And Now, Only Death is Certain...

01 June 2006

Jan Kruger, director legal services: structured debt finance The Standard Bank of South Africa Limited

Two maxims are often quoted in the field of corporate tax. The first, mostly used by taxpayers, is the principle from the ‘Duke of Westminster’ case that: “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.” The second, predominantly used by the regulators is that if “we all pay what we should, we will all pay less.” For either of these to apply, the tax legislation needs to be certain as to what is payable and in which circumstances. Unfortunately, the view held by most advisers is that international tax legislation is as clear as mud. Several components contribute to this uncertainty and a lot of debate could be had as to the causes. I will focus on three factors. The first is the compliance requirements surrounding financial statements and tax affairs; the second is anti-avoidance legislation and the application thereof; and the third is the sheer volume and complexity of tax laws. 

Compliance 

The international corporate world has been shaken by the Enron, WorldCom and Parmalat fiascos and legislators and regulators have reacted swiftly to prevent further recurrences of similar scenarios. The legislative changes that have been brought about and the actions of regulators are aimed at increasing the effectiveness of disclosures and discouraging the implementation of transactions that give rise to reputational and legal risks. In-house and private practice lawyers need to take note of these changes in two respects: first, the technical changes in law, but even more important, the purpose of these changes and how they are aimed at changing behaviours. 

The US legislator reacted to Enron and WorldCom by enacting Sarbanes-Oxley (‘Sox’) in 2002 to ensure more effective control of corporate governance and financial reporting. One of the ways in which this is achieved is by requiring the CEO and CFO of a relevant company to certify the accuracy of financial statements. Management needs to place a lot of trust in its legal, tax and compliance teams, which requires that these teams are strengthened and enlarged. Where previously the best in-house lawyers and advisers have been employed on the transactional side of institutions, one expects to find that these lawyers would now be employed to a greater extent in teams with tax and legal compliance functions. 

Sox covers the fields of law, tax and accounting and would therefore create the need for lawyers to have an understanding of all three areas to be able to properly advise their employers and clients. As more bodies are concerned with tax reporting, ie, the IRS, the Securities and Exchange Commission and state and local authorities, the ability to liaise with regulators will also become a necessary skill. The US legislation therefore creates the need for combined tax capabilities as never before. The effects of Sox will not be limited to the US: they are already being felt in the UK and EU and will have an effect in all developing countries that wish to deal with developed countries and where multinationals do business. 

Regulators have become increasingly active in addressing reputational-risk management, in respect of an international commercial and tax environment that shows ever more diverse and complex activities. Regulators require that companies have robust compliance divisions which are independent and increasingly active. They also insist on the participation of senior management and the board of directors in improved control and procedures for complex-structured products. 

Enron, WorldCom and Parmalat showed how complex-structured products can be abused, and how they can create legal and reputational risks if designed for illegal or improper purposes. To address this, on 14 May 2004 the US federal banking and securities regulators released a statement describing internal controls and risk management procedures to assist financial institutions to address and manage the risks associated with complex-structured finance activities. In the UK FS Regulatory Focus by PricewaterhouseCoopers, the contents of the statement are summarised by stating that financial institutions engaged in these structures should have policies and procedures in place to: 

• identify complex-structured finance transactions that may pose a heightened reputational and legal risk; 

• ensure that these structures receive enhanced scrutiny in the institution; and 

• ensure that the institution does not participate in illegal or inappropriate transactions. 

Again, the emphasis of these procedures is on the role of the board of directors and senior management and the need for them to foster a culture in the workplace based on transparency, ethical behaviour, integrity and the need to comply with laws and cooperate with regulators. 

Similarly in the UK, the FSA has sent out ‘Dear CEO’ letters to major investment banks operating in the UK, dealing with issues such as conflicts of interest and risks arising from financing transactions.

