The Fine (and Hazy) Line between Tax Avoidance and Tax Evasion
‘The difference between tax avoidance and tax evasion is the thickness of a prison wall.’
- Denis Healey
Keeping in mind the contradiction between the heading of this article and the quotation above, I wish to draw your attention to an illustration. In the 2001 movie ‘Blow,’ George Jung had argued in open court that the reason for his arrest was merelycarrying few plants over an imaginary line when the judge asked him about trafficking marijuana from Mexico to the United States. Now, the few plants he was referring to were marijuana plants and the imaginary line was the US - Mexico border. The man was carrying a few plants over an imaginary line. But according to the law, the plants he was carrying were Schedule I substances under the Controlled Substances Act, 1970. So, the unpleased judge sentenced Mr. Jung to two years of imprisonment for carrying illegal plants over substantially visible political boundaries. The purpose of this introduction was to enlighten the reader about how little the illusion of what is legal and illegal could be in today’s world. And as the title suggests, our topic of discussion today is to analyze this difference between legality (tax avoidance) and illegality (tax evasion) in regards to unpaid taxes.
Leaving all the technicalities out, the primary difference between tax evasion and tax avoidance is legality. Although, these terms came into existence to provide the taxpayers, governments, and courts with ease of defining the concept; that has not been the result. The Government and regulatory authorities prosecute any person or corporation that tries to reduce their tax liability by considering the latter’s actions as tax evasion. Whereas, the latter contends that they have acted within the purview of the law and were merely trying to minimize their liability. It’s for the courts to decide now. The taxpayer(s) will be acquitted if the courts decide the case by stating that he has merely avoided the tax and they will be convicted if the courts decide that the taxpayer was trying to evade the provisions of the tax law.
Drawing the Line
Tax avoidance is legally minimizing tax liability, including deductions (prescribed by the legislation), tax credits, tax deferral plans (like 401(k) plans) and so on. Concerning our above illustration of George Jung, tax avoidance is basically like carrying a few plants across an imaginary line – no illegality involved (as long as the facilities are plants and the imaginary line is not a political border). Whereas, tax evasion, on the other hand, is not a simple journey. Tax evasion is illegal as it is the failure of a taxpayer to pay actual taxes that they owe to the authorities by deceit, or by concealing the exact tax amount. Tax attorneys and accountants often try to reduce the tax liability of their clients by engaging numerous methods. But how will you know whether they are crossing this line and are moving over to do something illegal? Let’s read more to find out.
Mens Rea (also known as ill-intention or fraudulent intention) is one of the primary factors considered when trying to determine the difference between tax evasion and tax avoidance. Tax evasion is an illegal act by which a taxpayer tries to portray to the authorities that he or she is liable to pay lesser tax (than their actual liability – if they would disclose their income in good faith). The illegality in tax evasions comes into existence only when the taxpayer fails to disclose the actual amount of the revenue that they have gained in a particular transaction. To begin with, we should first understand why tax evasion is considered illegal.
Let us analyze this case to understand further: taxpayers in the US are liable to pay tax on their illegal income also. In the infamous case of James v. the United States, a reference made t the court on a question that whether taxpayers were responsible for payingtax on their illegal income. The appellant was one of the officials in a labor union and had embezzled approximately USD 750,000 from the union’s funds – but believe it or not, that was not the crux and issue of the case. Mr. James was held and tried for his failure to disclose this amount to the Internal Revenue Service (IRS) – or in short, tax evasion. It was a landmark case on tax evasions in the US at the time. The appellant contended that the funds were an illegal source of income and therefore did not fall under the ambit of ‘taxable income.' Therefore, the US Supreme Court had to determine whether the IRS could tax illegal sources of income. After studying the facts and analyzing the provisions, the Supreme Court held that the appellant had an obligation to disclose this illegal income under gross income.Subsequently to pay tax for it as per Section 22 (a) of the Internal Revenue Code of 1939 and Section 61 (1) of the Internal Revenue Code of 1954.It meant that the appellant was required to return the embezzled money to the rightful owners and also pay tax for it. 26 US Code § 7201 defines tax evasion and states that ‘Any person who knowingly attempts in any manner to avoid or elude any tax imposed by this title or the payment thereof, shall, regardless of other penalties under the law, be guilty of a felony. Further, a fine of not more than US Dollars 100,000 (US Dollars 500,000 in the case of fraud), or imprisoned not more than five years, or both, together with the costs of prosecution’.
