David Cameron offshore investment fund: What is the difference between tax avoidance and tax evasion?

Tax evasion is illegal, tax avoidance is not. So how do we distinguish the two?

Around half the companies featured in the leaked Panama Papers of law firm Mossack Fonseca were registered in the British Virgin Islands (Getty)

David Cameron insists he did nothing wrong by owning shares in an off-shore mutual investment fund, Blairmore, established by his late father. Others are accusing the Prime Minister of hypocrisy because he benefited from tax avoidance.

So who is right? To answer that question it is necessary to unpack and explore a few concepts.

What is the difference between tax avoidance and tax evasion?

First, it is necessary to pin down the difference between tax avoidance and tax evasion. Tax evasion is illegal, tax avoidance is not. So how do we distinguish the two? One definition of evasion - or abusively excessive avoidance - is “exploiting a tax advantage that Parliament never intended”.

A classic example of entirely benign tax avoidance is when ordinary people put their savings in an Individual Savings Account (ISA) to avoid paying income tax on the interest earned by their cash savings. ISAs were established by the Government to encourage regular people to save. So when people avoid tax in this way they are doing precisely what Parliament intended.

But there’s a big grey area in relation to a host of other tax avoidance schemes devised by accountants and generally marketed to wealthy people. Sometimes HMRC will argue that rich people are extracting a tax saving benefit that MPs never intended them to have. The rich people’s lawyers will argue that it is not clear what Parliament intended. Often the only way to resolve this question is in the courts.

An example of this kind of contested scheme in recent years are the film investment funds, established after the government introduced a tax break to encourage people to invest in films made in the UK. HMRC has challenged and shut down a host of these funds after concluding that they amounted to evasion.

Where does the Prime Minister’s offshore mutual fund sit in this benign avoidance-possible evasion spectrum?

It’s not clear that Parliament ever “intended” anything in relation to these sorts of investment vehicles. When the Thatcher government lifted restrictions on the amount of money UK residents could take out of the country in the 1980s it simply made it practically possible for Britons to buy into these offshore funds (which then invested in stocks and shares all around the world). It is common today for people to invest in off-shore funds – and many ordinary people will be doing so through their pension funds without even knowing it.

The primary concern of the tax authorities then and today is that the UK-resident owners of the shares of such funds pay income tax on the dividends they receive from their holdings and also capital gains when they sell the shares. This Cameron says he did (although the capital gains were not large enough to trigger the latter tax).

Some have raised the issue of the fact that the mutual fund, incorporated in Panama but based in the Bahamas, did not pay UK corporation tax. That’s true. But this is a somewhat confused complaint because mutual funds generally don’t pay corporation tax in the normal way anyway – even when they are registered in the UK. They are not profit-making corporations but investment funds where all cash surpluses are rapidly distributed to investors (or re-invested in the fund). Those surpluses are, as discussed above, taxable under the law when they are received and realised by investors in their home countries.

One potential issue, however, may be that the the Blairmore fund did not pay UK corporation tax while being effectively run from the UK (by David Cameron’s father and others) and was thus, really, a UK corporation.

But to prove that this was evasion, rather than legal avoidance, HMRC would need probably to demonstrate in court that the presentation of this fund as a Bahamas firm, rather than a UK firm, was a sham.

It would seem that Ian Cameron took care to avoid the possibility of such a charge by hiring Bahamas residents to fill roles such as treasurer and secretary and ensuring that a majority of the board was based outside Britain.

So who is right?

Is Cameron’s behaviour completely above board? Or is he a hypocrite for mouthing hard-line rhetoric on clamping down on aggressive avoidance while also benefiting from Blairmore? Reasonable people can take different views depending on how they interpret the facts.