Tax havens are countries with very low, or nil, tax rates on some or all forms of income. These rates are usually accompanied by accommodating financial institutions and other arrangements favourable to tax avoidance or evasion activities. The growth of tax havens has matched the growth of international trade and developments in communication technology. You can divide tax havens into three categories:
- The zero tax haven
- The low tax haven
- The tax haven that imposes tax at normal rates but grants preferential treatment to certain activities
The first two categories usually consist of small economies - often former British colonies or dependencies - that make up for the absence of direct taxation by the use of indirect taxes.
Ireland is an example of the third category, with its manufacturing incentives under which a special low rate of tax applies to manufacturing operations located there.
Tax havens have been criticised on the basis that they’re used for depositing the proceeds of criminal activities and they allow the wealthy to conceal the true extent of their fortunes from the communities in which they live. It seems, however, there is little evidence to support these allegations. In the preface to his book on tax havens, Milton Grundy, an offshore taxation expert, states:
The general view I have gathered is that tax havens must cause some loss to fiscal authorities throughout the world, but there must also be some truth in the proposition that a good deal of business is done via tax havens which, if the parties were contemplating a net after-tax return, would not get done at all.
Users of tax havens may well be seeking privacy as well as financial or fiscal benefit.
Relief from double taxation
Many countries offer relief from double taxation for the foreign taxes paid on a unilateral basis. There are several theoretical methods that can be used to achieve this. The country of residence may allow a deduction from taxable profits for the amount of foreign tax paid, on the basis that it is essentially a cost of obtaining those profits.
Alternatively the country of residence may adopt the source principle, and exempt the foreign profits from tax altogether, on the basis that tax has already been paid in the other country.
Finally, the country of residence may adopt the residence basis and reserve the right to tax the foreign profits, but allow a reduction in tax liability equivalent to the foreign tax paid.
The Organisation for Economic Co-operation and Development (OECD) is a group of 30 countries sharing a commitment to democratic government and the market economy. The OECD Model Convention deals with the question of relief from double taxation as follows: for some items of income or capital, the Model Convention gives an exclusive right to tax to one of the contracting states and the relevant article states that the income of capital shall be taxable only in a contracting state. The state in which the exclusive right to tax is vested is normally the state of which the taxpayer is a resident. In this situation, no double taxation arises.
For other items of income or capital, however, the right to tax is not exclusive, and the relevant article then states that the income or capital in question may be taxed in the contracting state of which the taxpayer is not resident. In such a case there may be double taxation, in which case the state of residence must give relief so as to avoid the double taxation.
Article 23 of the OECD Model Convention presents two alternative methods of relieving any double taxation that remains after the application of the income allocation provisions of the treaty. The methods are exemption and credit, and which method is actually used will depend on the agreement between the particular countries involved, some preferring the exemption method, others the credit method.
Under the exemption method, the country of residence relinquishes its right to tax income that has been taxed according to the treaty in the other country, the country of source.
Whether or not this is advantageous will obviously depend on the respective tax rates of the two countries. Under the credit method, the country of residence reserves its right to tax income allocated to the country of source, but will allow credit for the tax paid overseas in calculating the ultimate liability.
In the method of credit adopted by the OECD model, the amount of credit that is allowed for foreign tax is limited to a maximum of the amount of tax that would have been paid if the profits were earned in the country of residence.
The position is slightly more complicated when the foreign profits take the form of dividends from a foreign company in which a resident company holds shares. Dividends may then be subject to a withholding tax when they are remitted to the shareholder. Under an exemption system, payment of a withholding tax may be sufficient for the dividends to be exempt from tax in the country of residence of the shareholder.
Under a credit system, the question arises as to whether only the withholding tax will be credited, or whether recognition is also given to the tax on profits paid by the foreign country. In many countries that adopt a credit system - including the UK and the US - credit is allowed for the underlying tax (the tax paid by the foreign company on its profits from which the dividends are paid) - but only for substantial shareholdings, that is, non-portfolio investments
Tax competition generally refers to competition between different tax jurisdictions to encourage businesses and individuals to locate in their areas. At one extreme tax holidays may be granted, which mean that companies or individuals meeting certain criteria are granted favourable tax treatment for a period following their move into a new country.
There are conflicting views about tax competition: some believe that it has beneficial effects: for example, in encouraging governments to keep tax rates down. Other feel that it is damaging to the world economy because of the ensuing misallocation of resources.
In 1998, the OECD established a forum on Harmful Tax Practices, a subsidiary body of its Committee on Fiscal Affairs. The Forum produced a report that identified harmful tax practices and guidelines which asked member countries to identify preferential tax regimes and practices.
In 2000, the Committee on Fiscal Affairs identified 47 preferential tax regimes in nine categories of ‘potentially harmful’ areas (insurance, financing and leasing, fund managers, banking, headquarters regimes, distribution centre regimes, service centre regimes and miscellaneous activities).
So what, in the view of the OECD, is a harmful tax regime? The preferential regime criteria are those where:
- low (or no) taxes are imposed on the relevant income
- the regime is ring-fenced from the domestic economy
- the regime is not transparent, in that details are not clear or there is inadequate financial disclosure; and
- there is no effective exchange of information.
A further self review was performed by members in 2004, which entailed providing descriptions of regimes with reference to the above criteria.
Following this process, and its accompanying peer review, 18 regimes have been abolished, 14 amended to remove their harmful features, and 13 found not to be harmful.
In addition to the work being done by the OECD member countries, a number of countries and jurisdictions not within the OECD have committed themselves to adopt greater transparency and information exchange. By the end of 2003, 33 jurisdictions, in partnership with OECD member countries, had developed a model Agreement on the Exchange of Information on Tax Matters. An Informal Contact Group has been established comprising OECD members together with participating partners.
A meeting of the Informal Contact Group in Ottawa, Canada in October 2003 attended by representatives of 40 jurisdictions agreed that a level playing field has not yet been achieved and requires participation from those financial centres not currently part of the process.
Exchange of information for tax purposes is a laudable practice, but it will only be effective when the information available for exchange is reliable, which means that it is important for the countries entering into such agreements to have appropriate standards governing the maintenance and accessibility of accounting records.
A small number of countries and jurisdictions have chosen not to participate in the move towards greater transparency and information exchange, identified in a list of ‘Uncooperative Tax Havens’. In December 2003 these were:
- the Principality of Liechtenstein
- the Principality of Monaco
- Republic of the Marshall Islands
The Committee on Fiscal Affairs appreciates the limitations of traditional bilateral and unilateral measures to address harmful tax practices, and has examined a number of possible measures that could be adopted including denial of tax deductions or credits for payments to residents of countries that engage in such behaviour, and reporting requirements for residents transacting with persons in this sort of jurisdiction.
The description ‘harmful tax practices’ raises the question – harmful to whom? Certainly not to those trying to avoid tax!
About this article
This article is based on extracts taken from the Open University Business School course Issues in International Financial Reporting (B853)