OECD vs. Tax Havens, Part I: What Is A Tax Haven?

Recently, the OECD ramped up its conflict with tax havens by issuing a report titled, Action Plan on Base Erosion and Profit Sharing. Obviously, the purpose of this report is to provide a set of options that OECD countries can enact to counter the negative impact of tax base erosion, or the shifting of tax revenue away from developed/higher tax countries to lower tax/tax havens. But before I get to the report, a bit of background is necessary to provide some context to the conflict.

First, how did tax havens develop? As I noted in a post I wrote on my economic blog about the Cyprus situation:

First, let’s classify countries geographically. If you look at a map of the world and then look at the tax rates of most countries, the small countries — typically islands — have low to non-existent tax rates. The reason is actually pretty simple: they have small populations and small geographic areas. Hence, their need for tax revenue is greatly reduced (they don’t have a social safety net to pay for and they don’t have a great deal of infrastructure needs). This is why the islands in the Caribbean have become tax havens — a development made far easier because of electronic banking. And when low tax rates are combined with bank-secrecy laws, an entire industry is now born — offshore banking.

While these countries were bit players for the first half of the 20th century, their importance has increased as electronic commerce makes it far easier to form and manage companies from a distance and transfer certain types of assets through electronic or paper means. As the world economy become more integrated, these jurisdictions increased in importance, slowly draining tax revenue out of higher tax countries.

In response to this cash drain, the OECD issued a report called Harmful Tax Competition, An Emerging Global Issue in 1998. The report noted that as the modern economy developed, certain types of economic activities could be moved from higher tax to lower tax countries. Some of the more common structures include the following:

1.) Intellectual property centers: all Intellectual property is stored in an offshore company that is located in a low tax environment. The company’s branches pay royalties to the company, thereby draining cash from high tax countries to low tax countries.

2.) International finance centers: companies place all of their liquid financial assets in an offshore company which then provides financing to branches. Interest payments allow money to move from high tax countries to low tax countries.

3.) Offshore transportation registry: Companies with transportation sections place all of their transportation assets into an offshore company which then owns the various boats, planes and the like.

4.) Offshore e-commerce: a website located on a server is considered a permanent establishment for tax treaty purposes. Therefore, companies will house their websites on servers located in tax havens, creating a point of sale in the low tax jurisdiction and trapping profit there.

There are or course, many variations on the above along with others concepts.

The report also had to define a tax haven. They settled on with the following criteria.

1.) A low tax or no tax environment: this is an obvious main point that must exist. If the territory has 0% tax rate or a very low tax rate (say less than 10%), then it’s a good bet it’s a tax haven.

2.) Are there laws that prevent the effective exchange of information? If the home country can’t find out about a company’s activities in a jurisdiction, it’s highly likely that the company doesn’t want to have its activities discovered. This requirement also ties into another qualification: an overall lack of transparency. Secrecy also encourages certain types of activities such as money laundering and terrorist financing.

3.) The absence of a requirement that the activity be substantial. By now, we’ve all heard about the Cayman Island street address that is actually the home of over 1,000 companies. Obviously, no actual business is transacted at these locations; no meetings are held, no votes are taken no decisions are actually made. Instead, these companies only exist on paper, usually to house highly mobile company asset. The fact that no substantive business has to occur at these locations is very important, as it allows MNEs to create numerous paper companies.

4.) Does the jurisdiction hold itself out as a tax haven? Some places have an international reputation as an offshore tax haven. If a country says it is, it’s probably true.

5.) While the report notes that “failure to adhere to international transfer pricing principles” is an “other” factor, I would argue it’s a primary qualification — and one that exists in all tax havens.

There is hardly anything controversial in the above statements.

Next, we’ll look at the new report issued by the OECD.

In accordance with Circular 230 Disclosure

Mr. Stewart has a masters in both domestic (US) and international taxation from the Thomas Jefferson School of Law where he graduated magna cum laude. Is currently working on his doctoral dissertation. He has written a book titled US Captive Insurance Law, which is the leading text in this area.

He forms and manages captive insurance companies and helps clients in international tax matters, US entity structuring, estate planning and asset protection.

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