Tax Havens. Global Business and International Fiscal Law 307

Thus, although the UK may have formal power to take measures to end the attractiveness of some of these centres for tax avoidance, for example by signing tax information exchange treaties 1 on behalf of dependencies, this would be regarded as a blow to their offshore financial business which could undermine the economic viability of many of the island statelets and create political instability. It remains to be seen, however, whether the attempt to separate `respectable ¶from criminal financial transactions can be successful. The temptations offered by enormous movements of funds shrouded in secrecy are great and almost inevitably engender corruption, while there are few general economic benefits for the majority of the population. Thus, British government efforts have concentrated on improving supervision and attempting to curb the use of offshore financial facilities for criminal purposes see Chapter 10 section 2a below. Paradoxically, by reducing the possibility of fraud and improving security, these measures have facilitated the use of offshore centres for tax evasion and avoidance, which is increasingly their main raison detre. The occasional collapse of an offshore financial intermediary might indeed be the best deterrent to tax evasion, although it also hurts other investors. The provisions introduced to improve supervision, which include some cooperation with the international supervisory authorities, have only been acceptable provided they clearly exclude the investigation of tax avoidance and evasion. The continued and even growing use of these facilities in increasingly sophisticated but relatively legitimate ways, not only by TNCs but many businesses and individuals, has exacerbated the problems of tax authorities in allocating the profits of international business. Offshore centres have increasingly offered not only the possibility of formation of intermediary `letter­box ¶ companies, but of offshore financial subsidiaries, or subsidiaries providing services such as insurance, purchasing or marketing, or licensing of intellectual property rights and knowhow, which could be said to be more than merely nominal activities. The proliferation of such devices made it increasingly difficult for national tax authorities to assert jurisdiction over a fair proportion of the internationally­generated profits, especially on the basis of unilateral enforcement and the arms length approach. Both the use of tax havens for international avoidance and the question of transfer pricing increasingly became matters of public concern, frequently associated in the public mind with the less salubrious scandals hitting the headlines.

2. Tax Havens.

International tax avoidance is made possible by the existence of different national approaches to equity in the taxation of international activities, and the absence of any 1 Discussed in more detail in Chapter 10. comprehensive international approach to equity. Therefore, the broadest definition of a tax haven would include any country whose tax laws interact with those of another so as to make it possible to produce a reduction of tax liability in that other country. By such a definition virtually any country might be a `haven ¶in relation to another. Tax havens are therefore more narrowly defined as countries which offer themselves or are generally recognized as havens: this is referred to in the Gordon report as the `reputation ¶test US Treasury 1981, p.14. The OECD report on tax havens refers to the `classical tax havens ¶­ jurisdictions making themselves available for avoidance of tax which would otherwise be payable in relatively high tax countries, usually by attracting income from activities carried on outside the tax haven OECD 1987A­I, para. 10. The attitude of these reports is to stigmatize the havens: the Gordon reports reputation test is referred to as the `smell ¶test, and the implication clearly is that it is a bad smell. One reply to this view is that the problem lies not with the havens lack of regulations, but in the inappropriate, ineffective or unfair character of the regulations being avoided. Thus, Luigi Einaudi, who was one of the economists who authored the report for the League of Nations in 1923, later argued that haven states put pressure on others whose taxes are badly administered to make their taxation fairer Einaudi 1928, 35­6. It is claimed that in many or even most cases, the laws of the haven jurisdictions were not, historically, deliberately designed with international avoidance in mind: this has been argued, for example, on behalf of the Channel Islands Powell in Avery Jones 1974. This argument is somewhat disingenuous, since undoubtedly such countries were sought out and their laws and facilities exploited; and they have generally been maintained, advertised, and further developed for these purposes, often with the active encouragement of their state authorities. There are examples of the laws of such offshore havens being deliberately amended or adapted to attain or retain their attractiveness as offshore centres. A well­known case is the trusts law of the Cayman Islands, which was deliberately adapted in 1967, reputedly on the advice of a British tax lawyer, to deprive trust beneficiaries of any legal right of action, thus avoiding the `power to enjoy ¶provisions in the British anti­avoidance measures on family trusts discussed in Chapter 5 section 1 above; in riposte, the British statute was further amended in 1969 to provide that a beneficiary had a `power to enjoy ¶ even if it is not legally enforceable. On a later occasion, the Cayman Islands reinforced its bank secrecy law by enacting a Confidential Relationships Preservation law in 1976, as a response to the Miami District court decision in US v. Field. 