Clamping down on tax dodgers

At the beginning of April the world's 20 most powerful countries agreed to take action – including sanctions – against “un-cooperative” tax havens. But there are serious doubts about whether such good intentions will actually come to fruition, or if the threat of punitive actions can actually work


They were only 30 words tucked away on page four of a nine-page document which outlined the world’s 20 most powerful countries’ global plan for recovery and reform. But that was enough to grab the world’s headlines, and ruffle the feathers of those countries that were singled out by the Organisation of Economic Co-operation and Development (OECD) for their lack of appropriate transparency and their failure to live up to expected international tax standards.

It is estimated that developing countries lose nearly US$500bn of tax revenues each year as a consequence of tax avoidance and evasion. Around US$124bn of this, bigger than the annual overseas aid budget, is attributed to tax havens. Britain loses around £100bn a year. Unofficial estimates suggest that £18.5bn of this may relate to the use of tax havens. The United States is estimated to be losing around US$345bn of tax revenues each year, around US$100bn of which relates to tax havens.

John Christensen, director of the international secretariat of the Tax Justice Network, a campaign group, says that tax havens, which offer secrecy, low or zero taxation, and lax regulation (or a combination of all three) allow big companies and wealthy individuals to benefit from the onshore benefits of tax – like good infrastructure, education and the rule of law – while using the offshore world to escape their responsibilities to pay for it. The tax haven system is also widely used by criminals and terrorists. As a result, says Christensen, “tax havens are heightening inequality and poverty, corroding democracy, distorting markets, undermining regulation and curbing economic growth, accelerating capital flight from poor countries, and promoting corruption and crime around the world.”

In a report issued by the US Government Accountability Office (GAO) in January this year, it found that of the 100 largest public companies, 83 do business in tax-haven hotspots like the Cayman Islands, Bermuda and the British Virgin Islands, where they can move their income into tax-free accounts. Furthermore, 14 companies on the list had received bailout money from the US Treasury in the recent financial meltdown. Those on the list include Bank of America, which received US$45bn (and which has 115 subsidiaries in tax havens); Citigroup (US$45bn, and 427 subsidiaries in tax havens); American Express (US$3.4bn, and 39 subsidiaries in tax havens); and Goldman Sachs, (US$10bn, and 29 subsidiaries in tax havens), according to the Taxpayers for Common Sense watchdog group.

As a result, the US is preparing to strike back. On 4 May US President Barack Obama proposed several measures to address overseas tax avoidance and tax evasion. The President has proposed to limit the rules allowing corporations to “defer” their US taxes on foreign income, as well as proposing steps to reduce abuses of the foreign tax credit and the “check-the-box” rules that allow multinational corporations to cause their subsidiaries’ income to “disappear.”

It is not just the US which has become more concerned about tax avoidance. The topic appeared as a “major” item in April’s G20 summit in London. The final communiqué released on 2 April stated that the G20 agree “to take action against non-cooperative jurisdictions, including tax havens. We stand ready to deploy sanctions to protect our public finances and financial systems.” “The era of banking secrecy is over,” it said.  At the same time OECD published a list of countries that have failed – or refused – to sign up to any international standard for exchange of tax information. The OECD put Costa Rica, Malaysia, the Philippines and Uruguay on its blacklist of non-cooperative tax havens. A separate “grey list” of countries that have agreed to improve transparency standards but have not yet signed the necessary international accords included Liechtenstein, Luxembourg, Monaco and Switzerland.

The statement was applauded by most politicians in the US and Europe. Members of the European Parliament (MEPs) welcomed the G20 statement regarding bank secrecy and have lauded automatic exchange of information as the most effective tool to tackle tax avoidance. MEPs have also recommended that the EU should adopt at its own level an appropriate legislative framework regarding tax havens and has called on its international partners to do the same. The European Parliament wants the next G20 Summit to agree on co-ordinated and concrete action both to close down all tax and regulatory havens and to close “onshore” tax and regulatory loopholes which permit widespread tax avoidance, even in major financial centres.

But the G20’s 30-word commitment to curb the secrecy surrounding offshore banking and tax havens has left a lot of lawyers, campaigners, and tax experts unimpressed and in search of more answers as to how the intentions will be enforced. Miles Dean, director at Milestone International Tax Consultants, says that “the G20 was toothless and has made little impact on the fight against tax evasion”, adding that it “did nothing to prevent or clamp down on use of tax havens”.  “Labelling jurisdictions a ‘tax haven’ does not prevent them from being used for the avoidance of tax,” he says.

