Tax Havens – Treasure Islands or More?

TAX HAVENS: TREASURE ISLANDS OR MORE?

BY: Arunima Sodhani

The recent investigations by the International Consortium of Investigative Journalists (ICIJ) have exposed close to 2.5 million records of offshore accounts, shell companies, and dubious financial deals carried out by thousands of influential figures in global politics, business and law and their agents. The revelations have sent shock waves along financial and political corridors across the globe, not only because of the involvement of big names but due to the massive quantum of money alleged to be stashed away in the offshore accounts created for the purpose of domestic tax evasion. A report titled ‘Secrecy for Sale: Inside the Global Offshore Money Maze’ compiled by ICIJ throws light on how numerous people have managed to take advantage of the loopholes in the taxation system of their own country to export money to regions with relaxed tax laws in order to conveniently hoard their wealth. Further reports give details of how these internationally renowned individuals have called upon the expertise of accountants and bankers to aid them in their process of shielding their riches from the eyes of tax officials.

But one of the fundamental prerequisites for the successful completion of this process is the existence of such places where money can be invested in a manner that attracts lowest possible taxation rates. But there are several countries which offer this facility, and they are known as tax havens. The Britain based Tax Justice Network (TJN) defines tax havens as “ tax haven provides facilities that enable people or entities escape or undermine the laws, rules and regulations of other jurisdictions elsewhere, using secrecy as a prime tool.” Essentially, any country or sovereign which modifies its tax laws in a manner that reduces the tax payable to the government, in a bid to attract foreign investment is a tax haven. Such regions are characterised by nominal or no tax rates, utter lack of transparency with regard to tax legislations, disregard for foreign tax laws, and maintenance of confidentiality of account holders and ‘tax payers’ in the region. Tax havens also provide the facility of easy formation of companies so as to promote investing activities and also provide excellent offshore banking services and ensure secrecy of the identities of the account holders making use of the flexible regulations. They are called secrecy jurisdictions as they create legislations which are designed to undermine the legislations of foreign jurisdictions.

 In October 2011, TJN came up with the Financial Secrecy Index (FSI) which identifies and ranks tax havens according to their opacity. According to TJN, financial secrecy takes 3 different forms, first-the most popular form of bank secrecy, observed in countries like Austria and Switzerland, second- the creation of entities whose ownership and functioning is kept secret, prevalent in states like Delaware and Nevada in USA, and the third type of secrecy takes the form of barriers to co-operation and information exchange. The calculation of FSI combines two measurements, one qualitative and one quantitative. The qualitative measure looks at a jurisdiction’s laws and regulations, international treaties, and so on, to assess how secretive it is.  The assessment is given in the form of a secrecy score. The quantitative measurement attaches a weigh to take account of the jurisdiction’s size and overall importance to the global financial markets. In combining the two scores, the secrecy score is mathematically emphasised and the weighting is de-emphasised, in order to give secrecy its due importance.

