Welcome back to the Deep Dive. We're here to
help you navigate the confusing, sometimes contradictory
world of complex topics, sifting through the
sources to give you the most critical insights
minus the information overload. And today we
are tackling a field where really complexity
is the entire business model. We are talking
about taxes. Right. A topic where the difference
between just two words, avoidance and evasion,
can mean... Oh, absolutely. It can mean the difference
between being called a financial genius and facing
serious federal criminal charges. That is a life
changing difference. OK, so let's unpack this.
We are diving deep into the thin and often really
blurry line that separates legal tax planning
from what is, you know, just illegal tax fraud.
And it's a huge global battle. We want to show
you exactly how governments all over the world
are struggling to keep their revenue systems
intact against, frankly, relentless. financial
ingenuity. So our mission for this deep dive
is to provide some real clarity. We're going
to define this whole noncompliance spectrum.
We're going to expose some of the aggressive
methods used by both corporations and high net
worth individuals to shrink their tax bills.
And then we'll detail the increasingly complex
legislative and even judicial tools that revenue
services are deploying to fight back. Let's start
right at the foundation then. We have to establish
that critical distinction immediately because
everything else we talk about today really rests
on these definitions. Absolutely. So at its core,
you have tax avoidance. This is the legal use
of a tax regime to reduce the amount of tax you
have to pay. It's simply taking advantage of
the rules as they're written. So if the government
creates a tax credit for, say, investing in renewable
energy and I use it. That's just tax planning.
Exactly. That's tax planning. The government
explicitly intended for you to use that law.
But the word avoidance itself often has a bit
of a negative ring to it in public conversation.
Yeah, that's where the aggressive part comes
in, right? That's where the gray area begins.
If a scheme is exploiting a loophole, you know,
an unintended technicality or maybe a mismatch
between different countries laws, that shifts
into what we call aggressive tax avoidance or
sometimes tax mitigation. But the key point is
it's still, at least initially, legal. It is.
It operates within the bounds of the law. You're
using the statute exactly as it's phrased, even
if you are, let's be honest, violating the spirit
of that law. OK, so that's the gray area. Then
you have the complete opposite side of the spectrum
where there is no gray area at all. You have
tax evasion. Tax evasion is unambiguously and
unequivocally illegal. This is about a deliberate,
fraudulent attempt to defeat the imposition of
taxes. We're talking about overt deception. Dishonest
reporting, hiding money offshore and not telling
anyone. Exactly. Hiding money, declaring far
less income than you actually earned or knowingly
overstating your deductions or expenses. It is
a financial crime, plain and simple, and it's
often associated with that informal under -the
-table economy. Now, where does the term noncompliance
fit into all this? Our sources suggest both avoidance
and evasion can be seen as forms of it, but that
seems tricky given that one is legal. That's
a very valid point. And it's why that classification
is still contested, particularly in legal circles.
It's true that some people classify both as tax
noncompliance because, well, they both subvert
the state's tax system. They both reduce the
revenue the state was expecting to collect. But
one does it lawfully. And as long as it's lawful,
it's a lawful reduction of liability. But you're
right to point out the underlying intent for
both is the same, to reduce the overall tax bill
to the state. And when we look at the scale of
this problem. That intent is costing governments
globally an immense amount of money. I mean,
that really sets the context for why this is
such a high stakes battle. The magnitude is just
it's fascinating. And the timeline, too. Since
1995, we are talking about literally trillions
of dollars being transferred from OECD countries.
So the wealthier nations and also developing
countries and just channeled directly into tax
havens using these aggressive avoidance schemes.
Trillions is a number that's almost impossible
to really grasp. Can we narrow that down to like.
day -to -day corporate behavior? We can, if you
look specifically at multinational firms. The
data shows they shift an estimated 36 percent
of their total global profits to tax havens.
Wow. More than a third. More than a third of
the profits generated globally by Larden firms
are just moved to places where they face little
or no tax. That 36 percent figure alone tells
you this isn't just a few bad actors. It's a
systemic industrial scale challenge for every
Treasury Department in the world. And that's
revenue that could be funding. Yeah. Well, anything.
Public services, infrastructure, you name it.
Exactly. That massive scale brings us squarely
to the mechanisms. So when we talk about legal
tax avoidance, there's actually a framework for
understanding how these clever schemes are structured.
It's not random. It's built on these core financial
principles. That's right. Nobel laureate Joseph
Stiglitz provided an excellent framework laying
out three core principles that really underpin
almost all successful tax avoidance strategies.
