Tax Journal by Mark McLaughlin ATII TEPThe Ramsay principle will undoubtedly be a familiar expression to practitioners engaged in tax planning for their clients. What is the Ramsay principle, and how has the approach to tax avoidance developed through the Courts? Does a clear distinction exist between unacceptable avoidance and acceptable tax planning?Avoiding tax has long been a popular pursuit among taxpayers, a fact that has apparently not been lost upon the Revenue or the courts. In addition to negotiating a whole raft of targeted anti-avoidance legislation, the determined tax planner must also jump through a series of hoops established by the House of Lords in W T Ramsay Ltd v IRC ( STC 174) and developed through later tax cases.
'The Ramsay principle' will undoubtedly be a familiar expression to tax practitioners in general, due to its wide application. This approach to anti-avoidance has developed and evolved from the original judgement delivered by the Lords back in 1981. Subsequent tax cases decided through the courts and beyond have interpreted, tested and stretched the boundaries of that original judgement. The purpose of this article is to identify the fundamental elements of the Ramsay principle, which merit consideration initially before embarking upon tax planning initiatives.
Before Ramsay, the courts were often reluctant to deviate from a strict interpretation of the tax legislation. Whilst not necessarily condoning or approving of tax avoidance, on a number of occasions the courts ruled in favour of the taxpayer's attempts to minimise his liabilities. In Ayrshire Pullman Motor Services & Ritchie v CIR ((1929) 14 TC 754) Lord Clyde remarked:
"No man in this country is under the smallest obligation, moral or other, so to arrange his legal relations to his business or to his property as to enable the Inland Revenue to put the largest possible shovel into his stores. The Inland Revenue is not slow - and quite rightly - to take every advantage which is open to it under the taxing statutes for the purpose of depleting the taxpayer's pocket. And the taxpayer is, in like manner, entitled to be astute to prevent, so far as he honestly can, the depletion of his means by the Revenue".
The courts also attached importance to the principle established in IRC v Duke of Westminster ( 19 TC 490), in which payments were made by the taxpayer to domestic employees in the form of deeds of covenant, but which in substance were payments of remuneration. The House of Lords refused to disregard the legal character (form) of the deeds merely because the same result (substance) could be brought about in another manner. Lord Tomlin commented:
"Every man is entitled, if he can, to order his affairs so that the tax attaching under the appropriate Acts is less than it otherwise would be".
This standard, coupled with high tax rates during the 1970s, encouraged complex schemes of tax avoidance, many of which were commercially artificial and carried very little financial risk. However, it transpired that the Duke of Westminster case was of limited application, since it contained a single tax avoidance step. The problem faced by the courts was how to deal with pre-arranged avoidance schemes containing a number of steps. Even before Ramsay the courts were, on occasion, apparently willing to take a holistic approach in their consideration of such schemes. In IRC v Plummer ( STC 793), Lord Wilberforce commented that a scheme carried out with "almost military precision" entitled and required the court to look at the plan as a whole. The scheme in question was a 'circular annuity' plan, in which a charity made a capital payment to the taxpayer in consideration of his covenant to make annual payments of income over five years. The House of Lords held that the scheme was valid, although subsequent circular annuity schemes failed on the basis of the Ramsay principle that was soon to follow.
The Ramsay case
The tax avoidance scheme under consideration in Ramsay was "ready-made", but the approach adopted in this and subsequent cases has significant repercussions for tax planning generally.
In Ramsay, the taxpayer company wished to shelter a capital gain. It therefore made two separate loans to a newly-acquired subsidiary company, from funds made available by a finance house. Both loans carried interest. However, the taxpayer company subsequently reduced the interest on the first loan to nil, while interest on the second loan was doubled. The second loan was then sold to another company at a capital profit. The first loan was repaid at par and an equivalent capital loss was incurred in respect of the sale of shares in the subsidiary to another company. The taxpayer company sought relief for the capital loss, but contended that the capital profit was exempt from tax as a debt on a security. The House of Lords, whilst accepting that none of the steps involved represented a 'sham', considered the scheme as a whole and held that it should be treated as a nullity for tax purposes.
In his judgement, Lord Wilberforce stated that it was not a requirement, under the Duke of Westminster or any other doctrine, to consider individually each separate step in a composite transaction intended to be carried through as a whole. His Lordship described the following characteristics of 'circular' schemes of tax avoidance:
First - it is a clear and stated intention that, once started, the scheme shall proceed through the various steps to the end (whether there be a contractual obligation, or merely an expectation with no likelihood in practice that it will not proceed);
Second - the taxpayer does not have to use his own funds and at the end of the scheme the taxpayer's financial position is unchanged (except for the payment of fees and expenses to the scheme promoter);
Third - the whole and only purpose of the scheme was the avoidance of tax.
Development of the Ramsay principle
The Ramsay list of tax avoidance characteristics and circumstances was modified in subsequent House of Lords decisions. In IRC v Burmah Oil Co Ltd ( STC 30), the Lords held that the Ramsay principle applied to a scheme devised by the taxpayer's advisers, involving the taxpayer's own funds. Lord Diplock considered that, in order for the Ramsay principle to apply, there must be:
1) a series of transactions; which are
2) pre-ordained; and
3) into which there are inserted steps that have no commercial purpose apart from tax avoidance.
