6 The scale of tax havens and illegal money flows from developing countries

The Commission’s mandate encompasses a discussion of both legal and illegal money flows from developing countries to tax havens. A number of estimates of such flows have been made. Since the illegal flows by definition embrace funds which either have been acquired though crime or represent breaches of the law per se , they will be largely channelled outside official systems or concealed in other ways. Partly because of rules on the burden of proof and limited investigatory resources, statistics of crime revealed through the justice system will only represent a small fraction of the actual level of criminal activity. Given this, therefore, no direct measurements of such flows exist.

Tax havens publish few statistics which help to estimate the scale of illegal money flows and the holdings of various forms of assets.

This chapter presents various data and analysis which can throw light on the scale of illegal money flows from developing countries and on the size and distinguishing features of tax haven economies.

Tax havens are characterised by the fact that a large part of their activity is pure pass-through – in other words, the operations are owned and managed in other countries. In addition, the financial industry often has a disproportionate significance. This is illustrated in this chapter through various statistical indicators.

6.1 Scale of illegal money flows

6.1.1 Methods – highlights

For natural reasons, the scale of illegal money flows cannot be measured precisely. Instead, they must be estimated by methods which involve a substantial degree of uncertainty. It is even more difficult to estimate illegal money flows from developing countries and how large a proportion of these go to or pass through tax havens.

The weaknesses of the various measurement methods mean that it is advantageous to avoid relying on any one method and, instead, compare estimates produced by different approaches in order to draw conclusions on the basis of a variety of indicators.

In the main, two methods are relevant:

1. combining an estimate of the scale of illegal transfer pricing with one covering other flows based on figures from national accounts

2. measuring the amount of capital placed in tax havens and calculating income from these holdings.

A number of the methods reviewed below are limited in their ability to identify opportunities for manipulation within multinational companies, variations between gross and net figures for foreign trade in the national accounts, and so forth. In the Commission’s view, this suggests that these methods will often underestimate the scope of capital flight and illegal money flows. The following methods for estimating capital flight will be presented by the Commission:

1. direct estimates of proceeds from crime and tax evasion

2. use of national accounts data to estimate unregistered capital flight

3. methods for measuring manipulated transfer pricing

4. measuring the value of assets in tax havens and using the results to estimate unregistered income.

Below, the Commission refers to studies which use these methods to estimate either capital flight from developing countries or the scope of financial activity in developing countries.

A weakness with some of these methods in relation to the Commission’s mandate is that they are unsuitable for estimating total illegal money flows. Direct estimates (item 1 above) aim to assess income from all types of illegal activity. The methods in item 2 could be suitable for estimating all unregistered capital flows other than those which occur through manipulated transfer prices. As a result, the methods under item 2 are usually supplemented by separate estimates for transactions concealed through transfer pricing (item 3). The method in item 4 has been used to estimate concealed income through the return on the assets of individuals placed in tax havens. This can detect unregistered income from assets in tax havens and can be interpreted as an expression of accumulated illegal flows over a period, but not as an estimate of current income other than the return on holdings in tax havens or additions from other illegal activity.

6.1.2 Estimates – main points

Despite the uncertainties noted above, the Commission believes it can conclude that the scale of illegal money flows from developing countries to tax havens is very large, particularly viewed in relation to the size of developing country economies and tax bases. The most complete estimates indicate that the combined illegal capital flight from developing countries represents between six and 8.7 per cent of their GDP. By comparison, tax revenues for the poorest countries amount to about 13 per cent of GDP.

Income transfers through manipulated transfer prices probably account for the largest part of the illegal money flows from developing countries. Analyses carried out through the DOTS method (see section 6.1.6) on the basis of trade statistics indicate that the scale of manipulated transfer pricing in trade to and from developing countries amounted to roughly USD 500 billion in 2006. This corresponded to 6.5 per cent of foreign trade for these countries. Weaknesses in the method suggest that it yields an underestimate of the real scale.

Gross registered capital flows to developing countries totalled USD 571 billion in 2006 (World Bank 2007). Donor grants accounted for USD 70 billion of this. Estimates from Kar and Cartwright-Smith (2008) indicate that illegal money flows from these countries totalled USD 641-979 billion in 2006. Even the lowest estimate indicates that the illicit capital outflow is larger than the gross legal inflow. Illicit capital outflows correspond to about 10 times the total development assistance going to these countries.

The estimates above apply to all illegal money flows from developing countries. Not all of these go to tax havens. No estimates are available for the proportion of illegal money flows from developing countries which go to tax havens specifically.

