Cross-border tax planning: Brave New World

Managing Director of Wealth & Tax Advisory Services at HSBC Private Bank explains why legitimate tax planning requires more care than ever.

The central thesis of this article is that the ability to raise taxes has always been dependant upon taxing authorities having access to information about the affairs of their taxpayers and that recent developments in extracting information from tax havens has put taxing authorities in an unprecedentedly strong position to successfully tax cross-border transactions.

I will trace a short history of tax havens, demonstrate how they have operated in the modern era with such effect and describe the response of the developed nations to what they saw as a serious threat to their revenue base. Finally, I will look at the result of these developments and what it means for cross-border tax planning going forward.

A very short history of tax havens

By the 4th century B.C. Ancient Rome not only had an elaborate and well administered tax system which included sales tax, inheritance tax and import and export duties, but its very own tax haven. Delos was established as a tax free port which diverted shipping traffic from Rhodes (then not part of the Roman empire) which taxed ships at 2% of the value of their cargo.

Not much is known about the state of tax havens in the period between ancient Roman and modern times. However, it is safe to assume that they have always existed and also that they developed little during that period of relatively low international trade and investment flows and comparatively poor communications and technology.

So, jumping straight to the modern era, the tax havens in the Caribbean (like the Bahamas, Bermuda, the British Virgin Islands); in the Channel Islands (Jersey and Guernsey); and on the Continent (Luxembourg, Monaco and Liechtenstein) really only started to get going in the late 1950s or the early 1960s.

They did not experience significant growth in the volume of business until the 70s, 80s and 90s. In the early days, tax havens were the playgrounds of the seriously wealthy and were really only attractive to private client business. These were the days before offshore mutual funds, unit trusts or other offshore collective investment vehicles. One of the major reasons for the lack of international or cross-border investment in financial instruments was the existence of exchange controls. It was then very difficult in places like the United Kingdom, Australia, the Philippines, Canada, and even the US, to get permission from the central banks to send money abroad except for trade-related activities. Margaret Thatcher's first act when she was elected Prime Minister of Britain in 1979 was to suspend the Exchange Control Regulations. Bob Hawke's first act when becoming Prime Minister of Australia in 1983 was to float the dollar which required the suspension of exchange controls. Nowadays, few countries impose exchange controls and the prospect of them being reintroduced in this age of globalization are remote.

Goodbye exchange controls, goodbye taxes

So with the ability to send money around the world came the freedom to take oneself out of one's tax regime by moving one's money abroad.

In the 60s and 70s, although countries like the United Kingdom, Australia and Canada taxed their residents on a world-wide basis, there was generally little tax on foreign sourced income and where there was tax, it was very easy to plan around.

For example, in Australia, up until 1984, foreign-sourced income that was not completely exempt from tax in the country where it was earned was exempt from tax in Australia. All one had to do was to put one's money in a bank account in Hong Kong where the taxes were low and there was no further Australian tax on the income earned in Hong Kong. It was not until the 1960s that the United States introduced legislation to tax its citizens on the undistributed income of foreign companies owned by them. Before that, tax could be delayed until a dividend was paid to the US shareholder.

With freedom from exchange controls and weak systems of taxing foreign income or interests in foreign enterprises, money did what it does best, i.e. it found a home that was kind to it tax-wise.

The developed countries were slow, with the exception perhaps of the United States, to work out what was going on. By then, it was too late to reintroduce exchange controls. So they embarked upon a series of anti-avoidance tax measures that were designed to deprive their people of the tax deferral or avoidance benefits of having their money invested abroad. The developed countries all had high tax rates (remember in the sixties, Britain had a surcharge at 98 pence in the pound). But the tax havens, by then known as "offshore finance centres" ("OFCs") imposed little or no taxes and did not have any tax treaties with the developed countries which provided for the exchange of information. In response, the developed countries introduced legislation which removed exemptions on foreign income and provided instead for credits for foreign taxes against local taxes. The developed countries also brought in legislation which had the effect of taxing their residents annually on the income of foreign companies and trusts which they controlled, whether or not those foreign companies or trusts paid a dividend to them back in the home country.

The tug of war

So began "a tug of war". As the developed nations passed more sophisticated legislation to counter their subjects use of OFCs, so the OFCs developed new and sophisticated products and legal structures to circumvent this new anti-avoidance legislation.

By this time, there were at least 100 OFCs worldwide. It is estimated that there are now several trillion US dollars in the OFCs. Two years ago, there were estimated to be 20 billion Deutschmarks in Jersey alone. Through a combination of careful planning and plain tax evasion by citizens of high tax countries, it looked very much like the highly taxed and the OFCs had successfully collaborated to beat the developed nations, the "big boys" if you like, at their own game. The developed nations had simply run out of new ideas with respect to taxing their citizens on foreign income and investments. The consequent loss of revenue, despite the innovations in their legislative powers, remained huge and they were not about to stand for it. Remember, that by the early 90s, the pressure was on in the developed nations to lower tax rates and at the same time provide for ageing populations.

Lets shut down the tax havens

So this is what happened. The "big boys" teamed up to put pressure on the OFCs to change their laws and to force the intermediaries, mainly the banks, to gather, keep and handover, all sorts of information on their clients. The big boys had taken their own laws just about as far as that was possible so the OECD, the G7 nations, the European Union and the Financial Action Task Force together, and independently, ganged up on the OFCs, the little boys.

