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Tax evasion and tax avoidance: how to tell the difference

James Watkins - Law on the Web

  1. 15 September 2015
  2. Miscellaneous
  3. 0 comments
Sepia-toned money

Tax avoidance seems to have become a hot-button topic in recent times, with major corporations like Google, Starbucks and Amazon being called on the carpet for only paying a very small fraction of their UK profits in tax.

However, the government seems to have found it difficult to stamp out these practices, which might seem strange – isn’t tax evasion illegal? What’s the difference between that and tax avoidance?

Legally avoiding tax

These companies are not breaking any laws – rather than evading tax, they are avoiding it.

Tax evasion, which is simply the underpayment or non-payment of tax, is still illegal. If an individual or a company doesn’t pay any tax or doesn’t pay as much as they should, this is considered tax evasion.

An example of this would be if an individual fails to declare some or all of their income, or if a company underreports their profits, thereby reducing the amount of tax that HMRC expects them to pay.

Tax avoidance is a bit more complicated – it involves taking advantage of legal methods of reducing the amount of tax you have to pay.

There are plenty of methods to reduce the amount of tax you might have to pay – for example, by putting money into a tax-free Individual Savings Account (ISA). However, by combining different methods of tax relief or using them in ways for which they weren’t intended, high-earning individuals or companies can potentially shave millions off of their tax bills.

How does tax avoidance work?

Tax avoidance can come in many forms, but it often involves taking advantage of lower tax rates in other countries. Entire schemes are created for the single purpose of avoiding tax.

The K2 scheme

One such scheme, the K2 scheme, achieved infamy back in 2012 after an investigation by the Times newspaper found it was sheltering over £3 million for comedian Jimmy Carr, with over 1,000 others said to be benefitting from the scheme.

Participants in the scheme would “leave” their job to sign an employment contract with a shell company (a company with no operations or assets) offshore. The participants would then be hired to their original job, meaning that their employment status stayed essentially the same.

However, their original salary would go to the shell company. Instead of paying the individual the full salary, they would pay a fraction of the salary, and give the individual thousands of pounds in loans every month.

The loans could then be written down as tax liabilities, drastically reducing the amount of tax that would have been paid if the individual had received the money as a salary.

If it’s legal, then what’s the problem?

Some have apologised for their involvement in tax avoidance schemes. Jimmy Carr described his involvement as a “terrible error of judgement”, while Starbucks resolved to forego certain tax loopholes after an outcry.

Others say that that high-earning individuals and companies are perfectly within their rights to take legal steps to avoid tax, regardless of any ‘moral’ implications.

Google exec Eric Schmidt said that his company had a “fiduciary responsibility to our shareholders” to only pay the bare minimum in tax.

However, tax avoidance makes a noticeable difference to the UK’s coffers. HMRC figures have indicated that tax avoidance costs the UK around £4bn every year.

As a spokesman for HMRC said: “Tax avoidance is bending the rules of the tax system to gain a tax advantage that Parliament never intended.”

So why not crack down on tax avoidance?

It can be galling to hear about millionaires and billionaires avoiding millions of pounds worth of tax, especially if you have dutifully made your contributions throughout your working life (not to mention whenever you buy something).

Cracking down on tax avoidance is a rare issue that politicians are united on – chancellor George Osborne announced plans in the recent budget that would require companies to conform to the ‘spirit’ of tax law, rather than just following the letter of the law.

But tax lawyer Dan Neidle warns that UK tax law is so complex that the ‘spirit’ of the law is not always clear. This approach to tax, he warns, could leave the door open for the taxman to interpret the law in whichever way benefits him the most.

“The problem is that UK tax law is such a mess that it is impossible to say what Parliament did or did not intend,” he said. “So, in the end, you are taking a great deal of power and giving it to HMRC officials.

“You are no longer taxed from law, but on the basis of an official who is in no doubt subject to their own pressure to increase yields.”

Another problem is that there is no consensus over whether tax avoidance is immoral, or even exactly what it is.

For example, anyone can “avoid” tax by putting money into an ISA. For that matter, you can avoid tax by choosing to buy cakes (which are not subject to VAT) instead of biscuits (which are subject to VAT).

Martin Lewis, founder of consumer advice site, draws a distinction between “tax planning” and tax avoidance.

He regards the latter as a way to “manipulate the tax system…[to pay] less than you’re supposed to”, while tax planning is taking advantage of “state-encouraged schemes which are designed to encourage you to act a certain way” – for example, the tax relief from putting money into an ISA encourages people to save money.

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