2 Tax havens: categorisation and definitions

This chapter first discusses the concept of tax havens and how different institutions interpret the concept. It then provides a description of harmful structures in states that are not categorised or regarded as classic tax havens. The interaction between such structures within and beyond tax havens is important to understand how tax havens damage other states.

The Commission has not proposed a precise definition of the term “tax haven”, but takes the view that the combination of secrecy and virtually zero tax terms characterise such jurisdictions. Secrecy means both rules and systems that, for example, prevent insight into the ownership and operation of companies, trusts and similar entities, and the opportunity to register tax-free shell companies that actually conduct their business in other countries.

2.1 What is a tax haven?

“Tax haven” is not a precise term. No generally accepted criteria exist for determining the elements which should be given weight in classifying tax havens. The concept, therefore, finds no application in international law or national legal texts, but appears in certain legislative proposals which seek to authorise measures to counter harmful structures and the lack of information-exchange in tax cases.

Nevertheless, “tax haven” is a well-known and frequently used expression in the media and in everyday conversation. It is applied imprecisely to states characterised by the adoption of unusually low tax rates – either for their whole economy or for shell companies with foreign owners.

As a classification criterion, the tax base and level of taxation are complex to deal with. Countries which have traditionally levied high rates of tax have also introduced favourable tax arrangements in certain areas 1 – permanently or for defined periods – for certain taxpayers or taxable objects. Such solutions are generally a result of strong pressure groups, specific political preferences or special governmental needs. The justification may be, for example, that the arrangement is required in order to attract capital or that other countries have similar systems. Over time, therefore, the tax base and tax rates may be transient values in many states.

“Tax haven” is often used as synonymous with or an alternative to “offshore financial centre” (OFC) and “secrecy jurisdiction”, which reinforces the lack of clarity. No consensus exists on which functions must be exercised for a state to be characterised as an OFC.

Tax havens wish to present themselves as professional “financial centres”. This term is in itself so imprecise that such a categorisation provides no meaning. A “financial centre”, for example, could be a place where companies and other legal entities are registered but where no decisions are made on the acquisition or sale of financial assets or transactions between various parties. It is important to point out that very little of the value creation in the financial industry occurs in classic tax havens, but takes place overwhelmingly in major financial centres such as London, New York and Frankfurt. Given the requirements set in international financial markets for size, location, level of education, general infrastructure and expertise, most of the classic tax havens have no capacity to provide advanced financial advice.

Tax havens are occasionally described as “offshore” states, with activity in the structures which earn them this designation termed the “offshore sector”. Use of the “offshore” expression can give a false impression of tax havens as island states. This term reflects the fact that the operations which can earn them their tax-haven status observe their own rules, and not those applied for the rest of the country’s economic activity. Viewed from that perspective, the legal rules which govern this business are an “island” in relation to the rest of the legal system.

The Commission’s mandate uses the term “secrecy jurisdictions”. This is applied to jurisdictions with strict secrecy regulations. All states have such rules to protect important private and public interests in the community. Tax havens distinguish themselves by the way the regulations are formulated and the strength of their protection. Many have special legal provisions to enhance the duty of confidentiality that applies to the employees of banks and other financial institutions in respect of their relationship with clients. Secrecy is often reinforced by the absence of public registries containing significant information about companies and other legal entities conducting economic activity. The registries are often particularly deficient for companies that intend to pursue operations exclusively in other states. In addition, the information which might be available is difficult to access, even through collaboration with other states based on legal assistance agreements. See chapter 3 below for further details.

Regardless of the definitions used, the principal objections remain the same. The regulatory regime is constructed in a way which caters to circumventing private and public interests in other states – in other words, those states where the owners of the companies are domiciled or have their obligations. The tax base in other states is particularly affected, but structures in tax havens are in many cases also suitable for concealing a number of other forms of criminal activity.

Depending on the definition chosen, the world currently has between 30 and 70 “tax havens”. This implies that 15-30 percent of the world’s states might be classified in one way or another as tax havens. The Commission has not found it appropriate to produce a list of tax havens. Relatively clear criteria for defining tax havens would be required, along with an extensive assessment of domestic law in a number of states. The Commission would nevertheless emphasise that it is hardly difficult to distinguish classic tax havens from states that regulate certain sectors in ways similar to the regulations found in classic tax havens. Secrecy rules and lack of transparency, in particular, represent the biggest differences.

