The Ethical Corporation published an article yesterday under the title “Corporate disclosure: the tax blame game”. It said:

It’s too easy to demonise big companies that take steps to minimise their tax liabilities [but] in most developed societies, companies have the right — as do individuals — to arrange their affairs in such a manner as to minimise the amount of tax they pay. It is legal, even honourable. After all, a company that goes bankrupt because it paid more in tax than it needed to would be neither responsible nor competent.

The flavour of the article can already be gathered — that I can recall no company has ever gone into liquidation because it paid more tax than was necessary. As will be noted below, arguments in extremis are a characteristic of this debate, and do it no favours.

The author seeks to redeem himself by saying:

The maxim only holds true, however, so long as the degree to which you can minimise that liability passes some kind of intuition test about fairness. A big, prosperous corporation that makes large profits in a country and pays absolutely no tax there — well, that’s clearly not on.

But then you have to ask the question — what is the socially responsible right amount of tax to pay?

This is moving in the right direction — although the rest of the article does not. Indeed the conclusion betrays something that I have understood for some time — that the Ethical Corporation is basically anti-tax and is only, it seems interested in anti-tax articles. That conclusion says:

Which do we think is going to solve poverty, companies giving governments more cash, or companies being able to thrive and create jobs? If there is an optimal balance, where is it? Is it the same in all parts of the world?

The answers to those questions don’t give licence to the aggressive tax-avoiders, for sure. But it would be worth looking at each society that has emerged from poverty during the past century and establish how that happened. I doubt it was tax.

This is wrong I’m afraid for a number of reasons — not least because these are not either / or questions and the Ethical Corporation ought to know that. So let me explore why.

In extremis there are two positions a company might take on tax. One is that all tax is a bad thing and it should seek to avoid paying it at all costs. The might be called the neoliberal position — which assumes that tax is harmful to well being. It might quite fairly be called the fanatics or extremists position — and yes these terms are often applied to some who hold religious views — but neoliberal faith of this sort is akin to that.

The other end of the scale might be equated with relativism — the acceptance that any tax is acceptable. So if a tax charge is levied it is embraced, come what may.

Neither position makes any sense, and I’ll explain why in turn.

First, the neoliberal position assumes that tax is a bad thing to be avoided. In extremis there is one easy way to do that, which is is to avoid being in possession of any income, asset, gain or cash flow that might be subject to tax, but this of course is also to say that you should to avoid having an income, assets, gains or cash flows and in a modern economy that is not a recipe for well being.In that case the alternatives are twofold. the first is to break the law, which I presume we will agree is unethical, or it is to prioritise tax minimisation in behaviour. This however can also be contrary to well being. If, for example, a large income stream can be secured but with an associated tax charge attached which does however leave the person (legal or human) enjoying it net better off is it wise to mitigate the tax bill by refusing the income stream, or should the income be enjoyed and the tax paid? It is immediately apparent that a decision on tax has to be made. And it is also apparent that the decision to be made on tax is not independent of other variables; it is in fact inextricably linked to them. Tax considerations are, in other words, never taken in isolation. Any decision on tax will always have secondary consequences and most decisions on commercial mattes for corporations also have tax consequences. The simplistic position that a corporation has a duty to avoid tax is therefore simply not sustainable: even if such an obligation existed it is constrained and as such subject to significant, ethical, judgement.

I would argue the relativist position of accepting all tax charges, come what may, is also wrong. I am told by the tax directors of major pharmaceutical companies that they usually suffer demands for tax of about 200% of their profits each year, and negotiate down from there. They may exaggerate a little, but there is no doubt the demands made are higher than available profit. There is an institutional failure here, no doubt, but in the world in which we live these happen, and in the face of them it would be quite inappropriate to accept all tax charges as prima facie correct if in combination that cannot be true. Of course, the example is extreme and for a corporation or individual working in one state such a scenario is highly unlikely to exist (transfer pricing being the cause of the pharmaceutical companies’ problems) but even so, even within a UK environment tax authorities can make mistakes that need to be challenged and the law does provide alternative choices in the way in which transactions can be constructed, with the deliberate intent that the tax payer take advantage of those choices and these an and do have tax consequences. So long as they are clearly complying with the law the tax payer can exercise those choices, legitimately. This is not seeking to tax avoid, it is seeking to comply with the law. What is clear once again though is that choice has to be made, and in that case an ethical framework has to be found in which that choice can take place and this has to be translated into practical decision making tools.

Once a decision has to be made then it is impossible to claim that a value system is not in operation within a corporation: it always is. This cannot be externalised; for example it cannot be said that “shareholders require that we minimise tax” because first of all I have never seen a shareholder resolution to that effect, second, it is by no means clear that the will of shareholders is known since in most multinational corporations the shareholders will change frequently and thirdly, as the International Accounting Standards Board and others now recognise, such corporations are entities in their own right and it is ludicrous to argue that they are mere agents for their shareholders when, for example, those shareholders are just one of many stakeholders, let alone providers of capital (an issue discussed in more depth in here).  It sin therefore for the corporation — or at least its management — to make such decisions and not outsource and legally they are tasked to do so. And legally whilst they are required to act in the member's interests in some states (such as the UK) they are also allowed to consider other interests and they are also not required to act in short term interest alone — meaning that a decision to, for example, pay long term sustainable and transparent tax charges is one that all directors could quite properly defend in court as being in their long term member’s interests by delivering sustainable and certain earnings subject to low risk. It is apparent therefore that this is a matter of corporate ethics.

