Taxation laws and requirements vary dramatically by country, and this variation has created the framework for tax havens. A tax haven is a country that provides substantial advantages to taxpayers because of its tax system. A tax haven’s system may include a lower tax rate, more lenient or favorable tax deductions or credits and inherent financial privacy that impairs transparency. Taxpayers take advantage of these havens to reduce or evade taxation and to maintain secrecy about their financial activities. While tax havens can be used legally, they may also be used for illicit purposes. Furthermore, because they enable taxpayers to avoid paying domestic taxes, they directly result in the significant loss of government tax revenue.
Table of Contents
- How Does a Tax Haven Work?
- Who Uses Tax Havens?
- Are Tax Havens Legal?
- Which Countries are Considered Tax Havens?
- World’s Best Tax Havens
- Difference Between Tax Havens and Tax Shelters
- The History Behind Tax Havens
- Agreements, Laws and Treaties Regulating Tax Avoidance
- Organizations that Fight Against Tax Havens
- The Bottom Line
How Does a Tax Haven Work?
A tax haven may be used in various ways by individuals and businesses. While some people assume that a tax haven provides a tax-free structure, this is not usually the case. Countries that are considered to be tax havens generally profit substantially by enticing foreigners to conduct financial activities in their jurisdiction. While they charge a lower tax rate overall than other countries, they are generating more money via taxation than they otherwise would be able to earn. Some countries also generate revenue by charging registration or renewal fees. Nonetheless, it is still more financially advantageous for businesses and individuals to pay these various fees and taxes than the alternative. Because tax haven jurisdictions profit financially, reform is challenging.
A common way for businesses to take advantage of tax havens is by forming a subsidiary that is based in a tax haven country. While the parent company is based in the United States, all income generated by the foreign-based subsidiary is taxed by the foreign country at its lower tax rate. Individuals can also set up a small business in a foreign country and conduct all of the business’s activities via a foreign bank to take advantage of similar benefits.
Who Uses Tax Havens?
Many of the largest and most well-known U.S. corporations take advantage of tax havens to some degree. Notably, Apple uses Ireland to shield more than $214 billion dollars from U.S. taxation. Its efforts have resulted in the loss of more than $65 billion in estimated tax revenue to the United States. Both Nike and Goldman Sachs use Bermuda to collectively hold more than $39 billion dollars. Some of the other major corporations that utilize tax havens in various countries include Walmart, Chevron, IBM, Microsoft, Exxon Mobile, Pfizer and General Electric. These and other major U.S. multinational companies collectively hold more than $1.6 trillion in tax havens.
Individuals also use tax havens to reduce their tax liability. This includes avoiding the estate tax and other substantial personal taxes. Some individuals legally establish small businesses in foreign countries, and they operate legitimate businesses. Others have established mailbox companies, which do not actually conduct business and are used solely for the purpose of sheltering personal funds from taxation.
Are Tax Havens Legal?
Businesses can legally set up subsidiaries in any country that they choose. Under current laws, subsidiaries are taxed by the country that they are established in rather than by the parent company’s country. While this is legal, companies and individuals can and do abuse or misuse tax havens.
For example, GlaxoSmithKline was fined by the IRS over abusive transfer pricing activities in 2006. Essentially, its foreign-based subsidiary bought the parent company’s products and sold them at an advantageous price to avoid paying taxes in the United States.
Another tax avoidance strategy that many multinational companies use involves shell companies. Shell companies are subsidiaries that may have a physical office location, but they have minimal assets. They have no substantial operations, so their primary purpose is to serve as a floating bank account. This is a legal and common way to utilize tax havens to reduce corporate tax liability.
Some businesses also set up foreign holding companies. These are companies that hold equity or stock, and they do not sell goods or services. Instead, they are used to avoid taxation on royalties for intellectual property. This is a complicated structure, but it is legal.
Tax havens are used by criminals as well. Commonly, drug traffickers and terrorist groups launder money to conceal funds generated by illegal activities. The dirty money is cleaned through various layers of bookkeeping strategies and transactions so that it can enter the financial system legitimately. While there are many ways to launder money, a common strategy is for criminals to smuggle dirty money out of the country. They deposit it into bank accounts in tax haven countries so that its origins cannot be traced.
Tax havens are also used by businesses and individuals to evade paying taxes owed to the IRS. Tax evasion involves failing to report all income or profits. In some cases, it also involves overstating deductions. Tax evaders utilize various strategies and techniques, and one of these involves funneling money into accounts in tax havens. Tax evasion is not simply an avoidance of paying taxes. Instead, it involves the additional and obvious effort to actively evade taxes. This could include concealing income via a bank account in a tax haven country. It may also include using a double-booking system, holding property in an entity in a tax haven country and taking other significant efforts to conceal income.
Which Countries are Considered Tax Havens?
Several dozen countries are considered to be tax havens, but they achieve this status in unique ways. For example, Bermuda is a popular tax haven because it has a zero percent tax rate on corporate and personal income. Cayman Islands also does not have a corporate or personal income tax. More than that, it does not tax business payroll or capital gains. Furthermore, Cayman Islands does not withhold taxes on foreign businesses. Many corporations prefer to take advantage of the taxation in the Netherlands as well. The Netherlands specifically entices large businesses to conduct activities there by offering huge tax incentives.
