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Categorized | Financial

Did light touch tax become soft touch?


Posted on May 31, 2012

David Hartnett©Sarah lee

David Hartnett, who instigated several cross-border agreements aimed at catching tax evaders

On a clear October day, a small crowd of protestors gathered outside the imposing Portland stone headquarters of HM Revenue & Customs. The demonstrators had marched from the Occupy London site outside St Paul’s Cathedral to wave placards and denounce the UK’s top tax official. “We have had enough of your dodgy deals,” yelled one. “You have got to go.”

The target of their anger was Dave Hartnett, the permanent secretary for tax. An energetic 61-year-old with an untidy thatch of greying hair and an ebullient, occasionally bruising manner, Mr Hartnett has become the most controversial Revenue chief that Britain has ever seen.

To critics, he is the most wined-and-dined civil servant in Whitehall whose alleged sweetheart deals with big business cost Britain billions of pounds of tax. Mr Hartnett’s role in encouraging “far too cosy a relationship between HMRC and large companies” was cited in a scathing report by Parliament in December. Though slammed as inaccurate by HMRC, Margaret Hodge the MP who led the investigation hailed it as a “damning indictment”.

    HMRCClick to enlarge

    The accusations hit a raw nerve. Allegations that powerful tax-dodging companies enjoyed preferential treatment, though unproven, chimed with a growing resentment against tax injustice at a time of austerity and rising unemployment. “It’s a moral argument,” said Molly Solomons, a 26-year-old charity worker who took part in the October demonstration after public spending cuts cost her mother her university job and threatened her autistic brother’s disability allowance. “It’s wrong to smash our society into a million pieces while rich individuals and big business are lining their pockets by avoiding tax.”

    For insiders, the question is quite different. They do not doubt Mr Hartnett’s integrity or dedication. Their puzzle is why this brilliant, if idiosyncratic, veteran allowed himself to dominate the department with few checks and balances, leaving him ill-prepared for public scrutiny of his dealings with big companies.

    The spotlight will again fall on him on June 14 when Sir Andrew Park, a retired High Court judge known for his punctilious attention to detail, is due to issue a report to the National Audit Office on the “reasonableness” of five of the largest recent settlements between the tax department and big business. UK Uncut, a grass roots pressure group that organised the October demonstration, is set to have a day in court the same week as it tries to overturn one of those deals.

    Mr Hartnett declined to discuss the cases under review but he spoke to the Financial Times about his tenure and approach to tax.

    The ramifications of this row stretch beyond Britain. At the root of the allegations swirling around Mr Hartnett’s dealings with business lies his deliberate decision to seek a closer, less combative relationship between big companies and tax authorities. This calculated effort to put transparency and trust at the heart of tax administration – officially known as the “enhanced relationship” – has spread across much the world since 2008. Mr Hartnett played a pivotal role in its promotion, according to Jeffrey Owens, until recently the top tax official at the Organisation for Economic Co-operation and Development. “Dave was very much at the forefront of pushing the concept”.

    Pugnacious reputation

    Protesters in London demand the resignation of Dave Hartnett©Getty

    Mr Hartnett’s influence partly stems from his expertise. He stands out among his peers for his in-depth knowledge of tax, according to Mr Owens. “It is increasingly rare that the top person is a tax lawyer. It is a very political role. Dave is a rare commissioner who combines technical knowledge, strong management skills and good knowledge of how tax fits into the policy framework.”

    His technical expertise also made him a powerful figure at HMRC. He stunned MPs in October with his blunt assertion that he was the only Commissioner with “deep tax knowledge”, laying bare the department’s limited ability to conduct reviews of controversial tax cases at the highest level. This ability to find his way through the labyrinth of tax law was honed over a 35-year career in the tax authority. The one-time Classics student from Birmingham University joined in 1976 and entered a graduate training course at the Inland Revenue, as it was then called, where he was required to learn tax cases by rote. “For a while, tax seemed a lot less stimulating than Cicero’s speeches or letters,” he said in a recent interview.

    Mr Harnett pursued his first job with vigour. As a fresh and energetic investigator, he could take a combative approach to reluctant taxpayers and, on occasion, his superiors. George Gill, a colleague from that time, recalls him taking up the cudgels with head office on behalf of a small businessman grappling with an indefensible tax rule. “He blew his top when the official there showed no flexibility and offered no solution to the problem,” Mr Gill said.

