Finance Essays - Tax Havens
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Critical Analysis of Tax Havens within an International Context
The following paper will offer a critical analysis of tax havens within an international context. Specifically, this paper will argue that there is both good and bad to tax havens and that favourable tax policies can both assist the host country and multinationals eager to optimize their earnings and savings.
In particular, this paper will note how tax havens are often accused of creating unfair advantages for companies that are competing for public contracts; at the same time, tax haven policies in Bermuda have made that country a leading destination for e-commerce and technology firms.
Moving onward, there is evidence that the offshore financial services offered by these states have given them an unimagined degree of affluence – even if it is true that tax haven status is frowned upon international organizations like the OECD. Moreover, being a tax haven is no guarantee that overseas companies will actually take the time to establish legitimate business activities in the country.
Furthermore, the tax haven policies that grant generous tax rates to overseas operations have been accused of depleting the tax base of nations that are seeing their revenues drop as corporations flee for greener pastures; needless to say, this has grim consequences when one pauses to consider just how many social services are dependent upon public money for their survival. There are, of course, additional points that warrant a hearing, as well.
Individuals – at least in the United States – who think they will profit from flocking to overseas tax havens may find that the long arm of the American tax code will track them down wherever they may settle; on an even more serious note, the lack of institutional transparency found in tax haven lands not only allows criminals to avoid paying taxes but allows them to carry out their nefarious money laundering schemes.
Not least of all, this paper will also take the time to ponder how tax haven policies have facilitated tax avoidance on the part of the wealthy and have directly imperilled social services at the exact same time as they burden the middle class and lower class with a monumental tax burden; similarly, the generous tax policies of developing lands vis-a-vis foreign multinationals can unhappily deprive them of much-needed resources which can be put towards essential social services. Staying with the notion that there is both good and bad to be found in tax haven policies, this essay will embark on a brief discussion of the consequences upon corporations of utilizing the services of tax haven states.
On one hand, tax haven states indubitably serve as a means of protecting the savings of corporations during difficult periods; on the other hand, the hidden costs associated with moving from a western land to a third world nation (all because of the tax benefits to be realized) can bear with it unexpected hidden costs that can harm valuation.
One last thing this paper wishes to bring to the attention of its readers is that tax havens are not always found in developing lands – and these first-world havens can become the resting places for the savings of individuals who may not always have the best of reputations. In the end, tax havens certainly have a place in the world – but they will function infinitely better once definitive guidelines on their regulation can be drawn up by the international community and enforced rigorously by that same community.
Critics of international tax havens often point to the fact that they create unfair advantages for companies competing for government contracts elsewhere. To put it another way, concerns (in the United States) have been raised that these contractors (those who have subsidiaries in tax haven countries) are at an unfair cost advantage relative to their competition insofar as they are able to lower their United States tax liability by shifting income to what is commonly referred to as ‘tax haven parent’.
In a real sense, this means that powerful US corporations are shifting income from affiliates in high-tax countries to affiliates (subsidiaries) in low-tax countries so that they can reduce their overall tax burden. In 2002, the GAO revealed that 59 of the 100 biggest publicly-traded federal contractors were incorporated in a so-called ‘tax haven’ country that either did not tax corporate income or taxed the income at a rate below the American rate. Clearly, these countries have tax policies that attract American multinationals – with the technological and human resources they possess – but they also siphon money away from the US treasury at the same time as they give contractors prohibitive advantages during the bidding process.
One notable example of how contractors who exploit tax haven policies in other countries have excited the wrath of American legislators can be found by looking at the case of Accenture and its ugly fight only a few years ago with Illinois law-makers. During 2004, at least four contracts awarded to Accenture were attacked by legislators because the company had taken full advantage of a loophole in the Illinois tax code that permitted corporations to shift profits to overseas locations so as to avoid paying taxes in the state of Illinois.
The matter escalated in no time at all to the point where the State Comptroller was actually asking the Illinois Procurement Policy Board about the feasibility of blocking all payments to four Accenture contracts adding up to more than $2 million. On an even larger scale, the US House Appropriations Committee approved an amendment to the homeland security spending bill that effectively blocked Accenture from being a participant in the $10 billion US Visitor and Immigrant Status Indicator Technology Program.