The existence of fraudulent actions gives rise to the concept of tax evasion. Although tax evasion, as a whole, is considered a serious crime, there are different types of tax evasions. The negligence or omission in submitting the returns of income are considered less offensive than false or fake declarations. The latter may fall under tax fraud since it constitutes an explicit act with an ill-intent by the taxpayer to reduce or minimize his tax payables.
In a legally discreet way, on the contrary, one can mitigate the burden of tax by exploiting the loopholes in the taxation regime, where spending the resources on ‘constructive’ activities rather than ‘rent seeking’ activities. Tax avoidance can be determined by the complexities in the taxation regime of the country as complexities tend to leave a vacuum for bickering about the intention of the lawmaker and for innovative attempts to find arrangements within the text of law if it is not in its spirit. Hence, unsurprisingly tax avoidance attracts considerable attention in gray areas such as taxation of multi-national companies, where the country’s taxation system meets the foreign regime and complexity is imminent.
Avoidance behavior is typically an indication of the substitution effect and of ability to utilize the tax code to your advantage. Early, in 2007 Bradley Birkenfeld, a UBS banker, informed United states about the usage of UBS accounts as tax shelters. This activity allowed many US citizens to camouflage their income from the IRS, which can typically be construed as an avoidance scheme but was later categorized as an aid to hide taxable assets by opening offshore accounts. After one year, Switzerland bank accounts accuse UBS of tax evasion. Post the infamous UBS incident IRS in late 2009, initiated a program namely, Voluntary Disclosure Program as an incentive for those who will disclose their foreign accounts for evading taxes. Currently, in the US, tax avoidance is a legal practice, but the restriction applies to tax evasion.
The Disclosure of Tax Avoidance Scheme (DTAS) in the UK is a recent development as far as tax avoidance is concerned. The legislative framework introduced by the HM Revenue and Customs (HMRC) which updates the customs department about new tax avoidance schemes currently in circulation. DTAS rules are lengthy and complicated, and as soon as it is presumed that a person can obtain a tax advantage, thedisclosure regarding details of the arrangements referred to HMRC. The HMRC's stringent tax avoidance rules designed in such a way that not only the taxpayer but the accountants, consultants, and lawyers fall under the same purview as of the taxpayer. The prevalence of tax avoidance schemes and rules in almost all major countries has been successful in convincing governments that it is a difficult battle against tax evasion and tax avoidance.
UAE battle against tax evasion
The Organization for Economic Co-operation and Development (OECD), recently implemented Common Reporting Standard (CRS), a new reporting system to trace and monitor tax evading nationals overseas. CRS corresponds to Foreign Account Tax Compliance Act (FATCA) in the United States. CRS is a programme launched by OECD to which UAE, India, Canada, Turkey, Indonesia and other countries are signatories. Even though the UAE is relatively new to the taxation arena, the nation has already joined the battleground against the tax evaders to curb tax evasion. The convention signed under OECD provides all possible assistance in tax-related matters such as tax examinations, tax collection, automatic exchange, and tax examinations abroad. CRS is a step ahead to defeat the tax evaders as the system enables the authority to keep a record of information exchanged between the countries regarding individuals and expat bank accounts, including all the details of interest and income earned outside the territory.
The UAE government has not implemented technical provisions that distinguish between tax evasion and tax avoidance since the country was considered a tax haven for the many previous years. However, the implementation of value added tax in the state is expected to bring thorns in the corporate garden of the UAE. But only time can tell about the differences that VAT may bring about in the taxation regime in the country.
The amount of federal revenue at stake due to tax evasion every year is prominent enough to raise public concern. Government schemes for disclosing tax evasions is appreciable, whereas, it is far more critical for the country’s integrity that the taxpayer contribute their ‘fair share’ in tax revenue instead of making arrangements for evading taxes.
Tax Global Guide 2016-17 Volume 1: Tax on Corporate Transactions in the United Arab Emirates
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