Tax shelters are any method of reducing taxable income resulting in a reduction of the payments to tax collecting entities, including state and federal governments. The methodology can vary depending on local and international tax laws.
In North America, a tax shelter is generally defined as any method that recovers more than $1 in tax for every $1 spent, within 4 years.
Types of tax shelters
Some tax shelters are questionable or even illegal:
Offshore companies. Due to differing tax rates and legislation in each country, tax benefits can be exploited. Example: If Import Co. buys $1 of goods from India and sells for $3, Import Co. will pay tax on $2 of taxable income. However, tax benefits can be exploited if Import Co. is to set up an offshore subsidiary in the British Virgin Islands to buy the same goods for $1, sell the goods to Import Co. for $3 and sell it again in the domestic market for $3. This allows Import Co. to report taxable income of $0 (because it was purchased for $3 and sold for $3), thus paying no tax. While the subsidiary will have to pay tax on $2, the tax is payable to the tax authority of British Virgin Islands. Since the British Virgin Islands has a corporate tax rate of 0%, no taxes are payable.