Define: Tax Avoidance And Tax Evasion

Quick Summary of Tax Avoidance And Tax Evasion

Tax avoidance and tax evasion are both strategies employed to minimise tax liability, but they differ in legality and intent.

Tax avoidance involves using legal means to minimize tax liability by taking advantage of tax incentives, deductions, and loopholes provided by the tax laws. It involves strategic financial planning to structure transactions and assets in a way that reduces taxable income or maximizes tax benefits. While aggressive tax avoidance may push the boundaries of what is acceptable, it remains within the confines of the law.

On the other hand, tax evasion is the illegal act of intentionally misrepresenting or concealing income, assets, or transactions to evade paying taxes owed. It involves deliberate actions to deceive tax authorities, such as underreporting income, overstating deductions, or hiding assets offshore. Tax evasion is considered a criminal offence and can result in severe penalties, including fines, interest, and imprisonment.

In summary, tax avoidance is a legal practice that involves minimising tax liability through legitimate means, while tax evasion involves illegal actions to evade paying taxes owed.

Tax avoidance is the legal utilisation 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 to not pay taxes by illegal means. The term tax mitigation is a synonym for tax avoidance. Its original use was by tax advisors as an alternative to the pejorative term of tax avoidance. Lately, the term has also been used in the tax regulations of some jurisdictions to distinguish tax avoidance foreseen by lawmakers from tax avoidance, which exploits loopholes in the law.

Some of those attempting not to pay tax believe that they have uncovered interpretations of the law that show that they are not subject to being taxed; these individuals and groups are sometimes called tax protesters. An unsuccessful tax protestor has been attempting openly to evade tax, while a successful one avoids tax. Tax resistance is the declared refusal to pay a tax for conscientious reasons (because the resister does not want to support the government or some of its activities). Tax resistors 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 particular government policies that they oppose.

Tax Avoidance

Tax avoidance is the legal utilisation 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. The United States Supreme court has stated that “The legal right of an individual to decrease the amount of what would otherwise be his taxes or altogether avoid them, by means which the law permits, cannot be doubted.” See Gregory v. Helvering. Examples of tax avoidance include:

Country Of Residence

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 traveller; however, some countries, such as the U.S., tax their citizens, permanent residents, and companies on all their worldwide income. In these circumstances, moving abroad or simply transferring assets won’t help you avoid paying taxes.

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 United States. 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.

Double Taxation

Most countries impose taxes on income earned or gains realised 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 non-residents 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.

Legal Entities

Without changing country of residence (or, if a U.S. citizen, giving up one’s citizenship), personal taxation may be legally avoided by creating 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 realised, 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, or foundation may also be able to avoid corporate taxation if it is incorporated in an offshore jurisdiction (see offshore company, offshore trust, or private foundation). Although income tax would still be due on any salary or dividend drawn from the legal entity,. In order for a settlor (creator of a trust) 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.

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).

Statistics

The tax gap refers to the difference between the amount of tax that is legally due and the amount that a government actually collects.

In the United States, the IRS estimated in 2007 that Americans owed $345 billion more than they paid, or about 14% of federal revenues for FY2007.

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), but they often do not do so because doing so could serve as an admission of guilt. Suspected lawbreakers, most famously Al Capone, have therefore been charged with tax evasion when there is insufficient evidence to try them for their non-tax-related crimes. Other times, tax evasion can be used as “one more nail in the coffin” by prosecutors by stating that if a person earns illegal income, s/he may also be guilty of tax evasion. Those who attempt to report illegal income as coming from a legitimate source could be charged with money laundering. By contrast, in the UK, law enforcement agencies do not generally have access to tax returns, so illegal earnings can supposedly be safely declared, but in practice, those carrying on criminal activities generally prefer not to do so, and so they can sometimes be prosecuted for tax evasion rather than for other crimes. Soviet spy Aldrich Ames, who had earned more than $2 million cash for his espionage, was also charged with tax evasion as none of the Soviet money was reported on his tax returns. Ames attempted to have the tax evasion charge dismissed on the grounds his espionage profits were illegal, but the charges stood.

Economics Of Tax Evasion

In 1968, Nobel laureate economist Gary Becker first theorised the economics of crime. Based on that, Allingham and Sandmo produced in 1972 an economic model of tax evasion. He considered evasion of income tax, which is the main source of tax revenue in developed countries. According to them, the level of evasion of income tax depends on the level of punishment as provided in law.

