Tax planning can be defining as organizing the financial affairs of a person in the most tax efficient manner possible. Tax planning thus allows the other elements of a financial plan to interact more effectively by minimizing tax liability. It involves an advance assessment on tax implications on various decision alternatives with the objective of minimizing the tax burden or maximizing the value of benefits. It therefore calls for legitimate means of mitigating ones tax position either as an individual or corporate.
Tax planning is legal, in fact the government encourages it by extending tax incentives. Where it is within the law for a taxpayer to make some savings, there would be no reason to pay an extra dime. “…. there is nothing sinister in so arranging one’s affairs as to keep taxes as low as possible. ……… nobody owes any public duty to pay more than the law demands: taxes are enforced extractions, not voluntary contributions” (Justice Learned Hand, Comm. vs. Newman, 159 F.2d 848 [CA-2, 1947]).
Tax planning being an integral part of a financial plan should aim at one goal, wealth maximization. Tax planning is a holistic plan considering all cost and benefits associated with a scheme not just mere tax saving. For example, debt capital in a corporate set up is preferred because of the tax benefit on the interest, but a debt financing decision on this basis being oblivious of the repayments and restrictive covenants can be disastrous. Another example is the tax advantage on mortgages in an environment where houses are grossly overvalued, renting or constructing own property would turn out to be a better option.
Tax planning strategies
- Income shifting- income shifting involves shifting income from higher tax brackets to lower or even zero tax brackets. For example, a family running a small company has an option of getting the benefit in form of dividends. Dividends are not tax deductible suffers tax twice, at corporation rate and also the 5% withholding. The income can be shifted in form of salaries and allowances to directors who are the family members. The salaries are tax deductible so reduce the corporation tax on the company again salaries are taxed at graduated scale rate of tax (with personal relief on top) which is lower than corporation rate of tax.
- Timing tax planning strategy- is deferring income or deductible expenses from one-time period to another due to the tax rate differences between periods. For example, if capital investment deduction rate is 50% in 2020 and 100% in 2021, investors will defer investments until 2021. Timing strategy is also used to save cash flows by strategically deferring invoice date. For example if a firm invoices on 30th September the Value added tax will be due on 20th October (according to Kenyan VAT law). If the 30th September transaction is deferred by one day to 1st October then the VAT will be due on 20th November. This strategy does not save on tax but gives a whole months delay on cash flows.
- Conversion tax planning – Conversion is based on the premise that the law does not treat all the incomes and deductions the same. Converting equity in to debt is a classic tax planning example, or changing ordinary savings to retirement savings because retirement savings are tax deductible.
Aggressive tax planning
Aggressive tax planning consists in taking advantage of the technicalities of a tax system or of mismatches between two or more tax systems for the purpose of reducing tax liability. Aggressive tax planning is the point where tax planning goes beyond the policy intent of the law. Its ‘aggressive’ or ‘abusive’ nature makes it illegal, or contrary to the spirit of the law. Aggressive tax planning is also referred to as Tax avoidance,
Aggressive tax planning or Tax Avoidance is a Grey area in between tax planning (white) and tax Evasion (black) and of course most controversial issue in modern day taxation. Each party (tax payer and Tax agencies) tries to pull towards their side.
Read my previous article on Tax Avoidance