    His pugnacious reputation grew as he had worked his way up to the top, joining the nine-member Board of the Inland Revenue in 2000. Graham Aaronson, a leading QC who acted for multinationals in numerous cases, said he grew to admire Mr Hartnett though in his early years, “he was regarded as very confrontational: he was the hard man”.

    Vodafone dispute

    Vodafone

    The litmus test of the UK tax authority’s changing relationship with business was a long-running dispute with Vodafone over its record-breaking £112bn acquisition of Mannesmann, a German conglomerate in 2000.

    The UK-based telecoms group, having financed the deal out of Luxembourg, argued the acquisition had no impact on its British tax bill. HM Revenue & Customs disagreed, pointing to rules that allowed it to tax profits earned in low-tax jurisdictions. Vodafone’s riposte was that UK rules were trumped by European law – arising from the 1957 Treaty of Rome – that allowed companies in one country to set up subsidiaries in another.

    The two sides battled for nine years before the courts, which in 2009 ruled HMRC could investigate the Luxembourg subsidiary. Six months later, the two sides were in negotiations. In June 2010, Vodafone announced it would pay £1.25bn, the largest settlement in HMRC’s history but less than half the £3.1bn set aside in the company’s accounts for the dispute.

    Detractors claimed Vodafone had been let off the hook by as much as £8bn, based on rough estimates of Vodafone’s Luxembourg accounts. But tax experts have called that number wholly unrealistic since it does not take account of factors such as write-downs in Mannesmann’s value or the tax implications of the Treaty of Rome.

    Even so, two features of the settlement stand out. Vodafone told shareholders the tax payments span five years – an unusual concession from the authority. Moreover, it was agreed the tax was levied when dividends were paid by the offshore subsidiary so Vodafone would pay no interest.

    The concessions reflected Mr Hartnett’s fear of defeat if the case went to court, according to a person close to the case. If Vodafone had won, it would not only have scuppered HMRC’s claim; it would have set a disastrous precedent.

    The key question was whether Vodafone’s Luxembourg operation amounted to “genuine economic activity” – a phrase used in a landmark European court case in 2006 on a similar issue. Vodafone, which stopped building up a provision after the favourable 2006 judgement, maintains that its Luxembourg office, now employing more than 200 people, was always a genuine finance subsidiary.

    A retired High Court judge is to publish in June a review of the “reasonableness” of this and four other recent settlements. Critics say, no matter his findings, there was a shortcoming in the Vodafone deal. The Commissioners who signed off the deal also negotiated it. That and the constraints of taxpayer confidentiality left the UK tax authority struggling to prove the propriety of the settlement.

    By that time, relations between business and the Revenue had badly frayed. Companies, egged on by a new breed of highly aggressive advisers, were embracing artificial avoidance schemes as never before. The Treasury responded by closing loopholes and cracking down on tax planning. It amounted to “a constant feeling of paranoia” said Philip Gillett, then head of tax for ICI, the chemicals group.

    In 2001 Gordon Brown, then Chancellor, asked Mr Hartnett to conduct a review of links with business. The conclusions heralded a big change in the Inland Revenue’s dealings with large companies. “It became clear that business wanted certainty and better understanding. It wanted more trust,” Mr Hartnett recalled recently.

    He proposed a more mature relationship, based on risk assessment and a proportionate response from the Revenue. It was an attractive message for tax directors, recalled ICI’s Mr Gillett: “We started talking to each other and stopped playing games.” It also appealed to Gordon Brown, who in 2005 told the CBI, the business lobby group, that trust was the basis of the “correct modern model” for regulating financial services and administering tax. By offering “not just a light touch but a limited touch”, the government would focus attention where it should.

    This light touch regime was coupled with another of Mr Hartnett’s innovations dubbed the “tax on the boardroom agenda”. This initiative aimed to persuade the chairmen of large companies to consider tax risks as part of their approach to corporate governance. Mr Hartnett embarked on a series of lunches and other meetings with top business leaders to urge them to pluck tax out of the obscurity of the tax department and into the boardroom, where it could be seen through the lens of corporate social responsibility.

