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.

Contents 1 Tax avoidance 2 Tax evasion 2.1 Illegal income and tax evasion 3 The distinction in various jurisdictions 3.1 The distinction in the United States 3.2 The distinction in the United Kingdom 3.2.1 History of the distinction 4 Public opinion on tax avoidance 5 Responses to tax avoidance 6 Tax protestors and tax resistance 6.1 Definition of tax evasion in the United States 6.2 Application to tax protestors 7 Tax shelters 8 Quotes 9 See also 10 Notes 11 References 12 External links

[edit] 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 setting up a charitable trust or foundation. Alternatively, individuals may choose to establish an offshore company, trust or foundation in a tax haven. Depending on citizenship, it may be possible to reduce personal tax liability by moving to a low tax jurisdiction, such as Monaco or Switzerland for six months or over, or by becoming a perpetual traveler.

[edit] 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 declaring less income, profits or gains than actually earned; 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 fraudulent tax conduct is criminal, for example, 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.

[edit] Illegal income and tax evasion

In the United States, persons subject to the Internal Revenue Code who earn income by illegal means (gambling, theft, drug trafficking etc.) are required to report unlawful gains as income when filing annual tax returns (see e.g., James v. United States^[1]), but they often do not do so, because doing so could serve as an admission of guilt. Suspected lawbreakers, most famously Al Capone, have been charged with tax evasion when there is insufficient evidence to try them for their non-tax related crimes. By contrast: In the UK law enforcement agencies do not generally have access to tax returns and so illegal earnings can supposedly be safely declared but in practice those carrying on criminal activities generally prefer not to do so, and so can sometimes be prosecuted for tax evasion rather than for other crimes.

[edit] The distinction in various jurisdictions

The use of the terms tax avoidance and tax evasion can vary depending on the jurisdiction. In general, the term "evasion" applies to illegal actions and "avoidance" to actions within the law. The term "mitigation" is also used in some jurisdictions to further distinguish actions within the original purpose of the relevant provision from those actions that are within the letter of the law, but do not achieve its purpose.

[edit] The distinction in the United States

In the United States "tax evasion" is evading the assessment or payment of a tax that is already legally owed at the time of the criminal conduct.^[2] Tax evasion is criminal, and has no effect on the amount of tax actually owed, although it may give rise to substantial monetary penalties.

By contrast, the term "tax avoidance" describes lawful conduct, the purpose of which is to avoid the creation of a tax liability in the first place. Whereas an evaded tax remains a tax legally owed, an avoided tax is a tax liability that has never existed.

For example, consider two businesses, each of which have a particular asset that is worth far more than its purchase price. In the first case, the business sells the property and underreports its gain. The second consults with a tax advisor and discovers that it can structure the sale as a 1031 exchange for other property that it can use. In the first instance, tax is legally due, and the conduct is criminal. In the second instance no tax is due, because legally no sale took place, and the conduct is both lawful and aboveboard.

In the above example, tax may eventually be due when the second property is sold. Whether and how much tax will be due will depend on circumstances and the state of the law at the time. This is true of many tax avoidance strategies.

[edit] The distinction in the United Kingdom

The United Kingdom and jurisdictions following the UK approach (such as New Zealand) have recently adopted the evasion/avoidance terminology as used in the United States: evasion is a criminal attempt to avoid paying tax owed while avoidance is an attempt to use the law to reduce taxes owed. There is, however, a further distinction 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.^[3] 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.^[4] The use of the terminology avoidance/mitigation to express this distinction was an innovation in 1986: IRC v Challenge.^[5]

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. Important indicia are 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 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 expressed as finding “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 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^[6], where the House of Lords held that Parliament had “missed fire”.

[edit] History of the distinction

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.^[7] In 1900 the distinction was noted as two meanings of the word “evade”: Bullivant v AG.^[8] The technical use of the words avoidance/evasion in the modern sense originated in the USA where it was well established by the 1920s.^[9] It can be traced to Oliver Wendell Holmes in Bullen v Wisconsin.^[10] 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^[11]) 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.

