Tax havens are increasingly attracting attention today because of the sheer size of the phenomenon. Although reliable data on tax havens is still difficult to come by, the Bank of International Settlement (BIS) quarterly statistics showed that since the early 1980s about half of all international banking assets and liabilities were routed through offshore financial centres (OFCs). About a third of all multinational corporations' Foreign Direct Investment (FDI) go through tax havens. Estimates of gross tax avoidance perpetrated through tax havens are difficult to ascertain. There are no reliable figures on corporate tax avoidance which is presumably the principal reason why so much FDI is routed through tax havens. Individual tax avoidance and evasion is estimated conservatively to be somewhere between $US 800 billion to a trillion a year. Tax havens are also used as the principal route through which laundered money escapes developing countries.
Most of the significant tax havens existing today have developed around two principal geo-political poles. One pole has evolved with close links to the City of London. This includes British Crown dependencies such as the Channel Islands, Jersey, Guernsey and the Isle of Man, British Overseas Territories among which the most significant tax havens are the Cayman Islands, Bermuda, British Virgin Islands, Turks and Caicos and Gibraltar, and recently-independent British Imperial colonies such as Hong Kong, Singapore, the Bahamas, Bahrain and Dubai. Less significant in terms of impact, but more numerous, are newly independent British Pacific territories. The other pole developed in Europe and consists of the Benelux countries - Belgium, Netherlands and Luxembourg - Ireland, and of course, Switzerland and Liechtenstein. The only other significant tax havens today which are not part of these two poles are Panama and, to a lesser extent, Uruguay.
The history of tax havens is riddled with myths and legends. Tax havens are associated with tax avoidance, which, as far as we can tell, is as old as taxation itself. Tax havens are consequently viewed by some as the latest incarnation of an age-old practice, which in many ways they are. Modern tax havens, however, are sovereign states (or suzerain entities like the Channel Islands with considerable autonomy) that use their sovereign right to write laws in order to attract a certain type of international clientele. Tax havens must be viewed, therefore, as a distinct developmental state strategy that could have evolved only in the context of a robust international system of statehood, respectful of the sovereign right of states to write their own laws. Furthermore, the tax haven strategy is aimed exclusively at an international clientele and hence can be pursued successfully only within an integrated world market. Tax havens, in short, are a distinctly modern phenomenon, whose origins lie at the earliest in the late nineteenth century.
The brief overview of the history of tax havens presented here is organized into five sections. Firstly a working definition of tax havens is offered. The second section reviews the historical emergence from the late nineteenth century to the 1930s of the three distinct instruments of tax havens: low or zero taxation for non-residents, easy methods of incorporation, and legally-protected secrecy. The third section follows the initial phase of historic growth in tax havens from World War I through to the early 1970s. During these decades a small number of states, led by Switzerland, began to develop tax haven regimes as an intentional developmental strategy. The fourth section examines the subsequent period from the early 1970s up to the late 1990s when the number of tax havens rose dramatically, as did the scope, planning, and sheer volume of financial assets passing through them. This was the true heyday of the tax haven. Section five looks at the current phase of tax haven history, which began in 1998 with the publication of an OECD report on harmful tax competition. The same year also witnessed an intensification of the European Union efforts to combat tax havens. The crisis since 2007 has further intensified the pressure on tax havens. The full implications of the current phase of reaction to the enormous expansion of tax haven activity are still to be seen.
The term 'tax haven' has been widely used since the 1950s. Yet there is no consensus as to what it means. The problem is that on the one hand many governments use their sovereign right to enact law in order to help successful sectors within their economies to compete in the world economy or, alternatively, to spur the development of new competitive sectors. They often employ some combination of fiscal subsidies and sweeteners, including reductions in taxation (sometimes by informal or highly opaque set of arrangements) and removal of 'red tape' (i.e. regulation) to attract or retain mobile capital.
