Understanding the Difference: Tax Avoidance vs. Tax Evasion Explained

What is Tax Evasion?

Tax Evasion is an illegitimate way to minimize tax liability through unlawful techniques like inflating expenses or understating taxable income. Such fraudulent means are used with the motive of showing lesser profits to minimize one’s tax burden. Certain noted illegal practices are concealing income or relevant documents, making false statements, overstatement of the tax credit, not maintaining complete records of the transactions or accounting personal expenses as business expenses.

Tax evasion is an offense for which the assessee could be punished under Chapter XXII of the Income Tax Act, 1961. One common way people adopt to evade taxes is by transacting in cash without accounting for the same in books. However, to track and tax such transactions and the means utilized to evade tax, the government keeps a vigilant watch and picks the cases for assessment. If caught, a heavy penalty may be levied along with taxes.

For example, John owns a small business and generates significant cash income from his business activities. Instead of reporting the full income and paying the appropriate taxes, John engages in tax evasion to evade his tax obligations. John begins by intentionally underreporting his business income on his tax return. He manipulates his accounting records, inflates expenses, and hides some of his cash income. By doing so, he significantly reduces his reported income, which leads to a lower tax liability. John's actions constitute tax evasion since he deliberately and illegally manipulates financial information, hides income, and conceals assets to avoid paying the taxes he owes.

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What is Tax Avoidance?

Tax Avoidance involves using legal methods to minimize tax liability. In other words, it consists in using means within four corners of the tax law to minimize one’s tax burden. Although a legal method, it is not advisable as it ultimately aims to reduce the amount of tax that is payable by one for their own personal advantage, which is unfair exploitation of law. Tax avoidance is taking unfair advantage of the lacunae in the tax law by finding ways to avoid the payment of taxes. Tax avoidance is usually done by adjusting the accounts so that there will be no violation of tax laws or by finding loopholes in the law. Though lawful, it could be categorized as an offense in some cases.

For example, companies channel their funds through offshore branches to avoid paying taxes in their home country.

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What is Tax Planning?

Tax planning is a comprehensive evaluation of one’s financial situation using current known and estimated future variables and drawing out a feasible plan. Tax planning, like tax evasion/avoidance, is also done to reduce tax liability. However, it involves legal planning regarding investments, expenses, etc., to avail various exemptions and deductions provided under the tax laws.

E.g., Section 80C allows a deduction of up to INR 1,50,000 if specified investments are made. The most popular ways of saving tax through planning are investing in Life insurance policies, PPF accounts, National Saving certificates, Sukanya Samriddhi Scheme, term deposits, Provident Funds, etc. Tax planning involves planning the financial affairs to entitle the taxpayer to the benefits of deductions, exemptions, concessions, and rebates. Tax planning is a genuine approach to applying all the provisions within the tax law framework to the taxpayer’s benefit.

Difference between Tax Planning, Tax Evasion, Tax Avoidance

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What are the common methods of Tax Evasion or Tax Avoidance?

Not paying tax dues: Not paying taxes by the due dates or not paying taxes when called for by the tax authorities.

• Smuggling: Goods or articles are smuggled from one place to another to evade taxes.
• Not reporting/misreporting/under-reporting of income: A person may not report the income received during the year or may report less income or misreport the same. These are the common ways of evading taxes.
• Incorrect income tax returns(ITR): Concealing information in the ITR or filing inaccurate or incomplete information leads to tax evasion.
• Inaccurate financial statements: The tax payable is decided on the financial transactions of the taxpayer during a year. Taxpayers adopt ways to manipulate the books of accounts to deflate income and inflate expenses. This leads to lower tax liability.
• Fake documents to claim expenses or exemption: Taxpayers try to avoid taxes by providing fake invoices, documents, etc., which they manage to get created to claim expenses and exemptions.
• Keeping wealth in other countries: Taxpayers store wealth in countries like tax havens, Swiss Bank accounts, and the like to evade taxes on their income.

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Penalty for Tax evasion and Tax avoidance

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