Ireland does not have a low tax rate structure, but its unique tax laws have been advantageous for companies like Apple and others. Subsidiaries established in Ireland are not considered to be tax residents and do not have to pay corporate taxes as a result. Apple has been the subject of scrutiny because its Irish subsidiary is not subject to U.S. or Ireland taxation.
Some of the other popular tax havens include Switzerland, Mauritius, Isle of Man, the Channel Islands, Singapore, Hong Kong, Malta and Monaco. Because tax advantages vary dramatically from country to country, some individuals and businesses may determine that one specific country’s tax structure is most beneficial to their unique needs.
World’s Best Tax Havens
- Cayman Islands
- Channel Islands
- The Isle of Man
- British Virgin Islands
- Hong Kong
Difference Between Tax Havens and Tax Shelters
Tax havens and tax shelters are easily confused, but there are significant differences between them that you should be aware of. The Internal Revenue Service has established numerous exclusions and deductions that enable individuals and businesses to avoid taxes. These are written into the tax code, and they are legal. For example, there are capital gains shelters for homeowners who sell their primary residence for a profit as well as for investors who take advantage of a 1031 exchange. Tax-advantaged retirement accounts are also legal tax shelters.
On the other hand, a tax haven is not a legal loophole written into the tax code. It is a geographic location that has a low tax rate, no taxes or other financial benefits that enable individuals and businesses to avoid taxation. The use of tax havens can be legal as well, but they can also be abused in some cases. Money laundering and tax evasion are serious crimes in the United States, and these illicit activities are often supported or enabled by tax havens.
The History Behind Tax Havens
While the term “tax haven” became common vernacular in the 1950s, tax avoidance has been practiced for thousands of years. For example, around 200 B.C., Rome created a tax-free port in an effort to undercut trade in nearby Rhodes and to establish its superiority as a trading power. At the time, the trade tax rate charged by Rhodes was 2 percent, but Rome’s tax-free port was considerably more advantageous to traders. Rome continued to manipulate its tax policy in various ways to financially benefit its allies throughout its history.
Later in history, several European countries incentivized colonization in the New World through advantageous tax policies. Some of these countries include England, Spain and the Netherlands. One of the primary causes of the American Revolution was England’s efforts to raise taxes in its colonies after the area had been settled.
Switzerland and Lichtenstein became leading tax havens in the first few decades of the 1900s. Numerous countries in Europe and other areas around the world raised taxes to pay for reconstruction after World War I. Because Switzerland remained neutral, it did not have to raise taxes to pay for reconstruction efforts. Taxpayers took advantage of low tax rates in these areas. The prevalence of multinational businesses using tax havens to reduce tax liability increased in the 1950s.
Agreements, Laws and Treaties Regulating Tax Avoidance
The ability of a country to generate tax revenue is essential for its survival and prosperity. Tax revenue is used for public education, welfare, infrastructure, defense and many other essential expenditures. Because havens enable taxpayers to avoid paying taxes, many countries are rightfully concerned about the financial impact of tax havens. Some of the larger and more influential companies that have been negatively affected by tax havens and that have actively fought against them in various ways are France, the United States, the United Kingdom and Germany.
Impacted countries have addressed tax havens in different ways. For example, the United States has issued a Repatriation Tax Holiday several times in an effort to encourage multinational companies to bring their funds back into the United States. One instance of this was in 2004 when the tax rate was lowered to 5.25 percent. Countries have also tried to improve transparency in tax haven countries. For example, Switzerland and the United States established a transparency treaty related to Swiss bank accounts held by foreigners. The Foreign Account Tax Compliance Act passed by the United States in 2010 requires foreign countries to report bank account details of its citizens. The United States also actively prosecutes cases involving money laundering, tax evasion and other activities, which could deter some criminal activities.
In addition to these actions and the efforts of other individual nations, many countries are increasingly banding together to fight against tax havens collectively. For example, the G-20 London Communique introduced several multinational solutions to regulate tax havens uniformly. Nonetheless, tax havens continue to be popular and problematic today.
Automatic Exchange of Financial Information
To improve financial transparency and to ensure that tax entities are able to collect all revenue payable to them, dozens of countries have agreed to an Automatic Exchange of Information, or AEoI. This was developed by the Organisation for Economic Co-operation and Development. The participating countries have agreed to established standards that convey reports detailing financial information on foreign nationals to appropriate tax jurisdictions. By doing so, these countries are collectively protecting taxation and revenue-generating systems in all participating countries. Specifically, all financial institutions operating in these countries will report account balances, income, proceeds from sales and more to respective jurisdictions. While countries around the globe are already participating in the Automatic Exchange of Financial Information, tax havens continued to be heavily utilized.
