Cross-Border for LowTax writes: Tax evasion and tax avoidance measures have been matters of great concern for both tax authorities and taxpayers. Many individuals and businesses often find themselves caught in the crossfire even when a legal approach to tax planning was adopted. In undertaking an analysis of these measures, one starting point is to differentiate the concepts of "tax evasion", "tax avoidance" and "tax minimisation". These concepts cover a wide range of measures that are intended to minimize tax burdens, though the legal consequences of each are not the same.
Criminal vs. Illegal
Essentially, tax evasion is illegal and tax avoidance is unacceptable and can be illegal whereas tax minimisation is acceptable and legal.
Tax evasion is the general term for efforts by taxpayers to evade the payment of taxes by illegal means. In other words, tax evasion can be generally defined as the direct violation of a tax provision. It will typically result in a criminal sanction e.g. penalties and/or jail. According to the OECD report "International Tax Avoidance and Evasion: Four Related Studies" of 1987, the term "tax evasion" includes:
- failure to notify the tax authorities of the carrying out of an activity that is subject to tax;
- presenting false declarations, for example, with regard to non-existent losses;
- the use of fake invoices;
- opaque structures;
- leaving a country owing tax; and
- the use of proxies in other territories with the intention of simulating income not attributable to the taxpayer.
The difficulty is not so much to define tax evasion but rather to distinguish between "tax avoidance" and "tax minimisation".
Tax Avoidance: Acceptable and Unacceptable
Generally, tax avoidance has many alternative labels. It is often referred to as "aggressive tax planning", "impermissible tax avoidance", "abusive tax avoidance", "unacceptable tax avoidance", or "tax abusive shelters". Whichever term is used, tax avoidance is contrasted with tax minimisation which is often also referred to "acceptable tax avoidance", "tax planning" or "tax mitigation".
Tax avoidance is the legal exploitation of the tax regime by taxpayers by applying atypical structures to reduce tax whilst making a full disclosure of the material information to the tax authorities. Tax avoidance is an indirect violation of the law if the sole objective of the structure is to reduce or eliminate the tax burden. Although not normally illegal, tax avoidance can still result in heavy penalties
Tax minimisation is acceptable tax planning. It involves tax efficient ways to structure business transactions the effect of which remain within the letter and the intent of the law. Taxpayers are entitled to take account of potential tax savings when making business decisions but this should not be the dominant purpose, nor should artificial structures be put in place. There are no sanctions impose for such practice.
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Generally, taxpayers are free to arrange their affairs as they wish in order to save tax but there are limitations. In deciding whether a tax efficient transaction is acceptable or not, a careful analysis of the relevant legislation, methods adopted by the states to circumvent tax avoidance, together with the specific characteristics of each case will have to be taken into account.
According to the OECD report, tax avoidance has the following three elements:
1. a complex structure that lacks economic purpose;
2. a lack of transparency; and
3. taking advantage of loopholes in the law or applying legal provisions for purposes for which they were not intended.
The Rules
Many states have today adopted methods to counter tax avoidance which consequently make tax avoidance illegal. The most common methods are: (1) anti-tax avoidance provisions, for example, a general anti-avoidance rule (GAAR); (2) tax treaties; (3) anti-avoidance doctrines as applied by the courts. From a domestic law perspective, the adoption of these methods has to be done on the basis of the internal legal system, the position of the authorities and ultimately the pronouncements of the local courts. These methods provide in clear terms what will amount to unacceptable and therefore illegal voidance arrangement.
GAAR aims at deterring and preventing artificial and abusive tax avoidance schemes. It seeks to combat, inter alia, the following:
- the use of opaque intermediary companies with no business activities to minimize tax
- the financing of an operation using excessive debt for purely tax purposes
- sale or purchase services provided by related parties at a price higher or lower than they would have been agreed by independent parties by following the arm’s length principle
Tax treaties usually include a number of provisions that are intended to prevent the abuse of tax treaty or "treaty shopping". Treaty shopping refers to a situation where one adopts a tax structure to take advantage of more favourable tax treaties available in certain jurisdictions which would otherwise not be available. Anti-treaty shopping laws are included in most tax treaties in order to circumvent this situation.
Anti-avoidance doctrines applied by courts differ depending on whether the country concerned is based on common law or civil law. All of them look to the main purpose of the relevant arrangement or transaction. Briefly, the most common doctrines in common law jurisdictions include:
1. the business purpose doctrine requires that a taxpayer has a business reason other than avoidance of taxes for entering into a transaction;
2. the economic substance doctrine is used to deny tax benefits if the business transaction lacks any economic benefit other than a tax saving;
3. substance-over-form doctrine allows tax authorities to ignore the legal form of an arrangement and look to its real economic or commercial substance to prevent artificial structures from being used purely for tax avoidance purposes;
4. step-transaction doctrine treats a series of formally separate steps as a single transaction if they are in substance integrated, interdependent, and focused toward a particular end result; and
5. sham transaction denies beneficial tax treatment of transactions entered into primarily for tax avoidance, which lack a bona fide business purpose.
In most civil law jurisdictions, the following doctrines are usually applied:
1. abuse of right doctrine where a taxpayer exercises a right to arrange his/her affairs which lack a bona fine business purpose resulting in a third party's loss or burden unjustifiably;
2. abuse of law doctrine where the result is contrary to the intention of the law as there is an artificial transaction with a clear intention to avoid taxation.
The Bottom Line
A clear distinction between the terms "tax evasion", "tax avoidance" and "tax minimisation" is difficult but critical. Whether a tax planning transaction falls within the scope of any of the terms will depend on the facts and circumstances of each case.
As mentioned earlier, on one side tax avoidance is legal whilst on the other there are legal principles that render tax avoidance illegal. A tax avoidance is deemed to be acceptable or not only under the law of a given jurisdiction. Therefore, it is important to analyse the relevant legislation and other anti-avoidance measures taken by the given jurisdiction as well as to take into account the specific characteristics of each case. One can also look at successful company’s business models, practices and transactions that have been used to reduce the tax burden in a legal matter.
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