Legitimate tax avoidance is often encouraged by the government to meet policy objectives such as creating growth. When using these schemes, investors should consider their true policy intention, this article argues.

The furore about Panama-based accounts and other offshore activity can sometimes obscure the fact that avoidance of tax is something that governments often encourage to further objectives such as job creation, or to discourage unhealthy behaviour. Avoidance, let’s not forget, is not a crime, while evasion is. This distinction needs to be made at a time when the use of offshore centres to mitigate tax is seen in some quarters as shameful, when there is nothing necessarily wrong, and there is something quite possibly beneficial, in encouraging capital to be invested to generate the highest, most efficient rates of return. Of course, with “aggressive” tax avoidance, as far as the revenue authorities are concerned, the wrongdoing consists in actions without any positive intention (creating new business, quitting smoking, etc) simply to get a tax break. With “artificial avoidance”, though, much of the problem can be addressed if policymakers simplify and cut taxes, and reduce loopholes and breaks. (Such a view may not endear one to parts of the legal or accountancy professions.)

With all that in mind, here are comments from Ian Woolley, senior investment analyst at Hawksmoor Investment Management, a UK-based firm. This publication does not necessarily endorse all views of guest contributors and invites readers to respond; it is grateful for this contribution to debate.

The condemning cries against tax injustice in the past few weeks have been both deafening and, for the most part, ill-informed. Fortunately some sense has forced its way into the debate, and with it the acknowledgement that there is an important distinction between “tax evasion” and “tax avoidance”. Those hurling abuse at “tax avoiders” who themselves have a pension or Individual Savings Account are, of course, hypocrites.

Tax exemptions exist to encourage certain behaviours, whether that be to save for retirement or to invest in the growth of the UK economy. Where the moral campaigners have a point is when people use legal tax avoidance measures in a way that was not originally intended. Leaving aside the ethical issues, it is in these cases that investors are at the greatest risk of having their free lunch suddenly taken away. In addition to complying with the letter of law, investors would be advised to comply with its spirit, too. 

Consider Business Property Relief (BPR), which grants exemption from inheritance tax to funds invested in eligible unlisted (including AIM-listed) companies, held for at least two years. This is a substantial tax saving: families can potentially save 40 per cent of the amount invested. The basic idea behind this tax perk is logical: it allows family-owned businesses to pass to the next generation, and it actively encourages individuals to put their money into the growth plans of small UK companies, which are typically higher risk investments. In this way savings are used to create jobs, build factories, and ultimately drive the UK’s economic growth, instead of staying tucked away under the mattress.

Yet with that in mind, note that it is perfectly legal to gain inheritance tax exemption on AIM-listed companies that have their entire operations overseas and that may make little contribution to the UK economy. BPR is an exemption from UK tax, and its original intention was to benefit UK-based businesses. It is thus certainly possible - and arguably even logical – for future changes to the rules surrounding BPR to limit qualifying investments to those that are predominantly UK-based. 

Even more pertinently, consider those inheritance tax mitigation schemes that deliberately circumvent the rules by creating qualifying BPR assets without the intended nature or level of risk. To do this, some well-known providers set up trading companies for the sole purpose of meeting the relief rules, but that then invest in otherwise non-eligible assets, such as loans. There is a reason why inheritance tax relief does not extend to loaning money to businesses, and though one can skirt the rules by cloaking it in a corporate structure, such schemes are surely sailing very close to the wind. They satisfy the letter of the law, but pay no heed to its spirit. 

Again, investors in these schemes are most in danger of the BPR rules being updated to take back an undeserved tax relief. In itself, the notion of tax breaks for those that invest in smaller UK companies is logical and is a policy that has been supported by successive governments.

An AIM portfolio that invests in “real” businesses can, where suitable, be an excellent investment for both long-term growth and estate planning. However, I would argue it is important to stay true to the original spirit of BPR – and indeed any other tax mitigation schemes - as a safeguard against a clampdown on what is permissible. Those sailing too close to the wind are at the greatest risk of an abrupt change in direction.