And if you understand these, you can start to
see the pattern behind all sorts of different
corporate and individual schemes. OK, so what
are those three Stiglitz principles? And let's
start with the one that feels the most like,
you know, classic financial advice. The first
one is the simplest, but it's incredibly powerful.
Postponement of taxes. The idea is just that
the present value of a tax that's postponed way
into the future is far less than a tax you pay
today. A dollar today is worth more than a dollar
tomorrow. Precisely. If you owe $100 in tax today,
but you can legally delay paying it for, say,
30 years, you get to invest that $100 for three
decades. Right, which is the whole idea behind
things like pension plans. Exactly. The government
explicitly endorses postponement there. They
say, look, we'll tax you later when your income
is maybe lower in retirement. And that gives
you 30 or 40 years of tax deferred growth. Avoidance
schemes just take that concept and push the boundary,
trying to achieve, you know, perpetual postponement
or even elimination. OK, so that's the first
principle. The second one seems to involve shifting
the burden around inside a structure. That's
right. That's tax arbitrage across individuals.
This means. shifting liabilities between different
people or between different legal entities that
face different tax brackets or different marginal
tax rates over time. Can you give me a tangible
example of that just with individuals? Sure.
Take a high net worth family. The patriarch is
in a top tax bracket, let's say 37%, and he wants
to sell an asset. Well, instead of selling it
himself, he might structure transactions so the
income goes to maybe a limited partnership or
a trust where that income is taxed at a much
lower corporate rate. Or to a family member who's
in a much lower bracket. Or to a family member,
exactly. The overall family tax burden is legally
reduced just by shifting where the liability
lands. And this happens constantly inside corporate
groups, too, with transactions designed specifically
to exploit different rates between their subsidiaries.
So avoidance is basically... Exploiting differences,
differences over time and differences between
entities. What's the third principle? The third
is tax arbitrage across income streams. This
one uses the fact that governments tax different
types of income differently. For example, in
most places, capital gains from selling an asset
are taxed at a much lower rate than ordinary
income, like your salary or rent or dividends.
And so the goal of these sophisticated avoidance
schemes is to somehow convert that ordinary income
into capital gains income. Exactly. The schemes
are designed to change the character of the income,
even if the underlying economic reality is the
same. And really, the most sophisticated tax
avoidance devices, they use a combination of
all three of these Stiglitz principles at the
same time. OK, let's move to the practical methods
that leverage these principles, starting with
the most basic strategy for both companies and
individuals. Just where you choose to live, or
at least where your tax residence is. The basic
strategy is simple in concept, but, you know,
pretty difficult in execution. For a multinational
firm or a high net worth individual, you move
your company's legal home or your personal tax
residence to a low tax jurisdiction, what we
all call a tax haven. Right. So for individuals,
that's places like Monaco. And for corporations,
it's the Cayman Islands or the British Virgin
Islands, where corporate profits are barely taxed.
Correct. But there's a fascinating and often
really contentious exception to this strategy.
It's found in only two countries, and it shows
just how aggressive a government can be. about
retaining the authority to tax its citizens no
matter where they are. And that would be the
unique model used by the United States and, historically,
Eritrea. That's the one. These countries tax
their citizens on their worldwide income regardless
of where that citizen lives. So just moving abroad
and setting up a foreign residence is not enough
to avoid U .S. taxes. You are, for all intents
and purposes, a lifelong customer of the IRS.
That's an incredible compliance burden for millions
of Americans living abroad. And what's the response
from the ultra wealthy, who are often subject
to much higher rates? Well, our sources note
that some high net worth US citizens choose the
ultimate act of tax avoidance. They renounce
their citizenship entirely. It's an official.
public act to escape the complexity and the liability
of the U .S. tax system. And for those who stay
citizens but live abroad. There is the foreign
earned income exclusion, which lets you exclude
a portion of your salaried income earned overseas.
It was capped at about $100 ,000 in 2015, adjusted
for inflation from your U .S. taxes. But once
you go over that limit, the U .S. liability kicks
right back in no matter where you earn the money.
The sources also mention a much more, well, a
much more troubling long -term avoidance strategy
related to this. Yes, it's a dark but sort of
pragmatic phenomenon. Some U .S. parents living
abroad choose not to register their children's
birth with American authorities. So the child
is never recognized as a citizen? Exactly. And
therefore, they're not required to report their
earnings and pay American taxes for their entire
lives, even if they never set foot in the U .S.
It's an incredibly high price to pay losing citizenship
for your child. But it just speaks volumes about
the perceived burden of lifelong U .S. tax compliance.
