Report

by the Comptroller
and Auditor General

The exchequer departments

Tax reliefs

HC 1180 SesSIon 2013-14 28 march 2014

Our vision is to help the nation spend wisely.

Our public audit perspective helps Parliament hold government to account and improve public services.

The National Audit Office scrutinises public spending for Parliament and is independent of government. The Comptroller and Auditor General (C&AG), Amyas Morse, is an Officer of the House of Commons and leads the NAO, which employs some 860 staff. The C&AG certifies the accounts of all government departments and many other public sector bodies. He has statutory authority to examine and report to Parliament on whether departments and the bodies they fund have used their resources efficiently, effectively, and with economy. Our studies evaluate the value for money of public spending, nationally and locally. Our recommendations and reports on good practice help government improve public services, and our work led to audited savings of almost £1.2 billion in 2012.

Report by the Comptroller and Auditor General

Ordered by the House of Commons
to be printed on 27 March 2014

This report has been prepared under Section 6 of the National Audit Act 1983 for presentation to the House of Commons in accordance with Section 9 of the Act

Amyas Morse
Comptroller and Auditor General
National Audit Office

26 March 2014

HC 1180 | £10.00

This report examines the administration of the overall system of tax reliefs and, following this landscape review, we intend to examine the administration of particular reliefs.

© National Audit Office 2014

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10390 03/14 NAO

The National Audit Office study team consisted of:
Andy Morrison, Eleanor Fairbairn, Jonny Mood, Phil Wherry and Riaz Rahman, under the direction of Rob Prideaux.

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www.nao.org.uk

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Key contextual information

Tax reliefs

All tax systems include tax reliefs, which in many cases are an essential part of defining the scope and structure of a tax by providing rules which establish where the tax burden is and is not intended to fall.

Some reliefs, known as tax expenditures, are designed to deliver specific policy objectives by providing behavioural incentives to achieve economic and social objectives. These are often an alternative to public expenditure, and have similar effects.

Summary

Introduction

1 The government collects taxes to fund public services, and can use the tax system to help people, households and businesses with targeted financial support. All tax systems include tax reliefs, which in many cases are an essential part of defining the scope and structure of a tax by providing rules which establish where the tax burden is and is not intended to fall.

2 There are more than 1,000 tax reliefs in the UK. Reliefs can help maintain the competitiveness of tax systems and governments can use tax reliefs as a mechanism to redistribute wealth, support economic growth and influence behaviour. Tax reliefs may also be used for practical purposes such as establishing the correct income and profit for tax purposes and making the tax system simpler to use. Figure 1 summarises these different objectives as they are defined by HM Revenue & Customs (HMRC).

3 Some reliefs, known as ‘tax expenditures’, are designed to deliver specific policy objectives by providing behavioural incentives to achieve economic and social objectives. These are often an alternative to public expenditure, and have similar effects. Policy makers may prefer tax expenditures to spending programmes because they are thought to be the most effective and efficient way to achieve a policy objective.

4 Tax reliefs are delivered in various ways, and their design has implications for the complexity of the tax system, the costs of administration and the distribution of the taxpayer burden. This report uses a broad definition of the term ‘tax reliefs’ to include
all of the tax mechanisms illustrated in Figure 2.

5 HMRC publishes cost estimates for some reliefs, but does not total these figures. Doing so would give only a broad indication of the scale of the tax reliefs landscape for two reasons. First, interactions between tax reliefs mean that simply combining the costs of individual reliefs will tend to overstate the true picture; and second, HMRC does not have cost data for a large number of reliefs, and the effect of excluding these will understate the overall position. It is important to recognise that, while the provision of reliefs reflects government’s choices about where to place the tax burden, it would be unrealistic to assume that all of the revenue that appears to be foregone through tax reliefs could be collected. Some reliefs simply help define the tax base, such as the first three categories in Figure 1, and could not be otherwise collected. A higher overall tax burden could reduce economic productivity and the UK’s global competitiveness, and may not be sustainable in the medium term.

6 In this report we have shown the total cost of tax reliefs compared to GDP in order to give a broad indication of the scale of the tax reliefs landscape. HMRC has asked us to include the following text: “HMRC disagrees with the inclusion in Figure 3, paragraph 15 and paragraph 1.12 of the total of the costs of the separate tax reliefs. As the report itself explains at paragraph 5, HMRC does not publish this figure, because it does not represent an amount of money which might be obtained by Government – due, for example, to interactions between the reliefs. It is therefore misleading to refer to the figure.”

7 The cost of tax reliefs – so far as this is measureable – appears to be growing at a time when public spending is reducing. Each tax relief has an administration cost and carries the risk that revenue will be lost through error, tax avoidance and fraud. For tax expenditures, there is also the opportunity cost of the revenue foregone as a result of the policy decision to offer a relief. Reliefs may also have both intended and unintended consequences, such as the distortion of markets. The efficient and effective administration of the system of tax reliefs therefore presents a large and complex challenge for HMRC.

8 HM Treasury and HMRC (the exchequer departments) share oversight of tax reliefs and there is no single accounting officer responsible for their effectiveness. HMRC works with HM Treasury (the Treasury) to develop, design and deliver tax policy. The Treasury is responsible for strategic tax policy design and HMRC for delivering and maintaining policy and the administration of the tax system. The two departments share an analysis function, whose responsibilities include predicting the impact of changes to tax reliefs proposed in the budget and producing published statistics on tax reliefs and taxes in general.

Scope of this report

9 Under section 6 of the National Audit Act 1983, the Comptroller and Auditor General (C&AG) has powers to carry out examinations into the economy, efficiency and effectiveness of the way government departments use their resources in discharging their functions. The National Audit Act 1983 does not allow the C&AG to question the merits of policy objectives of the department which is being examined. This safeguards his independence and objectivity and makes him free from political influence. While our work therefore does not question policy intent, we do evaluate whether policy instruments are well-designed and adequate to deliver that intent.

10 HM Treasury has asked us to include the following text: “The Treasury does not agree that the above paragraph reflects NAO’s powers in relation to tax policy and therefore the scope of this report and future reports. The Treasury’s position is that all tax reliefs reflect policy decisions about the incidence of taxation and distribution of the tax burden, taken by ministers and agreed by Parliament. As such the Treasury’s view is that the design and impact of a relief are questions of policy and therefore outside of the NAO’s remit. The Treasury does not believe this fetters the ability of the NAO to look at the effectiveness of the way in which tax reliefs are administered by HMRC.”

11 In future work evaluating how tax reliefs are developed and implemented, we expect to place greatest scrutiny on tax expenditures where there is a responsibility on the exchequer departments to assess whether they are meeting their stated policy objectives. But we are interested in the administration of all tax reliefs, as structural features of the tax system also require effective administration and control to ensure they are not abused.

12 We therefore describe in this report the complete landscape of tax reliefs and the main ways in which reliefs of different types are administered by the exchequer departments. We intend to evaluate the administration of particular reliefs in later work. We do not question whether a tax relief is the right choice of policy instrument.

13 This report covers:

Part One: The landscape of tax reliefs in the UK; how they are used and the risks they carry;

Part Two: How the exchequer departments assess the performance of reliefs and respond to emerging differences between their performance and their intended objectives; and

Part Three: How the exchequer departments assess, monitor and respond to the risk that reliefs are abused.

Number and scale of tax reliefs

14 The number of reliefs is growing. In March 2011 the Office of Tax Simplification identified 1,042 tax reliefs in the UK. It reviewed a sample of 155 and recommended that 47 should be abolished – either because they had expired, there was no longer a policy rationale, the value was negligible, or the administrative burden outweighed the benefit. Since then Parliament has abolished 48 reliefs but has introduced 134 new reliefs. By December 2013 the total number of reliefs had increased to 1,128 (paragraph 1.11).

15 The value of reliefs in relation to tax revenue and public spending has increased in recent years. As a proportion of GDP, the sum of all tax reliefs has increased from 16 to 21 per cent since 2005-06, while tax revenues have decreased marginally. This increase is mainly explained by increases in the income tax personal allowance, the thresholds for national insurance contributions, and the standard rate of VAT (because as the standard rate of VAT rises, so does the value of VAT reliefs). The value of tax expenditures has increased in real terms from £91 billion to £101 billion over this period (from 5.9 to 6.5 per cent of GDP). Since 2010-11, while public spending has fallen sharply, the value of reliefs has continued to rise (Figure 3) (paragraph 1.12).