The fiscal portions of such policy packages are called Preferential Tax Regimes (PTRs) and include a wide array of initiatives and regulations designed to attract foreign capital. When in the late 1990s the European Commission decided to investigate tax abuse among EU member countries, it discovered 206 such regimes-and that figure does not include PTRs in dependent territories of EU member states such as the Channel Islands and Gibraltar. At heart, tax havens are merely another type of economic specialty practiced by states - albeit a specialty that is intended to be permanent and is, by its nature general (i.e. not focused on a specific industry or developmental goal). A tax haven is created and sustained with the help of particularly aggressive, and some would say virulent, PTRs. It is a specialty favored by the smallest independent jurisdictions in the world, and as a result, it is numerically the most popular type of competitive strategy. Dharmapala and Hines calculate that for a country with a population under one million, the likelihood of becoming a tax haven rises from 24 percent to 63 percent. The figure is probably higher if dependent jurisdictions such as the Caymans and Jersey are added to the list.
While some tax havens are easily recognizable, a highly mobile financial environment combines with the proliferation of PTRs to create a situation whereby any country may serve as a potential haven from the taxation of at least some other countries. As a result, the lines separating temporary PTRs, aggressive PTRs, and full, permanent tax havens are highly contested. As early as the 1980s, Vincent Belotsky, a high-ranking U.S. Internal Revenue Service (IRS) official, noted that many countries, including the United States, fit the conventional definition of tax haven. The United States, he wrote, 'applies a zero rate of tax on certain categories of income, including interest received by a non-resident alien individual or a foreign corporation from banks and savings institutions'. The line separating tax havens from other PTRs is arbitrary; described by Charles Irish as a 'matter of degree more than anything else'. The UK as well is considered by many to be a tax haven.
A tax haven strategy, however, is certainly not the centerpiece of either the United State's developmental strategy or (if more controversially), the UK's. As a result, many prefer to include the concept of intentionality in their definition of tax havens. Such a definition of tax havens would be: jurisdictions that deliberately create legislation to ease transactions undertaken by people who are not resident in their domain. Those international transactions are subject to little or no regulation, and the havens usually offer considerable, legally protected secrecy to ensure that such transactions are not linked to those who are undertaking them. Such transactions are 'offshore' - that is, they take place in legal spaces that decouple the real location of the economic transactions from the legal location, and hence remove the tax liability of the transaction from the place where it actually occurred.
One of the fascinating aspects of the development of the tax haven strategy is that it developed piece by piece and in different locations, often for reasons that had little to do with ultimate use. Only during the second phase of their development, from the end of WWI onward, are there signs that some countries, led by Switzerland and Liechtenstein, were beginning to develop a comprehensive policy of becoming a tax haven.
Probably one of the first instances of a tax haven to have developed were the U.S. states of New Jersey and Delaware in the late 19th century - and ironically, all the indications suggest that they are likely to be among the last to be dismantled. Both were not, and still are not, strictly speaking, tax havens, but may be credited as the originators of the technique of 'easy incorporation' which is used by all modern tax havens. Easy incorporation rules, to the point that today one can buy a company 'off the shelf' and begin trading in less than twenty four hours is one of the key aspects of the tax haven strategy. The concept began to develop during the 1880s. New Jersey was in dire need of funds. A corporate lawyer from New York, a certain Mr. Dill, persuaded New Jersey's Governor, Leon Abbet, to back his scheme of raising revenue by imposing a franchise tax on all corporations headquartered in New Jersey. Laws of incorporations were at that time still highly restrictive in Anglo-Saxon countries (a long term effect of the 1720 South Sea bubble). Corporate headquarters were attracted to New Jersey primarily due to its liberal incorporation laws, and to some extent by its relatively low rate of corporate taxation. When the Delaware legislature debated the drafting of a new General Incorporation Act in 1898, it sought to emulate the success of New Jersey. Here, again, a group of lawyers from New York played a prominent role in drafting the proposed act. It was obvious at the time that Delaware was enacting "liberal" laws to attract corporate business.
While the American states of New Jersey and Delaware may have invented the technique of attracting non-resident companies by offering amenable regulatory environments, since the 1920s, some Swiss cantons - led initially by the impoverished canton of Zug, located not far from Zurich - have copied this practice and brought it to Europe.
