Tax avoidance and tax evasion
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- This article discusses tax avoidance, tax evasion, tax mitigation, tax fraud, tax resistance and tax protest.
Tax avoidance
Tax avoidance is the legal utilization of the tax regime to one's own advantage, in order to reduce the amount of tax that is payable by means that are within the law. Examples of tax avoidance involve using tax deductions, changing one's tax status through incorporation or establishing an offshore company, trust or foundation in a tax haven.
Tax evasion
By contrast tax evasion is the general term for efforts by individuals, firms, trusts and other entities to evade taxes by illegal means. Tax evasion usually entails taxpayers deliberately misrepresenting or concealing the true state of their affairs to the tax authorities to reduce their tax liability, and includes, in particular, dishonest tax reporting (such as underdeclaring income, profits or gains; or overstating deductions).
Tax evasion is a crime in almost all countries and subjects the guilty party to fines or imprisonment.
Switzerland is a partial exception. Many acts that would amount to criminal tax evasion in other countries are treated as civil matters in Switzerland. Even dishonestly misreporting income in a tax return is not necessarily considered a crime. Such matters are dealt with in the Swiss tax courts, not the criminal courts. However even in Switzerland, some fraudalent tax conduct is criminal, e.g. deliberate falsification of records. Moreover civil tax transgressions may give rise to penalties. So the difference between Switzerland and other countries, while significant, is limited.
Tax evasion anecdotes
In the United States, persons who earn income by illegal means (gambling, theft, drug trafficking etc.) are required by the Internal Revenue Code to report unlawful gains as income when filing annual tax returns (see e.g., James v. United States, 366 U.S. 213 (1961)), but they usually do not do so, because doing so would serve as an admission of guilt. For this reason, suspected lawbreakers, most famously Al Capone, have been charged with tax evasion when there is insufficient evidence to try them for their substantive crimes. By contrast: In the UK law enforcement agencies do not generally have access to tax returns and so immoral or illegal earnings can supposedly be safely declared.
Avoidance and evasion compared
The fundamental difference is by definition: Tax evasion involves breaking the law; tax avoidance is using legal means to not pay tax. Tax evaded remains due. Tax avoided is not due.
Avoidance and evasion compared: The United States example
The use of the terms tax avoidance and tax evasion can vary depending on the jurisdiction. In the United States, for example, the term "tax evasion" (or, more precisely, "attempted tax evasion") generally consists of criminal conduct, the purpose of which is to avoid the assessment or payment of a tax that is already legally owed at the time of the criminal conduct. (The term "assessment" is here used in the technical sense of a statutory assessment: the formal administrative act of a duly appointed employee of the Internal Revenue Service who records the tax on the books of the United States Treasury after certain administrative prerequisites have been met. In the case of Federal income tax, this act generally occurs after the close of the tax year -- and usually after a tax return has been filed.)
By contrast, the term "tax avoidance" is used in the United States to describe lawful conduct, the purpose of which is to avoid the creation of a tax liability. Tax evasion involves breaking the law; tax avoidance is using legal means to avoid owing tax in the first place. An evaded tax remains a tax legally owed. An avoided tax (in the U.S. sense) is a tax liability that has never existed. A simple example of tax avoidance in this sense is the situation where a business considers selling a particular asset at a huge gain but, after consulting with a tax adviser, decides not to go through with the sale. Because no sale occurs, no gain is realized. The additional income tax liability that would have been generated by the inclusion of the gain on the sale in the computation of taxable income is simply not incurred, as the there was no sale and no realized gain.
In other countries such as the United Kingdom, the term "tax avoidance" in particular may have a broader technical meaning than that used in the United States.