The Ramsay principle had hitherto been confined to tax avoidance in the form of artificial schemes containing steps that were, in effect, self-cancelling. However, in Furniss v Dawson ( STC 153), the House of Lords applied the Ramsay approach to a scheme of tax deferral as opposed to avoidance, which was not circular or self-cancelling.
'Linear' avoidance schemes
In Furniss v Dawson, the taxpayers wished to sell their family company shares to an independent purchaser. As part of a prearranged plan to defer their capital gains tax liability, the taxpayers exchanged their shares in that company for shares in a newly-formed investment company (Greenjacket) incorporated in the Isle of Man. On the same day, Greenjacket sold the family company shares at the previously negotiated price. The taxpayers sought to rely on a capital gains tax exemption in respect of the company amalgamation, and a no gain no loss disposal of the family company shares by Greenjacket. The High Court and Court of Appeal ruled that the Ramsay principle applied only where steps forming part of the scheme were self-cancelling. They considered that it did not allow the share exchange and sale agreements to be disturbed as steps in the scheme, because they had an enduring legal effect.
The case proceeded to the House of Lords, where it was held that steps inserted in a preordained series of transactions with no commercial purpose other than tax avoidance should be disregarded for tax purposes, notwithstanding that the inserted step (ie the introduction of Greenjacket) had a business effect. Per Lord Brightman "that inserted step had no business purpose apart from the deferment of tax, although it had a business effect. If the sale had taken place in 1964 before capital gains tax was introduced, there would have been no Greenjacket".
The approach of the Lords to 'linear' tax avoidance in Furniss v Dawson marked a significant extension of the Ramsay principle, which hitherto had been founded upon 'circular' or self-cancelling schemes. The principle could be applied to both tax deferral and avoidance, and to situations in which the legal implications of the intermediate steps continued beyond the scheme itself. Referring to the previous criteria for the Ramsay principle to apply as set out in the Burmah case above, Lord Brightman redefined the necessary conditions:
1)a preordained series of transactions (or one single composite transaction); into which there must be
2) steps inserted which have no commercial (business) purpose (as distinct from a business effect) apart from the avoidance (or deferral) of a liability to tax.
The scope of the Ramsay principle was now emerging, but important questions remained unanswered. Would Ramsay apply where the (otherwise taxable) disposal was merely contemplated at the time when the tax avoiding or deferring transaction took place? Or was it necessary that there be no practical certainty that the preordained transactions would not take place?
In Craven v White ( STC 476 HL), the taxpayers exchanged their shares in a trading company (Q Ltd) for shares in an Isle of Man holding company (M Ltd), in anticipation of a potential sale or merger of the business. Meanwhile, the taxpayers had abandoned negotiations with one interested party, and later concluded a sale of Q Ltd's shares with another. M Ltd subsequently loaned the entire sale proceeds to the taxpayers, who appealed against assessments to capital gains tax.
The case once again proceeded to the House of Lords, who held in favour of the taxpayers, dismissing the crown's appeal by a majority of three to two. The dissenting argument was broadly that the Ramsay principle could be applied where the taxpayer had merely decided to carry out the scheme on an intended (taxable) transaction, if possible, by combining it with a prior avoidance transaction. However, the majority view was that a scheme was preordained if it was planned as a whole and carried through as a whole, ie where the avoidance transaction was undertaken at a time when there was no "practical likelihood" that the subsequent transaction would not take place. In Craven v White, the Lords noted that when the share exchange took place, there was no certainty that the shares in Q Ltd would be sold. In his judgement, Lord Oliver interpreted the following requirements for Ramsay to apply, ie "...the circumstances the court can be justified in linking the beginning with the end so as to make a single composite whole to which the fiscal results of the single composite whole are to be applied":
1) that the series of transactions was, at the time when the intermediate transaction was entered into, preordained in order to produce a given result;
2) the intermediate transaction had no other purpose than tax mitigation;
3) there was at the time no practical likelihood that the pre-planned events would not take place in the order ordained, so that the intermediate transaction was not even contemplated practically as having an independent life; and
4) that the preordained events did in fact take place.
Ramsay and the future
Has the Ramsay principle drawn a clear line between unacceptable avoidance and acceptable tax planning? Apparently not, based on the number of subsequent cases to be heard before the courts in which the Ramsay approach has been considered. Whether or not the principle applies would appear to be a question of fact for the Commissioners to decide, and there still remain sufficient uncertainties about Ramsay to cause concern (for example, what exactly does "no practical likelihood" mean?). The message for tax advisers therefore seems to be that planning should be undertaken at an early stage, perhaps at a time when there is no identified purchaser in a proposed transaction, or possibly when a future transaction is subject to external circumstances. The introduction of a general anti-avoidance rule to bring about greater certainty for tax planners is a solution that has already been considered. No doubt the courts will remain busy dealing with the Ramsay principle in the meantime.