Overview of Tax Avoidance and Tax Evasion
Tax Evasion and Tax Avoidance—Do you Know the Difference?
The distinctions between tax evasion and tax avoidance will be discussed in this article. The main distinction between the two is that tax avoidance is not a crime but the former, tax evasion, is. To put it more precisely, tax avoidance is the legal arrangement of one's affairs to reduce the tax burden, while tax evasion includes breaking the law to avoid paying taxes. Understanding the distinction and difference between tax evasion and tax avoidance is essential because the effects of tax evasion, which can include jail time, are more severe than those of unsuccessful attempts to legally avoid paying taxes.
What Does Tax Avoidance Mean?
Organizing one's tax affairs to reduce one's tax liability is legal. The Duke of Westminster principle states that taxpayers are free to set up their tax affairs in a way that lowers the amount of tax due, and it is derived from possibly the most well-known 1936 common law tax case, Inland Revenue Commissioners v. Duke of Westminster. An attempt to minimize one's tax affairs is of course not always successful. The General Anti-Avoidance Rule (GAAR) was adopted by Parliament in response to the Supreme Court of Canada case Stubart Investments Ltd v R, put forward rules to restrict unacceptably aggressive tax avoidance strategies.
The purpose of GAAR is to allow tax deductions for generally lawful business transactions while prohibiting tax deductions from abusive tax evasion activity. The regulation makes a distinction between lawful tax planning and dishonest tax avoidance. In other words, the goal of GAAR is to prevent specific arrangements from receiving tax benefits where they actually represent an abuse of the provisions of the Income Tax Act (ITA). A transaction that results in a tax benefit is characterized as an "avoidance transaction" by Section 245(3) of the ITA unless it can be fairly inferred that it was carried out principally for legitimate objectives aside from getting the tax benefit.
The application of the GAAR, which entails three steps, was summed up by the Supreme Court of Canada in Canada Trustco Mortgage Co v. R.:
- Identify any "tax benefit" resulting from a "transaction" in accordance with ITA sections 245(1) and 245(2);
- Ascertain if the transaction meets the requirements of s. ITA Section 245(3); and
- Analyze the avoidance transaction to see if it violates s. ITA section 245(4).
The line separating lawful tax mitigation and dishonest tax avoidance can be far from clear. The distinction is significant because, even though there won't be any penalties assessed, unsuccessful tax avoidance attempts will result in deductions being denied and if overly aggressive could result in gross negligence penalties. Hence, if you have any inquiries concerning these tax matters, speak with one of our knowledgeable Canadian tax lawyers.
Tax Evasion: What Is It?
Simply put, tax evasion is the illegal breach of statutory obligations intended to evade taxes. Sections 238 and 239 of the Income Tax Act (ITA) and section 327 of the Excise Tax Act (GST/HST) provide a thorough explanation of tax evasion. The CRA must show both the taxpayer's actus reus—the act of committing the tax crime—and the taxpayer's mens rea—the intention to commit the tax crime—in order to convict a taxpayer for tax evasion. It is necessary to establish both of these criteria—the guilty act and the guilty mind—beyond a reasonable doubt. Hence, the accused must willfully conceal income from reporting or claim tax credits or deductions for expenses that are not allowed. Some actions that could be viewed as tax evasion include:
- Setting up businesses and committing GST/HST fraud using false identification;
- Incorrectly claiming deductions; and
- Omitting or underreporting income from a particular source, such as cash transactions or undeclared income from offshore sources.
Tax Evasion and Tax Avoidance: How to Tell the Difference
Examining the taxpayer's motive is one technique to differentiate between tax evasion and tax avoidance. The taxpayer must intend to avoid paying known-to-be-due taxes in order to be found guilty of tax evasion. In R v Klundert, the Ontario Court of Appeal looked at the key distinction between tax evasion and tax avoidance. According to the Court, what separates a dishonest tax evader from a legitimate tax planner is the culpable state of mind. The former instead aims to avoid owing the tax, not to avoid paying the tax that is due.
Examining whether the transaction is plainly tax-exempt is another method of separating tax avoidance from evasion. A transaction has to be taxable in order to establish tax evasion. The problem might be related to tax avoidance, though, if it is unclear if the transaction is taxable.
Of course, there is no ambiguity with respect to unreported income or improperly claimed deductions. Those activities are always criminal tax evasion. However, if a taxpayer receives money from offshore, while CRA may try to characterize the funds as unreported income, they may well be nontaxable as, for example, a gift or inheritance. An expert Canadian tax lawyer can assist you in the circumstances.
Pro Tax Tip-Know the Boundaries of Tax Avoidance
The old adage that an ounce of prevention is worth a pound of cure is especially applicable in a tax planning scenario. Properly structuring your affairs, including where appropriate a detailed tax memo setting out the basis for your position, can save a lot of CRA tax grief in the long run. A taxpayer's case's outcome depends on competent tax planning and if necessary representation. If you are accused of tax evasion or the CRA has sent your case to the Aggressive Tax Planning branch of the CRA, get legal help from one of our expert Canadian tax and trial lawyers.
Frequently Asked Questions
I received an inheritance from my late father in Iran. These funds came in through a Hawala because of the foreign-exchange restrictions. CRA is saying this is unreported income and is threatening to charge me with tax evasion. What can I do?
Unfortunately, this is a very common scenario and requires a fight with CRA to prove the source of funds. All available documentation has to be assembled including proof of the will, translated into English. Because they are threatening tax evasion charges you should not deal directly with CRA but only through a knowledgeable Canadian tax lawyer.
I have been in the crypto market for several years and I have not reported my income. What can happen to me? How should I proceed?
All crypto transactions, including coin-to-coin exchanges, have to be reported to CRA. Failure to do that is tax evasion and you can be charged and potentially go to jail. At a minimum, you will have to pay penalties. If you have not yet been contacted by CRA you can submit a voluntary disclosure application which, if accepted, will eliminate the possibility of both criminal charges and gross negligence penalties. Depending on the nature of your transactions you may require a tax analysis memorandum setting out whether you need to report transactions on an income or capital gains basis.
"This article just provides broad information. It is only up to date as of the posting date. It has not been updated and may be out of date. It does not give legal advice and should not be relied on. Every tax scenario is unique to its circumstances and will differ from the instances described in the articles. If you have specific legal questions, you should seek the advice of a Canadian tax lawyer."