History of avoidance/evasion distinction: United States and United Kingdom
An avoidance/evasion distinction along the lines of the present distinction has long been recognised but at first there was no terminology to express it. In 1860 Turner LJ suggested evasion/contravention (where evasion stood for the lawful side of the divide): Fisher v Brierly (1860) 1 de G F&J 643 (England). In 1900 the distinction was noted as two meanings of the word “evade”: Bullivant v AG [1901] AC 196 (England). The technical use of the words avoidance/evasion in the modern sense originated in the USA where it was well established by the 1920s: Minimising Taxes, Sears, 1922, Vernon Law Book Co. It can be traced to Oliver Wendell Holmes in Bullen v Wisconsin, 240 U.S. 625, 630 (1916). It was slow to be accepted in the United Kingdom. By the 1950s, knowledgeable and careful writers in the UK had come to distinguish the term “tax evasion” from “avoidance”. However in the UK at least, “evasion” was regularly used (by modern standards, misused) in the sense of avoidance, in law reports and elsewhere, at least up to the 1970s. Now that the terminology has received official approval in the UK (Craven v White (1988) 62 TC 1 at 197) this usage should be regarded as erroneous. But even now it is often helpful to use the expressions “legal avoidance” and “illegal evasion”, to make the meaning clearer.
Distinction between tax avoidance and tax mitigation in the United Kingdom
In the United Kingdom and in jurisdictions following the UK approach such as New Zealand, a distinction is drawn between tax avoidance and tax mitigation. Tax avoidance is a course of action designed to conflict with or defeat the evident intention of Parliament: IRC v Willoughby, 70 TC 57. Tax mitigation is conduct which reduces tax liabilities without “tax avoidance” (not contrary to the intention of Parliament), for instance, by gifts to charity or investments in certain assets which qualify for tax relief. This is important for tax provisions which apply in cases of “avoidance”: they are held not to apply in cases of mitigation.
The clear articulation of the concept of an avoidance/mitigation distinction goes back only to the 1970s . The concept originated from economists, not lawyers. See for instance CT Sandford, Hidden Costs of Taxation, IFS, 1973. The use of the terminology avoidance/mitigation to express this distinction was an innovation in 1986: IRC v Challenge [1986] STC 548.
In practice the distinction is sometimes clear, but often difficult to draw. Relevant factors to decide whether conduct is avoidance or mitigation include: whether there is a specific tax regime applicable; whether transactions have economic consequences; confidentiality; tax linked fees. An important indicia is familiarity and use. Once a tax avoidance arrangement becomes common, it is almost always stopped by legislation within a few years. If something commonly done is contrary to the intention of Parliament, it is only to be expected that Parliament will stop it. So that which is commonly done and not stopped is not likely to be contrary to the intention of Parliament. It follows that tax reduction arrangements which have been carried on for a long time are unlikely to constitute tax avoidance. Judges have a strong intuitive sense that that which everyone does, and has long done, should not be stigmatised with the pejorative term of “avoidance”. Thus UK courts refused to regard sales and repurchases (known as bed-and-breakfast transactions) or back-to-back loans as tax avoidance.
Other approaches in distinguishing tax avoidance and tax mitigation are to seek to identify “the spirit of the statute” or “misusing” a provision. But this is the same as the “evident intention of Parliament” properly understood. Another approach is to seek to identify “artificial” transactions. However, a transaction is not well described as ‘artificial’ if it has valid legal consequences, unless some standard can be set up to establish what is ‘natural’ for the same purpose. Such standards are not readily discernible. The same objection applies to the term ‘device’.
It may be objected that a concept of “tax avoidance” based on what is contrary to “the intention of Parliament” is not coherent. The object of construction of any statute is always said to be to find “the intention of Parliament”. In any successful tax avoidance scheme a Court must have concluded that the intention of Parliament was not to impose a tax charge in the circumstances which the tax avoiders had placed themselves. The answer is that the expression “intention of Parliament” is being used in two senses. It is perfectly consistent to say that a tax avoidance scheme escapes tax (there being no provision to impose a tax charge) and yet constitutes the avoidance of tax. One is seeking the intention of Parliament at a higher, more generalised level. A statute may fail to impose a tax charge, leaving a gap that even a court cannot fill even by purposive construction, but nevertheless one can conclude that there would have been a tax charge had the point been considered. An example is the notorious UK case Ayrshire Employers Mutual Insurance Association v IRC, 27 TC 331 where the House of Lords held that Parliament had “missed fire”.
