tax shelter
   HOME

TheInfoList



OR:

Tax shelters are any method of reducing taxable income resulting in a reduction of the payments to tax collecting entities, including state and federal governments. The
methodology In its most common sense, methodology is the study of research methods. However, the term can also refer to the methods themselves or to the philosophical discussion of associated background assumptions. A method is a structured procedure for bri ...
can vary depending on local and
international tax International taxation is the study or determination of tax on a person or business subject to the tax laws of different countries, or the international aspects of an individual country's tax laws as the case may be. Governments usually limit the ...
laws.


Types of tax shelters

Some tax shelters are questionable or even illegal: *Offshore companies. Due to differing tax rates and legislation in each country, tax benefits can be exploited. Example: If Import Co. buys $1 of goods from
India India, officially the Republic of India (Hindi: ), is a country in South Asia. It is the List of countries and dependencies by area, seventh-largest country by area, the List of countries and dependencies by population, second-most populous ...
and sells for $3, Import Co. will pay tax on $2 of
taxable income Taxable income refers to the base upon which an income tax An income tax is a tax imposed on individuals or entities (taxpayers) in respect of the income or profits earned by them (commonly called taxable income). Income tax generally is computed ...
. However, tax benefits can be exploited if Import Co. is to set up an offshore subsidiary in the
British Virgin Islands ) , anthem = "God Save the King" , song_type = Territorial song , song = "Oh, Beautiful Virgin Islands" , image_map = File:British Virgin Islands on the globe (Americas centered).svg , map_caption = , mapsize = 290px , image_map2 = Brit ...
to buy the same goods for $1, sell the goods to Import Co. for $3 and sell it again in the domestic market for $3. This allows Import Co. to report taxable income of $0 (because it was purchased for $3 and sold for $3), thus paying no tax. While the subsidiary will have to pay tax on $2, the tax is payable to the tax authority of British Virgin Islands. Since the British Virgin Islands has a corporate tax rate of 0%, no taxes are payable. *Financing arrangements. By paying unreasonably high interest rates to a related party, one may severely reduce the income of an investment (or even create a loss), but create a massive capital gain when one withdraws the investment. The tax benefit derives from the fact that capital gains are taxed at a lower rate than the normal investment income such as interest or dividend. The flaws of these questionable tax shelters are usually that transactions were not reported at
fair market value The fair market value of property is the price at which it would change hands between a willing and informed buyer and seller. The term is used throughout the Internal Revenue Code The Internal Revenue Code (IRC), formally the Internal Revenue C ...
or the interest rate was too high or too low. In general, if the purpose of a transaction is to lower tax liabilities but otherwise have no economic value, and especially when arranged between related parties, such transactions are often viewed as unethical. The agency may re-evaluate the price, and will quickly neutralize any over tax benefits. However, such cases are difficult to prove. A
soft drink A soft drink (see #Terminology, § Terminology for other names) is a drink that usually contains water (often Carbonated water, carbonated), a Sweetness, sweetener, and a natural and/or Artificial Flavoring, artificial flavoring. The sweetene ...
from a
vending machine A vending machine is an automated machine that provides items such as snacks, beverages, cigarettes, and lottery tickets to consumers after cash, a credit card, or other forms of payment are inserted into the machine or otherwise made. The fir ...
can cost $1.75, but may also be bought in bulk for $0.25. To prove that the price is in fact unreasonable may turn out to be reasonably difficult itself. Other tax shelters can be legal and legitimate: *Flow-through shares/
limited partnership A limited partnership (LP) is a form of partnership similar to a general partnership except that while a general partnership must have at least two general partners (GPs), a limited partnership must have at least one GP and at least one limited p ...
s. Certain companies, such as mining or oil drilling often take several years before they can generate positive income, while many of them will go under. This normally deters common investors who demand quick, or at least safe, returns. To encourage the investment, the US government allows the exploration costs of the company to be distributed to shareholders as
tax deduction Tax deduction is a reduction of income that is able to be taxed and is commonly a result of expenses, particularly those incurred to produce additional income. Tax deductions are a form of tax incentives, along with exemptions and tax credits. T ...
s (not to be confused with
tax credits A tax credit is a tax incentive which allows certain taxpayers to subtract the amount of the credit they have accrued from the total they owe the state (polity), state. It may also be a credit granted in recognition of taxes already paid or a for ...
). Investors are rewarded by 1) the near instant tax savings 2) the potential massive gains if the company discovers gold or oil. In US terminology, these entities are given the generic title of "limited partnership" and in the past they may have simply been called a "tax shelter", being an archetypical tax shelter. However the
IRS The Internal Revenue Service (IRS) is the revenue service for the United States federal government, which is responsible for collecting U.S. federal taxes and administering the Internal Revenue Code, the main body of the federal statutory ...
limited the popularity of these plans by allowing the losses to only offset passive (investment) income as opposed to earned income. *Retirement plan. In order to reduce burden of the government-funded pension systems, governments may allow individuals to invest in their own pension. In the USA these sanctioned programs include Individual Retirement Accounts (IRAs) and 401(k)s. The contributed income will not be taxable today, but will be taxable when the individual retires. The advantage to these plans is that money that would have been taken out as taxes is now compounded in the account until the funds are withdrawn. With the
Roth IRA A Roth IRA is an individual retirement account An individual retirement account (IRA) in the United States is a form of pension provided by many financial institutions that provides tax advantages for retirement savings. It is a trust law, trust t ...
and the newly introduced (
006 Alec Trevelyan (006) is a fictional character In fiction, a character (or speaker, in poetry) is a person or other being in a narrative (such as a novel, Play (theatre), play, Radio series, radio or television series, music, film, or video ...
Roth 401(k), income is taxed before the contributions are made into the account but are not taxed when the funds are withdrawn. This option is preferred by those workers who expect to be in a higher tax bracket during retirement than they currently are. A similar system is available in the
United Kingdom The United Kingdom of Great Britain and Northern Ireland, commonly known as the United Kingdom (UK) or Britain, is a country in Europe, off the north-western coast of the European mainland, continental mainland. It comprises England, Scotlan ...
and is known as the
Individual Savings Account An individual savings account (ISA; ) is a class of retail investment arrangement available to residents of the United Kingdom. First introduced in 1999, the accounts have favourable tax status. Payments into the account are made from after-tax i ...
. These tax shelters are usually created by the government to promote a certain desirable behavior, usually a long-term investment, to help the economy; in turn, this generates even more tax revenue. Alternatively, the shelters may be a means to promote social behaviors. In
Canada Canada is a country in North America. Its Provinces and territories of Canada, ten provinces and three territories extend from the Atlantic Ocean to the Pacific Ocean and northward into the Arctic Ocean, covering over , making it the world ...
, in order to protect the Canadian culture from American influence, tax incentives were given to companies that produced Canadian television programs. In general, a tax shelter is any organized program in which many individuals, rich or poor, participate to reduce their taxes due. However, a few individuals stretch the limits of legal interpretation of the income tax laws. While these actions may be within the boundary of legally accepted practice in physical form, these actions could be deemed to be conducted in bad faith. Tax shelters were intended to induce good behaviors from the masses, but at the same time caused a handful to act in the opposite manner. Tax shelters have therefore often shared an unsavory association with
fraud In law, fraud is intentional deception to secure unfair or unlawful gain, or to deprive a victim of a legal right. Fraud can violate civil law (e.g., a fraud victim may sue the fraud perpetrator to avoid the fraud or recover monetary compe ...
.


