What’s the difference between tax avoidance and tax evasion?
In recent weeks we saw the publication of a landmark investigation into U.S. President Donald Trump’s business dealings surrounding the sweeping real estate empire built by family patriarch Fred Trump, all the way up to the present-day management of the business under Trump scions Donald Jr. and Eric.
Indeed, the venerable New York Times declared that “President Trump participated in dubious tax schemes during the 1990s, including instances of outright fraud, that greatly increased the fortune he received from his parents.” The newspaper goes on to document—in a nearly 13,000-word report—how the Trumps allegedly used tax shelters, shell companies and a range of other potentially dubious tools to minimize tax bills over the years, including avoiding a massive potential tax hit of nearly $500 million in estate and inheritance levies after Fred Trump’s passing.
Clients often ask our team to explain the difference between tax avoidance and evasion, which echoes an important distinction raised in the Times report between the Trumps’ New York real estate dealings and tax-planning compliance best practices. The short answer is: evasion is illegal and is never worth the risk. In Canada in recent years—as we’ve outlined in past blogs the Canada Revenue Agency has become increasingly sophisticated in tracking income and transactions for tax purposes, and levying back taxes, interest and fines as punitive measures to deter any and all nefarious behaviour.
But the Trump piece begs the question: to what degree is it acceptable to work to avoid—or minimize—taxes owing? Where does the agency draw the line when it comes to entrepreneurs leveraging the law to help minimize their tax burden? The obvious response is that minimization is kosher up to the point that legislation and CRA guidance allows. For instance, self-employed individuals commonly split business income with spouses or even adult children if those family members have some legitimate engagement with the business (serving as a corporate director or providing a relevant service, for example).
This not only helps to reduce the principal’s income tax hit, but is a tool those entrepreneurs can use to channel income to save for costly expenditures such as their children’s post-secondary education. However, if their 10-year-old is listed as an employee of the business, this would immediately raise the ire of the CRA unless it can be definitively proven that the child provided some value to their company. And yes, there are individuals who attempt to test the boundaries of otherwise legal and reasonable tax minimization strategies in similarly egregious ways. It never works, at least not in the long term.
Even the basic act of incorporating a business can help individuals minimize their tax burden by creating opportunities to leverage various tax benefits such as the Small Business Tax Deduction, which effectively taxes the income of a Canadian-controlled private corporation at a reduced rate. Incorporation also allows business owners to defer taxation by leaving profits within the corporation to grow, which can be reinvested. The additional retained earnings can be drawn down at a later date, perhaps when the owner has less income and is in a lower tax bracket.
Where individuals and corporations tend to run afoul of the CRA is in utilizing complex tax minimization schemes that flout either the letter or the spirit of federal (or provincial) tax laws. This would include (but is in no way limited to) deliberately underpaying taxes, over-claiming expenses or grossly underestimating income. Recent revelations connected to the so-called Panama Papers and other recent examples of high-profile offshore tax-avoidance strategies, have exposed complex maneuvers by wealthy individuals looking to shelter or hide income in overseas tax havens, often using offshore trusts and charitable donations as a tool to minimize taxation on their Canadian income.
Many wealthy taxpayers have become uncomfortably familiar with the CRA’s power to reassess previously allowed tax claims and returns, sometimes to the tune of hundreds of thousands of dollars in back taxes. In extreme cases, some of these individuals have been forced to settle with the tax man to avoid jail time. In the end the CRA always gets its money and reminds us all that the government has immense power to collect in situations where individuals or corporations are suspected of taking unreasonable steps to avoid taxes—or when overt attempts at evasion are exposed.
The bottom line is that if a tax-planning measure is aggressive and the promised returns seem too good to be true, it probably is. Another important rule: if you don’t understand the tax-planning tactic, don’t agree to it. As a taxpayer, you’re the one responsible to the CRA for filing tax returns that accurately reflect key information such as income and deduction claims. It’s your signature on the return and, ultimately, your legal liability.
Leverage tax law in a reasonable way and if you think your accountant is playing loose with the rules, seek a second (or third) opinion.
Marshall Egelnick, Managing Partner