Taxation: Issues of Tax Avoidance versus Tax Evasion
Call the Attorney at +92 21 34327747
Tax avoidance versus tax evasion has always been a hotly debated subject. The difference between tax avoidance and tax evasion is very narrow. Nowadays tax laws are being drafted in a manner to diminish the possibilities of tax avoidance though, yet tax planning offers many avenues to reduce tax liability. From this perspective, the study to differentiate between tax evasion and tax avoidance is interesting and noteworthy.
I begin this study by picking up an example from a decision of the US Supreme Court.1 According to the facts of the case; Gregory was the owner of M/s United Mortgage Corporation. On Sep 18, 1928 Gregory transferred 1000 shares of the Monitor Securities to the Averil Corporation.2 Averil
_____________________________________________________________
1. Gregory v. Helvering 293 US 465 (1935)
2. § 112(g) of US Revenue Act, 1928.
Corporation was dissolved on September 24, 1928 and its assets were distributed through liquidation. Thereafter Gregory sold 1000 shares of the Monitor Securities and thus avoided payment of tax due on those shares. The action of Gregory lead to litigation and gave rise to the following issues.
i. Whether or not the transactions made by Gregory conformed to the requirements of law?3
ii. Whether or not the ‘reorganization’ was permissible in revenue laws?
iii. Whether or not the act of tax avoidance did create mens rea?
iv. Whether or not the tax payer was avoiding the tax indeed?
The Supreme Court came to the conclusion that Gregory’s action of sale and transfer of assets neither had any business purpose nor a corporate objective. The device used by him on the name of corporate reorganization was a sham transaction and it defeated the real purpose of the statute. In court’s view, the purpose of sham transaction was to obtain preconceived gains, and there was no real intent to restructure the business or any of its part except to transfer shares to Gregory; the same was meant for a subsequent sale to defeat the purpose of law.4 The action of Gregory was in line with legal provisions though, yet it was a plan to abuse the process of law and to defeat its purposes, and there existed a clear intent to do so, hence the whole action to avoid tax became illegal. The court accordingly came to
__________________________________________________________
3. Id. n2.
4. The court was of the view that creation of Intermediary Corporation was meant to defeat the purpose of law.
The conclusion that any act or operation intentionally done to avoid the statute or to abuse the process of law would be out of the scope of law and illegal. The court applied the rule of substance over form on the principle that an even handed administration and enforcement of tax regulations is the true requirement of the statute.
In another case, however, Massachusetts Appellate Tax Board5 took a divergent view and ruled that the gains realized from the sale of the stock was the income of a Delaware corporation (which was doing no business in Massachusetts) and hence no tax was due from the said Delaware Corporation. The Board came to the conclusion that at the time of taxpayer's assignment of shares to its Delaware Corporation, the transaction was sufficiently uncertain to prevent the application of the substance-over-form rule.6
The Board's decision was challenged through an appeal by the tax commissioner. The Court of Appeal upheld the Board’s fact finding though,7 yet the Court of Appeals disregarded the form of the taxpayer's transaction and found his income taxable in Massachusetts.
The Supreme Judicial Court reversed the said decision of the Court of Appeal, and it reinstated the Board's decision.8 It may however, be noted, the case is fact-intensive and remains limited to its own facts.9
_____________________________________________________________
5. William I. Koch v. Commissioner of Revenue (TIR 94-7)
6. The Board found (as a "fact") that the taxpayer had a valid business reason for transferring the stock to the Delaware Corporation.
7. The court of appeal applied a strict standard to reject Board’s fact findings.
8. The Supreme Judicial Court concluded, given the deference due to the Board's fact-finding, the evidence before the Board was adequate to support its decision.
9. The Supreme Judicial Court did not repudiate substance-over-form analysis in Koch case.
The debate in respect of tax avoidance or tax evasion gives rise to two important principles: (i) tax avoidance or evasion occurs across the tax spectrum and is not peculiar to any tax type such as import taxes, stamp duties, VAT, PAYE and income tax etc; (ii) legislation that addresses avoidance or evasion must necessarily be imprecise. No prescriptive set of rules exist for determining when a particular arrangement amounts to tax avoidance or evasion.10
In a Tax Mitigation where taxpayer is entitled to mitigate or avoid it by Planning, the act is very much within the ambit of law.11 A description of tax mitigation was given by Tax Court of Newzeland12 and it was held by the court that where income tax stood mitigated by a taxpayer by reducing his income or incurring expenditure in explainable circumstances, there was no offence or illegality.
