Boots On The Ground: Why The UK Taxman Is Unable To Estimate The Offshore Tax Gap

Such was the political embarrassment to the UK Government that Lucy Frazer, Financial Secretary to the UK Treasury, was quickly bounced into announcing that HMRC will rectify the situation by publishing new estimates of the “offshore tax gap” in 2023.  The so-called “offshore tax gap” constitutes evasion (the deliberate underpayment of tax), failed tax avoidance by technical means or else underpayments resulting from simple innocent or careless errors.  With so many different ways in which underpayments have arisen in so many different circumstances, much will then depend on the quality of the data HMRC uses and the validity of its assumptions.

HMRC is now aware from the CRS alone of c. £570bn held by UK residents in financial accounts in the traditional so-called “tax havens,” as well as a further £280bn held by UK residents in overseas “onshore” jurisdictions.  However, thanks to CRS and the various data leaks, few UK residents are now foolish enough to believe that they can simply hide and invest funds in overseas accounts that HMRC will not find out about.  This is in stark contrast to the Post-War position that existed until the late noughties when UK residents held thousands upon thousands of such accounts with virtual impunity.  Thanks to the data leaks and data transparency initiatives – as well as a carrot and stick approach by HMRC initially offering a disclosure amnesty before ramping up penalties to eyewatering levels – most accounts were disclosed to HMRC and regularised.

Previously, many aggressive marketed tax avoidance arrangements utilised offshore trusts and offshore companies to engineer contrived tax advantages.  However, HMRC has also waged a relentless and largely successful war on such arrangements both through the UK tax courts and securing new legislation to firmly shut the door on future abuse.

HMRC reaped a bonanza of low-hanging fruit in eradicating hidden accounts and shutting down aggressive offshore schemes, but that low-hanging fruit is now gone.  What is left is generally much more difficult to detect with any certainty.  It varies from the most basic of innocent errors in reporting income and gains on overseas investments to technical and potentially contentious liabilities arising on individuals with interests in complex overseas structures set up with ostensibly the best professional advice.

Over the last few years, HMRC has made increasing use of its computer systems and ever more sophisticated algorithms to trawl mountains of data obtained from CRS, data leaks and bilateral sharing arrangements with other overseas tax authorities like the IRS.  Data is cross compared to the tax returns submitted by UK residents looking for potential anomalies that might point to omitted income and gains.  However, the process is still crude.  For instance, CRS is received in calendar year format and for that reason alone, tends to mismatch with the figures submitted in tax returns for the UK’s 5 April fiscal year end.  At the other end of the scale, the information received is far too limited to determine whether complex structures “work” for the purposes of anti-avoidance legislation – which, barring giant leaps forward in artificial intelligence, is beyond the capability of HMRC’s computers for the indefinite future in any event.

Faced with vast amounts of data and limited human resource to investigate, HMRC has increased its use of “nudge letters” – generic letters sent en masse to individuals, notifying them that HMRC has information that they have offshore income and gains that might not have been correctly reported on their tax returns.  The letters request that they check and disclose to HMRC any underpayments.  That is an efficient use of HMRC’s resources but barely scratches the surface of the potential non-compliance out there and relies upon recipients accepting that they have underpaid tax and voluntarily reporting it rather than continuing to blindly underpay or calling HMRC’s bluff.  Such nudge tactics were re-doubled during Covid – when many of HMRC’s investigations teams at its Fraud Investigation Service (FIS) were effectively stood down from opening new enquiries.  Indeed, the author understands from internal sources that HMRC FIS’s Offshore Corporate and Wealthy team did not open a single new Code of Practice 9 serious suspected fraud enquiry for nearly two years.

In light of its reliance on trawling crude data to encourage semi-voluntary compliance through nudging and its relative inactivity during Covid, it is hardly surprising that HMRC has found itself flailing around in the dark in trying to assess the remaining scale of the offshore tax gap.  However, to HMRC’s credit, it has steered clear – at least until next year – of producing an unreliable estimate for the sake of producing an estimate.

Of course, anyone can produce an estimate of anything. The accuracy, however, is subject to the quality of the data and the validity of the inevitable assumptions required.  As an example, one need only look at the estimates of offshore tax abuse produced by the Tax Justice Network (TJN) in – “The State of Tax Justice 2021”.  A 72-page document, it used crude data and broad-brush assumptions in attempts to estimate offshore tax abuse for every country in the world – including the UK.