Dean says that “corporates will always seek to legitimately reduce their tax liability since they have an obligation to their shareholders. Individuals will seek to avoid tax – through whatever means – if they perceive their liability to tax is unduly high or that they don’t receive value for money or a combination of both. Most developed countries have very sophisticated tax systems and anti-avoidance provisions to stem the flow of capital but they cannot prevent companies and individuals themselves relocating. In both instances taxpayers are much more mobile than governments give them credit for”.

David Whiscombe, director of BKL Tax consultants, says that the main problem which tax authorities have is that effective avoidance exploits the apparent inability of legislators to draft legislation which is sufficiently precise and comprehensive to achieve the aims of the legislature.   As a result, he says, the temptation is for legislation which (in the UK at least) has traditionally been very precise and specific to be replaced by so-called ‘principles based’ legislation which will set out in more or less broad terms what it seeks to achieve leaving the executive and the courts to develop the principle and apply it to specific circumstances.

“That may be effective as a flexible tool to counter novel avoidance but it has its own challenges: mainly that, almost by definition, it leads to uncertainty for business – indeed its very effectiveness depends on fuzzy rules,” says Whiscombe. “Nonetheless, that seems to be the way legislatures are going forward on anti-avoidance rules,” he adds.

Going after non-cooperative tax havens and jurisdictions is not a new project. In 1998, under pressure from major European Union countries, the OECD published a paper on what it called “harmful tax competition” and, in 2000, published a framework for sharing tax information. In 2002, this became the OECD Model Tax Convention (revised in 2005), which states that bank secrecy cannot be an obstacle to exchange of information for tax purposes. The OECD framework encourages nation-states to sign its Tax Information Sharing Agreement through a series of bilateral, not multilateral, treaties.

However, these moves are not without their flaws, says Prem Sikka, professor of accounting at the University of Essex. He points out that each treaty would need to be ratified by the parliament of the respective countries, which means that it is doubtful that poor, developing countries can muster sufficient political and economic clout to negotiate a treaty with larger nations. Even if that was possible, due to organised tax avoidance by multinational companies, many developing countries do not have effective tax administration structures to make the relevant requests for information, he says.

While any assault on tax avoidance, tax havens and banking secrecy may be welcomed, a number of problems remain – primarily that the G20 statement does not provide any details of possible sanctions. “Can sanctions really be imposed on countries that are not members of the OECD or had no say in developing the OECD Model Tax Convention?” asks Professor Sikka. “Any country escaping the OECD framework is likely to be attractive to those who value secrecy and tax avoidance. Thus, all countries need to sign up to the OECD framework and that might only be possible if the OECD membership is broadened. All that will take time, although the threat of sanctions has persuaded Andorra, Belgium, Luxembourg, Switzerland, Hong Kong, China, Monaco, and Singapore to adopt the OECD standards,” he says.

Furthermore, with conflicting economic interests and vagaries of language, there is no guarantee that all states will reach a common understanding of the OECD framework, especially as tax information sharing is not always automatic. Under the OECD framework, a state will not always be able to request information randomly on bank accounts held by its residents located in the other state.

Perhaps the biggest shortcoming of the G20 initiative is that it only seems to apply to individuals. Corporations, partnership trusts and other business vehicles are not covered by the OECD framework. So individuals could dodge taxes by making investments through corporate entities. “It is perfectly possible for UK citizens to form corporate vehicles that are domiciled in tax havens even though they might trade in Britain or have directors in this country. Thus these companies are totally beyond the reach of the G20 agreement,” says Professor Sikka.

Curbing “tax evasion and tax avoidance” is much bigger than constraining “banking secrecy”, says Professor Sikka, who points out that many multinational corporations avoid taxes through complex corporate structures, transfer pricing and royalty programmes. For example, Bernard Madoff has hidden his loot in offshore entities. Enron used nearly 3,500 subsidiaries to avoid taxes in the US, India and Hungary. Many of these were in the Cayman Islands which do not levy corporate taxes. WorldCom devised a royalty programme by creating an asset called “management foresight”. All companies in the group were required to pay royalties. Over a four-year period, the subsidiaries paid US$20bn in royalty fees. The paying companies got tax relief on the payment of royalties. However, since the receiving company was located in a favourable tax jurisdiction it paid little or no tax on most of its income. The transaction was internal to the WorldCom group and had no net effect on its global profits, but saved millions of dollars in taxes.

