensed to keep, and who shall keep a house for the reception of lunatics, shall be chargeable with any greater rate of duty than if such house had been let out to lodgers.141

The rationale for this section was that houses for the reception of lunatics and houses for lodgers were seen by Parliament as being private businesses. ‘Lodging Houses’ were chargeable, in the Duties upon Inhabited Houses Act 1778, under section III, which provided: that every person who shall occupy any dwelling house usually let by such person in part to lodgers, or with the purpose of usually so letting out the same, or any dwelling house, part whereof is occupied and used by the same person as a shop, the amount of whose last assessment or assessments, in respect of the Duties now payable on houses, windows, or lights, or on inhabited houses, or on dogs, clocks, watches, or timekeepers, shall be in the whole under three pounds, shall be exempted from any additional Rate or Duty; … .142

While the Assessed Taxes Act 1798 provided for exemptions in certain cases, these were not intended to continue ad infinitum but had to be reapplied for within a certain time-frame each year, as provided for at section LXXXV: 139 An Act … , above n 117, s XIX. The earliest Act which contains a tax on windows appears to be An Act for granting to His Majesty several rates or duties upon houses, for making good the deficiency of the clipped money 7 & 8 Will. III c 18 [1696]. 140 An Act for granting to His Majesty certain duties upon all inhabited houses within the kingdom of Great Britain 18 Geo III c 26 [1778] s XXXV. 141 An Act … , above n 117, s XX. 142 An Act … , above n 140, s III.

Book 1.indb 144

12/2/2011 8:21:46 AM

The Charitable Purposes Exemption from Income Tax of 1799 145 the allowance of any exemption from, or abatement to be made of the said Additional Rate or Duty, in the manner before directed, shall not have continuance or be in force for any longer term than the expiration of one week after the fifth day of January next ensuing the allowance of such exemption or abatement; but that it shall be lawful for any person to whom such allowance was granted, at any time during the continuance of the Rate or Duty hereby imposed, and so from time to time whenever there shall be occasion, to appeal again from the assessment made by virtue of this Act to the Commissioners … [who may subject to proof] on oath or affirmation continue the said exemption ….’.143

This requirement can be distinguished from the charitable purposes exemption in the Duties upon Income Act 1799 as the Assessed Taxes Act 1798 was intended as a continuing Act, whereas the Duties upon Income Act 1799 was intended only as a temporary war-time measure.

PART III: THE DEBATES ON PITT’S DUTIES UPON INCOME BILL DECEMBER 1798 – JANUARY 1799

Introduction The Assessed Taxes Act 1798 was a complex piece of legislation and, as such, one can appreciate why lack of compliance was rife. Hence Pitt’s frustration, and why it was that Ehrman observed that ‘[a]t some point probably in the later summer or early autumn of 1798 Pitt was therefore considering replacing the Triple Assessment [of 1798] by an outright Income Tax’.144 Ehrman explained that: [i]t seems impossible to specify a date. In a letter undated (but from its references to the Minister’s reviving health, to Ireland, and to the redemption of tithes) written probably between mid June and mid October and possibly (from Pitt’s movements) in late July or very early August, Pretyman mentions a conversation at Holywood which also included a ‘new Finance Bill for a tenth of income in place of the Assessed Taxes’ (to Mrs Pretyman). Undoubtedly the Minister had got as far as ‘heads of a Plan’ in September and by 31 October he had made extensive notes as the background for a Bill. Rumours of an impending scheme appeared in the London newspapers during that time (e.g., The Morning Chronicle of 10 October, The Times of 14 October, The True Briton of 17 October) and in November it was being widely discussed.145

Pitt’s Bill is Introduced to the House of Commons On 3 December 1798 The Times reported to its readers that on that day Pitt would ‘bring forward his new plan of taxation, in lieu of the Assessed Taxes. 143

An Act … , above n 117, s LXXXV. John Ehrman, The Younger Pitt: The Consuming Struggle (1996) 260. 145 Ehrman, above n 144, fn 3. 144

Book 1.indb 145

12/2/2011 8:21:46 AM

146

Michael Gousmett

… The principle of the plan, which is a certain tax on every man’s income, is universally acknowledged to be extremely fair, and highly judicious’.146 The first official record of the Duties upon Income Bill is to be found in the Journals of the House of Commons which recorded that on 3 December 1798, the House of Commons, having ‘resolve[d] itself into a Committee of the whole House’, moved ‘[t]hat an Act, made in the last Session of Parliament, intituled “An Act for granting to His Majesty an aid and contribution for the prosecution of the war”, might be read’.147 Pitt began the outline of his plans in the House of Commons by moving ‘that the [A]ct of the 38th of his present Majesty, chap. 16, for granting an aid or contribution to His Majesty, might be read, and that it might be an instruction to the Committee to consider of the said Act’.148 Pitt’s motion having been accepted, he then commenced to give a very long and detailed explanation of his proposal to tax income, beginning with an explanation of what funding was required, a total of £29,272,000, and for what purpose.149 Pitt expected to raise this amount from ‘the same resources … as are applicable at all periods, whether of peace or war’.150 After raising £6,150,000 from ‘[t]he land and malt … at £2,750,000 … the lottery, £200,000 … the growing produce of the consolidated fund [of] £1,500,000 [duty] upon exports and imports … at £1,700,000’, Pitt forecast a deficit of £23,000,000 which ‘must be raised either by a tax within the year, in the same manner as the Assessed Tax Bill of last year, or by a loan’.151 As the deficit of Assessed Taxes had to be subsidised by voluntary giving, due to ‘tricks and evasion’,152 Pitt had realised: that although the Assessed Taxes furnished the most comprehensive and efficient scale of contribution, there necessarily must be much income, much wealth, great means, which were not included in its application. It now appears that not by any error in the calculation of our resources, not by any exaggeration of our wealth, but by the general facility of modification, by the anxiety to render the measure as little oppressive as possible, a defalcation has arisen which ought not to have taken place. … In these sentiments, our leading principle should be to guard against all evasion, to endeavour by a fair and strict application, to realize that full tenth, which it was the original purpose of the measure of the Assessed Taxes to obtain, and to extend this as far as possible in every direction, till it may be necessary clearly to mark the modification, or to renounce, in certain instances, the application of it altogether. (Emphasis added.)153

146

[Editorial], The Times (London), 3 December 1798, 2. Journals of the House of Commons (1803) (20 November 1798 – 27 August 1799) vol 54. The Parliamentary History of England, (1819) (3 December 1798 to 21 March 1800) vol XXXIV 1. 149 The Parliamentary History, above n 148, 2. 150 ibid, 2. 151 ibid, 2. 152 ibid, 3. 153 ibid, 4. 147 148

Book 1.indb 146

12/2/2011 8:21:46 AM

The Charitable Purposes Exemption from Income Tax of 1799 147 In order to reduce evasion, Pitt proposed that new administrative measures were required, in the form of a statement of income. Pitt suggested that ‘[i]f, then, the Committee assent to this principle, they must feel the necessity of following it up, by more efficient provisions. They will perceive the necessity of obtaining a more specific statement of income than the loose scale of modification, which, under the former measure, permitted such fraud and evasion’.154 This could have been achieved by adapting ‘many of the regulations of the old measure … to a more comprehensive and efficient application of the principle. (Emphasis added.)155 After further arguing his case, Pitt finally declared that: to prevent all evasion and fraud, … it is my intention to propose, that the presumption founded upon the Assessed Taxes shall be laid aside, and that a general tax shall be imposed upon all the leading branches of income. … The details of a measure which attempts an end so great and important, must necessarily require mature deliberation. (Emphasis added.)156

There are two aspects of Pitt’s oratory that require a special mention. The first is that Pitt intended to use the Assessed Taxes Act of 1798 as the basis for new and improved regulations, and the second is his desire for ‘mature deliberation’. That being the case, why then was the matter of exempting organisations which undertook charitable purposes not considered, even in a sentence or two, in the House of Commons during the debate on the Duties upon Income Bill? One would have expected, at this early stage of the debate, that the charitable institutions of England might have become somewhat alarmed at Pitt’s intention ‘to extend this as far as possible in every direction, till it may be necessary clearly to mark the modification, or to renounce, in certain instances, the application of it altogether’,157 and that ‘a general tax shall be imposed upon all the leading branches of income’,158 and would have reacted accordingly. Given the precedent in the Duties upon Inhabited House Act 1778,159 in 1798 the charitable institutions may not have been concerned with Pitt’s proposal. Pitt was aware of the exemptions previously provided with respect to the Assessed Taxes with which: we have had so much experience of the evasions which have taken place; when we see the consequences which have resulted from a vague rule of exemption, and an indefinite principle of deduction; when we see that, by the different modes by which exemptions were regulated, persons, who probably would have shrunk from a direct fraud, have been able by different pretences to disguise to themselves the fair and adequate proportion which they ought to have contributed, it becomes more than ever necessary to render every case of exemption precise, and to guard every title to deduction from the danger of being abused. (Emphasis added.)160 154

The Parliamentary History, above n 148, 4. ibid, 4. ibid, 4. 157 ibid, 4. 158 ibid, 4. 159 An Act … , above n 140. 160 The Parliamentary History, above n 148, 7. 155 156

Book 1.indb 147

12/2/2011 8:21:47 AM

148

Michael Gousmett

Notably, Pitt made no mention of the exemption provided to hospitals and almshouses in the Assessed Taxes Act of 1798. Pitt also desired to prevent ‘the willing contributor from being taxed to the utmost proportion of his means, while his wealthy neighbour owes his exemption to meanness. [It is therefore] necessary to guard with greater strictness against every chance of evasion’.161 Pitt then explained at length how the proposed duty was to be collected, particularly in those situations: [w]hen doubts are entertained that a false statement has been given, it shall be competent for the Commissioners to call for a specification of income … from land, from trade, annuity, or profession, which shall entitle to deduction. … [E]very case of exemption or deduction shall be presented by the party, with his claim clearly specified. … To the truth of the schedule he shall make oath. (Emphasis added.)162

Pitt, having exhorted ‘the Committee to consider whether it may not be as well to leave that class to pay on the mitigated rate of assessment to which they are liable under the Assessed Taxes Bill, as to subject them to the general rate of the present Bill’,163 then stated ‘[t]hat it will also naturally enter into the consideration of the Committee, what allowances or exemptions ought to be extended to other descriptions of persons. (Emphasis added.)’164 Pitt had in mind ‘certain allowances and abatements [that] were granted to persons with large families’,165 which he suggested ‘was not carried far enough in the Bill of last year’.166 But Pitt made no reference to England’s charitable institutions. Pitt then explained that taxes were to be laid on various objects of income, the ‘first great object of income being the property derived from land’, by which Pitt meant ‘the rent of the land of this country’.167 Having described his plan in that regard in detail, Pitt explained that taxes would be levied on: that part of income from land which belongs to the tenant; tithes, [being] income enjoyed, either by lay or impropriators, or by the clergy; … mines; … shares in canals; … the sale of timber; … rent received for houses; … the profits gained by the professors of the law; … the professions; … the profits of retail trade; … the income spent in this country by person who derive it from other parts of the world; … the income of persons not in trade [including] [public and private] annuities of all kinds, public and private mortgages, and income arising from money lent upon securities under various denominations.168

Pitt also proposed ‘that when a general assessment upon income is to take place, no distinction ought to be made as to the sources from which that income may 161

The Parliamentary History, above n 148, 8. ibid, 8. 163 ibid, 10. 164 ibid, 10. 165 ibid, 10. 166 ibid, 10. 167 ibid, 10. 168 ibid, 12. 162

Book 1.indb 148

12/2/2011 8:21:47 AM

The Charitable Purposes Exemption from Income Tax of 1799 149 arise’.169 It was his intention that ‘[i]f persons possess incomes from various sources, they are to be calculated in the aggregate’.170 The foundations of tax policy were slowly but surely being laid. Here, Pitt was addressing the taxation of public annuities. The issue for Pitt was that stockholders ought also to contribute to the common good, stockholders having been previously ‘secured against any imposts’.171 Because of their support of the nation in time of need, Pitt stated that the duty of the stockholder, as with a member of the public, was that ‘if you expect from the state the protection which is common to us all, you ought also to make the sacrifice which we are called upon to make’.172 This concept is aligned with the definition of taxes by Judge Blackstone, who considered taxes as being ‘a portion which each subject contributes of his property, in order to secure the remainder’.173 Before proceeding with a recapitulation of the various branches of income and the gross income of each, which he proposed to tax at 10 per cent, Pitt declared that: I have thus rapidly gone through all the distinct branches of national rental, and of national profits, from which we have to derive the tax that I mean to propose to you without presuming to think that I have been able to do it with that accuracy of detail which can only be derived from practice, or with that certainty upon which you ought to repose. I have through the whole, been anxious to understate the amount of the estimate, and to overrate the exemptions and deductions that it would be necessary to make from each. I make the whole annual rental and profits after making the deductions which I think reasonable, £102,000,000 sterling. … Upon this sum a tax of 10 per cent is likely to produce £10,000,000 a year, and this is the sum at which I shall assume it. (Emphasis added.)174

The Wealth of Corporations and Churches During his presentation on his Plan of Finance, Pitt made no mention of the wealth of the established church of England, or of England’s many charitable institutions, and their investing activities. Yet according to Colquhoun’s 1815 publication, A Treatise on the Wealth, Power and Resources of the British Empire, in 1812 the aggregate income from income in the funds for ‘[p]ersons included in the various families mentioned above [in Colquhoun’s Table], who have incomes from the funds and other sources, including also trustees 169

The Parliamentary History, above n 148, 14 ibid, 16. 171 ibid, 14. 172 ibid, 15. 173 ibid, 83. During the debate on the Duties upon Income Bill on 14 December, Sir John Sinclair had referred to Blackstone, but did not mention the name of the case to which he had referred. The Parliamentary History, above n 148, 83. 174 The Parliamentary History, above n 148, 17, and W.S. Hathaway, The Speeches of The Right Honourable William Pitt (1808) vol 2 447. The text that I have emphasised is contained in Hathaway, but not in The Parliamentary History. 170

Book 1.indb 149

12/2/2011 8:21:47 AM

150

Michael Gousmett

for orphans, minors, and charitable foundations and institutions’, was ‘about £5,211,063’.175 Colquhoun also stated that: [c]haritable corporations and other benevolent institutions, of which there are a vast number in the kingdom, together with the Friendly Societies, consisting of 9,672 in England and Wales, uniformly place their surplus contributions in the funds, making a large aggregate in the course of the year. It is probable, that the funds of the Friendly Societies, with other associations of a similar nature, may amount to about £3,000,000. Including Scotland and Ireland, the funds of the societies in the United Kingdom may approach nearly to £3,500,000. … .176

Colquhoun provides further evidence of the extent of investments by charitable institutions in government funds in his discussion on the national debt, as he considered that: it is impossible to look forward to a period by which the extinction of the national debt shall dissolve the present system without exciting a considerable degree of alarm. Under such circumstances, it is not difficult to foresee the calamities, which would ensue from the vast masses of property belonging to charitable corporations, and societies, and to wards of chancery, minors and numerous classes of individuals where no adequate security could be obtained; and where the interest must be so reduced as to destroy many of the sources from whence a revenue is obtained for the support of the state. 177

Colquhoun went to considerable trouble to compile ‘An Account of the Property of Foreigners in the Public Funds of Great Britain’ for the four quarters ending on 10 October 1809, yet he did not include the charitable institutions and Friendly Societies in his figures.178 The total invested by ‘Foreigners’ in the public funds for those twelve months was £35,443,259 3s 9d, with exemptions from the Property Tax ‘of 10 per cent on the dividends’ totalling £59,298 5s 7d.179 That Colquhoun was able to produce these figures suggests that similar figures could also be produced for charitable institutions. Pitt also must have had the ability to discover more detail on the funds invested by charitable institutions, and what the ‘cost’ to the country of the forgone income by way of the charitable purposes exemption from Income Tax might have been. Of all the branches of income that Pitt had ‘rapidly gone through’, the public annuities were singled out for particular attention with respect to ‘that part

175 P Colquhoun, A Treatise on the Wealth, Power, and Resources, of the British Empire, in Every Quarter of the World (2nd ed, 1815) 125. Colquhoun considered that it was ‘probable’ that the Friendly Societies of the United Kingdom alone had ‘nearly up to £3,500,000’ invested in the funds. Colquhoun, above n 175, 277. The accuracy of Colquhoun’s figures have been brought into question, as ‘[t]he limitations of Colquhoun’s estimate are already well known’. PK O’Brien, ‘British Income and Property in the Early Nineteenth Century’ 12 The Economic History Review 2 (1959) 255, 255. See also P Deane, ‘Contemporary Estimates of National Income in the First Half of the Nineteenth Century’ (1956) 8 (3) The Economic History Review 339–354. 176 Colquhoun, above n 175, 277. 177 ibid, 277. 178 ibid, 298. 179 ibid, 298.

Book 1.indb 150

12/2/2011 8:21:47 AM

The Charitable Purposes Exemption from Income Tax of 1799 151 of the public annuities which have been redeemed by the nation [and] is to be exempted from the charge of the tax’.180 Pitt considered that: the rental of the public annuities may be estimated at £15,000,000 … there will, of course, be admitted the same exemptions to all annuitants who have less than £60 a year, and the same modifications to all who possess from £60 to £200 a year. At the same time it is to be considered, that these exemptions and modifications are only to apply to those individuals whose whole income amounts to less than £200 a year. … I am sure that I shall over-rate the amount of these exemptions and modifications, when I deduct one-fifth from the sum that I have stated the public annuities to be; but I do not admit that deduction, and therefore state the total of the income from the public funds at £12,000,000. (Emphasis added.)181

Why was Pitt not prepared to ‘admit’ the deduction? He had, after all, in effect made an allowance for between £3,000,000 and £3,500,000 to be exempt from his Duties upon Income Bill. After further detailing his proposal, Pitt moved two resolutions, the first being to repeal ‘An Act for granting to His Majesty an aid and contribution for the prosecution of the war’,182 that is, the Assessed Taxes Act 1798 of the last session. Pitt’s second resolution was that, in order to raise the supply granted to his Majesty: there be charged annually, during a term to be limited, the several rates and duties following, upon all income arising from property in Great Britain, belonging to any of his Majesty’s subjects, although not resident in great Britain; and upon all income of every person residing in Great Britain, and of every body politic or corporate, or company, fraternity, or society of persons, whether corporate or not corporate, in Great Britain, whether any such income shall arise from lands, tenements, or hereditaments, wheresoever the same shall be situated in Great Britain, or elsewhere; or from any kind of personal property, or other property whatsoever; or from any profession, office, employment, trade, or vocation ; … .(Emphasis added.)183

In opposing Pitt’s plan, Tierney accused Pitt of ‘[seeming] to expect either support or silence from this side of the House’.184 Tierney told Pitt to expect neither as, having opposed the Assessed Taxes, ‘it would be strange if I were silent upon a measure, which is … infinitely more destructive, even than that destructive measure’.185 Tierney considered Pitt’s plan to be a ‘monstrous proposition’. Tierney also considered that there were other options that should be considered before such a plan as Pitt was proposing was put in place. ‘At all events’, declared Tierney, ‘I must have it in my power to say to my constituents before I adopt this, that every other resource has been exhausted. Now I cannot say that, for there are others yet to be touched, which ought to go before this measure is resorted to. (emphasis added)’.186 Tierney had in his sights: 180

The Parliamentary History, above n 148, 15. ibid, 16. 182 ibid, 20. 183 ibid, 20. 184 ibid, 22. 185 ibid, 22. 186 ibid, 23. 181

Book 1.indb 151

12/2/2011 8:21:47 AM

152

Michael Gousmett

[the] many valuable things under the church establishment, not in the smallest degree beneficial to religion, but which only swell out the pomp and pride and imaginary greatness of some inflated individuals which ought to be brought in aid of the public burthens. The individuals possessing these things ought to be made to contribute their full share. The corporations also are liable in the same manner, as I conceive – [Here a cry of hear! hear! Hear!] Gentlemen might cry ‘hear, but he would repeat what he said: he was the last man in that House who would lay violent hands on any property; but when that was to be done, he thought the tax ought to be laid on a different description from that of individuals.187

While Tierney did not specifically mention charitable institutions, his reference to corporations suggests that he may have had them in mind. While Tierney was concerned that churches and corporations might not be required to share their burden of taxation, this point was not commented on by London’s newspapers. Both The Times and The Morning Chronicle reported on Pitt’s plans in their respective editions of 4 December 1798. The editor of The Morning Chronicle declared that: [a]t length our readers are put into possession of the plan of the Chancellor of the Exchequer, for a general assessment of property and income, under all its various forms of land rental, public annuity, profession, trade, or industry. It would not be possible for us, this day, to enter into any examination of a question so complicated, which affects more or less every individual in the country; but we shall feel it our duty to enter into the merits of the plan, and we respectfully invite gentlemen to communicate their thoughts on the subject, through the channel of this paper, as a means of information to the public. It shall be our duty to pay the utmost intention to the letters with which we may be favoured.188

In the view of the editor of The Times, ‘[t]he parsimonious man will now have to contribute in common with the man of more liberal principles and expenditure’.189 Such was the scepticism in which Pitt’s grand plan was held by the print media. The Times of 4 December, in describing the nature of Pitt’s ‘new Plan of Finance’, did so in a rather self-congratulatory manner by stating that the tax was, ‘as we have already observed, ... to be a tax upon income’.190 The Journals of the House of Commons record that, on 4 December 1798, the additional duties on the Assessed Taxes were repealed, followed by a resolution of considerable length which declared: [t]hat, towards raising the Supply granted to His Majesty, there be charged annually, during a term to be limited, the several Rates and Duties following, upon all income arising from property in Great Britain, belonging to any of His Majesty’s subjects, although not resident in Great Britain, and upon all income of every person residing in

187 The Parliamentary History, above n 148, 23; The Morning Chronicle (London), 4 December 1798, 3; The Times (London), 4 December 1798, 3. The text which is underlined was that as in The Times, but not in the other two sources cited. 188 [Editorial], The Morning Chronicle (London), 4 December 1798, 4. 189 [Editorial], The Times (London), 4 December 1798, 3. 190 [Editorial], The Times (London), 4 December 1798, 3.

Book 1.indb 152

12/2/2011 8:21:47 AM

The Charitable Purposes Exemption from Income Tax of 1799 153 Great Britain, and of every body politic or corporate, or company, fraternity, or society of persons (whether corporate or not corporate) in Great Britain, whether such income shall arise from lands, tenements, or hereditaments, wheresoever the same shall be situate, in Great Britain, or elsewhere, or from any kind of personal property, or other property whatever, or from any profession, office, employment, trade, or vocation … . (Emphasis added.)191

The Printing of the Duties upon Income Bill By the end of the eighteenth century, Bills before parliament were being printed for the use of the members of the House of Commons. However, in 1798, the printing of Tax Bills was a relatively new concept. Twelve years earlier the concept had been rejected by Parliament when, on 22 May 1786, Sheridan had attempted to have tax Bills printed. Sheridan held the view that: … every person would readily coincide with him in opinion, that there were no Bills of more importance than the Tax Bills. They ought, undoubtedly, to be [?] understood before they were passed; and no mode could [be?] more eligible for diffusing the information, than the printing of every Tax Bill previous to its final discussion. The practice of printing Bills was of modern date, as might be seen from Mr. Hatsell’s Precedents of the House of Commons, which he believed to be in possession of every gentleman conversant in parliamentary business. This custom however, had not as yet extended to Tax Bills; … As the printing of the Tax Bills would be attended with the happiest effects, [he] hoped no gentleman would oppose a measure of such [general] utility to the country. … He applauded the parliamentary maxim of [not] admitting petitions against a Tax Bill, during the same session in which the law was passed. If such a law were not enforced, there would otherwise arise very unnecessary delays. (Emphasis added.)192

Sheridan then moved ‘that the Bill relative to a tax on perfumery, be printed’.193 The motion was opposed, but particularly by none other than the Chancellor of the Exchequer, William Pitt, who: [expressed] his pleasure at discovering that the days of taxation were now nearly at an end, as the revenue of the country was considerably improved. If any good could be derived from the present motion, he would not on any account oppose it; but from a consciousness of [?] futility, he was of the opinion that it was needless to trouble the House with anything of the kind.194

The House of Commons then divided and a vote was taken: ‘Ayes 24 – Noes 199’.195 Sheridan tried again, on 24 May, when he moved for the printing of a Bill ‘for better securing the duties on starch’.196 Pitt again opposed the motion and, 191

Journals, above n 147, 56. The Parliamentary Register, (1787) vol XX 245. 193 ibid, 245. 194 ibid, 246. 195 ibid, 246. 196 ibid, 247. 192

Book 1.indb 153

12/2/2011 8:21:47 AM

154

Michael Gousmett

the question being called for, was ‘negatived’.197 However, by 1798, such Bills were being printed, even if not for the immediate convenience of the members of the House of Commons. The Parliamentary History does not contain a report of the debate on the Duties upon Income Bill in the House of Commons on 7 December 1798, the next report of debate by The Parliamentary History on the Bill being on 14 December 1798. An explanation for the omission of the debate on 7 December is to be found in The Times of 8 December in which its report of the debate in the House of Commons on 7 December consisted of only three short paragraphs, one of which stated that: Mr Pitt observed that the only object of the Committee at that time would be to fill up the blanks, in order that the Bill might be printed; and as he believed it would be more satisfactory for gentlemen to debate the clauses after the report should be brought up, he hoped there would be no objection to putting off the discussion till a more convenient opportunity.198

Thus I construe from this that the members of the House of Commons had not been provided with a draft of the Duties upon Income Bill to peruse on its introduction into the House of Commons by Pitt. There is nothing unusual in that, as such a practice continues today, at least as regards the Opposition. However, I note that a copy of Pitt’s Duties upon Income Bill being the basis for his debate in the House of Commons which began on 3 December 1798 does not appear to exist, as no such copy is listed in the House of Commons Sessional Papers for 1798–99.199 The first listing in the Sessional Papers concerning Pitt’s Duties upon Income Bill recorded that the Bill was ‘ordered to be printed’ as amended [on] 8 December 1798.200 This event was recorded in The Parliamentary Register of 7 December 1798, in these words: The Income Bill being in a Committee of the whole House, Mr Chancellor Pitt observed, that perhaps the Committee would dispense with formalities in the present stage of this important proceeding, as the amendments should be printed; and that he proposed to have the discussion of the measure on the recommitment of the Bill. The Bill then pro forma, passed the Committee, and the report was ordered for tomorrow. (Emphasis added.)201

11 December 1798 While the Members of the House of Commons were having trouble gaining access to copies of Pitt’s Duties upon Income Bill, the newspapers were having no such trouble. On 11 December The Morning Chronicle published an ‘Abstract of A Bill (as amended by the Committee)’, having declared that: 197

The Parliamentary Register, above n 192, 247. ‘Parliamentary Intelligence’, ‘Tax on Income’, The Times (London), 8 December 1798, 2. 199 Lambert, above n 121. 200 Lambert, above n 121, v. 201 The Parliamentary Register, (1799) vol VII 153. 198

Book 1.indb 154

12/2/2011 8:21:48 AM

The Charitable Purposes Exemption from Income Tax of 1799 155 [w]e feel it to be our duty to make everything give way in this day’s publication to an Abstract of the new Bill for a tax upon income; from which the public may see the provisions of the intended law.202

This is something that The Times was not prepared to do, as the editorial board declared, on 12 December, that: [w]e are lead to believe that there will not be any serious opposition made to the new tax Bill on income, the principle of which is generally approved. It is probable, however, that some modifications will be proposed in the Committee, and under these circumstances we rather defer giving the copy or Abstract of the Bill, until all the amendments are made. The Bill is expected to be debated on Friday, on its recommitment. (Emphasis added.)203

The Abstract, as published by The Morning Chronicle, included the comprehensive exemption clause for those entities with income applicable to charitable purposes, as well as other requirements applicable to such institutions. The draft clauses, which are identical to those of the Bill as printed, are reproduced in full below. And be it further enacted, That where any bodies politic or corporate, companies, fraternities, or societies of persons, whether corporate or not corporate, shall be entitled unto any annual income, to the respective amounts before specified, other than and besides any income applicable to charitable purposes, such annual income not applicable to charitable purposes only shall be chargeable with such and the like rates as any other annual income of the same amount will, under and by virtue of this Act, be chargeable with. Provided always, and be it further enacted, That no such bodies politic or corporate, companies, fraternities or societies aforesaid, shall be charged or chargeable, in respect of any income which, according to the rules or regulations of such corporations, companies, fraternities, or societies, shall be applicable to the payment of any annual dividends or interest to arise and become payable to any individual members of such corporations or public companies, or to any other persons or public bodies, having any share, right, or title of, in, or to any capital stock, or other property belonging to such corporations or public companies, nor in respect of which any dividends or interests [sic] shall, according to such rules and regulations, become payable; provided that such person or persons, corporations, companies, fraternities, or societies, to whom such dividends or interest shall be payable, shall be charged and chargeable in respect thereof, according to the amounts thereof, and the rates before specified, as and when the same shall be received by them respectively; and that an account of such dividends and interest ‘shall’ (inserted by TMC) be delivered to the Assessors of the parish or place, at the same time, and by the same persons, in the same manner as the statements of the income of such corporations and public companies chargeable upon them are required to be delivered.

202 203

Book 1.indb 155

‘Abstract of a Bill’, The Morning Chronicle (London), 11 December 1798, 3. [Editorial], The Times (London), 12 December 1798, 4.

12/2/2011 8:21:48 AM

156

Michael Gousmett

And be it further enacted, That the Chamberlain, Treasurer, Clerk, or other officer acting as Treasurer, Auditor, or receiver, for the time being, of every such corporation, company, fraternity, or society, shall, and he is hereby required within twenty-eight days after the publication of such general notices as herein mentioned, in the parish or place wherein the office of such Chamberlain, Treasurer, Clerk, or other officer shall be situate, to make out and deliver to the Assessors acting in and for such parish or place, a statement of the annual income of such corporation, company, fraternity, or society, according to the form specified in the Schedule to this act [sic] annexed, marked ( ) [sic] and shall also specify in such statement how much and what proportion of such annual income is not chargeable by virtue of this Act upon such corporation, company, fraternity, or society, and for what purposes the income, not chargeable [as] aforesaid, is or shall be applicable; and such Assessors are hereby required to transmit such statement to the respective assessors in the manner and for the purposes herein directed, as to statements of householders and others charged to the said rates by virtue of this Act. (Emphasis added.)204

These clauses in the Duties upon Income Bill then appeared in the Duties upon Income Act 1799 as sections 87, 88 and 90, respectively. The section V charitable purposes exemption, as it appeared in the Duties upon Income Act 1799, was not included within the Abstract as published by The Morning Chronicle. Neither did the five ‘Rules’ and seventeen ‘Cases’ ‘for estimating the income of persons’ as described by The Morning Chronicle, appear in the final Act.205 The Morning Chronicle made much more of an effort to publish the views of its readers than The Times, which may say more about the political leanings of the newspaper than its desire for market share. The issue of 14 December 1798 contained a number of extracts from writers’ letters, as The Morning Chronicle had by then, presumably due to the volume of correspondence that it was receiving, set upon the policy of ‘abridging the opinions [it] had received on the alarming Bill of taxation now in Parliament’.206 Of the many extracts published by The Morning Chronicle, which are interesting but too lengthy to quote here, none discussed the charitable purposes exemption from the Duties on Income, as described in the Abstract of the Duties upon Income Bill that The Morning Chronicle had published on 11 December. The Oracle and Daily Advertiser noted, in its publication of an ‘Abstract of the Bill (as amended by the Committee)’ on 13 December, that ‘[t]he income

204 Abstract of a Bill (as amended by the Committee, To repeal the Duties imposed by an Act, made in the last session of Parliament, for granting an aid and contribution for the prosecution of the war; and to make more effectual provision for the like purpose, by granting certain Duties upon Income, in lieu of the said Duties), The Morning Chronicle (London), 11 December 1798, 2. 205 ‘Abstract of a Bill’, above n 204, 2. Four Rules and eighteen cases were published as part of An Act for extending the time for returning statements under [39 Geo. III c. 13], passed in the present session of Parliament, intituled An Act to repeal the Duties imposed by an Act, made in the last session of Parliament, for granting an aid and contribution for the prosecution of the war; and to make more effectual provision for the like purpose, by granting certain Duties upon Income, in lieu of the said Duties; and to amend the said Act 39 Geo. III c. 22 [21 March 1799]. 206 [Editorial], ‘Tax upon Income’, The Morning Chronicle (London), 14 December 1798, 2.

Book 1.indb 156

12/2/2011 8:21:48 AM

The Charitable Purposes Exemption from Income Tax of 1799 157 of corporations, societies, … if not applied to charitable purposes, are to be taxed’.207 The Oracle was referring to the forty-fifth clause of the amended Bill,208 but made no further comment on this matter.

14 December 1798 The Journals of the House of Commons record that on 14 December 1798 the House was advised ‘that several other amendments are necessary to be made to the said Bill’,209 following which the Bill was re-committed to a Committee of the whole House. In his contribution to the debate, a Mr Simeon made an oblique reference to charitable institutions with his use of the word ‘corporation’.210 Kyd, in his 1793 A Treatise on The Law of Corporations,211 used the term ‘corporation aggregate’ as in ‘[a] trust for orphans’,212 or in describing the legal basis of an hospital where ‘the corporate succession is vested in trustees … [such as ] Sutton’s Hospital, commonly called the Charter House’.213 The Parliamentary History reported that Simeon: proceeded to take notice of the hints that had been thrown out upon a former occasion [but does not say what that occasion was], relative to the taking [of] the property to be found in corporation and church lands, for the use of the state. He hoped that would never be deliberately proposed in that House. Corporations were extremely useful for the purpose of administering local justice. (Emphasis added.)214

There are two points to be taken from Simeon’s comments. First, it is quite possible that Simeon was referring to the laws of Mortmain. Second, his reference to corporations being used to administer local justice bears a striking resemblance to Andrew’s use of ‘police’ in discussing the role of charitable institutions in eighteenth century England.215 Pitt also referred to ‘police’, but due to discrepancies between the two publications which reported the debate, The Parliamentary History and The Parliamentary Register, what Pitt actually said is difficult to ascertain. The report in The Parliamentary History is obviously based on the report of the debate in The Times, as the extract from The Parliamentary History is word-for-word that of The Times of 15 December, which both record Pitt as having said that:

207 ‘Abstract of a Bill (as amended by the Committee)’, Oracle and Daily Advertiser (London), 13 December 1798, Issue 21853. 208 Lambert, above n 121, 28. 209 Journals, above n 147, 78. 210 The Parliamentary History, above n 148, 88. 211 Stewart Kyd, A Treatise on The Law of Corporations (1793) vol I. 212 Kyd, above n 211, 20. 213 Kyd, above n 211, 27. 214 The Parliamentary History, above n 148, 88. 215 See Donna T Andrew, Philanthropy and Police: London Charity in the Eighteenth century (1989).

Book 1.indb 157

12/2/2011 8:21:48 AM

158

Michael Gousmett

[w]e must lay the contribution, then, either on capital or income. From this general operation, however, the hon. gentleman would exempt all those whom he is pleased to call exclusively the useful classes, and lay the whole of the weight on what he calls the useless class. In the class of useless the hon. gentleman has thought proper to rank all the proprietors of land, those men who form the line which binds and knits society together – those on whom, in a great measure, the administration of justice, and the internal police of the country depends;- those men from whom the poor receive employment, from whom agriculture derives its improvement and support and to whom, of course, commerce itself is indebted for the foundation on which it rests. Yet this class the hon. gentleman thinks proper to stigmatize as useless drones, of no estimation in the eyes of society. (Emphasis added.)216

Was the phrase ‘the internal police’ a reference to charitable institutions? From the research undertaken by Andrew, with her use of the phrase ‘redemptive police’, in her study of the eighteenth century charitable institutions of London, I suggest that is precisely what Pitt was referring to.217 The report in The Parliamentary Register of 14 December recorded Pitt as having said: [that] in order to ascertain the capital of the country, the only proper criterion that offers itself is that of income. The measure proposed goes to affect, in a just and equal manner, the commerce of the country, all proprietors of land, all to whom the commerce and economy of the country depended, all those through whom the administration of justice took place, all to whom the protection of the poor attached, and all who formed the great and important links in the vast chain of society.218

On 14 December 1798 Tierney also made a reference to corporations, as well as religious institutions, arguing that: [regarding] the subject of corporations; their expences [sic] had been termed innocent hospitality; but he would say, the instant the widow’s mite was taken away, that innocent hospitality ought to be termed a gluttony. In our present situation, some of the greater emoluments of the church ought to be taxed. (Emphasis added.)219

Shortly afterwards, Tierney threw out an even more threatening challenge, by asking: whether it would be likely to do good, to put on record the exact amount of the incomes of the several bodies corporate throughout the kingdom? He believed they would not be found themselves of rendering an account of their possessions, lest, in the hour of distress, the Government should know where to lay their hands. The church was proverbially jealous, and he believed, in some Deans and Chapters, [that] the Bursers [sic] were obliged to take an oath not to betray their secrets.220

216

The Parliamentary History, above n 148, 99. Andrew, above n 215, 6, 7, 25, 98, 108, 165, 168, 173, and 188. 218 The Parliamentary Register, (1799) vol VII 268. 219 ibid, 293. 220 ibid, 294. 217

Book 1.indb 158

12/2/2011 8:21:48 AM

The Charitable Purposes Exemption from Income Tax of 1799 159 The reference to the incomes of bodies corporate brings to mind Gilbert’s failed attempts to inquire into charitable donations, of which Tierney may well have been aware. However, in his challenge to the corporations and the churches, Tierney did not raise the issue of the taxation or exemption of charitable institutions. Lord Hawkesbury responded to Tierney by: [denying] that the Bill attacked corporations or the church in a partial manner; he had always held these institutions essential to the safety of the constitution and laws; but if they were as injurious as they were useful, he would contend for the preservation of their property, since, if it were seized or invaded, all other property would soon follow; a fact of which we had seen a striking instance in France. He contended that the Bill, instead of being a plan of indiscriminate rapine, as it had been called, spread itself equally over the community as any measure could do, having the same object in view.221

19 December 1798 On Wednesday 19 December the House again resolved itself into a Committee of the Whole House for the purposes of the Duties upon Income Bill.222 The only significant issue of that day’s debate was that Tierney expressed his disapproval: of the new modifications; he rose only to ask if it was [Pitt’s] intention to have the [Duties upon Income] Bill reprinted after the new clauses were brought up, or thus he might not have an opportunity of examining them previous to their discussion.223

Pitt assured him that ‘[i]t was indeed his intention that the Bill should be reprinted, but it was also his wish that no time should be lost, but that the discussion might take place on the report’.224

21 December 1798 On 21 December the question of the printing of the Duties upon Income Bill was again raised, but The Parliamentary Register merely recorded that ‘[a]fter some short observations from Mr Chancellor Pitt, Mr Wigley, and the Speaker, respecting the printing of the report on the Bill for a general tax upon income, and the consideration of it on Wednesday next, the House adjourned.225

221

The Parliamentary Register, above n 218, 295. Journals, above n 147, 86. 223 The Parliamentary Register, above n 201, 315. 224 ibid, 316. 225 ibid, 359. 222

Book 1.indb 159

12/2/2011 8:21:48 AM

160

Michael Gousmett

22 December 1798 Debate on the Duties on Income Bill continued on the 22 December 1798.226 What happened next, as reported by The Parliamentary Register (for this was not reported in The Parliamentary History) provides another very interesting insight into how Parliamentary proceedings were undertaken at that time. There are two points of particular interest. First, even after having been under debate for some weeks, the Duties upon Income Bill had yet to be printed for the Members of the House of Commons to study in detail. Second, with Christmas but a few days away, Pitt did not intend to let that interfere with his intentions. These points can be seen, the first in Tierney’s comments, then in Pitt’s somewhat terse reply. Mr Tierney had asked Pitt: whether it was his intention to bring on the consideration of the report on Wednesday? It could not be in the hands of gentlemen until that day, and therefore there would be no time to consider it until Thursday at the least, for Christmas Day was no day of business. He was not speaking for himself, for he wanted no time, but there were others in a different situation, who had gone into the country, who did not care to attend the detail of the measure in the Committee, but who waited to see the whole printed, and who wished to speak upon the subject once for all. An honourable friend of his he knew in particular to have been gone into the country, and who wished to speak upon this subject after the report was made, but he could not be prepared for that purpose without seeing what sort of a thing the Bill was when the Committee had done with it, and which he could not learn by post before Thursday. Under these impressions, he hoped he was not asking too much of the goodness of the Chancellor of the Exchequer when he begged that the report might stand for Friday, and the third reading of the Bill for Monday. It was said indeed, that all the proceedings on the Bill would be ready for delivery on Monday, but that could hardly be the case. It was now Saturday night, and he did not presume that the printers would labour on Sunday. He might, indeed, be justified in desiring the Bill to be postponed altogether after the holidays, but that he did not press; he only asked for a day or two, which might very well be granted, especially when the House was so thin. (Emphasis added.)227

In reply, Pitt responded that: [he] wished the Bill to be discussed upon the report, or upon the third reading. There was no surprise to be complained of in this case, for it was well known that all the Bill was gone through except the cases annexed to the schedule, which could not be expected to occupy much time; after which the new clauses were to be produced, and, as the whole was expected to be printed, there was nothing very remarkable in seeing the House was but thinly attended. He should be happy to accommodate any gentleman, but it must be recollected, not only that the convenience of that House, but also of another House of Legislature, ought to be attended to, and it was now clear that they could not enjoy the holidays until the Bill was discussed, or else it must be put off till a very inconvenient season. He stood in the same situation as the

226 227

Book 1.indb 160

The Parliamentary Register, above n 218, 396. The Parliamentary Register, above n 218, 396.

12/2/2011 8:21:48 AM

The Charitable Purposes Exemption from Income Tax of 1799 161 honourable gentleman, for he had no personal convenience to accommodate; nor did he see why the honourable gentleman, so laudably diligent himself as a Member of Parliament, could have any fellow feeling for seceders [sic] of any kind; and, indeed, the gentleman to whom he alluded was only a qualified seceder, who, although he did not [choose] personally to attend the House, was yet willing to receive intelligence of its proceedings by post. He expected the Bill and all the clauses to be ready for delivery on Monday. (Emphasis added.)228

This did not satisfy Tierney who argued ‘that the first payment of the Bill was not until the 5th of June, and therefore there was time for the operation of the Bill’.229 Pitt however, disagreed, there being a number of administrative tasks needing to be accomplished before that date, such as: appointing first and second Commissioners, making out lists, examining returns, classing them, and various other business preparatory to the first payment, [therefore] the time between that and passing the Bill, would not, with all the diligence the Legislature could use, be thought too long, and therefore he could not agree to any delay in this case.230

Having stated his position, the House then returned to the business of the day (or, more correctly, the night). It was during the course of this evening’s debate that Pitt declared that ‘every shilling taken from that class of the public that had families to provide for was taken from those to whom it was for the best interests of society to extend relief’.231 Yet still there was no mention of the possible effect of the proposed tax on charitable institutions. Finally, after it was determined that the Report would be considered further on 27 December, it was ordered: ‘[t]hat such a number of copies of the said Bill, as amended by the Committee, be printed, as shall be sufficient for the use of the Members of the House’.232 The Members of the House of Commons now had no excuse for not being fully informed of Pitt’s intentions.

The Re-printing of the Duties upon Income Bill A comparison of the reprinted Duties upon Income Bill of 22 December 1798 with that of 8 December 1798 reveals that only minor amendments had been made to the exemption clause relating to charitable institutions, with the removal of commas (indicated by square brackets below) and the inclusion of braces thus: That where any bodies politic or corporate, companies, fraternities, or societies of persons, whether corporate or not corporate, shall be entitled unto any annual 228

ibid, 397. The Parliamentary Register, above n 218, 397. 230 ibid, 396. 231 ibid, 407, 408. 232 Journals, above n 147, 95. 229

Book 1.indb 161

12/2/2011 8:21:48 AM

162

Michael Gousmett

income[,] to the respective amounts before specified[,] (other than and besides any income applicable to charitable purposes)[,] such annual income (not applicable to charitable purposes only) shall be chargeable with such and the like rates as any other annual income of the same amount will, under and by virtue of this Act, be chargeable with. (Emphasis added.)233

The above clause was also moved from the forty-fifth clause to the seventy-sixth clause in the re-printed Bill. However, the charitable purposes exemption clause as contained in the final Act, at section V, is not to be found in the Duties upon Income Bill as printed on 22 December.234 How the various amendments concerning the charitable purposes exemption clause came to be made remains a mystery. In particular, how section V came to be part of the Act of 9 January 1799 is more of a mystery, as there was no discussion concerning those changes in the debates between the reprinting of the Bill and the Bill becoming law on 9 January, 1799.

26 December 1798 On 26 December The Times published an abstract of the Duties upon Income Bill under the title ‘Abstract of the Amendments and Alterations in the Bill laying a Tax upon Income’.235 While the Abstract did not contain any reference to charitable institutions, Friendly Societies were mentioned regarding an amendment having been made which stated that ‘[n]othing in this Act shall extend to charge the fund of any Friendly Society established under the 33rd of His present Majesty’.236

31 December 1798 The Journals of the House of Commons for 31 December 1798 record: [t]hat the Order of the day, for the third reading of the Bill (now ingrossed) to repeal the Duties, imposed by an Act, made in the last Session of Parliament, for granting an aid and contribution for the prosecution of the war, and to make more effectual provision for the like purpose, by granting certain Duties upon Income, in lieu of the said Duties, be now read.237

On the House of Commons dividing to consider the Question ‘that the [Duties upon Income] Bill be now read a third time’, the result was in the affirmative, 233 Lambert, above n 121, [42]. This clause was the forty-fifth clause in the Bill as printed on 8 December 1798 and the seventy-sixth clause in the Bill as re-printed on 22 December 1798. 234 An Act … , above n 4, s. V. 235 ‘Abstract …’, The Times (London), 26 December 1798, 4. 236 ‘Abstract …’, above n 235, 4. The Act referred to was An Act for the encouragement and relief of Friendly Societies 33 Geo. III c. 54 [21 June 1793]. 237 Journals, above n 147, 127.

Book 1.indb 162

12/2/2011 8:21:49 AM

The Charitable Purposes Exemption from Income Tax of 1799 163 with 93 Yeas and 2 Noes.238 In spite of the Bill having been engrossed, and the Bill having been read a third time, three engrossed clauses were then ‘offered to be added to the Bill, by way of ryder [sic]’, each being ‘thrice read’ and ‘agreed to by the House to be made part of the Bill’.239 The ‘ryders’ added to the Bill related to ‘the Schedule containing the form of the declaration of the number of children’; ‘the income of property from the plantations, which shall not have been imported into Great Britain’; and ‘the appointment of Commissioners in the several divisions of the County of Lincoln’.240 There was no ‘ryder’ regarding charitable institutions.

Amendments to the Charitable Purposes Exemption Clause There is nothing in the debate in the Duty upon Income Bill in the House of Commons relating to the charitable institutions exemption clauses that explain why or how the wording in the Bill, as printed on 22 December 1798, came to be changed from that of 8 December 1798, nor how section V in the Duties upon Income Act of 1799 came to be introduced. A comparison of the clauses in the reprinted Bills of 8 and 22 December indicates the extent to which modifications were made. The forty-sixth clause of 8 December 1798 read: that no such bodies politic or corporate, companies, fraternities, or societies aforesaid, shall be charged or chargeable, in respect of any income which, according to the Rules or Regulations of such corporations, companies, fraternities, or societies, shall be applicable to the payment of any annual dividends or interest to arise and become payable to any individual members of such corporations or public companies, or to any other persons or public bodies, having any share, right, or title of, in, or to any capital stock, or other property belonging to such corporations or public companies, nor in respect of which any dividends or interests shall, according to such Rules and Regulations, become payable; provided that such person or persons, corporations, companies, fraternities, or societies, to whom such dividends or interest shall be payable, shall be charged and chargeable in respect thereof, according to the amounts thereof, and the rates before specified, as and when the same shall be received by them respectively; and that an account of such dividends and interest be delivered to the Assessors of the parish or place, at the same time, and by the same persons, in the same manner as the statements of the income of such corporations and public companies chargeable upon them are required to be delivered.241

However, the forty-sixth clause of the Bill of 8 December, as amended on 22 December and included as the seventy-seventh clause in the Bill, then read:

238

ibid, 127. ibid, 127. 240 ibid, 127. 241 Lambert, above n 121, A Bill [As amended by the Committee] … Duties upon Income otbp 8 December 1798 [un-numbered clause] 46, 29. 239

Book 1.indb 163

12/2/2011 8:21:49 AM

164

Michael Gousmett

that no such bodies politic or corporate, companies, fraternities, or societies aforesaid, shall be charged or chargeable, in respect of any income which, according to the Rules or Regulations of such corporations, companies, fraternities, or societies, shall be applicable TO CHARITABLE PURPOSES, OR to the payment of any annual dividends or interest to arise and become payable to any individual members of such corporations or public companies, or to any other persons or public bodies, having any share, right, or title of, in, or to any capital stock, or other property belonging to such corporations or public companies, nor in respect of which any dividends or interests shall, according to such Rules and Regulations, become payable; provided that such person or persons, corporations, companies, fraternities, or societies, to whom such dividends or interest shall be payable, shall be charged and chargeable in respect thereof, according to the amounts thereof, and the Rates before specified, as and when the same shall be received by them respectively, OTHER THAN AND EXCEPT DIVIDENDS AND INTEREST THE PROPERTY OF PERSONS NOT THE SUBJECTS OF HIS MAJESTY, AND NOT RESIDENT IN THIS KINGDOM, and that an account of THE AMOUNT OF such dividends and interest be delivered to SUCH INSPECTOR OR SURVEYOR AS SHALL BE AUTHORIZED FOR THAT PURPOSE UNDER THE HANDS OF THREE OR MORE OF THE COMMISSIONERS FOR THE AFFAIRS OF TAXES, UPON DEMAND THEREOF the Assessors of the Parish or Place, at the same Time, and by the same persons, AND in the same manner, as the statements of the income of such corporations, COMPANIES, FRATERNITIES, AND SOCIETIES, and Public Companies chargeable upon them are required to be delivered.242

None of the above amendments are listed in the 120 or so amendments to the Bill noted in the Journals of the House of Commons on 1 January 1799, nor of the 20 or so amendments of the following day, nor in the debate in the House of Commons. On 2 January, further amendments were recorded in the Journals of the House of Commons, but this time significantly fewer, there being only 21, of which two were of some significance as they concerned personal insurance and deductions from income with respect to ecclesiastical matters.243 The Parliamentary Register again noted that ‘several verbal amendments were agreed to’, after which, the Bill having passed, John Smith was ordered ‘[to] carry it to the Lords, and desire their concurrence’.244

The House of Lords The Journals of the House of Lords record that, on its receipt from the House of Commons on 2 January 1799, the Bill was read a first time and ordered to be printed, and on 3 January, the Duties upon Income Bill was to be ‘read a second

242 Lambert, above n 121, A Bill [As amended on re-commitment] … Duties upon Income otbp 22 December 1798 [un-numbered clause] 77, 43. The text in large capitals was that inserted in the clause of 8 December as amended on 22 December, with the text deleted from the earlier clause being indicated by strike-through markings. 243 Journals, above n 147, 131. 244 The Parliamentary Register, above n 218, 500.

Book 1.indb 164

12/2/2011 8:21:49 AM

The Charitable Purposes Exemption from Income Tax of 1799 165 time to-morrow, and that the Lords [were to] be summoned’.245 Finally, on 9 January 1799, the Lords’ Messengers, Mr Ord and Mr Wilmot, took the Lords’ message to the Speaker of the Commons to inform them that ‘[t]he Lords have agreed to the Bill … without any amendment’.246 The Duties upon Income Bill had been passed unanimously in the Lords, as ‘the contents had it without a division’, and the Bill was given Royal Assent by commission that same day.247 Thus it was that Great Britain’s second Income Tax Act became law. This event was recorded in The Times of 10 January without further comment,248 while The Morning Chronicle of 11 January stated that ‘[t]he Income Bill has received the Royal Assent. It is now a law, and the people have nothing to do with it, but to pay their ten per cent [sic]’.249

PART IV: THE NATURE OF EIGHTEENTH CENTURY POLITICS

Pitt’s personal style was to either work alone or only with people whom he could trust. Perceval explained that: Pitt must have felt, and his colleagues must have felt also, that he had such comprehensive talents and powers that he was himself essentially the Government in all its Departments – that he could form a Government almost of himself, and each of his colleagues must have felt that Pitt could do without him, though he could not do without Pitt.250

Instead of ‘building up a large personal following in parliament’, Pitt preferred to ‘[pick] out ambitious and talented individuals’, to whom he promoted ‘to positions of responsibility … [eschewing] party ties and remained a distant figure even to close allies’.251 He surrounded himself with ‘a core of dedicated activists who were essential to Pitt’s management of Parliament [and whom] he used … to gauge the sense of the House and to influence its debates’.252 On financial matters, Pitt drew on a wide circle of consultants who were drawn from: the active, doing members of the House [on whom he] focused his attention … rather than on the silent majority, many of whom attended only sporadically. … [As well as senior members of the both Houses] Pitt also used a number of back-benchers as very useful opinion formers. … [Pitt] looked to [these men] as sounding boards for his ideas and as back-up to his own efforts in debates.253

245

House of Lords, Journals of the House of Lords 1798–1800 vol 42 36. The Parliamentary Register, above n 218, 576. 247 ibid, 574. 248 ‘Parliamentary Intelligence’, The Times (London), 10 January 1799, 2. 249 [Editorial], The Morning Chronicle (London), 11 January 1799, 3. 250 John Ehrman, above n 144, 455. 251 Turner, above n 112, 110. 252 Duffy, above n 102, 116, 253 ibid, 118. 246

Book 1.indb 165

12/2/2011 8:21:49 AM

166

Michael Gousmett

One person to whom Pitt turned ‘as [a] sounding board for his ideas and as back-up to his own efforts in debates’,254 was John Sargent (1750–1831). Duffy describes Sargent as having been: Clerk of the Ordnance (1793–1802) and a former Director of the Bank of England, [and] a Pitt nominee to the balloted Select Committee on the Public Accounts in 1791, who in 1799 chaired the Income Tax Bill through its Committee stages in the Commons.255

There are no references in the Journals of the House of Commons to Sargent having chaired the Committee stages of the Income Tax Bill, as it was John Smyth, or Smith, who chaired the committee in December 1798 and January 1799.256 The Journals of the House of Commons of March 1799 record that Mr Bragge had chaired the Committee when the Duties upon Income Act of 9 January 1799 was further debated, after its introduction, with the intention of ‘explaining and amending the said Act’.257 Sargent is credited in the Oxford Dictionary of National Biography with having ‘secured tax exemption for physicians on 22 December 1797’,258 but there is no mention of Sargent having promoted the charitable purposes exemption in the Duties upon Income Act 1799.259 To Pitt, the charitable purposes exemption from his Duties upon Income might have been the least of his worries, yet Turner described him: [a]s a policy maker, [who] engaged in painstaking research in order to get his facts straight before making plans. … To major policy plans Pitt would devote himself singlemindedly for days or even weeks. His war-time financial measures involved exhaustive preparation and many long discussions with colleagues and advisers (on the Income Tax he sought the views of, among others, Rose, Auckland, Addington, Liverpool, Grenville and Canning). This concentrated effort helped Pitt to identify problems and contemplate solutions. Consultation was central to his approach. … Pitt often engaged his experts, political friend and (sometimes) junior officials in open discussion, during which he expressed doubts as well as confident expectations. (Emphasis added.)260

If there was one person whose papers might have assisted in identifying the progress of the charitable purposes exemption clause through the House of Commons, it was George Rose. Rose ‘had begun his long and profitable career as Secretary to the old Board of Taxes under Lord North … [and] became, in 1783, Pitt’s Secretary of the Treasury … [Rose] was Pitt’s right-hand man until 1801’.261 But here also, the trail ‘ran cold’.

254

ibid, 119. ibid, 118. 256 Journals, above n 147, 62. 257 Journals, above n 147, 313. 258 ‘John Sargent’, Oxford Dictionary of National Biography (2004) vol 48 966. 259 An Act … , above n 4. 260 Turner, above n 112, 143. 261 Arthur Hope-Jones, Income Tax in the Napoleonic Wars (1939) 58. 255

Book 1.indb 166

12/2/2011 8:21:49 AM

The Charitable Purposes Exemption from Income Tax of 1799 167 Pitt and the Lobbyists Surprisingly, no material from the late eighteenth and early nineteenth centuries on the charitable purposes exemption from Income Tax has come to light in the public domain. This is all the more surprising given that the tax was considered to be ‘a tax odious and unpopular to the last degree’.262 If such a proposal was so unpopular, then surely the charitable institutions would have been as outspoken as the general public during the short passage of the Duties upon Income Bill through the House of Commons in December 1798 and early January of 1799. Duffy described Pitt as ‘probably the most accessible Prime Minister of the Eighteenth century to commercial lobbying’.263 The MP Charles Abbot was told in 1796 that ‘[i]n his reception of the merchants, when they wait upon him, [Pitt] is particularly desirous of satisfying them that his measures are right’.264 Therefore, not having found any evidence of deputations from the charitable institutions of London concerning the Income Tax is all the more puzzling. This is even more so when one considers that ‘Pitt’s paper’s are full of schemes for taxes and advice on finance from every conceivable strata of society, [and] he appears as a man with contacts everywhere and ready to consult those intimately affected by his taxation proposals’.265 The mystery deepens when one reads that, according to O’Brien, ‘[Pitt’s] proposals for taxes frequently aroused opposition from pressure groups, occasionally powerful enough to enforce modifications’.266 There were significant lobbyists, in the form of ‘the West India merchants and planters, the East India Company … coal owners and their friends in Parliament … landowners … the ‘City Members’ …’,267 and, as well, ‘[p]ressure could be exercised through Parliament itself and also directly upon Ministers and public departments’.268 O’Brien also noted that ‘in taxation policy Chancellors of the Exchequer found their initiative limited by the presence of Parliament and pressure groups’.269 While ‘Parliamentary and public opinion held that the necessities of the poor should be taxed moderately or preferably exempt from taxation’,270 there is no evidence of this concept having been debated with respect to charitable institutions, yet somehow an exemption from Duties upon Income was provided for in Pitt’s Duties upon Income Act of 1799.271

262

Tayler, above n 109, 71. Duffy, above n 102, 137 citing P Langford, Public Life and Propertied Englishmen 1689–1798 (1991) 205. 264 Duffy, above n 102, 137 citing Colchester (ed), Abbott Diary [year not cited] vol 1 45. 265 O’Brien, above n 49, 29. 266 ibid, 29. 267 ibid, 30. 268 ibid, 30. 269 ibid, 351. 270 ibid, 351. 271 An Act … , above n 4, s V. 263

Book 1.indb 167

12/2/2011 8:21:49 AM

168

Michael Gousmett

Another resource that failed to provide evidence of lobbying by, or deputations from, charitable institutions, were the Journals of the House of Commons. This is perplexing, particularly as: [t]he Journals are full of references to petitions against particular taxes, which usually asserted that the tax in question would ruin the industry involved or in some way react adversely on the national interest. These petitions were often investigated by Committees of the House who reported to the Government on the potential effects of the proposed changes in taxation. Petitions sometimes formed part of a well organised campaign designed to mobilise public opinion against changes in taxation.272

Pitt’s personal papers contain some interesting material concerning the proposed Duties upon Income, but there were no specific challenges by charitable institutions. themselves. Again, this is surprising, especially as O’Brien wrote that: [g]roups affected by taxes also attempted to exercise influence directly upon Ministers and departments of State concerned with revenue such as the Treasury … . The papers of Pitt, Huskisson, Vansittart and Liverpool [contain] abundant examples of letters and memoranda designed to prevent or modify some proposed change in taxation.273

O’Brien also observed that ‘[s]tatesmen sometimes consulted interested parties before proceeding with a new tax’,274 yet there is no evidence that Pitt consulted with the charitable institutions of London regarding his plan of taxation. Neither do the Treasury archives provide any assistance. This was possibly because ‘[l]etters to the Treasury and to the departments responsible for the collection of revenue [were] on the whole concerned with the interpretation of tax law’.275 It is also possible that the reason that there is no evidence of charitable institutions submitting petitions on the Duties upon Income Bill of 1798 may be due to the fact that: [n]o good study has yet [as at 1967] been made of the organisation and mode of pressure group activity in the late eighteenth century, but it is obvious from the debates on taxation policy for the period 1788–1815 that the House of Commons contained spokesmen for the West India planters and traders, for the mercantile marine, for the East India Company, for the Bank of England and for particular industries as well as the more amorphous and less organised groups of members connected with the concerns of the City of London, and a majority who spoke for agriculture as a whole. In Parliament and on Parliamentary Committees members sought to defend particular industries or sectors of the economy against taxes and if possible to obtain advantages for the economic activity they represented. … Given the fluid nature of political allegiance, Governments of the day had to cultivate members of Parliament and to modify taxation policy in order to retain their support. (Emphasis added.)276

272

O’Brien, above n 49, 427. O’Brien, above n 49, 427. A further check of the Royal Historical Society Bibliography on the Society’s website failed to identify any new material on lobbying or petitions regarding Pitt’s charitable purposes exemption in the Duties upon Income Act 1799. 274 O’Brien, above n 49, 427. 275 ibid, 427. 276 ibid, 426. 273

Book 1.indb 168

12/2/2011 8:21:49 AM

The Charitable Purposes Exemption from Income Tax of 1799 169 Another reason may be that: [r]evenue policy … operated within a framework of ideology or canons of taxation. Parliamentary and public opposition to particular taxes often crystallised around fairly well defined and widely held attitudes and the Government not only sought to avoid opposition but also operated in terms of the same precepts which effectively limited its discretion in the selection of taxes. The basis for taxation can be found in the ideals of the age with respect to distributive justice and prevailing notions of how to promote economic development and national security. To summarise these ideals and notions crudely we can say that at the end of the eighteenth century most Englishmen opposed taxes which fell on the necessities of the poor, approved of levies on luxuries consumed by the rich, found all excises and a general tax on income repugnant to their liberal sentiments … . (Emphasis added.)277

Pitt and the Evangelicals Two of England’s prominent Evangelicals in the late eighteenth century were well placed to advise Pitt regarding the taxation of charitable institutions. These were Hannah More, and William Wilberforce, who had both the opportunity and passion to argue a case for the exemption of charitable institutions from Income Tax. More and Wilberforce were friends of Pitt’s, and both were deeply involved in charitable works through their religious convictions. No doubt Pitt would have respected their opinions which may well have been an influencing factor in ensuring that charitable institutions were provided with exemptions from taxes on their income in Pitt’s Duties upon Income Act.278

Hannah More For I was hungred [sic], and ye gave me meat: I was thirsty, and ye gave me drink: I was a stranger and ye took me in … Verily I say unto you, inasmuch as ye have done it unto one of the least of my brethren, ye have done it unto me.

Matt. XXV. 34-5, 40.279 As well as Anthony Highmore and his writings on charity from a legal and fiscal perspective, a person has emerged as someone who may have had a direct influence on Pitt and his plans of taxation in 1797 and 1798. While there is no apparent link between Pitt and Highmore, that is not the case with respect to 277

ibid, 427. An Act … , above n 4, s V. 279 Michael J.D. Roberts, ‘Head versus Heart? Voluntary Associations and Charity Organization in England, c. 1700-1850’ in Hugh Cunningham and Joanna Innes (eds), Charity, Philanthropy and Reform: From the 1690s to 1850 (1998) 66. 278

Book 1.indb 169

12/2/2011 8:21:49 AM

170

Michael Gousmett

Pitt and Hannah More (1745–1833), a writer and philanthropist of considerable prominence in the Pitt era.280 Stott has described More as being: part of the new puritanism steadily gaining ground in the wake of the French Revolution, which urged women to turn their backs on the allurements of the ball and the pleasure garden and find their vocations in the duties of the home and the expanding world of philanthropy.281

Although she often pleaded poverty, More ‘was to earn more than any other woman writer of her day’.282 More was ‘a firm friend and a valued correspondent of [William] Wilberforce’,283 (another of Pitt’s friends), whom she had met in the summer of 1787.284 Wilberforce assisted the sisters Hannah and Martha More with their Sunday school, ‘[both] financially and in counsel’.285 Both Wilberforce and Pitt subscribed to More’s publications, such as Cheap Repository, their subscriptions thereby ‘defray[ing] the expenses of printing and distribution, helping More to compete with the cheapest publications’.286 Stott has noted that Pitt’s 3-guinea contribution to the Cheap Repository tracts, as well as Pitt being ‘the only member of the government [of Cabinet rank] to subscribe, was a measure of his appreciation’.287 According to Wilberforce: [d]edicating one’s life to philanthropy and public work was the rational part of evangelicalism, the only way to make sure that religious excitement was not hypocritical or a trick of the mind. It brought the animated heart of the evangelical into harmony with worldly actions. (Emphasis added.)288

Such an opinion would have resonated with More, a person who was committed to deeds, not words. More, who held Pitt in high esteem,289 had a strong connection to Pitt, as: [More] also tried to encourage government action. During her visit to London in the spring of 1796 she spent five hours with Pitt’s adviser and former secretary, the Bishop of Lincoln, with a copy of the Prime Minister’s proposed Poor Law Bill in front of her, making ‘pretty free use of our pencils in the margin’.290

280 ‘Hannah More’, Oxford Dictionary of National Biography (2004) vol 39, 39. Coincidentally, More died in the same year as Wilberforce. 281 Anne Stott, Hannah More: The First Victorian (2003) 260. 282 Stott, above n 281, 1. 283 ‘Hannah More’, above n 280, 42. 284 Stott, above n 281, 90. 285 B Kirkman Gray, A History of English Philanthropy (1905) 247. 286 Charles Howard Ford, Hannah More: A Critical Biography (1996) 128. 287 Stott, above n 281, 145. Fourteen MP’s also subscribed. In all 760 people subscribed to Cheap Repository. See Stott, above n 281, 177. 288 B Wilson, Decency and Disorder: The Age of Cant 1789–1837 (2007), 82 citing William Wilberforce, A Practical View of the Prevailing Religious System of Professed Christians, in the Higher and Middle Class of this Country, Contrasted with Real Christianity [1797] 168–9. 289 Stott, above n 281, 100. 290 Stott, above n 281, 183 citing Gambier, More to Elizabeth Bouverie, Friday, 1796, 310.

Book 1.indb 170

12/2/2011 8:21:50 AM

The Charitable Purposes Exemption from Income Tax of 1799 171 ‘Bills’, wrote Innes, ‘were sometimes printed to facilitate their circulation to a wider audience. (Emphasis added.)’291 This suggests that Pitt may have invited More and Wilberforce to review his Duties upon Income Bill of 1798. The fact that More was asked by Pitt to comment on his Poor Law Bill echoes the comment by Innes that: [f]rom the beginning of the eighteenth century, and indeed from a much earlier date, [Members of Parliament] had no doubt been in the habit of seeking opinions from friends, acquaintances, neighbours, constituents and other interested parties as to the merits and limitations of measures they were currently considering.292

Elizabeth Bouverie, who died in September 1798, left More ‘a legacy of £300 and an annuity of £100 … which came as a relief to More, who knew that she would feel the pinch when Pitt’s novel Income Tax came into being’.293 Did More also think the same about charitable institutions? More told Wilberforce ‘crossly’ that was not happy with Pitt’s Income Tax: [as] it was all very well for her sisters … for once not at all pleased with her idol. Because their Bath house was already highly rated by the Assessed (Property) [sic] Taxes, they would not notice the change, ‘but to me whose Little Cowslip, was so little taxed, it will make the difference from about £5 a year to nearly [£]50’.294

There is also an interesting connection between More and Highmore, as More ‘subscribed to the African Institution, which replaced the Society for the Abolition of the Slave Trade in 1807’.295 Highmore was involved with the management of the funds of the African Institution, as his name appeared in the Institution’s Statement of Funds of 1823.296 As well as More and Highmore’s involvement with the African Institution, Wilberforce was also a member. This can be seen from Wilberforce’s diary of 12 November 1807 in which he recorded that he had been ‘[t]o [an] African Institution meeting, and back to dinner’.297 This raises yet another interesting question: did the involvement of Highmore, Wilberforce and More, as members of the African Institution, extend beyond their involvement with the Institution to other matters?

291 J Innes, ‘Parliament and the Shaping of Eighteenth-Century English Social Policy’ (1990) 40 Transactions of the Royal Historical Society 63, 88. 292 Innes, above n 291, 88. 293 Stott, above n 281, 214. 294 Stott, above n 281, 214 citing Bodleian, MS c. 3, fo. 45. More to Wilberforce, 18 December 1798. 295 ‘Hannah More’, above n 280, 42. 296 ‘Hume Tracts’, Eighteenth Report of the Directors of the African Institution: Read at the annual general meeting, held on the 11th day of May, 1824, with an appendix and supplement (1824) page unnumbered. 297 Robert Isaac Wilberforce and Samuel Wilberforce, The Life of William Wilberforce vol III (1838) 103, 348.

Book 1.indb 171

12/2/2011 8:21:50 AM

172

Michael Gousmett

‘On Charity’ The nature of Hannah More’s personality and religious fervour can be seen in an extract from her writings, in which she expressed her opinion that: though nothing is formally efficacious but the blood and merits of Christ, yet charity, as a divine grace, and one that will never cease, shows that our interest in Him and union with Him, are real and genuine. But to descend to the particulars of charity, and apply the different branches of it to the common purposes of life [sic]. Whenever we are promoting the good of mankind, either by assisting public institutions, or relieving individuals, we are obviously helping on [sic] the cause of charity … On the other hand, the purse may sometimes be open when the heart is shut. (Emphasis added.)298

This expression of charity harks back to that of Wilberforce, who considered that ‘philanthropy and public work was the rational part of evangelicalism’.299 More can thus be seen as being of a highly religious disposition, yet a pragmatic person who practised what she preached. More also discussed ‘pecuniary charity … [which] must be governed by the law of justice’.300 When ‘inquiring into the duties of charity’, More wrote, ‘we must not overlook the use to be made of riches, one of the talents implied in the parable’.301 Quoting Lord Bacon’s remark that ‘riches, when kept in a heap, are corrupt like a dunghill, but, when spread abroad, diffuse beauty and fertility’, a quote which ‘has been more admitted than acted upon’, More then declared that: [h]appily the age in which we live is so generously disposed to acts of beneficence, that there never was a period which less imposed the necessity to press the duty, to enforce the practice, or to point out the objects. A thousand new channels are opened up, yet the old ones are not dried up; the streams flow in abundance, as if fed by a perennial foundation.302

More provides a very clear picture of her philosophy concerning charity, particularly the use and practice of the ‘special endowments and opportunity’ bestowed on each person by God.303 ‘Charity’, wrote More, ‘is a virtue of all times and all places’.304 Then: ‘One Christian grace is never exercised at the expense of another, nor is it perfect, unless it promotes that other. This charity enjoys abstinently that she may give liberally’.305 ‘Above all [sic] things’, said St. Peter, ‘have fervent charity’.306 The inclusion by More of this advice from 298

Hannah More, ‘On Charity’ Works of Hannah More (1843) vol IX 101, 103. Wilson, above n 288, 82. 300 More, above n 298, 105. 301 ibid, 105. 302 ibid, 106. 303 ibid, 101. 304 ibid, 101. 305 ibid, 102. 306 ibid, 102. 299

Book 1.indb 172

12/2/2011 8:21:50 AM

The Charitable Purposes Exemption from Income Tax of 1799 173 St. Peter emphasises the evangelical’s focus on ‘conversion’ – ‘faith precedes works’.307 More’s religious fervour can also seen in that she ‘stressed that a Christian commonwealth required much more than charitable works and reasonable ethics. … Works without faith led to social disorder, while sending well-meaning donors to Hell’.308 More’s own commercial success allowed her to ‘fund a bevy of causes’,309 thus putting into practice what she preached to others. In More’s opinion, ‘the many striking acts of public bounty … justly entitl[ed] the present age to be called … the Age of Benevolence’.310 With such a forceful personality, one can appreciate that More would not have hesitated to speak her mind to Pitt of her opinions regarding the potential threat to charitable institutions of Pitt’s Duties upon Income Bill of 1798, had that been of concern to her.

William Wilberforce Another link in the chain to Pitt is provided by William Wilberforce (1759– 1833), politician, philanthropist, and slavery abolitionist.311 Wilberforce was also an Evangelical, evangelicalism being ‘a passionate and emotional religion of personal salvation through “conversion”’.312 As White explains: [a]t the end of the Eighteenth Century, with the stagnation and decline of Methodism, [evangelicalism] was a minority belief at its liveliest in Anglicanism. Its most powerful advocates were the so-called ‘Clapham Sect’ of wealthy laymen and clerics led by William Wilberforce, a Tory MP who lived in a mansion on Battersea Rise from 1795 to 1808.313

Whelan explains that ‘[t]he motivating factor which propelled the charitable bandwagon was a deep religious faith and, in particular, the great evangelical revival which began towards the end of the eighteenth century’.314 ‘The Evangelicals’, wrote Dr Cornish, ‘are known to the world, not by their writings,

307

My thanks to Professor John Cookson for clarifying this point for me. Ford, above n 286, 106. 309 ibid, 106. 310 ibid, 106 citing More, The Works of Hannah More (1832) 279. 311 ‘William Wilberforce’, Oxford Dictionary of National Biography (2004) vol 58, 879. 312 Jerry White, London in the Nineteenth Century ‘A Human Awful Wonder of God’ (2007) 420. According to Heasman, by the middle of the Nineteenth Century, possibly as many as three out of four voluntary charitable organisations can be regarded ‘as Evangelical in character and control’. Kathleen Heasman, Evangelicals in Action: An appraisal of their social work in the Victorian era (1962) 14. 313 White, above n 312, 420. In the first decade of the Nineteenth Century, the Clapham Sect was ‘the driving force’ of an awakening ‘social conscience [concerning] the outstanding social problems of the era’. Heasman, above n 312, 20. 314 Robert Whelan, The Corrosion of Charity: From Moral Renewal to Contract Culture (1996) 15. 308

Book 1.indb 173

12/2/2011 8:21:50 AM

174

Michael Gousmett

which are forgotten, but by their lives, which can never be forgotten’.315 For Wilberforce, ‘salvation was based upon the individual’s rejection of sin and turning to God’.316 This required that issues of poverty, unemployment and a lack of education be addressed, as ‘these often gave rise to, or were the result of, personal moral failings, such as alcoholism, idleness, criminal activity, and neglect of hearth and home’.317 Unless the Evangelicals addressed these matters, ‘men would go to Hell … and they themselves would go to Hell if they neglected to do everything in their power to save sinners’.318 The influence of the Evangelicals was such that by the second half of the nineteenth century, ‘three quarters of all voluntary organisations … [were] run by evangelical Christians’.319 Wilberforce, as a close friend of Hannah More, (who was ‘the [Clapham Sect’s] chief propagandist’,320) was also a philanthropist with a strong interest in the works of charities. Wilberforce’s relationship with Hannah More was significant in that as well as being a life-long friend, he funded More’s work ‘in promoting moral and social improvement [in the Mendips], and maintained a long-term commitment to supporting her work’.321 The esteem in which Wilberforce held Hannah More can be seen in a letter to her, in 1824, following a period of ill health that Wilberforce had suffered. ‘My dear friend’, he wrote: I should disobey conscience alike and feeling, if I were not to assign to you the priority over all my numerous correspondents, and except a few lines to our sweet Lady Olivia … this is the first of my epistolary performances since my long disuse of my pen. … I do not even yet open my own letters, much less do I read, or rather hear them.322

Wilberforce and More have both been described by Roberts as ‘paternalists who were not hostile to philanthropy … [having been able to combine] very effectively both outlooks’.323 Wilberforce, a generous man who in 1798 ‘gave away more than £2,000’,324 supported charities ‘not only in London and Yorkshire, but all over the country’.325 He would even ‘tear fifty-pound notes in half and send them, by different posts, to Hannah More for her schools’.326 In 1830, in his later years, Wilberforce wrote to his eldest son, saying that:

315 F.W. Cornish, History of the English Church in the Nineteenth Century (1910) vol I 15 cited by Heasman, above n 312, 15. 316 Whelan, above n 314, 15. 317 ibid, 16. 318 ibid, 16. 319 ibid, 16 citing Heasman, above n 312, 14. 320 White, above n 312, 420. 321 ‘William Wilberforce’, above n 311, 883. 322 R I Wilberforce and S Wilberforce, The Life of William Wilberforce vol V (1838) 219. 323 David Roberts, Paternalism in Early Victorian England (1979) 34. Paternalism consisted of ‘a rich, complex, and varied set of attitudes’. Roberts, ibid 6. 324 ‘William Wilberforce’, above n 311, 883. 325 Robin Furneaux, William Wilberforce (1974) 177. 326 Furneaux, above n 325, 177.

Book 1.indb 174

12/2/2011 8:21:50 AM

The Charitable Purposes Exemption from Income Tax of 1799 175 I never intended to do more than not exceed my income, Providence having placed me in a situation, in which my charities of various kinds were necessarily large. But believe me there is a special blessing on being liberal to the poor, and on the family of those who have been so; and I doubt not my children will fare better even in this world, for real happiness, than if I had been saving £20,000 or £30,000 of what has been given away.327

When he could not spend time on his charitable activities, ‘he liked to be the conducting rail for the charitable sparks of others’.328 ‘Factories did not spring up more rapidly in Leeds and Manchester than schemes of benevolence under [Wilberforce’s] roof’, declared James Stephen the Younger.329 According to Brown, Wilberforce subscribed to 69 societies, was patron of one, vice-president of 29, treasurer of one, a governor of five, and served on five committees.330 Any attempt by Pitt to tax charities would have found him confronted by yet another formidable opponent.

PART V: SEQUEL

By 1816, the Duties upon Income, which by then was known as the Property Tax, had been repealed. The process of repeal had taken two years, in spite of petitions from the Court of Common Council on 9 December 1814,331 and in 1816, the public.332 Finally, on 18 March 1816, the Property Tax was repealed by a narrow margin of 27 votes, with 238 for its repeal and 211 against.333 The Morning Chronicle expressed the hope that the repeal of: that odious measure against which an [sic] universal voice has been so loudly raised from one extremity of the island to the other … will deter [future governments] from any similar effort to thwart the wishes or oppose the interests of the people of England.334

However, a quarter of a century later, on taking office Sir Robert Peel was confronted with problems, domestic and international. Gash observed that ‘an Income Tax alone offered a reasonable prospect of raising the additional revenue needed in a form that was effective in operation, predictable in its yield, and equitable in its burden’.335 However, it would be a brave government that had

327

Wilberforce and Wilberforce, above n 322, 313. John C Pollock, Wilberforce (1977) 170. 329 Pollock, above n 328, 223. 330 Ford K Brown, Fathers of the Victorians (1961) 357. 331 ‘The Property Tax’, The Examiner (London), 11 December 1814, Issue 363. 332 See ‘Property Tax’, Caledonian Mercury (Edinburgh), 29 February 1816, Issue 14074; ‘Public meeting against the renewal of the Property or Income Tax’, Liverpool Mercury (Liverpool), 1 March 1816, Issue 244; ‘Petition to the Honourable the Commons of the United Kingdom of Great Britain and Ireland, in Parliament assembled’, Cobbett’s Weekly Political Register (London), 2 March 1816, Issue 9. 333 House of Commons, ‘Income Tax’, The Times (London), 19 March 1816, 3. 334 [Editorial], The Morning Chronicle (London), 19 March 1816, Issue 14626. 335 Norman Gash, Peel (1976) 213. Note that the phrase ‘Income Tax Act’ was not used until 1892 when the Short Titles Act of that year gave the title ‘Income Tax Act’ to the Acts of 1842 and 1853. A Farnsworth, Addington Author of the Modern Income Tax (1951) 3. 328

Book 1.indb 175

12/2/2011 8:21:50 AM

176

Michael Gousmett

enough courage ‘to revive a tax psychologically identified with the dictatorial powers of a state at war and unique in its inquisitorial basis of assessment’.336 Peel was indeed courageous, and his Budget of 1842 was considered by Sabine ‘as one of the most famous of the nineteenth century’.337 Peel’s Income Tax Act of 1842 was, ‘to all intents and purposes, a reprint of the Act of 1806’.338 While once again intended as a temporary measure, that was not to be and in time the Income Tax became enshrined in the budgets of future governments during the course of the nineteenth century.339 Peel’s Income Tax Act 1842 also contained extensive sections concerning the exemption of charitable institutions from Income Tax.340 However, as with the earlier such Acts, no definition of charitable purposes was provided. The problem for charitable institutions was that as Addington had introduced the concept of deduction at source in his Income Tax Act of 1803,341 charitable institutions were now required to file a claim for a refund of any Income Tax that had been deducted.342 By 1863, questions were being asked about the wealth of charitable institutions and their exemption from the Income Tax.343 In May of 1863, the charitable institutions were to feel the wrath of the Chancellor of the Exchequer, William Ewart Gladstone, which resulted in a well-orchestrated campaign by the charities of London which was as unprecedented as that of the behaviour of Chancellor.344 There could only be one winner, and it was not Gladstone. Once again, in 1888, the charitable purposes exemption from Income Tax came under scrutiny, when Lord Addington called for Returns to be laid before the House of Commons concerning details of Income Tax and charitable institutions.345 Coincidentally, 1888 is the same year that the Moravians began their case against the Special Commissioners. The issue of charitable purposes and exemption from Income Tax was about to be resolved, but it would a further three years before that was to be when, in 1891, Lord Macnaghten provided the solution that Parliament had not – how to determine ‘charitable purpose’ in order for a charitable institution to be exempt from Income Tax.346

336

Gash, above n 335, 213. Sabine, above n 7, 60. 338 Farnsworth, above n 335, 106. 339 See Gousmett, above n 1, Chapter 5 for a details of the Income Tax Acts from 1842 to 1891. 340 An Act … , above n 2. 341 An Act … , above n 89. 342 See Gousmett, above n 1, Chapter 7. 343 See Gousmett, above n 1, Chapter 6. 344 See Gousmett, above n 1, Chapter 6. 345 See Gousmett, above n 1, Chapter 7. 346 See Gousmett, above n 1, Chapter 8. 337

Book 1.indb 176

12/2/2011 8:21:50 AM

6 Contextualising the Development of the Tax Profession: Some First Thoughts* JANE FRECKNALL-HUGHES

ABSTRACT

T

HIS CHAPTER EXAMINES the context of the development of the Institute of Taxation in the light of the formation of professional financial bodies generally and in particular that of the Institute of Chartered Accountants in England and Wales (ICAEW), with which it shares much common ground. The chapter considers the extensive academic literature on the underlying theories of professional formation and development, and assesses the formation of the Institute of Taxation in this light. The chapter is part of a wider project which will examine more widely the history and development of the tax profession.

INTRODUCTION

The aim of this chapter is to examine the context of the development of the tax profession. This is the first part of a much wider study of the history and development of the tax profession in the UK. This particular chapter seeks to explore the context of the formation of the Institute of Taxation (IOT) in 1930 in the light of the formation of professional financial bodies generally and in particular that of the Institute of Chartered Accountants in England and Wales (ICAEW), with which it shares much common ground. * The author would like to thank the Chartered Institute of Taxation (CIOT) for a grant of £750 towards travelling expenses associated with this project, and for access to material required; and the late John Jeffrey-Cook for his very generous assistance, especially in granting access to his own working papers and research, both published and unpublished, on the history and foundation of the CIOT.

Book 1.indb 177

12/2/2011 8:21:50 AM

178

Jane Frecknall-Hughes

At first glance, the tax profession appears fragmented. Per Doyle (2010) and Frecknall-Hughes (2002), tax advice is given by a broad range of business professionals including accountants, solicitors, barristers, payroll agents, former and current members of government revenue authorities, tax experts working within industry,1 as well as those officially designated as tax consultants as a result of their membership of tax dedicated professional bodies, such as the Chartered Institute of Taxation (CIOT) in the UK. Some tax professionals work as sole practitioners or in accounting, legal or tax specialist partnerships and will undertake various kinds of tax work on behalf of clients. While some persons with a legal background will be found working within accountancy practices, the tendency is still very strong for those with legal training in tax to stay within the legal profession. Tax experts working in industry are more typically employees of a company, or group of companies, in which instance employer and client are the same. Throughout both academic and professional literature, tax practitioners are also referred to as tax advisers, tax agents, tax intermediaries,2 tax preparers and tax professionals without any significant differentiation between these terms.3 It might then appear that the taxation profession lacks standardised, institutional training, standard testing and licensing, does not have a professional monopoly and suffers from fragmented professional regulation. Anyone can set up in business as a tax practitioner in the UK.4 However, much the same is true in terms of tax practice worldwide.5 How did this situation arise in the UK?

REVIEW OF THE LITERATURE

There are numerous different professions and a vast academic literature which examines their varied pre-formation activities, the genesis of their professional organisations (often designated as ‘institutes’) and their continued development after formal professional organisation. This has led in turn to the formation of a 1 Tax experts working in industry may, of course, originate from any of the aforementioned groups, or those mentioned subsequently. 2 A more recent term adopted by the OECD (2008). 3 Tax preparers, however, is a term more usually used (and especially in the USA) to mean individuals or firms who provide assistance in completing individuals’ tax returns, that is, compliance services. They might only provide basic, rather than complex, tax advice. The 2009 HMRC report Working with Tax Agents in Ch 5 looks more closely at different definitions for different types of professionals. 4 The HMRC 2009 consultation document, Working with Tax Agents, does suggest, in Ch 5, some form of registration for the 12,000 estimated tax practitioners who are currently unregulated by any professional body. 5 The US, for example, has certified public accountants (CPAs), accountants without the CPA designation, enrolled agents and nationwide tax-preparation chains, such as H & R Block (Fisher, 1994; Hemans, 1996). Thuronyi & Vanistendael (1996: 160–163) examine the organisation of the tax profession in Europe, the United States, Canada and Australia, and find a similar degree of fragmentation and lack of monopoly.

Book 1.indb 178

12/2/2011 8:21:51 AM

Contextualising the Development of the Tax Profession 179 number of theories about how and why professions form. There is no one theory, however, which explains exclusively how all professions arise (West, 1996). It is, nevertheless, agreed that the development of any individual profession cannot be examined without taking account of the economic, political and legal context of its formation (Stacey, 1954; Wilmott, 1986; Walker, 1995; Maltby, 1999). Wilmott (1986: 557) suggests that ‘before the early 1970’s “functionalist” and “interactionist” perspectives were dominant’, but since then a “more critical approach” has developed which draws heavily upon the work of Weber and Marx’. He suggests that the functionalist perspective ‘attends to professions as integrated communities whose members undertake highly skilled tasks that are crucial for the integration and smooth operation of society’, citing, for example, the seminal work of Carr-Saunders & Wilson (1933), whereas interactionism studies professions ‘as interest groups that strive to convince others of the legitimacy of their claim to professional recognition’ (per Haug & Sussman, 1969). The critical perspective (Wilmott, 1986: 538) suggests that the ‘emergence of professional bodies is seen as a means of achieving collective social mobility by securing control over a niche within the market for skilled labour’ (per Larson, 1977), and is a ‘strategy for controlling an occupation, involving solidarity and closure, which regulates the supply of professional workers to the market’, also allowing a basis for domination of other bodies and associations operating in the same or a similar work domain. The move towards the development of a professional organisation is seen as an important step towards ‘occupational ascendency’ (Anderson, Edwards & Chandler, 2007: 382). This seems true, certainly, of the financially-based professions which developed in the 19th century, as opposed to the so-called ‘status’ professions, such as the church, medicine, the law and the military, which existed in pre-industrial Britain (see Edwards, Anderson & Chandler, 2007: 61). By a process referred to as ‘exclusionary closure’ (see Macdonald, 1995: 131), a collective typically seeks to exclude from membership those its elite regards as ineligible (Weber, 1978; Parkin, 1979) by defining a basis for exclusion or inclusion which may be by reference to one or more dimensions, such as social standing (defined by property ownership), credentials, race, sex, religion, language and so forth (see Chua & Poullaos, 1993). Once the boundaries have been defined, all future entrants must be appropriately selected, trained, socialised and moulded so as to provide a distinct service to the market requiring that professional service (Larson, 1977: 14; Macdonald, 1995: 189). In some professions, closure is achieved by registration, a process requiring the involvement of Parliament, and this latter results in a monopoly. Solicitors have been required to be registered since 1729 (by the Attorneys and Solicitors’ Act of that year) – far longer than any other profession. Registration of barristers is not required by law, but is, effectively by the judiciary. Accountants are not required to be legally registered, although registration was the first preference of the founding members of the ICAEW, which did not succeed. One of the inherent problems was (and remains) in defining the accountant’s work (Macdonald, 1985).

Book 1.indb 179

12/2/2011 8:21:51 AM

180

Jane Frecknall-Hughes

The context of the formation of the IOT in 1930 shares many of the features associated with the formation of the ICAEW in 1880. There is now a considerable body of academic literature, dating from the 1990s, devoted to the origins of the ICAEW, which will be drawn on here to provide parallels and contrasts. This is not to say that the literature devoted to the development of other professions is not relevant. It is, and immensely so. Taxation, arguably, has its roots in law, so an examination of the law profession’s involvement in the process of professionalisation of tax is also much needed, but will be reserved for a later phase of this project. In looking at the attempts by the ICAEW to define the professional boundaries of an accountant’s work, Anderson et al (2007: 382), following Macdonald (1995: 131–132), comment that established practitioners are ‘central’ to this process as they will typically agree on a definition of membership for those already practising the skills, usually referred to as a ‘grandfather’ clause, and one for new entrants, which will usually involve passing examinations. The dilemma here is whether to confine membership to ‘high status practitioners, thus ensuring the almost certain emergence of competitor institutions’ (Edwards, Anderson & Chandler, 2005: 239) or to include everyone, and run the risk of a diminished public perception (Perkin, 1989). The ICAEW tried to have the best of both worlds, but at the same time to try to eliminate the ‘scaff and raff’, the ‘self-styled’ accountants whose activities were damaging to the occupational group (Edwards et al, 2005: 230). Despite a narrowing of the jurisdictions claimed publicly by accountants in the 30 years prior to initial organisation formation (at least in London, from the evidence of trade directories as examined by Edwards et al, 2007), this left out a body of ineligibles who existed in sufficient numbers ultimately to form a competitor group – the Society of Accountants. This latter was particularly recruited from non-urban districts which the ICAEW founders had neglected, where it was usual for a practitioner to be more of a ‘jack of all trades’ – a tendency which long survived in rural districts. One has only to consider, for instance, the typical village shop which even today sells everything from postage stamps to bootlaces. Edwards et al (2005: 242, citing from The Accountant, 20 March 1886: 160) list the array of jobs members of the Society were perceived as doing – rent collectors, corn merchants, shopkeepers, valuers, collectors of taxes, bailiffs, secretaries of various concerns, civil engineers, school board clerks, overseers, timber agents, pawnbrokers and manure merchants (see also Edwards et al, 2007). This ‘grandfather’ type clause caused considerable difficulties for the newly formed ICAEW in terms of what constituted acceptable work practice for an accountant, as such a clause in the ICAEW’s 1880 Royal Charter appeared to allow work which newer members could not do (Anderson et al, 2007). One of the problems was that there was no clearly agreed definition of what ‘accounting’ involved, and persons who called themselves ‘accountants’ could, and did, involve themselves in all kinds of different work. Members of the

Book 1.indb 180

12/2/2011 8:21:51 AM

Contextualising the Development of the Tax Profession 181 five predecessor bodies,6 which merged in 1880 to form the ICAEW, generally had to be in practice as a ‘professional accountant’, ‘accountant’ or ‘public accountant’ (Anderson et al, 2007: 385) and the final version of the Charter agreed on ‘public accountant or some business which in the opinion of the Council is incident thereto or consistent therewith’ (ICAEW, 1882: 19). As it was common for accountants to carry on several businesses at the same time as being an accountant (Anderson et al (2007: 389) refer to these as ‘combined businesses’), the grandfather clause applied to these as well. Edwards & Walker (2007: 77) cite the instance of one John C Collier of Godalming, Surrey and John Clarey of Stone, Staffordshire (by reference to census enumerators’ books for 1881) who were respectively: ‘Bank Manager, Accountant, House Land and Insurance Agent, Distiller of Wood employing 11 labourers, Farmer of 1115 acres employing 6 labourers’ and ‘Certified School Teacher, Auctioneer, Valuer, Accountant, Commission Agent’.

However, this engendered a debate about how this kind of activity accorded with the ‘higher duties’ (ICAEW, 1882: 19) owed by members of the new Institute in terms of what comprised appropriate work and whether membership should be confined to accountants in public practice. Anderson et al (2007), looking at the period from 1880 to 1900, cite evidence in support of auditing, adjustment of partnership and executorship accounts, liquidations, bankruptcies and receiverships in chancery being acceptable, and look at ‘test cases’ from Institute records to see whether valuation, insurance, auctioneering, stock- and share-broking, agency, debt collection, money lending and estate agency were acceptable. Despite these activities being practised under the ‘grandfather’ clause, they were all deemed unacceptable, other than insurance, which caused considerable debate about the legitimacy of the ‘grandfather’ clause.7 Similarly Anderson et al (2007) examine instances of accountants working outside public practice, and which jobs were deemed allowable, though the ICAEW later became more flexible in this area. There is a clear attempt shown here to define what Abbott (1988) refers to as the jurisdiction (‘proper work’) of the profession in terms of what its members could and could not do, in a definite attempt to raise its status. The aim was for the profession to reach the same standing as that of lawyers (Walker, 2004a). This would be a means by which it could convince wider society of the legitimacy of its claims – something in which local societies had no great interest. Accountants aspired to climb the social 6 Walker (2004a: 127) examines the foundation of the Liverpool, London, Manchester and Sheffield institutes and finds that Liverpool was ‘instigated by lawyers anxious to establish a medium for negotiating the boundaries of bankruptcy work with local accountants’, whereas the others were keen to protect ‘established accountants from interlopers’. 7 The ‘jack of all (financial) trades’ activities of English accountants are also mirrored in Australia during a similar period (Carnegie & Edwards, 2001).

Book 1.indb 181

12/2/2011 8:21:51 AM

182

Jane Frecknall-Hughes

ladder too, and mimic the landed gentry, seeing this as part of being a highly regarded professional (Edwards & Walker, 2010). They aimed to distinguish themselves from those who were involved in commercial occupations, which were regarded as socially tainted because of an association with trade, which was a lower class activity. The true professional had a public service idea and autonomy (Walker, 1991: 268). Edwards et al (2005: 229) also comment that during the pre-organisational period, the ‘professionalisation process is marked by “signals of movement”…[with] an occupational group achieving greater economic reward and perceived respectability as the result of an enhanced degree of public recognition of the societal value of the services it offers’. In Abbott’s view (1988: 19), ‘control of work…brings the professions into conflict with one another and makes their histories interdependent’. He includes studies of accounting, medicine and law in development of his theory. One of his defining characteristics is that professions ‘expand their cognitive dominion by using abstract knowledge to annex new areas, to define them as their own proper work’ (1988: 102), whereas occupations fight over jurisdiction in the existing workplace. However, that does not mean that a dominant occupation cannot develop into a profession. He sees challenges to jurisdictions as beginning in two general ways: ‘by external forces opening or closing areas for jurisdiction and by existing or new professions seeking new ground’. This abstract knowledge (Edwards et al, 2007: 71) comprised ‘a mastery of the techniques and outputs from a system of double entry bookkeeping’, which practitioners then ‘modified…to fulfil new purposes, analysed and interpreted its outputs and developed its potential for generating financial information capable of fulfilling a variety of different purposes’ (Edwards et al, 2007: 75), such as: • accounting for the going concern, including installation and operation of accounting systems, preparation of accounting statements, auditing, dealing with registration and annual returns; • business disputes, failure and bankruptcy, including investigations, preparation of bankrupts’ accounts, acting as trustee in bankruptcy and receivers, arranging composition with debtors and creditors, acting as collector, arbitrator, umpire and referee; and • valuation and agency, including acting as valuer, appraiser, auctioneer, estate agent/ property broker, stock- and share-broker, insurance agent, general agent and loan arranger/money broker. • (The above is taken from Edwards et al, 2007: 79, Table 7)

Auditing needs became predominant as a result of the growth in joint-stock companies (especially railway, dock, colliery and iron companies) and municipal corporations in the 19th century. Maltby (1999), however, looks at the controversy over this professional rise – that audit had existed since the Middle Ages and was a timeless solution to the problem of agency (Watts & Zimmerman, 1983) versus the idea that it needs to be understood in its historical context and that the role the profession played in creating a market niche for itself must be

Book 1.indb 182

12/2/2011 8:21:51 AM

Contextualising the Development of the Tax Profession 183 recognised (Armstrong, 1987; Chandler & Edwards, 1996; Matthews, Anderson & Edwards, 1998). Maltby (1999: 46) looks at the ‘interplay between the market environment in the nineteenth century and the self-promotional activities of auditors’. Auditors marked themselves out as persons who understood business needs and had expertise to determine distributable profit (implying that their rivals in law did not). Insolvency work created a conflict with lawyers, as accountants were able to offer experience associated with dealing with going concerns and exploit opportunities offered by changes in law (the Bankruptcy Act 1831, 1861 and the Winding-up Act 1848), which allowed them to act in an official capacity. Lawyers complained of encroachment (Walker, 2004a: 135– 136), although there is also evidence of amicable sharing of duties with the legal profession (Walker 2004b, 2004c), especially in Scotland (Walker, 1991: 277), where younger sons of judges and lawyers commonly entered the accounting, rather than the law, profession. There is no evidence of jurisdictional wrangling with those involved in valuation, agency and surveying, possibly because professions in those areas were similarly nascent. Another attempt to raise status was in the requirements for new entrants. There was a requirement to obtain a position with a chartered accountant in practice, serve five years as an articled clerk (three years if a university graduate) and pass written and oral examinations. There were also financial barriers, as it could cost anywhere between 50 and 300 guineas to be taken on as an articled clerk, and a trainee would rarely receive a salary. On qualification, a fee of 10 guineas was payable to gain admission to the Institute.8 For admission on the basis of prior experience, a public accountant had to prove that he had been in practice for at least five years, and the range of activities was ‘significantly more restricted than for the founders’, for whom the ‘grandfather’ clause applied (Edwards et al, 2005: 246). It should be noted, however, that professions are by no means static. Dezalay (1991: 795) comments: ...an area like business consultancy abounds in examples of ambiguous situations where demarcation lines are contested because they are imprecise or have moved in the course of history. Certain ‘problems’ or ‘needs’ have disappeared, or have been transformed, as a result of technological or political developments.9 Others have been ‘left fallow’, more or less deliberately, by the profession from which, theoretically, they arose. This is the case for tax law consultancy which, for a long time, was disdained by top European lawyers, and which, as a consequence, was progressively appropriated by accountancy firms.

He comments (1991: 797, 805) that this work was seen as not respectable and on the fringes of what the higher levels of the continental legal profession deemed 8

See also Walker (1991: 272) on the high fees payable to the Edinburgh Society. Here Dezalay refers in a footnote to information technologies rendering the keeping of physical books of account obsolete by obliging ‘accountants with shiny sleeves’ to turn to new practices, citing Abbott (1988: 215). 9

Book 1.indb 183

12/2/2011 8:21:51 AM

184

Jane Frecknall-Hughes

acceptable. Audit specialists in the 1960s took the offensive by appropriating greater responsibilities in the tax area, claiming a good knowledge of taxation practice which was supported by a ‘long-standing familiarity with fiscal bureaucracies’. Through an ability to construct tax devices, which make it possible to minimise tax demands by exploiting loopholes in the law, accountants have gradually succeeded in occupying the position of consultants to economic leaders. Their presence at the inception of a transaction, which they helped to structure, ensures that they are well-placed to sell other services.

THE NEED FOR TAX ADVICE

If there were no need for the services a profession provides, then there would be no need for that profession. This is self-evident. The growth in the complexity, volume and importance of taxation legislation, especially in the latter half of the 20th century, has resulted in taxation becoming a distinct and highly specialised profession. It is evident that this trend began, however, in the later 19th century, when it was realised that income tax was a tax that was here to stay, and people needed help either to deal with it or find a legitimate way not to pay it. It seemed clear after the Crimean War that income tax would never be abolished, although Gladstone’s government had intended that it should expire in 1860. One of the very early tax specialist firms was the Income Tax Adjustment Agency, which began offering services in 1890, shortly followed by the Income Tax Repayment Agency in 1901. By 1914 ‘there were fourteen rivals’ (Jeffrey-Cook, 2002). It is interesting, in the light of comments made above, to note the case of the case of ‘Mr ACW Rogers, who enquired whether he could add the words “Income Tax Adjustment Agency” to his sign [as a chartered accountant] in 1894’ (Anderson, Edwards & Chandler, 2005: 43). His request was denied as the ICAEW did not like the idea of agency, as has been noted. It did not comment on the issue of taxation. Stopforth, in work looking at the growth of tax avoidance mechanisms (1990: 238) cites the comments of Sir Josiah Stamp in 1919: Taxation is now rapidly developing from a merely unpleasant incident into a dominating feature of daily life, and those features which hitherto have been of little interest, because they have been too small to matter, now become of great importance; the blemishes which were insignificant may now be intolerable because in the magnitude of the burden they have become sufficiently magnified or intensified to be within the range of ordinary human feeling.

Stopforth (1990) remarks on the development of professional expertise in the area of avoidance schemes in the period from about 1910, with the journal The Accountant setting up a regular advice column, because of the increasing importance of income tax, since the taxpayer realised ‘the advantages of

Book 1.indb 184

12/2/2011 8:21:51 AM

Contextualising the Development of the Tax Profession 185 professional assistance in a subject of such intricacy’, citing The Accountant, 6 June 1914. In 1922, the journal put up its fees as a result of the increased cost of providing such advice to its readers. It is also clear that the class of respectable and respected professional men, such as doctors, needed advice in dealing with taxes. For example, the ‘Queries’ section of the British Medical Journal in 1907 (Protest, 1907: 1286) has a query about the provisions of Finance Act 1907 on income tax, included between questions on whether tea or coffee is a better breakfast drink for someone suffering from sub-acute gout and constipation and whether dermatitis of the hands could be caused by Lysol, and an article entitled ‘home for dipsomaniac’, which is an answer to a previous query. Given the standing of doctors, it would be reasonable for them to expect to receive such advice from professionals of similar standing. One must also note that the professional journal Taxation was begun by Ronald Staples (a founder member of the IOT) in 1927 (Jeffrey-Cook, 2002), again to provide useful tax information in an increasingly complex environment. In 1931, Taxation carried an article on the formation of the Institute: Before the war10 there was little to learn about taxation law and practice but as the burden has increased with its ever-growing ‘ill-digested mass of legislation’, it has become a highly specialised subject and every accountant and solicitor in the country realises the importance of studying it. Learned judges and eminent lawyers are constantly admitting that the subject is one of the most intricate in their experiences, and as the years go by the Finance Act provisions relating to taxation seem to become more obscure and official publications more exacting. The recent announcement of the formation of the Institute of Taxation, therefore, came as no surprise to our readers who will realise that the need for such a body has long been felt. (Anon, reproduced in Taxation, October 1987: 34)

However, tax work had been done by lawyers for many years in terms of dealing with the estates of the deceased and so on (probate and succession duty, estate duty, etc). This was customary and associated with the fact that one needed a solicitor to make a will. It remains to be investigated (as mentioned above) how far the legal profession ‘colonised’ the newer areas offered by income tax. In a sense, it might be expected that they would be less proactive than accountants, as their role in events is typically as the end of a process (referring a matter to court). However, there is a disputed ‘border territory’ between the professions of law and accountancy (Freedman & Power, 1992: 1) into which tax undoubtedly falls. As Dezalay (1991) has suggested in reference to later events, it may be that solicitors did not initially see this type of work as falling into their work domain, though this is speculative at present.

10

Book 1.indb 185

World War I.

12/2/2011 8:21:51 AM

186

Jane Frecknall-Hughes FOUNDATION OF THE PROFESSIONAL BODY

The idea that established practitioners are important in the development of a professional body is reflected in the fact that the founders of the IOT in 1930 were established professional men. Seven11 were accountants of one sort or another, one was a barrister,12 five were ex-/current Revenue men.13 Some founders were both accountants/barristers and ex-/current Revenue men (JeffreyCook, 2005: 2). There can seldom have been a better subject-qualified group of people forming a professional body. The main objects of the new body were to ‘promote the study of taxation, hold examinations, facilitate the exchange of information, make representations and establish and maintain a high standard of conduct’ (Jeffrey-Cook, 1990: ii) Jeffrey-Cook (1991a: 14) suggests that the formation of a ‘professional association for persons engaged in taxation’ was discussed ‘no doubt because registration of accountants by law in order to bar unqualified persons was again topical’. While there was no problem about the type of work involved in this instance (it was all tax), unlike in the formation of the ICAEW, there was a problem about the type of people undertaking it. The Revenue Act 1903, s.13, had allowed accountants (as well as solicitors and barristers) to appear in income tax appeals. ‘Accountant’ in this context was defined as someone who had been admitted as a ‘member of an incorporated society of accountants’ (Jeffrey-Cook, 1991a: 14), and several bodies of these again existed, as a result of the ICAEW elitism referred to above. For example, there was the Society of Incorporated Accountants, formed in 1885, also the London Association of Accountants Ltd (incorporated in 1904), which eventually became the Association of Chartered Certified Accountants. It was not difficult for the unscrupulous to obtain a certificate and become a member of such a body and so become involved in the practice of tax. However, another feature of the times was that bodies also were being formed for more specialist types of accounting work, such as the Institute of Cost and Works Accountants in 1919. Taxation too undoubtedly requires specialist knowledge. In many ways, the move towards formation of a taxation body might be interpreted as part of a wider move towards specialisation in the financial professions, in cases where a new body of knowledge was needed and was being developed, operationalising the comments of Dezalay (1991). The new Institute will act as a central point for the collection and dissemination of information relating to taxation and will provide facilities for the exchange of views and the intelligent study of the subject. The rules regarding admission, it is stated, will be enforced rigidly and no ‘loop-hole’ will be left for the unqualified seeker after advertising opportunities. (Anon. (1931) 10 January 1931, Taxation, reproduced in Taxation, October 1987: 34)

11 E Edward Boyles, Roger Carter, Whorlow Legge, Cecil Newport, Adam Murray, Stanley Spofforth and Walter Smee. 12 Roy Borneman. 13 Ronald Staples, Gilbert Burr, Gordon Howard, AV Tranter and HA Silverman.

Book 1.indb 186

12/2/2011 8:21:52 AM

Contextualising the Development of the Tax Profession 187 Jeffrey-Cook (1991a: 14) comments that in the 1920s, the accounting institutes were opposed to registration, despite it having been a desiderandum on formation, especially of the ICAEW. One of the undoubted problems had been in defining the exact nature of an accountant’s work, but lack of definition did mean that accountants could actively expand into new (and profitable) areas. The nature of expansion, however, did create sub-groups who had a particular interest, like tax, who wished to maintain a reputation for high quality work. In a sense, the formation of the IOT was a reverse process of the usual process of professional body formation, as, instead of drawing together different local/ regional individual bodies into one, it drew out members from different existing professions, chiefly accountancy, law and the public sector (Inland Revenue) into one body which was always intended to operate at national level. As the writer of the 1931 Taxation article wrote: We are informed that the Council is most anxious to make it clear that the organisation is in no way set up in competition with existing bodies of professional accountants. Such a thing, of course, would be impossible. The aim is to act in an ancillary capacity and one of the qualifications for membership of the Institute of Taxation is membership of one of the older bodies. The work of the accountancy organisations is necessarily based upon a much broader foundation and membership of the new body will be available only to those members of the profession who specialise in taxation and possess the necessary qualifications. (Anon., reproduced in Taxation, October 1987: 34)

It seems quite clear that the founders of the Institute saw it as a ‘second tier’ professional body, for those who came to tax chiefly via accountancy (and law). This was mirrored in its admittance procedures. Although the Institute introduced its own examinations (thus offering a ‘first tier’ qualification), and the first were taken in 1932 (Jeffrey-Cook, 1991b: 124), it used a ‘grandfather’ type clause to accept members who had passed examinations of bodies of which it approved, who also had five years’ practical experience, and did not impose a requirement for members to pass its own examinations until 1965. The majority of members in early years were accountants (Jeffrey-Cook, 1991b: 124). The idea of a ‘second tier’ profession also meant that many of the issues faced by other bodies, such as social mobility, types of work that were legitimate, multiple business operations and so on, had already been addressed by members being drawn from existing professional bodies, so were ‘non-considerations’ at this stage. Someone joining the IOT was not likely to be bothered by the fact of a fellow member being a manure merchant, for instance. It does not seem, however, that the accountancy and law bodies shared the sanguine view of the writer of the 1931 Taxation writer that the IOT would be an ancillary, second tier body. In subsequent years, the Institute tried a number of times to obtain a Royal Charter. A report drafted by G Stephens, Assistant Secretary, in August 1980, refers to an attempt in 1952 (prompted by the twentyfirst anniversary of foundation) and a further consideration of the matter in 1972 (prompted by the fiftieth anniversary). Grant of a Royal Charter is the

Book 1.indb 187

12/2/2011 8:21:52 AM

188

Jane Frecknall-Hughes

ultimate confirmation of professional status and is recognised both by other professions and the public. The 1952 attempt failed because of doubts over whether a separate taxation profession existed, and if it did, over its likely threat to the existing accountancy and legal professions. The Institute had clearly noted the grant of Royal Charter in 1974 to the body which eventually became the Association of Chartered Certified Accountants. The 1952 petition for a Royal Charter was opposed by all the main law and accountancy professional bodies, chiefly the ICAEW. Additional reasons for opposition in 1952 were that taxation was (and, indeed, remains) a mixture of law and accountancy and was dealt with satisfactorily by existing law and accountancy bodies, from which most IOT members held a professional qualification anyway. Granting a Charter would mean that those possessed of the first level of the Institute’s qualification (then ATII) and no other would be tempted to offer unqualified legal and accountancy advice. It would harm members of the other bodies who did not join the IOT and was not necessary, as the Institute could continue to do good work without it.

CONCLUSION

This chapter has attempted to look at the context of the formation of the IOT in the light of the formation of professional financial bodies generally, drawing on the experience and literature related to the formation of the ICAEW to shed light on commonalities and differences. It seems that the functionalist and interactionist perspectives outlined by Wilmott (1986) predominate here, and the critical perspective is addressed by the fact that the profession started as a ‘second tier’ profession and drew it members from two other main professions – accountancy and law. It appears that the developing area of giving tax advice had been ‘colonised’ by accountants, as they expanded their professional domain by acquiring and applying new knowledge. To some extent, the issues of setting work boundaries had also been addressed by this, although the issue of excluding the unscrupulous practitioner remained, because of activities within the accountancy bodies. The IOT formation was an attempt to draw together the elite rather than exclude the ineligible, so in this respect it differed from the formation of the ICAEW. Conflict came from the root professions of accountancy and law, which did not initially see taxation as a separate profession as they were accustomed to deal with taxation as an element within their own professional domains.

