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Copyright 2000 Robert L. Sommers, all rights reserved.

July 2000 Hot Topics

Part 1 of a 2-part series

The Demise of the Off-Shore Tax Haven Industry, Part One


The U.S. and European Union have taken action to eliminate "tax havens" - countries that cater to individuals and corporations seeking to hide their identities, assets and business activities from government authorities in their "home countries" (the country where the individual or business actually resides). Tax havens have adopted specific laws permitting foreign individuals and companies to conduct business there without paying taxes or disclosing their ownership or business transactions.

These laws allow legitimate companies, as well as tax cheats, drug dealers, money launders and assorted other crime and fraud perpetrators, to avoid scrutiny by government authorities in their home country. Typically, the company maintains a minimal presence in the tax haven jurisdiction through an appointed agent, but has no employees, physical facilities, equipment, inventory or other operating assets actually located in the tax haven and does little or no business in the tax-haven country’s local economy.

The Organization for Economic Co-operation and Development ("OECD"), a Paris-based group dominated primarily by the U.S. and the European Union, issued a report on June 25, 2000, entitled "Progress in Identifying and Eliminating Harmful Tax Practices." The OECD "blacklisted" 20 countries as tax havens.

Just prior to the report's release, six countries, including Bermuda and the Cayman Islands (notorious tax havens for U.S. citizens and companies) agreed to cooperate with the OECD to eliminate their tax haven laws.

The OECD defined the goal of its report as follows:

… to secure the integrity of tax systems by addressing the issues raised by practices with respect to mobile activities that unfairly erode the tax bases of other countries and distort the location of capital and services. Such practices can also cause undesired shifts of part of the tax burden to less mobile tax bases, such as labor, property and consumption, and increase administrative costs and compliance burdens on the tax authorities and taxpayers.

In other words, mobile activities, such as banking or investment firms, can move operations to a tax haven country to avoid taxation by the home country, while a real estate development company owning buildings in the home country cannot. The report noted that its member and non-member countries were exposed to a significant revenue loss as a result of the "harmful tax competition" by tax havens.

How a Tax Haven Works

Countries that serve as tax havens enact special laws to attract foreign business. For instance, a company desiring to form a Cayman Islands corporation must pay a fee of approximately $800 per year to the Cayman Island government, and a bank or trust company must serve as agent for the company and maintain the company records. Bank secrecy laws make it a crime for the agent to disclose any information about the company or its owners. Although the company pays the annual fee, it is not taxed on its income; thus, the company can earn income and retain it in the tax haven without paying income taxes. Usually, the company is prohibited from engaging in business activities in the tax haven.

The result: The company and its owners generate income and profits throughout the world without paying taxes on the income. Also, the ownership and business activities are not disclosed; thus, ownership can be shifted easily and anonymously.

Note: Some tax havens, such as the British Virgin Islands, allow ownership through "bearer" shares. With bearer shares, the person possessing the shares owns the company -- ownership is anonymous. Of course, major problems arise if the bearer shares are lost, since it is impossible to determine who owns the company, but that is a risk that many owners of BVI companies are willing to take.

Defining a Tax Haven

The OECD used the above example to develop criteria to determine whether a taxing regime was a tax haven. The keys points – does the tax haven jurisdiction:

1. Have no or nominal taxation on financial or other service income with respect to the foreign entity.

2. Offer itself or is perceived to offer itself as a place where non-residents can escape tax in their country of residence. (In other words, does the jurisdiction market itself as a tax haven.)

3. Have "transparency" (are transactions subject to open and public reporting or disclosure).

4. Have adequate regulatory supervision or financial disclosure of activities.

5. Allow the exchange of information with other countries.

6. Tax the relevant income generated by the foreign enterprise on its geographically mobile financial and service activities.

7. Facilitate the establishment of foreign-owned entities without the need for a local substantive presence or prohibit these entities from having any commercial impact on the local economy.

Other factors include whether the foreign enterprise typically engages in local business activities within the jurisdiction and the relative size of the untaxed offshore business sector compared to the jurisdiction's overall economy.

Clearly, the OECD has targeted countries that provide companies and individuals the means to evade taxes in their home country. The key concern is whether the company or individual can be properly audited by the overseas authority in which the taxpayer would owe taxes. As stated above, those using tax havens do not actually have investments or operating assets located there; they are merely using a favorable set of laws while their actual investment and business activities continue, in the home country or elsewhere, unimpeded.

Thus, the formation of a tax-haven company is merely a paper transaction with little economic substance. It is designed to shift the tax base to a different country, without affecting the actual business operations of the company.

Countries which have no requirement to list directors and officers, or have no public reporting of a company's activities are the targets of OECD wrath since there is no way of knowing whether the taxpayer is properly reporting its income or is engaged in illegal activities. Usually, the audit and investigation trail stops cold when a tax haven jurisdiction is encountered.