The FSI ranks Maldives and Nauru, 2 small island nations as ‘exceptionally secretive’ rendering them the status of the best tax havens. It is said that owning a company in Maldives is easier than owning one in any other nation of the world. A study by PricewaterhouseCoppers hypothesized a flowerpot manufacturing company in Maldives which owned one building, two plots of land and had 60 employees. It would take the company’s accountant only about an hour to comply with the country’s tax codes. In comparison, an accountant in USA would take around 187 hours to comply with the country’s tax procedure, and USA is not even one of the countries with strict tax procedures. In Belarus, it would take 1080 hours. Moreover, Maldives doesn’t charge any income tax, property tax, or capital gains tax bestowing upon its citizens an absolutely tax-free existence. Nauru, the third smallest country of the world, also doesn’t impose any taxes and provides its citizens free education, health care, and other services; the government generates revenue from large quantities of phosphate export. Setting up a bank in the country costs only about $100,000 (i.e. Australian Dollar, Nauru doesn’t have a currency of its own) with no requirements for a local director, or any local presence for that matter, and the country is said to have 400 banks operating within the mainland. On similar lines, incorporation of a company costs around $1,000 and such companies can be used to hold land overseas, manage portfolios and avoid duties. Another group of islands which serve as a tax haven are the Cayman Islands in the Caribbean. Direct taxes are not imposed on the citizens, and the main sources of government income are indirect taxes (in the form of high import duties) and income from tourism. What makes the Caymans a tax haven is the ease of incorporation of companies and almost nil subsequent taxation. When incorporating, there is no need to reveal the true identity of the owners of the offshore company. Only one shareholder and one director are needed for company incorporation, who can be the same natural person. Cayman Islands have no taxation system in place for Cayman International business companies. Offshore corporations incorporated in the Cayman Islands will pay no income tax or corporate taxes on capital gained abroad. This makes the Cayman Islands boast of a thriving financial services industry with banking, hedge fund investments and securitisation being the largest sectors.  The Caymans have the 14^th highest per capita income in the world and their currency, Cayman Islands Dollar (KYD), trades at 1 KYD for 1.25 USD. The islands got worldwide press attention during the 2008 Presidential debates when Barack Obama criticized their tax haven status, declaring “There’s a building in the Cayman Islands that supposedly houses 12,000 US-based corporations. That’s either the biggest building in the world or the biggest tax scam in the world, and we know which one it is.”

But it is not only small, innocuous islands that serve as tax havens. One of the most popular tax havens of the world is Switzerland, with its infamous ‘Swiss accounts’. The country is notorious for being the most preferred haven by well-known and wealthy Europeans and other nationals including entrepreneurs and celebrities. Secrecy is the golden rule of the state with banking regulations prohibiting bankers to reveal details of their clients dating back to the 1700s. Information in Swiss bank accounts cannot be divulged without the consent of the bank account holder and giving out the information is deemed a criminal offense. Bank workers in Switzerland are expected to sign a secrecy oath, violation of which could lead to prison time. Interest gained on bank accounts owned by non residents is not taxed, and the accounts are not subject to estate taxes, inheritance taxes, or stamp duty. These advantages only make the offshore banking system more attractive. Incorporation and relocation of companies to Switzerland is also a very easy procedure, and the subsequent advantages in the form of low tax rates and several exemptions have lead to over 250 mostly European and U.S. companies shifting headquarters to Switzerland in 2003-09. KPMG calls it the ‘perfect headquarter location for international companies’ because of its tax laws, political stability, quality of life, educated workforce, and strategic position in Europe. Needless to say, the financial sector is a flourishing industry in the country with myriad services on offer including investment banking, wealth management, corporate tax avoidance structures etc. Total banking assets are estimated at 820 percent of GDP. But lately, its corporate tax laws and banking opacity have come under the microscope of international financial consortiums and Switzerland has agreed to information-sharing arrangements with some other jurisdictions, though only under massive international pressure. Switzerland has agreed to levy taxes as a participating country in the European Union Savings Tax Directive, but this initiative is full of holes and has raised little money.