Judicial doctrines

Aside from the attempts to stop tax shelters in the United States through provisions of the U.S.
Internal Revenue Code The Internal Revenue Code (IRC), formally the Internal Revenue Code of 1986, is the domestic portion of federal statutory tax law in the United States, published in various volumes of the United States Statutes at Large, and separately as Title 26 ...
, U.S. courts have several ways to prevent tax sheltering activities from happening. The judicial doctrines have a basic theme: to invalidate a transaction that would achieve a result contradictory to the intent or basic structure of the tax code provisions at issue. The following are the judicial doctrines: 1) ''The
Substance over form doctrine Substance over form is an accounting generally accepted accounting principles, principle used "to ensure that financial statements give a complete, relevant, and accurate picture of transactions and events". If an entity practices the 'substance ov ...
'' This doctrine is based on the premise that if two transactions have the same economic result, they should have the same tax result. To achieve this similar tax result, it can be necessary to look at the substance of the transaction rather than the formal steps taken to implement it. 2) ''The
Step transaction doctrine The step transaction doctrine is a judicial doctrine in the United States that combines a series of formally separate steps, resulting in tax treatment as a single integrated event. The doctrine is often used in combination with other doctrines, suc ...
'' Similar to the substance doctrine, the step transaction doctrine treats a series of formally separate steps as a single transaction to determine what really was going on with the transaction. 3) ''The Business Purpose Doctrine'' Courts will invalidate a transaction for tax purposes under this doctrine when it appears that the taxpayer was motivated by no business purpose other than to avoid tax or secure some tax benefit. This judicial inquiry largely is dependent on the taxpayer's intent. 4) ''The Sham Transaction Doctrine'' This doctrine looks for transactions where the economic activities giving rise to the tax benefits do not occur. A clear example of this doctrine is seen in '' Knetsch v. United States, 364 U.S. 361''. Sham transactions are classified as being one of two types, sham-in-substance, or sham-in-fact. 5) ''The
Economic Substance Economic substance is a Legal doctrine, doctrine in the tax law of the Taxation in the United States, United States under which a transaction must have both a substantial purpose aside from reduction of tax liability and an economic effect aside fr ...
Doctrine'' Under this doctrine, courts will invalidate the tax transaction if the transaction lacks economic substance independent of the tax considerations. This doctrines questions whether the purported economic activity would have occurred absent the tax benefits claimed by the taxpayer.