The Commission has found it more appropriate to identify key systems which have been adopted in classic tax havens and which, in the Commission’s view, are particularly damaging for other states. Furthermore, it describes how and why these are suitable for misuse and for causing loss and harm to public and private interests in other states. The main purpose is to demonstrate how these systems harm developing countries, but they can also be very damaging to developed countries.

The Commission’s classification of tax havens has many features in common with the criteria presented in the OECD’s 1998 report on Harmful Tax Competition: An Emerging Global Issue . This document discusses how a tax haven should be defined. The OECD identifies the following characteristics of these jurisdictions:

1. very low or no tax on capital income

2. a special tax regime for shell companies (ring-fencing)

3. a lack of transparency concerning ownership and/or lack of effective supervision

4. no effective exchange of information on tax issues with other countries and jurisdictions.

The second of these characteristics means, in reality, that tax havens create laws and systems through ring-fencing which primarily effect other states. This is a fundamental problem with tax havens. The first characteristic, concerning low or no tax on capital income, helps to make tax havens attractive, but it is the combination of this and the other distinguishing features which make them so damaging to other countries. What forms of taxation and levels of tax should apply to the state’s own citizens and within its own jurisdiction must be a decision for each sovereign state alone. The problem is that the damaging systems in tax havens primarily have a direct effect on the taxation rights of other countries, with income which should have been taxed where the recipient is domiciled, for example, being concealed in the tax haven. The sovereignty principle does not extend to granting freedom from tax on income which is wholly or substantially liable to tax in other states, even though it might seem that only recognised legal principles are being applied.

The Commission would emphasise that the damaging structures in tax havens not only influence tax revenues in other states. These structures are also suitable for conducting and concealing a great many forms of criminal activity in which it is important to hide the identity of those involved, where the crimes are being committed and what they involve. This includes such activities as the illegal sale of valuable goods, art, weapons and narcotics, human trafficking, terrorism, corruption, theft, fraud and other serious economic crimes. Generally speaking, the structures are suitable for laundering the proceeds of criminal activity. In Chapter 5, moreover, the Commission describes how the characteristics listed above collectively have major consequences in other countries, in particular for developing countries because they weaken the quality of institutions such as the legal system, the civil service in a broad sense and democratic processes.

2.2 Harmful structures in other states

The Commission would point out that the classic tax havens are not alone in promulgating systems that cause loss and harm to public and private interests in other states. Many countries possess elements of damaging structures, but they often do not have the full range of structures such as those found in fully-fledged tax havens.

Of particular significance are various pass-through arrangements. These undermine the tax base in both source and domiciliary states with the aid of intermediate companies (often a holding company) which have little or no commercial activity in the pass-through state. A case in point is the Netherlands. Data from the Dutch central bank reveal the scope of special financial institutions (SFIs). These are mainly shell companies suitable for undermining the tax base of other states. Their overall assets totalled EUR 4 146 billion as of 31 December 2008. Direct investments from the Netherlands accounted for just over EUR 2 200 billion, with the SFIs accounting for more than EUR 1 600 billion. That put the Netherlands in second place on the list of OECD countries with the largest direct investments, just behind the USA. Of the world’s total direct investment, 13 percent is invested in Dutch SFIs.

The Netherlands is probably the largest and most popular pass-through state in the world today. 2 The precondition for the pass-through model to function is that the pass-through company can be seen as domiciled under the tax treaty in the Netherlands and that the company is considered the beneficial owner, which means that it is the rightful owner of the income that passes through. This is often difficult to discover by states that are harmfully effected without access to information from the pass-through state. Since the Netherlands does not permit the same level of secrecy as tax havens, the Dutch holding company system is often combined with the use of companies in tax havens. The Netherlands is, therefore, a popular registration location because it confers legitimacy and also has an extensive network of tax treaties.

A number of other states not regarded as tax havens also permit pass-through companies which can damage the tax base in other countries by allowing artificial and commercially unnecessary companies to be inserted between the source and domiciliary state.

Some countries have introduced regulations which provide that foreigners who move there only pay tax on income earned locally, while revenue from other sources is regarded as tax-free – at least for a certain period. A significant difference nevertheless exists. This system applies to people who move to the jurisdiction, while the owners of international companies in tax havens are domiciled in other states.

