FEATURE

The Untold Secrets of Tax Havens

The underlying tax debate in the tax haven controversy has all too often been clouded by rhetoric, conflation with non-tax issues and a failure to consider arguments from the other side. This article scrupulously avoids delving into the technicalities of residence and source-based rules of taxation and the related issues of tax arbitrage using transparent or hybrid entities in order to try to present an accessible and balanced description of the tax haven debate from a tax perspective.

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The Havens Blackened

The Webster's dictionary defines a "haven" as "a place of safety; a shelter,"¹but these days, a "tax haven" is anything but safe. For several years, there have been various official statements associating tax havens with aiding tax evasion, money laundering, terrorism financing, unfair tax competition and rather amusingly, of being a "root cause" of the current financial crisis.² Be that as it may, the pressure against tax havens has recently become more intense.

President Obama has just declared in May that his administration intends to introduce legislation aimed at "shutting down overseas tax havens" and targeting wealthy individuals in the United States ("US") who use bank accounts in tax havens to hide income.³ UBS AG agreed in February to pay $780 million in a settlement to avoid US prosecution for allegedly helping many of its 19,000 US clients hide up to US$20 billion from the US tax authorities, a substantial part of it through the use of structures in tax havens.⁴ Most significantly, the (Group of Twenty Finance Ministers and Central Bank Governors)("G-20") called for sanctions against tax haven countries that are "non-cooperative" in its London communiqué issued in April. The G-20 boldly declared that "The era of banking secrecy is over." On the same day, the Organization for Economic Cooperation and Development ("OECD") published a list of countries that are failing to comply with what it calls "internationally agreed tax standards" relating to the exchange of information. These standards require, inter alia, that states enter into agreements to automatically exchange information "foreseeably relevant" to the administration and enforcement of the domestic laws of the other party to the agreement.⁵ The OECD list was made up of three main categories:
1. A "white list" of those countries that have substantially implemented the standard including the United Kingdom ("UK"), the US, France, Germany, China, Jersey, Guernsey, and the Isle of Man;

2. A "grey list" of 38 "tax havens" and "financial centers" that have committed to - but not yet fully implemented - the standard, including Switzerland, Belgium, Luxembourg, Austria, Lichtenstein and the Cayman Islands; and

3. A "black list" of four countries that have not committed to the standard - Costa Rica, Malaysia, Philippines and Uruguay.

These four countries have since committed to adhering to the OECD tax standard and have been "upgraded" to the grey list.⁶/p>

Apart from the OECD list, there has been a flurry of "blacklists" targeting low tax jurisdictions for retaliation primarily for the lack of disclosure of information. The US legislature, for instance, is considering a bill titled the "Stop Tax Haven Abuse Act" which designates 34 jurisdictions as "offshore secrecy jurisdictions" and enables the US tax authorities and courts to apply certain adverse presumptions in tax haven cases. The Russian Ministry of Finance has issued an order effective from January 2008 that denies certain Russian tax benefits to a list of 54 jurisdictions that "provide preferential tax treatment or that do not require the disclosure and provision of information to the Russian Federation on taxpayers registered in those states".⁷ Other countries that have announced similar lists include Italy, Mexico and Spain.⁸

Haven in the Eyes of the Beholder

Given the publicity surrounding the issue, we should all have a pretty good idea of what a "tax haven" is, or do we? The mention of tax havens conjures up images of secret bank accounts hidden in the Alps and "shell companies"⁹ in sunny exotic islands. Most people would readily point to Switzerland, well-known for its banking secrecy or the Cayman Islands, where President Obama recently described an "outrageous" situation where over 12,000 businesses claim a particular building as their headquarters.¹⁰ It seems that a "typical" tax haven is:
1. a small country;

2. with very low or no tax;

3. with an easy regime to incorporate shell companies; and

4. is secretive and uncooperative in exchanging information.

Let us test this understanding in a simple exercise. Table 1 shows a list of small jurisdictions exhibiting some of the "common characteristics" of tax havens described above.

Table 1

Table 2 shows the jurisdictions in Table 1 that have been named in recent "blacklists".