Any piece of writing on tax havens would be incomplete without a mention of Luxembourg, which ranks third in the Financial Secrecy Index. What sets the country, with the highest per capita income in the world, apart from other tax havens is (a) a right-wing government, which entirely backs the existing financial secrecy regime, and (b) the dominance of Luxembourg Stock Exchange (Bourse de Luxembourg) in the European financial securities market. For such a small country (the population being little over half a million), Luxembourg is a very fiscally robust economy housing the world’s second largest mutual funds market after USA, and Eurozone’s biggest private banking district. The Luxembourg Exchange is the biggest in Europe for listing of international bonds, the first being a Eurobond issued in the 1960s. The country was most favoured for the listing due to its favourable tax structure and lax regulations, and even today it is the most booming market for international securities. Another tax haven, with the number of registered businesses exceeding the population, is the state of Delaware in USA. In spite of not being widely regarded as a tax haven, it houses the registered offices of 63 percent of the Fortune 500 companies including big-wigs such as Apple, Coca-Cola, American Airlines, Wal-Mart and many others, at the infamous address 1209 North Orange Street. Corporations are attracted by Delaware’s exemption from taxation of the subsidiaries of holding companies (so the holding-company headquarters are located in Delaware). This helps the companies pay lesser tax in the state where substantive business activities are carried out, by routing their earnings to the holding company’s registered office in Delaware, and this provision is famously known as the ‘Delaware loophole’. Such is the ease of incorporation in the state that setting up a company takes less than an hour, and the office of the Secretary of State is open till midnight. Anonymity, one of the key features of a tax haven, is also a well established principle in Delaware and almost no information about the promoters, directors or beneficiaries of the company is required during registration. More information is required to get a driving licence than to register a company.  According to the New York Times, setting up a shell company in Delaware with “no employees, no assets and, in fact, no real business to speak of” is quite easy. As for direct taxes, the tax percentages imposed on the seven income tax brackets range from 2.2 percent to 6 percent, and the corporate tax rate is at flat rate of 8.7 percent. Delaware is undergoing a lot of pressure from other states of the US for closing the ‘Delaware loophole’ so as to save USA’s reputation, but officials refuse to succumb to the pressure saying “We have a system that is the greatest creator of wealth in the history of the world. We will not support any changes that change the friendliness of American business and close our doors to capital formation and the ease of doing business.”

A surprise mention on the FSI is of Japan, which accounts for a little under 2 percent of the global offshore market.  Even though corporate tax income is very high in Japan, it counts as a tax haven due to its secrecy measures, and exemptions earned on bonds. Since 1999 Japanese government bonds have been exempted from taxes and a range of financial regulations. Municipal bonds in 2007 and corporate bonds in 2010 were given the same privileges, making them a key avenue for parking funds. Japan’s weak directives on information exchange and transparency and tax exemptions provided to various foreign investment avenues have made it a destination for monetary flows.

But all this talk of tax havens raises a number of questions about the morality of such legislations prevailing in these jurisdictions, and why no steps are being taken by global authorities to curb this tax evading culture. A big question mark still hangs on the justification of tax havens with equally persuasive arguments from both sides, one criticizing them and the other defending. Advocates of the former say that tax havens are not merely regions where you have to pay low taxes, but are areas which help corrupt elitists skirt the regulations, legislations and laws of other areas for their own greed, using anonymity and secrecy as the prime tool. This is the reason Tax Justice Network uses the term ‘secrecy jurisdiction’ rather than the more common ‘tax haven’. It is said that tax havens are used only by criminals and they lead to a widened divide between the rich and poor, corrode the concept of democracy, and distort the harmonious functioning of markets. If a country has provided any corporation with an environment and regulations conducive to prosperous business activity which has lead to the corporation earning profits for itself and its beneficiaries, then it has a moral obligation towards the country and should pay its dues. It is true that tax havens provide benefits to companies and help increase profits, which is the foremost reason for any company to exist, but at what cost?

While all these criticisms abound, there are a few proponents of tax havens who argue that such jurisdictions are in fact favourable to economic growth. The first and foremost factor contributing to growth is the availability of sufficient capital. If the government acquires most of a company’s earnings, then the company isn’t left with much to contribute to growth. The only way to encourage growth is to encourage activity and that is not done with high taxation. Income is already taxed before it is invested, taxing again as capital gains simply discourages growth. Prosperity can only be attained in a system which rewards the contributors to economic growth and doesn’t discourage business activity. If a company is caught in the shackles of high taxation, it may be forced to incur debt which will push it into a never-ending cycle of loan repayments, a situation hardly complimentary to development. Countries with high taxes face a threat of capital flight to tax havens, but this is a competitive scenario. A simple matter of incentives and rationality. It is absolutely reasonable if efficient companies do not want to give an extraordinary sum of money to governments and want to invest it in such avenues which increase their wealth. Such behaviour is not tax evasion, it is tax planning.