There are also other examples of harmful structures outside of the tax havens. A number of countries have introduced types of companies which are exempt from audit requirements and/or charged little or no tax on specified tax bases. 3 These often involve company structures suitable for engaging in activities with structures based in tax havens and with states which have established a large network of tax treaties.

Certain states permit very harmful secrecy rules, even though they cannot be regarded as classic tax havens. 4 Examples include Switzerland and Luxembourg. These countries have recently agreed to establish tax treaties with information exchange also for suspicion of tax evasion, but traditional secrecy will continue for countries that do not have these treaties, including developing countries.

The same effect achieved by strict secrecy regulations is secured if lawyers (with an absolute duty of confidentiality) are permitted to act as nominee shareholders in limited liability companies. Generally speaking, the use of lawyers as advisors and facilitators for structures in tax havens reinforces the problems of uncovering criminal behaviour. This form of activity by lawyers falls outside the justification of their duty of confidentiality – in other words, the protection of communication with their clients in certain circumstances.

Taken together, a substantial number of states cause harm to other states by permitting arrangements which affect or undermine legal systems in the other states. These include the Netherlands, the USA (Delaware), the UK and Belgium. 5

2.3 How different institutions define the tax haven concept

Certain organisations have formulated relatively precise criteria for what identifies tax havens, OFCs, secrecy jurisdictions and the like, and have compiled lists of jurisdictions based on these criteria. This section presents some examples of such lists.

2.3.1 The OECD

The OECD began to work seriously on the issue of tax havens in 1996 as part of its activity related to tax issues. A list of 40 jurisdictions characterised as tax havens was drawn up by the organisation in 2000. 6 This list was based on the criteria in OECD (1998). The OECD changed its work in this area during 2001, and the 2000 list has not been used or updated. See table 2.1. A weakness of the list is that the OECD’s member states are not included.

In recent years, the organisation has concentrated its efforts related to tax havens on “harmful tax systems” and agreements on information exchange related to taxation. By the end of April 2009, all jurisdictions had expanded their agreements regarding the exchange of information, and the OECD consequently no longer considers any jurisdictions to be “non-cooperative tax havens”.

In connection with the G20 meeting in April 2009, the OECD compiled a list which divided countries and jurisdictions into four categories based on their declared willingness to enter into agreements on information exchange over tax issues as well as the actual establishment of such agreements. One of the four categories covers tax havens, as defined by the OECD in 2000, that have entered into many tax treaties. Jurisdictions which satisfy many of the criteria formulated by the OECD in 1998, but which have concluded many tax treaties, are grouped with the majority of OECD members (including Norway). Since the 2009 list is not based on an assessment of whether the jurisdictions are suitable for concealing assets and capital income or for money laundering, the list cannot be regarded as a categorisation of tax havens.

2.3.2 The IMF

The International Monetary Fund (IMF) has taken a completely different approach to secrecy jurisdictions from that taken by the OECD in recent years because it has a programme related to money laundering and financial monitoring in OFCs. The IMF has described the characteristics of OFCs in a number of contexts, and lists OFCs which have been invited to collaborate with the IMF. The organisation nevertheless lacks a clear definition or official list of OFC jurisdictions. A working document from the IMF (Errico and Musalem 1999) provides a list of 69 jurisdictions designated as OFCs. IMF (2008) contains a list of 46 jurisdictions that have been invited to collaborate on supervision and money laundering and to report data. The 2008 list is presented in table 2.1.

2.3.3 The US Senate Bill – Stop Tax Haven Abuse Act

A bill designated the “Stop Tax Haven Abuse Act” is before the US Senate. It was previously voted down, but it might now be re-introduced. The proposal includes provisions which give the tax authorities greater powers to pursue tax issues related to a specific list of secrecy jurisdictions. It also contains definitions of such jurisdictions, so that individual jurisdictions may be removed from the list or new ones added. The list of secrecy jurisdictions includes 35 countries. The principal criteria for being characterised as secret is that:

“(the jurisdiction) has corporate, business, bank, or tax secrecy rules and practices which, in the judgment of the Secretary, unreasonably restrict the ability of the United States to obtain information relevant to the enforcement of this title.” 7

The wording “this title” in the quotation above must be understood as taxation related to the foreign capital income of American citizens.

