The buildup was long, and the dénouement anticlimactic. On June 17, Swiss policymakers concluded a deal with US regulators to disclose financial information pertaining to about 4,450 American citizens suspected of hiding assets with UBS, a Swiss bank, for purposes of tax evasion.
A behind-the-scenes legal battle had been raging since early 2009, when America’s Internal Revenue Service (IRS) slapped UBS with a US$780 million fine and demanded the hand-over of tax information on lengthy list of US citizens whom it suspected of tax evasion. The IRS argued that between 2002 and 2007, UBS had helped some of its wealthy American clientele hide US$20 billion in assets, thus evading US$300 million per year in taxes.
UBS did not deny the charges, and the bank’s CEO Marcel Rohner issued a statement saying that “it is apparent that as an organization we made mistakes and that our control systems were inadequate.”
Yet while the bank may have admitted complicity in tax evasion, the situation did not sit well with some members of the Swiss government. Policymakers were only too aware that the country’s status as the world’s leading offshore financial center (OFC) – holding roughly one third of the estimated US$7 trillion kept offshore globally – was based on a reputation for strict privacy.
They responded by petitioning US courts to “refrain from issuing an order that would interfere with those negotiations and the more general intergovernmental relations between Switzerland and the United States.”
The big picture
“What was important about the UBS case is that it was an event which accelerated a much larger and more important process,” said David Spencer, of the Tax Justice Network, a non-governmental organization (NGO) dedicated to tax transparency. “That trend is for much broader and deeper tax information sharing and transparency among the international community.”
Spencer is referring to the parallel aggressiveness with which both the IRS and Organization for Economic Development and Cooperation (OECD) Forum on Transparency and Exchange of Information have ramped up tax compliance efforts. Since April of last year, the OECD’s enhanced offshore tax compliance programs have proven startlingly successful, with even the most intransigent OFCs now allowing at least some degree of international tax information exchanges.
Now, though, offshore investors are nervously asking where the OECD will draw the line on data privacy and security.
Under OECD regulations, OFCs must sign tax information exchange agreements (TIEAs) – although double taxation treaties (DTTs), which include information exchange provisions, will also suffice – with at least 12 countries to qualify for the “white list” of tax transparent jurisdictions. While there are some variations, under standard TIEAs, a country that suspects one of its citizens is evading taxes in an OFC must file a request for tax information on that person. The OFC jurisdiction can then review the request for information and act if necessary.
Between 2000 and 2008, just 45 TIEAs were signed. But from 2009 to August 1, 2010, 321 were signed in rapid succession.
In fact, the OECD program may have been too successful: Having proven that it has the capacity to disrupt at least some degree of tax evasion and money laundering, there are increasing calls for the organization to use its power to capture all nefarious financial activities, no matter what to cost to the privacy and security of tax information.
Someone needs to pay the bills
“I think the first thing that investors in the offshore world should understand is that there is no level of appeasement that will work,” said Dr Daniel Mitchell, a fellow at the CATO Institute, a libertarian Washington, DC-based think tank.
CATO and the Tax Justice Network may be on opposite sides of the political spectrum, but both agree that automatic exchanges of tax information and “tax harmonization” (equalized tax rates for OFCs) is inevitable. “All the current pressures and forces will combine to turn the Cayman Islands back into a sleepy fishing village for American tourists,” he argued.
The forces Mitchell is referring to are pressures from financially squeezed rich countries, and developing countries eager to get their hands on losses sustained from capital flight. Mitchell believes that the OECD and G20 push will follow roughly four stages: the break-down of existing privacy laws, followed by automatic exchange of tax information, then a drive for worldwide “tax harmonization,” and finally a push to raise corporate taxes.
He argues that many of these stages could be accomplished within the next two to five years, depending on the circumstances.
At present, the OECD’s drive stops short of automatic exchanges. Under the TIEA system, a country only hands over information in response to specific charges being made against an individual. Proponents of change argue that this system lacks the depth to make implementation meaningful.
First, OFCs are given considerable flexibility to determine whether a request is acted upon, and the speed at which it is carried out. Oxfam International, a UK-based NGO, says that Jersey has acted on just five requests for information since it signed an agreement with the US in 2001. Second, such a system prevents authorities from discovering malfeasance which might otherwise have gone undetected. Finally, developing countries, which disproportionately suffer from tax evasion, often lack the resources to file information requests with offshore jurisdictions.
Automatic tax information exchange agreements (ATIEAs) are being mooted as a more workable alternative. This system would grant member countries free access to tax information on citizens with holdings in another member country. The US and Canada already have an ATIEA for bank deposits, as do parts of northern Europe, and there is growing expectation that others will follow suit.
“It’s inevitable, the pressures to implement will be too great,” predicted Tax Justice Network’s Spencer.
Not so fast
But significant obstacles remain. The first is practical: ATIEAs simply create too much information, and the technical means of sharing vast quantities of data are not yet available. This has led to stories of boxes of data piled high in backroom offices, and it heightens the chances of information being leaked or misused.
Perhaps more importantly, the case-by-case basis of TIEAs prevents “fishing expeditions,” when a country tries to grab any information it can get on every citizen in the hope that something illegal will turn up. Many civil libertarians feel queasy at the idea of governments trawling through tax files, a priori assuming that everyone is guilty until lack of evidence proves them innocent. “How can they allow free flow of information? It’s just wrong,” argued Simon Mitchell, a legal consultant to Mayfair Trust Group, an offshore service provider.
