International Tax Law

TAX AVOIDANCE AND EVASION

What is Tax Avoidance as compared to Tax Evasion?

The classic distinction between tax avoidance and tax evasion can be attributed to Justice Oliver Wendell Homes (once an Associate Justice of the US Supreme Court).

He made the distinction in the case of Bullen –vs- Wisconsin (1916), 240,
U.S. 625 at page 630.

In the Bullen Case, Justice Oliver Wendell Holmes Stated, “when the law draws a line, a case is on one side of it or the other, and if on the safe side is none the worse legally that a party has availed himself to the full of what the law permits. When an act is condemned as evasion, what is meant is that it is on the wrong side of the line…”

The distinguishing characteristic of evasion is illegality.

If on the wrong side of the law, it is evasion.

If on the right side of the law, it is avoidance.

An author known as Emanuel Mchani defines tax avoidance as the act of structuring once affairs legally so that one is paying less taxes than he or she might otherwise pay.
Tax avoidance could involve making use of loopholes, which are inadvertent errors in the tax legislation, but more using the provisions of the law to ones advantage.

On the other hand, tax evasion is the attempt to reduce ones taxes or increase refundable credits by illegal means, e.g. making false statements about once income or deductions, or destroying records.

In the Indian case of McDowell & Co. Ltd – vs – CTO 154 ITR 148 [1985] Justice Reddy defined tax avoidance as the “art of dodging tax without breaking the law.”

It is the avoidance of tax payment without the avoidance of tax liability.

If the tax law is broken in the process of avoiding tax, it becomes tax evasion.

A classic example of a case on tax avoidance is the case of Duke of Westminster – vs – CIR [1936] AC in which it was held, “Every man is entitled if he can to order his affairs so that the tax attaching under the appropriate Act is less than otherwise would be. If he succeeds in ordering them so as to secure this result, then however unappreciative the commissioners of Inland Revenue or his fellow taxpayers may be of his ingenuity he cannot be called upon to pay increased tax.

In a House of Lords decision of 1997, Lord Noland in the case of IRC –V – Willoughby & Another [1997] distinguished tax avoidance as follows;
“The hallmark of tax avoidance is that the tax payer reduces his liability to tax without incurring the economic consequences that parliament intended to be suffered by any taxpayer qualifying for such a reduction in his tax liability.”

There is no attempt by any of the Kenyan tax legislations, to define either tax avoidance or tax evasion.

How does Tax Evasion Occur?

Broadly, tax evasion occurs when a tax payer uses fraudulent methods or deceptive behaviour to hide the actual tax liability.

Tax evasion would usually involve the following:
Failure by a taxable person to notify the tax authorities of his presence/residence or occurrence of taxable activities.
The failure to report the full amount of taxable income
The deduction claims for expenses that have not been incurred, or which exceeded the amounts that have been incurred but not for the purpose stated.
Falsely claiming tax relief (s) that is/are not due.
Failure to pay over to the tax authorities the tax properly due.
The departure from a country without paying taxes and with no intention of paying them.
Failure to report items or sources of taxable income, profits or gains, where there is a tax obligation to declare.
Transfer pricing.
  This is also a mechanism of tax evasion. A company based in a country with high rates of corporation tax could deliberately overpay for raw materials supplied by one of its subsidiaries in the low tax country where it will pay less.
  We shall expound on the issue of transfer pricing later.

How does Tax Avoidance Occur ?

  The following are examples of mechanisms employed to achieve tax avoidance:
Income splitting
  This entails the splitting of income between more than one tax payer so as to reduce the marginal tax rate.
  If one can manage to split one figure into several, the applicable marginal rate will be lower and therefore little taxable income.
  For example, if by earning Kshs. 1, 000, 000/= per month, one falls into the 30% tax rate, he can avoid tax by splitting the income into 4 individuals, if possible. The effect is, each of the individuals will have Kshs. 250, 000/= which may each fall into a lower tax rate, say 10% and thereby reducing the total payable.
  Is it plausible?
  How would it be logical to split ones income and give to others, and still retain that income as yours?
  If the income is still yours, wouldn’t it be illegal?