The letter confirms the more active approach of regulators, stating that: “You should expect to receive increasing scrutiny and challenge about current and developing practices from our supervisors…” The letter refers to the need for senior management to foster the right culture in institutions. Culture is defined as having two components, ie, the formal structures which have to comply with regulatory and legal requirements, but also the informal culture that establishes values and ethics, and shows employees what is generally acceptable behaviour. As to what kind of behaviour should be acceptable, the letter highlights in bold that Enron, WorldCom and Parmalat have shown that “financial institutions may face substantial risks when they participate in financing transactions that may be used by their customers to avoid regulatory or financial reporting requirements, evade tax liabilities and further other illegal or improper behaviour.” 

The letter focuses on reputational risks that may arise even where the “transactions technically comply with legal, accounting and regulatory frameworks”. It therefore places another hurdle in the way of the implementation of transactions, since management cannot simply rely on technical, legal or tax opinions to ensure these transactions comply with applicable law. It requires management to make a value judgement as to the reputational risks that may arise from concluding the transaction. The responsibility of senior management, and consequently of their advisers, is increased to ensure that market and credit risks as well as legal and reputational risks are addressed. 

The actions of the regulators seem to have blurred the distinction in the roles and activities of the legislature and the executive. This approach, coupled with adding further requirements over and above those laid down by the law, makes compliance a much more difficult task. The difficulty is that companies now need to comply with not only written law, but also the unwritten law that distinguishes between what amounts to a proper, as opposed to an improper, transaction. 

Tools and tests need to be devised that can measure and limit reputational risk. In the past this has often been dealt with by the ‘Sunday Times’ test, ie, would the company’s reputation still remain intact if the transaction was published on the front page of the Sunday Times. This gut-feeling test now needs to be developed into a more objective test to provide taxpayers and advisers with some certainty as to what they may and may not do. 

Anti-Avoidance 

The ‘Duke of Westminster’ principle was once again confirmed in the Canadian case of Canadian Trustco Mortgage Company v Canada, where the legality of a sale and lease-back transaction was confirmed, despite attempts by the Canadian Revenue to apply the General Anti-Avoidance Rules (GAAR). The view of the court was that: “Where Parliament has specified precisely what conditions must be satisfied to achieve a particular result, it is reasonable to assume that Parliament intended that taxpayers would rely on such provisions to achieve the results they prescribe.” 

The house of lords also applied this principle in the ‘Westmoreland’ case. Its application in this case, however, has been heavily criticised (see the article by Lord Templeman in the Law Quarterly Review (LQR [2001] 575)). Lord Hoffman defended the house of lords’ view in that case, in a talk to the IFA British Branch on anti-avoidance. He referred to the inherent ‘conundrum’ in tax avoidance: the tax authorities would allege tax avoidance by saying that a taxpayer had structured its transactions in a way that meant it was not subject to the tax to which, absent such structuring, it would otherwise have been subject, ie, the taxpayer was avoiding tax which parliament intended it should pay. The only way to demonstrate parliament’s intention, however, was to look at (and interpret) the relevant legislation. If the relevant legislation applied in order to tax the taxpayer, then there could not, by definition, be any avoidance. Conversely, if the relevant legislation applied in order to exempt the taxpayer from tax or give the taxpayer a deduction, then that could only mean that parliament did not intend the taxpayer to be taxed, and so again there could not, by definition, be any avoidance. Therefore, in Hoffman’s view, tax avoidance could only arise, where there had been judicial error, ie, where the courts had failed to interpret legislation correctly and thus had not taken proper account of parliament’s intention. According to Hoffman, an antiavoidance doctrine might be a suitable ‘bandage’ to correct the ‘mismatch’ only in these circumstances. 

Hoffman criticised the Ramsay doctrine which applies where there is a series of transactions with no economic effect on the taxpayer at all or, put another way, artificial or pre-ordained constructions designed to avoid tax. The Ramsay doctrine was akin to the doctrine (developed but rejected in Australia) of ‘fiscal nullity’. Hoffman stated that the Ramsay doctrine in its ‘pure form’ – ie, an external ‘rule’ imposed by the judges – deflected from the requirement that judges actually consider the meaning of legislation. Such view would seem to enhance certainty. 

