“A fine is a tax for doing something wrong. A tax is a fine for doing something right.” ~ Author Unknown
Benjamin Franklin wrote is 1789, “….in this world nothing can be said to be certain, except death and taxes.” While modern medicine has not yet found a way to stop the aging process, modern accounting practices and smart-tax planning methods have indeed found ways to avoid paying taxes, or at least some portion of taxes. But are these tax avoidance schemes legal, and how exactly do they differ from tax evasion, if at all?
Wikipedia defines tax avoidance as the “the legal usage of the tax regime in a single territory to one’s own advantage to reduce the amount of tax that is payable by means that are within the law.” While certain forms of tax avoidance may be considered 100% legal, it is almost never considered moral in the court of public opinion. In fact, many corporations and businesses that take part in this practice generally experience a backlash at some point.
Well-known tax avoidance schemes
K2 Scheme: Her Majesty’s Revenue & Customs (HMRC) has begun to crack down after a number of high profile cases involving well-known personalities in what was called the K2 Scheme. The scheme basically involved companies opening a branch off-shore. An employee would quit his job and then get rehired by this off-shore branch or shell-corporation (a company with just an outer shell and no significant assets or operations), for a lower salary. However, the company then loaned the employee a large amount of money, and wrote the sum off as a tax liability, thereby reducing the amount of taxes to be paid. The HMRC found that over 1,000 people used the K2 Scheme to avoid paying over £160 million in taxes. The UK eventually passed legislation to greatly discourage the use of K2 Schemes. This is a perfect example of tax avoidance that was not technically illegal, although it was not in the spirit of the law.
VAT Supply Splitting: Another fascinating tax avoidance scheme is called VAT Supply Splitting. To benefit from a lower VAT rate, customers split a single supply of goods or services into separate supplies. The result is lower VAT rates on each order, and is known as supply splitting. The HMRC considers this practice to be tax avoidance, and although technically legal, HMRC will challenge this arrangement and take these companies to court, claiming that they are receiving a tax advantage that is contrary to the law.
Off-shore Accounts: Certainly the most common way to avoid paying taxes is to maintain off-shore accounts in countries with a low tax jurisdiction or a tax haven. Governments individually determine how to deal with these accounts. The United States, for example, imposes a Federal Income Tax on its citizens regardless of where they reside, requiring a citizen to pay taxes on all worldwide income. Some US citizens will actually choose to revoke their citizenship to avoid paying Federal Income Tax on their off-shore accounts. The US government has also passed legislation over the years that allows the IRS to determine whether certain tax avoidance schemes are considered abuse of the system and are liable before a court. In the US, tax evasion by multinational corporations via offshore jurisdictions is estimated to be at least $130bn a year.
Panama Papers: Recently the EU has also focused on companies that are profiting from the use of off-shore accounts. This past June, the European Parliament put forth legislation that will require multi-national companies to report tax earnings and all financial data from all the countries in which they operate. This comes in response to the Panama Papers, a leaked document from 2016 that detailed the financial information of over 200,000 off-shore accounts from Panamanian law firm Mossack Fonseca, dating as far back as the 1970s. Many high net worth and highly public individuals were implicated by these documents. This legislation still needs the approval from the EU Member States but with EU countries losing between 40 to 160 billion Euros annually due to tax avoidance schemes, according to Reuters, it is only a matter of time before tax-saving schemes by multi-national companies are further exposed, triggering a worldwide ripple effect.
Luck of the Irish: Ireland offers very favorable tax breaks to corporations. Establishing a presence in Ireland has proven advantageous for companies seeking to escape the tax man. Dublin has been accused of violating EU tax law by providing multi-nationals with selective treatment and tax advantages not available to others. Now, under pressure from the Organization for Economic Cooperation and Development (OECD), Ireland announced that from the start of 2015 new companies registering in Ireland must also be a tax resident. Existing multinationals have until 2020 to comply.
Undoing decades of tax law, which differs from country to country, is never going to happen. What can help is a system of country-by-country reporting. The OECD – which is made up of 35 countries including the UK and US – has been mounting the pressure on multinationals and pushing a new “Base erosion and profit shifting” (BEPS) Action Plan. BEPS: “refers to tax avoidance strategies that exploit gaps and mismatches in tax rules to artificially shift profits to low or no-tax locations. Under the inclusive framework, over 100 countries and jurisdictions are collaborating to implement the BEPS measures and tackle BEPS.
So maybe Ben Franklin was indeed right after all, taxes are a certainty. While there are legal loopholes to lower taxes and legal techniques to avoid paying certain taxes, a knowledgeable tax advisor can help your company navigate through an uncertain tax landscape.