Nor are any estimates available for all illegal money flows to tax havens. However, it has been documented that placements by private individuals in such jurisdictions are very large, and that a big proportion of the capital placed there is not declared for tax. TJN (2005) estimates that placements by affluent individuals in tax havens amounted to NOK 10-12 000 billion in 2004. Official statistics indicate that the scale of such placements increased strongly in subsequent years, but the financial crisis has probably led to a reduction over the past year. Few data are available for estimating how large a share of these placements derive from developing countries. Cobham (2005) has assumed that 20 per cent of placements derive from developing countries. If so, this would mean that USD 2 200-2 400 billion has been transferred from developing countries to tax havens. This represents four years of gross capital inflow or more than 30 times the amount that the developing countries receive in the form of assistance. However, this estimate of illegal money flows does not include flows to tax havens from such activities as manipulation of transfer prices. These flows are probably significantly larger than the amount of income tax evaded on capital placements by private individuals.

6.1.3 More on different methods for estimating the scale of capital outflows

In this section, the Commission will discuss in greater detail the four methods mentioned in the introduction to this chapter for estimating the scale of illegal money flows between tax havens and other countries. The subsequent section sums up various efforts to quantify such money flows.

6.1.4 Direct estimates of proceeds from crime and tax evasion

Directly estimating the proceeds from crime and tax evasion is a simple method in principle, but one which involves considerable difficulties in practice relating to the identification of suitable data. The method involves using statistics and experience to answer the following questions:

• how extensive are various types of criminal activity in the economy?

• how large are the proceeds obtained by the criminals from this activity?

• how large a proportion of these proceeds is laundered?

• how is money laundering divided between the various countries/jurisdictions?

Statistics of charges, judgements and so forth can be found for certain types of criminal activity and in some countries. These can be used to support the estimates. In addition, substantial experience will be available through staff involved with law enforcement, customs service and the tax authorities. Figures from certain countries as well as research results on the relationship between other social conditions and the extent of criminal activity can be used to estimate the scale of crime where data or systematised police experience are not to be found. Similarly, selected individual cases related to money laundering can be used to identify the forces driving the choice of laundering locations.

The strength of this method lies in the fact that:

• it is intuitive

• it links criminal activity in one country with money laundering in another.

This method can also contribute to checking the consistency of other estimates based on completely different sources of information. The scope of money laundering in one jurisdiction, for example, can be either estimated directly or calculated with the help of estimates for the proceeds of crime and the proportion of these proceeds laundered in various forms and areas. In certain cases, a number of estimates can thereby be made of the same phenomenon. Such “triangulation” provides a basis for checking the consistency of different estimates.

The big drawback with this method is that it virtually assumes that the difficulty of finding suitable data has been overcome before one starts. It primarily comprises a summation of finalised estimates for various components of illegal capital flows. For examples of the application of the method, the Commission would refer to the website of Australian professor John Walker. 1

6.1.5 Using figures from national accounts

National accounts are built on the principles of double-entry bookkeeping, which means that the same amounts can be generated in a number of ways. “Income”, for instance, can be calculated from the input side (income formation) or by measuring “use of income”. Stocks can also be calculated directly or from the original stock plus/minus net investment/disinvestment and possible revaluations.

However, national accounts contain errors and deficiencies. Calculating income from both input (earnings) and output (use of income plus/minus changes in assets) sides, for instance, will not yield exactly the same figures. This creates various types of “unexplained discrepancies”. In certain cases, it is reasonable to assume that these are due to systematic errors – which arise, for example, because certain activities or transactions are consciously under-reported. In other cases, it can reasonably be assumed that unexplained discrepancies are entirely due to various types of unintended and more accidental measurement errors.

In principle, a country’s income surplus with other countries (current account surplus) should correspond to changes in its net asset balance (net assets and liabilities and the net stock of direct investments) with other states. Countries with well-developed systems for national accounting register the current account balance, net capital inflows and outflows, and stocks of and changes in various forms of assets and liabilities. However, the change in net national wealth will not correspond exactly to the surplus/deficit on current account. An item for “net errors and omissions” is accordingly included to ensure that the national accounts add up.

If the national accounts for a number of countries are compared, discrepancies can also be found in amounts that should have been identical but actually differ. (Commodity exchange between two countries should be identical in both countries’ trade figures, for example.) It has been known for many years that, according to national accounts statistics, the world has run a deficit on current account with itself. What this means is that outgoings on current account to all the countries in the world are larger than the income. In theory, total income and outgoings for all countries should be identical. When an unexplained discrepancy recurs year after year, it is reasonable to assume that this reflects either a fundamental error in the methodology or a form of deliberate erroneous reporting by some groups. A number of analyses are based on the assumption that part of the statistical variation in the balance of payments data can be attributed to capital movements which are not directly registered.

This provides the general foundation for three different methods which are all based on the use of national accounts to estimate illegal money flows. These three methods are presented in more detail below.

6.1.5.1 The hot money method

This approach has acquired its name because it focuses on capital considered to be particularly volatile.

It rests primarily on the assumption that the residual item of net errors and omissions in the balance of payments is an expression of capital flight. Transactions by governments and banks are excluded, on the assumption that these institutions are not involved in capital flight.

