Tax planning, tax avoidance and tax evasion: what are the differences?
1) Tax planning
Tax planning is a process of structuring transactions to minimise one’s liability to tax, and usually fulfills both the legal requirements and intent of the income tax law. It is closely supported by sound commercial decision.
2) Tax avoidance
A tax avoidance arrangement normally fulfils the legal requirements of the law, but not necessarily the intent of the law.
3) Tax evasion
Criminal offence which involves the reduction of one’s tax liability or obtainment of tax credits or refunds through illegal means such as the claim for fictitious or non-existent expense or failure to declare taxable income
The difference between tax evasion and tax planning/avoidance is relatively clear-cut. However, whether the arrangement constitutes tax avoidance or tax planning, is not as clear-cut as it seems. We will explore below the factors and examples of a tax avoidance arrangement.
Tax avoidance
The Inland Revenue Authority of Singapore (IRAS) adopts a ‘3-steps approach’ to determine an arrangement constitutes tax avoidance, as stated in the case law CIT v AQQ and another appeal [2014] SGCA 15.
Step 1: Whether an arrangement falls under Section 33(1) of the Singapore Income Tax Act (SITA)
The Comptroller may make tax adjustment, if in his opinion, there are ‘profit-shifting’ arrangements or the arrangements relieves any person from tax liability.
Step 2: Whether the taxpayer may avail himself of the statutory exception under Section 33(3)(b)
If an arrangement falls under Section 33(1) of the SITA, taxpayer would need to consider whether the arrangement satisfies Section 33(3)(b) of the SITA.
Section 33(3)(b) of the SITA states that Section 33 cannot be applied on any arrangement carried out for bona fide commercial reasons and that one of its main purposes is not avoiding or reducing tax.
Hence, any genuine business transaction resulting in incidental tax savings is not considered tax avoidance.
Step 3: Whether the tax advantage obtained arose from the use of a specific provision in the Act
If the taxpayer is unable to satisfy the Comptroller in step 2 (i.e not genuine commercial reason or one of its main purpose is to avoid or reduce tax), they would need to rely on other provision of the SITA to prove that this is a tax planning arrangement.
Factors to determine tax avoidance arrangement exists
In CIT v AQQ [2012] SGHC 249, the High Court set out a number of relevant factors to determine whether a tax avoidance arrangement exists. These factors are:
(i) The manner in which the arrangement was carried out;
(ii) The role of all relevant parties and any relationship they may have with the taxpayer;
(iii) The economic and commercial effect of documents and transactions;
(iv) The duration of the arrangement; and
(v) The nature and extent of the financial consequences that the arrangement has for the taxpayer
Examples of tax avoidance arrangement
The IRAS has issued an e-tax guide of examples of tax avoidance arrangement. This list is not exhaustive and is merely common examples.
- Circular flow or round-tripping of funds
Selling an asset to another business with an agreement to buy-back in the future. It usually have no change in a company’s financial position.
2) Setting up of more than one entity for the sole purpose of obtaining tax advantage
Setting up a company to maximise tax benefit (i.e New start-up or partial tax exemption scheme) may constitute tax avoidance.
3) Changes in the form of business entity for the sole purpose of obtaining tax advantage
As changing from sole-proprietorship to private limited companies may reduce tax liabilities (which we will be discussing in the other article), the IRAS may question if there are valid commercial reason to change the form of business entity.
4) Attribution of income that is not aligned with economic reality
Company may shift income derived from the company to a newly-incorporated shell company. This is not acceptable as the shell company has not done anything to earn the income.
Example of tax planning
Section 33 is aimed at tax avoidance schemes designed to avoid tax and is not intended to interfere with the tax consequences of genuine commercial transactions. The IRAS has provided 2 examples:
- Placement of money in local bank or outside Singapore
This is purely a commercial decision and IRAS would not interfere.
2) Non-remittance of foreign income
The SITA provides exemption of certain foreign-sourced income. As per point 1,
taxpayers should not be penalised for bringing in exempt foreign-sourced income instead of taxable foreign-sourced income as it is legislated in the SITA.
Why is it important to know the difference?
It is important to know the differences as different action will be taken by the Inland Revenue Authority of Singapore (IRAS) in regard to the different arrangement. Below are the action that will be taken by the Comptroller under the different scenarios:
Tax planning
There will be no action taken.
Tax avoidance
The Comptroller will issue additional assessment. The tax payable will be based on the tax liability if the taxpayer have not entered into a tax avoidance arrangement. There are no penalty for tax avoidance arrangement.
Tax evasion
Where a person wilfully evades or assist another person to evade tax, the penalty is based on 300% of the tax undercharged and in addition there is a maximum fine of $10,000 and/or maximum jail term of three years.
Conclusion
The difference between tax avoidance and tax planning lies in whether there are commercial reasons for the arrangement and the tax savings are merely incidental.