Thin Capitalization
  “Thin capitalization‟ is usually used to describe “hidden equity capitalization” through excessive loans.
  It is the artificial use of interest bearing debt instead of equity by shareholders with the sole primary motive to benefit from its tax advantages.  

  The loan may be provided on a market rate of interest but the size of the loan cannot be justified on bona fide business considerations.
  Such excessive interest payments constitute  hidden distributions that should be properly treated as dividend on equity capital. (i.e. equity capital is amount or capital raised by the equity owners or shareholders whereas debt capital is amount or capital obtained by way of loans).
  In case of equity capital, the shareholders would receive dividends which are taxable.
  On the other hand, in the case of debt capital or loans, the entity would be paying interest on the debt or loans, which interest would then be deducted from the income as an expense thus reducing the amount of income taxable.

Asset shifting
  This is achieved by shifting the asset producing income to another person or entity that is taxed preferentially, i.e. taxed less that the person or entity shifting the asset.
  You could transfer the asset to a charitable trust which enjoys preferential tax treatment.

                   iv. Sheltering of income
  This    is    done    by    receiving    incomes    in    tax    havens    e.g.
Switzerland and Cayman islands.
  Tax havens have lower tax rates or no tax charge at all.

  We shall later examine tax havens at length.

Income capitalization
  This means the conversion of taxable income into capital e.g. not declaring of dividends but instead converting of profits into capital to avoid non – payment of tax on dividends.

Measures Against Tax Evasion
  Generally, since tax evasion is illegal, legal penalties are used to deter tax evasion.

  However, certain measures can be used to minimize the weaknesses that are exploited by tax evaders.

  The most notable anti-evasion measures are those adopted by the European Union.

  These measures are based on the reality that tax evasion is a cross-border problem.

  These measures are as follows: Savings Tax Directive
  The EU operates by way of directives given for implementation by EU member countries.

  The EU Savings Tax Directive creates an information exchange system for tax authorizes to identify individuals who receive savings income in a member state other than his own.
  By doing so, the member states can collect data on the savings on the savings of non – resident individuals, and automatically provide this data to the authorities where the individual resides.

Savings Tax Agreements
  These are agreements entered between countries so as to assist countries in taxing citizens who have savings accounts in respective countries.

Administrative Co-operation
  This is done by strengthening administrative co-operation between member states by enabling tax authorities to benefit from exchanged data, information and experiences to better tax evasion.

Code of conduct on Business Taxation
  The code provides that the EU Member States should refrain from introducing, or amending any harmful tax measures that unfairly undermine other member state‟s revenue raising capacities.

    Iv.   Improving the exchange of information
  Rapid access to information is important in fighting tax evasion.
  More efficient methods of information exchange should be put in place.

Class should research on other measures applied against tax evasion.

 Measures against tax avoidance

Even though tax avoidance is not illegal, it nonetheless minimizes the revenue collected by government. There should therefore be ways of curbing tax avoidance. Some of the anti-avoidance approaches proposed are as follows:

Sniper approach
  This entails the enactment of specific provisions that identify with precision the type of transactions to be dealt with and prescribe against tax consequences.

Shotgun approach
  This entails the enactment of general provisions to hit broad types of avoidance practices in specific areas.

Administrative approach
  The control of tax avoidance is left to the discretion of tax authorities.
  In this case section 23 of the Kenyan Income Tax Act, gives discretion to the Commissioner of Income Tax Act to direct that adjustments be made as respects liability to tax to counteract the avoidance or reduction of liability to tax.
   This is done where the Commissioner is of the opinion that the main purpose or one of the main purposes for which a transaction was effected was avoidance or reduction to tax.