While American states came up with the technique of bidding for corporations by liberalizing incorporation laws, we must credit the British courts with the technique of 'virtual' residencies, allowing companies to incorporate in Britain without paying tax - a development that at least one commentator believes is the foundation of the entire tax haven phenomenon.
Many trace the origins of the practice to a series of rulings in the British law courts. Most significant among those was the 1929 case of Egyptian Delta Land and Investment Co. Ltd. V. Todd. It was demonstrated that although the company was registered in London it did not have any activities in the UK and hence was not subject to British taxation. This case created, argues Picciotto, "a loophole which, in a sense, made Britain a tax haven". Companies could now incorporate in Britain but avoid paying British tax. The ruling of the British courts proved significant because it laid down the rule not only for the United Kingdom but also for the entire British Empire, a point later exploited by jurisdictions such as Bermuda and the Bahamas and perfected in the 1970s by the Cayman Islands.
Threatened by the depression of 1929 and in particular by the series of bankruptcies in Austria and Germany in the early 1930s, the Swiss assembly began to debate an Amendment to the Bank Law to safeguard the Swiss banking system. Contrary to original intention, the Banking Act of 1934, in article 47, strengthened the principle of bank secrecy by placing it under the protection of criminal law. The new Swiss law demanded 'absolute silence in respect to a professional secret', that is, absolute silence in respect to any accounts held in Swiss banks - "absolute" here means protection from any government, including the Swiss. The law makes enquiry or research into the 'trade secrets' of banks and other organizations a criminal offence. Not surprisingly, very few academics and journalists have been prepared to risk jail for their research. The law ensured that once past the borders, capital entered an inviolable legal sanctuary guaranteed by the criminal code and backed by the might of the Swiss state.
Together with U.S. state laws and British virtual residencies, Swiss bank secrecy forms the third pillar of the offshore world, to be copied by other jurisdictions. It is worth our delving briefly into the work of scholars who have studied the history of these laws.
During the 1920s and 1930s, a few small countries led by Switzerland were beginning to make a name for themselves as tax havens. Liechtenstein, a small principality located between Switzerland and Austria, adopted the Swiss Franc as its currency in 1924, and at the same time enacted its own Civil Code. Liechtenstein synthesized and codified Swiss and Austrian practices, creating a new corporate form, the infamous Anstalt, based on the Austrian concept of the foundation. The new Company Law imposed no requirements or restrictions concerning the nationality of shareholders in Liechtenstein companies.
Kuenzler suggests that a Zurich-Zug-Liechtenstein triangle emerged as the first true tax haven hub during the 1920s. A few offshore holding companies and trusts existed in Switzerland before the war, but the number of holdings increased relentlessly after 1920. The canton of Zurich was not keen on offering tax privileges to these holding companies, but the city's financial elite used the more amenable and much poorer rural cantons of Glarus and Zug, which redrafted their laws on the advice of lawyers and bankers from Zurich's Bahnhofstrasse. Those same lawyers and bankers advised Liechtenstein. Through these facilities, Zurich became the centre for the Swiss societé anonyme and mailbox companies, eclipsing Basel by the end of the 1920s.
Luxembourg as well was among the first countries to introduce the concept of the holding company. Under the law of 31 July 1929, such companies became exempt from income taxes. There is evidence also that Bermuda, the Bahamas and Jersey as well as Panama were all used to a limited extent as tax havens in the interwar years.
The development of modern tax havens is normally associated with rising taxation in the 1960s. This is somewhat misleading for two reasons. First, as we saw, tax havens develop much earlier than the 1960s. Second, the 1960s were particularly important not so much because of the rise in taxation in advanced industrial countries, which indeed took place, but probably more because of a Bank of England ruling in 1957 and the emergence of the Euromarket, or the offshore financial market in the late 1950s. In September 1957 the Bank seems to have accepted the proposition that transactions undertaken by UK banks on behalf of a lender and borrower who themselves were not located in the UK were not to be officially viewed as having taken place in the UK for regulatory purposes even though the transaction was only ever recorded as taking place in London. The Euromarket is an inter-bank or 'wholesale' financial market which, due to this implicit understanding between the Bank of England and the commercial banks, is not regulated by the Bank. But since the transactions take place in London, no other authority regulates the market and hence it became effectively unregulated or 'offshore'. The development of the Euromarket in the City of London proved to be the principal force behind an integrated offshore economy, centred on London and including remnants of the British Empire.
