Summary Brief Number 23

What is ‘Offshore’? International Tax Evasion and Avoidance and How to Combat it Sol Picciotto

This briefing aims to explain the ‘offshore’ From early in the 20th century, when states system which enables both evasion and started to rely on income taxes, wealthy avoidance of tax, as well as of other types individuals and transnational corporations of laws and regulations, and discusses (TNCs) began to find ways to evade or countermeasures. All illicit cross-border avoid them. The basic technique was to financial flows exploit the offshore system, interpose an intermediary entity or conduit so understanding how it works is the between the source of income and its key to ensuring effective and coherent beneficial owner. This could ensure that countermeasures, in relation to tax, money- such income would not be taxed in either laundering and corruption. It was written as the source or residence country. The conduit a submission to the United Nations High could be a nominee account, or a legal Level Panel on Financial Accountability, person such as a company, or a trust. Such Transparency & Integrity. conduits are legal fictions, existing only on paper, electronically, or as brass plates on Offshore: an in-between an office building. These assets can be used space to generate income or gains from another National taxes on income, profits or gains country, to benefit persons resident in a usually apply to income defined by its source, third country. Generally, a chain of conduits or persons (individuals or legal entities) is used, in a ‘stepping-stone’ structure, to based on their country of residence or avoid withholding taxes at source as well citizenship. Other kinds of rules, such as those as residence tax (see Figure 1). It’s also on bribery and money-laundering, are usually possible for a person to use an offshore also based on residence or citizenship, and/or structure to avoid tax in their own country of the place where the activity takes place. residence, known as ‘round tripping’. SummaryBrief www.ictd.ac What is ‘Offshore’? International Tax Evasion and Avoidance and How to Combat it

Hence, ‘offshore’ is not a place but a system or characteristic of offshore laws or regulations is legal structure, enabling people or companies that they benefit non-residents of the country. based or living in high-tax countries to pay low They can be deliberately designed to do so, tax. Different kinds of haven are generally used or the benefit may simply result from limiting in combination, and almost any country can be the scope of national rules to residents of the a haven in some way and to some extent. That country. For example, in 1934 Switzerland’s

SummaryBrief is why ‘blacklists’ of havens are of limited use. political and financial elites decided to reinforce Much better tools are the Financial Secrecy its role as an offshore banking centre, which Index, which ranks countries by factors reflecting began early last century, by enacting a bank their importance in the offshore system (FSI secrecy law criminalising any disclosure of 2020), and the EU’s Directive on reportable information on clients (Farquet 2012, Guex cross-border tax avoidance arrangements 2000). Other jurisdictions have also passed (EU 2018), which specifies the basic offshore strong secrecy laws to attract financial deposits structures based on their ‘hallmarks’. from non-residents. Several European states, Although commonly thought of as small particularly the UK and the Netherlands, allowed countries, portrayed as palm-fringed islands, or encouraged their colonies or dependencies to countries of all sizes can act as havens, offer offshore facilities, which also benefited their by providing offshore facilities. The central own financial centres in London and Amsterdam. Figure 1 Basic offshore ‘stepping-stone’ structure

Residence country Source country

Parent Operating company company

Charges for Asset transfer Fees/royalties/interest services/inputs

Base haven Treaty haven Income flow

Base entity Conduit entity Rights to assets

Image: Author’s own.

Assets (capital, intellectual property rights etc.) are assigned at the direction of the Parent to a base entity resident in a zero-tax country, which lends or licenses them to the Operating Company via a conduit resident in a country with suitable tax treaties; the interest or royalties paid by the Operating Company reduce its tax on business profits, and are exempt from tax in the source country (due to the treaty); the Conduit also pays no or very little tax, passing the income through to the Base, where it is sheltered from Residence country tax, while being available to the ultimate owner.