Judicial avoidance doctrines
  Courts have stated certain principles that are intended to curb tax avoidance.
  These doctrines are also known as General Anti – Avoidance Rules (GAAR).
  The main guiding principles are:

The Motive Test/Business Purpose Rule
This rule attacks tax avoidance schemes that do not have a business purpose and those artificially designed merely to avoid tax.
Under this doctrine, a transaction must have a main or predominant business purpose (i.e. commercial justification) other than tax avoidance.
The mere tax advantage cannot be acceptable business purpose; it must show a business or non – tax purposes.
Thus it must have a valid business or economic purpose other than reduction of tax liability.
If the primary purpose is something other than tax avoidance, the transaction represents acceptable tax planning.
On the other hand, if the primary purpose is to obtain tax benefits and the transaction would not be carried without those benefits, the transaction is treated as unacceptable tax avoidance.

Artificiality Test / Substance over Form Rule
The acts must be assessed according to bona fide economic and commercial substance and not the formal content.
It requires the establishment of the underlying economic reality, not what is displaced on form/paper.
Taxation will then be based on the true commercial transaction, not what is portrayed on paper.
An example is where transactions have been shown on paper to have happened but have not really happened.
In this case, courts will apply tax rules on the true position, i.e. the alleged transactions have not happened.
A company, in order to avoid tax on dividends, may label a transaction as loan with exaggerated interest when in the real sense it is equity (the company would then claim to be paying interest on loan which is deductible from the company‟s income and thus reducing the amount of tax payable, yet in the real sense it is capital equity given by a shareholder that should attract tax when dividends are paid on it).
What is appearing on form is loan with exaggerated interest but the underlying on substantive economic transaction is equity capital.
The courts would then treat such „loan‟ transaction as equity and not loan, which in that case will attract taxes on dividends therefrom.
In case of Ridge Securities – Vs – IRC, court rejected a loan with interest at over 400% per annum as a loan transaction.
The 400% interest per annum would mean that a lot of the entity‟s income would be channeled to paying huge interests on the „loan‟, and thus depleting the taxable income and denying the tax collector the true tax.

TAX FRAUD

Types of Tax Fraud
Tax fraud involves tax evasion which is a deliberate attempt to illegally obtain a tax benefit.
This comes in many forms including:
Forging books of accounts
Using cooked statements
Failing to register as a tax entity
Failure to furnish tax returns
Failure to pay taxes,
Failure to keep records,
Failure to withhold taxes,
Obstructing, bribing and, or impersonating a tax official
Aiding and abetting a tax crime

Actions that lead to Tax Fraud/Tax Evasion?

a) Manifest Fraud
This occurs when shipping agents illegally alter manifests prior to uploading them to the Customs Manifest Management System (MMS), thereby setting the stage for false declarations.
b) Use of fake security bonds to clear transit goods
Some importers and clearing agents use fake Customs transit bonds to clear transit goods. This happens by collusion between clearing agents, insurance companies and Customs officers.
c) Diversion/Dumping of transit goods
Transit goods are goods imported through the East African Community (EAC) region to a country outside the region. Transit goods within the EAC region are not subject to import duty. However if the consignment fails to exit the region within the prescribed period and no official extension is granted, duty becomes due (this is diversion of transit goods). Customs department secure the duty due on transit cargo through the execution of a security bond. Goods prone to diversion include sugar, petroleum, rice and motor vehicles.

d) Customs Mis-declarations
A Customs declaration is a statement showing goods being imported on which duty will have to be paid. This is done by filling in a Customs declaration form. However, some importers/clearing agents make wrong declarations with the objective of evading payment of duties or reducing the duties payable. Making a wrong declaration (i.e. mis-declaration) is a prosecutable offence.

e) Smuggling
This involves importation or export of goods secretly in violation of the law, especially without payment of duties. Recent cases include: importation of high end vehicles cleared as mattresses, baby car seats, bed sofas, toys, clothes, beach beds, shoes, belts and handbags.
f) Fraudulent cancellation of export entries
This is use of fake Customs entries as proof of export, which thereafter leading to fraudulent VAT refund claims.

