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havens explained

The wide publicity given to tax havens has led many developing wise be applicable. But care should be countries to contemplate the adoption of similar status in taken to distinguish between operations order to speed up their development. This article defines both whose main purpose is that of diminish- the dividends and drawbacks of such a status. ing a taxpayer's total burden and those that have a bona fide business purpose. The latter are generally not considered tax Milka Casanegra de Jantscher haven operations, even if they take place in a . Some industries located in What do , , Hong of establishing a tax haven. Such coun- tax havens are engaged in producing Kong, , the , the New tries are likely to consider the tax haven goods for the domestic or international Hebrides, , and have label derogatory. . Some royalties are paid from tax in common? They are all "tax havens." In the absence of reliable data on the havens for patents or know-how actually As such they are apt to excite either pas- use being made of tax havens, exaggera- being used in the country. Some foreign sionate praise or passionate denunciation, tions flourish. The advantages that these citizens in tax haven countries. Even depending on the point of view of the countries offer to taxpayers are well de- though these individuals or corporations commentator. Those who recommend the scribed in guides written by professionals benefit from the country's low tax rates, use of tax havens may cite with approval who specialize in carrying out operations they do "real" business within its borders. the remark of Lord Tomlin that "every in tax havens for their clients. But hard In contrast, much "tax haven" business man is entitled if he can to order his statistical information on the extent of the is fictitious, in the sense that little or affairs so that the tax attaching under the revenue losses suffered by high-tax coun- none of it is effectively carried out in the appropriate Acts is less than it otherwise tries and the benefits which tax haven tax haven proper. Goods that are bought would be." Speaking of those who deplore countries derive from their status is woe- and sold by tax haven subsidiaries often their use, one writer observed that "many fully meager. There is general agreement do not pass through the tax haven's ter- of the pronouncements on the subject on only a few facts, principally that the ritory; they move directly from the coun- were sufficiently vehement to convince amount of business activity carried out in try of origin to the country of destination. one that nothing of the destruction tax havens is considerable, even though The assets of trusts that are established of the tax haven and a virtual embargo exact figures are not available. Moreover, in tax havens are usually kept thousands on [ of] ... capital would save the it appears that the use of tax havens by of miles away; and neither the grantor Republic." enterprises in high-tax countries—partic- nor the beneficiary is normally resident in ularly by multinational enterprises—is the tax haven country. What is a tax haven? growing. Tax haven operations consist funda- Essentially, a tax haven is a place where Even though the list of tax havens in- mentally in establishing within a tax foreigners may receive income or own cludes several developed countries, most haven country one or more legal entities, assets without paying high rates of tax are developing countries. It is precisely such as trusts, personal holding com- upon them. Although strictly speaking their example that other developing coun- panies, or corporate subsidiaries, and not all tax havens are countries, we can tries are tempted to follow, in the hope attributing, to them income earned else- refer to them as such here for the sake that becoming a tax haven will help them where in order that it should be taxed of convenience. In some havens the tax solve some of their economic problems. at the country's low rates—or perhaps relief that foreigners enjoy stems from the While the tax haven status does bring not taxed at all. This objective is usually absence of the chief forms of direct taxa- some benefits to the tax haven country, accomplished by either (1) accumulating tion—income, estate, and gift ; but it is one of the objects of this article to income in the tax haven country at low in most countries the relief stems from dispel the myth that the tax haven status rates of tax, to be withdrawn later and special features of the tax system that is a panacea for a country's economic invested elsewhere according to the in- result in a very low effective on problems. vestor's wishes; or (2) artificially shifting certain forms of foreign investment. Some business profits from high-tax countries The modus operand! countries that enjoy a reputation as tax to a tax haven country. havens have cultivated it. In others the Tax havens are used for a great variety In the case of passive investment, from features that make them a tax haven are of operations. The main purpose of those which dividends, interest, or royalties are merely a consequence of their having fol- who patronize them is to minimize the derived, trusts and personal holding com- lowed certain principles of taxation, such taxpayer's total tax burden by subjecting panies are used as buffers or screens as that of strict territoriality in applying at least a part of his income or between the real investor and his assets. income taxation, but without the intention to a lower effective rate than would other- For many years the creation of these 31