Book 1.indb 188

12/2/2011 8:21:52 AM

Contextualising the Development of the Tax Profession 189 REFERENCES

Abbott, A (1988). The System of Professions. An Essay on the Division of Expert Labor. Chicago, IL and London: University of Chicago Press). Anderson, M, Edwards, JR & Chandler, RA (2005). Constructing the ‘well qualified’ accountant in England and Wales. Accounting Historians Journal, 32(2): 5–54. Anderson, M, Edwards, JR & Chandler, RA (2007). ‘A public expert in matters of account’: Defining the chartered accountant in England and Wales. Accounting, Business & Financial History, 17(3): 381–423. Anon. (1931). The Institute of Taxation, Taxation 10 January 1931, reproduced in Taxation October 1987: 34. Armstrong, P (1987). The rise of accounting controls in British capitalist enterprises. Accounting, Organizations and Society, 12(5): 415–436. Carnegie, GD & Edwards, JR (2001). The construction of the professional accountant: the case of the Incorporated Institute of Accountants, Victoria (1886). Accounting, Organizations and Society, 26(4–5): 301–325. Carr-Saunders, AM & Saunders, PA (1933). The Professions. Oxford: Oxford University Press. Chandler, R & Edwards, JR (1996). Recurring issues in auditing: back to the future? Accounting, Auditing and Accountability, 9(2): 4–29. Chua, WF & Poullaos, C (1993). Re-thinking the state dynamic: the case of the Victorian Charter attempt, 1885–1906. Accounting, Organizations and Society, 26(4–5): 301–325. Dezalay, Y (1991). Territorial battles and tribal disputes. Modern Law Review, 54(6): 792–809. Doyle, E (2010). Cognitive Moral Reasoning of Tax Practitioners: A Preliminary Analysis Using a Context-Specific Version of the Defining Issues Test. Unpublished PhD Thesis, The University of Sheffield, Sheffield. Edwards, JR, Anderson, M & Chandler, R (2005). How not to mount a professional project: the formation of the ICAEW in 1880. Accounting and Business Research, 35(3): 229–248. Edwards, JR, Anderson, M & Chandler, R (2007). Claiming a jurisdiction for the ‘Public Accountant’ in England prior to organisational fusion. Accounting, Organizations and Society, 32(1–2): 61–100. Edwards, JR & Walker, SP (2007). Accountants in late nineteenth century Britain: A spatial, demographic and occupational profile. Accounting and Business Research, 37(1): 63–89. Edwards, JR & Walker, SP (2010). Lifestyle, status and occupational difference in Victorian accountancy. Accounting, Organizations and Society, 34(5): 551– 570. Fisher, A (1994). Finding the right tax adviser. Fortune, 21 March, 159–160, and 161.

Book 1.indb 189

12/2/2011 8:21:52 AM

190

Jane Frecknall-Hughes

Frecknall-Hughes, J (2002). An Empirical Investigation of the Share Valuation Work of Taxation Practitioners. Unpublished PhD Thesis, The University of Leeds, Leeds. Freedman, J & Power, M (1992). Law and accounting: transition and transformation. In eds. Freedman, J & Power, M, Law and Accountancy – Conflict and Cooperation in the 1990s (pp. 1–23). London: Paul Chapman Publishing Ltd. Haug, MR & Sussman, MB (1969). Professional autonomy and the revolt of the client. Social Problems, 17(2): 153–161. Hemans, D (1996). Choosing the right tax professional. Black Enterprise, November, 127–129. HMRC (2009). Modernising Powers, Deterrents and Safeguards. Working with Tax Agents: A Consultation Document. UK: HMRC. ICAEW (1882). Charter of Incorporation and Bye Laws. London: Henry Good & Son. Jeffrey-Cook, J (1990). A short history of the Institute of Taxation. Taxation Practitioner, December: ii–vi. Jeffrey-Cook, J (1991a). The Institute’s history I: Formation – 1930. Taxation Practitioner, January:14–15. Jeffrey-Cook, J (1991b). The Institute’s history II: Pre-incorporation 1930–1934. Taxation Practitioner, March:124–125. Jeffrey-Cook, J (2002). The first tax practice? Taxation, 18 July [online]. Available at: URL http://www.taxation.co.uk/taxation/print/1951 [Accessed 19 June 2010] Jeffrey-Cook, J (2005). The Institute of Taxation. Tax Matters – Souvenir Supplement to Tax Adviser, October: 2–7. Larson, MS (1977). The Rise of Professionalism: A Sociological Analysis. London: University of California Press. Macdonald, K (1985). Social closure and occupational registration. Sociology, 19(4) 541–556. Macdonald, K (1995). The Sociology of the Professions. London: Sage. Maltby, J (1999). ‘A sort of guide, philosopher and friend’: the rise of the professional auditor in Britain. Accounting, Business & Financial History, 9(1) 29–50. Matthews, D, Anderson, M & Edwards, JR (1998). The Priesthood of Industry. Oxford: Oxford University Press. OECD (2008). Study into the Role of Tax Intermediaries. Fourth OECD Forum on Tax Administration, Cape Town South Africa, 10–11 January. OECD. Parkin, F (1979). Marxism and Class Theory: A Bourgeoisie Critique. London: Tavistock Publications. Perkin, H (1989). The Rise of Professional Society in England Since 1880. London: Routledge Protest (1907). Income tax. British Medical Journal, 2 November: 1286. Stacey, NAH (1954). English Accountancy. A Study in Social and Economic History. London: Gee & Co.

Book 1.indb 190

12/2/2011 8:21:52 AM

Contextualising the Development of the Tax Profession 191 Stephens, G (1980). Report re: Royal Charter. John Jeffrey-Cook, Personal Papers. Stopforth, DP (1990). Settlements and the avoidance on tax on income – the period to 1920. British Tax Review, 7:225–250. Thuronyi, V & Vanistendael, F (1996). Regulation of tax professionals. In ed. Thuronyi, V, Tax Law Design and Drafting (pp. 135–163). Washington, DC: International Monetary Fund. Walker, SP (1991). The defence of the professional monopoly: Scottish chartered accountants and ‘satellites in the accountancy firmament’ 1864–1914. Accounting, Organizations and Society, 16(3): 257–283. Walker, SP (1995). The genesis of professional organization in Scotland: a contextual analysis. Accounting, Organizations and Society, 20(4): 285–310. Walker, SP (2004a). The genesis of professional organisation in English accountancy. Accounting, Organizations and Society, 29(2): 127–156. Walker, SP (2004b). Towards the ‘Great Desideratum’: The Unification of the Accountancy Bodies in England 1870–1880. Edinburgh: The Institute of Chartered Accountants of Scotland. Walker, SP (2004c). Conflict, collaboration, fuzzy jurisdictions and partial settlements. Accountants, lawyers and insolvency practice in the late 19th century. Accounting and Business Research, 34(3): 247–265. Watts, RL & Zimmerman, JL (1983). Agency problems, auditing and the theory of the firm: some evidence. Journal of Law and Economics, 26(3):613–633. Weber, M (1978). Economy and Society. London: University of California Press. West, BP (1996). The professionalism of accounting: a review of recent historical research and its implications. Accounting History, 1(1): 77–102. Wilmott, H (1986). Organising the profession: a theoretical and historical examination of the development of the major accountancy bodies in the UK. Accounting, Organizations and Society, 11(6): 555–580.

Book 1.indb 191

12/2/2011 8:21:52 AM

Book 1.indb 192

12/2/2011 8:21:52 AM

7 The Road to 1944: Antecedents of the PAYE Scheme JOHN H N PEARCE

ABSTRACT

T

HIS CHAPTER DEALS with the sequence of events that resulted in the introduction of the Pay As You Earn (PAYE) scheme for deduction of income tax from earnings. That scheme became operative during the course of the Second World War on 6 April 1944 – at a time apparently highly unsuitable for such a major change in tax administration. Beginning with the introduction of a voluntary scheme involving deductions on account of income tax in the 1930s, it is possible to trace a direct sequence through a compulsory deduction scheme imposed under section 11 of the Finance (No 2) Act 1940 to the PAYE legislation itself, enacted in 1943 and 1944. The system introduced in 1944 undoubtedly had popular support: but it is suggested that, during this sequence of events, different groups were in the lead at different times and that different groups supported the arrangements for different reasons.

I. The first part of the title to this chapter is a conscious echo of the title to Paul Addison’s book The Road to 1945. That book investigated how it was that during the years from 1940 to 1945 ‘popular opinion swung towards Labour and gave the party its ‘landslide’ victory at the 1945 general election’:1 an event surprising to many, both at the time and since. In this chapter, taking that as my cue, I investigate how it was that the United Kingdom came to make very

1

Book 1.indb 193

P Addison, The Road to 1945: British Politics and the Second World War (London, 1975) 13.

12/2/2011 8:21:52 AM

194

John H N Pearce

important changes to the administration of its income tax by introducing the Pay As You Earn (PAYE) scheme.2 That scheme came into force on 6 April 1944 – a date falling somewhat after the collapse of Italy in December 1943 and exactly two months before the landings in Normandy (which began on 6 June 1944). What sequence of events had produced that change in the administration of the United Kingdom’s income tax at a time apparently so unsuitable for such a major change? One approach to this question might be to explain away the change on the basis that it was not ‘major’; but it is my opinion that such an approach would be very much mistaken. So far as the structure of the PAYE arrangements is concerned, it has been stated that– An unusual feature of the British tax system is that income tax is not only levied on a cumulative basis, but also collected on a cumulative basis. In other countries it is common to levy tax cumulatively, but to collect it non-cumulatively. [In those other countries] Tax is paid each week on the basis of earnings in that week and if an adjustment is necessary when the whole year’s income is assessed (as is often the case for those with fluctuating earnings) this is done at the end of the year. The British tax system, by contrast, tries to ensure that at each point in the tax year an appropriate proportion of the whole year’s liability has been paid.3

At the time of its introduction, the PAYE scheme was recognised as involving major legislative changes and formidable operational problems. It also involved negotiations with the British Employers’ Confederation and the Trades Union Congress (TUC). But at this time it was also recognised that the new PAYE scheme followed on from earlier developments. And, in terms of tracing a definite sequence of events, I am able to trace such a sequence from 1931 through to 1944. But the departure initiated in 1931, in its turn, grew out of the collection regimes in existence at that time. So it is with the state of affairs in existence at the end of the 1920s that I begin.

II. By the end of the 1920s, the payment of income tax on the earnings of an employment was a subject that had become intricate. The earnings from an 2 The Royal Commission on the Taxation of Profits and Income stated that ‘The distinguishing feature of PAYE was and is its cumulative nature. The essence of the system is that in the first week of the year the employee gets 1/52nd of his personal allowances for the year set against the first week’s pay; in the first two weeks he gets 2/52nds of his allowances against the total of his first two weeks’ pay; in the third week he gets 3/52nds of his allowances against the total of the first three weeks’ pay; and so on until the end of the tax year. In addition, he automatically receives a growing amount of earned income relief and “reduced rate” relief. In this way the total tax deducted up to any given date is kept in line with the total pay to date’. Second Report (HMSO, London, 1954) (Cmd. 9105) 5 (para 12). 3 J A Kay and M A King, The British Tax System (Oxford, University Press, 1978) 29.

Book 1.indb 194

12/2/2011 8:21:52 AM

The Road to 1944: Antecedents of the PAYE Scheme 195 employment were nearly always charged to income tax under Schedule E.4 For the most part, too, income tax was charged upon the earnings of the year preceding the year of assessment.5 It followed (for example) that the earnings during the Income Tax year from 6 April 1929 to 5 April 1930 constituted the measure of income to be charged to income tax during the year from 6 April 1930 to 5 April 1931. (This proposition was subject to one major exception – and I will come to that exception a little later.) The time at which a taxpayer was required to pay income tax on the earnings of an employment, however, was a matter requiring careful analysis: and it is possible to distinguish four different categories of taxpayers. Under the Income Tax Act 19186 the charge to income tax under Schedule E was ‘in respect of every public office or employment of profit’.7 The first category of taxpayer consisted of those individuals whose earnings unquestionably fell within these words – notably civil servants. In this case the income tax chargeable was deducted on payment of the earnings.8 So, accordingly, (to give a specific example), the income tax due on the employment for the year from 6 April 1929 to 5 April 1930 was deducted from payments of income made during the year from 6 April 1930 to 5 April 1931. The payment of income tax accordingly took place one year in arrears. The rules applicable to Schedule E included one9 which made provision for tax ‘in respect of offices and employments of profit held under a railway company’; and, following the enactment of section 18(3) of the Finance Act 1922,10 it was clear that this rule applied to all such offices and employments. The second category of taxpayer, accordingly, consisted of those individuals to whom this rule applied. In this case the legislation provided that the company might make a deduction for income tax when earnings were paid.11 The various railway companies all had their own schemes under which deductions from employees’ pay were made – and those different schemes did not provide for deductions to be made from earnings on one single basis.12

4 The exception was the earnings from an employment wholly exercised abroad, with payment being made abroad. Income from such employments was chargeable – if at all – under Case V of Schedule D. The income from such employments is not considered further in this chapter. 5 This was a consequence of the enactment of section 45 of the Finance Act 1927 (17 & 18 Geo 5 c 10.) Income tax under Schedule E had previously been charged in respect of the current year of assessment. 6 8 & 9 Geo 5 c 40. This Act consolidated the income tax legislation then in force, which went back to the Income Tax Act 1842 (5 & 6 Vict c 35). 7 First Schedule, Schedule E, charge to tax. (Italics added). 8 First Schedule, Schedule E, rules 12 and 15. 9 Rule 7. 10 12 & 13 Geo 5 c 17. 11 ‘ ... the company may deduct out of the emoluments of the holder of any such office or employment ... the tax so charged’. (Rule 7(2).) Section 45(7) of the Finance Act 1927 appears to support a contention that the railway company was entitled to make a deduction. 12 IR 40/3859 has details about these matters for the years around 1931; and IR 40/7772 for the years immediately preceding the introduction of the PAYE scheme.

Book 1.indb 195

12/2/2011 8:21:52 AM

196

John H N Pearce

Since the charge to income tax under Schedule E was ‘in respect of every public office or employment of profit’, it followed that, if an office or employment could not be described as being of a public nature, the office or employment could not be charged to income tax under that Schedule. (The charge to income tax would have to be made under Schedule D instead.) It was against this background that the House of Lords held, in Great Western Railway Co v Bater (Surveyor of Taxes),13 that the charge to income tax under Schedule E was less extensive than the Inland Revenue (in accordance with previous practice) had contended. That decision was followed by the enactment of section 18 of the Finance Act 1922: and it was this section which ensured that the earnings from nearly all employments were chargeable to income tax under Schedule E. The third category accordingly consisted of those taxpayers whose presence within Schedule E was referable, as a matter of law, to the enactment of section 18: and if employment income falling within this category was chargeable to income tax under Schedule E, the general provisions for assessing and collecting income tax applied. The income tax due on that income was accordingly payable in two equal instalments: on or before 1 January during the year of assessment and on or before the following 1 July.14 So, accordingly, (to give a specific example), the employment income earned during the year from 6 April 1929 to 5 April 1930 determined the employment income chargeable to income tax for the year from 6 April 1930 to 5 April 1931. The income tax in question was payable in two equal instalments: on or before 1 January 1931 (a date nearly nine months after the end of the year in which the income had been earned and nearly 21 months after its beginning) and on or before 1 July 1931 (a date nearly 15 months after the end of the year in which the income had been earned and nearly 27 months after its beginning). In the case of taxpayers within this category, therefore, the payment of income tax took place at times considerably after the income had been received; payment might well, in practice, have no particular relationship to the earlier receipt of earnings; and taxpayers on tight budgets could easily be troubled. There was, however, a fourth and final category of individuals chargeable to income tax under Schedule E; and here the legal provisions applicable were very different. Section 131 of the Income Tax Act 191815 provided that– The Commissioners of Inland Revenue may make regulations generally, with respect to the assessment, charge and collection of income tax, in the case of weekly wageearners to whom the provisions of this Act ... apply ... .

The taxpayers in this fourth category were weekly wage-earners: and a ‘weekly wage-earner’ was an individual who received wages which were either calculated 13

[1922] 2 AC 1; (1922) 8 TC 231. Section 157(2) of the Income Tax Act 1918. 15 This section restated provisions originally contained in section 28 of the Finance (No 2) Act 1915 (5 & 6 Geo 5 c 89). 14

Book 1.indb 196

12/2/2011 8:21:53 AM

The Road to 1944: Antecedents of the PAYE Scheme 197 or paid by reference to any period of less than a month.16 The ambit of section 131, however, was also restricted by another provision in the 1918 Act, which had the effect that the section– ... applies only to weekly wage-earners employed by way of manual labour in respect of the wages arising from that employment, and does not apply to persons employed as clerks, typists, draftsmen or in any other similar capacity.17

So far as the assessment of weekly wage-earners was concerned, the legislation applicable at the end of the 1920s provided that– Weekly wage-earners shall be assessed and charged to tax in respect of their wages in each half of the year instead of in the whole year, and shall in all cases be assessed and charged in respect of the actual amount of their wages for that half-year, and as respects any such assessment and charge and the collection of the tax the provisions of this Act shall have effect as if tax were charged for each half-year instead of for the year.18

Weekly wage-earners accordingly constituted the major exception to the proposition that income tax under Schedule E was charged on the preceding year basis, being charged instead on the current year basis; and, additionally, income tax was charged by reference to periods of half a year as opposed to a full year. A further distinguishing characteristic of the regime applicable to this fourth category of taxpayers was that the provisions governing the assessment and payment of income tax were contained in secondary legislation.19 But those Regulations were confined to matters involving assessment and collection. They made no provision for deductions from wages on account of income tax; and placed no duty on employers to make such deductions. Income tax was assessed and charged by the Inspector of Taxes (as opposed to the Assessors and General Commissioners); and the inspector served a notice of assessment on every person assessed. The tax charged under any half-yearly assessment for the half-year ending on 5 October was payable on the following 1 January; and the tax charged under any assessment for the half-year ending on 5 April was payable on the following 1 July.20 So, accordingly, (to give a specific example),

16 See the definition in section 237 of the Income Tax Act 1918, restating a definition in section 27(2) of the Finance (No 2) Act 1915. 17 Rule 2(2) of the Rules applicable to Cases I and II of Schedule D in Schedule 1 to the Income Tax Act 1918, restating provisions originally contained in section 27(2) of the Finance (No 2) Act 1915. 18 Rule 2(1) of the Rules applicable to Cases I and II of Schedule D in Schedule 1 to the Income Tax Act 1918, as amended by section 18 of the Finance Act 1925 (15 & 16 Geo 5 c 36) and section 21 of the Finance Act 1926 (16 & 17 Geo 5 c 22). This provision had originally been enacted as section 27(1) of the Finance (No 2) Act 1915 and had applied on a quarterly basis. 19 The first Regulations were S R & O 1916/202. These were replaced by S R & O 1920/1991, which, in their turn, were replaced by S R & O 1925/702. The latter were in force at the beginning of the Second World War. (None of these sets of Regulations provided for citation.) 20 See the 1925 Regulations at regulations 2, 3 and 12.

Book 1.indb 197

12/2/2011 8:21:53 AM

198

John H N Pearce

for the year from 6 April 1929 to 5 April 1930, a weekly wage-earner had to pay the first half of the income tax due for that year on 1 January 1930 (before the end of the year of assessment but nearly nine months after its beginning) and the second half of the income tax on 1 July 1930 (nearly three months after the end of the year and nearly fifteen months after its beginning). Once again, therefore, payment of income tax took place considerably after the receipt of income; payment might have no particular relationship to the earlier receipt; and taxpayers on tight budgets could easily be troubled. The provisions of the Income Tax Acts relating to weekly wage-earners and to the dates on which income tax was payable were both considered by the Royal Commission on the Income Tax which reported in 1920. The Commission did not recommend legislative changes; but it was certainly not wholly opposed to the propositions that, in different circumstances, deductions on account of income tax might be made from earnings and that payments of income tax to the Inland Revenue might be made more frequently.21

III. In 1931, a year of financial crisis, the legislation enacted included income tax measures capable of imposing further strains on employees’ budgets. Section 8 of the Finance Act 193122 provided that three quarters of the income tax for any year should become payable on or before 1 January (instead of one half as previously) – leaving only one quarter to be paid on or before the following July. Section 6 of the Finance (No 2) Act 193123 raised the standard rate of income tax; and section 8 provided for the restriction of various personal reliefs. It was against this background that, on 9 October 1931, Mr W A Woods, Inspector in charge of City East E, sent a note to those above him in the Inland Revenue– ... I beg to submit that the present time is opportune for the introduction of schemes of deduction by employers of Income Tax from employees’ salaries. Owing to the large increase in tax to be paid now by employees on salaries, many taxpayers will find the payment of this tax too heavy a charge to meet out of any one monthly or quarterly salary cheque and will be forced to spread the liability. Already a number of large employers, such as banks and industrial concerns, have adopted schemes of deduction of a portion of the employees’ Income Tax liability monthly or quarterly. These deductions are paid over in one cheque to the collector at agreed dates for each instalment.

21 Report of the Royal Commission on the Income Tax (Cmd 615, 1920) 107–110 and 130 (paras 488–503 and 601). 22 21 & 22 Geo 5 c 28. Section 8 ceased to have effect for 1933–34 and subsequent Income Tax years (see section 29 of the Finance Act 1933 (23 & 24 Geo 5 c 19)); and the system of payment by two equal instalments was reinstated. 23 21 & 22 Geo 5 c 49.

Book 1.indb 198

12/2/2011 8:21:53 AM

The Road to 1944: Antecedents of the PAYE Scheme 199 It is submitted that if large employers of labour were approached to adopt a scheme to be approved between themselves and the local Income Tax Inspectors, many would welcome such an arrangement.24

The Board of Inland Revenue and the Chancellor of the Exchequer were keen that deduction schemes should be introduced.25 On 8 December 1931, the Chancellor of the Exchequer (Neville Chamberlain) expressed support for schemes of this nature;26 and, during the final months of 1931 and the early months of 1932, the Inland Revenue were at work on an outline plan under which large employers would enter into voluntary arrangements involving deductions on account of income tax from employees’ earnings. By April 1932 a printed Memorandum was in existence. A later version of the printed Memorandum, dated July 1933, stated that– The Board of Inland Revenue are prepared to make arrangements with Local and other Public Authorities and with business concerns employing considerable numbers of staff, under which the Income Tax payable by an employee in respect of his income from the employment will be collected in instalments by deduction from his remuneration. The tax payable by an employee in respect of his remuneration is due in two equal instalments payable respectively on the 1st of January and the 1st of July; and the object of the contemplated arrangement is to ease the burden on the employee by spreading payment of the tax over the year instead of collecting it in two lump sums. ... The tax will be deducted in equal monthly instalments. The tax due on the 1st of January will be deducted from the salary payments made at the end of October, November, December, January, February and March. The tax due on the 1st of July will similarly be deducted from the payments made for the months April to September inclusive. ... .27

The memorandum was written on the basis that the voluntary scheme would apply to employees in the third category that I distinguished earlier; but the Inland Revenue were also prepared to consider its application to weekly wageearners.28 The 1930s voluntary scheme, therefore, also provided for income tax to be paid in arrear – although in a manner likely to be preferable for employees’ 24

IR 40/3859. The document continues after the paragraphs quoted. ‘We are considering at present the possibilities of developing for the Local Authorities and the big Industrial undertakings voluntary arrangements for deduction of tax from pay, more or less on the lines of the arrangement running for some years with the London County Council ...’ . Gregg to Hopkins, 25 November 1931. In 1939, Gregg stated of this period that ‘it was felt strongly both by the Board of Inland Revenue and by the then Chancellor of the Exchequer, Mr Snowden, that something ought to be done to help the taxpayer ...’. Gregg to Financial Secretary, 31 October 1939. T. 160/927 (F 12728). 26 In a written reply to a Parliamentary Question. See Hansard, Fifth Series, vol 260, col 1708 (8 December 1931). 27 The Memorandum had the title ‘Memorandum by Board of Inland Revenue relating to Collection of Income Tax from Employees by Deductions from Pay’. There is a copy of each version of the Memorandum in IR 40/6041. The passages quoted are paras 1 and 2 and the first part of para 4 of the later version of the Memorandum, which continued to be used until after the outbreak of the Second World War. 28 See paras 3 and 9 of the later version of the memorandum. 25

Book 1.indb 199

12/2/2011 8:21:53 AM

200

John H N Pearce

budgets. In his 1932 Budget speech, Neville Chamberlain appealed for its use by local authorities and large industrial concerns on the basis that ‘it would be in the public interest that schemes of this kind should form a definite and permanent feature of our tax system’.29 But the voluntary scheme did not achieve the success that had been hoped. In February 1932 an Inland Revenue official recorded that ‘The publicity this subject received during November and December last led us to expect a wide movement by employers to adopt schemes of deduction. This did not prove to be the case.’30 A document, dated 15 July 1933, recorded use of the voluntary scheme by 70 public bodies and 40 private employers and by 11,871 employees out of a possible 55,179;31 and, at the beginning of the Second World War, only 65 local authorities and 44 commercial concerns were operating it.32 It was admitted in 1940 that the scheme had operated only ‘within a very limited range’.33 Its application to any particular employee depended both on the employer being willing to introduce the scheme and on the employee being willing to use it when introduced – and neither employers nor employees appeared particularly interested. But the voluntary scheme had nevertheless set a vitally important precedent: for, where it was in operation, it was clearly envisaged that the employer should make deductions on account of income tax when paying earnings to employees.

IV. The onset of the Second World War brought increased taxation; and one Government Minister wished to explore the proposition ‘that as income tax increases in severity the taxpayer will find it more difficult to meet his obligations and that from our and his point of view anything which helps him to pay promptly would in itself be a good thing.’34 His Note prompted a substantial reply by Cornelius Gregg, one of the Commissioners of Inland Revenue: but, at this stage, the Inland Revenue did not press for new measures.35 29

Hansard, Fifth Series, vol 264, col 1431 (19 April 1932). Memorandum by Whitwell, 22 February 1932. IR 40/3859. ‘Steps were taken by way of ministerial statements in the House and by way of circular to advertise this scheme and to evangelise Local Authorities and industry as to its advantages. The results were disappointing as we did not get anything like the widespread use that was hoped for’. Gregg to Financial Secretary, 31 October 1939. T 160/927 (F 12728). 31 Memorandum by Whitwell, 15 July 1933. IR 40/3859. He also observed that ‘In only one case has there been any desire to include Half Yearly workers in a scheme – and in that case (Daily Telegraph) only 9 Half Yearly workers were involved out of a total of 307’. 32 Gregg to Financial Secretary, 31 October 1939. T 160/927 (F. 12728). 33 Memorandum “Deduction at source of the Income Tax due in respect of salaries and wages”, 10 July 1940. T 171/354. 34 Unheaded Note by the Financial Secretary to the Treasury (Captain Crookshank), 23 October 1939. T 160/927 (F 12728). 35 Gregg to Financial Secretary, 31 October 1939. T 160/927 (F. 12728). This letter included the comment that ‘If anything is to be done now to promote payment of tax by instalments, the 30

Book 1.indb 200

12/2/2011 8:21:53 AM

The Road to 1944: Antecedents of the PAYE Scheme 201 Six months later, however, there is evidence of a change in approach. On 3 May 1940, in a letter apparently unrelated to any business immediately in hand, Gregg wrote to Sir Richard Hopkins, Second Secretary at the Treasury, enclosing a copy of the Memorandum of 1933. He then went on to say that– If it should prove necessary to increase the income tax payable by small incomes the question of practicability is whether the tax could be collected. There must come a point at which you are asking the man of small income to pay too much for he will not have saved the money to meet the bill. We are calling on the married man of £500 this year to pay £60 odd in instalments of over £30 on the 1st January and over £30 on the 1st July. We shall certainly not find it easy to collect. If his bill jumped to £100 involving £50 every six months, I think you will agree that it would be well nigh hopeless to expect him to pay. He could only do it if the £100 were spread over many moons. Any attempt to deal with the ‘£5 to £12 per week man’ through the income tax is only possible by the adoption of deduction at the source and giving the Revenue powers to make compulsory a scheme of deduction on lines similar to that laid down in the voluntary scheme. Should we not arm ourselves accordingly?’36

The question in the final paragraph is capable of indicating that the Inland Revenue discerned a possible opportunity. On 8 May 1940, Sir Richard Hopkins, in his turn, sent a manuscript note to Thomas Padmore, the Private Secretary to the Chancellor of the Exchequer– Sir G Canny37 to whom I have spoken agrees that it is too late to think of inserting this large new departure in the current Finance Bill38 but it cd be done in the autumn, ready for operation for the beginning of 1941/42. It is a suggestion that Inc Tax on salaries & wages, having been assessed in the proper amount by the IR authorities, shd in all instances be collected by the employer by deduction during the year in the same way as tax on Civil Service salaries is collected. It wd I think clearly be an immense help in getting in the tax on small incomes, on both workmen & otherwise, – wh. will be difficult enough at current rates & still more difficult at higher ones.39

At this point, on 10 May 1940, Winston Churchill succeeded Neville Chamberlain as Prime Minister; and then, shortly afterwards, Sir Kingsley Wood succeeded Sir John Simon as Chancellor of the Exchequer. It may be inferred that, during the early summer of 1940, the Inland Revenue and the Treasury were engaged in activities that were significantly different. Within the Inland Revenue, a Departmental Committee was appointed ‘to draw important thing is to get more Local Authorities and more big industrial concerns to operate this scheme [ie the voluntary scheme] ...’ . 36

Gregg to Hopkins, 3 May 1940. T 160/927 (F.12728). Sir Gerald Canny was the Chairman of the Board of Inland Revenue. 38 That Finance Bill received the Royal Assent on 27 June 1940 as the Finance Act 1940 (3 & 4 Geo. 6 c. 29). 39 Hopkins to Padmore, 8 May 1940. T 160/927 (F.12728). 37

Book 1.indb 201

12/2/2011 8:21:53 AM

202

John H N Pearce

up a statutory scheme on lines similar to the existing voluntary scheme for the collection by deduction at the source of the income tax due in respect of salaries and wages’.40 Within the Treasury, on the other hand, it may be inferred that the new Chancellor of the Exchequer was unaware of the action that the Inland Revenue was preparing. A manuscript endorsement on Sir Richard Hopkins’s note of 8 May, dated 4 June, stated that ‘When the Chancellor is ready we had better mention it to him.’ By the beginning of July, Sir Kingsley Wood had decided, for reasons that had nothing to do with the collection of income tax, to introduce a supplementary Budget at an early date;41 and, during the course of a discussion about this Budget, held on 5 July 1940, ‘On points of detail it was mentioned to the Chancellor that the Inland Revenue would certainly press for a system of deduction of Income Tax from wages in industry ...’ .42 After this, events moved rapidly. Next day a note signed by the Chairman of the Board of Inland Revenue, Sir Gerald Canny, stated that– The increases in Income Tax payable resulting from the foregoing alterations of the standard rate and reduced rate will make collection so difficult that it is considered essential that there should be instituted this year a system for collecting the tax from salaries and wages by deduction at the source, and a separate Note is being prepared on this subject.43

The separate Note duly followed on 10 July; and ended by stating– The raison d’être for the introduction of a scheme of deduction at the source is to be found in the fact that employees cannot pay their tax and the Revenue will not be able to collect it, unless payment is spread over the year. This can only be done by a system under which the tax is deducted weekly or monthly by the employer and paid over to the Revenue. It will impose the duty of deduction on the employer and will involve a great deal of work both for him and for the Revenue. But it is the only way by which collection of the tax can be secured.44 40 The official document of appointment is on IR 40/7454. It has the initials of Sir Gerald Canny and a date stamp which gives the date as 5 June 1940. 41 T 171/354 (Part A). The Chancellor’s priority was to be able to introduce purchase tax to which the Labour party (now part of the Governing Coalition) had earlier declared its opposition. For an account of the events leading to the decision to introduce this supplementary Budget see R S Sayers, Financial Policy 1939–45: History of the Second World War: United Kingdom Civil Series (HMSO and Longmans, Green and Co, London, 1956) 48–50. (This work is subsequently cited as ‘Sayers’.) 42 T 171/354 (Part A). 43 Note by the Board of Inland Revenue on suggested increases of taxation for the forthcoming Budget, 6 July 1940, para 5. On 8 July 1940, the Inland Revenue stated that ‘The increases in the standard and reduced rates of tax will in themselves impose such a burden upon many taxpayers that it will be impossible for them to pay in full by the due dates and unless the scheme of deduction of tax at the source is introduced so as to come into operation this year, it is inevitable that there will be heavy arrears piling up at the end of the year. ...’. Proposals for increases of taxation: Income Tax, 8 July 1940, para 5. T 171/354 (Part C). 44 Deduction at source of the Income Tax due in respect of salaries and wages, 10 July 1940. An undated note filed immediately after the document quoted stated that ‘With the high rates of tax, it is becoming impossible for the weekly and monthly wage-earners to meet their tax bill at halfyearly dates. The only way in which the tax can be satisfactorily collected from these taxpayers is to secure the spreading of payments over the whole year. It is proposed that a scheme should be put

Book 1.indb 202

12/2/2011 8:21:53 AM

The Road to 1944: Antecedents of the PAYE Scheme 203 Meanwhile, on 8 July, the Departmental Committee had reported:45 so, from mid-July, the Inland Revenue did indeed have a system of deduction for collecting income tax from earnings. On 15 July 1940, the Inland Revenue provided a draft for the Budget Speech in so far as it related to the legislation relevant for that Department;46 and, when he made his Financial Statement on 23 July, Sir Kingsley Wood followed the Inland Revenue draft closely.47 He stated that the time had now come– ... to extend the principle of deduction at source to the whole range of salary and wage earners from the manual wage earner paid weekly to the company director. ... If ... [a taxpayer] is to be able to pay and the Exchequer is to get in due time what it wants, the burden must be spread. Spreading the burden throughout the year is, therefore, I believe absolutely necessary, and the only satisfactory and workable method is deduction at source month by month or week by week. With the added burden of taxation which I have been compelled to propose, this problem of spreading the burden throughout the year becomes too serious and too extended to be left to voluntary arrangements, and I accordingly propose to make deduction of tax from salaries and wages compulsory.48

It was envisaged that the arrangements necessary to put the scheme into operation should be contained in Regulations to be made by the Commissioners of Inland Revenue: so, in due course, enabling legislation for new Regulations was enacted in section 11 of the Finance (No 2) Act 1940,49 where subsection (1) conferred power to– make provision for the assessment and collection of tax chargeable under Schedule E, including in particular provision for requiring employers and other persons to deduct any tax so chargeable from any payments made by them ... ; and any such regulations shall have effect notwithstanding anything in the Income Tax Acts ... .

This legislation was followed, on 3 October 1940, by the making of the Deduction of Income Tax (Schedule E) Regulations 1940. Among many other matters, the

into operation under which employers should be required to deduct every week or month from the payment of wages or salaries an appropriate amount in respect of income tax. This scheme would apply not merely to what are termed ‘wage-earners’, but over the whole field of salaries from the managing director to the clerk’. T 171/354 (Part C). 45 The original report is in IR 40/7454. There are copies in various places including IR 63/154 and IR 75/105. 46 The Inland Revenue’s draft material is in T 171/354 (Part C). 47 For the financial statement see Hansard, Fifth Series, vol 363, cols 637–657 (23 July 1940). 48 ibid, col 646. 49 3 & 4 Geo 6 c 48. This Act received the Royal Assent on 22 August 1940. In the House of Commons, both the Chancellor and a Labour MP, Mr F W Pethick-Lawrence, stated that they judged that this new policy was generally welcomed (see Hansard, Fifth Series, vol 363, cols 1285 and 1283 respectively (31 July 1940)). On the other hand, the measures proposed involved an extension of the powers of Central Government at the expense of the local administration of income tax: and this feature of the scheme led to some Parliamentary opposition (see Hansard, Fifth Series, vol. 364, cols. 1011–1021 (15 August 1940)).

Book 1.indb 203

12/2/2011 8:21:53 AM

204

John H N Pearce

Regulations imposed a duty on an employer to deduct tax from payments made to employees and to pay the sums deducted to the Collector of Taxes.50

V. The compulsory deductions system created in 1940 had to operate against a background in which there was a major expansion in the number of taxpayers.51 Table: Estimated number of individuals charged with income tax: 1938–39 to 1946–47 Financial years 1938–39 1939–40 1940–41 1941–42 1942–43 1943–44 1944–45 1945–46 1946–47

Number charged with income tax (Thousands) 3,800 4,100 6,000 10,200 13,000 13,500 14,500 15,250 14,000

It was during the Second World War that income tax ceased to be a ‘class tax’ and became a ‘mass tax’.52 The Inland Revenue was accordingly involved in much work: for it had created a system under which it had to notify employers of the income tax deductions to be made from the earnings of a rapidly increasing number of taxpayers. Unsurprisingly, there were criticisms. A first major criticism related to the system’s administration. By the end of 1941 there were significant arrears; and many notifications specifying the deductions to be made during the period from January to June 1942 were issued late, so that the deductions had to be allocated to a shorter period.53 A second major criticism related to fluctuating earnings: for ‘in industries in which wages fluctuate seasonally, some of the tax due in respect of the high earnings of summer is deducted during part of the winter, when the wages are much lower.’54 50 SR & O 1940/1776. The duty to make deductions from earnings was imposed by regulations 3(1) and 5(1); and the duty to pay the sums deducted to the Collector was imposed by regulation 11(1). 51 Throughout these years, the annual Report of the Commissioners of Inland Revenue included a Table showing the estimated number of taxpayers in recent preceding years. The table that follows in the text has been compiled from those annual reports. 52 I was introduced to this nomenclature in C C Jones, ‘Bonds, Voluntarism and Taxation’ in J Tiley (ed) Studies in the History of Tax Law: Volume 2 (Oxford, Hart, 2007) 427 at 428. 53 Further details may be found in the White Paper issued in April 1942 ‘The Taxation of Weekly Wage Earners’ (Cmd. 6348), at 4–5 (paras 13 and 15). 54 ibid at 5 (para 15).

Book 1.indb 204

12/2/2011 8:21:54 AM

The Road to 1944: Antecedents of the PAYE Scheme 205 This latter point attracted the attention of Ernest Bevin, the Minister of Labour, who wrote to Sir Kingsley Wood on 3 December 1941– I think you should know that one of the underlying causes of unrest among workers in the Shipbuilding Industry, particularly on the Clyde where the recent ‘token’ stoppage of work took place, is the way in which Income Tax deductions are made from wages during the period when earnings are relatively low. ... I believe that under the system adopted the heaviest deductions for income tax will be made in January when winter earnings are at their lowest point. ... I am, therefore, writing to ask if you could possibly consider some change in the system of assessment and deduction at least for industries in which earnings are much higher in summer than in winter. ... I feel most strongly that some way must be found of avoiding the dangers of the present situation.55

On 13 February 1942 Bevin returned to these matters in a Memorandum prepared for the War Cabinet. He stated ‘my conviction that the present system as it applies to the weekly wage earner must be modified’ and ended with the reflections that ‘In all these cases the real essence of the matter is that the wage earner budgets on the basis of his weekly earnings. ... Any system must be simple in its operation and must be related to current earnings.’56 Despite these criticisms, the Inland Revenue continued to have faith in the arrangements in existence. A second Departmental Committee ‘appointed to examine the working of the scheme for deducting tax from wages and salaries’ reported on 3 February 1942;57 and, while suggesting a number of detailed modifications, expressed the view that the current arrangements should continue. In forwarding the Report to the Chancellor, Sir Cornelius Gregg, now Chairman of the Board of Inland Revenue,58 took the opportunity to point out, in his covering note, that one of the main findings of the Committee was ‘that it is quite impracticable to adopt a scheme ... for levying the tax on the basis of current earnings’.59 The same approach was taken in a White Paper, published in April 1942 at the same time as the Budget. After specifying criticisms levelled against the existing system, the White Paper recorded that ‘the remedy which has been suggested is that the deduction of tax should be on the basis of the current week’s earnings’60 and stated that– There can be no doubt as to the attractiveness of the idea of the current earnings basis particularly in its automatic adjustment of the weekly tax deduction to correspond 55

Bevin to Wood, 3 December 1941. T 171/360. WP (42) 78, War Cabinet: Effect of Income Tax on the Weekly Wage-earner: Memorandum by the Minister of Labour and National Service, 13 February 1942. T 171/360. 57 Report of the Committee appointed to examine the working of the scheme for deducting tax from wages and salaries, 3 February 1942. T 171/360. 58 Sir Cornelius Gregg (knighted 1941) succeeded Sir Gerald Canny as Chairman of the Board of Inland Revenue early in 1942. He held this post until 1948. 59 Note from Gregg to Chancellor, 10 February 1942. T 171/360. 60 ‘The Taxation of Weekly Wage Earners’ (Cmd 6348), at 5 (para 15). 56

Book 1.indb 205

12/2/2011 8:21:54 AM

206

John H N Pearce

with the wage payable, but it has not yet been found possible to translate the idea into a scheme that will pass the tests of fairness and practicability which must govern any arrangement for the assessment and collection of the tax.61

The White Paper reached ‘the conclusion that any schemes so far formulated with the basis of current earnings must be rejected, and that the existing basis should be retained with ... modifications ...’.62 During the early months of 1942, Sir Kingsley Wood acted in accordance with the official advice he received – but he was also alive to other possibilities.63 On 18 March 1942, he received a deputation from the Trades Union Congress. The official note of the meeting recorded that the TUC stated that ‘They would have preferred a system related to current wages if a practicable scheme to that end could have been devised.’ The Chancellor of the Exchequer said that he appreciated the T.U.C. position. He assumed that it would meet their views if in his Budget statement he took the line that he was not deciding for all time that there should not be a tax on current earnings but merely registering the conclusion that in present circumstances there was no balance of advantage to be gained from the introduction of such a scheme. He would add that at the same time the amendments proposed to be introduced to the existing system would be watched carefully throughout the forthcoming twelve months to see whether they and the general system on which they would be grafted would be susceptible of further amendment and improvement.64

It may be inferred that, during the second half of 1942, there was a significant difference in outlook between the Inland Revenue and the Treasury. The Inland Revenue appear to have believed that existing arrangements were working well and had full ministerial support – but the Chancellor of the Exchequer and the Treasury were perfectly willing to consider other possibilities. The proposition that existing arrangements were not working well had been argued in The Economist during February 194265 in an article which moved from the Inland Revenue’s administrative difficulties to a larger problem capable of arising in the future– ... now that the income tax has become (as it should) an all but universal tax, affecting virtually every citizen with an income, the disadvantages of the system by which each income is individually returned and assessed, and the tax is collected at a considerable interval of time after the receipt of the income on which it is assessed, are becoming very obvious. ... [This] year’s great extension of the net of income tax has led to a 61

ibid, at 5 (para 16). ibid, at 11 (para 35). In the view of The Economist, the White Paper was ‘a very disappointing document indeed’. Issue of 25 April 1942 at 563. 63 Around the beginning of 1942 a considerable number of different proposals for deduction schemes were made and received consideration in official circles. See T 171/360. 64 Deputation from the Trades Union Congress to the Chancellor of the Exchequer on the subject of weekly wage-earners and income tax, 18 March 1942. T 171/360. For the relevant passage in the Budget Speech, see Hansard, Fifth Series, vol 379, cols 119–20 (14 April 1942). 65 Issue of 7 February 1942 at 176. 62

Book 1.indb 206

12/2/2011 8:21:54 AM

The Road to 1944: Antecedents of the PAYE Scheme 207 very great strain being put upon the Inland Revenue. The state of affairs can easily be exaggerated; there is overwork and delay, but, as yet, nothing more than that. But it must be remembered that the present experiment is being made in the most favourable possible circumstances. Incomes are rising and there is a strong patriotic motive for paying taxes. If there are difficulties in these conditions, what will happen when incomes start falling? If there is anything in the nature of a post-war slump the attempt will have to be made to collect tax on the high earnings of wartime from the low earnings, or the zero earnings, of slump. In short, if the system is not breaking down now, it will assuredly break down in peacetime.

VI. On 1 February 1943, the Treasury asked for draft paragraphs for inclusion in the Chancellor’s Budget speech;66 and the Inland Revenue submitted a draft which included the statement that ‘the modifications which were made in the machinery of collection last year have proved to be successful and have contributed to a smooth collection of the tax.’67 But this was not the only information the Chancellor received. On 6 March he was sent a note whose author indicated that he thought that there were ‘two points ... on which I think you ought to consider very seriously including some short statement in your Budget speech.’ One of these was wage-earners’ income tax; and on this point– ... although things are pretty quiet at present the real testing time on wage-earners income tax is going to be the first year after the war, when overtime and high piecework rates have come off. It is absolutely essential to post-war finances that we should be able to maintain wage-earners’ income tax as a permanency, but if, when the first year of lower earnings comes they have to pay tax on the previous year’s income when earnings were right at their peak, there will be such an outcry that the whole wageearners tax system might collapse altogether.68 It seems to me that our only chance of carrying on wage-earners’ income tax into the post-war period is to get it on to a current earnings basis before the drop in earnings comes. I believe the Inland Revenue only need a little encouragement and a little more time to get such a system worked out, and I believe it would be an enormous help if you could give some pointer in your Budget speech to say that you are looking ahead to the problem that will arise when earnings fall, and are closely examining the possibility of shifting on to a current earnings basis before that time comes.69 66

Proctor to Gregg, 1 February 1943. T 171/363. Income Tax – Wage Earners, 27 February 1943. T 171/363. 68 The Treasury and the Inland Revenue found this line of argument being deployed shortly before the PAYE proposals were made public on 22 September 1943. Companies engaged in the production of Lancaster aircraft ‘argued that in consequence of the existing system of income tax collection in arrear, their workmen demanded that their weekly wage packet should, after deduction of their weekly income tax contribution, which of course related to the high wages earned six months earlier during full flow production of other types of aircraft, still contain sufficient money to meet their family needs’. Note of Meeting held on 18 August 1943. T 171/366, item 10. 69 Note to Chancellor of the Exchequer by P D Proctor, 6 March 1943. T 171/363. Proctor was an Under Secretary at the Treasury. 67

Book 1.indb 207

12/2/2011 8:21:54 AM

208

John H N Pearce

Within the Treasury, attention was devoted to what the Chancellor should say on this matter;70 and the relevant passage in the Chancellor’s Budget speech contained some material capable of being linked with the Inland Revenue draft together with other material capable of being linked with the Treasury note. So far as the latter was concerned, the Chancellor said– I have not overlooked the suggestions that have been made to levy the tax on the basis of current earnings. I described the difficulties last year, and explained how, after receiving the advice of the Trades Union Congress and the British Employers’ Confederation, we had all agreed that no scheme had so far been produced which would be equitable and practicable. I said I would at any time be prepared to consider any new proposal which would meet the case, but no acceptable plan has as yet been forthcoming. There is, however, to be considered in connection with this whole matter the different situation that may arise on the return to peace-time conditions, when a considerable change-over in employment may be expected to take place. My advisers are now engaged in a close examination of this aspect of the matter and the consideration of a current earnings basis for the deduction of tax will not be ruled out of their deliberations.71

The Chancellor returned to this matter at the end of the Budget Debate when he stated that ‘the Board of Inland Revenue are now looking into this matter again and are aware of the desires of the House, and that if there is any possibility of some sort of solution, they are the expert body to provide such a scheme.’72 Following these statements, it may be inferred that the Inland Revenue felt under pressure to produce a scheme of this type. A third Inland Revenue Departmental Committee, ‘appointed to examine the possibility of introducing a system of deducting income tax on wages on the current earnings basis’, reported on 21 May 1943; and began by stating that– The public demand for a system of deducting tax on the current earnings or pay-asyou-go basis has reached the point at which it is hardly any longer a question whether such a system is or is not possible.

The authors of the Report also considered that Sir Kingsley Wood’s remarks at the end of the Budget Debate left no doubt that the Chancellor ‘regards the introduction of such a system as a necessity, if the Income Tax in post-war years is to continue to apply to wage-earning classes.’73 One year earlier, the Inland Revenue had rejected the practicability of any scheme based on a current earnings basis – but the Department was now able to propose just such a scheme. An early indication of the central concept had appeared in a document dated 24 April 1942 whose author had written– 70 In T 171/363 there is a document concerned with this subject and headed “Paragraph for Budget Speech”. The document, on a single sheet of paper, is partly in typescript and partly handwritten. 71 Hansard, Fifth Series, vol 388, col 946 (12 April 1943). 72 Hansard, Fifth Series, vol 388, col 1772 (21 April 1943). 73 Report of the Committee appointed to examine the possibility of introducing a system of deducting income tax on wages on the current earnings basis, 21 May 1943. IR 63/163 pp 1–35 at p 2 (para 1).

Book 1.indb 208

12/2/2011 8:21:54 AM

The Road to 1944: Antecedents of the PAYE Scheme 209 In the White Paper ... no mention is made of the ‘cumulative method’ which meets some of the objections against the other methods. As the agitation for current basis is not likely to die down, sooner or later this method will probably be put forward and it might be as well to consider it in advance.74

The scheme now proposed made use of the cumulative method. It was described by the Chairman of the Board of Inland Revenue, Sir Cornelius Gregg, in a covering Memorandum sent to the Chancellor on 28 June 1943, as– a scheme for placing the deduction of tax from employees both wage-earners and others on a ‘current earnings’ or ‘pay as you go’ basis under which the tax deducted from earnings in any financial year will represent the liability for that year and will be measured by the actual earnings of that year, the periodical deduction of tax keeping in step with any variation in the earnings.75

It is this Report that stands at the beginning of the direct road to the PAYE legislation. So far as the scope of the scheme was concerned, the Report envisaged that the scheme should be applied to the second, third and fourth categories I distinguished earlier in this chapter, but not to the first.76 How did the Report’s authors analyse the tasks ahead? One important point related not to the tasks needing attention, but to the time available for undertaking them. The best day for the introduction of a scheme employing the current year basis was 6 April – the beginning of a new Income Tax year. This implied a commencement date of 6 April 1944: with the obvious consequence that much work needed to be done very quickly. This point had implications for legislation; and the Report stated that– If, as we envisage, the scheme is to come into force on the 6th April, 1944, legislation before that date is absolutely essential and acceptance of the scheme would involve the introduction, at a very early date, of a special Bill, all the stages of which would have to go through within the next three or four months. ... .77

An Appendix to the Report listed ‘the main points upon which early legislation is necessary’78 But for the authors of the Report, these legal matters were not 74

IR 64/103. I have not yet been able to identify the author. The covering memorandum is at T 171/366 and at IR 63/163 pp 70-85 where the passage quoted is at p 70 (para 1). The White Paper published in September 1943 contained a passage very similar to that quoted. See ‘A New System for the taxation of Weekly Wage Earners’ (Cmd 6469) at 2 (para 4). 76 Paras 8 to 11 of Appendix I to the Report. IR 63/163 p 7. So far as official earnings were concerned, the Report stated (in para 9 of that Appendix) that ‘The present collection arrangements are rather unsatisfactory, particularly in the case of persons taking up new appointments, and if the scheme proposed for other employees works efficiently, the application of that scheme sooner or later to official emoluments may become inevitable’. 77 Para 6 of the Report. IR 63/163 p 3. 78 Appendix II to the Report. IR 63/163 p 19. The list was as follows– (1) The writing off of that part of the tax deductible on the old basis which would overlap the deductions on the new basis i.e. 10/12ths of the 1943/44 tax for manual wage-earners and 7/12ths of the 1943/44 tax for other employees. ... . 75

Book 1.indb 209

12/2/2011 8:21:54 AM

210

John H N Pearce

of the utmost priority. Since the scheme had not been disclosed to the TUC or to the British Employers’ Confederation, they suggested that, ‘having regard to the sweeping character of the legislation proposed, the Chancellor’s agreement to the main features of the scheme should be obtained before these two main bodies are approached.’79 Sir Cornelius Gregg made the same analysis. On 28 June 1943, a memorandum about the proposed scheme was sent to the Chancellor of the Exchequer, accompanied by a covering memorandum written by the Chairman,80 in which, among other things, he set out his own evaluation of the immediate priorities– There are many questions to be considered in connection with the scheme such as the alteration of the general basis of assessment to Income Tax, Schedule E, from preceding year to current year ... , the revision of the rules of assessment, the readjustment of assessing functions as between the Inspector of Taxes and the local Commissioners, the treatment of Life Insurance relief, etc., which are not dealt with in the Memorandum and into which I do not now propose to enter. Though these questions are important and raise difficult issues that will require legislation they are soluble and the adoption of the scheme for current earnings cannot be said to depend upon their solution. The main issue at the moment is whether the scheme has your approval in general principle, so that discussions can be entered into with the T.U.C. and the British Employers’ Confederation. Before any such discussion can take place it is in particular essential that a decision should be taken as to the ‘forgiveness of tax’ which is proposed ... and [as to] the consequential effect on Post War Credit, for these are matters on which policy must be clearly defined before contact is made with the T.U.C. ... .81

During the first half of July, the Treasury considered the documents submitted. Five of the Chancellor’s advisers commented: four of them favourably.82 Lord (2) Alteration of basis of assessment under Schedule E to that of the current year ... with possible relieving provisions in certain cases. (3) Transfer of Schedule E assessing from Commissioners to Inspector, and abolition of half yearly assessment of manual wage-earners. (4) Alteration of basis of Life Insurance Relief ... . (5) General power to Commissioners of Inland Revenue to make Regulations which would enable tax to be deducted on the proposed basis, if it is considered that the powers contained in Section 11 of the Finance (No. 2) Act, 1940, are inadequate. 79

Para 5 of the Report. IR 63/163 p 3. See IR 63/163 pp 36–69 for the memorandum about the scheme and pp 70–85 for the covering memorandum. The paragraph quoted is para 2 of the covering memorandum (at p 72). These documents are also at T 171/366, item 1. 81 Para 2 of the covering Memorandum. IR 63/163 p 72. The question of ‘forgiveness of tax’ arose because, if there were to be a change from a preceding year of assessment basis to a current year basis, income tax due for payment under the preceding year basis on a date after the current year basis had become operative would have to be written off. This approach appears to have helped to prompt Sir Kingsley Wood to favour a ‘small scheme’: for this involved the ‘forgiveness’ of a smaller amount. The question of ‘forgiveness’ appears to have diminished in significance in the latter part of 1943: it was accepted that a considerable part of the sum under discussion could never have been collected from wage-earners; and the ‘loss’ to the Exchequer was reduced if post war credits were correspondingly restricted. On this, see Sayers at 104–6. 82 The comments are at T 171/366, item 2. Those who commented were Mr Brittain, Sir Wilfrid Eady, Lord Catto, Lord Keynes, and Sir Richard Hopkins. (The dissentient was Lord Catto.) In 80

Book 1.indb 210

12/2/2011 8:21:54 AM

The Road to 1944: Antecedents of the PAYE Scheme 211 Keynes’s reactions were that the scheme was ‘a very ingenious plan, which, so far as I can see, ought to work and does not involve any consequential difficulties’ and that ‘the Revenue deserve to be congratulated on a very ingenious scheme, which is, I agree with them, not really as complicated as it may look at first sight.’83 Sir Kingsley Wood permitted the scheme to go forward. But, despite the support for the scheme in the Treasury and the Inland Revenue, it would seem that (in private at least) the Chancellor had grave reservations about what was proposed. The official documents reveal little about his own personal views; but, on one occasion, at a meeting with representatives of the British Employers’ Confederation, the Chancellor said– that he would speak frankly to ... the Confederation in a manner which might not be possible in a public speech. He would say in the House of Commons that the Government had been pressed on all sides to introduce a pay-as-you-earn scheme ... . There were two compelling reasons why it was essential to introduce a scheme, and to do so at once. The first reason was that we must make the change to a pay-as-you-earn scheme well in advance of the end of the war. There could be no doubt that if the war came to an end with the present income tax system for wage-earners in force there would be considerable difficulty and trouble. The second reason was that it seemed to him most important that the present conditions under which the wage-earners as a whole were making a contribution to the affairs of the State through direct taxation, should be maintained. But for these reasons, he would have been tempted to leave this big reform in the income tax system, applicable to many millions of workers, until after the war ... [He] had great anxieties of his own which would have made him wish to leave the matter over because of the great strain under which the Inland Revenue machine was already working. ... .84

With this in mind, it becomes easier to understand why, at a Ministerial Meeting held on 19 July 1943– The Chancellor of the Exchequer referred ... to the Pay-as-you-go Scheme ... and said that ... he had given further thought to the scope of the Scheme and had come to the conclusion that it would be better to limit the Scheme ... to all manual wage earners at present subject to half-yearly assessment and to all employees under Schedule E who are customarily paid weekly wages or are on a weekly contract; other Schedule E employees would be left as they were. In reaching this conclusion he was influenced July 1943 and in the following months much work was devoted in the Treasury to the financial implications of the PAYE scheme. There is a very valuable discussion of those financial implications in Sayers 103–8. 83 T 171/366, item 2. Keynes’s comments are partly printed in D Moggridge (ed), The Collected Writings of John Maynard Keynes, volume 22, Activities 1939–1945, Internal War Finance (Cambridge, University Press, 1978) 383–5. 84 Note on interview with representatives of the British Employers’ Confederation, 17 September 1943. T 171/366, item 9.

Book 1.indb 211

12/2/2011 8:21:54 AM

212

John H N Pearce

by the fact that the Scheme had been evolved primarily as a solution to the problem of the manual wage earner and that any extension of the Scheme to take in Schedule E as a whole would be likely to lead ... to claims for similar treatment from other categories of taxpayers. ... . The scheme was essentially a wage-earners scheme and he thought that the limitation of the scheme to this category of employees could be defended.

The note of the Meeting recorded that ‘It was agreed that the scope of the scheme should be further examined.’85 Nevertheless, a few days later, on 29 July 1943, the Chancellor outlined the scheme to the War Cabinet who ‘took note’ of the position;86 and this action was taken by those concerned with the scheme as permission to attack the tasks involved. Into what categories should those tasks be regarded as falling? It was possible for those concerned to do much useful work on the technical workings of the scheme; and the production of the documentation which the scheme envisaged gave rise to major operational exercises. A concentration on policy necessarily means giving less attention to these operational matters. But these operational matters were of vital importance. One Inland Revenue official who was fully involved in this work wrote later that it ‘involved a tremendous amount of what might be called ‘mechanics’ – preparation and printing of forms and tables – and it almost monopolised the work of the printing trade for some months.’87 It was reported that the tax tables printed contained 14 million figures; 88 and, shortly before the scheme was launched, The Times reported that a hundred printing firms in different parts of the country had been involved in printing some 35 million documents.89 Some months earlier, shortly before the publication of the White Paper in September 1943, Sir Cornelius Gregg had reported that– We are asking the Stationery Office to print half a million copies of the White Paper for sale to the public at 2d; the Parliamentary issue on Tuesday will of course be restricted and be priced on White Paper lines at 4d.90

But, so far as policy was concerned, it was necessary to obtain the consent of the British Employers’ Confederation and the Trades Union Congress to the introduction of the proposed arrangements. It was also necessary to enact legislation: and the enactment of legislation implied a resolution of the question of the scope of the scheme – a matter still receiving further examination. So far as the British Employers’ Confederation was concerned (according to a note made by Sir Cornelius Gregg), the Chancellor saw the Chairman and Director on 9 August 1943 ‘and informed them that a new plan for deduction on a current earnings basis had been evolved, and that he looked to the Employers’ Confederation in the national interest to accept this plan and work it, despite 85

Pay-as-you-go: Meeting with Ministers, 19 July 1943. T 171/366, item 5. W M (43) 107th Conclusions, 29 July 1943. T 171/366, item 8. 87 W Griffith, A Hundred Years: The Board of Inland Revenue 1849-1949 (London, 1949) 44. 88 Transcript of broadcast talk delivered on 10 May 1944. IR 74/244. 89 The Times, 4 April 1944, p 2 col b. 90 Gregg to Padmore, 18 September 1943. IR 40/7769. 86

Book 1.indb 212

12/2/2011 8:21:55 AM

The Road to 1944: Antecedents of the PAYE Scheme 213 any additional clerical work that might be involved.’91 At a later, more formal, meeting held on 17 September 1943, the Director reported that– ... the Confederation had come to the conclusion that the scheme was, in principle, acceptable from the employers’ point of view; that it was, in their view, highly desirable that a Pay-as-you-earn system should be brought into force for wage-earners; and that the scheme was by far the best that they had seen in this or any other country. They were, therefore, in favour of its early introduction ... .92

Acceptance of the proposed scheme was likely to have been helped by the fact that, so far as the volume of work to be done was concerned, ‘it was appreciated that the new system would give very considerable savings by comparison with the existing system’.93 This was a state of affairs that had been foreseen by Sir Cornelius Gregg, who had written earlier– the fact that employers have been operating the existing deduction scheme for three years will have made them deduction minded and more able and willing to carry out the work involved in the new scheme. Though the task should not now prove an insuperable one there is little doubt that if any attempt had been made to introduce such a scheme in 1940, when compulsory deduction of tax from wages was first thrust upon employers, it would have met with the most violent opposition from the employers and even with their good will would have seemed too difficult to understand and carry out. Employers have now become sufficiently accustomed to the principle of deducting tax from wages that the further step of requiring them to deduct on the more scientific basis now proposed would not meet with such a hostile reception.94

So far as the Trades Union Congress was concerned, no persuasion was necessary. Indeed, on 29 July 1943, before the TUC had been approached in any way, its General Secretary, Sir Walter Citrine, had written to Sir Kingsley Wood stating that ‘I have been asked to express to you a very keen desire of the TUC to see introduced at the earliest possible moment a ‘pay as you go’ system of collecting tax from weekly wage-earners.’95 When the TUC had been consulted, the response was ‘to thank the Chancellor and the Board of Inland Revenue for the production of what appears to be a very fair and extremely practical scheme.’96 So far as legislation was concerned, arrangements were made for the new scheme to be announced in the House of Commons on 21 September 1943. Another White Paper to explain the new scheme was prepared;97 and the new White Paper set out the scope of the scheme as envisaged at that time.98 It was 91

Note of Meeting held on 11 August 1943. T 171/366, item 9. Note on interview with representatives of the British Employers’ Confederation, 17 September 1943. T 171/366, item 9. 93 Note on points raised at the Meeting of the British Employers’ Confederation held on 14 September 1943. T 171/366, item 9. 94 Paragraph 25 of the covering memorandum of 28 June 1943. IR 63/163 p 85. 95 Citrine to Wood, 29 July 1943. T 171/366, item 9. 96 TUC (Woodcock) to Inland Revenue (Chambers) 17 September 1943. T 171/366, item 9. 97 ‘A New System for the Taxation of Weekly Wage Earners’ (Cmd 6469). 98 ibid, at 3 (para 4). 92

Book 1.indb 213

12/2/2011 8:21:55 AM

214

John H N Pearce

proposed that the scheme should apply to manual wage-earners and to other wage-earners whose wages were calculated weekly.99 On 21 September 1943, the day on which he was due to announce the new scheme in the House of Commons, Sir Kingsley Wood collapsed and died. The announcement was postponed for 24 hours; and was made instead by Ralph Assheton, the Financial Secretary to the Treasury.100 The proposed arrangements were favourably received;101 but the restricted scope of the scheme was criticised. A widely-held view was that the new scheme should apply to all employees. One periodical, for example, ‘regretted that HM Government does not find it possible at the present time to make the scheme operative for all employees. It seems quite impossible to argue that it is a good scheme for persons paid weekly but a bad scheme for persons paid monthly.’102 On 14 October 1943, the new Chancellor of the Exchequer, Sir John Anderson, opened the debate on the Second Reading of what was then called the Wage-Earners’ Income Tax Bill103 in a speech in which there was clearly a tension between the general principles capable of applying and the more restricted scope of the scheme decided upon by his predecessor. So far as general principles were concerned, the Chancellor stated that– If Income Tax were being started afresh as a new tax, I have no doubt that the new system would be applied universally to employment. It has many advantages.104

On the other hand, the application of the scheme was restricted. But– My mind is not closed, however, to the possibility of reconsidering the scope of the scheme. While I could not agree to wholesale extension accompanied inevitably by a very large remission – though I regard the principle of pay-as-you-earn as valid and suitable for general application at the proper time and in the proper way, and should like to work up to that – I have been giving very serious consideration to the case of salaried workers in the lower salary ranges. I recognise that a strong case may be made for early action in this matter, for these lower salaries, and if the opinion of the House 99 In private, the Chancellor’s colleagues in government may not have approved of the restriction on the scope of the scheme. An undated initialled note, which I attribute to ‘RA’ – ie Ralph Assheton, the Financial Secretary to the Treasury – recorded that ‘If there was a clause in the bill to give relief from double taxation and no mention of forgiveness I doubt if political difficulties would prevent the Chancellor going the whole hog and redeeming the sad error made years ago when the basis of the previous year was introduced. I think the original scheme was a real reform – the present modification deprives it of many of its greatest advantages, it wont suit employers, it wont suit the Inland Revenue and makes a horrible muddle of what was originally going to be a simplification. I hope the House will press the Chancellor on the matter but he may be assured I wont invite them to mutiny!’. T 171/366, item 8. 100 For the Parliamentary proceedings, see Hansard, Fifth Series, vol 392, cols 209-11 (22 September 1943). 101 See Sayers 108. 102 ‘Taxation’ vol 32 p 3 (issue of 2 October 1943). 103 The Bill was given a different title at a late stage in its passage through the House of Commons – and was accordingly enacted as the Income Tax (Employments) Act 1943. 104 Hansard, Fifth Series, vol 392, cols 1096–1107 (14 October 1943). The quotations in the text are at cols 1101 and 1102.

Book 1.indb 214

12/2/2011 8:21:55 AM

The Road to 1944: Antecedents of the PAYE Scheme 215 as expressed in debate should be in favour of such a concession, limited to that class, I shall be ready to come forward with suitable proposals on the Committee stage.

The Chancellor then ended his speech by indicating that he had in mind extending the scheme to those whose earnings did not exceed £600 per annum.105 The ‘opinion of the House as expressed in debate’ was not only in favour of the extension hinted at, but in favour of an extension to all those charged to income tax under Schedule E.106 On 20 October 1943, the House of Commons considered the Wage-earners’ Income Tax Bill in Committee.107 The amendment considered to clause 1 of the Bill was a proposal to the effect that the new PAYE arrangements should be extended to all income charged under Schedule E. Twenty five MPs made contributions to the discussion. No-one was overtly hostile to the extension: many were strongly in favour. The mover of the amendment announced in his summing-up that ‘I think it will be a very long day before any Amendment which I may have the privilege of moving in the future is found to carry such support in so many quarters as has been the case today.’108 Two other speakers were more pointed– I rise because this is said to be a Legislative Assembly, and legislation is supposed to reflect the will of the House of Commons as a whole. I do not remember such unanimity on any other point of substance during the years in which I have had the honour to be a Member of the House of Commons. Since the present discrimination creates a large number of anomalies which ought not to be created, I think that the Chancellor, if I may say so with great respect and humility, should bow to the unanimous desire of the House of Commons in respect of this proposal.109 I hope that the Chancellor will think again. He was very quick to see that some concession was needed, and in making that concession he met the wish of this House. Now he has been confronted with a very strong body of opinion. I am sure that if the late Chancellor of the Exchequer were here, he would recognise that that strength of opinion could not possibly be resisted. The Chancellor of the Exchequer knows – he said it in his speech – that sooner or later this change will have to come about. I cannot see any advantage in postponing the second half until a later year.110

105

ibid, col 1107. It was decided at this time that the PAYE scheme should apply to Civil Servants to the same extent as it applied to employees in the third and fourth categories distinguished earlier in this chapter. Sir Cornelius Gregg reported on 18 October 1943 that ‘I have informed Day [on behalf of the Civil Service’s Staff Side] that the Chancellor has decided to accede to the Staff Side’s request and include the Civil Service equally with outside employees. I told him that I assured the Chancellor that the Staff Side fully appreciated what the effect of this would be. Day told me that the wageearners and other junior grades that had fluctuating emoluments owing to overtime were all out to come in; that other grades, thinking of the fall in remuneration that might occur at the end of the war, acquiesced on that ground; but that some grades apparently had misgivings as to the wisdom of coming in. The pressure of the large battalions at the bottom was clearly the governing factor in the decision arrived at by the Staff Side.’ Gregg to Padmore, 18 October 1943. IR 63/163 p 132. 107 For these proceedings see Hansard, Fifth Series, vol 392, cols 1402–1480 (20 October 1943). 108 ibid, col 1451. Mr G S Summers (Northampton). 109 ibid, col 1448. Mr T Levy (Elland). 110 ibid, col 1419. Rt Hon F W Pethick-Lawrence (Edinburgh East). 106

Book 1.indb 215

12/2/2011 8:21:55 AM

216

John H N Pearce

The Chancellor accordingly found that the House of Commons wished him to reach decisions on the extension of the scheme ‘more speedily than I had contemplated’;111 and discussion was concluded on the basis that the question of the Bill’s scope would be considered further at the Bill’s Report Stage.112 On 28 October 1943, the Chancellor had an informal meeting with MPs, explaining that he considered the extension of the scheme to the whole of Schedule E would give rise to an unacceptable avoidance, and that pressure on the Parliamentary timetable was such that anti-avoidance provisions could not be included in the Bill as it then stood. The solution proposed was to enact the existing Bill with the extensions envisaged at the end of the Chancellor’s speech on 14 October; and then to follow that legislation with another Act extending the scope of the scheme and containing anti-avoidance provisions. ‘This line of action appeared to be generally acceptable to the members present.’113 On 2 November 1943, there were further Parliamentary proceedings on the Wage-earners’ Income Tax Bill.114 The Bill was re-committed; and Sir John Anderson set out the course of action he had placed before the unofficial meeting of MPs on 28 October. His exposition of the position does not appear, from Hansard, to have been particularly lucid – and cannot have been helped when, on two occasions, instead of referring to pay-as-you-earn, he referred to Lend-Lease.115 Mr F W Pethick-Lawrence, a former Labour Treasury Minister and the next MP to speak,116 took the opportunity to give his own exposition of the course of action that it was expected would now be undertaken.117 The Commons then went on to complete its consideration of the Bill. Among other matters, amendments were made to include within the scope of PAYE those employees whose earnings for 1943–44 did not exceed £600; and the title of the Bill was changed to reflect the extension of PAYE beyond wage-earners. The Income Tax (Employments) Act 1943118 received the Royal Assent on 11 November 1943. Following the enactment of the Income Tax (Employments) Act 1943, the legal position was that the PAYE arrangements, due to come into force on 6 April 1944, were to apply to those whose employment income did not exceed £600 during the 1943–44 Income Tax year. But the 1943 Act had been passed against an undertaking given by the Chancellor of the Exchequer to extend PAYE over the whole range of Schedule E taxpayers. This extension was duly 111

ibid, col 1420. ibid, cols 1451–2. 113 IR 63/163 pp 142–3. 114 For these proceedings see Hansard, Fifth Series, vol 393, cols 545–597 (2 November 1943). 115 ibid, cols 545–550 at 548 and 549. On the second occasion Sir John Anderson offered the mitigation that ‘these formulae are very confusing’. 116 Pethick-Lawrence has been described as ‘the doyen of Labour’s fiscal caucus’. BEV Sabine, British Budgets in Peace and War 1932-1945 (George Allen & Unwin, London, 1970) 189. 117 Hansard, Fifth Series, vol 393, cols 550–551 (2 November 1943). 118 6 & 7 Geo 6 c 45. 112

Book 1.indb 216

12/2/2011 8:21:55 AM

The Road to 1944: Antecedents of the PAYE Scheme 217 carried out by the Income Tax (Offices and Employments) Act 1944,119 which received the Royal Assent on 1 March 1944. On 9 March 1944, the Income Tax (Employments) Regulations were made;120 and, on 6 April 1944, those Regulations and the PAYE regime came into force. When Sir John Anderson announced, on 25 April 1944, during the course of his Budget Speech, that ‘all reports indicate that the new system has been successfully launched’, The Times recorded that there were cheers.121

VII. During the debate on the Second Reading of the Income Tax (Offices and Employments) Bill, early in 1944, one MP described it as ‘unique’. It is a Bill which has been forced upon the Government by the House. From the very beginning of the demand for Pay-as-you-earn the Government have resisted and the House has won a steady series of engagements against the Government. We were told first of all that Pay-as-you-earn was quite an impossible and impracticable suggestion, and instead of having a Pay-as-you-earn scheme we were given the modifications of the weekly deductions. Then, rather, I think, to the surprise of many of us, the Board of Inland Revenue produced a very brilliant cumulative scheme. Again it was limited in its operation, limited to manual workers and weekly wage-earners or rather earners who were paid within periods of less than a month. In the first Bill the Chancellor was compelled to extend its operation to all Schedule E earners up to £600. As a result of further pressure it was extended to all Schedule E incomes irrespective of amount.122

Somewhat earlier, during the Second Reading of the 1943 Bill, another MP had spoken in similar vein, stating that the Bill met ‘a very real demand of the country. This is a case in which the demand has produced the supply, which always seems to me the correct sequence of events.’123 This line of approach may indeed have much to be said for it in the context of the legislation of 1943 and 1944: but it is my opinion that an approach of this type cannot be put forward to explain the entirety of the sequence of events that ended with the PAYE regime coming into force. The voluntary scheme of the 1930s undoubtedly had the support of Government Ministers and the 119 7 & 8 Geo 6 c 12. For a very clear statement that this legislation that this legislation carried out the Chancellor of the Exchequer’s earlier undertaking, see the speech of Sir John Anderson on the Second Reading of the Bill. Hansard, Fifth Series, vol 396, col 1926 (10 February 1944). 120 S R & O 1944/251. In the National Archives, IR 40/9148B would appear from the description in the Catalogue to be the drafting papers for the PAYE Regulations, but those papers were marked as being closed for 75 years. Under the Freedom of Information Act 2000 (c 36) I required this decision to be reviewed – but was told, in reply, that the file had been missing since 1998. 121 Hansard, Fifth Series, vol 399, col 655 (25 April 1944); The Times, 26 April 1944, p 6 col a. 122 Hansard, Fifth Series, vol 396, col 1955 (10 February 1944). The speaker was Mr G Benson (Chesterfield). 123 Hansard, Fifth Series, vol 392, col 1164 (14 October 1943). The speaker was Mr P W Jewson (Great Yarmouth).

Book 1.indb 217

12/2/2011 8:21:55 AM

218

John H N Pearce

Inland Revenue: but it proved of little interest to the large organisations which were supposed to operate it or to employees of those organisations who were supposed to benefit under it. In 1940 the Inland Revenue forced the pace – only to find others putting it under pressure early in 1943. On the road to 1944, different groups were in the lead at different stages. A document prepared for use at the time of the public announcement on 22 September 1943 stated that– The object of the proposals is to overcome the difficulties which arise from the fact that, under the present scheme, the wage-earner’s tax is measured, not by his current wages, but by the wages paid to him many months previously.124

So far as Sir Kingsley Wood had been concerned, those difficulties had to be overcome to safeguard the high revenues that Central Government would continue to require after the war, and to which wage-earners, as a whole, should make a definite contribution. If the necessary changes were not made before the end of the war there would be considerable difficulty and trouble. Employers had more paperwork, but gained from the prospect of better compliance. The Inland Revenue, considering the sequence of events as a whole, gained from a system under which deductions were made from employees’ incomes and transmitted directly to the Department. Taxpayers gained from a system under which they could budget for short periods without having to worry about income tax liabilities which might perhaps be very substantial – and this state of affairs also pleased Trade Unions and members of the House of Commons. Everyone ended the journey together. But different persons had started the journey at different times, had travelled – from time to time – at different speeds, and had made the journey for different reasons.

124

Book 1.indb 218

Draft Announcement for the BBC. T 171/366, item 12.

12/2/2011 8:21:55 AM

8 Restricting Tax Relief on Business Entertaining and Gifts: 1948–1965* DAVID STOPFORTH

ABSTRACT

T

HIS CHAPTER USES primary source materials created by the Revenue and Treasury Ministers to trace the background to the introduction of restrictions on relief for expenditure on business entertainment and gifts in 1965. It shows how such expenditure grew dramatically during and immediately after WW2 due to food rationing, the desire to maintain business connections when certain activities were prohibited and the rapid increase in tax rates. It then examines in detail the Revenue’s reactions to this growth and their preparations for a coherent policy on which to base preventative legislation. Finally, the Revenue’s significant influence on of the final form of the legislation is demonstrated and their relationship with Treasury Ministers and the Chancellor’s Special Adviser, Kaldor, is explored. An essential characteristic of an effective tax administration is to foresee areas where the government might wish to take action. By doing so, it can analyse facts and issues to provide the basis of policy decisions and to determine the practical implications of likely changes long before it is certain they will be introduced. In turn, this requires a high degree of awareness of the current political scene, so that there will be no great surprises. Additionally, the administration must be on guard against areas where tax revenue may be lost and have practical solutions at the ready. This chapter uses primary sources to show how the UK * The author gratefully acknowledges support for the research at the National Archives from the Carnegie Trust for the Universities of Scotland, and the comments of attendees at the Cambridge Tax History Conference 2010. Special thanks are due to John Pearce (University of Exeter) who tracked down the responsibilities of the Revenue officials mentioned.

Book 1.indb 219

12/2/2011 8:21:56 AM

220

David Stopforth

Inland Revenue discharged these duties very efficiently in relation to business entertainment expenses, despite the many years which passed before legislative action was taken in 1965. It shows that this delay does not appear to have been a matter of the Revenue holding up tax reform, as it often did during this period1, but more as a matter of their pragmatism in the face of the Conservative Government’s likely resistance to such change, despite adverse press comment, public opinion and criticism in Parliament. The chapter also traces the influences on the development of the Revenue’s attitude to business entertainment and gifts and places it against the social background of the time. Finally, it considers the Revenue’s relationship with ministers and their major involvement in, and impact on, the formulation of the policy behind the 1965 legislation debarring tax relief on most business entertainment and gifts.

FACTORS ENCOURAGING BUSINESS ENTERTAINMENT

Until 1965, non-capital expenditure on business entertainment and gifts to business contacts was, like any other expenditure, an allowable deduction for tax purposes if it met the relevant tests for relief, which differed according to whether the individual was self-employed or an employee.2 By this time, such expenditure was commonplace and often lavish and the fact that it was effectively being subsidised by the tax system had for many years been subject to bitter resentment and criticism. No doubt the provision of entertainment and gifts had long been used to oil the wheels of business but its extent appears to have grown dramatically for three reasons during and immediately after WW2. First, although food rationing began in 1940 and continued until 1954, it did not apply to meals in restaurants, hotels and similar establishments. Those with the money to do so were seen to supplement their rations to such an extent that public resentment drove the Ministry of Food to introduce, in 1942, a maximum price of 5 shillings for all restaurant meals. This was of little effect as compensatory heavy cover charges and excessive pricing of drinks enabled the rule to be avoided. The fact that the wealthy continued to live very well was often recorded in their diaries which refer to much heavy drinking and large amounts of money being spent in the best hotels in London.3 Secondly, the shortage of some materials and 1

Daunton, Just Taxes (Cambridge University Press, 2002) p 280 For those who were self-employed, the expenditure merely had to be incurred wholly and exclusively for the purposes of the trade. In the case of employees, the expenditure had to be incurred wholly, exclusively and necessarily in the performance of the duties or in travelling in the performance of the duties. 3 For a detailed account of food rationing, see J Gardiner, Wartime Britain 1939–1945, Ch 7 (Headline Book Publishing, London, 2004). For one of the best accounts of luxury and extravagance, see RR James, Sir Henry ‘Chips’ Channon (Weidenfeld & Nicolson, London, 1967). 2

Book 1.indb 220

12/2/2011 8:21:56 AM

Restricting Tax Relief on Business Entertaining and Gifts: 1948–1965 221 the strict control of their use meant that certain products were no longer made and this encouraged many traders to call upon old customers to maintain their goodwill. The Revenue record, ‘as there was no real current business to discuss, the meetings frequently took place over the luncheon table’.4 Thirdly, as a result of increased tax rates the after-tax cost of providing entertainment or gifts was often fairly small. By 1941/42 the standard rate of income tax had doubled to 50 per cent over a period of four years and stayed at that rate until reducing to 45 per cent in 1946/47 and not reducing again until 1955/56. Small increases in the already high surtax rates over the same period meant that throughout the war the marginal surtax rate was 25 per cent on the slice of total income between £5000 and £6000 and reached 47.5 per cent on income over £25000. Clearly, businessmen with high incomes could entertain with a correspondingly high subsidy from the Exchequer.

LABOUR’S EXPENSES AND BENEFITS PROVISIONS OF 1948

Before 1948, employees’ expense allowances, or reimbursements made to them by their employers, were not normally counted as income, even if there was a resultant saving, benefit or amenity for the employees. Normally, only where a pecuniary liability of the employee was paid by the employer was the amount expended counted as part of the employee’s income. However, it was always open to the Revenue to count expenses received as income to the extent they could show that the amounts exceeded the actual expenses paid out by the employee which were allowable under the strict rules. The fact that the onus was on the Revenue to find cases of excess expenses made it relatively easy to evade tax liability. However, some employees ran into difficulties when they attempted to sue their employers following dismissal. They found the courts would not support them because their contracts were intended to mislead the Revenue by providing for an expense allowance which both contracting parties knew would never be wholly incurred on expenses. The intention was to evade tax and as such the contracts were contrary to public policy and therefore unenforceable.5 In 1948, the Labour Government introduced legislation which switched the burden of proof to directors and employees paid at the rate of £2,000 a year or more, inclusive of expenses and benefits – hereafter ‘executives’. The effect was to ensure that any sum paid or reimbursed to executives in respect of expenses was charged as income. The onus of showing that an equal and opposite deduction from income was due because the monies were spent wholly, exclusively and necessarily in the performance of the duties, or in travelling in the performance of the duties, was shifted to the recipient. As will be seen later, 4

TNA: IR82/170, para 31. Millar v Karlinski, CA 1945, 24 ATC 483, and Napier v National Business Agency Limited, CA 1951, 30 ATC 180. 5

Book 1.indb 221

12/2/2011 8:21:56 AM

222

David Stopforth

despite the change, only a very small proportion of entertainment expenses and round-sum allowances claimed as a deduction by those within the new system were subject to disallowance on scrutiny by the Revenue.

IMMEDIATE DIFFICULTIES WITH EMPLOYEES’ ENTERTAINMENT EXPENSES

The new legislation soon ran into difficulties and, by December 1949, the Chairman of the Board had to write to the Chancellor to explain a problem in respect of indirect costs of business entertainment at home by executives at the expense of their employers. Apparently this practice was not widespread, it mainly occurred in London, and often involved visitors from overseas. The arrangements either involved the provision of a round-sum expense allowance to cover indirect costs of entertainment or payment of all or part of the overhead expenses such as rent, rates, heating, lighting and servants. The Revenue’s approach in such cases was to allow a deduction only for the cost of food and to refuse a deduction for any proportion of the overhead costs of the property. This line was held until January 1951 when the Board of Inland Revenue met to consider the difficulties of this approach.6 By this time, experience had shown that there were a number of cases in which refusal to allow any deduction for overheads had led to a stalemate. The Revenue’s original stance was based upon the taxpayer having to show that part of the overhead expense met the strict rules for deduction, which could only be the case if the requirements of business entertainment made it necessary for the individual to have extra rooms, and possibly extra servants, over and above what would meet his personal needs. They had found two difficulties with this argument. First, the individual would be likely to succeed in his claim before Appeal Commissioners, particularly where one wing of the house was set aside for the exclusive use of guests, or where the company required the individual to do a lot of entertaining and deliberately acquired a larger property to do so. The second difficulty, which the Revenue saw as more serious, was that they already allowed a deduction for a proportion of the overheads if part of the house was used for the purposes of employment. For example, where there was an office in the house, they did not insist that it should be exclusively so used. It was realised that ‘if we continue to refuse all relief for overheads and by some miracle maintain this line before Commissioners, companies will achieve their objects by other methods’.7 The Revenue had already come across a case where a company had purchased a house in its own name and run it as a virtual hotel for distinguished guests with a director living on the premises in a quasi-managerial capacity. As he had his own quarters and no rights over the rest of the house, 6 7

Book 1.indb 222

TNA: IR31/220 pp 113–118. fn 6, para 9.

12/2/2011 8:21:56 AM

Restricting Tax Relief on Business Entertaining and Gifts: 1948–1965 223 they considered that he would only be chargeable on the value of those quarters and the services directly provided to him. The Board decided that their position on overheads relating to entertaining was no longer tenable and the Chairman submitted a paper explaining this to the Chancellor in order to keep him informed. Various interesting points concerning the Revenue’s views were made in this note. First, the Revenue explicitly stated that they did not wish to bring cases involving overheads to appeal because this ‘would be embarrassing to us’ because the point would largely be one of fact for the Commissioners ‘and we know from experience that in such matters they are likely to come down against the Revenue’.8 Secondly, they did not wish to run the legal argument that no deduction applied unless the whole expense met the strict tests and that no apportionment of personal and business elements was possible, because this conflicted with their existing practice. They therefore concluded that the wisest approach would be to avoid appeals and allow some proportion of the overhead expenses whilst endeavouring to restrict that proportion to reflect genuine business use and to exclude any expense ‘incurred to uphold or enhance the prestige of the director’.9 By this means they hoped to reach settlements which would be less unfavourable than either the decisions which Commissioners would be likely to give on appeal, or the amount allowable if there was some direct legislative provision for apportionment. The Revenue had thus lost in one significant area relating to restricting relief for entertainment expenses. They were soon to receive another blow in connection with entertainment expenses incurred by the self-employed.

BUSINESS ENTERTAINING BY PROFESSIONS

In October 1950, the Revenue succeeded in an appeal before the Special Commissioners where a partnership of two solicitors had claimed a deduction for the cost of entertaining clients. It had been the Revenue’s existing practice to resist such claims and this stance had been upheld in a number of cases taken before the Commissioners. They record that ‘the Special Commissioners … have virtually set a prohibition on the allowance of such expenditure … [and] the same line is taken by the City Commissioners’.10 There had been no case where the taxpayer decided to take the matter to the courts, but the solicitors referred to above intended doing so. This led to a careful analysis of their position at a meeting of the Board of Inland Revenue in February 1951 to consider the inconsistency of their practice in dealing with the apportionment of expenditure. Particular concern arose in two areas. First, the Revenue had given oral evidence to the Tucker Committee11 that 8

fn 6, pp 119–128 at App C, para 3. fn 6, para 4. fn 6, main document, para 4. 11 The Committee on the Taxation of Trading Profits. Cmd 8189. 9

10

Book 1.indb 223

12/2/2011 8:21:56 AM

224

David Stopforth

in some instances it was the practice to apportion expenditure with a mixed motive into allowable and disallowable items, eg expenses of a car used partly for private purposes, or local rates and the cost of services when a dwelling house is used partly for business purposes.12

They had also advised the Committee that this practice was not extra-statutory in view of existing case law.13 The Committee’s draft report indicated that this practice of apportionment applied to all items of expenditure having a mixed purpose. However, this was not Revenue practice in all cases, especially where entertainment expenses were incurred by professional persons, when any deduction was refused. The Board therefore decided to write to the Secretary of the Committee to explain that the current draft which stated that ‘in the case of expenditure for mixed purposes the present practice is to apportion …’ was too wide and to warn that if it appeared in the final report it ‘might lead to great trouble’, and particular difficulties in a case about to come before the courts.14 The Revenue therefore suggested a revised draft for the Committee which eventually appeared almost verbatim in their report.15 As an incidental matter, it was noticed that the instructions to inspectors of taxes needed to clarify that, where there was so called ‘mixed purpose expenditure’, there should be no argument made that the whole amount should be disallowed. The Deputy Chief Inspector wanted an instruction to be issued to prevent this strict approach being taken, except in the case of entertainment expenses incurred by professional persons. Revised instructions were provided for, and received, the Board’s approval. The second problem was that the Board had, only a few weeks earlier, agreed a change of policy concerning the apportionment of overhead expenses of executives who entertained business guests in their homes. Despite the inconsistencies between the treatment of entertainment expenses and other mixed motive expenditure of professional persons, and between the treatment of professional persons and executives, the Board believed this was justified. They saw a distinction between the generality of mixed motive expenditure and entertaining expenses by professional persons as … ‘however conducive to smooth business relations a professional man’s entertaining may be … there is no element of it which is not undertaken by him as a man, a member of the social community’.16 With this validation of the inconsistencies referred to above, the Board instructed that the appeal should be defended in the normal way. At the time of their decision, the Board knew that there would be no conflict with the Tucker Committee as it did not propose to make any recommendations 12

TNA: IR31/220 Note of Board Meeting, February 1, 1951, para 6. Lochgelly Iron and Coal Co Limited v Crawford 6TC 267 and Copeman v William Flood and Sons Limited 24TC 53. 14 TNA: IR31/220 February 1, 1951, para 6. 15 Report of the Committee on the Taxation of Trading Profits. Cmd 8189. April 1951, para 161. 16 TNA: IR31/220 para 11. 13

Book 1.indb 224

12/2/2011 8:21:56 AM

Restricting Tax Relief on Business Entertaining and Gifts: 1948–1965 225 concerning entertainment expenses, despite the matter being put to it by the Law Society. In the event, the Revenue lost the appeal in both the High Court and the Court of Appeal.17 It was held that no apportionment was possible and that where the sole object of the expenditure was business promotion it was allowable in full even if the activity necessarily involved some other result or the attainment or furtherance of some other objective, since that result or objective was necessarily inherent in the act. Therefore, expenditure would qualify in full, or not at all, according to the real motive or purpose of the entertaining, which itself was a matter of fact. The Court of Appeal, in May 1952, gave leave for the Crown to take the case to the House of Lords provided they did not seek to disturb previous orders for costs and did not ask for any costs in the House. It is not known why the Revenue did not take the matter any further.

THE REVENUE’S EVIDENCE TO THE ROYAL COMMISSION ON TAXATION OF PROFITS AND INCOME18

Despite the loss of the case referred to above, in evidence submitted to the Royal Commission, the Revenue seemed content with the position in respect of entertainment by the self-employed, as well as with entertainment by companies and employees. As regards the self-employed, their view was that, where a businessman could satisfy the Appeal Commissioners that his entertainment expenditure was wholly and exclusively for business purposes and contained no private element, there was no problem with the existing law. They could see no further restriction which could be imposed without causing difficulties in administration. Furthermore, any requirement that expenditure should be necessary in order to qualify for deduction was thought to be a ‘positively harmful … condition … for no one but the trader can be qualified by a similar knowledge of the actual facts and hazards of the particular enterprise’.19 They saw no principle to justify discriminatory treatment of entertainment and believed it was essentially just one form of advertising. However, they did point out that the effectiveness of the existing law was limited by the shortage of fully-trained tax inspectors. In a separate paper, the Board provided their views on a possible restriction of tax relief for expenditure on entertainment by the self-employed.20 They dismissed this proposal, as it would create great administrative complexity both for them and businesses, because they believed that certain classes of entertainment would have to be exempted from the rule, particularly the 17

Bentleys, Stokes and Lowless v Beeson, 33 TC 491. Cmd 9474. 19 Board’s Memorandum 39, para 13, 1952, Admissible Deductions, National Library of Scotland. Ref. GRG 19. 20 fn 19, Board’s Memorandum 68, February 20, 1953. 18

Book 1.indb 225

12/2/2011 8:21:56 AM

226

David Stopforth

entertainment of overseas customers. They also foresaw that there might be difficulties in designing a system to cover round-sum allowances granted to employees who then spent some of it on entertainment. Any such element would have to be related back to the employer’s accounts for a disallowance because a disallowance for the employee was thought unacceptable. As regards executives, again the Board expressed general satisfaction with the existing system despite ‘public criticism … that under the guise of business entertainment, high executives succeed in maintaining, at the taxpayers’ expense, a standard of living which they could not maintain out of their taxed income’.21 The Revenue expressly stated that they were not concerned about whether it was socially objectionable that one section of the community was living better than another by virtue of business entertainment, but only about whether in a particular case the entertainment was genuinely for business purposes. They were also not concerned about what standard of entertainment should be provided, whether it should have been more modest or not been given at all, so long as the expenditure was on genuine business entertainment. Generally, they found that it was. Claims for deduction of entertainment expenses by lowerpaid employees were rare, except in the case of commercial travellers, where the amounts were relatively insignificant. As regards executives, inspectors merely investigated whether the entertainment included any ordinary reciprocal hospitality of fellow executives or any private entertainment, including where private guests were asked to meet the business guests. Once satisfied on these points, inspectors would not normally question the standard of entertainment, the number of entertainment events, whether they could have been carried out more cheaply or that more business guests were invited than were strictly necessary. Furthermore, no restriction was made for any element of the cost relating to food provided to the executives.

THE VIEWS OF THE ROYAL COMMISSION

Given the arguments the Board presented to them, it is not surprising that the majority of the members of the Royal Commission neither recommended tightening up the law to deal with business entertainment nor the introduction of a specific restriction on the deduction of entertainment expenses. Such expenses should, it was believed, be subject to the same rules as those applying to any other category of expenditure. They could not see that entertaining was anything other than a proper cost of business chargeable against gross proceeds to arrive at true profit and they regarded the specific exclusion of items of expenditure like entertaining to be impracticable.22 However, these views were not unanimous. 21

fn 19, para 25. Cmd 9474 paras 125 and 126. It is interesting to note that JM Tucker QC was a member of the Royal Commission and also acted for the taxpayers in the Bentley case. 22

Book 1.indb 226

12/2/2011 8:21:56 AM

Restricting Tax Relief on Business Entertaining and Gifts: 1948–1965 227 In a Memorandum of Dissent23 by three members of the Commission the view was expressed that expenses such as advertising and entertainment were not necessarily directly or closely associated with trading operations. They were voluntary and the trader took account of the tax relief and therefore may have had ‘outlays of doubtful value, which it might not have been worth the trader’s while to incur at all in the absence of taxation’.24 As a consequence, they recommended that earned income relief should only be available to businesses which opted into a system which corresponded to the expenses rules for employees, and that those which did not so opt should get no relief for expenses unless they were ‘directly and inevitably involved in earning the profits of the current year [so as to] exclude all those payments … not manifestly necessary for conducting these operations’.25

GROWING PUBLIC DISQUIET

Despite the views of the majority of the Royal Commission, there had already been considerable grumbling about entertainment expenses which their report chose to ignore. It was probably the High Court decision in the Bentley case in late July 1951 which focused public attention on entertainment expenses. The fact that the QC who had presented the case for the Crown was also a Labour MP and had two fellow MPs with considerable experience of working for the Revenue led to the matter being repeatedly raised in Parliament. They attempted to insert a new clause into the Finance Bill of 1952 which would have altered the Revenue’s information powers in connection with entertainment allowances and expenses of executives. The proposal was that where entertainment allowances (together with any other expenses) exceeded £100 and were also greater than 1 per cent of the employment income (inclusive of such allowances and expenses) then the Revenue would have power to require a claimant to not only provide a detailed itemised account but also an affidavit that all information in connection with the claim was complete and accurate. The Revenue were also to be given power to require the taxpayer to be examined orally on oath on the accounts, documents, books and the affidavit. Failure to comply was to be punishable by imprisonment for up to three months and a fine of up to £1,000, or, in the case of a body corporate, up to £10,000. Unsurprisingly, the new clause was defeated. However, this was only after considerable debate26 which highlighted major differences of opinion on both sides of the argument. The Opposition could not, of course, give any specific examples of abuse but painted a broad picture of entertaining in restaurants and 23

Cmd 9474. Page 390 onwards. Memorandum of Dissent para 115. fn 23, para 129. 26 Hansard, Vol 501, May 28, 1952, cols 1573–609. 24 25

Book 1.indb 227

12/2/2011 8:21:57 AM

228

David Stopforth

the provision of flats and suites in hotels ‘as a means of luxurious tax evasion’27 and argued that ‘it would not be possible for a large number of the luxury restaurants and luxury hotels to exist at all … if it were not for the large expense allowances’.28 The Conservative responses moved between derisory laughter and arguments that the clause was merely ‘a deliberate attempt to promote prejudice against directors’.29 The Financial Secretary to the Treasury admitted that there was some abuse but argued that the Revenue’s existing powers were sufficient. However, he promised to ‘watch the operation of this very difficult branch of the law, and if it does appear … that we could usefully be armed with further powers we should not hesitate to come to Parliament and ask for them’.30 Despite this promise, the Leader of the Opposition (Gaitskill) warned that although in financial terms this area might not be the most important type of tax evasion, ‘from the point of view of the public attitude to taxation it is certainly among the most important sources of evasion precisely because it is an ostentatious type of evasion’.31 Importantly, he went on to completely dismiss some of the arguments circulating amongst his fellow Labour MPs. First, he explained that to disallow entertainment expenses entirely would not be practical because of its effect on the export trade. Secondly, he dismissed the argument that there should be a limit on the amount of entertainment expenses on which a company or individual could obtain tax relief, as this would involve practical difficulties in deciding an amount which would not be too high for some and unfairly low for others. His views seem to have set some of the boundaries for future discussions on the disallowance of entertainment expenses. In June 1953, just over a month after losing Bentley for the Crown in the Court of Appeal, Sir Frank Soskice QC was defending a new clause on the subject of entertainment expenses which he had put forward for the Committee stage of the Finance Bill.32 Again, his proposal involved the delivery of an affidavit but this time extending to the self-employed as well and without the severe penalties suggested in 1952. Debate on the clause followed the same lines as in the previous year and was largely based upon the ‘body of evidence that one accumulates from one’s ordinary contacts and conversations [which] make it obvious that there is very considerable abuse which ought to be repressed’.33 Strong support was given by an MP (Douglas Haughton) with long experience of working for the Inland Revenue and who still had strong connections as the Chairman of its Staff Federation. He argued that abuse of entertainment expenses was well known by those working day to day in the Revenue as well as by accountants and businessmen. 27

fn 26, col 1575. Mr Albu. fn 26, col 1576. Mr Albu. 29 fn 26, col 1580. LE Crosthwaite-Eyre. 30 fn 26, col 1593. Mr Boyd-Carpenter. 31 fn 26, col 1606. Mr Gaitskill. 32 Hansard, Vol. 516, June 23, 1953, cols 1805–37. 33 fn 32, col 1808. Sir Frank Soskice. 28

Book 1.indb 228

12/2/2011 8:21:57 AM

Restricting Tax Relief on Business Entertaining and Gifts: 1948–1965 229 They are certainly known to the general public, because they are repeatedly told that the rich pay at 19s or 19s 6d in the pound and the ordinary taxpayer walking along the street asks how does he do it if he is only getting 6d in the pound out of his large income! The explanation is plain. He is not doing it out of his own income; he is doing it out of funds provided for him or out of monies chargeable against the firm.34

Whilst expressing great respect for the experience and views of Mr Haughton, the Financial Secretary advised that the matter had been closely watched over the last year and it had been concluded that abuse was not widespread and further powers were not needed. Despite these assurances, the Opposition was unconvinced and believed that as the man in the street would also be unconvinced he would be ill disposed to the policy of wage restraint which the Government so favoured. Eventually, the Chancellor categorically denied that there was widespread abuse of entertainment expenses, a view which he claimed to be able to support as a result of his regular, direct contact with the Revenue. Although he agreed that there were some cases of abuse, he advised that these were being dealt with rigorously and pledged that the Government would continue monitoring the situation. Despite efforts by the Financial Secretary and the Chancellor to draw discussions on the matter to a close, just over two weeks later it was raised again. A new clause had been proposed for the Report Stage of the Bill in almost identical terms to the previous one, only extending its scope to living expenses and transport expenses. After almost two hours of debate, it is fair to say that almost nothing new was raised. The Financial Secretary merely reiterated the view that the abuse was neither widespread nor large and advised there was absolutely no evidence that it was increasing, but rather that there had been great exaggeration as to its scale. ‘… What we have heard today is largely repetition of gossip. I am advised that there is no evidence on an increase of this sort’.35 In an attempt to show that there was no complacency he pointed out that the Revenue had ‘evolved a new form, P11D, the purpose of which is to make quite clear to the people concerned the precise legal position of the duties imposed upon them’.36 Such repeated and intensive debate, combined with the ministerial assurances above, brought Parliamentary discussion of entertainment expenses to a close for a few years. However, in May 1956 the Shadow Chancellor (Harold Wilson) in an attack on tax avoidance raised ‘the very serious problem resulting from the different treatment of business expenses under Schedule D [self-employed] and Schedule E [employees]’.37 In particular, he had in mind business entertainment which he described as so uneconomic, wasteful and inflationary that it should only obtain tax relief to the extent of 50 per cent of the expenditure. He contended

34

fn 32, col 1815. Mr Haughton. Hansard, Vol 517,July 8, 1953, col 1284. Mr Boyd-Carpenter. 36 fn 35, col 1285. 37 Hansard,Vol 552, May 9, 1956, col 1260, Harold Wilson. 35

Book 1.indb 229

12/2/2011 8:21:57 AM

230

David Stopforth

that at almost every West End hotel some extravagant event was being hosted regularly where people travelled from all over the country with their fares, accommodation, tickets, dinner and drinks being largely paid for by the Chancellor. ‘No doubt the Chancellor goes to them sometimes and courteously thanks the associations for their hospitality. The boot is really on the other foot. The Chancellor is paying for the dinners and the associations should be thanking him’.38 He mocked that businessmen were ‘busy standing one another drinks and sending the bill to the Chancellor’.39

THE REVENUE RECONSIDER ENTERTAINMENT EXPENSES

Given the views of the Shadow Chancellor, the Revenue were prompted to review the whole question of relief for entertaining expenditure and prepared detailed papers on the subject. 40 These show a far more damning position than the Financial Secretary had admitted to Parliament a few years earlier. The first paper argued that the root of the public and political interest in entertainment expenses was based on the inequity of allowing one class of taxpayer to enjoy a much higher standard of living than another solely because of the ability to increase disposable income by devices to ensure that some receipts were taxfree. It made clear that following the Chancellor’s admission to Parliament in June 1953 that there were some false claims for entertainment expenses, Revenue practices had been overhauled and they were now confident that, in the field of employment, there was little untaxed beyond what was strictly allowable. Despite this, there was still a considerable problem, as the following extract shows. The entertainment of customers and clients and the giving of, eg Christmas presents to foster goodwill has for decades been a common practice, but shortages of materials, the desire to retain old customers and clients or to obtain scarce goods, and the scramble for new customers during and immediately after the war engendered a widespread practice of distributing extravagant favours and inducements which, in many cases, fall little if anything short of bribery. The entertainment provided which may include yachting holidays, a week at Ascot, etc, etc, is shared by the host and often his wife, and in some cases sets a new standard of living for them. Much of the cost is borne by the business. The charge against case one profits of companies cannot, in general, be prevented under existing law ….41

Given this situation, not surprisingly, the Revenue paper then considered whether some or all of the cost of entertainment should be disallowed and the practical difficulties of doing so. If Parliament decided to use income tax as an 38

fn 37, col 1261. fn 37, col 1262. 40 TNA: IR82/170. 41 fn 40, para 11. 39

Book 1.indb 230

12/2/2011 8:21:57 AM

Restricting Tax Relief on Business Entertaining and Gifts: 1948–1965 231 instrument of social policy to curb such expenditure, it was thought that there were two supporting arguments. The first was that the recipient of business entertainment received a valuable advantage which was not taxable despite being paid for with untaxed money and ‘these valuable benefits are notoriously prevalent throughout the business community’.42 The second argument was that such expenditure was ‘a symptom, and its allowance … an encouragement, of low business morality’43 and contended that, if the entertainment was lavish or involved gifts, it must be an inducement to act in favour of the donor in relation to some current or future business transaction and was thus ‘sufficiently near to bribery to appear to be reprehensible to the fastidious mind’.44 A third line of attack was that extravagant entertainment involved the encouragement of waste and inefficiency. Gifts to, and entertainment of, buyers and sellers are also inducements to accept that which, by open competitive standards, is not the best, and thus they encourage inefficiency, and a debased sense of values. In times of shortage, it tends to distort the economy by diverting vital raw materials into the hands of the less scrupulous manufacturers of possibly less important products.45

The paper then went on to consider what types of entertainment expenditure could be possibly regarded as acceptable. These included subsistence allowances to employees, costs of travelling in the performance of their duties and free samples of a manufacturer’s products distributed to the public generally. In addition, and for some odd reason not explained, ‘Foyles’ literary luncheons and light refreshments provided at a mannequin parade are clearly outside the field of review, although they are entertainment’.46 As regards entertainment of overseas buyers ‘the national interest would prevail over any theoretical objection’.47 Consideration was also given to the position of a solicitor whose practice brought him ‘delicate causes celebres’ where ‘the client dare not call at the solicitors office for fear of publicity, nor summon the solicitor to his own residence because servants will talk. Consequently, the solicitor will arrange a small dinner party at his own house’.48 Such situations were not thought to be sufficiently prevalent for special treatment to be given. However, an exception for entertaining customers on the business premises was thought acceptable, even if those premises were only temporarily occupied for the purpose of displaying products. The paper concludes that the best way forward would be to disallow all entertainment expenditure with very few exceptions. This approach was seen 42

fn 40, para 19. fn 40, para 20. 44 fn 40, para 20. 45 fn 40, para 27. 46 fn 40, para 30. 47 fn 40, para 32. 48 fn 40, para 34. 43

Book 1.indb 231

12/2/2011 8:21:57 AM

232

David Stopforth

as having the advantage of saving time for tax inspectors, even though it would result in the Chancellor coming under constant pressure to extend the exceptions. The alternative approach of requiring that entertainment expenses would have to be incurred necessarily for the purposes of the business was rejected because it ‘would involve nice questions of fact and degree and would probably end in Commissioners allowing much of the expenditure’.49 A week later a much shorter and more measured paper was submitted to the Chief Inspector of Taxes (Mr Norman), apparently by the superior officer of the writer of the first paper. This argued that the disallowance of genuine business entertainment would present serious difficulties of definition and ‘would be a headache both for inspectors and Commissioners’.50 In any event, it was thought that traders would be unlikely to spend money on outsiders beyond what the business would stand. This left the question of any element of personal benefit necessarily inherent in the act of promoting the business ‘which, by concession or tolerance, we allow in practice [for employees]’.51 It was thought that any legislation to distinguish the pure business motive from the desire to confer personal favours would be tricky and troublesome and that the Revenue would have difficulties in finding the facts. Their experience with employees was that they had found themselves handicapped because, on questions of figures and matters of detail they had to rely largely on the information supplied by the taxpayer. Finally, it was suggested that any such change would meet formidable resistance and would probably not raise sufficient tax to justify the additional burden on the administration. Given this lack of enthusiasm, it is not surprising that the Chief Inspector decided that there should be no further action. However, the matter did not rest there and in just under a year, the specialists were being asked for a paper on the disallowance of entertaining for the selfemployed ‘because of the concern at the amount of tax involved, the waste of the general taxpayer’s money and the widespread discontent caused by what has grown into a social evil’.52 To a large extent, this second internal review of the subject repeated the arguments already rehearsed the year before. However, some additional points were made. In connection with visitors from overseas it was argued that ‘there is a great deal of prestige entertaining and also of reciprocal hospitality on visits by businessmen to each other’s countries to the disadvantage of the two Treasuries and as a means of getting around exchange controls’.53 To prevent this, it was suggested that there should be a requirement that the expense was necessarily and directly incurred in earning the profits. The possibility of excluding reasonable amounts of expenses by professional entertainers was 49

fn 40, para 39. fn 40, Memorandum dated 26 November 1956 at para 4. 51 fn 40, para 5. 52 TNA: IR82/170, paper dated September 17, 1957 by Mr Morrell, a Principal Inspector in the Chief Inspector of Taxes Office. 53 fn 52, p 4. 50

Book 1.indb 232

12/2/2011 8:21:57 AM

Restricting Tax Relief on Business Entertaining and Gifts: 1948–1965 233 also considered and the provision of a two year period of grace was thought a suitable concession for advertising agents whose entertainment expenses were relatively large, though usually justified by the nature of their business. The paper also warned that there would be opposition, not only from those directly concerned, but also from ‘better class hotels in London and other big cities and in the larger holiday resorts and their employees’ unions and from theatrical, nightclub and similar interests’.54 A separate paper on the subject submitted by a Senior Principal Inspector (J Thompson) at the same time as the first contains such extraordinary and scathing statements that a substantial element of it is quoted below. People of all classes and parties are disturbed by the growth of this cancer in the country’s business and social life and some of its most uneasy witnesses are the accounting officers and auditors … responsible for … trading accounts and negotiating tax liabilities. When I was in City 5, the Deputy Chairman of Price, Forbes and Co Limited, one of the largest insurance brokers in the city, told me that he had ceased to patronise the Savoy because it was full of people whom he detested, exploiting the income tax advantages that had come their way. We see evidence of its effects both in our official and in our private lives. The dominating personalities in my own golf club are men who would have had some difficulty in gaining entrance a generation ago. Today they roll up in Bentleys, Jaguars and the rest; employ caddies at 12/6d plus a pint of beer per round; and would not think of playing without substantial bets on the match with a variety of side bets. … A dinner was held at the Dorchester to celebrate the Club’s jubilee and when the sale of tickets at 3 guineas each showed early signs of flagging, it was put around openly that there was no need to be economical about it because the cost of entertaining clients and customers could be charged to the Income Tax people. Civil servants and most … professional men … were, of course, unable to attend but were told later that it had been a great success.55

He proposed a complete disallowance of entertaining expenditure which could be justified on the basis that it was a measure the Government were forced to take in the fight against inflation. The only exception would be for direct expenditure on buyers from abroad. He believed that there was good reason for confining the exception ‘to buyers from Canada and USA and other hard currency areas, but a political howl could be raised about that’.56 As had happened in the previous year, the submission summarising these papers by their superior officer to the Chief Inspector was short and simple. It merely recommended the complete disallowance of entertaining expenses with a limited number of specific exceptions. However, before coming to a conclusion, the Chief Inspector asked Mr Ainley, a Senior Principal Inspector and specialist on employees expenses, whether he could produce a ‘simple but cast iron definition of entertainment which could be worked on at low cost 54

fn 52, p 5. fn 52, p 2. Memorandum by J Thompson, September 17, 1957. 56 fn 52, p 2. 55

Book 1.indb 233

12/2/2011 8:21:57 AM

234

David Stopforth

by inspectors’.57 In response, he defined entertainment as ‘any disbursements incurred in, or in connection with, or incidental to the provision for any person of hospitality of whatsoever nature’.58 This definition was thought to get to the root of the problem and, with a total prohibition on deduction for tax purposes, to present virtually no difficulty for inspectors to administer. Ainley’s paper took the matter further by giving his views on theoretical and practical matters relating to the issue. In theory, he saw no reason why anyone or anything should be excluded from complete disallowance and believed that, although the intermingling of business with food, drink and the amenities of a good life had grown considerably, business and pleasure could be kept quite separate. Furthermore, he argued that ‘the fact that the foreigner does this sort of thing does not necessarily mean … we must trim our own standards of commercial morality or business propriety to conform to his. There can still be a British way of doing things’.59 He pointed out that although restaurant entertaining was making the greatest impact on the mind of the general public, more expensive entertainment often took place out of the public’s gaze, for example at private house parties, shoots and on yachts. He also argued that much entertainment taking place in public escaped critical attention because it was possible that it was private but in fact was often claimed to be business, for example attendance at Ascot, Wimbledon and theatres. As regards hotel and restaurant entertaining, he thought the real problem was with directors of small private companies where reciprocal entertainment was more common. In such cases, each expenditure in isolation would often qualify as it looked like a business occasion. This left the Revenue with the difficulty of trying to substantiate any challenge. A further problem raised was how to deal with entertainment provided on business premises, such as meals to customers in the director’s dining-room, which were at the time subject to statutory exemption. Apparently, entertaining was built into the fabric of business and trading relationships in North and South America, Scandinavia, the Latin Countries and the Far East. In the latter two areas large businesses were controlled by a relatively small number of very wealthy people and the hospitality dispensed by them was particularly lavish. Thus, when the UK trader was required to provide reciprocal hospitality it had to be of an equivalent standard and this, he believed, was in the national interest. Next he referred to a constant succession, most particularly in London, of large scale conferences and trade exhibitions with attendant dinners, theatre visits, sightseeing and other entertaining where wives were expected to play a part as well. ‘These functions run [by] trade associations … are highly respectable and are often attended by members of the Government [where] there is some business advantage … but there is equally much junketing’.60 He pointed out that there were many other benefits provided 57

fn 52, Norman to Ainley September 27, 1957. fn 52, Ainley to Norman November 8, 1957. 59 fn 58, p 1. 60 fn 58, p 2. 58

Book 1.indb 234

12/2/2011 8:21:57 AM

Restricting Tax Relief on Business Entertaining and Gifts: 1948–1965 235 to employees which were either tax-free or taxed at an amount far less than their cost to the employer so that singling out entertaining expenditure might rally opposition from those fearful that their own benefits would be next for attack. Finally, the paper moves on to administrative considerations which would arise if exceptions were provided or only a partial restriction of the expenditure was made. It points out that to allow a deduction where a foreign visitor has been included in a private party would mean the rules would be capable of exploitation. A further problem to be faced was illustrated by the example of an American customer and his wife making up a dinner and theatre party of eight, including three UK directors and their wives, where a question would arise as to whether to allow all the expenditure or only a quarter of it. As regards an arbitrary limitation on the allowable expenditure of say 50 per cent, he pointed out that there would still be a need for inspectors to scrutinise claims and it would not eliminate the public opinion problem or the tax advantage. After all this effort and analysis no action was taken and the Chief Inspector merely records that ‘it is very useful to have these views on record against the possibility of future consideration’.61 Again, within the Revenue the issue of business entertainment had been brought to a close. However, without any corrective action, the matter soon came up again for public discussion.