“The main problem is that we are using eighteenth century definitions and legislation to combat a twenty-first century problem,” says Professor Sikka. “The simplest step to take would be to make sure that companies are taxed proportionately in the countries where they make their revenues, rather than where they are registered. That would eliminate the use of tax havens because very few companies actually make much of their revenue in places like Jersey,” he says.

Yet while the world’s most powerful nations have been eager to point the finger at their weaker counterparts for their failure to clean up their financial transparency, recent research has found that many OECD approved countries should not be above such criticism themselves.

The tub-thumping of the G20 leaders about closing down tax havens in every territory except their own may have played well in their respective home countries, but those jurisdictions consigned to the black and grey lists of the OECD table are far from impressed.

Luxembourg’s Prime Minister Jean-Claude Juncker – whose tiny country was included in the “grey” list of “jurisdictions that have committed to the internationally agreed standard, but have not yet substantially implemented” alongside such notorious tax havens as the Cayman Islands, Liechtenstein, and the Turks and Caicos Islands – has said that the tax-friendly US states of Delaware, Nevada and Wyoming should figure on an international blacklist of offshore tax havens as well.

A money-laundering threat assessment in 2005 by the federal government found that corporate anonymity offered by Delaware, Nevada and Wyoming rivalled that of familiar offshore financial centres.

Along with Belgium and Austria, Luxembourg came under pressure from its EU partners to ease its banking secrecy rules. They have recently agreed to relax their bank secrecy rules and exchange tax information with other countries under certain conditions, but only after putting up a fight. Luxembourg has over the years become a major European financial hub thanks in large part to its bank secrecy rules and low taxes.

“I would like all the bold leaders in Europe who insisted that those three EU countries that practice banking secrecy drop it show the same courage towards the United States,” Juncker said.

“The G20 has no credibility as an undertaking if Delaware, Wyoming or Nevada or far-flung islands from the United States are not on the blacklist,” he told lawmakers at the European Parliament in Brussels. “If there must be a blacklist then, America should have its place on it.”

The three US states are popular locations for incorporating businesses in large part because of the tax advantages of doing so while the US Virgin Islands are also known for their tax benefits. “I don’t hear any other prime minister than myself … raising this problem. Why doesn’t British Prime Minister Brown say to US President Barack Obama to put an end to the tax havens on American territory.”

Juncker certainly has a point. In March – one week before the final G20 communique – The Economist ran an article which examined the efforts of Jason Sharman, a political scientist at Australia’s Griffith University. Using a budget of US$10,000, the adverts at the back of the magazine and Google, he showed how easy it was to circumvent prohibitions on banking secrecy, forming anonymous shell companies and secret bank accounts across the world.

During his investigation, Sharman found that there is a more insidious form of secrecy, in which authorities and bankers do not bother to ask for names, something long outlawed in offshore tax centres such as Jersey and Switzerland but which has persisted in the US. The benefits for shady clients are clear to see: what their bankers do not know, they can never be forced to reveal.

The US state of Nevada – which makes a boast of its “limited reporting and disclosure requirements” – is a case in point. Nevada does not ask for the names of company shareholders, nor does it routinely share the little information it has with the federal government. And such an approach pays dividends to the local economy. The state, with a population of only 2.6m, incorporates about 80,000 new firms a year and now has more than 400,000, roughly one for every six people. A study by the Internal Revenue Service found that 50-90% of those registering companies were already in breach of federal tax laws elsewhere.

Sharman also tested several other approved OECD countries. He tried to open anonymous shell companies and bank accounts 45 times across the world. These were successful in 17 cases, of which 13 were in OECD countries. One example was the UK, where in 45 minutes on the internet he formed a company without providing identification, was issued with bearer shares (which have been almost universally outlawed because they confer completely anonymous ownership) as well as nominee directors and a secretary. All was achieved at a cost of £515.95.

Elsewhere, Sharman formed companies by providing no more than a scanned copy of his driving licence. In contrast, when trying to open accounts in Bermuda and Switzerland, he was asked for documentation such as notarised copies of his birth certificate. “In practice OECD countries have much laxer regulation on shell corporations than classic tax havens,” he said. “And the US is the worst on this score, worse than Liechtenstein and worse than Somalia.”