 There is no illegality involved in wanting to save money and investing it in profit yielding prospects, in fact it is a testimony to financial and economic prudence. It is in the interest of the company, the shareholders and other beneficiaries, and the wider society in which they operate. It leads to efficient resource allocation, leading to the betterment of society and higher living standards across the world. Tax havens only promote healthy competition in tax rates which may lead to lower tax rates across the world. They make governments think about an effective tax policy which will reduce capital flight from their countries. Milton Friedman once wrote “Competition among national governments in the public services they provide and in the taxes they impose is every bit as productive as competition among individuals or enterprises in the goods and services they offer for sale and the prices at which they offer them.” Taking the cue, many Scandinavian countries have implemented flat rate taxes on capital income which are lower than other tax rates as they have come to realise that it is better to collect some tax revenue at a low rate rather than no tax revenue at a high rate. An IMF official once said “today, individuals may be able to choose among many countries in deciding where to work, to shop, to invest their financial capital, to allocate the production activities of the enterprises they control and so on. In these decisions, they take into account the impact of taxes, especially as long as the tax systems of different countries diverge as much as they do today.”  The ideal tax system should have the lowest possible tax rates on savings, investments, risk-taking, and entrepreneurship as these are the activities that generate income and wealth.  Pervasive double-taxation of saving and investment is particularly harmful as it hampers capital formation which is, as all economic theories agree, the key to long-run growth and higher living standards.

Apart from economic justifications, tax havens can also be defended on moral grounds as human rights guardians. There are millions of people around the world who are subject to state-sanctioned religious, political, sexual, and economic persecution. These people are especially likely to be targeted if they have any money, so the ability to invest their assets offshore and keep that information hidden from governments can, in some cases, be a life-or-death matter. A wealthy Venezuelan entrepreneur always faces the risk of his family being kidnapped for ransom, which has according to the United Nations, become an industry in Venezuela. Corrupt tax officials may willingly sell information about the entrepreneur’s wealth to such hooligans. But if the entrepreneur’s money is safe in an offshore haven, he not only reduces the risk to his family, but also helps in reducing the crime rate. There are still many areas of the world where Jews are treated unfairly, particularly in the Middle East. And the persecution quite likely is linked to their wealth since extremists are especially likely to resent someone who is financially successful. Tax havens provide a refuge for religious minorities. The famous Swiss laws regarding banking secrecy were significantly strengthened in 1934 after Adolf Hitler took control in Germany. The ability to maintain assets in Switzerland – unknown to oppressive governments – may play a valuable role in helping people fight religious persecution. Sexual minorities still are persecuted in many nations such as Saudi Arabia or Iran. The ability to conduct financial operations in a tax haven may be the only way for homosexuals to guard against an oppressive government getting too much information. Consider the case of a family in Zimbabwe, one of the most politically unstable governments in the world. Expropriation is a common threat for those who are viewed as enemies by the nation‘s dictator, and a shell company in any tax haven is an ideal way of protecting family wealth. To protect these people from gross injustices, such measures are necessary. It is imperative to provide them with safe and confidential investment avenues, which may be directly linked to their livelihoods due to the fear of pervasive government oppression.

To conclude, tax havens aren’t indulging in criminal offences. The activities carried out are not illegal. The hedge funds in the Cayman Islands are legal, the British Virgin Islands specialize in legal company formation, and Bermuda has legitimate reinsurance firms. The illegality is restricted to private wealth hoarding in foreign countries without declaring it one’s own country. Transactions taking place in tax havens are not illicit, they are merely taxed at a lower rate. There are no laws being broken, only some loopholes being challenged. The world’s perception of tax havens is highly skewed, so much so that on some occasions they are even blamed for the sub-prime lending crisis, and a change is needed for the world to see the positive impacts these regions have on economic development, taxation policy correction, global market competition and human rights protection. It is time to realize that these nations play a valuable role in the global economy. It is time to realize that they aren’t ‘the bad guys’.