Table 2

Notice, there seems to be considerable differences in opinion as to whether a jurisdiction is a "tax haven". This difference is all the more surprising since all three countries (US, Russia and Italy) are members of the G-20. Furthermore, both the US and Italy are members of the OECD and Russia closely cooperates with the OECD on a wide range of areas including taxation.²² It is also interesting that Ireland does not appear as a tax haven in the US list when commentators have called it a "semi-tax haven"²³ and in the White House's own words, "nearly one third of all foreign profits reported by US corporations in 2003 came from just three small, low-tax countries Bermuda, Netherlands and Ireland."²⁴ In any event, we can make a few observations from the discussion thus far.

First, being small and having low taxes does not automatically make you a tax haven. Second, the tax haven lists inevitably come from large countries. Third, notwithstanding the OECD assertion that their criteria constitute "internationally agreed tax standards", even OECD members themselves differ as to which jurisdiction a tax haven is. Finally, the criteria of willingness to exchange information appears to be the only decisive factor in deciding the fate of those adjudged to be tax havens.

As an example, an offending jurisdiction can make absolutely no change to its tax rate or tax system and yet still qualify for the OECD "white list" by achieving the threshold of signing 12 information exchange agreements with other jurisdictions.²⁵ So where is the "tax" story in the term "tax haven"?

Havenly Sins

Cutting through the rhetoric and extraneous factors such as money laundering and terrorism financing,²⁶ we can look at the tax haven narrative in the following stylized way. Assume that the world is made up of large industrialised countries (represented by "State A") and small countries (represented by "State S").²⁷ In theory, each state is sovereign and is able to tax its residents (individuals, including foreigners and companies) within its borders by enacting and enforcing tax laws. No state is able to tax residents of another state since it cannot enforce its tax laws in the territory or courts of another sovereign state. In addition, people and especially, capital, are freely mobile across borders due to globalisation.

Suppose State A needs to tax its residents on income (e.g. interest earned from capital) to raise revenue to fund its state functions like providing healthcare and other social services. State S needs to do likewise and taxes its residents as well. If both State A and State S are taxed at the same rate, there will be no tax advantage to State A residents investing their capital in State S or vice-versa - any income earned in State S will be taxed at the same rate as in State A. From the perspective of State A, the playing field is level and states would compete for capital in the form of foreign investments based on natural factors²⁸ rather than an "artificial" advantage like a concessionary tax rate. However, State S is small and generally resource poor. Its only viable option to compete for investment capital is to offer a lower tax rate. Once State S lowers its tax rate however, State A would have to match with a lower rate, otherwise capital would flow to State S and erode State A's tax base.²⁹ That in turn, may prompt State A to retaliate by lowering its rate below that of State S's to draw capital away from State S. State S would then have to respond with further reductions. This form of tax competition is termed "harmful" by the OECD because it results in a race to the bottom as is evident from the dramatic fall in the average tax rate in developed countries from 58.5 per cent in 1980 to 33.5 per cent in the present day.³⁰
In an attempt to recapture the lost revenue from its capital being invested abroad, State A enacts laws to tax the offshore income of its residents. To determine who to tax and how much tax to levy, State A needs its residents to truthfully report offshore income, including interest from deposits in State S bank accounts or income from State S companies that they own. State A residents obviously have an interest in concealing or underreporting such income to avoid the tax. If State A requests this information from State S's banks and companies (even those beneficially owned by State A residents), they would refuse to cooperate, citing State S's policy of banking secrecy which renders disclosure of the information a violation of State S's law. State S would also not give the information.³¹ To make matters worse, some State A residents then take advantage of the secrecy regime to pose as foreign investors in State A. They use nominee bank accounts and shell companies to reinvest their capital back into State A. Such capital "round-tripping" enables these State A residents to enjoy any lower preferential tax rate that State A may offer to foreign investors or escape tax altogether if State A does not tax foreigners on their investment income.

If the narrative ends here, State S's insistence on secrecy would appear to be interfering with the legitimate collection of tax by State A from its residents. The clear solution to cross-border tax evasion from State A's view would be for State S to provide it with relevant information to allow it to properly enforce its domestic tax law on its own residents. Refusal to do so by State S would amount to aiding and abetting in tax evasion and we may sympathise with the rationale of State A (or a collection of states like the OECD) threatening State S with sanctions to compel it to cooperate and disclose the necessary information.