Statutory provisions

In 2010, the U.S. Congress amended the Internal Revenue Code to codify and clarify the rules for applying these doctrines under the over all heading of the "Economic Substance Doctrine." The codification is found in subsection (o) of Section 7701 of the Code. Under the Code, a taxpayer must (with certain exceptions) meet both of the following tests in order for a transaction to be respected. The transaction must change, in a ''meaningful way'', the taxpayer's economic position apart from the Federal income tax effects, and (B) the taxpayer must have a ''substantial purpose'' for entering into such transaction, apart from its Federal income tax effects. Under the Code, the term "economic substance doctrine" is defined as the common law doctrine under which Federal income tax benefits with respect to a transaction are not allowable if the transaction does not have economic substance or lacks a business purpose. The step transaction doctrine is incorporated into the codification.See section 7701(o)(5)(D).


See also

*
Asset protection Asset protection (sometimes also referred to as ''debtor-creditor law'') is a set of legal techniques and a body of statutory and common law dealing with protecting assets of individuals and business entities from civil money judgments. The goal of ...
*
ATTAC The Association pour la Taxation des Transactions financières et pour l'Action Citoyenne (''Association for the Taxation of financial Transactions and Citizen's Action'', ATTAC) is an activist organisation originally created to promote the e ...
NGO's criticism of tax haven and
underground economy A black market, underground economy, or shadow economy is a Secrecy, clandestine Market (economics), market or series of transactions that has some aspect of illegality or is characterized by noncompliance with an institutional set of rule ...
*
Corporate haven Corporate haven, corporate tax haven, or multinational tax haven is used to describe a jurisdiction that multinational corporations find attractive for establishing subsidiaries or Incorporation (business), incorporation of regional or main compan ...
*
Corporate Inversion A tax inversion or corporate tax inversion is a form of tax avoidance where a corporation restructures so that the current parent is replaced by a foreign parent, and the original parent company becomes a subsidiary of the foreign parent, thus mov ...
*
Free port Free economic zones (FEZ), free economic territories (FETs) or free zones (FZ) are a class of special economic zone (SEZ) designated by the trade and commerce administrations of various Country, countries. The term is used to designate areas in ...
*
Free economic zone Free economic zones (FEZ), free economic territories (FETs) or free zones (FZ) are a class of special economic zone (SEZ) designated by the trade Trade involves the transfer of goods and services from one person or entity to another, oft ...
* International Business Corporation * List of offshore financial centres *
Money laundering Money laundering is the process of concealing the origin of money, obtained from illicit activities such as drug trafficking, corruption, embezzlement or gambling, by converting it into a legitimate source. It is a crime in many jurisdictions ...
*
Offshore bank An offshore bank is a bank A bank is a financial institution that accepts deposits from the public and creates a demand deposit while simultaneously making loans. Lending activities can be directly performed by the bank or indirectly th ...
*
Offshore company The term "offshore company" or “offshore corporation” is used in at least two distinct and different ways. An offshore company may be a reference to: * a company, group or sometimes a division thereof, which engages in offshoring business p ...
*
Offshore Financial Centres An offshore financial centre (OFC) is defined as a "country or jurisdiction that provides financial services to nonresidents on a scale that is incommensurate with the size and the financing of its domestic economy." "Offshore" does not refer ...
*
Offshore trust An offshore trust is a conventional Trust law, trust that is formed under the laws of an Offshore Financial Centre, offshore jurisdiction. Generally offshore trusts are similar in nature and effect to their onshore counterparts; they involve a set ...
*
Panama Papers The Panama Papers ( es, Papeles de Panamá) are 11.5 million leaked documents (or 2.6 terabytes of data) that were published beginning on April 3, 2016. The papers detail financial and attorney–client information for more than 214,488 ...
*
Paradise Papers The Paradise Papers are a set of over 13.4 million confidential electronic documents relating to offshore investment Offshore investment is the keeping of money in a jurisdiction other than one's country of residence. Offshore jurisdi ...
* Son of BOSS *
Tax avoidance and tax evasion Tax noncompliance (informally tax avoision) is a range of activities that are unfavorable to a government's tax A tax is a compulsory financial charge or some other type of levy imposed on a taxpayer (an individual or legal person, legal en ...
*
Tax exemption Tax exemption is the reduction or removal of a liability to make a compulsory payment that would otherwise be imposed by a ruling power upon persons, property, income, or transactions. Tax-exempt status may provide complete relief from taxes, redu ...
*
Tax resistance Tax resistance is the refusal to pay tax because of opposition to the government that is imposing the tax, or to government policy, or as Taxation as theft, opposition to taxation in itself. Tax resistance is a form of direct action and, if in vio ...
*
Tax exile A tax exile is a person who leaves a country to avoid the payment of income tax or other taxes. The term refers to an individual who already owes money to the tax authorities or wishes to avoid being liable in the future for taxation at what they ...
*
Tax exporting Tax exporting occurs when a country A country is a distinct part of the world, such as a state (polity), state, nation, or other polity, political entity. It may be a sovereign state or make up one part of a larger state. For example, the ...
*
Tax haven A tax is a compulsory financial charge or some other type of levy imposed on a taxpayer (an individual or legal person, legal entity) by a governmental organization in order to fund government spending and various public expenditures (regiona ...


References

{{Reflist, 30em


External links


The Internal Revenue Service on tax shelters
Tax avoidance Ethically disputed business practices