The balance of payments measures a country’s income surplus and net wealth against other countries. In principle, changes in net wealth should roughly correspond to the income surplus. If the latter is larger than the registered growth in net wealth, the explanation could be that assets have been transferred out of the country and invested without having been recorded with the authorities.

Both positive and negative statistical variations can unquestionably arise in the balance of payments without illegal capital transactions being involved. The most important reason for a discrepancy is probably measurement errors which occur without the deliberate provision of deficient or erroneous information. To reduce the danger that measurement errors are interpreted as capital flight, variations of the hot money method have been developed which ensure that only large and stable discrepancies are interpreted as an effect of capital flight. Furthermore, variants exist which exclude various items in the balance of payments. These rest on an assumption that certain types of financial transactions are not used for illegal activity.

6.1.5.2 The Dooley method

This approach gets its name from its originator, Michael P Dooley.

It builds on an assumption that one can properly register income from legitimate foreign placements. 2 For the first year of the calculation period, net foreign liabilities are calculated either from stock figures in the national accounts or by estimating liabilities from net financial expenditure abroad together with an assumption of the income yielded by various assets. Changes in net liabilities are then calculated with the aid of the balance of payments and the net errors and omissions item for each year ahead. Finally, an estimate for legal and registered positions is extracted with the aid of net capital income and expenditure and assumptions for the income from various assets. Placements which do not yield income are regarded as capital flight. For the method to provide good estimates, it is crucial that correct estimates can be produced for the rate of return on various types of international capital positions. This method does not appear to have been used in recent years.

6.1.5.3 The residual method

The name says it all. This method builds on an assumption that unexplained (residual) growth in net liabilities is due to capital flight. While its technical basis is largely the same as for the hot money method, the residual approach does not distinguish between which sectors are involved in the transactions or which instruments are used. All statistical discrepancies between the current and capital accounts in the national accounts are therefore regarded primarily as an expression of capital flight. However, some studies exclude certain observations which are believed to be highly likely the result of chance, measurement or similar errors as opposed to capital flight. This is done by eliminating figures which fail to show a certain level of systematic correspondence with the hypothesis concerning the direction of capital flight.

Balance of payment figures can be used to produce estimates with this method. Nevertheless, some studies use other sources where these are considered to provide better data quality.

6.1.6 Methods for measuring manipulated transfer prices

The transfer pricing term is used in two ways. One refers generally to all transactions within one and the same group. The other applies the term to the transfer of income between different group entities by pricing intragroup transactions differently from the normal market price or from the price which would have been paid by independent players.

Determining prices for transactions between different entities in a group is very necessary. Intragroup pricing can become open to criticism and/or illegal if prices are set in order to transfer income to reduce the group’s overall tax obligation. Most countries prohibit concealed transfers of income between different parts of a group by setting artificially high or low prices for intragroup transactions. This violates both accounting principles and/or tax regulations.

The Commission has opted to use the term manipulated transfer prices for various forms of inaccurate pricing of intragroup transactions intended to move income between group entities.

Transfer pricing is a subject for both theoretical and empirical studies related to corporate behaviour and taxation. This research applies methods which cannot be used in practice to estimate the total scale of income transfers to low-tax countries through manipulated transfer prices. No dataset exists which could be used to produce a global estimate.

The three different methods based on figures from national accounts presented in the previous section are not suitable for detecting illegal income transfers through manipulated transfer prices. To establish an overall picture of money flows, these methods must be supplemented by calculations related to manipulated transfer prices.

At least three methods of transfer pricing take place:

1. income transfer with the help of intragroup pricing

2. income transfer to third companies by amending invoices

3. income transfer to third companies through supplementary invoices.

The first of these methods involves implementing a transaction between two entities within the same group at an artificial price so that profits are transferred from one entity to the other. Exposing such transfers, which are illegal under most countries’ tax or accounting regulations, calls for an independent assessment of whether the price of the underlying delivery is reasonable in relation to the market price of corresponding deliveries or to production costs. Alternatively, one can use the level of profit in the various group companies as an indication of whether prices for transaction between them are unreasonable. It is not unusual for multinational groups to have companies in tax havens which are credited with income, for example, from the use of the group’s name, patents and so forth. Issues related to such transfer pricing are very common in all multinational companies which have activities in different tax regimes, including those outside tax havens. In Norway, which has different rules and rates for ordinary income tax and for the taxation of such activities as shipping, power generation and petroleum operations on the Norwegian continental shelf, transfer pricing problems can also be encountered within the country as long as the company has operations in different areas of activity.

The second method of income transfer listed above involves the transaction passing via a company which is part of the same group as the seller (most commonly) or buyer of the delivery. The delivery is sold first to a shell company (located in a tax haven, for instance) and then from there at different (normally higher) price. That ensures an income transfer to the shell company from the rest of the group. This form of transfer pricing can be exposed by comparing the invoice price from the exporting country with the price charged to the importing country, or by making an assessment similar to that made under the first method for the first part of the transaction.