One country that has an excellent tax policy (if you are a wealthy corporation) is Bermuda. The British island dependency has no corporate income tax and is ‘tax-neutral’ in terms of how it treats holding companies. A holding company that is actually incorporated in the United States and which receives cash dividends from overseas affiliates/subsidiaries can see its gross dividends pass directly to shareholders.
Because of its generous tax policies, Bermuda is now marketing itself as an e-commerce center that is perfect for international technology companies located all over the world. Not surprisingly, the Bermudan approach to attracting technology firms (and the jobs and expertise they offer) has been picked up in countries like Ireland that are keen on targeting ‘preferred’ firms.
The benefits that accrue to tax haven states are sufficiently appealing that the countries employing this practice are extremely reluctant to part ways with it – even if it curries the disfavour of the international community. Most of all, the provision of what are called ‘offshore financial services’ has given these countries a measure of affluence they could not have achieved otherwise; indeed, many small island economies (referred to most commonly as simply SIEs) view the emergence of an Offshore Financial Center (OFC) as a panacea for economic disadvantage – possibly because (though it is not stated explicitly in the articles this writer has encountered) the employment opportunities that become available within the financial sector of the SIE courtesy the arrival of multinationals looking for attractive tax and financial services are undeniable.
Because examples give force and vigour to any argument, it is necessary to glance at the case study of Malta. Here, the tiny nation – which does not have an over-abundance of natural or human resources by any means – has become renowned for its status as a tax haven; more significantly, it has parlayed its generous tax concessions to foreign investors and companies into a situation wherein its financial services sector is burgeoning at a robust rate.
Specifically, 12 percent of Malta’s GDP was to be found in the financial services sector in 2004 and the sector employed about 6,000 local residents. Another good example of a country that has rescued itself from a troubling financial situation by turning itself into a tax haven is the Isle of Man.
Other research reiterates the idea that tax haven policies have a beneficial impact upon a country’s economic health. For example, whilst major tax havens have actually less than one percent of the world’s population (excluding the United States), and whilst they have (as of 2005) only about 2.3 percent of the globe’s gross domestic product or GDP, they nonetheless ‘host’ 5.7 percent of the foreign employment and 8.4 percent of the equipment, plant and property of American companies.
At the same time, the per capita real GDP in the tax haven nations grew by a healthy rate of 3.3 percent in the years 1982-1999 – almost 2.5 times the world average. Furthermore, in spite of fears that the combination of small populations and relative affluence in these lands would precipitate the creation of even larger governments, the reality is that the ratio of government to GDP in these locations is fairly reasonable.
Possibly prompted by the Bermudan example and by a few other states identified as ‘high priorities’, the OECD set about defining a tax haven in a seminal 1998 paper that continues to reverberate to this day. Most significantly, a tax haven country has a policy of not imposing taxes (or only nominal ones); offers itself or is viewed as offering itself, as a place that permits non-residents to escape taxation in their homeland (or nation of residence); does not have an effective exchange of information with outside parties; lacks transparency; and attracts businesses with no ‘substantial’ activities – these last two criteria, especially, will be touched upon at various points later in this paper.
In the defence of these two states, each one does impose indirect taxes; for instance, Bermuda has a fairly hefty payroll tax and also places taxes upon on all goods purchased on the island. Nonetheless, only the most ardent supporter would suggest that these two countries fail to rise to the level of tax-haven states.
In terms of attracting foreign multinationals, tax haven policies are difficult to beat. However, critics charge that countries like Bermuda do not simply attract ‘real’ economic investment but also ‘brass plate’ or ‘booking operations’ that are characterized by a lack of actual business activity; in other words, international organizations like the OECD become suspicious when they see companies locating to places like Bermuda (or even Ireland) which do not have a lot of business-related action taking place.
For countries that are trying to attract jobs as well as foreign capital, it would seem as though having tax haven policies can be a bit of a double-edged sword in the sense that a) other countries are sharply critical towards their ‘preferential’ taxation practices and b) these policies may not attract the jobs the aforementioned countries are hoping for. In fairness, tax haven policies in the United Arab Emirates (specifically, in the port city of Dubai) have attracted plentiful foreign investment on a scale that has (amongst other things) allowed the city to develop its communication and infrastructural capabilities while simultaneously wooing upscale tourists.
