This is not a technical article on what is or how to detect tax avoidance. That said, it's necessary for any conversation on the topic to observe that many people incorrectly think they can easily spot and discuss the topic without understanding the real world.
Let me first note that they are three terms that need consideration:
- Tax Planning
- Tax Evasion and
- Tax Avoidance
These easily overlap. Let me dispense with the second term first. Tax evasion is where a person blatantly ignores the law. Simple examples include the builder who works for cash under the table or the retailer who fails to disclose cash sales. There is no question that income tax and probably GST is payable but not paid. This is morally wrong and clearly illegal.
Tax planning is far more complex. Those accused of tax avoidance will normally counteract by saying that they have merely planned their affairs in a way that legitimately minimises their tax liability. Let’s look at some simple examples before treading into more complex territories.
- A taxpayer with a large sum to invest has a choice of investing directly and paying tax at 39% on the investment income or placing the funds in a Portfolio Investment Entity (PIE) and limiting the top tax rate to 28%.
- A taxpayer chooses to pay down their mortgage on their private home before paying off their business loan (where the interest is tax deductible).
- A consultant forms a company to carry on their business and so limits the top tax rate to 28%.
- A family decides to put their investments in a family trust and therefore reduces the top tax rate paid to 33%.
There are many examples of planning that reduces the tax payable by taxpayers making appropriate choices. Most would see the above examples as non offensive.
So, when does tax planning move over the line and become unacceptable tax avoidance? For example:
- Business manufactures a product in country A and sells to customers in country B. The majority of the profit is retained in country A (or vice versa).
- Business establishes a marketing business in a low tax country (country B). All exports are sold to that entity who in turn sells the product to a third country(country C). Products are shipped directly to country C.
- Establishing an international intellectual property company in a low tax country.
- Building company sells subsidiary property companies instead of selling individual properties.
Each of these could involve unacceptable tax planning or equally essential tax planning. To what extent are uncommercial steps inserted into the process for the ultimate objective of reducing a tax liability.
The most basic example is I) above. Profits need to be allocated between the countries so each country can get its “fair” share of tax but in turn each country will have its view on what is fair.
There are internationally accepted methodologies for allocating profits. The allocation should be based on:
- Nature of goods/services
- Importance of functions performed (manufacture, sales etc.), assets used, and risks assumed in each country
- Business strategies including terms of business
- Economic and market conditions
But most of this is under the control of the taxpayer. So, the allocation of profit becomes a controllable factor. The fair share of tax becomes a decision, at least in part, of the taxpayer.
To minimise the risk of being accused of unacceptable tax avoidance the taxpayer must have systems in place to determine what is a fair allocation of profits. Fair to whom?
The answer in today’s business world is to the stakeholders - not just the shareholders (or the management team). It must consider the communities in which the businesses operate, not just the country where the company head office or major shareholders are based.
This is not a simple exercise. How do you determine a fair allocation where, for example, a product is developed in country A, manufactured in country B, sold in country C and its major shareholders are in country D?
Getting the “right” balance is more about the culture of an organisation. Culture comes from the top. Don’t (just) blame the soldiers for carrying out their orders. In many cases management is rewarded for maximising (after tax) profits. The Board is responsible for establishing the culture and putting in place a management team to implement that culture. The Board determines the basis for rewarding management for meeting their objectives.
But the Board in turn is simply a collection of people. They are the guardians of the shareholders and have that wider responsibility to the broader stakeholders. The individual morals of the Directors determine their approach to setting an appropriate culture. Naturally it is heavily influenced by shareholder expectation and to some extent the laws which hold them accountable for their actions. In many cases the shareholders indirectly are the ordinary Mums and Dads via their pension funds.
This comes back to the training and selection of Directors. Directors should not be allowed to opt out of tax strategies on the basis that it is a technical topic, no more than they can opt out of setting the culture of an organisation. The tone must be set from the top. The Directors must own the culture and have in place systems to ensure that the culture is being observed.
That still does not answer the question “what is acceptable tax planning as opposed to unacceptable tax avoidance”. Unfortunately, that will always be a question of the facts in any circumstance and will often be influenced by the perspective of the country seeking to assert tax avoidance.
All the taxpayer can do is seek to protect themselves from the assertion by having a culture that seeks to do the right thing and having the appropriate safeguards in place to demonstrate their intent.