Morality of tax avoidance
Tax avoidance may be considered to be the amoral dodging of one's duties to society, or alternatively the right of every citizen to structure one's affairs in a manner allowed by law, to pay no more tax than what is required. Attitudes vary from approval to neutrality to outright hostility. Attitudes may vary depending on the steps taken in the avoidance scheme, or the perceived unfairness of the tax being avoided.
In the judiciary, different judges have taken different attitudes. As a generalization, for example, judges in the United Kingdom before the 1970s regarded tax avoidance with neutrality; but nowadays they regard it with increasing hostility. See the quotes below for examples.
Among tax practitioners, while of course there is no unanimity, the view most commonly held is that tax avoidance is not at all amoral. This may be because tax pracitioners are more aware than others how unfair, complex and sometimes ridiculous tax rules often are, and they see avoidance in that context.
Responses to tax avoidance
Tax avoidance in fact may have beneficial effects by
(1) ameliorating undesirable or unfair tax rules, such as the 98% tax rate which applied in the UK in the 1970's;
(2) facilitating business transactions which otherwise could not be done because the tax would be too great, and
(3) providing a lawful route for those who would otherwise practice tax evasion.
However avoidance also reduces government revenue and brings the tax system into disrepute. So governments need to prevent tax avoidance or keep it within limits.
The obvious way to do this is to frame tax rules so that there is no scope for avoidance. In practice this has not proved achievable and has lead to an ongoing battle between governments amending legislation and tax advisors finding new scope for tax avoidance in the amended rules.
To allow prompter response to tax avoidance schemes, the US Tax Disclosure Regulations (2003) require prompter and fuller disclosure of tax avoidance schemes, a tactic which was applied in the UK in 2004.
Some countries such as the US, Canada, Australia and New Zealand have introduced a statutory General Anti-Avoidance Rule (GAAR).
In the United Kingdom, there is no GAAR, but many provisions of the tax legislation (known as "anti-avoidance" provisions) apply to prevent tax avoidance where the main object (or purpose), or one of the main objects (or purposes), of a transaction is to enable tax advantages to be obtained.
In the UK, judicial doctrines to prevent tax avoidance began in IRC v Ramsay (1981) followed by Furniss v. Dawson (1984). This approach has been rejected in most commonwealth jurisdictions even in those where UK cases are generally regarded as persuasive. After two decades, there have been numerous decisions, with inconsistent approaches, and both the Revenue authorities and professional advisors remain quite unable to predict outcomes. For this reason this approach can be seen as a failure or at best only partly successful.
In the UK in 2004, the Labour government announced that it would use retrospective legislation to counteract some tax avoidance schemes.
Tax protestors and tax resistance
Some tax evaders believe that they have uncovered new interpretations of the law that show that they are not subject to being taxed: these individuals and groups are sometimes called tax protesters. However, many protesters merely rehash the same arguments that courts have rejected time and time again.
Tax resistance is the refusal to pay a tax for conscientious reasons (because the resister does not want to support the government or some of its activities). They typically do not take the position that the tax laws are themselves illegal or do not apply to them (as tax protesters do) and they are more concerned with not paying for what they oppose than they are motivated by the desire to keep more of their money (as tax evaders typically are).
In the UK case of Cheney v. Conn [1968] All ER 779, an individual objected to paying tax that, in part, would be used to procure nuclear arms in unlawful contravention, he contended, of the Geneva Convention. His claim was dismissed, the judge ruling that "What the [taxation] statute itself enacts cannot be unlawful, because what the statute says and provides is itself the law, and the highest form of law that is known to this country."
Definition of tax evasion in the United States; Example of application to tax protesters
The application of the U.S. tax evasion statute may be illustrated in brief as follows, as applied to tax protesters. The statute is Internal Revenue Code section 7201 (Template:Usc):
- Any person who willfully attempts in any manner to evade or defeat any tax imposed by this title or the payment thereof shall, in addition to other penalties provided by law, be guilty of a felony and, upon conviction thereof, shall be fined not more than $100,000 ($500,000 in the case of a corporation), or imprisoned not more than 5 years, or both, together with the costs of prosecution.
