Difference Between Tax Planning Tax Avoidance and Tax Evasion

Tax planning may be defined as an arrangement of one's financial affairs to take full advantage of all eligible tax exemptions, deductions, concessions, rebates, allowances permitted under the Income-Tax Act ,1961, so that the tax burden is minimised in the hands of the taxpayer without violating the legal provisions.

Tax avoidance is reducing or negating tax liability in legally permissible ways by structuring one's affairs. Any such transaction would be valid only if it has commercial substance and is not a colourable device.

The Supreme Court, in M/s McDowell and Co Ltd Vs Commercial Tax officer, 1985, (154 ITR 148(SC), held that for tax planning to be legitimate it must be within the legal framework and colourable devices cannot be part of tax planning. In deciding whether a transaction is a genuine or colourable device, it is open for the tax authorities to go behind the transaction and examine the "substance" and not merely the "form".

Tax evasion is the method or means by which the tax is illegally avoided through unacceptable means. It refers to a situation where a person tries to reduce his tax liability by deliberately suppressing the income or by inflating the expenditure, recording fictitious transactions, etc.

It is to be noted that the proposed Direct Tax Code (DTC) provides for general anti-avoidance rules (GAAR) to address the concerns of tax avoidance. The provisions of GAAR may be invoked by the commissioner of income-tax, wherein a taxpayer has entered into an arrangement to obtain tax benefit and such arrangement fulfils any one of the following conditions:
. it is not at arms length; or
. it represents misuse or abuse of the provisions of DTC; or
. it lacks commercial substance; or
. it is entered into or carried on in a manner not normally employed for bonafide business purpose.

To avoid arbitrary application of GAAR, it is expected that the Central Board of Direct taxes will provide the threshold limit and the guidelines to specify the circumstances under which GAAR may be invoked.

Accordingly, the new rules under DTC (ie, GAAR) shall have far-reaching implications on the transactions that lack commercial substance or represent abuse of tax provisions. As such, it is important for the taxpayers to understand the distinction between tax planning and tax avoidance to avoid unwarranted tax and penal consequences.