16 HMRC has not systematically categorised tax reliefs according to the function they perform. HMRC publishes a list of the main tax reliefs and their costs annually, identifying separately those it regards as tax expenditures. However, HMRC acknowledges that its categorisation is crude: some reliefs classed as tax expenditures, such as the relief on registered pension schemes, also contain structural elements; many of the smaller reliefs are not categorised; and, in common with most other tax administrations, a lack of relevant data means that HMRC does not know the cost of many reliefs (paragraphs 1.4 and 1.10).

How reliefs work and the tax at risk from abuse

17 Tax reliefs are an essential part of the tax system. All taxpayers and consumers benefit to some extent from tax reliefs, which also offer practical advantages to the exchequer. For example, tax expenditures can offer low administrative costs and provide differentiated financial support that would not be cost-effective through means-tested spending programmes. They may also target support or deliver objectives more effectively than a spending programme. However, the nature of the tax system means that it would not be feasible for most reliefs to work within a finite budget and the cost of reliefs can therefore rise beyond expectations (paragraphs 1.13 to 1.14).

18 Tax reliefs play a significant role in defining the scope of tax and determining where the burden of tax falls. For example, the threshold set for inheritance tax defines the scope of tax by providing that no tax is payable on most estates. Corporation tax rules provide flexibility to reduce the risk that the viability of a business is threatened by having to pay a high tax bill when it can least afford it. For example, loss relief helps to smooth the taxation of profit over a company’s lifespan, allowing trading losses to be carried back a year or carried forward to set off against future profits; and the deduction of interest from taxable profits can substantially reduce tax liabilities where major acquisitions have been funded by debt, thus making it easer for companies to invest (paragraphs 1.18 to 1.25).

19 All tax reliefs create opportunities to misuse and avoid tax. The number of reliefs and interaction between them adds to the complexity of the tax system and increases the risk of error. The risk of abuse varies according to many factors including the relief’s objectives and value, how it works, and the customer group. The efficient and effective administration of the system of tax reliefs therefore presents a large and complex challenge for HMRC (paragraphs 1.16 and 1.39 to 1.41).

20 The boundary between the legitimate use of tax reliefs and tax avoidance is not always clear. HMRC describes tax avoidance as an attempt to exploit legislation to gain a tax advantage that Parliament did not intend. It publishes a description of the types of avoidance scheme that it will always challenge because it regards them as contrived arrangements designed to avoid tax. Six of the nineteen types of avoidance it describes are designed primarily to exploit tax reliefs (paragraphs 1.33 to 1.38).

21 Some tax reliefs are the target of illegal tax evasion and criminal attack. The way some reliefs work means that HMRC makes payments to customers following claims, making them attractive to fraudsters. Criminals have exploited reliefs which involve a cash payment or refund to extract money from HMRC. Examples have included fraudulent claims for film tax relief, payments made to charities under gift aid, and VAT refunds made against zero-rated items. In each case a common approach has involved creating fake transactions to trigger payments from HMRC (paragraphs 1.39 to 1.41).

22 The value of tax at risk from the abuse of reliefs is unknown but likely to be significant. HMRC does not separately identify the tax at risk or lost through the abuse of reliefs. It publishes an annual estimate of the tax gap, which it estimated to be £35 billion in 2011-12. It estimated that £4.3 billion of tax was lost from cases where individuals and businesses had challenged HMRC’s interpretation of how the tax law, including rules for relief, should apply. It estimated that £4 billion of the tax gap arose from avoidance, a high proportion of which involves exploiting tax reliefs. Evasion and criminal attack accounted for a further £9.8 billion, some of which is explained by ‘VAT carousel fraud’ and other transaction based frauds that depend on certain products or activities being exempt from tax or taxed at a lower rate (paragraphs 1.43 to 1.44).

Monitoring performance

23 There is no documented framework specifically governing the introduction or modification of tax reliefs. In 2010 the Treasury increased the policy cycle for creating new reliefs from 7 to 18 months. This was to allow more time to consult on the objectives of a proposed measure, to appraise the options and to draft legislation. The Treasury also committed to developing a framework for the introduction of new reliefs, recognising that it should consider new reliefs carefully, and that these should only be introduced when there is a strong and proven case. It has yet to develop such a framework. Since 2011, the scope of tax impact notes has narrowed and an options appraisal is no longer required (paragraphs 2.8 to 2.12).

24 The monitoring arrangements for reliefs vary across HMRC, but it administers most reliefs as part of its wider administration of the tax streams. HMRC has over 100 analysts who routinely monitor trends and patterns in tax receipts and the impacts of tax policies. In doing so, they monitor those reliefs with the most significant impact on overall tax receipts and may undertake closer examination of a relief if its impact is not in line with expectations. HMRC has identified the need for more tailored monitoring arrangements for some reliefs. Of 46 reliefs identified on HMRC’s website as tax expenditures, it has established dedicated units to oversee 9. HMRC created these units to concentrate expertise and to promote particular outcomes, such as encouraging investment. By concentrating expertise in these areas HMRC is better able to give customers a consistent service, ensure compliance, and promote the take-up of reliefs (paragraphs 2.13 to 2.17).

25 HMRC does not evaluate tax reliefs systematically, and has commissioned few evaluations of their impact. The Treasury depends on HMRC’s feedback on the use of specific reliefs. Evaluation is important to understand the extent to which a tax relief is misused, its behavioural consequences and, in the case of tax expenditure, whether it is meeting its social or economic objectives. HMRC’s analysis unit has undertaken some evaluation of reliefs and has commissioned and published 19 external evaluations of tax expenditures since 2003, for which it paid £1.8 million in total. Most have focused on how the reliefs have changed behaviour, rather than seeking to quantify the benefits or estimate the costs of revenue foregone, avoidance, or administration. The evaluations cover reliefs worth around £6 billion a year, which is around 6 per cent of the known value of tax expenditures. More systematic or comprehensive coverage would require HMRC to allocate a greater proportion of its resources to evaluative work (paragraphs 2.18 to 2.20).

26 We found limited monitoring of changes in the cost of particular reliefs. HMRC reports the cost of around 200 reliefs to provide transparency, but it does not routinely produce data on trends to track movements in reliefs unless policy changes are proposed. Around a quarter of 92 principal reliefs we examined had experienced significant changes in value. We identified 26 tax reliefs which had increased by more than 50 per cent in real terms in the past ten years, and 30 which had increased by more than 25 per cent in the last five. There are many reasons why the value of a relief might increase, including a rise in the underlying rate of tax, but none of the increases prompted the exchequer departments to evaluate the reliefs concerned (paragraphs 2.21 to 2.27).

Managing the risk of reliefs being abused

27 HMRC responds proactively to the serious challenge of administering the complex system of tax reliefs and addressing the opportunities for abuse it creates. It is evolving its business model to increase the range and volume of compliance interventions, including by reinvesting £994 million of department-wide efficiency savings to tackle tax avoidance, evasion, criminal attack and debt between 2010-11 and 2014-15. It has developed cutting-edge technology that uses data in powerful ways to help it detect fraud and criminal attack (paragraphs 3.2 and 3.7).

28 The design of tax law is critical to reducing the scope for reliefs to be exploited by fraudsters or for the avoidance of tax. Since 2009, HMRC has formally assessed all new tax reliefs while still in draft form, focusing in particular on the design of measures that might give rise to fraud or avoidance. It is inherently difficult to predict how a new relief might be abused, however, due to the complexity of the way measures interact across the tax system and the contrived structures or transactions that may be created to abuse them. Where abuse is detected, HMRC may advise that legislation is introduced quickly or retrospectively to close a loophole, particularly where a large amount of tax is at risk. Some loopholes have been closed within days of HMRC becoming aware of them (paragraphs 3.3 to 3.5 and 3.12 to 3.13).

29 HMRC has high success rates in challenging avoidance schemes that exploit tax reliefs, but avoidance cases can take a long time to investigate and resolve. Some scheme promoters deliberately slow down the process because tax rules normally allow taxpayers to hold on to disputed tax, no matter how unlikely they are to succeed in litigation. HMRC estimates there are around 65,000 open cases involving marketed tax avoidance schemes. Over 85 per cent of these date back to 2009-10 or earlier. HMRC has consulted on measures to accelerate the payment of disputed tax where similar claims have already failed and these will be included within Finance Bill 2014 (paragraphs 3.16 to 3.18).