What is that ethic? What is right and wrong? And what is the relevant framework for decision making? There has to be one that provides clarity in that middle grey ground that it seems that directors alone — with their perpetual clarion calls for “certainty” — seem so keen to avoid, even when their own behaviour suggests that their capacity for tax risk on behalf of their employers is high.

There are clearly two parties to resolving any tax issue. The first is the state or sub-national authority to which tax is due. The second is the taxpayer. The ethics of tax apply to both, but are exacerbated by the fact that a taxpayer may owe tax (sometimes on the same source of income, gain, asset or cash flow) to different tax authorities, both of whom may lay claim to that taxing right. It is therefore obvious that decision making processes are required for both.

The ethics of taxing institutions at either national or sub-national level are relatively clear. First they must be backed by proper law. Second they must have appropriate powers to secure information to impose a tax charge, and they musty have the right to enforce those powers. Third, they must interpret that law properly when levying a charge. Fourth, there must be an appropriate appeals process if there is disagreement on interpretation of the law. And finally there must be a mechanism (hopefully democratic) for changing the law when it is itself unjust. That somewhat shortens an enormous area of debate, but covers the critical issues. In synopsis the issues are:

• having proper institutions;
• having appropriate law and means to interpret it;
• securing the data needed to assess tax properly;
• having the right to recover the tax due.

Deficiencies, if any, in this process impact on the choices a corporation makes when seeking to be ethical on tax. So, for example, many corporations seek to exploit weaknesses in the institutions relating to international tax, including:

• the absence of an international tax regime to properly coordinate relationships between tax authorities;
• differences between international regulations allowing their exploitation;
• the ability to hide transactions in secrecy jurisdictions meaning access to data is hard in some cases;
• the ability to hide tax liabilities in limited liability entities in turn owned by limited liability entities, any one of which is dispensable by a corporation at a moment’s notice if it so wishes but with each entity in a  group having its liabilities ring fenced one from another.

Other issues arise, of course. The point noted here is to show that there are ethical issues relating to the creation of proper institutions for taxation that need addressing, before the issue of the ethics of the tax laws promoted by individual jurisdictions is considered. This is not the point to explore what the ethics of those institutions and laws might be. What it is important to note in this discussion of corporate tax issues and the related ethics  is that given that these institutional issues remain unresolved the range of issues on which a corporation has to decide when addressing its own tax affairs increase as the environment of uncertainty they face is exacerbated by the failure of the international community to agree on taxation coordination policies, and this is to the detriment of that international community, corporations and all who depend on the tax paid by them.

What criteria does the corporation use for decision making with regard to tax in this case? It is my argument that any corporation has a duty to a wide range of stakeholders. A literature review, noted here, suggests they might be:

   ÔÇ? The equity investor group (shareholders);
   ÔÇ? The loan creditor group (banks and bondholders);
   ÔÇ? The analyst-adviser group who advise the above groups;
   ÔÇ? Business partners;
   ÔÇ? Consumers;
   ÔÇ? Employees;
   ÔÇ? The surrounding community i.e. the public at large;
   ÔÇ? Civil society organizations; and
   ÔÇ? Governments and their institutions.

This list does however ignore one group of considerable significance in this issue, being management them,selves, for whom financial statements are not prepared as they already have access to all the information they might need, but who none the less have a considerable influence over tax policy.  Indeed, it can be argued that tax policy might be run largely for managements benefit. Since J K Galbraith shattered the myth that companies are ruin for the benefit of her shareholders more than forty years ago in The New Industrial State it is ludicrous to think that tax is just another policy where the reason for a strategy is to meet the goals of management and not shareholders, or any other stakeholder group come to that.

In any company where management incentives / bonuses are linked to the generation of free cash flow (that is not the same as profit as provisions such as depreciation of assets and goodwill and charges for deferred tax will be ignored when calculating free cash flow — which is what economists would say management should maximise to enhance shareholder worth) then the incentive for management to tax avoid is enormous. One of the easiest ways of arranging for an increase in free cash flow is to minimise the current tax bill, even if a deferred tax bill is incurred none the less. These issues, and the potential impact they have on corporate tax planning and behaviour are looked at in a recent report I have prepared. The simple fact is that tax deferred is, in this case, the basis for the payment of a management bonus. The incentive to defer by avoidance (and that’s what avoidance usually achieves) is incredibly high in that case. Any discussion of the ethics of tax avoidance that ignores this fact is bound to miss the point. This ethical issue is not, as many would imply, a matter of “shareholders versus other stakeholders in a company”. It is a matter of “management versus all stakeholders”.

