Tax Havens: Back Above the Parapet

Danger lies in emotional legislative response

Originally published in the April 2009 issue

Reading the press over the past six months and certainly coming up to the G20 summit in April you will have seen many articles concentrating on tax havens. World leaders including Barack Obama, Gordon Brown, Angela Merkel and Nicolas Sarkozy have all made statements of varying tone regarding the status of tax havens and what ‘needs to be done’ about them. Often these statements have been in the context of comments about the financial crisis. Intentionally or not this gives the implication that tax havens bear responsibility for the crisis. Is this a fair comment or are tax havens an easy target for politicians desperate to find a cause not of their own making? More cynically, is it using the crisis as leverage to impose new rules that would not be considered appropriate in ‘normal’ times? Irrespective of the answers to these questions, tax haven jurisdictions are now above the parapet. Many hedge funds will be based in such jurisdictions and some hedge fund managers will place operations in such jurisdictions.

While there may be arguments for change, there is danger in legislation that is introduced in times of crisis led by emotional ratherthan rational thought processes. It can be ill considered, rushed and could easily miss the target it is intended to hit. More importantly it could prevent perfectly acceptable activities that were never intended to be halted.
The term ‘tax haven’ has been used to cover jurisdictions as diverse as Ireland and Vanuatu. Some would even include the UK and the US (for example, the states of Delaware and Nevada). The Organization for Economic Co-Operation and Development (OECD) gives the following definition:

• No or nominal tax on the relevant income
• No effective exchange of information in respect of taxpayers benefiting from the low tax jurisdiction
• Lack of transparency in the operation of the legislative, legal or administrative provisions
• The absence of a requirement that the activity be substantial as it suggests that a jurisdiction may be attempting to attract investment or transactions that are purely tax driven
• No or nominal tax is not sufficient in itself to classify a country as a tax haven

The general press impression seems to be that a tax haven is a lawless jurisdiction where rich and powerful corporations and individuals hide their earnings from their home country tax authorities, the ‘hiding’ being facilitated by rigid levels of secrecy which prevent the passing of information. Where tax havens are used for illegal activities, in the tax context let’s call them fraud/evasion, there seems a sensible argument in requiring them to cooperate. It is important to point out that the fraudster/evader will be resident in the more highly taxed and arguably regulated jurisdiction. Such jurisdictions will have legislation which ensures that residents are taxed on their income and will generally limit (but not necessarily eliminate) the possibility of legally using a low tax jurisdiction to mitigate tax.

There is altogether another discussion to be had on definitions. Fraud and evasion would typically be viewed as illegal while mitigation would be legal. Avoidance would be legal but to certain people not morally acceptable. To the latter point the UK has proposed a code of practice for banks which, according to the FT, would prevent them from using tax havens and undertaking tax avoidance. Tax avoidance being defined as …any outcome which could “reasonably be expected to be unintended by parliament or tax authorities.” How could that be interpreted and, more importantly, is it appropriate for someone to be taxed on the basis of intention rather than legislation, especially the intention of unelected officials? The issue should therefore be about access to the appropriate information to enable authorities to enforce their own legislation. Indeed this is the thrust of the OECD’s policy with regards to tax havens, and they have produced model Tax Information Exchange Agreements (TIEAs) which facilitate the exchange of information. Alternatively, or additionally, is it the intention that tax havens will be put under pressure to remove motivations for their use i.e. increasing their tax rates? If this is the intention, are we going to move to a worldwide acceptable tax rate?

On the information issue, it is interesting to note that many of the jurisdictions which would be classified as tax havens have TIEAs with major jurisdictions. The US signed a TIEA with Cayman in 2001, and Jersey in 2002. Perhaps more interesting is the number that have been signed or announced in recent months. Of the 49 signed since 2000, 23 have been signed since September 2008. This rush to sign TIEAs shows the pressure is being felt and that many tax havens are willing to cooperate.

So what has been proposed? In a European context it is not clear. There has been some call for a blacklist and sanctions against uncooperative jurisdictions, but very little detail. Hopefully the position will be clearer after the G20 summit. In the US concrete legislation has been introduced, the Stop Tax Haven Abuse bill . This is a variant of a previous bill co-sponsored by the now President Obama. It is not clear that the new bill will pass into law. Indeed this is probably unlikely, but it does give an insight into some of the thought processes. The key feature of the bill, which would impact hedge fund managers in the US, is the move to a central management and control test for tax residency. If an entity holds assets on behalf of investors and the decisions as to how those investments are made are taken in the US, the entity will be deemed a US corporate for federal tax purposes. Additionally, if the individuals with day to day responsibility for strategic, financial and policy decisions are predominantly in the US, the entity would be a US corporate for federal tax purposes. There is a materiality limit, if the entity does not have $50 million of gross assets. A fund currently managed out of the US that exceeds those limits would be subject to US tax. This would make London and other suitable jurisdictions an attractive option.

Low tax answers
One result of the current pressure on tax havens may be a shift in where people may look to achieve low tax answers. Indeed they may not have a choice and will be directed, for example, as the result of a black list which would penalise them for investing in bad jurisdictions. This could give a boost to jurisdictions in the EU that can provide low tax answers. These could include jurisdictions such as Ireland and Cyprus which have ‘low’ headline tax rates, or Malta and the Netherlands that while having higher headline rates have specific regimes which can make them effective. Additionally, from a personal perspective, the UK represents an effective jurisdiction for non-UK source income for non-UK domiciled but UK resident individuals. An added advantage in looking to utilise EU jurisdictions is that they are subject to overriding EU principles and legislation.

The G20 summit will now be over and, using my crystal ball, I believe they will suggest that countries which remain ‘uncooperative’ will be subject to sanctions. Most likely it will use the current OECD principles to determine who is uncooperative. There will be more TIEAs signed and more announcements of a willingness to share information. As a result, the list of uncooperative nations will be small. It is to be hoped that there is nothing more and, frankly, there are bigger issues to worry about.

1. Overview of the OECD’S work on International Tax Evasion – note 4, page 4, 24 March 2009
2. UK plans to ban use of offshore centres by Vanessa Houlder, Published: Financial Times 30 March 2009
3. Overview of the OECD’ work on International Tax Evasion – Annex V page 14, 24 March 2009
4. Introduced on March 2, 2009, Senator Carl Levin (D-Michigan) “Stop Tax Haven Abuse Act” (S. 506)

Stephen Rabel provides tax advice to the asset management industry including hedge fund, private equity and other alternative managers. Rabel’s career includes seven years in the investment management group at Ernst & Young and as a director in financial services at RSM Robson Rhodes.