How Do Tax Havens Work & Why Do They Exist?

With banks failing, governments coercing and economies collapsing, establishing yourself offshore is more important than ever. Despite the attention grabbing headlines showing solemn face bankers being slapped with heavy fines by the IRS for tax evasion, the offshore industry couldn’t be doing better.

The very reason why the IRS, FATCA and the US government regulators are becoming increasingly tight on foreign banks, offshore accounts and international transactions, is because the offshore industry is growing at such an alarmingly rate due to the current international political and economic uncertainties, that they felt compelled to intervene in hopes that some of the deferred tax revenue might cover their increasingly large deficit.

With banks failing around the world (2008-2010 500 banks closed in the US alone); governments coercing (through FATCA compliance regulations, and stolen retirement funds in Hungary, Poland, France); and economies collapsing, (Venezuela, Greece, and Argentina without mentioning half of Eastern Europe which is on the brink of collapse) the need to protect your assets is higher than ever.

Table of Contents:

• Why Do Tax Havens Exist?
• Advantages Of Foreign-Owned Non-Resident Companies
• How Do Offshore Tax Havens Work? The Unequal Balance Of Power
• Whats the Point of Offshore Financial Centers?
• Characteristics Of Tax Havens
• Takeaway

Why Do Tax Havens Exist?

While the offshore industry has been given a bad rap as it is smeared through countless headline-grabbing controversies. We have been built a narrative around offshore banking.

Sitting on private yachts smoking cigars with Panama hats, piles of cocaine sitting around cabanas in the Caribbean handing over briefcases filled with cash, secret meetings with suited government and bank officials to launder money through the banking system.

Offshore banking now is some exotic affair that has been romanticized. Money Laundering is almost made sexy. Provocative imagery is the only way to capture the imagination. And it seems like they did a good job, because now offshore banking is equated with tax evasion. 

Advantages of Foreign-Owned Non-Resident Companies

The simple fact is, that its a perfectly legal. Owning an offshore company whether in the Caribbean or Germany makes no difference. If I live in Canada with a UK bank account, I have an offshore account. If I live in Australia and I have a Cyprus Company, I have offshore company.

Foreign ownership of an offshore company or account is not as exotic and mysterious as all that it's made out to be. There are many liberal tax regimes that provide serious incentives for foreign capital. If you run a global or digital business, why wouldn't you go offshore?

It is of no surprise, then, that over 70% of Fortune 500 companies use offshore companies as a means to lower their tax burden. Despite whatever is said about offshore vehicles whether companies or accounts, they provide necessary services for companies conducting global business. 

How Do Offshore Tax Havens Work? The Unequal Balance of Power

The rise of global communication technology has virtually eliminated boundaries creating a hyper-globalized economy allowing financial flows access to markets in all corners of the world.

This has enabled the spread of global transactions stimulating innovation and growth along with many areas of the global economy.

However, the current trend of globalization is now fast becoming authoritarian, moving away from a hands-off liberalized version, as it has become entirely self-serving, governed and manipulated by the economic elites, Multi-National Corporations (MNC), and powerful state governments and institutions that have to a large degree forced their agendas and policies on the rest of the world.

Western industrialized countries have become more forcefully outspoken against the perceived inadequacies of the current offshore system as it watches frantically its capital flowing out to alternative low-tax markets.

This is, however, a natural movement of a person or asset in a liberalized economic order - one that seeks to maximize efficiency where one has a comparative advantage.

Intimidation tactics, trade barriers, and economic blacklisting have been used as a response as a means against the smaller Offshore Financial Centers (OFC) that do not go along with the new regulations and supervisory institutions established.

As many of these OFCs are former colonies whose economic development has been severely curtailed by continuous exploitation and occupation it has little other recourse but to create avenues of competition in sectors where it retains some advantage.

Since the last global financial crises, emerging markets have been particularly hit, coupled with the increased regulatory effects that have come since, has severely threatened the economy of many financial havens.

Whats the Point of Offshore Financial Centers?

In order to attract foreign capital, many emerging markets offer low tax burden recipes and vehicles to attract foreign investments.

Just like many western countries, seeking to attract investors and economic opportunities give advantages to companies seeking to establish themselves in certain sectors; similarly, many emerging market countries have created a financial environment that seeks to due to same - provide conditions that favor international investment and capital flows.

While certainly overly-exposed unregulated areas of the world's economy need tighter regulations to prevent malfeasance, they should do so in collaboration and not by brute force.

