22 May, 2024

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Tax Evasion vs. Tax Avoidance: Legal Smart Tax Saving Strategies for Small Businesses

Taxes are inevitable for any business. This compulsory payment is usually used to raise funds for government expenditure.

Certain infrastructures are needed for the ease of doing business, and without taxation, the government might be unable to provide them. Taxes are paid by both local and international companies operating in a country.

In Sri Lanka, for instance, to reduce the tax burden on businesses, the government signed Double Taxation Avoidance Agreements with 44 countries to tackle and reduce the prevalence of double taxation and tax evasion in international business dealings.

Double taxation is the dual imposition of taxes on the same income, assets, or financial transactions, leading to an excessive tax burden for affected individuals or entities. A typical example is taxing shareholder dividends after taxation as corporate earnings.

Meanwhile, while it is illegal for any business not to pay their taxes, you might have read about how some big companies managed to pay the least tax despite their whopping yearly profits. 

Surprisingly, this is legal; it is called tax avoidance. Unfortunately, most small business owners do not understand how to leverage smart tax-saving strategies to reduce their total tax.

Tax avoidance vs. tax evasion

Tax evasion involves intentionally misrepresenting a taxpayer’s financial situation to the tax authorities to lower their tax burden. This includes not reporting income and dishonest tax reporting, such as underreporting income, profits, or gains, claiming unwarranted deductions, bribing officials in corrupt countries, and concealing assets in secret locations. It is generally regarded as tax fraud.

Tax evasion is a significant problem in developing countries like Sri Lanka. It is rampant in the informal economy.

Ignoring tax payments or manipulating financial reports to reduce tax can be disastrous to any individual or business. Tax payment is inevitable for companies with a long-term growth projection and expansion plan. 

Governments face challenges in financing public projects and meeting their financial obligations when taxpayers do not pay their taxes or pay less than they owe. That is why companies that do not pay taxes might be unable to access certain governmental benefits and opportunities. 

On the other hand, tax avoidance is the employment of legal strategies within the confines of the tax code to lower the payable tax amount. It is a complex strategy best deployed with utmost care to avoid breaking the law.

If done right, the money saved through tax deductions can be reinvested into the business to hasten its expansion. 

Legal smart tax saving strategies for small businesses

Reducing your business tax liability without violating any tax code is possible. Below are some legal loopholes you may consider:

Debt financing

A company’s capital can be equity, debt, or a combination of both. Financing your business with debts instead of equity can provide some tax shield as debts incurred by a business or investment are allowed as tax deductions for business owners.

Gearing, however, should be executed in such a way that the interest does not exceed the tax you are trying to avoid. For individuals who operate more than one business, the debt does not necessarily have to be from a financial institution; it could be sourced from affiliate businesses or subsidiaries.

An amount recognized as bad debts is also tax deductible.

Reinvestment

First, it is essential to note that dividends are not tax deductibles. Also, reinvesting them does not provide any shield. However, it is possible to reinvest the profit from a business in the business or another business.

Reinvested money is considered a business expense. Acquiring another business can also provide a tax haven as the money spent on the venture is allowed in tax deductions. Business and investment are defined to include past, present, or prospective business.

Assets depreciation

Every business has depreciation assets. When you purchase a tangible asset, the value is sure to decrease over time. You will realize this when you plan to re-sell them in the future. As a business owner, it is possible to claim an asset’s depreciation value as a tax deduction.

The capital allowance for the depreciation of assets is typically granted based on the number of years applicable to the asset. For example, the Sri Lanka tax system permits five years for computers, data handling equipment, and peripheral devices.

Intangible assets have 20 years or the actual useful life of the asset. Goodwill does not qualify for asset depreciation. Expenses incurred in the liquidation of a company are also tax deductible. 

Donation to charity

As a business owner, another way to reduce the total tax amount for yourself and your business is through donations to charity. 

The charity is expected to be approved by the government and established to provide institutionalized care for the sick or those in need. The deduction is pegged at one-fifth of your company’s taxable income or LKR 500,000, whichever is less.

Contributions to the government also qualify for tax deduction. This, however, does not have a limit.

Royalty and ground rents

Royalty are payments made by a company to another company or individual for using their intellectual property. 

Intellectual property includes patents, trademarks, copyrights, and other intangible assets. Royalties are tax deductible provided the payment is incurred in the production of income during the year.

If you operate an IT company, for instance, instead of making the software you developed part of the company, it could be instead licensed to the main company while you charge royalties.

Ground rent is also tax deductible. As a business owner, if your company is sited on land you purchased with your money, you may be able to charge the company for ground rent instead of allowing it to be used for free.

Anti-avoidance rules in Sri Lanka

It is vital to note that the smart saving strategies highlighted in this article were as at the time of writing. The government of Sri Lanka can at any time review its tax code, blocking business owners from leveraging these loopholes. 

It is not unusual for a government to implement General Anti-Avoidance Rules (GAARs)

A GAAR is a set of broad and general principles-based rules within a country’s tax code that prevent taxpayers from leveraging loopholes to avoid paying taxes.

Also, before implementing any tax-saving strategy, it is recommended that you seek the advice of a professional to ensure you are not violating any law.

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