'Offshore', 'tax havens' and international tax rules – some background to the 'Paradise Papers' controversy

This note, written by an experienced tax adviser, aims to provide dispassionate background information on the “offshore” world – particularly as it affects private individuals - and how that world interacts with the UK's tax system. In doing so it aims to bring some light to some of the phrases and concepts at the heart of the debate sparked by the “Paradise Papers”. The note takes a Q&A format.

What is a tax haven?

A tax haven is surprisingly difficult to define.

The obvious definition is a country which seeks to attract international business by offering low or zero tax rates.

But the problem with that definition is that almost every country in the world, including Britain itself, offers tax incentives to attract international business.  Offering tax incentives is not confined to small islands in the Caribbean or off the British coast. Indeed many countries which have well developed tax regimes, such as Luxembourg and Ireland, and on occasion the UK itself, are described as tax havens by tax campaigners when focussing on particular incentives that these countries have adopted.

So a better definition might be a country which offers low or zero taxes to international business but which is also unwilling to share information about the transaction with the authorities back in the person’s home country.  In short a country which does not comply with international information sharing norms.

Can I find a list of tax havens anywhere?

Using the above definition, a good place to start is with what HMRC call “Category 3” territories.  See here.

These are countries which do not comply with international norms in the tax arena (and for which much higher penalties are charged if tax is later found to be due.[1]

But NOT on that list will be most of the usual places people might think of as tax havens:  Jersey, Guernsey, Isle of Man, Gibraltar, Bermuda, Bahamas, Barbados, BVI, Cayman etc.  These are all either category 1 or category 2 territories.

The Crown Dependencies (Jersey, Guernsey, Isle of Man) and British Overseas Territories would – with some justification – object to the term “tax haven” because, they will ask, “how does our offer of low tax rates differ from Britain's own offer of low tax rates?”  They prefer the term International Financial Centre (IFC).

The list of category 3 territories also needs to be read with some caution as a number of countries currently in category 3 have committed to a new international standard – the Common Reporting Standard (CRS) – by the end of 2018 and so will come off the list.  See further below

Are these countries loosely regulated?

Regulatory questions are really beyond the CIOT’s remit.  However, it would be fair to record that most IFCs have well developed regulatory regimes and many would strongly assert that in some respects they are more highly regulated than the UK or other so-called ‘onshore’ centres.

What information is shared between tax authorities?

Sharing of information internationally between tax authorities is a developing field and, as technology has improved and capital become more internationally mobile, information-sharing has also developed.

For decades, countries have had bilateral tax treaties with each other.  These regulate not only the amount of tax payable (to try and prevent double taxation of the same income/gains/capital), but usually contain a "mutual assistance” procedure where the tax authorities of one country can ask for the assistance of their counterparts in the other.  It would be fair to say that the mechanism for invoking such assistance was and is cumbersome.

More recently, within the last decade, there has been a drive for countries to create Tax Information Exchange Agreements (TIEAs).  These fulfil a similar role to “mutual assistance” but with less administrative hassle.  All of the Crown Dependencies and British Overseas Territories will have had TIEAs in place for several years.  However, it would be fair to note that TIEAs are reactive rather than proactive: information is only shared on request.

Automatic (proactive) information sharing between countries has taken longer to implement because the information systems to do this cannot be implemented overnight.  However, as a result of a US-led initiative - the Foreign Account Tax Compliance Act (FATCA) - many countries now have bilateral arrangements whereby financial institutions in a country will automatically provide client-data to the other country (either directly or via their home country's tax authorities).   FATCA has now been in place for the last two years (and in some cases longer).

FATCA (which is a series of bilateral agreements) is being superseded in most cases by the Common Reporting Standard (CRS) which is a multilateral agreement.  The UK and all the Crown Dependencies and British Overseas Territories are either already signed up to CRS or have committed to doing so by the end of 2018.  Signatories to CRS can be found here:  

The USA is currently not a signatory to CRS.

I can see that this information is shared between tax authorities, but is it also available to journalists or to the public?

In most cases no.

This has led to some criticism from tax campaigners.

IFCs would point out that the UK itself has no publicly available register of trusts and, until recently, has had no public register of the beneficial owners of companies[2].