Hoffman acknowledges, however, that his distinction in Westmoreland between juristic concepts (on the one hand) and business or commercial concepts (on the other hand) was a mistake, although the intention was merely to show that the juristic approach was to split out, and recognise, each individual transaction. In contrast, the business view was to look at the overall outcome. He, however, admitted to disappointment that the ‘Westmoreland’ case had instead given rise to a new problem: determining what was legal and what was commercial. This had muddied the principal point of Westmoreland, namely the importance of reading and understanding the relevant statutory provisions. 

Hoffman drew another distinction between looking at a transaction (or set of transactions) on an atomistic basis, ie, looking at each part of the transaction, and looking at these transactions as a whole. The determination of which approach was appropriate in a given case, however, would depend on the legislation in question, and therefore needed to be made on a case-bycase basis. For him there are thus no ‘short cuts’ to deciding tax cases, such as adopting labels like ‘tax avoidance’ or ‘tax mitigation’, and each case needs to be decided upon the construction of its legislation and its application to the relevant facts. 

These issues are debated around the world. In South Africa, a discussion paper on tax avoidance and the new section 103 of the South African Income Tax Act was recently published which, according to the minister of finance, was all about equality. It would target the people that can afford tax advisers and structures to pay less, which means, other people need to pay more. The paper aims to distinguish between tax evasion, impermissible tax avoidance and tax planning. Impermissable tax avoidance may be defined as a contrived arrangement designed to exploit loopholes in the tax laws. The South African GAAR would now focus on a presumption of abnormality and penalties for scheme promoters and taxpayers. 

According to the paper which deals with the ‘Canadian Trustco’ case, the Canadian courts have required a “contextual and purposive approach […] in order to find a meaning that harmonises the wording, object, spirit and purpose of the provisions of the Income Tax Act.” The Canadian courts have been cautious in calling it an “extreme sanction”, a “heavy hammer” and the “ultimate weapon”, and these will only apply where it is shown that an avoidance transaction as a whole has violated a “clear and unambiguous policy”. 

Although the UK has no GAAR, but does have specific anti-avoidance sections, it has adopted new disclosure requirements with respect to potentially abusive schemes. This is similar to what is now suggested in South Africa and what South African promoters of schemes are obliged to disclose. As with the UK, the US requires detailed disclosure requirements for potentially abusive transactions and places this obligation on promoters of schemes. This is arguably based on an internationally-held view, which was expressed in the US as a: “Congressional belief that tax shelters are driven by promoters and advisers as opposed to demand from taxpayers”. The effectiveness of the US judicial doctrines appears from the statement: “No one is selling the kind of junk that was being sold in 1999 […] the market has pretty much dried up.” 

The South African authorities have found section 103 largely ineffective as a deterrent for abusive schemes and other impermissible tax avoidance. Aggressive and increasingly sophisticated schemes continue to be marketed by ‘boutique’ financial institutions. They therefore wish to follow the examples set by the US and UK and focus on the disclosure of transactions and the promoters of these transactions. In conclusion, the South African paper refers to Lord Roskill’s statement: “The ghost of the Duke of Westminster and of his transaction has haunted the administration of this branch of the law for too long,” and that “the honest hard-working taxpayers of South Africa deserve better.” 

What is apparent from the above is that taxpayers and advisers cannot simply consider a transaction by looking at the relevant provisions of the legislation, but need to consider whether the arrangement of their tax affairs would be seen to be ‘permissible’ tax planning or ‘impermissible’ tax avoidance. 

Dealing with different jurisdictions and cross-border transactions where differing tax regimes and regulators come into play will not help either. Again, another unwritten law is layered over the tax laws, where the economic substance, commercial realities, and the purpose and spirit of the tax laws comes into play, and these need to be carefully considered when advising. 

Complexity 

In a review of European Tax Law, 4th Edition, George Gillham refers to the fact that most large corporations are now multinationals, where “services, goods and capital are increasingly streams of electrons rather than physical goods.” Cross-border tax issues have therefore become more and more relevant to lawyers advising these multinational corporates. But the tax laws have also become more and more complicated, as Gillham states: “[The] huge specialism that is European tax is growing at an exponential rate.” This statement is also true for the rest of the international community. 