Redemption of the Havens

However, as with any tale involving secrets and hideaways, there is another facet to the story. To begin with, there is the "minor issue" of respecting State S's sovereignty, which seems to be conveniently ignored. After all, it is State S's right to decide whether to tax or to forego taxing the income of foreign investors and foreign capital within its borders. As a practical matter, if State S imposes no tax or taxes foreign capital in a different way than State A, State S will not collect the relevant information that State A requires to impose its tax. Compelling State S to collect tax information that is "foreseeably relevant" to State A but which it does not need itself is arguably tantamount to forcing State S to help enforce the laws of State A. One can easily imagine a situation where the courts of State S would be called upon to compel disclosure if the State S company or bank in question refuses to disclose the information to State S authorities. Furthermore, even if State S was willing to cooperate, should it be forced to collect a different type of information every time there is a change in the way that State A wants to tax the offshore income of its residents?

Looked at from another perspective, is taxing offshore income the only solution to State A's problems? The challenge of raising revenues in the face of the need to keep tax rates low is common to all states, yet why is it that most states have coped without resorting to labelling others as tax havens? Some of the policy responses adopted by these states are as follows:³²
1. Have in place exit controls³³ or an exit tax on capital;

2. Increase the tax on its less mobile residents or activities that cannot relocate offshore;³⁴ or

3. Change or adopt a different basis of taxing its residents or activities that is less prone to evasion, for instance, taxing consumption with a Value Added Tax.³⁵

The common thread through all of these policies is that the exercise of authority remains within the state's boundaries in line with its sovereign territorial limits. In actual fact, most countries in the world adopt a form of actual or de facto territorial taxation. The trend since 1994 has been one of countries moving towards the territorial basis of taxation, rather than trying to extend their taxing jurisdiction over offshore income.³⁶ Unfortunately, State A is often reluctant to face up to the political difficulties (at least in democracies) of adopting such policies. There are limits to the extent that the tax burden can be shifted to the less mobile residents or activities within a state's borders. People vote but offshore capital and companies do not.

Be that as it may, if we accept that taxing offshore income is both justifiable and politically expedient, is there a way to achieve it without forcing State S to disclose information? Here, the key is to appreciate that State S is a small country that offers few opportunities to put capital to work. Capital cannot remain in tax havens to be productive; they must be reinvested into the prosperous and stable economies or the deeper capital markets of the State As of the world. Cayman Islands by itself cannot possibly utilise or generate sufficient income for the US$800 billion in bank deposits allegedly held in its banks.³⁷ Therefore, if the large industrialised states of the world could agree, they could eliminate almost all of the harmful tax effects of its residents' activities in State S by, for example, collectively imposing a withholding tax on all payments to State S by their residents.³⁸ Then, it will not matter whether State A knows who the beneficial owner of that bank account or shell company in State S is, the tax would have been collected by a paying agent in State A before it leaves State A in a manner that does not impinge on the sovereignty of State S. To avoid double taxation, the tax withheld can be refunded upon proof that the payment is to foreign investors from non-tax haven countries or upon satisfaction, that the payment is not to State A residents hiding behind State S entities or bank accounts.

The problem with this concept is the impossibility of expecting coordinated action by all the large industrialised states to impose roughly equivalent rates of withholding taxes on all outbound payments of income. If just one major state breaks rank and refuses to impose the withholding tax, it will instantly attract capital to the detriment of the other states since investors would get a higher return by investing in that state. Even if the other states were to be willing to refund the tax as described above, the compliance costs of having to claim a refund and the loss of privacy would greatly discourage foreign investors. A real world example of this situation is the US practice of taxing its residents on interest income at a rate of up to 35 per cent, but allowing interest income of non-residents with US bank deposits to be remitted tax free back to their own countries. If another state tries to impose a withholding tax on similar outbound payments, capital would simply bypass that state and invest in the US instead.

In a final twist to the tax haven saga, if State A does not tax the income of foreigners nor withhold on outbound payments, it will not know who the beneficial foreign owner of that income is. Therefore, short of State A expending efforts to collect information that it does not need for its own tax purposes, State A simply does not have the information to meet the OECD standards for exchanging information if it is to receive a request from another state for information on the payee of that outbound payment. The net effect is that State A is behaving like a "tax haven" vis-a-vis investors from other States (i.e. no tax and no information to exchange), no different from State S. Indeed, it is the contention of the Luxembourg prime minister,³⁹ the Economist magazine⁴⁰ and various commentators⁴¹ that some US states like Nevada, with its easy regime for incorporating shell companies, zero tax and refusal to disclose information, actually act as tax havens and should be included in the OECD's blacklist. A similar charge is levelled against the UK.⁴²

True Haven is a Place on Earth

The real untold story of the tax haven saga is that tax haven type behaviour is not unique to small, low tax countries. The reality of course is that small states lack the ability to impose sanctions on others, so it is futile for them to label others as tax havens. Moreover, there are clear alternatives to raising tax revenue or to achieving effective taxation of offshore income without resorting to forcing a weaker state to disclose information that it may not even collect for its own tax purposes. Notwithstanding the G-20's declaration of victory over banking secrecy, the realpolitik surrounding the tax haven issue suggests that the controversy will remain very much alive for a long time to come.

