Tax Havens: Shady Deals
Clemens Fuest, July 2011
The World Today, Volume 67, Number 7
Tax havens are commonly perceived as islands located somewhere under the tropical sun, where businessmen, lawyers and bankers engage in dubious affairs, escaping taxation and regulation in their home countries.
While there certainly are tax havens that correspond to this cliché, the real world of tax havens is more diverse, with various types of locations being used for different purposes.
The first of is a group of very small countries, frequently places like the Cayman Islands, Bermuda or Mauritius. Typically, these tax havens focus on the provision of legal and financial services, rather than the creation of large industrial production plants. The second type includes larger nations like Switzerland, Ireland, Panama or Hong Kong. These countries offer low taxes and a well-developed financial services industry, but are also locations for significant industrial production. Then there is a third and less well-known type of tax havens: areas of low taxation within countries that may otherwise have high taxes. This includes special enterprise zones and free trade zones, but also legal arrangements limited to certain types of firms. Some countries offer attractive tax arrangements to foreign investors which are not available for domestic firms.
What is it that makes countries become tax havens? Size is one factor. Small countries benefit more than large countries from offering low taxes because the business they can attract from other countries is large, relative to domestic activities. But being small is not enough. Political stability, a reliable legal system and good governance in general are of key importance. Countries with poor governance will never attract much foreign capital, even if they offer low taxes.
In recent years, tax havens have come under increasing critique. They are widely seen as helping firms and wealthy individuals from other countries to avoid and evade the taxes and regulations of their home countries. For instance, multinational companies may set up subsidiaries in tax havens, endow them with capital and lend money to their subsidiaries in more highly taxed countries. The interest paid would reduce taxable profits in high tax countries and generate profits in tax havens. This erodes tax revenue in the higher tax countries and intensifies tax competition by forcing other countries to reduce their taxes.
Another issue is that banking secrecy laws and a lack of cooperation between tax authorities allow residents of high tax countries to evade domestic taxation. The simplest way of doing so is to hold financial assets in an offshore bank account and avoid reporting the investment income to the tax authorities in the residence country. This is sometimes achieved using sophisticated instruments like foundations, trusts and offshore companies. Suspicion regarding tax havens has been fuelled by spectacular cases of tax evasion like that of the former CEO of the German company Deutsche Telekom, who was detected hiding millions of euros in a bank account in Liechtenstein.
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