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Smeal College of Business Taxation and Management Decisions: ACCTG 550Pennsylvania State University Professor HuddartCompliance and Evasion1. Planning, Avoidance, and EvasionTax practitioners contrast tax planning (structuring ones affairs tominimize the burden of taxation in ways that are clearly provided for inthe law), tax avoidance (legally circumventing the law to reduce tax throughascheme not clearly provided for in the law), and tax evasion (knowinglymisreporting or intentionally omitting material facts in violation of the law).Drawing sharp distinctions between tax avoidance and either tax planningor tax evasion is impossible.• Tax avoidance is legal but is often challenged by the taxing authority.• Aggressive tax planning increases the likelihood of incurring audit, re-assessment, penalty payments, negotiation and tax court costs. De-pending on the magnitude of the potential tax benefits from a planningopportunity and the clarity of the tax law organizations may decide toundertake or forgo a risky tax plan.2. Detection and enforcement• The ability of the taxing authority to verify the completeness of incomereporting and the allowability of deductions and credits varies with thetype of income.– E.g., salary and interest income in the U.S. are easier to verify thantip income because payors must report salary and interest paymentsto the IRS.– E.g., salary income is easier to verify than self-employment incomebecause the computation of business income depends on rules thatare more complex and more ambiguous than the rules that governthe recognition of salary income.• The level of tax compliance is a key feature of any tax system. In somecountries, the level of compliance is very high (e.g., the United States,Canada, and the United Kingdom) while in other countries much ofcSteven Huddart, 1995–2005. All rights reserved. www.smeal.psu.edu/faculty/huddartACCTG 550 Compliance and Evasionthe economic activity of the nation goes unreported and untaxed (e.g.,Brazil and Russia).–Tax rulemakers in high-compliance rate countries attribute compli-ance partly to perceptions among taxpayers that taxes are reason-able and equitable. A low rate of non-compliance fosters compli-ance because audit and investigation resources are more likely tobe brought to bear on tax evaders. In this equilibrium, taxpayersface greater costs from non-compliance because the likelihood ofdetection and enforcement is high.–Tax law non-compliance may be encouraged when tax rules areperceived by taxpayers to be unreasonable, unstable, inconsistent,or inequitable; where the rule of law is not established; or wheretax amnesties and political upheavals are common. When non-compliance is high, the resources expended on enforcement areoften low, and must be spread over many violators. This meansthe probability of enforcement action is low, which in turn meansthe returns to evasion are high.Page 2Compliance and Evasion ACCTG 5503. SecrecyOne of the challenges of doing tax research (and of breaking into the taxplanning business) is that organizations often prefer to not publicize theirtax planning activities.• One reason is because they fear a public relations backlash from at-tempts to reduce the total costs of operating a business venture byreducing tax payments.1• Another reason is that aggressive tax planners may wish to avoid pub-licity that might attract heightened interest from the taxing authority.For instance, the IRS sometimes launches audits based on anonymoustips or public outcry alleging improprieties.• Finally, tax plans are costly to develop but cheap to imitate. To protectthis investment in intellectual property, investment bankers and otherwho develop tax plans often keep the details of such plans secret andrequire participants in tax-advantaged structures that they market tocomply with non-disclosure agreements.4. Examples4.1 The Bishop Estate2• The Bishop Estate is the wealthiest charity in the United States. Itsassets are valued at between $8 billion and $10 billion, bigger thanHarvard and Yale combined. The trust was created in 1884 by PrincessBernice Pauahi Bishop who at her death placed 434,300 acres of herroyal lands in a perpetual trust and created the Kamehameha Schoolas its sole beneficiary. Hawaiian land reform in 1967 forced the trust todivest its landholdings and yielded proceeds to the trust in 1984 of $1billion.• For the year ended June 30, 1993, Bishop’s five governing trusteesearned $820,000 each—payments calculated, partly as a percentage ofthe trust’s tax-free investment income.1President Clinton was hurt politically when it was disclosed tax returns indicatingthat earlier in his career, the leader of the free world had claimed a tax deduction for usedunderwear he had donated to charity.2The information in this section is drawn from Alix M. Freedman and Laurie P. CohenWall Street Journal (April 25, 1995) “Bishop’s Gambit.”Page 3ACCTG 550 Compliance and Evasion–Trustees are appointed to age 70.– Board members receive 2% of the trust’s tax-free revenue.– Board members receive less compensation for taxable profits.• The Trust invests both passively and actively.–Ithas an 11% stake in Goldman Sachs.• Less than half of 1993 revenues were spend on the charitable educationalmission of the trust. The rest was reinvested in commercial enterprises.• U.S. tax law stipulates that passive investments by charitable entities arenot subject to income tax, but active investments (so-called unrelatedbusiness income or UBI) is subject to tax at corporate rates.– The Bishop Estate has developed both taxable and non-taxablearms of operation.–In1986 Bishop moved assets associated with an active business, theRoyal Hawaiian Shopping Center Inc., from a taxable subsidiary toits tax-free “parent.”– Subsequently a pattern of transfers between the tax-free and taxablearms emerged in which loss businesses migrate to the taxable armand profitable assets migrate to the tax-free arm.– The trust has also succeeded in converting active income intopassive income on some of its investments. An investment in anindustrial park was structured as a “participating mortgage.”• “Bishop appreciates the secrecy. Indeed, the trust is so shy about outsideinterference that it has nixed certain debt deals because of trustees’worries that financial information in the offering memoranda wouldcirculate too widely. In addition, Bishop is currently


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