Wow. That really puts it into perspective. OK,
so moving on to how countries try to make global
taxation work a bit more smoothly or at least
prevent double punishment. We have double taxation
treaties. Right. Most countries legally assert
the right to tax income that's earned within
their borders, no matter who owns it. These treaties
are basically bilateral agreements. designed
to prevent non -residents from being taxed twice,
once where the income is earned and then again
in their home country. They're essential for
international trade. But not just for smooth
trade. They could be exploited for avoidance,
can't they? Oh, absolutely. They introduce complexity
that creative tax planners exploit through a
practice known as treaty shopping. A multinational
might route income through a shell company in
a country that has a favorable treaty with the
host country just to get a lower tax rate, even
though the shell company does no real business
there. And that's why governments are very careful
about who they sign these treaties with. It's
a deliberate defensive measure. The scarcity
of treaties with places widely regarded as tax
havens, like the British Virgin Islands, is no
accident. Though there have been some heavily
exploited ones, like the one between Cyprus and
Russia, which acted as a huge loophole for years.
Another key method is using separate legal entities.
This is how the wealthy manage assets without
technically owning the income directly, right?
It goes back to that arbitrage principle. Exactly.
Individuals use vehicles like companies, trusts
or foundations, and yes, often offshore ones,
to receive income or realize gains instead of
the original owner. The assets are legally transferred
to this new entity and the entity becomes the
tax cat. If the income stays inside the entity,
the individual avoids immediate tax. So it's
like a holding tank for wealth to grow with the
goal of maybe converting that income stream later
on. But there's always a catch, isn't there?
Especially with trusts, the original owner or
the creator usually has to give up something
significant. Correct. For the structure to be
legally recognized as separate, the creator,
the settler, can't retain too much control. They
might be restricted from acting as a trustee
or even being a primary beneficiary. It's a real
tradeoff. You get tax avoidance, but you lose
immediate control of the assets or you might
not be able to benefit from them directly. And
the tax authorities are always scrutinizing these.
Oh, constantly. They spend enormous amounts of
time trying to determine if the settling maintained
effective control. If they did, the whole structure
can be considered a sham and just... for tax
purposes. Before we move on, we have to touch
on one very specific corporate method that perfectly
demonstrates that third Stiglitz principle, exploiting
the different rates between dividends and capital
gains. I'm talking about share repurchases. This
is a textbook example. Historically, companies
gave capital back to stockholders through dividends,
which are usually taxed at a higher ordinary
income rate. But instead of dividends, companies
can just buy back their own stock on the open
market. And how does that help the investor?
It lets the stockholders realize their gain by
selling their appreciated stock back to the company.
That sale is then classified as a capital gain,
which is taxed at that much lower capital gains
rate. It's a completely legal way to return capital
to investors in the most tax friendly way possible.
And it often drives up the stock price for the
remaining investors, too. Right. It reduces the
number of shares outstanding, which gives everyone
else a bigger piece of the pie. It's a win -win
for the investor's tax bill. That brings us to
maybe the most contentious corner of avoidance,
tax shelters. These are the schemes that live
right on the edge of legality. Often they're
created by the government for a good reason,
but then they get hijacked for aggressive, pure
tax reduction. A tax shelter is just any investment
that allows for a reduction in your income tax
liability. And as you said, they exist on a spectrum.
You have... the legitimate government intended
ones and then you have the highly questionable
abusive ones. Let's start with the legitimate
ones because the government actually wants you
to use these. They're basically subsidized behaviors.
Absolutely. They're incentives. Classic examples
in the U .S. include tax deductions for home
ownership like mortgage interest pension plans
and individual retirement accounts or IRAs. The
government is encouraging people to save for
retirement or encouraging social stability by
making homeownership more affordable. I think
the difference between a traditional IRA and
a Roth IRA is a brilliant, simple illustration
of that postponement principle from Stiglitz.
It illustrates it beautifully. With a traditional
IRA, you get an immediate deduction. Your income
isn't taxed today, but it's taxed when you withdraw
the funds in retirement. The Roth IRA flipped
that. You pay tax up front, but then the withdrawal
is tax -free later. So the Roth is for people
who think they'll be in a higher tax bracket
when they retire. Exactly. The choice depends
entirely on predicting your future tax position,
which is the very essence of tax planning. The
UK has a similar, very popular system with their
individual savings account, the ISA. And we also
see shelters used to encourage... Really risky,
but nationally important industries like resource
extraction. Yes. Through what are called flow
through shares or limited partnerships. Companies
involved in high risk stuff like early stage
mining or oil exploration, they often take years
to generate any income. So to encourage investment,
governments let the initial, often enormous exploration
costs, the losses, be passed directly through
to the shareholders as immediate tax deductions.