g) Import/Export of prohibited or restricted goods
Prohibited goods are the goods that cannot be imported/exported into/out of the country. Restricted goods are those which must meet certain conditions before clearance through Customs.
Examples: ivory, macadamia nuts, flora and fauna etc.

h) Fake payments of import taxes
This happens when Customs entries are fraudulently posted in the Customs system and validated with fake bank payment receipts.

i) Dealing with excisable goods without a valid licence
By Law, dealers in excisable products (especially tobacco, wines and spirits) should be licensed.

j) Nil/non filing income tax returns
All individuals with income are required by law to submit Income tax returns together with accounts where applicable. The returns are due on or before the end of the 6th month after the end of accounting period. Non-submission of tax return may result into prosecution.

k) Invoice fraud
The scheme involves shell companies through which money is channeled as payments for purchase of goods while in actual sense no goods are supplied.

l) Under declaration of income
By Law, all income earned in Kenya is taxable. However, some individuals under declare their income for purposes of reducing their tax liability.

TRANSFER PRICING
Transfer price is the price that one department or division of an entity charges for the products or services supplied to another division of the same entity.
Transfer pricing is the general term for the pricing of cross – border, intra – firm transactions between related parties.
Transfer pricing as such refers to the setting of prices at which transactions occur involving the transfer of property or services between associated enterprises, forming part of a Multinational Enterprise Group (MNE Group).
Transactions between these associated entities are also referred to as “controlled” transactions, opposed to “uncontrolled” transactions between non – related entities which can be assumed to operate independently. (On “an arm‟s length basis”).
Transfer pricing is a normal incident of how MNEs must operate, and as such transfer pricing does not necessarily give rise to an avoidance or tax evasion.
However, where the pricing does not accord with applicable norms internationally or as per domestic law, issues of “mispricing”, “incorrect pricing”, “unjustified pricing” or tax avoidance or evasion, arise.
Transactions between two related parties must be based on the “arm‟s length principle” (ALP).
Under ALP, transactions within a group are compared to transactions between related entities to determine acceptable transfer prices.

Transfer Pricing Methods
How is the arm‟s length principle applied in practice in order to determine the arm‟s length price of a transaction?
Various transfer pricing methods include:
i.  Comparable Uncontrolled Price (CUP).
  This method compares the price charged for a property or service transferred in a controlled transaction to the price charged for a comparable property or service transferred in a comparable uncontrolled transaction in comparable circumstances.
Resale Price Method (RPM).
  This method is used to determine the price to be paid by a reseller for a product purchased from an associated enterprise and resold to an independent enterprise.
Cost Plus
  This method is used to determine the appropriate price to be charged by a supplier of property or services to a related purchaser.
  The price is determined by adding to the cost the supplier incurred, an appropriate gross margin so that the supplier makes an appropriate profit in light of the market conditions.
Profit – based methods
  These are the profit comparison and profit split methods
Profit Comparison Method
  This method compares the level of profit that would have resulted from controlled transactions with the profits that would have been realized by comparable uncontrolled transactions.
Profit Split Method
  This method takes the combined profits earned by two related parties from one or a series of transactions and then divides the profits so as to replicate the division of profits that would have been anticipated in an agreement made at arm‟s length.

Transfer Pricing in Treaties
As seen, the UN and OECD Model Conventions at Article 9 provides for taxation of incomes of associated enterprises.
  Article 9 is a statement of the arm‟s length principle and allows for profit adjustments if the actual price on transactions between associated enterprises differs from the price that would be charged by independent enterprises under normal market terms.
 Transfer Pricing in Domestic Law
Article 9 of the Model conventions regulates the basic conditions for adjustment of transfer pricing and advises the application of arms length principle, but does not go into the particulars of transfer.
Article 9 is not „self – executing‟ as it does not create transfer pricing regime in a country.
Transfer pricing regimes are creatures of domestic law.
Each country is required to formulate detailed legislation to implement transfer pricing rules.
In Kenya, Section 18(3) of the ITA empowers the commissioner to adjust the profits accruing to a resident person from a course of business  conducted with related non – resident persons to reflect such profit as would have accrued if the course of the business had been conducted by independent persons dealing at arm‟s length.
The Transfer Pricing Rules 2006 (TP Rules) were introduced in Kenya in 2006, to supplement the provisions of Section 18 (3) of the ITA.
The TP Rules provide guidelines to be applied by related entities in determining the arm‟s length prices of goods and services in transactions involving them and to provide administrative regulations, including the types of records and documentation to be submitted to the commissioner by a person involved in transfer pricing arrangements.