Under this statute and related case law, the prosecution must prove, beyond a reasonable doubt, each of the following three elements:
- (1) the "mens rea" or "mental" element of willfulness -- the specific intent to violate an actually known legal duty;
- (2) the "attendant circumstance" of the existence of a tax deficiency -- an unpaid tax liability; and
- (3) the "actus reus" (i.e., guilty conduct) -- an affirmative act (and not merely an omission or failure to act) in any manner constituting evasion or an attempt to evade either the (A) assessment of a tax or (B) the payment of a tax.
An affirmative act "in any manner" is sufficient to satisfy the third element of the offense. That is, an act which would otherwise be perfectly legal (such as moving funds from one bank account to another) could be grounds for a tax evasion conviction (possibly an attempt to evade "payment"), provided the other two elements are also met. Intentionally filing a false tax return (a separate crime in itself) could constitute an attempt to evade the "assessment" of the tax, as the Internal Revenue Service bases initial assessments (i.e., the formal recordation of the tax on the books of the U.S. Treasury) on the tax amount shown on the return.
This statute is an example of an exception to the general rule under U.S. law that "ignorance of the law or a mistake of law is no defense to criminal prosecution." Under the Cheek Doctrine (Cheek v. United States, 498 U.S. 192 (1991)), the United States Supreme Court ruled that a genuine, good faith belief that one is not violating the Federal tax law (such as a mistake based on a misunderstanding caused by the complexity of the tax law itself) is a defense to a charge of "willfulness" ("willfulness" in this case being knowledge or awareness that one is violating the tax law itself), even though that belief is irrational or unreasonable. On the surface, this rule might appear to be of some comfort to tax protesters who incorrectly assert, for example, that "wages are not income." However, merely asserting that one has such a good faith belief is not determinative in court; under the American legal system the jury, in a jury trial, (not the defendant) decides whether the defendant really has the good faith belief he or she claims. With respect to willfulness, the placing of the burden of proof on the prosecution is of limited utility to a defendant that the jury simply does not believe.
A further stumbling block for tax protesters is found in the Cheek Doctrine with respect to arguments about "constitutionality." Under the Doctrine, the mistaken belief that the Sixteenth Amendment was not properly ratified and the mistaken belief that the Federal income tax is otherwise unconstitutional are not treated as beliefs that one is not violating the "tax law" -- i.e., these errors are not treated as being caused by the "complexity of the tax law."
In the Cheek case the Court stated:
- Claims that some of the provisions of the tax code are unconstitutional are submissions of a different order. They do not arise from innocent mistakes caused by the complexity of the Internal Revenue Code. Rather, they reveal full knowledge of the provisions at issue and a studied conclusion, however wrong, that those provisions are invalid and unenforceable. Thus, in this case, Cheek paid his taxes for years, but after attending various seminars and based on his own study, he concluded that the income tax laws could not constitutionally require him to pay a tax.
The Court continued:
- We do not believe that Congress contemplated that such a taxpayer, without risking criminal prosecution, could ignore the duties imposed upon him by the Internal Revenue Code and refuse to utilize the mechanisms provided by Congress to present his claims of invalidity to the courts and to abide by their decisions. There is no doubt that Cheek, from year to year, was free to pay the tax that the law purported to require, file for a refund and, if denied, present his claims of invalidity, constitutional or otherwise, to the courts. See 26 U.S.C. 7422. Also, without paying the tax, he could have challenged claims of tax deficiencies in the Tax Court, 6213, with the right to appeal to a higher court if unsuccessful. 7482(a)(1). Cheek took neither course in some years, and, when he did, was unwilling to accept the outcome. As we see it, he is in no position to claim that his good-faith belief about the validity of the Internal Revenue Code negates willfulness or provides a defense to criminal prosecution under 7201 and 7203. Of course, Cheek was free in this very case to present his claims of invalidity and have them adjudicated, but, like defendants in criminal cases in other contexts who "willfully" refuse to comply with the duties placed upon them by the law, he must take the risk of being wrong.
Cheek, 498 U.S. at 205-206 (footnote omitted; emphasis added).