So investors get an instant tax saving and the
potential for massive gains if the. project hits
right But the IRS did crack down on those by
restricting the losses so they could only offset
passive income, like from other investments,
not your earned salary. That limited their appeal
quite a bit. OK, now we cross the line into the
questionable or abusive shelters. These are the
really complex, multilayered schemes designed
purely for tax exploitation, usually sold to
high net worth clients by big accounting and
law firms. These were highly engineered, often
structured as limited partnerships. Their design
was purely to exploit rate differences, frequently
involving related parties and, you know, non
-fair market value transactions. Our sources
point to some infamous U .S. examples from KPMG
in the late 90s and early 2000s, schemes with
these complex names like FLIP and OPI. And the
goal was usually to create a massive paper loss
that could offset real income. A huge paper loss
coupled with a delayed low -taxed capital gain.
That was the magic formula. Let's simplify the
mechanism of a typical abusive financing arrangement.
What was the core trick behind something like
FLIP or OPI? The core trick was tax arbitrage
using synthetic debt. The taxpayer would create
an offshore shell company, a related party, and
then borrow money from that shell company at
some absurdly high interest rate. That interest
payment generated a massive deduction at home,
which could wipe out domestic investment income.
But if they paid the interest to a related offshore
company... Didn't that company then have to pay
tax on the interest income? Ah, but that's the
arbitrage. That offshore entity was located in
a tax haven where the interest income was barely
taxed or not taxed at all. The whole structure
was designed to create a big domestic deduction
by paying interest that immediately flowed back
to an offshore, untaxed -related party. And the
IRS's argument was that the whole thing was fake.
Basically. The flaw they targeted was that the
transaction prices, like the interest rate, were
not at fair market value and the entire structure
had no... business purpose other than tax reduction.
Since these schemes often technically followed
the letter of the law, how did governments fight
them? The sources detail a really fascinating
development of judicial doctrines in the US to
look past the formal steps. This is a critical
legal battleground. Courts realized they couldn't
just allow obvious abuse because a lawyer used
clever language. So they developed several key
doctrines to fight schemes that violated the
spirit of the law. starting with the most fundamental
doctrine of all time in tax law. That would be
substance over form. The idea here is dead simple.
If two transactions give you the same economic
result, they should have the same tax result,
regardless of the legal steps you took. It forces
courts to look at the economic reality, the substance,
not just the legal paperwork, the form. So if
the court has to look at the reality, How hard
is it for the IRS to prove that reality when
the paperwork is so deliberately confusing? It's
incredibly difficult, which is why they often
lean on the closely related step transaction
doctrine. This doctrine takes a series of formally
separate steps A, then B, then C, and just treats
them as a single unified transaction to figure
out the true nature of what happened. So it stops
people from breaking one taxable event into lots
of little non -taxable pieces. Exactly. Then
you have the famous doctrine that came out of
the U .S. Supreme Court case, Gregory V. Halvering
back in 1935. The business purpose doctrine.
Right. This one is all about intent. All about
intent. In that case, a taxpayer created a shell
corporation for just three days solely to transfer
assets tax free. And then she dissolved it. The
Supreme Court said, look, while you followed
the letter of the law, the transaction is invalid
because you were motivated by no business purpose
other than tax avoidance. Disregarded for tax
purposes, yes. And finally, you have the sham
transaction doctrine. This one looks for transactions
where the claimed economic activity and the tax
benefits that go with it didn't actually happen
or were completely illusory. The classic case
is Netsch v. United States. A guy supposedly
borrowed huge sums to invest in annuity bonds
to generate massive interest deductions. The
IRS successfully argued it was a sham because
the interest payments and repayments just canceled
each other out. There was no genuine economic
activity. So these judicial doctrines were really
effective against the most aggressive schemes.
But then the US Congress took it a step further
in 2010 and actually wrote one of them into law.
Yes, they codified the economic substance doctrine
in Section 7701 of the Internal Revenue Code.
This basically formalized the judicial principle
into a statutory requirement, largely incorporating
both the business purpose and the substance over
form tests. The goal was to give the IRS a clearer,
more standard tool and to impose strict penalties.
So what does a taxpayer have to prove now to
satisfy this codified doctrine? They generally
have to meet two tests at the same time. First,
the transaction has to meaningfully change their
economic position apart from any tax effects.
That's the economic reality test. Did you actually
take on any risk? And second, they have to have
a substantial purpose for the transaction apart
from the tax effects. That's the business purpose
test. And if you can't satisfy both, the transaction
gets thrown out and you get hit with penalties.
