The work of tax practitioners

1. Tax Administration Research CentreMaster Class, London 10 October 2014THE WORK OF TAX PRACTITIONERSProfessor Jane Frecknall-HughesHull University Business School

2. Overview… Part 1: analysis The work of tax practitioners Part 2: a theory of working Part 3: judging quality

3. Part 1, Analysis: Overview • Topicality. • Definition of a tax practitioner. • The nature of the taxation services market. • Review of the taxation practitioner literature. • A conceptual analysis of the work of tax practitioners.

4. Pt 1: Topicality

5. Pt 1: Definition of a tax practitioner “…covers a diverse group of individuals, business structures and professional groups who provide a range of tax services for their clients. Self-employed and in-house accountants, tax advisers and registered tax agents, tax agent franchises and legal practitioners in the tax area are all embraced by the term ‘tax practitioner’ ”. Devos, 2012: 5 Terms used – tax practitioner, tax preparer, tax professional, tax adviser, tax agent, tax intermediary, tax ‘structurer’, etc. Roles played – tax return preparer, responder to return queries, adviser on ‘tax minimisation’, valuer/mediator, ‘servant’ of tax authority in investigation.

6. Pt 1: Definition of a tax practitioner (cont.) • Responsible to: • Their client (primarily) (regular or one-off) • The government (as intermediary) • Their firm • Their profession • The wider public • Themselves • – but rather depends on what the practitioner actually does! • A tax practitioner is often referred to as ‘tax agent’ but not strictly an ‘agent’ in the true meaning of the word.

7. Pt 1: Nature of the taxation services market • The market is characterised by fragmentation, though the degree varies. • In the UK, tax services are provided by members of: • - professional tax/accountancy bodies (CIOT, ATT, IIT • (merged with CIOT), ACCA, ICAEW, ICAS, STEP, WCOTA); • - the legal profession (solicitors, barristers) • - former members of tax authorities in private practice • - the tax authority • …working in a variety of entities: • - accounting firms (Big Four, medium, small) • - legal firms • - specialist tax firms • - tax/financial functions of, for example, MNEs • - tax authority or other public sector entities

8. Pt 1: Nature of the taxation services market (cont.) → Lack of professional monopoly and fragmented professional regulation. Anyone in the UK can set up in business as a tax practitioner. HMRC (2009) suggests that there are some 12,000 tax practitioners currently unregulated by any professional body. The situation varies elsewhere. Australia and the USA require registration of certain types of practitioner, but not others, with the USA showing variation across different states. → Has resulted in lack of holistic study of the work of tax practitioners, so there is little conceptual/theoretical analysis of practitioners’ work.

9. Pt 1: Review of the tax practitioner literature • Surveys (USA and Australia) suggest a significant proportion of taxpayers use practitioner services (USA now > 50%). • An extensive literature (mostly US-based) suggests the following reasons: • - Correct preparation of return* • - Paying the least tax required (not equating to aggressive • tax avoidance) but some willing to overpay to save time) • - Avoidance of serious tax penalties • - Reducing likelihood of investigation/audit • - Increasing complexity of the tax system • - Legal ambiguity over type of income received* • * Linked to risk. More uncertainty → less risk taking by taxpayers, but more by practitioners.

10. Pt 1: Review of the literature (cont.) There is a significant amount of literature which focuses on factors affecting taxpayers’ compliance – general import being that perceptions of probable detection and severity of penalties deter non-compliance. Until recently this body of literature did not consider the likely impact of using a tax practitioner. The existing studies report that tax practitioners both increase and decrease levels of compliance, explained by Klepper and Nagin (1989) and Klepper et al. (1991): practitioners are “enforcers” in unambiguous contexts and “exploiters” in ambiguous ones…

11. Pt 1: Review of the literature (cont.) …practitioners’ levels of aggressiveness are affected by: - Client attributes (quality of records, etc.) - Their own concern about penalties - Possible loss of an important client - Opinions of others in the firm - Advocacy posture - Client risk preferences - Levels of ambiguity in a particular issue - Whether tax is due by the client - Experience with tax authority - Probability of tax investigation - Type of firm - CPA status or not - Single of group decision taking - Education level - Ethical concerns …with one of more of these working in combination

12. Pt 1: A conceptual analysis of the work of tax practitioners The literature refers to specific types of work done by practitioners (another variable?), but there is little conceptual analysis. What is going on?

13. Pt 1: A conceptual analysis of the work of tax practitioners (cont.) • Thuronyi and Vanistendael (1966: 148–151) suggested: • Tax planning • Advice ancilliary to financial and other services • Preparation and auditing of commercial accounts • Preparation of tax returns • Representation of the taxpayer before the tax • administration • Representation before the courts

14. Pt 1: A conceptual analysis of the work of tax practitioners (cont.) • 1. Tax compliance work • Preparation of returns on • behalf of the taxpayer for • submission to HMRC. • Involves reporting economic events that have occurred… • …but using such latitude as allowed to present information to client’s best interest (repairs v capital) – law clear, but situation to which it is applied may not be and may be genuine uncertainty.

