Tax Havens

How Globalization Really Works

Ronen Palan, Richard Murphy, Christian Chavagneux

• Publisher: Cornell University Press
• Year: 2013
• ISBN:
  9780801468551
• Topic: Business
• Subtopic: Taxation
• Index: Business

From the Cayman Islands and the Isle of Man to the Principality of Liechtenstein and the state of Delaware, tax havens offer lower tax rates, less stringent regulations and enforcement, and promises of strict secrecy to individuals and corporations alike. In recent years government regulators, hoping to remedy economic crisis by diverting capital from hidden channels back into taxable view, have undertaken sustained and serious efforts to force tax havens into compliance.In Tax Havens, Ronen Palan, Richard Murphy, and Christian Chavagneux provide an up-to-date evaluation of the role and function of tax havens in the global financial system—their history, inner workings, impact, extent, and enforcement. They make clear that while, individually, tax havens may appear insignificant, together they have a major impact on the global economy. Holding up to $13 trillion of personal wealth—the equivalent of the annual U.S. Gross National Product—and serving as the legal home of two million corporate entities and half of all international lending banks, tax havens also skew the distribution of globalization's costs and benefits to the detriment of developing economies.The first comprehensive account of these entities, this book challenges much of the conventional wisdom about tax havens. The authors reveal that, rather than operating at the margins of the world economy, tax havens are integral to it. More than simple conduits for tax avoidance and evasion, tax havens actually belong to the broad world of finance, to the business of managing the monetary resources of individuals, organizations, and countries. They have become among the most powerful instruments of globalization, one of the principal causes of global financial instability, and one of the large political issues of our times.

Part I

Tax Havens and Their Uses

Chapter 1

What Is a Tax Haven?

The term “tax haven” has been widely used since the 1950s.1 Yet there is no consensus as to what it means. The influential U.S. Treasury’s Gordon Report concluded: “there is no single, clear, objective test which permits the identification of a country as a tax haven” (1981, 21). Twenty-five years later, Jason Sharman reached similar conclusions. The term “tax haven,” Sharman writes, still “lacks a clear definition and its application is often controversial and contested” (2006, 21). Nevertheless, and despite controversies and debates, the list of countries considered to be tax havens has changed remarkably little since the 1980s, and the same is true of their roles and functions.

Competitive Policies in an Integrated World

Most studies of tax havens focus on the territories themselves. We believe, however, that to understand tax havens, one needs to appreciate the geopolitical and environmental conditions that gave rise to them in the first place. They did not produce that environment, nor can they influence it in a significant way; they simply learned to take advantage of the conditions they faced.

The modern state system is founded on the principles of sovereignty and sovereign equality. Each sovereign state has the right to write its own laws and pursue its own policies, including tax laws and regulations, within its own territory. During the twentieth century, each state developed its own system of taxation and regulation, and each reached for a different balance between competing domestic interests. Consequently, the world contains as many variants of tax and regulatory regimes as there are states.

Furthermore, particularly since the late nineteenth century, business has become increasingly mobile and international. Cross-border trade has grown at a tremendous pace, as have foreign direct investment and international portfolio investments. A related trend has been the rise of the large-scale economic units—internally differential, hierarchical, and bureaucratic—which are now known as Multinational Corporations (MNCs) or Multinational Enterprises (MNEs).

The traditional craftsman-turned-capitalist combined many skills in one person, acting as owner, buyer of raw material, producer, designer, salesperson, finance officer, and legal adviser. The modern corporation has evolved into a highly specialized bureaucratic machine in which different departments perform different functions. A typical modern MNE may set up manufacturing facilities in different countries, locate its headquarters, design, engineering, and finance departments elsewhere, and place its sales department in yet another location. As a result, an estimated 60% of all international trade takes place across frontiers but between different arms of the same company (OECD 2002). In an alternative model, many MNEs have chosen the “hollow” route, in which they subcontract out most if not all of their manufacturing, finance and legal services, advertising, sales, and so on.

These developments gave rise to what is often labeled interdependence and globalization. Even the largest economies in the world, such as the United States and China, have become specialists in manufacturing goods or services. Historically, country specialties have developed either because of active state or regional policy, or in many cases spontaneously, and they have developed for a great variety of reasons, including access to raw material, geo graph i cal location, topography, availability of human capital.

Many governments use their sovereign right to enact law in order to help successful sectors within their economies to compete in the world economy or, alternatively, to spur the development of new competitive sectors. They often employ some combination of fiscal subsidies and sweeteners, including reductions in taxation (sometimes by informal or highly opaque set of arrangements) and removal of “red tape” (i.e., regulation) to attract or retain mobile capital.

The fiscal portions of such policy packages are called Preferential Tax Regimes (PTRs) and include a wide array of initiatives and regulations designed to attract foreign capital. When in the late 1990s the European Commission decided to investigate tax abuse among European Union (EU) member countries, it discovered 206 PTRs—and that figure does not include PTRs independent territories of EU member states such as the Channel Islands and Gibraltar. The attractions ranged from generous depreciation allowances to subsidies to peripheral regions and various other types of tax holiday schemes (ECOFIN 1999). EU member states are not alone in this practice, and many states all over the world offer a bewildering variety of PTRs. Such behavior has led to considerable political tension between states and accusations of harmful competition, dumping, free riding, and cheating. Often such accusations are accompanied by calls for protectionism and economic retaliation.