One other problem with tax haven policies that offer low or non-existent tax rates is that international organizations like the OECD have asserted that they undermine the tax base (presumably of the countries that are seeing businesses flee elsewhere) and erode public services; in fact, ‘harmful’ tax competition has been compared to competitive devaluations and to tariff wars.
To expand on this last point, the OECD (in 1998), released a study which argued that tax haven countries divert large amounts of foreign direct investment and ‘taxable income’ away from OECD member states. The tension between the OECD and tax haven nations has long threatened those lands trying to give corporations and individuals advantageous tax rates as well as the benefits of greater privacy. However, there is some sense that this tension is dissipating as more and more tax haven states belatedly embrace international best standards of practice.
Be that as it may, only the most wildly optimistic person would dare say that the current hostility between the OECD and small tax haven states is not problematic; the willingness of the above-mentioned countries to cut multinationals ‘slack’ in terms of what they pay in the form of corporate taxes has raised the ire of the OECD and the powerful western nations which comprise its membership to such an extent that real political and even diplomatic problems could still linger in the future.
To get to the heart of the problem, the OECD’s penchant for naming transgressors and then ‘shaming’ them in the court of international opinion has been perceived as bullying in some quarters; certainly, the nations that are targeted – or have been targeted – by the OECD are small, politically and economically weak and burdened with limited economic prospects, save for the financial services and tax breaks they offer to foreigners.
One can maintain that a lot of this tension would simply go away if the countries engaging in tax haven policies and practices would cease their current practices – but that ignores the reality that these countries need the financial benefits that accrue from such activities; moreover, it is worth asking what the financial implications will be for multinationals and for the communities in developing lands that benefit – even if indirectly – from their presence.
Individual Americans who think that tax havens are the perfect thing for them should give the idea a bit more thought: tax haven nations may be enticing in many respects, but US tax law makes it hard for individuals to spirit money somewhere else in the expectation they will not have to pay.
For instance, US citizens are taxed on their world-wide income: the tax breaks found in places like the Caribbean, Luxembourg, or the Caymans do not apply to individual US citizens – just corporations. Furthermore, an offshore partnership aimed at mitigating the tax burden will not work for US citizens: the ‘rules’ simply assume that the private citizen earned so much money each year and do not view any profit from the partnership as being a simple long-term capital gain; as such, interest is added onto the taxes that the private US citizen must pay the government. As if that is not bad enough, the capital gains arising from the partnership is taxed as regular income and not as capital gain – which means higher tax rates in the end.
Beyond what has been discussed above, individuals and companies using tax havens to avoid paying taxes may not simply be doing this sort of thing to spare themselves at tax time: money launderers like tax haven countries like the Bahamas because of the fact they disclose little information about the companies or individuals doing business within their environs; additionally, money launderers tend to exploit tax havens to the fullest extent possible.
For all intents and purposes, tax haven policies really make life easier (though not trouble-free) for criminals eager to avoid the prying eyes of government. As an addendum, it must be mentioned that the United States government has recently taken action to reduce the ‘pay-off’ for wealthy individuals eager to exploit tax shelters. Remaining with America for just a while longer, the matter of off-shore tax havens has become so important to the United States government that exhaustive legislative hearings on this very matter have become de rigueur in recent years.
Yet another challenge posed by tax havens is that they are so difficult to tackle from a legal point of view – something that clearly favours criminals at the same time as it grossly disadvantages law enforcement. To elaborate, at least one noted scholar has commented that it is well-nigh impossible to formulate a universal definition of a tax haven that can be used to effectively combat the fiscal abuses associated with this global phenomenon.
Until such time as the international community comes to a universal understanding of the concept of a tax haven, criminals can feel reasonably secure that there will be at least a few places on earth willing to embrace them and their tawdry ‘business’ pursuits.
Despite the conceptual challenges posed, the United States – as much as any nation – has decided that it has had quite enough of the tax evasion and money-laundering activities characteristic of tax haven nations with their generous tax avoidance policies. Recent court decisions in the US have expanded the power of US states to tax the income of corporations that do not have a ‘physical lexus’ with the state.