15. Pt 1: A conceptual analysis of the work of tax practitioners (cont.) • 2. Tax planning/avoidance work • Definite and deliberate • manipulation of taxpayer’s affairs to reduce tax payable: • Acceptable, e.g., IHT reliefs, use of ISAs. • Stretching statute where law is unclear, but filtered by DOTAS. • Tax arbitrage. • Comments from the cases of Ayrshire Pullman and the Duke of Westminster, etc., used to support the legitimacy of avoidance, and Ramsay, etc., its unacceptability, but NB Hurlingham Estates Ltd v Wilde & Partners, Mehjoo v Harben Barker and HMRC GAAR guidance.

16. Pt 1: A conceptual analysis of the work of tax practitioners (cont.) • Legislative enactments of various kinds, e.g., TAARs. • Resorting to the Courts, e.g., Ramsay and many other cases (‘substance over form’ arguments and its developments). • From 2004, DOTAS. • The ‘moral card’, presaged by Lord Denning in Re Weston’s Settlements, and the change in language, tied more recently into emotional response against ‘tax arbitrage’. • The current GAAR.

17. Pt 1: A conceptual analysis of the work of tax practitioners (cont.) • Terminology shifts: • aggressive • unacceptable • abusive • illegitimate • illegal • Avoidance as ‘morally repugnant’ (presaged in Re Weston’s Settlements). • Body of work on tax practitioners and ethics (e.g., Doyle et al., 2012, 2013).

18. Part 2, A Theory of Working: Overview • The lacuna • Possible theories of tax practice • Negotiation theory

19. Pt 2: The lacuna “There is at present no general theory of tax practice. Rather there exists a small collection of studies that focus on particular features of this institution.” Erard, 1993: 164

20. Pt 2: The lacuna (cont.) This situation persists, with continued studies – and continued great interest, because of help needed from practitioners to comply with complex law and because of alleged involvement in avoidance (e.g., Starbucks et al., the PAC). So – practitioners help their clients to comply and (apparently) not to comply: how then to reconcile these apparently conflicting roles?

21. Pt 2: Possible theories of tax practice • Several theories might be considered to fit the complex work of tax practitioners: • Game theory • Agency theory • Exchange theory • Prospect theory • Stakeholder theory (not included in the paper, but also possible) • …but negotiation theory fits best.

22. Pt 2: Negotiation theory “Negotiation deals with two participants who have different needs and viewpoints attempting to reach an agreement on matters of mutual interest.” Martin et al., 1999: 65 “Negotiation is a decentralized decision-making process that seeks to find an agreement that will satisfy the requirements of two or more parties in the presence of limited common knowledge and conflicting preferences. Negotiation participants are agents who negotiate on their own behalf or represent the interests of their principals.” Braun et al., 2006: 271

23. Pt 2: Negotiation theory (cont.) The role of negotiation is greatly under-appreciated and is relevant in contexts wider than conflict resolution. There is now an extensive literature, often with a practical focus (e.g., ADR), but little theory. Wall Jr. (1985: 4) defines negotiation as: “a process through which two or more parties coordinate an exchange of goods or services and attempt to agree upon the rate of exchange for them. In this interaction, the primary objective may be an agreement or any other outcome indigenous to or resulting from the ongoing exchange.” Here comes the first intimation that in a tax scenario more may be involved than simply agreeing with a tax inspector how much tax a taxpayer should pay.

24. Pt 2: Negotiation theory (cont.)

25. Pt 2: Negotiation theory (cont.) • Stages of negotiation • Establishing the negotiation range • Reconnoitring the negotiation range • Precipitating the negotiation range

26. Pt 2: Negotiation theory (cont.) Determinants of negotiator behaviour NO = NO (interactions) + NO (agreement) If the outcomes could be identified at the end of the negotiation, then the net outcome to Party i would be given by: NOi = j(Rnij – Cnij) + (Rai – Cai) where: NOi = Net outcomes accruing to Party i Rnij = Reward to Party i resulting from interaction with Party j Rai = Reward to Party i resulting from the agreement Cnij = Cost to Party i resulting from interaction with Party j Cai = Cost to Party i resulting from the agreement

27. Pt 2: Negotiation theory (cont.) Determinants of negotiator behaviour However, during the negotiation, the negotiators will have to forecast the outcomes and will have expectations of the outcomes based on their own probabilistic estimates. The above ex-post model can then be written in an ex-ante form as follows: E(NOi) = j[E(Rnij) – E(Cnij)] + [E(Rai) – E(Cai)] where the terms have the same meaning as above, other than that the preceding E denotes an expected value and j denotes the sum of all the interactions with Party j.

