The Dilemma of Distinguishing Between Revenue and Capital

Introduction

Despite the fact that distinction between revenue and capital (the distinction) is central to the system of UK business taxation, one could still describe the question of whether receipt is of capital or income it as an “insoluble conundrum”. {Needs to have a better introduction with a brief line or two of the background and context; why there is difference between revenue and capital and what is its significance}

This paper analyses the merit of the distinction in respect of the UK business taxation, by considering its effects and design. Before turning to the assessment of the consequences and merit of the distinction, it will firstly examine how exactly does the tax law distinguish revenue from capital. As I will try to show, proper differentiation between those two concepts is essential to any system where income is the base for taxation. Lastly, the paper will consider whether there are any solutions that can better the current system and whether the distinction itself should be abolished. The paper concludes that while the distinction is flawed both in respect of its design and consequences, it nevertheless should (and will) not be abolished. {Signposting is done. It is clear how the essay will be structured}

Distinction between capital and revenue

According to UK tax code income and capital of an individual are taxed separately, thus it is essential to distinguish these two concepts. The legislation, however, does not provide us with general definition of income. Instead, income tax (IT) will arise as long as the receipt can be traced to a source in the tax code or is a particular type of receipt caught by the code. Since capital and income are mutually exclusive, it has to be ascertained whether the receipt is not of capital nature.

On the surface, distinguishing these two concepts may seem easy: any receipts that constitutes return of capital is a capital receipt, and any receipt that comes from current revenue is income. The matter, however, is turns out to be not that easy once someone analyses it in depth. Not only legislation fails to provide us with any bulletproof guidance, but the courts are also struggling to bring clarity to the matter. {Precise and clear distinction as well as the problem with clarity issue set out clearly}

Judicial approach

Despite the substantial number of judicial decisions and precedents in this field, the judges still have trouble with establishing a coherent and clear test that could aid with drawing the line between revenue and capital. While they take some criteria from previous cases, many of these ideas are outdated. For example, the famous analogy between the fruit and the tree prevented the courts from allowing deduction of depreciation, which was since amended by the legislation. {Here we need some explanation of the context of the fruit and tree analogy and the legislation} Furthermore, judges should approach metaphors with cautiousness, as they can often limit their reasoning. {What did Cardozo mean by this and how does this reflect on the way judges approach distinction between revenue and capital?}That could be true especially with regards to such a multifarious concept as taxable income. {one line why this is justified statement}

The difficulty in applying a consistent approach between cases involving the distinction can be illustrated by contrasting IRC v Hyndland Investment Co with Balgownie Land Trust v IRC. In the former case, a company purchased land and completed the building of flats on the land. In the span of six years sixteen flats were sold separately. The court found that the receipts were realisation of capital. In the latter case, a deceased person left his estate to trustees to be sold. They established a company with the heirs as shareholders. The company had troubles with selling the estate and purchased other property with borrowed money. Parts of the estate were sold in addition to the other property. Here the receipts were held to be income. In both of these cases facts were similar, however the outcomes were completely different. {one line why the courts took such divergent approach} This example and many others within the extensive case law in this field show that courts fail to provide a taxpayer with clear rules, and there is often no indication in what way a case may fall. One could even argue that courts show a degree of arbitrariness in their judgements. Such an approach, as it will be explored in detail below, results is uncertainty, which has negative implications for taxpayer and tax authorities.

Since, there is no bright line that one can draw between revenue and capital and the courts do not provide us with much clarity, a taxpayer may often not know whether the receipt or deduction is of revenue nature, until they are provided with a judgement. Before that, however, they will need to bear the costs of litigation. Moreover, due to different rates of IT and capital gains (CG) tax liability can significantly vary, which underlines the significance of proper characterisation of receipt or expenditure. {precise explanation given of why the distinction between revenue and income is important}

Consequences of the distinction

In order to properly analyse a feature of a tax system, one must look at its implications for taxpayers and tax authorities. With regard to the distinction, its consequences that are discussed below exhibit its flaws.

Uncertainty

Due to the issues with drawing a bright line between revenue and capital, the taxpayers are faced significant uncertainy. Justice Greene MR compared the issue to a “spin of coin” showing how uncertain and arbitrary judgements in this field can be, especially in the eyes of a taxpayer. For example, both Odeon and Law Shipping considered expenditure of repairs. In the latter case it was held to be of capital nature, but in the former, of revenue nature. In the High Court Pennycuick V-C distinguished Odeon from Law Shipping on the facts which was upheld by the CA. We have to remember that taxpayers without legal background are not able to notice nuances in the facts, that courts based their judgement on. Not only many taxpayers may not be able to afford expensive legal counsel, but sometimes even that does not guarantee winning. In such circumstances, a taxpayer is left with often huge costs, which could be avoided if the taxpayer had prior guidance of what is revenue and what is capital.

