After the first four years, the rest of my career was spent as a tax adviser. Alongside my professional work, I also spent 12 years on the Council of the Chartered Institute of Taxation.
Accordingly, I have often had to think about the ethical issues in taxation. In my view, the principles are actually quite simple.
From time to time, when reading some tax law, you may conclude that it is badly drafted, enabling taxpayers to pay less tax than they would have paid if the law were better drafted. What are your obligations in such circumstances?
I had to think about this in 2006 when reviewing that year's Finance Bill. I recently wrote about the experience in my May column in the magazine "Islamic Finance News." You can read it below.
Taxation is the Government legally taking your money to fund itself. In most countries, the Legislature creates tax laws, which are administered by the Executive part of the Government. Subject to any constitutional constraints, the Legislature can enact any tax laws that it wishes.
In my view, the sole obligation of the taxpayer is to pay those taxes which the law requires, and no more. If the tax law is badly drafted so taxpayers can rearrange their affairs to pay less tax, there is no moral impediment to them doing that. (Some countries do have specific laws to deny tax reductions arising from rearrangements that lack commercial justification.)
Similarly, I see no moral objection to tax advisers using their expert knowledge to assist taxpayers in reducing their tax liabilities if the relevant tax law is badly drafted. However, there are exceptions. I had a very good example about 15 years ago.
When the UK first legislated for the direct tax consequences of Islamic finance in Finance Act 2005, only two structures were covered. They were purchase and resale (the UK Government’s name for murabaha) and deposits giving rise to profit share return (the Government’s name for mudharabah).
In Finance Act 2006, the law was extended to cover two more structures, diminishing shared ownership (the Government’s name for diminishing musharaka), and profit share agency (the Government’s name for wakala).
In a wakala transaction, the agent (“wakil”) uses the principal’s money to earn a commercial return, part of which is then paid to the principal and part retained by the agent.
As soon as I saw the published text of Finance Bill 2006 (which became Finance Act 2006 once legislated), I identified a defect. The text gave the agent a deduction for the return paid to the principal, but did not make the agent initially taxable on that return. Accordingly, the agent would get a “free” tax deduction while being taxed on nothing.
(To explain numerically, assume the agent earns 75 using the principal’s money, pays 15 to the principal and keeps 60. Under the law as drafted, the agent would get a deduction for the 15 paid to the principal, but would not be taxed on anything!)
Given my desire for the UK to adapt its laws to facilitate Islamic finance, the last thing I wanted was for the new legislation to be used to avoid tax. This could damage the reputation of Islamic finance, and make the Government less willing to legislate for it in future. Accordingly, after consulting with colleagues at PwC, I wrote to HM Treasury to point out the drafting error in the Finance Bill.
The Treasury never accepted that the law was badly drafted.
However, two years [My error when writing the article. 2007 is only one year after 2006! However 12 months is still too slow; the Government should have amended Finance Bill 2006 as it was proceeding through Parliament.] later in Finance Act 2007 (Government’s are often slow closing tax loopholes) the law was revised to state explicitly that the agent was taxable on all of the commercial profits generated. This succeeds in leaving the agent with the correct taxable income after deducting the return paid to the principal. Using the earlier figures, the agent’s taxable income is 75 less a deduction for the 15 paid to the principal, making 60. That is the amount of the agent’s net profit, so the agent is now taxed on the right amount.
Mohammed Amin is an Islamic finance consultant and former tax partner at PwC in the UK.