Terry Baucher on the fine line between tax avoidance and evasion and the harsh consequences separating the two.

By Terry Baucher*

“Carter evades the onrushing Habana, passes to Gear who avoids a couple of Boks…”  In ordinary use “avoid” and “evade” are interchangeable.   In the tax world, however, there is a very clear distinction between tax avoidance and tax evasion, a point highlighted by the Minister of Revenue’s remark about “legitimate tax avoidance” in the recent 60 Minutes programme on New Zealand’s Foreign Trusts industry. 

The Minister’s remark caused some consternation even though the Prime Minister pointed out he had used “the absolutely correct technical term”.  As the Privy Council remarked in 2005 during Peterson v Commissioner of Inland Revenue “The line to be drawn between “tax evasion” and “tax avoidance” is clear enough.  The former is criminal. The latter is not.  It may be socially undesirable but is within the letter of the law”.

Similarly, the United States Internal Revenue Service, probably the most feared tax authority in the world, has a little quiz on its website explaining the distinction between tax avoidance and tax evasion which begins with the preamble “tax avoidance is perfectly legal and encouraged by the IRS, but tax evasion is against the law.”

So that’s all good then?  Not really.   Just as someone’s terrorist is someone else’s freedom fighter, so too with tax.  A person who organises his or her affairs to reduce the tax payable might be financially astute to some but reprehensible to others who feel such persons are not paying their “fair share”.  

Frankly, what represents a “fair share” of tax is impossible to define.  For anyone who is not taxed solely through PAYE the amount of tax payable on his or her income can be a very moving feast.  Is it “fair” if a person claims all the deductions available or none at all?  Similarly if you are faced with two prices for an item is it “fair” if you pay the highest price or the lowest?   

This is an admittedly simplistic approach to the matter but it’s worth making because if there is one thing I can say after my years in practise,  it’s that when it comes to tax very few people share the same view about what represents “fair”.   For example, back in 1989 after the top UK tax rate dropped from 60% to 40%, I asked a client if he wanted to maximise his pension contributions so as to reduce his tax bill (a perfectly legitimate approach under UK tax law). He declined, responding that he thought 40% was fair enough.  By contrast during the last decade 39% was seen by many here in New Zealand as too high. 

So with that in mind when does acceptable tax planning become unacceptable tax avoidance?  Consider the following examples:

Angela sets up a new software design business structured in such a way that the venture’s annual income tax bill is $50,000 less than would have been otherwise payable under a different structure.

Angela’s friend Brian, who runs a similar business, is always looking for ways to minimise his tax bill so he restructures along identical lines to Angela’s and achieves annual income tax savings of $40,000.  Furthermore he and his family are now eligible for working for families tax credits worth $10,000 a year. 

Cory, a plumber, doesn’t see the need to use “expensive” accountants and advisors.  Instead he offers “discounts for cash” and then under-declares his income “saving” himself $50,000 a year in income tax and GST. 

Where do these three examples lie on the avoidance/evasion continuum? 

Cory’s is the easiest: it’s flat out tax evasion.  When the IRD catches up with him not only will he be liable for the arrears of income tax and GST together with penalties and interest, as tax evasion is a criminal offence, Cory could also face up to five years in jail if convicted.

Brian is also in trouble.  Based on last year’s Supreme Court decision in Penny and Hooper vs. Commissioner of Inland Revenue, the fact that he re-organised his affairs to minimise his tax bill means he would almost certainly fall foul of the general anti-avoidance provision in the Income Tax Act.  But this is not a criminal offence so the maximum shortfall penalty he faces is 100% of the tax avoided.  Compare this with the 150% shortfall penalty for evasion which is likely to be imposed on Cory. 

And Angela? Has she found a path between tax avoidance and tax evasion in the form of tax “avoision”? (Yes, that word really exists outside The Simpsons).  

I would reply “yes”, but my answer is not as definitive as it would have been a few years ago.   In the past decade the boundary between acceptable tax planning and tax avoidance has shifted markedly in favour of the Commissioner following court decisions such as those in Penny-Hooper and Westpac Banking Corporation.   Ultimately, the distinction between the two is in the eye of the beholder, or as she is more usually called, the Commissioner of Inland Revenue.  If the Commissioner decides that Angela’s structure represents a risk to the tax base then matters may change. 

Back in the 1970s Denis Healey, the then British Chancellor of the Exchequer remarked “The difference between tax avoidance and tax evasion is the thickness of a prison wall”.   Next time I’ll look at how far Brian is testing Healey’s dictum and also whether owning your own home could represent a form of tax avoidance. 

*Terry Baucher is an Auckland-based tax specialist and head of Baucher Consulting Ltd.