At heart, tax havens are merely another type of economic specialty practiced by states—albeit a specialty that is created and sustained with the help of particularly aggressive, and some would say virulent, PTRs. It is a specialty favored by the smallest independent jurisdictions in the world, and as a result, it is numerically the most popular type of competitive strategy (Palan and Abbott 1996). Dharmapala and Hines calculate that for a country with a population under one million, the likelihood of becoming a tax haven rises from 24% to 63% (2006). The figure is probably higher if dependent jurisdictions such as the Caymans and Jersey are added to the list. Like other competitive state strategies, tax havens enact a range of legislation and tax rules that are aimed at attracting and developing what they call their offshore sector. Equally, and perhaps unsurprisingly, they are subject to the same accusations of harmful competition, free riding, parasitical behavior, and cheating.

Finance, Intangibles, and Tax Havens

The vast majority of the world’s PTRs were established to attract manufacturing and assembly lines. Tax havens, in contrast, are aimed primarily at other sectors. To understand what tax havens offer, we need to dwell briefly on some of the more spectacular and esoteric developments in the area of finance.

The financial system is normally divided into two branches, retail and wholesale. Retail banking (and other financial services such as insurance) tends to be a highly profitable business, which handles the financial requirements of individual savers and borrowers. Wholesale finance manages specialized, bulk financial transactions, often of unimaginable sums of money, traded between the financial institutions themselves, and it tends to be even more profitable. The Bank for International Settlements (BIS) estimates that about $3 trillion exchanges hands in the foreign currency market every day; and that there are outstanding derivative contracts in excess of $600 trillion, or twelve times the world’s GDP (BIS 2007). It is this wholesale financial market that “froze” during the 2008–9 crisis.

The wholesale financial markets burst the national boundaries in which they had operated since the end of World War II. Since the 1960s, they have been operating more or less as one globally integrated financial system. The wholesale financial system primarily trades in “incorporeal” properties: currencies, equities (shares), debt instruments (bonds), claims on existing and future earnings, hedging contracts and indices. However obscure and complex some of these instruments may appear, they are all contracts for the exchange of property titles. The existence of a global market simply means that a legal framework that supports such exchanges is global as well. Incorporeal properties have no tangible physical existence; they are represented as contractual agreements that are either printed out or, more commonly now, stored electronically.

Financial centers, retail and wholesale, which trade in these incorporeal properties evolved to service the financial needs of the economy that hosts them. Theoretically, the size of a financial center is linked to the size of the economy it services. However, the complexity of financial products and the vast sums of money involved have led to the development of highly skilled groups of workers in the various branches of banking, capital and credit markets, insurance, brokerage, accounting, and of course the law. As a result, financial systems have tended to congregate geographically in the major cities of the world. Profits generated in such centers are taxed by the countries in whose territories these centers are located, and the countries concerned serve as regulatory authorities over these financial centers.

The wholesale financial market trades in incorporeal assets which, by definition, are highly mobile, so the market possesses a flexibility that other sectors do not enjoy. The usual rules of economics still apply—like every other type of economic activity, financial transactions involve costs and income. Costs include the intellectual labor that goes into the making and arranging of a deal, including sunk overhead costs. Income is generated only at the point of the contract and can therefore be risky. However, financial actors can avoid taxation on profits, as well as regulations, by “booking” a contract somewhere other than the place where it was negotiated. For example, a financial transaction can be arranged in London, New York, or Frankfurt—places where specialists tend to be found. But to avoid UK, U.S., or German taxation and regulations, the transaction can be registered or “booked” in low-tax or lightly regulated jurisdictions such as the Cayman Islands. In such centers, almost all the bank branches are “shell” operations. In other words, the branches exist but do not actually do any business or have any assets.

It is not only banks and financial institutions that use tax havens for booking purposes. MNEs operate through complex set of subsidiaries, affiliates, and sub-contractors in many countries, and they are supposed to pay tax on profits made in the territory of each of these countries. MNEs, therefore, also have an incentive to book financial transactions in low-tax, lightly regulated countries. In addition, large MNEs have their own pension funds and may take advantage of lightly regulated/low-tax countries to reduce the handling costs of these funds. Because MNEs operate in many countries, they employ specialized holding companies to register management and financial activities in low-tax countries whenever possible. Banks and companies use a great variety of instruments to achieve these aims (discussed in detail in chapter 3). There are many more techniques that help companies, financial institutions, and rich individuals to avoid taxation or certain sorts of regulation. We discuss those in chapter three.

