Offshore Tax Evasion
How is tax evasion undermining the fairness and integrity of national tax systems?
Offshore tax evasion is not about small islands that do not impose income taxes: It is about all countries that lack transparency and that are not prepared to cooperate to counter tax abuse. These practices make it difficult for other countries to enforce their own tax laws.
With globally integrated financial markets and modern communication techniques, the creation of offshore financial accounts, shell companies and the like are just a click of a mouse away.
In this context, countries can no longer rely exclusively on their own sources of information to ensure compliance with their domestic tax laws.
This is true for all countries, whether OECD or non-OECD, developed and developing, large or small, that rely on income taxes to fund the necessary governmental expenditures voted for by their national legislatures.
In this new era of "banking without borders," wealthy individuals can easily evade capital income taxes in their country of residence by transferring capital abroad and channeling passive investments through offshore jurisdictions.
This type of tax evasion is facilitated by the existence of jurisdictions with strict bank secrecy rules that prevent information exchange with the residence country. The increased recourse to foreign institutional investors and shell companies with opaque structures based in offshore financial centers can make it very difficult for domestic tax authorities to track capital income.
With the growth of cross-border capital flows, the potential for abuse created by the lack of access to bank information for tax purposes and the resulting adverse consequences have increased exponentially.
At the same time, tax authorities find it more and more difficult to monitor foreign portfolio investments of their residents because of the removal of traditional sources of information on these transactions (e.g., exchange controls).
Thus, a decision by one country to prevent or restrict access to bank information for tax purposes is now more likely than ever before to adversely affect tax administrations of other countries.
We know the offshore evasion problem is big, but we do not have a precise estimate of the amount of tax at risk. Given that the main reason that tax evaders go offshore is the secrecy provided to enable them to hide their assets and income from their tax authorities, this is not surprising.
We can approach the issue by looking at the size of the offshore sector and its tremendous growth over the last decade:
• Using data from the BIS, IMF and OECD, we estimate that a total of $5-7 trillion is held offshore.
• Brazil reports a commercial deficit of $4 billion with the Caribbean islands.
• Singapore has now joined Luxemburg and Switzerland to become one of the top private wealth centers of the world.
• The Bahamas is now ranked among the top five locations in the world for offshore mutual funds and trust funds and has also developed a significant inter-bank market.
• The Cayman Islands are the world's fifth-largest banking center and the first among offshore jurisdictions with a prominent position both in the inter-bank business and in private banking.
• The British Virgin Islands has developed into one of the most successful centers for International Business Companies. Conservative estimates put the number of shell companies at over 300,000.
In recent years, the demand for offshore facilities has expanded considerably, owing to the high growth rates of cross-border investment and to the increased number of wealthy and not-so-wealthy individuals who are prepared to use the new technological and communication infrastructures to go offshore. There is also a growing use of multiple layers of transactions to structure offshore operations through vehicles located in different countries.
The gradual relaxation of reserve requirements, interest rate controls and capital controls in the main "onshore" markets and the creation of offshore banking facilities in some of the main industrial countries (the United States and Japan) have reduced the regulatory advantages of offshore financial centers, making them less attractive for conventional banking.
Of course, many of these offshore holdings and arrangements are undertaken for sound commercial and legitimate tax-planning reasons, without any intent to conceal income or assets from the home country tax authorities.
The experiences of tax authorities, however, lead them to believe that much of this money is there to evade or avoid tax. Some recent initiatives in OECD member countries bear this out:
• Ireland collected almost €840 million ($1.14 billion) from about 15,000 Irish residents hiding undeclared income in offshore bank accounts. This may not seem like a big number in the U.S. context, but it amounts to about 8% of total 2006 income tax collected — and almost 30% of 2006 income tax collected from self-employed taxpayers. Ireland is currently negotiating tax information exchange agreements with some of these jurisdictions.
• In Italy, a recent tax amnesty resulted in the disclosure of €75 billion ($102 billion) in assets held offshore.
• The United Kingdom has just launched an offshore compliance initiative which the accounting firm, Grant Thornton, estimates could bring in £5 billion ($10 billion) in back taxes, interest and penalties, which is almost 4% of income tax receipts.
• South Africa has estimated that it is losing 64 billion rand ($9.1 billion) to tax havens.
• The Australian government recently approved more than $250 million for a multi-agency operation to address the promotion of and involvement in offshore tax evasion schemes. The potential loss of tax revenue from the schemes involving one promoter alone was estimated to exceed $208 million.
Offshore tax evasion has effects that go beyond the lost revenue of the tax evaded. Offshore tax evasion undermines the fairness and integrity of national tax systems and adversely affects the willingness of the vast majority of law abiding taxpayers to voluntarily comply with their tax obligations.
Public attitudes to tax compliance are heavily influenced by perception, and the "voluntary" element of compliance can be badly eroded if a minority of taxpayers, usually those with significant incomes, can evade or are perceived to be evading their taxes by hiding assets offshore.
Competition on the basis of secrecy and lack of tax cooperation reduces global welfare, since decisions on where to locate funds are driven by the ease of evasion and not by the true economic return on capital.
This is especially true once the gross returns have been adjusted to reflect the often substantial fees of scheme promoters, arrangers, advisors, offshore trustees, nominees, etc.
Excessive bank secrecy and a lack of bilateral tax cooperation is particularly serious for developing countries, where offshore tax evasion may erode already weak tax bases — which can seriously undermine their ability to make the vital investments in social services and economic infrastructure upon which sustainable economic development depends.
Excessive bank secrecy and an unwillingness of countries to cooperate to counter tax abuse undermine the national fiscal sovereignty of other countries.
In a global environment, individual governments can maintain sovereignty over the design of their respective tax systems only insofar as they can count on the cooperation of other governments to share information needed to enforce their tax policy choices — choices that reflect their economic, social and political preferences.
This is true even for countries that have a territorial system of taxation because income derived in such countries can still be hidden offshore.
Editor’s note: This feature is adapted from the author’s testimony before the U.S. Senate Finance Committee on Offshore Tax Evasion on May 3, 2007.