Income transfer under the third method means that the main delivery is made at a low price. In addition, an invoice showing an excessive price is sent to the importer from a shell company in the same group as the exporter. This will again transfer income to the shell company from the exporter. To expose this type of income transfer, one must normally use the first method – in other words, documenting that a delivery has been made at an unreasonable price or that the outcome in the enterprises is unreasonable.

In addition to the three above mentioned methods, it is common to transfer income between group entities by adjusting their financing costs. A multinational company, for example, can use an internal bank in a tax haven to secure deductions for interest payments made on debt by subsidiaries in high-tax countries, achieving a tax arbitrage gain from differences between nominal tax rates. Companies are also partly able to manipulate interest rates used in such transactions. In that case, the actual assessment of the interest rate must use the same method applied to assess illegal transfer pricing. Both debt-equity and net profit ratios can be used as indicators for this type of transfer pricing. Efforts to reduce incentives for making such adjustments in tax regimes with high tax rates and the presence of branches and subsidiaries of international groups – as in the Norwegian oil industry, for example – include rules against thin capitalisation.

A number of methods exist for detecting and estimating income transfers through manipulated transfer prices. These approaches differ over the forms of manipulation they can detect. Most of them require very high data quality. As far as the Commission has been able to establish, no country can use data directly from public registries. Supplementary information is required in order to use the methods. 3 The requirements for data quality mean that the methods used for research into manipulated transfer prices cannot be applied to produce global estimates of such income transfers. Appendix 3 presents part of the research in this field, including studies of manipulated transfer prices in developing countries.

Global estimates of income transfers through the manipulation of transfer prices are produced by using international trade statistics. This approach is termed the DOTS method by some. 4 It builds on comparing trade statistics from import and export countries respectively. One often finds that data for imports by country A from country B do not coincide with the value of exports from country B to country A. In principle, these two amounts should be identical (assuming that transport and handling costs as well as customs duty have been eliminated).

In cases where data from two countries fail to match, the typical assumption is that trade statistics from industrial countries are correct while the figures from developing countries contain errors. Where they arise, differentials are interpreted as capital flight concealed by under-reporting of income in developing countries.

The assumption that statistics are mainly accurate in industrial countries and often erroneous in developing countries is supported to some extent by Almendingen et al (2008). This study compares data on Norwegian trade with Jamaica and Iceland respectively. Detailed trade statistics are compared to see if each country’s export data are consistent with the relevant trade partner’s import figures. The study indicates that consistency is good between Norwegian and Icelandic data, but weak between Norwegian and Jamaican data. Jamaica’s export figures are often lower than Norwegian data for imports from Jamaica.

As a result, the main trend supports an assumption that transfer prices for export deliveries from Jamaica to Norway are used to conceal income which would have been liable to Jamaican tax, but the findings are not statistically significant.

The DOTS method will only detect transactions where deliveries are repriced between the export and import location. Cases could also occur where the player or players do not need to show different prices at the two registration points. The specified value could then be the same at both points, but would diverge from the regular market price.

6.1.7 Estimating untaxed assets hidden in tax havens

This approach is used to estimate the scale of wealth placements by foreigners in tax havens and the return on these assets. One problem with the method is that tax havens often produce no statistics of assets placed with them by foreigners. The Tax Justice Network (TJN, 2005) has largely utilised estimates produced by international consultancy and audit companies. How these estimates are produced has not been made public, but the companies can be assumed to possess information through their role as advisors to financial institutions and investors. The TJN has also produced other estimates from official data (BIS), supplemented by estimates for other types of placements.

No information is available on the return achieved by investors on their placements in tax havens, nor on the proportion of this income declared to the relevant tax authorities. The TJN assumes that investors achieve normal market returns on these assets and that the bulk of the income is untaxed. Both these assumptions appear to be reasonable.

American data for direct investment suggest that the return on investment in tax havens is rather higher than for investment in other countries (see Figure 6.1). It is reasonable to suppose that the high return on investment in tax havens reflects the manipulation of transfer prices, so that the tax base is higher where taxes are at their lowest – in other words, in the tax havens.

¹ Rate of return is calculated as income in percent of the stock of direct investments measured at historical cost. Country grouping is based on OECD (2000)

Source The Commission"s calculations based on U.S. Direct Investment Abroad: Balance of Payments and Direct Investment Position Data, The Bureau of Economic Analysis (BEA)

The assumption that assets placed by private individuals in tax havens are not declared for tax in their country of domicile is supported by a number of recent cases. These have provided insights into how large a proportion of the wealth of private individuals is reported to the tax authorities in their country of domicile. The report from the investigation into the UBS case in the US (see US Senate, 2008) shows that 95 per cent of the UBS clients who opened an account in a tax haven failed to declare the existence of this account to the tax authorities. The UK tax authorities gained access in 2006 to a list of depositors with the tax-haven branches of a major bank. Of the almost 10 000 British depositors, only 3.5 per cent had provided account information to the tax authorities (see Sullivan, Martin A. (2007): Keeping Score on Offshore: UK 60 000, US 1 300, Tax Notes , 7 July 2007).