    Those meetings came to haunt him. They were characterised as a meals-for-deals strategy last October by MPs who in public hearings attacked Mr Hartnett for accepting 107 such free breakfasts, lunches and dinners over two years. In a meeting of the Public Accounts Committee, Ms Hodge, a Labour MP, said: “Had I, as a minister, done that with organisations I was doing business with, I would have been on the front of the Daily Mail and pushed out of my job.”

    Some tax professionals who reviewed the tax authority’s hospitality register accused Mr Hartnett of focusing on too small a group of top law and accountancy advisers. James Bullock, a partner of Pinsent Masons, a law firm, said there had been “a growing sense of unease amongst the profession and corporate taxpayers that Dave Hartnett was becoming to close to the ‘Big Four’ accountants and some law firms”.

    Businesses and former colleagues – as well as Mr Hartnett – insist it is absurd to suggest the lunches had any impact on disputes. Paul Morton, head of group tax at Reed Elsevier, the publishing group, said the dinners and informal engagements tended to be “very technical professional discussions” that helped officials develop a better understanding of business. John Bartlett, head of tax at BP, the oil company, said the initiative was “incredibly successful in getting this ethical approach to tax into British boardrooms”. Pat Ellingsworth, former head of tax at Shell, said: “I do think it enhances revenues because it puts pressure on taxpayers to be more conscientious. The publicity at board level is strong and inhibiting.”

    The exhortations were tacitly backed by threats as the authority ramped up its information gathering on companies’ avoidance schemes. The tax authority was receiving new information on cross-border tax shelters. An initiative known as the joint international tax shelter information centre was set up in 2004 by Mr Hartnett and his counterparts in the US, Canada and Australia and helped launch a crackdown on international arbitrage.

    But the coup de grâce were disclosure rules that Mr Hartnett introduced in 2004. This idea, partly inspired by new rules in the US, forced taxpayers and advisers to give the UK tax authority early tip-offs about avoidance schemes they wanted to market. It proved a game changer. Hundreds of audacious schemes came to light and were swiftly blocked. Tax avoidance, Mr Hartnett told advisers in 2005, was set to become “not worthwhile”.

    Problems within tax authority

    Mr Hartnett’s star rose. When Paul Gray, the Revenue’s chairman, departed after the 2007 loss of computer discs containing the child benefit records of every family in Britain, Mr Hartnett stepped up to acting chairman. His personality and management skills helped hold the badly rattled department together, according to colleagues, and in 2008 he was appointed permanent secretary for tax, with a salary of around £160,000 a year.

    But big problems were emerging within the tax authority. Morale among staff in the organisation was plummeting. In stark contrast to the rapid growth in other departments, the workforce in the tax office was forced to shrink by nearly a third in the second half of the decade. The government extracted deep cost savings with a merger of tax departments in 2005: the Inland Revenue, which collected income and corporate tax, and Customs & Excise, responsible for value added tax and customs duties. Some inspectors felt outgunned by the ranks of adept lawyers and accountants acting for companies and other big taxpayers.

    The idea that HMRC undertakes sweetheart deals is just plain bizarre to me

    – Will Morris, CBI tax committee

    A clash of cultures loomed within the newly formed HMRC as it set out to amalgamate teams and traditions. The Inland Revenue, known for its gentlemanly ethos, saw shades of grey in a dispute; Customs officials were more confrontational. “In Customs we had zero tolerance for avoidance; the Revenue was always trying to do deals”, said a former Customs official who was close to Mr Hartnett.

    The politicians favoured the Inland Revenue’s style. Chris Wales, Gordon Brown’s principal adviser on tax, said his political team had hoped the merger would “draw Customs closer to the ethos the Revenue had. I think it’s fair to say Customs was much more aggressive, which didn’t mean Revenue couldn’t be very firm. Generally I felt it had better judgement on when to push a case than Customs.”