©International Monetary Fund. Not for Redistribution legal entities for the purpose of obtaining Foreign also use "shell" banks or vantages offered by tax haven countries a was among the most branches located in tax haven countries to are advantages, these are by popular uses of tax havens. As a result of do - business. no means the only benefit that these countermeasures enacted during the past The activities of the financial sector are countries offer to foreign investors. few years in certain capital exporting largely of an ancillary or dependent Within the tax field, the absence of countries, the use of tax havens to . The main object of many of these other taxes such as estate, inheritance, shelter passive investment income has banks or trust companies is to provide and gift taxes may be as important to apparently not increased as fast as other services to other tax haven activities, such certain investors as the absence of an tax haven activities. as administering tax haven trusts and income tax. Bilateral tax treaties between At present, the most rapidly growing corporate subsidiaries and holding de- a tax haven country and some of the type of tax haven operation is that of posits for foreign investors. Much of the major developed countries are another shifting business profits from high-tax business of this sector is "real" business feature that may attract investors. The countries to tax haven countries. These in the tax haven. Banks and trust com- existence of a allows third- profit shifting transactions are usually panies that administer trusts or holding country investors to base their holding carried out by large corporations through companies do a large amount of the tech- companies in tax havens and obtain a tax haven subsidiaries, using sophisticated nical, audit, and legal work of administra- reduction in withholding taxes applied to methods that are designed to diminish tion in the tax haven country. In other the dividends and interest they receive the tax base artificially in high-tax juris- cases, however, such as the Euro-currency from developed countries with which the dictions while increasing it in the tax branches of foreign banks, the "real" ac- tax haven country has the tax treaty. haven country. tivity is carried out elsewhere, except per- Strict and well-enforced rules of - The most important of these methods haps for a nominal presence in the tax ing secrecy and, in general, the possi- involves : the setting of haven. bility of doing business without close prices on that are Tax havens also attract foreigners who supervision by government agencies are bought and sold between a parent com- come to work for foreign banks or other additional attractions usually offered b pany and its foreign subsidiary. No "arm's companies, and retirees, who decide to tax haven countries. Other factors, such length" bargaining takes place between establish their residence where the ad- as the low cost of doing business, the these parties, so the prices that are set vantage of a temperate is joined existence of liberal banking regulations, can be manipulated to minimize the enter- to that of a low-tax environment. In these and the absence of exchange controls are prise's total taxes. (The "arm's length" cases there is "real" activity in the coun- also important. These advantages were the relationship implies dealings between two try—whether working or merely residing chief reasons why foreign banks estab- independent and unrelated parties, where in it—and the tax factor is only one of lished Euro-currency branches Jh the prices are determined according to market several considerations that induce these Bahamas; the country's attractive tax forces.) For example, instead of a com- individuals to settle in a tax haven climate was apparently of only secondary pany selling goods directly to a foreign country. importance. Finally, a good communica- buyer and realizing a profit that is fully tions service, a well developed legal sys- taxable in its home country, it may sell Tax and other advantages tem with an abundance of legal and ac- the goods at an artificially low price to Low tax rates are perhaps the principal counting expertise, and, above all, a high its subsidiary in a tax haven country. attraction offered by tax havens. Usually degree of political and financial stability Thus, it shows only a small profit on these low rates are associated with income also help to make a country successful as which it has to pay a low tax, or perhaps taxation; in fact, what springs to mind a tax haven. even a loss! Its subsidiary then resells immediately upon hearing the words "tax the goods to the ultimate buyer at the haven" is the absence of income taxation, Countering tax loopholes normal price, earning a large profit, all of or the existence of a form of income taxa- which however is taxed at a low rate, or tion that