Tax Avoidance, Tax Evasion and Tax Planning

There are three different concepts viz. tax avoidance, tax evasion and tax planning. Tax Avoidance means an attempt to reduce tax liability through legal means, i.e. to regulate one’s financial affairs in such a way that one pays the minimum tax imposed by the law. This can be understood with a simple example. Tax Evasion and Tax avoidance are two different things. While Avoidance is legal management to avoid tax, tax evasion is illegal means to reduce tax liabilities, i.e. falsification of books, suppression of income, overstatement of deductions, etc.

Similarly, Tax planning is an accepted practice, whereby the taxpayer uses provisions of law to minimize his tax liability. Various methods of Tax avoidance are as follows:

Tax Havens

This implies to route profits through subsidiaries located in tax havens. Tax havens refers to the countries or territories where either very low tax is levied on certain items or not taken at all. Switzerland, Luxembourg, Isle of Man, British Overseas Territory, Bermuda, British Virgin Islands, Cayman Islands, Puerto Rico etc. are some of the popular tax havens around the world.

Treaty Shopping

Treaty shopping is considered to be a means of tax avoidance. The bilateral tax treaties are done to reciprocate the benefits between the residents of two countries but when someone from a third country invests in any of them just for the sake of avoiding tax and derives the benefits of low taxation, this is termed as treaty shopping. Countries use anti-treaty-shopping provisions such as Limitation of Benefit (LOB) clause and/or beneficial ownership provisions to counter the treaty shopping. For example, India included such LOB clause in relation to bilateral tax treaty with Singapore.

Limitation Of Benefit (LOB)

Limitation Of Benefit (LOB) refers to the rules that are put in place to counter the menace of treaty-shopping/ Such rules restrict availing of the treaty benefits by a conduit (compromised) entity formed for the purposes of treaty-shopping {they call it a letterbox entity}. It also restricts entities who attempt to claim double non-taxation; for example, LOB clause under India-Singapore tax treaty.

Round Tripping

India Round Tripping, money is routed back into the country by local investors through tax havens like Mauritius. In this, money from home country goes out through illegal channels and invested back in the same country via a second country with whom India has a tax treaty. For example, it was suspected that many Indians used round tripping method and invested the money back in India via Mauritius. Such problem is countered by including relevant clauses and rules in the taxation law. For example in India, the domestic companies routing their investments through Mauritius need to pay capital gains tax.

Transfer Pricing

Transfer Price is the price of the goods and services sold between related entities such as – parent company and daughter (subsidiary) company; or between branches of same entity. The fixing of price of goods and services between parent-subsidiary is called Transfer Pricing.

Tax Avoidance Using Transfer Pricing

Transfer pricing itself is not a means of tax avoidance if transfer price matches what the seller entity would charge to an unrelated customer (called customer at arm’s length). However, since lowering or increasing the prices between parent-daughter entities don’t affect the whole organization, the companies artificially increase or decrease the transfer price to avoid corporate tax. This processing of using unusual transfer pricing to avoid tax is called Base Erosion and Profit Sharing (BEPS).

Transfer Pricing Case Study

In 2009-10, TCS (Tata Consultancy Services) ad shown a net profit per employee of Rs 4.3 lakh. At the same time, Capgemini, a foreign IT firm with operations in India, recorded a net profit per employee of Rs 1.5 lakh. Thus, Capgemini showed a net profit per employee one third of TCS. Despite of similar business, similar in contract pricing and similar in salaries and other expenses, why the foreign IT firms reporting profitability numbers that are a fraction of their Indian peers? Moreover, the same difference went on the same lines on other scales such as revenue per employee, operating profit margin, net profit margin. This was due to the menace of Transfer pricing as per experts.

How it is done?

The subsidiaries of the foreign companies in India use transfer pricing to allocate most expenses / loss to India and most profits to their high-tax home country thus produce low taxable income or excessive loss on transactions. The Transfer Pricing has been under tough scrutiny by the authorities in India, which look for a better share in the tax from the companies. However, sometimes the companies claim and insist that they have done transfer pricing correctly. Due to this, Transfer pricing has been a key issue for both multinational corporations and tax authorities for a long time.

Most of the countries in the western world have their own rules regarding the transfer pricing. Indian Government also has took some proactive measures to resolve the disputes arising due to the transfer pricing.

Government Efforts in this Direction

The Government had introduced Transfer Pricing Regulations (TPR) through the Finance Act, 2001 on the basis of OECD guidelines. Currently, the transfer pricing rules are part of section 92 and 92F of the Income Tax Act. Basic premise of these rules is that the related party transactions should involve an arm’s length principle and the pricing should be such as if it would have been charged from an independent buyer. The rules postulate several methods of defining an arm’s length price such as Comparable uncontrolled price (CUP) method; Resale price method (RPM); Cost plus method (CPM); Profit split method (PSM); Transactional net margin method (TNMM) etc. To handle the dispute in calculation of tax liabilities, government established a  Dispute Resolution Panel (DRP) under Income Tax Act via the Finance Act 2009.

Dispute Resolution Panels

DRPs had been constituted at Delhi, Mumbai, Ahmedabad, Kolkata, Chennai, Hyderabad, Bengaluru and Pune. DRP consists of three commissioners or directors of income tax appointed by the Central Board of Direct Taxes (CBDT). Any foreign company, or any domestic company with transfer pricing issues, in whose case the income-tax assessing officer proposes to make any variation in the income or loss returned, may apply within a month of receiving the draft assessment order before the DRP for appropriate remedy by way of direction to the assessing officer.

Further, via the Finance Act 2012, the government extended these rules to domestic related party transactions exceeding Rs. 5 Crore also.

Thin Capitalization

Thin capitalization is when most part of company’s capital is made of debt instead of equity. When most of the capital is debt, the company has solvency risk. For tax avoidance purpose some companies indulge in artificial thin capitalization if there are tax benefits on receiving debt or loan. To counter this menace, governments need to introduce rules to disallow interest payments beyond certain limits.

Methods of Tax Evasion

Tax evasion involves illegal and unfair ways to get away without paying. Evasion of tax takes place when the people report dishonest tax. Falsifying the accounts, smuggling, false invoicing etc. are common methods of tax evasion.