Tax havens and the game of hide and seek

Insight into cross border tax practices of multinationals

Tax havens have attracted increasing attention from policy-makers and governments globally. Do these structures belong in a modernised economies?

The recent ‘Panama Papers’ scandal illustrated how wealthy individuals and companies have taken advantage of ‘tax havens’ or ‘secrecy jurisdictions’ and managed to keep their financial affairs relatively private.  However, the concept of using a tax haven with an attractive tax regime and a high degree of secrecy is an age-old notion used legitimately for tax planning purposes.

Inherently, tax havens are countries or jurisdictions offering certain tax benefits such as lower tax rates, credit mechanisms or deductions resulting in limited or no tax being levied on certain profits. Generally, tax havens offer businesses less red tape than other countries that have complicated exchange controls, labour and equity requirements. This contributes to the overall ease of doing business in these countries.    

There is no question that some individuals and companies may use tax havens illegally purely to evade tax. This usually involves creating shell companies or “letterbox” companies with no economic activity in order to hide profits and benefit from lower tax rates than in their true home jurisdictions. This could force companies to consider the reputational consequences of their actions. Nevertheless, tax havens can be used legally in tax planning where profits are properly attributable to the tax haven and sufficient economic substance is maintained. For example, companies seeking to operate within a tax haven should, in essence, be managed and controlled from that jurisdiction and have sufficient operations that can justify their tax residency. Consequently, many multinationals may find it attractive to take up their headquarters or perform certain activities within a tax haven to achieve a more favourable tax position than if these activities were undertaken in another jurisdiction. 

Globalisation has led to large corporations extending their structures across foreign boundaries with a considerable thought on the future tax implications. Different countries tax profits in different ways, some have lower or no withholding tax rates and others do not levy taxes on certain transactions. One of the most popular ways tax havens is being used by multinationals is for the protection and exploitation of intellectual property. In this way, intellectual property is held offshore and licensed to other group entities in various countries. All foreign sales and licensing fees will then be attributable to the tax haven. In some cases, licensing fees may be subject to royalties’ withholding tax at a rate much lower than the corporate tax rate in those jurisdictions. This makes it more tax efficient to hold and manage the intellectual property centrally via an entity situated in a tax haven. Therefore, tax havens have made efficient tax planning for multinationals achievable with relative ease.

One may wonder why tax havens allow individuals and companies such advantageous tax benefits and the associated secrecy. Most tax havens are not largely industrialised and do not require the enforcement of a large tax base. These havens maintain attractive tax regimes and minimum formalities to attract foreign investment, create employment opportunities and to encourage a transfer of skills to their jurisdiction.  However, these countries have also encouraged unfair tax competition due to a reduction in the tax base of other countries where taxes would have been due and payable. 

The Organisation for Economic Co-operation and Development (OECD) has developed various actions plans to combat tax Base Erosion and Profit Shifting (also known as BEPS).  The BEPS project is aimed to reduce schemes used to shift profits offshore, often to tax havens. One of these measures is country-by-country reporting, which requires large multinationals to report their global tax affairs to their local revenue authority for information exchange with other revenue authorities.  Through this, transparency will be enhanced and tax administrations will have adequate information to assess transfer pricing and base erosion risks. More importantly, transfer-pricing rules are combatting the improper allocation of group profits and expenses across borders by enforcing arms’ length principles. BEPS is now taking it further by applying pressure to all tax havens that are attracting foreign investors without requiring any economic substance.  

In light of this, world-renowned tax havens, such as Mauritius, have started to implement substance requirements to combat tax haven abuse. Much of these substance requirements relate to having a local presence in the tax haven as well as maintaining effective management and control from within the jurisdiction. Consequently, companies are denied any tax benefits where these requirements are not met.

In light of the BEPS action, plans and the drive for increased information exchange through country-by-country reporting, tax havens can still be used legally by multinationals. This can only be achieved where companies are willing to operate transparently with sufficient economic substance and are prepared to put the appropriate structures in place.

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