Where the UK is concerned, the publication estimates that the UK loses over £19bn to “Offshore Tax Abuse”.  Ranked on TJN’s figures against the rest of Europe, the UK is purportedly by far the biggest absolute loser to offshore tax abuse in Europe and the fifth biggest relative to GBP behind Luxembourg, Ireland, Cyprus and Malta.  However, closer scrutiny of the number crunching shows the figures are highly questionable. 

As a starting point, the TJN methodology estimates each country’s total offshore wealth based on assumed crude aggregated net capital outflows over time.  In the UK’s case, its citizens’ overseas wealth was found to be c. £854bn / US$1,133bn – much the same as the level of overseas wealth revealed to HMRC from CRS data.  However, the other fundamental assumptions are obviously untenable.  The TJN’s £19.2bn annual estimate of lost UK tax is based upon:

• the premise that all of the £854bn estimated UK owned wealth moved outside the UK also wrongfully left the UK tax net – when we know a huge proportion of it is either held directly and disclosed or else it is held indirectly in fully tax compliant pension or private equity funds;

• a 5 per cent average assumed rate of investment return applied to all of the said £854bn – coming to some £42.7bn of income supposedly kept away from the UK taxman;

• a flat 45 per cent rate of UK Income Tax – the England / Wales / Northern Ireland’s highest possible rate of Income Tax on investment income - applied to all of the £42.7bn.

The result is an estimate that is self-evidently grossly inflated and fails the credibility test.

HMRC is vastly better equipped than external campaigning organisations to produce much more sophisticated and accurate estimates.  However, at its core, any estimate ultimately depends upon two questions:

• what proportion of UK residents with offshore income and interests are not fully tax compliant; and
  
  
• what is the average quantum of such non-compliance?

Data exchange initiatives like the CRS and data leaks have largely laid bare the identities of the vast majority of UK residents with overseas income and interests but that is all.  The only sure way for HMRC to produce an accurate estimate is for it to investigate a statistically significant cross-section of taxpayers, and it has evidently not done so.  On 22 August 2022 - in response to a recent freedom of information (FoI) request from the author, HMRC declined to provide any statistics of the number of its offshore related tax investigations citing a public interest fear that revealing such information would encourage taxpayer non-compliance:

“Providing the information could help build a picture or reveal where HMRC is focusing its activities and could lead taxpayers or financial institutions to form judgements about the likelihood of HMRC investigating specific issues. This could damage the general climate of honesty among the overwhelming majority of taxpayers and financial institutions who comply with their obligations, and that is not in the public interest.”

This speaks for itself.

HMRC was willing in its FoI response to reveal that they had issued nearly 152,835 offshore related nudge letters in the years up to 31 March 2022 resulting in tax disclosures yielding £299,315,334.  However, that is an implied yield averaging less than £2,000 per letter – which is scarcely testimony to the effectiveness of the initiative in tackling major offshore non-compliance.

It does appear that HMRC’s investigation efforts are finally starting reboot after the Covid lull.  Indeed, HMRC now has high profile suspected fraud investigations into many of the UK customers of Euro Pacific Bank – a bank which HMRC, the IRS and other international tax agencies believe relocated from St Vincent and the Grenadines to Puerto Rico in attempt to enable its customers to escape detection through the CRS.  Such special projects cracking down on outlier abuse will make inroads into the offshore tax gap – both directly and through their deterrence value.  However, on their own, such initiatives will leave HMRC little better informed on the remaining scale of the overall problem.  For that, HMRC will need to dramatically ramp up the scale of its general effort – from basic random enquiries into offshore figures on tax returns through to complex risk-based investigations into large and sophisticated offshore structures.

Until it puts enough boots back on the ground, HMRC will not have a hope of accurately assessing the terrain.  It is going to be fascinating when HMRC finally releases its estimate to see not just what figure HMRC comes up with, but also how well it can justify it by pointing to a credible data set and credible assumptions.

Andrew Park
Andrew Park is a Partner at Price Bailey in the UK. He specialises in regularising back tax issues with the UK tax authorities for all types of clients and all taxes – including cryptocurrency investors now coming under investigation or receiving “nudge letter” invitations from HMRC to make voluntary disclosures. Andrew can be contacted at email: andrew.park@pricebailey.co.uk / tel. +44 07717 892 537