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Countries with large financial centres have plausibly be argued to be within the law. The also offered offshore facilities, by providing worse that can happen is that the arrangements stronger protection of client confidentiality for may be investigated and if challenged may be non-residents. Confidentiality can usually be found ineffective or unlawful. Since there is overridden by obligations to disclose information usually no penalty, especially if they are based to tax and criminal enforcement authorities; on legal advice, entering into such arrangements but many countries refused to obtain such entails little or no risk. At the worst, tax may information to help other countries enforce their eventually have to be paid, but meantime it is laws. Such obligations began to be accepted deferred. Hence, corporations have considered only relatively recently, for example the UK it legitimate to engage in avoidance, often did so for tax matters only in 2000. Secrecy is described as tax ‘planning’. Some even argue also enabled by the lack in most countries of that they are required to do so in pursuit of profit. public registers of the owners or beneficiaries Both international tax evasion and avoidance of legal entities such as companies, trusts use the offshore system, deploying similar or foundations. Hence, it is still possible to techniques that are linked and overlap. The circumvent arrangements for exchange of frequent claim that tax avoidance is legal is information by owning assets through an entity mistaken. Tax avoidance arrangements are in a jurisdiction with no register of beneficial frequently unlawful, in that they do not succeed ownership. Most US states have no corporate in avoiding tax. However, this greatly depends ownership register, and few countries require on the resources available for tax audit and disclosure of the parties to trusts. investigation. The UN Financing for Sustainable The grey zones: planning, Development report 2020 points out that data from the International Survey on Revenue avoidance and evasion Administration show that a high proportion of Using offshore arrangements may sometimes be tax audits identify underreported taxes, although proved illegal, under either civil or more rarely they rarely result in prosecutions for evasion criminal law. For example, ‘round tripping’ is likely (UN 2020, pp. 42-3). The data also show higher to be illegal. More often, such arrangements success rates for low-income countries, although are designed to exploit legal ‘grey areas’ that obviously such countries lack the capacity for result from the malleability of the abstract legal frequent audits, so much unlawful avoidance is concepts, particularly residence and source. For undetected. example, the beneficiaries of an offshore trust Hence, there is inevitably a ‘dark figure’ of can claim to have no income from abroad, even tax that has been avoided or evaded without if the trustees invest its assets as they direct and detection. When this occurs by using an offshore use the income for their benefit. It is particularly arrangement, it can be considered an illicit difficult to prove that an arrangement is criminal, financial flow. It may result from ineffective because this usually requires evidence of enforcement, due to lack of resources or other intent to break the law, or knowledge that the reasons (including corruption), or from ineffective arrangement is contrary to law. laws, sometimes in combination. Other kinds Wealthy persons or corporations can pay of illicit flows may also involve tax evasion or professionals to devise structures that can avoidance, so there is an overlap among these www.ictd.ac 3 What is ‘Offshore’? International Tax Evasion and Avoidance and How to Combat it

categories, which should be taken into account in ‘It would seem desirable to bill the tax haven analysing and quantifying them. subsidiary [in Switzerland] at less than an “arm’s length” price, because: (1) the pricing A good example of the grey zones is the might not be challenged by the revenue so-called Cum-Ex trading scheme which agent; (2) if the pricing is challenged, we exploited double taxation relief and is estimated might sustain such transfer prices; (3) if we to have cost various European countries a SummaryBrief cannot sustain the prices used, a transfer total of some €60 billion, around half of that price will be negotiated which should not be for Germany (Siegal 2020). This scheme was more than an “arm’s length” price and might certified as legal by elite law firm Freshfields well be less; thus we would be no worse off Bruckhaus, and has required enormous efforts than we would have been had we billed at by enforcement authorities to unmask, as well the higher price’.(Du Pont 1979, p.447). as amendments to legislation. Two bankers were finally convicted in late 2019, but they This viewpoint became prevalent among TNCs cooperated with prosecutors so received only and their tax advisers as early as the 1950s, suspended sentences (Storbeck 2020). Legal leading to the systematisation of the use of arguments can still be made that the facilitators offshore structures. committed no criminal offence, and even that the The use of offshore grew with the relaxation of scheme was within the law. currency and capital movement controls, and The systematisation of became generalised in the 1980s. International attempts to control the offshore system began offshore in the 1990s, e.g. through the Financial Action The basis for offshore emerged during the Task Force (FATF, set up in 1989) and the period of high tax rates after the first world war. Egmont Group (set up in 1995) to deal with In addition to bank secrecy, some countries money-laundering, and by the Basle Committee began to provide exemption from tax on foreign on Banking Supervision for financial prudence income for ‘holding companies’: Luxembourg standards. However, the tax aspects were taken enacted such legislation in 1929, and Swiss less seriously, and the G8/OECD project on cantonal laws had the same effect, in partnership ‘harmful tax practices’ begun in 1996 resulted with Lichtenstein (Farquet 2017, 233-4). US only in some improvements in exchange of lawyers enabled Panama to become a ‘flag of tax information on demand. There was little convenience’ for ships, to avoid labour legislation coordination between tax authorities and those as well as tax, and later alcohol prohibition. responsible for financial supervision. The FATF did not extend its reporting standards to tax Following the second world war TNCs, especially until 2012, and then only for ‘tax crimes’. The from the US, further developed the offshore improvements in financial supervision enabled system to expand internationally despite havens to proclaim their high standards and so restrictions on capital movements. For example, strengthen their attractiveness, while continuing a US court decision considering a tax avoidance to resist cooperation in tax enforcement. structure through a Swiss affiliate created by the US-based chemicals giant Du Pont in 1959, At the same time, TNCs further refined their found an internal memo that stated: tax avoidance structures, taking advantage of

