You have been successfully running a business in the United States, since a few years now, and earning hundreds of thousands in profits. Yet, every time the company closes its accounts, you feel blue as you see a big chunk (21 percent) of the profits being taken away in the form of corporate tax! It’s not hard to understand why you feel the way you feel. No one likes to see their hard-earned money being given away to the government, while you’re left with a mere fraction of you thought you were working for. But, what can you do, right? You can’t get away with not paying taxes; that’s tax evasion, it’s illegal. However, you come across a news article stating that Apple, a trillion dollar company, pays less than 1 percent in effective tax rate! And your only question is, “How?” Well, it is through the (legal way of) economics of Tax Havens.
Tax havens are exactly what the name suggests; a place of refuge from taxation. In other words, it is a country, generally offshore, that offers no or low tax rates to corporations and individuals. However, that’s just the tip of the economics of tax havens. Countries must meet certain criteria to be classified as one. The Organization of Economic Cooperation and Development (OECD) has listed three such attributes for identifying tax havens –
- No or Nominal Tax rates: The most commonly heard of tax haven in movies and series, the Cayman Islands, has no corporate tax, no income tax and no capital gains tax. Even if not zero, the tax rates in havens are much lower than the average global rate. However, there is a difference between countries offering tax incentives to attract foreign investment, and tax havens who market themselves as “offshore financial centers” without any substantial economic activity. They earn not from taxes but through the licensing fees companies pay to create shell companies on paper.
- Protecting Personal Information: Most tax havens have laws in place that prevent them from disclosing financial information to foreign authorities. Tax havens have the added feature of allowing corporations to claim taxes without actually being present in the country. Thus, just putting their names on a paper allows corporations to reap the benefits of tax havens.
- Lack of Transparency: The legal and administrative mechanism in such countries is generally opaque, i.e. it is hard to know what is happening behind closed doors.
These characteristics make countries like the Bahamas, Bermuda, the British Virgin Islands, Caribbean Islands, Liechtenstein, Netherlands, Panama, Switzerland and many more, attractive to corporations and even individuals. There is no doubt that such a machinery could, and does, facilitate illegal activities like money laundering and sheltering law-breakers. In fact, most people associate tax havens with criminal activities. However, a tax haven, in itself, is not completely illegal.
The economics of tax havens and how they work allow one to “avoid” taxes, i.e. reduce tax obligations through legal means (probably loopholes), and not “evade” tax which involves providing false information about the income flows and thus, committing fraud. So, if you have a bank account at an off-shore location, the income entering this account isn’t taxable; but you’re still disclosing your true income and not doing anything illegal. As a corporation, you are free to set up a subsidiary of your company in a tax haven. Thus, all the sales made and income generated through this subsidiary are subject to the tax laws of the off-shore country, which are considerably lower than where your parent company might be situated.
Another way is to “sell” your patents and intellectual property, your most valuable assets, to your shell company. This way when your parent company, in say USA, uses the patent, it has to pay a huge licensing or royalty fee that lowers the profits and hence results in a lower tax bill. Thus, you save a larger chunk of what you make in an indirect way. So that’s how Apple does it too, but a lot more complex than this. It involves two offshore companies in Ireland (AOI and ASI), one in Netherlands (AOE) and finally shifting profits to British Virgin Islands, bringing the effective tax rate down to less than 1 percent! And Apple isn’t alone; Nike, Microsoft, Amazon, Goldman Sachs and many more such large corporations are making use of loopholes in the current tax systems. It is, however, important to understand that while using tax havens might not be out rightly wrong, they do have a huge impact on the world economy.
Tax havens cost the governments between $500 billion and $600 billion a year, in lost corporate tax revenue. The economics of tax havens is such that large multinationals are able to enjoy the fruits while the smaller enterprises are left to pick up after them. The tax revenue lost to tax havens is made up by increasing the taxes on individuals and small businesses. The economic divide increases further. The revenue lost cost the average American taxpayer $1,000 and average small business $3,000 in 2012. Not being able to bear the excess burden might eventually put them out of business leading to monopolization. Moreover, losing out on billions in tax revenue leaves governments with empty treasuries that deprive investment in infrastructure, healthcare and education, and makes tackling existential threats (climate change, Covid pandemic) all the more harder.
So, despite knowing how these companies do it and the economics of tax havens, why do they get away with it? One might wonder why don’t the authorities simply declare tax havens illegal, and ensure corporations pay the same tax rates as the rest of us. The truth is, being large corporations, they have a huge influence on the economies of not only the tax havens but also the high-tax jurisdictions. They contribute not only socially but also economically. Even though the governments are aware that such corporations do not pay the full taxes, they encourage them to set up branches in low tax rate countries as they create millions of jobs and also stimulate businesses in the surrounding non-haven countries indirectly. And if they were to chase corporations for taxes, the economy would lose not only jobs but also billions worth of investment and their economic contribution in the form of dividends.
This is not to say that corporations should not pay their share of taxes, but that there are other aspects to be considered and the impact they have on the global economy. Nonetheless, efforts have been made by OECD and G-20 to curb tax avoidance. The Tax Information Exchange Agreements make it compulsory to share tax information; Mutual Legal Assistance Treaties require cooperation in legal matters and criminal investigations; Automatic Exchange of Financial Information in Tax Matter program requires havens to transmit tax-related information on non-citizens to the native countries. These measures have seen a decrease in bank deposits in tax havens by 20 to 25%. Thus, the question now is – do we control tax avoidance and lose out on the economics of tax havens, or do we keep our jobs & investments and let them get away with lower taxes?
- “The Good and Bad about Tax Havens”, Tax Foundation, dated August 1, 2019
- “It’s time to change the way global tax works”, World Economic Forum, dated February 2020
- “Is Going Offshore Illegal?”, The Expat Money Show
- “Tax Havens: All you need to know”, Investopedia, dated June 25, 2019