Tax havens offer particularly aggressive PTRs that are aimed at capturing mobile capital. They are largely repositories of contractual relationships and serve almost entirely as booking devices. It is rarely the case that the substance of the transactions booked in a tax haven actually takes place there. Hence, there is very little actual activity in tax havens, and they are often described as “virtual” centers (Palan 2003). We may define tax havens, therefore, as “legislative spaces.” They are jurisdictions that deliberately create legislation to ease transactions undertaken by people who are not resident in their domain. Those international transactions are subject to little or no regulation, and the havens usually offer considerable, legally protected secrecy to ensure that they are not linked to those who are undertaking them. Such transactions are “offshore”—that is, they take place in legal spaces that decouple the real location from the legal location. We should note that, defined in this context, “offshore” has little to do with geography, let alone small islands, but rather with legislative spaces (Palan 2003).

Definition Problems: PTRs and Tax Havens

This basic definition of tax havens raises several practical problems. Although some tax havens are easily recognizable, a highly mobile environment combines with the proliferation of PTRs to create a situation whereby any country may serve as a potential haven from the taxation of some other countries. As a result, the lines separating PTRs, aggressive PTRs, and tax havens are highly contested.

As early as the 1980s, Vincent Belotsky, a high-ranking U.S. Internal Revenue Service (IRS) official, noted that many countries, including the United States, fit the conventional definition of tax haven. The United States, he wrote, “applies a zero rate of tax on certain categories of income, including interest received by nonresident alien individual or a foreign corporation from banks and savings institutions” (1987, 59). Foreigners could use the U.S. banking system to avoid paying tax to their home countries on their savings. In addition, “United States banks offer a high level of banking secrecy to their foreign clients. Unlike domestic clients, foreign clients are excused from obtaining taxpayer identification numbers, their accounts are not reported to the IRS and there is no withholding tax” (1987, 60). Belotsky even suggested that the United States actively promoted itself as a tax haven (1987, 60). Indeed, when the German authorities began to worry about the erosion of the tax base in the late 1980s, topping their list of offending countries were not Switzerland and the Cayman Islands, but rather the United States, Belgium, the Netherlands, and Ireland (Weichenrieder 1996).

The line separating tax havens from other PTRs is arbitrary; it is a “matter of degree more than anything else” (Irish 1982, 452). Some tax havens even deny that they exercise a PTR, let alone an aggressive PTR. Colin Powell, while Jersey’s acting chief officer, said: “It is not the island that has made itself more and more attractive; it is the relatively high tax structures of the main industrial countries that have made them relatively unattractive” (Jeune 1999). In reality, we suggest, most tax havens are not as innocent as they pretend. Although we agree that on occasion particular legislation or tax rules may be used opportunistically for tax avoidance and evasion purposes, we believe that the states we discuss in this book have adopted tax haven legislation as a conscious, intentional, and long-term developmental strategy.

Tax haven regimes are set up not to suit the academic’s fondness for classification but for the commercial purposes of capturing “rent” from mobile capital. Any activities that become movable because of technological developments instantly become targets of the more agile tax havens. Tax was an obvious first target, and still is the major rationale for setting up these legislative spaces. However, many tax havens have realized the commercial value of extending the principle of tax haven legislation to capture other mobile businesses, such as shipping, casinos, and pornography. The Internet, for instance, created new opportunities for distant casinos, which were grabbed by Bermuda, Costa Rica, and the small island of Alderney.

As this happens, the “consumers” of tax havens—wealthy families, companies, and the professionals that set up tax haven entities—are discovering innovative ways of using them, often killing two birds with one stone. Diamond and Diamond (1998), for instance, believe that the main reason for the spectacular growth in the use of Caribbean tax havens by wealthy individuals during the 1980s and 1990s was not taxation per se but rather matrimonial, family, and insolvency issues. Such assets are hidden not from the tax authorities but from spouses, other family members, and creditors—although the tax haven’s location probably also helps to reduce taxation. Similarly, a U.S. regulation subjects hedge funds to U.S. banking and financial regulation if the fund involves more than one hundred partners. A tax haven avoids this rule—and supplies better tax treatment to boot.

Driven by competition, technological advance, and market needs, many tax havens have been branching out into new activities. The literature on tax havens has dealt with this proliferation of activities in two ways. One approach is to describe all these new businesses under the umbrella term of “tax havens.” Some experts, for instance, call the flag of convenience (FOC) arrangements practiced by countries such as Liberia or Panama as a form of tax haven (Irish 1982). The argument holds that tax remains the core but no longer the only defining characteristic of the tax haven. The other approach argues that a tax haven is a restricted category, but that some tax havens may also offer other services. This approach is particularly useful when it comes to controversy about the role of tax havens as offshore financial centers.

Definition Problems: The Confusion between Tax Havens and OFCs

The tax havens naturally exploit the proliferation of tasks that they perform for public relations purposes. Because of the association of tax havens with tax evasion, money laundering, criminality, and embezzlement, few tax havens wear the tag with pride. In fact, most if not all deny any association with tax evasion, and seek to present their policies as benign forms of PTR. At best (or worst), some tax havens are prepared to accept the less pejorative designation “offshore financial center” (OFC). Some advertise their offshore business sector on their official websites, and over the last few years OFC has become the description of choice, particularly by international economic organizations such as the International Monetary Fund (IMF), ...