ANOTHER ROUND OF PARLIAMENTARY PRESSURE

In the debates on the Budget Proposals and Economic Situation in April 1960, two matters were put forward by the Shadow Chancellor to support a restriction on the deduction for business entertainment to 50 per cent of the expenditure. First, was the Chancellor’s admission that the proportion of the nation’s £400 million bill for alcoholic drinks which was claimed for business entertainment was estimated at 10 per cent. Secondly, there had been articles in the Sunday newspapers, supposedly based on surveys in the Soho area, that many of the clubs ‘flourish largely under the patronage of expense accounts … so the [Chancellor] will be remembered as the patron of the new art forms which flourish in Soho’.62 Nothing further came of this pressure. The following year the Chancellor admitted that ‘there is something behind this strong feeling which undoubtedly exists that some so-called business entertaining goes further than purely business motives [and] this is an unhealthy feature both on business and social grounds’.63 He called upon those concerned to consider whether they could curtail the extent and scale of entertainment and warned that he would return to the matter the following year because he did not completely reject the possibility of legislative 61 62 63

Book 1.indb 235

fn 58, Handwritten note dated March 12, 1958 on the memorandum of November 8, 1957. Hansard, Vol 621, April 5, 1960, col 211, Mr Wilson. Hansard, Vol 638, April 17, 1961, col 815.

12/2/2011 8:21:58 AM

236

David Stopforth

action. In the meantime, the employer’s return of expenses and benefits (form P11D) was revised to provide more precise information and, for the first time, a leaflet was issued by the Revenue setting out the rules it followed when dealing with expense claims. The Chancellor’s admissions drew fire from the Opposition. Again there was a reference to striptease parlours ‘flourishing under the expense account racket’.64 A reference was also made to the fact that President Kennedy, within three weeks of taking office, had proposed drastic restrictions on deductions for travelling and entertainment.65 In an amendment to a clause giving relief for earned income for surtax purposes, the Opposition attempted to block any surtax relief for entertainment expenses and stated that they would have put forward a similar rule for income tax if they were not debarred from doing so by such an amendment being ruled out of order. Much anecdotal evidence was provided of the growth in the amount and extent of entertainment being provided, particularly in the case of roundsum allowances. Despite Opposition statements that the position had got out of hand in the United States, and was getting so here with increasing numbers of exaggerated claims for entertainment every year, no action was taken. As promised, the Chancellor did return to the subject of business entertaining in his 1962 Budget. However, he ignored the position of the self-employed and merely referred to the revised and more detailed form P11D for employees, which, he stated, would enable him to consider the whole matter again in the light of the additional information obtained.66 In the event, analysis of forms P11D for 1961/1962 showed that in the 71,000 cases where entertainment had been provided, only £0.9 million out of a total of £13.5 million of such expenses had been disallowed. For round-sum allowances there were 28,000 cases, and only £0.6 million of the £7.2 million of expenses were disallowed.67 It seems that these figures were not sufficiently damning to prompt the Revenue or the Chancellor to suggest any changes to the law on the deductibility of entertainment expenses. This would have to await the return to power of those who had complained so bitterly and so long about the injustices of the existing system.

PREPARATIONS FOR CORRECTIVE LEGISLATION

Not surprisingly, when they returned to power in October 1964, restricting tax relief for business entertaining expenses was a priority for the Labour Government. The Revenue’s previous work on the subject in 1956 and 1957 now came into its own. It was heavily drawn upon to provide the Chancellor with a note on the subject in 64

Hansard, Vol 638, April 18, 1961, col 991 Mr Wilson. President’s tax message, April 20, 1961. 66 Hansard, Vol 657, April 9, 1962, col 984 Mr Boyd-Carpenter. 65

Book 1.indb 236

12/2/2011 8:21:58 AM

Restricting Tax Relief on Business Entertaining and Gifts: 1948–1965 237 case the issue was raised in the November 1964 Budget debates. Although their advice to the Chancellor was merely to say that he proposed to investigate the matter fully, the note went on to provide an outline of the existing law and an explanation of the difficulties the Revenue were having with it. First, they pointed to the fact that, as entertainment expenditure was often partly for business reasons and partly for personal reasons, it was difficult to disentangle the two motives, let alone to check the accuracy of what the taxpayer said about those motives and the circumstances of the expenditure. Secondly, they argued that even with genuine business expenditure, the taxpayer often received a private benefit, such as a lunch, partly at the Revenue’s expense. Thirdly, they found that they could not challenge the scale of genuine business entertainment. They advised that there was no remedy for these problems in being more rigorous in administration and that the only way forward would be to withhold relief on an arbitrary basis regardless of motives and circumstances. They also urged the Chancellor that to disallow only a proportion of entertainment expenditure ‘would be unfair to the many businesses – perhaps found more in the North than in the South – which observe strict and even puritanical standards in business expenditure’.68 They recommended instead the disallowance of all entertainment expenditure, except on foreign buyers, because to do otherwise would cause a considerable waste of time for inspectors in analysing business expenses. They also cautioned the Chancellor to bear in mind the impact of this change on the hotel and restaurant industry and predicted that businessmen would ‘cast a censorious eye on all forms of Government entertainment’.69 Statistics were also provided which showed that in 1962/63, the number of employment cases involving entertainment expenses, and the amount of these expenses, had increased by 10 per cent over the previous year, yet the amount disallowed had fallen to represent only 5 per cent of the total expenses paid by employers to executives.70 The Chancellor’s first reaction was that the Revenue’s proposal for complete disallowance was rather severe unless there was some countervailing easement elsewhere. He suggested a reduction in the rate of corporation tax of 1 per cent.71 The issue of disallowing entertainment expenses was raised again by the Revenue at the end of November 1964 in response to a note by the Chancellor requesting suggestions for possible anti-avoidance measures. It is interesting to see that the Revenue categorised the business expenses field as being a matter of tax-avoidance and promised to provide the Chancellor with a full analysis of the subject in preparation for the forthcoming Finance Bill.72 67 Adjusting for the RPI increase up to mid 2010, these ammounts are approximately £15.5 million, £232 million, £10.3 million and £124 million respectively. Thus, about £330 million was allowed for tax purposes in respect of employees alone. However, the net cost to the Exchequer would have been considerably less. 68 TNA: IR63/230 p 321, November 11, 1964. 69 fn 68. 70 fn 68, p 323. 71 fn 68, p 330. 72 TNA: T171/808, November 30, 1964.

Book 1.indb 237

12/2/2011 8:21:58 AM

238

David Stopforth

The full paper submitted to the Chancellor in February 1965 largely repeated, with a little more detail, the paper submitted to him the previous November. Additionally, it explored some of the difficulties of legislating to deal with the problem. It suggested that the main defence to any criticism would have to be on broad grounds of social policy. Perhaps because the Chancellor had said that complete disallowance of entertaining was rather harsh, the Revenue came up with a proposal to allow a deduction for meals taken within normal business hours and suggested that this was the best way forward because total disallowance or partial disallowance ‘would be hitting the innocent as well as the guilty’.73 The business lunch was seen as a component of the business day while dinners, theatres and weekend parties were more likely to be social occasions rather than business ones. They advised that even this approach could be attacked as unfair by the businessman who was so hard pressed that he had to go for working dinners as well as working lunches and by those whose businesses did not fit ordinary office hours. Furthermore, the Revenue warned that ‘taxpayers would also point to receptions and dinner parties given by Ministers in the evening as showing a necessity of entertaining outside normal business hours’.74 At this time, the Revenue were proposing that a self-employed person, or a company entertaining on its own account, would suffer a disallowance of entertaining, and that an executive would be taxed on expenses received and would suffer a disallowance of any expenditure on entertainment. It was realised that this would be harsh, particularly for subordinate employees instructed to entertain, but the Revenue could not immediately find a suitable let out for such cases. However, as will be seen later, the Chancellor insisted that a solution to this problem should be found. Although they had statistics of expenditure on entertainment by employees as a result of P11D returns, there was no information on the amount of other business entertaining. As a result, the Revenue were only able roughly to estimate the tax yield from the changes at a total of £15 million75 a year in the case of total prohibition, and about half this if the disallowance applied to everything other than meals in business hours. However, as they pointed out, the change was not being considered as a matter of revenue-raising but rather as a law imposing a restraint on luxury achieving rough justice by refusing a tax deduction on broad lines. There were two other incidental matters raised with the Chancellor. First, it was pointed out that his proposal to reduce the corporation tax rate would be open to strong criticism by those who were self-employed and who would suffer a disallowance but get no corresponding benefit. Secondly, as the proposals would have a considerable effect on the hotel and restaurant industry, the Chancellor was advised that he might wish to consult the President of the Board of Trade. 73

fn 68, p 336. fn 68, p 337. 75 Approximately £259 million in current day terms. 74

Book 1.indb 238

12/2/2011 8:21:58 AM

Restricting Tax Relief on Business Entertaining and Gifts: 1948–1965 239 The Revenue’s detailed paper was passed by the Chancellor to his Special Adviser on the Social and Economic Aspects of Taxation Policy, Nicholas Kaldor, who strongly approved of the total disallowance of entertaining expenditure, as this was one of the main aspects of the tax system which the public at large regarded as grossly unfair. However, he also thought that this approach could be defended on the grounds that if nobody entertained at all, the total amount of goods and services produced and sold by the business community in trade within the UK would be unaffected, except in the case of the entertaining industry which was effectively receiving a large subsidy from the Exchequer. He rejected the compromise solution of allowing expenditure on meals within specified hours as completely unenforceable. As regards export entertaining, Kaldor believed that an exclusion was necessary but that the proposal merely to allow a deduction would be wide open to abuse because ‘it could always be said that some foreign buyers or agents were present, even if the great majority of guests entertained had nothing to do with the export business’.76 Instead, he proposed that a proportion of the total expenditure on entertaining should be deemed to have been incurred in connection with exports according to actual export performance. The impracticalities of this suggestion seemed to have escaped him but the Chairman of the Board noted ‘I told NK I did not like his ideas’.77 However, it seems that Kaldor had already spoken to the Chancellor and persuaded him to adopt his suggestion. The Chairman of the Board’s rejoinder was to explain that Kaldor’s proposal would not only offend the General Agreement on Trade and Tariffs but would also be difficult to justify to those who were attempting to break into the export market. He felt that it would be essential in order to avoid criticism to allow a deduction for the entertainment of genuine foreign buyers and suggested that any potential for abuse could be minimised by requiring that the expenditure would only be allowable if it was on a reasonable scale having regard to the persons entertained. Additionally, powers would be taken to require details of each occasion on which foreign buyers were entertained and the form of that entertainment so each event could be justified on its merits. Although the Chancellor was persuaded by the Revenue’s arguments, he could see no difference in principle as regards GATT between Kaldor’s proposal and what the Revenue had put forward.78 The Chief Secretary supported the Revenue’s views on administrative grounds but thought it might be necessary to tighten the rules in future, or even withdraw the relief, and suggested giving a warning about excessive claims in the Budget Speech.79 The Revenue proposals eventually formed the basis of the relief for foreign entertaining included in the Finance Bill and the Chancellor decided on a complete disallowance of all other business entertaining. 76

fn 68, pp 346–7. fn 68, Handwritten note on p 345. 78 fn 68, p 355. 79 fn 68, p 357. 77

Book 1.indb 239

12/2/2011 8:21:58 AM

240

David Stopforth

As the changes would have an effect on many businesses, the Chancellor authorised a senior Treasury official to consult his counterpart in the Board of Trade.80 No objection was raised and the two civil servants decided that the matter was not to be mentioned to the President of Board of Trade until a few days before the Budget Cabinet Meeting.81 The exact manner of operation of the rules had still not been decided but the Chancellor told the Revenue that we would prefer any disallowance to affect the tax liability of the business rather than the executive.82 He left it to the Revenue to work out how this could best be achieved. The Revenue provided the Chief Secretary with a very detailed account of the various ways in which businesses and their employees met expenditure for entertainment and suggested the methods by which the disallowance should operate in practice.83 In all except two situations, it was straightforward merely to disallow the expense in the employer’s tax computation. Despite this disallowance, it was emphasised that it would still be necessary to enter the amount on form P11D, as otherwise the employer would be able to pay remuneration free of income tax and surtax by labelling it as entertaining. The Revenue were adamant that even if the employee also suffered a disallowance, for instance because he had not satisfied the strict rules for deduction, there would be no question of going back to adjust the employer’s liability merely because there was a net tax charge on the employee. To this extent there could therefore be an effective double disallowance. The two situations in which there would be no disallowance to the employer were when an expense allowance was paid to cover both entertaining and other business expenditure (a round-sum allowance) and where the employee was required to pay for entertainment out of his own salary without reimbursement. The Revenue believed there was no alternative in such cases other than to disallow the entertainment expenses for the employee. This was because they could not tell how much entertaining was done until they examined his expenses claim, by which time it would be impracticable to go back to the employer’s computation and make a disallowance. It was realised that this would put a heavy burden on individuals affected, but the Revenue suggested that, as a result, these methods of providing for entertainment would eventually wilt away. Although there is nothing on the files to indicate it, the Chief Secretary must have approved the Revenue’s proposals as they were reproduced in legal form in the Finance Bill. The die was cast and it only remained to get the provisions through a hostile Opposition in Parliament and face a barrage of criticisms and special pleadings from businesses and trade associations.

80

TNA: T171/808 March 4, 1965. TNA: IR63/230 p 351 March 10, 1965. 82 fn 81, p 344 83 fn 81, pp 358–360. 81

Book 1.indb 240

12/2/2011 8:21:58 AM

Restricting Tax Relief on Business Entertaining and Gifts: 1948–1965 241 CONCLUSION

Food rationing during WW2 no doubt added to the hostility towards conspicuous entertainment in restaurants and hotels. As rationing continued for many years after the war, resentment festered while no action was taken to stop the tax relief on business entertainment which, with such high tax rates, reduced its real cost very considerably. For some, the issue took on a moral aspect and the tone of some senior specialists in the Revenue showed their disgust with the situation and, in one case at least, displayed intense snobbery about the types of person who had moved into higher social circles as a result of obtaining tax relief on various forms of entertainment. Despite such strong pressure from below, the most senior Revenue officials did almost nothing to instigate change. This could be seen as a clear example of their passivity at that time and of how they seemed more concerned that the tax system should remain easy to administer and that the status quo should be maintained. As Daunton notes, they ‘acted as a dam holding back reform up to 1964’.84 However, it could also be argued that the most senior officials resisted the pressure from more junior specialists because their political antennae detected that this particular change would not be accepted by the Conservative Government of the time. They were merely being pragmatic. Increasing pressure to restrict relief for entertainment expenses can be traced back to the Memorandum of Dissent to the report of the Royal Commission in 1955, which was largely the work of Nicholas Kaldor.85 Although this may not have contained very practical suggestions about what could be done, it pointed the Labour Party towards promising to make changes to improve the fairness of the tax system and triggered their repeated criticism of the treatment of entertainment expenses in Parliament. It seems that it was only this criticism which prompted the Revenue to consider and analyse the issue in sufficient detail to form the basis of future policy. However, nothing came of it until Labour returned to power in October 1964, when the matter received immediate attention and any residual Revenue resistance melted away. Once the political climate had changed, the Revenue were able to use their previous comprehensive studies of the subject to produce detailed advice to the new Chancellor (James Callaghan). The fact that he had spent his earlier career working for the Revenue enabled him to quickly see the practicalities of the proposed changes so that he placed little reliance on Kaldor, whose influence was negligible. Virtually all aspects of the Revenue’s proposals were accepted by the Chancellor and, it is fair to say, they were the driving force in determining most of the policy underlying the clause on business entertaining expenses in the Finance Bill, 1965, as well as its details. Their success was due to the combination of political acuity, foresight and advance preparation which are some of the hallmarks of an effective tax administration. 84 85

Book 1.indb 241

Daunton, Just Taxes, (Cambridge University Press, 2002) p 280. fn 84, p 279.

12/2/2011 8:21:58 AM

Book 1.indb 242

12/2/2011 8:21:58 AM

9 History of the International Taxation of Income from Services ANGHARAD MILLER

ABSTRACT

T

HIS CHAPTER EXAMINES the treatment of cross-border trade in services in the development of the model tax conventions. The extent to which income or profits from services are covered by the conventions is considered in the light of information on the type and magnitude of cross border service flows which was available to those involved in their development. Conclusions are offered on the adequacy of the principles contained in the present day model conventions with regard to developments in world trade in services which have taken place since those principles were adopted.

INTRODUCTION

The value of world trade in commercial services exports was estimated1 at $3.78 trillion in 2008, compared to merchandise exports of $16 trillion.2 Exports of services other than transportation and travel amounted to $1935 trillion. According to Pascal Lamy, Director-General of the WTO,3 more than half of annual world foreign direct investment flows are now in services and the growth in trade in services in recent years has been more rapid than that in world production and merchandise trade. Despite the undeniable importance of services in current world trade the conventions according to which the tax base for profits and gains arising from international trade is allocated between 1

WTO, ‘International Trade Statistics’ (Geneva 2009). A trillion is defined as $1,000,000,000 000. 3 fn 1 above. 2

Book 1.indb 243

12/2/2011 8:21:58 AM

244

Angharad Miller

taxing jurisdictions are predicated largely on international trade in goods. Only transport and the services of entertainers and sportspersons have their own rules in the model tax conventions. The model tax convention on which most other model tax conventions are based, the OECD Model,4 is based largely on principles developed in the early part of the 20th century, before the invention of the modern computer, let alone the internet, and when air travel was in its infancy.5 The aim of this chapter is to consider the history of the treatment of international trade in services in the model tax conventions. At their inceptions, what consideration was given to the treatment of profits from trade in services? This, and the changing patterns of world trade in the 20th century will be examined in order to consider whether of not the model tax conventions, in their current forms, provide an adequate framework for the division between states of the tax base represented by profits from trade in services as well as from trade in goods. Versions of the model tax conventions up to and including the 1963 draft OECD Model Convention6 and the 1980 UN Model7 Convention are the primary focus.8 Questions of pricing and of attribution of profits to service activities are vitally important but are for another paper. The term ‘trade in services’ is used to mean cross border trade. Definitions in documents of the supra-national bodies concerned with trade in services are rather sparse. The blueprint for national accounts developed jointly by several of the supra-national bodies, the System of Nation Accounts 2008,9 states that services are the result of a production activity that changes the conditions of the consuming units, or facilitate the exchange of products or financial assets.

Shelp10 defines services as an extremely heterogeneous group of economic activities often having little in common other than that their principal outputs are for the most part intangible products.

4

OECD, Model Tax Convention on income and on Capital (OECD, Paris August 2010). The first commercial jet crossed the Atlantic in 1958, followed by a rapid increase in air traffic. G Jones, The Evolution of International Business (Routledge, London 1996) at p52. 6 OECD, Draft convention for the Avoidance of Double Taxation with respect to Taxes on Income and Capital (Paris 1963). 7 United Nations, Model Double Taxation Convention between Developed and Developing Countries (Geneva 1980). 8 There have been changes to the Commentary on the OECD Model regarding the taxation of services including, in 2008, the introduction of material designed to form the basis of a ‘deemed services permanent establishment’ but the Model itself has not changed with respect to services since 1963. The UN Model has not been changed with respect to services since its first publication in 1980. 9 Commission of the European Communities and others, System of National Accounts 2008 (New York 2009 (Note: the ‘others’ are the IMF, the OECD, the UN and the World Bank). 10 RK Shelp, Beyond Industrialization – Ascendancy of the Global Service Economy. (Praeger Publishers, New York 1981). 5

Book 1.indb 244

12/2/2011 8:21:59 AM

History of the International Taxation of Income from Services

245

Hill11 offers a simpler definition: that services change the condition of a good or a person. For another general definition of services which treats services as a residual, the wording of the EC VAT Directive could be used supply of services shall mean any transaction which does not constitute a supply of goods.12

Trade in services takes many different forms, amongst them: • Trade which is largely independent of trade in goods, such as educational services. • Trade in which services are substituted for goods, for instance, the licensing of computer software as a substitute for the purchase of a printed manual • Trade which is complementary to, and which facilitates trade in goods. Obvious examples would be transport and distribution, telecoms, repair and refurbishment services, education and training of client employees in the operation of plant, leasing of goods, marketing. To the extent that this category of services faces barriers to entry in foreign markets, in an indirect sense, such barriers represent non-tariff barriers to trade in goods. • Trade recorded as trade in goods but whose price reflects the fact that there is a significant integral service element. An example would be the sale of a computer by a US firm to a UK customer where the price includes a warranty and access to a technical helpline. As Arkell13 points out, in recent times the value added content of goods, especially in the computer and information technology markets, includes increasing proportions of service inputs, in the form of research and design, for instance, so that the material content by only account for a small proportion of the value of the item in question. It would be a splendid starting point for a study such as this to compare the proportion of world trade in goods with that in services at various points in the 20th century. Unfortunately, data on trade in services has always been inferior in coverage and reliability to that covering trade in goods, if it has been collected at all, although the situation has improved greatly in recent years.14 Figure 1 illustrates the importance of exports of services in recent decades and demonstrates that exports of services currently account for around 20 per cent of total world exports. Exports are used throughout this chapter when considering the quantum of trade in services: figures for imports are also available but the statistics are less reliable as data collection has been even less complete than for exports of services.

11

TP Hill, ‘On Goods and Services’ (1977) 23 The Review of Income and Wealth 315. Council Directive 2006/112/EC. 13 J Arkell, ‘Services Statistics: The Key Issues’. International Trade and Services Policy. 14 Usable datasets for trade in services only exist from 1980 onwards although incomplete data is available for some countries for some earlier years. 12

Book 1.indb 245

12/2/2011 8:21:59 AM

246

Angharad Miller

Figure 1: Worldwide exports of services expressed as a percentage of total exports of goods and services

services exports as a % total exports

25%

20%

all services 15%

transport travel 10%

other commercial services

5%

0% 1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

Source: data extracted from WTO International Trade statistics15

The Scale of Trade in Services via Foreign Subsidiaries and Branches Trade in services via foreign affiliates (FATS)16 is thought to account for the bulk of world trade in services.17 In its simplest form, this is where services are provided in a foreign country via an overseas subsidiary which is tax resident in the overseas country. However, collection of the data is in its infancy.18 Whether this predominance of trade in services via foreign affiliates has always been the case is not known, as trade by a foreign affiliate resident abroad has traditionally been accounted for in national accounts as domestic trade rather than exports. Few countries collect statistics on the domestic trade of affiliates of foreign enterprises or on the trade of foreign affiliates of domestic firms, although such a requirement has recently been introduced by the IMF.19 A notable exception is the US. The US is, and has always been, a leading exporter of services and the relationship of exports of services (via means other than foreign affiliates) to 15 WTO International Trade Statistics 2009, http://www.wto.org/english/res_e/statis_e/its2009_e/ its2009_e. 16 The term ‘affiliates’ is used in world trade literature to include both majority owned foreign subsidiaries and branches where there is a physical establishment. 17 On the basis that this is the case in the US: see R Marshall and S Matthew (eds), International Trade in Services and Intangibles in the Era of Globalization (Studies in Income and Wealth, University of Chicago Press, Chicago 2009) p 9. Currently only about 20 OECD members make returns of FATS statistics. 18 I13 OECD countries, including the US, currently report FATS statistics. 19 IM Fund, Balance of Payments Manual (5th edn IMF, 2003).

Book 1.indb 246

12/2/2011 8:21:59 AM

History of the International Taxation of Income from Services

247

sales of services by foreign affiliates is shown in Figure 2 in order to demonstrate the dominance of trade in services via foreign affiliates:20 Figure 2: Comparison of US exports of services made via foreign affiliates with US exports of services made by other means 1200

billions of dollars

1000

800

U.S. exports of services

Services supplied to foreign persons by foreign affiliates of U.S. companies

600

400

200

0 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Source: data derived from Table B, US International Services, Bureau of Economic Affairs21

The Belief that Services Were Not Tradable22 The overwhelming emphasis in the model tax conventions, and indeed in key texts on economic history23, has been on trade in goods. As well as the lack of statistics on the scale of trade in services, this emphasis may be at least partly explained by the fact that many services have traditionally been considered to be non-tradable. Before the advent of means of communicating remotely such 20 As an example of the unsatisfactory history of recording trade in services, the leap in services supplied via affiliates in 2004 shown in Figure 2 is due to the commencement of inclusion in the figures of services provided by bank affiliates and services supplied by majority owned non-bank affiliates of US banks. Until then, such services had been excluded from the statistics. Certain other methodological changes also contributed to the large rise in reported supplies of services by foreign affiliates. (see J Koncz-Bruner and A Flatness, ‘US International Services. Cross-border Trade in 2008 and Services Supplied Through Affiliates in 2007’ Survey of Current Business). 21 available at http://www.bea.gov/international/international_services.htm. 22 ‘Tradable’ in this context means trade between persons normally resident locations remote from each other and, for our purposes, cross-border. 23 See, for instance, RCO Matthews, FC H and O-S JC, British Economic Growth 1856–1973 (Studies in Economic Growth in Industrialized Countries, Clarendon Press, Oxford 1982).

Book 1.indb 247

12/2/2011 8:21:59 AM

248

Angharad Miller

as telegraph, telephone, telex and fax and the internet, the provision of services demanded a face to face contact which necessarily limited trade in services. For instance businessmen would keep their books of account themselves or else employ a clerk rather than engage a firm of accountants.24 Until relatively recently, services could only be traded internationally if either the purchaser travelled to the seller’s location or vice versa. Services were considered incapable of being stored but rather such that they were automatically consumed at the time of production.25 However, as technology has advanced, the range of services which can be offered has grown, so that a service provider can operate beyond the range of physical travel. Electronic office communications and technology and better access to finance have all enabled industry to grow which then has further increased the demand for many types of services from outside providers. The expansion of the service industries fuels the grow of other industries: for instance, through the expansion of the financial services industry, more finance is directed to those enterprises most likely to succeed and financiers impose valuable accounting and cash flow discipline on their customers, helping to ensure sustained success. As Hoekman and Mattoo observe,26 even those services which might not be immediately linked with economic growth, such as health and education, are vital for such growth in that they improve the stock and growth of human capital. More recently, the growth in computing technology and the internet has fuelled business expansion in existing industries whilst causing the development of an entirely new services sector. The provision of services no longer necessarily implies physical proximity between purchaser and seller. Modern telecommunications and information technology have enabled a vast range of services to be supplied cross border without the movement of natural persons. As noted by UNCTAD in a 2002 report on this topic27 this has major implications for growth in the economies of developing countries who may have abundant resources in the form of labour but lack the means to send workers abroad. In any case, such temporary migration is often further hampered by the immigration policies of potential customer states. In its report, UNCTAD identifies four key factors influencing the tradability of services: • Technical: informatisation28 and international standardisation 24 S Broadberry and S Ghosal, ‘From the Counting House to the Modern Office: Explaining Anglo-American Productivity Differences in Services, 1870–1990’ (2002) 62 The Journal of Economic History 967. 25 Some authors hold the view that a stored service is an intangible asset and the sale of such is the sale of an asset. 26 Hoekman and A Mattoo, ‘International Trade:Trade in Services’ in AT Guzman and AO Sykes (eds), Research handbook in International Economic Law (Edward Elgar, Cheltenham 2007). 27 UNCTAD,’The Tradability of Consulting Services and its Implications for Developing Countries’ (United Nations, Geneva 2002). 28 the term ‘informatisation’ is used to mean the transformation of a state. It is used with respect to information in a manner analogous to the adoption of the term ‘industrialisation’ with respect to industry. In general terms, it may be though of as the computerisation of society to the extent that the use of information technology becomes the dominant force in commanding economic, political,

Book 1.indb 248

12/2/2011 8:22:00 AM

History of the International Taxation of Income from Services

249

• Economic: transport and transaction costs, economies of scale and scope • Regulatory: trade agreements, national regulations • Markets and organisational: internationalisation of markets and firms It is the combined effect of these factors which has led to the vast increase in tradability of services in recent decades.

THE CURRENT TREATMENT OF SERVICES IN THE MODEL TAX CONVENTIONS

Before examining the historical development of the treatment of services in the model tax conventions, a brief review of the current provisions relating to services is appropriate. The 2010 version of the OECD Model Convention deals with profits from trade in services in several ways. Profits from trade in services carried out via a foreign subsidiary company (or other type of affiliate) which is resident in an overseas territory are dealt with by the rules governing company residence. Hence if a subsidiary company makes profits from the sale of services in the state in which it is resident, that state has the right to tax the profits on the principles of both source and residence. Where a foreign branch of an enterprise provides services in the state in which the branch is established, the profits from those services are taxable there under the source principle. Income from transport services and the income of sportsmen and entertainers have their own special provisions. The apparent dominance in trade in services of trade via affiliates does not mean that services are adequately catered for in the OECD Model Convention. Figure 2 illustrates that the increase in trade in services via foreign affiliates of US firms has been accompanied by an increase in the export of services delivered via other means. A significant proportion of this increase is thought to be accounted for by services supplied to fellow group companies resident in other countries or by the parent company to the foreign affiliate. The service provider in this type of trade is not a resident of the state in which the recipient is tax resident. A key feature of cross border trade in services as opposed to trade in goods is that it is possible to achieve a high value and volume of trade in services without the need for a foreign subsidiary or a permanent establishment (in the form of a fixed place of business) abroad. The OECD Model does not currently include a ‘services permanent establishment’ although wording is offered in the Commentary for those countries wishing to include such a provision. 29 social and cultural development and is typified by rapid growth in the speed, quantity and popularity of information produced and distributed: See, for instance, G Wang, Treading Different Paths: Informatization in Asian Nations (Norwood, NJ: Ablex, 1994).  29 Note that the wording follows that in the 2007 (fifth) Protocol to the US-Canada Convention of 26 September 1980 rather than that in the UN Model Convention.

Book 1.indb 249

12/2/2011 8:22:00 AM

250

Angharad Miller

The UN Model Convention30 extends the definition of permanent establishment beyond the fixed place of business form and the agency form to include the so-called ‘services permanent establishment’. Where an enterprise provides services for more than six months in any twelve months, profits from those services are deemed to be earned by a permanent establishment and thus taxable in the country where the services are rendered. Crucially, no fixed place of business is required. The UN Model also awards taxing rights to the source country in respect of the profits from supervisory activities in relation to construction permanent establishments. Independent personal services are still dealt with separately in the UN Model Convention, although such provisions were deleted from the OECD Model Convention in 2008 on the grounds that the matters contained in the relevant article (Article 14) were adequately covered by Articles 5 and 7.

SERVICES IN THE ORIGINAL MODEL TAX CONVENTION

Many authors have written on the origins of the OECD and UN Model Conventions.31 In this chapter, the emphasis is on the consideration accorded to trade in services in the development of the models. The sharp increases in tax rates necessitated by the First World War brought the issue of the need for double taxation relief to the attention of the International Chamber of Commerce which, in 1920, called for agreement between the governments of the Allies to prevent double taxation.32 The newly formed League of Nations recognised the need for coordination of policies in the taxation of foreign income and in 1928 produced a set of four model bilateral double tax conventions with accompanying commentaries.33 The underlying report from four leading economists34 which informed these conventions reveals that the taxation of international services was not explicitly considered in any detail. The 1928 draft conventions35 did not attempt to divide up the tax base of a company between the various states involved but rather they took a schedular approach, allocating primary taxing rights according to the type of income 30

United Nations Income and Capital Model Convention 2001. For example, see L Friedlander and S Wilkie, ‘Policy Forum: The History of Tax Treaty Provisions – and why it is important to know about it’ (2006) 54 Canadian Tax Journal. 32 MJ Graetz and M O’Hear, ‘Original Intent of U.S. International Taxation’ (1996) 46 Duke LJ . It is thought that Graetz is referring to the report International Chamber of Commerce, Paris ‘Double Taxation’ Brochure No. 11, 1921. 33 General Meeting of Government Experts on Double Tax and Tax Evasion, ‘Double Taxation and Tax Evasion’ (League of Nations, Geneva 1928) The four conventions dealt with (1) income and property taxes, (2) succession duties, (3) administrative assistance in taxation and (4) judicial assistance in tax collection. 34 League of Nations Document EE.F.S.73.F.19. 35 Three alternative formulations of a draft convention on the prevention of double taxation were offered. 31

Book 1.indb 250

12/2/2011 8:22:00 AM

History of the International Taxation of Income from Services

251

stream. Income from the provision of services was not identified as a separate income stream. In drafting the model conventions, the government technical experts who formed the Financial Committee of the League of Nations were, in general, more concerned with the method to be adopted to prevent or reduce double taxation than with the question of jurisdiction to tax.36 The 1928 draft model conventions which dealt with the prevention of double taxation all used the same definition of permanent establishment and this definition by now omitted affiliated companies, it having been decided that these were to be treated as independent legal entities capable of having their own fiscal domicile. There was no mention of services in the article dealing with permanent establishment, although it was noted in the commentary accompanying the draft conventions that states had the right to conclude special conventions in the case of persons engaged in a profession, employment or trade which necessitated crossing the frontier.37 Neither was there any provision allocating taxing rights over income from services of professionals such as architects or lawyers where such services were performed other than in the state where the person was resident. These omissions are, at first glance, understandable, given the patterns of international trade and investment in the early part of the twentieth century. Rather than reflecting any significant degree of integration of international activities, the growth in foreign profits of most countries stemmed largely from mining of minerals and the production of raw materials. Jones38 estimates that by 1914 at least three-quarters of world foreign direct investment was concerned with the exploitation of natural resources. Dunning,39 reports that Britain accounted for the majority of all foreign investment in the world in the period leading up to the First World War.40 Although trade in goods dominated in the 1920s, the lack of provision for profits from trade in services in the League of Nations’ first Model Conventions is less understandable in view of the fact that the two dominant trading powers in the world in the first few decades of the twentieth century, the UK and the US, maintained statistics for trade in services, unlike most countries41. Thus they would have known the importance (or lack of it) of trade in services relative to trade in goods. Data from the US indicate that for most of the 1930s, the ratio of 36 The composition of this Committee is of interest: eventually it included representatives from Venezuela, Poland, Czecho-Slovakia, China and Roumania amongst others, so that it was not merely composed of representatives of the major trading nations at that time. 37 See fn 33 above at p13. 38 G Jones, The Evolution of International Business (Routledge, London 1996) 32. 39 Dunning, JH ‘Changes in the Level and Structure of International Production: The Last One Hundred Years’ in M Casson (ed) The Growth of International Business (George Allen & Unwin, London, 1983). 40 Although Jones (fn 38 above) has updated Dunnings’s original estimates and puts the proportion at 45%. 41 Although the UK’s figures for trade in services were amalgamated with those for foreign investment income and government transfers, to form the category ‘invisibles’.

Book 1.indb 251

12/2/2011 8:22:00 AM

252

Angharad Miller

imports and exports of services (including transport services) as a percentage of total imports and exports was about 20 per cent.42 Because few other countries maintained statistics on trade in services it is difficult to prove the dominance of the UK and US in respect of trade in services in the 1920s and 1930s but the dominance of these two countries in exports of goods is demonstrated in Figure 3. Figure 3: World exports of goods 1928 and 1928 by the major political groups 45% 40% 35%

1928 1938

30% 25% 20% 15% 10% 5%

Portugal and her oversea territories

Spain and her oversea territories

Italy and her oversea territories

Belgium, Belgian Congo and RuandaUrundi

Netherlands and her oversea territories

France and her oversea territories

United States and her oversea territories

British Commonwealth of Nations

All other countries

0%

Source: data taken from The Network of World Trade43

Even without the aggregation of trade by political groupings, the US and the UK were still the pre-eminent exporters of goods, as shown in Figure 4

42 Data from http://www.bea.gov/national/nipaweb/csv/NIPATable.csv?TableName=128&FirstY ear=1900&LastYear=2011&Freq=Year accessed October 2010. 43 Economic Intelligence Service. The Network of World Trade (II Economic and Financial 1942 II A3, League of Nations, Geneva 1942).

Book 1.indb 252

12/2/2011 8:22:00 AM

History of the International Taxation of Income from Services

253

Figure 4: World exports of goods 1928 and 1938 by individual country/region 18% 16% 14% 12% 10%

1928 1938

8% 6% 4% 2%

a er m an y Eu ro pe Fr an ce SE As In ia di a, Bu Can ad rm C a hi ,C a na ey & lo co n nt in en Afri ca al As Ja ia pa tic n, s O Ko ce re Be an a ia ,F lg iu or m m /L os ux em a bo N ur et g he rla nd s C ze ch Ita oly Sl ov ak i Sw a ed en U Sw SSR itz er la nd Au st ri a O

G

th er

er ic

U K La tin

Am

U S

0%

Source: Data from The Network of World Trade

Transport Services in the 1928 Draft Model Conventions As early as 1819, the Netherlands had realised the futility of trying to calculate and then tax the profits made by the operation of ships owned by foreign enterprises in Netherlands waters and thus passed a law44 which granted exemption from Netherlands tax provided the country which owned the vessels granted a reciprocal exemption to Netherlands shipping profits. The principle of reciprocal exemption with respect to the shipping industry was recommended to the Financial Committee of the League of Nations by the International Chamber of Commerce45 and was duly adopted in the 1928 draft model conventions so that only the State in which the transport enterprise had its real centre of management could tax its profits. This general principle has been adhered to ever since. The topic of taxation of transport services is not examined in further detail in this chapter as it is a specialised subject in itself.

44

Netherlands Law of May 21st, 1819. Technical Experts to the Financial Committee of the League of Nations, ‘Double Taxation and Tax Evasion’ (League of Nations, Geneva 1925) p 8. 45

Book 1.indb 253

12/2/2011 8:22:01 AM

254

Angharad Miller

SERVICES IN THE LONDON AND MEXICO DRAFTS46 OF THE LEAGUE OF NATIONS MODEL TAX CONVENTION

Following the publication of the 1928 draft model conventions, the League of Nations continued to work to refine the model convention most widely adopted.47 The Mexico Draft, published in 1943, may be viewed as the precursor to the UN Model Tax Convention in that it incorporates certain features including taxation of services, which benefit capital importing countries (as opposed to capital exporters). In particular, the nexus required before an enterprise may be taxed on any of its profits in a foreign country differed significantly from that in the 1928 draft models and the London Draft, which was published in 1946, even though the London and Mexico drafts both acknowledged that business profits of a foreign enterprise should not be taxed by the source country unless some minimum standard of nexus was met. That standard varied between the two: the wording of the Mexico Draft permitted the taxation of income from services without the requirement for a fixed place of business in the other state. The Mexico Draft is interesting in that it signalled the engagement of the major Latin American economies in the debate. Latin American countries have always placed heavy reliance on taxation on the source principle. None of the Latin American countries had been heavily involved in the development of the 1928 model conventions although there had been some representation in the latter stages of discussions48. Carroll49 explains their sudden involvement as resulting from a realisation that in the post-war period, developing countries of the Western Hemisphere would undergo industrial and commercial expansion. At the Mexico conferences, nearly all the participants were from Latin America and most participants favoured exclusive source taxation. Going further, they expressed a preference for the right to tax where the business or activity is carried out, without having to cross the threshold of having a permanent establishment. The relevant texts concerning the taxation of business income are compared in Table 1 (author’s emphases).

46 Fiscal Committee, ‘London and Mexico Model Tax Conventions Commentary and Text’ (League of Nations, Geneva 1946) Note that the Mexico draft is sometimes referred to as the 1943 League of Nations model and the London draft as the 1946 model. 47 Convention (a) (see fn 33 above), which recognised the importance of residence and adopted a schedular approach to the division of the tax base. A further draft appeared in 1935 which contained some specific provisions on the allocation of the taxation of the profits of banks and insurance companies having a permanent establishment in another state. These provisions were carried through to the London and Mexico drafts. 48 Argentina and Venezuela. 49 MB Carroll, ‘International Tax Law: Benefits for American Investors and Enterprises Aborad’ (1968) 2 International Lawyer.

Book 1.indb 254

12/2/2011 8:22:01 AM

History of the International Taxation of Income from Services

255

Table 1: Comparison of Article IV, London and Mexico Drafts Mexico Draft Income from any industrial, commercial or agricultural business and from any other gainful activity shall be taxable only in the State where the business or activity is carried out. If an enterprise or an individual in one of the contracting States extends its or his activities to the other State, through isolated or occasional transactions, without possessing in that State a permanent establishment, the income derived from such activities shall be taxable only in the first State

London Draft Income derived from any industrial, commercial or agricultural enterprise and from any other gainful occupation shall be table in the State where the taxpayer has a permanent establishment. If an enterprise in one State extends its activities to the other State without possessing a permanent establishment therein, the income derived from such activities shall be taxable only in the first State

The definition of a permanent establishment appears in the protocol to both drafts and is identical in both drafts. It contains no mention of services and focuses on the presence of a fixed place of business. The key difference is that the Mexico Draft is less reliant on the existence of a permanent establishment. Regular business activity in a state would be capable of being taxed there despite the absence of a permanent establishment, as defined. Thus, arguably, the provision of services other than on an isolated or occasional basis could be taxed by the state in which the services were performed even if there was is no permanent establishment, as defined. By contrast, the London Draft is more tightly worded: without the existence of a permanent establishment, as defined, there can be no right to tax business income. The Commentary on the two draft conventions 50 explains that the intention behind the wording of the Mexico Draft was to prevent the loss of revenue to states through the conduct of business activities there by foreign enterprises which did not have a permanent establishment. Specifically, it was considered that a ‘bright line’ test of permanent establishment might encourage avoidance by enterprises arranging their business affairs so that they fell just short of a permanent establishment or by enterprises concealing the existence of permanent establishments. These arguments supporting the wording of the Mexico Draft were not well received by the Fiscal Committee meeting in London in 1946, which observed that most double tax agreements concluded to date contained the permanent establishment criterion as the standard nexus requirement for the taxation of business profits. The overriding concern of the Committee was the prevention of double taxation rather than the prevention of tax evasion, which was considered to be an administrative matter. In any case, concealing the existence of a permanent establishment would merely shift the tax liability back to the 50

Book 1.indb 255

League of Nations Document C.88.M.88.1946.II.A at 4321.

12/2/2011 8:22:01 AM

256

Angharad Miller

country of residence, thus not facilitating tax evasion for the enterprise as a whole (although the Fiscal Committee did not acknowledge that there might be considerable tax savings where the rates of tax in the residence country were lower than that in the country where the concealed permanent establishment was situated). The Fiscal Committee also considered that ‘past experience was said to show that it is extremely difficult to tax foreign enterprises efficiently and equitably when they do not possess a permanent establishment in a country’.51

Income from Personal Services in the London and Mexico Drafts Article VII of both the London and Mexico Drafts specifically dealt with income from personal services and introduced the concept, for the first time, that remuneration for personal services should be taxable only in the country where the services are rendered. This was made subject to the requirement that the person must have spent at least 183 days in the other state. The 183 days requirement is still currently used in many treaties. The London and Mexico drafts both distinguished income of professionals from income from employment, stating that Income derived by an accountant, an architect, a doctor, an engineer, a lawyer or other person engaged in the practice of a liberal profession shall be taxable only in the contracting State in which the person has a permanent establishment at, or from, which he renders services.52

Interestingly, the standard of nexus adopted was ‘permanent establishment’ rather than the more recent ‘fixed base’. The Mexico draft also included specific provision for the taxation of the fees paid to directors, managers and auditors, stating that such fees are taxable only in the state where the enterprise has its fiscal domicile. Similar provisions appear the many treaties today which are based on the UN Model. This separate provision was deleted from the London Draft on the grounds that these items ‘did not appear to call for special rules and could be conveniently covered by the general provisions of the article relative to the remuneration from personal services and private employment’.53

51 League of Nations document C.37.M.37.1946.II.A: Fiscal Committee – Report on the Work of the Tenth Session of the Committee held in London form March 20th to March 26th, 1946 at page 14. 52 fn 46 above at Article VII (Mexico draft). Also Art VI para 4 of the London Draft. A minor difference between the two drafts is that the Mexico draft refers to a person engaged in the practice of a liberal profession, whilst the London Draft merely refers to a person ‘engaged on his own account in the practice of a profession’. 53 fn 46 above: footnote to Commentary on Article VI, London Draft. Note that following the end of the Second World War, the composition of the membership at the meetings of the League had shifted back to Europe and the US, ending the dominance of the South American members.

Book 1.indb 256

12/2/2011 8:22:01 AM

History of the International Taxation of Income from Services

257

SERVICES IN THE DEVELOPMENT OF THE 1963 DRAFT OF THE OECD MODEL

The London and Mexico Drafts prevailed until the first report of the Fiscal Committee of the Organisation for European Economic Cooperation (OEEC) was published in 1958.54 This report contained a proposal to develop a further Model Convention by 1961 and contributed four draft Articles for inclusion in such a Convention, including the permanent establishment article.55 The Committee adopted the approach of the London Draft, of permitting taxation of the profit of a foreign enterprise only if a permanent establishment existed. Considerable differences in the definition of a permanent establishment in the network of bilateral treaties amongst Members were noted, and a standard text was proposed. The stated object was to achieve much greater certainty, as well as making the work of the national tax authorities easier.56 The wording of the permanent establishment article which was proposed is easily recognisable as the forerunner of Article 5 in the current OECD Model Tax Convention and does not mention services. A fairly extensive Commentary was provided on this article. The first point to note is that the Committee considered that the essential characteristic of a permanent establishment was a fixed place of business.57 This indicates that the Committee did not consider that the provision of services with no such fixed place could give rise to a permanent establishment.58 The difficulties experienced in any country, except that of their tax residence, of taxing service providers was noted and the fact that each state would have sole right to tax itinerants residing therein was considered adequate compensation. A draft of the Model was published in 1963 with the Model finally being adopted in 1967.59 The Model made no reference to services in Articles 5 (permanent establishment) or 12 (royalties) but included a provision for taxation of independent services by the host state where there was a ‘fixed base’ and provided that royalty income should be taxable in the residence state only. The provision within Article 5 regarding building sites, construction or assembly projects made no reference to any supervisory services which might be provided in connection with such a site.

54 The elimination of double taxation. OECD Fiscal Committee. Report of the Fiscal Committee of the OEEC Paris September 1958. 55 (the others being the taxes to be covered by double tax agreements, the concept of fiscal domicile and the matter of tax discrimination on grounds of nationality). 56 fn 54 above, at para 28. 57 fn 54 above at para 1, p 45 (Annex B: Commentary on the Article on Permanent Establishment). 58 There was some consideration of itinerant merchants, pedlars and watermen, but it was considered that such persons would be subject to tax in the country of residence and therefore a special provision to deal with them was deemed unnecessary. 59 By that time, the Fiscal Committee had been reconstituted as the Committee on Fiscal Affairs within the OECD For an excellent description of the way the OECD’s work on taxation is organised, see HJ Ault, ‘Reflections on the Role of the OECD in Developing International Tax Norms’ (2008–9) 34 BrookJInt’l L.

Book 1.indb 257

12/2/2011 8:22:01 AM

258

Angharad Miller

There is no public record of the question of the taxation of services being raised again at the OECD until the discussions which led up to the publication of the 2005 and 2008 versions of the OECD Model Tax Convention.

Independent Personal Services in the 1963 Draft OECD Model At the second meeting of the Committee in 1959,60 amongst the articles presented for consideration was the article concerned with personal services. The Committee noted that existing conventions had abandoned the principle that the right to tax such services lay with the residence State and had awarded taxing rights to the State in which the services were performed. To achieve a measure of standardisation, the concept of a ‘fixed base’ was introduced which replaced ‘permanent establishment’ for the purposes of allocating taxing rights for personal professional services. Independent personal services now merited their own separate article. The Commentary explained the adoption of the concept of a fixed base as being necessary so as to ensure that the concept of a permanent establishment was reserved for commercial and industrial (as opposed to professional) activities. Curiously, with reference to the term ‘fixed base’, the Commentary states that ‘it has not been thought appropriate to try to define it’61 although certain examples were given, such as a physician’s consulting room or the office of an architect of a lawyer. The requirement for 183 days physical presence in the other state was removed with respect to independent personal services,62 but retained in the separate Article dealing with salaries and wages. In the case of income from the services of public entertainers and athletes, special rules were developed in the 1963 draft of the OECD Model Convention.63 Regardless of tax residence, such persons were to be taxed where the services were performed. The reason given for this departure from the general rules governing personal services was simply to avoid the practical difficulties which were encountered in taxing these people.

Conclusions on the Treatment of Services in the 1963 Draft of the OECD Model The 1963 Draft Model preserved the principle that profits from transport enterprises should be taxable only in the country in which the effective place of management was to be found. It introduced a new provision dealing with artistes and athletes and kept a special provision for the taxation of directors’

60

2nd Report of the Fiscal Committee of the OEEC, ‘The Elimination of Double Taxation’ (1959). fn 60 above P39 para 2. 62 But note that it remains today in the UN Model Convention and in many existing treaties. 63 fn 60 above P41 para 11. 61

Book 1.indb 258

12/2/2011 8:22:02 AM

History of the International Taxation of Income from Services

259

fees. However, the use of the source principle with reference to enterprise services was eschewed unless there was a fixed place of business. To form any conclusions as to whether this stance was reasonable it is necessary to consider what was known about the nature and extent of cross-border service trade at the time. Data from the statistical agencies in the UK and the US indicate that in the US, exports of services excluding transport, travel, royalties and licence fees totalled 2 per cent of all exports (the figure for 2009 was 14.9 per cent).64 Equivalent data for the UK is not so readily available, but total exports of services in 1963, including transport, accounted for 25 per cent of total exports.65 More information is needed on the detailed trade statistics but it is notable that the only type of services to receive special treatment in this Model besides transport services were the services of artistes and athletes. It seems unlikely that the value of such services was substantial in comparison to the value of cross border services being provided by commercial enterprises. The most likely explanations for the omission of specific provisions dealing with the right to tax income from enterprise services are that a) the statistics of most OECD members on trade in services at that time were incomplete or non-existent and b) services were not regarded as tradable cross-border, nor was there any expectation that they would become so.

A Note on Developments Regarding Taxation of Services in Subsequent Versions of the OECD Model No paper of the taxation of services would be complete without mention of the inclusion in the Commentary on the 2008 version OECD Model of some material relating to services. This version of the Commentary offers wording for a deemed services permanent establishment within Article 5 but in the most reluctant of terms. The OECD Model still does not include a services permanent establishment in its text. The Commentary notes, at some length, the administrative difficulties of taxing services provided by foreign residents in the absence of any fixed place of business. It then goes on to note that 42.14 Some States, however, are reluctant to adopt the principle of exclusive residence taxation of services that are not attributable to a permanent establishment situated in their territory but that are performed in that territory… 42.16 These States are concerned that some service businesses do not require a fixed place of business in their territory in order to carry on a substantial level of business activities therein and consider that these additional rights are therefore appropriate.

64 Data from Bureau of Economic Analysis US International Transactions Data Table 1. Released March 16, 2010. 65 CH Feinstein, Statistical Tables of National Income, Expenditure and Output of the UK 1855– 1965 (Cambridge University Press, Cambridge, 1972).

Book 1.indb 259

12/2/2011 8:22:02 AM

260

Angharad Miller

The wording for a deemed services permanent establishment offered in the Commentary does not follow the wording adopted in 1980 by the UN Model (see the next section) but rather follows that adopted in the 2007 (Fifth) Protocol to the US-Canada Double Tax Treaty of 1980.66 The material in the Commentary dealing with services does not provide any in-depth treatment of the rationale for the taxation of profits from services provided by non-residents, nor does it acknowledge the developments in provision of cross border services in terms of scale and ease of provision or the developments in the liberalisation of trade in services which took place in the 1990s.

SERVICES IN THE UN MODEL TAX CONVENTION

Around the time that the OECD Model was first published in final form in 1977,67 the United Nations (UN) mobilised its resources to consider whether the OECD Model was suitable for use in the negotiation of bilateral double tax treaties between developing and developed countries. The text of the UN Model Convention, first published in 1980, has always included the concept of a deemed services permanent establishment. It has also continued to include a separate Article 14 dealing with independent personal services whereas this article was removed from the 2008 OECD Model. The Mexico Draft of the League of Nations model might be considered to represent the needs of developing countries better than the London Draft. That is was largely ignored in favour of the London draft in the development of the 1963 draft OECD Model is a result of the initiative in developing a model treaty being taken over from the League of Nations by the OEEC.68 The UN came into being

66

See para 42.23 of the Commentary on Article 5, OECD 2008: Notwithstanding the provisions of paragraphs 1, 2 and 3, where an enterprise of a Contracting State performs services in the other Contracting State a) through an individual who is present in that other State for a period or periods exceeding in the aggregate 183 days in any twelve month period, and more than 50 per cent of the gross revenues attributable to active business activities of the enterprise during this period or periods are derived from the services performed in that other State through that individual, or b) for a period or periods exceeding in the aggregate 183 days in any twelve month period, and these services are performed for the same project or for connected projects through one or more individuals who are present and performing such services in that other State the activities carried on in that other State in performing these services shall be deemed to be carried on through a permanent establishment of the enterprise situated in that other State, unless these services are limited to those mentioned in paragraph 4 which, if performed through a fixed place of business, would not make this fixed place of business a permanent establishment under the provisions of that paragraph. For the purposes of this paragraph, services performed by an individual on behalf of one enterprise shall not be considered to be performed by another enterprise through that individual unless that other enterprise supervises, directs or controls the manner in which these services are performed by the individual. 67 OECD, Income and Capital Model Convention (Paris 1977). 68 This body (now the OECD) was created in 1948 as an adjunct to the Marshall plan which was set up to revive the economies of Europe in the aftermath of the Second World War. See

Book 1.indb 260

12/2/2011 8:22:02 AM

History of the International Taxation of Income from Services

261

in 1945 as successor organisation to the League of Nations. By the mid-1970s, the 1963 OECD draft model had been widely adopted by developed countries and in particular by the members of the OECD. This meant that developing countries,69 not being OECD members, had no say in the development or amendment of the provisions of the OECD Model which broadly favoured capital exporting countries. Disquiet with this state of affairs led the UN to put in place structures which would address the deficiencies of the OECD Model for developing countries and which would result in an alternative model tax convention. The need to address the issue of income from services of enterprises was acknowledged at an early stage in the development of the UN Model. In considering the treatment of international services provided by enterprises, the Secretary General, in his Report to the Second meeting of the UN Group of Experts concluded that commercial or industrial services of the magnitude then being provided was a comparatively recent development and noted that the 1963 OECD Draft Treaty did not mention this form of business activity.70

The Definition of Permanent Establishment in the UN Model An ad hoc group of experts on taxation was set up to develop the UN’s model treaty. The whole question of the degree of nexus needed to justify taxation of the trading income of a non-resident enterprise was debated, and these deliberations included the question of the taxation of income from cross-border services. Attempting to define the level of activity in a foreign country in general terms which might justify the imposition of tax, this group noted71 that under US law, a foreign enterprise became subject to tax in the US if it was engaged in trade or business there and derived income subject to tax from US sources. ‘Engaging in trade or business’ had no statutory definition but had been held by the courts to require progression, continuity or a sustained activity. It was noted that under US law, engaging in a single large transaction or a few isolated and unconnected transactions did not normally amount to the exercise of a trade or business in the US. The country practices in a number of other countries were

MJ McIntyre, Developing Countries and International Cooperation on Income Tax matters (unpublished manuscript, 2003). 69 A definition of what is meant by a ‘developing country’ is beyond the scope of this work. For convenience, the term ‘developing country’ is taken to mean any country classified as either ‘low income’, ‘lower middle income’ or upper middle income’ by the World Bank which basis its classifications principally on measurement of gross national income per capital: see http://web. worldbank.org/WBSITE/EXTERNAL/DATASTATISTICS/0,,contentMDK:20421402~pagePK:641 33150~piPK:64133175~theSitePK:239419,00.html last accessed 5 October 2009. The only original member of the OECD to fall into ‘developing country’ classification was Turkey. 70 fn 77 below at page 37. 71 Department of Economic and Social Affairs,’First Report of the Ad Hoc Group of Experts’ (Tax Treaties between Developed and Developing Countries, United Nations, New York 1969)at para 99.

Book 1.indb 261

12/2/2011 8:22:02 AM

262

Angharad Miller

examined. For instance, the UK made the distinction between doing business ‘with’ the UK and doing business ‘within’ the UK, with only the latter denoting a permanent establishment. The French practice was to tax business profits where there was habitual activity in France, where salaried employees were maintained in France or where the foreign investor carried out a complete commercial cycle of buying and selling in France, whether or not the foreign investor maintained a French establishment. The practices of a selection of developing countries were also reviewed. In the cases of Brazil and Mexico, it was noted that the power to tax the business profits of foreign enterprises was not wholly dependent on the existence of a fixed place of business. Interestingly, it was considered that the Indian ‘business connection’ doctrine, under which India awards itself the power to tax the profits of foreign persons who have a business connection with India, substantially extended the reach of Indian taxation. The term ‘business connection’ was understood to encompass any continuous relationship between a business carried on in India and a non-resident, who derived income through that connection. Reservations by the developing countries on the adoption in their tax treaties of the permanent establishment threshold for the taxation of business profits were noted, based on the fear that even with suitable modifications, foreign enterprises might devise ways of earning profits in the developing countries which were excluded from the host countries’ tax jurisdictions by reason of the definitions of permanent establishment laid down in the tax treaties.72 In contrast to the discussions leading to the development of the OECD model Convention, the question of the taxation of services was specifically considered. If profits from services provided by enterprises are included in the treaty definition of business profits, then the host state may only tax these profits if they are attributable to a permanent establishment. Further, if they are classed as business profits, then the only basis of taxation of these profits available to the host state is taxation on the net basis. On the other hand, if such profits are excluded from the definition of business profits, then the host state may tax them regardless of whether or not they are attributable to a permanent establishment and may choose the basis upon which to tax them, giving it the opportunity to levy tax on the gross amounts charged for the services.73 The exclusion of certain types of income from the definition of a permanent establishment may be viewed as a lack of protection from host country taxation for the foreign enterprise. 72 fn 71 above at para 145. Note that similar concerns had been raised in the discussions leading up to the Mexico Draft. 73 Thus a country such as India, well known for a wide interpretation of the source concept, defined the term ‘industrial or commercial profits’ in its treaty of 11 February 1965 with Greece, so as to exclude income in the form of rents,, royalties, interest, dividends management charges, remuneration for labour or personal services or income from the operation of ships or aircraft. By so doing, India reserved for itself the right to tax Greek residents on these items of income in the absence of an Indian permanent establishment and, if it so chose, to tax them on the gross basis.

Book 1.indb 262

12/2/2011 8:22:02 AM

History of the International Taxation of Income from Services

263

The definition of business profits was considered at some length at the first meeting of the Ad Hoc Group of Experts.74 It was noted that the OECD Model Convention did not contain such a definition.75 Income from services was examined and it was concluded that, as the OECD Model contained a separate article dealing with the rendering of independent personal services, so that these were taxable if supplied from a fixed base, then it would be appropriate to include within the definition of business profits, profits earned through the supplying of personal services of others. For guidance, the Group of Experts studied twenty two existing treaties, of which three distinguished management charges from personal services.76 Two excluded management charges from the definition of industrial or commercial profits; one went no further than this, leaving management charges governed purely by domestic law, whilst another exempted them from tax if earned through the permanent establishment. The third simply included them in the definition of business profits. A discussion of the various rules in use for determining the source of income makes reference to service fees paid by a resident of one country to a resident of another. Although most countries regarded the source of income as the place where services were rendered, a few taxed according to the place where the services were used, which could lead to double taxation. In such cases, the matter would need to be dealt with in the appropriate treatyThe taxation of enterprise services, defined as services rendered by corporations, was considered in depth at the second meeting of the Group of Experts.77 In the report of the Secretary-General to the Group of Experts which forms part of this report78 the growing importance of this type of business was noted, with management companies, companies engaged in equipment leasing and construction and engineering firms being cited as examples of firms almost wholly engaged in the provision of services. It was also noted that virtually all large enterprises operating internationally imparted technical and managerial knowledge to overseas affiliates and unrelated licensees and many had service centres set up in strategic geographic locations. A fundamental question debated was whether or not enterprises are capable of rendering independent personal services.79 It was reported that a rather obscure case had been heard in Scotland80 which indicated that the UK’s position would be that an enterprise, in its collectivity, carried on a trade rather than a profession and would therefore be considered incapable of rendering independent personal services. This meant that the income from services provided by enterprises would

74

fn 71 above. fn 71 above , at para 17. 76 Norway-Ceylon. Trinidad and Tobago-UK, Brazil-US. 77 Department of Social and Economic Affairs, ‘Second Report of the Ad Hoc Group of Experts’ (Tax Treaties between Developed and Developing Countries, United Nations, 1970). 78 fn 77above at p 37. 79 It is questionable whether the word enterprise even describes an entity or whether it describes an attribute. 80 CIR v Peter McIntyre Ltd, 12 TC 1006. 75

Book 1.indb 263

12/2/2011 8:22:02 AM

264

Angharad Miller

have to either be classed as business profits, dealt with under separate specific provisions, or not dealt with at all. In this last case, the income would fall under the ‘other income’ article. Article 21 ‘Other Income’ provides that any income not covered by other articles of the treaty may be taxed by the state where the taxpayer is resident and also, if it arises in the other contracting state, by that other state. Thus ‘other income’ may be subject to taxation by the host country using whatever methods and rates are set out in domestic law. If a country’s domestic law permitted taxation on the gross basis, then income from enterprise services might suffer tax on that basis if treated as ‘other income’.81 The consequences of omitting any specific provisions with respect to enterprise services were considered. In the 1960s, it was common for treaties to specifically exclude independent personal services from the definition of business profits. The Secretary-General’s report82 noted that these exclusions tended to refer to ‘labour or personal services’. This was thought to suggest that those drafting the provisions had in mind services rendered by individuals rather than by enterprises. Problems were foreseen if independent personal services were specifically excluded from the definition of business profits but the business profits article was then silent on the matter of enterprise services. One interpretation would be that profits from income from enterprise services was to be treated as business profits, and thus only taxed in the host state if connected with a permanent establishment there. An alternative interpretation and one which is far less satisfactory is as just discussed: that it falls into ‘other income’. A few treaties were specific on this issue: the Netherlands-US Treaty of 29 April 1948 (as amended by the 1965 Protocol) defined ‘industrial or commercial profits’ as …income derived from the active conduct of a trade or business, but does not include income dealt with in Article VII (dividends), Article VIII (interest), Article IX (royalties), Articles V and X (income from real property and natural resources), Article XI (capital gains) and Article XVI (personal services), other than income described in Articles VII, paragraph 3, VIII, paragraph 2, IX, paragraph 3 and XI, paragraph 2. The term ‘industrial or commercial profits’ includes profits derived by an enterprise from the furnishing of services of employees or other personnel. (Article III Para5 of the Protocol of 30 December 1965).

Thus in this treaty, income from independent personal services was excluded from business profits, whilst that from enterprise services was specifically included. Similar provisions existed in the Germany-US Treaty of 22 July 1954, as amended by the Protocol of 17 September 1965.83 In its consideration of the scope of 81 note that the OECD Model does not permit taxation of ‘other income’ except by the country of tax residence. 82 fn 77 above at p38. 83 Finer distinctions were not unknown: for instance, the Philippines-Sweden Treaty of 12 April 1966 distinguished between the furnishing of personal services by enterprises (treated as business profits) and income from the performance of personal services (not treated as business profits). The effect of this distinction, read with the articles of this treaty concerning business profits and

Book 1.indb 264

12/2/2011 8:22:03 AM

History of the International Taxation of Income from Services

265

the business profits definition, the Secretary-General’s report to the second meeting of the Group of Experts84 notes that enterprise services are frequently performed in the state of residence of the provider and only the results of the services are communicated to the recipient. On the other hand, certain services are normally provided in the state where the recipient is resident. If developing countries wished to exclude services from the definition of business profits, then they should be prepared to limit their domestic tax laws so that only profits from services performed in their territory by non-residents would be taxed.

The Germination of the UN Services Permanent Establishment Concept The Secretary General’s Report to the Second meeting of the Ad Hoc Group of Experts,85 acknowledged the inconsistency in excluding enterprise services from the definition of business profits, given the existence of corporations exclusively or predominantly engaged in the provision of services and the legal characterisation in many countries of income from services as industrial and commercial profits. However, to include services in the definition of business profits would preclude a developing company from taxing income from services provided by non-resident enterprises (either under the ‘other income’ provision or under some other special provision) unless a permanent establishment in the sense of a fixed place of business. existed. A compromise was suggested whereby the permanent establishment definition might be expanded to include income from enterprise services in the case of substantial services where the provider had no fixed place of business in the country of provision. The substantiality could be measured in terms of duration and/or the amount paid for them. This appears to be the first hint of the well known provision in treaties based on the UN Model, that profits from the furnishing of services may be taxed by the host country if such provision lasts for ‘six months in any twelve month period’.86

income from personal services, was to permit source state taxation of profits from the furnishing of enterprise services so long as there was a permanent establishment, as defined in Article 5. Article 5 of this treaty did not contain any specific mention of services so that the profits from the furnishing of services could only be subject to taxation by the source state if a fixed place of business or a dependent agent existed there. Article 13, ‘Income from Personal Services’, contained provisions which exempted income from the performance of personal services by the source state provided certain time based limits (183 days in the year) or certain monetary limits were not breached. Neither would an individual performing personal services in the other state be taxable there if he performed those services as an employee of a resident of his home state. Whilst the precise distinction between ‘furnishing of’ and ‘performance of’ personal services is not set out, this exclusion from Article 13 of services provided by employees of enterprises resident in the other state suggests that the type of personal services to be treated as giving rise to business profits were those provided by employees, as opposed to those provided by a sole trader or partner. 84

fn 77 above. fn 77 above at p 39. 86 Art 5(3)(b) UN Model Tax Convention 85

Book 1.indb 265

12/2/2011 8:22:03 AM

266

Angharad Miller

This is known as a ‘deemed services permanent establishment’ as the concept of a permanent establishment requires that there be a fixed place of business. In their discussions, some members of the Group of Experts expressed the view that the inclusion of a deemed services permanent establishment in Article 5 was by far the most important of the amendments under discussion, as often very large sums of money were involved.87 This is a very telling remark, as it supports the view that the countries represented on the Group of Experts saw the issue of taxation of services purely as one of protection of their tax base. Although the inclusion of enterprise services in business profits and the provision for a deemed services permanent establishment would only permit the host state to tax the income from those services on the net basis, as opposed to applying a final withholding tax (gross basis), this specific provision dealing with enterprise services would give the host state a degree of certainty as to its right to tax that income.88 As noted earlier, it is possible for a non-resident to provide high values and volumes of services without needing a fixed place of business in the country of where the services are provided. An alternative view might have been that taxation of enterprise services represent a barrier to trade and, in particular, a barrier to the import of knowledge and assistance of importance to economic development. Some of the members from developed countries considered that services were already included in the definition of a permanent establishment when Article 5 of the OECD Model Convention was read in conjunction with Article 7.89 Overall though, the Group of Experts was in agreement that the country where the services were performed should be entitled to tax the profits arising from the services, even in the absence of a fixed place of business, on the source principle. Limitations on the right to tax were discussed: monetary limitations were dismissed but time limitation was considered appropriate. There was some dissent from this view by the developing country members who considered they should be entitled to tax income from services without time limit.90

The ‘Six Months in Any Twelve Months’ Rule and its Interpretation Setting a requirement for six months in any twelve months on the physical presence of representatives of an international corporation in the other country was thought to cover most of the important situations whilst eliminating the 87

fn 77 above at para 65. Although by including services in come in the definition of business profits and providing for a deemed services permanent establishment, the host state gives up its right to tax income from services where that service provision falls short of that required by the deemed services permanent establishment definition. 89 Presumably, this would only be the case if Article 7 were worded so as to include the ‘force of attraction’ rule. 90 fn 77 above at para 63. 88

Book 1.indb 266

12/2/2011 8:22:03 AM

History of the International Taxation of Income from Services

267

administrative burden of dealing with sporadic activities. An important insight into the interpretation of the current services permanent establishment provision in the UN Model Convention is that the Group of Experts intended that the six month limit be applied on a cumulative basis to the presence of all representatives of a foreign corporation, rather than presupposing the continuous presence for at least six months of one or more individual representatives.91 A further point of discussion concerned whether or not the time period should be applied to individual projects or to the cumulative time spent by representatives of a foreign corporation on all projects being carried on in the host country. A disadvantage of applying the time limit to all projects being carried on was that a firm might be discouraged from accepting a second, unconnected project in the host country if this would mean that a current project, not of itself expected to breach the six month limit, would thereby be considered as being carried on by a permanent establishment. The Group of Experts was unable to reach agreement on this point. Some considered that including a rule as to multiple projects might create unfair host country tax burdens where one corporation had a single project of 3 months duration but another corporation happened to have two projects, each of three month’s duration. On the other hand, applying the six month rule only to ‘same or connected projects’ might leave the way open for a corporation to undertake multiple, unconnected projects in the host country, each of just less than six months duration, without bringing into existence any deemed permanent establishment. The draft paragraph eventually added to Paragraph 2 of Article 5 read as follows: the furnishing of services including consultancy services by an enterprise through employees or other personnel where activities of that nature continue within the country for a period or periods aggregating more than six months within any twelvemonth period

The Treatment of Independent Personal Services in the UN Model Convention The requirement for a fixed base or, in the case of treaties with developing countries, the use of a six month time limit which, if exceeded, gives taxing rights to the country in which the services are rendered were noted at the first meeting of the Ad Hoc Group of Experts.92 The six month time limit is still generally only found in asymmetric treaties93 and the Report made the interesting observation that extending more far-reaching relief might be in the best interests of a developing country.94 The deterrent effect of the threat of host country 91

fn 77above at para 67. fn 71 above. Those between a developed and developing country. 94 fn 71 above at para 184. 92 93

Book 1.indb 267

12/2/2011 8:22:03 AM

268

Angharad Miller

taxation if a six month stay is exceeded may result in a reduction in provision by foreign experts of much needed scientific or technical know how and of training for residents. This may be viewed of a tacit acknowledgement that host country taxes might act as hindrance to economic development. At their first meeting, the UN Group of Experts adopted the proposals concerning independent personal services which followed the 1963 OECD draft model in awarding source country taxing rights where the person providing the series had a fixed base in the other state but supplemented this with a provision giving the host country the right to tax income from services where the person providing them had no such fixed base but was present in the host country for over six months.

Other Types of Services Specifically Considered by the UN Group of Experts Supervisory Services in Connection with Building Sites, Construction or Assembly Projects The UN Model has always included supervisory activities in its definition of a permanent establishment consisting or a building site, construction or installation project. The Report of the Secretary General to the first meeting of the UN Group of Experts mentioned, almost in passing, that the NorwaySingapore treaty of 1966 included a provision whereby such supervisory services would create a permanent establishment if they were carried on for more than six months.95 The 1963 draft OECD Model contained no reference to supervisory services. There is no record of any debate on this issue at the meetings of the Ad Hoc Group of Experts and neither is their any justification or explanation offered for its inclusion in the Commentary on the 1980 UN Model. All that is recorded is that at their first meeting, the Group of Experts discussed the provision on building site permanent establishments in a form which included the term ‘or supervisory activities in connexion therewith’.96 Insurance Services A key feature of the provision of insurance services is the relative ease with which large markets can be accessed with little need for the enterprise to have its own personnel present in the customer country, let alone a fixed place of business. Insurance is commonly sold on a large scale by independent agents on behalf of non-resident providers. The OECD 1963 draft Model contained no special provisions for insurance companies, although the Commentary contained a note recognising that special problems could arise in the case of 95 96

Book 1.indb 268

fn 71 above at p 58. fn 71 above at p 12.

12/2/2011 8:22:03 AM

History of the International Taxation of Income from Services

269

insurance companies dealing by means of intermediaries, but deferred study of this point to a later date. The UN Model contains a special form of permanent establishment provision: Notwithstanding the preceding provisions of this article, an insurance enterprise of a Contracting State shall, except in regard to re-insurance, be deemed to have a permanent establishment in the other Contracting State if it collects premiums in the territory of that other State or insures risks situated therein through a person other than an agent of an independent status to whom paragraph 7 applies. (Article 5 para 8 Un Model Convention)

The origins of this provision are unclear but the report of the Secretary General to the first meeting of the Group of Experts97 informed the Group that special provisions with reference to insurance companies were included in France’s double tax treaties with Belgium (1964), Japan (1964) and Switzerland (1966) and also in the Belgium-Sweden treaty (1965) and Austria-Spain (1966). These provisions deemed an insurance company to have a permanent establishment in the other contracting state if it maintained a dependent agent there who contracted for insurance or collected premiums. Normally, an agent would only constitute a deemed permanent establishment of a foreign enterprise if he had, and habitually exercised, the right to bind the foreign enterprise in contract: the so-called ‘dependent agent’. In the case of insurance enterprises though, even the mere collection of premiums can, if the UN Model is adopted, cause a deemed permanent establishment to arise. The issue of foreign enterprises using independent agents to sell insurance in other countries had been addressed in the Commentary to the 1977 OECD Model and the problem had been neatly summed up as it is conceivable that these companies do large-scale business in a State without being taxed in that State98

The Commentary went on to suggest inclusion of a provision along the lines of that which the UN adopted. At the second meeting of the Group of Experts99 it was agreed that the following paragraph be inserted in Article 5: ….an insurance enterprise of a Contracting State shall, except in regard to reinsurance, be deemed to have a permanent establishment in the other State if it collects premiums in the territory of that State or insures risks situated therein through an employee or through an agent of independent status within the meaning of paragraph

This provision was adopted with only minor changes in the text of the UN Model. The rationale for its adoption was that the insured risks were situated within the 97

fn 71 above at p 57. para 38, Commentary on Article 5, OECD Income and Capita Model Convention (Commentary) 1977. 99 fn 77 above at p 10. 98

Book 1.indb 269

12/2/2011 8:22:03 AM

270

Angharad Miller

country and that it was relatively easy for persons to set up as independent agents of insurance companies so that there was little to distinguish between dependent and independent agents in the case of insurance. Views were expressed that the collection or premiums in a country or the insuring of risks situated in a country evidenced a source of income in that country. That source should be taxed, as for dividends, interest and royalties, using the source principle. No desire to tax insurance premiums on the gross basis was expressed though. There does not appear to have been any further discussion on the topic. The wording eventually adopted in the UN Model closely follows that proposed at the second meeting of the Group of Experts and the Commentary on the provision closely follows the wording of the Report of the second meeting of the Group of Experts. It is in the treatment of insurance services that the theoretical issues inherent in the international services are clear exhibited. Should the services be taxed where they are performed? In the case of insurance services, is the place of performance the place where the person insuring the risk resides, or where the risk to be insured is situated? Is there ever a case for taxation by a country purely on the grounds that the foreign enterprise is accessing a market in that country? The ease with which insurers can access foreign markets has continued to trouble tax administrations, even in countries where there is normally no recognition of any kind of services permanent establishment.100 Services Incidental to the Sale of Machinery or Equipment The Group of Experts also considered a proposal that services consisting of the installation, erection or other charges incidental to the sale of machinery or equipment should be taxable in the state in which the services were performed in cases where such charges exceeded 10 per cent of the sales price. These would be taxed in accordance with the rules of Article 7. This provision, which was and is contained in a number of treaties in force was not adopted in the UN Model itself. The reason given for its rejection was that it would not constitute an adequate solution to the perceived problem (that substantial services performed in a host country were being dressed up as part of the sale price of machinery or equipment). Complications would arise where installation was carried out by a firm other than the machinery supplier.101

100 See, for example, the Canadian cases of American Income Life Insurance Company v Canada 208 TCC 306 11 ITLR 52, Tax Ct of Canada, and Knights of Columbus v R 2008 TCC 307, 10 ITLR 827 Tax Ct of Canada, Ottawa. 101 Commentary on Article 5, Para B (3) UN Commentaries on the Articles of the UN Model Double Tax Convention between Developed and Developing Countries.

Book 1.indb 270

12/2/2011 8:22:03 AM

History of the International Taxation of Income from Services

271

The Treatment of Technical Service Fees In the early discussions of the UN Ad Hoc Group of Experts on royalties, there is no mention of the possibility of including technical service fees in the article dealing with royalties, thus giving the host country the opportunity to tax such fees on a gross basis. The distinction between royalties and service fees is crucial as royalties are usually taxed by the source country via a withholding tax on the gross basis or not at all.102 There is often a fine dividing line between payments which constitute royalties and those which constitute fees for services, particularly technical services. The thinking on this point in the development of the UN Model can at best be described as untidy. The 1972 Secretary General report for the third meeting of the UN Ad Hoc Group of Experts,103 deals with royalties and technical services fees in the same breath without attempting to set out any distinction between the two. In Annex II to the same report104 a summary of issues relating to the taxation of royalties submitted by the Indian member of the Group of Experts contains no mention of technical service fees, which is surprising in view of the widespread practice in Indian tax treaties of taxing technical service fees on the same basis as royalties. Neither is there any mention of technical service fees in the report of the discussions of the Group of Experts on the topic of royalties. However, in a discussion on the scope of royalties, the observation is made that the question of classification of income for treaty purposes is essentially one which concerns the preferences of the contracting countries as opposed to any legal analysis.105 Mexico, in its report to the fourth meeting of the UN Group of Experts106 in 1973, noted that because of the need for technology from more developed countries, it had tried to find favourable methods of tax treatment for income derived by non-residents in the form of payments for technical assistance services. Mexico had levied a 4 per cent effective rate on the gross, but had found that foreign enterprises were dressing up royalty payments, which were subject to a much higher rate of withholding tax, as payments for technical assistance.107 Thus it had been forced to increase the effective rate of tax on technical assistance fees to that charged on royalties.108

102 Although some treaties in force permit a deduction for direct costs before the withholding tax is applied to the royalties. 103 Department of Economic and Social Affairs. ‘Third Report’ (Tax Treaties Between Developed and Developing Countries, United Nations, New York 1972). 104 fn 103 above, at p110. 105 fn 103 above, at p 49. Of course, the legal analysis on this point of any one country might well simply reflect its preferences giving a ‘chicken and egg’ effect. 106 Department of Economic and Social Affairs Fourth Report of the Ad Hoc Group of Experts’ (Tax treaties between developed and developing countries, United Nations, New York 1973) The principal topic under discussion at this meeting was tax evasion and avoidance. 107 fn 106 above, at p136. 108 Mexico had also found it necessary to tighten up its rules permitting domestic taxpayers to claim deductions for technical assistance fees paid to foreign providers. In particular, rules were

Book 1.indb 271

12/2/2011 8:22:04 AM

272

Angharad Miller

The issue of the scope of the definition of royalties with respect to technical service fees was raised again at the seventh meeting of the Group of Experts in 1978. It was observed that even in the absence of the express inclusion of technical services fees in the treaty article dealing with royalties, some countries insisted on the inclusion in the definition of royalties of ‘information concerning industrial, commercial or scientific experience’ to include ‘brain-work’ and technical services.109 The Commentary on Article 12 records in some detail the deliberations of the Group of Experts, with the developing countries wanting to include technical services but the developed country members wishing to exclude them. This issue of technical service fees arose late in the day in relation to the publication of the UN Model and it appears that it went largely unresolved. The UN Model is silent on the matter of technical service fees, but many treaties in force, where at least one of the contracting states is a developing country, either include technical service fees in the royalty article or have a separate article, in both cases permitting taxation on the gross basis without the need for a permanent establishment.110

What Was Known About the Value of Trade in Services in the Late 1970s? Before leaving the subject of the UN Model Convention, it is instructive to review the list of countries reporting statistics on imports and exports of ‘other business services’111 to the IMF at the time the UN Model Convention was under final discussion. The inclusion of a deemed services permanent establishment in the UN Model is a significant departure from the OECD Model and it would be reasonable to expect that the discussions on the taxation of income from services took place in the light of knowledge of the approximate size of the tax base represented by fees charged by non-residents for services performed in the other state. It must be noted though that no such information is offered in the records of the meetings of the UN Ad Hoc Group of Experts. Figures for exports of ‘other commercial services’ are readily available from 1980 onwards, although their reliability is questionable. Nevertheless, a review introduced to ensure that services had actually been provided as opposed to merely made available, that the provider possessed the technical facilities to supply them and that they were provided directly and not through a third party. 109 Department of Social and Economic Affairs, ‘Seventh Report of the Ad Hoc Group of Experts’ (Tax Treaties between Developed and Developing Countries, United Nations, New York 1978, at p 47 Work on this issue was deferred, pending further study. 110 As at August 2010, there are 615 double tax treaties in force which contain provisions concerning technical service fees, mostly permitting tax on the gross basis. Only 96 of these treaties do not involve a developing country. 66 out of the 615 treaties contain provisions which expressly protect against taxation of such fees on the gross basis. Source: IBFD Tax Treaty database, author’s research. 111 ‘other business services’ excludes transport and travel.

Book 1.indb 272

12/2/2011 8:22:04 AM

History of the International Taxation of Income from Services

273

of WTO statistics112 reveals that for 1980, 109113 countries reported exports of ‘other commercial services’ (services excluding those of transport and travel). Overall, the value of services exports was 15 per cent of total exports of the countries reporting. (See Figure 1: Worldwide exports of services expressed as a percentage of total exports of goods and services Most of the countries which would use the UN Model Convention did have some capacity for collecting statistics on their exports of services at that time, although such reporting may have been in its infancy and some of it of poor quality. Whilst the bulk of the reported exports of services in 1980 (67 per cent) were accounted for by a handful of developed economies,114 nevertheless certain countries which were expected to use the UN Model in their treaty negotiations were reporting significant values of services exports115 some information as to the value of international trade in services would have been available to inform the discussions, had it been requested. As noted earlier, these countries must also have known that if they insisted on the inclusion of a deemed services permanent establishment then this would constitute a barrier to trade with respect to their to their exports of services as well as enabling them to tax imports of enterprise services on the source principle. With hindsight, the insistence on the inclusion of a services permanent establishment appears to be a short-sighted policy. It is now known that the percentage of a country’s GDP accounted for by services is a key difference between developed and developing countries. In 1971, the percentage of GDP contributed by services in developed countries was 56.1 per cent whilst in developing countries only 44.5 per cent. The gap has widened 112

http://stat.wto.org/StatisticalProgram/WsdbExportSp.aspx?ContentType=.xls&Language=E. Afghanistan, Albania, Algeria, Antigua and Barbuda, Argentina, Australia, Austria, Bahamas, Bahrain, Bangladesh, Belgium-Luxembourg, Benin, Venezuela, Bolivia, Botswana, Brazil, Bulgaria, Burkina Faso, Cameroon, Canada, Cape Verde, Central African Republic, Chile, Colombia, Comoros, Congo, Costa Rica, Cote d’Ivoire, Cyprus, Denmark, Dominica, Dominican Republic, Ecuador, Egypt, El Salvador, Ethiopia, Fiji, Finland, France, Gabon, Germany, Ghana, Greece, Grenada, Guatemala, Guyana, Haiti, Honduras, Honk Kong, China, Iceland, India, Iran, Ireland, Israel, Italy, Jamaica, Japan, Kiribati, Jordan, Kenya, Republic of Korea, Kuwait, Lesotho, Liberia, Libya, Madagascar, Malawi, Malaysia, Maldives, Mali, Malta, Mauritania, Mauritius, Mexico, Morocco, Mozambique, Myanmar, Nepal, Netherlands, Netherlands Antilles, New Zealand, Nicaragua, Niger, Nigeria, Norway, Oman, Pakistan, Panama, Papua New Guinea, Paraguay, Peru, Philippines, Poland, Portugal, Romania, Rwanda, Saint Kitts & Nevis, Saint Lucia, Saint Vincent and the Grenadines, Samoa, Sao Tome and Principe, Saudi Arabia, Senegal, Seychelles, Sierra Leone, Singapore, Solomon Islands, Somalia, Spain, South Africa, Sri Lanka, Sudan, Surinam, Swaziland, Sweden, Switzerland, Syria, Taipei, Tanzania, Thailand, Togo, Trinidad and Tobago, Tunisia, Turkey, Uganda, United Kingdom, United States, Uruguay, Yemen, Yugoslavia, Zambia, Zimbabwe. 114 France, the United States, the UK, Germany, the Netherlands, Belgium-Luxembourg, Japan and Italy. 115 For example, the combined ‘other commercial services’ of India, Mexico, Brazil, the Philippines, Iran, Chile, Egypt, Bulgaria, Columbia and Romania accounted for approximately 5% of world exports of these services. Some of the Latin American countries would have had regard to the Andean Community Model Treaty, but that treaty places even more emphasis on taxation on the source principle than the UN Model. Others, such as Mexico, did not start to negotiate double tax treaties at all until the early 1980s. 113

Book 1.indb 273

12/2/2011 8:22:04 AM

274

Angharad Miller

with time: corresponding figures for 2005 were 72.4 per cent and 52.1 per cent.116 If a developing country enters into treaties which provide that its exports of services to the treaty partner will be taxed by the treaty partner, then that developing country has deliberately hampered its ability to exploit the markets for international services. With respect to imports of services, although the drawback of taxation of such services as hindrance to the acquisition of vital technology was at least raised in the discussions of the Group of Experts, the potential beneficial effect on the efficiency of their domestic service providers was not appreciated.117 However the only documented evidence on the rationale for the inclusion of services is the simple observation that large amounts of tax revenues were at stake.118

THE TREATMENT OF SERVICES IN OTHER MODEL TAX CONVENTIONS

The United States Model Tax Convention The United States has developed its own model convention, based largely on the OECD Model. The first version appeared in 1996. Whilst services are not mentioned in the text of Article 5, the Technical Explanation to the 1996 Model which accompanies the Model states clearly119 that the US regards income from the furnishing of services as business profits and thus only taxable if that income is attributable to a permanent establishment. However, the Technical Explanation to Article 12 of the 1996 Model acknowledges that know-how (information concerning industrial, commercial or scientific experience) may, in some cases, include technical information conveyed through technical or consultancy services. Certain types of services are specifically excluded from this interpretation: general educational training of the user’s employees, information such as a technical plan developed especially for the user, payments for after-sales service, services rendered under a guarantee or pure technical assistance. Also 116

http://earthtrends.wri.org/searchable_db/index.php?theme=8 World Resources Institute. There is considerable evidence that the enthusiasm of the UN Group of Experts for taxing non-residents on income from services might be misplaced. In a 2003 Working Paper (J Nielson and D Taglioni, ‘Services Trade Liberalisation: Identifying Opportunities and Gains’ (OECD Trade Working Papers OECD Paris 2003) the OECD reported that developing countries have more restrictive barriers to imports of services than developed countries. From this, the authors conclude that developing countries have more to gain from services trade liberalisation then do developed countries. A startling result of the OECD research is that gains are expected to exceed those from liberalisation of trade in goods by up to a factor of five. The gains are expected to flow mainly from increased competitiveness and efficiency in the domestic markets for services as a result of imports of services, rather than from better access to international markets for services. This flatly contradicts the widely held view that developing countries need to protect their domestic service industries from incursions by the multinationals. 118 fn 77 above at para 65. 119 Technical explanation on para 7 of Article 7. 117

Book 1.indb 274

12/2/2011 8:22:04 AM

History of the International Taxation of Income from Services

275

excluded from treatment as royalties are payments for professional services.120 Following the adoption in 2007 of particular provisions for a services permanent establishment in the Fifth Protocol to the US-Canada treaty,121 it might be expected that future versions of the Model will contain provisions similar to that adopted in this Protocol.

The Andean Community Model Tax Treaty122 The most striking feature of this Model, published in 1971, is that it emphasises the source principle almost to the point of exclusion of the residence principle altogether. In particular, Article 7 states that earnings from business activities shall be taxable only by the Contracting State where these were obtained. The definition of business activities is wide: ‘activities carried out by the enterprise’ and so would encompass earnings from services. There is no possibility of circumventing this by incorporating a subsidiary to carry out service activities as there is a special article, Article 14, which states that The income earned by professional service and technical assistance companies shall be taxable only in the Contracting State in whose territory those services are rendered.

Consistent with this approach, income from personal services, including those provided by professionals and technicians is taxable only where the services are rendered. (Article 13). The history of the Andean Community Model Treaty is interesting and complex but given that it is not now used by the main South American economies it is of limited usefulness. The membership of the Andean Community is small so that only Bolivia, Columbia, Ecuador and Peru now use the model.123

THE LIBERALISATION OF TRADE IN SERVICES

Whilst a lack of explicit provision for the division of the tax base of profits from trade in services may have been understandable in the 1920s and 30s and even the 1960s, it is perplexing in today’s world. Services, such as currency exchange, banking services and the development of computer software have become far 120 The example is given of income from the design of a refinery by an engineer. Even though the engineer would doubtless have employed technical know-how in designing the refinery, no part of the payment for the design may be treated as know-how. Thus, although the 1996 Model leaves open the possibility of know-how being treated as royalties, this possibility is heavily circumscribed. If the provision of Articles 7 and 12 as adopted in a treaty follow the 1996 US model, then classification as business profits is more beneficial to the country of source than classification as royalty because Article 12 of the 1996 US model does not permit any withholding tax on royalty payments. 121 fn 29 above. 122 Decision 40, Cartagena Agreement (Andean Pact) of November 1971. 123 Chile was a founding member but left in 2006. Most of its treaties are based on the OECD Model.

Book 1.indb 275

12/2/2011 8:22:04 AM

276

Angharad Miller

more tradable with the advent of electronic communications. All manner of enterprise services and independent personal services have become tradable with the advent of cheap and frequent airline services. Electronic communications facilitate a mixed mode of supply of services whereby preparatory work and communication with the customer can be done in the home country prior to the making of site visits overseas. There has been a serious assault on non-tax barriers to trade in services in the form of the General Agreement on Trade in Services (GATS) which was signed in 1995 following the Uruguay round of negotiations at the WTO. The GATS has the potential to become the equivalent of the GATT in respect of international trade in services.124 The GATS is important to policy development in taxing profits from international services for two main reasons: firstly, it provides a major impetus for trade liberalisation in services which should lead to further increases in the international trading of services. Secondly, it introduces a raft of definitions and reporting conventions covering trade in services and has brought about a vast improvement in the nature and scope of reporting of trade in services within the national accounts of many countries. One of the problems in ascertaining the importance of trade in services has long been the unreliable, heavily aggregated and incomplete nature of statistics on trade in services in the national accounts of individual countries.125 As part of the introduction of the GATS the IMF, in consultation with the bodies responsible for the contents of the internationally accepted blueprint for national accounts,126 updated its requirements for the reporting of trade in services. Trade in services is now reported by most countries in some detail whereas prior to the GATS, very little was available. The GATS sets out an important framework which could be used to develop policy on taxing profits from trade in services. This framework not only sets out the different types of services: transports, business and so on, but it defines four main ways in which services can be delivered, the so-called four ‘modes’. It is these modes which are useful in determining the split of the tax base for profits from services. They are set out in Table 2.

124 The GATS lays down a framework within which pairs or groups of countries can enter into trade liberalisation arrangements in respect of services, although it does not, of itself, liberalise trade. 125 For a leading exponent on the paucity of historical and current recording of data on services trade, see RE Lipsey, ‘Measuring international Trade in Services’ in M Reinsdorf and MJ Slaughter (eds), International Trade in Services and Intangibles in the Era of Globalization (University of Chicago Press, Chicago, 2009). 126 fn 19 above.

Book 1.indb 276

12/2/2011 8:22:04 AM

History of the International Taxation of Income from Services

277

Table 2: The GATS modes of supply of service Description Mode 1

Mode 2

Mode 3

Mode 4

Examples

Treatment of profits under the Model Tax conventions Cross border supply: the Telecoms Taxed in state where service crosses the border Services supplied by supplier is resident (Art 4) but not the supplier post Tourism, repair of Taxed in state where Consumption abroad: supplier is resident (Art 4) the consumer crosses the machinery border to the supplier’s country Commercial presence A foreign subsidiary Taxed in state where abroad or branch subsidiary is resident (Art 4) or in where there is a permanent establishment (Art s 5 & 7) or Art 14 (fixed place) Taxed in state where Short term Movement of natural supplier resident unless consultancy persons, either: covered by a ‘service involving the visit Employees or of an expert to the permanent establishment’ Persons in business on consumer’s country provision, eg Art 5(3) of own account the UN Model. Where employees travel abroad, their salaries may be covered by Art 15

Modes 1 and 2 are fairly straightforward from a tax viewpoint. Mode 3 presents a challenge in that recording of Mode 3 services (trade via foreign affiliates) is still in its infancy, except in the US, as noted earlier. Additionally, the definition of ‘foreign affiliate’ in so far as it includes branches, does not map on to the permanent establishment definition in the model conventions with any precision, although that is a subject for another paper. Ideally, the definition of an affiliate, excluding subsidiaries, should be tied in to the Mode 3 definition so as to provide host countries with better information as to the existence of permanent establishments within their territories. It is in Mode 4 that enterprise services and independent personal services are located. Mode 4 covers the profits from services rendered abroad by natural persons who are not present in the host territory for long enough to become resident there. The ready availability and low cost of international air travel have vastly increased the tradability of Mode 4 services, although immigration barriers remain for many classes of workers. Mode 4 is problematic in terms of the GATS for several reasons. Firstly, even following the upgrade in the requirements for furnishing of national accounts to the IMF, there are no statistical requirements in place to collect data on the quantum of Mode 4 services. Secondly, Mode 4 services encompass a vast range, from the highly skilled professional manager

Book 1.indb 277

12/2/2011 8:22:05 AM

278

Angharad Miller

who is on site abroad for a few weeks to the illiterate, poorly paid long term migrant construction worker. Despite these weaknesses, the GATS framework provides a useful template which could be used in further development of the principles of taxing international service flows.

CONCLUSIONS

Perhaps the most interesting aspect of this review of the history of services in the development of the model conventions is the stark contrast between the level of consideration given to the taxation of profits from enterprise services in the two model conventions. The lack of any general provision for the taxation of enterprise services in the 1963 OECD draft Model may be attributed to two factors. Firstly that international trade in services, other than those provided by affiliates tax resident overseas and those embedded in the sale of goods, was virtually non-existent at the time that the Model was developed. Secondly, the authors of the Model were from capital exporting countries which would have had no vested interest in the taxing of profits from services provided by non-residents on the source principle, i.e. where performed. The OECD Model can be viewed as a product of its times. Those developing it could not reasonably have foreseen the changes in the patterns, and the expansion, of international trade made possible by improvements in transport, communications and the informatisation of societies. Neither could they have predicted the scale of the rise in international trade in goods, which fuels the rise in trade in services. The OECD’s continuing reluctance to address trade in services in the text of the OECD Model is puzzling given that this same organisation is instrumental in both the development of international tax norms and the promulgation of trade liberalisation. Within the OECD resides a wealth of knowledge on the current importance of, and the future potential of, trade in services. The impetus to tax at source profits arising from the provision of crossborder services noted in the development of the UN Model has stemmed entirely from capital importing countries. This may be considered a somewhat perverse strategy as an investigation into the taxation of foreign direct investment by way of manufacturing and processing operations by those same countries would reveal a clear strategy of offering tax incentives to such investment in order to attract it. A foreign enterprise wishing to set up a manufacturing or processing facility in a developing country may well be offered various incentives such as tax holidays, enhanced capital allowances or reduced rates of tax. On the other hand, tax barriers are placed in the way of foreign enterprises providing services, including the technical expertise and training which might enable a country to establish indigenous facilities. The sole rationale for the taxation of profits from enterprise services provided by non-residents offered by the UN Group of Experts is that very large sums

Book 1.indb 278

12/2/2011 8:22:05 AM

History of the International Taxation of Income from Services

279

of money are at stake127. There does not appear to have been any explicit recognition that it might be in a country’s best interests to forgo relatively large sums of potential tax revenues on enterprise services in order to encourage the supply of technical expertise which would aid that country’s wider economic development or to encourage beneficial competition which might improve the efficiency of domestic provision of services. The governments of developing countries may need to question their historic enthusiasm for taxing profits from services provided by non-residents as part of a general consideration of the removal of tax barriers to trade in the light of the proven economic gains to be had from expansion of international trade in services. Their dilemma they face is whether that trade will be one way, further benefiting developed countries or whether they can capitalise on their comparative advantage to increase their own exports and benefit from the increased competition introduced by services imports As for the developed countries, the present day scale of trade in services in comparison to trade in goods renders the current provisions for international taxation of trade in services inadequate. The historic treatment of services within both the OECD and the UN models is probably consistent with what was known about the importance of trade in services at the time those models were developed but the treatment of taxation of cross border services now requires a thorough, logical and well-informed review. The categorisation of services into the four GATS modes could be adopted in any such review thus introducing a measure of coherence with international trade law. There are arguments both ways as to whether the ‘bright line’ test of a fixed place of business as the standard of nexus for tax purposes ought now to be relaxed for trade in services in the light of developments in the ease with which and the ways in which services can be traded. There can be no argument, though, that in the light of the increase in services traded internationally, and considering the data on such trade which is now available, the issue of taxation of services in the model conventions requires a fundamental reappraisal.

127

Book 1.indb 279

fn 77 at para 65.

12/2/2011 8:22:05 AM

Book 1.indb 280

12/2/2011 8:22:05 AM

10 ERA Seligman: The Surprising Fiscal Sociologist1 ANN MUMFORD

ABSTRACT

T

HIS CHAPTER ARGUES that a presumed indifference of the American economist ERA Seligman to budgetary analysis is incorrect, and should not preclude his inclusion in the new, fiscal sociological movement. It suggests that Seligman was not indifferent, but, rather enormously ambitious, and in this sense believed that budgets, the most domestic of fiscal instruments, should be considered from international and comparative perspectives. This chapter concludes by suggesting that a simple step in a difficult project is to encourage scholars to look at the budgets of countries other than their own. This, of course, is very much the fiscal sociological project, although what Seligman would add to this is the possibility of a pragmatic outcome. For the project to continue, the chapter argues that Seligman’s famed ‘neglected British economists’ could be included in the new, fiscal sociological movement.

INTRODUCTION

The question which led to this chapter is quite simple. The project was to consult the work of the famed craftsman of international tax policy, Edwin Robert Anderson Seligman,2 and, within one of the themes of the Cambridge Tax History workshop 1 I am very grateful to Prof Ajay Mehrota for the significant assistance he has offered me with this project. Drafts of this research were presented at the Annual Meeting of the Law & Society Association in Chicago, May 2010; and, at the Cambridge Tax History Conference, 2010. The participants in these sessions offered a number of suggestions for improvement, for which I am very appreciative. Errors, of course, remain mine. 2 1861–1939. McVikar Professor of Political Economy at Columbia University, from 1904.

Book 1.indb 281

12/2/2011 8:22:05 AM

282

Ann Mumford

of summer 2010, to reconsider his views on the taxation of foreign income. The project was based on the assumption that this research would provide a detour from current trends in interdisciplinary tax policy research, dominated in the past ten years or so by the vibrant, ‘new fiscal sociology’ movement. As this chapter will explain, Seligman’s work, whilst complementary, generally is viewed as part of an intellectual project that is distinct from the research of Joseph Alois Schumpeter3 and his heirs, who together have formed the fiscal sociological movements, old and new. A review of Seligman’s writings, however, has changed the assumption of this project, and led to the following thesis: Seligman should be reconsidered as a precursor, if not a crucial component, of the fiscal sociological movement. Although he was not initially included within this movement, he should be now. As this chapter will explain, fiscal sociology may be defined as an interdisciplinary field which considers a government’s budget, and the tax laws and administrative structures that support it, to be the most important point of reference in analysis of the state. This field generally is perceived as having been started by a contemporary of Seligman’s, Schumpeter, whose writings have been approached with renewed interest in the twenty first century. Seligman, as a famously curious political economist, might have been thought to be an obvious participant in the fiscal, sociological movement, but this is not the case. In fact, Seligman has been excluded from fiscal sociology because of his perceived indifference to the role of the budget in the formation of government. This chapter will challenge the perception that Seligman was not interested in budgetary analysis, an assumption which has led to his exclusion from fiscal sociological analyses. As will be explained, Seligman was himself aware of this perception of his work and sought to explain his position more fully. These explanations will be considered an important part of the thesis of this chapter, which is constructed in two parts. The first part explains the significance of Seligman to the construction of tax scholarship as a discipline, and argues for re-engagement with his work. The second part is pinned to the subject of the budget: why new and old fiscal sociologists value it, and why Seligman thought it was important, but in a different way. The thesis will advance through engagement with the rich legacy that Seligman’s writing leaves scholars of tax history and policy, and, in its conclusion, will identify those areas of Seligman’s research which should form a part of the new, fiscal sociology.

I. JUSTIFICATION FOR THE REINVIGORATION OF SELIGMAN, AND HIS SIGNIFICANCE TO TAX SCHOLARSHIP AS A DISCIPLINE

‘It is a trite saying that the history of political economy is still to be written’.4 3 1883–1950. Chair at University of Bonn, Germany, 1925–1930. Lecturer and other posts at Harvard University, from 1930. 4 ERA Seligman, ‘On some Neglected British Economists’, (September 1903) 13(51) The Economic Journal 335.

Book 1.indb 282

12/2/2011 8:22:05 AM

ERA Seligman: The Surprising Fiscal Sociologist

283

There are two, major reasons why this project might need to explain itself at the outset. First, whilst Seligman is undoubtedly one of the giants of political economy, why is it necessary to integrate early twentieth century ideas into a modern movement, the ‘new’ fiscal sociology? Secondly, and perhaps more importantly, there is the question of uneasy bedfellows – ie, Seligman and Schumpeter. Schumpeter is the grandfather of fiscal sociology, famed for the observation that the ‘thunder of history’ is heard through a nation’s budget.5 Indeed, the great insight and value of fiscal sociology is its focus upon budgets. Essentially, this discipline teaches us that, if one wishes to learn more about a country’s history, its present concerns, the political structure, government, people, anything, then tax is the place to look, and the budget is where one will find it. An early challenge of this chapter, thus, is explaining the link between Seligman and Schumpeter. This is a more difficult task than it might first appear to be. As Seligman was enormously prolific, finding intellectual parallels between his research and that of any other political economist is generally going to be feasible. Seligman’s interests were vast, and his output was wide. In the context of his massive collection of writings, it is odd that he should be criticised for failing to write about anything; but, he has been (perhaps, mildly) criticised for omitting one thing – namely, the budget.6 As Schumpeter is the budget’s greatest champion, Seligman might appear to be the last political economist with whom Schumpeter should be associated. This perceived lack of interest is striking, given the breadth of topics he covered. This chapter argues that this assumption is untrue, and is perhaps an unintended consequence of the enormity of his intellectual ambition. The crux of the thesis is this: Seligman argued that the budget, perhaps the most domestic expression of the ambitions of the state, should be considered, and crafted, within an international context. Seligman’s potential importance to fiscal sociology emanates not solely from this contribution, but also from the important opportunity that may result from integrating one of modern taxation’s greatest scholars, with the current, new, fiscal sociology. The reason for this is that Seligman, perhaps, best can be described as a practitioner scholar. He viewed times of economic crisis – such as the one in which the new, fiscal sociology is flourishing – as opportunities for scholarship to provide leadership and economic, cultural and political enrichment. In this sense, he would have wished to lead the new fiscal sociology on a pragmatic course. Seligman integrated his approach to political economy into every aspect of his life. Thus, in their well-known article, Graetz and O’Hear have described Seligman as ‘..a lifelong academic – …a grand, systemic thinker’.7 Seligman 5 J Schumpeter, ‘The Crisis of the Tax State’, in International Economic Papers, pp 5–38 (1954), edited by A Peacock et al (New York: Macmillan) (original publication 1918). 6 Most famously in V O Key, ‘The Lack of a Budgetary Theory’. (December 1940) 34(6) The American Political Science Review 1137–1144, at pp 1139–140. 7 MJ Graetz & MM O’Hear, ‘The “Original Intent” of US International Taxation’, (1997) 46(5) Duke Law Journal 1021–1109 at p 1075.

Book 1.indb 283

12/2/2011 8:22:05 AM

284

Ann Mumford

even integrated his approach to his work into his religion, and was one of the founders of Ethical Culturalism.8 One of the many ways in which engagement with his scholarship is rewarding is simply from the fact that he wrote so much, and in so much detail, on subjects which may not quite have been forgotten, but are perhaps less considered by modern tax scholars. In addition to his enormous academic output, Seligman was also one of the founding editors9 of the original Encyclopaedia of the Social Sciences,10 a particular testament to his breadth of interest, which clearly extended beyond economics and taxation. The practitioner element of Seligman’s scholarship is evident in his efforts to integrate his theories of economic life into the political choices of the American government. The son of a famous banking family in New York, he had access to members of the US government at the highest levels. His brother, Isaac, headed the family investment house and was ‘…a leading member.. of the emerging national economic elite’.11 Isaac provided access to Raymond Moley, the famed New Dealer who changed his mind and became a conservative Republican. Moley was strongly influenced by (ERA) Seligman on the question of forgiving international debts to the US stemming from World War I. Indeed, there was a vibrant exchange on this question between Columbia University-based economists and theorists.12 Rosen relates that Moley later recalled that ‘[t]here was a Columbia round robin’ in 1927…advocating cancellation of the debts, and I signed it’.13 The field into which this chapter advocates Seligman’s inclusion, fiscal sociology, spans (like Seligman’s scholarship) a wide field, and its advocates include both knowing, and unknowing, participants. For example, Tocqueville has been heralded as an early pioneer of fiscal sociology, because of the primacy he placed on the importance of financial institutions in his studies of the interaction between government and society.14 The field has its share of knowing participants; most importantly, its leaders, the original, fiscal sociologists Schumpeter15 and Rudolf Goldscheid.16 As mentioned, their works were based on the principle that if one

8 ‘The founders were an inclusive group; thus, an Ethical Culturalist such as E.R.A. Seligman was comfortable in helping to found the organization because he shared the ethical aspirations of the liberal Protestants, although he was not one himself’. (in an analysis of the ‘religious roots’ of the American Economic Association) B W Bateman and E B Kapstein. ‘Retrospectives: Between God and the Market: The Religious Roots of the American Economic Association’. (1999) 13(4) The Journal of Economic Perspectives 249–257, at p 254. 9 With A Johnson. 10 Published in fifteen volumes over 1930–1935. 11 Silva, T Edward, and S Slaughter, ‘Prometheus Bound: The Limits of Social Science Professionalization in the Progressive Period’. (1980) 9 Theory and Society 781–819, at p 793. 12 ibid. 13 E A Rosen, ‘Roosevelt and the Brains Trust: An Historiographical Overview’. (1972) 87(4) Political Science Quarterly 531–557, at p 549. 14 M Leroy, ‘Tocqueville Pioneer of Fiscal Sociology’, 51(02) European Journal of Sociology 195–239. 15 See note 3, supra. The most relevant of Schumpeter’s works for these purposes is J Schumpeter, ‘The Crisis of the Tax State’, (1954) 4(7) International Economic Papers; but, also see, inter alia,

Book 1.indb 284

12/2/2011 8:22:05 AM

ERA Seligman: The Surprising Fiscal Sociologist

285

wishes to understand the state, one must study both its finances and its financial institutions.17 Seligman’s most famous work, perhaps, concerned the interaction of economic justice and debt, along the lines of his work with Moley, supra. What is not often appreciated in this work, however – and perhaps this is due to the expanse of the scholarship – is that Seligman often linked economic justice to the roots of the state, and, in this sense, was a fiscal sociologist. His primary concern, however, as a true pragmatist, was the pressing problem of the debt, from which he refused to be distracted until it was fixed. It was in 1899 that Seligman suggested that ‘the expert’ is able to ‘exert more influence’ in times of economic significance and crisis.18 Indeed, he viewed economic crises not only as opportunities to convince the US government to make the correct decision, but also as a chance to advocate an ethical approach to taxation and the economy. He approached such opportunities competitively, and extended this tactic to his intellectual work within the academy. Seligman’s views on the importance of the academic to the socio-economy fundamentally changed university life in the US. The Seligman Report, a 1915 publication for the American Association of University Professors, was a treatise on the role of the academic in political and economic life − and was perhaps best described by Metzger, who suggested that the treatise was essentially an argument that ‘…truth is never finally possessed but must be endlessly discovered, and that error is best corrected not by the pre-emptive use of power but by the competitive play of minds’.19 The Seligman Report was enormously influential; such that, as Metzger relates, it was ‘instantly acclaimed by AAUP members as a work of seminal significance…’20 Seligman’s integrated approach to intellectual and economic life provides the start of a response to the question: why Seligman (twentieth century), and why the ‘new’ fiscal sociology (twenty-first century)? The ‘new’ fiscal sociology, as coined by Mehrota and others, is predicated on Schumpeter’s work, and in particular the assertion that ‘the study of taxation can illuminate fundamental dynamics of modern societies’.21 Tax law can provide the tools for greater insight

J Schumpeter, ‘The Instability of Capitalism’, (1928) 38(151) The Economic Journal 361–386; J Schumpeter & E Schumpeter, History of Economic Analysis (Routledge, 1994); and J Schumpeter, Capitalism, Socialism and Democracy (Routledge, 2006). 16

1870–1931. Founder, in 1909, of the German Sociological Association. For Goldscheid, see, inter alia, (and especially, in English) R Goldscheid, ‘A Sociological Approach to Problems of Public Finance’, (1964) Classics in the Theory of Public Finance 202– 213; also (in the original German), R Goldscheid, Staatssozialismus oder Staatskapitalismus (Anzengruber-Verlag, 1917); R Goldscheid, Frauen, Freiheit und Friede (Anzengruber-Verlag, 1921); and R Goldscheid, Probleme des Marxismus (Die Sozialistischen Monatshefte GmbH, 1906). 18 S Slaughter and E Silva Edward, ‘Service and the Dynamics’ (1983) 54(5) The Journal of Higher Education 481–499, at p 483. 19 ibid. 20 The report was authored by Seligman, as chair of a committee of co-authors including the philosopher Arthur O Lovejoy. ibid. 21 An important book on fiscal sociology was published by CUP in the past year, establishing the fact that fiscal sociology has become a very much mainstream part of academic discourse. The New Fiscal Sociology (eds Mehrota et al, Cambridge University Press, 2009) ‘introduction’. 17

Book 1.indb 285

12/2/2011 8:22:06 AM

286

Ann Mumford

into both the economy and society; in fact, tax law may be the most important tool, certainly more significant than other forms of law. The starting point for fiscal sociology generally is the moment in a country’s (possibly, but not always) distant past when the state moves from pillage and plunder, to an organised form of tax collection, most likely with the purpose of funding wars. The budget is effectively a crucial, revealing moment for a country, much like a poker player’s ‘tell’.22 Fiscal sociologists (both new, and old) suggest that if one wishes to understand a country today, then one should seek, historically, that moment of organised tax collection.23 Fiscal sociologists (again, new, and old) then attempt to forge links between that moment, and subsequent moments of reveal – the budgets.24 The movement from using tax to fund wars, to using tax to fund the choices of the state, is continually open for analysis in successive budgets. This form of scholarship was initiated by Schumpeter as part of his desperate efforts to find the answer to preventing the second World War in the economic choices made by housewives in the 1930s German economy (for Schumpeter believed that the key to the German economy was held by housewives, who effectively governed trade with their unchallenged authority over the mundane, economic choices made in the marketplace).25 The ‘old’ fiscal sociology flourished during Schumpeter’s lifetime, and largely fell quiet in the late twentieth century. The socio-legal movement, and other intellectual developments, led to its revival in the early twenty-first century,26 such that Mehrota et al have claimed that ‘a new wave of multidisciplinary scholarship is poised for a significant intellectual breakthrough’.27 Where the old fiscal sociology spent perhaps too much time attempting to integrate some (perhaps diluted) Marxian theory with tax, the new fiscal sociology argues for appreciation of the centrality of taxation to modernity – enter, Seligman, perhaps the first truly modern tax writer. Seligman displayed some affinities with Marxian analysis, although he channelled this into his work developing the earliest forms of American institutionalism. Schumpeter, by contrast, engaged with Marx, but at the margins, leading to claims that Schumpeter had more or less abandoned Marxian thought.28 Seligman, perhaps with greater ease than

22 On this point see Musgrave, RA, ‘Theories of Fiscal Crises: An Essay in Fiscal Sociology’, The Economics of Taxation, Brookings Institution, Washington 316–390 (1980). 23 See J Backhaus, ‘Fiscal Sociology: What For?’, (2005) Handbook of Public Finance 521–541. 24 An interesting example of this kind of analysis is found in Mclure, M ‘Equilibrium and Italian fiscal sociology: A reflection on the Pareto-Griziotti and Pareto-Sensini letters on fiscal theory’, (2005) 12(4) The European Journal of the History of Economic Thought 609–633. 25 See, generally, JA Schumpeter, ‘The March into Socialism’, (1950) 40(2) The American Economic Review 446–456. 26 A special edition of the American Journal of Economics & Sociology in 2002 (61:1) was an important moment. 27 The New Fiscal Sociology (CUP), ibid, at p 60. 28 See generally OH Taylor, ‘Schumpeter and Marx: Imperialism and Social Classes in the Schumpeterian System’, (1951) 65(4) The Quarterly Journal of Economics 525–555. See also LJ O’Toole, ‘Schumpeter’s “Democracy”: A Critical View’, (1977) 9(4) Polity 446–462.

