Tax Evasion vs Tax Avoidance
I frequently have discussions on tax evasion vs tax avoidance. So many people think that any mention of using different jurisdictions, offshore accounts etc seems "suspicious".
There is tax avoidance or tax planning which is completely legal.
But tax evasion is illegal.
Within recent time however, there are cases where avoidance is declared as illegal. How does this work? Well taxation has been receiving much attention and this means that the debate has been an evolving one. It is impossible to discuss this area in Common Law jurisdictions without reference to case law. Impossible. Simply reviewing code sections is insufficient.
In the UK, we go back to 1936 where there was the famous Duke of Westminster’s case (1936) AC 1, where Lord Tomlin proclaimed:
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.
This principle, which lies at the heart of the tax evasion – tax avoidance impasse, can be called the Westminster principle. Fastforward to 2012, the Former Exchequer Secretary to the Treasury, David Gaulke MP, is quoted as saying that artificial structures that aggressively exploit reliefs contrary to parliament’s intended purpose through contrived, artificial schemes fall very clearly into the definition of avoidance. Aggressive tax avoidance is unacceptable. In a 2012 speech he went on to say -
§ Buying a house for personal use through a corporate entity to avoid SDLT is avoidance.
§ Channelling money backwards and forwards through complex networks for no commercial reason but to minimise tax is avoidance.
§ Paying loans in lieu of salaries through shell companies is avoidance.
§ And using artificial ‘losses’ deliberately accrued to claim back tax is avoidance.
So above I started off talking about Tax Evasion vs Tax Avoidance. Some luminaries have 3 categories instead of 2. Lord Templeman’s article in a 2001 Law Quarterly Review called “Tax and the Taxpayer” identified 3 approaches used to reduce tax burdens.
§ The first method is tax evasion and is a criminal offence. The taxpayer conceals or fraudulently misrepresents to the Revenue the incidence and ambit of his tax affairs. Tax evasion, apart from being unfair to the public by reducing the size of the public purse and unfair to fellow taxpayers who pay their fair share of tax, may lead to corruption and lawlessness. Vigorous efforts are made by the law enforcement authorities to detect and convict tax evaders.
§ The second method is tax avoidance, which does not involve unlawful conduct. The taxpayer’s advisers invent a scheme whereby he can hope to enjoy the benefit of a taxable event without becoming liable to pay the tax. A tax avoidance scheme includes one or more interlinked steps which have no commercial purpose except for the avoidance of tax otherwise payable, and can conveniently be described as artificial steps. A tax avoidance scheme does not leave the taxpayer any better or worse off but leaves the Revenue worse off. The question is whether the law should treat taxpayers differently depending on whether or not artificial steps are included in an otherwise clearly taxable transaction.
§ The third method is tax mitigation whereby a taxpayer incurs expenditure which reduces his taxable income or his taxable assets or whereby a taxpayer incurs expenditure which Parliament wishes to encourage or reward by a tax allowance or deduction. Tax mitigation may take a variety of forms but is distinguishable from tax avoidance; tax mitigation does not include any artificial step though the motive which inspires a taxpayer may be mainly or wholly the desire to reduce tax. A taxpayer may consider that premium bonds are a bad investment or that an ISA has a poor chance of increasing in value or that his children do not deserve his bounty. Nevertheless if he makes an investment or divests himself of property and otherwise fulfils the requirement of the legislation, then even though he may do so to reduce his tax, his motive is irrelevant.
Courts have been very active in distinguishing among the 3 categories. Reference is often made to the modern Ramsay Principle in this regard. Laid down in the famous WT Ramsay v. IRC decision of the House of Lords, (1982) AC 300, it is best stated as:
It is the task of the court to ascertain the legal nature of any transaction to which it is sought to attach a tax or a tax consequence and if that emerges from a series or combination of transactions intended to operate as such, it is the series or combination which may be regarded.
This principle can be placed in contradistinction to the one in Westminster, adopting a seemingly purposive construction method to unravel the ‘true nature’ of transactions entered into with the sole intention of avoiding ones legitimate tax liability. So one should examine the substance of a series of events as a whole rather than the form of a single transaction or event
Following the landmark decision of the House of Lords in WT Ramsay Ltd v IRC  AC 300, (1981) 54 TC 101, a series of decisions by the House of Lords and Privy Council, each drawing on its predecessors have developed a clear line of authority. The decisions are further and fully analysed in the recent judgment of Arden LJ (with whom Keene and Sullivan LJJ agreed) in Astall v HMRC  EWCA Civ 1010,  STC 137. They can be set out as a series of propositions:
- · i) The jurisprudence following Ramsay did not introduce a special doctrine peculiar to tax law. It represents the application in the tax field of established principles of broad, purposive statutory interpretation, rejecting formalism in fiscal matters: IRC v McGuckian  1 WLR 991, per Lord Steyn at 1000, Lord Cooke at 1005.