In essence, the courts have taken the position that an out-of-state corporations so-called ‘in-state economic presence’ renders the absence of a physical presence (headquarters or office buildings or any kind of physical structure at all) entirely irrelevant as to determining the state’s capacity to pursue that corporation for money.
Another problem that tax haven policies bring is that they give the wealthy one more means by which they can avoid paying their full weight in taxes. In essence, tax havens provide tax avoidance options to companies and to wealthy individuals; as a result, the tax burden ultimately ends up being borne (more and more) by the middle class and by those with fewer financial resources.
Suffice it to say, as the rich grow richer while the poor grow poorer (courtesy onerous tax burdens), the ability of the poor to invest in education plummets. Over time, this can lead to a general decline in productivity – a decline causing great harm to the country that is unable to keep the rich from exploiting one tax avoidance scheme after another.
The grim consequences of tax havens upon nations that are seeing the ‘flight’ of capital resources to far-off places reaches beyond just imposing a greater burden upon those ill-equipped to shoulder that burden; tax havens also imperil social services that are already under attack in an age of neo-liberalism. For example, in early 2005, it was reported that Canada’s top 5 banks shifted about $10 billion to offshore tax havens in the period from 1991 to 2004.
According to the academic who headed up the study, the utilization of offshore tax havens and shelters is tantamount to engaging in economic terrorism insofar as the monies lost make it difficult (with the potential to be impossible) for the government to finance social programs that need public funds to survive.
Despite the protestations of the banks in question that their foreign-based subsidiaries located in tax-haven lands such as Malta, Barbados and the Cayman Islands are simply a means of taking advantage of the competitive tax policies located overseas, the report stresses the aforementioned dollar figure and the fact that the total number of subsidiaries for the ‘big five’ stood at 73 as of the end of 2004.
Nor is the problem of tax avoidance confined just to wealthy western nations that are finding it increasingly difficult to provide appropriate social programs in an era when their populations are aging at an alarming rate: in countries that feature (or have featured in the past) tax haven policies, the government is often unable to collect all the taxes it would like to service all the social programs it would like.
For instance, whilst Chile has long been the most attractive country in the world when it comes to mining and direct investment in this field, the world’s leading copper producer also does not charge a royalty on the extraction of its most precious natural resource and its taxes are incredibly low – and sometimes non-existent because of legal accounting loopholes that allow for generous write-offs for things like equipment.
Tax haven policies appear to offer many positives and more than a few negatives – something this paper has noted time and again. While it can be argued a number of different ways, one would be remiss not to point out that private equity firms (or maybe any firm) doing business in a country in the midst of a financial downturn can – and certainly have – used offshore tax havens to shelter the profits on their investments; American equity firms, as a matter of fact, did precisely this during the late 1990s to protect their investments in Korean financial institutions.
Given what has been described in the last paragraph, it is tempting to say that companies which move their operations abroad to escape paying taxes at home benefit handsomely from the transfer; after all, why leave the technologically-advanced, human resource-rich and affluent west for a small or developing peripheral economy unless (amongst a few other reasons) the organization’s senior thinkers were intent upon saving as many dollars as possible from the taxman? Unfortunately, the expected tax savings do not automatically exceed the non-tax costs associated with the above-mentioned move; if anything, the decision to set up new subsidiaries (or to pick up stakes and move elsewhere) has manifested negative repercussions in the form of hidden and unexpected costs that negatively impact firm valuation.
Proceeding along, it is commonly heard – maybe less so than in the past – that tax haven nations are predominantly nations that are less developed than those countries found in the west; the truth, though, is rather more different. Difficult as it may seem, even affluent western nations can properly be described as tax havens – the United Kingdom being the best example. In London in particular, the favourable tax laws are such that many Russian elites – who, in some instances, have reputations that warrant a bit of polishing – have injected vast sums of capital into the local economy.
At the same time, London (and the United Kingdom in general) is not alone: Switzerland has also attracted plenty of Russian capital and it seems as though the two are responsible for the staggering flight of roughly $102 billion from Russia between 1998 and 2004. Again, the money that flows out of Russia now is the kind of money that could be directed towards such things as social programs and the like.
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