Exactly. It really sounds like an unending legal
cat and mouse game between ingenious tax advisers
and the government just constantly shifting the
goalposts of what legal actually means. That
cat and mouse game extends far beyond U .S. courts
now. It's rapidly shaping global economic policy.
The fight against avoidance requires these major
legislative tools, both specific and general,
being implemented internationally. Right. So
let's clarify those legislative tools. SAR versus
GAR. OK. SARs are specific anti -avoidance rules.
They target one specific practice, like a law,
that limits the deduction of interest paid to
a related party in a very specific situation.
They're like surgical strikes. And GARs. GARs,
or general anti -avoidance rules, are much broader.
They're designed to prohibit aggressive tax avoidance
that violates the general spirit of the code
no matter what specific technique you're using.
GARs sound like they give tax authorities a lot
more power, almost like the judicial economic
substance doctrine, letting them counter schemes
that haven't even been invented yet. They do,
and that's the whole point. Our sources note
that GARs exist in sophisticated places like
Canada, Australia, New Zealand, South Africa.
It's interesting that the UK historically opposed
the idea, thinking it was too vague and bad for
business confidence. But they eventually came
around. The sheer volume of aggressive avoidance
forced their hand. The UK introduced its own
GAR in 2013 to prevent tax reduction through
legal arrangements that serve no reasonable commercial
purpose. And while national governments were
doing this, the European Union implemented a
huge package to standardize the fight across
the entire bloc. That's the incredibly influential
European Union's anti -tax avoidance package,
or ATAD. It was implemented in 2016, and it was
the EU's big push for more effective corporate
taxation and a coordinated response to all this
profit shifting. And it required all member states
to apply five legally binding anti -abuse measures
by January 2019. That is a massive step towards
tax harm. across 27 different legal systems.
Let's walk through those five measures starting
with the one that targets those abusive financing
schemes we talked about. The first is interest
deductibility. This measure discourages artificial
debt arrangements by limiting how much interest
a company can deduct. The goal is to stop a multinational
from lending money internally to a subsidiary
in a high tax country like Germany and then sucking
all the profits out as tax deductible interest
payments. So you can't just use related party
loans to zero out your profits anymore. What
about companies that physically move valuable
assets around the world to avoid tax? That's
countered by the second measure. exit taxation.
This prevents tax avoidance when companies move
assets from a high tax country to a low tax one.
So if a valuable patent is developed in France
and a company moves ownership of it to a mailbox
company in Ireland just before selling it, the
French government can levy a tax on the value
of that asset at the point it exits. The third
measure goes back to that judicial battle we
just covered. It's the mandatory incorporation
of the GAR. This requires all member states to
disregard non -genuine arrangements, effectively
standardizing the use of a general anti -abuse
rule across the entire EU. And the last two measures
specifically target these multinational corporate
structures that rely on shifting profits to places
where no real work is being done. Yes. The fourth
is the Controlled Foreign Company rule. This
is designed to deter profit transfers to subsidiaries
in low or no tax countries where there's little
to no real economic activity. If a company is
deemed a CFC, its profits might be taxed immediately
in the home country, even if the money hasn't
been officially sent back to the parent company.
It makes it a lot less attractive to just set
up a shell company and a tax haven. And the fifth.
That is the switchover rule. This one prevents
double non -taxation. It makes sure that if a
country provides an exemption for foreign income,
it has to switch over to a credit method if that
foreign income was taxed at an extremely low
rate. It guarantees the income is taxed somewhere
at a meaningful rate. Outside of the EU, the
biggest international effort against all this
comes from the OECD, involving dozens of countries
globally. That's the Comprehensive Base Erosion
and Profit Shifting Initiative, or BEPS. The
goal of BEPS is to reform international tax rules
to ensure that profits are paxed where the actual
economic activity happens, not just where the
intellectual property is legally registered.
It's a fundamental challenge to the old loophole
-ridden system. And the UK put some immediate
aggressive teeth into that commitment with the
so -called Google tax. Right. The UK introduced
the Diverted Profits Tax, DPT, in 2015, which
the press immediately nicknamed the Google tax.
It was explicitly designed to discourage big
companies from shifting profits out of the UK
by imposing a tax originally 25 % on profits
that were considered diverted. So it basically
taxes the profits that should have been reported
in the UK, even if the accounting was done somewhere
else. Exactly. It was a unilateral measure intended
to force a change in behavior. The overall picture
here is clear. Tax avoidance. once a judicial
problem of just interpreting intent has become
this global legislative priority. We've spent
a lot of time on the legal, though often aggressive,
side of this. But now we have to cross the line
into the illegal realm, which is just the outright
lie, tax evasion. Tax evasion is where the dishonesty
begins. It's the illegal attempt to defeat taxes
by deliberate misrepresentation. This is fraud.