British banks began to expand their Euromarket activities in Jersey, Guernsey, and the Isle of Man in the early 1960s. By 1964, they were joined by the three big American banks - Citibank, Chase Manhattan, and the Bank of America.
In 1966 the Cayman Islands enacted a set of laws, including the Banks and Trust Companies Regulation Law, the Trusts Law, and the Exchange Control Regulations Law, and also its 1960 Companies Law, adopting in all these cases the classical tax havens model. The Caymans proved an astonishing success story. According to BIS statistics, in 2008 the Cayman Islands were the fourth largest financial centre in the world.
The late 1960s also saw Singapore's emergence as a tax haven. With the French Indo-China War having escalated into the Vietnam War, by the mid 1960s there were increased foreign exchange expenditures in the region, but a tightening of credit occurred in 1967 and 1968, contributing to rising interest rates in the Eurodollar market. As a result, dollar balances in the Asia-Pacific region became attractive for many banks. Singapore responded by setting up incentives for branches of international banks to relocate to Singapore. A branch of the Bank of America was the first to establish a special international department to handle transactions for non-residents in what was called the Asian Currency Unit (ACU). As with all other Euromarket operations, the ACU created a separate set of accounts in which to record all transactions with non-residents. Although the ACU is not subject to exchange controls, the banks are required to submit detailed monthly reports of their transactions to the exchange control authority in Singapore.
Singapore is currently emerging as the fastest-growing private banking sector in the world. Indeed, the main problem Singapore currently faces in its quest to become the world's largest private banking center is what it describes as a 'talent shortage' - a lack of specialist professional staff, even though the financial center employs about 130,000 people. Asset growth in Singapore has been phenomenal, rising from $150 billion in 1998 to $1.173 trillion by the end of 2007.
The relative success of European and Caribbean tax havens brought in new entrants to the game. The first Pacific tax haven was established in 1966, in Norfolk Island, a self-governing external territory of Australia. The Australian federal government sought consistently to block the development of the Norfolk haven, largely successfully for international purposes but not for Australian citizens. As Jason Sharman noted, though, once 'Norfolk Island set the precedent in 1966, Vanuatu (1970-71), Nauru (1972), the Cook Islands (1981), Tonga (1984), Samoa (1988), the Marshall Islands (1990), and Nauru (1994) have increasingly taken the standard route of copying legislation from the current leaders in the field and then engaging in fierce competition for business that has often generated only the thinnest of margins'. All these havens introduced familiar legislation modeled on the successful havens, including provision for zero or near-zero taxation for exempt companies and non-residential companies, Swiss-style bank secrecy laws, trust companies laws, offshore insurance laws, flags of convenience for shipping fleets and aircraft leasing, and more recently establishing advantageous laws aimed at facilitating e-commerce and online gambling.
Another important centre to have developed later was the Irish Financial Services Centre in Dublin. Following the success of its Shannon export processing zone, established in 1959, Ireland established the Irish Financial Services Centre in Dublin in 1987 with its favorable tax regime for certain financial activities and low corporate tax rate (12.5% in 2008).
In October 1975, Bahrain initiated a policy of licensing offshore banking units (OBUs), followed soon by Dubai. The 1980s and 1990s witnessed a great proliferation of tax havens in other regions of the world such as the Indian Ocean, Africa and now post-Soviet republics.
By the early 1990s, there were between sixty and one hundred tax havens in the world, depending on the definition one applies to the phenomenon. More worryingly, the BIS statistics showed that about half of international lending was routed through these havens, that at least one third of all international Foreign Direct Investment was routed through them as well, and that they have become an important instrument of tax avoidance worldwide, and have constituted the single largest drain on developing countries' economies. With activity on this scale it appeared that something had to be done.