exempts foreign investment. Are these all the elements necessary to not taxed at all, because the subsidiary is Though it is true that many of the ad- enable taxpayers from high-tax jurisdic- located in a tax haven. tions to minimize their tax burdens? In Another type of activity is carried out fact, there is one other element without in tax haven countries by the financial which they could not do so and that is sector. In most of these countries there Milka Casanegra the existence of features in the tax sys- exists a financial sector whose size and de Jantscher tems of developed countries that allow importance are out of proportion to the taxpayers to take advantage of the bene- size and resources of the country itself. fits offered by tax haven countries. Among This sector usually comprises a large these features are, for example, the more number of banks and trust companies, a Chilean national, favorable tax treatment granted to trusts most of which are branches or subsidi- has a law degree from located abroad than to domestic trusts, the University of , aries of foreign-owned institutions. The Santiago, and an and the mechanism of tax deferral that reasons for their presence in tax haven LL.M. degree from allows taxpayers of high-tax countries to countries are quite varied. These institu- Harvard University. defer income tax payments on income tions manage trusts and holding com- Mrs. Casanegra joined the staff of the Fund from foreign sources until it is repatri- panies that have been established to in 1972 and is now a Senior Tax Admin- ated. These and other mechanisms may shelter foreign passive investment income; istration Analyst. She was formerly Assistant be likened to escape valves left in their they hold deposits for foreign inves- Commissioner for Planning and Research in tax systems by high-tax countries, in tors; they provide administrative facilities the Internal of Chile. order to grant taxpayers relief from the for a variety of corporate subsidiaries. pressures of taxation. As as these 32 ©International Monetary Fund. Not for Redistribution provisions remain in effect, high-tax tion rules rely heavily on percentage cri- As a result, the provisions against the countries cannot place all the blame on teria, which have the merit of being use of tax havens that developed coun- tax havens for the losses of revenue they objective but which at the same time leave tries have lately introduced have mainly suffer. a wide margin for maneuvering by tax- affected the accumulation of passive in- During the past two decades some payers. Thus the anti-accumulation rules vestment income in tax haven countries, countries have moved to eliminate these usually apply only when the subsidiary not by banning accumulations outright, safety valves. The has established in a low-tax country is "con- but by making them more costly and pioneered the way, with other countries, trolled" by taxpayers in the high-tax complex. Therefore, the accumulation of such as , , , the country. "Control" is defined as owner- income by holding companies and trusts Federal Republic of , and the ship ofi more than 50 per cent of the is still possible, but only for very following that example. of the foreign subsidiary. The wealthy investors or the large corpora- The enactment of measures against the United States and Canada, however, only tions. As the latter are also the corpora- use of tax havens has not been easy and count corporations or individuals, each of tions that use transfer pricing to shift in each of these countries has produced whom owns more than 10 per cent of income to tax havens, and as transfer an uproar among interested taxpayers in the foreign corporation, toward the 51 pricing practices have not been much high-income brackets. per cent "controlling" share of the com- affected by the provisions against the use of tax havens, it is probable that the "clients" of tax havens are increasingly being drawn from higher-income and *there is a tendency to exaggerate the number of jobs greater-wealth brackets. In fact, some of created by tax haven activities" the movement against tax havens in de- veloped countries has stemmed from medium or small corporations that claim In general, legislation on this subject pany. This latter rule attempts to exclude that tax havens afford tax relief mainly is aimed at one or both of the following portfolio investment from the anti-accu- to large corporations, making objectives: (1) preventing the tax-free mulation provisions. The Federal Republic more difficult for other enterprises. accumulation by tax haven countries of of Germany does not employ this pro- certain forms of income, such as passive vision. Obviously, these percentage cri- Benefits to the tax haven investment income and income derived teria can be easily circumvented. A case But what are the benefits that tax from the assignment of service contracts in point is the recent increase in the havens may obtain from their status and to a foreign subsidiary; and (2) attacking number of subsidiaries in low-tax coun- what is the price they must pay for those the problem of transfer pricing, by at- tries whose parent company legally owns benefits? For developing one tempting to tax a parent company on the only 50 per cent