The Court ruled that such beliefs -- even if held in good faith -- are not a defense to a charge of willfulness. By pointing out that arguments about constitutionality of Federal income tax laws "reveal full knowledge of the provisions at issue and a studied conclusion, however wrong, that those provisions are invalid and unenforceable," the Supreme Court may have been impliedly warning that asserting such "constitutional" arguments (in open court or otherwise) might actually help the prosecutor prove willfulness. See also Spies v. United States, 317 U.S. 492 (1943); Sansone v. United States, 380 U.S. 343 (1965); Cheek v. United States, 498 U.S. 192 (1991).
Tax shelters
Tax shelters are investments that allow a reduction in one's taxable income. The U.S. Internal Revenue Service (a bureau of the United States Department of the Treasury) and the United States Department of Justice have recently teamed up to crack down on "abusive" tax shelters. In 2003 the Senate's Permanent Subcommittee on Investigations held hearings about tax shelters which are entitled U.S. TAX SHELTER INDUSTRY: THE ROLE OF ACCOUNTANTS, LAWYERS, AND FINANCIAL PROFESSIONALS. Many of these tax shelters were designed and provided by accountants at the large American accounting firms.
Examples of US tax shelters include: Foreign Leveraged Investment Program (FLIP) and Offshore Portfolio Investment Strategy (OPIS). Both were devised by partners at the accounting firm, KPMG. These tax shelters were also known as "basis shifts" or "defective redemptions."
Local terminology
In the Republic of Ireland, specifically Dublin, a nixer is a job, outside a normal job, for "cash-in-hand" - no tax paid. In Cork it is known as a foxer and in parts of the north of the Republic its known as a foreigner. It originates from the German word Nichts, none as in no taxes.
In the United States and Canada, working for cash and paying no income taxes or workman's compensation is called "under the table" compensation. Elsewhere, for example in the UK, an "under the table" payment is more usually a bribe.
Quotes
In the words of Lord Tomlin, in the UK House of Lords case, IRC v. Duke of Westminster (1936) 19 TC 490, [1936] AC 1:
- Every man is entitled if he can to order his affairs so as that the tax attaching under the appropriate Acts is less than it otherwise would be. If he succeeds in ordering them so as to secure this result, then, however unappreciative the Commissioners of Inland Revenue or his fellow taxpayers may be of his ingenuity, he cannot be compelled to pay an increased tax.
And Lord Clyde said, in Ayrshire Pullman Motor Services and Ritchie v. IRC (1929) 14 TC 754:
- No man in this country is under the smallest obligation, moral or other, so to arrange his legal relations to his business or to his property as to enable the Inland Revenue to put the largest possible shovel into his stores.
- “We agree with the Board and the taxpayer that a transaction, otherwise within an exception of the tax law, does not lose its immunity, because it is actuated by a desire to avoid, or, if one choose, to evade, taxation. Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one's taxes." - Helvering v. Gregory, 69 F.2d 809, 13 A.F.T.R. 806 (2d Cir. 1934),
Contrast more recent judicial comments. Lord Templeman said in IRC v. Fitzwilliam (1993) 67 TC at 756 (UK):
- In common with my predecessors I regard tax avoidance schemes of the kind invented and implemented in the present case as no better than attempts to cheat the Revenue.
Politicians and Revenue administrators will generally express disapproval of avoidance. According to Denis Healey, former UK Chancellor of the Exchequer:
- The difference between tax avoidance and tax evasion is the thickness of a prison wall.
This is often quoted but the meaning is not entirely clear. Perhaps it just means that avoidance is legal and evasion is illegal. If so, it is trite albeit neatly expressed. Probably it is intended to suggest that there is no moral difference, see above on morality.
See also
- Bottom of the harbour tax avoidance (Australia)
- Civil disobedience
- Tax resistance
- Tax haven
- Tax incidence
- Underground economy
External links
References
Taxation of Foreign Domiciliaries (James Kessler QC, 5th edition, 2005, Key Haven Publications) chapter 16 discusses tax avoidance in context of UK anti avoidance provisions.de:Steuerhinterziehung es:Evasión de impuestos he:תכנון מס ko:탈세 lt:Mokesčių optimizavimas ja:脱税 pl:Szara strefa