- · ii) The approach involves giving the statutory provision a purposive construction in order to determine the nature of the transaction to which it was intended to apply and then determining whether the actual transaction (which might involve considering the overall effect of a number of elements together) answers the statutory description: Barclays Mercantile Business Financial Ltd v Mawson  UKHL 51,  1 AC 684, (2004) 76 TC 446, per Lord Nicholls at .
- · iii) Revenue statutes are in general concerned with the characterisation of the entirety of transactions which have a commercial unity rather than individual steps into which such transactions may be divided: Carreras Group Ltd v Stamp Commissioner  UKPC 16,  STC 1377, per Lord Hoffmann at .
- · iv) Composite transactions do not cease to have a commercial unity only because they contain a commercially irrelevant contingency, deliberately included to create an acceptable risk that the scheme might not work as planned: IRC v Scottish Provident Institution  UKHL 52, (2004) 76 TC 538, per Lord Nicholls at .
- · v) The approach is not limited to a composite transaction. It can apply to a single multi-faceted transaction which on its face operated in a particular way but which when examined against the facts of the case does not operate as a transaction to which the statute was intended to apply: Astall, per Arden LJ at .
- · vi) However, whether the statutory provision under consideration is concerned with a single step or a broader view of the acts of the parties depends upon the construction of the language in its context: MacNiven v Westmoreland Investments Ltd  UKHL 6,  1 AC 311. Hence, the purpose must be discernable from the statute: the Court must not infer one without a proper foundation for doing so: Astall per Arden LJ at .
- · vii) Accordingly, the mere fact that a transaction is designed for no commercial purpose other than obtaining a tax advantage is not in itself sufficient ground to interpret the application of the statute to the transaction, or an element within it, so as to deny that advantage: MacNiven.
So as you can see, tax avoidance really is not as easy as examining the “facts and consequences”. This is why the case law in this space is continuously evolving in most common law jurisdictions. Poorly written legislation and high tax rates which incentivise tax avoidance add to the complexity.
Now let's jump over to the USA. American tax avoidance structures are particularly complex at times. There's an interesting structure called a self settled Trust which I found discussed in an article on Forbes magazine which I represent in full below. It shows just how far some American structures go in pushing the boundaries of tax avoidance / mitigation -
Is it any surprise that our new president, Donald Trump, may have strategically manipulated the tax code to avoid paying federal income tax? Mr. Trump calls this “smart,” and many in the same boat would agree. Similarly, sophisticated clients and advisors implement legal tactics to prudently preserve and protect wealth.
One strategy growing in popularity is the “self-settled” trust for asset protection. Under traditional trust law, a grantor conveys assets to a trustee, for the benefit of someone else, such as his children. The gift “divides” ownership between so-called legal title and equitable title. The trustee may legally oversee the assets (pursuant to a trust agreement) benefitting beneficiaries (who have no control over trust assets). Once the assets are in trust, they are generally protected from future creditors of the grantor, trustee (with legal title), and beneficiaries (with equitable title).
This splitting of legal and equitable title traditionally shields trust assets from creditors of
(1) the trustee, who has no legal right to use or distribute trust assets other than for the benefit of the beneficiaries; or
(2) beneficiaries, who have no legal ability to demand or direct distributions or convey title to trust assets.
Traditional trusts typically have a “spendthrift” provision which protects trust assets by restricting the beneficiary from assigning future income or trust assets to creditors (thereby prohibiting a creditor of a beneficiary from attaching trust income or assets). The traditional trust, for instance, allows parents and others to make protected gifts to children.
Self-settled trusts are distinct in that they are funded by a grantor who retains the benefit of trust assets. Only legal title is conveyed to a third-party trustee to put trust assets (theoretically) outside the reach of creditors. Several offshore jurisdictions and 16 U.S. states have enacted statutes permitting such arrangement. In these jurisdictions, the grantor may "have his cake (protection) and eat it (the assets) too." The grantor/beneficiary enjoys the fruits of the trust assets but has no legal right to transfer title or direct proceeds to creditors. Self-settled trusts are therefore often referred to as “asset protection trusts.”
Domestic asset protection trusts, or DAPTs may have their place in certain asset protection plans, but they still remain largely untested by the courts. Indeed, several non-DAPT states consider such trusts anathema to public policy. Often overlooked in predicting the effectiveness of an asset protection strategy is giving due consideration to which state’s law may ultimately be called upon to test it.
Consider the case of a resident of Washington (which offers no DAPT) who forms a DAPT for his own benefit in Alaska (which does have a statute permitting DAPTs). He names himself as a beneficiary and his son as co-trustee (along with an Alaska trust company). The grantor/beneficiary then proceeds to transfer a significant portion of his assets, including title to financial accounts, automobiles, and real estate interests into the trust.