WHAT IS BEPS?
Base erosion and profit shifting (BEPS) refers to tax planning strategies that exploit gaps and mismatches in tax rules to make profits ‘disappear’ for tax purposes or to shift profits to locations where there is little or no real activity but the taxes are low, resulting in little or no overall corporate tax being paid.

INTRODUCTION
In September 2015, the G20 Finance Ministers called on the OECD to build an inclusive framework for the implementation of the , with the involvement of interested non-G20 countries and jurisdictions, particularly developing economies, on an equal footing
The G20 Leaders reiterated this request in their November 2015 communique, in which they strongly urged the timely implementation of the project and encouraged all countries and jurisdictions, including developing ones, to participate. The OECD/G20 BEPS package had been developed by OECD and G20 countries working together on an equal footing through the BEPS Project of the OECD’s Committee on Fiscal Affairs (CFA). In 2016, the CFA decided to extend the BEPS Project and establish the OECD/G20 Inclusive Framework on BEPS. The CFA identified an initial group of 123 countries and jurisdictions1 that might be interested in joining OECD and all G20 members2 in the Inclusive Framework on BEPS. All members of the Inclusive Framework participate on an equal footing.

WHAT IS THE INCLUSIVE FRAMEWORK ON BEPS DOING?
Inclusive Framework members are working on the implementation and updating of the OECD/G20 BEPS package. With respect to implementation, the Inclusive Framework is focusing in particular on the four minimum standards:
1.    In the areas of harmful tax practices,
2.    abuse of tax treaties,
3.    Country-by-Country reporting for the activities of Multinational Enterprises, and
4.    improving dispute resolution mechanisms.
A Peer review processes ensure the effective and consistent implementation of the minimum standards in order to achieve a level playing field and protect countries’ tax bases. These existing standards and peer review processes are currently being reviewed to ensure they remain appropriate and fit for purpose. The Inclusive Framework also provides support to developing countries to facilitate understanding and implementation of the BEPS measures. Importantly, the Inclusive Framework is also working on new measures to help ensure the international tax system can meet the challenges of increasing digitalisation of the economy. The proposals under discussion include the possibility of a new taxing right which could allocate a percentage of residual profits of MNEs to the jurisdiction of their users or customers even where, because of digitalisation, the company may not have a traditional taxing presence in that country; and a set of rules to ensure all MNEs pay at least a minimum level of taxes on their profits somewhere in the world.

WHAT IS A DIGITAL ECONOMY?
The digital economy is the result of the widespread and transformative process brought on by Information and Communication Technology (ICT). All sectors, ranging from retail, financial services to education and broadcasting and media have been transformed by ICT technologies. So much so, that the digital economy is increasingly becoming the economy itself. It would therefore be difficult, if not impossible, to ring fence the digital economy from the rest of the economy for tax purposes.

Common Tax Planning

Individuals as well as corporate entities can mitigate their tax exposure by keeping the following points in mind as they conduct their affairs.

Keeping Complete and Accurate Records

Proper record keeping enables individuals and companies, first, to support allowable deductions from their gross income.

Accurate records will also help in the event of a tax audit or other proceedings against the taxpayer.

Getting Timely, Competent Tax Advice

Working with a competent tax consultant enables individuals and corporate entities to conduct their affairs in compliance with existing tax laws.

Challenging Tax Assessments

As we shall se later, the tax statutes provide avenues for individuals and companies to challenge tax assessments made upon them by tax authorities.