28. Pt 2: Negotiation theory (cont.) Negotiation strategy and tactics “A negotiation strategy is the broad plan or technique used to obtain the outcomes desired from the negotiation and the resultant agreement. Tactics generally are considered the components of the strategies.” Wall Jr., 1985: 35

29. Pt 2: Negotiation theory (cont.) Negotiation strategy and tactics (cont.) Wall Jr’s (1985) model incorporates strategy and tactics as part of negotiation. When applied to tax practice, it can include the idea of tax planning, which other models cannot easily encompass. Not only can it include planning, but it can allow for instances where the planning does not work – one can retreat and develop a new strategy; where it comes to nothing before ideas are even put to the client; and where it fails (when the negotiator’s opponent is successful).

30. Pt 2: Negotiation theory (cont.) Negotiation components

31. Part 3, Judging Quality: Overview • Review of the relevant literature. • Issues of quality: can market forces alone protect the public from poor quality tax work? • An economic analysis of the quality of the service provided by tax practitioners. • Simunic’s and Stein’s (1987a, 1987b) model. • Ways of improving the quality of the service provided by tax practitioners, e.g., by regulation if there is market failure.

32. Pt 3: Review of the relevant literature • Most of the work on tax practitioners is US-based, on particular aspects, but there are relatively few attempts to assess, evaluate or measure the quality of service a tax practitioner provides. • Erard (1993) summarises the literature into focal studies and econometric research. • Focal studies consider: • Role played in reducing taxpayer uncertainty. • Effect in reducing time and anxiety (returns and audit). • Usefulness in reducing tax liabilities. • Ability to exploit legal uncertainties of various kinds.

33. Pt 3: Review of the relevant literature (cont.) • Econometric work concentrates on: • Identifying the kind of taxpayers who seek help. • Whether employing a tax practitioner improves or worsens compliance. • Conclusions are that level of income, age, marginal tax rate, complexity of return (including lots of forms and schedules), marital status, self-employed status encourage use of a tax practitioner. • Taxpayers with high levels of education or tax knowledge tend not to use tax practitioners.

34. Pt 3: Review of the relevant literature (cont.) • Klepper et al. (1991) – formal model: • Formalises the argument that practitioners are both guardians against breaches of the legal code and exploiters of its legally ambiguous features… • …So play both enforcer role (→ greater compliance, unambiguous items) and advocacy role (→ greater non-compliance, ambiguous items). • If there are practitioner penalties, then enforcer role is magnified.

35. Pt 3: Review of the relevant literature (cont.) • Dubin et al (1992) and Erard (1993) also consider the possible effect of employing a different kind of tax practitoner. • CPAs and lawyers are associated with a higher level of non-compliance, but no exploration of innate ideas of different quality of service. • Tax services are the most common cause of malpractice suits against CPAs. • More recent research suggests greater complexities (Tan, 2009; Devos, 2012). • → All lead to very good reasons to look at the quality of the service a tax practitioner offers.

36. Pt 3: Issues of quality • As we have seen, the market for tax services is fragmented, with multiple bodies, and multiple terms used. • Terms are not defined – and anyone in UK can still set up as in business (‘caveat emptor’) – not regulated (ditto NZ). • Contrast Australia: tax agents required to be registered since 1943; in USA, mandatory federal registration of tax intermediaries, plus compliance checks, plus roll out of competency tests, CPD for other unlicensed persons. • Quality of work is an issue – see Green (1995), more recently ethical issues re tax havens, KPMG tax shelter fraud case, Starbucks, et al., PAC.

37. Pt 3: Issues of quality (cont.) • HMRC usually pursues the taxpayer in case of errors, not the practitioner. Client could claim for negligence, if could show had suffered financial loss. • Do companies which receive the kind of advice that means their CEOs have to answer questions before the PAC feel that their advisers have provided good quality advice?

38. Pt 3: Issues of quality (cont.) • How can one measure service quality? • Quality of tax compliance work: how closely the eventual tax liability corresponds to the minimum possible, given truthful reporting and perfect knowledge of tax law and the practices of HMRC. In practice, this idealised definition will become the extent to which the tax computations do not contain any significant errors or omissions as laid down by tax law. • Quality of tax planning/avoidance work: how closely the eventual tax liability corresponds to the minimum possible, given the taxpayer’s willingness to frame his or her affairs in the most tax efficient manner. • (May be interlinked)

39. Pt 3: Issues of quality (cont.) • Quality is not observable before and only certain aspects are observable after consumption. • Indicators of quality – compliance: • additional demands for tax and/or penalties because of errors • time taken to agree • investigation • Indicators of quality – avoidance: • theoretical minimum – not observable • DOTAS? • bad publicity

40. Pt 3: An economic analysis of service quality • Observability is key for economic analysis under • uncertainty re verifiability (cfAkerlof, 1970, used • car market). • In a market with imperfectly informed customers • and where producers have no chance to build a • reputation, high and low quality goods will sell for • the same price.