Since the time of writing of this article in June 2009, Luxembourg has been upgraded to the "white list" by the OECD after crossing the threshold (12 information exchange agreements) to be considered by the OECD to have substantially implemented the OECD standard for information exchange. The Cayman Islands with 10 agreements and the British Virgin Islands with ¹¹ agreements (per the OECD progress report of 8 July) are also hoping to join Luxembourg in the white list. In addition, French President Nicholas Sarkozy and U.K. Prime Minister Gordon Brown have called for a March 2010 deadline for tax haven jurisdictions to come into line with OECD standards or face penalties for failure to do so

Tzi Y Sim⁴³
E-mail: tys212@nyu.edu

The author welcomes any comments/suggestions

Notes

1 Webster's Revised Unabridged Dictionary, available at http://www.dictionary.net/haven.

2 See Elaine Abery, The OECD and Harmful Tax Practices, 2007 WTD 103-13 (May 29, 2007) and Joann M. Weiner, News Analysis: Surreal Events at the Brussels Tax Forum, 2009 WTD 74-3 (Apr. 21, 2009) where a member of the European Parliament was quoted as saying that "tax fraud is at the root of the [financial] crisis."

3 White House press release available at http://www.whitehouse.gov/the_press_office/leveling-the-playing-field-curbing-tax-havens-and-removing-tax-incentives-for-shifting-jobs-overseas/.

4 Wall Street Journal article available at http://online.wsj.com/article/SB123499439400216483.html.

5 Available at http://www.oecd.org/dataoecd/32/45/42356522.pdf.
6 Available at http://www.oecd.org/document/0/0,3343,en_2649_34487_42521280_1_1_1_1,00.html.

7 See Maureen O'Donoghue and Svetlana Bugayeva, Russia Issues New Blacklist, 2007 WTD 239-7 (Dec 12, 2007).

8 See remarks by Angel Gurría, OECD Secretary-General Conference on the Fight Against International Tax Evasion and Avoidance: Improving transparency and stepping up exchange of information in tax matters, Paris, France, 21 October 2008 available at http://www.oecd.org/document/12/0,3343,en_2649_201185_41542604_1_1_1_1,00.html..

9 Corporations that conduct little or no real economic activity and are used more for their corporate form than substance.

10 The White House address was available at http://www.whitehouse.gov/the_press_office/leveling-the-playing-field-curbing-tax-havens-and-removing-tax-incentives-for-shifting-jobs-overseas/.

11 CIA World Factbook. For Nevada, see Haven Hypocrisy, March 26th 2009, The Economist print edition. For Labuan, see www.cuti.com.my/guide_labuan.htm.

12 Except for Belgium and Nevada, see http://www.offshoreinvestment.com/SURVEY/iom.html. For Belgium, see Infobel Belgium Business - Firmenadressen (http://www.softguide.com/pj/1950/belgien-infobel-belgium-business-firmenadressen.htm). For Nevada, see Haven Hypocrisy, March 26th 2009, the Economist print edition. The Dubai figure is based on the number of members of the Dubai Chamber of Commerce and Industry, available at http://www.gulfnews.com/business/Economy/10262614.html.

13 Except for Jersey and the UAE, approximated based on the rate paid by US multinational corporations. See Martin A. Sullivan, U.S. Multinationals Paying Less Foreign Tax, 2008 TNT 53-5 (March 18, 2008).

14 Available at http://www.kpmg.com/SiteCollectionDocuments/Hedge_Funds/Jersey_HF_Taxation_2009.pdf

15 Note that offshore trading activities in Labuan is taxed at either three per cent of audited profits or fixed sum of RM20,000. For investment holding companies, investment income and capital gains are tax exempt from Year of Assessment 2008 (http://www.offshoreinvestment.com/SURVEY/labuan.html).

