What are Tax Shelters?

What are Tax Shelters?

It hardly matters whether you are a salaried individual or a businessman when it comes to paying tax. The deduction calculated on your earnings always takes its toll on your existent cash in hand, especially during the fiscal ‘ear ending’. However, there are a number of options available that actually help you to invest wisely, and at the same time save on tax. The methodology adopted, however, varies and depends on the local and international tax laws applicable in each case. There are different types of tax shelters, and a few are listed for consideration. Please keep in mind that in certain countries and cases, some of them are illegal.

You can consider investments in offshore companies to reduce tax. This is accomplished by transferring funds to the company that is established in a country other than your base country. This transfer can be declared to the tax authorities as ‘transfer of expense incurred’. This helps lower the taxable income considerably. However, you would have to ask your financial adviser to check for difficult international tax treaties between the nations, if any, which could affect the income and tax reduction.

You can also consider dedicated finance arrangements. You can come to an understanding with a related party and agree upon an unreasonably high rate of interest for the transaction. This can drastically reduce the income of the investment, and even show up as a loss. However, at the time of investment-withdrawal, the same becomes a massive capital gain. This helps further, as capital gains are taxed at a lower rate than any normal investment income.

Understanding the Dangers of a Haphazard Approach
The reported ‘flaws’ of the so-called questionable tax shelters usually arise out of transactions that are not reported at the market value of the same. In these cases, the interest rate is either too high or too low. If a transaction has no economic value, and has the sole purpose of lowering tax liability, especially between related parties, the deal is considered unethical. The tax agency will in such a case, re-evaluate the transaction, and duly neutralize any over tax benefits visible.

Tax Shelters That are Legal and Legitimate
Flow-through shares or limited partnership companies such as oil drilling take a long time to generate positive income, and some even ‘go under’ in the attempt. Such developments go against the vested interests of most investors, who demand quick and safe returns. Now, ‘exploration costs’ of such companies are distributed to shareholders in the form of tax deductions. Investors are rewarded for the investment by instant tax savings and potential gains as the venture upgrades. These tax shelters are archetypical in nature, where sometimes, the losses are allowed to offset passive investments, against the earned income.

Another great tax shelter option is a retirement plan. Governments all over the world now allow individuals to invest in their own pension. However, the contributed income may not be taxable immediately, but is so, when you retire. The advantage of a retirement plan is that the taxable amount is compounded into the account till the funds are finally withdrawn. Now, there are schemes being planned, and in certain countries, implemented, where the income is taxed before the contribution and not when the funds are withdrawn. This is a great tax shelter for those who predict for themselves a higher tax bracket by retirement.

Why are Tax Shelters Created?
Various tax shelters are created by governments to promote long-term investments that help the economy, and in turn, generates additional tax revenue. They also act as tools to promote social behavior and responsibility towards the economy. A tax shelter is designed as an organized program, in which individuals participate to reduce their taxes. They are intended to induce responsible behavior from the masses, but just the opposite also exists, and hence, the unwanted association with fraudulent activities.