30 The time needed to collect data and take remedial action places an onus on robust design and more proactive monitoring of the performance of reliefs. HMRC has introduced measures to require early disclosure of avoidance schemes seeking to exploit design weaknesses. By collecting data from across its business in real time – such as to track how a new relief or a significant change to relief is being exploited – HMRC could assess the extent of emerging threats sooner, allowing it to act more quickly to safeguard revenue. In the case of research and development (R&D) tax credits, we found that good practices – including the relief’s phased introduction, annual reporting of its performance, independent evaluations, and an estimate of its costs and benefits – had meant that the cost of the relief had stayed in line with forecasts. Wider application of these practices by the exchequer departments’ approaches could provide an effective control on the introduction of other reliefs (paragraphs 3.6 to 3.10 and 3.26 to 3.28).

Concluding comments

31 Tax reliefs are an important and longstanding element of fiscal policy and are growing in number. They are also essential to the effective operation of a tax system. This report is intended to describe the landscape across all tax reliefs in the UK, and to put Parliament in a position to consider whether the major elements in the management and responsiveness of the system are working adequately, or are in need of more focused attention.

Part One

Tax reliefs and how they are used

1.1 All tax systems include tax reliefs, which in many cases are an essential part of defining the scope and structure of a tax by providing rules which establish where the tax burden is and is not intended to fall. Reliefs can help maintain the competitiveness of tax systems and governments can use tax reliefs as a mechanism to redistribute wealth and support economic growth, and influence behaviour. Tax reliefs are also introduced for practical purposes such as establishing the correct income and profit for tax purposes and making the tax system simpler to use.

1.2 HM Treasury oversees the tax system, including designing tax reliefs. HM Revenue & Customs (HMRC) administers the tax system, including tax reliefs, and maintains tax policy.

1.3 In this part we consider:

the categorisation, number and scale of tax reliefs;

how tax reliefs are used; and

the potential tax at risk from abuse of reliefs.

The categorisation, number and scale of tax reliefs

Categorising reliefs: structural reliefs and tax expenditures

1.4 The UK has over 1,000 tax reliefs, allowances and exemptions (Figure 4). The reason reliefs are introduced, and the delivery mechanisms vary. Most reliefs are ‘structural’ in that they are integral to the way a tax is constructed and how it works, reflecting the government’s choices about who and what to tax. For example, some reliefs simply define the scope of a tax (such as exempting cabin crew from air passenger duty), others are allowances that make a portion of income tax-free (such as personal income tax allowance), and some are mechanisms to help certain groups of taxpayers (for example, £30,000 of some redundancy payments is tax-free). Other reliefs reflect international obligations (such as common laws within the EU, to ensure the EU single market works effectively. For example, the zero rate of VAT for international trade).

1.5 Reliefs may also be introduced to help or encourage particular taxpayers, activities or products in pursuit of social or economic objectives. Such reliefs are often an alternative to public expenditure, and have similar effects, and they are therefore called ‘tax expenditures’. For example, tax reliefs and credits are available to companies to encourage research and development (R&D) activity, a policy objective that has also been pursued through grant funding.

1.6 The distinction is not always straightforward between reliefs that are a part of the structure of the tax system and those that are tax expenditures. HMRC has not comprehensively categorised tax reliefs by objective or delivery mechanism. Figure 5 provides our analysis of the value of reliefs by objective.

The number and scale of tax reliefs

1.7 HMRC reports annually on around 400 tax reliefs and has assessed the cost of these where it has sufficient data. HMRC has estimated the value of 92 principal tax reliefs and 88 minor tax reliefs. Twenty reliefs account for almost 85 per cent of the estimated value of tax reliefs (Figure 6).

1.8 HMRC publishes cost estimates for some reliefs, but does not total these figures. Doing so would give only a broad indication of the scale of the tax reliefs landscape for two reasons. First, it does not allow for any behavioural changes as a result of the reliefs and the interactions between tax reliefs mean that simply combining the costs of individual reliefs will tend to overstate the true picture; and second, HMRC does not have cost data for a large proportion of reliefs, and the effect of excluding these will understate the overall position. It is important to recognise that, while the provision of reliefs reflects government’s choices about where to place the tax burden, it would be unrealistic to assume that all of the revenue that appears to be foregone through tax reliefs could be collected. A higher overall tax burden could reduce economic productivity and the UK’s global competitiveness, and may not be sustainable in the medium term.

1.9 As the nature of tax reliefs varies so widely, it is more meaningful to consider the constituent parts of their summed value than to focus on the aggregate figure:

Tax expenditures accounted for £101 billion in 2012-13. The largest relief classified by HMRC as a tax expenditure was relief on contributions to registered pension schemes (£22.8 billion).

Reliefs that, by HMRC’s definition, achieve the desired progressivity of the tax system accounted for £140 billion. By far the biggest single component was the personal allowance on income tax, valued at £68.5 billion in 2012-13. Any decision to change the level of the personal allowance would make a significant difference to the combined value of all reliefs.

Other structural reliefs in 2012-13 summed to £93 billion.

1.10 HMRC has insufficient data on tax returns to make a reasonable estimate of the value of 219 other tax reliefs that it reports. The estimates are incomplete because data is not always available. Most of the Organisation for Economic Co-operation and Development (OECD) countries have similar gaps in data. Most countries that report costs focus primarily on tax expenditures (Figure 7). They do not report the aggregate value of all reliefs, including those that are structural features of the tax system. Comparisons are limited as definitions of tax expenditures vary. Only France and Italy have estimated the value of more tax reliefs than the UK.

1.11 Creating reliefs in the tax system can add to complexity.1 In 2010, HM Treasury set up the Office of Tax Simplification to help simplify the tax system. In March 2011, the Office of Tax Simplification identified 1,042 tax reliefs in the UK. It reviewed a representative sample of 155 and recommended that 47 should be abolished either because they had expired, there was no longer a policy rationale, the value was negligible, or the administrative burden outweighed the benefit.2 Since then Parliament has abolished 48 reliefs and introduced 134 new reliefs. By March 2013 the total number of reliefs enacted in UK law had increased to 1,128.

1.12 The measurable value of reliefs has increased relative to tax revenue. As a proportion of GDP, the summed value of tax reliefs has increased from 16.3 to 21.3 per cent since 2005-06, while tax revenues have decreased marginally. Most of this increase is explained by increases in the value of structural reliefs, with the personal allowance alone rising from £45.6 billion to £68.5 billion in real terms over this period. Other significant factors are increases in the thresholds for National Insurance contributions and the standard rate of VAT (because as the standard rate of VAT rises, so does the value of VAT reliefs). Tax expenditures increased in real terms from £91 billion to £101 billion over these eight years, rising from 5.9 to 6.5 per cent of GDP (Figure 3).

How tax reliefs are used

1.13 All UK taxpayers use tax reliefs to some extent. For example, nearly everyone who lives in the UK is entitled to an income tax personal allowance, the amount of income that each person is allowed each year before having to pay tax; and all consumers benefit to varying degrees from reduced and zero rates of value added tax on certain goods. Some reliefs can only be used in specific circumstances and require the taxpayer to claim them.

1.14 The use of tax reliefs offers some practical advantages to the exchequer but also carries risks. For example, tax expenditures can offer low administrative costs and provide differentiated financial support that would not be cost-effective through a means-tested spending programme. However, most tax expenditures cannot be controlled by setting a finite budget, as are spending programmes, so the costs can rise beyond expectations. Moreover, all tax reliefs carry the risk that they will be misused to avoid or evade tax. The number of reliefs and the interactions between them also add to the complexity of the tax system and increase the risk of error.

1.15 Most people and businesses use reliefs in the way intended by Parliament. However, each tax relief creates potential routes to be exploited in ways not intended. The range of behaviours include:

Using the relief as intended. This may involve a change in the taxpayers’ behaviour to take advantage of the relief.

Adopting a different legal interpretation of tax relief rules from that intended by Parliament, or one which tests the boundaries of that intent.

Tax avoidance – creating contrived financial or operating arrangements purely or primarily to exploit a tax relief.