The UK has recently implemented a register - known as the Register of Persons with Significant Control (PSC) - of the ultimate ownership of companies and is implementing a register of the ultimate ownership of real estate.  It is also implementing a register (but not a public one) of the beneficiaries of trusts.  However, the UK has gone out on a limb in this respect and the Crown Dependencies and British Overseas Territories appear unlikely – for fear of losing business to other non-UK IFCs -- to implement similar measures until there is international consensus on this. The most common argument for not requiring details of ultimate ownership to be made public is a general right to privacy.  Additionally, in some cases there is a genuine concern about the risk to families (e.g. from kidnapping), especially in countries where the rule of law is patchy.

How did tax havens (IFCs) come about?

Every country in the world has always had the sovereign right to set its own tax rates.  And every country has the right to seek to attract international business by doing so.

The modern development of IFCs really started after World War 2.  The UK found itself with a series of impoverished Crown Dependencies (Jersey, Guernsey, Isle of Man - particularly the former two which had been occupied during the war) and overseas territories (e.g. Caribbean islands) which the UK had, given its own post-war position, few means of supporting.

The idea developed of allowing those countries to develop financial services as a way of supporting their economies.

With improved travel and communications and subsequent advancements in IT, these countries prospered.  The idea was soon copied by others.

Why do we allow tax havens?

This is as much a political, economic and constitutional question as a matter of tax insight. However there appear to be three broad historical reasons.

First, because every sovereign country is allowed to set its own tax rates.  This is a fundamental principle of international relations.  One country should not be allowed to set the tax rates of another. Even colonies gained almost total control over their tax systems as the idea developed that they should be expected to evolve toward independence.

Second, because if - ignoring the first point - these countries were not allowed to attract financial services business, many of them would need development aid themselves.  The recent hurricanes in the Caribbean have shown just how impoverished some of these countries would be without a financial services industry.

But third, and possibly most importantly, because IFCs play an important role in the world economy without which a lot of international trade would not take place.

What role do IFCs play in the world economy?

It may seem counter-intuitive to some, but IFCs do play an important role in the world economy – which is undoubtedly why they have been permitted to survive.

The role they play is allowing complex international transactions to be co-ordinated without an additional layer of tax as a result.

To take an example, a town in the UK wants to build a new shopping centre at a cost of say half a billion pounds.  You won't find any one person with that sort of money lying around.  But you will find plenty of people willing to invest in the UK real-estate market.  Those people might include pension funds, sovereign wealth funds in the Gulf, wealthy middle-eastern individuals, industrial conglomerates in Europe, investors in the USA.  All of these need to be co-ordinated - a "fund" needs to be put together.

Each of these people will be taxed in their home country according to their home country’s rules.  And the shopping centre will be taxed in the UK in accordance with the UK's rules.  The last thing that investors want is a third layer of tax in the place where this is co-ordinated.  That might be the difference between a project proceeding and not proceeding.

IFCs allow the co-ordination of international transactions without any extra tax costs on top of those imposed in the home countries.

So long as the IFC complies with international information-sharing norms (see above) so that the home countries can tax in accordance with their own rules then it is difficult to see what there is to complain about in this.

It should be noted that most ‘onshore’ jurisdictions provide ‘approved’ vehicles of various descriptions to allow investments of various kinds to take place on a largely tax exempt basis on the basis that the appropriate tax will be charged when the investor gets their return. For example, in the UK there are pension funds, investment and unit trusts, and Real Estate Investment Trusts. You can argue that these compete with IFCs (and many do, to varying extents), or that they remove the need for IFCs (which ultimately they could do, although many of these ‘vehicles’ operate with commercially cumbersome conditions and it takes considerable time and effort for legislators and administrators to get the design of these right).

The Olympics as an analogy

Probably one of the most complex international transactions is the Olympics.  Athletes, coaches, medics and support staff; suppliers; sponsors and advertisers will come from more than 200 countries.

Each of those countries will tax in accordance with their own rules.  A US sponsor of a Jamaican sprinter will have US and Jamaican tax consequences of that sponsorship. 