Book 1.indb 286

12/2/2011 8:22:06 AM

ERA Seligman: The Surprising Fiscal Sociologist

287

Schumpeter, is famed for ‘…the patrolling and the transgressing of academic boundaries’.29 The possibility of finding a place for Marx in the activist, political economy of Schumpeter, through the prolific writings of Seligman, is one reason for suggesting that Seligman might take part in this creation of the new fiscal sociology. This might be achieved by focusing on one of Seligman’s most important pieces of research, his work with the ‘neglected British economists’.30 Indeed, this essay will conclude by suggesting that an early point of investigation in the ‘reinvention of Seligman as fiscal sociologist project’ will be the place that the ‘neglected economists’ might assume within the ‘new fiscal sociology’ – an analysis that seems, in several ways, to be motivated in part as a reaction against the theories of Adam Smith. Even if Smith was not embraced by Seligman, he very much embraced British economic thought, generally – concerning which Seligman consistently offered praise and engagement throughout his writing. Seligman’s work with British political economy seems to be motivated by two, fundamental principles. First, he suggested that British economic scholarship is so superior to work found elsewhere in the world, that any serious scholar could easily choose to study no other country.31 Secondly, this importance should contain the exception only of Smith, who (in Seligman’s opinion) had the unfortunate impact of distracting many twentieth century scholars from studying the truly great British writers.32 Seligman’s lack of enchantment with Smith appears to start at the point of classification of taxes. Generally, Seligman rejects the assumption that it is possible to distinguish some forms of payment to the government, from others, as taxes.33 As Seligman asked, in an otherwise approving appraisal of Charles Bastable’s34 theories of public finance, if one, like Smith, is prepared to make such classifications, then what about charges for marriage certificates, or payments for copyright?35 Oncken,36 who was admired by Seligman,37 perhaps best described the complaints of his contemporaries about Smith when he 29 Tallack, Douglas. ‘Review: [untitled]’. (1994) 28(1) Journal of American Studies 110–111, at p 110. 30 This work extended primarily over the following published articles: Edwin R A Seligman, ‘On Some Neglected British Economists’, op cit note 4, at p 335, ERA Seligman, The economic Interpretation of History (Columbia University Press, 1902) and ERA Seligman & JH Hollander ‘Ricardo and Torrens’, (1911) 83(21) The Economic Journal 448–468. 31 ‘The literature of economics in Great Britian, from the end of the sixteenth to the middle of the nineteenth century, so far transcends in importance that of other countries that the neglect of all but great masters of the classical school is as remarkable as it is deplorable’. ERA Seligman, (1903) On Some Neglected British Economists, op cit note 4, at p 335. 32 ibid. 33 ERA Seligman, ‘Adams’s Science of Finance’, (1899) 14(1) Political Science Quarterly 128–140, at p 713. 34 Irish economist, writing primarily around the turn of the last century. 35 Seligman, op cit note 33, at p 713. 36 August Oncken, 1844–1911, German economist. 37 See ERA Seligman, ‘Review: [untitled]’, (1903b) 18(2) Political Science Quarterly 350–352 But cf ibid at p 351, where Seligman criticises, in fairly strong terms, Oncken’s ‘under-emphasis’ on ‘Turgot’.

Book 1.indb 287

12/2/2011 8:22:06 AM

288

Ann Mumford

offered that Smith, first, was viewed as lacking ‘scientific sincerity’; and, second, as guilty of ‘preach[ing] extreme materialism’.38 In this sense Seligman’s interest in the great British economic theorists was not simply intellectual. He probed their writings for indications of solutions to problems plaguing his own country (the United States) at that time. Seligman’s pragmatic approach provides clear hope for the comparative tax scholar. As he explained: [i]n addressing myself to the task of presenting a survey of the practical problems of public finance I am naturally confronted by the difficulty that the actual problems assume a different aspect in various countries, an aspect largely colored by fluctuating political, economic, and social conditions. Notwithstanding this diversity, however, there can be discerned an underlying uniformity in the modern fiscal development of civilized nations...39

On the question of which country earned the title ‘civilized’, England clearly led the field, both in terms of its historic literature, but also due to the (more modern) early twentieth century efforts to reform taxation. Thus, in 1912 Seligman wrote, with barely concealed admiration, that ‘...England is attempting to realise the more modern social ideals in taxation’.40 Ever the pragmatist, Seligman attempted to find the process by which such ‘social ideals’ were realised; and, in so doing, was attracted to perhaps the most famous British budget of all time. Indeed, given the combined fame of this budget with the extent of Seligman’s admiration for it, it is surprising that the new fiscal sociology has yet to engage with Seligman, if only as a means of incorporating his detailed work. The reason for this, again, may be that, in the vastness of Seligman’s scholarship, it may be easy to miss some things; and, thus, the following section of this chapter will hope to act as remedy.

II. THE BUDGET: FROM SCHUMPETER TO (YES) SELIGMAN

a) ‘The People’s Budget’ Seligman wrote that the most remarkable features of the history of tax include the ‘successive waves of reform’.41 These events are extraordinary because they seem to happen in different countries at the same time, for reasons that may not necessarily be clear, or obviously connected to the sharing of ideas or mutual observation.42 Two particular years he selected to demonstrate this were 1909 and 1910, during which time he suggested that reform movements in Great Britain, 38 A Oncken, ‘The Consistency of Adam Smith’ (1897) 7(27) The Economic Journal 443–450, at p 444. 39 ERA Seligman, ‘Pending Problems in Public Finance’ (1905) 20 Political Science Quarterly 480–492, at p 480. 40 ERA Seligman, ‘Recent Tax Reforms Abroad’ (1912) 27 Political Science Quarterly 454–469. 41 ibid, at p 454. 42 ibid.

Book 1.indb 288

12/2/2011 8:22:06 AM

ERA Seligman: The Surprising Fiscal Sociologist

289

Germany and Austria flourished, and displayed elements of convergence.43 It is in the analyses of these important budgets that the thesis of this chapter primarily rests, as his interest can only be described as Schumpeterian. Thus, this chapter focuses on the famous British budget of 1909. Seligman engaged with what he described as ‘the famous Lloyd George budget’, which, he argued, ‘…while making in some respects a departure in fiscal policy, is nevertheless to be considered in the main as a logical development of a movement initiated some time ago’.44 Seligman was referring to Lloyd George’s ‘People’s Budget’, which was easily one of the most controversial budgets of the twentieth century, if not of all time.45 The driving force behind this budget was that, in his words, ‘[n]o Chancellor of the Exchequer has ever had to raise so much money for the necessities of the country’.46 The title for the Budget comes from Lloyd George’s following, well-known phrase: I am one of the children of the people. I was brought up amongst them and I know their trials and their troubles. I therefore determined in framing the budget to add nothing to the anxieties of their lot, but to do something towards lightening those they already bear with such patience and fortitude.47

This budget has caused some degree of confusion amongst scholars, some of whom at one point – in a view that has since largely been rejected – argued that Lloyd George designed the budget in such a way as to invite its rejection by the House of Lords.48 The fame, and indeed constitutional significance, of the budget is that it led to the introduction of the Parliament Act 1911. Included amongst the controversial aspects of the Budget were increases in the rates of taxation that applied particularly to those with higher incomes. A general rate of 9d. on the pound applied to those on lower incomes, whereas annual incomes above £3,000 had to pay 1s. 2d. in the pound. A new supertax of 6d. in the pound for those earning £5000 a year also was introduced, in addition to raising death duties, and significant taxes that applied to the sale of property.49 Decrying what they perceived to be a clearly redistributive budget, the Conservative majority in the House of Lords attempted to block it.50 To counter this threat, Lloyd George 43

ibid. ibid. 45 As is suggested in a fascinating archive on the Number 10 website: http://www.number10.gov. uk/history-and-tour/prime-ministers-in-history/davidlloyd-george. 46 http://www.number10.gov.uk/history-and-tour/prime-ministers-in-history/davidlloyd-george/ 1909-peoples-budget-transcript. 47 ibid. 48 This is explained throughout BK Murray, ‘The Politics of the “People’s Budget’’’, (1973)16(03) The Historical Journal 555–570, but, in particular, at pp 555–556. Murray directs the reader to R Jenkins, Mr Balfour’s Poodle: Peers v. People (Papermac, London, 1999), although Murray uses the 1954 edition, at pp 40–42: ‘[f]or the view that the Budget was intended as an alternative to a battle with the Lords’. 49 These details are available on ‘The People’s Budget – Tax the Rich’. http://timesonline.typepad. com/timesarchive/2009/04/the-peoples-budget-1909.html. 50 Murray, BK ‘The Politics of the “People’s Budget”’ (1973) 16(03) The Historical Journal 555– 570, at p 556. Murray writes that the House of Lords had been ‘harassing’ the government, and blocking several of its plans, for some time before 1909; and, thus, relations were strained. 44

Book 1.indb 289

12/2/2011 8:22:06 AM

290

Ann Mumford

travelled the country, giving several stump speeches describing the members of the House of Lords as old, wealthy men who were keen to stop the budget which promised to fund the Old Age Pensions Act, introduced a year earlier in 1908.51 With the House of Lords then at a very low ebb in popularity, Henry Asquith’s Liberal government seized the opportunity to introduce the 1911 Parliament Act, which significantly reduced the powers exercised by the House; and, in particular, removed their ability to block ‘money bills’ and other forms of legislation. The House of Lords then attempted to block even this legislation, but were thwarted both by King George V’s agreement with Asquith’s famous threat to create two hundred and fifty new Liberal peers so as to be able to outvote the Conservative majority in the House of Lords. This threat was enough to force the Conservatives to retreat, and the Parliament Act passed.52 Seligman described this budget as a balance between two classes of government expenditures; historical, and future. The future expenditures, on the newly created pensions, were evident. The government also however had a significant amount of past expenditures on ‘naval armaments’ for which to pay53 – hence, the suggestion that such a budget had been coming for ‘some time’.54 The result of this ‘augmentation’ in tax collection, Seligman later argued, was that, by 1913–1914, which, as Seligman emphasised, was significant as the last full year before World War One, ‘taxation yielded [the healthy amount of] about £163 millions’.55 Seligman described as ‘praiseworthy’ the decision by Great Britain to raise as many funds as possible at the outbreak of the first World War through taxation.56 This initial decision ultimately proved unsustainable as the debts of the war rapidly proceeded to outpace the amounts that could be raised through taxation; and, thus, debts were undertaken.57 Seligman’s analysis of the budget is wholly unique, and departs from traditional engagement. For example, he emphasises that direct taxation was not the entire story in the famous budget of 1909. Seligman explained that, when Lloyd George realised in that year that he would need ‘about fourteen millions’58 to fulfil his plans for the government, he decided that more than one-half of that should come from indirect taxation. Thus, taxes were raised on alcohol, tobacco, petrol and car ownership, and customs and stamp duties were increased.59 51

See ibid, at p 559. See BB Gilbert, ‘David Lloyd George: Land, The Budget, and Social Reform’, (1976) 81(5) The American Historical Review 1058–1066. at pp 1060–1066, who suggests that this Budget was in some ways more significant to Lloyd George because of the fact that it began his programme of land reform. The funding of the newly created pensions was significant, but not as significant as this. 53 ERA Seligman, ‘Recent Tax Reforms Abroad’, (1912) 27(3) Political Science Quarterly 454–469, at p 454. 54 ibid. 55 ERA Seligman, ‘Comparative Tax Burdens in the Twentieth Century’, (1924) 39(1) Political Science Quarterly 106–146, at p 112 (sic). 56 ERA Seligman, ‘The Cost of the War and How It Was Met’, (1919) 9(4) The American Economic Review 739–770, at p 748. 57 ibid. 58 ERA Seligman. ‘Comparative Tax Burdens…’, supra note 56, at p 113 (sic). 59 ibid. 52

Book 1.indb 290

12/2/2011 8:22:06 AM

ERA Seligman: The Surprising Fiscal Sociologist

291

The main focus of attention in this budget, however, as Seligman acknowledged, was direct taxation – and, in particular, what Seligman described as the newly introduced principle of ‘differentiation’. ‘That is to say’, as Seligman explained, ‘a distinction was now made whereby “unearned” income was taxed at a higher rate that ‘earned’ income’.60 Seligman also explained that the combination of the supertax and ‘abatements for children’ contributed to a melding of the ‘differentiation’ principle with the ‘graduation’ principle.61 Nonetheless, as mentioned, the role of indirect taxation in this budget was important to Seligman, who mistrusted efforts to rely upon indirect taxation to manage debt or redress excess commitments of government expenditure. By way of example, ‘[t]he demand for a general sales tax’, he suggested, ‘always arises in times of storm and stress’.62 Such efforts always risked resulting, Seligman warned, in an ‘inequitable and undesirable form of taxation’.63 Interestingly, however, the most controversial aspects of the 1909 Budget were not to last. Seligman explained that the source of the most ‘resistance’ in the House of Lords, leading directly to the ‘epoch-making constitutional changes of the following year’,64 were the taxes on land. The new taxes included ‘the undeveloped land duty; the incremental value duty; the reversion duty; and the mineral rights duty’.65 These taxes produced ‘most obstinate resistance’, such that the costs of enforcement and valuation far exceeded the yield of the taxes.66 Thus, significant efforts to enforce the taxes had been abandoned by 1920.67

b) The ‘Twentieth Century Mandeville’ Seligman’s interest in comparative war economies, and in comparative taxation more generally, led to some contemporary criticism. In particular, he was dubbed ‘the twentieth century [Bernard] Mandeville’, in honour of the famed eighteenth century political economist.68 Mandeville is the author of the famous political satire, The Fable of the Bees.69 This book is a thinly veiled satire on the first Duke of Marlborough, John Churchill’s, alleged ambition to promote the War of Spanish Succession for, allegedly, wholly personal motivations.70 The 60

ibid (sic). ibid. 62 Seligman, Edwin R A ‘The Fiscal Outlook and the Coordination of Public Revenues’, (1933) 48(1) Political Science Quarterly 1–22, at p 3. 63 ibid. 64 ibid. 65 ibid, at p 14. 66 ibid. 67 ibid. 68 See ERA Seligman, ‘Who is the Twentieth Century Mandeville?’, (1918) 8(2) The American Economic Review 339–349. 69 B Mandeville & J Tonson, The fable of the Bees (J Tonson, 1730). 70 See SP generally Lamprecht, ‘The Fable of the Bees’, (1926) 23 The Journal of Philosophy 561–579. 61

Book 1.indb 291

12/2/2011 8:22:07 AM

292

Ann Mumford

general thrust of the text is that a hive of bees survives, even thrives, until some of the bees start to question whether honesty should motivate their choices – and, inevitably, the hive collapses. Thus, it is a thinly veiled attack on Christian morality, as well as the political issues of the day. Although the great scandal of Mandeville’s work lies in he suggestion that the Duke of Marlborough was essentially a war monger, the interest of the text derives from the slight suggestion that the self-interest of war mongering actually may lead to a common good. The roots of the characterisation (which he rejected) that he was the twentieth century Mandeville are easily found in some of Seligman’s earlier writings. Of particular interest is Seligman’s work on the ways in which (he argued) public finance changed fundamentally in the twentieth century. For example, Seligman suggested that expectations of the private individual from the public, economic sphere changed dramatically.71 As a direct consequence of what he described as the growth of industrial democracy, ‘[a] scale of public expenditure which would have appeared absurdly lavish to former generations now seems barely adequate to modern necessities’.72 In America, in particular, public revenue had increased in a degree of proportion to the growth of the private wealth from which it was collected; but, he suggested, the relationship was more complicated than that. Private wealth did not simply fund public revenues, but was dependent upon the structures which public revenues funded for its existence.73 Seligman argued that ‘[t]he function of fiscal science is to point out to the legislator the necessary results of his actions’.74 These results are both fiscal and social. Whether or not principles of ‘economic justice’ are fulfilled must be considered by legislators, or by what Seligman described as a ‘fiscal scientist’, but the true challenge lies in defining exactly on which terms economic justice should be defined.75 So, for Seligman, the problem lies in interconnectivity. If, in the twentieth century, one expected more from the state than ever before, and if the state were more able to respond to these expectations than ever before, then demanding that the state should perform a more redistributive function would appear to be a natural progression – but for the fact, Seligman would caution, that to a large extent the wealth of the state is dependent upon private fortunes. Private fortunes also are no longer solely dependent upon capital, but also (in one of the hallmarks of industrial democracy) reliant upon the consumption of what Seligman described as the ‘laboring classes’.76 The increased demand for consumption – indeed, the growth of capitalism – represented for him ‘the very tap-root of modern progress’.77 71 Previously, he wrote, ‘[t]he collective wants of individuals were small in comparison with their private wants; public expenditure was insignificant; and the needs of government revenue were easily satisfied’. ERA Seligman, ‘Adams’s Science of Finance’, (1899) 14 Political Science Quarterly 128– 140, at p 130. 72 ibid. 73 ibid, at pp 130–131. 74 ERA Seligman, (1905) ‘Pending Problems in Public Finance’, 20 Political Science Quarterly 480–492, at p 481. 75 ibid. 76 ibid, at p 482. 77 ibid.

Book 1.indb 292

12/2/2011 8:22:07 AM

ERA Seligman: The Surprising Fiscal Sociologist

293

Seligman was keenly aware that the first World War had dispelled any notion that it would be possible in the twentieth century for an economist to be wholly domestic in focus. This is perhaps where Seligman departs from the fiscal sociologists, but not because he believes that the budget is unimportant. His painstaking work with the ‘People’s Budget’ dispels that suggestion. Rather, Seligman suggested that the social and economic problems of another country are quite likely to become the problems of one’s own if not redressed. For solutions, he advocated attention both to trade, and, by extension, to double taxation – a scourge likely to occur even within a single jurisdiction.78 Seligman’s belief in the importance of the budget was qualified only by his insistence that such an inherently domestic tool of social and economic stability could never be as useful as measures that are more international in nature. As he explained, I do not wish to belittle for a moment the importance of setting one’s own house in order, as… with our attempt to balance the budget… But I do wish to point out that all these plans will be fruitless unless they involve the acceptance of the international point of view – international planning as over any and against any futile national planning.79 He suggested that what was needed was another Adam Smith (certainly not the original), whom he at least credited with moving financial analysis away from an individualist focus; or, perhaps, ‘another Grotius’, in reference to the famed builder of the philosophical foundations of international law.80 In this he valued Smith for his ambitions, if not the content of his analyses. The clear implication is that too much attention to the budget ultimately will amount to so much distraction activity, drawing concern away from the more important issues of how these efforts will complement, or clash, with international trends in trade and taxation.

III. SELIGMAN’S PLACE IN THE NEW, FISCAL SOCIOLOGY: THE INTERNATIONAL ELEMENT

These are extraordinarily prescient observations, occurring as they do before modern globalisation. Remarkably, however, in the early twenty-first century, the suggestion that domestic tax policy is potentially threatened by unanticipated interaction with globalised trade, and vice versa, appears to be readily accepted by international lawyers, but perhaps not as easily by tax lawyers. As Christians et al argued, in 2008, …a proposal that may not be controversial among those with a particular interest in international law, but may be less accepted among those primarily interested in tax

78 ibid, at p 483: ‘Problems of double taxation resting upon interstate and interlocal complications arise to confront us at every turn’. 79 ERA Seligman, ‘The Breakdown in World Trade’, (1932) 15 Proceedings of the Academy of Political Science 3–5, at p 4. 80 ibid, at p 5.

Book 1.indb 293

12/2/2011 8:22:07 AM

294

Ann Mumford

law [is] that international social and institutional structures shape, and are shaped by, historical and contemporary domestic policy decisions.81

Christians’ proposal may be based on Seligman’s hopes for budgetary analyses; ie, that they should occur through an incorporation of comparative and international perspectives. Towards this end, Seligman suggested that truly modern tax analysis was distinguished by three factors: ‘[t]hese are, in order, the pursuit of justice, the emphasis put on the modern economic phenomena, and the insistence upon the conformity with economic principle’.82 Much of Seligman’s work on these topics occurred within his study of the ‘neglected’ British economists.83 Seligman’s efforts (in 1903) to engage with these ‘neglected’ economists was published in two parts in the Economic Journal.84 This work has relevance in particular to the revived ‘fiscal sociology’ movement, and to the importance that writers in this movement place on the significance of tax history in shaping social change. Although Seligman reserved particular praise for Andrew Hamilton’s An enquiry into the principles of taxation (1790),85 and its focus on land and farmers; largely, Seligman devoted time to Spence,86 Higgs,87 and the ‘physiocrat’ controversy.88 Physiocracy originated in France towards the latter half of the eighteenth century, and was predicated upon the idea, or the dream, of the possibility of organising economic thought. Their focus, always, was upon the producers. Spengler described the theories of the physiocrats as follows: [t]he continuity of economic activity was contingent, as was its expansion, the physiocrats held, upon the continuity and the expansion of the effective demand (ie, consumption), at prices satisfactory to farmers, for agricultural produce and raw materials.89

One of the aspects of physiocratic thought which appealed to Seligman was the potential of using economic growth to foster social objectives.90 These objectives

81 Christians, Allison, Steven Dean, Diane Ring & Adam H Rosenzweig, ‘Taxation as a Global Socio-Legal Phenomenon’ (2008) 14 ILSA Journal of International and Comparative Law 303–315, at p 303. 82 ERA Seligman, ‘Pending Problems in Public Finance’, (1905) 20 Political Science Quarterly 480–492, at p 480. 83 ERA Seligman, ‘On Some Neglected British Economists’, above note 4. 84 ibid, at p 335. 85 Printed for, and sold by, J Debrett, 1790, which Seligman described as an ‘anonymous’ pamphlet. (ibid, at p 335 (1903)). The British Library catalogue describes Hamilton as ‘a writer on taxation’, and does not give his dates (nor distinguish him from other, famous namesakes). 86 William Spence, 1783–1860. Economist and (primarily) entomologist. Fellow of the Royal Society from 1834. 87 Henry Higgs, 1864–1940. Long service to the Royal Economic Society. 88 Seligman (1903), at p.336 (and throughout the text). 89 J J Spengler, ‘The Physiocrats and Say’s Law of Markets. II’. (1945) 53(4) The Journal of Political Economy 317–347. 90 ‘The social theory of fiscal science which has been here expounded thus affords a solution of problems which have long vexed the investigator. It supplements the work of the sociologists who have thus far made almost no attempt to apply their theories to economic life. It rounds out the efforts of

Book 1.indb 294

12/2/2011 8:22:07 AM

ERA Seligman: The Surprising Fiscal Sociologist

295

were pursued without the rather more modern contexts of progressivity, or the taxation of income. As Seligman explained, [t]he taxation of incomes is a comparatively modern idea. Its introduction may be ascribed to two distinct causes: on the one hand the need of increased revenues, and on the other the professed desire to round out the existing tax system in the direction of greater justice.91

Thus, in this ‘social theory of fiscal science’, Seligman emphasised the importance of collectivity, reciprocity and community.92 This also places Seligman within the context of the revived ‘fiscal sociology’ movement, and connects his research with insights of classic, fiscal sociological scholars. The importance that writers in this movement place on the significance of tax history in shaping social change forges this connection. The British writers in many cases were primarily concerned with local, agriculturally based economies. Their conclusions suggest that, even if the ‘neglected economists’ are concerned with farmers, the big question, still, is all about trade, the more of which, the better. This is because Seligman believed ‘[t]hat the only way to get along… whether in war or in peace is to produce more than you consume’.93 This explains his interest in the 1909 People’s Budget, largely because Seligman primarily views it as a war time budget’.94 The fact that there was an attempt to pay for a war through taxation, at least in part, as opposed to debt, captured his attention. In this, he wondered, had he found the exception to his mandate opposing most forms of ‘excessive’ taxation?95 The exception would derive from fostering a sense of allegiance to the cause of a war, and not simply from paying for it.96 Perhaps, then, the exception to tax efficiency is social justice – but, as ever with Seligman, it is intertwined. the economists to trace the social implications of their science’. ERA Seligman, ‘The Social Theory of Fiscal Science II’. (September 1926) 41(3) Political Science Quarterly 354–383, at p 381. 91 R K L Collins and D M Skover. ‘The Future of Liberal Legal Scholarship’. (1988) 87 Michigan Law Review 189–239, at p 207, fn 75. 92 ‘We can therefore not contrast collective with individual wants; but must first classify individual wants into separate, reciprocal and collective wants, and then further classify collective wants into private and public wants, according as they are satisfied by private or public groups’. ERA Seligman, ‘The Social Theory of Fiscal Science II’., op cit, at p 357. 93 ERA Seligman, ‘Who is the Twentieth Century Mandeville?’, (1918) 8 The American Economic Review 339–349, at p 340. 94 ‘…U.S. financing of the Great War was superior to nearly all other major participants in the conflict. Only Great Britain, which followed a similar path of relying on current taxation, was able to fund roughly one-fifth of its war expenditures with taxes, though it suffered from an increasing price level that exceeded U.S. inflation’. Mehrota, AK ‘Lawyers, Guns, and Public Moneys: The US Treasury, World War I, and the Administration of the Modern Fiscal State’, (2010) 28 Law and History Review 173–225, at p 183. 95 ‘Other leading experts such as Edwin R. A. Seligman of Columbia and Charles J. Bullock of Harvard feared that a resort to excessive taxation would blunt the incentives for economic productivity’. ibid, at p 204. 96 (citing Seligman) ‘…paying taxes directly to the federal government gave citizens a greater stake in how public funds were raised and used, and that direct taxation ultimately helped forge a renewed sense of civic identity’. ibid, at p 223.

Book 1.indb 295

12/2/2011 8:22:07 AM

296

Ann Mumford

One of the reasons Seligman admired Enquiries into the Principles of Taxation97 is that he credited this text with effectively introducing the ‘diffusion theory of taxation’.98 The ‘diffusion or optimistic theory’ of taxation, according to Seligman, was included in ten historical schools of thought as to the incidence of taxation.99 Seligman credits the Italian economist Pietro Verri100 with formulating the basics of the theory, which, simply, is that ‘every tax naturally tends to bring about an equilibrium because it strikes everyone according to his consumption’.101 This proposal was developed further by the French mathematician Nicolas-François Canard,102 whose anti-physiocratic writings (in Seligman’s view) rest upon the proposition that ‘[t]he aim of every man is to turn his labor into that particular kind of occupation that will give him the greatest rent or surplus’.103 In this process, every tax is passed on, until its incidence is sufficiently diffused amongst all, achieving the previously described state of equilibrium.104 The strongest proponent of this theory in England, Seligman explained, was William Murray, the first Earl of Mansfield.105

97

See n 86, above. ERA Seligman, ‘On Some Neglected British Economists’, op cit note 5, at p 339. ERA Seligman, ‘On the Shifting and Incidence of Taxation’, (1892) 7(2/3) Publications of the American Economic Association 7–191, at p 11. The diffusion theory is number 4. The other schools include, briefly (and in Seligman’s words and in order): the early theories; the Physiocratic theory; the absolute theory; (at number five) the pessimistic theory; the capitalization or amortization theory; the eclectic theory; the socialistic theory; and, the quantitative or mathematical theory. 100 1728–1797. Philosopher and economist; member of the Royal Swedish Academy of Sciences (from 1786). 101 ERA Seligman, ‘On the Shifting and Incidence of Taxation’, (1892) 7(2/3) Publications of the American Economic Association 7–191, at p 39. 102 1750? – 1833. Professor of Mathematics, Moulins, Alliers. 103 ERA Seligman, ‘On the Shifting and Incidence of Taxation’, (1892) 7(2/3) Publications of the American Economic Association 7–191, at p 40. Bastable explained that Canard received a prize from the French academy for an essay challenging the idea that all taxation should fall upon landowners. Bastable explains that, according to Canard, [t]he process of diffusion is carried out by exchange, buyer and seller in each transaction dividing the amount of tax imposed, and at every fresh exchange a division of the part of taxation transferred takes place until ultimately the charge is spread over all the parties concerned. Extending this conception to the whole society, taxation comes to be regarded as after a time diffused equably among all its members. The qualification as to time is important, for the process of diffusion is not complete at first; consequently old taxes are the best, and all new taxes, or even changes in existing ones, are to be deprecated as disturbing the beautiful and harmonious distribution which relieves the legislator of any trouble respecting the apparent merits or demerits of existing taxes. C Bastable, Public Finance (London: Macmillan and Co, Ltd, 1917) at III.V.17. For Seligman’s review of this text, see ERA Seligman, ‘Bastable’s Public Finance’, (1892) 7(4) Political Science Quarterly 708–720. 104 This is a simplified version of a complex theory, which is explained in clearer detail in ERA Seligman, ‘On the Shifting and Incidence of Taxation’, (1892) 7(2/3) Publications of the American Economic Association 7–191, at pp 40–44. 105 Seligman relates the following quotation: ‘I hold it to be true that a tax laid in any place is like a pebble falling into and making a circle in a lake, till one circle produces and gives motion to another, and the whole circumference is agitated from the centre’. ibid, at p 47, citing ‘Speech on taxing the colonies’, in Lord Mansfield’s ‘Collected Speeches’, quoted by FA Walker, Wages Question, 316. 98 99

Book 1.indb 296

12/2/2011 8:22:07 AM

ERA Seligman: The Surprising Fiscal Sociologist

297

Seligman thought the diffusion theory was too simplistic to be taken seriously, even if he admired earlier writers for having tried to develop it more fully. He explained his objections to this theory in an article he published in 1893, in which he queried why advocates of diffusion equilibrium bothered to worry whether a tax is progressive or not, given that its incidence would always be passed down to the consumer.106 Indeed, he complained that ‘…the most heated opponents of progressive taxation…have been advocates of the diffusion theory of taxation, without perceiving the absurdity of their position’.107 As Seligman later wrote, Canard ‘and his slender band of followers’ made the mistake of failing to acknowledge ‘the obvious cases where there is no shifting at all’.108 A theory which assumed that no one really bears taxes could not fully investigate the potential for economic justice in a tax system – thus, Seligman, ever the pragmatist, would reject it at the least for its incompleteness (although he goes a step further and rejects it as inaccurate). A belief that taxes ‘stay where they are put’ led to a number of unfortunate consequences, including an overly exclusive focus on direct taxation, to the exclusion of indirect taxation.109 Indirect taxation should not be used to achieve, surreptitiously, the aims of the state – a mild, underlying criticism of the famous Budget of 1909 – nor should its potential to impact upon economic justice be ignored. A wider, more comprehensive view of the socio-economy was necessary in all respects: ‘..our complex modern industrial society has rendered necessary a transition from the individual to the social point of view, and calls for a study of taxation based on the existence of economic law’.110 This interesting foretelling of Christians’ call for a more contextual analysis of international tax law111 is based upon Seligman’s view of tax law as an important tool in ‘economic justice’. One of the first steps in a pragmatic approach to economic justice is to determine where power lies, and it is in this step that budgetary analysis may be useful. Thus, for example, Seligman considered the power to fix a budget to be a central illustration of where authority lay in the division of government in French colonial rule.112 A second step is a truly expansive and inclusive review of public finance, and the impact of taxation upon budgetary objectives. The ‘neglected’ British economists proved able in these tasks, but as to Seligman’s contemporaries, he was selectively complementary. It is particularly helpful to the thesis of this chapter to note that Seligman criticised Bastable for 106 ERA Seligman, ‘The Theory of Progressive Taxation’, (1893) 8(2) Political Science Quarterly 220–251, at p 248. 107 ibid. 108 ERA Seligman, ‘Social Aspects of Economic Law’, (1904) 5(1) Publications of the American Economic Association 49–73 at p 65. 109 ibid. 110 ibid. 111 See discussion starting at page 13, above. 112 ERA Seligman, ‘The French Colonial Fiscal System’, (1900) 1(3) Publications of the American Economic Association 21–39, especially at p 27.

Book 1.indb 297

12/2/2011 8:22:08 AM

298

Ann Mumford

paying insufficient attention to the budget in his sweeping review of public finance.113 Indeed, he had a tendency to criticise in book reviews of his British contemporaries if budgetary analyses were subsumed within other categories, or insufficiently highlighted.114 The aspect of budgeting which caused Seligman perhaps the greatest amount of anxiety was the subject of deficit, and, indeed, it is for his approach to debts from the first World War that he may be best remembered. But to stop at the point of calls for debt forgiveness, and to focus solely on the pragmatic aspect of his scholarship, is to miss the depth and the quality of his intellectual endeavour. Given that he concluded that the vast majority of the first World War was paid for almost entirely through budgetary deficit, he considered that ‘the entire wealth of the world’ was impacted by the weight of these debts.115 This could be dismissed as simple concern with balancing the budget, an effort which Seligman described as ‘vital’.116 In a subtle but no less important way however he linked the outcome of balanced budgets directly with the prospects for a truly global ‘economic justice’.117 A path to achieving this would be through comparative budgetary analysis, and consideration of national budgets in light of international concerns – in other words, a pragmatic, fiscal sociological project.

CONCLUSION

A project that began by considering Seligman’s approach to the taxation of foreign income, through his ‘social theory of fiscal science’, has concluded by suggesting that Seligman should assume a place within the ‘new fiscal sociology’. This chapter has argued that Seligman’s presumed indifference to budgetary analysis is incorrect, and thus should not preclude his inclusion. Rather, Seligman was enormously ambitious, and believed that budgets, the most domestic of fiscal instruments, should be considered from international and comparative perspectives. A simple step in a difficult project may simply involve scholars considering the budgets of countries other than their own. This, of course, is very much the fiscal sociological project, although what Seligman would add to this is the possibility of a pragmatic outcome. So, for the project to continue, 113

C Bastable, Public Finance (London: Macmillan and Co, Ltd, 1917) at p 720. For example, Seligman, in critical engagement with the economist Henry Carter Adams [1851–1921; Professor of Political Economy, University of Michigan, from 1921], addressed the intellectual classification of budgetary analysis. He wrote that ‘[i]t may be urged that either this subject [of the budget] should be treated separately [from the general heading of expenditure] or the general heading of the book should be ‘Budgets and Financial Organization’. ERA Seligman, ‘Adams’s Science of Finance’, (1899) 14(1) Political Science Quarterly 128–140, at pp 131–132. 115 Seligman, op cit note 57, at p 770. 116 Seligman, op cit note 63, at p 1. 117 ibid, at p 21. 114

Book 1.indb 298

12/2/2011 8:22:08 AM

ERA Seligman: The Surprising Fiscal Sociologist

299

the intellectual base, first, might include Hamilton and other ‘neglected’ economists. Seligman valued the work of Spence, Higgs and others from this era because they engaged with physiocratic thought, which, amongst other things, considered the potential of using economic growth to foster social objectives.118 These objectives, as discussed, were pursued without the rather more modern contexts of progressivity, or the taxation of income. But this could be extended in a modern, fiscal sociology, and include, by way of example, assessment of the value Seligman ascribed to the ‘political effects’ of the taxation of foreign income119 and their influence on the taxation of corporations.120 This chapter concludes by suggesting that it should be possible to place Seligman’s ‘neglected economists’ within the modern, fiscal sociological movement; and, indeed, Seligman himself. The reason for this approach is that these analyses may advance beyond a straightforward analysis of ‘what would Seligman think of problems that he did not live to see’ – a project which could be dismissed as speculative. Indeed, part of the appeal of combining Seligman with fiscal sociology, is the attraction of extending theory to pragmatism. It is perhaps primarily for this reason that this chapter has aimed to emphasise the importance of Seligman’s writings to both UK and US tax scholarship, and to argue for reconsideration of his writings on the history of economic thought.

118 ‘The social theory of fiscal science which has been here expounded thus affords a solution of problems which have long vexed the investigator. It supplements the work of the sociologists who have thus far made almost no attempt to apply their theories to economic life. It rounds out the efforts of the economists to trace the social implications of their science’. Seligman, Edwin R A ‘The Social Theory of Fiscal Science II’. (September 1926) 41(3) Political Science Quarterly 354–383, at p 381. 119 ERA Seligman, ‘The Effects of Taxation’, (March 1923) 38(1) Political Science Quarterly 1–23. 120 ERA Seligman, ‘The Taxation of Corporations. I’, (June 1890) 5(2) Political Science Quarterly 269–308.; ERA Seligman, ‘The Taxation of Corporations. II’, (September 1890) 5(3) Political Science Quarterly 438–467; and ERA Seligman, ‘The Taxation of Corporations. III’, (December 1890) 5(4) Political Science Quarterly 636–676.

Book 1.indb 299

12/2/2011 8:22:08 AM

Book 1.indb 300

12/2/2011 8:22:08 AM

11 Charles Herckenrath’s 100 Per Cent Death Tax Rate ONNO YDEMA AND HENK VORDING

ABSTRACT

M

ANY PUBLICATIONS HAVE been dedicated to the justification of death taxes. A remarkable contribution is the study of the Dutch author Charles Herckenrath, who advocated a 100 per cent rate – in fact, a total ban on succession of wealth to the heirs. In this chapter Herckenrath’s views will be discussed against the background of alternative traditional views on the justification of inheritance taxation.

INTRODUCTION

An ancient papyrus dating from the 7th century BC contains a deed, in which an old man transfers his property to his sons at a nominal price, with the aim of avoiding inheritance tax.1 Present day inheritance taxes have a long ancestry – as has their avoidance. The question is now whether such taxes will have a long future. Among those authors who envisage a long future for the inheritance taxes Charles Richard Constant Herckenrath (1863–1935) takes a remarkable place. This teacher of French language at various highschools in the Netherlands is mostly known for his French/Dutch dictionary which is still being republished in new editions, but his interest went beyond linguistics. For example, in 1898 he had his Problèmes d’esthétique et de morale published, which to the delight of the author got a place at the Bibliothèque de Philosophie Contemporaine in France. His main focus however was on social justice. This is apparent from the voluminous Beknopt Leerboek der Staathuishoudkunde (Concise Handbook of 1

Book 1.indb 301

From M West, The Inheritance Tax (New York, 1908) pp 11–12.

12/2/2011 8:22:08 AM

302

Onno Ydema and Henk Vording

Political Economy, 1899), a translation and adaptation of Charles Gide’s Principes d’économie politique (1884), though Herckenrath in later editions would gradually grow further apart from the work of Gide and would include more of his own personal views. Herckenrath also published a utopian novel Reis naar Hedonië (Travel to Hedonia, 1903), describing how a people driven from their homes built a new society. In Hedonia everyone would be able to achieve his potential and would almost naturally find his ideal destination in the community. He published the work under the pseudonym Ria Gelmi, and it is amusing to find him quoting Gelmi without informing his reader that the quotes were the fruits of his own pen. For this contribution we shall use his treatise on the inheritance tax of 1904, De sociale quaestie en het erfrecht, the social question and the right of inheritance, a treatise which the author further elaborated on in Le mal social et ses remèdes (1920), Die Heilung der Gesellschaft (1923) and La guerison de la société, le mal principal social (1927). The author comes to radical views, but nevertheless he seems to have been taken seriously by his contemporaries and his ideas were the subject of debate in professional journals and meetings.2 Herckenrath’s Sociale quaestie includes a plea for the inheritance tax as a pillar of social justice and hence it affects the right to property as a legal institution. From a negative perspective the inheritance tax reduces the owner’s freedom to dispose of his property after death. In a constructive view however it allows that purchasing power is transferred to successors who acquire such advantage without any effort, albeit the tax reduces the advantage. The inheritance thus directly affects the distribution of income and wealth in the community. Hence the right of inheritance has always been one of the key legal areas throughout history, especially in civilibus. When it comes to the tax component, the question is often raised why a ‘double tax’ would be justified, the inheritance being the result of savings after payment of income tax. The opposite and equally legitimate question is, why differences in personal wealth, even if these exist rightly within a generation, should be transferred to the next generation. The latter is the key question of Herckenrath. He regarded the right to inherit as one of the ‘grandes causes économiques générales [...] and not the least one’.3 He advocated an inheritance tax at a 100 per cent rate, a radical position, which effectively made his work primarily a Utopian treatise. Nevertheless, his arguments are still relevant for current thinking on inheritance taxation.

TAX REVENUE

The financial needs of the state were often the immediate cause for an inheritance tax to be introduced. That was certainly true for the year 5 AD, when Emperor 2 J Posthumus, CRC Herckenrath (1867–1935) en de onvindbare zesde druk NF van zijn Fransch Woordenboek, in De Woordenaar, Nieuwsbrief van het Matthias de Vries-Genootschap V, 1 (May 2001). 3 Herckenrath, p 19.

Book 1.indb 302

12/2/2011 8:22:08 AM

Charles Herckenrath’s 100% Death Tax Rate 303 Augustus introduced such a tax at a 5 per cent rate, and it was also the argument at the time of its introduction in the period of the Dutch Republic. In the early 20th century, when Herckenrath was writing his works, the yield of the inheritance tax amounted to no less than 10 per cent of total tax revenue; and in other countries the revenue of the tax was equally substantial. Whatever the yield, Herckenrath did not consider the revenue argument persuasive. The importance of the inheritance tax was that it should support a wider solution to the ‘sociale quaestie’, the issue of social relations. As for the argument itself – it cannot logically be decisive in its own right. The fact that a government needs money does not explain its choice between available tax instruments. It simply means that the citizens will collectively have to pay some amount of tax, without implying an answer to questions of design (which tax bases?) and allocation of burdens (which rates and exemptions?).

ABILITY TO PAY

A traditional approach to issues of tax burden allocation is the principle of ability to pay – whatever that may entail. Whoever wants to explain the inheritance tax as based on this principle, may alternatively view the tax in relation to the ability of the prospective testator, or the increased capacity of the donee. From a testator’s perspective, the inheritance tax can be as a final assessment of lifetime ability to pay. It is as if the state allowed its citizen to increase its duty to society until the moment he would be able to make his final contribution, without objection, thereby settling his debt.4 The state levies taxes on income previously received by the deceased that had so far escaped taxation, ‘still recovering the debt, which has increased for years’.5 If the testator does not wish to burden his heirs, he may smooth the tax over several years, for example by means of a life insurance. The inheritance tax is then transformed into a periodic wealth tax, or, if you will, into a tax on surplus income. The argument as outlined here is not very convincing. From the testator’s point of view, the inheritance tax will usually be a ‘double tax’ as income tax has already been paid. Nevertheless, some modern authors still explain the inheritance tax as a single capital gains tax payable at the end of one’s life.6 But if fact, the tax that has definitely not been paid is the tax on consumption. If the inheritance tax is regarded as a means to make up for consumption taxes avoided by frugality, it would bear resemblance to the ancient right of exue. Such a justification seems unsustainable; tax payment is simply a matter of time as the donees (or their donees) will use the inherited wealth to increase their level of consumption. 4

Cf Sprenger van Eyk/Vroom, De wetgeving op het recht van successie (The Hague, 1884) p 8. PWA Cort van der Linden, Leerboek der Financiën (The Hague, 1887) p 431v. Cf PL Dijk, Theoretische grondslagen der belastingheffing bij het openvallen van nalatenschappen (Ars Notariatus VII, Amsterdam, 1956) pp 18, 20, 45–46. 5

Book 1.indb 303

12/2/2011 8:22:08 AM

304

Onno Ydema and Henk Vording

Alternatively, one can consider the heir as the target of the tax legislator. From this perspective, the inherited sums could simply be added up to the heir’s taxable income, and no special inheritance tax would be needed. Nevertheless, ‘the increase in capacity to pay’ is often regarded as the justification for the inheritance tax.7 It is hard to see logic in this reasoning. If we would accept that an inheritance constitutes taxable income to the donee, any deviation from the normal rules of income taxation would need quite another justification than ability to pay taxation. Indeed, an inheritance tax would deviate from normal income taxation by ignoring the donee’s overall economic position, as well as by taking account of his family ties with the deceased. The authors of an authoritative handbook on inheritance taxation, Sprenger van Eyck and Vroom, give the example of a poor man who receives a large inheritance, and through the first progression (rate progression according to the value of the inheritance) must pay a higher rate than a wealthy beneficiary, who receives a smaller sum.8 Some authors therefore advocated and still advocate the so-called third progression: aside progression to amount transferred and to the family relation of the donee to the testator, a progression would be introduced relative to the wealth of the heir at the time of acquisition.9 In Herckenrath’s proposal, the principle of ability to pay taxes is irrelevant. He promotes a 100 per cent tax to rule out the transfer of wealth from one generation to the next one, without having in mind some general standard of tax burden distribution within generations. FAMILY PROPERTY CONSIDERATIONS

One of the differences between a tax on income and a tax on inheritances is that in the latter, the degree of kinship between donor and donee is of consequence. In this, Dutch authors often referred to the Roman vicesima, quoting Pliny the Younger (60/61 – 112/113 AD) who described the 5 per cent tax as tolerable when imposed on distant heirs, but as a heavy burden when it comes to close relatives of the deceased.10 The vicesima included a first-degree exemption to reflect the basic idea of ‘family property’: the testator’s children had always been entitled to his estate and, later on, would transfer it to their own next of kin. This idea is still being upheld in the Dutch literature; its reflection in civil law is the forced share; and in tax law it is the inheritance tax exemption provisions and the relatively 6 D Subotnik, ‘On Constructively Realizing Constructive Realization: Building the Case for Death and Taxes’, in University of Kansas Law Review XXXVIII 1989, pp 1–38; RB Smith, ‘Burying the Estate Tax Without Resurrecting its Problems’, Tax Notes LV 1992, pp 1799–1811, cf Bartlett, lc, nt 86. 7 Sinnighe Damsté, ‘Wet op de Inkomstenbelasting 1914’, 4th edition, quoted in H Schuttevâer and JW Zwemmer, De Nederlandse Successiewetgeving (4th edn, Deventer, 1992) p 84. 8 Sprenger van Eyk and Vroom, p18, cf B Bartlett, ‘Wealth, Mobility, Inheritance and the Estate Tax, National Center for Policy Analysis’, Policy Report 235 at www. ncpa.org, fn 77. 9 In the Netherlands eg HJ Hofstra, Socialistische Belastingpolitiek, Amsterdam 1946, p 247. 10 Pliny, Panegyricus 37.1–2.

Book 1.indb 304

12/2/2011 8:22:08 AM

Charles Herckenrath’s 100% Death Tax Rate 305 low rates for close relatives. Parents’ desire to support their children is thus recognised in law.11 Distant relatives, on the other hand, would not necessarily have grown into the perception that the legacy would be theirs eventually.12 This distinction is reflected in another traditional argument in favour of inheritance taxation: that the tax causes little pain to the taxpayer. The assumption is that the inheritance comes as a positive surprise; paying tax reduces the pleasure but does not take it away. This conclusion can be found repeatedly in 19th century tax literature: with Proudhon in France, Bentham and Mill in England, Von Hock in Germany and in the Netherlands with Sprenger van Eyk and Vroom. The argument seems relevant to distant relatives rather than close ones. As Jeremy Bentham held in the first half of the 19th century: ‘hardship depends on disappointment, disappointment upon expectation ...’.13 and heirs other than in a straight line should obviously have no direct expectations. Who dormant gains purchasing power is not likely to protest against the levy, Congressman Morille said in 1864: ‘those who ‘sleep’ never complain’.14 Herckenrath squarely rejects the concept of ‘family property’. He refers to the English economist John Stuart Mill (1806–1873), who had considered the concept as a feudal relict and who illustrated his view that property belongs to individuals rather than to families by pointing out that according to civil law in the England of his time parents had the power to disinherit their children.15 The Dutch civil law of Herckenrath’s time had a comparable approach, allowing the testator to favour individual children over and above their forced share, or rule out other children for the excess of such share, which is contrary to the notion of family ownership. Herckenrath recognised that the system in his age constituted a compromise between the ancient idea of family property and individual ownership. He explains that curtailing the freedom to provide for the next generation would have an adverse effect on family relationships. If a parent has fewer opportunities to transfer wealth to his children, this could reduce his sense of responsibility. Inheritance taxation could lead to Platonic situations, where the parent-child relationship is affected.16 Translated into more contemporary terms: if the government averts the legal obligations of the citizen to his close relatives, this may lead to a blurring of moral standards; it stimulates individualism at the expense of traditional social relationships. Whether or not based on the concept of family property, the right to private property seems to include the right to transfer that property to others, during life or at the moment of death. But this inclusion is not self explanatory. In the 11

J Bentham, The Theory of Legislation (New York, 1931) p. 177, cf Iggers, p 134. Cf Antoine Louis Claude, Comte Destutt de Tracy, Economie politique, ch 7 (Distribution des richesses); cf for the Netherlands J van der Poel, De vooropstellingen van ons belastingrecht (Amsterdam, 1957) p 104. 13 W Tait (ed), The Works of Jeremy Bentham (Edinburgh, 1843) II, p 589; cf Grover, p 229. 14 Paul, oc, p 16. 15 Mill, Principles of Political Economy, b II, Ch II para 9. About the freedom to appoint one’s heirs in Engeland from 1724 to 1938 cf AR Mellows, The Law of Succession (London 1973) p 205. 16 Plato advocated the education of children by the state, to advance the equality of opportunity. 12

Book 1.indb 305

12/2/2011 8:22:09 AM

306

Onno Ydema and Henk Vording

age of Herckenrath, a 1898 U.S. court decision ruled as follows: ‘The right to take property by devise or descent is the creature of law, and not a natural right – a privilege, and therefore the authority which confers it may impose conditions on it’.17 Death taxes may then be conditions imposed on the state-guaranteed transfer. Herckenrath’s reasoning goes somewhat differently, however. In his view all members of the community as such would have a claim on the assets of individual members, which claims would rank beyond the claims of individual members on the assets of their family members. Indeed, Herckenrath argues, if the deceased did not inherit the estate during his life, he must have acquired the estate through his efforts. If that estate consists of money, that money represents a certain amount of social resources that he could have received in exchange for his efforts, as if that money is a credit. If the deceased had failed to redeem the coupon for that credit, the coupon would end being valid and the deceased then materially presents the community a gift. His heirs, under the present context, would not have a claim under that coupon. The whole purchasing power of the coupon would accrue to the community that had enabled the deceased to build his estate in the first place. If the community offered him the opportunity to build a bigger estate than he could use in his personal lifetime, according to Herckenrath it would be fairer that the estate would then be allotted to the community than that it would fall to some individual that found himself in the vicinity of the deceased through accidental birth.18

EQUAL OPPORTUNITIES

The idea that inheritance taxation might be used to redistribute wealth and economic opportunities was developing in Herckenrath’s time. In 1884 for example, the American utopian socialist Edward Bellamy pointed at the danger of economic dislocation due to the increasing imbalances in the distribution of wealth. The right to inherit should therefore be maximised to a reasonable amount.19 Two decades later, Herckenrath against the same background reminded his readers of the saying latifundia perdiderunt Romam – huge land ownerships destroyed Rome. It may be that lack of morals was the principal cause, but the great wealth of a small elite and poverty among the masses would have caused the corruption of morals. Without intervention, the rich would become richer and the poor would get poorer. That argument sounds subjective, and that is, to a certain extent true. An investigation into the concentration of wealth in England and Wales from 1670–1875 shows that fairly constantly 5 per

17 Magoun v Illinois Trust & Savings Bank, 170 US 283, 288 (1898). Quoted in E Frankel Paul ao.(eds), Property rights (Cambridge, 1994) p 33, nt 34. 18 Herckenrath, pp 25–27. 19 Paul, lc, p 65.

Book 1.indb 306

12/2/2011 8:22:09 AM

Charles Herckenrath’s 100% Death Tax Rate 307 cent of the population held approximately 73 per cent of the national wealth. However, birthright seems to have been the main reason for this concentration of wealth and not an assumed regularity as the adage that money attracts money. Still, in the 19th century the top 1 per cent of the population realised a relative increase of 49 per cent to 61 per cent of the national wealth, which does seem to support the adage after all. Partly due to the progressive inheritance tax, this growing conflict between rich and poor was reduced.20 For England and Wales Sandfort points out that between 1911/13 and 1960 the share in private wealth of the richest 1 per cent of the population had decreased from 69 per cent to 42 per cent. One of the reasons would be the tendency to distribute the estate in smaller portions among the descendants in order to avoid excessive assessments in progressive death taxes.21 For the same purpose of avoiding excessive wealth concentration Roosevelt in 1906 advocated a progressive inheritance tax for the United States to create a ceiling for wealth that could be transferred at death.22 For this reason his contemporaries accused him of ‘stimulating the latent envy that the improvident feel toward the thrifty’.23 A century later that argument is still alive, in a recent opinion piece we find statements such as: the inheritance tax ‘... is a tax on industry and thrift, on intergenerational altruism, on work and savings without consumption’.24 But more important is whether the redistributional effects are indeed as significant as for example Sandfort assumed. In a British study from 1960 it is alleged that the value of invested wealth usually doubles in value during the lifetime of its owner and that this already shows that the inheritance tax at the then prevailing rates can barely have a redistribution effect.25 A dozen years later Richard Wagner called the redistributive impact of inheritance taxation in the United States a ‘fiscal illusion’. A proportional rate of at least 77 per cent would be necessary to stop the accumulation of wealth by successive generations.26 The extremes may lie in the desire to see the redistributive effect already at the first

20 In a contribution in 2000 the effect of transfer at death is doubted; wealth would be earned mostly in the United States, not inherited, and seldom pass on to a third generation: cf Bartlett, lc. 21 Sandfort, pp 28–29. Meade 1964, pp 54 ff. 22 In a speech in 1906: ‘A progressive tax on all fortunes beyond a certain amount, either given in life or devised or bequested upon death to any individual – a tax so framed as to put it out of the power of the owner of one of these enormous fortunes to hand on more than a certain amount to any one individual.’ Paul, p 88. Also in ‘The New Nationalism’, speech in Osawatomie, Kansas, 31 August 1910, reprinted in FW Coker (ed), Democracy, Liberty, and Property, Readings in the American Political Tradition, (New York, 1942) p 681. 23 As the New Yorks Globe in respect to Roosevelt’s speech to Congress on 31 January 1908. Paul, p 90. 24 EJ McCaffery, ‘Death to the Death Taxes II, The Moral Case’, www.deathtax.com/deathtax/ deathtax2tax2.html. 25 AA Tait, ‘Death Duties in Britain’, in Impôts sur la fortune y inclus droits de la succession – debt management (Brussels, 1962) p 153. 26 At intervals of possession per generation of 30 years and a net rent of 5%. This last percentage seems difficult to reach, however, due to taxes and inflation. Wagner 1973, p 17. In 1972 the death taxes and the gift would procure less than 2% of the federal plus the state budgets. Wagner 1973, lc, pp 7–11, 30, 48.

Book 1.indb 307

12/2/2011 8:22:09 AM

308

Onno Ydema and Henk Vording

succession. Many variants are conceivable, such as the proposal of the former Ghent professor Francois Huet, who in Le Règne Social du Christianisme (1853) suggested that the transition of self-earned funds should be admitted, but wealth that the testator himself had inheritated could be confiscated. A bit more moderate but on a similar normative basis is the 1897 proposal of the Belgian industrialist Ernest Solvay, who also accepted the transfer of selfearned funds but who suggested that wealth inherited by the testator should be taxed with a special rate, increasing the more often the wealth had been transferred from earlier generations. That would serve social justice, while the incentive to produce and accumulate wealth through personal efforts would not be endangered. A similar proposal was developed by the Italian philosopher Eugenio Rignano, who allowed the first transition at the then existing rates, the second transition at a 50 per cent rate and who blocked the third transition with a 100 per cent rate. A letter with this proposal was published in 1920 in the socialist party newspaper Critica Soziale and reappeared four years later in an edited translation in the United States under the title The Social Significance of the Inheritance Tax (1924), while a modified version in England was published in 1925 as The Social Significance of Death Duties.27 In the Netherlands the idea that wealth should never survive three successions can be found in the writings of Hendrik Jan Hofstra. In his Socialistische Belastingpolitiek (Socialist Tax Policy, 1946) he considered high rates justified – 50 per cent or more in the first degree of kinship, or 80 to 90 per cent in the second or third degree – with the intention that old capital after three generations would have disappeared.28 Eventually, every generation would then be confronted with the task of delivering an active contribution to the community. For Herckenrath such a solution would not bring the desired result fast enough. He advocated a proportional rate of 100 per cent. In his mind everyone should have equal opportunities in life and he found this principle irreconcileable with the benefits of inherited capital. Although his proposal goes far beyond that of Roosevelt in 1906, the same starting point applies: wealth disparities would only be acceptable if there would be a social justification for their existence. The community should be a ‘meritocracy’, where personal merits count,29 or, in a French expression, ‘la carrière ouverte aux talents’.30 Herckenrath implicitly raises the issue whether the right to inherit can be combined with the democratic constitutional state. From an economic point of view the inheritance leads to concentration of wealth, especially if viewed over longer time spans, with the disadvantage that the socially desired equality of opportunity is frustrated. The single permissible aristocracy in a democratic constitutional state, would be the 27 Cf G Erreygers and G di Bartolomeo, ‘The debates on Rignano’s Inheritance Tax Proposal’, Working Paper no 85 (2005) Dipartimento di Economia Pubblica, interneteditie, AA Tait, lc, p 163v. 28 Hofstra, oc, pp 246–247. 29 Cf billionaire Warren Buffett in The Wall Street Journal, 16 February 2001. 30 FA Hayek, Law, Legislation and Liberty, A New Statement of the Liberal Principles of Justice and Political Economy, II, The Mirage of Social Justice (Chicago, 1976) p 84.

Book 1.indb 308

12/2/2011 8:22:09 AM

Charles Herckenrath’s 100% Death Tax Rate 309 aristocracy of merit. The holding of a high social position, power and fortune should be consequences of personal merit, not of birth.31 Everyone should be confronted with the need to achieve a goal, as Herckenrath states, in a peaceful but vibrant and sharp competition, and to that purpose he advocates an equal economic starting position for all members of the community. This preludes John Rawls’ A Theory of Justice (1971), in that material things in the community should be divided equally: ‘The first principle of justice’ would be ‘one requiring equal distribution’.32 Indeed, if citizens in an imaginary situation would outline a society where they would eventually be born, without knowing what position they would occupy in that society, then they would choose a society in which equality of opportunity is paramount. The legal concept of inheritance seems to be a violation of that principle, and it may well add up with all the other ways in which parents can endow their offspring with better opportunities. As Rawls said: ‘It is perfectly true, as some have said,33 that unequal inheritance of wealth is no more inherently unjust than unequal inheritance of intelligence’.34 That points to the limits of the case for ‘equal opportunities’ inheritance taxation. To be perfectly fair ‘one should deliver artificial advantages to the weak, the ugly and the stupid, so that eventually each would have a similar sum in the enjoyment of life’ as Herckenrath contemplated many decades before Rawls came with similar ideas about compensations for the weak. But Herckenrath immediately rejected such advantages as contrary to a healthy evolution of society. Trying to provide equal benefits, equal power and equal access to goods to all would subordinate the interest of the community to the (alleged) interest of individuals. Social justice, instead, would mean that everyone is endowed in straight relation to the services that he offers to the community.35

THE STATE AS UNIVERSAL HEIR?

Herckenrath’s proposal would imply that the state becomes effectively the sole heir of all its citizens, and he realises that such a consequence cannot be accepted. ‘The state is the prime waster of capital’: the reproductive capacity of private wealth will disappear in one year as consumption if it becomes ordinary income to the state.36 Herckenrath has the same argument for the ability of the state to manage the estates it inherits from its citizens: that management will be suboptimal by definition. He has little regard for the benevolence of civil

31

Herckenrath, p 21. For a criticism of the idea of collective property: A Flew, ‘Private Property and “Social” Justice’, in C Kolbert (ed),The Idea of Property in History and Modern Times, the Sir Ian Mactaggart Memorial Lectures and Complementary Essays (Glasgow, 1997) pp 124–129. 33 Referring to F. von Hayek, The Constitution of Liberty, Chicago 1960, p 90. 34 Rawls, lc, pp 142–143. 35 Herckenrath, pp 14–17. 36 Van der Poel 1957, pp 105–106. 32

Book 1.indb 309

12/2/2011 8:22:09 AM

310

Onno Ydema and Henk Vording

servants; the state as a collective body and universal heir of all individuals, would have to put such tremendous resources in the hands of those in its administration that the largest waste, corruption, bribery and abuse of power would easily be imaginable. This spectre he did not need to describe in much detail: ‘There will be an army of higher and lower civil servants who do not feel the interest they have in production, and who will do their work... as state employees normally do’.37 Herckenrath then considers to use the increase in inheritance tax revenue to reduce the rates of other taxes. He rejects the idea out of hand: with the easy revenue of a 100 per cent inheritance tax, citizens would underestimate their overall tax burdens. And the effectively felt burden of the taxes is precisely the tool to keep citizens actively involved in the state affairs. ‘So, there remains no alternative but to divide the inheritance’. This could easily be done by liquidating all legacies when they are received and dividing the balance by the number of inhabitants. Herckenrath calculates an annual allowance of about 52 guilders, for young and old – more than a skilled worker’s monthly wage. For minors, the government would save their allowance. If the child would reach the age of maturity then he would have a compounded starting capital of about 2000 guilders, or twice that amount through marriage.38 That would be a substantial seed capital; 4000 guilders in 1904 may tentatively be compared with a sum of EUR 200,000 in 2010. The proposal to use death taxes as leveling instruments to mitigate the social question is obviously not new. The positions of 19th century authors such as Proudhon, Bentham, Mill and Royer are commonly quoted in later studies. Not even the proposal to distribute the proceeds of the state confiscations at death was new. In Francois Huet’s study for example, half a century before Herckenrath, we find a proposal to distribute the proceeds of such taxes directly to the citizens, although he awarded the proceeds to a smaller circle of people of a certain age. But Huet wanted to achieve a similar position for starters in the economy as Herckenrath some decades later.39 In the Utopia of both authors young people would receive a starting capital from the state at the threshold of their active lives. In a modern version we could think of a basic income, or ‘the $10,000 solution’ of Charles Murray, an annual cheque to all American citizens age 21 and older in the social war against poverty, a distribution that would still leave a sufficient incentive for individuals to continue working. That benefit would also provide a ceiling to redistribution, individuals that believe they need more support from the state should find a deaf ear. This is roughly in line with the plan presented by Herckenrath.40

37

Herckenrath, p 27. ibid, pp 30–37. 39 Cf G Erreygers and G di Bartolomeo, ‘The Debates on Rignano’s Inheritance Tax Proposal’, Working Paper no 85 (2005) Dipartimento di Economia Pubblica. 40 Murray in The Los Angeles Time of 9 April 2006. 38

Book 1.indb 310

12/2/2011 8:22:09 AM

Charles Herckenrath’s 100% Death Tax Rate 311 IMPLICATIONS FOR THE SOCIALE QUESTIE

Herckenrath believed that implementation of his proposal would have far-reaching consequences for society. The carelessness and apathy among the deprived would disappear if they would be offered new financial horizons, and the extravagance and satiety of the well-to-do would diminish. The rich are generally happier and are usually in better mood than the poor, argued Herckenrath, apparently not convinced of the saying that money cannot buy happiness. On the contrary, the community at large would benefit from a better distribution of wealth and that would even be in the interest of the rich.41 For Herckenrath this is not an utopian scenario, nor is it an issue of personal preference: ‘This is a demand for justice. No-one can claim to be appointed in a position just because his father held it earlier, and no-one can claim the reward for work done by his father, uncle or cousin. We all have equal right to the inheritance that our ancestors left us, just because nobody in particular is entitled to it’.42 The practical effect of Herckenrath’s proposal would be that people would neither be condemned to poverty, nor entitled to effortless privilege, just because of the place they were born. Social security payments would be unnecessary. The annual allowance would not by far suffice to retire, but it would provide a financial basis for those who want to lead a productive life. With the exception of some unfortunate infirm who would receive additional charity donations everyone would make a choice to work or to starve. If one would be particularly lazy, one could always become a domestic servant – Herckenrath apparently lifts a corner of the downside of having domestic personnel. Whoever did not take the initiative to educate himself would have no-one else to blame when only the roughest and dirtiest work would be available for him. It would also reduce the waste of the working class (contemporary authors regularly complained that the lowest income classes spent what little they had on alcohol), since the general apathy of those classes would decrease. Because of the consequent great leveling the poor gain an opportunity to improve their position, and get perspective on personal welfare through personal efforts. This would lead to an efficient allocation of talents, and the overall prosperity of the community would increase. At the same time, at the top of the income ladder the ‘horrified parasitism of the propertied class’ would eventually disappear. Here Herckenrath seeks support from the incredibly wealthy American industrialist Andrew Carnegie, unfortunately without specific quote. Possibly Herckenrath found a contribution by Carnegie in the 1890 North American Review. In this contribution, it was argued that accumulation of wealth becomes possible in an interaction of the community and the individual, and consequently it would be reasonable if the community would receive a share. The heirs even at confiscatory rates would not be unreasonably affected. 41 42

Book 1.indb 311

Herckenrath, p 24. ibid, p 43.

12/2/2011 8:22:09 AM

312

Onno Ydema and Henk Vording

On the contrary, Carnegie says a year later: ‘That the parent who leaves his son enormous wealth generally deadens the talents and energies of the son, and tempts him to lead a less useful and less worthy life than he otherwise would, seems to me capable of proof which cannot be gainsaid’.43 It goes without saying that ‘the putrid sons of the financial scion’ should be saved from such fate. According to Congressman Ham Lewis in 1932, the inheritance tax is therefore to focus on those ‘who spend their time capering upon their yachts in distant waters, accompanied with their diamond-bedecked Delilahs as their companions of joy’.44 That undeserved fate, the state of hereditary layabouts, as Hofstra in the Netherlands called them ten years later, should not be awarded to them. In Herckenrath’s mind the class of no-use rentiers would disappear, the sons and daughters of rich dads, cousins of rich uncles and aunts should not be able to lead a a lazy life, they should invest in their training and the good for nothing class would more or less evaporate.45 As to his political denomination, Herckenrath did not regard himself a socialist, quite the contrary: ‘The solution I propose is fully in the liberal line, it actually is just a consistent application of the principle of free competition’.46 Of more practical nature is the question whether rich citizens would perhaps ensure that there are no taxable assets at their deaths. Moderate rates in the death taxes could have a positive effect; they would encourage saving when the propensity to favour the heir to be is inelastic. Obviously this effect is lost at a 100 per cent rate. The incentive for private initiative in the later years of one’s life would be reduced to nil. The moderate proponents of the death tax would still not be impressed, even at high rates. True entrepreneurs, as we read on occasion, would derive so much pleasure gathering wealth that they would not likely let an inheritance tax prevent pursuing their personal thrive for material and social success.47 For an extreme supporter of the death tax as Herckenrath that argument is very much valid: ‘Someone who has at one time got the habit of working and saving will keep pleasure in work, and will not lightly become a waster and a loafer in his old age’.48 But then, would a man in his golden years not be devoted to escape the 100 per cent inheritance tax? We started this article with the example of the elderly Egyptian who attempted to evade the inheritance tax of his time about 43 A Carnegie, ‘The Advantages of Poverty’, in E C Kirkland (ed), The Gospel of Wealth (Cambridge, 1891, reprint 1962) pp 50–77. 44 US Congress, Senate, Congressional Record, 72d Cong, 1st session 1932, pt 9:10196, gecit in Leff, p 51. 45 Herckenrath, pp 43–45. 46 ibid, p vi. 47 Carnegie, quoted in Paul, p 66, and after that mutatis mutandis quoted by H Simons, Personal Income Taxation, 1938, p 20, and WJ Blum and H Kalven, ‘The Uneasy Case for Progressive Taxation’ in The university of Chicago Law Review XIX (Spring 1952) 3, p 438. MN Rothbard calls the argument a ‘ridiculous assertion’. Rothbard, ‘The Uneasy Case for Degressive Taxation, A Critique of Blum and Kalven’, The Quarterly Journal of Austrian Economics IV (Spring 2001) p 47. 48 Herckenrath, p 61.

Book 1.indb 312

12/2/2011 8:22:10 AM

Charles Herckenrath’s 100% Death Tax Rate 313 three thousand years ago by transferring his property at a nominal price to his kin. Does this early example of estate planning not already demonstrate, that people always find ways to avoid inheritance taxes, in the interests of those to whom they feel a special affinity? In the Netherlands, between 1817 and 1830, taxpayers were required to endorse their tax returns with an oath, which was strongly criticised at the time on the basis of the assumed harm to morality. Apparently the temptation to evade taxes was too big even for the conscientious citizens.49 Herckenrath hastens to declare that his proposal does not mean that inheritances as such would be abolished, and – in case anyone would take him for a socialist – that it was not his intention to take from the rich to give to the poor. The state, by paying the proceeds of the tax to the individual members of the community, will create an idea of quid pro quo, he believes. ‘Our sense of gratitude and our sense of equity will already tell us that if we are constantly (...) awarded contributions by the community, we should sometimes do something for the community as well’.50 And even though the law will be evaded to some extent, Herckenrath said, ‘Better half an egg than an empty shell’. Moreover, the existing taxes would continue and the related registers would enable the tax authorities to check on the causes of the wealth of the second generation. It would be as difficult for an individual recipient to enjoy his wealth as for someone who ‘by extortion or fraudulent actions made his fortune’. 51

THE DEVELOPMENT OF INHERITANCE TAXATION IN THE NETHERLANDS SINCE THE 19TH CENTURY

The first law on inheritance taxation dates from 1817 and existed for forty years, with some minor amendments to increase its effectiveness. Its most notable feature was an exemption for first-degree relatives. In 1857, new legislation was proposed to parliament, because the 1817 law had proved to lead to a considerable flow of legal procedures while also leaving many tax planning opportunities. One of the elements of the proposal was to abolish the exemption for first-degree relatives – be it in an extremely limited way.52 It was precisely this element that led to strong resistance in parliament, and in the end, the law of 1859 continued a full exemption. An important consideration against first-degree taxation was that it would oblige families to disclose their overall net wealth. A second argument was the moral impact: first-degree relatives would be tempted to evade the tax by hiding the transfer of financial assets. The taxation of inheritances between first-degree relatives was only adopted in 49

Sprenger/van Eyck p 7. Herckenrath, p 67. ibid, pp 68–69. 52 Only inheritances by (grand)parents of their deceased (grand)children would be taxable, and only to the extent that their inheritance would exceed their forced share. The main idea behind this was to hamper tax planning. 50 51

Book 1.indb 313

12/2/2011 8:22:10 AM

314

Onno Ydema and Henk Vording

1878 – at a time when the ‘social question’was developing (for example, the first labour legislation was introduced in 1874). The debate on the introduction of progressive personal income taxation was also gaining in political weight; tax legislation itself was becoming an issue of social policy. Successive rate increases in the following decades led to a progressive inheritance tax and a quadrupling of tax revenues between 1890 and 1920. The 19th century development of the inheritance tax shows that it was used, to some extent, a substitute for a personal income tax. The first personal income tax was only introduced in the Netherlands in 1892/3, and a fully synthetic tax only in 1914. Given the lack of a personal income tax throughout the 19th century, the inheritance tax was made to include some provisions that resembled an estate or transfer tax for specific situations: the inheritance of foreign bonds and shares, and the inheritance of real estate on Dutch territory from a foreigner. In both cases, the actual reason was protectionistic: to encourage domestic portfolio investment, and to discourage the acquisition of Dutch real estate by foreigners. Both of these provisions met growing liberal resistance from the middle of the century ‘It is not the duty of the State to force or hinder its citizens in their choice of investments’. The differential treatment of foreign bonds and shares was reduced in the 1859 reform by the introduction of an estate tax on all financial assets. The reason was that the existing set of taxes largely exempted revenues from financial assets, as compared to real estate and businesses. But that gap, the government realised, could never be filled adequately by an estate tax if transfers among first-degree relatives were exempted. In the end, this estate tax could be reduced (and the surcharge for foreign financial assets abolished) when the personal income tax developed into a better way of taxing financial assets. The estate tax on Dutch real estate inherited from non-residents was reduced when the corresponding revenues became taxable under the personal income tax (1914), but continued to exist until recently. In the 20th century, the main changes in the law addressed the tax rates (sometimes reduced, usually increased) and specific tax planning constructions. The 1956 rewrite was of a technical nature. The most important substantive change concerned business capital: starting with a possibility of postponed payment, an exemption (partial but generous) was introduced in the 1990s. It was substantially increased in the 2010 tax reform. Tax planning and tax evasion remained important issues throughout the legislative development of the inheritance tax. Early in the 19th century, taxpayers (donees) were obliged to authenticate their tax declaration by an oath. Later on, specific rules were adopted, eg, regarding the valuation of debts, and the transfer of assets with the purpose of escaping inheritance taxation. But throughout the 20th century, the inheritance tax can easily be qualified as the most important field of tax planning. High rates (up to 68 per cent), and rate differences based on family relationship, increased the pressure; the text of the law became dominated by anti-avoidance rules, often of a very specific nature.

Book 1.indb 314

12/2/2011 8:22:10 AM

Charles Herckenrath’s 100% Death Tax Rate 315 The 2010 inheritance tax reform connected the themes of simplification and anti-avoidance. Simplification of the rate structure and lower rates have been paid for by increased (expected) revenue. In its explanatory memorandum, the Cabinet suggests that ‘paying inheritance tax is no longer a concern to the very wealthy, but to the middle class’. Given the choice between abolishing the tax and improving it, the Cabinet argues for the latter option. Receiving an inheritance without effort does increase one’s ability to pay tax; and taxing inheritances causes less economic damage than taxing labour and business activity. The rate structure of the tax has now been simplified considerably. Rates for partners and children are 10 per cent and 20 per cent, for grandchildren: 18 per cent and 36 per cent, and for all others: 30 per cent and 40 per cent. The higher rates apply to inherited amounts from 125 thousand euro upward. Partners receive an exemption of 600 thousand euro’s. The main budgetary coverage comes from measures to include foreign trusts more effectively in the tax base. Even while donations to trusts are taxable, the practices is that wealthy families are able to transfer large capitals among themselves without much interference by the Dutch fisc. From 2010 onwards, trusts will be transparant for tax purposes, with the effect that the trust capital is treated as if it still belonged to the donor.

IS THERE ROOM FOR THE DEATH TAXES IN THE 21ST CENTURY?

Since Herckenrath’s era, we have made a considerable progress towards his Hedonia, where poverty no longer exists, and where the ‘sociale quaestie’ actually is resolved. Perhaps we even find that we missed the mark for Utopia, because in the vision of Herckenrath there is emphatically no room for a tax mix that taxes the active to the benefit of the inactive who have been made dependant on the community. This being said there is no social need anymore for the far-reaching solution Herckenrath stood for. But what about the moderate inheritance tax? The Dutch lawyer Bordewijk was clear about the future of this tax in the Netherlands of the 30s: the ‘unerfreuliche reality’ is that ‘the (inheritance) tax exists, it will continue’, and in current Dutch comments such as Schuttevaer/Zwemmer this assessment is called ‘justified’.53 In the U.S. we see a different movement. In California, the State Gift and Inheritance taxes fell back 1980. In the familiar rhetoric of the tax rebels it was stated that the government has no right to redistribute property and it was also found unfair that all wealth taxed already during the life of the testator by the income tax would be taxed again. Furthermore, the tax no longer only covered the top-10 per cent wealth, as originally intended. As a result of the sharp rise in real estate values the target group became much wider. Under such circumstances the 53

Book 1.indb 315

Schuttevâer/Zwemmer, p 87.

12/2/2011 8:22:10 AM

316

Onno Ydema and Henk Vording

redistributive role of the death taxes is less recognisable.54 Anno 2000 the federal estate tax and gift tax in the United States yielded only U.S. $30 billion, which represents approximately 1.5 per cent of federal revenues,55 the same percentage as the inheritance tax in the Netherlands today. According to the Joint Economic Committee of the U.S. Congress and the Senate in December 1998, the majority of revenues derive from medium wealth, while the most wealthy estates actually were relatively milder affected.56 This again makes the redistributive role of inheritance taxes less recognisable. The underlying arguments apply also for the Netherlands. With proper estate planning, the tax burden is minimised, and thus it falls relatively heavily in the smaller estates which the deceased has failed to protect. Readers involved in estate planning will usually advise their clients who have substantial assets not to transfer their estate in a jurisdiction with heavy death duties. At the very least they will advise their clients to avoid as much as possible the rate progression, for example transferring wealth timely or against friendly considerations on to the succeeding generation. Besides legal ways there are of course many non-legal ways to evade the death taxes, which often go beyond the control of the tax authorities. When we would chose to implement the ideas of Herckenrath, even if only partially, a substantial inheritance may offer a positive contribution to the ‘sociale quaestie’ aiming at an equal starting position for new citizens, the democratic ideal of a meritocracy would be promoted. From this point of view death taxes continue to fit within the present political constellation. But in practice these taxes mainly seem to increase the burden on the smaller estates, while they will have little impact on the larger estates. Herckenrath found no obstacle in this objection, as we have seen, but the society in which he published his work, in 1904, may have required radical measures where a half egg actually was better than an empty shell. Now, a century later, there is no need for such radical surgery and for us the main question remains, why those who are affected by the death taxes may reasonably be required to pay. The positive responses that have been formulated in the fiscal theories seem difficult to reconcile with the skewed distribution of the pressure of the the inheritance tax in practice. Some authors therefore advocated a very moderate rate, so that the costs of the estate planning would outweigh the tax burden.57 We do not known the burden that the old man in the Egyptian case tried to dodge. At a moderate rate, he would probably not have stripped before going to bed. At the rate of Herckenrath however he would certainly from the moment of his children’s birth have started his estate planning, despite all arguments that Herckenrath raised in favour of the death taxes.

54 M Bauer, Direkte Demokratie und Finanzpolitik in den USA, Volksabstimmungen über Haushaltsfragen, Steuern und Verschuldung in Kalifornien, Diss Nürnberg 1997, p 159. 55 Bartlett, lc. 56 Cf ibid, lc. 57 Nahuys, p 119v.

Book 1.indb 316

12/2/2011 8:22:10 AM

12 The History of Death Duties and Gift Duty in New Zealand MICHAEL LITTLEWOOD1

ABSTRACT

D

EATH DUTIES WERE introduced in New Zealand in 1866 and abolished in 1993. For most of that period, they played a significant and much-debated role in the country’s tax system. But in the years after the Second World War, successive governments narrowed the scope of these taxes, reduced the rates at which they were charged, and did little to prevent avoidance. By 1980 estate duty – the sole surviving death duty – had ceased to make a significant contribution to the public finances and public attitudes had changed so much that its abolition in 1993 was hardly even controversial. Gift duty was introduced in 1885, as a means of preventing the avoidance of death duties; but when estate duty was abolished in 1993, gift duty was left intact as an anomalous stand-alone tax. In 2010, the government announced that gift duty would be abolished, bringing the history of death duties and gift duty in New Zealand to a close.

INTRODUCTION

This chapter traces the rise and fall of death duties and gift duty in New Zealand from 1866, when death duties were first introduced, until the present day.2 It is 1 I am grateful to Sir Ivor Richardson, John Tiley, David V Williams, Barry Littlewood and Alex Frame for their advice on various aspects of the chapter and to Chris Jenkins and Thomas Ebben for helping with the research on which it is based. 2 For earlier accounts of the history of death duties in New Zealand, see Anonymous ‘Death Duties: Streamlining the System of Collection’ (1955) New Zealand Law Journal 193; Taxation

Book 1.indb 317

12/2/2011 8:22:10 AM

318

Michael Littlewood

a legal history, but seeks to place the development of the law within its political and economic contexts. The story has a number of strands, largely because there was not just one death duty but several – sometimes simultaneously, sometimes sequentially – namely probate duty, legacy duty, succession duty and, finally, estate duty. These were not merely different names for the same tax; rather, as the names suggest, the scope of each was different. As for gift duty, it was added to the system in 1885 to stop people avoiding death duties by giving their property away – usually to their children or on trust for their children, who would in due course inherit anyway. In the beginning, from 1866 to about 1890, death duties were intended simply as a revenue measure, but the Liberal government of 1890 to 1912 saw them also as a means of breaking up large fortunes and redistributing wealth. The first Labour government – 1935 to 1949 – was likewise attracted both to the revenueraising potential of these taxes and to their progressiveness. These governments significantly increased the rates of tax and were assiduous in confronting avoidance. Right-wing governments were philosophically opposed to taxes on wealth, but prior to the Second World War reduced neither the scope of the death duties nor the rates at which they were charged. For one thing, they needed the money. It seems also, however, that the idea of steeply progressive death duties enjoyed broad popular support and that cutting them back would have been electorally expensive, even for right-wing political parties. These dynamics changed in 1949, when the National Party – formed in 1936 and thenceforth the dominant right-wing party – won the general election and commenced what in retrospect looks like a long-term programme aimed at the dismembering of the death duties system. Over forty years, successive National governments narrowed the scope of the system, progressively reduced the rates of tax, and did next to nothing to contain avoidance. As a result, estate duty – from 1955 the sole remaining death duty – slid into desuetude. Death duties had always been susceptible to avoidance, but as the century progressed estate planning (as it was called) became more common and more sophisticated and was undertaken on a larger scale. Partly for that reason, estate duty produced very little revenue. It was also altogether overshadowed by the colossal revenueraising capacity of the income tax and, later, the value-added tax (in New Zealand called Goods and Services Tax or GST). Eventually, once the death duty system had been reduced to an irrelevance, it was easy for the government – National, again – to abolish it. That happened in 1993. Since gift duty was originally an adjunct to death duties, one might have expected it to have been in New Zealand: Report of the Taxation Review Committee (RE Owen, Government Printer, Wellington, 1967) (the Ross Report); L McKay ‘Historical Aspects of the Estate Tax’ (1978) 8 New Zealand Universities Law Review 1; D Duff ‘The Abolition of Wealth Transfer Taxes: Lessons from Canada, Australia, and New Zealand’ (2005) 3 Pittsburgh Tax Review 72; A Basrur ‘The Conception and Birth of the Stamp Duties Act 1866’ (2008) 14 New Zealand Journal of Taxation Law and Policy 45; and P Goldsmith, We Won, You Lost, Eat That! A Political History of Tax in New Zealand since 1840 (David Ling, Auckland, 2008).

Book 1.indb 318

12/2/2011 8:22:10 AM

The History of Death Duties and Gift Duty in New Zealand 319 abolished too – but that was not what happened. Instead, gift duty was left as a stand-alone tax. Seventeen years later, in 2010, the government – National, once more – announced that it proposed to abolish gift duty with effect from 2011. That National governments should have hollowed out and then killed a progressive wealth tax is unsurprising. What is curious is that successive Labour governments did almost nothing to reverse this process, or even slow it down. The explanation consists of several factors. First, Labour’s last attempt to make something of death duties was an unhappy experience. It happened in 1958, when the second Labour government effected steep increases in various taxes, including increasing the maximum rate of estate duty from 40 percent to 60 percent (the highest it was ever to reach). The consequences of this and other measures included a landslide loss at the next election, which scarred the party badly. Secondly, death duties produced very little revenue, but very considerable vexation. Thirdly, since about 1980 there has been a worldwide trend away from progressive taxes and towards flat ones – and the abolition of death duties can be seen as part of that trend. And, last but not least, in 1977 the state of Queensland in Australia abolished death duties – perhaps tempting affluent New Zealanders to retire there, taking their fortunes with them. The chapter contains five main parts. Part I supplies a very brief overview of the constitutional and political contexts in which New Zealand’s tax system has evolved. Part II examines the legislation by which death duties were introduced in 1866 and the refinements effected between then and 1909. Prominent among these was the introduction of a tax on gifts in 1885. Part III considers the Death Duties Act 1909, which transformed death duties and gift duty into something resembling their modern form. Part IV covers the heyday of death duties in New Zealand – the period from 1909 to 1949, during which death duties supplied a significant though dwindling part of the government’s revenues. Finally, Part V examines the decline of estate duty, which began in 1949 and culminated in its abolition in 1993, leaving gift duty for 18 years as an anomalous stand-alone tax.

I. CONSTITUTIONAL AND POLITICAL CONTEXTS

The Constitution The crucial date in Britain’s colonisation of New Zealand is generally reckoned to be 6 February 1840, when a treaty was signed at Waitangi in the Bay of Islands, 200 kilometres north of Auckland. The signatories were one William Hobson3 (a naval commander who was to become the Colony’s first governor) 3 William Hobson was born in Ireland in 1792 and joined the British Navy at the age of nine. He served in the Napoleonic wars and also in the Caribbean before being despatched to Australia and New Zealand in 1836. He was appointed Governor of New Zealand in 1841 but died in 1842. Hobson Bay and Mount Hobson in Auckland are named after him. The biographical data in this chapter are generally from Dictionary of New Zealand Biography, http://www.teara.govt.nz/en/ biographies/.

Book 1.indb 319

12/2/2011 8:22:10 AM

320

Michael Littlewood

on behalf of the Crown and about 40 Maori chiefs on behalf of themselves and their peoples. Over the next few months, more Maori chiefs signed, bringing the total eventually to more than 500. Some tribes, however, declined to sign.4 The Treaty was in both Maori and English. It was very short, consisting of only three brief articles. Article I conferred on the Crown either ‘sovereignty’ (English version) or ‘kawanatanga’ (Maori version; the word is usually translated as ‘governorship’).5 Article II guaranteed to the Maori ‘the full, exclusive and undisturbed possession of their lands and estates, forests, fisheries and other properties’. And Article III extended to Maori ‘all the rights and privileges of British subjects’. The status and meaning of the Treaty were contentious from the beginning and remain so today.6 But whatever its legal effect, the Treaty marked, more or less, the founding of New Zealand as a British colony. In commemoration of its signing, the sixth of February, Waitangi Day, is New Zealand’s principal national holiday. For the first few years of the colonial period, New Zealand was ruled by a governor appointed by the British government. Eventually the Imperial Parliament enacted the New Zealand Constitution Act 1852, which established a partially representative system of government more or less in accordance with the mid-nineteenth century British colonial norm. The Governor was still appointed by London and he still ran the government (meaning the executive), but the legislative function went to a Parliament composed of the Governor, an upper chamber (called the Legislative Council), and a lower chamber (the House of Representatives).7 The House of Representatives was elected (though not, initially, by universal suffrage)8 and the Legislative Council was appointed by the Governor, in the name of the Crown.9 Universal male suffrage was instituted in 1879 and women won the vote in 1893. In the beginning, elections were held rather erratically, but since 1881 there has generally been an election every three years.10 Over a period of years, the New Zealand Parliament gradually came to control the executive. The power of the Governor waned, and that of the Premier (the leader of the House of Representatives) grew. Towards the end of the nineteenth century the Premier was slowly transformed into the Prime Minister, in 1907 the Colony became a Dominion, and in 1917 the Governor became the GovernorGeneral. Over the course of the twentieth century, New Zealand’s ties with the

4 See generally C Orange, The Treaty of Waitangi (Allen & Unwin, Wellington, 1987) and M Palmer, The Treaty of Waitangi in New Zealand’s Law and Constitution (Victoria University Press, Wellington, 2008). 5 For example, Palmer, above n 4 at 61–63. 6 See for example David V Williams ‘The Treaty of Waitangi – A “Bridle” on Parliamentary Sovereignty?’ (2007) 22 New Zealand Universities Law Review 596. 7 New Zealand Constitution Act 1852 (UK), s 32. 8 New Zealand Constitution Act 1852 (UK), s 41. 9 New Zealand Constitution Act 1852 (UK), s 33. 10 On New Zealand’s constitutional history generally, see P A Joseph, Constitutional and Administrative Law in New Zealand (3rd edn, Thomson Brookers, Wellington, 2007) chs 2–4.

Book 1.indb 320

12/2/2011 8:22:11 AM

The History of Death Duties and Gift Duty in New Zealand 321 United Kingdom gradually weakened, though the British monarch is still the head of state and the Governor-General her local representative (as in Australia and Canada). In 1951 the Legislative Council was abolished, leaving New Zealand as one of the few countries in the world with a unicameral Parliament. Over the last 30 years or so the Treaty of Waitangi – regarded by successive governments for the first 140 years as an irrelevant nullity – has been accorded a vague constitutional status, and some effort has been made to redress the government’s breaches of it. And in 1996, the ‘first past the post’ electoral system was abolished and replaced by a system of proportional representation.

Political Parties Political parties emerged in New Zealand in the late nineteenth century. Until then, Members of Parliament had been either independent or joined in loose ad hoc groupings. The first political party was the Liberal Party, which was formed in 1891 and led by John Ballance.11 The Party evolved out of a group of liberal MPs who had campaigned together for the 1890 election. They won that election, formed the government and established the Liberal Party. Ballance died in 1893 and was succeeded by Richard ‘King Dick’ Seddon – a large, violent, barely educated publican who became a supremely effective populist politician and New Zealand’s longest-serving Prime Minister.12 The Liberals won six more consecutive elections – in 1893, 1896, 1899, 1902, 1905 and 1908 – and governed until 1912. Thereafter, the Party declined. It never won another election, but it left an enduring legacy. Most pertinently, Ballance may be regarded as the father of the New Zealand tax system. In 1878 (as Treasurer in the administration led by Sir George Grey)13 he instituted a land and property tax and in 1891 (as Premier) an income tax.14 It was also the Liberal government – though after Ballance’s death – that produced the crucial Death Duties Act 1909. Also in 1909, the conservative opposition belatedly formed the country’s second political party. Perversely, they called it the Reform Party. It was initially led by Bill Massey, another large man, a farmer and a frequent citer of the Bible, who became

11 John Ballance was born in Ireland in 1839 and as a young man emigrated to New Zealand, where he became a journalist and newspaper proprietor before entering Parliament in 1875. He became Premier in 1891 and died in office in 1893. He was an early advocate of female suffrage and, by the standards of the day, Maori land rights. 12 Richard Seddon (1845–1906) was born in Lancashire, left school at 12 and in 1863 emigrated to Australia in search of gold. In 1866 he continued to New Zealand, became an MP in 1879 and led the Liberal government from 1893 until his death in 1906. At his peak, he weighed about 125 kilograms. 13 Sir George Grey (1812–1898) was Governor of, in turn, South Australia (1841–1845), New Zealand (1845–1853), the Cape Colony (1854–1861) and New Zealand again (1861–1868), before becoming Premier of New Zealand (1877–1879). 14 Luke Facer ‘The Introduction of Income Tax in New Zealand’ (2006) 12 Auckland University Law Review 44.

Book 1.indb 321

12/2/2011 8:22:11 AM

322

Michael Littlewood

the country’s second-longest serving Prime Minister.15 The Reform Party governed from 1912 to 1928 (except during the First World War, when there was a coalition government). The New Zealand Labour Party was established in 1916 and first formed a government in 1935. Labour’s victory induced the Reform Party to merge with the United Party (effectively the remnants of the Liberal Party) to form the National Party. That happened in 1936. From 1935 until 1996, every government was formed by either the Labour Party (on the left) or the National Party (on the right); that is, one or other of them controlled a majority of the seats in the House of Representatives. Since the introduction of proportional representation in 1996, the Labour and National parties have still dominated the political process, but they have always been obliged to enter into coalitions or, at least, confidence and supply agreements with one or more smaller parties to form a government.

II. THE EARLY YEARS: 1866–1909

The Introduction of Death Duties in 1866 For the first quarter-century of its existence, the colonial government funded itself mainly by means of customs duties and land sales.16 Notable, too, was the establishment of an income tax in 1844 – a very early example of a British colonial income tax. But this proved a failure and was repealed only a year later.17 By the early 1860s, it had become apparent that the government’s revenues were inadequate. The need was exacerbated by the war that had broken out between the colonial government and some Maori, largely over the latter’s refusal to sell land at a price the former was prepared to pay. To meet the need, the government proposed to introduce stamp duty – that is, a tax on specified classes of document, payment being evidenced by the affixing of a stamp to the document in question.18 It proposed, too, that the documents specified would include some relating to inheritance. In other words, the proposed stamp duty would incorporate a system of death duties. As generally happens with proposed new taxes, this one encountered both opposition and prevarication. He would support it, said one legislator, but only if customs duties were reduced.19 Another said that he was unable to endorse

15 William Massey (1856–1925) was born in Ireland, emigrated to New Zealand in 1869 and served as Prime Minister from 1912 until 1925. Massey University is named after him. 16 Muriel F Lloyd Prichard, An Economic History of New Zealand (Collins, Auckland, 1970), chs 3 and 4. 17 See K Heagney The Genesis and Early Evolution of New Zealand Income Tax: An Examination of Governor Fitzroy’s Experiments with Taxation, 1843–1845 (PhD Thesis, Massey University, 2009) and O Kabzamalov, ‘New Zealand’s Forgotten Income Tax’ (2010) 16 Auckland University Law Review 26. 18 New Zealand Parliamentary Debates, 15 September 1865 at 545 (Henry Sewell). 19 New Zealand Parliamentary Debates, 22 September 1865 at 590 (Julius Vogel).

Book 1.indb 322

12/2/2011 8:22:11 AM

The History of Death Duties and Gift Duty in New Zealand 323 the new tax just yet, because the government had not provided sufficient information as to how it would work. And taxation had already, observed a third, ‘reached its utmost limits’.20 It was suggested, too, that an income tax might be less objectionable.21 Most of the debate, however, was devoted to the idea that the government should resolve its financial difficulties by selling land that it had recently confiscated from the ‘rebel natives’ – and that if that proved insufficient, it should confiscate more land, and sell that.22 The ‘reasonableness’ of this proposition, it was agreed, ‘could not be controverted’,23 but there was nonetheless a problem: the Maori from whom the land had been confiscated were a ‘bloodthirsty’ lot, likely to ‘come upon’ the purchasers ‘and tomahawk them’.24 Together with the land, said another, ‘there would be taken a certain number of bullets’.25 The confiscated lands would therefore fetch much lower prices than would otherwise have been obtainable. For that reason, the government postponed the sale of confiscated lands. The possibility of an income tax it rejected also, on the grounds that, in the Colony’s rather wild circumstances, it would be difficult and expensive to administer. As for reductions in customs duties, the government declined to commit itself. Eventually, the Premier, the aristocratic Frederick Weld,26 forced the issue by threatening to resign, observing that it might be better to leave the governance of the Colony to those who thought they could carry it on without money and that he would wish them ‘all the success their superior cleverness would deserve’.27 This threat worked and the Stamp Duties Act 1866 was duly enacted. The Act was closely modelled on legislation enacted in New South Wales the year before,28 much of which, in turn, had been copied from relevant United Kingdom legislation – the Stamp Acts, the Legacy Duty Act 1796 and the Succession Duty Act 1853.29 The New Zealand Act was composed of four parts. Part I imposed duty on deeds and various other instruments ‘relating to transactions between living persons’.30 More specifically, it imposed duty on contracts in writing, bills of exchange, bills of lading, conveyances, cheques, 20

New Zealand Parliamentary Debates, 22 September 1865 at 591 (Crosbie Ward). New Zealand Parliamentary Debates, 22 September 1865 at 589 (Sewell). 22 New Zealand Parliamentary Debates, 22 September 1865 at 589 (William Reynolds). 23 New Zealand Parliamentary Debates, 26 September 1865 at 592 (Sewell). 24 New Zealand Parliamentary Debates, 26 September 1865 at 595 (Francis Dillon Bell). 25 New Zealand Parliamentary Debates, 26 September 1865 at 595 (John Wilson). 26 Sir Frederick Weld (1823–1891) was born in Dorset. In 1844, he travelled to New Zealand, where he became a sheep farmer. In 1853, when the Colony’s Parliament was established, he became a member of it. He was Premier in 1864–1865 and later the Governor of, in turn, Western Australia (1868–1845), Tasmania (1875–1880) and the Straits Settlements (1880–1887). 27 New Zealand Parliamentary Debates, 3 October 1865 at 637. 28 Stamp Duties Act 1865 (NSW). See New Zealand Parliamentary Debates, 29 September 1865 at 632 (Sewell). 29 For instance, s 107 of the New Zealand Act was copied from s 90 of the New South Wales Act, which in turn was copied from s 18 of the Succession Duty Act 1853 (UK). The New South Wales section suffered from two obvious errors, both of which were replicated in the New Zealand equivalent. 30 Stamp Duties Act 1866, Part I and Schedule I. 21

Book 1.indb 323

12/2/2011 8:22:11 AM

324

Michael Littlewood

leases, insurance policies, promissory notes, receipts, transfers of leases and transfers of shares. In most instances, the duty was one percent of the value of the transaction, or less. Various kinds of documents relating to minor transactions were exempt.31 Part II imposed a duty on probates, Part III a duty on legacies, and Part IV a duty on successions. In form, these taxes were all stamp duties – the payment of the tax was denoted by means of a stamp impressed upon or affixed to a document required in connection with the estate or inheritance in question. Probate Duty Probate duty was imposed on both probates and letters of administration. Liability was based on the value of the personal property (meaning property other than land, but including leaseholds) which the deceased had the power to dispose of by will.32 The duty was £1 where the ‘effects’ of the deceased were worth less than £100; £2 if they were worth more than £100 but less than £200; and so on.33 Legacy Duty and Succession Duty Legacy duty and succession duty were both imposed on inheritances. The difference, as in the United Kingdom, was that succession duty was imposed on land (including leaseholds) and legacy duty was imposed on property other than land.34 The rates of legacy duty and succession duty were the same. In both cases, as in the United Kingdom, the rate of tax varied, not according to the value of the property in question but according to the degree of consanguinity between the deceased and the beneficiary. If the beneficiary was a child or other direct descendant of the deceased, the duty was charged at one percent; if a brother or sister, three percent; if a niece or nephew, five percent; and so on. Property left to a spouse was not dutiable at all; and property left to a stranger (that is, a person unrelated to the deceased) was dutiable at 10 percent.35 Duty was imposed only on legacies and successions worth £20 or more and only if the deceased’s total estate was worth £100 or more.36 How many estates exceeded that threshold is impossible to say, because at that time the economic data published by the government was rudimentary in the extreme. Indeed, the

31

Stamp Duties Act 1866, Schedule I. Stamp Duties Act 1866, s 44. According to the Ross Report (above n 2) at 480, probate duty was calculated on the total value of the deceased’s estate, both real and personal. But this is difficult to reconcile with the wording of the statute; see ss 44 and 45 and Schedule II. 33 Stamp Duties Act 1866, Schedule II. 34 The line between legacy duty and succession duty is not entirely clear, because of weak drafting – for instance the mistakes referred to above n 29. 35 Stamp Duties Act 1866, Schedules III and IV. 36 Stamp Duties Act 1866, ss 58 and 107. 32

Book 1.indb 324

12/2/2011 8:22:11 AM

The History of Death Duties and Gift Duty in New Zealand 325 data generated by the administration of the death duties eventually enabled the government to compile more useful economic statistics than previously. But in the 1890s (by which point the statistics had improved markedly), of all the adults dying in New Zealand, only about 20 percent left estates of £100 or more.37 In 1866, the percentage was presumably lower. There appears to have been no reason for having two taxes (when a single tax imposed on successions of both land and other property would have achieved exactly the same results, with less complexity), other than that was what was done in the United Kingdom. Similarly, there seems to have been no discussion of the reasons for taxing remoter relatives and strangers more heavily than closer relatives; again, it seems to have been simply assumed that it would be best to do what was done in the United Kingdom.38 Geographical Scope Like the United Kingdom and New South Wales precedents on which it was based, the New Zealand Stamp Duties Act 1866 contained no express territorial limitation – the duties it imposed were not expressly confined to property situated in New Zealand, or to persons resident or domiciled in New Zealand. But the United Kingdom statutes were interpreted on the basis of the situs principle; that is, they were interpreted as only applying to property situated in the United Kingdom. This was however subject to the maxim mobilia sequuntur personam (movables follow the person) – meaning that personal property should be treated for legal purposes as if situated in the place where its owner is domiciled, even if it is in fact somewhere else.39 The geographical scope of the New Zealand statute seems not to have been litigated, but the combined effect of these two principles would appear to have been as follows. (a) Land situated in New Zealand was dutiable, even if the deceased was resident and domiciled elsewhere. (b) Land situated outside New Zealand was not dutiable, even if the deceased was resident and domiciled in New Zealand.

37 The New Zealand Official Government Year Book 1898 (Government Printer, Wellington, 1898) at 285. The figures ranged from 15 per cent in 1894 to 26 per cent in 1897. 38 As regards the United Kingdom, Stephen Dowell explains that bills providing for duties on inheritances of personal property and land were introduced in the British Parliament in 1796, but only the former was passed into law (as the Legacy Duty Act 1796); and that a duty on inheritances of real property was eventually imposed in 1853, by the Succession Duty Act of that year. See S Dowell, History of Taxation and Taxes in England (Longmans Green, London, 1884, republished Frank Cass & Co, London, 1965) vol 2 at 213–214. But he does not explain the reason for having two taxes rather than just one. Not does he explain why the rates of tax were varied according to the relationship between the deceased and the inheritor. See also A Hanson, The Succession Duty Act (Stevens and Haynes, London, 1865) and C W Goodwin The Succession Duty Act (John Crockford, London, 1853). 39 See Re Wallop’s Trust (1864) 1 De G J & S 656; 46 ER 259 and Hanson, above n 38 at 2–7.

Book 1.indb 325

12/2/2011 8:22:12 AM

326

Michael Littlewood

(c) Personal property situated in New Zealand was dutiable if the deceased was domiciled in New Zealand, but not otherwise. That is, if the deceased was domiciled somewhere other than in New Zealand, his personal property was not dutiable even it was situated in New Zealand and he was resident in New Zealand.40 (d) Personal property situated outside New Zealand was not dutiable, even if the deceased was resident and domiciled in New Zealand. In other words, the mobilia principle worked in only one direction, not both – it exempted property situated in New Zealand (if the deceased was domiciled elsewhere), but it did not tax property situated outside New Zealand (if the deceased was domiciled in New Zealand). It seems likely that many of the more affluent settlers retained their United Kingdom domicile, in which case the colonial government’s losses to the mobilia principle may have been considerable. Maori At this time, most Maori lived outside the effective control of the colonial government and their property rights and inheritances were generally not governed by colonial law. It seems likely, therefore, that the taxes provided for by the Act of 1866 were seldom collected from Maori. As will be seen, legislation enacted in 1909 provided expressly for the taxation of Maori estates,41 but the earlier legislation was silent in this respect. Avoidance The Act contained a number of anti-avoidance provisions, copied from the United Kingdom via New South Wales. For instance, one method of avoiding death duties might be to make an inter vivos transfer of one’s property to one’s children, or on trust for one’s children, but retaining for oneself a life interest. The Act contained provisions dealing with this kind of device.42 Another method might be for the property owner to make a gift inter vivos, but on the basis that it does not take effect until his death (known as a donatio mortis causa).43 The Act dealt with this possibility by deeming such gifts to be legacies.44 A particularly notable anti-avoidance measure was section 99, which provided (among other matters) as follows:45 40 A person does not lose his original domicile (typically his country of birth) merely by residing elsewhere. Rather, he generally retains it until such time as he evidences an intention to make some other place his permanent home. Thus, for example, a Briton could reside in New Zealand for many years without losing his United Kingdom domicile, if he intended ultimately to return to the United Kingdom. See Winans v Attorney General [1904] AC 287 and the cases there referred to. 41 See below at n 110. 42 Stamp Duties Act 1866, ss 96–99, copied from Succession Duty Act 1853 (UK), ss 5–8. 43 See Cain v Moon [1896] 2 QB 283. 44 Stamp Duties Act 1866, s 62. 45 Emphasis added.

Book 1.indb 326

12/2/2011 8:22:12 AM

The History of Death Duties and Gift Duty in New Zealand 327 And where any Court of competent jurisdiction shall declare any disposition to have been fraudulent and made for the purpose of evading the duty imposed by this Act such Court may declare a succession to have been conferred on such person at such time and to such an extent as such Court shall think just and such last-mentioned person shall be deemed to have taken a succession accordingly derived from the person making such disposition as predecessor.

Again, this replicated verbatim a provision in the New South Wales Act,46 itself copied from the United Kingdom Act.47 These provisions were plainly aimed at the possibility that a person might seek to escape succession duty by disposing of his property before he died; and their effect was that in some circumstances such a disposition would be deemed to be a succession, and so would be dutiable. They are, therefore, the seed that ultimately grew into gift duty. Their scope, however, is far from clear. In particular, what was meant by fraudulent and evading? Did fraud mean merely an intention to deprive the Revenue of what might otherwise be due to it? Or did it entail dishonesty? Did evade mean simply avoid, or something else? There appear to be no reported cases on the scope of s 99 (and curiously little authority on the equivalent provisions enacted in other jurisdictions),48 but some years later, as will be seen, the Privy Council was to take a very narrow approach to the interpretation of its successor (s 35 of the Deceased Persons’ Estates Duties Act 1881 – see below).

A Single Succession Duty: 1875 The Stamp Act 1875 repealed the Act of 1866 and in place of the several death duties provided for by the earlier Act established a single succession duty, charged in respect of both real and personal property. This duty was charged on successions at rates ranging from one percent to 10 percent, depending on both the value of the property and the relationship between the deceased and the successor.49 As before, the closer the relationship, the lower the rate of duty. And, as before, successions to a husband or wife were exempt.50 The system’s geographical scope likewise remained unchanged. Since there was now only one tax, rather than three, the legislation was simpler – and that was presumably what motivated the change, though the proceedings of Parliament do not disclose its thinking.51

46

Stamp Duties Act 1865 (NSW), s 83. Succession Duty Act 1853 (UK), s 8. See also Probate and Succession Duty Act 1876 (South Australia), s 27. 48 The United Kingdom section (s 8) was interpreted narrowly in Attorney General v Noyes (1881–1882) LR 8 QBD 125 at 132–134. 49 Stamp Act 1875, s 106 and Second Schedule. 50 Stamp Act 1875, Second Schedule. 51 New Zealand Parliamentary Debates, 10 August 1875 at 233–239; 14 September 1875 at 340– 342; 14 October 1875 at 442–443. 47

Book 1.indb 327

12/2/2011 8:22:12 AM

328

Michael Littlewood

The Introduction of Estate Duty: 1881 The Deceased Persons’ Estates Duties Act 1881 was New Zealand’s first standalone death duty statute – as opposed to stamp duty statutes imposing death duties. It abolished succession duty and replaced it with estate duty. The difference was that succession duty had been imposed on the beneficiaries’ interests separately,52 whereas estate duty was imposed on the net value of the deceased’s whole estate.53 Thus, the total liability to succession duty had depended on how many beneficiaries there were, on how the estate was divided among them, and on the relationship between the deceased and each of the beneficiaries, whereas liability to estate duty depended simply on the size of the estate – the number of beneficiaries, their relationship to the deceased and the manner of the division of the estate among them being irrelevant. This basic principle was, however, subject to two very large exceptions. First, property passing from a husband to his widow was exempt54 (though there was no exemption for property passing from a wife to her widower) and, second, property passing to the children or grandchildren of the deceased was dutiable at half the rate that would otherwise have applied.55 As before, the rates of duty were progressive, ranging from two percent (on estates over £100 but less than £1,000) to 10 percent (on estates over £50,000).56 And as before, the £100 threshold probably excluded at least 80 percent of estates from liability.57 The reason for switching from succession duty to estate duty is not entirely clear,58 but estate duty was simpler than succession duty, so it seems likely that that was the reason. Geographical Scope and Domicile Unlike the Acts of 1866 and 1875, that of 1881 expressly stated its geographical scope: estate duty was imposed on all of the deceased’s property ‘situated in the Colony of New Zealand’ notwithstanding that the deceased ‘had at the time of his death a foreign domicile’.59 In other words, the mobilia principle was excluded.60 This would have been a substantial expansion in the scope of the system if, as seems likely, it was common for affluent New Zealand residents to retain their United Kingdom domicile. But property outside New Zealand remained beyond the scope of the tax, even if the deceased was resident and domiciled in New Zealand. 52

Stamp Act 1875, s 106 and Second Schedule. Deceased Persons’ Estates Duties Act 1881, ss 7 and 5. 54 Deceased Persons’ Estates Duties Act 1881, s 36. 55 Deceased Persons’ Estates Duties Act 1881, s 37. 56 Deceased Persons’ Estates Duties Act 1881, Schedule. 57 See above at n 37. 58 New Zealand Parliamentary Debates, 16, 17 and 20 September 1881. 59 Deceased Persons’ Estates Duties Act 1881, s 8. 60 See In re Thomas Greenwood (Deceased) (1888) 6 NZLR 737 at 742 and Hay v Commissioner of Stamps (1902) 22 NZLR 716. 53

Book 1.indb 328

12/2/2011 8:22:12 AM

The History of Death Duties and Gift Duty in New Zealand 329 The Anti-Avoidance Rule Curiously, the anti-avoidance rule contained in section 99 of the 1866 Act (and recited above)61 was dropped in 1875, but revived in a refined form in 1881. It was now section 35 and it was worded as follows:62 It shall be lawful for any Court of competent jurisdiction, on the application of the Commissioner, to declare any disposition of real or personal property to have been made for the purpose of evading the duty imposed by this Act, and also to declare that duty is payable on the property comprised in such disposition….