Why Countries Become Tax Havens

For a small island country with an economy consisting of fishing or tourism, the lure of becoming a tax haven may be irresistible. After all, it needs only to pass special foreign legislation to create a new and vibrant economic sector. There are stories that for some island countries the revenues generated by the tax haven economy surpass traditional tourist industries in just a couple of years of operation.

Tax havens usually have the OECD criteria listed above as part of their taxing regimes since these features make a country an effective tax haven. Also, because of the proliferation of tax havens throughout the world, they are in fierce competition with each other and continually need to pass the most "tax-friendly" legislation to attract business.

As noted above, the foreign enterprises are usually insolated from the country's local economy. Tax havens make their money by charging a set licensing fee per company. For instance, if the country charges an annual fee of $700 and there are a million foreign companies or individuals using the taxing regime, the country earns $700,000,000 a year, just by enacting a special set of foreign laws that do not adversely impact its local economy.

In addition, these laws usually require that the company retain its books and records in the tax haven and have a resident of the tax-haven country as a board member or officer of the company. This gives rise to the off-shore banking industry which typically charges a minimum of $1,500 per year to provide these services to the foreign company or individual. Additional fees are charged for monetary transactions and other services. This creates a banking industry in the jurisdiction which becomes another source for tax revenues and employment.

Tax Evasion vs. Bank Secrecy

The OECD countries are worried that with the increase in personal wealth and the ability to easily move money to foreign countries, member countries are losing significant tax revenues through tax evasion made easier by the proliferation of tax havens; particularly with tax haven-based companies advertising their services on the internet. Protecting the tax base against lost revenues is a major concern of these countries.

Their fears are apparently justified: A report by Merrill Lynch and Gemini Consulting states there are 7 million millionaires (measured in U.S. dollars) world-wide, a 17% increase over the past 10 years, living in the following countries: (i) U.S. - 2.5 million; (ii) Europe - 2.2 million; (iii) Asia 1.7 million; and (iv) about 600,000 in Latin America and the Middle East. This represents a vast sum of potential tax dollars that can be moved beyond the reach of the home country.

Historically, bank secrecy laws have served an important political function. Germany, because of its past dealings with dictatorships, traditionally resisted relaxation of bank secrecy laws, contending those laws were essential to its citizens as a safeguard against political dictatorship. Germany recently embraced banking information exchange, noting that secrecy laws are no longer protecting citizens against dictatorships but are being used by international drug dealers and money launderers to hide criminal enterprises.

Thus, the European tradition of bank secrecy used by Switzerland and Liechtenstein to protect against political tyranny is giving way to the new reality that these laws have become the domain of international criminals and tax dodgers. In contrast, the tiny island tax havens in the Caribbean and the Pacific have no such lofty historical concerns about political persecution, they are in the tax haven game for the money -- pure and simple.

The U.S. Role

The U.S. co-chaired the OECD Forum on Harmful Tax Practices committee that produced the report. U.S. Treasury officials are serious about cracking down on tax haven activity, especially those countries close to U.S. borders, such as Bermuda, the British Virgin Islands and the Cayman Islands.

When the report was released, U. S. Treasury Secretary Lawrence H. Summers welcomed the OECD's report on the global effort to protect the integrity of national tax systems from harmful tax competition. He immediately issued a press release:

"The identification of tax havens and potentially harmful tax regimes is a crucial step in preventing distortions that could undermine the benefits of enhanced capital mobility in today's global economy. It is our hope that the listed tax haven jurisdictions will take this opportunity to work with the OECD to reform their harmful tax practices." … "We encourage all countries to follow the example set by the OECD member countries and six non-member jurisdictions that have committed to eliminating harmful tax practices."

Because the report was issued by an international group, it gives the U.S. political cover to attack the tax haven laws of Bermuda and Cayman Islands, without appearing or acting as the imperialist enforcer against the weaker nations within the Western Hemisphere.

The choice of the little-used OECD as the venue to rid the world of tax havens was no accident: The OECD is completely controlled by the U.S. and the European Union and, unlike the World Trade Organization, the tax haven countries have no standing to register complaints. In other words, the OECD issued its report without having to consider arguments in favor of tax havens. In contrast, if the OECD used the WTO to complain about the unfair tax competition, there would have been a long, complicated and uncertain legal process with which to contend.

The OECD's report was not about pronouncing innocence or guilt; it was a forum used to publicly ostracize tax haven countries and blacklist them, making sure that the citizens of the OEC-D countries knew full-well that they were "at risk" if they continued to transact business in these jurisdictions.

However, the U.S. faces a dilemma: it needs the cooperation of the Caribbean tax havens to combat drug trafficking and money laundering. Therefore, the report takes a conciliatory approach, urging the listed tax havens to cooperate with respect to money laundering and tax evasion crimes by sharing information, rather than resorting to a blanket embargo against all the financial activities occurring in the jurisdiction.

This could create a conflict within the U.S. and other developed countries between taxing agencies, concerned about tax losses, and drug enforcement agencies, worried about crime. The bottom line: The OECD countries will probably tolerate the favorable tax treatment given by tax haven countries to foreign companies provided there is no shielding of criminal activities or tax evasion.


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