6.1.8 Statistics and actual calculation results for the various methods

The Commission is not aware of any written publication of calculations based on direct estimates of proceeds from crime (see section 6.1.4) or of relatively new estimates based on the Dooley method (section 6.1.5.2).

The only estimates which are reasonably up-to-date and suitable for identifying capital flight from developing countries in particular combine the residual and DOTS methods (see sections 6.1.5.3 and 6.1.6 respectively).

In relation to the Commission’s mandate, these studies have the weakness that they cannot identify the extent to which tax havens are used to conceal capital flight. The scope of tax haven use has been clarified to some extent through data on financial balances in these jurisdictions. These data are far from complete, however, and the lack of information on the proportion of the assets deriving from developing countries is, accordingly, a weakness from the Commission’s perspective.

6.1.9 Capitalism’s Achilles Heel

The heading for this section is the title of a 2005 book by Raymond Baker, based on data for 2004 and earlier. This volume presents a number of estimates of capital flight from developing countries.

Baker carried out an interview-based survey to identify tax evasion through transfer pricing in multinational companies. The management of 550 companies was interviewed on the use of manipulated transfer pricing in cross-border trade. 5 Baker concludes that 45-60 per cent of all international transactions related to the sale of goods and services take place at manipulated prices. Erroneous pricing in these transactions account for 10 to 11 per cent of the value. On this basis, Baker concludes that transfer pricing accounts for five to seven per cent of world trade.

Baker also concludes that capital flight from developing countries amounts to USD 539 to 778 million per year, corresponding to six to 8.7 per cent of GDP in all developing countries during 2004. His estimates are not based on a single method, but on an overall assessment of a number of different studies and methods.

6.1.10 Ndikumana and Boyce – estimate of capital flight from Africa

Ndikumana and Boyce (N&B, 2008) have estimated capital flight from Africa. They emphasise that these estimates are confined to capital movements related to breaches of law, but assume that the bulk of the flows relate to criminal activity. The estimates embrace unregistered capital movements and erroneous invoicing of trade flows. N&B use what Kar and Cartwright-Smith (2008) describe as the residual method combined with the DOTS approach. Their study presents estimates for individual countries from 1970 to 2004. In addition to estimating capital flight, they analyse the link between the foreign debt of the countries and capital flight as well as the connection between structural features of national economies and economic policies on the one hand and the scale of capital flight on the other.

The scale of capital flight is estimated as the sum of unexplained increases in net foreign debt and assumed erroneous pricing in foreign trade. Estimates for erroneous pricing build on the normal assumption that trade data for the industrial countries are accurate. Generally speaking, the method is based on interpreting the difference between industrial states’ imports from Africa (in accordance with statistics from industrial nations) and Africa’s exports to the industrial states (as specified in statistics from the African countries) as an expression of capital flight. An identical approach is used for African imports from developed countries.

The results indicate that capital flight varies sharply from year to year and between countries. Accumulated over the 1970-2004 period, capital flight is estimated at USD 420 billion (converted to 2004 prices). With calculated interest accumulation, capital flight is assumed to total USD 600 billion over the same period. This corresponds to almost three times the total foreign debt of the countries concerned.

According to the analyses, a positive statistical correlation clearly exists between capital flight and debt. N&B believe that 62 per cent of the debt accumulated by African countries during the period flowed straight out in the form of capital flight. Furthermore, according to N&B, it seems that capital flight is self-reinforcing: high capital flight in one year appears to stimulate capital flight the following year. High economic growth and low inflation seem for their part to reduce capital flight. The real rate of interest (relative to the international level) does not appear to have any effect. Nor does the development of the financial market in the countries (measured as lending by financial institutions relative to GDP). The study finds no correlation between the size of exports of petroleum and other non-renewable resources and capital flight – in other words, the problem of capital flight is not confined to nations which would be characterised in other contexts as suffering from the “resource curse”.

6.1.11 Kar and Cartwright-Smith (2008)

Kar and Cartwright-Smith (2008) discuss various methods, and estimate capital flight from developing countries from 2002 to 2006. They also use various filters to exclude arbitrary effects. These include eliminating estimated capital flight from a country if the calculation does not yield positive figures for such flight in three out of five years and if average capital flight amounts to less than 10 per cent of the country’s exports.

The authors apply both the hot money method and two variants of the residual method. These approaches give an estimate for capital flight from the developing countries in 2006 of USD 337 to 939 billion. The hot money method provides a substantially lower estimate than the residual approach. According to the authors, data problems make the hot money method unsuitable for such calculations in many developing countries. The variants of the residual method yield estimates of USD 641 to 939 billion for 2006.