Evasion Of Customs Duty

Customs duties are an important source of revenue in developing countries. The importers purport to evade customs duty by (a) under-invoicing and (b) misdeclaration of quantity and product-description. When there is ad valorem import duty, the tax base is reduced through under-invoicing. A misdeclaration of quantity is more relevant for products with a specific duty. The production description is changed to match an H.S.S. Code commensurate with a lower rate of duty.

Smuggling

Smuggling is the importation or exportation of foreign products through an unauthorised route. Smuggling is resorted to for total evasion of leviable customs duties as well as for the importation of contraband items. A smuggler does not have to pay any customs duty since the products are not routed through an authorised or notified customs port and, therefore, are not subject to declaration and payment of duties and taxes.

Evasion Of Value Added Tax (VAT)

During the latter half of the twentieth century, Value Added Tax (VAT) has emerged as a modern form of consumption tax through the world. Producers who collect VAT from consumers may evade tax by underreporting the amount of sales.

Control Of Evasion

The level of evasion depends on a number of factors, one of which is the fiscal equation. People’s tendency to evade income tax declines when the return for due payment of taxes is not obvious. Evasion also depends on the efficiency of the tax administration. Corruption by tax officials often renders control of evasion difficult. Tax administrations resort to various means for plugging in the scope of evasion and increasing the level of enforcement. These include, among others, the privatisation of tax enforcement, tax farming, and the institution of pre-shipment inspection (PSI) agencies.

Corruption By Tax Officials

Corrupt tax officials cooperate with taxpayers who intend to evade taxes. When they detect an instance of evasion, they refrain from reporting in return for illegal gratification or bribe. Corruption by tax officials is a serious problem for the tax administration in a huge number of underdeveloped countries.

Role Of Middleman

It is often alleged that tax lawyers and chartered accountants help taxpayers, including firms and companies, evade taxes. In the same vein, the Clearing and Forwarding agents help in evasion of Customs duties. It has been suggested that removal of human interface is a reliable solution to this problem.

Level Of Evasion And Punishment

Tax evasion is a crime in almost all countries and subjects the guilty party to fines and/or imprisonment. In China, the punishment can be as severe as the death penalty. 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. It is often considered that the extent of evasion depends on the severity of the punishment for evasion. Normally, the higher the degree of punishment, the higher the level of evaded amount.

Privatisation Of Tax Enforcement

Professor Christopher Hood first suggested the privatisation of tax enforcement to overcome limitations of government tax administration in controlling tax evasion. Some governments have resorted to privatising tax enforcement in order to enhance efficiency of the tax system. The assumption is that revenue leakage will be lower under a privatised regime. In Bangladesh, part of Customs administration was privatised as early as 1991.

Tax Farming

Tax farming is an old means of collecting revenue when it is difficult to determine the leviable amount of taxes with certainty. government leases out the collection system to a private entity for a fixed amount, which then collects the revenue and shoulders the risk of attempts at evasion by the tax-payers. It has been suggested that tax farming may be a solution to the problem of tax evasion seen in developing countries.

PSI Agencies

Pre-shipment Agencies like SGS, Cotecna, etc. are employed to prevent evasion of customs duty through under-invoicing and misdeclaration. However, in recent times, allegations have been lodged that PSI agencies have actively cooperated with the importers in evading customs duties. authority in Bangladesh has found Cotecna, a PSI agency of Swiss origin, guilty of complicity with the importers for evasion of customs duties on a huge scale. The same company, Cotecna, was implicated for bribing Pakistan’s prime minister, Benazir Bhutto, to secure contract for importation by Pakistani importers. She and her husband were sentenced both in Pakistan and Switzerland.

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.

The Distinction In The United States

In the United States, “tax evasion” is evading the assessment or payment of a tax that was 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 above-board.

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:

• 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 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). 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 that 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 dates back only to the 1970s. The concept originated from economists, not lawyers. The use of the term avoidance/mitigation to express this distinction was an innovation in 1986 (IRC v. Challenge).

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; and tax-linked fees. Important indicators are familiarity and use. Within a few years of a tax avoidance arrangement becoming widespread, legislation almost always prohibits it. 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 that have been carried on for a long time are unlikely to constitute tax avoidance. Judges have a strong intuitive sense that what everyone does and has long done should not be stigmatised with the pejorative term “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 to 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 the 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 in 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, where the House of Lords held that Parliament had “missed fire”.

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

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 and 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 generalisation, 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.

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 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.

Tax Protesters 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 are posing the same arguments that the Federal 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, 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, with 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

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 wilfully 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), 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 wilfulness — 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. 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 offence. 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.

