Tax Haven. The phrase immediately visualizes in to a scenic place with natural surroundings, beautiful beaches, posh localities and of course large banks.
One can imagine how these places manage to deck themselves up in such a mystique manner with no huge businesses or infrastructure in sight. Well, part of the answer, if not full, lies within the Banks at these places. Most of the large Multinational Companies maintain their bank accounts with various banks established at these tax havens.
What is a Tax Haven, though?
It is a jurisdiction which levies minimum tax to the foreign individuals as well as businesses. In 1998, the OECD (Organization for Economic Co-operation & Development) released certain factors through which a tax haven jurisdiction can be identified. One of the most conclusive factors was that these jurisdictions levy zero or very less tax on the income earned by individuals or businesses. However, one might wonder, if such governments are levying less taxes, how do they earn? And how do they manage to maintain the upstate environment, the lavishness of the territory? The answer lies within the policy of Indirect taxation.
Tax haven countries levy high rates of Import Duties & Customs Duties in order to offset their revenues from Direct Tax collections. Furthermore, even if the businesses find it lucrative to register themselves in these countries or operate a bank account, maintain a safety deposit vault; a hefty amount is charged for registration & maintenance. Apart from that, the authorities may also charge a license fees, etc. just to continue a hassle-free operation within their geographical boundaries. So, in a way the tax havens manage to generate a recurring revenue stream in the absence of Direct Tax collections like the non-tax haven countries.
Furthermore, in order to attract more corporate investments into their Banks, the tax havens announce various concession schemes where the investors shall receive a concession in quarterly maintenance charges for maintaining a certain balance in the bank accounts, lower registration fees if certain % of the employees are locally employed, etc. Due to these schemes, the banks operating within the tax havens do not have to face a liquidity crunch which lets them expand their lending business at a constant rate. An ever-increasing capital base, attractive clientele makes these banks appear as powerful financial centers with global influence.
So, one might wonder what could be the issue in depositing the hard-earned money into these banks with such concessional rates? It may have something to do with "Monetary Morality".
The issue arises not due to huge deposits made into the tax haven countries however it is the motive of tax avoidance/planning as the potential inference of these huge deposits. Various Multinational Companies (MNCs) having a major geographical presence, set up their subsidiaries/branches in the tax havens. Majority of the profit is shifted out to these subsidiaries in order to reduce the tax liabilities by routing sales through these subsidiaries. Certain entities also incur huge expenditure through their Holding Companies at the Home country/ jurisdiction (place where the company actually carries out its business) where tax rates are high, so that profits are lowered & the impending tax burden is reduced and vice versa.
One of the most convenient methods to increase income in tax havens & increase expenditure in non-tax haven countries is the Unsecured Loans. The subsidiary company will provide loan to its holding company at exorbitant rates which shall increase the interest expenses of the Holding company thereby reducing its profits; and at the same time the income of the subsidiary shall increase due to heavy interest receipts from the Holding company. However, this practice has been curbed to a great extent by the Government of India by the introduction of Section 94B of Income Tax Act, 1961.
The introduction of Section 94B was a part of an Action Plan under BEPS Action Plans. Base Erosion & Profit Shifting (BEPS) is a series of tax planning strategies used to shift profits & lower tax liabilities using the tax haven countries. The BEPS Action Plans were introduced by the Organization for Economic Co-Operation & Development (OECD) in 2015 & till date 15 BEPS Action Plans have been introduced which assist the member nations of the OECD to eradicate the tax evasion initiated through tax havens.
Tax Havens: Why?
The concept of taxing the income where it "accrues or arises" has led to the increase in the practice of tax evasion/avoidance by large multinational companies. These companies generate enormous amounts of revenues and use the tax havens to enjoy the benefits of lower taxes. In few cases, after proper scrutiny, it was concluded that the effective tax rate for these companies was lower than the statutory tax rate of their home countries. The amount of tax revenue the governments would have received if there were no tax havens runs into some Trillion Dollars. ($1.30 Trillion approx.)
Major Multinational companies using tax havens include a premium mobile manufacturing company, a leading sportswear company, a leading user interface manufacturing company, a mobile OS manufacturing company and a plethora of huge financial institutions as well. Apart from enjoying the various tax benefits these companies are at the pinnacle of their businesses and are on a continuous expanding spree due to the constant availability of capital. The elite & well-established Investment Banks which operate globally provide the services of setting up businesses for their clients in these tax havens under the guise of "Wealth Management Services".
Not only overseas but various prominent Indian companies or their global counterparts utilize tax havens in order to minimize tax liabilities. They use countries which have favorable tax treaties with India such as Mauritius or the Cayman Islands who have signed Double Taxation Avoidance Agreement (DTAA) and a Tax Information Exchange Agreement (TIEA) respectively. These treaties assist the companies in lowering their tax liabilities, especially capital gains tax. Some of the Indian companies use tax havens to manage their Intellectual Properties as well.