This is quite obviously true: to ague that the equity investor group is somehow distinct from all other stakeholder groups in the company is wrong. Whilst it it true that the holding of wealth in most societies is very skewed towards a minority it is also true that large numbers in societies such as the UK have some interest in the shareholdings of many corporations through pension funds, insurance funds and so on through which they save. These people do not, however, have one interest in that capacity and another a civil society, or he public or as employees or as consumers. Those interests coincide, overlap and intermingle into a coalescence of opinion that is likely to approximate to the position that they would expect a corporation to take on tax planning. They are not, for example, going to say as a shareholder “minimise tax” and as the public “pay your fair share” or as an employee say “pay your fair share like I do” but expect their investment adviser to demand something different. Such dichotomy is considered aberrant and inconsistent, and rightly so.

In that case corporations cannot say “we have a duty to our shareholders to minimise tax” and expect anyone to believe them: they won’t, precisely because that is not what real shareholders (as opposed to some advisers to those shareholders) say or expect. There is, therefore, no foundation for the claim that executives who minimise tax are fulfilling their shareholder's wishes. the wishes of those shareholders are likely to be much more complex than that, and the claim by companies that they must do this is a simple excuse for their maximisation of free cash flow which is likely;y to trigger maximum bonuses for executives and those who report to them, which is a different issue altogether, but at the core of the ethics of the institutional structures that surround this complex issue.

What then should corporations do with regard to tax? I think the ethical duty is clear. It is derived from the fact that all corporations are, by definition, incorporated. In the process a parliament grants the members of  limited liability companies the most phenomenal economic privilege: they cannot be sued for the debts the company incurs if all goes wrong even though they get all the benefit if things go right. I argue that the granting of that privilege does, however, carry with it two reciprocal obligations. The first is to account for how the privilege is used — which means putting full and proper accounts on public record so we can know exactly what our companies are up to. The second obligation is to pay for the privilege — and that means complying fully and willingly with the tax (and other) laws passed by the UK (and other) parliaments that creates those laws using exactly the same authority that they use to grant the privilege of limited legal liability. Of course these two obligations are also related — the accounts must properly explain how much tax is paid.

In combination these obligations mean that a company does not have a duty to be “tax efficient”. Instead it has a duty to society to be tax compliant in exchange for the benefit of limited liability granted to its shareholders. Indeed that is implicit in the primary concern of most accounting regulation — which is not to protect members but to protect creditors of the company — to whom the duty of care of the directors is actually paramount and for which there is criminal responsibility of neglected. Tax authorities  to whom a duty of care therefore exists and to whom an obligation to pay must be honoured are one such authority.

Putting these observations together suggests that:

1) The duty of care of a company is to the public primarily and to make payment in full to creditors specifically;

2) tax authorities are creditors acting in the pubic interest as agents of the government that granted the corporation its licence to operate. There is therefore a specific duty of care to tax authorities;

3) The right of shareholders is not and never can be paramount: their claims are always residual after other claims have been settled. It must therefore always be wrong to put shareholders before tax authorities when order of priority as to payment arises.

In that case a clearer position emerges that lets us resolve the “extreme” (and legally unjustifiable) position of neoliberalism that says that tax must be avoided and the relativist position that says all charges must be accepted. This summarised in the concept of tax compliance. Tax compliance is seeking to pay the right amount of tax (but no more) in the right place at the right time where right means that the economic substance of the transactions undertaken coincides with the place and form in which they are reported for taxation purposes. This needs a little explanation.

First, the right amount of tax means that the law is properly applied and that the choices available in law are honoured. This means a company can quite legitimately argue with a tax charge it thinks is improperly imposed.

Second, the right place means that tax is due in the country where the economic substance of a transaction arises. As a matter of fact “offshore” for tax purposes means a location where a transactions is recorded but where the substance does not arise. By definition therefore an offshore location can never be the place where the economic substance of a transaction arises. A creditor has not been settled as a result.

Third, economic substance requires that the transaction has really occurred — artificial steps in transactions therefore have no place in tax compliance. If used then the obligation to pay a creditor has been avoided.

Fourth, reporting is at the core of this issue. All cards must be placed face up on the table to tax authorities, and in accounts too. There is no room for opacity.

What is the outcome? The right amount of tax being paid, and no more. That’s not dispute free, of course. But a policy based on openness, transparency and accountability to all involved minimise shareholder risk, means that the residual they have to enjoy is really theirs to have, sustainably and for the long term, and means that the obligation to society and to creditors is met.

In this policy there is an ethic for tax — and for tax planning that resolves the dilemmas corporations face within the clear parameters of the laws established and the world.

This does not resolve the ethic of how those tax authorities should manage their relationships — which is for another blog — but the position for corporations is, on this basis clear and unambiguous and responsible and far removed from the thinking reflected in the article to which this blog first referred. The fact is that tax is not distinct from the development of a society, it is integral to it. It is a mistake to think otherwise, and that is why a corporation has to embrace tax payment within its own code of conduct for behaviour if it is to be ethical. And that is why it also ha to account for that payment — because the duty to do is implicit in its contract with the people of the state who grant its privileged right to trade.

PS This blog has been written quickly and may need editing