11 October 2009

Tax havens: A modest proposal

Posted for the tech-illiterate Hank Scorpio:

1. History

Tax havens date back to medieval Europe and were originally set up as a safe place to bank your cash at a time of civil and international turmoil. If Dan Brown is to be believed, the Knights Templar owed much of their power and prestige to providing financial services to those going on Crusades or pilgrimages to locations where law enforcement agencies were unregulated to say the least.

In modern times, the first recognisable tax haven was Switzerland, which offered a secure home for rich refugees from Bolshevik Russia and Nazi Germany. Its neutrality in the Great War afforded it a unique status in Central Europe inasmuch as it did not have to finance massive rebuilding of its infrastructure, which meant that it was able to keep its taxes much lower than its neighbours. Adopting neutrality again in the Second World War cemented its economic stability and its "no questions asked" policy about the source of the money, or Nazi gold, it sheltered, made Switzerland immensely attractive to investors with more cash than scruples.

2. Tax havens defined

The key features of a tax haven are:

(i) nil or nominal taxes;
(ii) lack of effective exchange of information with foreign tax authorities;
(iii) lack of transparency in legal or administrative processes;
(iv) no pernickety insistence that its "customers" should actually be based in the country;
(v) self-promotion as an offshore financial centre

The OECD has formally identified 72 countries as tax havens, of which 30 are Commonwealth countries or Crown dependencies. These include the Isle of Man, which has no capital gains tax, stamp duty or inheritance tax. The top rate of income tax is 18%, and payments are capped at £100k p.a. Although nominally independent and self-governing, the Isle of Man has no need to worry about including anything in the tax bill for defence spending, as the UK guarantees the island's security. And health and dental care are conveniently provided by the NHS. So, UK taxpayers are effectively subsidising the island, allowing it to attract business away from the mainland by offering cut rate income tax and virtually no corporation tax.

It's not all good news for the Manxpersons though. Jeremy Clarkson lives there.

The UK itself is arguably a tax haven, though it might not feel like it for us poor wage-slaves. The IMF, not exactly a refuge for bleeding heart liberals, has had the temerity to apply the tag to us, thanks to the City's burgeoning role in providing tax avoidance schemes and resisting international calls for greater financial transparency.

3. Globalisation and the growth of tax havens

Deregulation of financial services in the last 25 years has opened the door to a huge expansion of global trade. Capital has become ever more mobile as financial transactions have been made easier by the fax, the internet etc. It is no longer necessary to be physically present in a country to take advantage of its services. As Barack Obama said in 2007

"There's a building in the Cayman Islands that supposedly houses 12,000 US corporations, which means it is either the largest building in the world or the biggest tax rip-off in the world, and I think we know which one it is."

The vast increase in the wealth of a tiny elite is testimony to the "success" of globalisation as it has exploited the mobility of capital with the connivance of tax havens, which shamelessly prize secrecy over decency.

In his 2007 book, 'Capitalism's Achilles Heel", Raymond Baker said

"For the first time in the 200-year run of the free market system, we have built and expanded an entire integrated global financial structure the basic purpose of which is to shift money from poor to rich...In my reading of history and in my judgment, this reality is the ugliest chapter in global economic affairs since slavery."

4. Tax avoidance/ tax evasion

The difference between the two was famously described by Denis Healey as "the thickness of a prison wall", and the truth is that the lines have become increasingly blurred. What is clear though is that the existence of tax havens as a vehicle through which income can be channelled and therefore taxed, disproportionately favours those who are wealthy enough to access the expertise of dodgy accountants.

In 2007, Grant Thornton, an accountancy firm, calculated that the UK's 54 billionaires paid income tax totalling just £14.7M on combined wealth of £126Bn.

According to a report by Christian Aid in 2008, "a full 50% of world trade is reported to take place through tax havens."

Clearly, the good folk in these tax havens aren't doing much in the way of creating the goods and services on which this trade is based. However, the useful service they provide to global corporations is a PO box and a local lawyer to whom contracts can be faxed, and thus the tax (stamp duty, corporation tax etc) is charged at local rates as opposed to those that apply where the corporation is truly based or where the work is actually carried out.

A typical example of avoidance in this area is transfer pricing, by which a corporation will sell goods or services to a subsidiary company in a tax haven. In doing so, the corporation can set the price so that it incurs a loss on the deal in its home jurisdiction while inflating its profit in the tax haven. As the tax haven is likely to have nominal corporation tax at best, the actual level of global profits can be manipulated to ensure that balance sheet losses occur where the tax liability would be heavier.

Given that 60% of all global trade is now reckoned to take place between corporations and their subsidiaries, the amount of tax lost here is immense. The OECD has estimated that anything between $1 trillion and $1.6 trillion is illegally exported by companies and individuals every year, and transfer pricing is one of the predominant means by which it's done.

5. Money laundering

Money laundering involves transferring money between accounts to disguise its true origin, typically that it's the proceeds of crime. Because tax havens have bank secrecy laws, protecting the confidentiality of their clients, they are the most popular route for organised criminals and terrorist groups to launder their money.

It's pactically impossible to calculate how much money is laundered through tax havens each year, although estimates range from $500Bn to $1 Tn.

The social impact is huge: it helps to ensure that crime does indeed pay for drug traffickers and mafia groups, helping them to expand their operations, leading to more drugs on the streets, in turn leading to more violence and crime. The tax lost means that the rest of us have to pay higher taxes to cover the shortfall and to finance the policing of more criminal activity. And of course it means that terrorist activity is better financed and thus more sophisticated and difficult to combat.

When it emerged that nine of the 9/11 hijackers had been financed through money laundered through Dubai, one might have expected the Emirates to have been in for a rough time.

To put it bluntly, Dubya was characteristically wrong when he named the countries forming an Axis of Evil. The War on Terror would have been more effectively waged if he'd trained his guns on Switzerland, the Caymans and elsewhere and told them that they either give up the criminals or face the consequences.

6. The future

The recent G20 conference focussed heavily on tax havens and their complicity in the financial crisis. The OECD has started publishing black, grey and white lists of all countries based on their cooperation with international measures to open up the corporate books. A number of jurisdictions, such as Liechtenstein, Jersey, the British Virgin Islands and the Bahamas have recently signed agreements with the UK Treasury on sharing information.

There are encouragng signs that the days of the tax havens could be numbered as the financial crisis deepens and the wisdom of international cooperation becomes evident. But until every tax haven is required to give up its secrets, the rich and powerful will continue to exploit that secrecy and the rest of us will pay to varying degrees.