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The Difference Between Tax Avoidance, Tax Evasion and Tax planning? One of Them is illegal!

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No one really likes paying tax. Sure, we might be proud to make a contribution to society and understand that our taxes got to pay for important things we collectively need (and, of course, sometimes stupid things no one needs) but most of us would rather also have more money in our own pockets.

But some people will do anything they can not to pay tax - even if it's not always legal.

1. Tax Evasion

Tax evasion is breaking the law. By definition tax evasion means not paying tax you legally owe and therefore is definitely illegal.

Most countries apply extra penalties to tax evaders who are caught and charge interest on past tax bills. Of course, whether or not tax evaders are caught will depend on how efficient the authorities in that country are. And on how clever and ruthless the evaders are.

Everyone apart from the wackiest libertarians and anarchists agrees that tax evasion is morally wrong - if you evade tax you are doing something clearly illegal.

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Tax Reliefs

Special exemptions from tax the are created by the Government are called tax "reliefs". Tax reliefs vary by country and even by state or local authority. Governments use them to encourage certain behaviours and discourage others. Some things that often attract reliefs are:

  • Charity donations (to registered charities)
  • Pension contributions and/or pension income
  • Certain kinds of investments, such as in business startups
  • Buying government debt (such as investing in gilts in the UK)

2. Tax Planning

Tax planning on the other hand is perfectly legal. Different countries decide, from time to time to give tax breaks to certain things. It might be on investment in certain startup businesses or on lending money to the Government or income in special savings accounts. It might be for donations to charity or paying money into a pension plan.

The reduction in tax paid here was planned and agreed by the Government and there is nothing at all wrong in making use of it - that's what you're meant to do - so long as you use it in the way it was intended.

Tax planning is clearly not immoral, if you are complying with the spirit of the law. For example if you get tax relief on your pension contributions, that money should go to fund yourself in retirement.

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3. Tax Avoidance

This is a grey area. Some people say tax avoidance is legal. It isn't. Others say it is illegal. It isn't that either.

Confused? You should be. Tax avoidance happens in that grey zone where that way of not paying tax has not yet been proved illegal. On the other hand it could be proved illegal at any time and it certainly hasn't been approved by the authorities. That makes it very risky.

If your adviser sells you a dodgy plan (for a hefty fee) to avoid tax, which is then proved illegal YOU Are responsible for paying the back taxes and maybe fines and interest on top. And will you get your fee back? Unlikely.

Make sure you ask plenty of questions about any tax plan your adviser suggests to you (They won't call it avoidance). In particular make sure that you find out if it has ever been tested in court or specifically approved by the tax authorities.

Some countries have a general anti-avoidance rule which makes any scheme that does not obey the spirit of the tax law illegal. Others have to specifically outlaw practices they don't like and you can't quite be sure whether a plan will be ruled in or out until someone takes it to court.

Summary

Tax planning is a sensible way to make the most of your finances. We should all do that. The Government expects us to. Tax evasion is clearly illegal and not a good idea unless you can fund years of expensive litigation. Tax avoidance is too much of a risk. So make sure that when your advisor comes to you with a nifty tax dodge you ask the right questions - for example has this been tested in court?

Do this and you'll pay exactly the right amount of tax, not too much (by not planning) or too little (by cheating). And, if nothing else, you can be proud of your contribution to society.

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