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a fundamental flaw in international tax rules. Comprehensive automatic When these laws were devised in the 1920s exchange of tax information it was understood that TNCs are unitary firms The OECD’s Common Reporting Standard operating under central direction and control, so (CRS), established in 2014, provides a basis tax authorities were given the power to adjust the for automatic exchange of financial account accounts of their local subsidiaries or branches information for tax purposes between all in each country to ensure a fair allocation of countries, supervised by the Global Forum, the global profit. However, it was agreed to based at the OECD. This is a major step forward, focus on the accounts of each national affiliate, but significant improvement is needed. adjusted to ensure that they showed a level of profit in line with similar independent companies. In 2019, 95 countries participated in exchanges, In practice this gave a green light for TNCs to but this still does not include most developing set up offshore entities, which expanded from countries. A major gap is that the USA is not the 1950s. This was further encouraged by the participating, so its own system under the Foreign Guidelines on Transfer Pricing issued by the Account Tax Compliance Act (FATCA) is not OECD in 1995. These reinforced the ‘arm’s subject to peer review. The Global Forum’s peer length’ principle, requiring the attribution of reviews of the exchange of information on request profits to be based on analysis of the functions have found the US only ‘partially compliant’ on the performed by each affiliate and on the pricing of availability of ownership and identity information. transactions between them. TNC tax advisers Also, the US bilateral agreements under the built on this to create even more complex FATCA are asymmetrical, the information supplied corporate structures, fragmenting activities and by the US to its partners does not comply with the locating affiliates fulfilling high-value functions CRS, and is less than it receives (Knobel 2016, in low-tax countries (Picciotto 2018, pp. 40-42). pp.13-14). The US has 113 agreements in force This was further facilitated by the digitalisation of under the FATCA, but only 98 that provide for the economy, which made offshoring easier. even this limited degree of reciprocity.

Combatting the offshore This still falls well short of a global system: only four system African countries have participated in the OECD system by the end of 2019 (Ghana, Mauritius, More determined efforts have been made to Seychelles and South Africa), and six have combat the offshore system in the past decade, agreements with the US (Algeria, Angola, Cabo due to the political pressures created by the Verde, Mauritius, Seychelles and South Africa). fiscal crises following the great financial crash of 2007-9 (Picciotto 2020). These have aimed at Recommendations: (i) To improve coherence both tax evasion by rich people and avoidance and alignment the US should either join the CRS by TNCs. While great strides have been made, system, or ensure full reciprocity and participate more still needs to be done to make these in the peer reviews by the Global Forum; (ii) a measures effective, especially for developing major effort is needed to build the capacity of countries. It is also important to improve the developing countries to participate in the CRS, coherence between tax measures and those and particularly to enable them to make good aimed at money-laundering and corruption. use of information they would receive through it. www.ictd.ac 5 What is ‘Offshore’? International Tax Evasion and Avoidance and How to Combat it