And in economic theory, the decision to evade
taxes is treated as a rational crime, which is
just a fascinating way to look at something.
so morally questionable. It is. The theoretical
foundation was laid by Gary Becker back in 1968,
who modeled criminal behavior as a rational choice.
Then it was applied specifically to tax evasion
by Allingham and Sanmo in 1972. They modeled
the decision of a risk -averse person, the taxpayer,
who maximizes their utility by choosing the optimal
level of undeclared income. So if I'm a taxpayer
thinking about evading, what determines my decision
in this model? It depends on three things. The
probability of detection, let's call it P, the
level of punishment, F for fine, and your own
level of risk aversion. If the chance of being
caught P is low and the fine F is minor, a rational
person might choose to evade because the expected
gain outweighs the expected cost. Which connects
theory directly to enforcement. Governments are
just trying to raise P and F to make evasion
an irrational choice. Exactly. Every enforcement
measure, every audit is an attempt to dramatically
raise that. P factor. Later research also added
a sociological component, noting that compliance
tends to go up when tax spenders believe their
money is being used appropriately. The exchange
relationship hypothesis. Governments quantify
the damage from all this using the tax gap. What
exactly is that? The gross tax gap is just the
difference between the true tax liability for
a given year and what was actually paid on time.
It has three parts, non -filing, under -reporting
and underpayment. What's the scale of that in
the U .S.? U .S. data suggests voluntary compliance
is only about 85%, leaving a tax gap of about
15%. We're talking hundreds of billions of dollars
every year. And interestingly, the IRS identifies
small businesses and sole proprietorships as
the single largest contributors to that gap.
Why small businesses specifically? Mostly because
their income is less visible. If you're a wage
earner, your income is reported to the IRS by
your employer on a W -2. It's almost impossible
to evade. But if you run a cash intensive small
business, it's much easier to underreport your
receipts. And while evasion is widespread, these
studies using leaked financial data have really
shown a spotlight on how evasion scales with
wealth, which kind of contradicts the idea that
this is just a small business problem. This is
a critical point about wealth disparity. Studies
based on leaks like the Swiss leaks and the Panama
Papers show that evasion rises sharply with wealth.
The most striking finding is that the richest
point zero one. of individuals are about 10 times
more likely to engage in tax evasion, and they
may be evading as much as 25 % of their total
taxes. 25%. That drastically shifts the narrative.
This means the highest forms of wealth are often
linked to the most aggressive, fraudulent behavior.
So let's look at the illegal methods themselves,
starting with basic income tax evasion. On the
income tax front, it's just deliberately misrepresenting
your affairs, either declaring less income or
overstating deductions to illegally reduce your
taxable income, creating fake expense receipts,
deliberately omitting bank accounts from declarations,
that sort of thing. But evasion isn't just about
income tax. It's a huge problem in international
trade and consumption taxes, too. Oh, absolutely.
In developing countries, customs duties are a
huge source of national revenue. So importers
try to evade them in a few ways. The most common
is underinvoicing, where the value of the goods
is deliberately understated to reduce the tax
base. They also engage in misdeclaration of the
product to match a lower duty rate. Like claiming
high value machinery is just low value spare
parts. Precisely. And if you want total evasion
of customs duties, you just result to smuggling.
Right. And moving to consumption taxes, how does
evasion work with VAT or sales taxes? For producers
who collect VAT, evasion is mostly done by underreporting
sales to the government. A common, though often
low enforcement, problem in federal countries
like the U .S. involves consumers legally buying
something in a lower tax state, but then failing
to report and pay the use tax in their home state.
Can you give an example of that? Sure. Say you
live in a state with a 7 % sales tax, but you
drive across the border to a state with no sales
tax to buy a new $50 ,000 car. Legally, you're
supposed to pay that 7 % use tax to your home
state when you register it. Failing to do so
is technically illegal evasion. The government's
fight against evasion is relentless, but historically
they've had their own internal problems. Indeed.
Corruption is a major hurdle. In many developing
countries, corrupt tax officials will detect
evasion, but then take a bribe to look the other
way. This just undermines the whole system. We
also see private agencies that are meant to prevent
evasion that themselves become complicit. Those
are the pre -shipment inspection, or PSI agencies
like Kutekna. These third -party companies are
hired to prevent customs duty evasion by verifying
invoices. But documented cases in places like
Bangladesh and Pakistan have shown these agencies
cooperating with dishonest importers, leading
to huge national scams. But transparency is the
modern weapon of choice, especially in the U
.S., against the corporate vehicles of evasion.
