Any method of decreasing taxable income in a payments to tax collecting entities, including state and federal government. The most common type of tax shelter is an employer-sponsored 401(k)plan.
a.Types of tax shelters
Some tax shelters are questionable or even illegal:
Offshore companies. A company which is incorporated outside the jurisdiction of its primary operations regardless of whether that jurisdiction is an offshore financial centre. Due to differing tax rates and legislations in each country, tax benefits can be exploited. Example: If Import Co. buys $1 of goods from India and sells for $3, Import Co. will pay tax on $2 of taxable income. However, tax benefits can be exploited if Import Co. is to set up an offshore subsidiary in the British Virgin Islands to buy the same goods for $1, sell the goods to Import Co. for $3 and sell it again in the domestic market for $3. This allows Import Co. to report taxable income of $0 (because it was purchased for $3 and sold for $3), thus paying no tax. While the subsidiary will have to pay tax on $2, the tax is payable to the tax authority of British Virgin Islands. Since the British Virgin Islands has a corporate tax rate of 0%, no taxes are payable. Financing arrangements. By paying unreasonably high interest rates to a related party, one may severely reduce the income of an investment (or even create a loss), but create a massive capital gain when one withdraws the investment. The tax benefit derives from the fact that capital gains are taxed at a lower rate than the normal investment income such as interest or dividend. The flaws of these questionable tax shelters are usually that transactions were not reported at fair market value or the interest rate was too high or too low. In general, if the purpose of a transaction is to lower tax liabilities but otherwise have no economic value, and especially when arranged between related parties, such transactions are often viewed as...