Tax evasion – where individuals and businesses deliberately, and illegally, set out to not pay the tax due.

Criminal attack – where organised criminals or other parties set out to systematically exploit tax reliefs to defraud the tax system and extract payments from HMRC.

1.16 Several industries and groups take a strong interest in tax rules and ways to advise their clients on how they can make the best use of the available reliefs. Accountancy firms, major banks and leading lawyers support and advise individuals and businesses on their tax affairs. Providing tax advice is worth almost £2 billion a year in the UK to the ‘big four’ accountancy firms alone, and almost $25 billion globally.3 In addition, some specialist accountancy firms have business models that depend on creating and promoting avoidance schemes.

1.17 In this section we consider case examples to illustrate how a sample of reliefs are used. We focus on five areas, drawing on HMRC’s data and website and other public sources:

Reliefs which define the structure and scope of a tax

Use of tax expenditures

Challenging HMRC’s interpretation of tax law

Tax avoidance involving reliefs

Illegal evasion and criminal attack.

Reliefs which define the structure and scope of a tax

1.18 All tax systems include tax reliefs which in many cases are an essential part of defining the scope and structure of a tax by providing rules which establish where the tax burden is and is not intended to fall. This section describes some examples of reliefs which define the structure and scope of a tax.

Reliefs from inheritance tax

1.19 Inheritance tax is an example of a tax which under HMRC’s definition, provides progressivity in the tax system by ensuring the burden falls most on those who can most afford to pay. It is unlike most other taxes in that the amount of relief far exceeds the amount of tax collected. Several reliefs define the scope of the tax and the value of these reliefs in 2012-13 was £22.4 billion, seven times the value of tax collected (Figure 4).

1.20 In 2010-11, there were 560,000 deaths, of which 16,000 (3 per cent) resulted in an inheritance tax liability. Most estates were not notified for probate because there was a surviving spouse or because they were relatively small. Of the 260,000 deaths that were notified for probate, 36,000 estates were valued at above the tax threshold. Of these, 20,000 did not have to pay any inheritance tax because of the value of reliefs and exemptions they were able to claim.

Corporation tax reliefs

1.21 The distribution of corporation tax is not spread evenly. A small number of very large businesses pay significant amounts. In 2011-12, 35 of the UK’s 975,000 companies paid 21 per cent of all corporation tax. The largest 800 businesses, dealt with by HMRC’s Large Business Service, have typically contributed around half of all corporation tax paid in recent years. However, in 2012-13 more than half of the 800 largest businesses paid less than £10 million each in corporation tax. Around 20 per cent of these 800 businesses paid no corporation tax in 2012-13.

1.22 The amount of corporation tax paid by individual businesses may also vary significantly each year, according to their industry and individual trading conditions. For example, in 2010-11 a quarter of all businesses paying corporation tax had no corporation tax payable in the previous year.

Loss reliefs

1.23 Loss reliefs help smooth the taxation of profit over a company’s lifespan. They allow trading losses to be carried back a year or carried forward to set off against future profits from the same trade. The aim is to ensure that tax is charged on the overall profits, recognising that losses may first need to be incurred before a company makes a profit.

Group loss relief

1.24 Group relief ensures that the same overall UK corporation tax is paid regardless of whether a business chooses to operate through a single company or many companies. Companies within a group can transfer losses to set against group profits in that year. Analysis of corporation tax statistics indicates that group loss reliefs play a significant role in stabilising the amount of corporation tax paid (Figure 8).

1.25 Deduction of interest from taxable profits can substantially reduce tax liabilities where major investment or acquisitions have been funded by debt. Figure 9 shows how a loan arrangement to pay for an acquisition might work when funded by loans within a group. In this example a company takes out a loan from its subsidiary overseas to finance a major acquisition. The overseas subsidiary in this example is responsible for borrowing money from the markets to fund the group’s activities. The company spreads the cost of the acquisition in instalments across its lifetime, so that it recognises the costs when it generates profits. In addition, lifetime interest on the loan will reduce profits that incur tax in the UK until the loan is repaid. The loan can be structured so the company repays it in one payment. This generates larger interest deductions rather than where the loan is paid off in instalments. The interest that the subsidiary gets is taxed in a country with a lower tax rate. This kind of tax planning can be effective within existing tax rules, although there are rules that limit the scope of such tax planning.

Use of tax expenditures

1.26 Those reliefs known as tax expenditures are designed to deliver specific objectives by providing behavioural incentives to achieve economic and social objectives. This section describes examples of tax expenditures.

Pension saving

1.27 To encourage individuals to take responsibility for retirement planning, the government provides pensions tax relief on personal and employer contributions, and scheme investment income and gains. Each year around 500,000 individuals with combined private pensions wealth of £120 billion, built up by making use of this relief, start to access their pension savings. The cost of providing this relief is around £23 billion a year.

Investment by businesses

1.28 The Seed Enterprise Investment Scheme (SEIS) is designed to help small, early stage companies raise equity finance. SEIS offers tax reliefs to individual investors buying shares in small companies at a very early start-up stage. It has helped over 1,600 companies to raise over £135 million of funding through the scheme.

1.29 Research and development (R&D) tax reliefs provide companies with an incentive to carry on additional research and development. In 2011-12 over 12,000 companies invested £11.9 billion in research and development. These companies claimed R&D tax credits worth almost £1.2 billion.

Support for oil and gas production

1.30 Oil and gas field allowances are available for new fields and existing ones where there is declining production. The allowances are intended to support the extraction of oil and gas in commercially marginal fields, helping to maximise the productive life of those fields.

Inheritance tax

1.31 Agricultural and business property relief are two of the tax expenditures that commonly reduce or remove liability to inheritance tax. These reliefs aim to ensure that family businesses do not have to be broken up and sold to pay inheritance tax. Under agricultural property relief, farmed land can qualify for relief. Other assets eligible for relief include an interest in a business, assets used in that business or unlisted shares. Figure 10 shows that the value of these reliefs has grown faster than the amount of tax collected. The reliefs are regularly cited by firms that undertake tax planning as ways of reducing inheritance tax that are relatively easy to use.

Challenging HMRC’s interpretation of tax law

1.32 Taxpayers can challenge HMRC’s interpretation of tax relief rules. For example, a recent legal case disputed whether a painting displayed in a stately home that was open to the public should be exempt from capital gains tax. The First Tier Tax Tribunal found that it was not exempt from capital gains tax. This decision was appealed and the Upper Tax Tribunal ruled that it was correct to classify the painting as ‘plant’ (a working asset) because it was actively attracting visitors to the heritage site. As a result it was treated as a ‘wasting’ asset for tax purposes and was exempt from capital gains tax when it was sold for £9.4 million, even though it had appreciated in value.4 HMRC took this case to the Court of Appeal in a bid to restore the decision of the First Tier Tax Tribunal, but it did not find in HMRC’s favour. Lord Justice Briggs commented that the judgment may be “surprising to those unfamiliar with the workings of Capital Gains Tax ... but this is the occasional consequence of the working of definitions and exclusions which, while aimed successfully at one potential inroad into the charge to tax, unavoidably allow others by what the legislators appear to permit as an acceptable if unwelcome side-wind.”5 HMRC will need to decide whether it wishes to appeal the decision, seek a legislative change, or accept that the definition should stand.

Tax avoidance involving reliefs

1.33 HMRC describes tax avoidance as an attempt to exploit legislation to gain a tax advantage that Parliament did not intend. HMRC has highlighted areas where it is concerned about the aggressive use of tax reliefs to avoid tax. Since 2011 HMRC has published ‘spotlight’ articles online highlighting 19 types of avoidance schemes that it will challenge. Of these, six involve tax reliefs (Figure 11). All of the schemes use artificial transactions.

1.34 Avoidance schemes use artificial and complex transactions. HMRC won a recent tax tribunal that involved individuals who had claimed to be engaged in the second-hand car trade. The scheme aimed to generate large tax deductible losses for the incidental cost of obtaining finance. Figure 12 shows how complex the operation of this scheme was and shows the flows of money.

1.35 The boundary between the appropriate use of tax rules and tax avoidance is not always immediately obvious. Some tax planning and use of reliefs goes beyond what is reasonable under UK tax rules, including variations of the examples we have described earlier in this part.