The first point of pressure was on members of the European Union. For example, the EU pressured the Netherlands sufficiently to make the Netherlands Antilles Government change its law to remove many of the benefits of that OFC. The EU pressured Denmark to change its recently introduced legislation which had provided for a tax-friendly holding company law. About that time, the OECD started to talk about "harmful tax competition" and pressured its own members Luxembourg, Austria, Belgium not to have low tax regimes which they felt were "harmful tax competition" and to hand over lots of information on bank accounts. The G7 Group formed the FATF (the Financial Action Task Force) in 1989 and began putting all sorts of pressure on countries all around the world to tighten up banking laws so that banks knew a lot more about the true identity of their customers and the nature of the business that they were conducting through their accounts. The developed nations in their various groupings made up wish lists of changes they wanted to be made in the OFCs and they included the following:

  1. Improved exchange of information treaties with the OFCs - the US has been particularly successful in this regard.
  2. Access to information about bank accounts in the OFCs - again the US leads the way and was spectacularly successful in gaining information from Cayman banks on US citizens who had credits cards issued on Cayman bank accounts.
  3. They produced a list of tax havens with a view to "shaming" countries from being on the lists - this list still exists.
  4. They put pressure on high tax countries with low tax territories such as the United Kingdom and the Netherlands to ensure that their dependent territories were not playing the tax haven game too strongly. A good example of this is the extension of the proposed European Saving Directive to the dependant territories of Britain such as the British Virgin Islands and the Cayman Islands.
  5. They also pressured the OFCs to disclose the beneficial ownership of entities set up in those places both for tax and money laundering reasons.
  6. They pressured places like the British Virgin Islands to not allow bearer shares of companies and they sought changes in the laws of the OFCs to require company accounts to be filed annually, to ban nominee directors, to enter into extradition treaties, to enforce foreign tax judgements through their courts and to disclose beneficial ownership of trusts. In some instances, they threatened sanctions against the OFCs, threatened to reduce foreign aid (Mauritius is a good example), to suspend air services and even in one case to deny Nuie, a small island in the South Pacific, access to the international banking system.

The tax havens fight back

The responses by the various OFCs varied considerably. Mauritius and the Cayman Islands took a very meek approach and promised all sorts of changes to their laws - some of which have already materialized. Places like the Cook Islands initially treated the naming on the list as free advertising but have since come to heel.

The Caribbean OFCs in particular lobbied the US and the UK hard to point out their legitimate role in international finance and that the US and the UK were also tax havens for many.

All of the pressure, particularly by the OECD was looking as if it would wane when the Bush Administration gained power in 2000. Treasury Secretary O'Neill, said that he did not feel comfortable with the idea of high taxing nations ganging up and putting pressure on low tax jurisdictions to change their tax laws. So, the offshore world breathed a collective sigh of relief thinking that without American funding and support, the OECD campaign to put the OFCs out of business would fizzle out.

The impact of 9/11

Then came 9/11. Everything changed. All of the US reticence disappeared as the war on terror began. Why should the war on terror be of any concern to the OFCs? Because transparency became the catch-cry and the United States wanted full access to banking information and entity owning information throughout the offshore world. They didn't want it for tax. They wanted it, and still want it, to cut off to the blood supply of the Al Quaeda network, etc. But information gained in the pursuit of terrorism is also information for tax purposes. And with the increasing ability and willingness of countries to swap information for all purposes, there is no way that what-s available for anti-terrorism will not be used for tax collection.

Where to now?

So where are we and where are we headed? Words like "know your client" and "source of funds" are the catch phrases of modern international banking. Opening a bank account in Hong Kong in the name of a British Virgin Islands company is a near impossibility particularly if the shareholders and directors are not in Hong Kong. If the company is owned by a trust, it is a double nightmare. If you want your company to send money to another company, you may have to tell the bank why. If your company receives in its bank account substantial sums of money or even regular payments, you may need to tell the bank what the money's for and exactly where it came from. If the bank is suspicious about the transaction, i.e. if they form a reasonable suspicion that the money they are dealing with is somehow linked to, say, tax evasion, they are in most places duty-bound to report the transaction to their local agency and the bank officer commits a criminal offence if they tell you that they've made a report.

Australia, the US, the UK and Canada have recently announced the establishment of a joint task-force which will be a well staffed secretariat based in New York. The taskforce will assist their respective tax administrations in addressing challenges arising from aggressive cross-border tax planning by exchanging information on tax avoidance arrangements and those who promote them.

The Australian ATO can now trace withdrawals from ATM machines using foreign credit cards - a favourite method of tax evaders to access secret offshore funds.

The US IRS are proposing establishing a 'whistle-blower' office designed to give its tax collectors an inside advantage when fighting complicated tax shelters developed for, and used by, wealthy taxpayers and corporations. Informants who tell of tax evasion stand to win 15-30% of recovered taxes and penalties. The US have put the IRS and the Immigration Department under a single department and they are talking to each other like they have never talked before.

The President of the Philippines has recently stated her intention to raise more taxes under existing laws through much tougher enforcement.

The tax collectors are in the best position they have been in for a long time, possibly since Ancient Roman times. They have never had so much access to so much information and information is power in the hands of the tax collectors just as it is with anyone else.

Get smart, get legit!

So what does this mean? It means that cheating on taxes is more dangerous than ever and it means that legitimate tax planning requires more care than ever.

But the good news is that in the cross-border context in particular, there is still lots that can be lawfully done to achieve what most people consider to be an acceptable rate of tax. Zero tax is often, but not always, an overly ambitious goal these days.

The careful use of corporate vehicles, trusts and partnerships still allows for significant and entirely legitimate reduction in exposure to income, capital gains and inheritance taxes. The use of life insurance and retirement schemes is becoming increasingly popular in shielding income from tax in high tax countries whilst at the same time allowing for tax efficient inter-generational wealth transfers.

Rome wasn't built in a day; nor is most family wealth. It is more important than ever to get smart about the impact of taxes. The old approach of meeting tax circumstance with guile is finished; the smart money now meets tax circumstance with strategy.