“A key distinction we like to make is between secrecy and confidentiality,” said George Hodgson, of the Society of Trust and Estate Practitioners (STEP). “Everyone agrees that secrecy must be taken away. But confidentiality and privacy certainly should not go with it.”
The ATIEA concept may work well in Europe, where the EU’s political structure has laid the foundations for supra-national sovereignty. But will other jurisdictions be as willing to share any and every piece of information that they have about a foreign citizen? Judging from the heavy resistance to ATIEAs shown by OFCs, the answer seems to be an emphatic “no.”
The push for ATIEAs to deepen the ties of OECD tax-information sharing countries is accompanied by a push to broaden the base of networked countries. The current focus of the TIEA and DTT program is OECD member countries and small financial centers, which tend to be reasonably wealthy. Proponents of expansion would like to see the inclusion of OECD candidate nations (Brazil, China, Estonia, Indonesia, Israel, Slovenia and South Africa) as well as developing nations in sub-Saharan Africa and Latin America.
Furthermore, current rules stipulate that OFCs must sign TIEAs with 12 countries, but without specifying which ones. Jurisdiction are therefore able to select partners whose information requests will have the lowest impact on their bottom line.
Of the first 180 TIEAs signed in the few months after the requirement was introduced, 66 were agreements between OFCs themselves, according to a November 2009 report by Richard Murphy of Tax Research UK. Of the remaining 114, 67 were with the “Nordic Seven” (Denmark, the Faroe Islands, Finland, Greenland, Iceland, Norway and Sweden), and 28 of these with just the Faroe Islands, Greenland and Iceland.
The implication is that OFCs are taking the easy way out – satisfying their OECD requirements by signing TIEAs with Nordic countries that will almost certainly generate few information requests.
Proponents of expansion argue that either the minimum number of TIEAs for a white listing should be increased, or a requirement be introduced that some agreements be signed with low-income countries. The counter-argument is that expanding TIEAs beyond a critical mass could be dangerous, especially as it pertains to information security in developing countries (see article).
Thus far, the OECD has been trying to strike a balance in its push forward. The most important regulation it has introduced recently is the OECD Global Forum, a country-by-country series of peer reviews to spot jurisdictions attempting to slip through loopholes in the regulatory structure (although, as Mayfair’s Mitchell noted, an odd pairing system means “some countries get screwed”).
Jeffrey Owens, director of the OECD Centre for Tax Policy and Administration, acknowledges a jurisdiction that merely signs 12 TIEAs with its offshore peers is unlikely to pass muster. “If a country gets 12 and then closes the door, no. We expect countries to continue to negotiate after they reach the 12," he said. But at the same time, the OECD has been assiduously careful not to call for automatic exchanges, and has shown no indication that it will stop mass signings with the “Nordic Seven.”
Nevertheless, many wonder how long the organization can hold out against populist cries for all tax information to be available everywhere. “In private, many OECD officials admit that they need to get the institutions right before moving forward,” said Hodgson of STEP. “But their public pronouncements certainly slant towards as much expansion as rapidly as possible.”
What does all this mean for offshore investors? The worst-case scenario outlined by CATO’s Mitchell – complete tax harmonization for all OFCs – is certainly not appetizing: As transparency becomes the norm across OFCs, cash-strapped rich countries will strive to draw back business and tax revenue by forcing their tax competition to set “fair” rates.
His solution is for OFCs to “drag [their] feet,” by resisting or attempting to undermine all OECD regulation. It is a strategy already being pursued by some OFCs, but these are in a minority.
Others believe that OFCs will change, but not necessarily be destroyed.
Mayfair’s Mitchell notes that operating within a legal framework offers investors protection from the fly-by-night, semi-legal operators whose dodgy dealings have stigmatized the entire offshore industry. It also offers investors more firm legal redress should their investments encounter fraud.
In this sense, the continued existence of OFCs depends on their ability to offer a level of service that is equally if not more efficient and effective than that available onshore – plus whatever tax efficiency is permitted by law. Investors will turn to OFCs for their less controversial virtues: coordinating investments and operations over multiple jurisdictions, asset protection, foreign equity listings, investment funds, trusts, foundations and of course, lower taxes.
Moreover, legally and politically clean and participatory investors could hold greater political capital to encourage OFCs to sign DTTs. In addition to fulfilling the OECD’s information exchange requirements and ensuring that the same income isn’t tax in two locations, DTTs often come with a raft of tax breaks on dividends, royalties, capital gains and interest payments.
“Treaty shopping” – setting up in a jurisdiction based on the tax advantages offered under its DTTs – is already rife within the offshore industry, as are governments policies intended to stamp out such practices.
Still, it will be tempting for many offshore investors to take a more dyspeptic view. When asked whether he thinks OFCs can head off further regulation (such as tax harmonization) by demonstrating good faith in compliance with OECD transparency requirements, CATO’s Mitchell pauses. “That’s like saying if you feed your right leg to a crocodile it will make him a vegetarian.”
This article was originally featured in China Offshore Quarterly, available here.
This article was originally featured in China Offshore Quarterly, available here.