1.36 HMRC has challenged inheritance tax avoidance that uses the purchase of agricultural property as described in paragraph 1.31. An amendment to legislation in 2013 stopped an exploitation of the rules that had allowed debts to reduce the value of an estate regardless of whether the debt was paid after death. Some arrangements involved loans to buy agricultural land that qualified for a relief, so that the taxable value of the estate was reduced twice. Other arrangements involved contrived debts that were not repaid so there was no real reduction in the value of the estate.

1.37 Group companies have been known to take advantage of group relief using artificial means in the past. An unintended consequence of group relief is that it can lead to trading of deferred tax assets. A method used to reduce tax has been the targeted purchase of companies with large trading losses. In 2013 HMRC introduced rules which complement long-standing anti-avoidance rules, to restrict this practice.

1.38 Some companies have used loan arrangements to gain additional tax relief, using artificial structures that provide no operational benefit other than to reduce tax through interest deductions. In Figure 9, the loans come from the overseas subsidiary through money it has borrowed from the market. If the subsidiary was funded by money provided from the operating company, rather than from borrowing, then the arrangement would be unlikely to comply with UK tax rules and would be considered avoidance.

Illegal evasion and criminal attack

1.39 Some reliefs involve customers making claims that entitle them to a payment or refund of tax from HMRC. These include tax credits paid out under film tax relief, payments made to charities under gift aid, and VAT refunds made against zero-rated items. Being able to claim cash payments means that these reliefs are subject to criminal attack. HMRC has processes to identify and tackle criminal attack. We reviewed instances where criminal gangs exploited reliefs such as zero-rated VAT on exports and gift aid to get money from HMRC. In each case, the common approach was to create fake transactions that triggered payments from HMRC (Figure 13).

1.40 Film tax relief has also been subject to instances of attempted fraud using fake transactions. In 2013, the individuals behind Evolved Pictures were prosecuted and convicted for misusing reliefs. Under the guise of producing a film, Evolved Pictures told HMRC that it had spent millions of pounds on the film, including paying actors and film set managers. The company claimed that this meant a VAT repayment was due and that the production was entitled to film tax relief. However, during checks HMRC found that this work had not been done. It therefore challenged the company’s claims of £1.5 million in VAT repayments and £1.3 million in film tax credit.

1.41 Pension relief is also subject to fraud. Two people were recently found guilty of setting up false pension schemes to claim relief by hiding fake contributions among genuine payments. They triggered almost £5 million of payments to the scheme administrator. The perpetrators included a leading tax professional, the former president of the Association of Taxation Technicians.

1.42 Certain features of the tax system may make them at more risk of abuse. This is an area where more detailed research and evidence gathering would be useful.

The value of tax at risk

1.43 HMRC does not estimate the tax at risk or loss from taxpayers abusing reliefs. Instead, it monitors all the tax it considers to be at risk across the tax streams, without separately identifying which elements relate to the potential abuse of reliefs. It publishes an annual estimate of the tax gap which it defines as “the difference between the amount of tax that should, in theory, be collected by HMRC, against what is actually collected”.6 The IMF considers the UK’s estimates of the tax gap to be “one of the most comprehensive studies of the tax gap internationally”.7

1.44 HMRC estimated the tax gap to be £35 billion in 2011-12. Of this, £4 billion arises from avoidance, a high proportion of which involves exploiting reliefs. It estimates £4.3 billion of potential tax loss from cases where HMRC and individuals or businesses have different views of how the tax law, including rules for relief, applies to specific and often complex transactions. Evasion and criminal attack account for £9.8 billion of the gap. Between £0.5 billion and £1 billion of this is missing trader intra-community fraud.

1 HM Treasury, Tax policy making: a new approach, June 2010.

2 Office of Tax Simplification, Review of tax reliefs – final report, March 2011.

3 HC Committee of Public Accounts, Tax avoidance: the role of large accountancy firms, Forty-fourth Report of
Session 2012-13, HC 870, 26 April 2013.

4 Upper Tier Tribunal Court Judgment, Lord Howard of Henderskelfe (Deceased) v Revenue and Customs [2013] UKUT 129 (TCC), 11 March 2013.

5 Court of Appeal Judgment, HM Revenue and Customs v Lord Howard of Henderskelfe (Deceased), [2014] EWCA Civ 278, 19 March 2014.

6 HM Revenue & Customs, Measuring tax gaps 2013 edition, 11 October 2013, p. 6.

7 International Monetary Fund, Assessment of HMRC’s Tax Gap Analysis, August 2013, p. 8.

Part Two

How the exchequer departments assess the performance of reliefs

2.1 As government auditors, we expect to see evidence of an effective system of controls to administer tax reliefs. We have considered the approach of the exchequer departments against good practice from Treasury guidance and overseas and academic research (Figure 14 and Appendix Three).

2.2 In this part we consider how reactive the exchequer departments are to emerging differences between the reliefs’ performance against their expressed intention and intended benefits. We consider:

the role of the exchequer departments, the Treasury and HMRC, in developing, monitoring and evaluating tax reliefs;

how the departments use data to monitor and evaluate the cost and benefit of tax reliefs; and

whether movements in the value of reliefs merit further investigation.

The role of the exchequer departments in developing,
monitoring and evaluating tax reliefs

2.3 The Treasury and HMRC oversee tax reliefs. The Treasury proposes new tax rules and HMRC provides technical advice and feedback on administering the tax system, including tax reliefs. HMRC is responsible for ensuring that tax administration complies with UK and EU legislation, while also making the system as efficient, effective and as easy to understand as possible.

2.4 There is no single accounting officer responsible for tax reliefs. HMRC works in partnership with the Treasury to develop, design and deliver tax policy. The Treasury is responsible for designing tax policy and HMRC implements and maintains it. This work includes predicting the impact of proposed changes to tax reliefs and publishing statistics on tax reliefs and taxes in general. The Office for Budget Responsibility scrutinises HMRC’s forecasts for new measures.

2.5 Figure 15 shows the management cycle of reliefs and the responsibilities of each department.

2.6 All public sector organisations are expected to follow the principles in Managing Public Money, which sets out the standards expected of all public services. The Treasury also publishes guidance for public sector bodies on completing appraisals before committing funds to a policy (The Green Book) and guidance on evaluation (The Magenta Book). The Green Book sets out the principles in relation to appraisal which may be relevant to the way that policy options for tax expenditures are considered, and should form the basis of any investment decision relating to the implementation or administration of a relief (for example, purchase of new IT systems, creation of new units). Similarly any evaluation of the tax relief which Government commits itself to might sensibly draw on the principles set out in the Magenta Book. Whether and how to act on the outcome of any evaluation which considers the extent to which the relief addresses any policy objectives is a policy matter for ministers.

2.7 The NAO considers that a clearer statement about the responsibility on the exchequer departments for administering tax reliefs and tax expenditures would aid transparency and accountability.

Developing reliefs

2.8 Tax reliefs are developed the same way as other tax measures. For each budget proposal, a detailed costing is undertaken to forecast the effect of the change on tax receipts for the next five years. These figures are published alongside the Budget. In developing these forecasts HMRC estimates the levels of take-up and possible non-compliance. These assumptions are scrutinised by the Office for Budget Responsibility. HMRC and the Treasury told us that the creation of the Office for Budget Responsibility had brought greater transparency to tax forecasts and receipts.

2.9 In 2010, the government increased the policy cycle for creating new reliefs from 7 to 18 months to allow more opportunities for consultation, options appraisal, and drafting legislation. HMRC told us that where a longer consultation period had been implemented, it had led to fewer amendments to bills because technical issues were resolved in consultation, rather than during the passage of legislation.

2.10 The Treasury has recognised that it should consider new reliefs carefully, and only introduce them when there is a strong and proven case. In June 2010, the Treasury committed to developing a framework for introducing new reliefs.1 It also proposed to use ‘sunset clauses’ more, and to do more post-implementation evaluation to ensure that the case for continuation of the relief remains strong. Treasury has not yet introduced the framework for introducing new reliefs.

2.11 Under the Treasury’s proposals it argued that when the government makes changes to the tax code there must be enough time for the policy and legislation to be properly scrutinised. In 2011, tax information and impact notes (TIINs) were introduced to replace tax impact assessments. Figure 16 summarises the requirements for different types of policy changes. Impact assessments no longer include an options appraisal or quantify the financial impact of risks (such as avoidance) as they did until 2010.