of the stock, but in of the main apparent advantages of being profits it would have obtained if the practice exercises full control without a tax haven is the possibility of achiev- transaction with its subsidiary had taken being subject to the anti-accumulation ing a higher employment level. This is place at arm's length. provisions. particularly attractive to countries with a The tax systems of a number of indus- Apart from those loopholes due to the narrow resource base, which tend to have trialized countries, such as Canada, the percentage criteria, there are other im- chronic problems. Federal Republic of Germany, the United portant exceptions to these rules that However, there is a tendency to exag- Kingdom, and the United States, permit have usually been enacted in response to gerate the number of jobs created by tax domestic companies to postpone the pay- special interest groups. This is the case, haven activities. The establishment of ment of taxes on profits earned by foreign for example, of the exceptions to these hundreds and even thousands of corpora- subsidiaries until those profits are repatri- rules that until recently favored shipping tions and trusts and the large number of ated. This has made attractive the estab- interests in the United States. transactions that technically take place in lishment of foreign personal holding com- tax haven countries are generally accom- Transfer pricing panies in tax haven countries that can plished by using little manpower within accumulate income either free of tax or In spite of the shortcomings of the the tax haven country. The case of Nor- subject to a very low effective rate. The rules that attempt to prevent the accumu- folk Island, a possession of Australia and rules recently enacted in some developed lation of tax-free income in tax havens a former tax haven, illustrates this point. countries to prevent this accumulation through holding companies, these rules According to a survey quoted in a manual generally require the income of these appear to have been more successful than on tax havens, in 1972 more than 1,450 foreign holding companies to be taxed the provisions designed to curb the use companies were incorporated in Norfolk on an accrual basis, thereby eliminating of transfer pricing to shift income from Island—nearly one per inhabitant. Never- the tax deferral privilege that the owners high-tax to low-tax jurisdictions. The tax theless, it appears that the tax haven previously enjoyed. laws of several developed countries con- sector was directly benefiting only 25 There are several reasons why these tain provisions to ensure that sales and residents of the Island, as much of the rules are complex. Perhaps the main one other operations carried out between business was being carried out by lawyers is the wish of the developed countries to domestic corporations and their foreign and accountants in Australia. soften their impact upon companies that subsidiaries are transacted at arm's length It should be remembered that the main are accumulating income in low-tax juris- prices. These provisions are difficult to purpose of tax haven activity is to avoid dictions for normal business reasons, administer, since the actual determination taxation and that no business or is without intending to avoid taxes. In order of the arm's length price is fraught with actually carried out in the country. The to achieve this purpose, anti-accumula- complexity. main exceptions are the institutions in

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©International Monetary Fund. Not for Redistribution the financial sector, which are the prin- sources may be taxable while income from affairs. Secrecy and supervision do not go cipal generators of employment oppor- foreign sources is exempt. Moreover, in well together, and generally the latter suf- tunities and additional demand for serv- most tax haven countries indirect taxes fers in tax haven countries; accordingly, ices within the tax haven sector of the such as duties, sales taxes, and it is not surprising when bank failures or . However, these institutions others are fully applicable. other financial problems do occur. usually prefer to staff their organiza- Another circumstance that may frighten The drawbacks tions with expatriates—particularly in the away investors is the suspicion that a higher positions—so not all the jobs Is there a price to be paid for all these country's leaders are considering impor- created by this activity will be available advantages? Yes, and it is generally not tant changes that may include national- for nationals of the host country. fully apparent when countries set out to ization or other radical measures. Even Other economic activities are also become tax havens but may become bur- the smallest indication of this may pre- stimulated by tax haven operations. Con- densome later. cipitate a flight of depositors and other struction is boosted, principally of com- The problems created and constraints investors. A tax haven government must mercial buildings. As in the case of em- imposed by the tax haven status vary ac- also be cautious about hinting that it may ployment, the number of new buildings cording to the degree of development of change its tax policies