Tax avoidance vs. tax evasion has always been a hotly debated issue. Gradually, tax laws have been so reconstituted that the possibility of legal tax avoidance have been decreased. And today, the difference between tax avoidance and tax evasion is very narrow.
In this background, an effort has been made to study and define this important area of taxation. I begin by taking an example from the US Supreme Court's ruling given in the case of Gregory. Let us start our review by going through the brief of this case.
Facts: This is a case of tax avoidance. Gregory was the owner of M/s United Mortgage Corporation USA. Keeping in line with the provisions of Section 112(g) of the US Revenue Act of 1928, on September 18, 1928 Gregory transferred 1000 shares of the Monitor Securities to the Averil Corporation. Thereafter Averil Corporation was dissolved on September 24, 1928 and its assets were distributed through liquidation. Gregory, thereafter, sold 1000 shares of the Monitor Securities by avoiding tax on the same.
Issues
i. Whether or not the transactions made by Gregory conformed to the provisions of Section 112 of the Revenue Act, 1928?
ii. Whether or not the 'reorganisation' in terms of the Revenue Act, 1928 was perfect?
iii. Whether or not the motive of tax avoidance created mens rea?
iv. Whether or not the tax payer was avoiding the tax?
Analysis: The court came to the conclusion that Gregory's said operation of the transfer sale of assets neither had any business purpose nor a corporate objective. The device used on the name of corporate reorganisation was a sham transaction and it defeated the real purpose of the statute. The purpose of this sham transaction was to obtain preconceived gains and there was no real intent to restructure business or any of its part, except that to transfer shares to Gregory for subsequent sale. The intermediary corporation was created to defeat the purpose of law. The operation so conducted, though in line with legal provisions, was in fact a plan to abuse the process of law and to defeat its purpose and since there was a clear intent to defeat the law, hence the whole operation does not fall within the framework of law.
Conclusion: The court ruled 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 hence illegal. The court applied the rule of substance over form and the principles that an even-handed administration and enforcement of all the tax laws is the requirement of statute.
Current position: The dictum given in Gregory v Helvering remains intact even today. However, in a 1993 in a Massachusetts case of Koch2, the Mass Appellate Tax Board took a divergent view and ruled that the gain realised from the sale of the stock was the income of the Delaware Corporation which was doing no business in Massachusetts. Thus, it ruled that there was no tax owed to Massachusetts by Koch. The ruling was based upon the Board's conclusion that at the time of the taxpayer's assignment of shares to his Delaware Corporation, the transaction was sufficiently uncertain to prevent the application of the substance-over-form rule. The Appellate Tax Board also found as a "fact" that the taxpayer had a valid business reason for transferring the stock to the Delaware Corporation.
The Tax Commissioner appealed the Board's decision to the Massachusetts Court of Appeal. Applying a strict standard in favour of upholding the Board's fact-finding, the Court of Appeals nevertheless held as a matter of law that the record demonstrated the presence of a step transaction. The Court of Appeals therefore disregarded the form of the taxpayer's transaction and found his income taxable in Massachusetts. The Supreme Judicial Court reversed the decision of the Court of Appeals, however, and reinstated the Board's decision. The Supreme Judicial Court concluded that, given the deference due to the Board's fact-finding, the evidence before the Board was adequate to support its decision.
The Koch case is a fact-intensive and will be limited to its own facts. The Supreme Judicial Court did not repudiate substance-over-form analysis in Koch case.
Two general points can be made about tax avoidance and evasion. First, 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. Secondly, legislation that addresses avoidance or evasion must necessarily be imprecise. No prescriptive set of rules exists for determining when a particular arrangement amounts to tax avoidance or evasion. This lack of precision creates uncertainty and adds to compliance costs.
In a Tax Mitigation (Avoidance by Planning) situation taxpayers are entitled to mitigate their liability to tax and will not be vulnerable to the general anti-avoidance rules in a statute. A description of tax mitigation was given by Lord Templeman in CIR v Challenge Corporate Ltd3: it was held that income tax stood mitigated by a taxpayer who reduced his income or incurred expenditure in circumstances which reduced his assessable income or entitled him to reduce his tax liability.
A better way of approaching tax avoidance is to regard it as an arrangement that, unlike mitigation, yields results that the Parliament did not intend. It nullifies any arrangement to the extent that it has a purpose or effect of tax avoidance, unless that purpose or effect is merely incidental. Where an arrangement is void, the tax authority is given power to adjust the assessable income of any person affected by it, so as to counteract any tax advantage obtained by that person.4
Tax Evasion Mitigation and avoidance are concepts concerned with whether or not a tax liability has arisen. With evasion, the starting point is always that a liability has arisen. The question is whether that liability has been illegitimately, even criminally been left unsatisfied. In CIR v Challenge Corporation Ltd,5 Lord Templeman said: "Evasion occurs when the Commissioner is not informed of all the facts relevant to an assessment of tax". Innocent evasion may lead to a reassessment. Fraudulent evasion may lead to a criminal prosecution as well as reassessment.
Over the years, many have indulged in numerous examples of such tax arbitrage using elements in the legislation at the time. Examples are finance leasing, non-recourse lending, tax-haven (a country or designated zone that has low or no taxes, or highly secretive banks and often a warm climate and sandy beaches, which make it attractive to foreigners bent on tax avoidance and evasion) 'investments' and redeemable preference shares. Low-tax policies pursued by some countries in the hope of attracting international businesses and capital is called tax competition, which can provide a rich ground for arbitrage.
Economists who favour tax competition often cite a 1956 article by Charles Tiebout (1924-68) entitled "A Pure Theory of Local Expenditures". In it he 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. 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 obviously requires the expert to do the needful.
1. Gregory v. Helvering: 293 US 465 (1935)
2. William I. Koch v. Commissioner of Revenue (TIR 94-7)
3. CIR v Challenge Corporation Ltd (1986) 8 NZTC 5,001 at 5,006; V20 (2002) 20 NZTC 10,233 at pp 37 and 39.
4. Challenge Corporation v CIR [1986] 2 NZLR 513, 549 (CA).
5. ibid supra 2.
(The writer is an advocate and is currently working as an associate with M/s Azim-ud-Din Law Associates)