Thus, it was no longer necessary for the Commissioner to show that the impugned disposition was fraudulent, but he still had to show that it was made for the purpose of evading duty. What this meant was considered by the Privy Council in Minister of Stamps v Townend.63 This was the third in a trilogy of Privy Council decisions, the first two of which – Simms v Registrar of Probates64 and Payne v The King65 – involved very similar provisions contained in statutes enacted in the colonies of South Australia and Victoria respectively. All three cases were about death duties; in all three, the deceased had sought whilst still alive to escape the duty by giving property to his children; and in all three the statute in question contained a rule extending the duty to property disposed of for the purpose of evading it. The Privy Council held (a) that evasion requires ‘underhand dealing’66 and (b) that disposing of property with the intention of escaping duty is not in itself underhand and therefore not evasion.67 The three cases are important for three reasons. First, their consequence was that section 35 and its Australian equivalents failed to prevent the mischief at which they were aimed, and that some other remedy was therefore required. As has been intimated, the remedy adopted in New Zealand was simply to tax gifts – irrespective of the motives of the donor and irrespective also of the period elapsing between the making of the gift and the death of the donor. Secondly, these cases seem to be a significant step in the evolution of the modern distinction between tax evasion (misrepresenting or failing to disclose the facts relevant to a liability to tax) and tax avoidance (arranging the facts with a view to producing a lesser liability than might otherwise arise). And, thirdly, it seems to have been the Privy Council’s narrow reading of these rules against evasion that prompted the New Zealand and Australian legislatures to incorporate in their income tax statutes the general anti-avoidance rules for which these statutes are famous (or, perhaps, infamous).68 61

See above at n 45. Emphasis added. 63 [1909] AC 633. 64 [1900] AC 323. 65 [1902] AC 552. See also Bullivant v Attorney-General for Victoria [1901] AC 196. 66 Simms v Registrar of Probates [1900] AC 323, 334. 67 Minister of Stamps v Townend [1909] AC 633. 68 See M Littlewood ‘The Privy Council and the Australasian Anti-Avoidance Rules’ (2007) British Tax Review 175. 62

Book 1.indb 329

12/2/2011 8:22:12 AM

330

Michael Littlewood

Deed of Gift Duty: 1885 The cumbersomely named Deceased Persons’ Estates Duties Act 1881 Amendment Act 1885 made two main changes. First, the burden of estate duty was increased. In particular, whilst the maximum rate of duty remained at 10 percent, the threshold at which it applied was reduced from £50,000 to £20,000. There was also added a surcharge of three percentage points on all inheritances going to strangers – so the highest rate of duty was 13 percent (payable on a gift to a stranger out of an estate of more than £20,000).69 Property passing to the deceased’s spouse was exempt.70 Secondly, the Act of 1885 introduced a tax on gifts. Its aim was to protect estate duty. The problem was that a man (or a woman, but it seems usually to have been a man) could avoid estate duty by giving his property to his children before he died. As the Premier, Sir Robert Stout,71 put it, ‘some people spend the last days of their lives considering how they may rob the state of revenue’.72 The anti-avoidance rules contained in the earlier legislation seem already to have been regarded as inadequate, though it would be some years yet before that was confirmed by the Privy Council (in the Simms, Payne and Townend cases, discussed above). But what inspired the new tax – beyond the problem it was designed to solve – is unclear, for in the United Kingdom there was no tax on gifts at that time. Nor, it seems, was there anything comparable elsewhere in the Empire. During the American Civil War, the Union had enacted a statute deeming gifts of land to constitute successions, thus rendering them subject to estate duty.73 But this provision was confined to real estate and was repealed at the end of the war. It is possible that the New Zealand tax was copied from the American one, but there seems to be no evidence of this.74 If it was an indigenous 69

Deceased Persons’ Estates Duties Act 1881 Amendment Act 1885, Schedule. Deceased Persons’ Estates Duties Act 1881 Amendment Act 1885, s 18. 71 Sir Robert Stout (1844–1930) was born in the Shetland Islands and emigrated to New Zealand in 1863. He practised law before becoming an MP in 1875. He became Attorney General in 1878, but resigned from Parliament in 1879 after falling out with the Premier, Sir George Grey (see above n 13). He re-entered Parliament in 1884 and a month later became Premier after organising a vote of no confidence against the incumbent, Harry Atkinson. Two weeks later Stout lost a vote of confidence and Atkinson regained the Premiership. A week later, Atkinson was removed by yet another vote of no confidence. Stout became Premier again and remained in that position until 1887, when he lost his seat. He became an MP again in 1893 and remained in Parliament until 1898. In 1899, he was appointed Chief Justice and served in that capacity until 1926. He was a friend and ally of John Ballance (see above n 11) and shared similar political views, with particular interests in land reform, education and women’s suffrage. He is the only person to have been both Premier of New Zealand and Chief Justice. 72 New Zealand Parliamentary Debates, 17 July 1885 at 84. 73 Internal Revenue Act 1864 (US) 13 Stat. 223, s 132. 74 On the United States tax, see H Dresser, Internal Revenue Laws: Act Approved June 30, 1864, As Amended, and the Act Amendatory Thereof, Approved March 3, 1865, with Copious Marginal References, a Complete Analytical Index, and Tables of Taxation (D Appleton & Co, New York, 1865) at 79; E H White (ed), Fundamentals of Federal Income, Estate, and Gift Taxes, with Emphasis on Life Insurance and Annuities (4th edn, Insurance Research & Review Service, Indianapolis, 1958) 70

Book 1.indb 330

12/2/2011 8:22:12 AM

The History of Death Duties and Gift Duty in New Zealand 331 initiative, it is possible that the credit for it should go to Stout, who seems to have been a thoughtful and creative lawyer. In any event, the scope of the new tax was rather limited: it was only imposed on deeds of gift75 (and so was colloquially known as deed of gift duty). Gifts effected by other means – delivery or instruments other than deeds – remained untaxed, and so presumably tended to be used instead. The duty was charged at the same rates as estate duty, except that the rate of duty was determined by and applied to the value of the gift, rather than the value of the donor’s entire estate. A gift of less than £20,000 would therefore have been taxed at a lower rate than an estate of more than that amount; so considerable scope remained for taxpayers to reduce their overall liability to duty by means of inter vivos gifts. This problem was to persist until the abolition of estate duty in 1993. The threshold beneath which no gift duty was payable was the same as for estate duty – £100. That was still in 1885 sufficient to permit the affluent to achieve substantial reductions in their liability to estate duty without incurring any liability to gift duty.76 Moreover, there was no provision for aggregation. Thus it would appear to have been possible to alienate any amount of property without incurring any liability by making any number of gifts of £100 each simultaneously or in quick succession. Whether the Act was administered so as to permit this is unclear but later, as will be seen, rules were introduced requiring the aggregation of gifts, thus preventing, or at least limiting, this form of abuse. In 1891, the legislation was amended so as to impose deed of gift duty not only on deeds, but on other instruments also.77 But gifts effected by delivery, without any form of documentation, remained beyond the scope of the tax. This method was not confined to chattels; gifts of cash and some securities – for example bearer shares and deeds acknowledging debts – can also be effected by delivery. The problem was therefore a large one.78 In 1895 the Act was amended again so that the applicable rate of duty would no longer be determined by the value of the gift, but by the total wealth of the donor.79 The logic of this is apparent, given that the purpose of deed of gift duty was to protect estate duty. Even so, this approach would seem to have entailed an extraordinary compliance burden, in that it would have required any person making a dutiable gift to determine the extent of his wealth, to disclose it to the Revenue, and to supply evidence in support – and to do so again, the next time he made a dutiable gift. How this was administered is unclear.

at 183; and J A Cooper, ‘Ghosts of 1932: The Lost History of Estate and Gift Taxation’ (2010) 9 Florida Tax Review 875. 75

Deceased Persons’ Estates Duties Act 1881 Amendment Act 1885, s 10. See above at n 37. Stamp Acts Amendment Act 1891, s 7. 78 See New Zealand Parliamentary Debates, 10 December 1909 at 908–909 (John Findlay). 79 Stamp Acts Amendment Act 1895, s 6(2); see also the Ross Report (above n 2) at 483. 76 77

Book 1.indb 331

12/2/2011 8:22:12 AM

332

Michael Littlewood

Also in 1895, the Family Homes Protection Act of that year introduced an exemption from death duties for registered family homes worth up to £1,500,80 presumably exempting many estates altogether and significantly reducing the duty on many more. This exemption was amended from time to time81 and remained an important feature of the system until death duties were abolished in 1993.

III. THE DEATH DUTIES ACT 1909

In 1909, the Liberal government then in office, led by Sir Joseph Ward (a generally successful but at one point bankrupt entrepreneur who was Prime Minister from 1906 until 1912 and again from 1928 to 1930),82 procured the enactment of completely new legislation – the Death Duties Act 1909 – transforming both estate duty and gift duty into something resembling their modern form. As regards estate duty, the Act was closely based on the United Kingdom legislation. The politics also resembled what had happened in the United Kingdom some months earlier. There, a Liberal government had been elected in 1906 and in 1909 David Lloyd George,83 as Chancellor of the Exchequer, had delivered his famous ‘War Budget on Poverty’, in which he had proposed a progressive income tax for the purpose of financing the expansion of the welfare state. This Budget had been rejected by the Lords, prompting a constitutional crisis, culminating in the emasculation of the Upper House as a political force.84 Similarly, many of the members of New Zealand’s Upper House – the Legislative Council – were opposed to Ward’s proposals. Cognizant of what had happened in the United Kingdom, however, they refrained from voting against them.85 Before examining the terms of the 1909 Act, it is apposite to note that it was a qualitatively superior piece of legislation to those that had gone before. In the

80

Family Homes Protection Act 1895, s 30. Joint Family Homes Act 1950, s 16; Joint Family Homes Act 1964, s 22; Joint Family Homes Amendment Act 1972, s 3; Joint Family Homes Amendment Act 1974, s 12. 82 Sir Joseph Ward was born in Melbourne in 1856. His father died of alcoholism in 1860 and in 1863 Ward emigrated to New Zealand with his mother. He became an MP in 1887 and held a number of posts in the Liberal administrations headed by John Ballance (above n 11) and Richard Seddon (above n 12). He was Prime Minister from 1906 to 1912 and the wartime coalition’s Minister of Finance from 1915 to 1919. He became Prime Minister again in 1928, as head of the United/ Labour coalition, but his health failed him and he resigned and then died in 1930. He was a Minister of the Crown (holding a variety of portfolios) for 23 years, which is still a record. 83 David Lloyd George (1863–1945) was a Liberal MP (1890–1945), Chancellor of the Exchequer (1908–1915) and Prime Minister (1916–1922). He is widely regarded as a key figure in the First World War and the subsequent peace talks and was central to the establishment of the welfare state in the United Kingdom. He is the only British Prime Minister to have been Welsh. 84 Martin Daunton Trusting Leviathan: The Politics of Taxation in Britain, 1799–1914 (Cambridge University Press, Cambridge, 2001) at 364–365. 85 New Zealand Parliamentary Debates, 10 December 1909 at 912 (Robert Loughnan); 13 December 1909 at 972 (George Smith). 81

Book 1.indb 332

12/2/2011 8:22:13 AM

The History of Death Duties and Gift Duty in New Zealand 333 late nineteenth century and the early twentieth, the New Zealand government’s legislative drafting capacity was, to put it kindly, rudimentary; and the standard of drafting was generally what one would expect of a small, remote colony. In 1907, however, the standard of drafting improved dramatically when the Attorney General, John Findlay,86 himself unusually competent, appointed as chief draftsman John Salmond, perhaps the strongest jurist New Zealand has ever produced.87

Death Duties The first change effected by the 1909 Act was that it reintroduced succession duty, on top of estate duty. Consequently, there were two death duties: the whole of the deceased’s dutiable estate was chargeable to estate duty88 and, in addition, each beneficiary was charged succession duty.89 Secondly, the 1909 Act increased both the rates at which estate duty was charged and also the exemptions. The threshold beneath which no estate duty was payable was increased from £10090 to £500.91 The government had estimated the private wealth ‘per head of total estimated population’ in New Zealand at £335,92 so presumably many estates escaped duty entirely and many more were dutiable at the lower rates. Also, if an estate was worth £10,000 or less, the first £5,000 going to the deceased’s widow was free of duty.93 Widowers, however, received no such relief. Under the 1881 Act, the highest rate of estate duty had been 10 percent. In 1885, it had been increased to 13 percent;94 and in 1909, it 86 John Findlay (1862–1929) was a prolific author and, before becoming a politician, had practised law in partnership with Sir Robert Stout (see above n 71). In 1906, Ward appointed him to the Legislative Council so that he could serve as Attorney General (1906–1911). After several unsuccessful attempts, he was elected to the House of Representatives in 1917 and served until 1919. 87 John Salmond (1862–1924) was born in Northumberland and emigrated to Dunedin with his parents in 1875. He studied law at Otago and University College London, practised law for 10 years and in 1897 was appointed Professor of Law at the University of Adelaide. In 1906 he returned to New Zealand to take up the foundation chair in law at what is now Victoria University of Wellington and in 1907 he was appointed as Counsel to the Law Drafting Office, where he remained until 1911, when he became Solicitor General. He was made a King’s Counsel in 1912, knighted in 1918 and appointed a judge of the High Court (as it is now called) in 1920. His major works are Jurisprudence or the Theory of Law (Stevens and Haynes, London, 1902) and The Law of Torts (Stevens and Haynes, London, 1907), both of which are regarded as classics. See generally A Frame, Salmond: Southern Jurist (Victoria University Press, Wellington, 1995). 88 Death Duties Act 1909, s 3. 89 Death Duties Act 1909, ss 14 and 15. 90 Death Duties Act 1908, Second Schedule. 91 Death Duties Act 1909, s 12. 92 The New Zealand Official Yearbook, 1908 (Government Printer, Wellington, 1908) at 537. The estimate related to 1906. Later, the government acknowledged that its calculations were rather imprecise: The New Zealand Official Yearbook, 1911 (Government Printer, Wellington, 1911) at 656–657. 93 Death Duties Act 1909, s 13. 94 Deceased Persons’ Estates Duties Act 1881 Amendment Act 1885, Schedule.

Book 1.indb 333

12/2/2011 8:22:13 AM

334

Michael Littlewood

was increased again, to 15 percent (on estates of over £145,000 – a threshold high enough to exclude all but a tiny number of estates).95 As for the reintroduced succession duty, it was charged at rates ranging from two percent to 20 percent, depending on the value of the property and the relationship between the deceased and the successor. If the successor was the wife of the deceased, or a child or other descendant, the first £20,000 was exempt; if the value of the property exceeded £20,000, the whole of it was dutiable at two percent (except that the amount of duty could not exceed the amount by which the value of the property exceeded £20,000). If the successor was the husband of the deceased, the first £20,000 was dutiable at two percent and the balance at four percent. If the successor was any other relative of the deceased ‘in any degree not exceeding the fourth’, the first £20,000 was dutiable at five percent and the balance at 10 percent. In all other cases, the first £20,000 was dutiable at 10 percent and the balance at 20 percent.96 Succession duty was charged on the whole of the succession, not on only what was left after the deduction of estate duty, so the maximum combined rate of duty was 35 percent (15 + 20 = 35).97 One of the government’s aims was to increase its revenues, but the reintroduction of succession duty was intended to fulfil other objectives also, as Ward explained:98 The considerations to be kept in view in framing this kind of legislation are the total amount of wealth left by a deceased person; the relationship of the beneficiary – whether dependant, relative, or stranger; and the amount left to any one person, whether related or not. For example, if the total estate is £500,000 it should pay at a higher rate than an estate of £5,000, and a graduated scale should be imposed increasing with the value of the estate; if the beneficiary is a total stranger or distant relative he should pay on the share coming to him at a higher rate than a dependant – like a wife or child; and if a fortune is left to one person – whether a dependant, relative, or stranger – it should be taxed at a higher rate than a small share going to the same person.

Moreover, the government thought it desirable, as an end in itself, to attack large fortunes, as Findlay explained:99 Surely there may be a good deal to be said for the view expressed by John Stuart Mill that it is unwise in most cases that any one man should be endowed with wealth to such an amount as to place him entirely beyond the need of earning his own living…. More young men have been made shipwreck by having too much wealth left to them than from any other cause….

95

Death Duties Act 1909, s 4 and First Schedule. See Anonymous, above n 2 at 194. Death Duties Act 1909, ss 16, 17 and 18. In Re Holmes (1912) 32 NZLR 577. 98 New Zealand Parliamentary Debates, 29 November 1909 at 442. 99 New Zealand Parliamentary Debates, 10 December 1909 at 907. See also 13 December 1909 at 973. 96 97

Book 1.indb 334

12/2/2011 8:22:13 AM

The History of Death Duties and Gift Duty in New Zealand 335 George Laurenson, another Liberal MP, spoke to similar effect:100 [T]here is an opinion rising up not only in this country, but in Great Britain, and also in America and Germany, that all taxation should aim not only at the raising of revenue, but also at the more equitable distribution of the wealth which the community produces…. After all, what good does money do for those who inherit it? If you want to see a failure in life, give me the case of the son of a wealthy man.

Thirdly, the 1909 Act contained much more elaborate provisions – copied from provisions in force in the United Kingdom and familiar to the modern eye – clawing back into the deceased’s estate property which he had sought to put beyond the reach of the tax. Most pertinently, a deceased person’s estate was deemed to include (for the purposes of duty) – (a) any gift made by the deceased in the last three years of his life;101 (b) any gift made by the deceased at any time unless ‘bona fide possession and enjoyment’ had been assumed by the donee at least three years before the death of the deceased;102 and (c) any property the subject of a donatio mortis causa made by the deceased at any time.103

Fourthly, the Act expanded the territorial scope of the system. The basic rule remained the same: that duty was only imposed on property ‘situated in New Zealand’.104 Thus, duty was payable on the property of the deceased that was situated in New Zealand at the time of his death and also on gifts clawed back into his estate if the property gifted was situated in New Zealand at the time of the gift.105 These rules applied to both estate duty and succession duty. But there was also added a rule – s 7 – that movable property would be deemed to be situated in New Zealand if the deceased was domiciled in New Zealand.106 This, too, applied to both estate duty and succession duty. It seems reasonable to suppose that the principal purpose of s 7 was not to extend what might be thought of as the natural scope of the system, but to prevent avoidance. It had previously been possible to avoid estate duty and succession duty by shifting movable property offshore. This was so not only of chattels but also, more importantly, of money and various kinds of security. For example, it seems to have been accepted that a simple debt (such as a bank account) is situated where the debtor (the bank) is resident107 and that shares in a company are situated where the share register is situated.108 100

New Zealand Parliamentary Debates, 29 November 1909 at 449. Death Duties Act 1909, s 5(1)(b); compare Customs and Inland Revenue Act 1881 (UK), s 38(2), as amended, and Finance Act 1910 (UK), s 59. 102 Death Duties Act 1909, s 5(1)(c); compare Customs and Inland Revenue Act 1889 (UK), s 11. 103 Death Duties Act 1909, s 5(1)(d). See above at n 43. Curiously, although the Acts of 1866 and 1909 dealt with donationes mortis causa, those enacted in between – the Acts of 1875, 1881, 1885, 1891 and 1895 – did not. 104 Death Duties Act 1909, s 5. 105 Death Duties Act 1909, s 5(1)(a), (b), (c) and (d). 106 Death Duties Act 1909, ss 7 and 2 (definition of ‘personal property’). 107 Byron v Byron (1596) 1 Cro. Eliz. 472; 78 ER 709; English Scottish and Australian Bank Ltd v Commissioners of Inland Revenue [1932] AC 238. 108 Attorney General v Higgins (1857) 2 H. & N. 339; 157 ER 140; Brassard v Smith [1925] AC 371. 101

Book 1.indb 335

12/2/2011 8:22:13 AM

336

Michael Littlewood

Fifthly, the Act provided for relief against double taxation where property situated outside New Zealand was subject both to New Zealand death duties (as would be the case with movable property if the deceased was domiciled in New Zealand) and also to duty in the country in which the property was situated. In such cases, the foreign duty was to be deducted from the duty payable in New Zealand.109 In other words, the Act provided for what we would now call a tax credit. Sixthly, the Act made special provision for Maori. It exempted from death duties – both estate duty and succession duty – ‘any property included in a succession order made by the Native Land Court or Native Appellate Court’. Instead, such property would be chargeable to a special tax called native succession duty, which was charged at two percent on property worth £200 or more.110 Finally, the 1909 Act did not re-enact s 35 of the 1881 Act – that is, the section imposing duty on property disposed of ‘for the purpose of evading’ it.111 Presumably the government had concluded, in light of the Privy Council’s decision in Townend,112 that legislating against tax evasion (or avoidance, as it would now be called) was doomed to failure; and that broadening the tax on gifts was the best available solution to the problem.113

Gift Duty The 1909 Act also extended gift duty, so as to impose it on gifts effected by delivery, as well as those made in writing.114 As in 1885, this seems to have been a purely indigenous initiative, for there was still no tax on gifts in the United Kingdom at that time (other than the claw-back provisions referred to above). As mentioned above,115 a tax on gifts had been introduced in the United States in 1864 – but that was a temporary wartime measure, confined to gifts of land. The New Zealand gift duty, in contrast, was a permanent peacetime measure, imposed on gifts generally, of both land and personalty. Also, the New Zealand tax was imposed on gifts as such, rather than by deeming them to be successions. Many countries – for example the United Kingdom, the United States, and Australia – were later to impose taxes on gifts; the New Zealand tax, if it was indeed the first tax of this kind, was therefore a significant contribution 109

Death Duties Act 1909, s 32. Death Duties Act 1909, s 80. The Native Land Court was established in 1865. Its main function was to convert customary Maori land ownership into titles recognized by the colonial legal system. The Court still exists but since 1954 it has been called the Maori Land Court. 111 See above at n 62. 112 [1909] AC 633. See above at n 63. 113 The legislation was consolidated in 1908 but s 35 of the 1881 Act had been preserved as s 32 of the Death Duties Act 1908. 114 Death Duties Act 1909, ss 37–40. 115 See above at n 73. 110

Book 1.indb 336

12/2/2011 8:22:13 AM

The History of Death Duties and Gift Duty in New Zealand 337 to the development of tax law worldwide. The credit for it presumably goes to Salmond and Findlay. Gift duty’s function was simply to protect estate duty, which the Dominion’s richer residents were routinely avoiding by making undocumented gifts to their children.116 As some of the legislation’s critics observed, taxing undocumented gifts would present considerable difficulty of enforcement. In particular, the Revenue would have no effective means of discovering a gift of cash, unless the parties chose to report it.117 The government acknowledged that that was so,118 but proceeded regardless. Its approach was vindicated, in that gift duty, in its extended form, clearly reduced the level of death duty avoidance, though it by no means eliminated it. ‘Gift’ was defined as generally including ‘any disposition of property without fully adequate consideration’119 (though the Revenue generally refrained from querying transactions between unrelated parties).120 Like estate duty and succession duty, gift duty was only charged on property ‘situated in New Zealand’ (at the time the gift was made); but if the donor was domiciled in New Zealand, any personal property included in the gift was ‘deemed to be situated in New Zealand’ – and therefore dutiable.121 The latter part of this rule was a necessary anti-avoidance measure; without it, a person domiciled in New Zealand could have avoided the duty by removing property from New Zealand and then giving it away. The donee would then have been able to return the property to New Zealand without paying duty on it. Again, this technique would have worked not only with chattels but with money and securities also – so anyone game to use it would typically have been able to reduce his dutiable estate considerably without exposing himself to gift duty. In some circumstances property was chargeable to both gift duty and death duties. Most obviously, that was so if a person made a dutiable gift and then died within three years. In such cases, the gift duty paid was set off against the death duty payable.122 Gift duty was charged at a flat rate of five percent.123 Since the top rate of estate duty was 15 percent and succession duty was imposed on top of estate duty, there was enormous scope for the affluent to reduce their overall liability by giving their property away, even where their gifts were subject to duty. Gifts worth £500 or less were exempt,124 so the duty was effectively confined to the 116 New Zealand Parliamentary Debates, 29 November 1909 at 442 (Ward); 8 December 1909 at 807 (Ward); 10 December 1909 at 908–909 (Findlay). 117 For example New Zealand Parliamentary Debates, 29 November 1909 at 446 (Thomas Wilford); 8 December 1909 at 799 (James Allen) and 803 (William Herries). 118 New Zealand Parliamentary Debates, 10 December 1909 at 909 (Findlay). 119 Death Duties Act 1909, s 38. If the donee provided partial consideration, the gift was measured by the extent of the inadequacy. 120 ILM Richardson Adams and Richardson’s Law of Estate and Gift Duties (4th edn, Butterworths, Wellington, 1970) at 11. 121 Death Duties Act 1909, s 41. 122 Death Duties Act 1909, s 59. 123 Death Duties Act 1909, s 46. 124 Death Duties Act 1909, s 44.

Book 1.indb 337

12/2/2011 8:22:13 AM

338

Michael Littlewood

affluent.125 To prevent abuse of the exemption, gifts from the same donor to the same donee were aggregated if made within six months of one another.126 Thus, the donor could not defeat the rule by making a number of gifts of £500 each simultaneously or in quick succession. He could, however, make the most of the exemption by making the largest possible non-dutiable gift (that is, £500) to each of numerous donees every six months. Since the Act aggregated gifts only where both the donor and the donee were the same, it incentivised donors to make gifts to as many donees as possible – for example, to grandchildren as well as children. This problem became apparent almost immediately and two years later, in 1911, the rule was amended: instead of imposing a limit of £500 on the value of gifts going duty-free to each donee every six months, it now imposed a limit of £1,000 on the total duty-free gifts made by the donor every twelve months.127 This was a much more serious constraint and gave rise to what became known as gifting programmes. That is, the affluent took to systematically making gifts to the value of £1,000 per year (or whatever the threshold was – it was changed from time to time) so as to minimise their liability to death duties. Sometimes they gave away more, if the gift duty payable was less than the death duty saved.128 This depended on whether the taxpayer was married or not, how many children he had, and so on. Usually such gifts went to a discretionary trust established for the benefit of the donor’s children.

IV. DEATH DUTIES AT THEIR PEAK: 1909–1949

The 1909 Act was a tremendous success, for the system’s basic shape remained mostly intact until death duties were abolished in 1993. There were changes of course, but most were trivial. Even those that could be counted as structural – of which there were several – were more in the nature of technical refinements than radical change. But although the system’s structure remained largely unchanged, there was considerable volatility in the rates of tax, mostly driven by party politics.

The Reform Government of 1912 to 1928 The Liberal Party remained in office from 1890 until 1912. It was then replaced by the right-wing Reform Party, led by its founder, Bill Massey.129 The Reform 125

See above at n 92. Death Duties Act 1909, s 44. Death Duties Amendment Act 1911, s 8. 128 See L McKay ‘The Estate and Gift Duties Act 1968 – Time for a Change of Concept’ New Zealand Law Journal, 15 March 1977 at 97. 129 See above n 15. 126 127

Book 1.indb 338

12/2/2011 8:22:13 AM

The History of Death Duties and Gift Duty in New Zealand 339 Party remained in government from 1912 until 1928 – except for the period from 1915 to 1919, during which the Reform and Liberal parties formed a wartime coalition, with Massey as Prime Minister and Ward130 as Minister of Finance. Massey served as Prime Minister from 1912 until 1925. He set the tone of his administration at the outset, in 1912 and 1913, with the brutal suppression of strikes – thus encouraging the development of the New Zealand labour movement. Modifying the Exemptions: 1915 In 1914, the New Zealand government enthusiastically joined in the First World War. According to Massey, ‘All we are and all we have are at the disposal of the Imperial Government’131 – but conscription was nonetheless highly controversial. In 1915 the coalition government amended the Death Duties Act. First, it reduced the exemption from succession duty for successions to the children of the deceased from £20,000 to £5,000,132 but extended it to cover other descendants (grandchildren and great grandchildren). Secondly, it was problematic to send a man to war and then, when he was killed, tax his estate – so where the deceased died while on military service, there was an exemption from estate duty of £5,000 for his widow and for each of his descendants.133 Thirdly, the 1915 Act introduced an exemption from gift duty for gifts from the same donor to the same donee not exceeding £20 per year in aggregate, if made ‘in good faith as part of the normal expenditure of the donor’.134 This was copied from an exemption contained in the United Kingdom claw-back provisions.135 Finally, there was also a new exemption for any gift made ‘towards the maintenance of the wife, husband, or any relative of the donor’, so long as it was ‘not excessive in amount, having regard to the legal or moral obligation of the donor to afford such maintenance’.136 This seems not to have been copied from anywhere, but devised locally. It would seem to be problematic, in that any gift could be said to be ‘towards the maintenance’ of the donee and opinions differ as to moral obligations. It was interpreted as exempting gifts made out of income, but not gifts of capital.137 Six years later, this aspect of the rule evidently having proved problematic, there was added to the legislation the following solution:138 130

See above n 82. Quoted in GH Scholefield The Right Honourable William Ferguson Massey, MP, PC, Prime Minister of New Zealand, 1912–1925: A Personal Biography (HH Tombs Ltd, Wellington, 1925) at 24. 132 Finance Act 1915, s 92; New Zealand Parliamentary Debates, 28 September 1915 at 291 (Ward). 133 Finance Act 1915, s 93. 134 Finance Act 1915, s 101(1)(a). 135 Finance Act 1910 (UK), s 59(2). 136 Finance Act 1915, s 101(1)(b). 137 EC Adams The Law of Estate and Gift Duties in New Zealand (3rd edn, Butterworth & Co, Wellington, 1956) at 29. 138 Death Duties Act 1921, s 44(2). 131

Book 1.indb 339

12/2/2011 8:22:14 AM

340

Michael Littlewood

The determination of the Commissioner that a gift is not entitled to exemption under this section shall be final and conclusive.

Shifting the Burden Upwards: 1920 In 1920, the higher rates of estate duty were increased, the maximum going from 15 percent to 20 percent (on estates of over £100,000).139 This was a revenue measure, undertaken by the right-wing Reform government with some reluctance.140 At the same time, the threshold beneath which no estate duty was payable was increased from £500 to £1,000 and the lower rates of duty were decreased. These seem to have been simple vote-winning measures – their effect was that about two thirds of estates were excluded from liability and most of the rest were taxed at the lower rates.141 The rates of succession duty were changed too, but the changes were more complex, varying with both the size of the succession and the relationship between the deceased and the successor. Some of the rates were increased, but not all, and some were decreased. For instance, the maximum rate applicable where the successor was the wife or a descendant of the deceased was increased from two percent142 to four percent.143 The 1920 Act changed not only the rates of succession duty, but also the thresholds at which they applied.144 Consequently, the combined effect of the changes is not easily summarised. Overall the burden of succession duty was probably increased, but not by much. The 1920 Act also transformed gift duty – which under the 1909 Act had been a flat tax charged at 5 percent145 – into a progressive one. The threshold beneath which no duty was payable remained at £1,000 per year;146 gifts of £1,000 to £5,000 were taxed at five percent; of £5,000 to £10,000, at 7.5 percent; and of more than £10,000, at 10 percent.147 These changes lessened the scope for avoidance, but the £1,000 exemption and the fact that the rates of gift duty were all much lower than the top rate of estate duty (20 percent) meant that they by no means eliminated it.

The United Governments of 1928 to 1935 In 1928, the Reform Party’s long term in office eventually came to an end. The new government was formed by a coalition of the United Party (an offshoot of 139

Death Duties Amendment Act 1920, s 3 and Schedule. New Zealand Parliamentary Debates, 15 October 1920 at 620–624 (Massey). 141 The New Zealand Official Yearbook, 1920 (Government Printer, Wellington, 1920) at 381–383. See also New Zealand Parliamentary Debates, 15 October 1920 at 625 (Thomas Wilford). 142 Death Duties Act 1909, s 16. 143 Death Duties Amendment Act 1920, ss 4(2)(c) and 4(4)(f). 144 Death Duties Amendment Act 1920, s 4. 145 Death Duties Act 1909, s 46. 146 Death Duties Amendment Act 1920, s 5. 147 Death Duties Amendment Act 1920, s 5. 140

Book 1.indb 340

12/2/2011 8:22:14 AM

The History of Death Duties and Gift Duty in New Zealand 341 the disintegrating Liberal Party) and the Labour Party (at this point a rapidly growing political force). The Prime Minister was United’s Sir Joseph Ward, in his second term in that role – as is recounted above, it was during his first administration that the landmark legislation of 1909 had been enacted. Ward’s health deteriorated, however, and in 1930 he resigned, to be succeeded by George Forbes.148 A few months later, the United/Labour government increased the rates of estate duty, raising the maximum from 20 percent to 30 percent (on estates of over £100,000).149 The aim was merely to raise revenue; the earlier objective of breaking up large fortunes seems to have been forgotten.150 The rates of succession duty were left unchanged, as were the rates of gift duty, except that the threshold – that is, the total value of gifts a person could make each year before exposing himself to duty – was cut from £1,000 to £500.151 In 1931 the agreement between the (now centrist) United Party and the (left-wing) Labour Party broke down, and United formed a new government in coalition with the (right-wing) Reform Party. Forbes continued as Prime Minister. These arrangements lasted until 1935 – a period during which there was no significant amendment of the Death Duties Act.

The First Labour Government: 1935–1949 New Zealand’s first Labour government was elected in 1935 and remained in office until 1949. Initially the Prime Minister was the charismatic Michael Joseph Savage, who died of cancer in 1940 and was given the extraordinary accolade of a large park-like mausoleum with a splendid view of Auckland Harbour.152 He was succeeded by Peter Fraser, a notably principled man who had been imprisoned on a charge of sedition for his opposition to conscription during the First World War.153 Under Savage’s leadership the government greatly expanded its spending on health, education and welfare and embarked on a large public housing programme. It also engaged in extensive economic regulation – imports, exports, industrial relations and currency exchange were all much more comprehensively regulated than before.154 But despite massive increases in public spending, the death duty system remained for several years unchanged. 148 George Forbes (1869–1947) entered Parliament in 1908 as a Liberal and was Prime Minister from 1930 to 1935. In 1892 he was the captain of the Canterbury rugby team but he seems to be generally regarded as an ineffectual politician. 149 Finance Act 1930, s 29. 150 New Zealand Parliamentary Debates, 18 August 1930 at 339–342, 406–407 (Forbes). 151 Finance Act 1930, s 30. 152 Michael Joseph Savage (1872–1940) was born in Australia and emigrated to New Zealand in 1907. He became a Labour MP in 1919, leader of the Labour Party in 1933, and Prime Minister in 1935. 153 Peter Fraser (1884–1950) was born in Scotland and emigrated to New Zealand at the age of 26. He became an MP in a by-election in 1918 and was Prime Minister from 1940 (when Savage died) until 1949 (when Labour, under his leadership, lost the election). 154 M Bassett The State in New Zealand, 1840–1984 (Auckland University Press, Auckland 1998), chs 7 and 8.

Book 1.indb 341

12/2/2011 8:22:14 AM

342

Michael Littlewood

Then, in August 1939, a week before the Second World War was declared, the Labour government increased the rates of all three duties – estate duty, succession duty, and gift duty. The maximum rate of estate duty remained unchanged at 30 percent but the lower rates and the thresholds were adjusted so as to produce increases in liability of about 20 percent for medium-sized estates.155 Succession duty was likewise increased. If the successor was the husband or wife of the deceased or a direct descendant, the new top rate of duty was five percent (up from three percent for husbands and four percent for wives and descendants); in the case of other relatives ‘in any degree not more remote than the fourth’, 12 percent (previously 10 percent); and for strangers 25 percent (previously 20 percent).156 The rates of gift duty were increased also, with the highest rate (imposed on gifts of more than £10,000 per year) being raised from 10 percent to 12 percent.157 Both the government and the public were acutely aware of the imminent prospect of increased military spending, but curiously little was said about it in Parliament. Instead, Fraser (as Acting Prime Minister, Savage being by now on his deathbed) justified the tax increases by reference mainly to spending on public housing, railways, schools, police stations, hospitals and so on.158 On 3 September, Britain declared war on Germany and New Zealand did the same. Savage, in one of his last public acts, declared:159 With gratitude for the past and confidence in the future we range ourselves without fear beside Britain. Where she goes, we go; where she stands, we stand. We are only a small and young nation, but we march with a union of hearts and souls to a common destiny.

Later that month, the War Expenses Act 1939 increased the rates of all three duties by a third.160 Thus the maximum rate of estate duty rose from 30 percent to 40 percent; the maximum rate of succession duty rose from 20 percent to 26.66 percent; and the maximum rate of gift duty rose from 12 percent to 16 percent. This Act also increased every liability to income tax by 15 percent.161 It provided for the revenues it produced not to be paid into the Consolidated Account, but kept in a separate War Expenses Account and devoted to military spending.162 The Finance Act 1940 effected further increases in the rates of estate duty, succession duty and gift duty. Liability to estate duty was increased substantially at all levels. Also the threshold below which no estate duty was payable was 155

Finance Act 1939, Schedule; compare Death Duties Act 1921, First Schedule. Finance Act 1939, s 26; compare Death Duties Act 1921, s 17. 157 Finance Act 1939, s 27; compare Death Duties Act 1921, s 46. 158 New Zealand Parliamentary Debates, 24 August 1939 at 519. 159 Quoted by Barry Gustafson From the Cradle to the Grave: A Biography of Michael Joseph Savage (Penguin, Auckland, 1988) at 251. 160 War Expenses Act 1939, s 7. 161 War Expenses Act 1939, s 4. 162 War Expenses Act 1939, s 2. 156

Book 1.indb 342

12/2/2011 8:22:14 AM

The History of Death Duties and Gift Duty in New Zealand 343 reduced from £1,000 to £200.163 Thus very modest estates now became dutiable,164 though the burden on them was relatively light. The top rate of estate duty stayed at 40 percent, payable on estates of £100,000 or more. But this 40 percent rate was now applied to the whole of the estate rather than, as before, only the excess over £100,000.165 The increases in the rates of succession duty were more complex. As before, there were different schedules of rates for wives, husbands, children and so on – all were increased significantly.166 For instance, where the successor was a child of the deceased, the maximum rate of duty was increased from 6 2/3 percent167 to 16 percent.168 The increases in the rates of gift duty were substantial, too. For instance, the highest rate – payable by persons making gifts of more than £20,000 per year – was increased from 16 percent169 to 25 percent170 (still much lower than the top rate of estate duty and therefore still allowing much scope for avoidance). As Walter Nash,171 the Minister of Finance, explained, the reason for these increases in taxation was to finance military spending.172 But increasing death duties whilst asking people to put their lives in jeopardy was problematic. In 1943 the exemption for servicemen’s estates was extended to cover the merchant marine.173 And in 1944 partial relief was provided from the double death duties that arose where a serviceman inherited property from another serviceman and then died.174

V. THE DECLINE AND ABOLITION OF DEATH DUTIES: 1949–2011

The right-wing National Party, successor to the Reform Party, won the 1949 election and governed for most of the rest of the twentieth century. Part of its programme, in accordance with its philosophical objection to taxes on wealth, 163

Finance Act 1940, s 26 and First Schedule. The New Zealand Official Yearbook, 1941 (Government Printer, Wellington, 1941) at 668–670. 165 Finance Act 1940, s 26 and First Schedule. 166 Finance Act 1940, s 27 and Second to Seventh Schedules. 167 The rate of tax provided for by the Finance Act 1939 was 5 percent, to which the War Expenses Act 1939 had added one third, making 6 2/3 percent. 168 Finance Act 1940, s 27 and Fourth Schedule. 169 The rate of tax provided for by the Finance Act 1939 was 12 percent, to which the War Expenses Act 1939 had added one third, making 16 percent. 170 Finance Act 1940, s 28. 171 Walter Nash was born in England in 1882, emigrated to New Zealand in 1909, and entered Parliament in a by-election in 1929. When Labour won the 1935 election under Savage, Nash became the Minister of Finance; when Fraser died in 1950, Nash became the leader of the Labour Party (in opposition); and when Labour won the 1957 election, Nash became Prime Minister; see below. He remained in that position until the 1960 election, which Labour lost. He remained in Parliament until he died in 1968, aged 86. 172 New Zealand Parliamentary Debates, 18 July 1940. 173 Finance (No 3) Act 1943, s 7; New Zealand Parliamentary Debates, 24 August 1943 at 988 (Nash). 174 Finance (No 3) Act 1944, ss 19 and 20; New Zealand Parliamentary Debates, 13 December 1944 at 726 (Nash). 164

Book 1.indb 343

12/2/2011 8:22:14 AM

344

Michael Littlewood

was to cut death duties as circumstances permitted. As the century progressed, estate planning became more and more prevalent and was met with what one commentator described as a ‘virtual complete absence of legislative counter measures’.175 The National Party was naturally content to see the duties atrophy and eventually Labour lost interest in saving them. The taxes’ susceptibility to avoidance, in turn, made them inequitable. Those who got rich quickly and died young tended to suffer their full impact, as did those few who were reluctant to engage in avoidance. But wealthy families burdened by no such qualms were invariably able to mitigate their liability to a considerable degree. Moreover the middle class were less able than the rich to afford the advice required to mitigate liability. The duties’ inequity was thus accentuated. Partly for these reasons and partly because of the enormous growth of income tax, the death duties wasted away and became increasingly unimportant. In 1915, they accounted for 13.5 percent of the government’s revenues; in 1935, 8.8 percent; in 1955, 4.0 percent; in 1975, 1.4 percent;176 and in 1990, just 0.3 per cent.177

The National Government of 1949–1957 The National government elected in 1949 remained in office until 1957. The Prime Minister for the whole of that period was Sydney Holland, an ebullient debater and effective organiser who had led the National Party since 1940 and built it from troubled beginnings into the country’s dominant political force.178 The 1952 Tax Cuts In 1952, the National government cut the rates of estate duty and succession duty by 20 percent across the board.179 The maximum rate of estate duty was thus reduced from 40 percent to 32 percent. These were the first reductions in death duties since their introduction in 1866, and marked the beginning of the system’s decline. The rates of gift duty, and the thresholds, were left unchanged. The main reason for the cuts in estate duty and succession duty was simply 175

See McKay, above n 2 at 24. McKay, above n 2 at 21. OECD, Revenue Statistics 1965–2007, 2008, Table 61 (New Zealand – Details of Tax Revenue). 178 Sydney Holland (1893–1961) became an MP in 1935 and was Prime Minister from 1949 until 1957. One of his main contributions was to abolish the Legislative Council (the upper house of Parliament), which was dominated by members appointed during Labour’s 14 years in office. Holland appointed 25 new members – enough to constitute a large majority – who then voted the Council out of existence. Like Massey (see above n 15), Holland took a confrontational approach to industrial disputes – in particular, the 1951 waterfront dispute, the largest industrial dispute in New Zealand’s history, which he resolved by using the military to load and unload ships. Later the same year, he called a snap election and was returned to power with an increased majority. It was during his term in office, in 1951, that the ANZUS (Australia-New Zealand-United States) military alliance was established. 179 Death Duties Amendment Act 1952, s 2(1). 176 177

Book 1.indb 344

12/2/2011 8:22:14 AM

The History of Death Duties and Gift Duty in New Zealand 345 that the National Party was philosophically in favour of cutting taxes, especially on farmers and the affluent, wherever possible.180 There was also a change in rhetoric – there seems now to have been virtually no support, even from Labour, for the theory that the tax system (or any other means) should be used to break up large fortunes.181 The Abolition of Succession Duty: 1955 Towards the end of Holland’s term as Prime Minster, the 1909 Act was repealed and new legislation was enacted – the Estate and Gift Duties Act 1955. As its title suggests, the Act made a fundamental change: estate duty and gift duty were preserved, but succession duty was abolished. This simplified the system – which, according to the government, was its aim182 – but it also lightened the burden. To compensate for the abolition of succession duty, the Act increased the rates of estate duty; to compensate for the abolition of the preferential treatment of widows and children built into succession duty, the exemptions built into estate duty were refined. By modern standards, the schedules of rates for estate duty and gift duty were bizarre. There were 39 different rates of estate duty, from four percent to 59 percent. These were structured so as to produce a maximum total liability (on estates of £100,000) of 40 percent. Estates of more than £100,000 were taxed at a flat rate of 40 percent from the first pound.183 Although the rates of estate duty were increased, the abolition of succession duty reduced the overall burden on estates of up to about £12,000 in value. In other words, the burden on many of the National Party’s supporters was reduced. The burden on larger estates remained about the same. Estates worth less than £1,000 – about a quarter of the total184 – were exempt. Overall, revenue from death duties was calculated to fall by 17.5 percent.185 The 1955 Act provided for exemptions from estate duty for the deceased’s widow and ‘infant children’ (meaning under the age of twenty one) and also for any other person accepted by the Commissioner as dependant on the deceased.186 These exemptions were so structured as to cover the whole of the deceased’s estate, if it was worth £12,000 or less and he left all of it to his wife and infant children. To the extent that the estate was worth more than £12,000, the amount of the exemptions was progressively reduced. The Act also provided for quick succession relief – if A died leaving property to B, and B died within five years 180

New Zealand Parliamentary Debates, 23 October 1952 at 2,073–2,076 (Charles Bowden). New Zealand Parliamentary Debates, 23 October 1952 at 2,076–2,077 (Nash). 182 New Zealand Parliamentary Debates, 27 October 1955 at 3,462–3,464 (Jack Watts, Minister of Finance). See also Anonymous, above n 2. 183 Estate and Gift Duties Act 1955, First Schedule. 184 The New Zealand Official Yearbook, 1957 (Government Printer, Wellington, 1957) at 1,133– 1,135. 185 Watts, 1955 Budget Speech, 21 July 1955. 186 Estate and Gift Duties Act 1955, s 17. 181

Book 1.indb 345

12/2/2011 8:22:15 AM

346

Michael Littlewood

of A, then the duty payable on the part of B’s estate that he had inherited from A was reduced. The extent of this relief varied, according to the period elapsing between the two deaths. The maximum was 50 percent (if B died within one year of A); the minimum was 10 percent (if B died between four and five years after A).187 If B died more than five years after A, no relief was provided for. The 1955 Act also modified the rates of gift duty.188 The threshold below which no duty was payable was £500. Thereafter, as with estate duty, the number of brackets was by modern standards excessive: there were 22 of them, from five percent to 39 percent, but subject to an overall maximum of 25 percent. Thus, the highest rate of duty remained the same as before. Previously, however, that rate had been applicable to gifts worth more than £20,000, whereas it was now imposed only on gifts worth more than £30,000. The overall effect of the new rates was that for gifts large enough to attract tax at the heavier end of the scale, the burden remained unchanged; at the lighter end, however, the new rates produced reductions in liability. Overall, the revenue from gift duty was expected to fall by 20 percent.189

Labour’s Last Hurrah: 1957–1960 In 1957, there was a change of government: Labour won the election with a majority of two. This second Labour government was led by Walter Nash, then aged 75.190 Labour had campaigned on the basis that it would introduce PAYE, as planned by the National government, but that in the first year of PAYE, every taxpayer would get a rebate of £100. Although derided by National as a bribe, this manoeuvre proved successful. But within a year of taking office, the new government faced a balance of payments crisis.191 It was reluctant to cut spending or break its expensive election promises, so was obliged to increase taxes. In his 1958 Budget, the Minister of Finance, Arnold Nordmeyer,192 effected steep and unpopular increases in the taxes on beer, cigarettes, cars and petrol.193 He also drastically increased estate duty: not only was the maximum rate increased sharply from 40 percent to 60 percent (the highest it was ever to reach), but the level at which the top rate applied was slashed from £100,000 to £30,000.194 The maximum rate of gift duty likewise reached its highest ever point – 30 percent, if 187

Estate and Gift Duties Act 1955, s 19. Estate and Gift Duties Act 1955, Second Schedule. 189 Watts, above n 185. 190 See above n 171. 191 Basset, above n 154 at 293. 192 Arnold Nordmeyer (1901–1989) was a Presbyterian minister before becoming a politician. He entered Parliament in 1935 and held various offices in the first Labour government before becoming Minister of Finance in the second. In 1963, he succeeded Nash as leader of the Labour Party (in opposition). 193 New Zealand Parliamentary Debates, 1958, Appendix B6. 194 Estate and Gift Duties Amendment Act 1958, s 2 and First Schedule. 188

Book 1.indb 346

12/2/2011 8:22:15 AM

The History of Death Duties and Gift Duty in New Zealand 347 the donor made gifts within 12 months totalling more than £40,000.195 But these were desperate short-term moves, akin (as the economist Henry Simons said in a similar context) to ‘dipping deep’ into large fortunes ‘with a sieve’.196 Nordmeyer might have done better to leave the rates of duty as they were, and concentrate on combating avoidance. The Budget was characterised by the Opposition as the Black Budget and the name stuck, blighting Nordmeyer’s political future.

The National Government of 1960–1972 In 1960, there was another change of government – National, led by the pompous but effective Keith Holyoake, winning by 46 seats to 34.197 Labour’s loss was widely attributed to the tax increases of 1958. Holyoake won another three elections consecutively – in 1963, 1966 and 1969 – and National remained in office until 1972. The 1961 Tax Cuts Again, the new government wasted no time in amending the rates of tax in accordance with its basic philosophy. In 1961 it reduced the rates of both estate duty and gift duty. As regards estate duty, the government simply reversed the increases effected by the Labour government three years earlier: the maximum rate of duty was cut from 60 percent to 40 percent and the size of estate to which the top rate applied was raised from £30,000 to £100,000.198 Similarly, the maximum rate of gift duty was cut from 30 percent to 25 percent, though the threshold at which that rate applied was reduced from £40,000 to £30,000,199 making gift duty a marginally more effective anti-avoidance measure. Basing the System on Domicile: 1968 In 1968 the legislation was again consolidated. The new Act – the Estate and Gift Duties Act 1968 – made numerous trivial improvements in the system and also 195

Estate and Gift Duties Amendment Act 1958, s 3 and Second Schedule. H Simons, Personal Income Taxation: The Definition of Income as a Problem of Fiscal Policy (University of Chicago Press, Illinois, 1938) at 219. 197 Keith Holyoake (1904–1983) entered Parliament in 1932 as its youngest member and left it in 1977 as its oldest. He was Prime Minister for two months in 1957 and from 1960 to 1972 and also Governor-General from 1977 to 1980. Under his leadership the New Zealand military joined the United States’ venture in Vietnam. He is the only person to have been both Prime Minister and Governor-General of New Zealand (though Sir George Grey was both Premier and Governor – see above n 13). A large block of land at Kinloch near Taupo purchased by Holyoake escalated dramatically in value when a publicly financed road was built nearby: B Gustafson, Kiwi Keith: a Biography of Keith Holyoake (Auckland University Press, Auckland 2007) ch 5. 198 Estate and Gift Duties Amendment Act 1961, s 2 and First Schedule. 199 Estate and Gift Duties Amendment Act 1961, s 4 and Second Schedule. 196

Book 1.indb 347

12/2/2011 8:22:15 AM

348

Michael Littlewood

one fundamental change: the basis of the charge to tax (both estate duty and gift duty) was changed from situs alone to situs plus domicile. Thus estate duty was imposed on all of the deceased’s property ‘wherever situated’ if he was ‘domiciled in New Zealand at the date of his death’, and also on all of the deceased’s property ‘situated in New Zealand’, even if he was domiciled elsewhere.200 Similarly, gift duty was imposed on all gifts, wherever situated, if the donor was domiciled in New Zealand at the date of the gift and also on all gifts of property situated in New Zealand, even if the donor was domiciled elsewhere.201 Basing estate duty and gift duty on domicile as well as situs constituted a fundamental reconceptualisation of both taxes but its practical import was less than that might suggest, for two reasons. First, as has been explained, the charge already covered personal property situated outside New Zealand, if the deceased or the donor was domiciled in New Zealand.202 Thus, the only real difference produced by the change was to bring land outside New Zealand within the scope of system. Secondly, the 1968 Act, like the previous legislation, provided for relief from double taxation where the deceased was domiciled in New Zealand and died leaving assets elsewhere.203 Thus, the extension in the geographical scope of estate duty effected in 1968 would generally have made a significant difference only if the deceased was domiciled in New Zealand and owned land situated in some territory that did not impose a death tax. Similarly, the extension in the geographical scope of gift duty effected in 1968 would generally have made a difference only if the donor was domiciled in New Zealand and made a gift of land situated in some territory that did not tax gifts. How much use had been made of these gaps in the system is unclear, but attaching liability to domicile would seem to have closed them. The 1968 Act also refined the rates of duty, but these changes seem not to have made any significant difference in the burden, though the scales of rates now referred to dollars rather than pounds, the currency having being decimalised and renamed in 1967. For estate duty, the first $8,000 of the deceased’s estate attracted no liability. This seems to have exempted just over half of all estates.204 Thereafter, there were 41 rates of tax, ranging from less than one percent (on estates marginally exceeding $8,000) to 40 percent (from the first dollar on estates exceeding $200,000).205 As for gift duty, the Act increased the non-dutiable threshold from $2,000 to $4,000 per year and reduced all the rates of duty on gifts of up to $60,000 per year. There were 21 rates of gift duty, ranging from less than one percent (where the donor’s gifts for the year marginally exceeded $4,000) to 25 percent (where they exceeded $64,000).206 200

Estate and Gift Duties Act 1968, s 6. Estate and Gift Duties Act 1968, ss 61 and 63. 202 See above at n 106. 203 Estate and Gift Duties Act 1968, ss 40 (estate duty) and 77 (gift duty). See above at n 109. 204 In 1967, 53 percent of estates were worth less than $8,000: The New Zealand Official Yearbook, 1969 (Government Printer, Wellington, 1969) at 767. 205 Estate and Gift Duties Act 1968, First Schedule. 206 Estate and Gift Duties Act 1968, Third Schedule. 201

Book 1.indb 348

12/2/2011 8:22:15 AM

The History of Death Duties and Gift Duty in New Zealand 349 Shifting the Thresholds: 1970 In 1970, the government – still National, still led by Holyoake – reduced the rates of estate duty again. The threshold beneath which no duty was payable was raised from $8,000 to $12,000 and reductions were effected for most estates. The top rate of duty was 40 percent, as before, and the threshold above which it applied was lowered from $200,000 to $150,000, but this rate now applied only to the excess over the threshold, whereas it had previously applied from the first dollar.207 Again, in other words, the burden on many National supporters was lightened. The rates of gift duty remained unchanged.

The Third Labour Government: 1972–1975 The 1972 election was won by the Labour Party under Norman Kirk, an authentic working-class boy who had left school at 12 and made good.208 The third Labour government, like the second, lasted only a single three-year term – perhaps partly because Kirk died in office in 1974, at the age of 51. During those three years, there were no significant amendments to the Estate and Gift Duties Act. One reason for this was Kirk’s concentration on foreign policy – for instance, sending two frigates to Mururoa (an atoll about half way between New Zealand and Mexico) in protest at French nuclear weapons testing there. Labour seems also to have concluded that death duties were not an effective method of engineering a wholesale redistribution of wealth. Perhaps, too, the Party was no longer so enthusiastic in its pursuit of that objective. And 1960 had left it acutely aware of the way in which unpopular taxes can cost elections.

The National Government of 1975–1984 The 1975 election was won by National, led by the unsavoury demagogue Robert Muldoon.209 His administration remained in office until 1984.

207

Estate and Gift Duties Amendment Act 1970, First Schedule. Norman Kirk (1923–1974) entered Parliament in 1957 and was leader of the Labour Party in opposition (1965–1972) and Prime Minister (1972–1974). 209 Robert Muldoon (1921–1992) became a National MP in 1960, a member of the Cabinet in 1963, Minister of Finance in 1967, Deputy Prime Minister in 1971, leader of the National Party (in opposition) in 1972, and Prime Minister in 1975. As Prime Minister (1975–1984), he attempted to repair the country’s economic woes by enacting legislation ‘freezing’ wages and prices and by injecting substantial government funds into industrial projects, such as an oil refinery. These measures were unsuccessful, and the National Party nowadays seems generally to regard him as an embarrassment. 208

Book 1.indb 349

12/2/2011 8:22:15 AM

350

Michael Littlewood

The 1976 Tax Cuts In 1976, in accordance with its pro-business and pro-farming philosophy, the government again reduced the burden of estate duty. The rates of duty remained much as before, but the thresholds at which they applied were raised. The threshold beneath which no duty was payable was raised from $12,000210 to $25,000,211 exempting roughly two thirds of estates from duty.212 The threshold above which the maximum rate (still 40 percent) applied was raised from $150,000213 to $255,000,214 concentrating the burden on larger estates. As regards gift duty, the 1976 Act compressed the schedule of rates by raising the threshold below which gifts were not dutiable (from $4,000 per year to $8,000 per year) but lowering the point at which the maximum rate applied (from $64,000 to $40,000). The maximum rate of gift duty remained unchanged at 25 percent.215 The main consequence of these measures was that raising the threshold beneath which no duty was payable permitted larger duty-free gifting programmes than had been possible before. The ‘Virtual Abolition’ of Death Duties: 1979 Muldoon won the 1978 election and in 1979 his government dramatically simplified the rates of duty and massively raised the thresholds beneath which no duty was payable. In the case of estate duty, the multiple rates of tax were abolished and replaced by just one – 40 percent – charged on the excess of the estate over $250,000.216 The threshold beneath which no estate duty was payable was thus increased tenfold, from $25,000 to $250,000, so the tax was now confined to the unambiguously wealthy. As for gift duty, the threshold beneath which no duty was payable was increased from $8,000 to $15,000 per year, permitting significantly larger gifting programmes. On gifts exceeding $15,000 per year, duty was charged at progressive rates ranging from 5 percent to 25 percent (on gifts totalling over $40,000).217 According to the government, these changes were necessary to alleviate estate duty’s unduly harsh impact on farmers, for, it maintained, the burden of the duty was rendering some family farms uneconomic and even forcing young farmers to sell their inheritances to pay the duty.218 But, as one contemporary commentary convincingly asserted, it is difficult to take this argument seriously.219 210

Estate and Gift Duties Amendment Act 1970, First Schedule. Estate and Gift Duties Amendment Act 1976, First Schedule. 212 The New Zealand Official Yearbook, 1977 (Government Printer, Wellington, 1977) at 681. 213 Estate and Gift Duties Amendment Act 1970, First Schedule. 214 Estate and Gift Duties Amendment Act 1976, First Schedule. 215 Estate and Gift Duties Amendment Act 1976, Second Schedule. 216 Estate and Gift Duties Amendment Act 1979, First Schedule. 217 Estate and Gift Duties Amendment Act 1979, Second Schedule. 218 New Zealand Parliamentary Debates, 27 June 1979 (Duncan MacIntyre). 219 RA Green and L McKay, ‘The Estate and Gift Duties Amendment Act 1979: the Demise of Wealth Transfer Taxation’ (1980) 10 Victoria University Law Review 227. 211

Book 1.indb 350

12/2/2011 8:22:15 AM

The History of Death Duties and Gift Duty in New Zealand 351 For one thing, such consequences were in fact extremely rare. Moreover, even if estate duty had been inequitable in its effect on farmers, the 1979 reforms were far broader than was necessary to overcome that problem – their effect was to reduce the number of dutiable estates from about a third220 of the total to about 1.7 percent and to cut the revenue produced by the Act by ‘at least 85 percent’.221 Consequently, estate duty and gift duty combined would account for only 0.2 percent of the government’s total revenues. As the authors observed, this amounted to the ‘virtual abolition’ of death duties.222 They pointed out, too, that the rationale for reducing the burden – that a tiny number of young farmers were obliged to sell their inheritances to pay the duty – was the exact opposite of the argument upon which the duties had been increased in 1909 (that it is desirable to break up large fortunes and that inherited wealth harms those who receive it). Of course, the National Party and the interests it represented had been opposed to death duties all along, but even the Labour Party seems to have forgotten that it had once been opposed to large concentrations of wealth. Indeed, it supported the Bill. There would seem to have been a sea change in popular attitudes. Raising the Thresholds: 1983 In 1981 the governing National Party, still led by Muldoon, won a third term in office and 1983 saw further amendments to the Estate and Gift Duty Act. The rates of duty remained the same, but the thresholds were greatly increased again, lessening the burden and simplifying the process of estate planning. For estate duty, the threshold beneath which no duty was payable was increased from $250,000 to $450,000. To the extent that an estate exceeded $450,000, it was dutiable at the same rate as before – 40 percent.223 As regards gift duty, the 1983 amendment raised the threshold beneath which no duty was payable to $27,000 and the point at which the maximum rate of duty (25 percent) was payable to $72,000.224

The Fourth Labour Government The Labour Party, led by the obese and boisterously eloquent David Lange, won the 1984 election and remained in power for six years.225 This was a curious 220

See above at n 212. Green and McKay, above n 219 at 229. 222 Green and McKay, above n 219 at 227. 223 Estate and Gift Duties Amendment Act 1983, First Schedule. 224 Estate and Gift Duties Amendment Act 1983, Second Schedule. 225 David Lange (1942–2005) was a graduate of the University of Auckland Law School and practised law before becoming a Labour MP in 1977. He became Prime Minister in 1984 at the age of 41 (making him the youngest New Zealand Prime Minister of the twentieth century) and continued in that office until 1989, when he resigned following serious discord within the Cabinet. He remained an MP until 1996. 221

Book 1.indb 351

12/2/2011 8:22:15 AM

352

Michael Littlewood

period in New Zealand history. On the one hand, Lange instigated a policy of not permitting nuclear arms into the country. This policy, which is still in force today, won widespread support domestically and much admiration internationally, though it also prompted the United States and Australia to expel New Zealand from ANZUS (the military alliance to which the three countries had, until then, belonged). On the other hand, the Labour government’s economic policy was hijacked by its own Minister of Finance, Roger Douglas, who unexpectedly turned out to hold extreme right-wing views.226 He instituted large income tax cuts – reducing the top rate from 66 percent to 33 percent – and made up the shortfall by introducing GST.227 He also initiated a policy of selling state assets and deregulating much of what had previously been regulated.228 Unsurprisingly, given his economic philosophy, he made no attempt to repair the failing estate duty system.

The National Government of 1990–1999 In 1990 the National Party, led by Jim Bolger, a gentlemanly farmer, was returned to power.229 He led his party to victory again in the 1993 election – the last to be held using the ‘first past the post’ system. Proportional representation – introduced in 1996 – produced a very different outcome: for the first time since 1935, no party held a majority of the seats in Parliament. National won 44; Labour 37; and various other smaller parties 39 between them. Bolger remained in office by entering into a coalition with the largest of the small parties, New Zealand First – a populist, xenophobic party, which specialised in appealing to elderly voters and won 17 seats. A year later, however, he was deposed by his own party and Jenny Shipley, a former primary school teacher, became New Zealand’s first female Prime Minister.230 The Abolition of Estate Duty In the 1990 election campaign, National promised, among much else, to abolish estate duty, and in 1993 the National government fulfilled this promise. The 226 Roger Douglas (1937– ) entered Parliament as a Labour MP in 1969. When Labour won the 1972 election, he became a member of the Cabinet at the age of 34. In 1984, he became Minister of Finance under Lange, but the two fell out badly because of what Lange (and many Labour voters) saw as Douglas’s betrayal of Labour’s values. Douglas later left the Labour Party and founded the far-right ACT Party. After several years away from politics, he re-entered Parliament in 2008. 227 Goods and Services Tax Act 1985. 228 J Kelsey, The New Zealand Experiment (Auckland University Press, Auckland, 1995). 229 Jim Bolger (1935– ) entered Parliament in 1972. He was a member of the Cabinet (1975–1984); leader of the National Party in opposition (1986–1990); and Prime Minister (1990–1997). 230 Jenny Shipley (1952– ) became an MP in 1987, a member of the Cabinet in 1990 and Prime Minster in 1997. She continued as Prime Minister until the 1999 election, which National lost, and retired from politics in 2002.

Book 1.indb 352

12/2/2011 8:22:16 AM

The History of Death Duties and Gift Duty in New Zealand 353 justification offered by Wyatt Creech,231 the Minister of Revenue, was that estate duty was easy to avoid and therefore capricious.232 That was true, but he neglected to mention that one of the reasons the duty was easy to avoid was that successive governments – mainly his own party – had failed to enact appropriate anti-avoidance measures. The government would seem to have had several other reasons for abolishing estate duty, though these were not mentioned by Creech. Mainly, the ruling National Party was, as ever, philosophically opposed to taxes on wealth. Also, estate duty was by this time producing hardly any revenue – less than 0.3 percent of the government’s total tax revenues.233 Abolishing it was easily affordable and made virtually no difference to the state of the public finances. Moreover, most voters seem to have been unconcerned about the fate of estate duty, because it played an insignificant role in the public finances, whereas the tiny minority who were obliged to pay it were affluent, influential and resented it bitterly. There was a risk, too, that estate duty would encourage wealthy retirees to emigrate (having first sold their dutiable New Zealand assets) – in particular, to Queensland (for New Zealand citizens have an unrestricted right of residence in Australia), where the warm climate made for a pleasant retirement and estate duty had been abolished in 1977.234 Last but not least, various other countries – most pertinently, the United States – appeared to be in the process of abolishing their estate duties. Thus the New Zealand government’s abolition of estate duty could be portrayed as being in accordance with an emerging worldwide norm. Labour opposed the abolition of estate duty, on the ground that the small affluent elite paying it were not the sector of society most deserving of a tax cut. But there was no talk of the deleterious effect of inheritance on those who inherit, of the desirability of breaking up large fortunes, or even of the merits of largescale redistribution.235 Nor was there any discussion of the theory – orthodox, in the rest of the world – that, if liability to tax is to be based on ability to pay, the income tax should be supported by both a capital gains tax and some form of death duty.236 Indeed, one Labour member oddly asserted that abolishing estate duty would make it harder for families to retain their farms, though he did not explain why.237 Another bizarrely argued that the abolition of estate duty favoured the dead over the living.238 Evidently death duties had so declined in importance that the issue was no longer deserving of speeches prepared in advance. 231 Wyatt Creech (1956– ) became a National MP in 1987. He held various ministries in the National government of 1990–1999, including revenue, health and education and was Deputy Prime Minister (under Shipley) in 1998–1999. He retired from politics in 2002. 232 New Zealand Parliamentary Debates, 30 March 1993 at 14,458. 233 See above at n 177. 234 Succession and Gift Duties Abolition Act 1976 (Queensland). See, generally, Duff, above n 2. 235 New Zealand Parliamentary Debates, 30 March 1993 at 14,459–14,467 (Michael Cullen, David Caygill and Richard Prebble). See above at notes 98 to 100. 236 The classic statement is Simons, above n 196. 237 New Zealand Parliamentary Debates, 30 March 1993 at 14,466 (Prebble). 238 New Zealand Parliamentary Debates, 30 March 1993 at 14,468 (Clive Matthewson).

Book 1.indb 353

12/2/2011 8:22:16 AM

354

Michael Littlewood

The National government did not, however, simply repeal the legislation (that is, the Estate and Gift Duties Act 1968, as amended). Instead, it enacted the Estate Duty Abolition Act 1993, which left the 1968 Act intact but suspended the operation of estate duty. Section 3 of the Act provided: No estate duty shall be payable under the Estate and Gift Duties Act 1968 in respect of the estate of any person who dies on or after the 17th day of December 1992.

Why the government did not simply repeal the principal Act (or, at least, Parts 1, 2 and 3 of it, which provided for estate duty) is unclear. Perhaps it was to allow time to collect the duty on the estates of those who had died before 17 December 1992. Six years later, in 1999, the government (still National, but now led by Shipley) repealed Parts 1, 2 and 3.239 Gift Duty as a Stand-Alone Tax Curiously the Acts of 1993 and 1999 only abolished estate duty. Gift duty was left intact.240 Indeed, the 1999 Act even contained a number of provisions aimed at improving the administration of gift duty. For example, it contained new rules relating to the valuation of land and shares.241 Thus, whilst the principal Act was still called the Estate and Gift Duty Act 1968, it now provided for only one tax, namely gift duty. It had the appearance of a heavy tax, being charged at rates of up to 25 percent on the value of the gift, but despite its formidable appearance, it was a strange and vestigial thing – the fiscal equivalent, perhaps, of the human appendix. It produced virtually no revenue and, like the appendix, seemed to serve no useful purpose. Most of the populace lived their lives completely unaffected by it. It seldom if ever inhibited the transfer of wealth within families, though it routinely determined the manner in which transfers were made (usually through trusts). And, like the appendix, it was on occasion acutely painful.242 As has been explained, the purpose for which gift duty was established was to protect death duties. That gift duty was left standing when estate duty – the last surviving death duty – was abolished therefore requires an explanation. The reason was that the government thought it possible that gift duty might incidentally serve other useful functions also – in particular, that it might deter people from transferring their assets to trusts with a view to (a) avoiding income tax, or (b) circumventing the rules relating to various means-tested social welfare benefits or (c) escaping their creditors. The government therefore wanted to keep 239

Estate Duty Repeal Act 1999. Estate and Gift Duties Act 1968, Parts 4, 5 and 6 (as amended). Estate Duty Repeal Act 1999, s 8. 242 See Policy Advice Division, Inland Revenue Department Regulatory Impact Statement: Gift Duty Repeal, 4 October 2010 at [28] and Begg v Commissioner of Inland Revenue [2009] NZCA 160, an unusual case in which the Inland Revenue unsuccessfully challenged the efficacy of a gift duty avoidance scheme supplied by the Public Trust – a Crown entity – to some of its elderly clients. 240 241

Book 1.indb 354

12/2/2011 8:22:16 AM

The History of Death Duties and Gift Duty in New Zealand 355 gift duty in place as a temporary measure while it investigated the scale of these abuses and devised more direct methods of controlling them, if need be.243 But shortly after repealing the estate duty legislation in 1999, that government was voted out of office and the abolition of gift duty was consequently deferred.

The Fifth Labour Government: 1999–2008 Labour won the next three elections – in 1999, 2002 and 2005 – and, with the support of various minor parties, remained in office until 2008. The Prime Minister throughout this period was the formidable Helen Clark.244 Her government increased the maximum rate of income tax from 33 to 39 percent but made no attempt to revive any form of death duty. Nor, however, did it abolish gift duty. This anomalous tax therefore remained in force, producing hardly any revenue but causing considerable inconvenience.

The Present National Government: 2008–present In 2008, a National government – supported by the right-wing ACT Party and also, curiously, the generally left-wing Maori Party – was elected under the leadership of John Key, a cheerful, one-time Merrill Lynch executive.245 He had campaigned promising tax cuts, and duly reduced the maximum rate of income tax from 39 percent to 33 percent. To make up the loss in revenue, GST was increased from 12.5 percent to 15 percent.246 The government then conducted a review of gift duty, concluded that it served no useful purpose,247 and introduced legislation providing for its abolition with effect from 1 October 2011.248 At the time of writing, it seems highly probable that this legislation will soon be enacted.

243

See Policy Advice Division, above n 242. Helen Clark (1950– ) lectured in political studies at the University of Auckland before becoming a Labour MP in 1981. She was Prime Minister from 1999 to 2008 and in 2009 became the Administrator of the United Nations Development Programme. 245 John Key was born in 1961. His father died in 1967 and he and his two sisters were brought up by his mother, living in a state house in Christchurch. Before entering politics, Key worked as a foreign exchange trader for Merrill Lynch. He became a National MP in 2002 and Prime Minister in 2008. With a fortune of NZ$50 million, he is New Zealand’s richest MP. 246 Taxation (Budget Measures) Act 2010, ss 31–37 and 45. 247 Policy Advice Division, above n 242. 248 Taxation (Tax Administration and Remedial Matters) Bill 2010, cl 110. 244

Book 1.indb 355

12/2/2011 8:22:16 AM

356

Michael Littlewood CONCLUSION

Death duties played an important role in New Zealand’s public finances for over a hundred years, from 1866 (when they were first introduced) until the mid1970s (when the yield of estate duty declined to the point where it was no longer significant). This strand of the country’s fiscal history raises several questions. Was the abolition of estate duty a good idea? If not, would it be a good idea to reinstate it? Is there something about New Zealand that makes death duties a less advantageous tax there than elsewhere? More generally, is estate duty, or any other form of death duty, a good tax? New Zealand’s estate duty was not a good tax, because it was too susceptible to avoidance – mainly because Parliament failed to enact appropriate countermeasures. The experience of other countries – for example, the United Kingdom – seems to demonstrate that a well designed death tax can be worthwhile. Such taxes are progressive and can make a useful if modest contribution to the public finances. And death is a relatively convenient time to impose a tax, so long as reasonable allowance is made for the deceased’s spouse and dependants. Death taxes are prone to avoidance, but nonetheless reasonably straightforward and economical to administer. In New Zealand’s case, however, there is a particular problem: Australia has no death tax. The reintroduction of estate duty, or any other death tax, in New Zealand would therefore tend to motivate the affluent elderly to migrate, taking their wealth with them – and the New Zealand government already regards the loss of people to Australia as a significant problem. New Zealand is unusual in that not only are there no death duties, but there is also no capital gains tax – and never has been. Thus, two progressive taxes common in other comparable countries are both conspicuously missing. Perhaps this is a coincidence. But it is tempting to wonder whether there is something about the political process in New Zealand, or perhaps even something in the national psyche, that works against the taxation of wealth. And, as noted above, the maximum rate of income tax is currently only 33 percent – lower than in many other countries. One possible factor explaining the lack of wealth taxes in New Zealand is that many of the country’s richer citizens have emigrated; wealth taxes would presumably tend to exacerbate this problem. What, then, of gift duty? Whether it was a good idea to reduce the scope of estate duty and then abolish it is debatable. But if there is to be no death duty of any kind, the retention of gift duty would seem difficult to justify. If estate duty were to be revived, gift duty would serve the useful function of protecting it from avoidance (though an integrated system for taxing inter vivos gifts and inheritances – as in the United Kingdom – would be better).249 On its own, however, gift duty is a considerable nuisance and achieves nothing useful. Since 249

Book 1.indb 356

McKay, above n 128.

12/2/2011 8:22:16 AM

The History of Death Duties and Gift Duty in New Zealand 357 there would appear to be no prospect of death duties’ being revived in New Zealand in the foreseeable future, the better course would be to abolish gift duty also. As has been intimated, it seems probable that that will happen later this year, bringing the history of death duties and gift duty in New Zealand to an end.

Book 1.indb 357

12/2/2011 8:22:16 AM

Book 1.indb 358

12/2/2011 8:22:16 AM

13 An Older Tale of Default on Greek Bonds MALCOLM GAMMIE

ABSTRACT

‘S

OURCE’ WAS A fundamental structural concept of Addington’s income tax. In terms of collection, the practical conception that underpinned Addington’s tax was collection at the source by deduction wherever possible. This found particular expression in the idea of ‘charges on income’, comprising those cases in which a person undertook an obligation to pay a defined monetary amount charged on a fund. Such payments were ordinarily to be made under deduction so that the recipient suffered tax at the source. This offered a practical collection method for income derived from UK sources but could not operate on foreign income where direct assessment of the person in receipt of or entitled to the income had to be resorted to. Given that difference one might expect the rules for determining income as UK or foreign to be well established. In fact, the case law is sparse. The leading case on the topic is usually regarded as the National Bank of Greece case, where for a third time the House of Lords had to consider the consequences of a default on Greek bonds. In fact, careful consideration of the arguments reveals that the case is authority for the correct source of interest paid by a guarantor rather than the question of whether that interest paid was UK or foreign income.

INTRODUCTION

In a previous paper I considered the origins of fiscal transparency under the UK income tax.1 As I noted then, the Income Tax Act 1842 contained an 1 M Gammie, ‘The Origins of Fiscal Transparency in UK Income Tax’ in J Tiley (ed), Studies in the History of Tax Law, Volume 4 (Hart Publishing, 2010).

Book 1.indb 359

12/2/2011 8:22:16 AM

360

Malcolm Gammie

implicit distinction between property and activities that are ‘income producing’ and ‘participatory’ rights in such income producing property and activities, ie rights representing an entitlement to the income produced by the property and activities charged to tax. Broadly, the former were described in the Schedules and Cases of the Acts; the latter were not. What was charged to tax was (and still is) the income from particular income-producing property or activities. The property and activities described in the Schedules and Cases were the ‘sources’ of income that were charged to tax. In contrast, income derived from participatory rights – notably those represented by partnership interests, shares in bodies corporate, many trust interests and rights under life insurance policies – were not within the scope of any Schedule or Case as such. These participatory rights were not the source of income charged to tax but provided the basis for assessment in particular persons’ hands of income from property and activities that had been charged rather than being themselves the subject matter of charge. In between these two categories of income producing property and activities and participatory rights was the category of ‘charges on income’, that is a specific charge on the payer’s sources of income in general rather than an entitlement to income from a specific source that had been charged to tax. As I suggested in my previous paper, a reason why the 1842 Act identified annuities, yearly interest and annual payments and charged them separately to tax was probably because it was not possible to say that the legal rights that they involved (giving rise to the payer’s obligation to make those payments) were rights that entitled the payee to any specific item of the payer’s income. The obligation that the payer undertook to pay an annuity, yearly interest or other annual payment did not vest in the payee any entitlement to income from specific property that was charged to tax under one of the Schedules or Cases. The payee, therefore, could not be assessed directly in respect of that item of income. Only the payer could be so assessed but the burden of the tax could be passed to the payee through the mechanism of deduction at source.

FOREIGN POSSESSIONS

Charges on income aside, the other element that demanded some qualification to this scheme linking the concept of a source of income – the income producing property and activities described in the Schedules and Cases – and the concept of ‘participatory’ rights to income, was that relating to foreign property and activities. The issue in the case of foreign income was that the charge to tax, notably that under Schedule D, was framed in terms that depended on both the identification of the source and of the person entitled to the income it produced.2 2 My previous paper may have suggested that the linking of the charge on foreign income producing property with the residence status of the person entitled to it originated in the Income Tax Act 1853 (see section 1). The linkage can, however, also be seen in the original form of Schedule D in the 1842 Act.

Book 1.indb 360

12/2/2011 8:22:17 AM

An Older Tale of Default on Greek Bonds

361

The essential point is that foreign income is charged to tax in the hands of a resident person but is not charged to tax in the hands of a non-resident.3 Nevertheless, even in the case of foreign income it is still possible to see the distinction that is drawn between ‘source’ and ‘participatory rights’. In Colquhoun v Brooks,4 the question was whether Mr Henry Brooks was liable to assessment in respect of unremitted profits of Brooks, Robinson & Co, window glass, oil and colour merchants, of Melbourne, Australia. The Surveyor of Taxes contended that Mr Brooks, as a UK resident, should be assessed under Schedule D Case I in respect his share of the partnership profits, whether remitted or not. Mr Brooks, however, had played no active part in the conduct of the firm’s business: he was a ‘sleeping partner’. It could not be said, therefore, that the trade of Brooks, Robinson & Co had been conducted within the United Kingdom. As the assessment provisions at the time made no provision for assessing the profits of a trade carried on entirely outside the United Kingdom, the implication was that such profits were only assessable in the hands of a resident person as and when and to the extent they were remitted. Having considered the machinery of assessment and concluded that the Act did not as such charge the profits of a trade conducted wholly abroad, Lord Herschell continued5— The rule, styled the fifth case, which I have already referred to, deals with the duty to be charged in respect of possessions in any of Her Majesty’s dominions out of Great Britain and foreign possessions. Now the word ‘possessions’ is not used in the part of the Schedule D. which describes the subjects of the tax. Speaking generally, they are defined to be the profits arising from property and those arising from trades and professions. When, therefore, the term ‘possessions’ is employed it seems to indicate an intention to cover by it something more than property. And it is difficult to see why, unless the intention were to embrace something more, the latter word was not used. Possessions’ is a wide expression; it is not a word with any technical meaning: the Act supplies no interpretation of it. And I cannot see why it may not fitly be interpreted as relating to all that is possessed in Her Majesty’s dominions out of the United Kingdom, or in foreign countries. And if so I do not think any violence would be done to the language if it were held to include the interest which a person in this country possesses in a business carried on elsewhere. So to construe the Act would have the advantage of removing the glaring anomaly to which I have referred as inevitably flowing from the rival construction and of taxing alike such portion only of the profits arising abroad whether from property or trade as is received in the United Kingdom.

Lord Macnaghten reached a similar conclusion— Turning now to the ‘fifth case’, I ask why are not the Respondent’s profits and gains from his Melbourne business within the ‘fifth case’? What is the meaning of the term

3 ‘The Income Tax Acts, however, themselves impose a territorial limit, either that from which the taxable income is derived must be situate in the United Kingdom or the person whose income is to be taxed must be resident there’. Colquhoun v Brooks 2 TC 490 per Lord Herschell at 499. 4 (1889) LR 14 App Cas 493; 2 TC 490. 5 2 TC at 502.

Book 1.indb 361

12/2/2011 8:22:17 AM

362

Malcolm Gammie

‘possessions’ in that case? The word ‘possessions’ is not a technical word. It seems to me that it is the widest and most comprehensive word that could be used. Why, for instance, should not possessions in Ireland ‘mean everything, every source of income that the person chargeable has in Ireland, whatever it may be? Why should not ‘profits from possessions out of Great Britain’, which is to be found in Schedule G., No. XI., and recalls the expression ‘income out of Great Britain’ in the Act of 1799, mean profits from every source of income abroad? – I use the expression ‘source of income’ because it is as a source of income that the Act contemplates and deals with property and everything else that a person chargeable under the Act may have, and the Act itself, in section 52, uses the expressions ‘sources chargeable under the Act’ and ‘all the sources contained in the said several schedules’ as describing everything in respect of which the tax is imposed.

As both extracts illustrate, the ‘source’ was the trade and not Mr Brook’s interest in the partnership as such. In other words, the distinction between ‘source’ and ‘participatory interest’ is maintained. Mr Brook’s partnership interest represented his entitlement to profits which, when remitted, could then be assessed. Thus, in determining whether the profits of a trade, as the subject matter of charge, were derived from a UK or a foreign source, one looked to where the trade was carried on. The nature, characteristics and location of Mr Brook’s interest in the partnership did not enter into the matter. The nature and characteristics of an Australian partnership interest at the time were no doubt identical to those of an English partnership and without any contrary evidence that is the basis upon which the House of Lords would have approached the matter. There was no suggestion, however, that the income should properly be regarded as ‘foreign’, and therefore subject only to remittance taxation, solely because this was an Australian partnership interest. It was always open to Mr Brooks to invest in the Australian partnership without actively participating in the conduct of the partnership business. He was able to show, therefore, that the trade was conducted wholly abroad notwithstanding that he, as a UK resident partner, could be regarded as carrying on the trade of Brooks, Robinson & Co. Companies were in a less fortunate position. They were usually unable to demonstrate that the trade was conducted wholly abroad because some aspect of the company’s management or business could generally be found in the UK. Accordingly, they ordinarily remained liable to be assessed under Schedule D Case I on the whole of their trading profits, whether derived from transactions at home or abroad.6 Their only escape was to vest the trade fully in a company incorporated and resident abroad, in which case they were liable to tax in respect of their share of the profits represented by dividends under Case V.7 As a result a difference arose between the taxation of dividends

6 Cesena Sulphur Co v Nicholson (1876) 1 Ex D 428; 1 TC 88; Imperial Continental Gas Association v Nicholson (1877) 1 TC 138; London Bank of Mexico and South America v Apthorpe [1891] 2 QB 378; 3 TC 143. 7 In a number of early US brewery cases the Commissioners held that the brewing trade was in fact being conducted by the UK parent company from the UK. In Kodak Ltd v Clark (1903) 4

Book 1.indb 362

12/2/2011 8:22:17 AM

An Older Tale of Default on Greek Bonds

363

paid by UK resident companies, which until 1965 were not as such8 the subject matter of charge under any Schedule or Case, and dividends from a non-resident company which were charged to tax under Schedule D Case V as income arising from foreign possessions.9 The principal part of the analysis in my previous paper on Transparency concerned the application of the concepts of ‘source’ and ‘participatory interest’ in the foreign trust context supplied by the Archer-Shee cases.10 Those cases concerned Lady Archer-Shee’s interest in a New York trust and the essential question was whether the trust was ‘transparent’ or not. In Baker v Archer-Shee the House of Lords concluded that Lady Archer-Shee’s interest as beneficiary was a participatory right entitling her to the underlying income of the trust. Accordingly, the Inland Revenue could look to the underlying property of the trust – the foreign shares and securities – and assess her husband, Sir Martin, to tax in respect of income from property that the Act charged to tax. In Garland v Archer-Shee new evidence of New York law indicated that Lady Archer-Shee’s trust interest did not in fact given her any immediate entitlement to the underlying income of the trust. In both cases Lady Archer-Shee had received the underlying trust income but the significance of this new evidence lay in the state of the law at the time on remittance. Income from foreign securities was charged to tax under Schedule D Case IV on the full amount of the income arising in the year of assessment, whether or not remitted to the UK.11 Income arising from foreign possessions, other than stock, shares or rents, was only charged on the remittance basis.12 Lady Archer-Shee, believing that her trust interest represented a foreign possession under Case V, received and retained the income in New York. The nature of Lady Archer-Shee’s interest was therefore fundamental to Sir Martin’s liability in respect of the income she derived from the trust. From an English law perspective viewed as a participatory interest in the underlying trust property the income fell within the charge to tax and he could be assessed on it as it arose. However, once he had established that the relevant foreign law gave his wife no immediate entitlement to the trust income, the income fell outside the scope of charge (being foreign income of non-resident trustees) and the income that she received from the trustees could not be traced to its original source. Her income became income arising or accruing TC 549 the Inland Revenue failed to establish that the company could be assessed on its American subsidiary’s profits where the only control exercised by the UK parent was shareholder control. 8 A UK dividend might, however, be brought into account as a component of a Case I computation, Cenlon Finance Co Ltd v Ellwood [1962] 2 WLR 871; 40 TC 176. 9 IRC v Reid’s Trustees (1949) 30 TC 431. For further consideration of the development of the taxation of company dividends, see Avery Jones, Defining and Taxing Companies 1799 to 1965, in this volume. 10 Baker v Archer-Shee [1927] AC 844; 11 TC 749; Garland v Archer-Shee [1931] AC 212; 15 TC 693. 11 ITA 1918, Schedule D, Rules applicable to Case IV, para 1. 12 ibid, Rules applicable to Case V, para 2.

Book 1.indb 363

12/2/2011 8:22:17 AM

364

Malcolm Gammie

from a foreign possession (her trust interest), taxable at the time only on a remittance basis. In this respect there was no difficulty in concluding that Lady Archer-Shee’s trust interest was ‘foreign’. Everything about it was ‘foreign’: the settlor was a US citizen, the trust was constituted under his will and governed by New York law, the trustee was resident in New York and the trust property comprised foreign shares and securities. Not every case, however, is so distinctly foreign. In particular, under the scheme of the tax that I have described, income derived in the form of a charge on income is capable of presenting particular problems. The obligation giving rise to the payment may appear to be a UK or a foreign obligation but the fund on which the charge is imposed may suggest the contrary. The characterisation of the income as UK or foreign in such cases could be important for UK resident persons so long as they could benefit from the remittance basis. It could also be important for non-resident persons who were not liable to tax in respect of income that had a foreign source but who would be liable to suffer UK income tax, usually by deduction at source, if the charge on income had a UK source. It was this latter issue that arose for consideration in the case of the Greek bonds.

THE NATIONAL BANK OF GREECE CASES13

The Factual Background In 1927 the National Mortgage Bank of Greece issued £2,000,000 7 per cent sterling mortgage bonds in bearer form, repayable on 1 December 1957 and guaranteed by the National Bank of Greece.14 Following the occupation of Greece by Axis forces in April 1941, payments under the bonds ceased to be made and were not resumed after the War.15 In November 1949 Greek Emergency Law No. 1318 (subsequently confirmed by Act of the Greek Parliament) suspended payment until June 1952. The Greek law operated to suspend not merely all remedies for enforcement of the bonds in question but also the obligation to make payments. In short, the moratorium provided an effective defence against any bondholder who sued in Greece to recover outstanding interest or principal. The moratorium on payments was subsequently extended beyond 1952. 13 I am indebted to Graham Aaronson QC for pointing out to me some years ago that the traditional view at the time (which I held) of National Bank of Greece SA v Westminster Bank Executor and Trustee Co (CI) Ltd as an authority on this issue was probably wrong and for suggesting the correct way to view the case. Any errors or omissions in the following analysis and its conclusion, however, are mine alone. 14 In 1935 the interest rate was reduced to 4¾ per cent and it was provided that bondholders resident in Greece should be paid only in drachmae. 15 The National Mortgage Bank either did not have the money to pay or was unable to obtain sterling to do so. The Bank could only pay in sterling with the permission of the Greek Government, which was never forthcoming; see UGS Finance Ltd v National Mortgage Bank of Greece and National Bank of Greece SA [1964] 1 Lloyd’s Reports 446 per Denning MR at 449.

Book 1.indb 364

12/2/2011 8:22:17 AM

An Older Tale of Default on Greek Bonds

365

In 1953 the guarantor bank was amalgamated with the Bank of Athens by a Greek decree under Act of the Greek Parliament to form the National Bank of Greece and Athens SA.16 Under the Greek decree the amalgamated bank was declared the universal successor to the rights and obligations of the two former banks, which were thereupon dissolved. The amalgamated bank duly registered a place of business in the UK under the Companies Act 1948 and thereafter carried on business there.

Mr Metliss’ Case17 In 1955 the borrower made an offer to bondholders on the basis that the nominal value of the bonds would be reduced by half and the interest from 1941 to 1954 would be waived. Interest thereafter was to be reduced to 2½ per cent. Mr Cyril Metliss, who held £29,700 of the bonds, was not minded to accept. Instead, he presented his unpaid interest coupons to Hambros Bank in London (one of the paying agents named in the bonds) and when payment was refused he sued the National Bank of Greece and Athens SA in London for payment. The Bank’s defence was straightforward: the proper law of the bonds was English law and English law would not recognise a foreign decree modifying the terms of the bonds or substituting one party for another. Alternatively, if English law did recognise the substitution of the amalgamated Bank for the original guarantor, it should also recognise the Greek moratorium on payments. The status of a foreign decree purporting to substitute18 one party for another to a contractual obligation governed by English law was at the time without prior authority. Viscount Simonds summarised the difficulty for the appellant bank19— Here is a company whose status is recognized by the courts of this country because it is incorporated by the law of its domicile. By that law it is invested with duties, powers, assets, liabilities. It admits that, if sued in Greece, it would be liable on the bonds here in question, subject always to the benefit of any moratorium. It comes to this country, carries on its business, and assumes unchallenged possession of the assets of the dissolved company. It is a strange climax of this narrative that it then disclaims a liability to which that dissolved company was undoubtedly subject. I do not think that an English court of justice should readily give effect to such a pretension.

Unsurprisingly the House of Lords, in agreement with the Courts below, decided that the National Bank of Greece and Athens SA had succeeded to the obligation under the original guarantee. The House also decided, however, that the Bank could not rely upon the Greek moratorium to refuse payment. In 16

The amalgamated bank was subsequently renamed the National Bank of Greece SA. National Bank of Greece and Athens SA v Metliss [1958] AC 509. 18 Without any novation under which the bondholders would agree to the substitution. 19 [1958] AC 509 at 522. The Law Lords were Viscount Simonds, Lords Morton, Tucker, Keith and Somervell. 17

Book 1.indb 365

12/2/2011 8:22:17 AM

366

Malcolm Gammie

short, the original guarantor could not have done so and there was nothing in the Greek decree to suggest that the Bank should be in a better position than the original guarantor even though the moratorium was in force when the Bank succeeded to the guarantee obligation. Lord Tucker put the point succinctly20— On the second point, namely, the effect of the Greek moratorium, I am of the opinion that Greek law is irrelevant. This was an English debt and the obligation to pay it, its quantum and the date of payment, are all governed by English law which will not give effect to the Greek Moratorium. Denning L.J. (as he then was) said in the Court of Appeal:21 ‘We recognize that Greek law has power of life and death over the company which it created, and we must accept the substitute whom it has provided. But when the substitute stands in our courts to answer for an English debt, it must answer according to English law, which says that the debt must be paid according to its terms’. It is argued that the liability which attached to the new bank at birth was only a suspended obligation, but the nature of the obligation under an English contract must be determined by English law and the Greek moratorium would not have availed the original guarantor in an English court. It follows, in my opinion, that it cannot avail the appellant company ...

Mr Adams’ Case22 Mr Metliss was therefore entitled to recover what was due to him.23 But the National Bank of Greece and Athens SA, now renamed the National Bank of Greece SA, had not left matters as they were. Four days after Mr Metliss had succeeded in the High Court the Greek Parliament changed the law, with retrospective effect, to except the new National Bank from succession to these (or any other) guarantee obligations of the old (dissolved) National Bank in respect of gold and foreign currency securities. Mr Adams was not deterred: he sued the National Bank to recover the principal and interest due on the bonds he held notwithstanding the change in the Greek law. The clash now was between the principle that the new National Bank was created and invested with its particular attributes under Greek law (which English law recognised) and the principle that English law would not recognise any purported alteration or discharge under foreign law of an English law obligation. The first principle relied upon the proposition that what Greek law had brought into existence Greek law could change. The second principle relied on the proposition that the new National Bank had been brought into existence and had succeeded to the guarantee obligation and the change in Greek law, once that had happened, merely sought to discharge it from that obligation. 20

ibid at 529–530. [1957] 1 QB 33, 46. Adams and Others v National Bank of Greece SA [1961] AC 255. The Law Lords were Viscount Simonds, Lords Reid, Radcliffe, Tucker and Denning. Lord Denning had been part of the Court of Appeal who had found in favour of Mr Metliss. 23 But only for the six years prior to the issue of the writ and not back to 1941 as Mr Metliss had claimed, see [1957] 2 QB 33. 21 22

Book 1.indb 366

12/2/2011 8:22:18 AM

An Older Tale of Default on Greek Bonds

367

The House of Lords decided the matter in Mr Adams’ favour.24 Lord Reid set out the two principles in his speech25— The argument for the respondent was that Metliss succeeded because at the time when he claimed his money Greek law made the respondent, the new bank, liable to meet the guarantee obligations of the old bank; but that the appellants cannot succeed because, at the time when they claimed their money and the principal debtor failed to pay, Greek law provided that the respondent was not liable to meet the old bank’s guarantee obligation. One must look to Greek law at the relevant time, and the relevant time was the date when the principal debtor failed to pay its debt; the respondent had then ceased to be guarantor. But for Greek law No. 2292 no one would have any right to sue the respondent in respect of the old bank’s obligations. What Greek law gave, Greek law can take away, and law No. 3504 has taken away from the appellants what law No. 2292 give (sic). When Metliss’s cause of action arose the respondent stood in the shoes of the old bank because it had been directed by Greek law to do so; when the appellants’ cause of action arose the respondent did not because it was then directed by Greek law not to do so. If the appellants’ right against the respondent was a Greek right, if it arose under Greek law and not under English law, I would regard that argument as unanswerable. But in my judgment, the decision in Metliss’s case established that the appellants’ right is an English right.

Lord Radcliffe, with reasons confined to four sentences, also noted that the Court of Appeal were in error in thinking that Mr Adams’ rights were derived from the law of Greece. His rights, ‘were based upon the law of England, and that as part of that law the universal succession created by Act 2292 of the Greek legislative authority and the decree of February 27, 1953, made thereunder, rendered the respondents liable upon the guarantee of their predecessors’.26 The UGS Finance Case27 At that point the National Bank bowed to the inevitable and began to pay bondholders what was due to them. The interest coupons, however, included a provision that they were liable to be forfeit if not presented within six years of their due date. The bond conditions stated that coupons were ‘proscribed and void’ if not presented within six years. Bondholders were therefore paid the principal and interest for the last six years. Somewhat speculatively, UGS Finance Ltd bought up a large number of old coupons that had been detached from the bonds when the bonds were paid off and sought to recover interest 24 In Adams’ case, in contrast to Metliss, the amalgamated bank had succeeded in the Court of Appeal. 25 [1961] AC 255, 278–279. 26 ibid at 284. 27 UGS Finance Ltd v National Mortgage Bank of Greece and National Bank of Greece SA [1964] 1 Lloyd’s Reports 446. The Court comprised Lord Denning MR and Lords Justice Harman and Pearson.

Book 1.indb 367

12/2/2011 8:22:18 AM

368

Malcolm Gammie

from 1941.28 In this respect they failed. While the Court of Appeal considered that the conduct of the National Mortgage Bank amounted to a waiver of the six year condition for presentation of the coupons, this could only benefit couponholders who were influenced by it (and therefore did not present their coupons for payment). It could not benefit a purchaser such as UGS who took the coupons subject to the terms endorsed upon them. UGS did not appeal the matter to the House of Lords.

The Westminster Bank Case29 It was against this background that the saga of the Greek bonds reached the House of Lords for a third time, but this time raising a tax issue. What the National Bank offered in respect of outstanding interest coupons was to pay the interest on presentation of the coupon less a deduction equal to the standard rate of UK income tax. Bondholders for their part insisted on payment of the interest gross. The High Court The matter came direct to the Queen’s Bench Division of the High Court as an issue between the National Bank and its bondholders although the Inland Revenue instructed an amicus curiae to address the Court, if called upon.30 The National Bank’s case in the High Court was that its payments were ‘interest of money’ or ‘other annual payments’. They were therefore charged to income tax under Schedule D,31 specifically Case III,32 and liable to deduction of income tax at source by virtue of section 169(1)(c) of the Income Tax Act 1952.33

28

Notwithstanding the previous adverse decision on the point by Sellars J in Mr Metliss’ case. National Bank of Greece SA and Westminster Bank Executor and Trustee Co (Channel Islands) Ltd [1970] 1 QB 256 (CA); [1971] AC 945 (HL); 46 TC 472. 30 See 46 TC at 475 to 477 for an outline of the approach adopted by the Courts and Inland Revenue in cases between two private parties that raised issues of concern to the Inland Revenue. In the event, Donaldson J at first instance decided against allowing the Inland Revenue’s counsel, Mr J P Warner, to intervene. The Court of Appeal, however, did allow Mr Warner to address the Court (see 46 TC at 484F). In the House of Lords Mr Warner was called upon only on the question whether the income in question could fall at the same time within both Case III and Case IV of Schedule D, see 46 TC at 491E. 31 Section 122(1)(b) ITA 1952: ‘all interest of money, annuities and other annual profits or gains¼’ The origins of this separate head of Schedule D probably lie in the separate charge to tax imposed on such payments under section 102 ITA 1842. As enumerated they impose no explicit territorial limitation. 32 Under section 123(1) ITA 1952: ‘Case III—tax in respect of (a) any interest of money, whether yearly or otherwise, or any annuity, or other annual payment, whether such payment is payable within or out of the United Kingdom, either as a charge on any property of the person paying the same by virtue of any deed or will or otherwise, or as a reservation out of it, or as a personal debt or obligation by virtue of any contract ...’. 33 Section 169 required deduction of tax at source where any yearly interest of money, annuity or other annual payment was payable wholly out of profits or gains brought into charge. By the time 29

Book 1.indb 368

12/2/2011 8:22:18 AM

An Older Tale of Default on Greek Bonds

369

The bondholders, for their part, argued that they were entitled to payment gross because the payments represented by the interest coupons were, so far as the National Bank was concerned, claims to be paid a sum of money by virtue of the obligation to which it had succeeded. In other words, the source of the payment was the National Bank’s obligation under the guarantee to which it had succeeded to pay a sum on presentation of the coupon, but not the original bond. At first instance and in the Court of Appeal it was common ground that if the obligation evidenced by the interest coupons had been discharged by the borrower, the National Mortgage Bank of Greece, the interest would not have fallen under Case III but would have fallen under Case IV of Schedule D as ‘income arising from securities out of the United Kingdom’.34 Neither party appears to have argued that the source of the payment was the bond rather than the guarantee obligation. The National Bank argued, however, that the payment that they were obliged to make under the guarantee was not secured (and was therefore not a foreign security within Case IV) and represented income arising in the United Kingdom (and so was liable to deduction at source). As a starting point Donaldson J thought that this was correct35— The Defendants’ obligation to pay is evidenced by the bond, but there is no right to resort to any specific fund or property to secure the discharge of that obligation. Any income arising from a payment by the Defendants is not, therefore, income arising from securities within the meaning of Case IV as explained by Viscount Cave in Singer v Williams (1920) 7 TC 419, at page 431. The Defendants’ obligation under the guarantee is a collateral security to the charge on Greek property and both secure the Mortgage Bank’s obligations. The obligation under the guarantee itself is, however, unsecured. As to the second point,36 income arising from payments by the Mortgage Bank which, if recoverable at all, can only be recovered in Greece, quite clearly arises out of the United Kingdom. On the other hand, income arising from payments made voluntarily or compulsorily by the United Kingdom branch of the Defendants equally clearly arises within the United Kingdom.

This was all that Mr Justice Donaldson had to say on the question of whether the payments were UK or foreign source income. His conclusion reflected what was common ground before him (that the bond was a foreign security) and the case came to the House of Lords the National Bank had abandoned as untenable any reliance on section 169 and based their argument on section 170, on the basis that the payments were not payable or not wholly payable out of profits or gains brought into charge to income tax; see 46 TC at 492E-G. Section 170(1)(a) applied to any interest of money, annuity or other annual payment charged with tax under Schedule D. The National Bank had also abandoned the submission that the payments were ‘interest of money’; see 46 TC at 494F-I. 34 See 46 TC at 478E-F (HC); at 487G-H (CA). The judge stated that this was, ‘because the Mortgage Bank had no UK branch and the payments were secured on real property in Greece’. In the Court of Appeal the bondholder said that this was not common ground and that a reason why the obligation of the Mortgage Bank was a security out of the United Kingdom was because it was not resident in the United Kingdom and not because it had no branch in the United Kingdom; see [1970] 1 QB 256 at 262A. 35 46 TC 478G-I.

Book 1.indb 369

12/2/2011 8:22:18 AM

370

Malcolm Gammie

what the parties had argued (that the obligation under the guarantee and not the bond was the source of the payment). The remainder of his judgment was directed to the questions whether the payments in discharge of the National Bank’s guarantee obligation were ‘interest of money’ and, if not, whether they were ‘other annual payments’. In this respect he concluded that the payments were income but were neither interest of money37 nor annual payments. In essence the Judge accepted what the National Bank said on the source and its location and what the bondholders said about the character of the payments. The bondholders’ reason for not arguing, at least in the alternative, that the bond was the source of the payment and that the interest was not therefore subject to deduction at source is perhaps less obvious. Their principal argument was that the National Bank’s obligation to pay on the presentation of the coupons was, essentially, a ‘one-off’ obligation. The payment due on the coupon lacked the element of recurrence that would bring it within the scope of an ‘annual payment’. Possibly it might have been hoped that this argument would offer UK resident bondholders a basis for saying that the payments were not liable to income tax at all.38 The plaintiff bondholder, however, was non-resident. Accordingly, it would suffice for it to establish that the payment was not subject to deduction at source irrespective of its character as income or otherwise.39 Given that the obligation to pay under the bonds had effectively been extinguished in Greece and that the bondholders’ only right to be paid was ‘an English right’ and not a Greek right, the plaintiff bondholder might presumably have been advised that it was either too difficult or too risky to base its claim on the fact that the source of the payments was the underlying bond. Inevitably, the plaintiff might then have had to accept that the National Bank was at least correct in saying that the payments were either interest or, in any event, annual payments. The risk, having regard to the situation in Greece, would then be that the source of those payments would be regarded as UK and subject to deduction of tax. As it was, the Judge concluded that the payments were neither interest nor annual payments. As a result income tax was not required to be deducted at source notwithstanding his conclusion that the payments were UK source income, and not arising under a foreign security. The Parties’ Argument in the Court of Appeal In the Court of Appeal the National Bank pursued broadly the same arguments. The plaintiff bondholder, however, seems to have adopted a bewildering variety 36 The first point was whether the payment was secured. The second point was whether the payments constituted UK source income. 37 Relying on IRC v Holder [1932] AC 624; 16 TC 540. 38 This appears to be part of the argument in the House of Lords: ‘If the view be taken that payment by a guarantor in paying a debt is something different in quality from payment of interest by the primary debtor, there is nothing to make it income of the recipient’; [1971] AC 945 at 951B. 39 As a trustee the characterization as income or capital might also have been important for trust purposes.

Book 1.indb 370

12/2/2011 8:22:18 AM

An Older Tale of Default on Greek Bonds

371

of arguments.40 Given the result at first instance, the bondholder maintained its argument that the payments were neither interest nor annual payments. At the same time it said that the Judge was wrong in thinking that the payments were income. The bondholder, however, also argued that if the payments were income the judge was wrong to conclude (a) that they were not income arising from foreign securities, (b) that the income arose from payments made by the National Bank’s UK branch, and (c) that the payments gave rise to a receipt for the bondholders that was different in character or quality from what they would have received if the National Mortgage Bank had paid what was due. It seems that the bondholder was trying to ride two, possibly three, horses. Its starting point was that the National Bank’s payments under its guarantee were not income. If it was wrong about that, however, it sought to mitigate the risk that the payments were subject to deduction at source by arguing that it was income arising from foreign securities within Case IV and not subject to the obligation to deduct under section 169 or section 170. What does not appear to change in the bondholders’ approach is the basic premise that the source of the payments was the National Bank’s guarantee obligation.41 Essentially, if the payments under the guarantee obligation could be said to be income then the payments could be said to be income arising from foreign securities because the bonds were foreign securities and the payments (if income) could still be said to arise from those securities, whether paid by the primary debtor or by the guarantor, either as a general matter or through subrogation. Put another way, a non-resident such as the plaintiff would not have been charged to tax in respect of interest on the securities and a payment by the guarantor in satisfaction of that obligation could not then give rise to income that was so charged. As regards the foreign character of the security, the bondholder submitted that42— The situs of the security remained at all times in Greece, which was also the residence of the primary debtor and of the universal successor to the original guarantor ... the locus of a debt is where the debtor resides. If follows ... that the situs of the debt in this case is Greece, and the fact that the guarantor has selected a branch in the United Kingdom to pay the debt is quite irrelevant to the question whether this is income arising from a foreign security within Case IV.

No doubt it was objected on behalf of the National Bank that it had not selected its UK branch at all. That was where it had been forced to honour the bonds 40 See the summary in the official report in [1970] 1 QB 256 at 261H-262D and 263D-265C. Sachs LJ referred to ‘the ever widening range of conflicting submissions’ but also noted the two constants that (i) the National Bank had to establish Case III as the correct Case if it was to succeed and (ii) the common ground that payments on the coupons by the Mortgage Bank would have been Case IV. 41 This appears from the summary at ibid 263F-G where it is recorded that the bondholders, ‘while contending that there is still in law a valid distinction between the position of the guarantor and that of the primary debtor, which affects the quality of the payments made’ ie as income, interest or annual payments. 42 ibid at 264C-D.

Book 1.indb 371

12/2/2011 8:22:18 AM

372

Malcolm Gammie

and the coupons upon presentation by bondholders. In reply, the National Bank made the point that whatever the character of the bonds when they were issued in 1927, the obligation on those bonds had been extinguished by the Greek Parliament. Thus,43 What the bondholders receive when they get interest payments on the coupons from the guarantors is essentially ‘interest’ or ‘annual payment’ and is certainly income; but it is not income ‘arising from’ a foreign security, for the foreign security has ceased to exist ... The only source of liability is the guarantor’s obligation under the English contract by reason of which the bondholders, being unable to get anything from the primary debtor, can sue the guarantor who, though not ‘resident’ ... is permanently carrying on business within the jurisdiction. If therefore the income arises here, it is not income from a foreign security.

For good measure, however, the National Bank argued that even if the payments did fall within Case IV they were still subject to the rules of sections 169 and 170 so that if the payer were in the UK the payment had to be made under deduction. At this point the Court of Appeal heard submissions from Counsel for the Inland Revenue. The Revenue disassociated itself from the suggestion that section 169 and 170 could extend to income within Case IV. As to whether the payments were within Case IV, however, the Revenue did not accept that when the bonds were issued the guarantor’s obligation was a foreign security even though the Mortgage Bank’s obligation as primary obligor was always a foreign obligation. According to the Revenue44— The basic test for determining whether the payments are income arising in the United Kingdom is to be found in Dicey and Morris on The Conflict of Laws, 8th ed. (1967), p. 508, rule 79,45on the determination of the situs of things. Applying that rule here, the debt is enforceable only in England where it is situate and this is the place where the income arises. The test generally applied in the case of a personal obligation is the residence of the debtor. But that test cannot be a rule of thumb (a) because it affords no solution in a case where the debtor has more than one residence and (b) because if, in the present case, it had been found that the defendants were resident only in Greece, the absurd consequence would arise that the source of this income was in the one country which denies its existence. Residence is important because in most cases it is where the debtor is resident that the debt can be enforced. But the true test is: in what country is the obligation primarily enforceable?

The Court of Appeal’s Decision Lord Denning, sitting now in the Court of Appeal as Master of the Rolls, confronted the National Bank for the fourth time. Having recounted the events 43

ibid at 265F-G. [1970] 1 QB 256 at 267B-D. ie ‘Choses in action generally are situate in the country where they are properly recoverable or can be enforced’. Rule 120(1) in the 14th edition of Dicey, Morris & Collins, see fn 69 below. 44 45

Book 1.indb 372

12/2/2011 8:22:19 AM

An Older Tale of Default on Greek Bonds

373

leading to the Greek moratorium on payment, he noted that, ‘For all practical purposes the liability of the principal debtors and guarantors has become extinguished in Greece and the securities have gone with it’.46 Having then referred to the Metliss and Adams litigation he concluded47— So it is now clearly established by decision of the House of Lords that the National Bank of Greece S.A. (as the universal successor of the original guarantors) is liable to pay the principal and interest on the bonds, such liability being enforceable by action in the English Courts and recoverable by execution against its assets in England.