The bill contains amplifications of the main criterion, but provides room for the exercise of judgement. However, certain specific criteria are also provided to define secrecy jurisdictions. These include the categorisation of jurisdictions with “regulations and informal government or business practices having the effect of inhibiting access of law enforcement and tax administration authorities to beneficial ownership and other financial information” 8 as secrecy jurisdictions. One possible interpretation of this provision is that countries which establish forms of ownership without mandatory registration of beneficial ownership in registries to which the authorities can obtain access through a court order will be regarded as secrecy jurisdictions. Even countries with such systems which enter into an agreement on the exchange of tax information with the USA will continue to be regarded as secrecy jurisdictions if they do not establish registries of beneficial ownership.

The bill’s list of secrecy jurisdictions was not compiled by the direct application of its own criteria. The selected jurisdictions are identical to those which the US Internal Revenue Service (IRS) asked the courts to request access to with regard to credit cards use by Americans. The IRS had a justifiable suspicion that Americans were using these jurisdictions to avoid tax. As a result, the list does not include secrecy jurisdictions which are little used by Americans in this way. More jurisdictions would probably have been defined as secret if the bill’s criteria had been applied in a systematic manner. See table 2-1.

2.3.4 Tax Justice Network

The Tax Justice Network (TJN) is an organisation that works to promote understanding of the significance of taxation and the harmful effects of tax evasion, tax competition and tax havens.

Tax Justice Network (2007) Identifying Tax Havens and Offshore Financial Centres contains a list which includes all the jurisdictions on the OECD’s tax haven list as well as all those considered by the OECD to have a “potentially harmful tax regime”. It also incorporates countries which the TJN found were being recommended by websites involved in the marketing of tax planning.

2.3.5 Comparisons of various designations

Jurisdictions included on all four of the lists are fairly small countries or partly autonomous regions. On the other hand, the TJN list also includes relatively populous countries such as Switzerland, the Netherlands, South Africa and Singapore, as well as the world’s largest financial centres – New York and London. 9

2.3.6 Discussion of designations

As noted above, “tax haven” as a term is neither precise nor well-defined. Furthermore, the term is often used together with offshore financial centre and secrecy jurisdiction. The lack of precision in the use of concepts results in differing categorisations. In addition, actual categorisations by international organisations are affected by the desire of many states to prevent their designation as a tax haven. Designations by international organisations are also partly the result of negotiation-like processes. As a result, for example, the OECD’s 2000 list does not include any of its member countries.

The Commission takes the view that certain jurisdictions have regulatory regimes and systems that provide good opportunities for evading tax in other countries, for money laundering and for evading economic liability. It is countries and jurisdictions with such systems that the Commission would characterise as tax havens. A number of countries and jurisdictions have regulatory regimes which accord with all the general characteristics of tax havens cited above, but many more meet only one or a few of these criteria. The damaging effects for other countries can occur even though only some of the criteria are met. A few examples can illustrate this point.

• The Netherlands exchanges information both through an extensive network of tax treaties and through the EU’s savings directive. The Netherlands imposes a 30 percent tax on interest income and 25 percent on dividends from companies in which the taxpayer has a large equity holding. Consequently, the Netherlands fails to meet characteristics one and four in the above list. Nevertheless, the Netherlands can be regarded as a tax haven because it has regulations which allow companies to reduce their tax in other countries by establishing shell companies there (van Dijk et. al 2006). The Netherlands has amended some of its tax regulations and is in the process of phasing others out, so that the damaging effects can be reduced, but it could still be regarded as a tax haven for multinational groups.

• Individuals and companies that want to evade tax, launder money or evade economic liability find it attractive to be able to establish companies under false or concealed identities. Such companies become particularly attractive if it is also possible to open an associated bank account. In a test to determine how simple it was to establish companies under false names, Professor Jason Sharman found that it was easier to do this in countries such as the USA and the UK than in many countries normally regarded as tax havens. 10 Generally speaking, a number of countries not considered to be tax havens have regulations and practices which are well suited to committing various types of economic crime.

• Gordon (2009) reviews 21 cases involving economic crime committed by “politically exposed persons”. Many of these involve the creation of shell companies in order to conceal the criminal activity and its proceeds. In half of the cases, the companies are established in countries which Gordon does not regard as tax havens.

The Commission has not had the opportunity to review the laws and regulatory practices in all of the countries where these issues are relevant, and for that reason it cannot present all the nuances of these issues. Instead, the Commission will devote chapter 3 to presenting what it means by harmful structures and to demonstrating how these are constructed in many tax havens.