to meet revenue demands, for such hints may destabilize the tax haven sector. This seriously con- Itox haven countries tend to be more vulnerable strains the formulation of a coherent to domestic , as there is a natural external factors than developing9 countries reluctance among authorities to jeopardize that are not tax havens the tax haven sector by any changes, how- ever necessary, in the tax system. required is much smaller than the size of the country, the size and composition of International factors the tax haven sector might indicate, as its tax haven sector, and the kind of bene- hundreds of holding companies or other fits granted to this sector. In general terms, Internationally, one of the factors that subsidiaries may require only enough the most troublesome problems arise in can influence tax haven investment is the office wall space orv which to hang a developing countries where the tax haven attitude of developed countries toward nameplate. Only those enterprises that sector contributes a relatively important this activity. The measures against the actually do something—again mainly share to the country's gross national use of tax havens already taken by them enterprises in the financial sector;—require product (GNP). have all had some impact. Future meas- sizable office space to carry out their At first glance this may appear para- ures are already being studied by some activities. Another activity that may be doxical. The fact that the tax haven sector developed countries that will make the use stimulated is tourism, particularly if the is contributing substantially to GNP of tax havens more costly and complex country enjoys an agreeable climate and should mean that new economic activity than it is at present. meetings of directors in the country are is taking place, which is desirable. This Fluctuations in the economy and a requirement for incorporation. A tax is true, but the problem lies in the nature disturbances in international financial mar- haven country may also attract retired of tax haven activity. As its main purpose kets also affect tax haven activities. Com- persons as residents, and their presence is that of , tax haven activity petition among tax havens trying to outdo provides employment opportunities and generates very little investment in tangi- one another by offering rriore stability, helps bring in foreign exchange. ble assets; therefore, tax haven business lower taxes, and better commercial facil- The existence of a large financial sector is extremely volatile and lacking in sta- ities accentuates the volatility of tax haven has other important effects too. It may bility. investment. help a country maintain a free and open The one sector that does engage in real Tax haven countries tend to be more foreign exchange and payments system. economic activity—the financial sector— vulnerable to external factors than devel- In addition, the advantage of having a is heavily dependent on what occurs in oping countries that are not tax havens. readily accessible is con- the rest of the tax haven sector. If this Not only are they sensitive to changes in siderable. issues may foreign business disappears, the domestic international commodity prices like other be underwritten or subscribed to by activity will not be sufficient to retain the developing countries, as well as to inter- foreign banks, thereby making funds large number of banks, insurance com- national economic fluctuations, but they available for public investment and eco- panies, and other organizations that form are also directly affected by the tax poli- nomic development. the financial sector of a tax haven country. cies of developed countries, which are Finally, the tax haven sector is a source Tax haven activity is highly sensitive beyond their control. Accordingly, the of revenue to the government. However to national and international develop- greater their dependence on tax haven liberal the tax system of a country may ments. Within a tax haven country itself, activities, the more unstable is their eco- be, there will always be some form of the slightest whiff of financial scandal— nomic situation. These considerations, to- tax or fee for which the foreign investor such as a prominent bank defaulting on gether with the constraints that the tax will be liable. These contributions range its obligations—is enough to send inves- haven status places on the formulation of from a simple annual fee payable by all tors in search of another tax haven that national fiscal policies, suggest that devel- corporations established in the country offers more security. Situations such as oping countries should think twice before to income tax on profits considered to be these are difficult to prevent, as one of aspiring to become tax havens. Mean- of domestic origin. For example, in the the things investors look for in tax havens while, those that are already tax havens case of banks that do both domestic and is absolute secrecy and as little prying as should try to diminish their dependence foreign business, profits from domestic possible by government officials into their on the activities of this sector. ED

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©International Monetary Fund. Not for Redistribution