16 Corporations are not taxed in the Jebel Ali Free Zone.

17 Based on the list of Offshore Secrecy Jurisdictions in the Stop Tax Haven Abuse Act.

18 Based on the November 2001 list, see Gianluca Queiroli, A Comparison of Italian and U.S. CFC Legislation, 2003 WTD 120-17 (Jun. 23, 2003).

19 See footnote 8, supra.

20 Jurisdictions in the OECD's "grey-list".

21 Hong Kong is included as a footnote under China which is in the "white list."

22 See OECD website available at http://www.oecd.org/document/42/0,3343,en_2649_34487_38598698_1_1_1_1,00.html.

23 Martin Sullivan in a 2004 Tax Notes article, quoted at http://www.finfacts.ie/irelandbusinessnews/publish/article_10005150.shtml..

24 The White House address was available at http://www.whitehouse.gov/the_press_office/leveling-the-playing-field-curbing-tax-havens-and-removing-tax-incentives-for-shifting-jobs-overseas/. Note that the reference to Bermuda, the Netherlands and Ireland was later withdrawn due to Dutch diplomatic protest.

25 The Director of the OECD Centre for Tax Policy and Administration suggested that Jersey, Guernsey, and the Isle of Man qualified for the "white list" by, inter alia, signing at least 12 tax information exchange agreements with other jurisdictions.

26 This is not to deny that these are genuine and serious concerns associated with some tax havens. However, a discussion of these issues is beyond the scope of this article.

27 One may quickly infer that State A refers to "America" and State S to "Switzerland" but "State A" and "State S" can just as meaningfully represent any one of the large countries in the G-20 and OECD that advances the anti-tax haven agenda and one of the small states that is a tax haven candidate respectively.

28 Such as availability of natural resources, markets and labor.

29 Capital flight is accompanied by corporations moving their activities abroad resulting in a lower level of domestic investment and economic activity, less income generation and consequently a lower tax collection.

30 Based on the average of personal income tax rate and corporate rate in developed countries in 1980 vs the present, see Daniel J. Mitchell, Since When Is Tax Competition a Bad Thing, Mr. President?, Media release by the Cato Institute (May 4, 2009).

31 State S may refuse to allow a "fishing expedition" and request that State A identify a particular person or entity that is allegedly avoiding tax. State S may also refuse on the grounds that tax avoidance in State A is not a criminal offense in State S.

32 This excludes the marginal improvements like improving tax enforcement and compliance within its own territory.

33 This does not necessarily mean stopping outflows of capital but can take the form of reporting requirements for example.

34 This can take the form of taxing less mobile factors like land (e.g. property tax in Hong Kong) and labor. It is easier to tax wages by requiring employers to withhold taxes before they are paid out to workers than to tax companies that can shift income around subsidiaries. This can also take the form of taxing location bound services like retail, food and beverage operations or services like haircuts.

35 Singapore, for instance, has gradually reduced its individual and corporate income tax rate over the years and made up much of the revenue loss with increased taxation on consumption (e.g. GST and cars).

36 See Reuven S. Avi-Yonah, Back to the Future? The Potential Revival of Territoriality, The John M. Olin Center for Law & Economics Working Paper Series No. 88 (2008).

37 Testimony of Robert M. Morgenthau before the United States Senate Permanent Subcommittee on Investigations, July 18, 2001.

38 This is the insight of Professor Avi-Yonah of the University of Michigan. See Reuven S. Avi-Yonah, 'Obama's International Tax Plan a Major Step Forward,' 2009 TNT 85-6 (May 6, 2009).

39 See Charles Gnaedinger, Luxembourg, Other Tax Havens React to OECD Grey List, 2009 WTD 64-4 (April 7, 2009).

40 See Haven Hypocrisy, March 26th 2009, the Economist print edition.

41 See e.g. Marshall J. Langer, Harmful Tax Competition: Who Are the Real Tax Havens?, 2000 WTD 243-17 (Jan 29, 2001).

42 See e.g. Daniel Mitchell, Tax Haven Myth vs Reality, Prosperitas, May 2007, Vol. VII, Issue IV, citing the Financial Times article, Tax haven London, May 1, 2007, available at http://www.ft.com/cms/s/86c3040c-f780-11db-86b0-000b5df10621.html.

43 The author is a tax attorney practising in New York.