Judges recommend that it is safest “to go by precedent” and one should “search through the cases and see whether the instant problem has come up before”. That approach however does not only help with uncertainty but is also incredibly inefficient for judges themselves. The fact that courts failed to establish any set of rules or test is surprising, considering the legal system’s focus on certainty of law. If even judges with years of legal experience, consider that the distinction created “an intellectual minefield” how can a taxpayer be expected to structure their tax affairs with certainty. {reasonable explanation is given to summarise the point}

Need to consider other concepts

In some circumstances a person trying to distinguish capital from revenue, may also need to consider meaning of other concepts with regards to receipt in question which can be highly dependent on the facts in case. If necessity for such task arises, it will most likely require the taxpayer to seek further advice, and as the time spent by the tax advisor on a particular issue increases, so do taxpayer’s costs. An example of such situation can be shown with respect to stock in trade. While gains on stock in trade are usually associated with IT it is not necessarily a set-in-stone principle, as sale of stock-in-trade in the course of winding up are generally considered capital. {good points but need more elaboration. Perhaps using support and evidence from academic material would help to tighten this argument}

Opportunities for avoidance

While analysing the distinction, it can be noticed that the distinction is artificial and hardly supported by any strong criteria. Such a feature makes it easier for taxpayers to find ways for avoidance by converting income capital. This can be illustrated by the example of shares. A taxpayer who holds a portfolio of shares may either sell the shares or wait for a dividend to be declared. If they choose the latter option, they will be liable for IT, as dividends are considered income. However, if they choose the former, they are only liable on the gains arising from the disposal. Tax avoidance is not only disadvantageous, because it results in smaller less revenue being collected, but also tax authorities, seeking to collect as much tax possible, in some instances may choose to sue the taxpayer, which leads to in more litigation and wated resources. Furthermore, if there are opportunities for avoidance, a taxpayer will spend money seek expert advice to save as much money on tax as possible. That can be especially inefficient if the scheme fails and the taxpayer has to additionally pay the tax due as well as costs of litigation. {these are good arguments, but they need support from academic material}

Good tax design and merit of the distinction

While the distinction has several negative consequences for taxpayers and tax authorities, it is worth to examine its merit by focusing on principles of good tax design. Although there are several models of good tax design, the most popular are 4 canons of taxation set out by Adam Smith. In order for a tax system to be considered good, it should follow these principles. If taxes on the other hand do not comply with these canons, one should ask whether there is a good justification for this failure to comply. Generally, it should be noted that all taxes need not necessarily follow all the principles in order for the tax system to be good. Nevertheless principles of good tax design are useful tools in assessing merit of the distinction. Here, I will focus on several principles that I believe are the most relevant for our analysis. {a brief listing of Adam Smith’s 4 canons will be useful to set the background as you do deal with these below}

Certainty

According to second canon of Adam Smith a tax should be designed as to avoid any uncertainties. As shown above, one can clearly conclude that the distinction is far from being clear. The problem with certainty lies at the very root of distinction, since the definition of income is essential to distinguish revenue from CG. Not only there are difficulties with defining the concept in the first place, but also there does not seem to be any consensus with regards to any good test among the judiciary. Since there is lack of certainty, the taxpayer is unable to determine whether their actions are correct. That leads to increase in litigation, which is burdensome for the tax system as a whole. {this repeats some of the material already discussed earlier. Adding some academic based arguments or evidence would help to make this part a useful addition to what has already been said}

Convenience

According to the third cannon tax should be levied at the time and manner most likely convenient for the taxpayer. While income in the UK is taxed annually, capital is taxed according to realisation principle, so once gain is realised. An alternative solution would be to tax capital based on accruals, thus based on increase in value regardless of the asset regardless of whether it was realised. The latter option would be incompatible with the principle, as the taxpayer would not always have the ability to pay the levied tax, due to lack of liquidity. Furthermore, there would be problems with valuing the increase and if this was a duty of a taxpayer, they would be faced with additional costs. The problems with taxing based on accruals is the reason why the distinction is essential. IT cannot function without creating a periodical system, as it is the most practical. On the other hand, when dealing with gains we cannot tax it regularly as it occurs occasionally.