That brings us to the landmark Corporate Transparency
Act, CTA, in the U .S., enacted in 2021. Shell
companies have historically provided this opacity
used to conceal identities for everything from
tax evasion to money laundering. The CTA mandates
that most companies disclose their beneficial
ownership information, the BOI to the Financial
Crimes Enforcement Network, or FinCEN. And how
does that raise the P, the probability of detection
in that old economic model? By dismantling anonymity.
The goal is simple. Instead of tracking a shell
company, regulators can now see who the real
person, the beneficial owner, is behind the entity.
This makes it exponentially harder for that 0
.01 % to hide assets behind layers of paper companies.
It directly increases the risk of being caught.
Theory and legislation are one thing, but specific
case studies... really reveal the human ingenuity
and then the public accountability that follows
these maneuvers. And we've seen aggressive avoidance
become a huge national controversy, especially
in the UK and EU, fueled by public anger over
companies diverting these vast profits away from
where their sales actually happen. So let's pull
the curtain back on those infamous corporate
profit shifting schemes used by the big tech
giants. They often have these. colorful food
related name. Indeed, we have the double Irish,
the Dutch sandwich and the Bermuda black hole.
Companies like Google, Apple, Microsoft, PayPal,
Facebook, they all use these mechanisms to divert
profits from high tax places like the UK or the
US to low tax havens like Ireland, the Netherlands
and Bermuda. Can you simplify the double Irish
with a Dutch sandwich so we can grasp the mechanism?
The mechanism was complex but ingenious. It relied
on two Irish companies and one Dutch intermediary.
So a U .S. company licenses its intellectual
property to an Irish subsidiary that's located
in a tax haven like Bermuda. This is the company
that will ultimately get the income. OK. The
operational European subsidiary, say in Dublin,
then pays massive royalties to that first Irish
company for the use of the IP, which drastically
reduces its taxable income in Ireland. And here's
the trick, right? Here's the trick. Normally,
Ireland would tax those royalty payments. But
by inserting a Dutch holding company, that's
their sandwich, the tax is eliminated under EU
rules. So the money flows through Ireland, through
the Netherlands, and eventually lands in that
first Irish company in the Bermuda tax haven,
having incurred almost zero tax anywhere along
the way. That list of names is practically a
who's who of global corporate power. And when
these practices became public, the backlash was
intense. It peaked around 2012 in the UK. MPs
hauled in executives from Google, Amazon and
Starbucks, accusing them of moral misconduct.
This led to widespread public outrage, even boycotts.
Starbucks, feeling the brand damage, subsequently
committed to paying 20 million pounds to HMRC,
basically a goodwill payment, even while Amazon
and Google defended their actions as entirely
legal. But despite that defense of legality,
the EU has been particularly aggressive in trying
to claw back what it calls illegal state aid
disguised as favorable tax deals. That's the
high profile case of Amazon and Luxembourg. In
2017, the EU ordered Amazon to repay a staggering
250 million euros to Luxembourg. The EU ruled
that a specific sweetheart deal between them
was illegal state aid, allowing Amazon to artificially
reduce its tax bill. The EU sees that not as
avoidance, but as an illegal subsidy from the
state. And it's important to note, this isn't
just a problem for multinationals with exotic
schemes. The UK tax gap data reveals a major
domestic issue, too. Absolutely. The HMRC's 2025
analysis indicated that small business tax avoidance
is substantial, responsible for 60 % of the UK's
£47 billion annual tax shortfall. So this happens
across the spectrum, though the complexity and
scale just increased dramatically with wealth.
Let's shift focus from corporate... corporate
structures to the ultimate strategies used by
high net worth individuals, specifically those
revealed in those leaked IRS documents published
by ProPublica in 2021. This data exposed how
billionaires accumulate massive wealth while
often paying incredibly low or even zero effective
income tax rates. The individual strategies rely
heavily on that tax arbitrage principle. One
key technique is compensation shift. Avoiding
high ordinary income tax by taking compensation
as stock or options, which are taxed at the lower
20 % capital gains rate when you sell, instead
of a salary, which is taxed at that top rate
of 37%. You avoid the high rate just by changing
the character of the income. But the most publicized
and arguably most effective technique is the
buy -borrow -die technique. This is the ultimate,
purely legal example of Stiglitz's principles
in practice, resulting in the complete elimination
of a tax liability. It truly is ingenious in
its simplicity and effectiveness. It neatly combines
avoidance of income tax, access to capital, and
elimination of estate tax, all within the legal
framework. Okay, let's break down the three steps.