The last thing that athletes want is for the host city to impose another layer of tax, form filling and the possibility of double-taxation.

This is why the Olympic movement insist, as a condition of awarding the Olympics to a city, that that country creates a tax-free zone around the event.  The UK did just that in 2012.

This isn’t to say that the Olympics isn’t taxed.  Everyone is taxed in their home country according to their home country’s rules.  The tax-exemption just allows the event to take place without an additional layer of tax.

So surely you’re not saying that everything is perfect with tax havens?

No. As the Paradise Papers, and the Panama Papers before them, have shown, there are undoubtedly situations where structures involving IFCs are used inappropriately.  It is important, however, to distinguish the different ways in which this happens.

First, there are situations where taxpayers and advisers simply get the law wrong.  For instance a person might mistakenly believe themselves to be not resident or not domiciled in the UK – and therefore to be outside the UK system altogether - when in fact they are so resident or domiciled.  In situations like this – and given the complexity of the UK’s tax system it is easy to make innocent mistakes – it is not really a question of evasion, avoidance, mitigation or otherwise.  It is simply ineffective – and the tax, together with interest and sometimes penalties, needs to be paid.

Second, there are situations where advisers find a way of saving tax which is legal but clearly contrary to the intention of Parliament (i.e. had Parliament thought about it, it would have drafted the law differently).  The professional rules of CIOT and the other main tax and accountancy bodies in the UK would prevent advisers from giving such advice, but it is possible that the unregulated might seek to create such structures.  When challenged by HMRC such schemes generally fail on technical grounds, but – on the odd occasions when they are effective – the behaviour falls short of criminal activity.  Such structures may include offshore elements.  Sometimes the offshore provider is unwittingly involved; sometimes not.  The issue here, however, is really with the UK’s own rules rather than an offshore problem per se.  Such avoidance often involves UK structures as well as offshore ones.  This is not solely an offshore problem.

Third, and most seriously, there are situations where criminals seek to find ways to conceal their true intentions or the true position, either to evade tax or to hide and launder dirty money.  But, again, this is not solely an offshore problem.  To use an analogy, some criminals drive cars; but not all criminals are car drivers, and not all car-drivers are criminals.

It is reasonable to expect that with increased international information sharing – particularly the “Common Reporting Standard” - that the opportunities for this sort of abuse (both avoidance and criminal activity) will be greatly reduced. In particular the incentive to spread avoidance schemes across multiple jurisdictions to make it harder for a single tax authority to see the full picture should be much diminished. But it is important to recognise that much depends on the data analytic capability of the authorities – this challenge will be quite a different one to that which they traditionally have had, of knowing anything of what is going on at all. Now they will be getting masses of data, and their key task will be making sense of it and seeing the wood for the trees.

What is the difference between tax evasion and tax avoidance?

Tax evasion is criminal.  Tax avoidance is legal.

That distinction is as old as tax, but it isn't the most interesting one.  The more interesting question these days is where, along the spectrum, sensible tax planning becomes morally unacceptable tax avoidance.

The UK has, over the last few years, gone some way to try and answer that question.  The UK now recognises at least four different categories:

Tax evasion – criminal

Tax "abuse" – something which no reasonable person could consider to be reasonable - and since the "General Anti-Abuse Rule" (GAAR) in 2013 - now ineffective

Tax “avoidance” – something which is contrary to the intention of Parliament – legal but morally questionable. HMRC frequently challenge this activity in the courts and enact legislation to close it down.

Tax “mitigation” – taking advantage of a relief which Parliament has specifically granted in the way in which Parliament intended you to do so.

Part of the difficulty with the current debate is that “tax avoidance” is often used as a catch-all term for the last three categories without distinguishing between them.

Notes 

[1] Category 1 territories are those which comply fully with international norms.  Category 2 (to which intermediate penalties apply) are for countries which comply sufficiently with international norms or have committed towards working to do so.

[2] Details of the registered owner of shares have been available from Companies House for some time.  However, the registered owner may not be the same person as the true “beneficial” owner – in the same way, for instance, that the registered keeper of a car may not be the true owner of it.

By John Barnett. John is a Tax Partner at Burges Salmon and a member of the Council of the Chartered Institute of Taxation