Saturday, September 1, 2007

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. By contrast tax evasion is the general term for efforts by individuals, firms, trusts, and other entities to evade taxes by illegal means. The term tax 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. 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. 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).

Tax avoidance
One way a person or company may lower their taxes due is by changing one's tax residence to a tax haven, such as Monaco or Switzerland, or by becoming a perpetual traveler; however, some countries, such as the U.S., tax their citizens, permanent residents, and companies on all their worldwide income. In these cases, taxation cannot be avoided by simply transferring assets or moving abroad.
The United States is unlike almost all other countries in that its citizens, and legal permanent residents, are subject to U.S. tax on their worldwide income even if they reside temporarily or permanently outside the USA. U.S. citizens therefore cannot avoid U.S. taxes simply by emigrating. According to Forbes magazine some nationals choose to give up their United States citizenship rather than be subject to the U.S. tax system; however, U.S. citizens who reside (or spend long periods of time) outside the U.S. may be able to exclude some salaried income earned overseas (but not other types of income) from U.S. tax. The 1995 limit on the amount that can be excluded was US$80,000.

Country of residence
Most countries impose taxes on income earned or gains realized within that country regardless of the country of residence of the person or firm. Most countries have entered into bilateral double taxation treaties with many other countries to avoid taxing nonresidents twice -- once where the income is earned and again in the country of residence (and perhaps, for US citizens, taxed yet again in the country of citizenship) -- however, there are relatively few double-taxation treaties with countries regarded as tax havens. To avoid tax, it is usually not enough to simply move one's assets to a tax haven. One must also personally move to a tax haven (and, for U.S. nationals, renounce one's citizenship) to avoid tax.

Double taxation
Without changing country of residence (or, if a U.S. citizen, giving up one's citizenship), personal taxation may be legally deferred by creation of a separate legal entity to which one's property is donated. The separate legal entity is often a company, trust, or foundation. Assets are transferred to the new company or trust so that gains may be realized, or income earned, within this legal entity rather than earned by the original owner. Usually one is only personally taxed on property and earnings that one actually owns; thus, by donating assets to a separate legal entity, personal taxation can be avoided, although corporate taxes may still be applicable. If the legal entity is ever liquidated and the assets transferred back to an individual, then capital gains taxes would apply on all profits.
The company/trust/foundation may also be able to avoid corporate taxation if incorporated in a offshore jurisdiction (see offshore company, offshore trust or offshore foundation). As settlor (creator of the trust), in order to avoid tax, there may be restrictions on the type, purpose and beneficiaries of the trust. For example, the settlor of the trust may not be allowed to be a trustee or even a beneficiary and may thus lose control of the assets transferred and/or may be unable to benefit from them.

Legal entities
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 and/or imprisonment - in China the punishment is death.
In Switzerland, many acts that would amount to criminal tax evasion in other countries are treated as civil matters. 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.

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.

Illegal income and tax evasion
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.

The distinction in various jurisdictions
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. 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 (like kind 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.
Illustrations of the distinction between tax evasion and tax avoidance can be found in the movies:Tax avoidance and tax evasion
In The Shawshank Redemption, the main character shows the head prison guard how to avoid an inheritance tax by giving the inheritance to his wife, as a one-time tax free gift. The distinction in the United States
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. where the House of Lords held that Parliament had "missed fire".

The distinction in the 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.) 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.

History of the distinction
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.

Public opinion on 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 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.

Responses to tax avoidance

Main articles: Tax protester, Tax protester arguments, and Tax resistance Tax protesters and tax resistance
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:
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.) 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.

the "mens rea" or "mental" element of willfulness — the specific intent to violate an actually known legal duty;
the "attendant circumstance" of the existence of a tax deficiency — an unpaid tax liability; and
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
    the payment of a tax. Definition of tax evasion in the United States
    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."

    Application to tax protesters
    According to some estimates, about three percent of taxpayers do not file tax returns at all.

    Failing to file returns in the United States

    Main article: Tax shelter Tax shelters
    If the page can be expanded into an encyclopedic article, rather than a list of quotes, please do so and remove this message.
    "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 [2].
    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 sub nom. Gregory v. Helvering, 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. It also may be 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
    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.

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