1 International tax consultants frequently offer, or are called upon, for help in designing the legal and administrative facilities of small offshore jurisdictions, with the intention of attracting the registration of intermediary companies and the 1 In re Grand Jury Proceedings, US v Field 1976, see Chapter 10 section 2.aii below. development of offshore financial business see e.g. US Senate 1983 p.11. Although havens have also been under pressure to tighten up the supervision of their financial sectors, as we have seen in the previous section, this has made them more attractive for tax avoidance and even evasion. Defenders of havens must therefore fall back on legitimising havens by attacking the tax system which gives rise to them. Sometimes this is done straightforwardly from the perspective that all taxes are evil and therefore any means of legitimate avoidance but not illegal evasion, of course is justified e.g. Langer 1988, Ch.1. The very term `haven ¶is used to conjure positive images, sometimes reinforced by equivalents in other languages ­ `oasis ¶in German, `paradise¶in French Chambost 1989. The more sophisticated versions of this approach point to the defects in the arrangements for prevention of international double taxation, which from the point of view of international capital were remedied by the devices they pioneered. This view accurately indicates that it is not merely a matter of delinquent countries, but a systemic problem. As advisors and consultants discovered and exploited havens, state authorities had to decide how far they were willing to tolerate or encourage their use. The arguments for tax exemption of foreign­source income were widely accepted; and even those countries, such as the US and UK, which maintained the residence principle based on capital­export equity, still allowed tax deferral, within limits which they tried to control. Countries such as Switzerland or Luxembourg were willing to tolerate or even encourage the use of their laws, exempting foreign­source income and imposing no withholding tax on interest or other payment outflows. This was hardly surprising in view of the social and economic importance of banking and finance to these countries. Others, such as the Netherlands and later Singapore, fostered provisions which would encourage the setting up of holding companies to act as regional headquarters of TNCs in their jurisdictions. However, when the increased sophistication of international avoidance began seriously to undermine tax equity and effectiveness, they later came under pressure at least to limit the more blatant devices. At the same time, centres with fewer advantages to attract financial business have usually been more willing to overstep the bounds of propriety; in some cases, they had already been used as convenient financial bolt­holes for those involved in organized crime: e.g. Panama and the Cayman Islands. The more `respectable ¶ havens such as Switzerland have justified themselves, both by the arguments about international equity, and by pointing to the more extensive facilities offered by the `delinquents ¶whose activities would be harder to control. Delinquent countries may be less vulnerable to pressures from the powerful than might be supposed: they may have few other opportunities for economic development, and their state structures may be too weak to resist corruption US Congress 1983A, Pt. V, pp. 45­95. Such havens can be used both for deliberate evasion and for grey­area avoidance, of taxes and other laws. The key to international avoidance of business taxes is the use of intermediary companies and trusts. This enables a taxpayer to channel revenue through an intermediary legal person and thereby save tax by changing the character of the eventual benefit to the ultimate recipient. The location of the intermediary in a specially­chosen jurisdiction lends an entirely new dimension to a chain of transactions: like two closely­marked football players passing the ball to a third one who is unmarked, it can create major gaps in the defences of tax authorities. For an individual or family, or a firm doing business nationally, the use of such a foreign intermediary company is more likely to be classified as either tax evasion or illegitimate avoidance. The TNC, however, since it is composed of an international