2.12 Staff we spoke to said that the Budget Policy Oversight Panel considers the risks during the design process. The panel consists of Treasury and HMRC directors responsible for developing tax policy. The panel governs across the policy partnership and focuses on risks to policy development within the budget cycle, rather than administrative risks. Our discussions with staff indicated a strong culture in both departments to consider and tackle the risk of avoidance and new measures are routinely proofed against avoidance by specialist staff. However we could not find evidence of a broader, structured risk assessment for new reliefs to identify risks for future monitoring. Instead reliance is placed on continuity of HMRC staff involved in design discussions with Treasury colleagues.

Monitoring reliefs

2.13 In general, HMRC and the Treasury monitor overall tax receipts for each tax stream. Monitoring arrangements for reliefs vary across HMRC. The department administers most reliefs as part of the wider administration of the relevant tax stream which allows HMRC to take a wider view of how reliefs are used alongside other relevant tax rules. HMRC has over 100 analysts who routinely monitor trends and patterns in tax receipts and the impacts of tax policies. HMRC sometimes uses specialist units to administer a relief and monitor its performance. HMRC must balance competing objectives to collect tax and encourage take-up of reliefs to meet policy objectives. HMRC has greater incentive to focus on collecting tax to achieve targets for tax yield. It has rarely set targets or performance measures for take-up of reliefs, or for achieving social or economic objectives. We observed that some tax teams do focus largely on reliefs. For example specialist teams monitoring share schemes and capital gains tax.

2.14 Within HMRC, each tax is assigned a product owner who has responsibility for the legislative frameworks that define it, including the relevant reliefs. HMRC may assign a dedicated product owner to manage a relief depending on its purpose and significance, and its role in the wider structure of the tax.

2.15 HMRC does not distinguish the cost of monitoring tax reliefs from the wider administration of the tax system. The costs may be significant. The business tax group, whose customers frequently use reliefs, employed 4,000 people and cost £199 million in 2012-13. Around 15 per cent of 27,000 staff working on individuals’ tax deal with specialist areas of personal tax where the use of reliefs is common, such as inheritance tax, capital gains, charities and high-net-worth individuals. These areas cost around £110 million to administer in 2012-13.

2.16 HMRC has tailored monitoring arrangements for some tax expenditures. Of the 46 tax expenditures identified on HMRC’s website, it has established five dedicated units to oversee nine reliefs. Specialist units oversee tax reliefs relating to research and development, film tax relief and creative sectors, small company investment schemes, foreign business investors, and tonnage tax. HMRC created the units to concentrate expertise because the reliefs require specialist technical knowledge. The reliefs are also intended to promote particular outcomes, such as encouraging investment. The specialist teams help to give customers a consistent service, and to promote compliance and take-up.

2.17 We examined three specialist units (R&D, film tax and the small companies enterprise centre) which HMRC identified as its best practice examples (Figure 17). The units did not have targets for take-up but all of these units carried out work to promote the relief. The R&D unit was the only unit to routinely report on performance. It had overseen an increase in claims from 6,000 to 18,000 a year while also reducing resources by 40 per cent. It was also the only unit to test a sample of claims; the other units carried out 100 per cent testing. HMRC told us that the film tax relief unit reviews all claims due to the low volume of applications and undertakes differing levels of scrutiny depending on the detail of the claim. There is a statutory requirement on HMRC to provide a definitive response to any application for Enterprise Investment Scheme or Seed Enterprise Investment Scheme approval. The total staff cost of the units is £4.1 million a year.

Evaluating and reporting on reliefs

2.18 HMRC identifies the major policy changes where there is a case for an evaluation. HMRC has limited resources to undertake this work internally and has to focus on the areas that offer the most valuable return. The exchequer departments sometimes commission independent evaluations of reliefs, provided by external research organisations. HMRC has commissioned 19 such evaluations since 2003, for which it paid £1.8 million in total. Most have tended to focus on the impact of the reliefs rather than assessing the costs of revenue foregone, avoidance or administration. The evaluations cover reliefs costing at least £6 billion a year, around 6 per cent of the known value of tax expenditures. Figure 18 summarises the findings.

2.19 The exchequer departments do not have a framework to evaluate tax reliefs systematically. HMRC told us that it tended not to commission evaluations because it did not consider them to be cost-effective. For example, HMRC told us that in some cases it would not be possible to obtain meaningful results from evaluation, or that gathering the necessary data would impose a disproportionate burden on the public or business.

2.20 HMRC’s internal analysts may undertake closer examination of a tax relief if they have a material impact on tax receipts. This may result in internal unpublished evaluations of the relief. For example, in 2010 it undertook an evaluation on the reformed regime for pension contributions relief, the largest of the reliefs it categorises as a tax expenditure.

Monitoring changes in the values of reliefs

2.21 HMRC does not actively monitor the actual costs of all new reliefs against forecast amounts. Tax reliefs are not subject to the same controls as spending programmes because there are no budgets and income is not collected, but they are monitored as part of the wider monitoring of tax receipts. Nonetheless variance analysis can be valuable in understanding why levels of tax revenue vary, how far tax reliefs are used, and to detect rising abuse.

2.22 We found limited monitoring of changes in the cost of particular reliefs. HMRC reports estimates of the cost for around 200 reliefs to provide transparency. It also produces corporation tax statistics, R&D statistics and information on film tax reliefs. HMRC’s analysis unit does not routinely produce data on trends, unless it is specifically requested. For example, requests for further analysis may be made if a policy change is being considered or if levels of tax receipts are not as expected. The data HMRC publishes annually includes previous year comparators, so significant movements in estimates between years may be identified but movements over longer periods may not.

2.23 Around a quarter of 92 principal reliefs we examined had significant changes in value. We identified 26 tax reliefs that had increased by more than 50 per cent in real terms in the past ten years (to 2012-13). Some 30 reliefs had increased by more than 25 per cent in the past five years. The analysis excludes movements that can be wholly explained by an increase in the rate of VAT.

2.24 In many cases policy changes have contributed to overall changes in the level
of tax relief, but this is not always the case. We identified six principal tax reliefs where
no policy change had occurred and the value of the relief had increased by more than
50 per cent in ten years. In some cases increases may be due to the growth of particular
services or asset values. For example, the value of the exemption from income tax for
government securities held by non-residents grew because the amount of government
securities held by non-residents increased from £159 billion in 2007 to £417 billion in 2012. Despite cost significantly exceeding original forecasts, HMRC has not reviewed
the reliefs.

2.25 Some reliefs have experienced substantial increases within five-year periods. We identified four reliefs that had increased by more than 50 per cent in real terms since 2008-09 and where there had not been a policy change (Figure 19). The total value of these reliefs increased from £575 million to £1.2 billion in 2012-13 in real terms. The movements in estimates have not triggered evaluations for any of the reliefs.

2.26 Even where policy changes cause cost variations, monitoring against forecasts helps assess the impact on tax revenue. We identified nine reliefs where a change in policy did not fully account for the increase in the cost of the relief over the past ten years. For example, Figure 20 shows the correlation between announced changes to venture capital trusts (VCTs) and the enterprise investment scheme (EIS) and the movement in overall costs. The Treasury, in its 2004 budget forecast, estimated that changes to VCTs and EIS – including a two-year temporary change to the level of income tax relief for VCTs – would have no cost impact in 2004-05. The changes would then cost an additional £55 million in 2005-06, and an additional £60 million in 2006-07. In 2004-05 the cost before the change was £200 million. The actual cost increased to £480 million in 2004-05 and to £580 million in 2006-07. In 2007-08, the cost fell to £230 million.

2.27 More recent changes to caps on VCTs and the EIS announced in 2011 are not subject to time limits. Early data indicate that the changes are costing more than expected. The Treasury has forecast these policy changes will add to the cost of the reliefs by £105 million in 2012-13, and then between £110 million and £120 million each year for the following three years. In 2012-13 there was an actual increase of £205 million, almost double the forecast. HMRC told us this is due to the introduction of the feed-in tariffs initiative, from April 2010, that resulted in large amounts of investment into the renewable energy sector.

