Everyone has the right to try to avoid taxes. But when does completely legal tax avoidance become illegal tax evasion?
The answer is intuitive. Tax avoidance is doing everything possible within the law to reduce your tax bill. Tax evasion is taking measures to pay less tax than you are legally obliged to pay.
For instance, US Supreme Court Justice Louis Brandeis wrote:
"I live in Alexandria, Virginia. Near the Supreme Court chambers is a toll bridge across the Potomac. When in a rush, I pay the dollar toll and get home early. However, I usually cross the Potomac on a free bridge outside the downtown section of the city. This bridge was placed outside the downtown Washington, D.C. area to serve a useful social service: getting drivers to drive the extra mile to help alleviate congestion during rush hour. If I went over the toll bridge and through the barrier without paying the toll, I would be committing tax evasion. If, however, I drive the extra mile outside the city of Washington and take the free bridge I am using a legitimate, logical and suitable method of tax avoidance, and I am performing a useful social service by doing so. For my tax evasion, I should be punished. For my tax avoidance, I should be commended."
That tax avoidance serves a useful social purpose is obvious when considered from the standpoint of an individual or business. After all, taxes are merely another expense in the family budget or a cost of doing business. Your duty to your family dictates that you take whatever legal measures are available to reduce the taxes it pays. A company has a fiduciary duty to its shareholders to minimize its tax expenditures.
US federal appeals court Judge Learned Hand acknowledged this concept in a 1935 ruling:
“Anyone 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."
In a 1947 dissent Hand went on to state:
"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: taxes are enforced exactions, not voluntary contributions.”
Nor is there an obligation, at least historically, for you to take the most conservative approach in determining your tax obligations. Felix Frankfurter, another Supreme Court justice, wrote in 1947:
"As to the astuteness of taxpayers in ordering their affairs as to minimize taxes, we have said that, 'The very meaning of a line in the law is that you intentionally may go as close to it as you can if you do not pass it.”
Similar principles applied historically outside the US. In the House of Lords, at the time the highest court for the UK, Lord Tomlin wrote in a 1936 decision:
“Every man is entitled if he can to order his affairs so 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 Austria, the courts have concluded that exploitation of a tax loophole is not considered abuse. This is true even if an Austrian taxpayer uses the terms of a tax treaty to not only avoid double taxation but to avoid all tax on certain income.
Yet despite this ringing legal endorsement of tax avoidance throughout the world, there have been efforts in recent years to blur the difference between tax avoidance and tax evasion. Yesterday's legal tax avoidance has been converted into today's illegal tax evasion. As former British chancellor Denis Healey put it, “The difference between tax avoidance and tax evasion is the thickness of a prison wall.”
Efforts to conflate tax avoidance and tax evasion began in earnest in 1998, when the Organization for Economic Cooperation released a landmark study entitled Harmful Tax Competition: An Emerging Global Issue. The premise of this study was that tax competition between individual countries is inherently bad. It concluded that governments should take measures to crack down on individuals and companies using perfectly legal methods to reduce their tax obligations. In the OECD’s view, individuals and companies who do so are shirking their duty to society.
The OECD’s efforts to convert formerly legal tax avoidance strategies into tax evasion have been very successful. The most visible sign of this trend has been the ongoing vendetta against low-tax countries, which have been branded with the pejorative label of “tax havens.” These jurisdictions – often isolated islands with few natural resources – generally support themselves through tourism and import duties. Many of them don’t impose income taxes, because their legal systems aren’t sophisticated enough to ensure compliance.
That’s made little difference to their detractors. Low-tax jurisdictions have been compelled to enforce the tax laws of high-tax countries through information exchange agreements. Under the OECD’s newest initiative, the “common reporting standard” (CRS), they’ll be forced to collect data on non-resident investors and send it to tax authorities in high-tax nations.
This a dangerous burden to impose. Because of the sorry state of computer security in many of these tiny jurisdictions, the CRS is likely to lead to a global epidemic in identity theft and other criminality.
In high-tax countries, courts have attempted to make a distinction between "permissible" tax avoidance and "abusive" tax avoidance. For instance, in 2003, a federal appeals court disallowed a tax deduction taken by a company because there was no business purpose for the deduction other than reducing the company’s tax liability. The court declared that in order for a taxpayer to have a transaction upheld for tax avoidance purposes, it must be a transaction the taxpayer would have engaged in regardless of its tax benefits.
In other words, US courts can now invalidate everyday business decisions that take in mind, rationally, the impact of taxes. The decision, along with more recent rulings, opens the door to countless abusive situations.
Meanwhile, many countries (although not yet the US), have adopted the General Anti-Avoidance Rules (GAAR). These rules establish a legal doctrine that invalidates, for tax purposes, any arrangement you enter into for the purpose of obtaining a tax advantage. They exist because tax laws have become so complex that neither legislators nor tax administrators can anticipate every possible tax avoidance scenario.
Again, these rules impose a burden of uncertainty on taxpayers. Revenue authorities in countries with GAAR rules in effect have carte blanche to define any transaction they believe is "abusive" as being in violation.
Modern taxation is immensely complex. When even tax attorneys who have spent their entire careers studying tax laws disagree on their interpretation — an everyday occurrence — the average person has very little practical guidance as to what constitutes "acceptable" or "unacceptable" tax avoidance.
However, there is a standard that anyone can apply in making this distinction. That standard is common sense.
The element shared in nearly all tax avoidance schemes that are invalidated by the courts, either under a specific statute or under GAAR, is that they promise something too good to be true. A simple test you can use to determine if the IRS and the courts would challenge your tax avoidance efforts is to ask yourself: "If I were to read about this technique in the news, would I be skeptical, or not?"
For instance, if you live in the US or any other country that imposes an income tax, you can't eliminate your tax liability by engaging in a series of transactions that magically converts your income into debt. I regularly advise clients to avoid tax avoidance schemes that fail the common sense test or that otherwise promise benefits that appear "unreal."
In the absence of a definitive standard of "acceptable" tax avoidance, this may be the best advice short of expensive legal analysis — that in the end may well be disputed by revenue authorities or the courts.