On Friday the Isle of Man confirmed the story trailed here on 16 October that its tax system, which it claimed complied with the requirements of the EU Code of Conduct for Business Taxation, has failed to secure the approval of the European Commission. As the Isle of Man press release on the issue said:

The EU Code Group met on 16 October 2007, and considered the DPC. It considered the DPC only and not the Isle of Man's '0/10' taxation system for companies which conforms to the principles of the Code of Conduct. The DPC, however, was found by the EU Code Group not to conform to the principles of the Code of Conduct.

This is disingenuous. The 0/10 tax system the Isle of Man has (and which Jersey and Guernsey has copied) is simply a system where companies are charged to 0% corporation tax unless they're finance companies when they're charged to 10%. The Code of Conduct was never meant to regulate tax rates. As such if the Isle of Man wants to set tax rates which are harmful to its own economic well being and are designed to ruin the economies of Jersey and Guernsey (as is the IoM's aim) then the EU is going to do nothing to stop them. Only the UK could do that, by withdrawing the £270 million direct subsidy it gives the IoM each year to be a tax haven and to have a GDP per head higher than the UK - at cost to the UK taxpayer.

That means the DPC was in fact the only part of the new tax system that had to meet EU approval - and it failed, as I predicted it would in 2005. To explain, the DPC is a tax called the Distributable Profits Charge. This, according to the IoM:

is not a corporate income tax; it is a measure designed to maintain income tax revenue flow from individuals now that the standard rate of corporate income tax is 0%. It is a charge on Manx resident members of companies: accounted for by the company on their behalf, and creditable against their personal income tax liability when distributions are eventually made.

Which is true, but far from the whole truth. The purpose of the charge was succinctly summarised in the latest press release:

The introduction by the Isle of Man of a standard corporate income tax rate of 0% in 2006 could have led to broader loss of revenue. Manx resident individuals and the trustees of certain trusts ... owning companies taxed at the standard rate could have chosen to leave profits in the company rather than paying them out as distributions which would be taxable as part of their personal income. The DPC was introduced at the same time as the 0% corporate tax rate specifically to limit the impact of this sort of planning.

And as the IoM then notes:

We understand that as the DPC is paid by companies on behalf of their Manx resident shareholders only, it is viewed by the EU Code Group as differentiating between resident and non-resident owned companies and therefore 'ring fencing' the latter group from parts of the tax system. Ring fencing is considered harmful in the context of the Code of Conduct.

Absolutely right. The DPC was a deliberate ring fence introduced even though the IoM had given an undertaking to remove them.

What is absurd is that the IoM has known this since 2005. They had a copy of my presentation, noted above, since then, but chose to ignore it and were instead abusive about the Tax Justice Network when we were in fact right on this issue all along. The IoM also knew that I gave this presentation to the relevant officials in the EC who advise on these issues in 2006. I was grateful for that opportunity and hope it does at least in some small part allow me to claim a role in the overturning of this blatantly abusive tax system which at no time embraced the spirit of the EU Code of Conduct.

The IoM now says it has:

given a commitment to the EU that its business taxation system will conform to the principles of the Code of Conduct.

I would love to believe them but I don't. After all, they claimed the DPC did that and it was blatantly obvious it did not. That's because the IoM does not understand principles. It is dedicated to rule abuse: that is the basis of its tax economy. That practice is inconsistent with a commitment to principles. As a result they failed to embrace the spirit of the Code because that spirit is something alien to them. Indeed, as I noted in my presentation, an IoM solicitor well versed in its tax practices said in 2005:

It is now apparent, from an international initiative perspective, that a zero rate of tax is not harmful as long as it is applied fairly within an economy and does not discriminate between resident and non-resident participators. The approach taken by the island was recently described by The Daily Telegraph as "a neat piece of footwork".

The original link to this has now gone I'm afraid. But the comment in the Telegraph was appropriate: the IoM did a "neat piece of footwork" because it had no intention of complying with the spirit of the Code. And it's now clear it did not.

Nor do I think their proposed replacement for the DPC will do so either. In fact that proposed replacement provides no evidence at all that the IoM intends to comply with the Code. All the replacement does is to seek to avoid the Code altogether by moving the location of the ring fence outside the scope of business taxation and into the domain of personal taxation. It says as such in the press release where it says:

we are confident that the new system proposed does not relate to business taxation and is therefore outside the mandate of the EU Code Group.

To put it another way, they are seeking to perform another "neat piece of footwork".

What's the difference between the DPC and the new proposal? You'll be hard pressed to spot it. There is in fact just one of any substance. The explanation requires a little understanding of the two schemes.

Under the DPC regime if an IoM company that had IoM resident shareholders did not distribute 55% of its profits as calculated for tax purposes to its shareholders then it had instead to pay 18% of that profit to the IoM government. This payment was deemed to be income tax paid by it on behalf of those shareholders. Of course the EU realised that this was in fact a corporation tax on the profits of locally owned companies by any other name and the claim that these companies therefore paid tax at 0% was disingenuous, to say the least.

The new arrangement is called the Attribution Regime for Individuals (ARI). Under it the way of calculating the profits of IoM companies does not change at all. And companies with IoM resident shareholders still have to distribute 55% of their profits to their members or the ARI comes into play (notice the similarities with the DPC already?). And if they don't make that distribution then, as the IoM notes:

The ARI will apply to Isle of Man resident individuals with an interest (in effect a shareholding) in a "relevant company". Such individuals will be taxed on their appropriate share of the distributable profits of the company (the "attributed profits"). Distributions out of such attributed profits when subsequently received by resident individuals will be tax-exempt.