    I think he [Hartnett] got caught up with his success and became complacent

    – Former colleague

    The tough approach won out in 2005 over an avoidance scheme used by a slew of banks to ease tax bills on employees’ bonuses. The hardliners dug in their heels, resisting a compromise offer from the banks to pay 33 per cent of the outstanding bill. They were rewarded with a decisive victory when all the banks, with the notable exception of Goldman Sachs, caved in and paid their national insurance contribution bills in full. But HMRC waived the interest on the late payments, sowing the seeds of the hugely damaging row that broke when Mr Hartnett settled the Goldman case five years later.

    This victory spurred HMRC to codify a new “litigation and settlement strategy” in 2007. If the case was weak, it should be dropped. If it was strong, it should be fought to the bitter end. The long-standing practice of offering package deals – under which the taxpayer would agree to pay out on some disputes if others were dropped – was banned.

    It was an effective deterrent but also a recipe for intransigence. By 2010 a backlog of cases was estimated to be between 10 and 20 man years of work, according to Ernst & Young. Companies complained that the delays over disputes was souring an otherwise much-improved relationship. One business, quoted in a survey by Norton Rose, a law firm, accused the Revenue of acting in an “irrational, irritating and bullying way”.

    Even Mr Hartnett conceded the strategy had its flaws. In an interview with the in the summer of 2010, he said: “I think we got it [the litigation and settlement strategy] a bit wrong in the way we explained it to our people. They thought it was a great sword of justice. Sometimes some of our people outside the large business service are too tough in the way they seek to use the LSS [litigation and settlement strategy]. There are examples of people being too rigid about it.”

    That summer, as a new coalition government came to power, the policy was subtly changed. Litigation became a last resort, particularly for small cases that were clogging up the system. Long-running disputes were settled. Money flowed into the Treasury’s depleted coffers. In July 2010, Ernst & Young told clients that a “more flexible environment” created an opportunity to “agree a more acceptable settlement than had previously been available.”

    Even though the overwhelming majority of disputes had always ended in negotiated settlements, the new, more collaborative approach was a difficult message to get across. For the disenchanted, Mr Hartnett’s long-standing willingness to get personally involved in deals was also disturbing. A former colleague said: “The trouble with Dave is he could never stop being a tax inspector and never stop meddling with things. He meddled in stuff he shouldn’t have meddled with.”

    One former colleague recalls being so angered by Mr Hartnett’s interventions that he was barely on speaking terms, although with hindsight he concedes they were justified. Another former colleague defended Mr Hartnett’s instinct to resolve disputes. “Some inspectors are guilty of wishful things. Dave has a good nose. He is saying to them ‘dream on’. On occasion you do need someone more senior to force them to take a more realistic view. “

    “The sort of people employed in the Revenue are very good technically but they do not have a practical feel,” a lawyer who has closely watched the Revenue said. “That is what Dave has in buckets. He gets exasperated when they take a narrow view of things.”

    Bad relations

    Tensions over Mr Hartnett’s role in disputes came to a head soon after he invited the New York-based global head of tax of Goldman Sachs to fly over for a meeting in November 2010 that aimed to resolve several long-standing disagreements, including the dispute over national insurance contributions that the bank had refused to settle in 2005.

    Dave was very much at the forefront

    – Jeffrey Owens, OECD, on efforts by the Revenue to improve links with business

    The meeting had another goal, according to a source close to the matter. A few weeks earlier, Chancellor George Osborne had voiced outrage that only a handful of banks had signed up to a code of conduct promising not to undertake aggressive avoidance. He set a deadline of the end of November 2010 for the largest 15 banks to sign. One aim of the meeting was to persuade Goldman – the last of the 15 to agree – to sign.

    Relations between the two sides were bad. In the national insurance dispute, Goldman had spent five years “raking every conceivable point in the Tribunal” and putting up a ‘stooge’ witness” according to an internal HMRC memo. HMRC had also dug in its heels, displaying what a tribunal judge in 2009 described as “blustering intransigence”.

    Mr Hartnett told MPs at the recent hearing that he went to the meeting, accompanied by two colleagues who dealt with the bank’s tax affairs, “to make the relationship work” and did not consult with lawyers beforehand. When MPs questioned why he and his colleagues made a deal with Goldman that waived interest on the late payment – a figure the National Audit Office estimated to be between £5m and £8m – he gave few details.

    Mr Hartnett said he believed at the time that there was a “legal impediment” to collecting the interest. Citing taxpayer confidentiality, he refused to tell MPs the nature of the legal impediment, stoking their anger and suspicion.