Foreign Account Tax Compliance Act (FATCA)
In 2010, the United States passed the Foreign Account Tax Compliance Act, or FATCA. This federal law requires foreign financial institutions to provide reports for all accounts owned by American entities or individuals. More than that, it requires American citizens to report this information themselves using Form 8938. It applies to all citizens as well as green card holders regardless of where they live. Institutions that report to the IRS may be required to withhold tax revenue on behalf of the United States. While this law was designed to raise tax revenue, it has generally not been effective. One reason for its relative failure is because the United States has not reciprocated reporting efforts to other countries. In addition, some financial institutions are unable to comply because of privacy laws in their own countries. Some critics of FATCA also point out that this law has resulted in the renunciation of citizenship by numerous individuals living overseas. As a result, there have been substantial efforts in the Senate and in the House of Representatives to repeal or to overhaul FATCA.
Bank Secrecy Act
The Bank Secrecy Act of 1970 was passed to prevent and to detect financial crimes like tax evasion and money laundering. The law has been amended several times over the years, and it requires financial institutions to report daily transactions that exceed $10,000. It also requires institutions to keep financial records related to cash purchases and to take steps to identify and report other suspicious monetary activities. Some opponents have fought against the Bank Secrecy Act with the claim that it violates their rights of due process and against unwarranted search and seizure. However, the courts have consistently upheld the law.
Under the Bank Secrecy Act, financial institutions are required to prepare and submit five unique reports in specific situations. A currency transaction report must be filed directly with the Financial Crimes Enforcement Network if cash transactions exceed $10,000 in a single day. A suspicious activity report must be submitted to the same entity if activities indicate possible wire transfer fraud, money laundering, check fraud or other crimes. Another report that may be required in the foreign bank account report, which provides details on U.S. residents and citizens who hold more than $10,000 in a foreign account. A monetary instrument log is used to record and report cash purchases of traveler’s checks, money orders and cashier’s checks that have a value of at least $3,000. The currency and monetary instrument report is required when these monetary instruments are shipped or transported into or out of the country when the face value exceeds $10,000. Financial institutions that fail to comply with the Bank Secrecy Act face hefty penalties.
Base Erosion and Profit Shifting (BEPS) Project
Base Erosion and Profit Sharing, or BEPS, refers to the act of multinational businesses to actively exploit taxation gaps and regulatory loopholes in different jurisdictions or countries. Essentially, it is a type of tax-shifting strategy that is designed to lower the company’s tax liability. In the process, it erodes the tax base or tax revenue generation capabilities of countries with higher taxes.
The Organisation for Economic Co-operation and Development, or OECD, states that BEPS result in the loss of up to $240 billion in tax revenue per year worldwide. More than that, multinational corporations based in the United States are among the most significant beneficiaries of BEPS. One reason for the prevalence of this taxation strategy among U.S. multinational companies was related to the country’s global corporate taxation system. Many other countries operate with a territorial corporate tax system, which helps to offset the taxation gap. However, the United States passed the Tax Cuts and Jobs Act of 2017, which improved corporate tax rates on foreign-sourced income.
The OECD has launched the BEPS project to address this serious problem worldwide. Numerous measures have been suggested, and some of these have been adopted in various areas. For example, large multinational companies are required to report all revenue on a country-by-country basis, and this is conveyed to the appropriate tax revenue department or organization. It has also established transfer pricing rules with arms’ length requirements between parent companies and subsidiaries. The project has also had a positive effect on some established tax havens. For example, Mauritius has recently shifted its policies to require companies to contribute substantially to the local economy in order to take advantage of the country’s tax benefits. While these and other efforts are curbing some abuse of tax havens, multinational corporations are still able to take advantage of tax haven benefits in impacted areas by offering economic substance and by maintaining transparency.
Organizations that Fight Against Tax Havens
One of the most active, influential and effective organizations fighting against tax havens is the OECD. Its notable contributions include its BEPS project and the Automatic Exchange of Financial Information. In addition, national governments have actively worked toward tax haven reform. For example, the EU Savings Directive that passed in 2003 was designed to automate the exchange of financial information about its members. The United States government moved for a multinational approach with the passage of its Foreign Account Tax Compliance Act, which was reciprocated through Intergovernmental Agreements with France, Spain, the United Kingdom, Germany and Italy. The G20 has continuously focused on tax havens, such as through the establishment an automated standard for the exchange of financial information. Other multinational initiatives include the CRS Multilateral Competent Authority Agreement, the EU Directive on Administrative Cooperation and others.
The Global Forum has also worked in conjunction with the OECD for tax haven reform. These two organizations focus on ensuring that established standards are applied uniformly. The Global Forum also provides training for government officials as well as technical assistance to work toward cohesiveness and uniformity. This organization actively promotes the secure conveyance of automated financial information, and it is responsible for the establishment of a peer review process.
Because tax havens are heavily used by multinational companies around the world and are responsible for billions of dollars or more in collective corporate tax savings, these companies may need to take advantage of tax haven benefits in order to remain competitive. However, tax havens erode tax revenue generation capabilities in countries with higher tax rates. They also are particularly damaging to developing countries that do not have a solid and established tax base. Tax havens are a serious problem that have rightfully garnered ample attention for many decades, but they continue to be used and abused. Because this is a global problem that may continue until all tax havens have been eliminated, further collaborative efforts may be required to properly address the problem.