Panama Papers: What can the UK government do?

April 06, 2016 12:21 PM

The leak of millions of documents from the Panamanian law firm Mossack Fonseca has reignited a debate over “tax havens”. Much of the coverage thus far has centred on the financial affairs of disreputable world leaders who would have great difficulty explaining why such vast assets are being held in a place like Panama.

In instances where individuals are using facilities in rogue jurisdictions to evade tax and conceal the proceeds of criminal activities, the relevant authorities should come down on both the individuals and the jurisdiction like a ton of bricks.

It is however important to note that all countries considered as tax havens are not the same, and that they play an important role in the global economy.

What is a tax haven?

There is no accepted definition, but the OECD, a group of industrialised countries, gives four criteria:

  • The jurisdiction imposes no or only nominal taxes
  • There is a lack of transparency
  • There are laws or administrative practices that prevent the effective exchange of information for tax purposes with other governments on taxpayers benefiting from the no or
  • nominal taxation
  • There is an absence of a requirement that the activity be substantial

These criteria are themselves subjective, and some campaigners have published lists of supposed tax havens which go so far as to include the US state of Delaware, the Netherlands and Ireland. These are not generally considered as tax havens and the United States has the highest corporate income tax rate in the developed world. Clearly, some just use the term pejoratively rather than to meaningfully categorise jurisdictions.

Are concerns over tax havens justified?

When most people think of tax havens, images of suitcases full of cash being deposited in numbered accounts in places like the Cayman Islands and Switzerland in films like The Firm and The Wolf of Wall Street spring to mind.

Today, such practices and secrecy don’t exist in the overwhelming majority of jurisdictions. Transparency has greatly increased in recent years, with the vast majority of low-tax financial centres signed up to an OECD initiative called Automatic Exchange of Information (AEOI). To quote from the OECD directly:

“It [AEOI] provides for the exchange of non-resident financial account information with the tax authorities in the account holders’ country of residence. Participating jurisdictions that implement AEOI send and receive pre-agreed information each year, without having to send a specific request.”

“Clamping down” or even “banning” tax havens is often espoused by some campaigners as the answer to world poverty. Leaving aside the obvious practical difficulties of the UK changing the laws of other sovereign states, the amount of tax avoidance that actually takes place is often hugely overstated.

On the topic of profit shifting, James Hines, a professor of economics at the University of Michigan says that:

“Some of the latest evidence suggests that the semi-elasticity of income reporting is roughly 0.4, which means that a corporation that is located in a country with a 25 percent tax rate, and that has the opportunity to reallocate some of its taxable income to a country with a 15 percent tax rate, will typically arrange its financial and other affairs to reallocate 4 percent of its income to the lower-rate country. Other, rather more persuasive, evidence suggests that multinational firms earning profits in high-tax countries find ways to reallocate 2 percent of those profits to low-tax foreign jurisdictions.”

What about Panama?

Panama is one of four jurisdictions which have not committed to AEOI, and by far the largest – the others are Bahrain, Vanuatu and Nauru.

It appears that accounts and companies in Panama, described by the OECD as the “last, ultimate tax haven” appear to have been used as a repository for the ill-gotten gains of some unsavoury characters. The highly opaque nature of corporate ownership in Panama appears to be facilitating tax evasion, drugs trafficking and terrorism. This is clearly totally unacceptable, and the rest of the world must exert pressure on Panama to change its ways under threat of serious action.

However it’s important that all small low-tax jurisdictions are not tarred with the same brush.

Do “tax havens” have a legitimate purpose?

Small, low-tax jurisdictions play an important role in the global economy. They ensure that returns from certain investments are not taxed twice by providing a tax neutral environment. As Gordon Casey, Managing Director of a hedge fund consultancy based in the Cayman Islands explains:

“Imagine that you are an investor living in the Middle East but the fund is set up in a country that has a withholding tax on all redemption payouts – as a foreigner you are not required to pay tax on your redemptions, but because you invested in a fund in that country, an amount has, nevertheless, been withheld. You might then have to hire a tax lawyer to appeal to the tax authority in order to recover the portion of your redemption that was inappropriately withheld.”

Other jurisdictions, particularly Bermuda and Guernsey, are important for insurance. Guernsey for example is the leading centre for “captive insurance companies” which are set up to insure the risks of parent companies or subsidiaries. The regulatory burden of doing this in the UK is prohibitive and around half of the FTSE 100 have such companies domiciled in Guernsey. This is not done to avoid tax.

More broadly, Hines, identified five key economic roles of international financial centres:

Stimulating foreign direct investment (FDI) in high-tax countries: Levels of FDI in high-tax countries is sensitive to the availability of financing structures that use offshore financial centres. This is especially important for developing countries – half of their inward investment comes via offshore financial centres. If they ceased to exist, a great deal of this investment would not take place.

Discipline of financial markets: International financial centres limit the extent to which large financial institutions can exploit local monopolies to the detriment of local businesses and individuals.

Promotion of good governance: Successful International financial centres score highly on the World Bank’s indicators of governance quality. Market actors would not be willing to devote extensive resources to such jurisdictions without high quality governance. This is not so much the case with Illicit funds where secrecy may be the main consideration.

Tax collection and competition: The availability of low-tax opportunities that use international financial centres has permitted governments in developed countries to maintain large domestic tax bases without triggering tax competitions. Views will differ as to the extent to which this is positive, but there is good reason to believe international financial centres have allowed governments of large countries to implement the tax policies they want in the face of international competition

Growth: International financial centres have enjoyed rapid economic growth. They tend to be desirable places to live with high living standards

What can the UK government do?

The UK government, and for that matter the rest of the world, must put pressure on Panama to sign up to global agreements concerning the exchange of information with other countries’ authorities.

It’s important however that the baby is not thrown out with the bathwater. Most offshore financial centres are not used for tax evasion or hiding the proceeds of crime, but play an important economic role. What’s more, finance often accounts for very large proportions of the economies of such countries.

If the UK were to place, for example, Jersey under direct rule and subject it to the UK’s tax regime, its unique selling point would be lost and its economy destroyed.

While the UK government must work with international partners to counter tax evasion and other crimes relating to Panama, they should also be focusing on making the UK a better place to live and do business. Many offshore trust structures for example are set up to escape Inheritance Tax – a pernicious tax whose abolition we have long argued for. Significantly reducing the burden of taxes like this would reduce the incentives to set up such structures in the first place.

However if politicians, especially those governing the country, are going to be critical of the use of legal, tax efficient practices and accuse those who do so of immorality, they cannot do so with any credibility if they are found to be engaging in such practices themselves.

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