    The UK tax authority had a history of problems in collecting national insurance debts. Ray McCann, now a director at Pinsent Masons, a law firm, headed up a special effort in 2003 and 2004 to enforce payments when he was at the tax authority. “The Revenue has a chequered history on taking the necessary action to ensure national insurance claims are protected from the expiry of time limits. The rules are very complicated”, he said.

    The tax authority in 2003 issued hundreds of county court claims to banks and others over avoidance schemes. But it was too late to collect the interest that accrued on the debt for at least some of the banks involved in the 2005 settlement, according to two people involved in the matter. That prompted a policy decision to waive the interest charge for all the banks. Mr Hartnett told Parliament that the 2005 settlement, which he oversaw, explained why he had mistakenly believed there was a legal impediment to collecting interest from Goldman.

    One middle-ranking member of staff sounded an alarm about the Goldman deal after he read about it in the minutes of an internal lawyers’ meeting.

    In one of several letters to MPs and the National Audit Office in early 2011, Osita Mba, an Oxford-trained lawyer working for HMRC, revealed details of the Goldman case, which he alleged suggested “potential criminal offences such as fraud by abuse of office, misconduct in public office and cheating the Revenue”.

    Mr Mba complained that the NAO initially refused to investigate his complaints. He sent the same letters to Parliament’s Public Accounts Committee and sparked a firestorm.

    Mr Hartnett’s senior colleagues are vocal that they do not believe rules were bent to secure these deals. Graham Black, president of the union that represents senior tax officials, said neither he nor any of Mr Hartnett’s long-time colleagues saw the tax official as less than even-handed in his dealings. “I have absolutely no doubt about Dave Hartnett’s integrity and have not met people who have.”

    This view is shared by tax directors. Will Morris, chairman of the CBI tax committee, said: “The idea that HMRC undertakes sweetheart deals is just plain bizarre to me. Anyone who has dealt with HMRC and in particular Dave Hartnett knows they hold most of the cards. They are not a soft touch.”

    Billions recouped

    Some tax professionals think those accusing Mr Hartnett of favouritism have focused on the wrong target, pointing instead to pioneering deals he struck with Liechtenstein and Switzerland. These agreements, designed to recoup billions of pounds from wealthy users of secretive tax havens in return for lenient penalties or anonymity are praised by many advisers as pragmatic but viewed by some as unprincipled.

    The accords lend insight to Mr Hartnett’s negotiating style when working with other national tax authorities. Oupa Magashula, commissioner of the South African Revenue Service, has a close relationship with HMRC and said Mr Hartnett’s approach to investigating and information sharing was “done in his estimable style of searching for a common or mutual benefit”. It was offered, he said, “in a spirit of true partnership often way beyond standards expected in law or international treaties”.

    The trouble with Dave is he could never stop  . . . meddling with things

    – Former colleague

    Mr Hartnett championed greater cooperation and capacity building throughout Africa, he says. He also travelled widely, giving public speeches about how to organise tax collection. “Dave Hartnett has left an indelible mark in Africa”, he said.

    In the US, too, there is praise. Don Korb, who was IRS chief counsel between 2004 and 2009, and now works for Sullivan & Cromwell law firm in Washington swapped ideas with Mr Hartnett on many occasions in his term. “Dave is certainly a cutting edge thinker in the world of tax administration”, he said.

    But when Mr Hartnett retires this summer, accolades like these are likely to be drowned out by recriminations. Anthony Thomas, until recently president of the Chartered Institute of Taxation think tank, said Mr Harnett has been publicly pilloried. “Rather than being remembered as a dedicated public servant with deep tax knowledge who acted with honourable intent, he will be remembered as the man who allegedly did deals with Goldman Sachs and Vodafone”.

    A former colleague who has admired Mr Hartnett for much of his career said the damage to his reputation can can be traced to the same characteristics that made him great. “Where have things gone wrong? I think he got caught up with his success and became complacent. He should have seen the warning signs and pulled back from hands-on involvement and strengthened governance” he said.

    “He was an inspirational figure. He was the tax man’s tax man. But he probably didn’t look in the rear-view mirror.”