Having given the background Lord Denning then noted that if the payments were within Case IV the non-resident bondholder would be entitled to receive payments without deduction or to recover any tax deducted.48 He then outlined what the bondholders had argued about the character of the payments49— The first question argued before us was whether the sums payable by the universal successor come within the description (in Case III) of ‘any interest of money, whether yearly or otherwise, or an annuity, or other annual payment’. I must say that when the guarantors pay under the guarantee I think they pay ‘interest’. They pay the interest due under the bonds which they have guaranteed. But the bondholder says that they do not. He says that when the guarantors pay under their guarantee the indebtedness changes its character. He agrees that when the principal debtors pay the interest it is truly interest of money: but he says that when the guarantors pay under their guarantee they pay the like amount, but it is not then a payment of interest. It is payment of a debt due under the guarantee.

This argument did not appeal to Lord Denning, who considered that the payments were ‘interest of money’ and, if not, were ‘annual payments’.50 His view, however, was that the payments did not have to be dealt with under Case III if they fell within Case IV as income arising from securities out of the United Kingdom. On this point Lord Denning concluded that the payments were within Case IV51— ... it is quite plain that until 1941 the income payable to the bondholders did arise from securities out of the United Kingdom. It arose from securities in Greece, where the principal debtors were resident, where there were properties which were security for the indebtedness and where the guarantors were resident. But it is said that after 1941, or at rate after the Greek legislation of 1949 to 1956, the income did not arise from any securities in Greece at all. There were no properties in Greece available to meet it. The Courts of Greece would not allow any bondholder to sue for the principal or interest. There was no possibility of getting anything out of Greece to meet the bonds. It was

46

[1970] 1 QB at 269C-D; 46 TC at 484A. [1970] 1 QB at 269F; 46 TC at 484D. 48 He did not, however, say in terms that sections 169 and 170 cannot apply to Case IV income. 49 [1970] 1 QB at 270C-E; 46 TC at 485A-C. 50 Sachs LJ thought that the payments were annual payments but nevertheless within Case IV. Karminski LJ formed no view on the issue. 51 46 TC at 486E-I. 47

Book 1.indb 373

12/2/2011 8:22:19 AM

374

Malcolm Gammie

only recoverable in England by action against the universal successor of the guarantor. Accordingly it is said that the indebtedness is now here, and here only: see New York Life Assurance Co. v Public Trustee [1924] 2 Ch. 101. So the income now arises here and here only. I can see the force of this argument, but I cannot accept it. These are bearer bonds which are international in character. They may pass from hand to hand in the countries of the world. Their character – and the character of the income from them – does not change with wars or rumours of wars, or with the imposition of a moratorium, or the lifting of it. If the bonds start as foreign securities, they go on as foreign securities. At any rate, the bearers are entitled so to regard them. When a bearer presents a coupon for payment, it may be honoured by the principal debtor or by the guarantor – he need not inquire which it is – suffice it that it is paid. His security for payment has always been property in Greece and the personal guarantee of a Greek company, which will have the right of subrogation given to guarantors. That makes it income arising from securities out of the United Kingdom.

The other members of the Court agreed on this issue. Lord Justice Sachs in particular noted that52— It would be strange if the coupon holder’s tax recovery rights changed because it was the guarantor who provided the money: but this is the contention of the guarantors, who seek in effect to say that the quality of their payment differs from that of the principal debtor. It is suggested that, because the terms of the guarantee read in isolation prima facie produce an English debt paid in England, the result is a Case III payment even if the guarantor is (as was common ground) non-resident qua the income tax law. Even if that were so (despite Stokes v Bennett [1953] Ch 566, per Upjohn J.), I am not prepared to look at this guarantee in such isolation. Taking the terms of the bond as a whole, the guarantor for the purposes of Cases III and IV (with which alone this case is concerned) simply steps into the paying shoes of the principal debtor, and having made the payment comes away by virtue of subrogation with the creditor’s clothes vis-a-vis that debtor. At every stage it is a foreign security transaction – and none the less so because a moratorium (which may or may not be now continuing) at one time suspended or may still suspend the creditor’s right to sue and to enforce his rights of security, or even if the Greek Government has now fully barred legal action in Greece – matters left in the air on the evidence. A foreign security does not in income tax law cease to be a foreign security because a foreign government by legislation impairs the collateral or underlying security, any more than it would because some other third party physically destroyed it.

The Parties’ Arguments in the House of Lords53 In the House of Lords, the National Bank maintained its argument that the payments arose under the guarantee and not under any security and that the 52

[1970] 1 QB 256 at 273D-H; 46 TC 487H-488D. The Law Lords were Lord Hailsham LC, Viscount Dilhorne and Lords Upjohn, Donovan and Pearson. 54 [1971] AC 945 at 948–953. 55 ibid at 948C–D and 955G–956A. 53

Book 1.indb 374

12/2/2011 8:22:19 AM

An Older Tale of Default on Greek Bonds

375

income arose in the United Kingdom as the only place in which the obligation was enforceable.54 It abandoned its argument that the payments were interest and relied solely upon the argument that the payments were ‘annual payments’ within section 170 of the Income Tax Act 1952.55 Heyworth Talbot QC for the National Bank acknowledged that56— It is common ground that the [National Bank] must fail if these payments, which are made by them in this country and under an English contract and are enforceable here alone, arise on securities out of the United Kingdom. Only if the payments fall within Case III are they amenable to the provisions of section 170.

His argument, however, was that the payments were not ‘income arising from securities out of the United Kingdom’ but were made pursuant to and in fulfilment of the obligation of the guarantors. That income had a UK source, in particular, because57— What is here in question is an annual payment arising in the United Kingdom. Payment can only be enforced there. It arises under the guarantee and, even though the guarantee is embodied in the bond, the only recourse is to sue the guarantor in this country. What one must look at here is the income arising and it can only arise in the United Kingdom. It is an annual payment but it does not arise from the security because there is no security against which it could be enforced. The guarantee is unsecured and is not itself a security ... One must look less at the proper juristic description of the rights in question (ie whether or not they are a security), looking rather at the source of the income. But for the moratorium there could have been enforcement in Athens. The effect of the moratorium was to change the source of the income, so that the source of this income is now the place where the obligation of the debtor to pay can be enforced ... The court must look at the situation, asking what kind of payment this is, not interest but an annual payment. Because the United Kingdom is the only place where the guarantor can be required to pay and does pay, it cannot be taken as having arisen elsewhere than in the United Kingdom.

For its part the bondholder fell back on the argument that had succeeded at first instance, namely that the payments were not ‘annual payments’ because they lacked the necessary element of recurrence.58 The bondholder went on to argue, however, that— If the payment by the guarantor has the quality of interest or annual payment, the provisions of Case III of Schedule D are not available here, since the obligation, whether under bond or coupon, is assumed by a non-resident to a non-resident ... In the alternative to these contentions, both bond and coupon constitute foreign securities, to which, it is now conceded, the machinery of deduction under Case III cannot extend.

56

ibid at 948D. ibid at 948H–949F. 58 ibid at 950G–951D; 956A–D. 57

Book 1.indb 375

12/2/2011 8:22:19 AM

376

Malcolm Gammie

This final point appears to reflect an important shift in the bondholder’s argument. The bondholder has clearly shifted its focus from the guarantee obligation to the obligation under the bond and coupons. Its contention to this point that the payments were neither interest nor annual payments required the focus to be upon the guarantee obligation. To the extent that the bondholder had referred to the bonds in its arguments in the Court of Appeal, this appears to have been designed to support its argument that if the payments under the guarantee obligation were income, they should be regarded as income within Case IV because they originated from the bonds as foreign securities. At no stage, however, does the bondholder appear to have referred to the obligation under the coupons as contrasted with the obligation under the guarantee to discharge the debt represented by the coupons. The view it had presumably taken was that it could not accept that the payments derived from the coupons because the payments would then necessarily have the character of interest and potentially subject to deduction under section 170. It appears, however, that at a late stage the National Bank had conceded that both bonds and coupons were foreign securities so that payments under them would not be subject to deduction in this bondholder’s hands. Counsel for the Revenue was called to comment upon two issues: whether there was an overlap between Case III and Case IV and whether an ‘annual payment’ within Case III could be derived from a foreign security within Case IV. The origins of this point lie in the early insurance company cases, where income derived by UK resident insurance companies from foreign securities was found to be assessable under either Case I (as a component of their trading computation) or under Case IV, leaving the Inland Revenue free to elect between the two Cases of Schedule D.59 In that case, the income from foreign securities was clearly charged to tax both as a component of the resident company’s trading computation under Case I and as its gross income under Case IV. Income from foreign securities was not, however, charged to tax in the hands of a non-resident person. Only UK source income was charged in its hands.60 Accordingly, the only option was Case III, if the source of the payments was in the UK. The House of Lords’ Decision Lord Hailsham LC delivered the only speech and noted at the outset that for the National Bank to succeed it had to show that the payments were ‘charged to 59 See eg Liverpool and London and Globe Insurance Co v Bennett [1913] AC 610; 6 TC 327. See also R Thomas, ‘The Crown Option’ in Tiley (ed), Studies in the History of Tax Law, Vol 4 (Hart Publishing, 2010). 60 Colquhoun v Brooks (1889) 14 App Cas 493; 2 TC 490; see above. 61 Similarly, it was irrelevant to decide whether the payments fell within Case IV as income from foreign securities or Case V as income from a foreign possession. If the source of the income was foreign Schedule D did not operate to charge the income to tax in the hands of a non-resident person; see [1971] AC 945 at 956H; 46 TC 472 at 495G.

Book 1.indb 376

12/2/2011 8:22:19 AM

An Older Tale of Default on Greek Bonds

377

tax under Schedule D’, as required by section 170. In doing so he immediately pointed to the fundamental issue that is illustrated by both Colquhoun v Brooks and the Archer-Shee cases. It was immaterial how the payments were characterised – as interest, annual payments or some other species of income receipt.61 If they derived from a foreign source the Act did not charge them to tax in the hands of a non-resident person.62 ‘Having recognised that fundamental point, the key to the House of Lords’ decision is its conclusion that the source of the payments was the original bond and not the obligation that the National Bank had assumed as universal successor to the original National Bank of Greece. Thus:63 The Appellants acquired no obligation different from that of the original guarantors, and that was the obligation imposed on the original guarantors by the terms of the bonds. In my view, the bond itself is a foreign document, and the obligations to pay principal and interest to which the bond gives rise were obligations whose source is to be found in this document.

Taking Stock on Greek Bonds In the end, the National Bank of Greece case turns out to be a case that identifies the ‘source’ of particular income but tells us rather less about the criteria that are to be used in determining whether the income created by the obligation or ‘charge on income’ is UK or foreign. Thus, Lord Hailsham makes the point that the relevant obligation was that imposed by the terms of the bonds and that that obligation had not changed.64 The source of the payments in question – whether they were made by the principal obligor (the Mortgage Bank) or by the guarantor (whether the original National bank or its universal successor) – was the instrument creating the obligation and not as a separate matter the obligation under the guarantee, as had been the principal contention of both parties throughout. He then states that the bond is ‘a foreign document’, ie the bond itself is foreign property, but without explaining what makes it foreign property. In fact, once he had decided that the source of the payments was the bonds and not the guarantee obligation which the National Bank had inherited, it was a matter of concession by the 62 The payments would have been charged to tax in the hands of a resident and in that case the rules applicable to foreign dividends (ie interest, dividends or other annual payments of a person not resident in the UK) in sections 187 to 190 ITA 1952 would presumably have applied. The National Bank had necessarily disclaimed any reliance on these provisions for the deduction that it sought to make because that would have amounted to an admission that the income was foreign and section 190 conferred a specific exemption for foreign dividends paid to non-resident persons. 63 46 TC at 494E; emphasis added. 64 If the National Bank had assumed the obligation to pay interest through novation, that would have operated to create a new obligation. That could then have been regarded as a separate source and its location determined by reference to the situation of that obligation rather than the original bonds.

Book 1.indb 377

12/2/2011 8:22:19 AM

378

Malcolm Gammie

National Bank that the source was a foreign source.65 He had no reason to examine that proposition. The conclusion that the bond itself represented a foreign source obligation, however, is not a difficult one, that presumably being the reason for the National Bank’s concession. Immediately before the previous citation Lord Hailsham had summarised the principal characteristics of the bond as follows66— I have come to the conclusion that the source of the obligation in question was situated outside the United Kingdom. This obligation was undertaken by a principal debtor which was a foreign corporation. That obligation was guaranteed by another foreign corporation which, as was conceded before us, had at no time any place of business within the United Kingdom. It was secured by lands and public revenues in Greece. Payment by the principal debtor of principal or interest to residents outside Greece was to be made in sterling and either at the offices of Hambros Bank or Erlangers Ltd. or (at the option of the holder) at the National Bank of Greece in Athens, Greece, by cheque on London. Whichever method of payment was selected, it was pointed out before us that, whatever use were made of the option, discharge of the principal debtor’s obligation would have involved in the ordinary course either a remittance from Greece to the paying agents specified in the bond or, at the option of the holder, a cheque issued within Greece though drawn on London, and presumably payable there out of funds remitted by the debtors from abroad. It was also pointed out that the bond contained no provision for payment by the guarantor at any particular place or in any particular country. The only circumstances relied on by the Appellants as supporting their contention that the obligation was located inside the United Kingdom were as follows. Although the original guarantor had no branch in the United Kingdom, the present Appellants had acquired one on their universal succession in London. Moreover, it was urged that, since discharge of the obligations under the bond in Greece had been caught by the moratorium enacted by the Greek Government, it followed that the only place at which the obligation could have been discharged or enforced was in London. Speaking for myself, I do not see how an obligation originally situated in Greece for the purposes of British income tax could change its location either by reason of the fact that one guarantor had been substituted for another, or by reason of the fact that the second guarantor so substituted subsequently acquired a London place of business, or by reason of the fact that the Government of Greece had by retrospective legislation altered by moratorium and substitution of a new guarantor for the purposes of Greek law the obligations imposed upon the principal debtor and the guarantor.

As with Lady Archer-Shee’s trust, almost everything associated with the bonds was foreign. The fact that the bonds were governed by English law and that interest was payable in sterling in London, through UK paying agents, appears irrelevant to the characterisation of the obligation as a foreign obligation. By 65 This clearly appears from the National Bank’s reply, where it said: ‘It is not disputed that if the claim had been against the principal debtor and there had been no moratorium in Greece and if the claim had been for interest under the terms of the bond, the source of the interest would have been foreign’; see [1971] AC 945 at 952H. 66 [1971] AC 945 at 954H–955F; 46 TC 472 at 493G–494E.

Book 1.indb 378

12/2/2011 8:22:19 AM

An Older Tale of Default on Greek Bonds

379

way of contrast Lord Hailsham accords the source of the funds for payment – essentially Greek money – greater significance. This is consistent with the concept of a charge on income being a charge on the payer’s funds. In this respect it is not just a matter of the identity or residence of the obligor that matters. Although Lord Hailsham refers to the fact that the obligation was undertaken by a foreign corporation, his reference to the absence of a UK place of business suggests the possibility that a foreign obligor may have a UK fund to charge; conversely, the obligation of a UK obligor may be a foreign obligation where the fund concerned comprises foreign property.67 The other point that emerges from the National Bank of Greece case confirms a point that I noted in my paper on Fiscal Transparency,68 namely that the approach that applies in the case of taxes on property such as stamp, inheritance or wealth taxes, which ordinarily adopt the situs rules of private international law, does not extend to income tax.69 Choses in action generally are situate in the country where they are properly recoverable or can be enforced.70 A simple contract debt is locally situate where the debtor resides, that being prima facie the place where he can be sued.71 A specialty debt is situate where the deed is physically situate.72 None of these is determinative of the question posed by under the Income Tax Acts as to whether the obligation creating the charge is a foreign obligation.73 Most notably, in National Bank of Greece, the bonds were bearer bonds. Accordingly, the property represented by the bonds and the interest coupons attached to them would ordinarily be situated wherever they could be found from time to time.74 There was no suggestion that their character as bearer bonds was in any way relevant to the matter.

67 As is apparent from section 138 ITA 1952; see also sections 131 and 248(4)(c) Income and Corporation Taxes Acts 1970. 68 Gammie at pages 60–61. 69 Lord Denning’s reliance on the rule in Dicey & Morris in Alloway v Phillips [1980] STC 490; 53 TC 372 at 387 is, in this respect, incorrect. It may be that Lord Denning was recalling what the Revenue’s amicus had submitted to him in the Court of Appeal in the National Bank case, without paying too much attention to how that case had finally been decided by the House of Lords. 70 Rule 120(1) in Dicey, Morris & Collins, The Conflict of Laws, 14th edition, Volume 2 (Sweet & Maxwell, 2006). 71 New York Life Insurance Co v Public Trustee [1924] 2 Ch 101. ‘Residence’ in this context refers to residence for the purposes of jurisdiction and not residence for tax purposes, Kwok Chi Leung Karl v Commissioner of Estate Duty [1988] 1 WLR 1035 (PC) 72 Commissioner of Stamps v Hope [1891] AC 476 (PC). 73 The significance previously accorded a ‘specialty’, in particular before the abolition of exchange controls, may have reflected an appropriate practical solution accepted by the Inland Revenue for securing a ‘foreign source’ to the obligation but was most likely irrelevant to the issue as a matter of law; see Gammie, Rules for determining income and expenses as domestic or foreign: United Kingdom Report in Cahier de droit fiscal international, Volume LXVb (Kluwer, The Netherlands) (1980) at page 645. 74 A-G v Bouwens (1838) 4 M & W 171; Winans v A-G (No 2) [1910] AC 27. While this rule ordinarily applies for tax purposes, it does not necessarily apply in relation to all other issues, Dicey, Morris & Collins, op cit, paras 22–041.

Book 1.indb 379

12/2/2011 8:22:20 AM

Book 1.indb 380

12/2/2011 8:22:20 AM

14 Avoiding Evasion: An Australian Historical Perspective MARGARET MCKERCHAR AND CYNTHIA COLEMAN

ABSTRACT

A

USTRALIANS HAVE HAD a history of tolerance towards those who do not comply with their tax obligations. Indeed at times this tolerance has verged on admiration for those who exploited the law. This chapter traces the history of tax evasion and tax avoidance in Australia post World War II (WWII) in respect of income tax. It begins by explaining the legislative powers of the Commonwealth and then considers the effect of jurisprudence and the accounting and legal professions in creating an environment, particularly in the 1970s, in which blatant noncompliance was able to flourish. The effectiveness of subsequent anti-avoidance measures is then discussed. The fundamental lesson learnt from a historical perspective is the importance of well-drafted legislation in enabling compliance with and enforcement of tax laws. Welldrafted legislation and the ability to look to its intent can enhance the quality of jurisprudence, provide greater certainty for taxpayers, and empower the tax administration. Further, the professional bodies have a role to play in ensuring that their members abide by codes of conduct and in promoting a more responsible attitude towards tax compliance. Avoiders and evaders are not inherently evil people; they are really just you and I, or like us but with more opportunity.1

1 P Swan, ‘Reforming the System: An Economist’s View’ in D Collins (ed), Tax Avoidance and the Economy (ATRF, 1984) pp 47–56 at p 47.

Book 1.indb 381

12/2/2011 8:22:20 AM

382

Margaret McKerchar and Cynthia Coleman INTRODUCTION

Australia’s beginnings in 1788 as a British convict settlement may never have occurred if not for the revolt by the North American colonies against the then British policy of taxing American tea. Smith described this linkage as a ‘peculiar twist of history’,2 but it could well be at the heart of why the eminent Professor Ross Parsons almost 200 years later described Australians as being ‘very flexible about their personal views on paying tax, and tolerant nationally’.3 After all, could a population of convicts and former felons reasonably be expected to abide by any law, let alone those relating to taxation?4 Tax compliance was not an issue for the various military governors in the early days of convict settlement in Australia simply because there was literally nothing to tax. However, as the free colonists began to arrive there was perceived to be the beginnings of taxable wealth during Governor Hunter’s term (1795–1800) and taxes were levied on imports and duties imposed on spirits, wines and beers. These taxes and duties were relatively simple to collect and remained the mainstay of the Australian colonies until the middle of the 19th century with direct, progressive taxes not emerging until after the abolition of transportation and the gold rushes of the 1850s.5 The gold rushes saw the arrival of a great wave of migrants in search of gold and what followed was a tax-led revolt known as the Eureka Stockade. To raise much needed revenue, both the colonies of New South Wales and Victoria required miners to purchase a mining licence at 30 shillings a month. This licence was effectively a form of tax and, as the burden fell equally on those who found gold as it did on those who did not, and it was bitterly resented by the latter. There was also considerable resentment between the wealthy landowners, or squattocracy, who dominated the Legislative Councils of New South Wales and Victoria at the time, and the miners and mining communities, who, in contrast, had very little representation. In 1855 attempts to enforce the licence fee on the goldfields at Eureka (near Ballarat in Victoria) provoked riots, rebellion and the loss of thirty lives. The much hated gold tax was subsequently abolished,6 but it is generally regarded as the turning point in stimulating the population’s belief in democracy and progressive taxation,7 both of which underpin what is a fundamental expectation of Australians today – to be given ‘a fair go’ as part of an egalitarian society.

2

J Smith, Taxing Popularity: The Story of Taxation in Australia (ATRF, Sydney, 2004) p 7. R Parsons, ‘Reforming the System: A Lawyer’s View’ in D Collins (ed), Tax Avoidance and the Economy (ATRF, 1984) pp 57–64 at p 64. 4 See note 2 p 9. 5 See note 2 pp 7–14. 6 In fact it is somewhat remarkable that prior to 1 January 1991 the proceeds of gold mining in Australia were exempt from income tax. 7 See note 2 p 17. 3

Book 1.indb 382

12/2/2011 8:22:20 AM

Avoiding Evasion: An Australian Historical Perspective 383 Australian history records that larrikins8 (for example, bushrangers) are usually well tolerated and indeed often applauded.9 But when it comes to tax noncompliance, how far does this tolerance extend and to whom? Against this background, this chapter sets out to explore the history of tax evasion and tax avoidance in Australia post World War II (WWII). Prior to this period there had been reliance on the indirect taxes discussed briefly above, in addition to mining royalties and death and land taxes; and evasion was evident.10 The most significant shift post WWII which exacerbated the even more pronounced political unpopularity of taxes in Australia, was the then single-minded reliance on income-tax which is central to the focus of this chapter.11 Before turning to the post WWII era of tax history in Australia, it needs to be appreciated that representative government was granted to the Australian colonies by a series of British Acts: New South Wales (1842, 1855); Victoria (1850); Tasmania (1856); South Australia (1856); Queensland (1867); and Western Australia (1870,1890). In 1865 the British Parliament passed the Colonial Laws Validity Act 12 which granted independent power to legislate to the colonies. This Act remained in force until 1986 when the Australia Act (Cth) provided that it would not apply to state laws made after its commencement. Australia became a Federation in 190113 and its first Commonwealth income tax Act, the Income Tax Assessment Act (ITAA), was legislated in 1915. The legislative powers of the Commonwealth remain limited to what was transferred to it at commencement and residual powers rest with the states. Some federal powers are concurrent with those of the states and some are exclusive to the Commonwealth. Taxation is a concurrent power, but during WWII the states transferred the power to collect income tax to the Commonwealth and this arrangement remains in place.

JURISPRUDENCE IN THE 1940S–1970S

What was evident in Australia prior to WWII was that in applying and interpreting the law as read literally, there was a presumption that any doubt be resolved in favour of the taxpayer as citizens were to be protected ‘against the arbitrary confiscation of their wealth by government’.14 As Krever explained, the courts did not question Parliament’s right to impose taxation, but insisted that 8

A larrikin is a colloquial term for a ‘mischievous youth’ (Macquarie Dictionary, 1981). R Ward (ed), The Greats: The 50 Men and Women Who Most Helped to Shape Modern Australia (Angus & Robertson, Sydney, 1986). 10 For example, the High Court in Wilson v Chambers and Co Pty Ltd (1926) 38 CLR 131 discussed the meaning of the word ‘evasion’ in relation to the underpayment of customs duty. 11 See note 2 at p 102. 12 28 & 29 Vic, ch 63 (Imp). 13 Commonwealth of Australia Constitution Act 1900 (Imp), 63 & 64 Vic, ch 12 (Imp). 14 R Krever, ‘Murphy on Taxation’ in J Scutt (ed), Lionel Murphy: A Radical Judge (McCulloch Publishing, South Melbourne, 1987) pp 128–143 at p 129. 9

Book 1.indb 383

12/2/2011 8:22:20 AM

384

Margaret McKerchar and Cynthia Coleman

taxes could only be levied in ‘clear and unambiguous language open to no other construction’.15 That is, there was an expectation that fairness must prevail. In the early years post WWII this expectation was largely met in that attempts by taxpayers to elevate form over substance in tax cases were rarely successful in the High Court, particularly under the leadership of Chief Justice Owen Dixon (1952–1964). As Krever explained, whilst the High Court respected the nominal form of transactions as portrayed by taxpayers, it devised income tax doctrines that ensured consistency between the tax consequences and the true economic substance of the transactions. In spite of there being many loopholes in the income tax law available to enterprising taxpayers at the time, this support (or ‘responsible intervention’) by the High Court did result in a long period of stability in tax jurisprudence in Australia.16 Sir Garfield Barwick was appointed Chief Justice of the High Court of Australia in 1964 and held this position until 1981. Following his appointment, the support of the Australian income tax system by the High Court was seen to dissipate quickly and the ‘pillars of judicial construction’ began to be dismantled and be replaced by a doctrine of ‘strict literalism’.17 Public and political awareness of the existence of tax avoidance and tax evasion in Australia increased dramatically in the 1970s and early 1980s18 as high rates of inflation coupled with high rates of taxation imposed considerable pressures and revenue losses became more apparent. However, interest in both tax avoidance and tax evasion was evident well before this time.

THE PROFESSIONS IN THE 1950S

In 1957 Professor Pedrick of Northwestern University, Chicago wrote a comparative paper on tax practice and the legal profession in the United States (US) and Australia (or ‘Oz’).19 At the time the field of taxation was dominated by accountants and there were concerns that the legal profession had ‘largely missed the bus, mainly as a result of ignorance’.20 Pedrick observed that there was a dearth of writing by the Australian legal profession on taxation, with the profession’s principal journal (the Australian Law Journal) having averaged substantially less than one article per year on taxation over a 30-year period.21 This detachment by the profession was further evidenced by the fact that until

15

See note 14. See note 14. 17 See note 14 at p 130. 18 DJ Collins (ed), Tax Avoidance and the Economy (ATRF, Sydney, 1984) p vii; Krever at note 17. 19 WH Pedrick, ‘Tax Practice and the Legal Profession’, The Australian Law Journal, Vol 31, 1987, pp 267–291. 20 RW Baker, ‘Lawyers, Accountants and Taxes’, Australian Accountant, Vol 26, 1956, pp 343–345 cited by Pedrick at note 19, p 276. 21 See note 19 at p 277. 16

Book 1.indb 384

12/2/2011 8:22:20 AM

Avoiding Evasion: An Australian Historical Perspective 385 this year (ie 1957) there had not, in the whole country, been one full time law teacher engaged in teaching in the tax field.22 Pedrick highlighted that even in the 1950s, there were tax experts in ‘the Land of Oz’ who were wizards in making things seem to be very different from what they really were and believing themselves (on occasions) that these things were real, being ‘adept with trusts, family partnerships, assignments, private companies and all sorts of magical manipulations’.23 He described ‘elaborately contrived and technically elegant schemes of tax avoidance (or evasion)’ as being the modern facts of life and cited the case of Newton v Federal Commissioner of Taxation24(at the time pending on appeal before the High Court from the judgement of J Kitto) as being one of the most engaging of recent schemes by the wizard or one of his disciples. Pedrick concluded that the legal professions in both the US and Oz ‘must acquaint themselves with the tax field and what may begin as a forced acquaintance will surely ripen to affection and indeed devotion’.25 Indeed, there have subsequently been many disciples (ie practitioners) who have become well acquainted and adept in what Justice Mason described as ‘the art of tax minimization’.26

DISTINGUISHING BETWEEN TAX EVASION AND TAX AVOIDANCE

Interestingly, in the 1950s Pedrick27 regarded tax avoidance and tax evasion as one and the same activity though there was evidence from the United Kingdom at the time of the existence of an emerging distinction.28 In Australia the distinction between tax evasion and tax avoidance appeared to attract little attention until the late 1970s.29 Tax avoidance in Australia was generally then regarded as a legal problem and was defined as a transaction which:

22

See note 19 at p 278. See note 19 at p 279. (1958) 98 CLR 1. 25 See note 19 at p 281. The (then) Mr H T Gibbs QC (Queensland) responded to Professor Pedrick’s paper and disagreed with this statement about acquaintance ripening to affection stating that ‘I think few who have wandered the maze set by the Sales Tax Acts, to take one illustration, could ever become devoted to sales tax law, and I think that even to become fond of the provisions of the Income Tax and Social Services Contribution Assessment Act requires a capacity for devotion which is greater than most lawyers possess.’ (p 283). Sir Harry Gibbs was Chief Justice of the High Court of Australia 1981–1987. 26 Cridland v FCT (1977) 140 CLR 330. Sir Anthony Mason AC KBE QC was Chief Justice of the High Court of Australia 1987–1995. 27 See note 19. 28 See for example, GSA Wheatcroft, ‘The Attitude of the Legislature and the Courts to Tax Avoidance’, Modern Law Review, Vol 18, No 3, 1955, pp 209–230. 29 See for example, SEK Hulme, ‘Tax Avoidance’ in J Wilkes (ed), The Politics of Taxation (Hodder & Stoughton, 1980) pp 227–250; IG Wallschutzky, ‘Towards a Definition of the Term “Tax Avoidance”’, Australian Tax Review, Vol 14, No 1, 1985, pp 48–58. 23 24

Book 1.indb 385

12/2/2011 8:22:20 AM

386

Margaret McKerchar and Cynthia Coleman

a) avoids tax; b) was entered into for the purpose of avoiding tax or adopted some artificial or unusual form for the same purpose; c) was carried out lawfully; and d) was not a transaction which the legislation had intended to encourage. 30

Most early tax avoidance schemes in Australia rested on at least one of the following principles: a) Splitting taxpayer’s income among members of the family through the use of entities such as partnerships and trusts. b) Spreading taxpayer’s income over time thereby enabling deferral or reduction of tax liability and in some cases complete escape. c) Exploiting the company form of organisation to avoid or reduce taxpayer liability on saved income or to take advantage of loopholes available to a company but not to an individual shareholder.31 d) Capitalising a taxpayer’s income, deducting capital expenditure from income or converting income into capital gains. e) Arranging to receive income in the form of expense allowances or income in kind which are difficult to tax fully. f) Tax avoidance through transactions involving the crossing of national boundaries.32

Parsons argued that tax avoidance was ‘not wrongful, if we judge wrongfulness by the law and accept the rule of law’; and that tax avoidance may be innocent, or may be the conscious exploitation of loopholes. 33 That is, tax avoidance was acceptable to a large extent, more in line with being a larrikin or possibly a rebel, rather than being a villain. In contrast, tax evasion occurred when tax was not paid though the law required payment.34 That is, tax evasion was an illegal activity, and always wrongful.35 It was recognised that different strategies were needed to counter tax evasion and tax avoidance. As Parsons explained, to counter tax evasion required the tax administrator to enforce the law whereas to counter tax avoidance required that the law be ‘a perfect expression of the policies of the law’.36 In theory Parsons was correct, but the reality at the time was that the law was not the perfect expression of policy, and even if it had been, the approach 30 P Groenewegen, ‘Distributional and Allocational Effects of Tax Avoidance’ in DJ Collins (ed), Tax Avoidance and the Economy (ATRF, Sydney, 1984) pp 23–38. 31 Groenewegen (see note 30 at p 26) highlighted the importance of this strategy by citing evidence from the Taxation Review Committee’s Report (ie the Asprey Review) (1975, para 16.3) indicating that there was an increase of 349% in private companies against 127% in public companies from 1955–56 to 1971–72. 32 See note 30 at pp 25–28. In developing these principles the earlier work of RI Downing, HW Arndt, AW Boxer and RL Mathews, Taxation in Australia: Agenda for Reform (Melbourne University Press, Melbourne, 1964). 33 See note 3 at p 57. 34 See note 33. 35 For an early example of tax fraud see Denver Chemical Manufacturing Co v Commissioner of Taxation (NSW) (1949) 79 CLR 296 at pp 313–14. 36 See note 33.

Book 1.indb 386

12/2/2011 8:22:20 AM

Avoiding Evasion: An Australian Historical Perspective 387 of the High Court could not be controlled. Similarly, the administrator in enforcing the law could do so more ably if supported by the High Court. The widely held view was that the High Court, under the then leadership of Chief Justice Barwick, was biased toward the taxpayer and that tax avoidance was able to flourish as a result.37 The appointment of Justice Lionel Murphy to the High Court in 1975 did eventually trigger a shift away from the pedantic legal approach that had prevailed at the time in dealing with tax avoidance schemes.38

EARLY ANTI AVOIDANCE PROVISIONS

Section 260 (ITAA 1936) was the initial general anti-avoidance provision included in the ITAA since inception and operative until 27 May 1981 at which time it was replaced by Part IVA (ITAA 1936). Parsons described both as being absurd exercises in reform.39 Section 260(1) (ITAA 1936) provides that: (1)  Every contract, agreement, or arrangement made or entered into, orally or in writing, whether before or after the commencement of this Act, shall so far as it has or purports to have the purpose or effect of in any way, directly or indirectly: (a)  altering the incidence of any income tax; (b)  relieving any person from liability to pay any income tax or make any return; (c)  defeating, evading, or avoiding any duty or liability imposed on any person by this Act; or  (d) preventing the operation of this Act in any respect; be absolutely void, as against the Commissioner, or in regard to any proceeding under this Act, but without prejudice to such validity as it may have in any other respect or for any other purpose.

By the late 1970s it was widely believed that section 260 was ‘emasculated’ by the High Court to the extent that the Commissioner ceased to argue its application in his submissions to the Court.40 One aspect of that emasculation was the socalled ‘choice doctrine’ whereby if the Act gave a taxpayer a choice between an action that would not attract tax and an action that would, section 260 would not deny him the advantage of the action that did not attract the tax. It was held to be irrelevant that the circumstances yielded an inference that the taxpayer wanted the advantage from the action taken.41 Many Australian cases42 in the 1970s were thus decided and often made reference to the highly influential decision in Inland Revenue Commissioners v Duke of Westminster 43 in which Lord Tomlin said: 37 PW McCabe, ‘Background to the “Bottom of the Harbour” Investigation’, in DJ Collins, Collins (ed), Tax Avoidance and the Economy (ATRF, Sydney, 1984) pp 1–4 at p 3. 38 See Krever at note 14. For example, see FCT v Everett (1980) 143 CLR 440 and FCT v Westraders (1980) 144 CLR 55. Krever (p 134) describes these cases as the ‘high water mark of absurd literalism’. 39 See note 3 at p 59. 40 See Parsons at note 39; and Krever at note 14 p 131. 41 Mullens v FCT (1976) 6 ATR 504. 42 Following on from Mullens case at note 41, see also Slutzkin & Ors v FCT (1977) 140 CLR 314 and Cridland’s case at note 26. 43 [1936] A.C. 1.

Book 1.indb 387

12/2/2011 8:22:21 AM

388

Margaret McKerchar and Cynthia Coleman

[E]very man is entitled if he can to order his affairs so as that the tax attaching under the appropriate acts is less than it would otherwise be. If he succeeds in ordering them so as to secure this result, then, however unappreciative his fellow tax payers may be of his ingenuity, he cannot be compelled to pay the increased tax.

This view was similarly expressed in Latilla v Inland Revenue Commissioners 44 in which Lord Simon stated that ‘however elaborate and artificial some methods may be, those who adopt them are entitled to do so’. In Australia this concept of ‘entitlement’ subsequently came under attack from various quarters including the McCabe-La Franchi Report45 and the later Costigan Royal Commission into organised crime.46

SINKING TO THE MURKY DEPTHS OF THE HARBOUR

McCabe and La Franchi were appointed by the Victorian Liberal Government in 1978 as special investigators pursuant to the provisions of the Victorian Companies Act. They were not empowered to investigate any possible breaches of the ITAA or the Federal Crimes Act. At the time the Victorian Corporate Affairs Office was concerned with the lodgement of numerous documents which contained false or misleading particulars.47 In the course of their investigation McCabe and La Franchi asked questions about the motives which led to the false and misleading documents being lodged. They had extraordinary powers in the collection of evidence. If an officer of a company under investigation claimed privilege then the answer would not be admissible in any subsequent proceedings, however, an answer was required to be given to the investigators. McCabe explained that it was because of this power that they were able to ascertain facts and identify persons that the Australian Taxation Office (ATO) had not been able to do. What they unearthed was an unprecedented series of frauds against the Commonwealth involving tax evasion schemes that involved some 6,688 companies and between AUS$500m and AUS$1,000m in evaded taxes.48 It appeared that until the 1970s tax avoidance had been reasonably tolerated by the Australian population. However, cases such as WP Keighery Pty v FCT 49 and FCT v Casurina Pty Ltd 50 provided prototypes for the avoidance

44

[1943] AC 377. PW McCabe and DJ La Franchi, ‘Report of Inspectors appointed to investigate the particular affairs of Navillus Pty Ltd and 922 other companies’ (Government Printer, Melbourne, 1983). 46 FC Costigan (Chairman), ‘Royal Commission on the Activities of the Federated Ship Painters and Dockers Union’, Final Report (AGPS, Canberra, 1984). 47 See note 37 at p 1. 48 A Freiberg, ‘Ripples from the Bottom of the Harbour: Some Social Ramifications of Taxation Fraud’, Criminal Law Journal, Vol 12, 1988, pp 136–192 at p 137. Note that by 1985 the activity of tax avoidance and tax evasion was estimated to cost the Australian revenue about $3 billion per year. See I Potas, ‘Thinking About Tax Avoidance’, Trends and Issues in Crime and Criminal Justice, No 43, 1993, pp 1–8 at p 3. 49 (1957) 100 CLR 66. 50 (1971) 127 CLR 62. 45

Book 1.indb 388

12/2/2011 8:22:21 AM

Avoiding Evasion: An Australian Historical Perspective 389 industry which then flourished. Adding fuel to the fire, a number of judicial decisions on tax avoidance in the 1970s were widely regarded as ‘mistakes’.51 The mass production of tax avoidance schemes in the 1970s and the extent to which they had become ‘democratised’ finally led to them being intolerable.52 They had simply gone too far. As Grbich so eloquently described it, the tax avoidance industry had gone from ‘bravado to farce to tragedy’.53 Perpetrators were no longer seen as larrikins, but as outright villains. Whereas in Duke of Wesminster54 the taxpayer had done nothing false or deceptive in his tax planning, the tax avoidance schemes on the 1970s in Australia involved fraud and dishonesty.55 Many of these schemes involved (but were by no means limited to) the stripping of a company’s assets and accumulated profits before its tax liability fell due, and the company was then transferred to someone of limited means. This despatching of the company to the ‘bottom of the harbour’, often along with its records, meant that the ATO along with and other unsecured creditors, were left empty handed.

LEGISLATIVE REFORM

The Government then waged war on tax avoidance and had the support of the Law Council of Australia and the Institute of Chartered Accountants (ICA). The Law Council reminded lawyers that they should act as professional advisors only and not as entrepreneurs in promoting schemes. The ICA had an ethical ruling in place that a member should not associate himself with any arrangement involving documents or accounting entries that were intended to misrepresent the true nature of the transaction or depended on a lack of disclosure.56 A great deal of legislation was then enacted specifically to address tax avoidance and tax evasion, with considerable emphasis on ensuring the clarity of its intention and meaning.57 That is, it was well recognised that the overly literal interpretation

51 See note 3 at p 61. The cases identified by Parsons were Investment and Merchant Finance v FCT (1971) 125 CLR 249; Curran V FCT (1974) 131 CLR 409 and Europa Oil (NZ) Ltd [No2] v CIR(NZ) [1976] 1 All ER 503. The first two were decisions of the Australian High Court. The third was a decision of the Privy Council interpreting a section of the New Zealand Act framed in words similar to the Australian tax legislation. The finding in this third case was anticipated to a degree by the Australian High Court and applied in FCT v South Australian Battery Makers (1978) 140 CLR 645. 52 See note 48 at p 138. 53 Y Grbich, ‘Problems of Tax Avoidance in Australia’ in JG Head (ed), Taxation Issues of the 1980s (ATRF, Sydney, 1983) pp 414–432 at p 414. 54 See note 43. 55 RV Gyles, ‘Conspiracy to Defraud the Revenue’, The Australian Law Journal, Vol 58, October 1984, pp 567–572 at p 571. 56 See note 37. 57 For example, transfer pricing legislation was enacted in 1977; the Crimes (Taxation Offences) Act (Cth) made tax evasion a serious criminal act in 1980; the Crimes Act 1914 (Cth) was amended in 1982 making it an offence to defraud the Commonwealth (the original penalty of $50,000 or 5 years imprisonment for this offence was doubled in 1986). For further examples and discussion see Potas at note 48.

Book 1.indb 389

12/2/2011 8:22:21 AM

390

Margaret McKerchar and Cynthia Coleman

of Commonwealth legislation had contributed to the proliferation of tax avoidance schemes. It was beyond Parliament’s power to control the Courts (and in particular, the High Court), but it could to some extent exert influence by legislative reform. This issue was addressed initially by the introduction in 1981 of section 15AA of the Acts Interpretation Act 1901 (Cth) which allowed the courts to draw upon the purpose and intention of legislation and effectively ameliorated the overly literal interpretation of Commonwealth legislation which had contributed to the escalation of tax avoidance schemes.58 It is arguable that this provision merely enacted existing principles of statutory interpretation which had been developed through case law. Much more important was the enactment of section 15AB in 1984. Section 15AB(3) provides that persons may rely on the ordinary meaning of the act taking into account its context and underlying purpose when this is not clear from the provisions of the act in question. That is, the courts could now rely on a wide range of extrinsic materials (including explanatory memoranda and parliamentary speeches) when interpreting a provision. Without doubt Part IVA (ss 177A to 177G ITAA 1936), also introduced in 1981, was regarded as the main weapon against tax avoidance. Part IVA was intended to overcome what was otherwise a deficiency in the law in terms of the expression of policy, but it would only do so when it was concluded from all the circumstances that action had been taken ‘for the purpose of enabling the relevant taxpayer to obtain a tax benefit’.59 As described by Cashmere, Part IVA was a remedial piece of legislation designed to set aside the extension of the choice principle and to overcome other shortcomings in section 260.60 Yet in spite of there now having been a number of significant High Court decisions61 on Part IVA, there still remains today uncertainty about its application and a lack of clarity relating to the principles which are to be applied.62 In particular, section 177A requires that there be a ‘scheme’ the definition of which remains unclear. Section 177C requires that there be a ‘tax benefit’, that is, the taxpayer must have made choices available under this statute as a threshold to the application of Part IVA. Finally, under section 177D there must be a dominant purpose of gaining a tax benefit by entering into or carrying out the scheme. The actual subjective purpose of those involved in the scheme or benefiting from it is not relevant.63 Unlike section 260 which only annihilated a transaction, Part IVA allows the Commissioner to cancel the scheme and substitute an alternate course of action to be taken in lieu of the scheme. In 1999 the then Government 58

See Potas at note 48, p 3. See note 39. 60 M Cashmere, ‘Towards an Appropriate Interpretative Approach to Australia’s General Tax Avoidance Rule – Part IVA’, Australian Tax Review, Vol 35, No 4, 2006, pp 231–247. 61 FCT v Peabody (1994) 181 CLR 359; FCT v Spotless Services Ltd (1996) CLR 404; FCT v CPH Property Pty Ltd (2001) 47 ATR 229; and Hart v FCT (2004) 217 CLR 216. 62 See note 60 at p 247. 63 See Eastern Nitrogen Ltd v FCT (2001) 46 ATR 474. 59

Book 1.indb 390

12/2/2011 8:22:21 AM

Avoiding Evasion: An Australian Historical Perspective 391 announced that Pt IVA would be further strengthened by expanding the concept of ‘tax benefit’, tightening the ‘reasonable expectation’ test and giving the Commissioner wide powers to cancel benefits. However, more than a decade later the legislation is yet to be introduced.64 Parsons65 believed in 1984 that the back of the tax evasion industry had been broken, at least in the short term, and that new standards of integrity had been imposed by making an example of those that Australian society had previously excused. However, there have been many other examples of ‘magical’ tax planning throughout the 1990s and beyond and the battle appears set to continue. While Part IVA offered potential as a weapon against tax evasion, it took 13 years for Part IVA (ITAA 1936) to receive its first interpretation in the High Court in FCT v Peabody.66 This delay was deliberate on the part of the ATO because the High Court’s interpretation of section 260 had effectively destroyed its role as a general anti-avoidance rule. By not litigating Part IVA taxpayers were uncertain what limits court decisions might impose on its operation and hence were more conservative in their arrangements. Further, the attraction of tax avoidance had spread well beyond being the domain of only the wealthy. The mass-marketed agricultural schemes of the 1990s which involved round robins and non-recourse loans are a good example of how many ordinary taxpayers, including blue-collar workers, were willing to participate in arrangements that were clearly dubious and to which Part IVA (ITAA 1936) was held to apply.67 Many further integrity measures have been enacted including the personal services income regime in 2000 (Pt 2–42 Div 84–87 ITAA 1997) to prohibit income splitting of personal services income); the non-commercial losses regime in 2000 (Div 35 ITAA 1997); and of course, measures designed to deter the promotion of tax exploitation schemes in 2006 (Div 290 in Sch 1 of the Tax Administration Act). These more tailored reforms, together with some success on the part of the Commissioner in applying Part IVA (ITTA 1936) and a shift to less literal judicial interpretation, have had some effect in deterring tax avoidance. It appears that the further strengthening of Part IVA (ITAA 1936) as announced in 1999 was deemed to be unnecessary as a result.

CONCLUDING COMMENTS

The history of tax evasion and tax avoidance in Australia is indeed a colourful one and there appears to be no shortage of larrikins, heroes, villains and felons. Just who is playing which role at any point in time is not always easy to determine. The fundamental lesson learnt from a historical perspective is that well-drafted 64

R Woellner et al, 2010, Australian Taxation Law, CCH, Sydney at p 1636. See note 3 at p 4. 66 (1994) 181 CLR 359. 67 See for example FCT v Sleight (2004) 55 ATR 555. 65

Book 1.indb 391

12/2/2011 8:22:21 AM

392

Margaret McKerchar and Cynthia Coleman

legislation is essential so that the rules of engagement are clear. Taxpayers need certainty in managing their tax affairs, and the tax administration needs to be able to enforce the law. Well-drafted legislation and the ability to look to the intent of the law both enhance the quality of jurisprudence. Similarly, the professional bodies have a role to play in ensuring that their members abide by codes of conduct that meet societal expectations. There will always be taxpayers and practitioners who are less averse to risk and tempted by wizardry. Empowering the tax administration with the necessary enforcement tools can be an effective deterrent to the more adventurous taxpayers and tax practitioners. At the same time, promoting a positive community attitude to tax compliance is important and ‘having a fair go’ should mean everyone should pay their fair share of tax. Paying less is anything but heroic and should not be tolerated. However, as history does tend to repeat itself the game is unlikely to ever be over so complacency on the part of the tax authorities is not recommended when it comes to avoiding evasion.

Book 1.indb 392

12/2/2011 8:22:21 AM

15 Do We Need 7(3)? History and Purpose of the Business Profits Deduction Rule in Tax Treaties RICHARD VANN

ABSTRACT

T

HE DEDUCTION RULE has been deleted from the new business profits article in the 2010 version of the OECD Model. Its history suggests that at least one purpose of the rule was to prevent non-discrimination. As the 2010 changes do not directly deal with all forms of discrimination at which it was directed, it is suggested that the OECD should restore a version of the deduction rule to the Commentary as an option for countries with the discriminatory rules in domestic law (particularly a rule which prohibits deductions for expenses incurred outside the country). The deduction rule was also one manifestation of other deeper issues on the appropriate way to allocate profits to permanent establishments which remain unresolved.

INTRODUCTION

The current rules in tax treaties for business profits of permanent establishments (PEs) have recently received their greatest alteration since they were created in the 1950s as a result of the Report on Attribution of Profits to Permanent Establishments representing over a decade of work by the Organisation for Economic Co-operation and Development (OECD).1 One result is that the 1 The Report exists in two ‘final’ versions: OECD, Report on the Attribution of Profits to Permanent Establishments (2008) available at http://www.oecd.org/dataoecd/20/36/41031455.pdf, and OECD, Report on the Attribution of Profits to Permanent Establishments (2010) available at

Book 1.indb 393

12/2/2011 8:22:21 AM

394

Richard Vann

deduction rule has been deleted from the new business profits article in the OECD Model of 2010.2 This chapter considers the history of the business profits deduction rule and, in that light, whether its purpose was to prevent certain kinds of covert discrimination against PEs or whether it was intended to operate as a qualification on the separate enterprise arm’s length principle for PEs. It is argued that at least one purpose of the rule was non-discrimination in addition to and independent of that principle. As the principle has not changed in any way relevant to this issue, it is suggested that the OECD should restore a version of the deduction rule to the Commentary as an option for countries with the kind of rules at which it seems to have been directed. The history makes evident, however, that the rule was one manifestation of other deeper issues as to the appropriate way in which to allocate profits to PEs and those issues remain unresolved.

THE QUESTION

The former Article 7(3) (and Article 7(2) to which it is apparently linked) of the OECD Model Tax Convention on Income and on Capital (OECD Model) provided:3 2. Subject to the provisions of paragraph 3, where an enterprise of a Contracting State carries on business in the other Contracting State through a permanent establishment situated therein, there shall in each Contracting State be attributed to that permanent establishment the profits which it might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment. 3. In determining the profits of a permanent establishment, there shall be allowed as deductions expenses which are incurred for the purposes of the permanent establishment, including executive and general administrative expenses so incurred, whether in the State in which the permanent establishment is situated or elsewhere.

Article 7(3) was often associated with the view that, as a qualification on the separate enterprise arm’s length principle in Article 7(2), PEs cannot generally http://www.oecd.org/dataoecd/23/41/45689524.pdf, as well as a variety of earlier drafts. The former (called the 2008 Attribution Report) discusses the then current version of Article 7 on business profits and contained a recommendation that the article be redrafted to accommodate the conclusions reached on attribution. The latter was released contemporaneously with the final version of the new Article 7 (itself released in earlier drafts) and eliminates all discussion of the former Article 7 because it is intended as a companion to the new version of the article. As the interest here is the history and purpose of the deduction rule, the former version will be referred to in this chapter. 2

OECD, Model Tax Convention on Income and on Capital (Condensed version, 2010) 26–27. OECD, Model Tax Convention on Income and on Capital (Condensed version, 2008) 26–27. Because virtually all existing treaties are based on the 2008 version, its text and Commentary are reproduced as an Annex to the Commentary in 2010, note 2, 154–173, but for clarity references in this chapter are to the 2008 publication where that version is being discussed. 3

Book 1.indb 394

12/2/2011 8:22:22 AM

History and Purpose of the Business Profits Deduction Rule in Tax Treaties 395 deduct certain internal (notional) charges, notably interest, royalties and management or service fees but only a proportion of actual expenses of these kinds incurred by the enterprise to third parties.4 The competing views are expressed in the analysis of the deduction rule in the 2008 Attribution Report as follows:5 The perspectives on Article 7(3) tend to focus on two competing interpretations. One interpretation is that the provision is aimed primarily at ensuring expenses of a PE’s activity are not disallowed for inappropriate reasons, in particular, because the expense is incurred outside the PE’s jurisdiction, or is not incurred exclusively for the PE. The other view is that Article 7(3) modifies the arm’s length principle articulated in Article 7(2), in that6 … another part of the enterprise cannot recover more than its costs with regard to expenses incurred for the purpose of the PE, unless those expenses relate directly to dealings with third parties.

The Report concluded that the first interpretation was correct historically but that the second interpretation which regards Article 7(3) as a qualification of Article 7(2) was adopted by a number of countries, even though they agreed that modification of the arm’s length principle in this way was not desirable. Deletion of Article 7(3) was a simple way to resolve the issue though it was 4 OECD 2008 Model, note 3, Article 7 Commentary paras 28–49 at 126–132. The Commentary was altered as far as was considered possible in 2008 as a result of the 2008 Attribution Report, note 1, to water down this view; it is stated more clearly in the previous 2005 version, OECD, Model Tax Convention on Income and on Capital (Condensed version, 2005) Article 7 Commentary paras 17–23 at 121–126. Again for clarity reference will be made to the 2005 version where that more clearly reflects the prevailing view before the 2008 Attribution Report. 5 Note 1, Part I para 285; the OECD had available to it a much earlier unpublished version of this chapter when this material was drafted and closely followed the analysis of that version in paras 284–290; further looking into the history suggests that there were deeper factors at play and that the ambiguity noted as well as other ambiguities were present from the beginning. 6 The other view came in two parts, the first of which has been deleted in the quotation. It was that ‘costs allocable to a PE should be deductible even if they exceed what an arm’s length party would incur.’ Although it is possible that the deduction rule is thought in some quarters to deal with this matter, the problem was commonly raised in relation to Article 7(2). It concerned whether an excessive payment by the enterprise to an associated but separate enterprise which was not a resident of the PE country could be adjusted under Article 7 (Article 9 of the treaties between the country of residence of the enterprise or of the associated enterprise on one side and the PE country on the other side not being relevant as it requires an enterprise of the PE state to be involved). It arises out of the concluding words of Article 7(2) and in a further variant was thought also to create problems for adjustments between two PEs of the same enterprise in different states as opposed to adjustment between the (part of the) enterprise in the state of residence and the PE state. The 1977 Commentary expressed the view that adjustments were possible for both variants under Article 7(2) but also provided that countries concerned with the wording could alter it, OECD, Model Double Taxation Convention on Income and Capital (1977) Article 7 Commentary para 10 at 74. In 1994 a further (confusing) change to the Commentary was made suggesting that the problem only existed between PEs of the same enterprise but containing an alternative text that seemed to cover off both variants, OECD 2005 Model, note 3, Article 7 Commentary para 11 at 117. All reference to the matter was dropped from the Commentary in 2008. The new 2010 Article 7 deals with the matter expressly, note 2, Article 7 Commentary para 24 at 136 though with a reverse confusion – the new text can deal with both variants but the Commentary regards it as a problem only for associated enterprises. Treating this matter as an Article 7(3) problem may have been regarded as strengthening the case for its omission. The matter is not further discussed in this chapter.

Book 1.indb 395

12/2/2011 8:22:22 AM

396

Richard Vann

not suggested in the 2008 Attribution Report which regarded it as ‘needed’ if understood in the sense of the first interpretation above; deletion came later as the redrafting of Article 7 occurred.7 The same part of the former Commentary dealing with deductions for interest, royalties and management or service fees also canvassed the issue of whether any profit should be attributed to good management of the enterprise and concluded in the negative. This discussion has a long history and is part of deeper divisions about the appropriate way to allocate profits to PEs, including the treatment of deductions. It helps to explain why ambiguity surrounded Article 7(3) and why its deletion does not represent a resolution of the deeper divisions.

LEAGUE OF NATIONS

Allocation of profits to permanent establishments was one of the matters left over for further work after the three original income tax treaty drafts were developed in the period 1925–1928 which taxed PEs on the portion of the income produced in the PE state and were very vague as to how this amount was to be determined.8 The follow up work was started by the newly established Fiscal Committee in 1929 when it was decided to obtain detailed information on current practice and for this purpose to dispatch a questionnaire.9 At the 1930 meeting, Adams, the main US delegate of the time, summarised the results of the questionnaire on the methods used in various states and for apparently the first time the treatment of deductions receives brief mention:10

7 Three other provisions in the former Article 7 suffered the same fate: the formulary apportionment fallback rule in paragraph 4, the purchase rule in paragraph 5 and the continuity of method rule in paragraph 6. The removal of the first two is clearly signalled in the 2008 Attribution Report, note 1, Part I paras 291–299, and of the third is the natural corollary as it was designed to prevent taxpayers or tax administrations making strategic switches between the main method and the fallback method; by contrast the deduction rule is described as ‘needed’ at para 56. 8 Much of the League of Nations published material is collected in Joint Committee of Internal Revenue Taxation, Legislative History of United States Tax Conventions (US Government Printing Office, 1962) Vol 4, ‘Model Tax Conventions’ (hereafter LHUSTC4) available online at http://setis. library.usyd.edu.au/oztexts/parsons.html, item 3. Prior to 1930, the discussion of taxing business profits was brief and general, without any mention of deductions. In 1923 the economists’ report had a two page addendum not reproduced in LHUSTC4 saying that theory did not provide a clear answer and referring to various ways briefly that profits could be determined, Bruins, Eunadi, Seligman and Stamp, Report on Double Taxation (1923, document EFS73 F9) 52–53. In 1925 there was discussion of empirical/formulary methods in Europe, LHUSTC4 at 4076, which seem to be approved but the final resolutions, LHUSTC4 at 4091, talk in terms of profits being based on accounts. The 1927 draft model favours accounts as the primary method, LHUSTC4 at 4125, while the three 1928 models and commentary drop references to accounts and seem to go back to empirical/formulary methods, LHUSTC4 at 4162 (draft 1a), 4170 (draft 1b), 4173 (draft 1c), 4166 (commentary). 9 LHUSTC4, note 8, 4199. 10 LHUSTC4, note 8, 4218. His summary also canvasses most of the other issues related to deductions that were examined at greater length in the next stage of the project.

Book 1.indb 396

12/2/2011 8:22:22 AM

History and Purpose of the Business Profits Deduction Rule in Tax Treaties 397 When a company has a debenture debt, is the charge on this debt ascribed solely to the real centre of management or is it distributed between the different permanent establishments? In the latter case, what is the system of distribution? Practically all countries recognise the rule of apportioning the interest charge on a debenture debt of the company to the various branches or sources as a part of the overhead or debt in the proportion that they are concerned, or in proportion to capital employed (Italy, Sweden), to assets (Japan), to profits (Spain), or to income, receipts or some other factors (Germany), or to gross income (United States of America). Belgium regards such charges as attaching exclusively to the foreign central office responsible for the issue, unless a part of the loan has been especially allocated for the requirements of the Belgian establishments. Where the head office is abroad, Portugal takes no account of debts. As Great Britain does not allow interest to be deducted in determining assessable profits, no question of apportionment arises.

It is telling that the first deduction issue raised relates to interest as consensus on a single method to deal with interest still eludes the OECD 80 years later even after the recent years of work on attribution.11 All approaches referred to by Adams seem to involve allocation of actual interest expense. The reference to overhead may also suggest that the principle extended beyond interest.

Carroll Report After receipt of a grant from the Rockefeller Foundation it was possible to carry out this work on a significant scale and the task was entrusted to Adam’s assistant, Carroll.12 He supervised a five volume study of profit allocation consisting of three volumes describing the treatment in many countries, one volume setting out the accounting treatment of branch profits and one volume containing Carroll’s conclusions from the study. He poses the problem of dealing with overhead as the main question to be answered in allocating profits to a local PE of a foreign enterprise:13 The general concept of taxable net income being the difference between gross income and allowable expenses incurred in earning such income, one of the principal problems of allocation is presented when the income arises in one country, whereas some of the incidental expenses are incurred in another country. Should income be allocated to the place of expense in order to cover it, or should expense be allocated to the establishment where the income arises and is entered in its books? Some items of income and expense are definitely allocable to a certain establishment, but there is generally a large residuum of items of income and expense which are not definitely

11 The 2008 Attribution Report has a number of alternative ‘authorised OECD approaches’ in relation to interest at a number of levels, note 1, Part I paras 136–206. 12 LHUSTC4, note 8, 4209–4210, 4229–4230. 13 Carroll, Taxation of Foreign and National Enterprises Volume IV Methods of Allocating Taxable Income (1933) at paras 333 and 336, available at http://setis.library.usyd.edu.au/oztexts/ parsons.html, item 5.

Book 1.indb 397

12/2/2011 8:22:22 AM

398

Richard Vann

allocable, and it is these items of income and expense that present the most difficult problems in allocation… The principal category of not definitely allocable expenditure is that incurred at the real centre of management of the enterprise which benefits the enterprise as a whole, such as interest paid on borrowed capital which is used throughout the enterprise, including establishments in other countries, and items of general overhead, such as salaries of directors and officers charged with the general administration of the business, the expense of a central staff of accountants or other technical experts, and sometimes the expense of a general advertising campaign conducted at the real centre of management. Should any profit be ascribed to the activities of general management as such, or the other indicated activities which take place at the real centre of management?

The first paragraph quoted suggests that the process is the mechanical one of moving expense to income or income to expense to achieve the necessary matching but the second indicates that more is at stake – where do the profits end up as a result of this process. Carroll’s answer to this question is long and convoluted but can be summarised as follows.14 He identified the case of manufacture of goods by a PE in one country and sale by a PE in another country as the principal issue that needed to be dealt with and, perhaps surprisingly in light of later developments, regarded banking and insurance PEs as not raising such difficult allocation problems. The large majority of countries used the accounts of the enterprise as the means to allocate profits which he approved in preference to what he called empirical methods (such as a percentage of sales revenue being allocated to the PE of sale) and fractional apportionment (now commonly called formulary apportionment under which net global profit of the enterprise is allocated by reference to factors such as payroll, assets and/or sales). Most countries also used the sale between independents method for dealing with the case of manufacture in one country and sale in another (that is, treated the manufacturing PE as selling the goods to the sale PE) and in determining the profits taxable in each country allocated part of the interest and overhead expense incurred by the head office to PEs on some ratio basis, though often being quite strict in policing the allocation with the common result that such expenses were not recovered in the sale PE. The US in particular had specific legislation allowing a proportion of head office overhead for PEs of foreign enterprises but in practice found that this treatment was not reciprocated for US enterprises with PEs abroad.15

14

Note 13, principally chs V, XII. League of Nations, Taxation of Foreign and National Enterprises ( 1932) 245–246 in chapter on the US by Weare and McMorris. This publication is effectively Volume I of the Carroll study though not labelled as such; the same point is made at various other points in the summary of US law and by Carroll in his general discussion. By this time there was jurisprudence in the US indicating that expenses incurred outside the US in relation to a US business or as general overhead or interest could be deducted even in relation to income years before enactment of the detailed source and deduction allocation rules in 1921, Louis Roessel & Co Ltd (1925) 2 BTA 1141, Standard Marine Insurance Co Ltd (1926) 4 BTA 853; cases involving the detailed rules began to appear in the 1940s (concerning 15

Book 1.indb 398

12/2/2011 8:22:22 AM

History and Purpose of the Business Profits Deduction Rule in Tax Treaties 399 Carroll fundamentally disagreed with the sale between independents approach and preferred what he called the remuneration for services approach, that is, in the manufacture and sale case the PE of manufacture was treated as retaining title to goods and the PE of sale was treated as a sales agent to be remunerated for selling services on a commission basis.16 Indeed Carroll argued for extension of the remuneration for services approach to as many PE cases as possible where there was shared income and expense. He gave several reasons for this very strong preference. First, he regarded the real centre of management of an enterprise as the main generator of its income and hence it should receive the main share of profits. In this regard he often mentions the Swiss system of the praecipuum,17 a percentage of net profit awarded in priority to the real centre of management in recognition of the value of management before profits are allocated to PEs for other activities. Although that concept was used as part of a system of fractional apportionment of net profit which Carroll rejected except as a last resort, he clearly regards the underlying idea as correct and effectively produced by the remuneration for services approach.18 Secondly, Carroll regards the remuneration for services approach as preferable administratively because it can be based purely on activities and accounts in the country of the sale PE whereas the sale between independents approach requires verification of the factory price outside the country of sale. Thirdly, it deals with timing issues and overall losses income years in the 1930s), Third Scottish American Trust Co Ltd (1941) 41–1 USTC 167, Balfour Williamson & Co Ltd (1943) 1 TCM 852. The litigation suggests that the US had similar difficulties with overhead and interest expenses as did foreign countries. The language of apportionment used in the US was ‘there shall be deducted the expenses, losses, and other deductions properly apportioned or allocated thereto and a ratable part of any expenses, losses or other deductions which cannot definitely be allocated to some item or class of gross income.’ 16 Note 13, para 677, ‘The control and management, financial and technical, are centred there [the principal establishment/real centre of management]. At the meetings of the directors the decisions are taken which make or break the enterprise. There the risks are centred. The profit or loss results from all the activities of the enterprise taken together, but how can the part attributable to the establishment in each country be most readily measured? If we recognise the fact that the real centre of management, especially if it is situated at the principal productive establishment, is the most vital part of the enterprise, the most practical approach to the problem is to give it the residuum of profit or loss after allocating to each outlying secondary establishment compensation for the services it has rendered to the enterprise in accordance with what would be paid to an independent enterprise rendering such services.’ In other words Carroll supports the approach that the recent spate of business restructuring in a separate enterprise context has been designed to achieve, see Vann, ‘The Secret Agent’s Secrets’ (2006) British Tax Review 345. 17 Variants of this term are used in different languages, Carroll himself referring to ‘préciput.’ The Latin version used in the text literally means that which comes first. The system still continues in Switzerland, Oberson and Hull, Switzerland in International Tax Planning (IBFD, 3rd edn, 2006) 106–110; the amount varies case by case and is usually stated to be in the range of 10 per cent and upwards to over 30 per cent of total profits, depending on what is done at the real centre of management. 18 There is also a strong undercurrent in the discussion of greedy overreaching by countries of sale in the amount of profits they allocate to sale PEs; the remuneration for services approach reduces that problem significantly in Carroll’s view.

Book 1.indb 399

12/2/2011 8:22:22 AM

400

Richard Vann

better than the sale between independents approach.19 Fourthly, it required fewer fictions; while Carroll proposed the separate enterprise arm’s length principle for PEs he considered that the theory should not be pushed too far and should be moderated by practical considerations. Fifthly, and most germane to the issue under consideration, Carroll regards the remuneration for services approach as superior as it effectively eliminates the need to allocate interest and overhead; all that is necessary is to use the appropriate commission to reflect the activities undertaken by the sale PE and then deduct the local expenses of that PE. If a substantial part of the profits are being allocated to the real centre of management, then the overhead incurred there will be deducted against those profits, including interest expense as an enterprise selling on commission requires little or no capital. In this regard the sale between independents approach is doubly disadvantaged: it requires allocation of interest and overhead which he regards as an impossible task,20 and also requires checking to ensure against double counting of overhead as some or all overhead expense is likely to be included in the notional sale price by the PE of manufacture to the PE of sale. The overall outcome was that Carroll favoured the use of accounts and the separate enterprise arm’s length principle which was in use by a majority of countries but rejected the most commonly used sale between independents approach in favour of the remuneration for services approach. In the result he did not have to develop elaborate principles for allocating interest and overhead though he recognised that the sale between independents approach required such principles. Two short paragraphs deal with deduction of interest and overhead under his preferred approach.21 Interest would only be allowed on actual loans raised by the PE to the extent that the loans did not exceed what was appropriate for the PE; deduction of overhead would be avoided, with the ratio of gross profits of PEs used for allocation to the extent that it was considered appropriate to allow overhead.

19 If the sale between independents approach is used a notional profit arises to the PE of manufacture when goods are sent to the PE of sale, but this involves recognition of income before the enterprise as a whole realises any income and may lead to adjustment of the notional profit if the goods are sold at a loss. Under the remuneration for services approach on a commission basis, neither the PE of manufacture nor the PE of sale recognise income until sale and losses are thrown onto the real centre of management if the sale is at an overall loss as the PE of sale still earns its commission. Carroll admitted one exception for the export of raw materials like agricultural produce and minerals from the country of production to which he would apply the world market price at the time of sale to determine the profit of the PE in the country of production. 20 In relation to interest, Carroll adds further issues against allocation in addition to those mentioned in the text: the policy problem of distinguishing between debt and equity to prevent deduction of returns to equity; a technical reason having to do with the legal nature of a PE (not separate from and therefore unable to contract with the rest of the enterprise as to which see further below note 22 and text); and a practical reason based on the difficulty of determining the source of funds of a PE. 21 Note 13, paras 681–682.

Book 1.indb 400

12/2/2011 8:22:22 AM

History and Purpose of the Business Profits Deduction Rule in Tax Treaties 401 Except in the case of banks, Carroll did not consider it appropriate to allow deductions for notional interest to PEs. He justified this approach in part on the legal impossibility of a loan from head office to PE but the same is true of the notional service or sale contracts required under the remuneration for services and sale between independents approaches. What he really seems to mean is that no notional contract should be constructed that does not rely on real inflows or outflows from the enterprise as a whole and this is in effect another argument for the remuneration for services approach because commission is tied to an external transaction. As borrowings by banks relate to their loans to customers, this condition is satisfied although the allowance of interest on intra-enterprise loans is effectively an application of the sale between independents approach.22 Although Carroll at several points notes problems with royalties and management or service fees being used along with interest deductions to divert profits, they receive virtually no discussion in his proposed allocation regime for PEs. The main reason again flows from his preference for the remuneration for services approach. To the extent that research, services and management occur at the real centre of management, no expenses need to be allocated out and no contract of services from the real centre of management to the PE needs to be constructed as the profits from these activities accrue automatically to the real centre of management. To the extent that PEs carry out research giving rise to intellectual property or services like advertising without themselves utilising the research or services to earn income from third parties or being directly involved in the income earning activities of the enterprise, Carroll regarded the PEs in relation to these activities as only indirectly contributing to income and not generally to be rewarded for the research or services even on the remuneration for services approach. Rather the expenses of such PEs are to be allocated to the PEs of the enterprise or the real centre of management which carry out the activities directly earning the income of the enterprise. Carroll apparently does not feel any tension in rewarding these activities substantially when done at the real centre of management and not at all when done elsewhere, nor in relation to the allocation of overhead problem they reintroduce which he has otherwise assiduously avoided.

Draft Convention on Transfer Pricing At the meeting of the Fiscal Committee in 1933 after completion of Carroll’s endeavours, a draft convention generally following his recommendations 22 See note 13, para 679 for the legal impossibility idea. Although he does not express it in terms of what the OECD has now labelled the relevant business activity and functionally separate entity approaches to attribution, the clear impression from Carroll’s work is that his mindset is in terms of the former rather than the latter which is now the authorised OECD approach, 2008 Attribution Report, note 1, Part I, paras 59–79. As Carroll comes from the US his approach in this regard is not surprising since US domestic law allocation rules are built on the relevant business activity approach.

Book 1.indb 401

12/2/2011 8:22:23 AM

402

Richard Vann

was produced containing the original versions of what became in the OECD Model Article 7 on Business Profits and Article 9 on Associated Enterprises, the latter covering adjustment of transfer prices between separate but associated enterprises. There is no express mention of the fundamental divergence between Carroll’s preferred remuneration for services approach and the majority practice of the sale between independents approach, the Committee merely noting: In view of the diversity of national laws and the extreme complexity and variety of the individual cases that arise, the Committee thought it advisable to prescribe only general principles. Mr. Carroll’s very detailed report can be usefully consulted as a guide for the application of those principles to the complex cases that are encountered in practice.

Specifically in relation to interest deductions, the Committee stated in the brief Commentary:23 [The equivalent of Article 7(2) of the OECD Model] does not expressly regulate the allocation of interest on debts, but it follows from the principles laid down … that such interest will not be attributable to an establishment unless it refers to debts contracted by the permanent establishment itself commensurately with its own needs as an independent enterprise. In the case of debts contracted by the international enterprise, a portion of the interest may be deducted from the income of the dependent permanent establishment, provided that the money borrowed has been used for the particular requirements of that establishment, that the amount reasonably corresponds to what would have been required by an independent enterprise and that the interest charges have not been included in the prices and remunerations entered in the accounts.

This view differs from the treatment of interest by Carroll under the remuneration for services approach and fits more closely with the sale between independents approach. The underlying assumption seems to be that there generally should be no deduction for notional interest. The 1933 draft contained, as Carroll suggested, a special article for banks which applies the general rules but also authorises deductions for internal interest charges at the interbank offered rate other than in respect of the permanent capital allocated to the PE, which is consistent with the view that notional interest was not generally allowed in the sense that a special rule was required for such deductions.24

23

LHUSTC4, note 8, 4246. LHUSTC4, note 8, 4242, 4247. While the minutes of the meeting refer to the article on banks being necessary because it ‘derogates in certain essential points’ from the general provisions on calculation of PE profits, it does not specifically identify this case (or any other case) as one of them. Further the Commentary on the banking provision states, ‘Moreover, it precludes the possibility of deducting interest on sums advanced to a permanent establishment in lieu of capital. As a matter of fact, this latter rule could normally apply also to enterprises other than banks.’ Which may suggest that internal interest charges are deductible. Perhaps this part of the banking provision is simply intended to set the interest rate to be used and to deny the deduction on PE capital (though its drafting, LHUSTC4, 4244–4245, suggests in relation to deductions that two functions are being performed, providing for a deduction which would not otherwise be available and setting its rate). 24

Book 1.indb 402

12/2/2011 8:22:23 AM

History and Purpose of the Business Profits Deduction Rule in Tax Treaties 403 The more interesting point is that this discussion occurs in a context where there is no equivalent to Article 7(3) – that provision does not make its appearance until later. The only provision that comes close to the issue in the 1933 draft states that business income does not include certain categories of income, and adds:25 There shall be excluded with the above-mentioned items of income the related expenses (including general overhead) and charges.

So overhead expenses get an express mention only in this negative way, but the suggestion conversely is that for business income they are deductible. It is not clear, however, that the reference to overhead extends beyond the overhead expenses of the PE concerned to other overhead of the enterprise as a whole.26 Deductions in the form of royalties and specific service fees do not receive any mention. The Reports of the 1935 and 1936 meetings of the Fiscal Committee do not advance matters with regard to deductions although there is some redrafting, renumbering and expansion of the allocation rules for business profits. At this point the Draft Convention on the Allocation of Business Profits (1935 draft) in part read:27 1. If an enterprise with its fiscal domicile in one contracting State has permanent establishments in other contracting States, there shall be attributed to each permanent establishment the net business income which it might be expected to derive if it were an independent enterprise engaged in the same or similar activities under the same or similar conditions. Such net income will, in principle, be determined on the basis of the separate accounts pertaining to such establishment. Subject to the provisions of this Convention, such income shall be taxed in accordance with the legislation and international agreements of the State in which such establishment is situated. 2. The fiscal authorities of the contracting States shall, when necessary, in execution of the preceding paragraph, rectify the accounts produced, notably to correct errors or omissions, or to re-establish the prices or remunerations entered in the books at the value which would prevail between independent persons dealing at arm’s length. 3. If an establishment does not produce an accounting showing its own operations, or if the accounting produced does not correspond to the normal usages of the trade in the country where the establishment is situated, or if the rectifications provided for in the preceding paragraph cannot be effected, or if the taxpayer agrees, the fiscal authorities may determine empirically the business income by applying a percentage to the turnover of that establishment. This percentage is fixed in accordance with the nature of the transactions in which the establishment is engaged and by comparison with the results obtained by similar enterprises operating in the country. 25

LHUSTC4, note 8, 4247. This approach is consistent with Carroll’s recommendations for drawing the line between business and other income and deductions associated with non-business income, note 13, paras 616–617. Carroll apparently did not feel the same difficulty of apportionment in this context as he did in relation to business income though the reason why is not clear. 27 LHUSTC4, note 8, 4253–4254, Article III. This draft generally follows Carroll’s recommendations but without any indication of a preference for the remuneration for services approach. 26

Book 1.indb 403

12/2/2011 8:22:23 AM

404

Richard Vann

4. If the methods of determination described in the preceding paragraphs are found to be inapplicable, the net business income of the permanent establishment may be determined by a computation based on the total income derived by the enterprise from the activities in which such establishment has participated. This determination is made by applying to the total income coefficients based on a comparison of gross receipts, assets, number of hours worked or other appropriate factors, provided such factors be so selected as to ensure results approaching as closely as possible to those which would be reflected by a separate accounting.

Paragraph 1 corresponds to Article 7(2) in the OECD Model except that the latter does not contain the reference to the use of accounts. Paragraphs 2 and 3 have no equivalent in Article 7 while the first sentence of paragraph 4 corresponds to some degree to the former Article 7(4) on formulary apportionment.

Mexico and London Drafts 1940–1946 For the next few years the Fiscal Committee was preoccupied with other matters but in 1939 a revision of the 1928 drafts was suggested.28 Notwithstanding the intervention of World War II considerable progress was made on this project, including the appearance in the drafts for the first time of the business deduction rule and publication of the Mexico 1943 and London 1946 drafts.29 The dominant figure during this period was once again Carroll.30 He prepared a lengthy document on treaty practice and revision of the League drafts, part of which was incorporated in an official League of Nations document.31 The former includes a section discussing the taxation of business profits and not surprisingly emphasises the influence of Carroll’s earlier study and the League draft on treaty practice in relation to taxation of PEs. As evidence Carroll 28 Although not expressly mentioned in the Report of the 1939 meeting, the suggestion appeared in a pamphlet published by the League of Nations, Carroll, Prevention of Double Taxation and Fiscal Evasion: Two Decades of Progress under the League of Nations (Document II Economic and Financial 1939 IIA 8) 43 which is referred to in the Report, LHUSTC4, note 8, 4292; the suggestion is attributed to the 1939 meeting in the Report of the 1946 meeting, LHUSTC4, 4304. The need to make studies of the treaties concluded after the 1928 models to identify trends and the influence of the models was referred to at the 1936 and 1937 meetings of the Fiscal Committee, LHUSTC4, 4261, 4270. 29 Naturally few documents were published in this period and it is necessary to rely on the League of Nations archives to understand developments. The fullest account of the period is found in Simontacchi, Taxation of Capital Gains under the OECD Model Convention (Kluwer, 2007) 62–119. The author wishes to thank Stefano Simontacchi for making available the main documents from this period relating to the deduction provision. 30 He had attended all League of Nations Fiscal Committee meetings in the period 1927– 1946 except for 1931 and 1933, was Chair at the 1938 and 1939 meetings, although no longer in government employment, and was the driving force during the war years. 31 Carroll, Revision of the 1928 Draft Conventions on Double Taxation in the Light of Treaty Provisions (1939–1940), League of Nations Fiscal Committee, Study by Mr Mitchell B Carroll on the Draft Conventions Prepared by the General Meeting of Government Experts on Double Taxation and Tax Evasion of 1928 (Document F/Fiscal/123, 1940), both provided by Stefano Simontacchi.

Book 1.indb 404

12/2/2011 8:22:23 AM

History and Purpose of the Business Profits Deduction Rule in Tax Treaties 405 primarily relies on the slightly increased appearance of a power of rectification of PE accounts in which he includes versions of paragraph 2 of the 1935 draft quoted above and the adoption of variations of the 1935 draft’s equivalent to OECD Model Article 9. The latter of course does not refer to PEs but to separate enterprises.32 He notes that there is variation in provisions he regards as influenced by paragraph 2 but does not mention that none of them contain the criterion of independent parties dealing at arm’s length in that paragraph or paragraph 1 which is the central provision for the separate enterprise arm’s length principle in the PE context. The evidence for adoption of the Carroll’s work in actual treaties in relation to PEs is sparse. The nearest referred to by Carroll is the France Switzerland treaty 1937 which in the equivalent of the 1935 draft paragraph 2 refers to:33 the profits or benefits (if any) derived indirectly from the fixed establishment, or conveyed or assigned to third parties, whether in the form of increases in the price of purchase or reductions in the price of sale or in any other form.

The closest adoption of the 1935 draft in relation to PEs seems to be its incorporation by reference as a guide in the Hungary Netherlands treaty 1938 Article 4(3):34 If an undertaking has permanent establishments in both Contracting States, each State shall tax that part of the income which is earned in its territory. For the purpose of giving effect to this article, the supreme tax authorities of the two Contracting States shall by common accord lay down rules of apportionment and shall be guided in this connexion by the ‘Draft Convention for the Allocation of Business Income between States for the Purposes of Taxation’ prepared by the Fiscal Committee of the League of Nations. 32 The 1935 draft, judging by treaty provisions up to 1940, was clearly much more influential for separate enterprises than it was for PEs. The earliest version appears in the France US treaty of 1932, negotiations for which were initiated by France in February 1930, Joint Committee of Internal Revenue Taxation, Legislative History of United States Tax Conventions (US Government Printing Office, 1962) Vol 1, 8 and finalised by mid 1930, Carroll, note 28, 49. This was around the time Carroll commenced his work on allocation of profits and it seems likely that he played some part in the drafting. Carroll was originally in the US Department of Commerce which had different objectives to a fiscal authority (increasing the prosperity of US business); he spent a short time with US Treasury and then was in private practice. He was associated with various business and legal groups throughout including the International Chamber of Commerce, National Foreign Trade Council, American Bar Association and Inter-America Bar Association. 33 Carroll, note 31, Part III, 24–25. France used this kind of language in several other treaties around this time in relation to its tax on income from movable capital, eg, Sweden 1936, Romania 1942. The English versions of the treaties referred to in this article are generally sourced from the Tax Analysts Worldwide Tax Treaties Database available by subscription from www.taxanalysts. org or www.lexis.com; in turn for the period to 1945 these seem to be based on League of Nations translations of the treaties which were not in English as an original language. 34 Carroll was apparently unaware of this treaty at the time as it is not mentioned in the list of comprehensive treaties in his 1939 pamphlet for the League of Nations, note 28. The pamphlet was less forceful in asserting acceptance of the Draft Convention and Carroll’s work, though it does state that the accounts ‘would be verified by reference to local factors, thereby obviating the need of recourse to head office accounts’ which it will be recalled was one justification for the remuneration for services approach, and he regards his recommendations as having been adopted by the Fiscal Committee, note 28, 28, 31.

Book 1.indb 405

12/2/2011 8:22:23 AM

406

Richard Vann

In the discussion of empirical (percentage of turnover) methods Carroll refers to early Austrian arrangements that used a customary commission basis in the state of sale where no other specific method applies, harking back to his preference for the remuneration for services approach in the country of sale. He also has a section on the praecipuum, though not by that name, which indicates that a special allocation to the real centre of management was often expressly excluded in treaties, though found in a few treaties. In the League document reproducing parts of Carroll’s study, there is a discussion of the 1928 draft 1c which Carroll regarded as dominant in treaty practice of the three 1928 drafts and a suggested new draft. In the discussion of draft 1c, Carroll asks whether the following amendments relevant to the discussion here should be made: a) that where the activities of a branch are in the nature of those of a commissions agent or broker, the assessment may be based on the customary commission for such services … b) that no allocation of income shall be made to the head office of the enterprise unless profit-making operations are affected there; or that a minimum percentage of net income should be allocated to head office …

His draft includes an addition to the percentage of turnover provision in paragraph 3 of the 1935 draft of the customary commission basis but nothing on a special allocation to the real centre of management. Deductions do not receive any mention in either document outside the special provision for banks. A sub-committee of the Fiscal Committee met in The Hague in April 1940. The draft it produced did not include Carroll’s suggestion for the use of customary commission but did adopt the praecipuum:35 If by application of the above-mentioned rules the total profit of the enterprise which is attributable to the real centre of management of the enterprise is less than … per cent of that profit, that part of the profit shall, however, be attributed to the real centre of management as a compounded assessment (de facon forfaitaire) for purposes of taxation and shall not be taxable in the State where the other establishments of the enterprise are situated.

When this draft was considered by the first regional tax conference in Mexico in June 1940, Carroll’s customary commission suggestion was added to the percentage of turnover provision corresponding to paragraph 3 of the 1935 draft. The praecipuum was replaced with the first appearance of the deduction rule:36 35 Legal of Nations Fiscal Committee, Second Report of the Meeting of Members and Corresponding Members of the Fiscal Committee, Mexico City, June 3–15, 1940 Prevention of International Double Taxation, Income & Property Taxes (Document F/Fiscal/127, 1940) 11, footnote 1. This document provided by Stefano Simontacchi contains the 1940 Mexico draft and in the footnotes records its variations from the Hague draft. 36 Note 35, 10 (commission provision) 11 (deduction rule). The author has not been able to trace a direct source for this form of drafting. The obvious candidates are the US provision, note 15, and the

Book 1.indb 406

12/2/2011 8:22:23 AM

History and Purpose of the Business Profits Deduction Rule in Tax Treaties 407 In determining the net income on the basis of the separate accounting of the permanent establishment, there should be deducted a properly apportioned part of the general expenses of the head office of the enterprise.

There are a number of questions raised by this sudden appearance of a specific provision on deductions. If the praecipuum approach was regarded as unacceptable why not just delete it, rather than replace it by the deduction rule. The answer to this question is suggested by one of the few existing treaties which referred to deductions; the closest provision to this deduction rule in an earlier treaty is in France Switzerland 1937:37 It is understood that a proportion of the general expenses of the head office of enterprise, shall be debited to account of the several permanent establishments.

Carroll in his study of treaty practice and suggested revision of the League drafts noted that this treaty seemed designed to preclude the praecipuum through its exclusion of the head office from being a PE if no profit earning activities were carried out there.38 As noted previously the Swiss praecipuum approach allocated a certain amount of net profit to headquarters activities which meant in effect that head office expenses were deducted against that income. If no such headquarters allocation was accepted by the other country, the alternative was to ensure that the head office overhead expenses were appropriately allocated to PEs.39

French provision next quoted in the text. Though each expresses the same idea, neither seems to be the direct source. The 1935 draft in relation to PEs similarly does not seem to have any history in actual treaties and this provision seems to continue the trend. The other main change to the paragraphs of the 1935 draft quoted above was the addition of a corresponding adjustment rule to paragraph 2. In the draft overall the definition of business profits in the earlier versions has disappeared and with it the related rule on deductions; the text of the drafts regarding financial institutions remains essentially the same but according to the Commentary the provisions ‘state explicitly certain corollaries of the method of separate accounting’ rather than derogating from the general principle, LHUSTC4, note 8, 4341. By contrast Carroll still thought it was ‘necessary to overcome the general rule of law that one part of a legal entity cannot charge interest to another’ (Carroll, ‘Allocation of Income for Tax Purposes’ Paper for 1945 Meeting of Tax Committee of the Inter-America Bar Association, Santiago, 6, again provided from the League archives by Stefano Simontacchi). 37 Protocol Ad Article 4 para 7. This was also the treaty Carroll referred to as the closest adoption of the League 1935 draft for allocation of profits to PEs, note 33 and text. The Hungary Switzerland 1942 treaty is an instructive comparison; it contains the same rule for allocating profits to PEs which Switzerland borrowed from its French treaty but retains the praecipuum and so omits the deduction rule. Switzerland has a number of other treaties still in operation which permit the praecipuum generally or in specific cases, Denmark 1973, Ireland 1966, Netherlands 1951, Sweden 1965; for later usage of this provision by France, see note 41 and text. Very occasionally other treaties prior to 1946 had provisions on expenses in a formulary apportionment approach such as Czechoslovakia Poland 1925 Article 2(3), ‘The common receipts of such establishments shall, as a general rule, be allocated in proportion to the funds and capital allotted to those establishments, and the common expenditure shall be allocated in proportion to the receipts. In certain cases the Finance Ministers of the two States may agree upon a different system of allocation. … Receipts obtained in one country from the sale of goods purchased in the other country, and the expenditure corresponding to such receipts, shall as a general rule be divided equally among the establishments concerned in the transaction.’ 38 Carroll, note 31, Part III, 28. 39 Avery Jones and others, ‘Origins of Concepts and Expressions Used in the OECD Model and Their Adoption by States’ (2006) 60 Bulletin for International Taxation 220, 242 note 258 in

Book 1.indb 407

12/2/2011 8:22:24 AM

408

Richard Vann

While this link between the exclusion of the praecipuum and the inclusion of the deduction rule provides an explanation for the change made to the Hague draft, it would mean that the deduction rule was only required in a very limited number of cases – for countries which used the praecipuum concept and agreed in a treaty to give it up. Moreover, viewed from this perspective it seems to be only a precautionary rule as it is assumed in other contexts in the Hague and 1940 drafts that revenue necessarily brings with it related expenses without special rules.40 France nonetheless continued the practice established by the 1937 treaty with Switzerland of including its own particular forms of the rectification of accounts and deduction provisions in many of its subsequent treaties until the end of the 1950s.41 Something more would seem to be involved suggesting a broader purpose for the rule. Although the minutes of the meeting where the change occurred do not provide much insight,42 the change continued through the two subsequent Mexico (1943) and London (1946) drafts with only a slight change in wording (‘should be deducted’ changed to ‘may be deducted’).43 The commentary to the 1943 and 1946 drafts states:44

relation to Switzerland UK 1954 and the Swiss view of the deduction provision there. Although there was no actual deduction of head office expenses under the Swiss system which operates as a formulary method of allocating net profit of the whole enterprise, the separate enterprise arm’s length principle operating through separate accounts requires that revenue and expense of a PE be identified and so required adaptation to expressly include or exclude the praecipuum idea. Praecipuum could be included as an overriding amount of net profit as in the Hague draft or by allocating some proportion of revenue to the head office and with it part of the expense. If it were excluded, then the expense of head office management activities that related to PEs needed to be moved to the PE, compare note 13 and text. 40 As seen above, note 25 and text, the definition of business profits in the 1930s drafts worked by expressly excluding certain items of income and their related expenses. Although this provision is dropped from all the 1940s drafts, the issue of excluding certain revenue and expense remained. Both the Hague and 1940 Mexico drafts (though not the 1943 Mexico and 1946 London drafts) contained an exclusion from attribution of profits to PEs for purchasing activities. When this was picked up by the OECD, the Commentary consistently provided that related expenses could not be deducted even though there was no reference to that effect in the text of the Model, note 3, Commentary Article 7 para 57 at 134. 41 Canada 1951, Denmark 1957, Finland 1957, Italy 1958, Luxembourg 1958, Netherlands 1949, Norway 1953, Saar 1948, Switzerland 1953 (the last again with the exclusion of the praecipuum). In its treaties with major powers, France does not insist on this practice, Germany 1959, UK 1950, US 1939. The French practice was also adopted by some other countries, eg, Norway Switzerland 1956. 42 The English version of extracts from the minutes provided by Stefano Simontacchi are sketchy. Mexican delegates supported the Hague draft but after the member of the League Secretariat raised questions about how the amount would be fixed and Carroll pointed out that the US did not have any concept of the real centre of management, the praecipuum provision was dropped. There does not seem to be a record of discussion of the substitution of the deduction rule. 43 LHUSTC4, note 8, 4400–4401. The report of the 1940 Mexico meeting, note 35, indicates that while the principles were agreed, the language was not, so some drafting change was to be expected. It does not seem that the change from should to may was intended to be significant. 44 LHUSTC, note 8, 4341. The commentary is not official in the same way as the OECD Commentary; it was prepared by the League Secretariat subsequent to the meetings and was not approved as such by the delegates who adopted the drafts. For the justification for the equivalent of Article 7(2) in terms of non-discrimination, see LHUSTC4, note 8, 4338.

Book 1.indb 408

12/2/2011 8:22:24 AM

History and Purpose of the Business Profits Deduction Rule in Tax Treaties 409 Though the method of fractional apportionment is mentioned by the Model Convention only in the third place, after the methods of separate accounting and percentage of turnover, this does not mean that the partial use of fractional apportionment is excluded when, as is generally desirable, branch establishments are taxed according to the method of separate accounting. There are, indeed, in most enterprises with two or more establishments certain items of expenses that must necessarily be apportioned in order to achieve the object of separate accounting, which is to place branches of foreign enterprises on the same footing as domestic enterprises. An application of this idea is found [in the deduction provision] [emphasis added].

The emphasised words in the quotation indicate the purpose – a form of nondiscrimination rule. As is evident from the quotation, however, this is regarded as only one application of the non-discrimination nature of the business profits rules; the commentary also regards the separate enterprise arm’s length principle applied to PEs as a form of non-discrimination rule. Focusing for now on the issue in relation to the deduction rule, it has already been noted that foreign PEs of US enterprises often had their overhead expenses disallowed, even though the US allowed such expenses for US PEs of foreign enterprises. Although the problem may have been largely a practical one of proving such expenses to the satisfaction of the local tax administration, a number of countries had/have rules in their tax law that effectively denied deductions for actual head office expenses either because they did not relate exclusively to the activities of the PE (that is, apportionment was/is forbidden) or because they were incurred outside the PE country. To some extent these further rules were directed at potential avoidance (even where actual expenses were provable which was difficult for expenses paid outside the country, their relevance to the PE was difficult to establish and partly depended on the say-so of the taxpayer). And to some extent they were simply the outcome of the systemic nature of the deduction system in question, for instance, if the general deduction rule covered only expenses exclusively related to the earning of taxable income as in the UK and many countries whose tax law in this respect derives from the UK.45 In both cases such rules effectively (covertly) discriminated against PEs and their foreign owners but in cases where they also applied to domestic enterprises (as was common), they are not touched by the modern explicit non-discrimination rules in Article 24 as explained hereafter. In any event there was no express PE non-discrimination rule in the League drafts

45 Although these provisions existed at the time, Carroll’s five volume project did not seem to detect reliance on them to disallow deductions. The problem that these rules create is that the head office overhead relates to both income taxable to the PE and income of the rest of the enterprise which is not taxable in the PE country, thus failing the ‘exclusively’ test. Rules denying deductions for payments outside a country also will disallow most head office overhead. Australia had such rules in the income taxes of the colonies that became states but due to sloppy drafting this was not carried over to the federal income tax enacted in 1915. An attempt to insert the rule in the federal income tax in 1921 was unsuccessful for procedural reasons, Harris, Metamorphosis of the Australasian Income Tax: 1866 to 1922 (Australian Tax Research Foundation, 2002) 196–197.

Book 1.indb 409

12/2/2011 8:22:24 AM

410

Richard Vann

(although Carroll’s 1940 draft contained one).46 There is, however, no explicit statement that the purpose of the deduction rule was to deal with such cases. Although the League work during this period was concerned with the draft models and not revisiting the detailed work on allocation of the 1930s, not surprisingly the debate about the remuneration for services and sale between independents approaches lurks below the surface. The adoption of Carroll’s suggested commission rule for the percentage of sales fallback rule favours the former while the deduction rule favours the latter. The commentary, however, in a number of respects very clearly supports Carroll’s preference. To the extent that profits are to be allocated to purchasing offices (which the commentary generally rejects), the remuneration for services by commission basis is considered the only justifiable approach. More significantly in relation to the fallback rule on commission, the commentary states:47 It may be noted that this ‘commission basis’ may, when appropriate, be used by establishments keeping regular accounts and entitled to be assessed according to the method of separate accounting.

As with Carroll’s earlier work there is no express mention of deductions for royalties and specific service fees. The League drafts of the 1940s, however, refer in the PE definition to ‘other fixed places of business having a productive character’ which are designed to exclude places of business which do not directly contribute to sales such as research establishments etc.48 Presumably their costs were intended to be distributed to the productive establishments as Carroll had proposed but there is no statement to this effect. In summary the League of Nations work provided the equivalents of Article 7(2) and 7(3) of the OECD Model. The purpose of the latter is stated to be nondiscrimination but there are a number of deeper issues which touch deductions. While the praecipuum as such is rejected, the idea underlying it and the debate around the remuneration for services and sale between independents approaches which significantly affect what overhead can be deducted in the PE state are unresolved.

46

League of Nations, note 31, 19 in Article XX. LHUSTC4, note 8, 4340. Further, the commentary, 4348, emphasises that one purpose of the accounts rule is that it is only necessary to check events and documents in the PE country which is one of Carroll’s arguments for his preferred approach. The commentary shares Carroll’s earlier concern about overreaching by the country of sale (which it calls extra-territorial taxation). 48 LHUSTC, note 8, 4334–4335. In Carroll’s earlier work and in subsequent developments at the OECD, there is also an ongoing interplay between the attribution of profits and the PE definition, particularly the cases now dealt with in Article 5(4) of the OECD Model which excludes various activities from amounting to a PE. The relationship is that if certain activities do not warrant the allocation of any profits, then they should not amount to a PE. 47

Book 1.indb 410

12/2/2011 8:22:24 AM

History and Purpose of the Business Profits Deduction Rule in Tax Treaties 411 1946–1963

Treaty Practice For a decade after the conclusion of the League of Nations work in 1946, there was little activity on tax treaties in international organisations as the United Nations (UN) was caught up in a variety of political issues which rendered its Fiscal Committee so ineffective that it was disbanded in 1954. Nonetheless countries were very active in negotiating treaties, especially the UK and the US who had considerable catching up to do compared to mainland European countries which generally had reasonably extensive pre-War treaty networks (other than with the UK or US). The UK and the US adopted the separate enterprise arm’s length provision for PEs from the League drafts in their 1945 treaty though in a much stripped down form and then continued in the same vein for the next decade.49 The deduction rule did not appear in the UK US 1945 treaty but began to appear in many US treaties from 1948 in two variants. It will be noted that in terms of the rules concerning apportionment of expenses and payments outside the country, the 1946 League draft seems, expressly at least, only to deal with the former – it lacks the words referring to the place where expenses are incurred in the modern version of Article 7(3). The first US variant which also lacks this element made its earliest appearance in its New Zealand treaty of 194850 and the second variant which covered it in its Canada protocol of 1950:51 In the determination of the net industrial and commercial profits of the permanent establishment there shall be allowed as deductions all expenses, wherever incurred, reasonably allocable to the permanent establishment, including executive and general administrative expenses so allocable. 49 The first treaty to adopt the League style of language directly was Canada US 1942 which was negotiated during the period when the work of the League Fiscal Committee was effectively confined to the Americas and represented an attempt by the US to develop a treaty network within the Americas generally which did not eventuate, see Simontacchi, note 29, 88–89. At the 1940 Mexico meeting the US delegates are recorded in the minutes, note 42, as expressing the view very strongly that they considered the League draft on allocation of profits to PEs much too detailed and that they preferred a simple statement of a ‘little’ rule. The Canadian treaty reflected a turnaround in this view as it adopted paras 1 and 2 and a combined version of paras 3 and 4 of the 1935 League draft quoted above, note 27 and text. A few other US treaties of the 1940s used similar versions, South Africa 1946, Belgium 1948 but the US used only the first sentence of the first paragraph out of the quoted part of that draft in most other treaties of the period. 50 Article III(5), ‘In the determination of the industrial or commercial profits of the permanent establishment there shall be allowed as deductions all expenses … which are reasonably applicable to the permanent establishment, including executive and general administrative expenses so applicable.’ The deleted words are discussed in note 94 and text below. To similar effect are US treaties with Australia 1953, Austria 1956, Germany 1954 and Switzerland 1951. 51 Article I(a). To similar effect are Belgium protocol 1952, Finland 1952, Honduras 1952, Italy 1952, Japan 1954; nine US treaties signed in the period 1945–1960 that entered into force lacked the deduction rule. Note that from this time on the deduction rule uses ‘shall’ rather than the ‘may’ of the League 1943 and 1946 drafts.

Book 1.indb 411

12/2/2011 8:22:24 AM

412

Richard Vann

Moreover although the League draft covers only head office expenses and arguably thus does not extend to expenses of PEs in other countries that benefit a particular PE, all the US treaties that included the deduction rule applied it to all overhead expenses not just head office expenses, as does Article 7(3). The US practice spread, though not broadly, to some other countries by the mid 1950s.52 The US legislative history says very little and does not give any clear guidance on the purpose of the provisions. The New Zealand provision is said to ‘spell out rules of administration inherent in the Article in any event’ and to be ‘included to conform to the desires of the New Zealand delegation’ suggesting that nothing was achieved from the US viewpoint.53 In relation to Canada the provision is said to give ‘formal recognition’ to and be ‘declaratory’ of existing practice under the Canada US 1942 treaty, without indicating what the practice was apart from allowing a proportion of head office expenses.54 Only in relation to one treaty does it seem to be suggested that something was gained by the provision.55 While Canada had a rule which would have created a problem for apportionment, it was repealed in 194856 and there was no rule preventing deduction of expenses paid offshore. Belgium is a country with both forms of rule and the same provision appeared in a 1952 protocol to the Belgium US 1948 treaty so this would appear to be the first case where the provision was effective to deal with both of the rules referred to above. Belgium accepts that the deduction provision overrides its domestic law in both these respects.57 That treaty and protocol, however, were approved in the US along with the Australia 1953 treaty, which does not contain the ‘wherever incurred’ wording. Australia had neither form of rule then (or now). The legislative history suggests that both variants of the rule were to the same effect but otherwise does not identify the specific problems to which it is directed.58 If rules of these two kinds are the basis of the business profits deduction rule (indicating a non-discrimination purpose), the

52 First variant, eg, Austria Germany 1954, Canada Germany 1956, Canada Netherlands 1957; second variant, eg, Switzerland UK 1954. For the similar approach but with different wording adopted by France in this period, see note 41 and text. 53 US Treasury, ‘Memorandum concerning Income Tax Treaty Negotiations between the United States and New Zealand’ (12 April 1951) sourced from Tax Analysts database, note 33. 54 See Joint Committee, note 32, Vol 1, 494 (Transmittal Message), 607 (Senate Foreign Relations Committee Report). 55 US Treasury, ‘Technical Memorandum to Accompany the Text of the Proposed Income Tax Convention between the United States and Austria’ (30 July 1957) sourced from Tax Analysts database, note 33, ‘The article confers two benefits to American business interests (a) it recognizes the allowability of head office expense and (b) some assurance that in any case in which conflicting rules of source arise a solution will be found.’ 56 Avery Jones, note 39, 241. 57 ibid, 241–242. 58 The Transmittal Message in relation to the Belgium US protocol 1952, Joint Committee, note 32, 257, states, ‘That new paragraph would contain provision corresponding, for example, to article III(5) of the existing income-tax convention with New Zealand and article I(a) of the existing income-tax convention with Canada, under which a reasonable part of head-office expense of an enterprise would be deductible by a foreign branch. Such provisions are designed to encourage, in practical operation, the application by Belgium of principles similar to those recognized by the United States.’

Book 1.indb 412

12/2/2011 8:22:24 AM

History and Purpose of the Business Profits Deduction Rule in Tax Treaties 413 same comment as for the French treaty practice following the France Switzerland treaty 1937 can be made – there is no clear correlation between cases where the problems arise and the rule is being used.59

OEEC Draft The next stage of development of the business profits deduction rule was in the Organisation for European Economic Co-operation (OEEC), the predecessor of the OECD which became the international organisation responsible for tax treaties in the mid 1950s following the failure of UN work in the area. Working Party 7 (WP7) consisting of delegates from the UK and Netherlands was set up in 1957 to deal with what became Articles 7 and 9 of the OECD Model. In its first report the deduction rule appeared in its modern form with a few minor language differences, though numbered as paragraph 4 (paragraph 3 being the purchase rule).60 It was clearly derived from US treaty practice. They explained that provision as follows:61 This paragraph amplifies, in relation to the expenses of a permanent establishment, the general directive laid down in paragraph 2. In the Group’s view it is valuable to include [the] paragraph … if only for the sake of removing doubts. The paragraph specifically recognises that in calculating the profits of a permanent establishment allowance is to be made for expenses, wherever incurred, that were incurred for the purposes of the permanent establishment. Clearly in some cases it will be necessary to estimate or to calculate by conventional means the actual amount of expenses to be taken into account. In the case, for example, of general administrative expenses incurred at the head office of the enterprise it may be appropriate to take into account only a proportionate part based on the ratio that the permanent establishment’s turnover (or perhaps gross profits) bears to that of the enterprise as a whole. Subject to this, the amount of expenses of the permanent establishment should, in the Group’s view, be the actual amount so incurred.

The non-discrimination justification has disappeared from view and there is no mention of the kinds of specific rules that created problems for overhead. Like the US, the rule seems to be regarded by the OEEC as precautionary. Its inclusion on that basis is perhaps surprising as WP7 generally favoured brevity in writing the business profits rules rather than spelling them out in great detail as had occurred in the League drafts. Apart from the first two sentences, language of this kind continued to be used by the OECD in the Commentary up until the omission of Article 7(3) from the Model.62 To understand why the precautionary 59

Note 41 and text. FC/WP7(57)1, 4. The OEEC archives are available online at www.taxtreatieshistory.org; documents are referred to by the OEEC system of numbering. The UK was the rapporteur for WP7 and thus primarily responsible for its contents. It was not a significant user of the deduction rule at this time. 61 FC/WP7(57)1, 15. 62 OECD 2008 Model, note 3, Article 7 Commentary para 27 at 125–126. 60

Book 1.indb 413

12/2/2011 8:22:25 AM

414

Richard Vann

view changed over time it is necessary to return to broader issues about taxation of business profits. WP7 in its first report also raised for discussion the issues of deductions for interest, royalties and management/services fees and the use of the praecipuum prefaced by the following comment:63 In the Working Group’s opinion the general directive of paragraph 2 that the allocation of profits to a permanent establishment should be made on the basis of the fiction that the permanent establishment is a separate enterprise need not necessarily be applied rigidly in all the consequences which could in theory be associated with it. In a number of actual cases such an application of the said fiction might well raise difficulties. The Working Group has deemed it desirable to bring up for discussion specific cases and has endeavoured to propose solutions which meet the requirements of practice.

These issues attracted considerable discussion in the Fiscal Committee,64 though the initial position taken by WP7 survived more or less intact throughout the process and up until recently. As in earlier times the issues were seen as potentially qualifying the ‘theory’ of the separate enterprise arm’s length rule. For interest and royalties WP7 rejected deduction of notional interest or royalties payments ‘to avoid difficulties in practice’ but would permit deduction of a share of actual expenses of that kind, specifically referring to the deduction rule in that context. Banks are excepted from this approach in view of ‘the fact that making and receiving advances is narrowly related to the ordinary business of such enterprises.’ That is, they draw the line on the basis of whether the notional transaction is like the transactions entered into by the enterprise with third parties as part of its main business activities. For services the issue is expressed more in terms of whether there should be a mark-up rather than whether the notional transaction should be recognised at all but practicalities are again the justification.65 The discussion of the praecipuum is to the same effect, it again being noted that the head office expenses of management would be deducted against PE income but without a mark-up.66 The last issue as usual opens up broader questions. Although Carroll had made headway with the League of Nations, as a way of implicitly rewarding management, towards acceptance of the remuneration for services approach, it is decisively rejected by WP7 – indeed it is not clear that the delegates were even 63

FC/WP7(57)1, 11–12. The substantive discussions of the work of WP7 are in the following documents: FC/M(58)4, FC/M(58)5, FC/M(59)2, FC/M(59)3 (the main discussion of these particular issues), FC/M(59)4, FC/M(60)1. Other important issues debated were force of attraction, fallback empirical/formulary methods (the original draft did not contain such a provision but what became Article 7(4) was inserted during the discussions), profits from purchasing activities and the relationship with other articles (which was left unresolved as the dividends, interest and royalties articles were also in course of development). 65 The limit to exclude notional transactions akin to the profit earning activities of the enterprise from this approach only appeared late in the process by confining the no mark-up view to ‘ancillary’ services, FC/M(60)1, 6. 66 FC/WP7(58)1, 12–14. 64

Book 1.indb 414

12/2/2011 8:22:25 AM

History and Purpose of the Business Profits Deduction Rule in Tax Treaties 415 aware of the early history in this area. The sale between independents approach is accepted without question in the application of what became Article 7(2) in terms that remained in the Commentary until 2005.67 In the discussion of ancillary services, the remuneration for services commission method is heavily criticised in rejecting any mark-up:68 the profits of the permanent establishment should not be increased by the addition of a ‘commission’ figure. While, on one view, to include a commission figure in the profits of every permanent establishment that has incurred expenses otherwise than for its own purposes could be defended in theory as a consequential application of the fiction of separate enterprise (as said above), it would inevitably be found exceedingly cumbersome in practice. There would be scope for lengthy argument about, and usually no concrete basis for determining, the percentage to be used in calculating the amount of notional commission. In the great majority of cases the accounts of the permanent establishment would doubtless take account only of the actual expenses incurred … it would, therefore, be necessary in the great majority of cases first to settle how the ‘commission’ element was to be calculated and then to re-write the accounts of the permanent establishment. Considerations of practical administration seem to the Group to weigh heavily against such a course.

As noted previously the sale between independents approach considerably increases the need to deduct interest and overhead in calculating the profits of PEs which may explain why the matter attracted particular attention in the OEEC. It is clear that initially WP7 thought the issues around interest, royalties and ancillary services related to the way in which the general separate enterprise arm’s length principle was to be applied rather than having anything directly to do with the deduction rule, though the conclusions reached by WP7 were regarded as activating the deduction rule. Perhaps for that reason, although no explanation is given, in the next report of WP7 the ordering of the text of Article 7 which prevailed until it was rewritten in 2010 was settled on.69 The Fiscal Committee discussion of interest, royalties, services and the praecipuum involves the same mix of issues as noted in the League period: the significance of the separate enterprise fiction (in particular the argument that because the PE and the rest of the enterprise are part of the same legal entity in the usual case a PE cannot enter into legal transactions with the rest of the enterprise), concerns about disguised distributions of profits (debt-equity type issues), economic arguments about the operation of the separate enterprise arm’s length principle, possible double counting of expenses and practical concerns. There is no mention of a non-discrimination basis for the provision. The UK delegate became convinced during the discussion that there was an economic reason for the proposed treatment of interest, royalties and ancillary services 67

FC/WP7(58)1, 11, OECD 2005 Model, note 4, Article 7 Commentary para 14 at 118–119. FC/WP7(58)1, 13. 69 FC/WP7(59)2. This draft also introduced the equivalents of Article 7(4), (6). In the League of Nations drafts the deduction rule was also separated from the separate enterprise arm’s length principle. 68

Book 1.indb 415

12/2/2011 8:22:25 AM

416

Richard Vann

and that these issues properly belonged with the Commentary on the deduction rule. That change was made in the final report of WP7 and continued until recently. Further, in deference to Switzerland’s objections, the residence country was permitted to utilise a praecipuum but if this were not accepted by the PE country, the residence country was expected to give way but otherwise the clear preference for the sale between independents approach over the remuneration for services approach remained.70

MODERN DEVELOPMENT AND DEMISE

OECD In 1977 the apparently logical consequence of the 1963 Commentary suggesting some conflict between Article 7(2) and (3) was moved to the text by explicitly linking them, making the former subject to the latter and the Commentary was changed to the same effect.71 In 1994, the link made in 1977 was elaborated by an addition to the Commentary explicitly putting the internal charges issue in the divide between Articles 7(2) and (3) and significantly elaborating on when one or other applied, based on whether the dealing was directly related to the external business of the enterprise (such as transfer of goods from head office to PE for sale by the PE to third parties) or was purely internal in which case only an allocation of expense was allowed.72 In relation to royalties, the idea that notional transactions were not permitted because the enterprise was a single legal entity was explicitly adopted along with a cost contribution approach to intellectual property.73 The material on the praecipuum remains more or less untouched at this point. It was still asserted that the two provisions were consistent:74 there is no difference of principle between the two paragraphs. Paragraph 3 indicates that in determining the profits of a permanent establishment, certain expenses must 70 FC/WP7(60)1, 11–13, OECD 2005 Model, note 4, Article 7 Commentary paras 17.4–23 at 123–126. The emphasis on the practical reasons for the position regarding interest and royalties was also removed as there was disagreement whether it was practice or something deeper in the debate. 71 OECD 1977 Model, note 6, Article 7 and Commentary paras 11, 15 at 28–29, 75, 76. The Commentary says that Article 7(2) is subject to Article 7(3), that the latter clarifies rather than amplifies Article 7(2), and the reference to its purpose being to avoid doubt has gone. 72 OECD 2005 Model (the last to retain the 1994 changes intact), note 4, Article 7 Commentary paras 17–17.2 at 121–122. This idea had been used in relation to banks from OEEC times, see note 65 and text. Until this time the Commentary was quite explicit that interest etc were being dealt with in relation to Article 7(3) as a matter of convenience, OECD 1977 Model, note 6, Article 7 Commentary para 16 at 76, ‘Apart from what may be regarded as ordinary expenses, there are some classes of payment between permanent establishments and head offices which give rise to special problems, and it is convenient to deal with them at this point.’ 73 OECD Model 2005, note 4, Article 7 Commentary para 17.4 at 123. To some extent the same approach is applied to interest, para 18 at 124. 74 OECD 2005 Model, note 4, Article 7 Commentary para 17 at 121.