Beneficial ownership supervision. Some other countries have adopted such policies, such as the Ukraine. The very existence of automatic exchange of information is an important deterrent, but its Recommendations: (i) monitoring of the CRS sustainability and effectiveness depend on the should include evaluation of the quality of quality of the information. The key to this is compliance by financial intermediaries with the transparency of legal persons and arrangements, requirement to identify beneficial owners; (ii) SummaryBrief to ensure that information is provided on the both the FATF and the CRS should require the real individual who is the beneficial owner (BO) establishment of public registries of beneficial of income. The CRS covers only accounts ownership of legal entities, and of other assets, with financial institutions, and the quality of available for searching online; (iii) the FATF and the information exchanged relies on accurate CRS should establish a limit on the ‘layering’ identification of beneficiaries. of legal entities, by obliging participating jurisdictions to require that participation in a The Global Forum has adopted the FATF legal entity by other than a natural person is Guidance on Beneficial Ownership (FATF permissible only if the ultimate BOs in that entity 2014) which, together with its Best Practices can be ascertained; and (iv) there should be guidance (FATF 2019) recommends a 3-pronged further strengthening of cooperation between approach to identification of BOs. One of these authorities responsible for tax and money- utilises ownership registers (for companies), laundering, both at international level (OECD and the others depend on obligations for financial FATF) and national level (e.g. through improving institutions, companies or professional service the sharing of data between revenue authorities providers to hold and supply the data when and financial information units). required. Although they recommend combined use of all three sources, neither the FATF nor Ending TNCs’ use of the CRS require the establishment of ownership registries, nor do the High-Level Principles on offshore structures BO Transparency adopted by the G20 leaders The Tax Annex to the G20 world leaders in 2014. Hence, in most countries identification Declaration in 2013 mandated the OECD Action of beneficial owners largely relies on service Plan on Base Erosion and Profit Shifting (BEPS) to providers or financial institutions, many of which reform international tax rules to ensure that TNCs have been found delinquent in the past. Also, could be taxed ‘where economic activities occur determined evaders can still hide behind layers and value is created’. This clearly requires ending of entities and nominees. TNCs’ use of offshore arrangements. Unfortunately, the first outcomes of the BEPS project in 2015 The international standards clearly show only patched up existing rules. In particular, the that a key element in an effective system is arm’s length principle was retained, with extensive the establishment of public registries. Due to amendments to the Transfer Pricing Guidelines, political pressures, in 2018 the EU amended which only made them even more complex. its money-laundering Directive to require public registers for companies, trusts and other legal The main advance was the establishment of a entities, and in May 2020 adopted an Action Plan system of Country-by-Country reports (CbCR) for a comprehensive policy, including EU-level by TNCs, which for the first time will provide

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from many in the business and investment Effective taxation of communities, but it is voluntary.