Calculations for each year in the 2002 – 2006 period are also presented in the study. The conclusion is that capital flight increased by about 150 per cent from 2002 to 2006. These calculations indicate that the growth was fairly steady, but particularly strong in 2002-2003 and 2005-2006.

No complete country-by-country breakdown is provided by the report, but figures are presented for regions and for the 10 countries with the biggest capital flight. Not surprisingly, given their income from international trade, China and Saudi Arabia top the list for capital flight. Capital flight from China is about four times larger than the figure for Saudi Arabia. Sub-Saharan Africa accounted for three to four per cent of total capital flight. This corresponds well with the calculations of N&B (see the previous section), which reflects the fact that the methods employed in the two studies are closely related and that they use many of the same data sources.

6.1.12 The Price of Offshore

This heading is the title of a report from the TJN in 2005. The report is based on a number of sources for assets held in tax havens, including annual surveys of the assets of wealthy private individuals ( Global Wealth Report from Boston Consulting Group and World Wealth Report from Merrill Lynch/Cap Gemini). Use is also made of banking statistics from the Bank for International Settlements to support the view that financial assets of wealthy private individuals in OFCs total USD 9-10 000 billion. Other claims (including the ownership of companies in OFCs) are roughly estimated to total about USD 2 000 billion. Furthermore, the annual return on these assets is assumed to be seven to eight per cent. That makes income from these assets about USD 860 billion. Assuming that such earnings would normally have been liable to tax at 30 per cent, assets placed by wealthy private individuals in tax havens represent an estimated annual loss of roughly USD 255 billion in tax revenues.

A. Cobham (2005) uses part of the same data. He assumes that the proportion of assets in tax havens belonging to residents of developing countries is similar to the share of these countries in world GDP (20 per cent). Based on the estimates and assumptions in The Price of Offshore , he then calculates that the developing countries as a whole lose about USD 50 billion per annum from the use of tax havens by wealthy individuals to evade tax.

The method used in The Price of Offshore – estimating the return on assets placed in tax havens – can only be used to estimate one type of illegal money flow. This is the failure to pay tax on income from assets transferred to a tax haven which should have been taxed in the owner’s country of domicile. Based on the results of the other methods mentioned above, income transfer through the use of transfer pricing is the dominant form of illegal money flow. The method used in The Price of Offshore would not register this at all. That is because the method only detects the estimated return on holdings and not additions to these holdings through transfer pricing. Moreover, the method is partly based on data which relate exclusively to the assets of individuals rather than companies. One could also well imagine that companies have financial income which they do not declare for tax. Nor is the growth in assets through transfer pricing the only aspect which fails to be detected. The method in The Price of Offshore will generally be unsuitable for detecting gross flows to and from holdings in tax havens. One must assume that drawings are often made on these holdings in the form of consumption, or where the owner completes a money laundering process by transferring assets to locations where their ownership is no longer concealed behind the secrecy rules of a tax haven.

6.2 The economies of tax havens

6.2.1 Market share for banks in tax havens

As mentioned above, official data on the scale of placements in and from tax havens are very limited, and such information is not in itself an estimate of illegal behaviour but illustrates the size of financial activity in tax havens.

In a report from 2000 (IMF, 2000), the IMF estimated that 50 per cent of international positions in the world’s banks are held by banks in OFCs. See the discussion of the various definitions of tax havens in chapter 2. The IMF utilises a broad definition of OFCs in the report, which includes London, Dublin, the Netherlands, Singapore and Switzerland.

Data from the Bank for International Settlements (BIS) can be used to illustrate how the position of tax havens as financial centres has changed over time. These statistics are based on bank balances in countries which report to BIS, but only includes the international positions of the banks. Over time, BIS has persuaded a growing number of countries – and particularly tax havens – to report data.

As noted earlier in the Commission’s report, no unambiguous definition exists for which countries and jurisdictions should be regarded as tax havens. Whether the major financial centres, such as London, Singapore, Luxembourg, Dublin, Hong Kong and the Netherlands, are included is particularly important when assessing the scale of international banking operations in tax havens. These centres are regarded as tax havens (or secrecy jurisdictions or OFCs) by some but not by others. The figures below show data for tax havens based on both narrow and broad definitions of these jurisdictions.

Figure 6.2 shows that positions in tax havens expanded strongly until the financial crisis contributed to a contraction in 2008. The BIS banks have net debt with tax havens – liabilities exceed assets. This probably reflects the fact that many placements in tax havens involve the establishment of shell companies, trusts, foundations and so forth, and that some of the assets in such entities are deposited in banks.

¹ Aruba, Bahamas, Bahrain, Barbados, Belize, Bermuda, British Overseas Territories, Cayman Islands, Cyprus, Dominica, Gibraltar, Grenada, Guernsey, Hong Kong, Isle of Man, Jersey, Lebanon, Liechtenstein, Luxembourg, Macao, Malta, Mauritius, Netherland Antilles.