Book 1.indb 416

12/2/2011 8:22:25 AM

History and Purpose of the Business Profits Deduction Rule in Tax Treaties 417 be allowed as deductions whilst paragraph 2 provides that the profits determined in accordance with the rule contained in paragraph 3 relating to the deduction of expenses must be those that a separate and distinct enterprise engaged in the same or similar activities under the same or similar conditions would have made. Thus, whilst paragraph 3 provides a rule applicable for the determination of the profits of the permanent establishment, paragraph 2 requires that the profits so determined correspond to the profits that a separate and independent enterprise would have made.

This hints at yet another explanation of Article 7(3), that it was designed to ensure net taxation of business profits, which is taken up under the next headings. At the same time, the 1994 changes began to move the Article 7 approach towards that which prevailed for transfer pricing between separate enterprises which is not surprising as the OECD was just starting on substantial revision of the transfer pricing guidelines at this time.75 In particular the functional analysis makes its appearance (albeit briefly) and the Commentary is neutral between the sale between independents and remuneration for services approaches – which approach applies depends on the functions assumed by different parts of the enterprise.76 In relation to services a mark-up is now permitted:77 [w]here the main activity of a permanent establishment is to provide specific services to the enterprise to which it belongs and where these services provide a real advantage to the enterprise and their costs represent a significant part of the expenses of the enterprise [but not where] the provision of services is merely part of the general management activity of the company taken as a whole as where, for example, the enterprise conducts a common system of training and employees of each part of the enterprise benefit from it.

The treatment of interest likewise reflects some shift though ‘the ban on deductions for internal debts and receivables should continue to apply generally’ but not to banks.78 The shift implicit in these changes is carried (almost) to its logical conclusion in the 2008 Attribution Report. Under the general approach in that Report the PE is hypothesised in the first step of the analysis and attributed assets, liabilities and capital based on a transfer pricing functional analysis. In the second step the transfer pricing guidelines are applied by analogy to the dealings of the PE with the rest of the enterprise as if the dealings were transactions between

75 Although both the Report on Attribution of Income to Permanent Establishments and the draft transfer pricing guidelines were released in 1994, the former had been largely produced prior to 1992 when work on the revision of the guidelines began. 76 OECD 2005 Model, note 4, Article 7 Commentary para 12.1 at 117. 77 OECD 2005 Model, note 4, Article 7 Commentary paras 17.6–17.7 at 123. The effect is to shift part of the enterprise’s profit away from the PE either to the PE rendering the services (if the state of location of that PE asserts taxing jurisdiction) or to the state of residence of the enterprise. 78 OECD 2005 Model, note 4, Article 7 Commentary paras 18–20 at 124–125.

Book 1.indb 417

12/2/2011 8:22:25 AM

418

Richard Vann

separate entities. As a result of this approach it is possible for notional interest, royalties and service fees to be deducted by the PE. The fulsome adoption of the functionally separate entity approach in that Report is not, however, applied in every respect and always to the fullest extent.79 What is more important about the Report is its emphasis on significant people functions and risk in driving the attribution of profits:80 the authorised OECD approach attributes to the PE those risks for which the significant functions relevant to the assumption and/or management (subsequent to the transfer) of risks are performed by people in the PE and also attributes to the PE economic ownership of assets for which the significant functions relevant to the economic ownership of assets are performed by people in the PE.

In effect this adopts the idea underlying the praecipuum of rewarding (and privileging) management functions and represents a significant shift in transfer pricing analysis generally, but particularly for PEs. We have come full cycle and are now much closer to the Carroll approach to PEs than the sale between independents approach which has prevailed for much of the history of attribution to PEs.81 One implication should be that fewer overhead and other deductions of the enterprise as a whole are allocated to the PE so that the deduction problem is solved in the way Carroll proposed, but the overall impression of the Report is that PE deductions will be an even more fraught issue as dealings are constructed between PE and the rest of the enterprise to generate deductions in relation to a much broader range of notional transactions. Hence in the OEEC/OECD period the 1946 covert discrimination explanation of the business profits deduction rule disappeared and the rule came to be associated with a more basic question of whether certain expenses receive special treatment different from the treatment that may be implied in the separate enterprise arm’s length principle. As the treatment of interest, royalties and services fees that became linked to the rule were hard to fit with the separate enterprise arm’s length principle, it is not surprising in the new Article 79 It would require a much longer chapter to deal with this in any detail. It can be noted, for example, that the credit rating of a PE is not performed separately from the enterprise as a whole based on the fact that the overall enterprise is a single entity and cannot have separate different credit ratings for different parts; notional interest will not be deductible outside the finance sector unless the enterprise has a full-blown treasury operation and tangible assets used by a PE are generally regarded as owned by the PE (in contrast to intangible property where use does not imply ownership), 2008 Attribution Report, note 1, Part I paras 33, 36, 100, 130–135 (credit rating), 186– 188 (treasury dealings), 104, 229–234 (tangible property). 80 2008 Attribution Report, note 1, Part I para 18. 81 In relation to financial enterprises the relevant people are referred to as the ‘key entrepreneurial risk taking’ (or KERT) personnel. The emphasis on risk reached its high-water mark in the 2004 draft of the Report when ownership always followed management of risk in relation to an asset but was then diluted to the statement in the text which allows other people than the risk managers to determine ownership of assets other than financial assets. For the general implications of the Attribution Report in relation to risk and personnel and the significant shift in thinking involved for transfer pricing generally, see Vann, note 16, Vann, ‘Taxing International Business Income: HardBoiled Wonderland and the End of the World’ (2010) 2(3) World Tax Journal 291.

Book 1.indb 418

12/2/2011 8:22:25 AM

History and Purpose of the Business Profits Deduction Rule in Tax Treaties 419 7 that the deduction rule has been eliminated as the reasons for it (apart from discrimination) have been generally rejected in the 2008 Attribution Report. The OECD Model, however, has a special non-discrimination rule for PEs so it remains to consider whether that rule can perform (some of) the functions of former Article 7(3). Before turning to that question, the treatment of the provision in the other major model tax treaties of the US and UN are briefly considered to see what, if anything, they add about the history and purpose of the rule.

UN and US Models After its earlier failure in relation to tax treaties, the UN returned to the topic in the late 1960s with the formation of the Ad Hoc Group of Experts on Tax Treaties between Developed and Developing Countries. One of the first issues addressed was the taxation of business profits where a number of variations on OECD positions were adopted. In particular there was a much fuller version of Article 7(3) which in effect took the OECD Commentary position on interest, royalties and service fees directly into the text of the article.82 Many of the familiar arguments in the history above recur but of main interest here is the explicit mention of one of the rules which is thought to underlie the non-discrimination explanation of Article 7(3) but seems to receive no express mention in the League of Nations, OEEC or OECD history:83 Deductions of expenses incurred outside territory … some members from developing countries felt that expenses incurred outside their territory should not be permitted to reduce the profits of the establishment. Other members from the same group, while not rejecting the deduction entirely, pointed 82 See UN, Tax Treaties between Developed and Developing Countries (Document E/4614 ST/ ECA/110, 1969) 13–15, 29, 62–63, UN, Tax Treaties between Developed and Developing Countries Second Report (Document E/4936 ST/ECA/137, 1970) 14, 46, UN, Guidelines for Tax Treaties between Developed and Developing Countries (Document ST/ESA/14, 1974) 28–29. This position arrived at very early in the deliberations has remained the UN rule since, the Model adding to the OECD version the following, Model Double Taxation Convention between Developed and Developing Countries (Document ST/ESA/PAD/SER.E/21, 2001) 14–15, ‘However, no such deduction shall be allowed in respect of amounts, if any, paid (otherwise than towards reimbursement of actual expenses) by the permanent establishment to the head office of the enterprise or any of its other offices, by way of royalties, fees or other similar payments in return for the use of patents or other rights, or by way of commission, for specific services performed or for management, or, except in the case of a banking enterprise, by way of interest on moneys lent to the permanent establishment. Likewise, no account shall be taken, in the determination of the profits of a permanent establishment, for amounts charged (otherwise than towards reimbursement of actual expenses), by the permanent establishment to the head office of the enterprise or any of its other offices, by way of royalties, fees or other similar payments in return for the use of patents or other rights, or by way of commission for specific services performed or for management, or, except in the case of a banking enterprise, by way of interest on moneys lent to the head office of the enterprise or any of its other offices.’ 83 UN, Tax Treaties between Developed and Developing Countries, note 82, 14.

Book 1.indb 419

12/2/2011 8:22:26 AM

420

Richard Vann

to the difficulties of determining the expenses of the foreign head office that could be identified specifically for purposes of the establishment. One member from a developing country, who was of the opinion that the rule in paragraph 3 of article 7 was too broad, drew attention to the observation in the OECD Commentary, where it was stipulated that deductions for interest, royalties and fees for management services charged by the head office of the permanent establishment should generally not be allowed. As this principle was rational and sound and since the general rule of determining the profits under paragraph 2 gave the impression that such expenses could be charged to the permanent establishment, he suggested that a passage based on the Commentary … should be incorporated into the relevant paragraph 3. … Some members from developed countries expressed the view that the disallowance of such expenses as a deduction was not compatible with the principle of paragraph 3, but they were prepared to consider the last suggestion.

Here the rule about disallowance of expenses incurred outside the PE country is closely linked to Article 7(3) as elsewhere in UN documents as a reason for the rule – the non-discrimination explanation of the League of Nations in 1946. Such rules were commonly found in countries, especially Latin American countries, with strict territorial tax systems. The same kinds of differences of opinion about the relative scope of Articles 7(2) and 7(3) as discussed above are also evident which was further reason for spelling out the position clearly. As a result of its more prescriptive nature, the UN Model provision does not lend itself to the kind of interpretive flexibility that was found over the years in the OECD version. It also raised much more squarely the issue of needing to change the article if the conclusions of the 2008 Attribution Report were to be accepted. The UN has flatly rejected that report and will retain its current version of Article 7(3).84 The US Model in its successive versions of 1976, 1977, 1981 and 1996 also added words to the deduction rule by specifically extending the list of deductions that it covered to:85 research and development expenses, interest, and other expenses incurred for the purposes of the enterprise as a whole (or the part thereof which includes the permanent establishment).

84 UN, Report on the fifth session of the Committee of Experts on International Cooperation in Tax Matters (19–23 October 2009) 9, available at http://www.un.org/esa/ffd/tax/fifthsession/index. htm, ‘it should be noted that the Committee had not viewed the approach in the OECD 2008 report as relevant to the United Nations Model Convention. Th[e next] update should also include a short statement as to why the United Nations Model Convention varied from the new OECD approach.’ 85 United States Model Income Tax Convention, 20 September 1996, sourced from Tax Analysts database, note 33, Article 7(3). The earlier versions of the US model also found there are the same. The 2006 version reverts to the OECD wording of Article 7(3) and includes in relation thereto model protocol language requiring that the OECD Attribution Report in effect be applied to its interpretation. This means that the US in 2006 read Article 7(3) as requiring non-discrimination (see note 5 and text) and that depending on the situation there could be a mark-up on services to a PE from head office, as is made clear in the 2006 Technical Explanation of the provision (which also, however, retains the net taxation explanation of 1996). The 2006 model and explanation appear on the Tax Analysts database.

Book 1.indb 420

12/2/2011 8:22:26 AM

History and Purpose of the Business Profits Deduction Rule in Tax Treaties 421 The 1996 Technical Explanation stated the purpose in this way: This paragraph is in substance the same as paragraph 3 of Article 7 of the OECD Model, although it is in some respects more detailed. Paragraph 3 provides that in determining the business profits of a permanent establishment, deductions shall be allowed for the expenses incurred for the purposes of the permanent establishment, ensuring that business profits will be taxed on a net basis … The paragraph specifies that the expenses that may be considered to be incurred for the purposes of the permanent establishment are expenses for research and development, interest and other similar expenses, as well as a reasonable amount of executive and general administrative expenses [emphasis added].

In terms of the list of expenses little is added, but the US here provides another explanation of Article 7(3) as designed to ensure that a PE is taxed on a net basis. As mentioned above this idea is also hinted at in the OECD 1994 changes. This might be just a variation of the non-discrimination idea but it could also be designed to produce net taxation of a PE even if an equivalent local enterprise is not taxed on such a basis but is subject to some other form of taxation, for example, a local insurance company taxed on a percentage of premiums as a form of income tax. Generally earlier documents assume that business profits will be taxed on a net basis rather than requiring it though there are occasional hints that net basis taxation was an issue of concern.86 The US is sensitive to this matter as shown by the requirement for net basis taxation in relation to income from real property which is expressed in a way which reinforces the net taxation view of Article 7(3):87 A resident of a Contracting State who is liable to tax in the other Contracting State on income from real property situated in the other Contracting State may elect for any taxable year to compute the tax on such income on a net basis as if such income were business profits attributable to a permanent establishment in such other State. …

In the UN and US cases there is thus more justification for a non-discrimination reading of Article 7(3), and in the case of the US a net taxation requirement. This may have been necessary in 1940–1946 when the deduction rule was introduced as the then models did not have a PE rule in the non-discrimination article as the OECD now does in Article 24(3). In the modern context the issue arises of the relationship of Article 7(3) and Article 24(3) and the results for discrimination of the omission of the former from the Model in 2010.

Non-discrimination and Business Profits The OEEC/OECD non-discrimination article (apart from the deduction rule now in Article 24(4) of the OECD Model which dates from 1977) was developed 86 For intimations of this issue see the debate about Spanish terms for income/profits in the Mexico 1940 minutes, note 42. 87 Tax Analysts database, note 33, for all versions of the US model.

Book 1.indb 421

12/2/2011 8:22:26 AM

422

Richard Vann

slightly earlier than the business profits rule but partly parallel with it so it is not surprising that WP7 of the OEEC did not consider how Article 7 fitted with Article 24. Indeed the parallel work may have contributed to the lack of consideration of the possible non-discrimination explanation of Article 7(3) as the OEEC working parties generally steered clear of issues that seemed to belong with another part of the OEEC work. It was noted above that the League of Nations gave nondiscrimination as part of the explanation for the equivalents of both Articles 7(2) and 7(3). The history of the non-discrimination article would take us far beyond the reach of this chapter but in any event it is only recently that the OECD has begun to explore the relationship of that article with the rest of the Model as part of a review of its non-discrimination rules, the first step of which was to revise the Commentary on the current non-discrimination article.88 In that process the OECD recognised that if another provision of the Model permitted a particular form of discrimination, to that extent the operation of Article 24 was excluded. Conversely, although not stated as such, if another provision of the Model prevents discrimination not covered by Article 24, the latter would not be seen to qualify the former. Further, Article 24 is not to be interpreted as covering covert discrimination but is limited to explicit discrimination.89 If we turn to the separate enterprise arm’s length rule in Article 7(2) in any of its versions, it has the typical language of a non-discrimination rule (‘engaged in the same or similar activities under the same or similar conditions’) but critically does not provide a referent like nationality or residence which would give the rule bite as a non-discrimination rule unless it is read in. This is exactly what the League of Nations did in 1946:90 [the separate enterprise arm’s length principle] helps to enforce the principle of equality of treatment of foreigners by placing, in principle, branches of foreign enterprises on the same footing as similar establishments of domestic enterprises as regards the computation of receipts and expenses. [emphasis added]

The OEEC working party on non-discrimination did not adopt this view and hence felt that a separate provision was necessary, developing Article 24(3) for this purpose.91 That is not to say that Article 7(2) cannot work as a rule dealing with covert discrimination. This approach is now adopted by the OECD in the 2010 Commentary for explaining why no separate treaty rule is needed to deal with domestic law tax rules that deny deductions for expenses that do not relate exclusively to taxable income (the problem arising from certain domestic apportionment rules noted above):92 88 OECD, Application and interpretation of article 24 (non-discrimination): Public discussion draft (2007) available at http://www.oecd.org/dataoecd/59/30/38516170.pdf, incorporated with some modifications in the Article 24 Commentary in 2008. 89 OECD 2010 Model, note 2, Article 24 Commentary paras 1–4 at 332–333. 90 LHUSTC4, note 8, 4338. 91 FC/WP4(1), 5–7. Working Party 4 consisted of delegates from the Netherlands and France. 92 OECD 2010 Model, note 2, Article 7 Commentary para 31 at 139. For this kind of rule, see note 44 and text.

Book 1.indb 422

12/2/2011 8:22:26 AM

History and Purpose of the Business Profits Deduction Rule in Tax Treaties 423 domestic law rules that would ignore the recognition of dealings that should be recognised for the purposes of determining the profits attributable to a permanent establishment under paragraph 2 or that would deny the deduction of expenses not incurred exclusively for the benefit of the permanent establishment would clearly be in violation of paragraph 2 …

This is a plausible way to dispose of such apportionment rules as a problem for PEs and is consistent with the much greater play given to the separate entity aspect under the functionally separate entity approach now endorsed by the OECD. It is hard to see, however, how such an approach would deny the operation of a domestic rule such as noted by the UN which denies deductions for all enterprises, resident or non-resident with a PE, for expenses incurred offshore as there is no impact from treating the PE as a separate enterprise under Article 7(2) on the effect of such a rule. Moreover, Article 24(3) could not apply in such a case as there is no difference in treatment of residents and non-residents in relation to such payments though in the nature of a PE it is much more likely that such rules will impact on non-residents with PEs than residents, which as already noted is a case of covert discrimination.93 Some states introduce an additional element into Article 7(3) in their treaties, for example, Australia’s treaties typically add the words ‘and which would be deductible if the permanent establishment were an independent enterprise which paid those expenses.’94 The purpose is to deal with the kind of expenses that are denied or limited in deduction to all enterprises such as entertainment expenses so that a non-resident with a PE cannot argue that the deduction of such expenses is required by Article 7(3). The Commentary in 2008 was amended to make clear that Article 7(3) did not have this effect.95 If such an addition is adopted,

93 Attempts to bring in Article 24(4) in some combination with Articles 7(2) and/or 24(3) would likewise seem doomed to failure because the denial of deduction rule, if expressed in the simple form in the text, would equally apply to an offshore payment to a resident or non-resident by a resident or a non-resident. It is possible that a PE could get better treatment than a resident by arguing that if a notional transaction is involved, it can treat the notional payment to the rest of the enterprise as having been made onshore and not offshore. The OECD 1977 Model, note 6, Article 7 Commentary para 15 at 76 stated in relation to Article 7(3), ‘The deduction allowable to the permanent establishment for any of the expenses of the enterprise attributed to it does not depend upon the actual reimbursement of such expenses by the permanent establishment.’ This would not help in the case in question as it was dealing with deducting a share of an actual payment that in the case in question is assumed to be made offshore. But the idea that no payment (reimbursement) is required by Article 7(2), if applied to the functionally separate entity approach, could mean that the deduction is available without any payment being made under a notional transaction because no question arises of whether payment is made onshore or offshore. The OECD Model 2010, note 2, Article 7 Commentary para 34 at 140 deals with reconciliation of Article 24(3) with the separate enterprise arm’s length principle and states that Article 24(3) requires that the result be the same if the transaction is notional or the PE is deducting a share of actual expense but in applying Article 24(3) it seems to tie the tax treatment back to the actual expense incurred by the enterprise to third parties and so would not assist the taxpayer in the example under consideration if the actual payment is made offshore. 94 Australia Japan 2008. The New Zealand US 1948 treaty also had this addition, see note 50 and text. 95 OECD 2008 Model, note 3, Article 7 Commentary para 30 at 126. In one sense it is surprising that the OECD took so long to come to this conclusion; in another it is not, as difficult line drawing

Book 1.indb 423

12/2/2011 8:22:26 AM

424

Richard Vann

however, it does not seem to change the outcome for a domestic law tax rule denying deductions generally for offshore payments (or similar rules applicable equally to residents and non-residents which involve covert discrimination) as a resident enterprise cannot deduct them either. The broader justification of Article 7(3) that it is intended to provide for net taxation of PEs goes further than this covert non-discrimination approach though also encompassing it. It would require that a PE be taxed on a net basis even if in similar circumstances a resident enterprise is taxed differently and not just apply to rules more directly covered by the language of Article 7(3). Unless general deduction denial or limitation rules such as for entertainment are to be overridden, the difficulty for such a broad approach is to draw a distinction between rules that do not have any international implications and rules that are apparently neutral but effectively prevent net taxation in international situations which leads back to a covert discrimination approach though more broadly focused. Any number of possibilities can be imagined. A rule requiring some form of gross taxation of say agriculture in a developing country where most farmers are small and subsistence in nature would hardly work appropriately for a multinational agri-business and may amount to covert discrimination. On the other hand some form of such taxation for insurance may be appropriate for both local and multinational enterprises because they would be more substantively similar. It seems unlikely that the fairly literal OECD approach to the nondiscrimination article would find in Article 7(3) such an extensive prevention of covert discrimination that required this kind of line drawing. There is nothing in current or historic OECD materials that would support such an approach. The Commentary already provides an example of a possible non-discrimination provision outside Article 24 in relation to taxation of entertainers under Article 17 on a net basis:96 Where a resident of a Contracting State derives income referred to in paragraph 1 or 2 and such income is taxable in the other Contracting State on a gross basis, that person may, within [period to be determined by the Contracting States] request the other State in writing that the income be taxable on a net basis in that other State. Such request shall be allowed by that other State. In determining the taxable income of such resident in the other State, there shall be allowed as deductions those expenses deductible under the domestic laws of the other State which are incurred for the purposes of the activities exercised in the other State and which are available to a resident of the other State exercising the same or similar activities under the same or similar conditions.

is then involved as appears in the following text. The League of Nations had an express provision to bring it about. It is not a problem under the OECD 2010 Model with the deletion of Article 7(3). 96 OECD 2010 Model, note 2, Article 17 Commentary para 10 at 224–225. Compare the similar US model provision, note 87 and text, which, however, does not refer to taxation of residents in the way this variant does.

Book 1.indb 424

12/2/2011 8:22:26 AM

History and Purpose of the Business Profits Deduction Rule in Tax Treaties 425 This provision neatly demonstrates the issue. The particular problem at which it is directed is not covered by Article 24 because, in relation to Article 24(3), the non-resident need not have a PE and, in relation to the deduction provision in Article 24(4), because gross basis taxation of entertainers is generally not limited by reference to whether expenses are incurred to non-residents. Accordingly it was considered necessary to provide an optional non-discrimination rule outside Article 24 but it will be noted that the suggested provision takes the tax treatment of the resident as the referent even though requiring net taxation. How would that affect a provision like a denial of entertainment expenses applicable to residents and non-residents alike – such a rule contradicts the requirement of net taxation but not the similar treatment as residents. In summary on non-discrimination, the current approach under the OECD Model would seem to require quite specific and well framed rules to deal with possible forms of covert non-discrimination in the area of taxation of business profits rather than relying on broad interpretation of existing rules. The author is in favour of the OECD approach, being unconvinced by the current broad approach of the European Court of Justice under EU rules as the appropriate kind of response for tax treaties. Nonetheless covert discrimination should be dealt with where possible and to that end a provision like Article 7(3) but clearer in its drafting and intent would seem to be necessary at least as an option in the Commentary to the extent that general rules denying deductions for offshore payments continue to exist. The OECD should also seek to identify and deal with other domestic tax rules that can impact unfairly on PEs. The new Commentary to the OECD 2010 Model represents a beginning not an end to addressing this issue.

The Future More broadly the treatment of deductions demonstrates the deep kinds of divisions that exist in thinking about the taxation of PEs and multinational enterprises generally. The 2008 Attribution Report represents a return to an approach that allocates profits away from PEs especially in relation to the important intangible elements that go towards generating the income of the modern multinational. The current OECD exercise of reconsidering the treatment of intangibles in the context of separate but associated enterprises97 may begin to provide a rebalancing in thinking but that is by no means inevitable.

97 OECD, ‘Transfer Pricing and Intangibles: Scope of the OECD Project’ (2011) available at http:// www.oecd.org/dataoecd/10/50/46887988.pdf.

Book 1.indb 425

12/2/2011 8:22:26 AM

Book 1.indb 426

12/2/2011 8:22:26 AM

16 The Negotiation and Drafting of the 1967 United Kingdom – Australia Taxation Treaty C JOHN TAYLOR

ABSTRACT

T

HE 1967 UNITED KINGDOM – Australia Double Taxation Treaty was the first taxation treaty that Australia entered into after the publication of the 1963 draft OECD Model and was based on a United Kingdom draft influenced by the 1963 draft OECD Model. The treaty and the negotiations leading up to it are evidence of the Australian response to the 1963 draft OECD Model relatively shortly after its publication. Australia recognised that the treaty would ‘stand as something of a precedent’ as an indication to Australia’s potential treaty partners of how it would seek to vary several articles in the 1963 draft OECD Model. The chapter focuses on articles in the treaty most relevant to direct foreign investment or which highlight features of Australian treaty practice at the time and proceeds by examining archival evidence relating to the negotiation and drafting of these articles in the treaty. Then using examples from subsequent Australian treaties the paper argues that the 1967 United Kingdom – Australia Treaty had a significant influence on key structural features of and on the detail of several articles in subsequent Australian tax treaties. The 1967 United Kingdom – Australia Double Taxation Treaty is important for several reasons. It was the first treaty that Australia entered into after publication of the draft OECD Model and was based on a United Kingdom draft influenced by the OECD Model. Hence the treaty and the negotiations leading up to it are evidence of the Australian response to the draft OECD Model relatively shortly after its publication. Secondly the treaty was an indication to Australia’s potential treaty partners as to how it would seek to vary several articles in the OECD Model. In particular the treaty gave clear signals as to the

Book 1.indb 427

12/2/2011 8:22:27 AM

428

C John Taylor

rates of withholding tax on dividends, interest and royalties that Australia was prepared to agree to and that Australia would not agree to a non-discrimination article. In contrast to the OECD Model and United Kingdom practice the treaty contained some structural features, namely the replacement the ‘other income’ article with an article confined to third country tax that developed out of distinctive features of earlier Australian treaties. The United Kingdom at the time was a major trading and investment partner for Australia and was a net exporter of capital to Australia. This chapter will focus on articles in the treaty most relevant to direct foreign investment, or which highlight distinctive features of Australian tax treaty practice of time: namely: taxes covered; definitions of resident company; definitions of permanent establishment; industrial and commercial profits; income from immovable property; capital gains; associated enterprises; shipping and air transport; dividends; interest; royalties; foreign tax credits; other income; and non discrimination. Articles of relevance only to particular industries (film business and insurance) are not discussed in this chapter nor are the exchange of information, mutual agreement, and assistance in collection articles. The chapter proceeds by examining archival evidence1 relating to the decision to renegotiate the 1946 Treaty and the negotiation and drafting of selected articles in the 1967 Treaty. Following the discussion of the decision to renegotiate and the negotiation and drafting the paper will then, using examples from later Australian treaty practice, argue that the 1967 United Kingdom – Australia Treaty had a significant influence on key structural features and on the detail of several articles in subsequent Australian tax treaties.

THE DECISION TO RENEGOTIATE THE 1946 UNITED KINGDOM – AUSTRALIA TREATY

The origins of the treaty can be traced to a request by the United Kingdom for a protocol to the 1946 United Kingdom – Australia treaty. The 1946 treaty had required the United Kingdom to give a foreign tax credit to United Kingdom shareholders in Australian companies for underlying Australian corporate tax irrespective of the level of shareholding. At the time the 1946 treaty was entered into the United Kingdom operated what was in effect a form of dividend imputation system and had previously, under the system of Dominion Income Tax Relief, given a partial credit for underlying corporate tax irrespective of the 1 The archival sources relied on have been: William McMahon, ‘Confidential For Cabinet Committee On Taxation Policy, Submission 123 (McMahon, Submission 123), The Double Taxation Agreement With The United Kingdom.’ 3 March 1967, National Archives of Australia, Series A5842, Control Symbol 123; ‘Double Taxation : Re-negotiation of the Present Agreement between the United Kingdom and Australia’, National Archives of Australia, Series Number A571 Control Symbol 66/3007 (Australian Treasury file); ‘Revision of Double Taxation Agreement – Australia’ United Kingdom National Archives, IR 40/16741 (Inland Revenue file).

Book 1.indb 428

12/2/2011 8:22:27 AM

The 1967 United Kingdom – Australia Taxation Treaty

429

level of shareholding. When the United Kingdom introduced unilateral relief in 1950, credits for underlying tax were available irrespective of the level of voting power held by the recipient where the paying company was a resident of a Commonwealth country although a 25 per cent minimum voting power held by a United Kingdom resident company was required where the paying company was a resident of a non Commonwealth country.2 In 1965 the United Kingdom moved to a classical corporate tax system by introducing a corporation tax that was regarded as a separate tax from the tax on shareholders. As a consequence the United Kingdom sought to limit foreign tax credits for underlying corporate tax in its double taxation treaties by renegotiating the credit provisions in treaties through protocols. The general United Kingdom policy was to require a minimum 10 per cent voting power before an underlying credit was available in a treaty with a Commonwealth country but in some instances required a 25 per cent minimum voting power in treaties with non Commonwealth countries.3 The policy was consistent with amendments to the United Kingdom’s unilateral relief provisions, effective from 5th April 1966, under which a minimum voting power of 10 per cent was required for an underlying credit where the paying company was a Commonwealth resident while a 25 per cent minimum voting power was required where paying company was resident in a non Commonwealth country. From April 1966 onwards unilateral relief for underlying corporate tax irrespective of whether the paying company was resident in a Commonwealth or non-Commonwealth country was only available where the recipient of the dividend was a United Kingdom company.4 Rather than merely amending the foreign tax credit provisions of the treaty through a protocol Australia preferred that a new treaty be entered into. Australia had long thought that several features of the 1946 required revision. In particular, the exemption for dividends paid to a 100 per cent United Kingdom parent was inconsistent with the 50 per cent reduction in Australian 2 See the discussion in J E Talbot and G S A Wheatcroft, Corporation Tax, And Income Tax Upon Company Distributions (London, Sweet & Maxwell Ltd, 1968) at 18–01 pp 279 to 280. See also the discussion in C N Beattie and J C Wisely, Corporation Tax (2nd edition, London, Butterworths, 1966) at pp 170–171. Prior to their amendment in 1966 the provisions in operation were contained in Part I of the Seventeenth Schedule of the Income Tax Act 1952 (United Kingdom). Under para 3 of the Seventeenth Schedule a credit for foreign underlying corporate tax where the paying company was resident in a Commonwealth country was granted to a United Kingdom company that held a minimum of 10% of the voting power in the paying company. Where the paying company was a resident of a non Commonwealth country a credit for underlying tax was available for United Kingdom companies that held a minimum of 25% of the voting power in the paying company. Paragraph 4 of the Seventeenth Schedule then allowed a credit for foreign underlying tax to both individual and company recipients irrespective of the level of voting power held where the paying company was a resident of a Commonwealth country. 3 See the discussion of United Kingdom treaties in this period in Talbot and Wheatcroft, supra note 2 at 18–07 and 18–08 pp 282–284. 4 See the discussion in Talbot and Wheatcroft, supra note 2 at 18–09 to 18–11 pp 284–286 and in Beattie and Wisely, supra note 1 at pp 170–171. The changes in relation to the unilateral treatment of dividends paid by Commonwealth resident companies were achieved by repealing Paragraph 4 of the Seventeenth Schedule of the Income Tax Act 1952 (United Kingdom).

Book 1.indb 429

12/2/2011 8:22:27 AM

430

C John Taylor

tax agreed to under Australia’s subsequent treaties with the United States, Canada and New Zealand. Australia was concerned that the withdrawal of relief for underlying tax would remove the inducement for portfolio investment in Australia and might result in a reduction in the actual flow of portfolio investment. At a meeting between Australian and United Kingdom officials in Canberra in February 1966 the Australian delegation did not dispute the right of the United Kingdom to alter its taxation arrangements in a manner which best suited its own interests but pointed out that when a revision was to be made to the double tax treaty that affected the overall balance Australia was entitled to look for matching concessions. The Australian view was that this meant that a complete revision should be undertaken.5 In addition, Australia at the time was contemplating changes to its rules relating to the taxation of cross border dividends, interest and royalties. The United Kingdom view, by contrast, was that there was an urgent need for a protocol amending the foreign tax credit provisions in the treaty, as it feared the logical inconsistency between the new system of Corporations Tax and the treaty provision for an underlying credit irrespective of the level of shareholding could lead to a serious distortion in the United Kingdom tax system. United Kingdom officials assured the Australians that the United Kingdom was prepared to enter into discussions for general review of the treaty once a protocol had been agreed to.6 Throughout March, April and early May of 1966 the United Kingdom continued to request that Australia enter into a protocol.7 By 24th May 1966 the United Kingdom had made arrangements to renegotiate its treaty with New Zealand in the northern hemisphere autumn of 1966 or in the spring of 1967 and WHB Johnson the Under Secretary of the Board of Inland Revenue took the opportunity to ask if Australia could give any further indication of when it would like to undertake a complete review of the treaty.8 Originally it was envisaged that negotiations would take place in November 1966 but the Australian general election intervened and commitments of ministers and the illness of one of Australia’s experienced negotiators9 meant that the negotiations were rescheduled for March and April 1967 in Canberra.10

5

Inland Revenue file, ‘Notes of Meetings In Canberra 25th February 1966’. Inland Revenue file, ‘Notes of Meetings In Canberra 25th February 1966’ and WHB Johnson (Board of Inland Revenue) to ET Cain (Commissioner of Taxation) 1st March 1966. 7 Inland Revenue file, WHB Johnson to ET Cain 1st March 1966, ET Cain to WHB Johnson 1st April 1966, WHB Johnson to ET Cain 5th May 1966, ET Cain to WHB Johnson 17th May 1966. 8 Inland Revenue file, WHB Johnson to ET Cain 24th May 1966. 9 Inland Revenue file, Telegram From Canberra To Commonwealth Office 5th October 1966 (forwarding message from Australian Treasury to United Kingdom Chancellor of the Exchequer), Commonwealth Office to Canberra 13th October 1966 (forwarding message from the United Kingdom Chancellor of the Exchequer to the Australian Treasurer. 10 Inland Revenue file, FB Harrison to JF Wearing 18th October 1966, FP Harrison (British High Commission, Canberra) to WR Bickford, Economic Relations Department, Commonwealth Office, London, 21 November 1966. 6

Book 1.indb 430

12/2/2011 8:22:27 AM

The 1967 United Kingdom – Australia Taxation Treaty

431

THE INITIAL UNITED KINGDOM DRAFT

The United Kingdom submitted a draft treaty, influenced by the 1963 OECD draft Model, to Australia for consideration 20th September 1966.11 Prior to submitting the draft treaty the United Kingdom Board of Inland Revenue sought representations from other government bodies, business groups and from selected businesses on ‘points to which you wish to draw our attention’ in negotiating.12 Most representations were not received until after the draft was submitted and generally the representations from business groups and businesses do not appear to have had significant influence on the United Kingdom negotiating position.13 AUSTRALIAN REACTIONS TO THE INITIAL UNITED KINGDOM DRAFT AND CORRESPONDENCE BETWEEN OFFICIALS PRIOR TO NEGOTIATIONS

Australian Internal Reactions at the Official Level Australian internal reactions at the official to the United Kingdom draft can be seen in a letter by W J O’Reilly (Acting Second Commissioner of Taxation) to Sir Richard Randall (Secretary to the Commonwealth Treasury) dated 16th November 1966 and an accompanying memorandum.14 In analysing the United Kingdom draft O’Reilly and the Memorandum compared it with the previous Australia – United Kingdom treaty of 1946, the OECD Draft Model Convention and with previous United Kingdom treaty practice, particularly its recently concluded treaty with New Zealand. Many of the issues raised in O’Reilly’s letter and in the Memorandum had also been raised in negotiating the 1946 treaty. Corporate Dual Residence Tiebreaker One concern was with the proposed tiebreaker on corporate dual residence (place of effective management) in Article 3(3) of the draft. O’Reilly pointed out that a company incorporated in Australia but centrally managed and controlled in the United Kingdom would be an Australian resident for purposes of Australian domestic law, and hence (because of the ITAA 1936 s46 inter-corporate dividend rebate), be effectively exempt from Australian tax on dividends it received while Article 9 of the draft would mean that dividends that it paid to its United Kingdom parent would not be subject to Australian tax. O’Reilly noted that 11 Inland Revenue file, WHB Johnson to ET Cain 20th September 1966, FB Harrison (Inland Revenue) to JF Wearing (Commonwealth Relations Office) 20th September 1966. 12 Letters were sent on 12th September 1966 to The Board of Trade, The Treasury, The Confederation of British Industries, The British and Commonwealth Banks Association, The Taxation Committee of the British Insurance Association, the ANZ Banking Group and other businesses are contained in the Inland Revenue file. 13 An undated summary of the representations is contained in the Inland Revenue file. 14 W J O’Reilly (Acting Second Commissioner of Taxation) to The Secretary to the Treasury (Sir Richard Randall) and accompanying memorandum, 16th November 1966, Australian Treasury file.

Book 1.indb 431

12/2/2011 8:22:27 AM

432

C John Taylor

the problems of dual residency had been satisfactorily dealt with (presumably in the Australia – United Kingdom context) in the past without resorting to dual residency tiebreakers and that there did not seem to be convincing reasons for using dual residency tiebreakers in the proposed agreement. O’Reilly pointed out that the United Kingdom draft adhered closely to the OECD Model but that the tiebreaker provisions had been considerably modified in the recently concluded United Kingdom – New Zealand treaty.15 The Memorandum commented that an approach like that in the United Kingdom – New Zealand treaty would be more favourable to Australia than the tiebreaker in the United Kingdom draft but would not eliminate the possibilities for exploitation of tiebreaker provisions referred to earlier. Permanent Establishment The Memorandum noted that, apart from paragraph 4, the definition of ‘permanent establishment’ in the United Kingdom draft was a copy of the definition in the OECD Model. O’Reilly observed that the definition was much narrower than Australia would desire and narrower than the definition in the United Kingdom – New Zealand treaty. The Memorandum pointed out several respects in which the definition in the United Kingdom draft differed from that in the Australian model convention. These were that the United Kingdom draft did not include the following specific instances of a permanent establishment: • • • • •

An agency; An oil-well; An agricultural, pastoral or forestry property; An installation project that existed for more than twelve months; Supervisory activities on a building site or a construction, installation or assembly project for more than twelve months; and • The use or installation of substantial equipment or machinery by, or under contract with, an enterprise of one of the countries. An ‘agricultural or pastoral property’ had specifically been included in the definition of permanent establishment in the 1946 United Kingdom treaty. An agency, an oil well and the use or installation of substantial equipment had first been expressly mentioned in the ‘includes’ portion of the definition in the 1953 15 Under the United Kingdom – New Zealand Treaty a New Zealand company was defined as one which met the New Zealand definition of corporate residency (place of incorporation and centre of administrative or practical management in New Zealand or which was centrally managed and controlled in New Zealand. Under that Treaty a United Kingdom company was a company which was centrally managed and controlled in the United Kingdom which was not a New Zealand company. The effect of this definition would have been to exclude a company which was incorporated and had its centre of administrative management in New Zealand from being a United Kingdom company even if it were centrally managed and controlled in the United Kingdom. It may also have been arguable that a company with its central management and control divided between the United Kingdom and New Zealand would have been a New Zealand resident.

Book 1.indb 432

12/2/2011 8:22:27 AM

The 1967 United Kingdom – Australia Taxation Treaty

433

United States treaty. Installation projects and supervisory activities had not been expressly mentioned in any taxation treaty that Australia had entered into prior to 1966. The reference to these items appearing in the Australian model clearly suggests that Australia had developed a formal model treaty for use in negotiations by this stage. While the author as yet has not been able to locate a model Australian treaty dating from this period, it seems likely that it would have been developed in response to the several requests for a taxation treaty that Australia received from other countries between 1946 and 1966.16 O’Reilly’s concern also shows that the structure of earlier Australian treaties may have influenced Australian interpretation of later treaties even though they had a different structure. In earlier Australian treaties, such as the 1946 United Kingdom treaty and the 1953 United States treaty, the definition of ‘permanent establishment’ was a ‘means and includes’ definition; a form well known to common lawyers. Under a ‘means and includes’ definition the items referred to after the word ‘includes’ may deem items to be covered by the term that would not fall within the ‘means’ portion of the definition. The definition of ‘permanent establishment’ in the 1966 United Kingdom draft was structured differently and followed the OECD Model in this respect. Thus Article 4.1 of the draft was a ‘means’ definition of ‘permanent establishment’ and Article 4.2 stated that ‘permanent establishment’ ‘includes especially’ a list of specified items. Article 4.5 expressly deemed what would now be referred to as dependent agents to be permanent establishments. O’Reilly’s letter appears to reflect a concern that all of the items specified in his letter would have to be included in either Article 4.2 or in a specific deeming provision for them to be regarded as permanent establishments. This reflects thinking that sees Article 4.2 as functioning to deem items to be permanent establishments whether or not they were within the Article 4.1 definition. This interpretation is understandable given the ‘means and includes’ drafting of the definition of permanent establishment in Australia’s previous treaties. It is questionable whether this construction of the definition in the United Kingdom draft was appropriate given the presence of Article 4.5 which specifically deemed certain agencies to be permanent establishments. In 16 Although Australia received requests from several European countries for a taxation treaty in this period the only countries with whom even preliminary steps toward negotiations commenced were Singapore and Japan. Singapore requested a treaty in 1963 the same year as the OECD draft model was released. It appears highly likely that the development of these features of the Australian model began at this time. The OECD draft model contained an article deeming a building site or construction or installation project to be a permanent establishment if it lasted for more than twelve months. The Australia – Singapore treaty of 1969 (the next taxation treaty entered into by Australia after the 1967 United Kingdom treaty) contained a similar provision within the ‘includes’ portion of the definition but with a more easily satisfied time requirement periods aggregating six months within any 12 month period. (Australia – Singapore treaty 1969 Article 4(2)(i). The Australia – Singapore treaty also contained a deeming provision in relation to supervisory activities for periods aggregating six months within any 12 month period. In the Japan treaty of 1969 a building site or a construction, installation or assembly project was deemed to be a permanent establishment where it existed for more than six months as were supervisory activities carried on in relation to a building site, construction, installation or assembly project for more than six months.

Book 1.indb 433

12/2/2011 8:22:28 AM

434

C John Taylor

that respect the drafting arguably reflected the view that is currently taken in the OECD Model Commentary that the equivalent of Article 4.2 merely lists examples of items that are within the equivalent of Article 4.1 and that the only items that are permanent establishments that are not within the Article 4.1 definition are those that are expressly deemed to be permanent establishments under articles such as Article 4.5.17 The Memorandum noted that, under the United Kingdom draft, in contrast to the 1946 United Kingdom treaty agricultural, pastoral and forestry properties were dealt with under Article 5 (income from immovable property) and that this, if anything, would be on a basis that was more favourable to a source country than would taxation as a permanent establishment under the industrial and commercial profits article. As compared with the 1946 United Kingdom – Australia treaty the United Kingdom draft did not treat an agent who filled orders on a non resident’s behalf from a stock of goods maintained in Australia as a permanent establishment. The Memorandum noted that the absence of an equivalent provision and the presence of deeming warehousing activities to not be a permanent establishment meant that Australia would be unable, in the absence of anything more, to tax such activities by a United Kingdom firm. In a recognition of the bi-directional nature of trading relationships, however, the Memorandum observed that the converse was also true and that the levying of United Kingdom tax on the warehousing of Australian exports in the United Kingdom had been considered by the Department of Trade to be ‘something of an obstacle’ to export market development expenditure. The Memorandum noted that the United Kingdom draft did not include an equivalent provision to one found in Australia’s treaties with both New Zealand and Canada dealing with the situation where a United Kingdom company participated in the capital of an Australian company which manufactured goods to order for the United Kingdom company. The goods would then be sold by the United Kingdom company to an Australian company. Under the 1946 Australia – United Kingdom treaty Australia was unable to tax the United Kingdom company under the industrial and commercial profits article as it did not have a permanent establishment in Australia.18 The Memorandum noted that not only were provisions dealing with this situation contained in the Australia – New Zealand19

17

See OECD Commentary on Art 5(2) para 12. This was the situation arising in Case 110, (1955) 5 CTBR (NS) 656 where the Board of Review held that the United Kingdom company was not taxable under the Industrial and Commercial Profits article as it did not have a permanent establishment in Australia. For a discussion of the current relevance of the issues raised by Case 110 and the decision of the English courts in Firestone Tyre & Rubber Co Ltd v Llewellin (1957) 37 TC 111 see R J Vann, ‘Tax Treaties: The Secret Agent’s Secrets’ (2006) British Tax Review 345–382. The issue had been raised but not resolved at meetings between United Kingdom and Australian tax officials in London in 1959. See ‘Australian Double Taxation Talks; Meeting 22nd April 1959 and ‘Australian Double Taxation Talks; Meeting 11th May 1959, Inland Revenue file. 19 Article II(2) of the Australia – New Zealand Double Taxation Treaty of 1960. 18

Book 1.indb 434

12/2/2011 8:22:28 AM

The 1967 United Kingdom – Australia Taxation Treaty

435

and Australia – Canada20 treaties but also that the United Kingdom – New Zealand treaty contained a provision of this kind21 which was an improvement on the equivalent provision in the Australia – New Zealand treaty. Income from Immovable Property Article 5 of the United Kingdom draft, a provision based on the OECD Model, was new to Australia and O’Reilly considered that it was not essential in the Australia – United Kingdom context, that its inclusion might be avoided if possible, and, if it were included, that some clarification of its scope would be required. The Memorandum noted that under Article 5 Australia could continue to tax rents from United Kingdom owned property situated in Australia and royalties from the exploitation of Australian natural resources. The article would also mean that Australia could tax profits from agricultural and forestry enterprises in Australia without having to determine if the profits were industrial and commercial profits attributable to a permanent establishment in Australia. The Memorandum commented on problems that could arise due to differences between English and Australian law in relation to the classification of property as movable or immovable in the case of debts secured by immovable property. The Memorandum referred to the statements in the OECD commentary that no special provision in the income from immovable property article dealt with debts secured by immovable property as the question was settled by the provision (under the interest article) for a 10 per cent tax in the source country.22 Industrial or Commercial Profits and Associated Enterprises O’Reilly regarded the draft Industrial or Commercial Profits article as ‘basically satisfactory in concept’ but commented that it would be desirable for it to recognise Australia’s right to apply its general law where information was insufficient for the arm’s length basis provided for in the Article to be applied. The Memorandum noted that all of Australia’s existing agreements contained a provision to this effect. 23 The Memorandum explained that the chief provision that could be used was ITAA 1936 section 136 which enabled the Commissioner to determine ‘on an arbitrary basis’ the taxable income of a business controlled abroad where the Australian business either produced no income or less than might be expected. The Memorandum regarded section 136 as ‘an important section and one which it will be to Australia’s advantage to have recourse to if necessary under the new agreement’. The Memorandum pointed out that 20

Article II(2) of the Australia – Canada Double Taxation Treaty of 1957 Article II(viii) of the United Kingdom – New Zealand Double Taxation Treaty of 1966. 22 OECD Commentary on Article 6 paragraph 2.2. 23 This aspect of Australian treaty practice originated in the 1946 Australia – United Kingdom treaty. See the discussion in C John Taylor, ‘The Negotiation and Drafting of the UK – Australia Double Taxation Treaty of 1946’ [2009] British Tax Review 201 at 226 to 230. 21

Book 1.indb 435

12/2/2011 8:22:28 AM

436

C John Taylor

New Zealand had secured the ability to apply its equivalent provision in its recent treaty with the United Kingdom. O’Reilly’s letter and the Memorandum raised the same point in relation to Article 8 the Associated Enterprises article. It is clear from the Memorandum that the impetus for these modifications to the United Kingdom draft of these articles came from the third country (New Zealand). Thus the emphasis in the Memorandum is on what concessions third counties have recently been able to obtain from the United Kingdom rather than on what was normal United Kingdom practice. The Memorandum noted that remuneration of an enterprise for personal services, dividends, interest, royalties and rents were excluded from the definition of industrial and commercial profits except when effectively connected with a trade or business carried on through a permanent establishment. The Memorandum pointed out that in the latter case these items would be regarded as industrial or commercial profits and thus subject to full rates of source country tax. The comment should be read in the context of the limitations on the taxing rights of the source country of these types of income that are contained in other articles in the treaty. In particular O’Reilly’s comments on the interest article (discussed in more detail below) indicate that, in the absence of the interest article, the exclusion of interest from the definition of ‘industrial or commercial profits’ would have meant that Australia would have retained full source country taxing rights over interest. This had been the case under the 1946 treaty. The Interest article in the draft treaty limited source country taxation of interest. Hence it is understandable that the Memorandum commented that, in the present circumstances, regarding personal services income, dividends, interest, royalties and rents effectively connected with a permanent establishment as industrial or commercial profits would favour Australia. Neither O’Reilly’s letter nor the Memorandum made any express reference to whether capital gains would be within the definition of ‘industrial or commercial profits’. The Memorandum also raised an issue about the appropriateness of the reference to ‘under the same or similar conditions’ in paragraph 3 of the article. The Memorandum pointed out that ‘It is generally because of the conditions that exist between an enterprise and its establishment that the derivation of profits can be transferred at will between one country and the other. By having to calculate the attributable profits on the basis of the conditions that do in fact exist, the country in which the permanent establishment is situated may have to work on the basis of special conditions that it ought to be able to ignore for this purpose’. Australia had also raised the same problem when it negotiated the 1946 treaty and had the phrase removed after protracted negotiations. The Memorandum noted that when the 1946 treaty was negotiated Australia gave assurances that the attribution of profits to a permanent establishment would be determined on the basis that its activities were carried on under the same or similar conditions as were present in the case of the permanent establishment except for any special conditions imposed by the head office or a related entity.

Book 1.indb 436

12/2/2011 8:22:28 AM

The 1967 United Kingdom – Australia Taxation Treaty

437

The draft allowed for the deduction of all reasonable expenses, calculated on an arm’s length basis, in determining profits attributable to a permanent establishment. The Memorandum pointed out that the equivalent provision in the Australia – United States treaty of 1953 allowed Australia to apply the principles in ITAA 36 section 38 in calculating profit. The Memorandum suggested that it would be useful for Australia to have the section 38 principle recognised in the new treaty with the United Kingdom. The Memorandum observed that the definition of ‘industrial or commercial profits’ in the draft included income from the furnishing of services of employees or other personnel and commented that this was necessary to enable the country of source to tax profits of public entertainer companies. A subsequent section of the Memorandum argued that a source rule, along the lines of provisions in the 1946 treaty and in Australia’s treaties with Canada and New Zealand, should be inserted in the industrial and commercial profits article. The Memorandum regarded this as necessary if Australia were to tax such income of a non resident and if the United Kingdom were to give credit for the Australian tax. If a source rule were not present the Memorandum pointed out that it would be fruitless to regard ‘public entertainer’ companies as having a permanent establishment in Australia if the ordinary source rules meant that the income of the company arose outside Australia. The comment reflects concern about the operation of Australian domestic law in the absence of the article. Following the decision of the High Court in FCT v Mitchum (1965) 113 CLR 401 it was uncertain when the income a company which provided the services of a public entertainer would have an Australian source. Shipping and Air Transport Both O’Reilly’s letter and the Memorandum noted that the draft article continued to tax shipping and air transport on a residence basis but contrasted the draft article with both the 1946 treaty and the recently concluded United Kingdom – New Zealand treaty. Under the 1946 agreement the exemption only applied to ships registered in the United Kingdom and operated by a United Kingdom resident. Under the draft, and in the New Zealand agreement, the exemption would apply wherever the ship was registered provided it was operated by a United Kingdom resident. In addition, in combination with the definition of ‘international traffic’ in Article 2, the exemption in the draft applied, consistently with the 1946 treaty, to ships and aircraft operated by a United Kingdom resident solely between places in Australia. Under the United Kingdom – New Zealand agreement, by contrast, the exemption only applied to traffic between places in New Zealand where that traffic was in the course of a voyage which extended over more than one country. The Memorandum noted that the absence of a requirement of registration in the United Kingdom and the definition of ‘international traffic’ in the draft meant that under it the exemption would apply to profits of a United Kingdom operator of an Australian registered

Book 1.indb 437

12/2/2011 8:22:28 AM

438

C John Taylor

tanker wholly between Australian ports. The Memorandum commented that if Australia sought to continue to confine the operation of the exemption to ships registered in the country of residence then the United Kingdom might be expected to argue that the Australian arbitrary method of calculating shipping profits as 5 per cent of outwards freights and passage moneys did not give a true measure of Australian source income. This might then mean that there would be problems in obtaining a United Kingdom credit for the Australian tax paid by United Kingdom operators of ships registered outside the United Kingdom. The Memorandum observed, however, that this was ‘the opposite side of the coin’ to the use of arbitrary methods by the United Kingdom in calculating the profits of life assurance companies24 and that ‘the UK may not press the point’. Dividends Under the 1946 Treaty no tax was imposed on dividends paid by 100 per cent subsidiaries to parent companies resident in the treaty partner country. The Australian tax on other dividends and the United Kingdom surtax on other dividends were both reduced by 50 per cent under the 1946 Treaty. The 1966 United Kingdom draft did not specific rates of source country tax on dividends but envisaged that a different, and O’Reilly presumed lower, rate would apply where the dividend was paid to a shareholder controlling 25 per cent or more of the voting power in the paying company. The Memorandum noted that the United Kingdom – New Zealand treaty provided for a uniform 15 per cent rate on dividends. The Memorandum considered that the United Kingdom might be contemplating the rates specified in the OECD Model, namely 5 per cent for non portfolio dividends and 15 per cent for other dividends. If so, the Memorandum commented, Australia would be gaining revenue in the wholly owned subsidiary situation but would be losing revenue in respect of companies where 25 per cent of the voting power but less than 100 per cent of the shareholding was controlled by a United Kingdom resident. The Memorandum pointed out that, because of the availability of a credit for underlying tax for United Kingdom companies having at least 10 per cent of the voting power in the paying company, the United Kingdom revenue would generally not benefit in these cases from any reduction in the Australian tax on dividends below 15 per cent. The Memorandum went on to observe that there would be no benefit to the Australian revenue from the United Kingdom proposals in relation to United Kingdom dividends received by an Australian company but that there would be some benefit in the case of dividends received by Australian individuals.25

24 At the time both United Kingdom and Australian tax law contained special provisions that taxed certain profits of life assurance companies using arbitrary methods. This chapter does not discuss the treaty negotiations relevant to these provisions. 25 For non private companies and for private companies which did not have a Division 7 tax undistributed profits tax liability, the s46 rebate meant that no Australian tax would be collected

Book 1.indb 438

12/2/2011 8:22:28 AM

The 1967 United Kingdom – Australia Taxation Treaty

439

The Memorandum pointed out that the draft contained a definition of the dividends in respect of which United Kingdom tax was to be limited for the purposes of the treaty. The definition, particularly in relation to private companies, adopted an ‘in substance’ approach under which interest and royalties could be classified as dividends in some circumstances. This meant that it would include some items that would not be dividends for Australian domestic law purposes and even some that would not be taxable under Australian domestic law. When combined with Articles 10(4) and 11(4) of the draft the Memorandum considered that the effect of the definition of ‘dividend’ appeared to be that the United Kingdom could levy tax at dividend rates on certain interest and royalties that could be treated as dividends under United Kingdom law. In the case of interest on a foreign source dividend. Hence any reductions in United Kingdom tax on dividends paid to Australian companies would not result in any additional Australian tax being collected. By contrast, under Article XII(2) of the 1946 United Kingdom – Australia Double Tax Treaty an Australian resident taxpayer was entitled a foreign tax credit for net United Kingdom tax deducted from a dividend provided the Australian resident elected to have the dividend grossed up for the net United Kingdom tax deducted. Article XII(2) was subject to provisions as Australia might enact. Hence, as Article XII(2) was subject to s45 the combined effect of s45 and s46, as noted above, was that for non private companies and for private companies that did not have a undistributed profits tax liability, s46 meant that no Australian tax would be collected on a United Kingdom source dividend. The operation of Article XII(2) is discussed in JAL Gunn, OE Berger and M Mass, Gunn’s Commonwealth Income Tax Law And Practice (7th edn, Butterworths, Sydney, 1963) at 4563–4574E. Examples illustrating the interaction of Article XII(2) and s46 in the case of dividends received by Australian private companies are in [4569] and [4570]. These points were noted in the comments on Article 21 in O’Reilly’s Memorandum. Article XII(2), however, meant that Australian taxpayers other than companies could be entitled to net United Kingdom tax deducted at the standard rate. In essence this involved allowing an Australian resident shareholder other than a company a credit for United Kingdom corporate tax irrespective of the Australian resident’s level of shareholding in the United Kingdom company. O’Reilly’s Memorandum in commenting on Article 21 of the United Kingdom draft noted this possibility but saw it as only a transitional problem given the changes to the United Kingdom corporate – shareholder tax system. Following the introduction of corporation tax in 1965 the United Kingdom had, pending the conclusion of a new treaty, unilaterally decided to limit its tax on dividends paid by United Kingdom companies to Australian residents to 15% being the rate of tax levied by Australia on dividends paid by Australian companies to United Kingdom shareholders. Australian authorities had been notified of this intention at a meeting of United Kingdom and Australian inland revenue, tax, treasury and high commission officials at Canberra on 25th February 1966. See ‘Revision of Double Taxation Agreement – Australia’ United Kingdom National Archives, IR 40/16741 ‘Note of Meeting In Canberra 25th February 1966. Article 21(1)(b) restricted the availability of credits in the United Kingdom for Australian underlying corporate tax to United Kingdom companies which had a 10% or more voting power in the Australian company paying the dividend. The United Kingdom draft indicated that the corresponding provision was to be drafted by Australia. A marginal note to Article 21 of the United Kingdom draft indicated that the inclusion of Article 21(1)(b) was subject to reciprocity. O’Reilly’s Memorandum commented that, given that the s46 rebate meant that Australia did not normally tax foreign source dividends received by Australian companies, the United Kingdom might not insist on reciprocity. This together with the comment in O’Reilly’s Memorandum of the need to deal with the transitional problem of Australia giving credit for underlying United Kingdom corporate tax on dividends make it reasonably clear that O’Reilly was envisaging that Australian resident portfolio shareholders would not be entitled to underlying foreign tax credits on United Kingdom sourced dividends. If so then limiting the United Kingdom tax on portfolio dividends to 15% in contrast to deduction of tax at the standard rate of 38.75%, would, when combined with the s45 foreign tax credit, have meant that more Australian tax would be collected on dividends paid by United Kingdom companies to Australian portfolio shareholders.

Book 1.indb 439

12/2/2011 8:22:28 AM

440

C John Taylor

this would be where the interest was paid to an Australian company with greater than 50 per cent control. In the case of royalties this would be where the royalty was paid between companies under common management where the Australian company had a greater than 50 per cent control. Under the draft the concessional rates of tax on dividends were only available to beneficial owners of the dividends. The Memorandum recognised that this was an anti avoidance provision but observed that both Australia and the United Kingdom taxed trustees on dividends. A solution to this problem had been developed in the United Kingdom – New Zealand treaty but the Memorandum observed that the solution there adopted would mean that an Australian charitable trust would be subject to full rates of United Kingdom tax on United Kingdom sourced dividends it received. The Memorandum commented that Article 9(4) was understood to relate to anti dividend stripping provisions in United Kingdom law and was intended to allow the United Kingdom to tax at full rates dividends paid to an Australian dividend stripper. Article 9(7) of the draft extended beyond the equivalent provision in the 1946 Treaty in that it precluded Australia from taxing dividends paid by United Kingdom residents to shareholders who were not Australian residents as distinct from the narrower subset of shareholders who were United Kingdom residents. The Memorandum commented that this aspect of the extension in Article 9(7) was consistent with Australia’s treaties with Canada and New Zealand and with the Australian model treaty. Clearly here the progressive development of Australian treaty practice is referred to as being consistent with United Kingdom treaty practice as evidenced by the draft. The Memorandum noted, however, that Article 9(7) would also free a United Kingdom private company operating in Australia from undistributed profits tax but commented that undistributed profits tax was rarely levied on non resident companies. The Memorandum here implicitly makes a comparison with Australian treaty practice and also points out difficulties under Australian domestic law. Interestingly neither O’Reilly’s letter nor the Memorandum refer to the saving provision in the 1946 United Kingdom treaty; a provision which had been the product of considerable negotiation. However, the primary concern in the 1946 negotiations was with the imposition of undistributed profits tax on an Australian resident subsidiary of a United Kingdom company not with the imposition of the tax on a branch of a United Kingdom company. Nonetheless Australia in 1946 had been concerned that a United Kingdom company trading in Australia not be put in an advantaged position when compared with an Australian company.26 In the interim, however, Australian undistributed profits tax had been narrowed by not being applied to public companies thus limiting the prospects of it applying to an Australian branch of a United Kingdom multinational. 26 See the discussion of the negotiation of the 1946 United Kingdom – Australia Treaty in Taylor, supra note 23.

Book 1.indb 440

12/2/2011 8:22:29 AM

The 1967 United Kingdom – Australia Taxation Treaty

441

Interest As discussed in Part II, under the 1946 Treaty interest had not been dealt with under the distributive rules with the intention that the source country retain full taxing rights in relation to interest. O’Reilly’s letter stressed this point. The Memorandum noted that the draft Article 10 taxed interest on a residence basis except in the case of interest effectively connected with a permanent establishment. Where the borrower and lender were not at arm’s length the exemption from source basis taxation was not to apply to interest above a normal commercial rate. Both the Memorandum and O’Reilly’s letter observed that the United Kingdom – New Zealand treaty did not contain an equivalent article and concluded that this meant that New Zealand retained full source country taxing rights in relation to interest.27 Royalties The draft royalties article, Article 11, differed from the equivalent article in the 1946 Treaty in that it meant that film royalties, in addition to other royalties, would be taxed on a residence basis. As was the case with the 1946 Treaty, the definition of royalties did not extend to mineral royalties. Both O’Reilly’s letter and the Memorandum contrasted the draft article with the equivalent provision in the United Kingdom – New Zealand treaty. That treaty imposed an upper tax rate of 10 per cent on the source taxation of royalties except in the case of royalties effectively connected with a permanent establishment. O’Reilly commented that under the United Kingdom – New Zealand treaty motion picture royalties were excluded with the effect that they remained taxable under the provisions of the law of each country. The Memorandum noted that New Zealand currently levied taxes equivalent to 11 per cent of the gross rentals of British films. Capital Gains Although the draft contained a capital gains article O’Reilly’s letter commented that it had no real relevance while Australia did not have a capital gains tax. Both O’Reilly’s letter and the Memorandum observed that, from the United Kingdom perspective, the article added little if anything to existing United Kingdom law. The Memorandum categorised the article as applying a similar principle to that applied in the industrial and commercial profits article, namely that source taxation of capital gains was only permitted in relation to property 27 The Memorandum also noted that Article 10(5) had no equivalent in other Australian agreements. The article allowed a source country to tax interest derived by a tax exempt institution from interest bearing securities traded on a stock exchange where the institution was trafficking in securities. The Memorandum commented that Article 10(5) did not appear to have any effect for Australian tax purposes.

Book 1.indb 441

12/2/2011 8:22:29 AM

442

C John Taylor

which was an asset of a permanent establishment in the source country. The comment in part reflects differences between the draft article and the capital gains article of the 1963 draft OECD Model Convention. Article 13(1) in the OECD Model gave the state of situs the right to tax gains from the alienation of immovable property. No equivalent provision was contained in the 1963 United Kingdom draft under which, except in the case of gains from the alienation of ships and aircraft, source taxation of capital gains was confined to situations where the gain was from the alienation of property forming part of a permanent establishment of an enterprise of one of the territories in the other territory or of property pertaining to a fixed base available to a resident of one of the territories in the other territory for the purpose of performing professional services. Such source taxation was also permitted under the OECD Model. In addition, both the draft and the OECD Model, explicitly gave the source country the right to tax gains from the alienation of the permanent establishment itself or of the fixed base.28 The Memorandum commented that the practical effect of the insertion of the article would be to similarly limit Australian source taxation of capital gains if Australia ever introduced a capital gains tax. O’Reilly’s letter commented that one advantage of the article was that it would limit the scope of future United Kingdom capital gains tax on Australian property to what was contained in the present United Kingdom law. The fact that source taxation under the capital gains article in the draft was confined to situations where the property alienated formed part of the property of a permanent establishment or pertained to a fixed base, together with the fact that capital gains (unlike dividends, interest and royalties) were not explicitly excluded from the operation of the industrial and commercial profits article raises questions about the scope of the industrial and commercial profits article. As the draft contemplated that capital gains on property forming part of the property of a permanent establishment were to be taxed under the capital gains article it is clear that the draft did not intend for such capital gains to also be the subject of source taxation of a permanent establishment under the industrial and commercial profits article. In other words the draft did not consider that capital gains were within industrial and commercial profits as defined even though (unlike dividends, interest and royalties) they were not expressly excluded from the definition. The explanation for this may be that under United Kingdom and Australian law capital gains had not been included in the ordinary concept of an income as a business gain and in the United Kingdom had only been taxed through the introduction of statutory provisions that explicitly taxed capital gains. An interpretation of treaties which saw industrial and commercial profits as not including capital gains and which saw capital gains taxed under a separate 28 Unlike the OECD Model the draft did not contain provisions excluding gains on moveable property dealt with under Article 22 of the OECD draft (dealing with Taxation of Capital) from taxation under the capital gains article. The draft did not contain any equivalent to Article 22 of the OECD Model.

Book 1.indb 442

12/2/2011 8:22:29 AM

The 1967 United Kingdom – Australia Taxation Treaty

443

article would thus seem natural to United Kingdom tax officials as it would mirror the structure of United Kingdom domestic law taxing capital gains.29 Other Income The Memorandum noted that the Other Income article was new to Australia and that it taxed income from sources not otherwise mentioned in the Treaty on a residence basis. The Memorandum commented that under all of Australia’s existing treaties income not expressly mentioned may be taxed in the source country with the residence country allowing a credit for the source country tax. As O’Reilly’s letter pointed out the draft article was precisely the converse of Australia’s existing agreements. The Memorandum identified the income that would be covered by the article as the draft stood at that point.30 This was: income from a trust or estate; some alimony payments; and income derived from a third country. In the case of trust income the Memorandum considered that the draft might exempt all income derived by a United Kingdom resident from Australia via a trust; if so this would clearly be inappropriate. O’Reilly considered that, nonetheless, with some technical amendments the article might prove satisfactory. Whether or not this was possible would, in O’Reilly’s view, depend on the general context of the Treaty as concluded in other respects. Credits O’Reilly noted that the main point about the Credit article was that it would withdraw credit for Australian underlying corporate tax in respect of dividends paid by an Australian company to a United Kingdom resident except where the recipient was a company that controlled 10 per cent or more of the voting power in the Australian company. The Memorandum noted that this change was in line with the amendments to the unilateral credit provisions which the United Kingdom had enacted in its domestic law. As noted earlier this change in the credit article was the United Kingdom’s principal objective in renegotiating the Treaty. The Memorandum observed that the draft contained a note to the effect that crediting of underlying tax by the United Kingdom was ‘subject to reciprocity’. The Memorandum pointed out that the section 46 rebate meant that dividends received by Australian public companies from United Kingdom 29 The question of whether Australia’s pre capital gains tax treaties provided protection from Australian taxation of capital gains made by enterprises that did not have a permanent establishment was answered in the affirmative in Virgin Holdings SA v Commissioner of Taxation [2008] FCA 1503 and in Undershaft v Commissioner of Taxation [2009] FCA 41. See the discussion of these cases in R J Vann, ‘Comment on Virgin Holdings SA v Commissioner of Taxation [2008] FCA 1503 and Undershaft v Commissioner of Taxation [2009] FCA 41’ (2009) 11 International Tax Law Reports 653–672. 30 Here it is worth noting that the draft included ‘interest’ and ‘capital gains’ articles. If these articles had been excluded, as had been previous Australian treaty practice, then interest and capital gains would have been dealt with under the ‘other income’ article.

Book 1.indb 443

12/2/2011 8:22:29 AM

444

C John Taylor

companies did not bear Australian tax and that, except in unusual cases, this would be the position in the case of Australian private companies. The Memorandum considered that, in these circumstances, the United Kingdom might not insist on reciprocity. Non Discrimination Both the Memorandum and O’Reilly’s letter noted: that there was no equivalent provision in existing Australian treaties; that, subject to certain reservations by New Zealand, it was contained in the United Kingdom – New Zealand Treaty; and that it was an OECD provision. O’Reilly went on to list examples of ways in which Australia discriminated between residents and non-residents. These were: (i) the rebate on dividends received by resident companies; (ii) limiting to residents only deductions for capital subscribed to prospecting companies; and (iii) the exemption for residents of income derived from the mining of uranium. The Memorandum explained that the article would mean that Australia would have to free from Australian tax a dividend flowing to a United Kingdom company where the dividend was attributable to its Australian permanent establishment. The Memorandum considered that a situation where a dividend might be attributable to an Australian permanent establishment was where dividends flowed to a United Kingdom resident bank from its Australian subsidiary. The Memorandum noted that the article would mean that capital subscribed by a non resident to petroleum exploration companies would have to be deductible and that this, presumably because of the operation of the United Kingdom’s foreign tax credit system, could produce benefits for the United Kingdom Treasury rather than for the United Kingdom investor. The Memorandum also referred to proposals for the introduction of withholding taxes on interest and royalties under which the tax cost for a payer who failed to withhold varied according to the residence status of the payer. The Memorandum commented, ‘This sort of differentiation may, it seems, be prohibited by article 22’. O’Reilly referred to a memorandum sent to the Treasurer, dated 7th July 1964, as part of the Japanese negotiations. For the reasons set out in that memorandum O’Reilly considered the article undesirable and commented, ‘Even if it were re-drafted to permit us to continue all our present ‘discriminations’ it would still be clearly restrictive on future policy’. A similar concern is evident in the Memorandum which states that acceptance of the article would preclude Australia in the future from discriminating against foreign owned companies. After noting that State taxes and other Commonwealth taxes would be within the prohibition the Memorandum pointed out that the equivalent article in the United Kingdom – New Zealand Treaty only applied to the taxes covered by the that Treaty.

Book 1.indb 444

12/2/2011 8:22:29 AM

The 1967 United Kingdom – Australia Taxation Treaty

445

Initial Australian Reactions at the Ministerial Level As noted above, the key reason why the United Kingdom wanted the 1946–47 treaty renegotiated in 1967 was because changes in the United Kingdom system of corporate shareholder taxation meant that the United Kingdom wanted the foreign tax credit provisions in the treaty restricted. William McMahon, the Australian Treasurer in 1967, in a submission to cabinet considered that this change was one that Australia would have to agree to: It is this conflict between the provisions of the agreement and their new law that the British are particularly anxious to remove. Clearly we will have to accommodate them on this. The requirement, which is a legacy of the peculiar form of their former taxation system, is inconsistent with their present system, and it would not be reasonable to ask them to retain it. For them, it means that investors in companies operating in Australia are taxed more lightly than investors in companies operating at home, which is contrary to their basic policy.31

The submission considered that the United Kingdom draft (and the OECD model on which it was based) technically unsatisfactory at several points. This was because the provisions had been designed to suit the situation of bidirectional income flows that existed between the main OECD countries and not the position as between the United Kingdom and Australia where the income flows were largely uni-directional.32 The submission argued that any treaty Australia negotiated with the United Kingdom at this time would ‘stand as something of a precedent’ when it came to negotiate treaties with other countries especially given the United Kingdom’s renewed interest in EEC membership.33 As will below several features of the Australia – United Kingdom Double Taxation Treaty of 1967 were to become part of Australian Double Taxation Treaty policy and practice for the next three decades. The end result of the negotiations was a Double Taxation Treaty which still retained some features of the colonial model in its definition of industrial and commercial profits and in the absence of a capital gains tax article or another income article but which was closer to the 1963 Draft OECD Model than Australia’s previous Double Taxation Treaties had been. The submission regarded the following as the key United Kingdom proposals: 1. A more restrictive definition of ‘permanent establishment’ than was contained in the 1946–47 Treaty removing some agency activities of United Kingdom firms from Australian tax; 2. That shipping and aircraft profits continued to be taxed on a residence basis but irrespective of the place of registration; 3. A reduced rate of taxation on dividends paid to residents of the other country with a further reduction for dividends paid to companies with a 25 per cent or more shareholding; 31

Mc Mahon, Submission 123, p 5, para 9. McMahon, Submission 123 at pp 13–14, para 24. 33 McMahon, Submission 123, at p 13, para 25. 32

Book 1.indb 445

12/2/2011 8:22:29 AM

446

C John Taylor

4. Interest and royalties (including film royalties) to be taxed on a residence basis; 5. The credit for Australian underlying corporate tax to be only available to United Kingdom companies with a 10 per cent or more shareholding in the Australian company; 6. A non discrimination article; 7. Taxation of other income on a residence basis.34

McMahon’s submission and the cabinet decision on what should be Australia’s negotiating position on key articles in the United Kingdom draft are discussed in the following paragraphs. Note that the primary focus of the submission and of the cabinet decision is on setting a clear initial Australian negotiating position on withholding tax rates, exemptions and the scope of definitions with little or no consideration being given to the technical issues raised in O’Reilly’s letter and the Memorandum. Permanent Establishment The submission regarded the definition of permanent establishment in the United Kingdom draft as unduly restrictive, being more restrictive than the definition in the 1946–47 treaty which was itself thought to be unsatisfactory in several respects. The submission recommended pressing for a more comprehensive definition of permanent establishment which would include an agency, an oil well and an installation project existing for more than twelve months.35 The technicalities in relation to the definition of permanent establishment were to be left to the negotiators, along with other matters such as the treatment of pensions, subject to consultation where necessary on a ‘best interests’ basis.36 Dividends The 1946–47 Treaty reduced Australian tax at source on dividends by one half and exempted dividends paid by 100 per cent subsidiaries to their United Kingdom parent from Australian shareholder tax. The exemption of the dividend paid to a United Kingdom parent company when combined the effects of the United Kingdom’s then new foreign tax credit system appeared to produce benefits for the United Kingdom investor when a comparison was made with the position under the Dominion Income Tax Relief system. The effective rate of tax on these dividends was reduced from 66.25 per cent under the Dominion Income Tax Relief system to 50 per cent being the United Kingdom standard rate. The exemption had been negotiated as part of an overall package which importantly included the replacement of Dominion Income Tax Relief with the more generous United Kingdom foreign tax credit system.37 34

ibid, at pp 14–15, para 24. ibid, pp 23–24, paras 46 to 47. 36 ibid, at p 24, para 48. 37 For a detailed discussion of the negotiations see, Taylor, supra note 23. 35

Book 1.indb 446

12/2/2011 8:22:29 AM

The 1967 United Kingdom – Australia Taxation Treaty

447

By 1967, however, Australia was viewing the exemption from a different perspective. The comparison now made was no longer between the Treaty position and the position under Dominion Income Tax Relief. Rather, the comparison was between the Treaty position and what the position would be under the United Kingdom’s foreign tax credit system if withholding tax on dividends paid by Australian 100 per cent subsidiaries had merely been reduced rather than exempted. Australia appreciated that, when the exemption was viewed from this perspective, its principal beneficiary was the United Kingdom Exchequer not the United Kingdom direct investor. In the absence of the exemption it was likely that United Kingdom parent companies would have most, if not all, of their United Kingdom tax on dividends received from their Australian subsidiary eliminated by the United Kingdom foreign tax credit system. The submission recommended and cabinet decided that Australia argue for a uniform maximum rate of 15 per cent withholding tax on all dividends (except for certain special transactions through permanent establishments). This proposal was consistent with Australia’s other three double taxation agreements and with the United Kingdom’s newly revised agreements with the United States, New Zealand and Canada. Eliminating the exemption for dividends paid by 100 per cent subsidiaries to their United Kingdom parent would increase the overall tax burden on these dividends but would put them in the same position as United Kingdom companies with a 10 per cent or more shareholding in an Australian company who would obtain a United Kingdom foreign tax credit for the underlying Australian corporate tax. This was seen as removing the strong incentive that the exemption provided for United Kingdom companies to acquire and retain 100 per cent ownership of Australian companies. Using the same logic Australia did not favour the United Kingdom proposal for a further reduction in withholding tax for dividends paid to United Kingdom companies with 25 per cent or more ownership.38 The submission makes a concrete recommendation on Australia’s opening negotiating position on withholding tax rates, something that neither O’Reilly’s letter nor the Memorandum did. Conversely, the submission is less concerned with detailed technical questions than are either O’Reilly’s letter or the Memorandum. Interest The 1946–47 Treaty was silent on the taxation of interest, as had been all of Australia’s other Treaties prior to 1967, leaving full taxing rights with the source state. McMahon’s submission proposed to continue to assert this right but proposed to introduce a withholding tax system for interest paid to non residents.39 Again, in contrast to both O’Reilly’s letter and the Memorandum, the submission proposed a firm decision on an initial negotiating position. 38 39

Book 1.indb 447

McMahon, Submission 123 at pp 16–17, paras 27 to 29. ibid, at pp 18–19, paras 33 to 34.

12/2/2011 8:22:30 AM

448

C John Taylor

Royalties The 1946–47 Treaty gave Australia the right to tax film and television royalties. McMahon’s submission was that Australia’s initial negotiating position should be that Australia should have the right to tax royalties at source through the use of a proposed withholding tax system.40 The submission contrasts with both O’Reilly’s letter and the Memorandum by recommending a firm decision on the imposition of tax at source. Shipping Profits The Submission proposed, as a bargaining point in negotiations, that Australia have the right to tax 2.5 per cent of the outward freight and passenger fares from shipping. In the absence of a treaty Australia taxed 5 per cent of the freight and fares. Australia expected strong resistance from the United Kingdom on this point and was prepared to concede it to gain the right to tax coastal shipping which the United Kingdom had recently conceded in treaties with New Zealand and Canada.41 Foreign Tax Credits The Submission recognised that Australia would have to concede a minimum shareholding qualification for the United Kingdom credit for foreign underlying tax. Australia, as a bargaining ploy to assist on other issues, proposed that the qualification be a 5 per cent United Kingdom corporate shareholding not the 10 per cent minimum shareholding requirement of United Kingdom domestic law. In 1967 foreign source dividends received by Australian public companies (and by private companies in most situations) were not subject to Australian tax because of the ITAA 1936 section 46 inter-corporate dividend rebate. Hence, Australia had not regarded it as necessary to grant a corresponding credit for United Kingdom underlying tax in the inter-corporate context. The Treasurer recognised, however, that if Australia were to adopt a general foreign tax credit system, the United Kingdom would expect Australia to give credit for United Kingdom underlying corporate tax in equivalent circumstances to those where the United Kingdom gave such credit. 42 If it adopted a general foreign tax credit system Australia recognised that it would also have to give equivalent relief to that provided by the United Kingdom for other dividends, interest and royalties.43 In 1967 Australia’s dividend withholding tax system still permitted a non resident to elect to be taxed on an assessment basis with credit being given for the withholding tax deducted. For foreign tax credit purposes the United 40

ibid, at pp 19 to 20, paras 35 to 38. ibid, at pp 17–18, paras 30 to 32. 42 ibid, at p 20 to 22, paras 39 to 41. 43 ibid, at p 23, para 45. 41

Book 1.indb 448

12/2/2011 8:22:30 AM

The 1967 United Kingdom – Australia Taxation Treaty

449

Kingdom had refused to credit Australian dividend withholding tax and only credited Australian tax where the United Kingdom shareholder elected to be taxed in Australia on an assessment basis. The Treasurer proposed to remove the right for non resident shareholders to elect to be taxed on an assessment basis in the expectation that this would mean that the United Kingdom would thereafter credit Australian dividend withholding tax.44 Non Discrimination The origins of Australia’s long standing opposition to the non discrimination article can be seen in its response to the United Kingdom’s request for a non discrimination article based on the OECD Model. The Treasurer’s submission noted that the proposed article would conflict with certain provisions of Australian law such as the restriction of the inter-corporate rebate to resident companies. The Treasurer commented that, ‘While it might be possible to negotiate provisions with sufficient qualification to make them compatible with our law, I think it would be best to avoid any provisions on “non-discrimination”’.45

Correspondence between Australian and United Kingdom Officials on the Draft Prior to Negotiations The Australian Commissioner of Taxation (ET Cain) wrote to WHB Johnson Under Secretary of the United Kingdom Board of Inland Revenue on 13th December 1966 raising technical and drafting points and seeking clarification on some aspects of United Kingdom law. Cain expressly stated that his letter did not represent the beginning of formal negotiations, that he had not had direction from Ministers on the form or substance of the agreement and stressed that his letter did not refer to any matters which from an Australian government viewpoint were major matters of policy.46 Johnson made a detailed reply to Cain’s letter on 3rd February 1967.47 In the following paragraphs each of Cain’s points and Johnson’s response to it will be discussed together. The discussion will also highlight differences between Cain’s letter and the correspondence 44 Mc Mahon, Submission 123, at pp 17–18, paras 30–32. McMahon, Submission 123 at pp 20–22, paras 39–41. McMahon, Submission 123, at p 23, para 45. Mc Mahon, Submission 123, at p 22, para 43. The election had primarily been introduced to accommodate New Zealand shareholders in Australian companies. The need for the election on this basis had disappeared when New Zealand replaced its exemption for income sourced in a Commonwealth country with a foreign tax credit system. The removal of the election had been recommended in Australia, Report Of The Commonwealth Committee On Taxation (the Ligertwood Committee), Canberra, 1961, at page 110, paragraph 543. 45 McMahon, Submission 123, p 20 para 38. 46 ET Cain, Commissioner of Taxation to WHB Johnson, Under Secretary, Board of Inland Revenue, Board Room, Inland Revenue, 13th December 1966. Inland Revenue file. 47 WHB Johnson to ET Cain, 3rd February 1966. Inland Revenue file.

Book 1.indb 449

12/2/2011 8:22:30 AM

450

C John Taylor

between O’Reilly and Randall and in the cabinet submission by McMahon. The discussion will be confined to selected articles. Residence Cain raised doubts as to whether the scope of the definition of ‘resident’ in the draft would include entities, such as a company incorporated in Australia or a contributor to the Commonwealth Superannuation fund who were Australian residents by virtue of the statutory definition in Income Tax Assessment Act 1936 (Cth). Cain pointed out that Australia had been satisfied with the definition of resident of Australia and of the converse term in the 1946 Australia – United Kingdom treaty and had never found dual residence to be a serious problem under it. Cain’s letter goes on to raise the issue of the corporate dual residence tiebreaker that O’Reilly had raised in his letter to Randall. Unlike O’Reilly, Cain does not refer at this point to the then recent United Kingdom treaty with New Zealand. Johnson noted the suggestion that the definition in the 1946 treaty might be preferable but went on to say that his view was that it was necessary to first discuss whether it was desirable to eliminate dual residence and, if so, if Australia could be persuaded to accept the basic United Kingdom proposal to then find a solution to the difficulties Cain had mentioned. Johnson stressed that it would be unfortunate to retain the old definition as all new United Kingdom treaties contained a similar definition to the one in the draft which was followed the OECD recommendation. In addition there would be awkward problems under United Kingdom law (as amended by changes in the corporate tax system) concerning any company with dual residence status. Permanent Establishment Cain stated that the definition of ‘permanent establishment’ in the draft fell somewhat short of what Australia had viewed as adequate and enclosed what was evidently the definition in the Australian model. Cain also indicated that Australia was interested in paragraph (viii) of the definition in the United Kingdom – New Zealand treaty of 1966 which deemed there to be a permanent establishment in certain circumstances where an enterprise of one of the contracting states sold in the other territory goods manufactured, assembled, processed, packed or distributed in the other contracting state by an industrial or commercial enterprise for or at the order of the first mentioned enterprise. At this point Cain also referred to equivalent articles in Australia’s treaties with Canada and New Zealand. The point had been raised in O’Reilly’s letter and, as noted earlier, this request was a response to the situation that arose in Case 110 (1955) 5 CTBR 656 where Australia was unable to tax a United Kingdom company operating an arrangement of this nature as the company did not have a permanent establishment in Australia.

Book 1.indb 450

12/2/2011 8:22:30 AM

The 1967 United Kingdom – Australia Taxation Treaty

451

Johnson’s response was that while it was helpful to have Australia’s views he was not sure that the Australian draft (particularly paragraph (2)(ii) dealing with substantial equipment) was entirely satisfactory from the United Kingdom viewpoint. Johnson went on to say that he did not think that further discussion could be usefully carried on through correspondence but that it ought to be possible to reach a solution acceptable to both sides in the negotiations. Johnson’s letter contained no specific comment on paragraph (viii) of the United Kingdom – New Zealand treaty. The omission is interesting as the problem dealt with under the article had been discussed at a meeting of Australian and United Kingdom officials in 1959 minutes of which are contained in the file that Johnson was using for the renegotiation of the Australian treaty in 1967.48 Hence the omission is unlikely to be due to ignorance of the problem on Johnson’s part but more likely reflects a desire to reserve the United Kingdom’s position on the issue pending face to face negotiations. Cain pointed out that draft Article 4(4) (covering with companies providing the services of public entertainers or athletes) dealt with a situation of concern to Australia and expressed fears that the real profit might not be derived by the company that ‘carries on the activity of providing the services’ of the entertainer. As discussed above the same issue had been raised by O’Reilly. In contrast to O’Reilly’s letter, Cain makes no mention of the need for a source rule. Johnson’s response on this point was simply to note that Australia was giving further consideration to the adequacy of paragraph (4) and to indicate that the United Kingdom had no objection to ‘tightening it up’. Industrial and Commercial Profits Cain pointed out that Australia would probably want to take up the requirement in Article 6(3) that the profits attributable to a permanent establishment be determined by postulating the existence of ‘the same or similar conditions’ in the relationship between the permanent establishment and the enterprise of which it was a part. Cain more succinctly makes the same point as had been made in O’Reilly’s letter as discussed earlier, namely that there could be circumstances in which a true arm’s length profit could only be ascertained by postulating different conditions from those which in fact applied. Although O’Reilly and the Memorandum had raised the 1946 negotiations as the background to the Australian position Cain does not mention this in his letter to Johnson. As was the case with O’Reilly’s letter, the background to the request if not its specific content can be found in Australia’s negotiations on the 1946 Australia – United Kingdom treaty. Johnson’s response was merely to note that Australia would pursue this point in negotiations. Cain raised the issue of providing for cases where information was insufficient to determine the profits to be attributed to a permanent establishment. Both 48 ‘Australian Double Taxation Talks, Meeting 11th May 1959, paragraph 3, Inland Revenue file. ‘Australian Double Taxation Talks, Meeting 22nd April 1959, paragraph 3(a), Inland Revenue file.

Book 1.indb 451

12/2/2011 8:22:30 AM

452

C John Taylor

O’Reilly’s letter and the Memorandum had explained the background to the Australian position at length by reference to the 1946 treaty negotiations and then section 136 of Income Tax Assessment Act 1936 (Cth). Once again Cain’s letter does not mention the background to Australia’s request in the 1946 treaty negotiations and in section 136. Johnson’s response was to indicate that the United Kingdom was prepared to add a sentence in similar form to Article III(3) of the 1946 treaty with Australia and Article III(3) of the then current United Kingdom treaty with New Zealand. Cain’s letter went on state that Australia wished to be able to apply Income Tax Assessment Act 1936 (Cth) section 38 on the basis that it was a simplification of but not a departure from the principles in Article 6(4) of the draft (dealing with allowing expenses in calculating the profits of a permanent establishment). Once again the issue had been discussed in the Memorandum which had pointed out that the Australia – United States treaty of 1953 allowed Australia to apply the principles of section 38. Interestingly, however, Cain’s letter does not refer to the equivalent provision in the 1953 treaty between Australia and the United States. Johnson’s reply was simply that the United Kingdom did not consider section 38 in any way in conflict with Article 6(4) or that it would prevent Australia from applying the principles of Article 6(4). Another matter that Cain stated was of interest to Australia was the assignment of territorial source to profits attributable to a permanent establishment. The Memorandum had raised this issue in the specific context of the profits of public entertainer companies but Cain’s letter raises it in a the context of industrial and commercial profits generally. As was the case with the Memorandum, Cain’s letter at this point probably reflects concern about the adequacy of Australian source rules particularly in relation to income of public entertainer companies. Johnson’s response was that, following the OECD Model Article, it had not been the United Kingdom’s practice to include a source rule and questioned whether a source rule was any longer necessary. Johnson’s letter goes on to state that if it were necessary on the Australian side to include a special source rule then the United Kingdom would be happy to do so. Cain also raised several questions for Johnson concerning Article 6 in the context of determining the profits of insurance companies including the effect of the non discrimination article on them.49 Both O’Reilly’s letter and the Memorandum had discussed the non discrimination article at length. In contrast to the detailed discussion of specific objections Cain’s letter merely asks a question about the potential effect the article might have on ‘the companies’, clearly meaning insurance companies. While O’Reilly’s letter 49 The first concerned relief for management expenses against dividends from United Kingdom companies. This had not been raised in either O’Reilly’s letter or the Memorandum and it is difficult to ascertain the influence of any of the listed factors behind the request. The second was what effect the adoption of a non-discrimination article might have on ‘the companies’. It is unclear from the context whether at this point Cain was referring to Australian or United Kingdom companies or, for that matter, to companies generally.

Book 1.indb 452

12/2/2011 8:22:30 AM

The 1967 United Kingdom – Australia Taxation Treaty

453

and the Memorandum are concerned with technical problems Australia might confront if it adopted a non discrimination article Cain’s letter here takes the form of a polite enquiry. Associated Enterprises In relation to the Associated Enterprises Article (Article 8 of the draft) Cain indicated that the Australian preference was for something corresponding to Article IV of the 1946 Treaty with emphasis on Article IV(2) and Article IV(3). The same issue had been raised in O’Reilly’s letter and in the Memorandum. Johnson’s reply was that the United Kingdom was ready to include something corresponding to Article IV(3) of the 1946 Treaty and referred Cain to Article IV(2) the recent United Kingdom Treaty with New Zealand. Dividends Cain indicated that Australia anticipated difficulties in relation to the ‘beneficial ownership’ test proposed for dividends given that, under the Australian tax system a trustee could be taxed on income accumulating in the trust and, as the ultimate title to the income often depended on contingencies, the beneficial ownership of dividends paid to trustees would not be clear. This could mean that an Australian trustee receiving dividends from a United Kingdom company might not be entitled to the reduced treaty rate of withholding tax. The point had been raised less explicitly in the Memorandum. Johnson agreed that the concept of beneficial ownership was not always easy to apply in the trust context50 and referred Cain to how the United Kingdom had attempted to deal with the issue in its recent treaty with New Zealand and indicated that a similar formula could be adopted in Australia’s case. Johnson indicated, however, that United Kingdom view was that this was not necessary as in the case Cain had mentioned the United Kingdom considered that relief from United Kingdom tax would be available under the current draft. As an alternative Johnson suggested that the ‘subject to tax’ test from the 1946 Treaty could be used. The recent United Kingdom treaty with New Zealand had excluded certain redeemable share capital and security in respect of shares from the definition of dividend. Cain asked what the significance of the exclusion was. Johnson advised that under United Kingdom law certain distributions were deemed to be dividends and, when paid to a non resident tax on them was limited to the appropriate agreement rate. Although this worked well in the case of cash distributions it was not a practical possibility where the dividend was in the form of a distribution of redeemable shares and hence such distributions had been excluded from the definition of dividend in the New Zealand agreement. Johnson went on to point out that there were contrary arguments and that the current United Kingdom view was that it was not worthwhile complicating a double tax treaty to deal with an event that was unlikely to arise.

Book 1.indb 453

12/2/2011 8:22:31 AM

454

C John Taylor

Cain asked for details of how the United Kingdom proposed in practice to apply the reduced rate on dividends under the treaty. Did the United Kingdom contemplate deduction at source at the reduced rate rather than at the standard rate and, if so, could these arrangements involve Australian residents using reputable nominee companies in the United Kingdom to hold shares in United Kingdom companies. These issues had not been raised in either O’Reilly’s letter or the Memorandum nor in McMahon’s cabinet submission. Significantly, Cain did not raise issues about the rate of tax on dividends in his letter evidently regarding this as a matter of policy to be discussed in negotiations as distinct from a technical or drafting issue. Johnson replied that the United Kingdom was working out arrangements to give effect to the reduced rates under treaties. These were in place in the case of subsidiary companies paying dividends to parents. Johnson reported on arrangements that had begun to be made in relation to the situations: (a) where Australian residents held shares in United Kingdom companies via United Kingdom nominee companies; and (b) where Australian held shares directly in United Kingdom companies which had an Australian share register. The United Kingdom’s concern was to ensure that procedures were in place so that ‘the relief does not get into the wrong hands’. Paragraphs 9(5) and (6) of the dividend article in the draft provided that the reduction in the rate of tax on dividends in Article 9(1) did not apply where the dividend was effectively connected with a trade or business carried on by the non resident through a permanent establishment in the other treaty partner country provided a sale of the shareholding would be regarded as a trading receipt. Cain asked for elucidation of the United Kingdom’s views on these questions. Had administrative guidelines been set for determining when a dividend was effectively connected with a trade or business carried on through a permanent establishment? Cain assumed that Article 9(5) was not to be construed so that a company whose profit on a sale of shares would be a capital gain would not be entitled to the reduced rate on dividends. These issues had not been realised in either O’Reilly’s letter nor in the Memorandum. Johnson’s reply was that the United Kingdom had no formal rules for determining when a dividend was ‘effectively connected’ with a permanent establishment and noted that the words had been taken from the OECD model. Johnson referred Cain to the Commentary on the OECD model in noting that the object of the language was to do away with the ‘force of attraction’ principle. In a narrow interpretation 50 The United Kingdom Inland Revenue file on the negotiation of the 1967 United Kingdom – Australia treaty contains a note, dated 6th January (apparently 1966 from the order in which it appears in the file) commenting on the meaning of ‘beneficial owner’. The note points out that the expression ‘beneficial owner’ was not defined in United Kingdom statute law but had been considered by United Kingdom courts. The note indicates that, generally speaking, a beneficial owner of property may be said to be one who has the right to the use and enjoyment of property, including, on a sale, the right to the proceeds. The note goes on to point out that the beneficial owner is not necessarily the same as the legal owner. Examples from the law of trusts are given to illustrate the point. ‘Beneficial Ownership’ 6th January, Inland Revenue file.

Book 1.indb 454

12/2/2011 8:22:31 AM

The 1967 United Kingdom – Australia Taxation Treaty

455

of ‘effectively connected’51 Johnson stated that in general the United Kingdom considered that generally there should be no difficulty in identifying when interest, dividends and royalties were effectively connected with a permanent establishment. Johnson expected that the only interest and dividends effectively connected with a permanent establishment would be when ‘financial concerns’ drew interest and dividends in the course of carrying on their normal business. Johnson confirmed that Article 9(5) was not intended to deprive a company whose profit on a sale of shares was treated as a capital gain from the reduced rate on dividends. The United Kingdom was prepared to apply the reduced rate on all dividends, even those effectively connected with a permanent establishment, except where the owner of the effectively connected holding was an individual or a financial concern. Financial concerns included the proceeds of share sales in their taxable profits and the proceeds were therefore properly described as ‘trading receipts’52 Interest and Royalties Articles 10 and 11 of the United Kingdom draft gave the residence country the exclusive right to tax interest and royalties. Although this was contrary to prior Australian treaty practice (which was that the source country retained full taxing rights in relation to interest) Cain’s letter (in contrast to O’Reilly’s letter, the Memorandum and McMahon’s cabinet submission) did not raise this issue. In relation to interest Cain’s letter merely asked for an explanation of the purposes for United Kingdom law of Articles 10(4) and 10(5) and 11(4). Johnson explained that, Articles 10(4) and 11(4) (for the purposes of determining their character in the hands of a non resident recipient) overrode provisions in United Kingdom law which re-characterised certain interest and royalty payments as dividends (and hence denied a deduction to the payer). The override did not apply where the recipient company was under United Kingdom control. Johnson explained that Article 10(5) was an anti avoidance provision aimed at preventing bond washing by tax exempt bodies and paralleled similar provisions in United Kingdom domestic law.

51 The interpretation of the expression ‘effectively connected’ given in Johnson’s letter is narrow by comparison with the paragraph 31 of the Commentary on Article 9(4) in the OECD Model the relevant portion of which makes the point that Article 9(4) does not adopt the ‘force of attraction’ principle but goes on to merely comment that dividends are taxable as part of the profits of a permanent establishment if they are paid in respect of holdings forming part of the assets of the permanent establishment or are otherwise effectively connected with the permanent establishment. The Commentary does not limit the application of Article 9(4) of the Model to ‘financial concerns’ or other entities where profits from sales of particular shares were included in their taxable profits. 52 Cain also asked what was the purpose of Article 9(4) of the draft noting that it evidently related to features of United Kingdom law. Johnson replied that Cain’s assumption was correct and explained that the article was aimed at preventing tax avoidance through dividend stripping which would otherwise be possible due to the application of the ‘franked investment income’ provisions of United Kingdom law dealing with inter-corporate dividends.

Book 1.indb 455

12/2/2011 8:22:31 AM

456

C John Taylor

Capital Gains Cain pointed out that Australia did not at present have a capital gains tax and commented that this kind of tax was not covered by any of Australia’s existing agreements. Cain asked whether the article in any way varied the practical effects of United Kingdom law regarding capital gains derived by non residents. Johnson replied that the article did no more than reproduce the substance of United Kingdom law but that since drafting it a loophole had been discovered which would enable a United Kingdom resident to go to a foreign country, such as Australia, for one year, and while there realise a capital gain on United Kingdom property tax free. Johnson indicated that to prevent this the United Kingdom would like to add a ‘subject to tax’ test in Article 12(3). Other Income As noted earlier, none of Australia’s earlier treaties had contained an ‘other income’ article. This point that had been made in both O’Reilly’s letter and the Memorandum. Indeed the premise of Australia’s earlier treaties was that full source country taxing rights were retained in relation to types of income not specifically covered by a treaty. Cain commented that the other income article in the draft would operate, so far as United Kingdom residents subject to Australian tax were concerned, to income from a trust, some alimony payments and to income derived from a third country. Australia was concerned that, under the draft, dividends derived from Australia through a trust would have to be exempted in Australia. Cain also asked what income of Australian residents would the article, in the United Kingdom’s view, extend. Johnson replied that the article was ‘a sort of long stop’ intended to regulate the treatment of odd types of income which had not been specifically dealt with elsewhere in the treaty. Hence it was not possible to give an exhaustive list of the types of income which it might cover. Johnson agreed that the obvious cases were trust income, alimony payments and third country income and noted that Australia had reservations about the application of the article to trust income. Credits As the United Kingdom had a general capital gains tax while Australia did not Cain enquired whether, if Australia taxed a profit as ordinary income in circumstances where the United Kingdom taxed it as a capital gain would the United Kingdom give credit for the Australian income tax against the United Kingdom tax on the capital gain? This issue had not been raised in either O’Reilly’s letter nor in the Memorandum. Johnson confirmed that credit would be granted. The draft had indicated that the United Kingdom would only grant a credit for underlying corporate tax if Australia reciprocated. Cain pointed out that, except

Book 1.indb 456

12/2/2011 8:22:31 AM

The 1967 United Kingdom – Australia Taxation Treaty

457

in unusual cases involving private companies, the inter-corporate rebate provision, ITAA 1936 section 46, usually freed Australian companies from tax on dividends. This point had also been raised in both O’Reilly’s letter and in the Memorandum. Johnson replied that the credit provisions in the draft simply reflected current United Kingdom law but would continue to bind the United Kingdom in the event of changes to United Kingdom domestic law. Given that the United Kingdom was binding itself in this way it considered that it was entitled to ask Australia to undertake a corresponding obligation. Johnson suggested that either the credit be contingent on the continuance of Australia’s effective exemption or that the two countries should consult to establish new rules (as had been done in the United Kingdom’s treaties with Canada and New Zealand). Johnson explained that this was what was meant by reciprocity and failing it an alternative would be to drop the credit clause altogether and allow each country’s domestic law to operate. Cain also commented that for Australia to give credit for United Kingdom tax it appeared to be necessary to have an election to gross up United Kingdom dividends. Cain indicated that, as United Kingdom law was understood in Australia, it appeared that only the net dividend after deduction of United Kingdom tax would be included in an Australian shareholder’s assessable income in the absence of an election to gross up. This issue had also been raised in the negotiation of the 1946 United Kingdom – Australia treaty.53 The issue had not been raised in either O’Reilly’s letter nor in the Memorandum. Johnson did not reply to Cain’s comment.

THE NEGOTIATIONS IN CANBERRA MARCH – APRIL 1967

As noted above, an Australian Federal Election was called for November 1966. As a result the commencement of negotiations in relation to the new treaty was deferred until 31 March 1967. The initial negotiations were held in Canberra over a 10 day period. Australia was represented in the negotiations by Sir Richard Randell (Secretary to the Treasury), Mr Pryor, Mr Daniel, Mr Ross of the Treasury, Mr ET, Cain (Commissioner of Taxation), Mr Wicks, Mr W J O’Reilly (Second Commissioner of Taxation), Mr TC, Boucher, and Mr Hill of the Australian Taxation Office and Mr R Hutchinson (First Assistant Crown Solicitor) of the Attorney General’s Department. The United Kingdom was represented by Mr W H B Johnson (Under Secretary, Department of Inland Revenue), Mr F P Harrison (Assistant Secretary, Department of Inland Revenue), Mr Robertson (Principal, Department of Inland Revenue) and by Miss Harrison from the British High Commission.54 53 See the discussion of the drafting of the 1946 United Kingdom – Australia Treaty in Taylor supra note 23. 54 ‘Notes of Meetings; March–April 1967’, First Day, 31st March 1967, Morning Session, p1, Inland Revenue file. Note dated 31 March 1967 ‘Opening Meeting with United Kingdom Delegation’, Australian Treasury file.

Book 1.indb 457

12/2/2011 8:22:31 AM

458

C John Taylor

E T Cain’s opening address in the negotiations pointed out that Australia approached many of the issues from a different point of view as it was a net importer of capital and was not a maritime nation. Cain stated that ‘Much of the folklore on double taxation has been built up on the experience of countries quite differently situated, and there is a limit to the extent that we can accept it’.55 The United Kingdom ‘Notes of Meetings In Canberra’ record that in their opening remarks the Australian representatives ‘pointed out that they did not regard the O.E.C.D. Model as entirely suitable to the circumstances of their country’. It is possible that Cain departed from his draft text and explicitly mentioned the O.E.C.D. Model but it is also possible that the United Kingdom delegation interpreted the remarks from Cain’s opening address quoted above as referring to the O.E.C.D Model. All records of the negotiations and the draft of the address itself confirm that Australia was particularly concerned about provisions in the United Kingdom draft relating to dividends, interest, royalties and shipping profits. On the first day of negotiations the parties agreed that the United Kingdom draft of September 1966 would form the basis for the discussions. The remainder of the first day of negotiations was devoted to an examination of the broad outline of each article of the September 1966 draft.56 Both the ‘official’ Australian report of the negotiations and handwritten notes by an Australian Treasury official record that Mr Johnson, the leader of the United Kingdom delegation, indicated that his Government had taken a very firm line on shipping profits.57 The themes in Cain’s opening address were consistent with the emphasis in McMahon’s cabinet submission discussed above.

Taxes Covered The Notes of Meetings for the first day record that in Australia the agreement would apply to the Commonwealth Income Tax including the tax on undistributed profits of private companies. The Australian delegation confirmed that the Australian States did not levy their own income taxes.58

55 ‘Draft Notes of a Statement by the Commissioner’, Australian Treasury file. ‘Opening Meeting with United Kingdom Delegation’, Australian Treasury file, confirms that E T Cain was scheduled to give the opening address at the conference. ‘Notes on discussions 13/3/67 – 14/4/67, Australian Treasury file, handwritten notes (apparently made by an Australian Treasury Official) confirm that Cain made an opening address but do not indicate what the content of the address was. 56 Notes of Meetings , First Day, 31st March 1967, Morning Session, p1, Inland Revenue file. Report of discussions on 31 March 1967, Australian Treasury file. Notes on discussions 13/3/67 – 14/4/67, Australian Treasury file. 57 Report of discussions on 31 March 1967, Australian Treasury file. Notes on discussions 13/3/67 – 14/4/67, Australian Treasury file. 58 Notes of Meetings, First Day, 31st March 1967, Morning Session, p1, Inland Revenue file.

Book 1.indb 458

12/2/2011 8:22:31 AM

The 1967 United Kingdom – Australia Taxation Treaty

459

Definitions Resident On the first day Australia raised a substantive issue concerning the corporate residence tiebreaker. The United Kingdom draft had used place of effective management as the sole tiebreaker for corporate residence. The Australians were concerned that a company incorporated in Australia but managed and controlled in the United Kingdom interposed between an Australian resident company and United Kingdom shareholders would be a United Kingdom resident for treaty purposes. The interposed company would nonetheless be an Australian resident under Income Tax Assessment Act 1936 (Cth) for section 46 purposes and hence would be entitled to an inter-corporate dividend rebate. Australia would not be entitled to tax dividends paid by the interposed company to United Kingdom shareholders as the interposed company would be a United Kingdom resident for treaty purposes. The end result would be that dividends paid by the first Australian company which ultimately found their way to United Kingdom shareholders would escape Australian tax altogether. The United Kingdom delegation appreciated the problem but pointed out that the tiebreakers were intended to avoid the taxation of dual resident companies by both countries. The Notes of Meetings record that, ‘It might be possible to meet the Australians’ problem by provisions along the lines of those in the recent New Zealand agreement’.59 As discussed earlier, the issue and the arguments in support had been raised in O’Reilly’s letter and in the Memorandum. The issue was raised again in the afternoon session of the second day of negotiations. Here the Australians raised the same scenario of a company incorporated in Australia but managed and controlled in the United Kingdom. The Notes of Meetings record that the Australians explicitly referred to proposed Article 9(7) as preventing Australia from taxing a dividend paid by the interposed company to United Kingdom residents and to the shareholder not being liable to United Kingdom tax because of the credit provisions. The Australians suggested that the definition of resident company be amended so that a company would be a resident of Australia if it were an Australian resident under Australian domestic law and would be a resident of the United Kingdom if it were a resident of the United Kingdom under United Kingdom domestic 59 Notes of Meetings, First Day, 31st March 1967, Morning Session, p2, Inland Revenue file. The Notes of Meetings do not explicitly refer to the inability of Australia to tax subsequent dividends paid by the interposed company to United Kingdom resident shareholders but this would have been the combined effect of the tiebreaker and draft Article in the circumstances contemplated. The Notes of Meetings merely record that the use of the interposed company would secure the dividend rebate and escape Australian tax on the dividends. ‘Notes of discussions 13/3/67 – 14/4/67, Australian Treasury file, in commenting on the discussion of Article III(3) of the draft on the first day note that a company incorporated in Australia would be a resident for purposes of the s46 exemption but that the ‘effective management’ tiebreaker ‘cld give complete exemption’.

Book 1.indb 459

12/2/2011 8:22:31 AM

460

C John Taylor

law provided it was not a resident of Australia. The United Kingdom delegation objected that this proposed definition was too wide, given the Australian tests of company residence.60 It would appear that the real United Kingdom objection was that the width of the Australian tests of company residence would mean that in the situation where an Australian incorporated company was managed and controlled in the United Kingdom it would be an Australian resident for treaty purposes and not a United Kingdom resident. The Notes of Meetings record that a possible compromise was: (a) that for all purposes other than dividends paid by dual resident companies the definition include a corporate residence test along the lines of either the September 1966 draft or United Kingdom – New Zealand agreement61; and (b) that the dividend article should provide that, in the case of dual resident companies, Australia was entitled to tax dividends paid to United Kingdom shareholders and that the United Kingdom was entitled to tax dividends paid to Australian shareholders.62 The initialled draft implemented this agreement but, as discussed below, was subject to further amendment through correspondence following the completion of negotiations. On the afternoon session of the eighth day, at Australia’s request, it was agreed to use the expression ‘Australian resident’ throughout the treaty and not the expression ‘resident of Australia’ which was used in the original draft. This was to avoid confusion as Australia used the expression ‘resident of Australia’ in its domestic law.63 60 Under the definition of ‘resident’ as it applied to companies in Income Tax Assessment Act (1936) as it then stood a company was a resident of Australia if it: (a) was incorporated in Australia; or (b) not being incorporated in Australia carried on business in Australia and either: (i) was centrally managed and controlled in Australia; or (ii) had its voting power controlled by Australian residents. 61 Under the United Kingdom – New Zealand Double Taxation Treaty of 11th August 1966 the definitions of corporate residence were contained in Article II and were as follows: (j) The term ‘New Zealand company’ means any company which is – (i) Incorporated in New Zealand and which has its centre of administrative or practical management in New Zealand whether or not any person outside New Zealand exercises of is capable of exercising any overriding control or direction of the company or of its policy or affairs in any way whatsoever; or (ii) Managed and controlled in New Zealand; (k) The term ‘United Kingdom company’ means any company which is managed and controlled in the United Kingdom and is not a New Zealand company. (l) (i) The term ‘resident of the United Kingdom’ means any United Kingdom company and any other person who is resident in the United Kingdom for the purposes of United Kingdom tax and the term ‘resident of New Zealand’ means any New Zealand company and any other person who is resident in New Zealand for the purposes New Zealand tax. 62 Notes of Meetings, Second Day, 3rd April 1967, Afternoon Session, pp 3–4, Inland Revenue file. Report of discussions on 31 March 1967, Australian Treasury file, the official Australian record of the discussions is much briefer at this point and merely comments on article 3: ‘The article was found to be technically unsatisfactory in some respects and some clauses were redrafted along lines acceptable to Australia. One clause remained unacceptable to Australia but the United Kingdom undertook to provide a form of words which it was thought would meet Australia’s requirements.’ Notes of discussions 13/3/67 – 14/4/67, Australian Treasury file, handwritten notes by an Australian Treasury official 3rd April 1967 record that there was a drafting change to Article 3(2)(a) but that O’Reily said that Article 3(2)(d) was ‘politically undesirable’ and suggest that Johnson agreed to take Article 3(d) out. 63 Notes of Meetings, Eighth Day, 11th April 1967, Afternoon Session, p 2, Inland Revenue file. For Australian domestic law purposes the relevant definition was contained in Income Tax Assessment Act (1936) Cth s6(1).

