In the first part of this special four part report, I talk about a very controversial but also a very important topic concerning the use of Tax Shelters and Tax Schemes.
Right from the outset it is important to understand the difference between these two types of products that can produce substantial tax savings.
Understanding Tax Shelters and Tax Schemes
A Tax Shelter could be described as an investment in a particular type of product that produces tax benefits, such as the ability to offset the cost of the investment against your income tax; alternatively, you might invest to defer a capital gain of the same value.
A Tax Scheme on the other hand is a method of artificially creating a tax loss through a complex series of transactions. Again, the loss generated could be used either against income or capital gains tax.
Tax Adviser or IFA?
Now one of the biggest issues that faces the taxpayer is who should I go to for advice about using these Tax Shelters or Tax Schemes?
Tax Shelters use government approved investments, whereby the government has created the tax incentive and often the normal place to go is to an Independent Financial Advisor (IFA).
However, it is vital to appreciate that their tax knowledge in relation to these investments is very often limited. Therefore the best way to proceed is actually to have on board a tax advisor who understands the tax issues related to these investments. The tax advisor will then be able to give you the appropriate tax advice, as recommended by the IFA.
A note of caution about Tax Schemes
Now, when we start talking about Tax Schemes (especially the more artificial products), then extreme caution needs to be exercised!Many of the promoters of these Tax Schemes have a reputation for ignoring other possible alternatives, (be they other Tax Schemes or Tax Shelters) and they also downplay or ignore the substantial tax risks of such schemes.
Following the introduction of the new Disclosure Rules by Revenue & Customs in the Finance Act 2004 (they generally came into effect on December 2nd 2004);
the whole landscape for such artificial Tax Schemes has altered radically. Two key decisions of the House of Lords in November 2004 also played a significant part in limiting Tax Schemes to those that had an underlying commercial basis and were not merely relying on an artificial transaction.
It was common to pay a Tax Scheme promoter between of 10% and 25% of the sum invested into the scheme. In return, the taxpayer would be able to avoid tax on all that amount of income or capital gain.
Here is an example of an artificial transaction that has commonly been used:
You would purchase a highly complex derivative contract giving you the right to benefit from the movement in some financial asset. Then by buying and selling the same contract within a very short period of time you would generate a tax loss. All the paperwork could be signed in a single session and in reality the buying and sale would have been pre-arranged. This type of artificial transaction was particularly widespread in the city with the top employees of the Investment Banks, who received bonuses in the millions.
So, in effect after the tax scheme had paid the promoter, they would receive the rest of the money totally tax free, saving between 25% and 75% of their tax. That was the theory anyway. In the past, some Tax Schemes were challenged and others seemingly slipped through the net!
The Inland Revenues Gets Tough on Tax Schemes
What has happened with the disclosure rules is that anybody that promotes a Tax Scheme now has to disclose how that Scheme works in an outline form to the Revenue & Customs, within 30 days of starting to market that Scheme. Once the Scheme has been registered with Revenue & Customs; all the information is sent to a specialist unit and a reference number is allocated to the scheme. The allocated reference number must go on the tax returns of every person or company that uses the particular Tax Scheme.
This makes it far easier for the Revenue & Customs to know who has invested in a particular Tax Scheme. To date, virtually every Scheme that has been disclosed has been stopped by the Revenue & Customs within at most three to six months from them becoming aware of it. There are very few exceptions to this experience, although promoters will often make claims otherwise.
By using the unique reference number, they are able to write to the taxpayer and actually use their existing powers to deny tax relief for investment in the Tax Scheme pending the outcome of their inquiries.
The real effect of this is that anybody investing in these Tax Schemes is unlikely to get any tax relief at all! They are more likely to be involved in funding a long and costly investigation in which lawyers and accountants will earn substantial fees. In other words, an investor would be taking an incredible gamble in assuming that somehow their Tax Scheme is still going to get through the net and not be challenged
Watch out for the Scheme Promoters
Sadly there are still companies out there who are promoting these Schemes because of the huge fees involved. Other professional advisers are often persuaded to help promote these Schemes because of the money they can earn in commission. They often do not really appreciate the complexity, or the risks involved themselves as the tax issues are often very complex and outside their experience.
Some of the practices the promoters employ are a cause for concern. There have been instances where promoters are aware that a Tax Scheme is under enquiry by Revenue & Customs; yet they still sell that Tax Scheme in the following tax year (without telling the new investors that the old, but identical version of the Tax Scheme is under enquiry and tax relief has been denied). Naturally, tax relief will be denied to the new investors too!
Obviously, the attraction for a scheme’s promoters is the huge fees that are charged, and once they have got your money, you may need to pursue a legal fight to get it back!
Ask these Questions before Investing in any Scheme
Anyone that is thinking of investing in a Tax Scheme would be well advised to take independent advice from a tax specialist (familiar with tax schemes), who can hopefully point out the real risks and suggest better alternatives.
However, before involving a tax specialist, you would be well advised to ask the following questions:
- 1.The first thing to ask is whether the particular Tax Scheme has been disclosed to the Revenue & Customs. If it has, then ask what its reference number is.
- 2.The next thing to ask is, whether the promoters of the scheme are aware or have knowledge of any Revenue & Customs enquiries in relation to the particular Tax Scheme; either the current version or any earlier versions of the Tax Scheme.
3.Ask whether the scheme has got an extensive Counsel’s opinion from a leading tax Barrister (preferably a Queens Counsel), saying that the particular Tax Scheme works. If it has, then ask to see that advice and show it to your own tax adviser. An important point to note here is that you should ask to see the whole of the Counsel’s opinion and the initial questions, or the instructions placed before the Counsel.
- 4.Ask if the scheme has had any correspondence from Revenue & Customs confirming they accept the particular Tax Scheme works. And be sure to check the date on such letters carefully. Any letters older than several months are probably of little use.
In the next issue
In the second part of this four part special report I will start to look at the legitimate government tax shelters that are available to help make significant tax savings.
The largest and most exciting of these is called Film Partnerships, and I’ll be discussing this in more detail in the next issue.