TNCs should be based The work on the BEPS project on international on treating them in tax implications of digitalisation of the economy reached the important conclusions that (i) the accordance with the whole economy has been affected, not just a economic reality that they particular sector, and (ii) it has exacerbated the problems of existing tax rules. The continuing are unitary firms under work is focusing on the central principles of centralised control. taxable nexus and allocation of profits of TNCs. The latest proposals have moved towards more simplified methods of allocation, starting from an overview of all the TNC’s affiliates in every the TNC’s global profits, which is a significant country, and the assets, employees, income and step forward. However, they still envisage a tax paid and due in each country. However, the continuing important role for existing transfer CbCRs are delivered to the tax authority of the pricing methods, which provide a perverse TNC’s home country, and access is available incentive for TNCs to devise complex offshore only to tax authorities of other countries structures. participating in a system run by the OECD, Effective taxation of TNCs should be based on which polices compliance with its rules. These treating them in accordance with the economic include strict requirements of confidentiality, reality that they are unitary firms under as well as insistence that countries apply the centralised control. Three methods of unitary arm’s length principle and the OECD approach taxation were evaluated by the Independent to transfer pricing. Consequently, very few Commission for the Reform of International developing countries are able to receive CbCRs Corporate Taxation (ICRICT 2019), which (in Africa only Mauritius, Seychelles and South concluded that the fairest and most effective Africa). The CbCR scheme is under review this method would be formulary apportionment. year by the G20, but the consultation document The G24 group of developing countries has put issued by the OECD does not propose any forward proposals for apportionment based on improvement in transparency of the reports. a balance of factors of production (employees, Nevertheless, the many submissions by civil users, working capital) and consumption (sales). society organisations to this consultation, as Due to the Covid crisis efforts to achieve an well as some by small business and others, agreed solution this year are likely to focus on strongly urged that CbCRs should be public. the specific problem of highly digitalised firms, CbCRs contain high-level information, so could but it is hoped that a wider solution could be not reasonably be considered commercially found in the near future. confidential. The Global Reporting Initiative has issued a standard for corporate public Recommendations: (i) the G20 should this year disclosure on tax which includes a template require publication of country-by-country reports; for CbCR (GRI 2019), which is close to that of (ii) the BEPS project should develop principles the OECD. This was developed in consultation for formulary apportionment of TNC profits along with TNCs and stakeholders, and has support the lines of the G24 proposals. www.ictd.ac 7 8 Summary Brief What is ‘Offshore’? International Tax Evasion and Avoidance How to and and Combat it Evasion Tax International ‘Offshore’? is What First publishedbytheInstituteofDevelopmentStudiesinJune2020©Studies, ICTD isbasedattheInstituteofDevelopmentStudies,BrightonBN19REUK. and quotestobereferencedasabove. acknowledgment Foundation. Readersareencouragedtoquoteandreproducematerialfromtheseries.Inreturn,ICTDrequestsdue expressed herein donotnecessarilyreflecttheUKGovernment’s officialpolicies,northoseoftheBill&MelindaGates The ICTDisfundedwithUKaidfromtheGovernmentandbyBill&MelindaGatesFoundation;however Sol Picciotto Credits G24 (2019) FATF (2014) guerres. Alphil, Neuchatel. la doubleimpositionetl’évasionfiscaledurantl’entre-deux- Analyse delapolitiquehelvétiquedanslesnégociationssur la SecondeGuerremondiale:Unehistoireinternationale. Interwar Period International Tax Cooperation. Farquet C(2017) Economic History, 27. Economic HistorySociety:EHESWorking Papersin Farquet C(2012) relation toreportablecross-borderarrangements. automatic exchangeofinformationinthefieldtaxation amending Directive2011/16/EU asregardsmandatory EU (2018) States. 608F.2d 445-461. Du Pont(1979) reading Further FATF (2019) Persons from digitalisation FSI (2020) . Council Directive Financial SecrecyIndex Proposal foraddressingtaxchallengesarising Guidance: Transparency and Beneficial Ownership Best PracticesonBeneficialOwnershipforLegal isEmeritusProfessor, LancasterUniversity, andSeniorFellow, InternationalCentrefor Tax andDevelopment. : An InternationalComparison.European E. I.DuPontdeNemours&Co,v. United . G24Working Groupon Tax Policyand La défenseduparadisfiscalsuisse The RiseoftheSwiss Tax Haveninthe T Brighton BN19RE,UK at theInstituteofDevelopmentStudies International Centrefor Tax and Development (EU)2018/822of25May2018 +44 (0)1273606261 . Tax JusticeNetwork. F +44(0)1273621202 avant .

United Nations. Picciotto, Sol(2018) Parliament. Implications forEurope.Greens/EFA GroupintheEuropean 2020 Corporations and thegrowthoftransnationalcorporations. ICRICT (2019) cfm?abstract_id=3587542 GRI (2019) And EuropeWants Justice’ Siegal, David(2020)‘ItMayBetheBiggest Tax HeistEver. 2020). Available atSSRN: technocratic politicsinglobaltaxgovernance(April28, Between intergovernmentalismandsupranational Picciotto, Sol(2020) Technocracy intheEraof Twitter. in firstcum-exscandaltrial’ Storbeck, Olaf(2020)‘Two formerLondonbankersconvicted Knobel, Andres (2016) fair andcomprehensivesolution. UN (2020) . Inter-Agency Task ForceforSustainableDevelopment,

E [email protected] Financing forSustainableDevelopmentReport Standard GRI207: Tax 25/3 International Corporate Tax Reform: International tax,regulatoryarbitrage The RoleoftheU.S.asa Tax Haven https://papers.ssrn.com/sol3/papers. New York Times , 23January Financial Times 19March . Transnational , theviews Towards a . . .