Source Bank for International Settlements

Although there has been strong growth in the absolute level of positions between tax havens and BIS banks, the tax havens’ share of the total positions of the BIS banks has not actually increased. See also Figure 6.4, which shows the proportions for a narrow and broad definition of tax havens respectively.

If the UK, the Netherlands and Ireland are included in a broader definition of “tax haven”, a higher proportion of positions are naturally found with tax havens. But the pattern is otherwise the same since the end of the 1990s. See Figure 6.4.

¹ Aruba, Bahamas, Bahrain, Barbados, Belize, Bermuda, British Overseas Territories, Cayman Islands, Cyprus, Dominica, Gibraltar, Grenada, Guernsey, Hong Kong, Isle of Man, Jersey, Lebanon, Liechtenstein, Luxembourg, Macao, Malta, Mauritius, Netherland Antilles. Panama, Samoa, Singapore, St. Lucia, St. Vincent, Switzerland, Turks and Caicos Islands, Vanuatu, West Indies Great Britain, Netherlands and Ireland

Excluding inter-bank positions, placements from tax havens account for just over 25 per cent of liabilities in the BIS banks (deposits and borrowings). See Figure 6.5. The tax haven share showed a rising trend until 2003, but has since been relatively stable. The proportion of the BIS banks’ assets (loans, securities, etc) in tax havens has tended to rise over time, but has never exceeded 20 per cent of total assets.

The BIS figures could be used as an indication of which tax havens are the largest and how the extent of tax haven use has developed over time. As mentioned above, however, these data do not measure the scale of capital flight associated with illegal activities.

• First, illegal money flows do not necessarily find expression in a loan or deposit between a tax haven and a bank in another country. The funds could, for instance, be injected into a company or a trust which in turn buys shares or other securities in an open jurisdiction.

• Second, it is important to note that not all positions related to tax havens are associated with illegal behaviour. This applies particularly when using a broad definition of tax havens. The broad definition used above embraces financial centres which are also among the most competitive for activities which do not require particular secrecy. Even the narrow definition includes centres fairly certain to encompass substantial international activity which is not attracted by the secrecy on offer.

6.2.2 Where does the capital in tax havens originate?

The IMF shows in a 2008 report (IMF, 2008) how international assets and liabilities held by the banks in groups of OFCs break down by continent. These figures are reproduced in Figure 6.6. A key feature is that this market is characterised by regional segments. Europeans primarily use European OFCs, Americans use those in the Americas, and so forth. Nor does this survey pick up all use of tax havens to conceal illegal activity. Funds deposited in trusts and then in a bank in the same country would not be included, for example.

¹ The specified countries and country groups are: The United Kingdom (UK) Japan (JP), USA, Africa (AF), America except USA (WH), Europe (EU), Asia and Oceania (AP), Middle East (ME) and unallocated (UA). The tax havens are grouped in (1) Europe, Middle East and Africa  (EU+ME+AF), (2) America (WH) and  (3) Asia (except Middle East) and Oseania (AP)

Source IMF (2008)

6.2.3 Direct investments to and from tax havens

A number of different types of legal constructions can be relevant when placements are made in or from tax havens. In many cases, it will be appropriate to establish a company in a tax haven. The value of this company will be regarded as a direct investment regardless of whether it pursues production or is simply a shell entity.

UNCTAD produces statistics for direct investment over national boundaries. All the major tax havens report data to UNCTAD. Countries such as the UK, Hong Kong, Switzerland and Luxembourg place high on the list for the size of both inward and outward direct investment. However, it is only when the investment figures are compared with the size of the various economies that a number of the tax havens really stand out.

Figure 6.7 shows that Iceland is the only one of the 11 jurisdictions with the largest inward direct investment which could not be regarded as a tax haven. All the others would be defined as tax havens. 6 Inward direct investment to the British Virgin Islands equals USD 2.7 million (almost NOK 18 million) per capita. While the Cayman Islands and Hong Kong also stand out from all the others, they are nevertheless far behind the Virgin Islands.

Source UNCTAD.

Direct investment to and from offshore companies, exempted companies, trusts and the like will probably be substantially under-reported. Governments in tax havens normally lack good information about activities in these structures. Section 7.5.5 on the pass-through of capital in Mauritius shows, for example, that while outward direct investment from this country totalled USD 285 million as of 31 December 2007, data from India indicate that direct investment from Mauritius to India alone can be estimated at more that USD 38 billion at the same date.

The scale of direct investment in the Virgin and Cayman Islands must primarily reflect purely financial operations rather than production activities. It is fairly inconceivable that capital per job in a whole economy should amount to several million kroner. Another way of illustrating the scale of direct investment is to view it in relation to the size of the economy. This is presented in Figure 6.8. Inward investment to Vanuatu equaled to 102 per cent of GDP. The comparable proportion for Norway is about 20 per cent.