Book 1.indb 460

12/2/2011 8:22:32 AM

The 1967 United Kingdom – Australia Taxation Treaty

461

Permanent Establishment The definition Permanent Establishment was briefly discussed on the morning of the first day of negotiations. The Australian delegation indicated that they intended to raise the question of including oil and gas wells and agricultural and pastoral properties in the definition. The Australians also wanted a provision similar to Article II (1) (p) (viii) of the United Kingdom – New Zealand Agreement (which expressly included a subsidiary company engaged in business in trade or business in the other State whether or not through a permanent establishment) and wanted an agent who filled orders from stock to be included.64 This issue had been raised by Cain. In addition, either O’Reilly’s letter or the Memorandum had raised all these issues. The Notes of Meetings record that the Australians’ reasons for including agricultural and pastoral properties in the definition of permanent establishment were explained and the Australian request was agreed to. Johnson had explained that the omission of such properties from the definition of permanent establishment was due to them being dealt with in the OECD Convention under Article 5 relating to immovable property.65 It was noted that agricultural and pastoral properties were included in the definition of permanent establishment in the 1946 Treaty as it did not contain an immovable property article. The disadvantage of including them under the immovable property article as in the September 1966 draft was that it did not give the protection of the rules in the Business Profits article about the allowance of reasonable expenses. It appears to have been agreed at this point that ‘it would be preferable to deal with such property in the present article, and to add a reference to forestry’.66 The Notes of Meetings of the third day also record that the word ‘installation’ was added to sub-paragraph 2(g) to cover a person who contracts to manufacture, supply and install equipment.67 It was agreed on the third day that provision dealing with supervisory activities along the lines in the United Kingdom – New Zealand Agreement would be added. It is clear from handwritten notes by an Australian Treasury official that these additions were requested by Australia.68 Nonetheless it appears from O’Reilly’s letter 64

Notes of Meetings, First Day, 31st March 1967, Morning Session, p2, Inland Revenue file. Notes of discussions 13/3/67 – 14/4/67, Australian Treasury file, handwritten notes by an Australian Treasury official, 4th April 1967. 66 ‘Notes of Meetings,Third Day, 4th April 1967, Morning Session, p2, Inland Revenue file. Notes of discussions 13/3/67 – 14/4/67, Australian Treasury file, handwritten notes by an Australian Treasury official, 4th April 1967. The handwritten notes by the Australian Treasury Official convey the impression that the suggested solution was proposed by Mr Johnson of the United Kingdom delegation. 67 Notes of Meetings, Third Day, 4th April 1967, Morning Session, p2, Inland Revenue file. Notes of discussions 13/3/67 – 14/4/67, Australian Treasury file, handwritten notes by an Australian Treasury official, 4th April 1967. 68 Notes of Meetings, Third Day, 4th April 1967, Morning Session, p2, Inland Revenue file. Notes of discussions 13/3/67 – 14/4/67, Australian Treasury file, handwritten notes by an Australian Treasury official, 4th April 1967. 65

Book 1.indb 461

12/2/2011 8:22:32 AM

462

C John Taylor

discussed earlier that an equivalent article was in the Australian model treaty that had been developed by that time. At Australia’s request, the minimum period in sub-paragraph 2(g) was agreed to be reduced to six months.69 The equivalent provision in both the United Kingdom draft and the United Kingdom – New Zealand treaty of 1966 had a contained a twelve month minimum period for building sites or construction or assembly projects. No minimum period had been specified in the equivalent article in the 1960 Australia – New Zealand treaty. No precisely equivalent article had been contained in any of Australia’s earlier treaties. Hence the 1966 treaty with the United Kingdom is the first instance in an Australian treaty with six months being the minimum required period for a building site, construction or assembly project to be classified as a permanent establishment. The Memorandum had indicated that the Australian model of the time required a minimum period of twelve months before an installation project was regarded as a permanent establishment. Handwritten notes by an Australian Treasury official at the negotiations indicate that here Australia asked for the inclusion of a reference to an ‘installation’ project lasting twelve months and make no mention of a request to reduce the minimum period to six months.70 Agreement was also reached on the morning session of the fourth day on other changes to the definition requested by Australia. One amendment agreed to at this point was that: (a) ‘on behalf of’ be substituted for ‘in the name of’ in paragraph 5 to cover the agent who acts for an undisclosed principal.71 Paragraph 5 of the draft was identical to the 1963 OECD Draft Model Convention. The change of language agreed between Australia and the United Kingdom here clearly reflects an attempt to accommodate the language of the article to the common law concept of ‘agent’. The Notes of Meetings also record that at this point that, as requested by Australia, it was agreed to add words at the end of paragraph 6 to cover an agent who, because of a special relationship with the principal, does not charge commission at the going rate.72 Curiously in the final treaty the addition suggested was not made to paragraph 6. Handwritten notes by an Australian Treasury official record O’Reilly as observing that the United Kingdom draft had dropped the idea of a special relationship between an agent and his principal.73 It is likely that O’Reilly’s comment that the United Kingdom had dropped the idea of such an article was making a comparison between the United Kingdom draft and the 1946 Australia – United Kingdom

69

Notes of Meetings, Fourth Day, 5th April 1967, Morning Session, p2, Inland Revenue file. Notes of discussions 13/3/67 – 14/4/67, Australian Treasury file, handwritten notes by an Australian Treasury official, 4th April 1967. 71 Notes of Meetings, Fourth Day, 5th April 1967, Morning Session, p2, Inland Revenue file. Notes of discussions 13/3/67 – 14/4/67, Australian Treasury file, handwritten notes by an Australian Treasury official, 5th April 1967 ‘Article 4 (Cont)’. 72 Notes of Meetings. Fourth Day, 5th April 1967, Morning Session, p2, Inland Revenue file. 73 Notes of discussions 13/3/67 – 14/4/67, Australian Treasury file, handwritten notes by an Australian Treasury official, 5th April 1967 ‘Article 4 (Cont)’. 70

Book 1.indb 462

12/2/2011 8:22:32 AM

The 1967 United Kingdom – Australia Taxation Treaty

463

treaty which limited the equivalent exclusion to situations where the broker or general commission agent received remuneration at the rate customary in the relevant class of business.74 The Australian Treasury official’s notes record Mr Johnson as replying that he regarded some cases as being covered by Article 8 (the ‘associated enterprises’ article) but that he did not see how or why a permanent establishment could be regarded as existing in these cases. The notes by the official then state, ‘Addition Agreed’.75 The absence of the agreed addition in the final version of the treaty is therefore puzzling. In the afternoon session of the third day Australia pointed out that Article 4(3) (e) [which deemed certain activities not to amount to a permanent establishment] could mean that a person who sold information through a place of business would be deemed not to have a permanent establishment. It was agreed that the draft of Article 4(3)(e) would be revised.76 The final version of the Treaty did not contain the words ‘for the collection of information’ in Article 4(3)(e). This was at variance with the 1963 Draft OECD Model and with subsequent versions of the OECD Model. The notes by the Australian Treasury official indicate that Australia sought addition of clause 8(p)(viii) of the United Kingdom – New Zealand treaty and note that this was ‘OK’.77 As is clear from the United Kingdom Notes of Meetings the reference should have been to Article II(1)(p)(viii) of the United Kingdom – New Zealand Treaty of 1966. 78 The final version of the Australia – United Kingdom Treaty included Article IV(8) which was identical in form to Article II(1)(p)(viii) of the United Kingdom – New Zealand Treaty. Article VIII(4) dealt with the problem raised in Case 110 (1955) 5 CTBR (NS) 656 discussed earlier in this chapter. The United Kingdom Notes of Meetings also note that ‘It was agreed to add a sub-paragraph dealing with an agent who fills orders from stock to be a permanent establishment’.79 The handwritten notes by the Australian Treasury official make it clear that the addition was at Australia’s request.80

74

Article II (1)(j) of the 1946 United Kingdom – Australia Treaty. Notes of discussions 13/3/67 – 14/4/67, Australian Treasury file, handwritten notes by an Australian Treasury official, 5th April 1967 ‘Article 4 (Cont)’. 76 Notes of Meetings, Third Day, 4th April 1967, Afternoon Session, p3, Inland Revenue file. 77 Notes of discussions 13/3/67 – 14/4/67, Australian Treasury file, handwritten notes by an Australian Treasury official, 5th April 1967 ‘Article 4 (Cont)’. 78 ‘Notes of Meetings, Fourth Day, 5th April 1967, Morning Session, p2, Inland Revenue file. There was no clause 8(p)(viii) in the 1966 United Kingdom – New Zealand Treaty. The author considers that the reference to this clause was a clerical error by the Australian treasury official and that the reference should have been to clause II(p)(viii) which deemed there to be a permanent establishment in certain cases where there was a special relationship between principal and agent. Article 4(8) of the 1967 United Kingdom – Australia Treaty is identical in form to Article 2(p)(viii) of the 1966 United Kingdom – New Zealand Treaty. 79 Notes of Meetings, Fourth Day, 5th April 1967, Morning Session, p2, Inland Revenue file. 80 Notes of discussions 13/3/67 – 14/4/67, Australian Treasury file, handwritten notes by an Australian Treasury official, 5th April 1967 ‘Article 4 (Cont)’. 75

Book 1.indb 463

12/2/2011 8:22:32 AM

464

C John Taylor

On the afternoon session of the third day Australia explained the concern about Article 4(4) in the context of companies providing the services of public entertainers that had previously be raised in Cain’s letter as discussed earlier. The Australian fear was that Article 4(4) would not catch a company providing (possibly through an intermediary) the services of an entertainer under a slavery contract. Australia then submitted an alternative draft which read as follows: An enterprise of one of the territories shall be deemed to carry on business in the other territory though a permanent establishment situated therein in relation to income (other than dividends) which it derives from or in relation to contracts or obligations for the rendering within the other territory of the services of public entertainers or athletes such as are referred to in Article 15.

The United Kingdom objected that the Australian draft would deem there to be an Australian source and enable Australia to get tax in circumstances where this might not be possible under Australian domestic law. The United Kingdom view was that it was justifiable to ensure that a treaty did not open up avenues for avoidance but it was ‘quite another matter’ to use a treaty to make good gaps in domestic anti avoidance legislation. The Notes of Meetings then record that a solution might be to exclude supplying the services of public entertainers from the definition of industrial or commercial profits.81 This suggestion was followed up on the morning session of the fourth day where it was to exclude the services of entertainers from the definition of industrial and commercial profits.82 The handwritten notes of an Australian Treasury official record that this was at Australia’s request and was based on the form of the Australia – New Zealand treaty which excluded such profits from the definition of industrial and commercial profits.83 Australia had already indicated on the first day that it wanted Article 15 (dealing with Artistes and Athletes) strengthened to cover companies which supplied the services of entertainers.84 On the morning session of the sixth day it was agreed that, as it was conceivable that Australian courts might in some circumstances deem income from ‘employment, etc’. exercised in Australia to have a non Australian source it was agreed that a source rule was necessary in Articles 13, 14 and 15 (professional services, dependent personal services and entertainers respectively).85 This is an early example of a continuing Australian treaty practice of deeming there to be an Australian source where there might not be an Australian source outside the treaty. Interestingly the United Kingdom does not appear to have objected to the existence of a deemed source rule in this context although, as noted above it objected to such an extension in the context of industrial and commercial profits. 81

Notes of Meetings, Third Day, 4th April 1967, Morning Session, p 3, Inland Revenue file. Notes of Meetings, Fourth Day, 5th April 1967, Morning Session, p 2, Inland Revenue file. 83 Notes of discussions 13/3/67 – 14/4/67, Australian Treasury file, handwritten notes by an Australian Treasury official, 5th April 1967 ‘Article 4 (Cont)’. 84 Notes of Meetings, First Day, 31st March 1967, Afternoon Session, p 4, Inland Revenue file. 85 Notes of Meetings, Fifth Day, 6th April 1967, Morning Session, p 1, Inland Revenue file. 82

Book 1.indb 464

12/2/2011 8:22:32 AM

The 1967 United Kingdom – Australia Taxation Treaty

465

In the afternoon session of the third day Australia raised the case of a United States company which had appointed a United Kingdom company as its sole distributor in Australia on a commission basis of its products. The United States company licensed the United Kingdom company to manufacture its products and use its trade marks, reimbursed the costs of manufacture and loaned all the machinery necessary to manufacture its products. The United States company was treated as having an Australian permanent establishment under the Australia – United States Treaty where permanent establishment was defined as including ‘the use or installation of substantial equipment or machinery by, for , or under a contract with, an enterprise of one of the countries’. While the United Kingdom agreed that there was some justification for treating the company as having an Australian permanent establishment in the example given the United Kingdom considered that the Australian formula was too wide as it might, for example, cover plant supplied under a hire purchase agreement or ordinary plant hire and hence might ‘cut across’ the royalty article. No further mention is made of this request in either the United Kingdom or Australian records of the negotiations nor in the subsequent correspondence. A provision to this effect was not included in the final version of the Treaty although variants on it appear in several subsequent Australian treaties, most notably in the 1982 Australia – United States Treaty.86

Industrial and Commercial Profits The United Kingdom draft of September 1966 contained a definition of ‘Industrial And Commercial Profits’ in terms which excluded dividends, interest or royalties and rents other than dividends, interest or royalties and rents effectively connected with a trade or business carried on through a permanent establishment in one of the territories and excluded remuneration for personal (including professional) services.87 The Notes of Meetings for the morning session of the first day record that the Australians wanted a source rule in the industrial and commercial profits article as the Australian domestic rule was ‘not very precise’. The point had been raised in both O’Reilly’s letter and in the Memorandum. The Notes of Meetings indicate that the United Kingdom was prepared to acquiesce so long as this did not mean that there was an Australian source where there was not one under Australian domestic law.88 The Australian delegation commented that it did not regard paragraph (4) of the Industrial and Commercial Profits article as being inconsistent with Income Tax Assessment Act 1936 section 38 but preferred to apply section 38 as they 86

Australia – United States Treaty, 1982, Article 5(4)(b). Article 6 of United Kingdom Draft, September 1966, Inland Revenue file. 88 ‘Notes of Meetings, First Day, 31st March 1967, Morning Session, p2, Inland Revenue file. 87

Book 1.indb 465

12/2/2011 8:22:32 AM

466

C John Taylor

regarded it as a short cut that saved arguments. The United Kingdom delegation undertook to consider the issue further.89 Australia wanted two further types of income to be excluded from the industrial and commercial profits article. These were the taxation of film business90, over which Australia wished to retain its current tax treatment, and coastal shipping.91 It was noted that, if Australia’s source country taxing rights were to be preserved over coastal shipping, it would be necessary to exclude coastal shipping from the definition of industrial or commercial profits.92 The United Kingdom delegation pointed out on the morning session of the first day that, unlike the position under the 1946 treaty, the draft exempted management fees from tax in the source country. 93 Paragraph (3) of the article, which required the use of arm’s length in determining the profits of a permanent establishment was discussed in the afternoon session of the fourth day. The Notes of Meetings comment that in making this determination it ought to be possible to ignore the special relationship between a head office and a branch. The Australians doubted whether the phrase ‘under the same or similar conditions’ would allow this to be done. It was agreed to use paragraphs (3) and (4) of Article III of the 1946 Treaty instead. This would entail adding the source rule and the information provision that was contained in the 1946 Treaty.94 89 Notes of Meetings, First Day, 31st March 1967, Morning Session, page 3. Inland Revenue file. Notes of discussions 13/3/67 – 14/4/67, Australian Treasury file, handwritten notes by an Australian Treasury official, 31st March1967 contain the following comment, VI source rule J (Johnson) some hesitation (H) cf s38 film business & reinsurance COS 90 The negotiations in relation to the taxation of film business are not discussed in detail in this chapter. 91 ‘Notes of Meetings, First Day, 31st March 1967, Morning Session, 3, Inland Revenue file. 92 Notes of Meetings, First Day, 31st March 1967, Morning Session, 3, Inland Revenue file. 93 Notes of Meetings In Canberra, First Day, 31st March 1967, Morning Session, p2, Inland Revenue file. 94 Notes of Meetings, Fourth Day, 5th April 1967, Morning Session and Afternoon Session p2, Inland Revenue file. Articles III(3) and III(4) of the 1946 Treaty read as follows: (3) Where an enterprise of one of the territories is engaged in trade or business in the other territory through a permanent establishment situated therein, there shall be attributed to that permanent establishment the industrial or commercial profits which it might be expected to derive in that other territory if it were an independent enterprise engaged in the same or similar activities and its dealings with the enterprise of which it is a permanent establishment were dealings at arm’s length with that enterprise or an independent enterprise; and the profits so attributed shall be deemed to be income from sources in that other territory. If the information available to the taxation authority concerned is inadequate to determine the profits to be attributed to the permanent establishment, nothing in this paragraph shall affect the application of the law of either territory in relation to the liability of the permanent establishment to pay tax on an amount determined by the exercise of a discretion or the making of an estimate by the taxation authority of that territory: Provided that such discretion shall be exercised of such estimate shall be made, so far as the information available to the taxation authority permits, in accordance with the principle stated in this paragraph. (4) No portion of any profits arising from the sale of goods or merchandise by an enterprise of one of the territories shall be attributed to a permanent establishment situated in the other territory by reason of the mere purchase of the goods or merchandise within that other territory.

Book 1.indb 466

12/2/2011 8:22:32 AM

The 1967 United Kingdom – Australia Taxation Treaty

467

Business profits were discussed again in the afternoon session of the fourth day. Here ‘trade or’ was added to ‘business’ in the definition of ‘industrial and commercial profits’ to ensure consistency with paragraph (6) of Article 6.95 The calculation of business profits was also discussed during the afternoon session of the fourth day. The Australians further explained that section 38 simplified calculations by obviating the need to analyse all elements going into a wholesale price. The United Kingdom delegation appears to have agreed to the inclusion of a section 38 source rule at this point ‘especially if it can be done on a reciprocal basis’.96 The Australians indicated that they would produce a form of words that would allow the principles of section 38 to be applied.97 Interestingly, questions were raised as to whether it was entirely appropriate to speak of expenses connected with profits; evidently reflecting a view that ‘profits’ necessarily referred to a net figure after expenses. The meeting decided, however, not to alter the article. There is no further mention of discussion of the Industrial and Commercial profits article in the Notes of Meetings.

Associated Enterprises The Notes of Meetings of the morning session of the first day record that it might be desirable to include a provision to cover estimated profits where actual figures were not available as had been done in the 1946 Agreement.98 The issue was raised by Australia again during the afternoon session of the fourth day. The United Kingdom then pointed out that the article was in the standard form adopted in almost all United Kingdom agreements. The Australians argued that the proposed wording of Article 8 was less precise than the wording of Article IV of the 1946 Treaty and that the latter wording had been tested in the courts and had been found to work as intended. The meeting then decided to substitute Article IV of the 1946 Treaty, including the source rule and the information provision for draft Article 8.99

95

Notes of Meetings, Fourth Day, 5th April 1967, Afternoon Session, p2, Inland Revenue file. Notes of discussions 13/3/67 – 14/4/67, Australian Treasury file, handwritten notes by an Australian Treasury official, 5th April 1967. 97 Notes of Meetings, Fourth Day, 5th April 1967, Morning Session, p2, Inland Revenue file. Notes of discussions 13/3/67 – 14/4/67, Australian Treasury file, handwritten notes by an Australian Treasury official,5th April 1967. 98 Notes of Meetings, First Day, 31st March 1967, Morning Session, p3, Inland Revenue file. 99 Notes of Meetings, Fourth Day, 5th April 1967, Afternoon Session, p3, Inland Revenue file. There is no reference to subsequent discussion of the ‘associated enterprises’ article in the Notes of Meetings. 96

Book 1.indb 467

12/2/2011 8:22:33 AM

468

C John Taylor

Dividends To understand the negotiations in relation to the dividend article it is necessary to outline the tax treatment of dividends paid to non residents under both United Kingdom and Australian domestic law in 1966. In the United Kingdom in years of assessment after 1965–66 all dividends paid by United Kingdom resident companies were subject to income tax under Schedule F at the standard rate of 41.25 per cent in 1966. The tax was deducted by the paying company. A recipient of the dividend, depending the personal circumstances of an individual recipient, might also be liable to surtax on the dividend up to a maximum rate of 11s in the £. Dividends received by United Kingdom companies were not subject to United Kingdom corporation tax. Dividends received by a United Kingdom resident company from another United Kingdom resident company from 5th April 1966 onwards represented ‘franked investment income’. Income tax deducted, or treated as deducted, from franked investment income received by a United Kingdom company could be offset against the recipient company’s liability to account to the Inland Revenue for income tax deducted from dividends that it paid. Where the income tax deducted on franked investment income exceeded the recipient company’s liability to deduct income tax on distributions that it made further relief from income tax was available to it under section 62 of the Finance Act 1965 (United Kingdom). Section 62 allowed surplus franked investment income to be treated as a profit subject to corporation tax so as to absorb other reliefs from corporation tax which were available to it. Non resident companies were not chargeable to corporation tax on dividends received from United Kingdom resident companies and were not entitled to reliefs from income tax that applied to franked investment income.100 Under section 31 of the Finance Act 1966 (United Kingdom) with effect from 5th April 1966 the United Kingdom tax payable on a dividend paid to an Australian resident (for treaty purposes) was limited to the amount of Australian tax that would be payable in the converse situation. This limitation was necessary as the 1946 treaty, while reducing United Kingdom surtax on dividends by one half, had not limited in any way the tax subsequently introduced under Schedule F in 1965–66.101 100 See Talbot and Wheatcroft, supra note 2: Introduction (summarises relevant United Kingdom rules at the time) at 1–02 pp1–3, 1–04 p4; Basis of charge: generally at 3–01 p18; Profits chargeable 3–02 pp19 to 20; Principles governing computation at 4–01 to 4–02 pp 27 to 29; Schedule F at 9–02 to 9–05 pp 119 to 122; Franked Investment Income at 10–01 to 10–06 pp 138 to 141; Other Taxed Receipts 10–07 to 10–09 pp 141 to 142; Chapter 12 Surplus Franked Investment Income: Set-Off Of Certain Reliefs pp163 to 173; and Withholding tax on United Kingdom income at 18–18 pp289 to 290. See also Beattie and Wisely, supra note 1: Chapter 3 The Charge of Corporation Tax and Exemption from Income Tax and Capital Gains Tax pp 51 to 59; Charge of income tax (describing position on payment of dividends) pp97 to 100; Franked Investment Income pp 103 to 109; and Dividends paid by United Kingdom companies to non-residents pp 171 to 172. 101 See the discussion in Talbot and Wheatcroft, supra note 2 at 9–02 to 9–05 pp 119 to 122 and at 18–18 pp 289 to 290 and in Beattie and Wisely, supra note 2 at pp 171 to 172.

Book 1.indb 468

12/2/2011 8:22:33 AM

The 1967 United Kingdom – Australia Taxation Treaty

469

The United Kingdom legislation in 1966 also had detailed rules, contained in Finance Act 1965 sections 74–79, Schedule 11 Part II and Schedule 18 dealing with close companies. A close company was defined as one controlled by: (i) five or fewer participators; or (ii) by participators who are directors.102 A participator was defined as a person (being an individual or a company) with a share or interest in either the capital or income of the relevant company. Associates of participators were within the definition of participator as were companies controlled by each participator or associate.103 Control was defined in terms which referred both to de facto direct or indirect control and to the possession of or ability to acquire the greater part of the voting power, issued capital, income distributions, or assets on winding up (including via the redemption of redeemable preference shares).104 Non resident companies were not treated as close companies nor (subject to conditions105) were companies controlled by non-close companies, nor (subject to conditions106) were companies whose shares were quoted on a United Kingdom stock exchange.107 The close company rules: (i) restricted deductions for directors’ remuneration, interest and certain other outgoings by a close company; (ii) imposed penal treatment on loans and restrictive covenant payments by a close company; (iii) extended the meaning of ‘distribution’ as it applied to close companies; and (iv) apportioned shortfalls in distributions to members of a close company for income tax and surtax purposes.108 102

See the discussion in Talbot and Wheatcroft, supra note 2 at 15–13 pp 215 to 216. ibid, at 15–02 p 209. 104 ibid, at 15–09 p 213. 105 The conditions essentially were that: (i) through the beneficial ownership of its shares the company was controlled by one of more non close companies; and (ii) none of the tests of control by five or fewer participators could be satisfied without including among those participators one of those non-close companies. For the purposes of this test the fact that a company was a non-resident was of itself treated as making it non-close. See the discussion in Talbot and Wheatcroft, supra note 2 at 15–15 pp 216 to 217. 106 In essence the conditions were that shares (other than preference and participating preference shares) carrying between them not less than 35% of the voting power in the company were: (i) unconditionally allotted to or acquired by the public; (ii) beneficially held by the public at the relevant time; and (iii) within the preceding year the shares were dealt with and quoted on a United Kingdom stock exchange. In 1966 ‘the public’ was not defined but shares could not satisfy the ‘held by the public’ requirement if they were held by: (a) any director of the company or his or her associate; (b) any company controlled by one or more of the persons identified in (a); or (c) any associated company of the company. See the discussion in Talbot and Wheatcroft, supra note 2 at 15–16 pp 217 to 218 and at 15–17 p 218. Finance Act 1967 (United Kingdom) introduced a definition of when shares would be regarded as being held by the public. The definition added two new positive requirements and a new negative requirement to the three negative exclusions that had previously applied. The additional requirements were that the shares were either: (i) held by a resident non close company or by a non resident company that would be a non close company if it were a resident company; (ii) held on trust for certain superannuation funds or retirement schemes other than certain schemes for the benefit of employees or directors (or their dependants) of the company or of a company controlled by the company or an associated company of the company; or (iii) not comprised in a principal member’s shareholding. In broad terms a principal member was a person holding more than 5% of the voting power in the company except where there were more than 5 such persons in which case the principal members were the five with the greatest percentages of voting power. See the discussion in Talbot and Wheatcroft, supra note 2 at 15–17 pp 218–219 and at 15–18 p 219. 107 See the discussion in Talbot and Wheatcroft, supra note 2 at 15–13 pp 215 to 216. 108 For a brief summary see the discussion in Talbot and Wheatcrcoft, supra note 2 at 15–01 p 208. 103

Book 1.indb 469

12/2/2011 8:22:33 AM

470

C John Taylor

Income Tax Assessment Act 1936 (Cth) section 45 allowed Australian resident taxpayers a foreign tax credit in respect of tax on dividends paid by a non resident company to the taxpayer where the taxpayer was personally liable for the tax under the law of the foreign country. The upper limit of the credit was the lesser of: (i) the Australian tax (reduced by any refund or credit to which the taxpayer was entitled) otherwise payable on the dividend; or (ii) the amount of Australian tax payable in respect of the dividend in accordance with section 16 of the Income Tax (International Agreements) Act 1953 (Cth). Australian resident companies were allowed a rebate under Income Tax Assessment Act (1936) section 46 equal to the average rate of tax payable by the company. The calculation of the average rate of tax payable under section 46 did not take into account undistributed profits tax which at the time could have been payable by a private company. In the case of a non private company the combined effect of section 45 and section 46 and of section 16 of the Income Tax (International Agreements) Act 1953 (Cth) was that, as there was there was no tax otherwise payable (because of the operation of the section 46 rebate) no credit was available to the company under section 45. In the case of a private company the exclusion of Division 7 undistributed profits tax from the calculation of ‘average rate of tax’ for section 46 purposes meant that, where a private company had an undistributed profits tax liability, it would be entitled to a section 45 credit in respect of that liability.109 The draft dividend article left the rate of withholding tax on dividends blank but was based on the assumption that different rates would apply to portfolio and non portfolio dividends. The Notes of Meetings for the morning session of the first day record that the Australian delegation proposed a rate of 15 per cent for both portfolio and non portfolio dividends but that the question was reserved for further discussion later.110 The United Kingdom raised the issue of rates again on the morning session of the second day suggesting that the OECD rates of 15 per cent for portfolio dividends and 5 per cent for non portfolio dividends apply. The United Kingdom also suggested that the OECD definition of the type of company qualifying for the lower rate be adopted but did not consider this test sacrosanct.111 The Notes of Meetings then set out in some detail the arguments that the United Kingdom advanced in favour of its proposal. The provisions in the 1946 Agreement, which exempted dividends paid to a 100 per cent United Kingdom parent, were characterised as being inconsistent with modern conditions and with Australia’s policy of encouraging local participation. It was admitted that the United Kingdom had agreed to a uniform 15 per cent A more detailed account of the effect of the rules is contained in Talbot and Wheatcroft, supra note 2 Chapters 16 and 17. 109 Detailed examples showing the effect of the interaction of these provisions are contained in JAL Gunn, OE Berger and M Mass, Gunn’s Commonwealth Income Tax Law And Practice (7th edn, Butterworths, Sydney, 1963) at pp 1303–4. 110 Notes of Meetings, First Day, 31st March 1967, Morning Session, p 3, Inland Revenue file. 111 Notes of Meetings, Second Day, 3rd April 1967, Morning Session, p 1, Inland Revenue file.

Book 1.indb 470

12/2/2011 8:22:33 AM

The 1967 United Kingdom – Australia Taxation Treaty

471

rate on dividends in several of its recent agreements but the United Kingdom delegation regarded the situation with Australia as distinguishable as, given that the complete exemption for wholly owned subsidiaries had been running for a long time, a large number of companies would be affected by any change and a 15 per cent withholding tax would only add to their tax burden. The United Kingdom balance of payments would suffer both from the reduction in the rate on outbound portfolio dividends and from an increase in Australian tax on inbound dividends from 100 per cent subsidiaries. The Voluntary Program was already restricting the increase in United Kingdom investment in Australia but a 15 per cent withholding tax on dividends paid to direct investors would be a positive discouragement of it.112 The United Kingdom also argued that there should be broad equality of treatment between a branch and a subsidiary. For this reason Australian tax on subsidiary dividends should be kept to a minimum as a high rate would encourage United Kingdom businesses to convert their subsidiaries to branches.113 The Australian delegation’s response to these arguments was that Australia had long been unhappy with the exemption for dividends paid by 100 per cent subsidiaries. All of Australia’s other agreements had a uniform 15 per cent rate on dividends and to concede a lower rate on dividends paid to United Kingdom parents would cause Australia difficulties in negotiations with other countries and political opinion in Australia was strongly against it. Given the inbalance of income flows between the two countries a low rate of tax on subsidiaries’ dividends would cause a substantial loss to the Australian revenue. By contrast a 15 per cent rate would not cause a loss to the United Kingdom revenue as the extra tax would be borne by the companies concerned (presumably because of limitations on the United Kingdom’s foreign tax credit although this is not stated in the Notes of Meetings). A 15 per cent rate on dividends taken with the Australian rate of corporate tax would produce a total rate of around 51 per cent on non portfolio dividends which Australia did not regard as exorbitant. Australia was not concerned about possible avoidance (by implication through the conversion of subsidiaries to branches) as Australia would not be any worse off than it was now given that it was not collecting any tax on dividends paid by wholly owned subsidiaries.114 The rate of tax on dividends was next discussed on the morning session of the third day. There, the Australian delegation agreed to make a submission to their ministers for a reciprocal 10 per cent rate on interest and royalties and a uniform 15 per cent rate on dividends.115 Surprisingly the Notes of Meetings do not record any discussion of the reasons behind the shift in the United Kingdom’s attitudes to the taxation of dividends. Given that the submission for a uniform rate of 15 per cent on all dividends was to be made along with 112

ibid. ibid. 114 ibid. 115 Notes of Meetings, Third Day, 4th April 1967, Morning Session, p 1, Inland Revenue file. 113

Book 1.indb 471

12/2/2011 8:22:33 AM

472

C John Taylor

submissions for rates of 10 per cent on interest and royalties it may be that Australia’s agreement to the latter rates was regarded as a matching concession for the United Kingdom conceding its position on non portfolio dividends. While the rates of tax on interest and royalties were high by OECD standards they did represent a reduction in Australian source taxation of these items of income which had previously been taxed at full marginal rates. How dividends were to be defined in the treaty was also discussed in the morning session of the second day. Under United Kingdom domestic law various types of company distributions were treated as dividends for tax purposes. The United Kingdom view was that logically all such distributions should be taxed at the dividend rate. Where the United Kingdom legislation treated interest and royalties as dividends the United Kingdom view was that the alternatives were to treat them as dividends or tax them accordingly or to treat them as interest or royalties (as the case may be) on the basis that from a non resident’s perspective all that was being received was interest or royalties. The United Kingdom adopted the latter approach but expected reciprocity.116 Article 9(4) of the draft (an anti dividend stripping provision) would have meant that the limitations on source taxation in Articles 9(1) and (2) would not have applied to dividends paid to a shareholder, who was not subject to tax in its state of residence, owning 10 per cent or more of the shares on which the dividends were paid. The comments in the Notes of Meetings for the morning session of the second day on this paragraph are somewhat confusing. Evidently the deletion of the phrase ‘not subject to tax’ had been discussed although the previous Notes of Meetings do not record such discussion. The Australian delegation pointed out that the deletion of the phrase would leave all Australian shareholders within the mischief of the provision. The Notes of Meetings then record that the United Kingdom offered to write in an upper rate. The Australian inter-corporate dividend rebate would mean that all companies qualifying for the rebate plus all companies with losses and exempt entities would be caught. The Notes of Meetings then record that it was decided that Article 9(4) only apply to United Kingdom dividends flowing to Australia. At the same time a decision was made to remove the explicit direction in the proviso that the onus of satisfying the bona fide test rest with the shareholder.117 The issue of what was an effectively connected dividend was discussed on the morning session of the second day. The issue had been raised in Cain’s letter to Johnson. The discussion at the meeting (with the United Kingdom) merely confirmed that sales of shares in a 100 per cent subsidiary would not constitute trading receipts. The United Kingdom pointed out that under Australian law Australian banks received an inter-corporate dividend rebate under ITAA 1936 s46 but United Kingdom banks operating through branches in Australia did not. From the United Kingdom perspective Australian law meant that United

116 117

Book 1.indb 472

Notes of Meetings, Second Day, 3rd April 1967, Morning Session, p 2, Inland Revenue file. ibid.

12/2/2011 8:22:33 AM

The 1967 United Kingdom – Australia Taxation Treaty

473

Kingdom banks were at a competitive disadvantage when compared with Australian banks and that this was something which should be removed in the treaty. The basis of the United Kingdom argument presumably was that the dividends effectively connected with an Australian branch of a United Kingdom bank would be taxed under the industrial and commercial profits article and not under the dividend article. Taxing dividends received by the branch under the industrial and commercial profits article effectively involved giving the branch analogous treatment to an Australian resident company so far as the inclusion of dividends in assessable income was concerned but analogous treatment was not given in the case of the inter-corporate dividend rebate under s46. The Notes of Meetings record that the Australian reply was that Australia could levy dividend withholding tax on dividends paid by a resident company to a non resident shareholder but could not do this in the case of branches and hence took the tax where it could.118 The Australians had indicated on the morning session of the first day that they were not happy with Article 9(7) applying to Australian undistributed profits tax. The United Kingdom delegation indicated that their view was that the ban on undistributed profits tax was complementary to the ban on taxation of dividends paid by a non resident company to a non resident shareholder and that the Australian definition of private company meant that a wide range of companies, some of them quite substantial, were exposed to undistributed profits tax.119 The issue was discussed again on the morning session of the second day. It was noted that United Kingdom private companies were seldom, if ever, caught by undistributed profits tax. Australia was nonetheless concerned that, if it were to renounce undistributed profits tax on United Kingdom private companies in the Treaty, then United Kingdom private companies would be able to ‘plough back tax free’ a greater amount of retained profits than would similarly placed Australian companies.120 The United Kingdom response was that this was essentially an anti-avoidance issue and that this was properly a matter for the residence country. If the United Kingdom close company legislation were taken into account then United Kingdom companies were no better off.121 In the morning session of the second day a possible compromise was suggested to include a proviso in paragraph (7) that each country would undertake to levy only the same tax on non-residents as on residents.122 The Notes of Meetings do not indicate which delegation proposed this compromise. In the afternoon session of the second day it was decided to substitute a provision similar to Article VI(8) of the New Zealand treaty for paragraph (7). Article VI(8) of the New Zealand treaty restricted a source country from imposing tax on dividends 118

Notes of Meetings, Second Day, 3rd April 1967, Morning Session, p2, Inland Revenue file. Notes of Meetings, First Day, 31st March 1967, Morning Session, p3, Inland Revenue file. 120 Notes of Meetings, Second Day, 3rd April 1967, Morning Session, p2, Inland Revenue file. 121 ibid. 122 ibid. 119

Book 1.indb 473

12/2/2011 8:22:34 AM

474

C John Taylor

paid by a non resident company to a non resident shareholder but did not in terms prevent the source country from imposing undistributed profits tax on the non resident company. 123 The treatment of dividends paid in what was described as the ‘New Broken Hill’ situation (where a United Kingdom resident company paid dividends funded solely from Australian source profits to Australian resident shareholders) was to be a major point of disagreement in the negotiations which was not to be finally resolved until several months after the negotiations were otherwise concluded. In the negotiations in Canberra in March and April 1966 the issue was first raised on the afternoon session of the second day. The Australian delegation asked for a provision similar to Article 9 (8) of the United Kingdom – Canada Treaty arguing that there should be no United Kingdom tax on the dividends in the New Broken Hill situation simply because Australian source profits had passed through a conduit United Kingdom company en route to Australian shareholders.124 The United Kingdom response was that to give shareholders relief because dividends were funded a particular geographic source of profit would be inconsistent with the separate entity theory that now underpinned both Australian and United Kingdom corporate-shareholder taxation. Furthermore, the New Broken Hill situation was merely a variant on a company which had profits from several jurisdictions and in the latter case it was impossible to apportion dividends according to the source of profits. The United Kingdom delegation indicated that United Kingdom Ministers would have to be consulted before a decision could be made.125 The Australian delegation raised the New Broken Hill issue again on the morning session of the sixth day stating that if the United Kingdom was willing to drop the non discrimination article and tax on dividends in the New Broken Hill situation Australian ministers were prepared to accept, though with considerable reluctance, a shipping exemption. The Australian delegation further indicated that they would like a decision on the New Broken Hill situation before the end of discussions but that if no decision were reached by then they were authorised to initial the draft, with the shipping exemption, on the basis that the matter could be raised again at government level. The United Kingdom delegation’s response was that their ministers might take the view that except for Broken Hill relief the agreement was merely a standard agreement without a non discrimination article and might want some matching concession from Australia.126 The Australian delegation pointed out technical problems that would be involved in giving effect to a New Broken Hill concession if the United Kingdom

123 Article VI(8) of the United Kingdom – New Zealand Double Taxation Treaty of 11th August 1966 read as follows: VI(8) The Government of one of the territories shall not impose any form of taxation, in addition to tax on the company’s profits, on dividends paid by a company which is resident of the other territory to persons not resident in the first mentioned territory. 124 Notes of Meetings, Second Day, 3rd April 1967, Morning Session, p3, Inland Revenue file. 125 ibid.

Book 1.indb 474

12/2/2011 8:22:34 AM

The 1967 United Kingdom – Australia Taxation Treaty

475

were to agree to one. The proposed exemption was to apply where a United Kingdom resident company paid a dividend to an Australian resident company in a situation where 90 per cent of the profits of the United Kingdom company were derived in Australia. The actual situation in New Broken Hill was that New Broken Hill, a United Kingdom company carried on business in Australia through a branch. The relevant Australian corporate shareholder was CRA but another company, BHC, was interposed between New Broken Hill and CRA. For CRA to obtain the proposed exemption on dividends received from BHC it would have to show that the dividends could be traced through to New Broken Hill’s profits. To ensure the exemption was obtained, BHC could dispose of its 32 per cent shareholding in New Broken Hill to CRA or to some other Australian company. However, if the shareholding were disposed of to CRA then CRA would own 54 per cent of the shares in New Broken Hill with the result that New Broken Hill would be an Australian resident for Australian tax purposes and a United Kingdom resident for treaty purposes. This would mean that Australia could impose a 15 per cent withholding tax on dividends paid by New Broken Hill to United Kingdom shareholders but the 90 per cent of profits rule would mean that the United Kingdom would be prevented from taxing dividends paid to Australian corporate shareholders. The Notes of Meetings comment that the problem would have to be resolved by providing that where the 90 per cent rule applied Australia would not treat the company as a resident for the purposes of the ‘criss cross’ rule.127 The position in relation to trusts was discussed on the morning session of second day. The Australians explained that Australia taxed the trustee of a discretionary trust and the trustee of estates in the course of administration where no beneficiary was presently entitled to the trust income. The Australians envisaged that the United Kingdom draft of September 1966 might open up opportunities for tax avoidance. The example given was that of a United Kingdom trust set up with a fund of Australian shares and Australian beneficiaries. The Australian view was that under the draft Australia would only get 15 per cent withholding tax on the dividends, the United Kingdom might have to give up its tax on the winding up of the trust, and Australia would get nothing more as it did not tax distributions out of trust accumulations.128 The Notes of Meetings record that it was agreed to not put any special provision for trusts in the dividend article and to consider excluding trust income from 126

Notes of Meetings, Sixth Day, 7th April 1967, Morning Session, p1, Inland Revenue file. Notes of Meetings, Sixth Day, 7th April 1967, Morning Session, p2, Inland Revenue file. Subsequent references to New Broken Hill in the Notes of Meetings are in the context of the Non Discrimination article and the general conclusion to the negotiations. 128 Where no beneficiary was presently entitled to the income of the trust estate or to any part of the income of the trust estate Income Tax Assessment Act (1936) Cth s99 as it then stood a trustee was assessed and liable to pay tax on the net income or the relevant part of the net income. At that time no provision in the Income Tax Assessment Act (1936) Cth taxed beneficiaries on subsequent distributions of accumulated income. 127

Book 1.indb 475

12/2/2011 8:22:34 AM

476

C John Taylor

the ‘sweep up’ (ie other income) article as had been done in the New Zealand Agreement.129

Interest Subject to some exceptions, principally where payment was made to a permanent establishment, the United Kingdom draft of September 1966 exempted interest from source taxation.130 If agreed to this would have represented a very significant change from the 1946 Treaty where full source country taxing rights in relation to interest were retained. The draft interest article was discussed in the afternoon session of the first day of negotiations. The Notes of Meetings observe that the current Australian system of taxing interest paid to non residents at marginal rates was easily avoided as tax was not payable where interest was paid on a contract which enabled the lender to enforce payment without deduction of tax.131 Australia was proposing to introduce a withholding tax likely to be at a 10 per cent rate. Australia argued for a reciprocal limitation of the rate to the proposed rate of Australian withholding tax. The United Kingdom objected that, in effect, this would allow Australia but not the United Kingdom to tax at its full statutory rate. Given this the United Kingdom view was that it might be preferable to drop the interest Article altogether.132 The interest article was discussed again on the morning session of the third day. The details of the then current Australian system of taxing interest were outlined as were Australian plans to introduce a 10 per cent withholding tax on interest paid to non residents. The Notes of Meetings record that Australia was not prepared to surrender to the residence country entirely its right to tax interest but would accept a reciprocal rate of 10 per cent and that this was agreed and that the Australians would produce a revised draft of Article 10. It was also noted that, as Australian borrowers received a deduction for interest paid Article 10(4) needed to be reciprocal as did Article 10(5) even though Australia did not then have anti bond washing provisions.133

129

Notes of Meetings, Second Day, 3rd April 1967, Morning Session, p 2, Inland Revenue file. Article 10 of United Kingdom Draft, September 1966, Inland Revenue file. 131 At the time of the negotiations in Canberra in 1967 Australian treatment of interest paid to non residents was unchanged from the treatment that applied in 1945. See the discussion of that treatment in Taylor, supra note 23 at 202 to 204. 132 Notes of Meetings. First Day, 31st March 1967, Morning Session, pp 3–4, Inland Revenue file. 133 Notes of Meetings, Third Day, 4th April 1967, Morning Session, p 1, Inland Revenue file. The interest article is not mentioned subsequently in the Notes of Meetings. 130

Book 1.indb 476

12/2/2011 8:22:34 AM

The 1967 United Kingdom – Australia Taxation Treaty

477

Royalties The draft Royalty article was discussed on the afternoon session of the first day. The Notes of Meetings observe that at the time large amounts of royalties and know how payments were leaving Australia but that Australia was unable to tax them either because the contracts were arranged so that it was difficult to allege an Australian source or because they were ‘dressed up’ as industrial and commercial profits. The Australian delegation evidently indicated that the government’s intention was to legislate to define royalties in similar terms to those used in Article 5 of the United Kingdom draft and to deem them to have an Australian source and tax them on an assessment basis if they were exploited in Australia. Australia’s view was that the country of source ought to have the right to tax but that it was prepared to concede a reduced rate of tax in the treaty.134 By contrast, the view expressed by the United Kingdom delegation was that royalties should be taxed on a residence basis. This was on the basis that the gross royalty did not represent true profit as it took no account of expenses. Only the country of residence was in a position to tax royalties fairly as only the country of residence was able to say what expenses ought properly to be allowed.135 There was further discussion of the Royalty article on the morning session of the third day. The then current Australian treatment of royalties paid to non residents was outlined in more detail. Australia taxed royalties on a net basis at normal rates and claimed entitlement to tax royalties paid to non residents on the basis that the royalties were: (a) paid out of Australian source profits; (b) deductible from the payer’s Australian source profits; and (c) because Australia provided the conditions under which the licensor could exploit knowledge. It was noted that the outflow of royalties to the United Kingdom was considerable with the Australian estimate being between $A10 million to $15 million while the United Kingdom estimate was $A7 million gross. The United Kingdom delegation’s view was that royalties should be taxed on a residence basis reiterating the reasons given on the first day and arguing that exemption in the source country encouraged the free interchange of technical knowledge. The United Kingdom view was that the rate of source country tax should not exceed 10 per cent. The Notes of Meetings record that the Australian delegation would make a submission to Australian ministers to the effect that the rate on royalties (including copyright royalties) not exceed 10 per cent and that there be a uniform 15 per cent rate on dividends.136 On the morning session of the third day it was also agreed that ‘information’ be added after ‘rights or property’ in Article 11(3) to cover title to receive payments 134

Notes of Meetings, First Day, 31st March 1967, Morning Session, p3, Inland Revenue file. Notes of Meetings, First Day, 31st March 1967, Morning Session, p 4, Inland Revenue file. 136 Notes of Meetings, Third Day, 4th April 1967, Morning Session, p 1, Inland Revenue file. 135

Book 1.indb 477

12/2/2011 8:22:34 AM

478

C John Taylor

from know-how. The Notes of Meetings record that a definition along the lines of the definition in the United Kingdom – New Zealand agreement would conform more closely to the new definition proposed to be put into Australian domestic law. Hence it was agreed to redraft Article 11(3) accordingly.137

Shipping and Air Transport The Notes of Meetings of the morning session of the first day record that Australian Ministers had given instructions that Australia should have the right, in any new agreement, to tax United Kingdom shipping profits in accordance with Australian domestic law. The United Kingdom would not agree to this and produced a written statement of the United Kingdom view.138 The United Kingdom was prepared to agree to allow Australia to tax the profits of ships engaged in coastal trade but wanted to give further consideration to whether to extend this concession to voyages between Australia and Papua New Guinea.139 On the morning session of the first day the Australian delegation also indicated that they wanted to examine the definition of ‘international traffic’ to ensure that it would allow Australia to tax the profits of voyages solely between Australian ports.140 The official Australian record of the discussions notes that shipping profits were discussed again on the third day and that there was ‘a total opposition of views, which was not resolved’.141 This record notes that the Australians stressed that Ministers had given firm directions on the taxation of international shipping and that any question of derogation from this position would have to be referred back to Ministers.142 The United Kingdom ‘Notes of Meetings’ records that the Australian delegation commented that ‘their Ministers might be more inclined to accept the United Kingdom views on the taxation of shipping if they could report a favourable solution to the dividend question’; something on which the United Kingdom had not yet reached a final decision.143 The treatment of shipping profits was only finally resolved through correspondence, discussed below, following the conclusion of the negotiations.

137 Notes of Meetings, Third Day 4th 1967, Morning Session, p 2, Inland Revenue file. The royalties article is not mentioned subsequently in the Notes of Meetings. 138 Both the ‘Notes of Meetings’ and the official Australian ‘Report of Discussion’ refer to the United Kingdom circulating a paper on the first day setting out its views on the international taxation of shipping and air transport. The author has been unable to locate the paper in either the United Kingdom National Archives or the National Archives of Australia. 139 Notes of Meetings, Morning Session, p 4, Inland Revenue file. 140 Notes Of Meeting, First Day, 31st March 1967, Morning Session, p1, Inland Revenue file. 141 Report of discussions on 4th April 1967, Australian Treasury file. 142 Report of discussions on 4th April 1967, Australian Treasury file. 143 Notes of Meetings, Third Day, 4th April 1967, Morning Session, p 1, Inland Revenue file. The only subsequent mention of the shipping and air transport article in the Notes of Meetings is in the morning session of the 9th day under the general heading.

Book 1.indb 478

12/2/2011 8:22:34 AM

The 1967 United Kingdom – Australia Taxation Treaty

479

Immovable Property Income from immovable property was originally dealt with in Article 5 of the United Kingdom draft of September 1966.144 The Notes of Meetings for the morning session of the first day record that the article ‘dealt with agricultural enterprises but there might be some advantage in transferring to Article 4’.145 Clearly this suggestion came from the Australian delegation. As noted above, the Notes of Meetings also record that on the first day the Australians indicated that they intended to raise the issue of including agricultural and pastoral properties in the definition of permanent establishment. The article was discussed again on the morning session of the first day in the context of the definition of permanent establishment. As noted above the Australians pointed out that agricultural and pastoral properties were included in the definition of permanent establishment in the 1946 Treaty as it did not contain an immovable property article. The Australian view was that the disadvantage of including them under the immovable property article as in the September 1966 draft was that it did not give the protection of the rules in the Business Profits article about the allowance of reasonable expenses. It appears that the United Kingdom then agreed with the Australian suggestion on this point.146 The article was discussed again on the morning session of the fifth day. By this stage it had been renumbered as Article 8. The Notes of Meetings record that it had been agreed that the article should be amended to allow ‘agricultural enterprises etc to have their expenses in accordance with the principles in article 6’. Difficulties in the interpretation of the article and possible conflicts with article 6(7) [which taxed effectively connected rents as business profits] were noted. As the article did not ‘secure any result other than that achieved under domestic law’ a decision was made to delete it.147 This comment in the Notes of Meeting provides support for the view that it was intended that each treaty partner’s domestic law would have its full effect in relation to items not specifically dealt with in the treaty.

Capital Gains The United Kingdom draft of September 1966 had included a capital gains tax article. On the afternoon of the first day of negotiations the Australians pointed 144

Article 5 of United Kingdom Draft, September 1966, Inland Revenue file. Notes of Meetings, First Day, 31st March 1967, Morning Session, p 2, Inland Revenue file. Article 4 contained the definition of Permanent Establishment. Including agricultural enterprises within the definition of Permanent Establishment would mean that they were taxed under the Industrial and Commercial Profits article which was Article 6 in the draft of September 1966. 146 Notes of Meetings, Third Day, 4th April 1967, Morning Session, p 2, Inland Revenue file. 147 Notes of Meetings, Fifth Day, 6th April 1967, Morning Session, p1, Inland Revenue file. 145

Book 1.indb 479

12/2/2011 8:22:34 AM

480

C John Taylor

out that, although Australia had no capital gains tax at present, the existence of the article would ‘tie their hands’ in relation to the United Kingdom if they ever introduced one in the future. The United Kingdom pointed out that the draft article was reciprocal but that an article based on the OECD Model was an alternative if Australia did not like the draft article. The Australians questioned the need for the article and indicated that they would prefer that the article be dropped altogether something which the United Kingdom delegation indicated they would consider.148 Handwritten notes by an Australian Treasury official observe that the political climate, in the Senate for example, was against CGT and that the inclusion of the article might prevent passage of the DTA through the Senate.149 The article is not mentioned again in either official record of the discussions until the fifth day where both official records confirm that the article was to be omitted.150 It is clear from the notes of the meeting that the Australian delegation considered that by not including a capital gains tax article in the treaty Australia would retain full rights to levy capital gains tax on United Kingdom residents if it subsequently introduced a capital gains tax.

Other Income The United Kingdom draft of September 1966 contained an ‘other income’ article which gave the country of residence exclusive right to tax income not expressly mentioned in other articles.151 On the afternoon of the first day of negotiations the Australians stated that they considered that this article only needed to cover third country taxes and that they were concerned about its application in the case of trusts.152 The United Kingdom representatives stated that they were advised that the article would not prevent the United Kingdom from taxing dividends going to Australian beneficiaries of a United Kingdom trust.153 This analysis appears to have been based on the view, held in both the United Kingdom and Australia, that dividend income retained its character as dividend income when it flowed through a trust. The notes on the afternoon session of the 5th day of negotiations record that the article ‘contradicts the Australian’s general philosophy concerning the taxation of income flowing abroad and they cannot accept it as it stands’. 148 Notes of Meetings, First Day, 31st March 1967, Morning Session, p4, Inland Revenue file. See also Notes of discussions 13/3/67 – 14/4/6, Australian Treasury file, handwritten notes by an Australian Treasury official, 31st March 1967. 149 See also Notes of discussions 13/3/67 – 14/4/6, Australian Treasury file, handwritten notes by an Australian Treasury official, 31st March 1967. 150 Notes of Meetings, Fifth Day, 6th April 1967, Morning Session, p 1, Inland Revenue file. Report of discussions on 6th April 1967, Australian Treasury file. The Australian record makes it clear that the article was omitted at Australia’s request. 151 Article 20 of United Kingdom Draft, September 1966, Inland Revenue file. 152 Notes of Meetings, First Day 31st March 1967, Afternoon Session, p 5, Inland Revenue file. 153 Notes of Meetings, First Day 31st March 1967, Afternoon Session, p 5, Inland Revenue file.

Book 1.indb 480

12/2/2011 8:22:34 AM

The 1967 United Kingdom – Australia Taxation Treaty

481

The notes record that the Australians were prepared to accept the results of the article as regards third country tax. It was noted that if the article were to be so restricted then there would be nothing in the Treaty dealing with alimony, but this was not seen as being of comparatively minor importance. Australia at the time regarded alimony as exempt to the recipient and as non deductible to the payer. Restricting the article to third country tax was not seen to create problems in relation to trusts as both the United Kingdom and Australia treated income flowing through a trust in which beneficiaries had an absolute interest as retaining its original identity. The notes comment that the absence of another income article would only be felt in the case of discretionary trusts which would be treated on an empirical basis. The notes then record that ‘It was in consequence agreed that the Article should be amended to restrict its scope to third-country tax’.154 It is reasonably clear from the notes that, by restricting the other income article to third-country taxes both parties considered that they would retain full taxing rights in relation to income not otherwise dealt with in the Treaty. This is particularly evident from the Australian comment that the original article, which gave exclusive taxing rights to the residence country, contradicted Australia’s general philosophy concerning the taxation of income flowing abroad.

Credits As noted above, the major reason why the United Kingdom wanted the Australian treaty reviewed was to restrict the circumstances in which it would, following the introduction of United Kingdom corporation tax, grant a foreign tax credit for underlying foreign corporate tax. The draft credit article limited the availability of credits for underlying corporate tax to situations where the recipient of the dividend was a company holding a 10 per cent or greater interest in the paying company. Draft article 22(1)(b) indicated that the United Kingdom would grant credit for Australian corporate tax in this situation. A marginal note in the draft indicated that the inclusion of (b) was subject to reciprocity. The draft indicated that the reciprocal provision was to be drafted by Australia. In the afternoon session of the first day of negotiations the Australian delegation proposed that the minimum percentage shareholding for which an underlying foreign tax credit would be allowed should be reduced to 5 per cent. In the United Kingdom view there was no logic in this suggestion. The reason for the minimum shareholding requirement was to limit credit for underlying tax to dividends from ‘trade investment’. It was unlikely that a trade investor would have a less than 10 per cent shareholding but it was possible that a portfolio investor might hold 5 per cent.155 154 Notes of Meetings, Fifth Day, 6th April 1967, Afternoon Session, p 2, Inland Revenue file. The other income article is not mentioned subsequently in the Notes of Meetings. 155 Notes of Meetings, First Day, 31st March 1967, Morning Session, p 5, Inland Revenue file.

Book 1.indb 481

12/2/2011 8:22:35 AM

482

C John Taylor

On the question of reciprocity the Notes of Meeting record that on the first day the United Kingdom’s preferences were in the following order: (1) to write in each country’s domestic laws; (2) to link the United Kingdom commitment to the continuance of the present Australian exemption; and (3) to have a consultation provision on the New Zealand model.156

The Notes of Meeting indicate that Australia’s preference at this stage was for 3.157 The credit article was not discussed again until the afternoon session of the fifth day. By this time Australia was no longer pressing for a reduction in the minimum shareholding percentage for an underlying foreign tax credit. The Australian delegation explained their reasons for preferring to deal with reciprocity by using a consultation provision modelled on the United Kingdom – New Zealand treaty. The Australians regarded the first alternative, of writing in each country’s domestic laws, as removing their freedom of action for a considerable time in the future. They were concerned that the second alternative, of linking the United Kingdom’s commitment to the continuance of the present Australian exemption, might mean that the United Kingdom could be released from its obligation to provide an underlying foreign tax credit if Australia did nothing more than change its law by adopting a foreign tax credit system which provided for underlying foreign tax credits. The United Kingdom accepted the Australian proposal that there should be consultation to establish the new rules if and when Australia’s existing rules were changed.158 The Notes of Meetings then record that rules would be needed to resolve conflicts between the United Kingdom and Australian law on the source of interest and royalties to enable credit to be given for tax deducted from ‘criss cross’ dividends paid by dual resident companies.159 The credit article was also briefly discussed in the afternoon session of the sixth day. Here it was agreed to amend Article 21(4) so that it could apply both where Australia gave relief in the form of credit (as in the case of dividends) or exemption. In the same session source rules for dividends, interest and royalties were inserted.160 156 The relevant provision in the 1966 United Kingdom – New Zealand Treaty was Article XVIII(2) (b) which read as follows: In the event that the Government of New Zealand should impose a tax on dividends received by companies which are resident in New Zealand the Contracting Governments will enter into negotiations in order to establish new provisions concerning the taxation of such dividends derived from sources in the United Kingdom. 157 Notes Of Meeting, First Day, 31st March 1967, Morning Session, p 5, Inland Revenue file. 158 Notes of Meetings, Fifth Day, 6th April 1967, Afternoon Session, p 2, Inland Revenue file. 159 Notes of Meetings, Fifth Day, 6th April 1967, Afternoon Session, p 2, Inland Revenue file. The Notes of Meetings also record that the insertion of source rules in Articles 13, 14 and 15 meant that the source rule in paragraph (3) of the credit article was no longer necessary so far as it related to personal and professional services but that it needed to be kept for services on board ships and aircraft. 160 Notes of Meetings, Sixth Day, 7th April 1967, Afternoon Session, p3, Inland Revenue file. At this session it was also agreed to amend the source rule in Article 21(4) dealing with services aboard ships and aircraft to make it consistent with Article 14(3).

Book 1.indb 482

12/2/2011 8:22:35 AM

The 1967 United Kingdom – Australia Taxation Treaty

483

Non Discrimination The United Kingdom draft of September 1966 contained a non discrimination article. None of Australia’s previous Double Taxation Treaties had contained a non discrimination article and, moreover, a non discrimination article had not been requested by Australia’s treaty partner in any of those earlier treaties. The Notes of Meeting for the afternoon session of the first day of negotiations record that the article was not acceptable to Australian ministers. Although Australia did not discriminate on the basis of nationality the notes list a number of examples of ways in which Australia did discriminate against non residents. The discriminatory treatments listed in the notes are: (a) the inter-corporate dividend rebate; (b) the exemption for profits for uranium mining; (c) the tax reliefs to residents who subscribe capital for mineral exploration. The notes observe that, while Australia at the time did not levy a branch profits tax and while the then government was not contemplating levying such a tax, there had been a good deal of political controversy on the subject. Including a non discrimination article in the treaty was seen as likely to be highly embarrassing by adding fresh fuel to arguments over branch profits tax.161 The United Kingdom responded to the Australian arguments on the non discrimination article on the first day by saying that one of functions of a double taxation agreement was to do away with discrimination against non-residents and that a non discrimination article was therefore ‘a natural constituent of an agreement’ and pointed to similar articles in their agreements with the United States, Canada and New Zealand. The United Kingdom argued that there was noting in the draft article that would prevent Australia from ‘refusing the dividend rebate’ and that it could be amended so as to enable the exemption for uranium mining to be continued in its present form. The United Kingdom delegation pointed out that the absence of a non discrimination article would mean that Australian insurance companies would not be able to get full relief for their management expenses.162 On the argument that the inclusion of the article would restrict Australia’s freedom in the future the United Kingdom delegation responded that this was true of any article in the agreement.163

161

Notes of Meetings, First Day, 31st March 1967, Afternoon Session, p 5, Inland Revenue file. In Ostime v Australian Mutual Provident Society [1960] AC 459 a majority of the House of Lords held that an Australian insurance company’s taxable surpluses were ‘industrial and commercial profits’ and hence were only taxable under Article III(2) of the 1946 United Kingdom – Australia Treaty and not on a proportion of its world wide income attributable to the United Kingdom under United Kingdom domestic law. As a consequence the United Kingdom amended its domestic law so as to continue to apply a global apportionment approach to determining the income of a life assurance company that was subject to United Kingdom tax. The draft treaty contained savings clause in relation to these provisions in United Kingdom domestic law. Johnson had commented in his letter to Cain of 3rd February 1967 that in the absence of the savings clause Australian life companies could only claim management expenses except that under the non discrimination article relief could be allowed against the part of the dividends attributable to the United Kingdom branch. 163 Notes of Meetings, First Day, 31st March 1967, Afternoon Session, p 6, Inland Revenue file. 162

Book 1.indb 483

12/2/2011 8:22:35 AM

484

C John Taylor

The non discrimination article was discussed again in the morning session of the fourth day of negotiations. The United Kingdom reiterated its arguments from the first day adding that the article would also override the Finance Act provision which denied a resident company a deduction for interest paid to a non resident. The United Kingdom delegation then linked the non discrimination article with the negotiations over the treatment of dual resident companies (typified at the time by New Broken Hill) and the rates of withholding tax on dividends. The delegation indicated that the United Kingdom would be prepared to consider relief in the dual resident company case if there was a matching concession by Australia on either the non discrimination article or in agreeing to the OECD rate on dividends.164 The Notes of Meetings record that the Australian response to the United Kingdom’s request for a balancing concession was to raise the issues of the treatment of shipping profits and the United Kingdom’s wish to withdraw underlying tax relief for portfolio dividends. As the withdrawal of credits for underlying tax for portfolio dividends was the issue that had generated the negotiations in the first place the Australians were on strong ground with this argument.165 The Notes of Meetings summarise the Australian argument as follows: It has long been felt that the existing agreement was weighted in the United Kingdom’s favour but Australia had been prepared to live with it as long as the United Kingdom had a tax system favourable to overseas investment. It was now a question of whether the concessions so far offered were an adequate compensation for the changed situation brought about by the corporation tax.166

The United Kingdom replied to this argument by saying that credits for underlying tax would still be available for direct investment (which they presumed to be the form of investment of greatest concern to Australia) and, subject to certain conditions, for insurance company portfolio dividends which could be written into the agreement if necessary. The United Kingdom also pointed out that any source tax on subsidiary dividends would be a disincentive to investment as it would fall on the parent company.167 The Notes of Meetings then record that the United Kingdom undertook to put to Ministers Australia’s compromise proposal that New Broken Hill (ie dual resident company) dividends should be exempt but that the exemption should be withdrawn if Australia subsequently introduced a branch profits tax.168 On the morning of the sixth day the Australian delegation indicated that if the United Kingdom was prepared to drop the non-discrimination article and to exempt New Broken Hill type dividends and provided there were no other 164

Notes of Notes of 166 Notes of 167 Notes of 168 Notes of 165

Book 1.indb 484

Meetings, Fourth Day, 5th April 1967, Morning Session, p 1, Inland Revenue file. Meetings, Fourth Day, 5th April 1967, Morning Session, p 1, Inland Revenue file. Meetings, Fourth Day, 5th April 1967, Morning Session, p 1, Inland Revenue file. Meetings, Fourth Day, 5th April 1967, Morning Session, p 1, Inland Revenue file. Meetings, Fourth Day, 5th April 1967, Morning Session, p 2, Inland Revenue file.

12/2/2011 8:22:35 AM

The 1967 United Kingdom – Australia Taxation Treaty

485

matters in the agreement adverse to Australia, then Australian ministers would, with great reluctance, accept a shipping exemption. The Australian delegation indicated that they would like a decision on the New Broken Hill issue before the end of the discussions but that if none were forthcoming they were authorised to initial the agreement with a shipping exemption on the understanding that the New Broken Hill issue would be taken up at a government level.169 The United Kingdom representatives replied that they would telegraph home for instructions but commented that their Minister might regard the agreement, without the New Broken Hill clause, as being merely a standard agreement without a nondiscrimination article and might want some matching concession.170 Johnson arranged for a telegram to be sent to Brookes of Internal Revenue on 7th April 1967. The telegram indicated that the Australians were ‘anxious that dividends paid to their residents by UK companies operating almost wholly in Australia should be exempt from UK withholding tax’ and gave New Broken Hill as an example of such a company. The exemption sought in the New Broken Hill situation would be withdrawn if Australia ever imposed a branch profits tax. Johnson also indicated that the Australians were very reluctant to exempt international shipping profits. Johnson went on to summarise what, on the basis of discussions to date, he saw as the likely content of the balance of any agreement with Australia. There would be uniform reciprocal rates of 15 per cent on dividends, 10 per cent on interest and 10 per cent on royalties, credit relief for underlying tax for portfolio shareholders would be withdrawn, there would be no non discrimination article (‘because the Australians refuse to commit themselves in this way’) and Australia would retain the right to tax premiums for the reinsurance in London of Australian risks. Johnson commented that he had made what case he could for a 5 per cent rate on subsidiary dividends but had to concede that ‘a 15 per cent rate was in line with a common pattern’. Johnson reported that the Australians had indicated that if Johnson could be given the authority to concede New Broken Hill relief they would initial a text containing a shipping exemption on while reserving the right to reopen the matter at a Government level. The Australian’s had requested that Johnson seek the necessary authority and wanted the matter settled, if possible, during the discussions in Canberra. Johnson summarised what his reply to the Australian request had been; that United Kingdom Ministers may take the view that New Broken Hill relief was not appropriate in an agreement that did not contain a non discrimination article, provided no protection for United Kingdom insurers and in other respects was no more than satisfactory. Johnson had also indicated to the Australians that United Kingdom Ministers would be preoccupied with the budget at that time. Johnson considered that, as a last resort, the United Kingdom should accept the bargain proposed by the Australians but noted that 169 170

Book 1.indb 485

Notes of Meetings, Sixth Day, 7th April 1967, Morning Session, p 1, Inland Revenue file. ibid.

12/2/2011 8:22:35 AM

486

C John Taylor

it was possible, if unlikely, that if the Australians were left to raise the matter at a Government level the United Kingdom could secure a reduction of tax on non portfolio dividends as well as the shipping exemption.171 In response to Johnson’s telegram some ‘back of the envelope’ calculations were undertaken by officers of the United Kingdom Board of Inland Revenue to determine the likely net revenue effect of the Australian proposal.172 Brookes replied to Johnson by telegram on 11th April 1967. Brookes indicated that New Broken Hill Relief could not be conceded without Ministerial Authority and that it was impossible to obtain the Chancellor of the Exchequer’s decision at that time. In addition, ‘we should have to square treasury first on balance of payments aspects’. Brookes’ advice was that it would be wiser not to initial anything as initialling would involve accepting Australia’s view on non discrimination, non portfolio dividends, and insurance. The Australian reservation on shipping meant that their initialling of that article was worthless. There was no objection to settling the drafting of these and other articles without prejudice to the policy.173 The next mention of the non discrimination article in the Notes of Meetings is in the record of the morning session of the ninth day. The notes record that the United Kingdom delegation communicated the gist of the reply, summarised above, that they had received from London.174 The Australian representatives replied that they had authority to initial an agreement with a shipping exemption, provided there was no non discrimination article and provided that the agreement was satisfactory in other respects. If there was no concession on the New Broken Hill issue they reserved the right to raise the matter at a governmental level independent of the agreement.175 The United Kingdom delegation’s response was that if such an approach were taken their Minister might want a quid pro quo elsewhere in the agreement and that they would not want to do anything at this point that would inhibit him from doing this.176 The United Kingdom concern appears to be reflected in the decision recorded in the Notes of Meeting at this point: ‘it was agreed that the draft should be initialled on the terms provisionally accepted during the course of the negotiations, with the addition of a covering memorandum to the effect that if New Broken Hill were raised, Ministers feel free to exercise their right to re-open other matters’.177 Johnson sent a telegram to Brookes on 12th April 1967 reporting Australian offer to initial a text which did not contain Broken Hill relief but which did include a shipping exemption and which dealt with other matters in the manner 171 Telegram, Canberra to Commonwealth Office, Following for Brookes, Inland Revenue, from Johnson, UK team, 7th April 1967. Inland Revenue file, Part II. 172 File notes dated 7th April 1967, Inland Revenue file, Part II. 173 Telegram, Commonwealth Office To Canberra, Following Personal for WHB Johnson, U.K. Team From Brookes, 11th April 1967, Inland Revenue file, Part II. 174 Notes of Meetings, Ninth Day, 12th April 1967, Morning Session, p1, Inland Revenue file. 175 ibid. 176 ibid. 177 ibid.

Book 1.indb 486

12/2/2011 8:22:35 AM

The 1967 United Kingdom – Australia Taxation Treaty

487

set out in Johnson’s telegram of 7th April 1967 on the basis that the Australian government might raise the issue of New Broken Hill relief with the Chancellor of the Exchequer separately on the condition that they would not seek to change other items if New Broken Hill relief was refused. Johnson reported that the delegates had agreed, subject to Brookes’ approval, to initial the draft text together with a memorandum recording the Australian Government’s wish to approach the Chancellor of the Exchequer about New Broken Hill relief and that, in the event of such an approach, the United Kingdom Government might wish to re-open matters on their side. Johnson considered the proposed agreement acceptable. The non-discrimination article was probably of little practical significance, the United Kingdom had a uniform 15 per cent rate on dividends in other agreements, had conceded insurance to Australia and to other countries in previous agreements and the United Kingdom now had its own desire to reverse the decision in Ostime v Australian Mutual Provident Society.178 Brookes’ brief telegram in reply dated 12th April 1967 simply stated ‘Content you should initial’ on the terms set out in Johnson’s telegram.179 A draft was evidently initialled at this point and members of the United Kingdom delegation left Australia on 16th April 1967.180

THE SUBSEQUENT CORRESPONDENCE AND DRAFTING

Following the conclusion of the negotiations Australia prepared a draft which was initialled by the delegations and forwarded to the United Kingdom. Major issues and detailed drafting amendments were then eventually resolved through correspondence without further meetings between officials.

New Broken Hill The major issue to be resolved following the discussions in Canberra was Australia’s request for an exemption from United Kingdom dividend withholding tax in the case of United Kingdom companies with the overwhelming majority of their business activities in Australia paying dividends to Australian resident shareholders. Following the return of the Inland Revenue taxation treaty delegation to London, correspondence passed between United Kingdom government officials on policy issues associated with the Australian request. The United Kingdom Inland Revenue file appears incomplete at this point and it is 178 Telegram From Canberra To Commonwealth Office, Following For Brookes From Johnson, 12th April 1967, Inland Revenue file, Part II. 179 Telegram From Commonwealth Office To Canberra, For WHB Johnson Inland Revenue Team From Brookes Inland Revenue, 12th April 1967, Inland Revenue file, Part II. 180 Telegram From Canberra To Commonwealth Office, Following For Inland Revenue (JM Green), 14th April 1967, Inland Revenue file, Part II.

Book 1.indb 487

12/2/2011 8:22:36 AM

488

C John Taylor

difficult to ascertain the precise sequence of correspondence and events. The initial recommendation from Inland Revenue to the United Kingdom Treasury noted that although there were benefits for the United Kingdom in the Treaty (removal of the requirement to give credit for underlying corporate tax and the exemption of shipping and aircraft profits from source taxation) the Treaty did not contain a non discrimination clause and made a number of other concessions to Australia particularly in relation to the level of source taxation permitted on dividends, royalties and interest. The uniform rate of 15 per cent source taxation on dividends contrasted with the exemption of subsidiary to parent dividends in the 1946 Treaty. The revenue cost was estimated at £1.5 million but the greater part of this was expected to fall on United Kingdom parent companies rather than on the Exchequer. At a cost of £0.25 million royalties were to be taxed at 10 per cent at source in contrast to the complete exemption under the 1946 Treaty. Interest was to be subject to 10 per cent taxation at source which while an improvement from the 1946 Treaty (under which a source country could tax interest at its domestic rate) represented a ‘derogation from our ideal, which is again complete exemption’. The recommendation noted, however, that the overwhelming proportion of interest received by United Kingdom residents from Australia was on Australian government securities and was exempt from source taxation. The recommendation made was for the Chancellor of the Exchequer to refuse any special relief in the New Broken Hill situation for the present time and to wait for a further approach from Australian Ministers in the expectation that it was ‘just conceivable’ that Australia might then offer something in exchange such as a reduction in the withholding tax rate on dividends paid by Australian subsidiaries to their United Kingdom parent.181 The Treasury view, on 10th April 1967, prior to the conclusion of the negotiations was to refer to a 1966 decision to not exempt dividends from withholding tax in the New Broken Hill situation and to suggest that the Inland Revenue put in writing a request for a reconsideration of this decision.182 Cain wrote to Johnson on 19th April 1967 reiterating the discussion that had occurred during the negotiations in Canberra relating to problems envisaged when both New Broken Hill relief and a criss cross dividend rule for dual resident companies applied. After noting that solutions to the problem discussed in the Canberra negotiations had not been found to be workable, Johnson suggested that a 90 per cent rule along the lines of the United Kingdom – Canada Treaty be adopted whether or not the dividend paying company was a dual resident and that the criss cross dividend rule continue to apply. In support of the Australian 181 Memorandum, ‘PS 1152/67Mr Baldwin’, Inland Revenue file, Part II. From the content of the memorandum it is clear that this is from Inland Revenue to Treasury. From the content, the location in the file and from the context of surrounding documents it appears likely that this was the first memorandum sent by Inland Revenue to Treasury after the conclusion of the discussions in Canberra. 182 Memorandum to (obscured) P Dodd, Mr Lavelle, from B P Hudson, 10th April 1967. Inland Revenue file, Part II.

Book 1.indb 488

12/2/2011 8:22:36 AM

The 1967 United Kingdom – Australia Taxation Treaty

489

request Cain pointed out that if New Broken Hill had been permitted by the United Kingdom Treasury to migrate to Australia the United Kingdom would have been in a much worse revenue position than it would be under the 90 per cent rule proposal. In Cain’s view Australia was seeking a ‘half way house’ between two points of view and stressed that he was writing as one official to another and that if a Government to Government approach became necessary that would be at a later stage. A draft 90 per cent rule article was attached to Johnson’s letter.183 Johnson sent a draft submission to the Chancellor of the Exchequer to David Hubback of the United Kingdom Treasury on 16th May 1967. The draft submission considered the Australian request as set out in Cain’s letter ‘quite unacceptable’. The objection was that the combination of the 90 per cent rule and the criss cross dividend rule could mean that where a company fitting within the 90 per cent rule was a dual resident company the United Kingdom would be prevented from levying withholding tax on dividends it paid to Australian residents but the criss cross rule would mean that Australia would be able to levy withholding tax on dividends that it paid to United Kingdom residents. The draft submission proposed that the 90 per cent rule apply either: (a) to companies that were single residents of the United Kingdom or to dual residents on the condition that Australia gave up its withholding tax on dividends paid to United Kingdom shareholders of any dual resident company qualifying for relief under the 90 per cent rule; or (b) only to companies that were single residents of the United Kingdom. An advantage of alternative (a) was that it would reduce the size of problems encountered in relation to dual resident companies as it would mean that, instead of each country taxing and giving credit for dividends from some of these companies each country would exempt dividends from them. The draft submission summarised arguments for not agreeing to this form of relief with Australia at all and estimated the revenue cost and balance of payments effects of agreeing to the relief. The draft submission considered that the overall cost of the relief (an upper estimate of £32,000 per year) was unlikely to be large when compared with the gain to the United Kingdom from having a uniform 15 per cent withholding tax rate in the dividend article (estimated to be £3 million per year). The overall recommendation in the draft was that, on considerations of cost and the general balance of the Treaty there were ‘insufficient grounds for refusing the Australian request’. There was a risk that if the Australian Treasurer approached the Chancellor of the Exchequer direct he might reopen the reciprocal exemption of shipping profits as a bargaining strategy. The hope was that, with the necessary authority, Inland Revenue would be able to get the Australians to agree to the amended United Kingdom proposal at the official level. Johnson suggested that there be a meeting with Treasury officials prior

183 E T Cain, Commissioner of Taxation to W H B Johnson, Board Room, Inland Revenue, 19th April 1967, Inland Revenue file, Part II. 184 W H B Johnson to D F Hubback, 16th May 1967. And ‘Double Taxation Negotiations with Australia – treatment of dividends paid by United Kingdom companies out of Australian profits to

Book 1.indb 489

12/2/2011 8:22:36 AM

490

C John Taylor

to finalising the Inland Revenue submission to the Chancellor.184 Hubback replied to Johnson on 8th June 1967 expressing doubts about the approach taken in the draft submission in relation to both New Broken Hill relief and the treatment of dividends paid by dual resident companies and the inter-relation between them but considered that further discussion between Treasury and Inland Revenue officials would be desirable.185 The matter was then discussed at a meeting between Johnson and Harrison from Inland Revenue and Hubback and other Treasury officials. The meeting agreed that the provisions relating to ‘criss cross dividends’ were ‘water under the bridge’ as they had been agreed in the Canberra negotiations and therefore were not something which the United Kingdom could now ‘go back on’. It would be necessary to explain to the Australians that credit for Australian withholding tax on criss cross dividends could only be given to United Kingdom individuals and not to United Kingdom companies. The Treasury view was that New Broken Hill relief was justifiable in principle and that although there would be loss to balance of payments on current account there would be likely to be a gain on capital account as shares in New Broken Hill would become more attractive to Australian investors. Treasury was anxious that the relief not provide an incentive for New Broken Hill (or any other company) to become and dual resident. Hence alternative ‘b’ of the Inland Revenue submission was thought to be preferable. The meeting realised, however, that alternative ‘a’ would be beneficial to the United Kingdom when dividends flowed to the United Kingdom. The problem was deciding what terms the Australians were likely to settle on. Settlement might be possible at the official level on terms which would not be possible if the matter were later raised by Australian ministers. The meeting decided that Inland Revenue should prepare an abbreviated revised submission to the Chancellor of the Exchequer, shown first to the Treasury in draft, recommending alternative ‘b’ but seeking authority to agree to alternative ‘a’ if necessary to dispose of the matter at an official level.186 Johnson sent an amended draft submission to Hubback the next day and noted that he had just received a letter from Australia raising various technical issues and that he would like to deal with the New Broken Hill relief question at the same time and hence asked for Treasury comments on the draft submission as soon as possible. Johnson’s letter pointed out that the advantages of alternative ‘b’ had turned out not to be as great as had been thought. 187 The Treasury response was that this meant that the argument in favour of conceding Australian shareholders. PS 1152/67’ United Kingdom National Archives, IR 40/16741 Revision of Double Taxation Agreement – Australia, Part II. 185 D F Hubback to W H B Johnson, 9th June 1967. United Kingdom National Archives, IR 40/16741 Revision of Double Taxation Agreement – Australia, Part II. 186 Note by F B Harison, 20th June 1967, ‘Australian Double Taxation Agreement’. And ‘For The Record, Double Tax Negotiations with Australia, Note of a Meeting in Mr Hubback’s Room, Second Floor, Treasury Chambers, Great George Street, on Tuesday 20th June 1967 at 11 o’clock a.m.’, Inland Revenue file, Part II. 187 W H B Johnson to D F Hubback, 21st June 1967, Inland Revenue file, Part II.

Book 1.indb 490

12/2/2011 8:22:36 AM

The 1967 United Kingdom – Australia Taxation Treaty

491

relief was not sufficiently strong and that the response should be to refuse the request and, in the event that the Australian Treasurer intervened, to refer back to promises that Australia made in 1965 when the voluntary program was introduced. If necessary alternative ‘b’ in the original submission could be a fall back position in preference to starting with alternative ‘b’ and falling back to alternative ‘a’.188 Further correspondence and drafts followed189 culminating in a submission dated 27th July 1967190 which, as grounds for agreeing to relief, stressed the limited extra cost of the relief, the cost of providing credits for underlying Australian corporate tax in the meantime, and the possibility that the Australian Treasurer might link the question of the relief with the exemption of shipping. The final submission was prepared after another meeting between Inland Revenue and Treasury officials at which Treasury agreed that relief should be granted and that the final submission to the Chancellor for the Exchequer should stress the grounds set out above.191 The compromise solution proposed in the final submission was to offer relief but on terms which would mean that Australia could not tax dividends paid to United Kingdom residents by a company enjoying the relief. The final submission did not set out in detail how this aim was to be achieved but either alternative ‘a’ or ‘b’ in the original submission would have achieved it.192 The Chancellor of the Exchequer asked the Chief Secretary of the Treasury to deal with the submission and on 1st August 1967 the Chief Secretary agreed to have to the inclusion of the compromise article included in the agreement.193 Johnson wrote to Cain on 4th September 1967 stating that the United Kingdom could not agree to Australia’s proposal of 19th April 1967 in relation to New Broken Hill dividends but was prepared to grant relief provided there would be no Australian tax on dividends paid by the company to United Kingdom residents. Johnson stated that in the United Kingdom view the ‘least unsatisfactory’ way of achieving this was to confine the relief to dividends from single resident companies and attached a draft article having this effect.194 Cain 188

D F Hubback to W H B Johnson 28th June 1967, Inland Revenue file, Part II. D F Hubback to W H B Johnson, 4th July 1967. An undated draft apparently referred to in Hubback’s letter immediately follows it in the United Kingdom Inland Revenue file. Inland Revenue file, Part II. 190 ‘Mr Baldwin, Double Taxation Negotiations with Australia – Treatment of dividends paid by United Kingdom companies out of Australian profits to Australian shareholders.’ 27th July 1967 unsigned on Board Room, Inland Revenue letterhead, Inland Revenue file, Part II. 191 ‘Australian Agreement, Note of meeting at the Treasury on Tuesday, 25th July’, dated 26th July 1967, Inland Revenue file, Part II. 192 F B Harrison to D F Hubback 27th July 1967 includes the comment, ‘you will see that we have eliminated the two alternatives which were originally in paragraphs 8(a) and (b) as on further thought it did not seem necessary to trouble Ministers with all the ins and outs’, Inland Revenue file, Part II. 193 ‘Double Taxation Negotiation With Australia – Treatment Of Dividends Paid By United Kingdom Companies Out Of Australian Profits To Australian Shareholders’ Note by B T Houghton dated 1st August 1967, Inland Revenue file, Part II. 194 W H B Johnson to E T Cain, 4th September 1967, Inland Revenue file, Part II. 189

Book 1.indb 491

12/2/2011 8:22:36 AM

492

C John Taylor

replied by an undated telegram stating that he was unable at that point to give an answer on the question but would reply as soon as practicable. 195 An Australian Treasury internal minute paper dated 11th September 1967 indicates that the Australian concern at the time was that, CRA might want to limit Australian equity participation in New Broken Hill so as to avoid it becoming a dual resident and hence having Australian withholding tax levied on dividends it paid to United Kingdom residents and United Kingdom withholding tax levied on dividends that it paid to Australian residents.196 The New Broken Hill question had still not been settled by 11th October 1967 when Cain sent a fresh draft of the Treaty to Johnson.197 However, it is likely the Cain had recommended accepting the United Kingdom proposal of 4th September 1967 as the draft of 11th October 1967 prepared by Australia excluded dual resident companies from the 90 per cent New Broken Hill relief.198 The British High Commissioner in Canberra advised the Commonwealth Office in London on 26th October 1967 that the Australian Treasurer’s formal agreement on the New Broken Hill provision had not yet been received but that it was hoped that this would be settled by the end of the week.199 Finally, on 28th October 1967 Cain advised Johnson by telegram that, ‘subject to Government approval of agreement as a whole your proposal on N.B.H.C. is accepted’ and indicated that action was being taken to put the complete text before the Australian cabinet.200 Although available archival records are unfortunately incomplete it appears that on this issue the United Kingdom achieved its aim of discouraging New Broken Hill and other companies from becoming dual residents and Australia failed in its objective of discouraging the company from limiting its Australian equity but benefitted the company and its Australian shareholders by eliminating United Kingdom tax on dividends flowing to its Australian shareholders.

Other Matters Cain’s letter to Johnson of 16th June 1967 had enclosed a revised draft Treaty incorporating a total of 48 amendments proposed by Australia. The letter was accompanied by notes explaining the rationale behind the proposed amendments.201 E F Harrison of the United Kingdom Inland Revenue reviewed the proposed amendments on 27th June 1967 and passed his comments on to 195 For Mr W H B Johnson, Board Room, Inland Revenue, Somerset House. From Commissioner of Taxation, for distribution to Mr Johnson only, Inland Revenue file, Part II. 196 Department of the Treasury, Minute Paper, F C Pryor, First Assistant Secretary to Acting Secretary, 11th September 1967, Australian Treasury file. 197 E T Cain to W H B Johnson 11th October 1967, Inland Revenue file, Part II. 198 Draft of 11.10.67 Articles 4 and 8, Inland Revenue file, Part II. 199 Canberra to Commonwealth Office 26th October 1967, Inland Revenue file, Part II. 200 Telegram, For Johnson, Board Room, Inland Revenue, Somerset House, From Commissioner of Taxation. 28 October 67, Inland Revenue file, Part II. 201 ET Cain to WHB Johnson,16th June 1967, Inland Revenue file, Part II.

Book 1.indb 492

12/2/2011 8:22:36 AM

The 1967 United Kingdom – Australia Taxation Treaty

493

Mr Williams, the United Kingdom Chief Inspector of Taxes, for his comments on 27th June 1967.202 Following receipt of Wiliiams’ comments on 3rd July 1967,203 Johnson advised Cain of the United Kingdom response to the proposed amendments by letter on 4th September 1967.204 Cain viewed the response favourably reporting to the Australian Treasurer that from a preliminary examination it would ‘go a long way towards expediting early settlement of the terms of the new agreement at the official level’.205 Most of the Australian amendments dealt with stylistic or grammatical matters and were readily agreed to by the United Kingdom. Other amendments either dealt with issues which the countries continued to discuss through correspondence before reaching final agreement or dealt with drafting features which, although readily agreed to by the United Kingdom, were significant from an Australian perspective and had longer term effects on Australian tax treaty practice. Criss Cross Dividends As noted above it had been agreed during the negotiations in Canberra that each country would apply withholding tax to dividends paid by dual resident companies to shareholders resident in the other country and that the country of the shareholder’s residence would give credit for the withholding tax. The United Kingdom Chief Inspector (Company Taxation) had on 21st April 1967 raised technical difficulties that would be associated with the implementation of the draft article using existing United Kingdom law.206 Implementation problems were confirmed through subsequent legal advice.207 The view developed in the United Kingdom Inland Revenue that amending relevant United Kingdom legislation was ‘presumably out of the question’ and that the Australians would have to be told that it would not be possible to gross up a dividend from a dual resident company subject to Australian withholding tax in calculating the recipient’s Schedule F tax and to then give credit for the Australian tax against the Schedule F tax. The Inland Revenue view was that, if United Kingdom Treasury agreed, giving New Broken Hill relief could be offered to the Australians on the condition that there would be no credit for Australian withholding tax on other dual resident companies.208 202 FB Harrison to Chief Inspector (Mr Williams), Australian Agreement, 27th June 1967. FB Harrison, Comments on the amendments proposed in the attachments to Mr Cain’s letter of 16th June 1967, Inland Revenue file, Part II. 203 To Mr Harrison, 3rd July 1967, Inland Revenue file, Part II. 204 WHB Johnson to ET Cain, 4th September 1967, Inland Revenue file, Part II. 205 ET Cain to The Commonwealth Treasurer (William McMahon) 8th September 1967, Australian Treasury file. 206 Draft Australian Double Tax Agreement – Article 19. To: Mr Williams. Treatment of Double Dividends. C I (Company Taxation) 21 April 1967, Inland Revenue file, Part II. 207 File note, ‘Double Taxation Credit – Dual Resident Companies’. Undated. Inland Revenue file, Part II. This note records a meeting between Mr Johnson, the author (evidently another Inland Revenue official) and Mr Tavare (‘the Solicitor’) on 5th May 1967. 208 File note, ‘Credit for Dual Resident Companies’, undated, Inland Revenue file, Part II.

Book 1.indb 493

12/2/2011 8:22:36 AM

494

C John Taylor

The Australian draft of 16th June 1967 amended the criss cross dividend rule so that it enabled withholding tax to be levied on dividends paid by a dual resident company to residents of a country other than the taxing country rather than to residents of the treaty partner country only. Cain commented that the proposed amendment would be practicable for Australia to administer and asked whether the United Kingdom would have any significant administrative problems with it.209 The Australian note explained that the criss cross dividend rule was developed in the negotiations because of Australian fears that Australian withholding tax on dividends could be avoided by the interposition of a dual resident company between an Australian subsidiary and a United Kingdom parent. The note then points out that the same type of avoidance would be possible where a dual Australian – United Kingdom resident company was interposed between an Australian subsidiary and a parent company in a third country. Harrison made two comments on the criss cross dividend amendment. First, that, for the technical reasons, alluded to earlier, it was not possible to give credit for Australian tax on dividends paid by a dual resident company where the recipient United Kingdom shareholder was a company. Second, draft amended Article 8(7) was defective as it required the United Kingdom and not Australia to relieve double taxation where the shareholder was a dual resident even where Article 3 treated the shareholder as a United Kingdom resident.210 Williams agreed with these comments.211 Johnson’s 4th September 1967 letter to Cain outlined the impossibility under existing United Kingdom domestic law in giving effect to the criss cross dividend provisions in the credit article of the initialled draft, indicated the United Kingdom’s unwillingness to change its domestic law for what was likely to be a rare case, and submitted an alternative draft Article 19 which deleted the requirement to give credit for the other Treaty partner’s withholding tax where the paying company was a dual resident. On the proposed amendment to the criss cross dividend rule in Article 8 Johnson commented that the United Kingdom’s original aim was to ensure that dual resident companies dividends did not suffer withholding tax in both countries and pointed out that the instances in which there were third country shareholders in a dual resident company must be very rare. The Australian proposed amendment to the draft could mean that the United Kingdom was required to give relief to a resident of a third country from United Kingdom tax in respect of Australian tax. Johnson doubted whether it was within United Kingdom law on double tax relief to include such a provision in a Treaty between the United Kingdom and Australia. The United Kingdom preference was for a rule which dealt only with single resident companies and enabled each Treaty partner to tax dividends 209

ET Cain to WHB Johnson, 16th June 1967, Inland Revenue file, Part II. FB Harrison to Chief Inspector (Mr Williams), Australian Agreement, 27th June 1967. FB Harrison, Comments on the amendments proposed in the attachments to Mr Cain’s letter of 16th June 1967, Inland Revenue file, Part II. 211 To: Mr Harrison, 3rd July 1967, Inland Revenue file, Part II. 210

Book 1.indb 494

12/2/2011 8:22:37 AM

The 1967 United Kingdom – Australia Taxation Treaty

495

paid by dual resident companies to residents of third countries. This could be achieved by deleting the proviso from amended articles 8(7) and 8(8) but in the draft article he now submitted Johnson had used a different method to achieve the same result with a view to having a definition of ‘dual resident’ that would accommodate New Broken Hill relief.212 Johnson’s proposed amendment meant that neither country could impose tax on a dividend paid by a company resident in the other treaty partner country to a shareholder other than a resident of the taxing country except where the paying company was a dual resident. Cain’s telegram in reply to Johnson’s letter of 4th September 1967 acknowledged the United Kingdom’s difficulties with Article 8(8) and agreed to a rule governing single residents only with the proviso being accepted whether or not New Broken Hill relief was agreed to. Cain’s telegram proposed a further amendment aimed at accommodating the situation where dividends were beneficially owned but not received by a shareholder and at overcoming difficulties associated with the undefined expression ‘residents of the firstmentioned territory’ in the case of a dual resident. This proposed amendment was the final version of Article 8(7) and 8(8) used in the Treaty. Cain commented that the United Kingdom’s proposed amendment to Article 19 had ‘proved troublesome to us’ but the conclusion had been reached that the proposed amendments could be accepted.213 Johnson agreed to this proposal in a telegram to Cain dated 29th September 1967.214 Trusts Difficulties associated with the use of accumulation trusts had been discussed but not resolved during the Canberra negotiations. Cain’s letter outlined again the planning strategy that Australia had been concerned with during the Canberra negotiations. Cain asked whether Johnson was in a position to say how United Kingdom law would operate in the situation contemplated.215 Discussions and correspondence within the United Kingdom Inland Revenue determined that the United Kingdom should not depart from the concession that it made to trustees when income was distributed to residents from other countries but recommended an amendment to Article 8(1) which attempted to avoid its application to trustees by referring to dividends ‘which such a resident is presently entitled to receive’. Johnson advised Cain of this view and of the proposed amendment in his letter of 4th September 1967.216 Cain’s telegram in reply appreciated the United Kingdom’s effort to ‘relieve our dilemma’ but saw difficulties with the proposed solution and instead preferred to revert to the original text on the understanding that where beneficiaries in United Kingdom trusts were Australian residents and 212

WHB Johnson to ET Cain, 4th September 1967, Inland Revenue file, Part II. Telegram, ET Cain to WHB Johnson, 4th September 1967, Inland Revenue file, Part II. Telegram, WHB Johnson to ET Cain, 29th September 1967, Inland Revenue file, Part II. 215 ET Cain to WHB Johnson,16th June 1967, Inland Revenue file, Part II. 216 WHB Johnson to ET Cain, 4th September 1967, Inland Revenue file, Part II. 213 214

Book 1.indb 495

12/2/2011 8:22:37 AM

496

C John Taylor

vice versa the reduced Treaty rates of withholding tax on dividends, interest and royalties would not apply.217 Johnson’s response on 29th September 1967 was to ask for an explanation of Australia’s objections to the United Kingdom’ revised suggestions. The United Kingdom had two difficulties with Australia’s interpretation of ‘beneficially owned’. First, it did not seem logical to base the treatment of accumulation trusts on the residence of beneficiaries who might not derive any benefit from the trust. Second, the United Kingdom had been adopting a more generous interpretation in its other Treaties. While the United Kingdom was agreeable to the Australian Treaty having a different result from others this would have to be through a different form of words. The United Kingdom would be embarrassed if it adopted a different construction of its usual Treaty formula.218 Cain replied by telegram on 7th October 1967 indicating cryptically that ‘Our objections to your proposal largely attributable to known attitudes outside official area. Question of accumulation trusts particularly delicate here’. A test based on residence of the trustee was, with respect, less logical than one based on residence of the beneficiary and the words ‘presently entitled to receive’ were not regarded as fitting comfortably into Australian law and its administration. The Australian view was that the United Kingdom’s interpretation of ‘beneficially owned’ in the original text was potentially exploitable for tax avoidance. The Australian judgment was that it would ‘need more than that’ to justify total exclusion of accumulation trusts from reduced rates’. It is unclear what ‘that’ was referring to but it is possible that the referent may have been the proposed amendment in Johnson’s letter of 4th September 1967. On this issue Cain’s telegram concluded ‘In all circumstances willing to revert to original text and apply your interpretation. In event either country finds actual evidence of exploitation matter could presumably be looked at again’.219 Hence the final version of the Treaty contained the original text of Article 8(1). Residence The compromise discussed on the afternoon session of the second day of negotiations in relation to corporate residence had been implemented in the initialled version of the treaty. In the initialled draft the expressions ‘resident of the United Kingdom’ and ‘resident of Australia’ were defined as having the meaning that those terms had under, in the former case, the laws of the United Kingdom relating to tax and in the latter under the laws of Australia relating to tax. The notes explained that if these expressions were not defined in this manner there would be difficulties when one country had to interpret the other’s ‘residence’ term. The expression ‘resident of the United Kingdom’ had no special meaning for Australia. The amendment, based on the approach 217

Telegram, ET Cain to WHB Johnson, 4th September 1967, Inland Revenue file, Part II. Telegram, WHB Johnson to ET Cain, 29th September 1967, Inland Revenue file, Part II. 219 Telegram, ET Cain to WHB Johnson, 7th October 1967, Inland Revenue file, Part II. 218

Book 1.indb 496

12/2/2011 8:22:37 AM

The 1967 United Kingdom – Australia Taxation Treaty

497

taken in the Australia – New Zealand Treaty of 1960, overcame this difficulty by defining the expressions by reference to the domestic law of the country in which it appeared. A related amendment added the phrase ‘being a resident of Australia’ to the definition of ‘Australian company’ in Article 3(1)(a)(i). The reason given for the amendment was that in its absence the definition of ‘Australian company’ could include a company which was not an Australian resident. The amendment required that an ‘Australian company’ for the purposes of the Treaty be an ‘Australian resident’. This meant that, as distinct from the definition in the United Kingdom – New Zealand treaty, to be an Australian resident for treaty purposes a company had to be a resident of Australia for purposes of Australian domestic law. Cain’s letter explained the reason for this amendment by citing an example of a company incorporated in New Zealand and carrying on business there but which was centrally managed and controlled in Australia. Cain considered that, prior to the amendment the company would be an Australian company for purposes of the treaty but would not be an Australian resident. Cain considered that this would enable the company to receive a reduced rate of United Kingdom tax on, say, interest while Australia would not be taxing the interest as the recipient company would not be an Australian resident. Although the amendment was agreed to by the United Kingdom without question Cain’s reason for seeking it is interesting in that it was not until 2004 that the Australian Taxation Office released a ruling220 clearly stating that a company in a situation analogous to the example given by Cain would not be an Australian resident. As the definitions of ‘Australian company’ and ‘United Kingdom company’ were mutually exclusive it was not possible for companies to be dual residents.221 The combined effect of these provisions in the treaty was that a company that was incorporated in Australia and had its centre of administrative and practical management in Australia would be an Australian company and not a United Kingdom company even if it was managed and controlled in the United Kingdom. Where a company was not incorporated in Australia it could only be an Australian resident for treaty purposes where it was managed and controlled in Australia. Where it was managed and controlled in the United Kingdom then it would be a United Kingdom resident for treaty purposes. Where management and control was both in Australia and the United Kingdom the effect of the definitions was that the company was an Australian resident. Where it was managed and controlled in neither Australia nor the United Kingdom it would be neither an Australian company nor a United Kingdom company as defined. It could still, however, be an Australian resident as ‘a person (other than a United Kingdom company) who is a resident of Australia’. Hence in the situation where 220 Taxation Ruling TR 2004/15 Residence of companies not incorporated in Australia – carrying on business in Australia and central management and control. 221 In addition to the discussion in the text see R W Parsons, ‘Tax Problems Relating to a United Kingdom Business Operating in Australia – I’ (1968) British Tax Review 177 at pp 183 to 184.

Book 1.indb 497

12/2/2011 8:22:37 AM

498

C John Taylor

a company was not incorporated in Australia, was not managed and controlled in either Australia or the United Kingdom but carried on business in Australia and had its voting power controlled by Australian shareholders the company would be a resident of Australia for both Australian domestic law purposes and for treaty purposes. Ironically the convoluted drafting would not in all cases have dealt with the problem raised by Australia where an Australian incorporated company was interposed between an Australian company engaged in active business operations and a United Kingdom parent. Where the interposed company was centrally managed and controlled in the United Kingdom and where (as would be likely to be the case with a mere holding company) its centre of administrative or practical management was not in Australia it would be a United Kingdom company and hence a United Kingdom resident for treaty purposes. Nonetheless, as a company incorporated in Australia it would still be an Australian company for Australian domestic law purposes and hence be entitled to the section 46 inter-corporate dividend rebate.222 Nor was the United Kingdom’s concern about the breadth of the definition of Australian resident company under Australian domestic law entirely met. In the situation discussed above a company would be an Australian resident for both Australian domestic law and treaty purposes. It may be that the United Kingdom did not regard this situation as raising significant issues from a United Kingdom perspective given that it contemplates a company that was not managed and controlled in the United Kingdom. The definition represented a compromise from the initial positions of both countries where a company was incorporated and had its centre of administrative or practical management in Australia notwithstanding it being centrally managed and controlled in the United Kingdom. The definition represented a compromise by the United Kingdom where the central management and control of a company was divided between the United Kingdom and Australia. Unlike the relevant provisions in the United Kingdom – New Zealand treaty of 1966 the Australia – United Kingdom treaty included an additional tiebreaker which stated: (3)

Where by reason of the provisions of paragraph (1) of this Article a person other than an individual is both a United Kingdom resident and an Australian resident – (a) it shall be treated solely as a United Kingdom resident if it is managed and controlled in the United Kingdom; (b) it shall be treated as an Australian resident if it is managed and controlled in Australia.

222 By contrast if the parent had directly owned shares in the Australian company conducting active business operations the parent would not have received the s46 inter-corporate dividend rebate as only Australian resident recipient companies were entitled to the rebate. In these circumstances the dividend would have been subject to Australian withholding tax at the treaty rate of 15%.

Book 1.indb 498

12/2/2011 8:22:37 AM

The 1967 United Kingdom – Australia Taxation Treaty

499

Given that the terms ‘Australian company’ and ‘United Kingdom company’ were mutually exclusive it was not possible for a company to be a dual resident. The tiebreaker was directed at entities such as trusts. Miscellaneous Several other amendments in the Australian draft of 16th June 1967 which were readily accepted by the United Kingdom affected subsequent Australian treaty practice for some years. These amendments and the rationale behind them will be briefly noted here. Several amendments reflect the influence of changes in Australian domestic law between the commencement of the negotiations and the conclusion of the drafting on the final form of the Treaty. Bills proposing the levying of withholding tax on interest and royalties were introduced into Australian Parliament on 3rd May 1967 and Cain provided Johnson with details of the Bill on the next day.223 Under those bills neither interest nor royalties technically had to have an Australian source before Australian withholding tax could be imposed. Hence Australia requested amendments to the interest, royalty and credit articles in the Treaty which had the effects of limiting the source basis tax that could be imposed on interest and royalties and of enabling the residence country to give credit for the source basis tax notwithstanding that neither the interest nor the royalty might technically be sourced in the country levying the source basis tax. Australia sought to amend Article 4(8) [definition of permanent establishment] of the initialled draft by deleting the phrase ‘in the other territory’. The accompanying notes (clearly reflecting concern about fact situations like those in Case 110 (1955) 5 CTBR (NS) 656) explained that Australia was concerned that manufacture in Australia and sale to Australians for a British enterprise might leave it open to the British enterprise to argue that it did not have a permanent establishment in Australia if the sales were concluded in London. Johnson’s view was that, while the United Kingdom appreciated Australia’s point, the proposed amendment went too far as it would apply where the proposed purchaser was in a third country. The United Kingdom proposed that the words ‘to a person in the other territory’ be used in place of ‘in the other territory’. Cain’s telegram in reply did not comment on the United Kingdom proposal which was reflected in the final version of the Treaty. Australia also sought to amend Article 7 (Associated Enterprises) by substituting ‘might be expected to accrue to it’ for the words ‘would have accrued’. The accompanying notes explained that the amendment was one that Australia would like to have accepted but which it would not press if the United Kingdom had strong objections to it. Australia considered that the amendment

223

Book 1.indb 499

ET Cain to WHB Johnson, 4th May 1967. Inland Revenue file, Part II.

12/2/2011 8:22:37 AM

500

C John Taylor

would provide the article with a more practical measure of profits which could be taxed to an enterprise under the article. Johnson in reply stated that the United Kingdom had no strong objections to the amendment, thought that ‘might have been expected to accrue’ were preferable to the Australian proposal, but pointed out that the original phraseology was in line with the United Kingdom’s existing treaties generally and was used in the 1946 United Kingdom – Australia treaty. Hence Johnson thought it was better to ‘stick to the text as initialled’ but indicated that he would leave the final decision to Cain. Cain’s telegram indicated that the words ‘might have been expected to accrue’ were acceptable to Australia and this phrase was used in the final version of the Treaty. At the negotiations in Canberra the parties had agreed that Article 18 (the ‘other income’ article) be redrafted so as to be confined to third country tax. Australia sought to amend the article as it appeared in the initialled draft so that it only applied to dual residents of Australia and the United Kingdom. If the provision applied to single residents a resident of the United Kingdom (for example) could arrange to ensure that income flowing to Australia was sourced in a third and hence subject to United Kingdom but not Australian tax. In reply Johnson did not consider that the initialled draft was ‘likely to lead to untoward results’ but had no objection to making it more precise. Johnson went on to identify an additional problem that could arise with dual residents in connection with dividends, interest and royalties. If an individual who was a United Kingdom resident under the ordinary law but was an Australian resident under the Treaty received dividends from a company in a third country the United Kingdom could not tax but if he received dividends from an Australian company (that was not a United Kingdom resident) then nothing in the initialled or revised Article 18 which would prevent the United Kingdom from taxing the dividend up to a rate of 15 per cent. Accordingly Johnson suggested a further amendment to Article 18 aimed at resolving this problem. Cain’s telegram in reply accepted the United Kingdom amendment but commented that where income had a dual source Australia assumed that the source rule of the country to which residence was allotted would apply. In Cain’s view there were other situations where the provision could apply such as rent from Australia derived by a dual resident whose residence the Treaty allotted to Australia.

SIGNIFICANCE OF THE TREATY

The Treaty was the first Australian treaty to come into force after the introduction of Australian interest and royalty withholding tax. It was also the first Australian treaty entered into after the publication of the 1963 Draft OECD Model. Two major policy messages were apparent from the Treaty. First, the Treaty gave a clear signal on what Australia’s position was on rates of withholding tax. Despite the fact that these rates were higher than those suggested in the Draft OECD Model Australia managed to maintain them in

Book 1.indb 500

12/2/2011 8:22:37 AM

The 1967 United Kingdom – Australia Taxation Treaty

501

almost all the treaties that it entered into until the 2001 Protocol to the Treaty with the United States. Second, the Treaty also signalled that Australia would not agree to the non discrimination article; a position that Australian adhered to (with the exception of the 1982 United States Treaty224) until the United Kingdom Treaty of 2003.225 Policy on withholding tax rates was determined at a Ministerial level and was influenced by prior Australian Treaty practice and by economic considerations relevant to current and expected trade and investment flows between the two countries. Policy on the non discrimination article also was determined at a Ministerial level and was primarily influenced by Australian domestic law considerations. The Treaty continued several structure features that had characterised earlier Australian treaties. It did not have an ‘other income’ article, did not have a capital gains article and defined industrial and commercial profits as excluding specified items. Instead of an ‘other income’ article the negotiations developed an article dealing with third country tax which found its way into several Australian treaties226 up to the 1980 treaty with Canada which was the first Australian treaty to contain a general ‘other income’ article.227 The policy decision to continue these structural features appears to have been made at the official level and, in part, reflects a belief that the absence of a general ‘other income’ article and the exclusion of specified types of income from the definition of ‘industrial and commercial profits’ meant that full source country taxing rights were maintained in relation to items of income not expressly mentioned in the Treaty. This too was the thinking behind the exclusion of a ‘capital gains’ article. Again past Australian treaty practice was a dominant factor in developing this policy but economic and Australian domestic law considerations also appear to have had an effect. Several features of the detailed drafting of the Treaty were to find their way into subsequent Australian treaties particularly in the period before Australia joined the OECD. Some of these were refinements or continuations or the drafting of prior Australian treaties228 while others, such as the way ‘resident of Australia’ was defined, Article 4(8) dealing with the situation in Case 110 224 The United States Treaty 1982 contained a more limited non discrimination article (Article 23) than the equivalent provision in either the OECD or US Models. Moreover, Article 23 of this treaty was excluded from the provisions given the force of law in Australia by s6(1) of the International Tax Agreements Act 1953 (Cth). 225 United Kingdom – Australia Treaty 2003, Article 25. 226 For example: Australia – Singapore Treaty 1969, Article 16; Australia – New Zealand Treaty 1972, Article 17; Australia – Germany Treaty 1974, Article 20; Australia – Netherlands Treaty 1976, Article 22; Australia – France Treaty 1976, Article 21. 227 Australia – Canada Treaty 1980, Article 21. This article applied to items of income of a resident of one of the countries which was not expressly mentioned in the earlier articles. Unlike the OECD ‘other income’ article, however, this article gave the source state a right to tax other income arising in it. 228 For example: Article 5(4) which incorporated the ITAA 1936 s38 approach to calculating industrial and commercial profits was based on an equivalent article in the Australia – United States Treaty 1953; and Article 7 which copied Article IV of the 1946 Australia – United Kingdom Treaty.

Book 1.indb 501

12/2/2011 8:22:38 AM

502

C John Taylor

(1955) CTBR (NS) 656, and the adjustments in the interest and royalty articles to accommodate the language of the new Australian withholding tax provisions were developed as part of these negotiations. Here prior Australian treaty practice, Australian domestic law considerations, prior United Kingdom treaty practice and the prior treaty practice of other countries (particularly New Zealand) appear to have been the dominant influences on the detailed drafting. Ironically the provisions which, apart from the non discrimination article, which were the subject of the most extensive negotiations and correspondence, namely the New Broken Hill provisions, were not replicated in any subsequent Australian treaty. New Broken Hill represented a then unusual situation of a United Kingdom resident company with most of its income derived from Australian sources and with a high percentage of Australian shareholders. An exact repetition of those precise circumstances was unlikely to recur although subsequent treaties (such as the United Kingdom Treaty of 2003) contained particular and distinct provisions dealing with analogous situations. Economic considerations appear to have been dominant for both Australia and the United Kingdom in relation to the New Broken Hill issue. Some of the detailed drafting features of the Treaty were rarely or never repeated in subsequent Australian treaties. In some instances, such as the anti dividend stripping provision in Article 8(4)229, this was because of unusual features in the United Kingdom draft or because of particular features of United Kingdom domestic law. In these cases prior United Kingdom treaty practice, the treaty practice of third countries and Australian domestic law considerations were the major influences on the drafting. In other instances, such as Article 4(3)(e), articles closer to or corresponding the OECD Model were preferred in subsequent treaties particularly after Australia joined the OECD. Each country could be satisfied with some aspects of the Treaty. The United Kingdom achieved its major objective of restricting the credit for underlying corporate tax and while it agreed to higher rates of source country taxation than it would have hoped the rates were in line with those that it had agreed in other treaties. Although the omission of a non discrimination article conflicted with United Kingdom policy its absence was not regarded as having practical consequences in the Australian context. Australia, in its first negotiation dealing with a draft influenced by the OECD Model, managed to continue a policy of high levels of source basis taxation through the agreed rates on dividends, interest and royalties and the broad definition of permanent establishment. Saving provisions preserving the operation of particular features of Australian law were introduced or refined. Australia achieved relief from United Kingdom tax on dividends in the New Broken Hill situation and managed to not agree to a non discrimination article but had to concede residence taxation of shipping. The latter concession would prove to be damaging to Australia in its next tax treaty negotiation with Japan. 229

Book 1.indb 502

Article 8(4) was article 9(4) in the original United Kingdom draft.

12/2/2011 8:22:38 AM