network of affiliated companies, can much more legitimately structure this network so as to optimize the total tax burden of the TNC as a whole. It is important to stress that these strategies optimize, rather than minimize, tax liability, since it is necessary to bear in mind the transaction costs of complex arrangements, including their effect on the firms management structure, as well as the risk that they might be disallowed or fail in some way. Nevertheless, international competition puts considerable pressure on a firm to establish a corporate structure which minimizes its tax exposure. Avoidance strategies can be broken down into four main options: a channelling inter­affiliate payments, especially dividends, through intermediary companies formed in countries chosen so as to minimize both withholding taxes at source and taxation of foreign income payments on receipt; b reducing the taxable business profits of an operating affiliate, by allocating costs such as R D and interest on loans, or charges for services such as insurance or distribution, to be paid to an intermediary in a low­tax country; c raising finance from international capital markets on beneficial terms due to the tax avoidance and evasion possibilities; or d marshalling the TNCs income from all sources to make best use of tax benefits, e.g. by ensuring sufficient income is derived from sources outside its country of residence to make full use of available tax credits. Tax havens may be divided into three broad categories. The main havens are those which have no or very low taxes on all corporate or business income. An intermediary `base ¶ company formed in such a jurisdiction can freely engage in a variety of activities on behalf of the corporate group; the charges it makes to affiliates can reduce their tax liability, while accruing profits to itself which are subject only to the havens nolow­tax regime. However, most such countries Base­Havens do not benefit from participation in the network of double tax treaties, so they are not suitable locations for holding companies, since payments of dividends, interest and fees to them would be subject to high withholding taxes at source. 1 The second 1 Some low­tax havens did, for historical reasons, benefit from some treaties, but these have in most cases been cancelled or modified in recent years: see Chapter 7 below. category of haven consists of countries with conventional tax systems and benefiting from double tax treaties, but which levy no or little tax on receipts of foreign­source or passive investment income Treaty­Havens. Since they often have some double tax treaties, they can be used as locations for intermediary `conduit ¶ companies, which receive dividends and other payments, having paid low withholding taxes at source due to the treaty, and usually transmitting them on to a base company in a low­tax country. Finally, a large number of countries offer particular tax incentives or benefits, which may sometimes be exploited for a particular international tax advantage. Attempts have been made by some countries to define and even list tax havens, usually in anti­haven legislation, if it is based on a locational rather than a transactional approach see Chapter 7 below. Thus, the Japanese measures define as a haven a country which levies tax at less than half the Japanese corporate tax rate, and authorize the Ministry of Finance to designate a definitive `black list ¶ The French law refers to countries with tax rates less than two­thirds that of France, while the German refers to 30 and the UK 50 of their respective company tax rates. The French and German lists are administrative `grey lists ¶ for guidance and not legally binding; while the UK publishes a `white list ¶ of exempt countries, with a second, much longer, list of conditionally exempt countries i.e. the exemption excludes corporations benefiting from specified tax incentives. No official list is published by the US, but several government departments maintain internal lists, including the IRS in its tax audit guidelines see PSI Staff Study, US Congress 1983a, pp.10­11; Caccamise 1988, 555. These official lists provide an authoritative guide to tax havens; but they are not entirely reliable, since they are infrequently revised. Also, the designation tends to focus on havens which for for geographical or other reasons are favoured by the designating countrys residents; and it may be cautious, since official designation of a haven can be a politically delicate act see Table 2 and Arnold 1985, 1986. These factors account for variations between lists published by each country, as well as differences from lists sometimes compiled by specialists or academics e.g. Wisselink in Rotterdam IFS 1979; A.Rappako 1987, 34­5. The various tax planning encyclopaedia prepared by specialist tax advisers, on the other hand, give a comprehensive examination of very many countries according to the particular advantages they offer Chambost 1989; Diamond and Diamond 1974­; Langer 1988; Saunders 1990­; Spitz 1990­.

3. Intermediary Company Strategies.