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‘Tax Reduction’ and ‘Tax Evasion’

2011.06.15

In dealing with tax-related businesses, the daunting question that is most frequently asked is about classification between 'tax reduction' and 'tax evasion'. However, classification between 'tax reduction' and 'tax evasion' is so ambiguous, and extension of the concept is not clear. So, first, the legality of the activities shall be decided. For example, 'tax reduction' is accepted as a legal action while 'tax evasion' is as illegal action by the court. 
 
In fact, it is no wonder that people wants to reduce taxes because paying taxes is an obligation of citizen which has no returns. Naturally, various methods are currently used to reduce taxes, and in some cases, such efforts are rightfully led to 'tax reduction'. But in most cases, tax reduction efforts are treated as tax evasion provoking public criticism and resulting in additional taxes. Recently, the Supreme Court ruled on a social controversial issue 'the Yen Depot Swap', so in this regard, I would like to go over the fine line between 'tax reduction' and 'tax evasion'. 
 
In providing tax counseling, the pertinent method to reduce tax is so called, "Title registration under a third person's name" which means to register one's income or properties under the third person's name. The Republic of Korea has adopted a progressive tax system by which the tax rate increases as the taxable base amount increases, and a heavy tax on 'multi-house owner per household', and capital gain tax on the person who possesses the listed shares more than a certain ratio. Accordingly, if title registration of income or properties under the third person's name is admitted under the tax laws as legal acts, it may be the one way to reduce taxes to be paid for. However, tax is a financial charge imposed on an income, and if there is a person who practically controls and supervises the transaction or the property which incurs the actual income, the income may not be attributed to the person registered. 
 
U.S. Supreme Court Justice Holmes used the celebrated fruit and tree metaphor to explain that the fruit must be attributed to the tree from which it came. In other words, a mere assignment of income does not shift the liability for the tax. Our court also judged consistently that if any ownership of an income, property or transaction which is subject to taxation is just nominal, and there is other person to whom such income belongs, the other person shall be liable to pay taxes. Therefore, title registration of an income or property under the third person's name is highly likely to be acknowledged as 'tax evasion'. 
 
Next is about abnormal transaction practice such as a method of involving two or more activities or transactions as if the relevant parties have made a direct transaction or have conducted an activity or transaction in succession to receive unjust tax benefit. And this involves multi-stage sales and circumvention activities. In terms of economic effects, multi-stage sales and circumvention activities have same economic effects as the general activities (refer to activities which incur tax imposition). However, different tax ratio may apply if it is imposed depending on types of activities, and applying different taxation system to the economic activities which have same economic effects may run counter to the principle of the equity of taxation. Consequently, it may raise questions over whether it shall be acknowledged as 'tax reduction' or 'tax evasion'. 
 
As aforementioned, recognizing the activity of registering the title of income or property under the third person's name as 'tax evasion' is indisputable. Accordingly, abnormal transaction practice is at the center of disputes over 'tax evasion'. However, one thing to bear in mind is that tax laws stipulates about multi-stage sales and circumvention activities, making the disputes be limited to those which are not prescribed in the laws. 
 
In academia, two points of view over the economic activities, 'economic observation' and 'legal observation', are confronted with each other, and similar polarity can be observed from the whole world not only in our country. According to economic observation principle under which activities with identical economic effects shall be applied by identical taxation, multi-stage sales or circumvention activities shall be treated as the general activities. It is based on the equality principle of 'same thing should be treated as same and different thing should be treated as different.' 
 
Meanwhile, legal observation principle prescribes the taxes to be paid pursuant to the tax laws which stipulate tax requirements, and the legal form of each activity shall be respected. Therefore, even if the multi-stage sales or circumvention activities is applied by different tax ratio from that of the general activities, it may be an inevitable consequences. Such legal observation is based on the principle of no taxation without law. 
 
As the legal basis for 'economic observation' and 'legal observation' have credible legal position, respectively, and the two parts are sharply confronted with each other, so it cannot be easily concluded. However, due to the characteristics of the tax laws based on the legal stability and the predictability, and the difficulties of evaluating the 'economic equality', the taxation according to 'economic observation method' seems to be rarely recognized as a realistic taxation method. Likewise, the Supreme Court has released decisions to the effect that taxation shall follow the 'legal observation method', and recently, with respect to 'Yen Depo Swap' case, the court upheld the original decision as below, and reaffirmed its position. 
 
"In engaging in economic activities, the taxpayer may select one out of several juridical relations for the purpose of achieving same economic purpose, so even such selection aims to avoid heavy taxes, it shall be valid unless there are special reasons to be recognized as a disguised act. And according to the principle of real taxation, regardless of its legal form, in order to negate the legal effect of transactions conducted by the taxpayer as the tax evasion, tax laws shall provide individual and detailed disclaimer provisions under the principle of no taxation without law. (Supreme Court Decision delivered on May 13, 2011. 2010DO5257. Seoul High Court delivered on January 28, 2010, 2009GU23565)." 
 
In conclusion, according to the court decision, the efforts to reduce taxes via multi-stage sales or circumvention activities which are not stipulated by the tax laws are likely to be recognized as 'tax reduction' rather than 'tax evasion'. 
 
However, whether or not the court maintains its position continuously is remained to be seen as Article 14 (3) of the Framework Act on National Taxes that "Where it is recognized as a method of receiving unjust benefit pursuant to this Act or tax-related Acts, such as an indirect method through a third party or a method of involving two or more activities or transactions, this Act or tax-related Acts shall apply as if the relevant parties have made a direct transaction or have conducted an activity or transaction in succession, according to the economic substance of such activity or transaction" is newly inserted.

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