Definition

Tax shelter is the financial arrangement that helps to reduce or completely eliminate the tax liability.

Description

The tax authorities closely monitor businesses for all complex transactions. And these transactions may have economic complexity which is questionable. To prevent any confusion, this is where tax shelter plays in.

Tax shelter techniques make use of deductions, exemptions, credits, or deferrals provided by tax laws to minimise the amount of taxable income legally.

Tax shelters can include retirement accounts, real estate investments, and specific business expenses, offering a way to protect income from high tax rates while remaining within legal boundaries.

Importance of tax sheltered investments.

1. You must make investment for tax shelter for these reasons:
2. Tax Savings: Tax shelter can help you reduce tax burden both for the present and in the future also.
3. Wealth Accumulation: You can accumulate wealth by saving taxes. Explore possible ways to eliminate tax liability and push investment opportunities.
4. Retirement Planning: With tax-sheltered investments, you can also save for your retirement and plan for a secured financial future.
5. Risk Management: You can manage risks by investing in some tax-sheltered investments. Look for options that bring in some additional benefits like life insurance or disability income protection.

How to create a tax sheltered account?
 

These are the steps to create a tax sheltered account:

• Identify the Right Account:

Determine your financial goals (retirement, education, healthcare). Research different tax-advantaged accounts (IRAs, 401(k)s, HSAs, etc.)Consider factors like contribution limits, tax benefits, and investment options.

• Meet Eligibility Requirements:

Ensure you meet the income and age requirements for the chosen account. Some accounts require employer participation (e.g., 401(k)).

• Choose a Financial Institution:

Select a bank, credit union, or investment firm that offers the desired account. Compare fees, investment options, and customer service.

• Complete Account Application:

Provide personal information, employment details, and beneficiary information. Choose investment options based on your risk tolerance and financial goals. Set up contribution amounts and withdrawal schedules (if applicable).

• Fund Your Account:

Transfer funds from your bank account to the tax-sheltered account. Consider automatic contributions for consistent savings.

• Review and Monitor:

Regularly review your account balance, investment performance, and contribution limits. Make adjustments as needed to align with your financial goals. Consider seeking professional advice for complex tax situations.

Trends that can affect tax shelter

Some of the trends that can affect tax shelter:

• Increased Regulatory Scrutiny:Governments worldwide are intensifying their efforts to crack down on tax avoidance and evasion. This has led to stricter regulations, increased audits, and penalties for those involved in aggressive tax planning.  
• Economic Globalisation: As businesses operate across borders, tax authorities collaborate to share information and combat tax evasion. This reduces the effectiveness of cross-border tax shelters.  
• The digital revolution has significantly enhanced the capabilities of tax authorities. With the aid of advanced data analytics, they can now scrutinise large volumes of data, making it increasingly challenging to conceal income or manipulate transactions.
• Many jurisdictions are now prioritising ethical tax practices. To this end, they are introducing economic substance tests to ensure that transactions are driven by genuine commercial purposes rather than just tax benefits. This approach significantly reduces the viability of certain tax shelters.   

Example

Let us assume ABC Pvt. Ltd., a manufacturing company, sets up a new unit in a Special Economic Zone (SEZ). Under the SEZ Act, profits from this unit are eligible for a 100% income tax exemption on export income for the first 5 years. 

For the next 5 years, a 50% exemption applies, and an additional 50% exemption is available for the subsequent 5 years if the profits are reinvested in the business. 

This allows ABC Pvt. Ltd. to significantly reduce its tax liability on export profits, leveraging the SEZ tax incentives to enhance its financial performance and reinvest in business growth.

ABC Pvt. Ltd. sets up a new manufacturing unit in India's Special Economic Zone (SEZ). In its first year, the unit earned ₹10 crore in export profits.

Tax Benefits for First 5 Years: The company is eligible for a 100% tax exemption on the ₹10 crore export profits.

Calculation:

1. Total Export Profits: ₹10 crore
2. Tax Exemption (100%): ₹10 crore
3. Income Tax Rate: 30% (assuming a standard corporate tax rate)

Tax Savings in the First Year:

• Tax Liability: ₹10 crore × 30% = ₹3 crore
• Tax Exempt: ₹3 crore
• Net Tax Paid: ₹0 (due to 100% exemption)

In this scenario, ABC Pvt. Ltd. does not pay any income tax on the ₹10 crore of export profits for the first year, resulting in a total tax saving of ₹3 crore, thanks to the SEZ benefits.

FAQ

What are tax sheltered accounts?

Financial accounts, known as "tax-sheltered accounts," are made to minimise or postpone tax payable on investments or income. 

Any growth in these accounts is usually tax-deferred or tax-free. And contributions to them will result in tax benefits like deductions or exemptions.

Retirement accounts such as 401(k)s and IRAs are famous examples since the payments can be tax deductible, and the investments grow tax-free over time. Withdrawals are typically subject to taxation later on and frequently at a reduced rate.

What is a shelter rule property?

Shelter Rule Property refers to property acquired from a bona fide purchaser. This means the new owner inherits the same legal protections as the original buyer, even if they would only sometimes qualify for them. Essentially, they are 'sheltered' by the original buyer's status.