Panama Papers Explained: The Difference Between Tax Evasion and Avoidance

View of buildings in Panama City, April 4, 2016. A massive leak of 11.5 million tax documents has exposed the secret of offshore dealings. Rodrigo Arangua/Getty

The huge data leak from Panama-based law firm Mossack Fonseca is "the biggest wake-up call for the public around the world," according to tax experts.

It has lifted the lid on how the rich and powerful use a country where taxes are levied at a low rate in order to hide away their extortionate wealth.

If you are a rich business owner in Germany, an international drugs dealer or the head of a brutal regime, the methods of evading tax are all pretty similar.

But in response to this massive disclosure, Mossack Fonseca said it has always complied with international protocols to ensure the companies it incorporates are not used for tax evasion, money-laundering, terrorist finance or other illicit purposes.

So, what is legal? And what is the difference between tax evasion and tax avoidance?

In truth, there are legitimate or "legal" ways of using tax havens, and the 11.5 million leaked files, allegedly connected to Mossack Fonseca, do not necessarily indicate illegal activity. But shell companies and offshore accounts can be used to mask the origin of financial transactions and ownership. These files, according to the International Consortium of Investigative Journalists, include people and companies that the U.S. has blacklisted due to drug trafficking and terrorism links.

The leaked files predominantly raise questions about the ways in which the system can be used and abused. More than half of the 300,000 firms said to have used Mossack Fonseca are registered in British-administered tax havens, which U.K. Prime Minister David Cameron has vowed to crack down on. And in one instance, an American millionaire was apparently offered fake ownership records to hide money from the authorities—this included using a 90-year-old British man as a "beneficial owner."

Tax avoidance, generally, is entirely legal and encouraged to be thought of as "bending the rules" as opposed to breaking them. On a small scale it can mean putting money into an Individual Savings Account (ISA) so you do not have to pay income tax or capital gains on that money. On a larger scale it can mean paying an accountant or tax expert to exploit loopholes in the law to minimize your tax bill.

But while saving into an ISA or pension may be smart and encouraged, not all methods of tax avoidance are condoned. And if the taxman disagrees with how you have reduced your tax bill it can demand you pay it back, plus the interest and penalties. This is where the grey area lies.

It happened to Take That singer Gary Barlow in 2012. He and many other celebrities invested in Icebreaker, a scheme that was supposed to buy up intellectual property rights to generate income. In fact, very few rights were bought and most of the money just circulated in a closed circle within the scheme, generating paper losses that investors could use to offset against their profits elsewhere for tax purposes. U.K. government department Her Majesty's Revenue and Customs (HMRC) disapproved of Icebreaker and after a legal battle hefty tax bills landed on the doormats of all the celebrities involved—Barlow alone is believed to have had to pay back millions.

Tax evasion, on the other hand, is entirely illegal. It is where you deliberately break the rules and deceive the taxman about what your tax bill should be.

Examples of tax evasion are failing to file a tax return, not declaring your full income or hiding taxable assets. If you are caught evading tax, you could be sent to prison for up to 10 years in the U.K.

However, both tax avoidance, on the more serious end of the scale, and tax evasion seem to fall under the "morally wrong" category.

"To determine whether a scheme is legal or not, it must be heard in a court of law," John Christensen, director and co-founder of the UK-based Tax Justice Network, which investigates the offshore wealth industry, tells Newsweek. "The vast majority of tax avoidance schemes are written into loopholes which essentially undermine the rule of law and democracy. Legal, maybe, but it is a very grey, murky area and it contributes massively to the unequal economic reality of what is happening.

"The Panama papers are the biggest wake-up call for the public around the world. They expose this immoral activity."