Apart from that, one of the issues which attracts funds towards tax havens is Asset Protection. The prima facie objective is to safeguard the assets from potential claims, lawsuits, government seizures, etc. E.g. Switzerland, it is known for its banking secrecy laws, although they have been relaxed over the years owing to international pressures, the Swiss laws offer robust privacy protections for account holders, specifically in the case of wealth management and trusts. Another example is of Lichtenstein, which offers a high level of confidentiality and a protection for assets registered in the name of trusts.
Furthermore, certain tax havens do not have mandatory successor laws so that individuals and entities have a greater liberty in deciding how their wealth is distributed. This is particularly beneficial for asset protection since an individual’s wealth or an entity’s wealth controlled by an individual does not automatically get transferred to any creditors or claimants in the event of a legal dispute.
In some cases, tax havens may also be used as a front of illegal activities apart from tax avoidance. This has been one of the reasons why tax havens are infamous. Most popular of the illegal activities is money laundering which involves the transfer of illegally secured/earned funds under a blanket of various shell companies to make it look like a normal fund transfer if and when traced.
So, how can this practice be curbed? After all, every jurisdiction has its own rights to tax the receipts/income in its country as per their legislature. On the other hand, any entity or a person earning income would want lower taxes as far as possible. In order to curb the investment in tax havens or offshore destinations, various non-tax haven governments maintain a strong legislature against investment in tax havens thereby applying continuous pressure on tax haven jurisdictions to provide information regarding investments received from citizens of non-tax haven jurisdictions. This is why the Base Erosion and Profit Shifting (BEPS) Rules have been implemented to combat the tax evasion/avoidance strategies.
Tax Havens vis-à-vis BEPS Rules
The BEPS Rules are designed to ensure that the profits are taxed where the economic activity and value creation ensues and not just profits being transferred from higher tax jurisdiction to lower tax jurisdiction. In spite of these rules being implemented, various companies still use tax havens. Following are some vital points which put a light on this issue:
Compliance with BEPS and DTAA
The intention of BEPS is to curb tax avoidance/evasion; yet where DTAAs are signed by India with other countries such as Mauritius and Singapore, the BEPS do not negate the DTAA. However, BEPS Action Plan 6 (Preventing the granting of Treaty benefits in inappropriate circumstances) ensures that tax treaty benefits are not enjoyed by entities that are set up only for the purpose of tax avoidance.
Substance over Form requirement
The BEPS Action Plan 5 (Harmful Tax Practices) includes a requirement for substantial economic activity to be present in a tax haven for it to be considered as a legitimate and legal arrangement. So, to comply with this rule, the companies using tax havens will have to carry out some economic activities like have an office space, local management and employees, management of assets, etc. to be categorized as a business company. If no such transactions are found, such companies may be deemed as "shell companies" by the non-tax haven jurisdiction.
Apart from the above-mentioned compliances, the entities in tax havens have to comply with the OECD's Common Reporting Standard (CRS) for automatic exchange of tax information and country-by-country reporting obligations. The CRS increases transparency and reduces the odds of tax havens being used for illicit purposes.
E.g. In order to comply with all these provisions and achieve tax benefits, an Indian company may set up a Holding company in Singapore (which has signed a DTAA with India) to manage its international operations in the Asian continent. The company in Singapore shall have a real office with employees and management making key decisions. Hence, the entity could validate that the operations in Singapore are essential to the international business strategies such as conducting regional sales drives, etc. Such an arrangement could be acceptable under the BEPS Rules. It is one of the many ways tax havens operate along with BEPS Rules.
Initiatives by the OECD
The Automatic Exchange of Financial Account Information program under the Organization for Economic Co-Operation & Development (OECD) is one of the various modes applied to ensure offshore investments are reported on a regular basis by all the participating countries in the OECD. In spite of such programs in place & a host other activities implemented to increase the information exchange, certain countries are reluctant to participate. However, at times this leads to an unmitigated financial disaster of serious proportions. E.g. Cyprus, whose financial sector is mostly dependent on its status as a tax haven, collapsed in 2013-14. It was only after its acceptance through an agreement to strictly comply with international financial information exchange & formulative tax compliance, the European Central Bank, European Commission and the International Monetary Fund accepted the request of Cyprus Government for a bail-out of around $10Bn. The Cyprus Government was also required to seize around 47% of the uninsured deposits in the Bank of Cyprus, the largest commercial bank in Cyprus. Foreign depositors with accounts in various banks in Cyprus were hit hard under these terms.
Conclusion
To conclude, it can be said that even though the tax havens look attractive destinations of investments or stashing the cash, they are in a vulnerable position, both financially & to a certain extent morally, which is exacerbated by the information pressure exuded by the international community as a whole. Still, companies prefer to use tax havens since they are ready to adhere to the substance-over-form principle and other BEPS rules. However, for the jurisdictions/ countries which are considered to be tax havens, it is the need of the hour to rethink & reshape their financial policies & overall banking structure to keep themselves from a deepening crisis!
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