Neutrality

One noteworthy principle that Adam Smith fails to consider is neutrality. The factor was considered however in Mirlees review. Tax is neutral if it avoids distortions on the market. While neutrality will not be desired at all times, the Review underlines the importance of neutrality by considering as a “benchmark for assessing a tax system”. A consequence of tax not being neutral is that people are encouraged to arrange their affairs in the manner that will reduce their liability and therefore it they spend more money on expert tax advice which is economically unproductive. Furthermore, deviations from neutrality can create opportunities for avoidance of tax. Even if those consequences do not have huge negatives impacts on economy, they are still in some way harmful as it leads to divergence of resources for both taxpayers and tax authorities. {good use of academic material}

Justifications

Based on the analysis above, the distinction is at odds some with principles of good tax design. However, in order to assess its merit, one should also look at the justifications and reasoning behind the distinction.

Generally, tax can influence the directions in which people become wealthy. Therefore, by taxing CG favourably to income, the legislators can encourage investing. {reference needed} However, if we tax gains to heavily taxpayer will be discouraged to invest. Consequently, taxpayer will not have an incentive to earn more and their productivity will be decreased have, which is not beneficial for the economy. On the other hand, Bagchi concludes in her article that favoured treatment leads to ill effects on equity. {Bagchi’s point needed further elaboration} I believe that it can be especially visible with regards to tax avoidance. While both small and big taxpayer may have very similar opportunities to avoid tax liability under the distinction, they can have often different capabilities with regards to obtaining expert tax advice. A small company owner that is unable to access a team of experienced advisers may not even realise that any tax manoeuvre is possible, while a huge multinational can save a lot of money by structuring their affairs in a correct way. Moreover, one can also wonder whether creating an incentive for investment is worth creating such an arbitrary distinction. As Prebble noted, the distinction is “fundamentally flawed”, as it does not have any basis in economic reality. However, as explained discussing Convenience, he also recognises the distinction is necessary for a tax system that calculates income annually.

Solutions to the problems with the distinction

Despite the fact that the distinction is riddled with flaws, its existence is not necessarily unjustified in the UK tax system. While there is many ways that one try correct the issues with the distinction, abolishing it is not necessarily the most appropriate, since a consequence of abolition would be the need to drastically change the way individuals are taxed under the UK business taxation. It cannot be forgotten that transition from one system to another poses significant difficulties. For example, period of transition may be difficult politically and a reform so fundamental as the one discussed will generate windfall and losses on a wide scale for a brief period after transition. {reference needed to substantiate this argument. For example, has this happened somewhere else where such ill effect is noted?}

Establishing a general definition of an income would not be necessarily be of much help either. One could argue that it would provide clarity for a taxpayer, as well as give better guidance for courts and limit their ability to provide arbitrary judgements. On the other hand, the subject of taxable income is too multifarious to provide a uniform definition, and inaccurate definition would only create further issues and no real advantage.

Alternatively, CG and income could be taxed at the same rate. Since neither of the taxes would be taxed at a more favourable rate, applying the correct characterisation of receipt or expenditure, would be of lesser significance and as mentioned above that could get rid of some inequities. However, that solution is not likely to be adopted. Majority of countries has reduced tax rates on individual long-term CG, while some countries completely refrain from imposing such a tax. An example of such country is the US, where despite the fact that short-term CG are taxed at the investor's ordinary IT rate, long-term gains are taxed at lower rate. A strong argument for favourable treatment of gains is the fact that reduced CGTs generate greater investing in young companies. For example, after reducing top federal CGT in the US from 40% in 1978 to 20% in 1981, California’s Silicon Valley soared to life nurturing such companies like Amazon or Apple. Furthermore, increasing CGT to the rate of IT can enforce the “lock-in” problem, which occurs when taxpayers are putting off selling their investments to avoid the tax hit. “Lock- in” effect reduces market inefficiency as people hold assets longer than optimal and therefore miss out on opportunities to diversify their portfolio. Therefore despite the arguments against favourable treatment mentioned in the previous paragraph, I believe that they are outweigh by the advantages of such treatments. {good use of academic material to support argument} Continue your journey with our comprehensive guide to Corporate Tax Avoidance and Transparency.

Conclusion

To distinguish capital from revenue is not an easy task even for experienced judges, which has negative consequences for individual taxpayers, but also tax authorities. Looking at the distinction in light of principles of good tax design shows further flaws. Nevertheless, this paper does not argue that the distinction should be abolished, nor the tax rates unified. There are good reasons why the distinction is incredibly useful in our system, and CG should be treated more favourably than income. In light of the above considerations one can only hope that judges appreciate the uncertainty arising with regards to the distinction and try to create a more clear and consistent approach in deciding whether the receipt/expenditure is of revenue or capital nature.