Published: July 7, 2020
Last Updated: June 11, 2021
Introduction to Tax Evasion and Tax Avoidance
This article will examine the differences between tax evasion and tax avoidance. Generally speaking, the difference is that the former, tax evasion, is a criminal act, and the latter, tax avoidance, is not. More specifically, tax evasion involves illegally breaching statutory duties to evade paying tax, while tax avoidance involves legally organizing one’s affairs to minimize the tax burden. This distinction is crucial because the consequences of tax evasion are more severe than the consequences related to failed attempts at tax avoidance.
What is Tax Avoidance?
It is not illegal to organize one’s tax affairs to minimize the tax burden. The Duke of Westminster principle, from perhaps the most famous common law tax case Inland Revenue Commissioners v Duke of Westminster, states that taxpayers are entitled to arrange their tax affairs to reduce the amount of tax payable. However, not all attempts to minimize one’s tax affairs will be successful. As a response to the Supreme Court of Canada case Stubart Investments Ltd v R, which proposed guidelines to limit unacceptable tax avoidance arrangements, the Parliament enacted the General Anti-Avoidance Rule (GAAR).
The goal of GAAR is to prevent tax deductions from abusive tax avoidance transactions while allowing tax deductions for otherwise legitimate commercial transactions. The rule distinguishes between legitimate tax planning and abusive tax avoidance. In other words, the purpose of GAAR is to deny tax benefits of specific arrangements that amount to an abuse of the provisions of the Income Tax Act (ITA). Section 245(3) of the ITA defined an “avoidance transaction” as a transaction that gives rise to tax benefit, unless the transaction may reasonably be considered to have been undertaken primarily for bona fide purposes other than obtaining the tax benefit.
The Supreme Court of Canada in Canada Trustco Mortgage Co v R summarized the application of the GAAR, which involves three steps:
- Determine whether there is a “tax benefit” arising from a “transaction” under section 245(1) and 245(2) of the ITA;
- Determine whether the transaction is an avoidance transaction under s. 245(3) of the ITA; and
- Determine whether the avoidance transaction is abusive under s. 245(4) of the ITA.
The distinction between legitimate tax mitigation and abusive tax avoidance is far from clear. The difference is crucial because failed attempts at tax avoidance will result in disallowance of deductions, although no penalties will be levied. Thus, if you have any questions about these tax issues, consult with one of our experienced Canadian tax lawyers.
What is Tax Evasion?
In simple terms, tax evasion involves illegally breaching statutory duties to evade paying tax. A detailed description of tax evasion may be found in section 238 and 239 of the ITA and section 327 of the Excise Tax Act. To convict a taxpayer for tax evasion, the CRA must prove the actus reus of the taxpayer, which is the act of committing the tax crime, and the mens rea of the taxpayer, which is the intention to commit the tax offence. These two elements, the guilty act and the guilty mind, must be proven beyond a reasonable doubt. Thus, the accused must knowingly fail to report income or claim expenses or tax credits that one is not entitled to deduct. Some practices that may be considered tax evasion involve:
- Using fake identifications to set up businesses and commit GST/HST fraud;
- Improperly claiming deductions; and
- Under-reporting or failing to report income from a specific source, including cash transactions or unreported offshore income.
Differentiating Between Tax Evasion and Tax Avoidance
One way to distinguish between tax evasion and tax avoidance is by examining the intent of the taxpayer. For tax evasion, the taxpayer must have an intent to evade payment of taxes that are known to be owing. The Ontario Court of Appeal in R v Klundert examined the main distinction between tax evasion and tax avoidance. The Court stated that the culpable state of mind is the factor that distinguishes the legitimate tax planner from the dishonest tax evader. The former does not intend to avoid the payment of a tax that is owed but instead intends to avoid owing the tax.
Another way to distinguish between tax evasion and tax avoidance is by examining whether the transaction is clearly subject to tax. A requisite to finding tax evasion is that a transaction must be subject to tax. However, if it is unclear whether the transaction is subject to tax, then the issue may be in the realm of tax avoidance.
Toronto Tax Lawyers Can Help
Proper tax representation is crucial in the outcome of a taxpayer’s case. Contact one of our experienced Canadian tax and trial lawyers for representation if you are facing a charge of tax evasion, or if the CRA has referred your file to the Aggressive Tax Planning division of the CRA.
"This article provides information of a general nature only. It is only current at the posting date. It is not updated and it may no longer be current. It does not provide legal advice nor can it or should it be relied upon. All tax situations are specific to their facts and will differ from the situations in the articles. If you have specific legal questions you should consult a lawyer."
Tax avoidance, unlike tax evasion, is concerned with the spirit of the law and not fraud. An example of an unacceptable tax avoidance would be using a partnership to transfer property to a purchaser in order to defer any gain on sale. Another example might be using a preferred share buyback program in order to convert a salary into capital gains for better tax treatment.
A tax benefit is a mechanism that the CRA provides that reduces the amount of tax an individual or company pays. It is perfectly legal to take advantage of them. A tax lawyer will be able to tell you which ones you can use, as well as explain how to qualify for tax credits.
Tax mitigation is not the same as tax avoidance. Mitigation uses tax laws to achieve a lower tax bill. It is the process of fully understanding the rules and maximizing your use of the mechanisms and schemes put in place to keep your tax bill low. Tax avoidance is when someone takes advantage of gaps in the law to avoid paying taxes. In other words, not following the spirit of the law. It is not illegal, but the CRA scrutinizes those that do this more than other taxpayers.