Have you ever thought of some crazy obvious scheme that would allow you to pay virtually no tax? Well you and everybody else… That’s why the above two rules were created. The idea being to limit these possible schemes with those with whom you may have close ties and also whatever other schemes people may come up with.
Now, there are tons of legal ways that the government specifically creates to help people avoid taxes for the purpose of incentivizing certain behavior (trusts, depreciation…). However, any other kinds of transactions are very limited. For example, how many times have you read that a certain type of transaction is only allowed with those at arm’s length (this could include things like selling assets for a loss, for example). Being at arm’s length, very simply, means someone unrelated, with whom there is no collusion, and where both parties are acting in their own self-interest. While this definition applies to all individuals, one massive exception is that all blood-related individuals are deemed to be dealing at non-arm’s length regardless of how they are actually dealing. This is because the value of an asset is inherently questionable. Nobody can truly give an absolute value for a piece of land, and so, if two individuals are related, they would be easily able to manipulate this to their advantage and sell property for below market value, while still remaining within a legal gray area, where it would be tough to prove the valuation was low…
Those blood relations considered automatically non-arm’s length are: parents/children, grandparents/grandchildren, and brothers and sisters. Keep in mind that these include in-law relationships formed by marriage or common law partnerships. Children also include step-children and adopted children.
While I very briefly mentioned the concerns which established this rule in the first place, I wanted to dive in a little deeper now. Let’s say that I own a piece of land worth $100,000 (which I purchased for $100,000. Assuming the arm’s length restrictions didn’t exist, I then sell this piece of land to my brother for $50,000, registering a $50,000 loss which I can use to reduce my tax burden, while a family member keeps that property and even potentially immediately sells it back to me for $50,000, effectively allowing me to purchase the property I wanted and write off a 50k loss on paper which was all arranged.
Now, it is that last part which is where GAAR comes in. GAAR stands for General Anti-Avoidance Rules. This is effectively a law which allows tax authorities from striking down any tax avoidance scheme which while technically within the boundaries of the legal texts and the rules for the participants, has no financial or organizational purpose besides avoiding taxes. Obviously, that last qualification prevents the most blatant examples (like for example selling a property only to immediately repurchase it in 2 days), but still makes the burden for proof very large. In order to get around this restriction, all you would have to do is provide some kind of benefit (besides taxes) for why such a structure exists, and it would likely be considered a valid action.
Overall, I hope this has given you a better idea of how the world of taxation operates, and why tax-avoidance isn’t so visibly rampant.
By: Mateo Gjinali
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