Stephen Daly graduated from University College Cork with a BCL (International) degree in 2012. As part of the degree, he spent one year as an Erasmus student at the University of Oslo, Norway. He is currently undertaking an LLM at University College London and proposes to write his dissertation on International Insolvency Law
With the recent revelations about Starbucks, Amazon and Google in relation to their exploitation of loopholes in International Tax Regimes, Tax Avoidance has once again become a hot topic in the media. This letter examines another method which has historically been used to avoid tax liabilities, namely exploitation of the Source Doctrine for Income Tax purposes.
The fully referenced version of the letter is available here.
What do Harry Redknapp and Romanian witches have in common? Last year, Harry Redknapp’s tax affairs were dragged through the court regarding unpaid taxes in relation to several payments, totalling £227,000, from Serbian American business tycoon Milan Manderic. Redknapp’s defence and subsequent acquittal to two charges of cheating the public revenue pivoted on the argument that these payments could not be linked with Redknapp’s profession. In Romania, ‘witchcraft’ was not recognized as a profession under Romanian Labour Laws until 2011. Therefore, earnings from the practice of witchcraft were not susceptible to income taxation as the gains could not be said to have been derived from a profession.
Both instances rely upon a principle in Tax Law known as the Source Doctrine, which is said to be “a cardinal feature of the income Tax Acts”. This letter seeks to explain the basis for the above results and provide examples of other instances where income tax may legitimately be avoided through invocation of the principle.
The Source Doctrine
Lord MacNaghten once succinctly defined Income Tax as “a tax on income”. For gains to become susceptible to income tax, they must flow from a source defined under a Schedule in the Tax Acts. Judges often adopt the “fruit from the tree” metaphor (the fruit being the income and the tree being the source) in order to explain that receipts which are revenue are chargeable to income taxation and those which are capital are not. If revenue therefore fails to fall within the parameters of the Schedules, it is said to be “source-less” and cannot be subjected to income taxation. In this respect, “the source doctrine complements the scheduler system”.
The source doctrine, in effect, has created a legal “lacuna” for taxpayers. Notwithstanding, Lord Blackburn’s assertion of it seeming “impossible that the Schedules could be extended more widely”, my research concludes that several streams of revenue may fall outside the scope of the Schedules and avoid income taxation liability. It is not suggested that the invocation of this principle, in all instances, completely absolves liability to tax. Rather, the principle may permit circumvention of the Income Tax regime. For example, if the marginal rate of taxation in Ireland is 41%, it is obvious to see why a person would prefer to pay at the rate of Gift Tax which might be 30% if the circumstances permitted!
Gains which fall outside the scope both Case I and Case IV of Schedule D
Schedule D Case I of the TCA 1997 dictates that tax will be charged “in respect of any trade, profits or gains arising out of lands, tenements or hereditaments”. In Leeming v Jones, the House of Lords held that the once-off profits from the sale of a rubber estate did not arise from a “trade”, thus falling beyond the jurisdiction of Case I. In such instances, the Revenue Commissioners often attempt to utilise Schedule D Case IV, the “sweeping up Case”, which provides that income tax will accrue “in respect of any annual profits or gains”. Such sums are however to be ejusdem generis with other types of income brought into charge to taxation. In Leeming v Jones, the profits resulted from “an isolated transaction of sale but not of a transaction of sale by way of trade”. It could not be analogous to a trade and thus fell outside the scope of Case IV.
The consequence of the above is that, inter alia, winnings from betting, gambling or lotteries are not chargeable for Case IV purposes, as “a bet is merely an irrational agreement”.
Ex Gratia Payments
Elsewhere, the source doctrine prescribes that “receipt of a mere voluntary gift or other “windfall”” cannot be income”. In McGarry (Inspector of Taxes) v. R, ex-gratia payments to a general manager for gratuitous services rendered were held to be in the nature of a “windfall” and thereby not assessable under Case IV. Indeed, the same conclusion was reached in Redknapp’s case.Consequently, voluntary payments such as gratuitous pensions or regular voluntary payments from a parent to a child will not be liable to income tax. However, gifts annually received (e.g. Christmas gifts), tips and other windfalls closely connected to the trade do fall within the scope of Case IV.
The Source Year
A further limb of the source doctrine is that in order for a person to be assessed in respect of income for a particular tax year, it is necessary for the source to have existed in that same year . If “no gains arise to the person entitled during the year in which the duties are to be charged, that person cannot be made liable to pay income tax in respect of that source”. In Bray v Best, the respondent taxpayer received an appropriate share of an ‘Employee Share-Ownership Trust’ capital post-takeover in a year when his former employment had ceased to exist. The House of Lords unanimously held that the source from which the emolument arose no longer existed. Thus, the sum could not be assessed under Schedule E for that year. Subsequent legislative intervention however has diluted the power of this ‘source year’ aspect of the source doctrine.
This letter has sought to pragmatically assess the manner in which the source doctrine may be invoked to avoid income tax liability. The author must now however issue a very important disclaimer. An overarching theme of this letter has been that it is only in exceptionally limited circumstances that gains which look like income will not be liable to income tax. Given the potential liabilities for failure to pay taxes, it is better to err on the side of caution in relation to such revenues. Indeed, it is contended that it has taken the most well-trained tax consultants and stubborn taxpayers to avail of the loophole.
Is mise le meas,