Offshore Tax Havens: Corporate Use, OECD Policy, and U.S. Reform

Why Tax Havens Are Appealing to Businesses

Many businesses embrace tax havens because they offer unique opportunities to avoid paying taxes and provide other financial benefits. While the United States currently has relatively weak laws preventing offshore tax havens, many experts expected this to change in the near future, particularly under the leadership of President-elect Barack Obama.

A tax haven is a country that has low taxes or, in some cases, no taxes at all. In some offshore countries, taxes are lowered in an attempt to help companies that are organized there but operate outside the country. These countries do so in order to attract foreign investment.

Individuals and businesses alike can take advantage of the benefits offered by tax havens, but it is primarily beneficial to corporations. Some people or companies exploit these benefits by moving to the haven country and establishing residency. Others create a corporation in that country and transfer funds and assets to that location. Once they have done so, all new income generated by the company or trust is subject to the tax laws of the haven country's jurisdiction.

United States businesses recognize and take advantage of tax haven financial incentives. In 1999, approximately 59% of U.S. multinational companies had affiliates in one or more tax havens (Desai, Foley, and Hines, 2006b). A tally of the overall property, plant, and equipment held abroad by American firms in 1999 reveals that 8.4% was located in tax havens — a significant figure given that such jurisdictions represent a small share of global investment.

In addition, foreign tax havens had unusually high concentrations of foreign employment. About 6.1% of total foreign employee compensation and 5.7% of total foreign employment were located in tax haven affiliates. U.S. companies placed 15.7% of their gross foreign assets in the major tax havens in 1999; those havens accounted for 13.4% of total foreign sales and 30% of total foreign income. A great deal of this tax haven income included money from foreign affiliates owned by parent companies indirectly through their tax haven affiliates.

The Increasing Popularity of Tax Havens

There are about 45 tax haven countries in the world today, all of which tend to be small, affluent, and well-governed (Hines, 2007). Some of the most popular include Ireland, Hong Kong, Luxembourg, and the Cayman Islands. Each of these countries attracts disproportionate shares of global foreign direct investment, which has resulted in unusually fast economic growth over the past few decades.

These countries attract U.S. investors by offering lower tax rates. According to Hines (2007), they allow investors to retain most of their locally earned pretax income, in the hope that foreign companies will invest heavily in their regions. They also present opportunities for investors to use tax havens to avoid paying taxes to the governments of other countries. "For individuals, who are taxed by their home governments on income earned in tax havens, tax avoidance typically entails willful income misreporting," according to Hines (2007, p. 3). "For businesses, tax avoidance can be accomplished by the use of financial arrangements, such as intrafirm lending, that locate taxable income in low-tax jurisdictions and tax deductions in high-tax jurisdictions."

Furthermore, companies have the option to adjust the prices at which affiliates from different countries buy and sell goods to one another. "Most governments require that firms use arm's-length prices — those that would be used by unrelated parties transacting at arm's length — for transactions between related parties, in principle thereby limiting the scope of tax-motivated transfer price adjustments," according to Hines (2007, p. 4). "In practice, however, the indeterminacy of appropriate arm's-length prices for many goods and services, particularly those that are intangible or for which comparable unrelated transactions are difficult to find, leaves room for considerable discretion."

This means that whenever a company completes a transaction with a tax haven affiliate, it can use that transaction to reallocate income from high-tax locations to the tax haven affiliates themselves, or possibly to other low-tax foreign locations. This makes it very lucrative for investors to seek out foreign tax havens.

Tax haven countries pose a threat to other countries around the world that rely on higher tax revenues to sustain strong economic activity. "Tax avoidance carries mixed implications for governments of nearby countries, since it may erode tax bases and therefore tax collections, implying that the greater economic activity associated with nearby tax havens might come at a high cost in terms of foregone government revenues," according to Hines (2007, p. 7).

OECD Statements on Harmful Tax Practices

1. They can erode the national tax bases of other countries;
2. They may alter the structure of taxation by shifting part of the tax burden from mobile to relatively immobile factors, and from income to consumption;
3. They can discourage taxpayer compliance and increase the administrative costs of enforcement; and
4. They may hamper the application of progressive tax rates and the achievement of redistributive goals.

In essence, when a tax haven country applies no or only nominal taxes on income — whether business or personal — residents of non-haven countries may "divert their investments and be free riders of the public goods available in their home countries," according to Almeida (2004). The non-haven governments are then pressured to shift the tax burden from mobile to immobile factors such as labor, consumption, and property. As a result, progressiveness and redistribution are undermined.

Today, it appears that both governments and the public are becoming less tolerant of tax havens. Tax havens were recently cast in a negative light when a major scandal in Europe was exposed, involving secret bank accounts in Liechtenstein (Francis, 2008). A multimillion-dollar sum was paid to an informer who disclosed hundreds of names behind tax-dodging accounts held by German business tycoons, approximately 100 American taxpayers, and tax avoiders from other countries. The IRS subsequently announced that it was "initiating enforcement action" against the 100 Americans involved, stating that "combating offshore tax avoidance and evasion are high priorities."

The Bush administration did little to prevent tax haven losses. However, it appeared that the incoming Obama administration would make changes to the law in the near future. Obama described Ugland House in Grand Cayman — a building home to thousands of tax haven corporations — as "the biggest tax scam on record." Many experts expected him to make an effort to close or limit tax havens.

Opponents of tax havens believe that shutting them down would raise substantial revenues and reduce the growing income gap in the United States between the wealthy and the middle and lower classes. This is largely because wealthy individuals are far more likely to use tax havens than those in lower income brackets.

Conclusion

Reporter Scott Cohn wrote a story about Enron, which created more than 600 partnerships in the Caymans — a British colony — but employed no one there and built no facilities (Irvine, 2002). However, the tax havens themselves were not the reason Enron failed. Cohn visited the Caymans and reported that many companies find them attractive.