1 HM Treasury: Tax policy making: a new approach, June 2010.

Part Three

How the exchequer departments assess, monitor and respond to the risk that reliefs are abused

3.1 In Part One we identified how tax reliefs are used and where this may differ from what was intended either from legal interpretation, tax avoidance, tax evasion or criminal attack. In this part we consider how aware or reactive the exchequer departments (HM Treasury and HM Revenue & Customs (HMRC)) are to the risks of abuse. We consider:

how HMRC tries to design out avoidance;

how the exchequer departments use information to detect types of abuse;

HMRC’s response to evidence of abuse; and

the time needed to repeat the management cycle of design, monitoring and evaluation to ensure that reliefs are used effectively.

3.2 HMRC’s future business model involves an increased focus on compliance and enforcement. HMRC is reinvesting £994 million between 2010-11 and 2014-15 to tackle tax avoidance, evasion, criminal attack and debt. HMRC expects the investment to help to secure £22 billion a year in compliance revenues by 2014-15 – almost 70 per cent more than 2010-11.

How HMRC designs out avoidance

3.3 Since 2009 HMRC has formally assessed new legislative measures to identify potential avoidance risks. Before that, HMRC considered avoidance risks in new measures on a more ad hoc basis. HMRC assigns new tax measures a level of risk based on, for example, how much of the tax system it covers and an assessment of the cost. Measures assessed as high risk are subject to examination by experienced avoidance specialists at HMRC while still in draft. HMRC also considers the potential for fraud where the reliefs provide payments or credits.

3.4 As part of the design phase of tax reliefs, HMRC also considers how reliefs may interact with other parts of the tax code and the potential this creates for avoidance. This is inherently difficult to do as it involves identifying abnormal ways of using the reliefs, which may rely on the fine detail of legislation. The tax tribunal case, discussed in Part One, demonstrates the complex ways in which avoidance schemes try to take advantage of different parts of the tax code (Figure 12). The scheme relied on combining two rules in the tax code in a novel way, using rules on stock lending which treats manufactured dividends as a fee, and rules on income tax trading which allowed fees to be tax deductible. The manufactured dividend rules would normally only apply to banks and financial traders, and the rules on income tax to individuals. HMRC estimated the total tax at risk from this scheme was £290 million.

3.5 HMRC has had success in using ‘principle-based legislation’, which sets out at a high level the principle behind the legislation. Although this type of legislation still contains detailed rules, articulating the principle behind the legislation allows the courts to apply the principles to new variants of avoidance that may not have existed when the legislation was drafted. HMRC told us that this is far less likely to result in loopholes than in legislation which is heavily prescriptive. The government introduced ‘group mismatch’ rules in 2010 using principle-based legislation. These rules tackled incidents where an interest deduction in one group company was not matched by an equivalent receipt in the creditor company. HMRC identified that its previous attempts to tackle this through piecemeal changes to legislation had only resulted in new types of avoidance which attempted to get around the new rules. Since the new legislation was introduced no further schemes of this type have been disclosed.

How the exchequer departments use information to detect
threats and abuse of reliefs

3.6 HMRC’s primary source of information on the use of tax reliefs comes from taxpayer returns. For each tax stream, case officers check a sample of returns while a series of automated checks assesses the risk for all taxpayers. Certain reliefs are flagged as high risk on HMRC systems. Taxpayers using these reliefs are more likely to be selected for review.

3.7 HMRC checks taxpayer returns against other data sources, including whether a taxpayer uses a registered avoidance scheme. Its CONNECT system checks claims against data collected from a wide range of sources to identify patterns, hidden relationships and inconsistencies or suspicious activity in tax returns. HMRC estimates that CONNECT has yielded around £2.6 billion in extra tax, on an investment of £45 million since it was launched in 2010.

3.8 HMRC is adding 100 extra investigators and extra risk and intelligence staff to identify and deal with avoidance and evasion by the wealthiest individuals. It is increasing the number of specialist personal tax inspectors to prevent inheritance tax evasion and avoidance, using offshore trusts, bank accounts and other entities.

3.9 HMRC seeks to keep the administrative cost of the tax system, including the burden it imposes on taxpayers, to a reasonable minimum. Tax returns therefore have a limited capacity which restricts the amount of information HMRC collects on tax reliefs. HMRC lists 219 tax reliefs on its website where the cost of reliefs is not known because data is not collected. Gaps in data also restrict the potential for computer checks. HMRC has people and systems to assess the risk of abuse based on information from third parties, but their effectiveness depends on the quality of the information provided.

3.10 HMRC has developed ways to provide earlier warning of avoidance. Since 2004 ‘disclosure of tax avoidance schemes’ (DOTAS) rules require promoters to tell HMRC about their schemes. Scheme users should put the scheme reference number on their tax returns. HMRC checks for anomalies. However some promoters seek ways to not disclose schemes, meaning HMRC must still undertake other checks to identify all avoidance schemes. HMRC has consulted on enhancing DOTAS and improving the information it collects and draft legislation for the 2014 Finance Bill was published in January 2014.

HMRC’s response to evidence of abuse

3.11 Where HMRC identifies abuse of reliefs it has a choice of responses. Its course of action will depend on whether the misuse of a relief is technically legal or illegal and the strength of its evidence. It can:

propose changes to legislation in response to avoidance activity to keep the use of tax reliefs within the intended scope;

litigate and test the avoidance activity at tax tribunal; and

investigate and prosecute where fraud is suspected.

Responses to avoidance activity

Use of legislation

3.12 When HMRC detects an avoidance loophole it may recommend that the government changes the law. Parliament has enacted 40 anti-avoidance measures since 2010. HMRC may advise that legislation is introduced quickly to counter further activity of a similar nature, particularly where the avoidance activity puts large amounts of tax at risk. This may be done as a precautionary measure, where HMRC believes that the avoidance will not succeed when tested in court but wants to stop further claims. This has allowed loopholes to be closed within days of HMRC becoming aware of them (Figure 21). HMRC may also recommend that the government introduces a targeted anti-avoidance rule to improve compliance with existing legislation.

3.13 Sometimes reliefs may be abolished entirely in response to abuse. In December 2012 the government announced that it would abolish income tax relief for the payment of patent royalties, with immediate effect. HMRC had no evidence of any use of the relief that was not for the purpose of tax avoidance.

3.14 Government introduced a ‘general anti-abuse rule’ (GAAR) from July 2013, which is designed to tackle abusive tax avoidance schemes where the current law is unable to defeat arrangements that achieve a tax outcome the legislation had not intended. HMRC will need to prove to the court whether a particular arrangement is abusive, rather than for the taxpayer to prove that it is not. The rule is subject to a ‘double reasonableness’ test as a taxpayer safeguard and an independent panel will provide non-binding advice on whether it is appropriate for HMRC to proceed with a GAAR challenge.

3.15 The rule has yet to be tested in practice. HMRC estimates that introducing this legislation will protect £235 million in tax revenue between 2014-15 and 2017-18. HMRC has published examples of cases that it believes would have been prevented under the GAAR. Four of these directly relate to misuse of tax reliefs, including a case involving capital allowances worth over £70 million in lost tax.

Litigation of avoidance activity

3.16 Dealing with attempts to avoid tax using reliefs does not necessarily require a change to the law. HMRC may assess that the scheme does not work under current legislation. Where HMRC disputes the use of a tax relief it will issue a revised assessment of the tax liability, or it may take other appropriate action and encourage taxpayers to settle and make appropriate payment as early as possible. Where the taxpayer is unwilling to settle, HMRC will continue to challenge the claim and, if necessary, contest it in the courts. Figure 22 shows an example timeline for this process based on five marketed avoidance schemes involving tax reliefs.

3.17 Avoidance schemes can take a long time to investigate and resolve. Some scheme promoters deliberately slow down the process because some tax rules allow taxpayers to hold on to disputed tax, no matter how unlikely they are to succeed. HMRC estimates there are around 65,000 open cases involving marketed tax avoidance schemes. Over 85 per cent of these date back to 2009-10 or earlier. Two significant areas of open avoidance cases are stamp duty land tax reliefs and sideways loss relief. HMRC has consulted on measures to accelerate the payment of disputed tax where similar claims have already failed and these will be included within Finance Bill 2014.

3.18 HMRC has a good rate of success when it does litigate. In November 2012, we reported that between April 2010 and October 2012 110 cases entered litigation. Of these cases 60 had judgments at the time of our report, and HMRC had been successful in 51 (85 per cent) of them.