41. Pt 3: An economic analysis of service quality (cont.) • Moral hazard and adverse selection conspire to reduce • the availability of high quality goods: • Moral hazard because sellers can maximise profits by selling poor quality products. • Adverse selection because such sellers will drive higher quality producers from the market. • Hence average quality overall reduced and market size shrinks.

42. Pt 3: An economic analysis of service quality (cont.) • If product quality post consumption can be determined, even if only imperfectly, there will be a reputational effect – of high quality product, fewer clients leave and word of mouth advertising, e.g., will attract new clients to the high quality firm: product quality will reach an equilibrium level and not fall to lowest level. • Other firms deterred from entering because high quality • firms will invest in non-salvageable firm specific assets. • Model of how a tax practitioner chooses a particular level • of service quality for compliance work can be developed • from the audit service model of Simunic and Stein (1987a, 1987b).

43. Pt 3: Simunic’s and Stein’s model • Model assumes: • an uncertain world in which economic agents are concerned primarily with the distribution of wealth; • that taxpayers are concerned with their distribution of future wealth, conditional on a set of tax returns; and • that tax practitioners are concerned with their distribution of future wealth, conditional upon the service itself.

44. Pt 3: Simunic’s and Stein’s model (cont.) qjk = h { [fjkajk (cj, zj, sjk)], fj } where : qjk = taxpayer j’s perception of the quality of the tax service by tax practitioner k h = a function fjk = taxpayer j’s perceived distribution of wealth with respect to tax effects determined by tax practitioner k ajk = the tax service for taxpayer j by tax practitioner k cj = a set of characteristics of taxpayer j zj = a set of environmental factors relevant to taxpayer j sjk = the inputs of tax practitioner k to the tax service for taxpayer j (tax service scope) including the quantities of such inputs fj = taxpayer j’s perceived distribution of wealth before any tax effects determined by tax practitioner k

45. Pt 3: Simunic’s and Stein’s model (cont.) • Therefore, tax service quality is some function of the difference between j’s prior (pre-tax service) and posterior (post-tax service) distributions of wealth. • In the model: • taxpayers are expected to revise their priors based on ajk alone – i.e., the fact that the tax service is performed by tax practitioner k. • tax practitioners are expected to revise their priors based on their full knowledge of cj, zj and sjk.

46. Pt 3: Simunic’s and Stein’s model (cont.) • The final part of the model examines the relationship between tax service quality and tax service quantity (i.e., time spent on the tax service). • From the tax practitioner’s perspective, tax service quality and tax service quantity measure the same dimension. • For example, tax service quality could be measured by the conditional probability of producing a large tax saving given a particular interpretation of existing tax law.

47. Pt 3: Simunic’s and Stein’s model (cont.) • However, the important aspect of Simunic’s and Stein’s (1987a, 1987b) model is that when the taxpayers are introduced who can observe neither inputs nor output directly, the equivalence between tax service quality and tax service quantity breaks down. • Tax service quality to consumers is a function of brand name and reputation and this user perceived tax service quality determines the level of quantity, which is necessary to maintain an existing reputation. • Formally, a profit maximising tax practitioner’s problem is to minimise tax service costs subject to the constraint of the user perceived quality:

48. Pt 3: Simunic’s and Stein’s model (cont.) minimise p . sj subject to: h { [fjaj (cj, zj, sj) ], fj } = qj sj >/= IRmin where: p = a vector of market prices for the various tax service inputs; sj = the inputs of the tax practitioner to the tax service for taxpayer j; aj = the tax service for the taxpayer j; qj = the user perceived tax service quality for that tax practitioner implied by tax practitioner’s present reputation; and HMRCmin = some minimum required level of tax service quality necessary to comply with generally accepted HMRC requirements.

49. Pt 3: Simunic’s and Stein’s model (cont.) • The value of Simunic’s and Stein’s model is that it shows that a tax practitioner may choose to undertake more tax service work than that necessary to meet HMRC minimum requirements, in order to meet the reputational expectations of taxpayers. • The question then becomes one of determining how taxpayers form reputational expectations of the work of a particular tax practitioner or firm of tax practitioners – but no publicly available data, other than the ‘well known’ fact that most HMRC District Offices maintain a ‘black list’ of questionable tax advisers. • What to use? Professional designation? Generic reputation (= composite, one area affecting another)?

50. Pt 3: Ways of improving the quality of the service • Market forces are unlikely to ensure high quality service. • Does regulation have a role to play? • The usual purpose of regulation is to ‘protect the public’ – often against bureaucratic power. It is unclear what this might mean in the context of tax services in relation to HMRC.