Source UNCTAD

Most of those who establish a company in such jurisdictions channel its capital in the form of financial claims or direct investments in other countries. As a result, tax havens have large direct investments not only inward but also outward. Figure 6.9 shows that tax havens also dominate among countries with the highest direct outward investment per capita.

Source UNCTAD

Where outward direct investment is concerned, Iceland and Sweden as well as eight areas which can be defined as tax havens have the largest per capita holdings. The Virgin Islands stand out even more markedly here, with outward direct investment corresponding to almost USD 7 million or NOK 45 million per capita.

When inward and outward investment in the Virgin Islands are compared, the latter can be seen to be much larger than the former. It seems inconceivable that the population of these islands and the companies they own should have assets which can explain the difference between inward and outward direct investment. Moreover, it will emerge below that the Virgin Islands does not have a particularly large banking sector. The Commission takes the view that a possible explanation could be that a great deal of capital enters the Virgin Islands through trusts and the like, and that much of it flows out again in the form of direct investment.

Figures for the Netherlands do not include special financial institutions (SFIs). These are special structures suitable for tax planning. Dutch tax regulations and an extensive network of tax treaties make this country attractive as the location of holding companies. The majority of these are shell companies, even though they formally have an address and management in the Netherlands. However, the management can often be regarded as front persons. The real leadership is located in other countries. Nonetheless, the Dutch tax rules have also contributed to attracting a number of genuine head offices – in other words, ones where the company management sits. Excluding the SFIs, the Netherlands had direct investments abroad totalling EUR 606 billion as of 31 December 2008. When the SFIs are included, this figure rises to EUR 2 227 billion or almost USD 200 000 per capita. Including the SFIs, the Netherlands comes a close second to the US as the country with the largest outward direct investments. 7

Figures for direct investment can also be put in perspective by looking at the number of companies registered in the various jurisdictions. No international statistics are available through a standardised methodology, and many companies do not publish figures. However, the Commission is not aware of any national figures for the three jurisdictions with the largest inward direct investment in relation to GDP (see Figure 6.8). The number of companies per 1 000 inhabitants in these countries were:

• Virgin Islands: 17 917

• Cayman Islands: 1 815

• Bermuda: 213.

By comparison, Norway had 40 enterprises with limited liability per 1 000 residents. Including sole proprietorships would more than double this figure.

6.2.4 Significance of the financial sector in tax havens

Capital flows to secrecy jurisdictions in many different forms. Some of it enters as deposits in or other types of claims on banks. More of it goes to companies, trusts and similar entities in these jurisdictions, and then is placed in banks or other financial claims in secrecy jurisdictions before being channelled to countries with an activity which can take advantage of the capital and thereby provide a return on it.

Although direct investments to and from tax havens are substantial, capital from the financial sectors in these countries is far greater. Among the pure tax havens (small economies with large financial balances), the Cayman Islands with USD 1 672 billion had the highest international bank claims. By comparison, direct investments from the Virgin Islands were just over USD 150 billion. A number of tax havens (including Hong Kong, the Netherlands and Switzerland) had larger direct investments than the Virgin Islands, but these countries also have substantial economic activity which is not particularly associated with secrecy. As a result, it cannot simply be assumed that direct investments abroad from these countries represent the reinvestment of funds which they have received because of their secrecy and facilitation of pass-through activities.

Table 6.1 shows the size of bank assets in selected tax havens. The Cayman Islands are distinguished by an extremely large bank sector, with international assets totalling more than 700 times their GDP. By comparison, assets (national and international) equal 1.3 times GDP in Norwegian banks and 2.5 for the eurozone. The table ranks countries by the size of their international bank assets in relation to GDP. Switzerland, which is regarded as a major financial centre, lies in 17th place. Calculated by the absolute size of international bank assets, Switzerland ranks second among the countries in the table.

Table 6.2 illustrates the financial sector’s significance for secrecy jurisdictions. It presents indicators for all the countries and jurisdictions which report the relevant figures to the IMF (2008). For comparative purposes, it also shows figures for the UK, the USA and Norway. The UK and the USA embrace the world’s two largest financial centres, and the significance of the financial sector – particularly in Britain – is far greater than is normally the case.

The financial sector accounts for 50 per cent of GDP in Jersey. In five of the jurisdictions, it accounts for more than 17 per cent of employment. Value creation (in other words, the contribution of the industry to GDP) per employee is extremely high in a number of these countries.

Much of the financial industry in tax havens is run from abroad, and particularly from the major financial centres such as London and New York. An indication that activity in the banks registered in secrecy jurisdictions is partly run from other locations can be obtained by calculating the size of bank assets per financial-sector employee in the tax havens. This figure comes to more than USD 250 million in the Cayman Islands. Although almost 75 per cent of bank assets represent inter-bank positions, it seems entirely unreasonable to suppose that each bank employee actual manages such large positions. One must also take into account that the financial industry embraces many activities other than managing bank assets.