As is apparent from the South African discussion paper, GAAR provisions have been amended regularly and tax laws tend to become more and more voluminous and complex, with articles that stretch to several pages having sentences with 100 or more words in them. It seems as though tax legislation is drafted to patch problems created by structured transactions and therefore become more and more structured finance tax, which is really aimed at a very small percentage of the day-to-day commercial activity and yet affects it severely. Tax and legal advisers struggle to interpret tax laws more than most other pieces of legislation and it has arguably become impossible for the individual or small business with no or small tax and legal teams to understand and implement the provisions of tax laws. 

Conclusion 

Arguably, the uncertainty and complexity created by the above factors has created a corporate tax environment where companies and their senior management and board members may well be exposed to risks, such as tax costs, penalties and personal liability that they cannot fully comprehend. It calls on lawyers and other tax advisers to advise their employers and clients without being able to give certainty. Tax opinions will probably become increasingly caveated, even on the simplest of transactions, and it would be difficult for any party to be sure that it has complied with all written and unwritten laws, and may well create more reputational risks, especially with respect to relations with regulators. 

These times call for tax advisers, both inhouse and external, to be very cautious and conservative in their advice, to consult widely and to cooperate closely with the relevant regulators. Hopefully it will ensure that the ‘junk’ that has caused all these uncertainties will disappear and not prejudice bona fide business. As we have seen, however, uncertain laws create more loopholes and more opportunities for unscrupulous advisers. 

Selecting Counsel 

In an environment as I have sketched above, the selection of external advisers by companies has become a critical issue as the wrong advice could lead not only to legal and credit risks but also to reputational risks. What we have also seen is that using a big name does not necessarily ensure that your transaction will be risk free. 

As the environment becomes more complex and risky, the need to employ a person with the necessary skills and experience becomes non-negotiable. Budgetary constraints need to be carefully considered against the risks and amounts that are at stake; the saying, ‘penny wise pound foolish’ applies as never before. Lawyers will need to improve their skills tremendously and these skills will come at a cost. Lawyers also need to recognise when they are out of their depth and not attempt to advise where they are not totally comfortable with the issues at hand. 

We reject the word ‘outsource’ when employing external counsel. The word suggests a handing over of responsibilities and control in the matter. We believe that the in-house lawyer should only use external counsel when he requires expertise beyond his own or where he needs more resources in a matter. The in-house lawyer and the selected external counsel then form a team that will debate and resolve legal questions and so provide better advice to management. The role of the in-house lawyer therefore becomes increasingly important, especially where senior management and boards of directors rely on their in-house teams to sign off on transactions. 

Based on the requirement to form a team with external counsel and the need to ensure that transactions are not only compliant with the relevant legislation but are also ethical and comply with integrity requirements, it makes sense to use a select number of highly skilled experts with whom a relationship of trust and understanding can be formed. This will allow for the free flow of all relevant information and therefore better advice which can be relied upon. Care needs to be taken, however, by external counsel not to become so economically and professionally dependent on one client that its objectivity may be compromised. There must be free and robust debate on all issues which culminate in the right advice and not the advice the client may want. 

As suggested above, lawyers will need to improve their skills not only on the technical side but also attain a very good understanding of all issues that may have an effect on a transaction. The abovementioned laws and the activity of regulators also creates reputational risk for advisers and law firms. Lawyers will need to ensure that they have been properly instructed before advising and also ensure that they are part of the implementation of the transaction or the advice, in order to ensure that it is properly applied. Similarly, from the in-house lawyer’s perspective, it makes sense to use the lawyer that opined to implement the transaction, in order to ensure a congruence between the opinions obtained and the transaction implemented. 

The present corporate tax environment poses extreme challenges to in-house and external lawyers, but at the same time provides significant opportunities for advising. It will require lawyers to take a step backwards and to look at deals and other issues that they advise on from a holistic perspective to ensure that the transactions concluded comply with all relevant laws and also with regulatory requirements. Furthermore, lawyers will need to act with the highest levels of integrity and ethics and ensure that their clients do the same. Advice, especially on complex structures, will need to be carefully considered (rather erring on the conservative side) and caution must be taken to ensure that the client’s reputation will not be tainted by these transactions.

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