These regulations come primarily through the economic hegemony of highly developed nations that seek to retain their grip over the world's economy by exploiting their unequal balance of power enjoyed primarily from its past imperialistic legacy.

And so, such countries not wanting to lose any possible tax revenue, have used regulatory bodies including the U.S. Government, EU, OECD, and FATF to ensure that their place in the world order remains intact.

Income tax competition remains a significant sore spot for many developed countries that seek to keep a firm hold on their tax base.

The OECD deems such income tax competition as harmful to the global economic order, and suggests that they are acts of ‘civil disobedience against income redistribution’.

Characteristics of Tax Havens

As mentioned, there is no one universally recognised definition of a tax haven, and therefore it is not always black and white what we consider to be a tax haven. The Organisation of Economic Cooperation and Development (OECD) has, however, outlined some key features which can be used to identify a tax haven. They include the following criteria:

1. Zero or Nominal Taxes:

The key defining feature of tax havens is that they impose zero or only nominal (extremely low) taxes. The precise tax regime may differ in each tax haven, but they are common in that foreigners can easily utilise them to escape high taxes in their home countries.

2. No Information Sharing:

While information sharing agreements are becoming the norm in most countries around the world, tax havens usually separate themselves from the rest by protecting the personal financial information of foreigners who engage in business activities in the jurisdiction. It is becoming increasingly difficult for countries to completely avoid sharing financial information of foreign residents with their home countries due to a rise in information sharing treaties and OECD pressure for financial transparency. However, tax havens commonly do their utmost to protect the privacy of foreigners using their services, which is what makes them more attractive than traditional onshore jurisdictions. 

3. Lack of Transparency:

The third defining feature of tax havens identified by the OECD is their general lack of transparency. This means that there is more going on behind the scenes that is unbeknown to the general public and outside world. The legislative and administrative processes lack full transparency, leading to secret rulings, flexible laws, loopholes, and so forth. It is important to note that this is an extreme generalisation and certainly may not be true of all tax havens. 

In addition to these three features mentioned by the OECD to define tax havens, the United States Government Accountability Office has put forth two more characteristics of tax havens. They are:

4. No Physical Presence Requirements:

A common feature of tax havens is that they do not require foreign entities (businesses or individuals) to maintain a significant local presence in order to utilise the country for their financial activities. This makes it very easy for foreigners to utilise tax havens for the advantages they bring, without needing to physically relocate or engage in business activities within the jurisdiction. Tax havens make it simple to obtain residency on their shores without physically living there. 

5. Actively Promote Themselves as Tax Havens:

One final common characteristic of tax havens is that they tend to actively promote themselves as such. The idea here is that tax havens fully intend to position themselves as attractive offshore financial centers in an attempt to bring in substantial foreign investment.

While the features of tax havens discussed above might put a negative spin on these jurisdictions as seen through the eyes of regulatory bodies like the OECD, tax havens can in fact be completely legitimate and useful financial tools to help optimise taxes, increase financial privacy, and protect one’s valuable wealth. The two primary types of entities that can benefit from tax havens are:

1. High net worth individuals looking to secure tax residency in a jurisdiction with a more favourable regime than their home country. These individuals are able to utilise the benefits of tax havens for tax optimisation, financial privacy, asset protection, and other benefits such as estate planning, investment opportunities, and so on.
2. Businesses looking to establish their base in a more friendly regulatory environment with lower taxes, fewer trade restrictions, privacy, and asset protection. The major advantage of tax havens is that they allow businesses to register in their jurisdiction without needing to have a physical presence or conduct normal business activities in the country of choice, while still being able to enjoy the many benefits that the tax haven has to offer. 

There is, of course, some overlap in the above. For structural purposes, it may be best for an individual to incorporate a “shell company” in an offshore tax haven to best take advantage of the tax benefits available. Shell companies are a type of legal entity created in tax havens. They exist as legally registered companies on paper, but engage in no actual business activities. Individuals can use shell companies for added privacy (by shielding their personal identity), better tax treatment and greater asset protection through an additional layer of protection. 

In addition to foreign individuals and businesses being able to benefit from tax havens, the tax haven countries themselves also benefit greatly by attracting an inflow of foreign capital into their financial institutions and banks. For many tax havens, the offshore finance industry makes up a large proportion of their GDP and is often their largest industry. 

Takeaway

The dangers of labeling one form of competition as dangerous and another as advantageous, like income tax and commercial trade, for instance, comes with biases and colors what should be pure open market liberalization.

It moves farther away from a free open border economic globalization that encourages innovation and competition through the freedom of financial movement and becomes more like a fascist world order of slaves and masters.