Responses to fraud

3.19 HMRC statistics indicate that the tax gap has reduced over the past six years as a proportion of tax due. It has fallen from 8.3 per cent of tax due in 2005-06 to 7 per cent in 2011-12.

3.20 One significant reason for the reduction is HMRC’s progress in tackling missing trader and carousel fraud of VAT (we illustrate this abuse in Figure 13). HMRC is reinvesting £25 million of efficiency savings to projects directly related to tackling VAT missing trader intra-community fraud, with the aim of generating benefits of £1.6 billion over the spending review period. We reported in 2012-13 that HMRC had used industry intelligence well to respond to the risks of VAT fraud and had liaised with other European tax administrations to tackle it. By enhancing its monitoring of business sectors and introducing a number of sector-specific interventions, it has reduced the tax loss from a peak of £3 billion to £4 billion in 2005-06.1 The amount of tax lost has stayed broadly stable between £0.5 billion and £1.5 billion from 2007-08 onwards with the estimate for 2011-12 being between £0.5 billion and £1.0 billion.

3.21 HMRC is also setting up local taskforces to identify and deal with tax cheats, using criminal and civil powers. These taskforces have focused on activity relating to specific reliefs. For example, in July 2011, an HMRC taskforce focused on fast food establishments in London, where the amount of zero-rated VAT sales did not conform to HMRC’s expectations based on its analysis of national data. This taskforce raised £25 million by encouraging businesses to make accurate disclosures about their VAT obligations rather than risk prosecution.

3.22 HMRC is allocating more resources to increase the pace and number of tax evasion cases being brought before the criminal and civil courts. It has recruited an additional 200 criminal investigators to increase the number of people prosecuted for tax evasion from only 165 in 2010-11 to 1,165 by 2014-15.

Timeliness of HMRC’s response

3.23 The timeliness of data on tax reliefs is limited by the timing of tax returns (although some claims for relief may be made outside the tax return process). Although data are collected monthly for PAYE returns, filing deadlines for the self-employed and companies, where the risk of abuse is greater, lag behind the financial year to which they relate.

3.24 A risk with introducing new reliefs is that they will cost more than expected, both through legitimate and improper use. HMRC’s monitoring needs to be informed by an accurate understanding of taxpayer behaviour. Depending on the timing of events and accounting periods, individuals and companies can file returns up to 21 months and two years (for companies) after a relief is first used.

3.25 In Part Two we reported on monitoring arrangements for three units, which HMRC identified as good practice examples. Here we review how the costs of film tax reliefs and R&D reliefs changed following policy changes, to consider the challenge in maintaining the effective design of reliefs. Two of the reliefs monitored by the third unit – the small companies enterprise centre – are discussed in paragraphs 2.26 to 2.27.

3.26 We found that the costs of film tax relief have varied significantly following policy changes. Figure 23 shows how the annual cost of film tax relief rose to over £650 million at its peak in 2006-07. When film tax relief was introduced in 1997 it was forecast to exist for three years and to cost £30 million.2 Both HMRC and the Treasury acknowledged that the design of the relief meant it was susceptible to abuse by avoidance schemes. Further changes were made to extend the scope of the relief before evidence of abuse was uncovered. The Treasury forecast that restrictions it had introduced in 2002 would save over £200 million in each of the subsequent two years.3 Further measures were introduced in 2005 to curb avoidance, however costs continued to increase until 2007 when the relief was redesigned and reintroduced. Since 2007 the relief has focused on the producers of films, rather than the investors under the old scheme, and since this change HMRC does not believe that this relief can be subject to the same large scale abuse.

3.27 In contrast, the cost of R&D tax credits has risen broadly in line with forecasts from £590 million in 2004-05 to £1.2 billion in 2011-12. A number of factors may have contributed to this success, spanning the development, monitoring and evaluation cycle. The Treasury has steadily broadened qualifying criteria in four stages over nine years. HMRC’s R&D specialist unit publishes an annual report of performance, and in the past ten years it has undertaken three evaluations. This was the only relief we identified where cost–benefit analysis had been used to consider its success in achieving its objectives.

3.28 By collecting data from across its business in real time – such as to track how a new relief or a significant change to relief is being exploited – HMRC could detect emerging threats sooner, allowing it to act more quickly to safeguard revenue. Appendix Three identifies good practices that it can follow to improve assurance on performance through the lifecycle of reliefs.

1 Comptroller and Auditor General, HM Revenue and Customs 2012-13, 2 July 2013, Part 3.

2 House of Commons Debate, 2 July 1997, cc 307-308, available at: www.publications.parliament.uk/pa/cm199798/cmhansrd/vo970702/debtext/70702-21.htm#70702-21_spmin1, accessed 10 March 2014.

3 HM Treasury, Budget 2002, available at: http://webarchive.nationalarchives.gov.uk/20100407010852/http:/www.hm-treasury.gov.uk/bud_bud02_chapter_a.htm, accessed 10 March 2014.

Appendix One

Our audit approach

1 We intend to carry out a series of studies to assess whether in developing, introducing and modifying tax reliefs, the exchequer departments (HM Treasury and HM Revenue & Customs (HMRC)) exercise appropriate control and rigour. This report examines the administration of the overall system of tax reliefs and, following this landscape review, we intend to examine the administration of particular reliefs.

2 This report considers:

the landscape of tax reliefs in the UK and the risks they carry, with examples of how they are abused;

how the exchequer departments assess the performance of reliefs and respond to emerging differences between their performance and their intended objectives; and

how the exchequer departments assess, monitor and respond to the risk that reliefs may be abused.

3 Our audit approach is summarised in Figure 24. Our evidence base is described in Appendix Two.

Appendix Two

Our evidence base

1 We reached our findings on the administration of the overall system of tax reliefs in the UK following our analysis of evidence collected between October 2013 and January 2014.

2 This landscape review does not seek to conclude on the value for money of the overall system of tax reliefs in the UK. Instead it sets out: the number and value of tax reliefs in the UK and how they are used; the systems in place to administer tax reliefs in the UK; and what we would expect from an effective system of controls throughout the lifecycle of tax reliefs.

3 To define the tax reliefs landscape and assess how tax reliefs are administered in the UK:

We undertook interviews with HM Treasury and HMRC on the design, monitoring and evaluation processes that exist for tax reliefs. We also undertook specific discussions on risk and abuse with HMRC’s anti-avoidance team.

We visited three specialist units (the R&D Unit in Cambridge, the film tax and creative team in London and the Small Companies Enterprise Centre in Cardiff). We also conducted interviews with the specialist teams that monitor share and saving schemes, pensions, capital gains tax and inheritance tax. We observed how reliefs are discussed at tax stream level (for corporation tax).

We met the Office of Tax Simplification to discuss the work they undertook in 2011. We undertook further analysis with them to provide an updated total of the number of reliefs in the UK. We compared this data to the data produced by HMRC.

We analysed published HMRC data on the cost of reliefs, on the tax gap and from its regular ‘spotlight’ publications on avoidance. We adjusted costs to reflect real rates where appropriate.

We examined relevant Treasury publications, including budget publications for the past ten years. We mapped out cost and policy changes to consider the speed of the exchequer departments’ response in tackling abuse. We adjusted costs to reflect real rates where appropriate.

We undertook a review of Tax Information and Impact Notes (TIINs) and evaluations published by HMRC and the Treasury relating to reliefs. We compared these to the coverage of previous tax impact assessments and public expenditure impact assessments.

We held discussions with various experts, including tax practitioners, academics and government officials.

4 To establish a framework for the effective control throughout the lifecycle of a relief:

We reviewed HMRC’s developing framework for categorising reliefs.

We commissioned the Tax Administration Research Centre to consider: how to define and categorise tax reliefs; how tax reliefs should be costed; and appropriate methods for evaluating the effectiveness of tax reliefs.

We undertook a literature review to provide overseas comparisons. We reviewed relevant reports on tax reliefs produced by individual countries, comparative information produced by the International Monetary Fund and the Organisation for Economic Co-operation and Development (OECD) and guidance produced by the US Government Accountability Office.

Appendix Three

Good practice approaches to improve assurance over tax reliefs

1 Figure 25 identifies good practice examples that can be followed to improve assurance on performance through the lifecycle of reliefs.

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