[edit] Public opinion on tax avoidance

Tax avoidance may be considered to be the 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 through 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 immoral. This may be because tax practitioners are more aware than others how complex and sometimes unbalanced tax laws can be in certain situations, and they see avoidance in that context.

[edit] Responses to tax avoidance

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 led 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 than previously required, a tactic which was applied in the UK in 2004.

Some countries such as the Canada, Australia and New Zealand have introduced a statutory General Anti-Avoidance Rule (GAAR). Canada also uses Foreign Accrual Property Income rules to obviate certain types of tax avoidance. 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 United States, the Internal Revenue Service distinguishes some schemes as "abusive" and therefore illegal.

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, and it has subsequently done so on a few occasions.

[edit] Tax protestors and tax resistance

Main articles: Tax protester, Tax protester arguments, 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^[12], 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."

[edit] Definition of tax evasion in the United States

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^[13]:

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
   1. the assessment of a tax or
   2. 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^[14]) 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.

[edit] Application to tax protestors

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^[15]), 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) would be a valid 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 assert, for example, that "wages are not income."^[16] However, merely asserting that one has such a good faith belief is not determinative in court; under the American legal system the trier of fact (the jury, or the trial judge in a non-jury trial) 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.^[17]

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.^[18]

[edit] 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."

Although things such as home ownership, pension plans and Roth IRA's could be thought of as "tax shelters", insofar as funds in them are not taxed provided that they are held within the IRA for the required amount of time, the original use of the term "tax shelter" was to describe investments known as limited partnerships.

Originally, it was possible for investors in limited partnerships such as oil exploration ventures or real estate investment ventures to use the losses of the partnership to offset their income, lowering the amount of income tax that was necessary to be paid. These things could be structured so that it was actually beneficial to those in a high tax bracket to setup a partnership which only lost money. However, Congress in 1986 introduced the limitation on tax deduction for business losses only to those taxpayers who were actually exposed to loss by closing the "so-called" passive activity loss loophole in Section 263. In the tax trade, they are called the at risk loss rules. Coupled with the hobby loss rules it greatly reduced the avoidance by taxpayers who engaged in non profit-making activity only to generate deductible losses.

[edit] Quotes

"Only the little people pay taxes," said Leona Helmsley, American property tycoon.

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.

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.

In the UK in the 1930s, this quote was put on the back of business cards of those marketing tax avoidance schemes, to the consternation of the Inland Revenue; see Philip Baker QC [1].

At that time, the same view was held among the judiciary in the USA:

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), aff'd, 293 U.S. 465 (1935).

Also in the US, the influential Judge Learned Hand once famously remarked judicially:

There is nothing sinister in so arranging one's affairs as to keep taxes as low as possible. Everybody does so, rich and poor; and all do right, for nobody owes any public duty to pay more than the law demands.

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. Denis Healey, former UK Chancellor of the Exchequer said:

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.

Regardless of the views of contemporary judges and administrators, taxpayers still tend to approve of tax avoidance. For instance, Kerry Packer, an Australian media tycoon said

Now of course I am minimising my tax ... and if anybody in this country doesn't minimise their tax, they want their heads read.
— "Australia's Richest Man Fights Tax Man And Overstates Tax Bill", Crikey, March 25, 2005.

And the subtleness of the distinction between evasion and avoidance was expressed by Will Rogers:

The income tax has made more liars out of the American people than golf has. Even when you make a tax form out on the level, you don't know when it's through if you are a crook or a martyr.

[edit] See also

• Bottom of the harbour tax avoidance (Australia)
• Civil disobedience
• "Margolis Schemes"
• Tax resistance
• Tax exile
• Tax haven
• Tax incidence
• Underground economy

[edit] Notes

[edit] 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.

[edit] External links

• Tax Justice Network - research into "the negative impacts of tax avoidance, tax competition and tax havens"