At times, it turns out that the assessments by the tax authorities are on the higher side.

Compliance

Taxpayers can avoid exposure to tax problems (stiff penalties, interest, possible shutdown of business, and distractions from

usual activities) by complying with tax laws and regulations

However, it is not illegal to arrange one’s affairs in such a manner as to minimize tax burden.

TRANSFER PRICING
Transfer price is the price that one department or division of an entity charges for the products or services supplied to another division of the same entity.
Transfer pricing is the general term for the pricing of cross – border, intra – firm transactions between related parties.
Transfer pricing as such refers to the setting of prices at which transactions occur involving the transfer of property or services between associated enterprises, forming part of a Multinational Enterprise Group (MNE Group).
Transactions between these associated entities are also referred to as “controlled” transactions, opposed to “uncontrolled” transactions between non – related entities which can be assumed to operate independently. (On “an arm‟s length basis”).
Transfer pricing is a normal incident of how MNEs must operate, and as such transfer pricing does not necessarily give rise to an avoidance or tax evasion.
However, where the pricing does not accord with applicable norms internationally or as per domestic law, issues of “mispricing”, “incorrect pricing”, “unjustified pricing” or tax avoidance or evasion, arise.
Transactions between two related parties must be based on the “arm‟s length principle” (ALP).
Under ALP, transactions within a group are compared to transactions between related entities to determine acceptable transfer prices.

Transfer Pricing Methods
How is the arm‟s length principle applied in practice in order to determine the arm‟s length price of a transaction?
Various transfer pricing methods include:
i.  Comparable Uncontrolled Price (CUP).
  This method compares the price charged for a property or service transferred in a controlled transaction to the price charged for a comparable property or service transferred in a comparable uncontrolled transaction in comparable circumstances.
Resale Price Method (RPM).
  This method is used to determine the price to be paid by a reseller for a product purchased from an associated enterprise and resold to an independent enterprise.
Cost Plus
  This method is used to determine the appropriate price to be charged by a supplier of property or services to a related purchaser.
  The price is determined by adding to the cost the supplier incurred, an appropriate gross margin so that the supplier makes an appropriate profit in light of the market conditions.
Profit – based methods
  These are the profit comparison and profit split methods
Profit Comparison Method
  This method compares the level of profit that would have resulted from controlled transactions with the profits that would have been realized by comparable uncontrolled transactions.
Profit Split Method
  This method takes the combined profits earned by two related parties from one or a series of transactions and then divides the profits so as to replicate the division of profits that would have been anticipated in an agreement made at arm‟s length.

Transfer Pricing in Treaties
As seen, the UN and OECD Model Conventions at Article 9 provides for taxation of incomes of associated enterprises.
  Article 9 is a statement of the arm‟s length principle and allows for profit adjustments if the actual price on transactions between associated enterprises differs from the price that would be charged by independent enterprises under normal market terms.
 Transfer Pricing in Domestic Law
Article 9 of the Model conventions regulates the basic conditions for adjustment of transfer pricing and advises the application of arms length principle, but does not go into the particulars of transfer.
Article 9 is not „self – executing‟ as it does not create transfer pricing regime in a country.
Transfer pricing regimes are creatures of domestic law.
Each country is required to formulate detailed legislation to implement transfer pricing rules.
In Kenya, Section 18(3) of the ITA empowers the commissioner to adjust the profits accruing to a resident person from a course of business  conducted with related non – resident persons to reflect such profit as would have accrued if the course of the business had been conducted by independent persons dealing at arm‟s length.
The Transfer Pricing Rules 2006 (TP Rules) were introduced in Kenya in 2006, to supplement the provisions of Section 18 (3) of the ITA.
The TP Rules provide guidelines to be applied by related entities in determining the arm‟s length prices of goods and services in transactions involving them and to provide administrative regulations, including the types of records and documentation to be submitted to the commissioner by a person involved in transfer pricing arrangements.

LAW NOTES 

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