Isle of Man resident individuals will generally be treated for income tax purposes as receiving any attributed profits 12 months after the end of the accounting period of the relevant company.

Now it so happens that the tax due by most such shareholders will be at 18%, because that's the basic rate in the IoM. So the tax due will be calculated as:

Distributable Profit x 55% x 18%

But, actually that was the formula for the DPC. The formula now reads:

Attributable Profit x 55% x 18%

With, I should add, the attributable and distributable profits being calculated identically in almost every case. So, let's be candid, the way in which this tax charge is calculated has not changed at all. The only change is that now the company will not be required to pay the tax on the individual's behalf. Instead it will have to tell the IoM tax authorities what those individuals might owe and then the person to whom the profit is attributed will have to pay the tax instead of the company, and whether or not they've received a penny from it, or not. That's it. That's the total change the IoM is making. This they believe means that the tax is now a personal tax and not a business tax. That's their neat footwork.

Except that it's very obvious that this is a charade. To make the ARI work the company is going to have to:

1) Be sure whether it has IoM resident shareholders or not. If it has not it's taxable profit is likely to be zero and no tax computation is needed. Indeed, no tax return will be submitted. On the other hand, if it has local shareholders it has a whole raft of tax accounting to do. Make no mistake: that's a tax ring fence in its own right. The simple difference in the basis of calculation of the liability is enough in itself for this to leave the ARI in breach of sections 4 and 5 of the Code;

2) It will have to calculate its taxable profits using tax rules, not accounting ones, but only if it has IoM resident shareholders. And then it will have to tell those shareholders what that taxable profit is and how much of it is attributable to them. It will not have to do this for non-resident shareholders. That communication requirement is another ring-fence.

3) Then it will have to tell the IoM tax authorities what its taxable profits are, and what part is attributable to which shareholder, as it has to under the DPC. After all, how otherwise will the tax authorities know that tax is being paid in the correct amount by the right person?

4) Finally, the shareholder will have to pay the tax whether or not they have received any income from the company - which seems to be a blatant abuse of human rights - and the IoM has legislation on this.

So the only change is that the IoM now has no recourse to the company to recover the tax due. But since the company has at all other stages to be a party to the process of supplying the information so that the tax can be paid this is a tiny change in the system. As the above makes clear, the difference in procedure for locally owned and internationally owned companies remains massive. That difference is designed to maintain the ring fence to ensure that, as the IoM itself says, its residents cannot enjoy the benefit of owning companies paying 0% corporation tax, although that benefit is offered to the residents of all other countries that wish to incorporate a company in the Isle. That is in direct contravention of section 2 of the Code.

In the process a massive abuse of human rights is introduced and Manx owned companies are effectively forced to distribute an arbitrary 55% of their profits, putting them at a competitive disadvantage to foreign owned companies working in their economies who can retain all their profits to finance growth at lower cost then locally owned companies. This is in breach of section 4 of the Code.

It's obvious as a result that the ring fence is still alive and well, and bar recourse to the company, operates exactly as in the case of the now outlawed DPC. That's because both are designed to ensure that the tax advantages of the 0% tax rate are:

ring fenced from the domestic market so they do not affect the national tax base.

Those words come straight from the Code of Conduct and are a criteria for rejection of any tax practice as harmful. The DPC was harmful. So is the ARI. And to claim it is not within the scope of business taxation when its sole purpose is to collect tax due on business profits is pushing credibility beyond any acceptable limit. As a result I have no doubt the ARI will be as unacceptable to the EC as was the DPC.

Why am I so sure I'm right? Well there are two reasons. The first is that the IoM has failed to take into account the change in the spirit of tax management in the EC. The Halifax decision changed EU tax management for good. We now have a concept of "community abuse". As the European Court of Justice said on that case:

No-one is entitled to exploit Community provisions fraudulently or abusively. That principle of the prohibition of abusive practices extends to the sphere of VAT.

I'd suggest it will also apply here. The Code is being interpreted abusively by the IoM. It will fail for that reason.

Second, what the IoM is proposing to introduce is what Jersey looked at introducing in 2005 and rejected after advice from me as an official adviser to them, which I was at that time. The only significant difference between what the IoM is proposing now as an ARI and what Jersey proposed then was that Jersey called it "look through"" taxation. Incidentally, PWC agreed with my opinion on Jersey's plans, and by implication on what the IoM is now doing when they told Guernsey not to go for such a scheme as it would not be EU Code compliant.

It staggers me that the IoM can think it can rely on such subterfuge. By doing so it proves that its claim that it will "confirm to the principles of the Code of Conduct" is hollow. Worse, it puts out a clear signal that it is open to abusive business that seeks to aggressively avoid the laws of other nations, because that is what it is trying to do itself. No doubt hot money will flow in as a result.

But there's an upside to this. First of all the IoM's lack of goodwill is now apparent. Second, the EU has shown itself willing to stand up to this abuse. Third the UK's role in allowing this to happen has been exposed, and the need for countries within and beyond the EU to bring pressure to bear on the UK to stop tax haven abuse has become more obvious. Fourth it's become clear that the EU Code of Conduct has teeth and ultimately there will be no way out for the Crown Dependencies. Their economies are now very obviously designed to service an industry that is unsustainable. It will still take time for the EU Code of Conduct to strangle the tax haven activities of these places, but kill them it will.

And that's very good news indeed.