Application To Tax Protesters

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 defence to criminal prosecution.” Under the Cheek Doctrine (Cheek v. United States), 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 defence to a charge of “wilfulness” (“wilfulness” 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.” 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 wilfulness, placing 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 belief that the Sixteenth Amendment was not properly ratified and the 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 utilise 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 wilfulness or provides a defence 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 “wilfully” refuse to comply with the duties placed upon them by the law, he must take the risk of being wrong.

The Court ruled that such beliefs—even if held in good faith—are not a defence to a charge of wilfulness. The Supreme Court may have been hinting that making “constitutional” arguments about 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.” They said this because making such “constitutional” arguments (in public or otherwise) could help the prosecutor prove wilfulness. Daniel B. Evans, a tax lawyer who has written about tax protester arguments, has stated that:

If you plan ahead to use it [the Cheek defence], then it is almost certain to fail because your efforts to establish your “good faith belief” are going to be used by the government as evidence that you knew that what you were doing was wrong when you did it, which is why you worked to set up a defence in advance. Planning not to file tax returns and avoid prosecution using a “good faith belief” is kind of like planning to kill someone using a claim of “self-defence.” If you’ve planned in advance, then it shouldn’t work.

Failing To File Returns In The United States

According to some estimates, about three per cent of taxpayers do not file tax returns at all. In the case of U.S. federal income taxes, civil penalties for wilful failure to timely file returns and wilful failure to timely pay taxes are based on the amount of tax due; thus, if no tax is owed, no penalties are due. The civil penalty for wilful failure to timely file a return is generally equal to 5.0% of the amount of tax “required to be shown on the return per month, up to a maximum of 25%. By contrast, the civil penalty for wilful failure to timely pay the tax actually “shown on the return” is generally equal to 0.5% of such tax due per month, up to a maximum of 25%. The two penalties are computed together in a relatively complex algorithm, and computing the actual penalties due is somewhat challenging.

In cases where a taxpayer does not have enough money to pay the entire tax bill, the IRS can work out a payment plan with taxpayers.

For years for which no return has been filed, there is no statute of limitations on civil actions—that is, on how long the IRS can seek taxpayers and demand payment of taxes owed.

For each year a taxpayer wilfully fails to timely file an income tax return, the taxpayer can be sentenced to one year in prison. In general, there is a six-year statute of limitations for with respect to Federal tax crimes.

Tax Shelters

Tax shelters are investments that allow, or purport to allow, a reduction in one’s income tax liability. Although things such as homeownership, pension plans, and Individual Retirement Accounts (IRAs) can be broadly considered “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 term “tax shelter” was originally used to describe primarily certain investments made in the form of limited partnerships, some of which were deemed by the U.S. Internal Revenue Service to be abusive.

The Internal Revenue Service 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 on tax shelters, titled “US TAX SHELTER INDUSTRY: THE ROLE OF ACCOUNTANTS, LAWYERS, AND FINANCIAL PROFESSIONALS.” Many of these tax shelters were designed and provided by accountants at large American accounting firms.

Examples of U.S. tax shelters include the Foreign Leveraged Investment Programme (FLIP) and Offshore Portfolio Investment Strategy (OPIS). Partners at the accounting firm KPMG were responsible for both. These tax shelters were also known as “basis shifts” or “defective redemptions.

Prior to 1987, passive investors in certain limited partnerships (such as oil exploration or real estate investment ventures) were allowed to use the passive losses (if any) of the partnership (i.e., losses generated by partnership operations in which the investor took no material active part) to offset the investors’ income, lowering the amount of income tax that otherwise would be owed by the investor. These partnerships could be structured so that an investor in a high tax bracket could obtain a net economic benefit from partnership-generated passive losses.

In the Tax Reform Act of 1986, the U.S. Congress introduced a limitation (under 26 U.S.C. § 469) on the deduction of passive losses and the use of passive activity tax credits. The 1986 Act also changed the “at-risk” loss rules of 26 U.S.C. § 465. Coupled with the hobby loss rules (26 U.S.C. § 183), the changes greatly reduced tax avoidance by taxpayers engaged in activities only to generate deductible losses.

Disclaimer

This site contains general legal information but does not constitute professional legal advice for your particular situation. Persuing this glossary does not create an attorney-client or legal adviser relationship. If you have specific questions, please consult a qualified attorney licensed in your jurisdiction.

This glossary post was last updated: 9th April, 2024.