Get Clarity on the Difference between Tax Planning and Tax Avoidance

Shreya Patel

13 Jul, 2023

Tax Planning is the process of reducing tax liability on taxpayers by making the maximum use of deductions, allowances, exemptions & relief provided under the Income Tax Act. It is conducted with an object of financial planning to ensure tax efficiency.

Tax Planning is an arrangement and structuring of financial affairs in such a manner that most of the tax benefits can be availed by an assessee. This is done by applying the majority of permissible benefits, deductions, rebates & reliefs, thereby reducing the taxable income.  

Objectives of Tax Planning

• Tax Reduction: Assessee can considerably reduce his taxable income by making use of the various deductions/reliefs that are made available under the Income Tax Act 1961^[1]. It involves the smart application of Income Tax provisions to reduce tax liability.
• Avoidance of litigation: Taxpayers always want to minimize their tax liability, while the tax authorities want the same to be justified. The tax authorities ensure that no tax evasion is made by the assessees. Tax planning is one process that ensures that the tax liability of the assessee is reduced in conformity with the legal provisions. Hence, the dispute between the assessee and the tax authorities is avoided, which means the chances of litigation are avoided.
• Productive Investment: Tax Planning helps in attaining the objective of channelizing the taxable income into various investment plans. The assessee can make intelligent investments and simultaneously reduce his tax liability.
• Boosting the economy: An economy grows with the growth of its citizens. Tax Planning leads to the flow of white money freely, which in turn helps in the financial progress of the economy.

Understanding Tax Avoidance

In Tax Avoidance, a taxpayer arranges his financial affairs in such a way that his tax liability is reduced without going out the ambit of the law. Tax avoidance is legal. However, it is not considered ethical as the taxpayer takes undue advantage of the loopholes in the law to evade payment of tax.

Methods of Tax Avoidance

Tax Avoidance is a way of avoiding tax payments in a manipulative manner. A taxpayer can avoid tax payment by indulging in different activities such as:

• Hiding facts
• Creation of sham transactions without reflecting the true purpose
• Make fictitious contracts or transactions
• Mold actions without falsification of the accounts

Difference between Tax Avoidance & Tax Planning

Practical Examples

Tax avoidance

• A taxpayer for minimizing his tax liability can contribute to Individual Retirement account (IRA) before 15^th April, because those contributions are deductible from the taxable income and lower the tax bills of the assessee.
• Claiming deductions such as mortgage interest, property tax, medical expenses, charitable contributions, etc.
• At times, companies indulge in the practice of tax avoidance by paying the director’s income in the form of a “Director’s loan.” Such loans are either not repaid or are written off at the end of the year.

Tax planning

• By investing in any scheme of ELSS or tax-saving mutual fund with a lock-in period of 3 years.
• By investing in tax saving, FDs, EPF, etc.
• By making an investment in the national pension scheme that was introduced by the government for the unorganized sector or professionals to have a pension after retirement
• Investment in Unit-linked Insurance Plans, which are a mix of insurance as well as investment.
• Investment and withdrawals from the scheme of Sukanya Samriddhi Yojna, which are tax-free.

Steps of Tax Planning

• Early Planning: Most of taxpayers start their paperwork when the due date of filing the tax return is close. Thus, taxpayers are encouraged to plan their tax savings early to have a better estimate of the investments and benefits that can be claimed by them.
• Tax Liability: It is the step of the actual calculation of taxability based on income and after claiming all the rebates and deductions. Preparing an estimate of tax liability beforehand can also help in structuring the investment and savings part.
• Risk level: This step involves estimating the optimal level of investment risk as per the current financial situation of the taxpayer. The following factors have to be considered for risk profile:
• The risk associated with the amount of expected return
• Level of risk that the taxpayer is ready to undertake
• Level of risk that is acceptable by the taxpayer

FAQ