A better way of approaching tax avoidance is to regard it as an arrangement, unlike mitigation, which yields results that Parliament did not intend. For example arrangements in the form of tax planning nullify the legal impact to the extent that it provides a purpose or a base for tax avoidance, except that the said purpose or effect is merely incidental. And where an arrangement is void, the tax authorities are empowered to adjust the assessable income of any person affected by it in order to counteract the obtained tax advantage.13
Tax Evasion, mitigation and avoidance are concepts concerned with the issue namely, whether or not a tax liability has arisen. With evasion, the
_____________________________________________________________
10. This lack of precision creates uncertainty and adds to compliance costs.
11. Where taxpayers are entitled to mitigate their liability to tax and will not be vulnerable to the general anti-avoidance rules in a statute.
12. See CIR v Challenge Corporation Ltd (1986) 8 NZTC 5,001 at 5,006 V20 (2002) 20 NZTC 10,233 at pp 37 and 39.
13. Challenge Corporation v CIR [1986] 2 NZLR 513, 549 (CA).
starting point is always that a liability has arisen. The question is whether that liability has been illegitimately or even criminally been left unsatisfied. In CIR case,14 it was observed by the court: “Evasion occurs when the Commissioner is not informed of all the facts relevant to an assessment of tax”. An innocent evasion may lead to a re-assessment but fraudulent evasion may lead to criminal prosecution as well as re-assessment.
Over the years it has been witnessed that many did indulge in numerous examples of tax arbitrage using different legislative elements. Examples are financing, leasing, non-recourse lending, tax-havens,15 and rates 'investments' in redeemable preference shares. On the other hand low-tax policy was pursued by many countries in the hope of attracting international businesses and capital.16
Variations in tax rates among different countries are good, because they give taxpayers more choice and thus more chance of being satisfied. This also puts pressure on governments to be efficient. There is at least one big caveat to this theory that taxpayers are highly mobile and able to move to wherever their preferred combination of taxes and benefits is on offer.
It is important to make sure that we understand the nuances of good tax planning. Whilst it is understood that tax planning is becoming more difficult and there is only a thin line between what is right and wrong. It lays down heavy responsibility on the tax experts to remain within the framework of law.
_____________________________________________________________
14. Id.
15. A country or designated zone that has low or no taxes, or highly secretive banks and often a warm climate and sandy beaches, which makes it attractive to foreigners bent on tax avoidance and evasion.
16. These policy options are known as tax competition and it can provide a rich ground for arbitrage. See also Economists who favor tax competition and often cite a 1956 article by Charles Tiebout (1924-68) entitled "A Pure Theory of Local Expenditures". The author argued that faced with a choice of different combinations of tax and government services, taxpayers will choose to locate where they get closest to the mixture they want.
AUTHOR: zafar iqbal
Copyright Azimuddin Law Associates
More information about Azimuddin Law Associates
Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer. For specific technical or legal advice on the information provided and related topics, please contact the author.
_____________________________________________________________
1. Gregory v. Helvering 293 US 465 (1935)
2. § 112(g) of US Revenue Act, 1928.
Corporation was dissolved on September 24, 1928 and its assets were distributed through liquidation. Thereafter Gregory sold 1000 shares of the Monitor Securities and thus avoided payment of tax due on those shares. The action of Gregory lead to litigation and gave rise to the following issues.
i. Whether or not the transactions made by Gregory conformed to the requirements of law?3
ii. Whether or not the ‘reorganization’ was permissible in revenue laws?
iii. Whether or not the act of tax avoidance did create mens rea?
iv. Whether or not the tax payer was avoiding the tax indeed?
The Supreme Court came to the conclusion that Gregory’s action of sale and transfer of assets neither had any business purpose nor a corporate objective. The device used by him on the name of corporate reorganization was a sham transaction and it defeated the real purpose of the statute. In court’s view, the purpose of sham transaction was to obtain preconceived gains, and there was no real intent to restructure the business or any of its part except to transfer shares to Gregory; the same was meant for a subsequent sale to defeat the purpose of law.4 The action of Gregory was in line with legal provisions though, yet it was a plan to abuse the process of law and to defeat its purposes, and there existed a clear intent to do so, hence the whole action to avoid tax became illegal. The court accordingly came to
__________________________________________________________
3. Id. n2.
4. The court was of the view that creation of Intermediary Corporation was meant to defeat the purpose of law.
The conclusion that any act or operation intentionally done to avoid the statute or to abuse the process of law would be out of the scope of law and illegal. The court applied the rule of substance over form on the principle that an even handed administration and enforcement of tax regulations is the true requirement of the statute.
In another case, however, Massachusetts Appellate Tax Board5 took a divergent view and ruled that the gains realized from the sale of the stock was the income of a Delaware corporation (which was doing no business in Massachusetts) and hence no tax was due from the said Delaware Corporation. The Board came to the conclusion that at the time of taxpayer's assignment of shares to its Delaware Corporation, the transaction was sufficiently uncertain to prevent the application of the substance-over-form rule.6
The Board's decision was challenged through an appeal by the tax commissioner. The Court of Appeal upheld the Board’s fact finding though,7 yet the Court of Appeals disregarded the form of the taxpayer's transaction and found his income taxable in Massachusetts.