Step one, buy earn. The billionaire accumulates
massive capital assets, stocks, real estate,
and crucially, they never sell them. Since tax
law only recognizes income when assets are sold,
they never generate taxable income, even if their
net worth goes up by billions. So unrealized
gains are untaxed. How do they pay for their
lifestyles without selling anything? That is
step two, borrow. They use those accumulated
untaxed assets as collateral to take out huge
low -interest bank loans. And crucially, loans
are not taxed as income, so they can spend the
borrowed money on living expenses, essentially
accessing their wealth tax -free. That's the
perfect tax arbitrage. Borrow to spend, avoiding
the income tax from selling. What happens at
the end? That's step three. die. When the billionaire
passes away, the assets get what's known as a
step up in basis. This is the magic phrase. It
resets the cost basis of the asset to its fair
market value on the date of death. All of those
accumulated, unrealized capital gains, billions
of dollars worth are just zeroed out. The heirs
can then immediately sell the asset and pay no
capital gains tax on a lifetime of appreciation.
So by never selling, they never generate taxable
income. And by dying, decades of accrued tax
liability are just erased for the heirs. It is
the perfect legal loophole for intergenerational
wealth transfer. And that's entirely legal under
current U .S. tax law. The data is clear. Dozens
of America's biggest businesses have used offshore
havens, with some analysis showing large U .S.
companies paying an effective tax rate of about
negative 9 % per annum in 2021 when you factor
in all the loopholes. This brings us back to
public opinion. When these sophisticated, though
legal, maneuvers are exposed, the reaction is
usually swift and hostile. We shift from a discussion
of technical law to one of morality and fairness.
The public debate really pits two core philosophies
against each other. On one side, avoidance is
seen as dodging duties to society. On the other,
it's upheld as the right of every citizen to
pay no more tax than required by law. And what
does the current public temperature look like?
Public polling, especially in the UK in 2025,
showed continued high levels of concern over
corporate tax avoidance and huge support for
tightening regulations. similarly eu surveys
found high support for a global minimum tax for
multinationals There's this palpable sense that
many companies espouse corporate social responsibility
while engaging in maximum tax avoidance. The
public is starting to see tax contributions as
part of a company's social license to operate.
Yes. And in response, we've seen the growth of
proactive ethical transparency, like the fair
tax mark. Right. The fair tax mark was set up
in the UK in 2014 as an independent certification
scheme. It recognizes companies that commit to
paying tax, not just according to the letter
of the law, but in. accordance with the spirit
of all tax laws. It explicitly penalizes companies
for using options that are clearly contrary to
that spirit. It's essentially a public accountability
mechanism that tries to put a tangible measure
on the spirit of the law. Yes. And major companies
are signing up because they see the market risk
of reputational damage. Big names like the co
-op, SSE, Lush Cosmetics, and internationally,
companies like Iberdrola are getting certified.
It shows that market recognition for ethical
tax practices is a growing factor, directly challenging
the idea that maximum tax reduction is always
the best strategy. This has been a fascinating
journey into the complex shades of gray in tax
law, from government -intended tax breaks all
the way to outright criminal fraud. The key takeaway,
especially on the avoidance side, is that the
line between legal and illegal is constantly
being tested and redefined by legislative and
judicial responses. Right. We've seen the introduction
of GARs in the U .K., the U .S. codifying the
economic substance doctrine, the EU's comprehensive
ATET package. The battle is just ongoing, and
tax ingenuity is always one step ahead of enforcement.
That summarizes the dynamic perfectly. We have
seen how the very richest in society use sophisticated
but entirely legal techniques like the buy -borrow
-die method to benefit from those differential
tax rates, effectively eliminating capital gains
tax liability entirely. And it's just a simple
three -step wealth planning mechanism. Which
raises a crucial question for you, the listener,
to consider as you reflect on this deep dive.
Given that general anti -avoidance rules and
judicial doctrines, like the business purpose
doctrine, are designed specifically to invalidate
schemes that have no business purpose or no economic
substance other than tax reduction, does the
continued prevalence and broad acceptance of
tools like the buy, borrow, die technique, a
mechanism whose sole function is to eliminate
tax liability, suggest that the legal goalposts
for what constitutes an acceptable business purpose
have to fundamentally shift? Or does this just
prove that the critical distinction between legal
avoidance and illegal evasion inevitably and
perhaps fatally blurs when personal wealth reaches
an extreme self -sustaining scale? Think about
that tension between individual right and societal
reliance.