The Supreme Judicial Court reversed the said decision of the Court of Appeal, and it reinstated the Board's decision.8 It may however, be noted, the case is fact-intensive and remains limited to its own facts.9
_____________________________________________________________
5. William I. Koch v. Commissioner of Revenue (TIR 94-7)
6. The Board found (as a "fact") that the taxpayer had a valid business reason for transferring the stock to the Delaware Corporation.
7. The court of appeal applied a strict standard to reject Board’s fact findings.
8. The Supreme Judicial Court concluded, given the deference due to the Board's fact-finding, the evidence before the Board was adequate to support its decision.
9. The Supreme Judicial Court did not repudiate substance-over-form analysis in Koch case.
The debate in respect of tax avoidance or tax evasion gives rise to two important principles: (i) tax avoidance or evasion occurs across the tax spectrum and is not peculiar to any tax type such as import taxes, stamp duties, VAT, PAYE and income tax etc; (ii) legislation that addresses avoidance or evasion must necessarily be imprecise. No prescriptive set of rules exist for determining when a particular arrangement amounts to tax avoidance or evasion.10
In a Tax Mitigation where taxpayer is entitled to mitigate or avoid it by Planning, the act is very much within the ambit of law.11 A description of tax mitigation was given by Tax Court of Newzeland12 and it was held by the court that where income tax stood mitigated by a taxpayer by reducing his income or incurring expenditure in explainable circumstances, there was no offence or illegality.
A better way of approaching tax avoidance is to regard it as an arrangement, unlike mitigation, which yields results that Parliament did not intend. For example arrangements in the form of tax planning nullify the legal impact to the extent that it provides a purpose or a base for tax avoidance, except that the said purpose or effect is merely incidental. And where an arrangement is void, the tax authorities are empowered to adjust the assessable income of any person affected by it in order to counteract the obtained tax advantage.13
Tax Evasion, mitigation and avoidance are concepts concerned with the issue namely, whether or not a tax liability has arisen. With evasion, the
_____________________________________________________________
10. This lack of precision creates uncertainty and adds to compliance costs.
11. Where taxpayers are entitled to mitigate their liability to tax and will not be vulnerable to the general anti-avoidance rules in a statute.
12. See CIR v Challenge Corporation Ltd (1986) 8 NZTC 5,001 at 5,006 V20 (2002) 20 NZTC 10,233 at pp 37 and 39.
13. Challenge Corporation v CIR [1986] 2 NZLR 513, 549 (CA).
starting point is always that a liability has arisen. The question is whether that liability has been illegitimately or even criminally been left unsatisfied. In CIR case,14 it was observed by the court: “Evasion occurs when the Commissioner is not informed of all the facts relevant to an assessment of tax”. An innocent evasion may lead to a re-assessment but fraudulent evasion may lead to criminal prosecution as well as re-assessment.
Over the years it has been witnessed that many did indulge in numerous examples of tax arbitrage using different legislative elements. Examples are financing, leasing, non-recourse lending, tax-havens,15 and rates 'investments' in redeemable preference shares. On the other hand low-tax policy was pursued by many countries in the hope of attracting international businesses and capital.16
Variations in tax rates among different countries are good, because they give taxpayers more choice and thus more chance of being satisfied. This also puts pressure on governments to be efficient. There is at least one big caveat to this theory that taxpayers are highly mobile and able to move to wherever their preferred combination of taxes and benefits is on offer.
It is important to make sure that we understand the nuances of good tax planning. Whilst it is understood that tax planning is becoming more difficult and there is only a thin line between what is right and wrong. It lays down heavy responsibility on the tax experts to remain within the framework of law.
_____________________________________________________________
14. Id.
15. A country or designated zone that has low or no taxes, or highly secretive banks and often a warm climate and sandy beaches, which makes it attractive to foreigners bent on tax avoidance and evasion.
16. These policy options are known as tax competition and it can provide a rich ground for arbitrage. See also Economists who favor tax competition and often cite a 1956 article by Charles Tiebout (1924-68) entitled "A Pure Theory of Local Expenditures". The author argued that faced with a choice of different combinations of tax and government services, taxpayers will choose to locate where they get closest to the mixture they want.
AUTHOR: zafar iqbal
Copyright Azimuddin Law Associates
More information about Azimuddin Law Associates
View all articles published by Azimuddin Law Associates
Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer. For specific technical or legal advice on the information provided and related topics, please contact the author.