The astonishing statistics associated with tax havens tell us that they have played a central role in skewing developments in the world economy. How could the leading industrial countries allow these small jurisdictions to rise and flourish apparently at their direct fiscal expense? In fact, countries such as the US, UK, France and Germany have sought from time to time to close certain loopholes, pressurizing this or that tax haven to change some of its rules and policies. There were also some feeble attempts, dating back to the interwar period to try to develop a coordinated international response to tax havens. But frankly, not much was accomplished. Indeed, as previous sections have indicated, paradoxically the very same countries, with the possible exception of France and Germany after the Second World War, have been major players in the development of the tax haven phenomenon.
Nevertheless sentiment in the developed countries began to change towards the end of the 1990s. Since then a number of initiatives, led initially by the OECD 'harmful tax competition' campaign, began to gather steam. Jason Sharman exposed these efforts as largely arguing that tax havens were able to exploit the contradictions of the OECD campaign, for example, the preferential treatment it gave its own members such as Switzerland and Luxembourg. Yet, only three years later, it appears that tax havens are now under greater threat today than ever. While concern about tax havens goes back a long time, their full impact on the world economy took a long time to mature and seems now to be appreciated most keenly by the leaders of the European Union. While the OECD campaign has been largely in the doldrums, the EU has emerged as a more effective leader to address the issue of tax havens and their economic consequences. Whether, however, the important support of the USA will be forthcoming under the Obama administration remains to be seen. Both the Clinton and the George W Bush administrations were alert to the issue, and the Clinton administration was one of the drivers of the multilateral efforts against tax havens. But one of the first acts of the Bush administration was to withdraw support for multilateral efforts to combat harmful tax competition. President Obama, however, signaled his concerns regarding tax havens while he was still a Senator. At this point pressure on tax havens is intensifying. The G-20 London Communiqué devotes a whole section to proposals to re-regulate tax havens. Some predict that banking secrecy is unlikely to survive in its present form much further into the 21st century. Yet, despite growing pressure on tax havens, the most recent BIS statistics show no decline in the aggregate volume of money that goes through them.
Tax havens now span the entire world, serving all the major financial and commercial centers. Modern tax havens are still largely organized in three groups. First and still by far the largest is made up of the UK-based or British Empire-based tax havens. Centered on the City of London and fed by the Euromarket, it consists of the Crown Dependencies, Overseas Territories, Pacific atolls, Singapore, and Hong Kong. The second consists of European havens, more specialized as headquarter centers, financial affiliates, and private banking. The third consist of a disparate group of either emulators, such as Panama, Uruguay, or Dubai, or new havens from the transition economies and Africa.
By grouping tax havens in this way we begin to appreciate the difficulties, as well as the opportunities, for developing a coordinated international campaign to fight them. The OECD is clearly ill equipped to deal with tax havens, not least as many of its members, including the UK, Switzerland, Ireland and the Benelux countries are themselves considered tax havens. In addition, the financial crisis has weakened the United States and Western Europe, and given greater room for manoeuvre to creditor countries, such as the Gulf States, some of which are emerging as significant tax havens, and Singapore and Hong Kong; the latter protected by China. Nevertheless, the pressure on public finance is intense, and while governments can ill afford to raise taxation, fearing further decline in domestic consumption, recovering any taxes lost through tax havens will be an attractive proposition. The pressure on tax havens, therefore, is likely to continue.
The UK is clearly critical to any future international efforts to combat tax havens, not least as half-a-dozen of the most important tax havens are dependencies of the UK. The EU is already clamping down on the Belgian co-ordination centers and other special provisions of this sort. And if the EU, the US and China come to an agreement on tax havens, it is more than likely that Honk Kong and Singapore will succumb as well. The Gulf States, meanwhile, with their commitment to Islamic banking, clearly aim at a specialist, regional market rather than the non-Muslim majority of tax haven users.
But what exactly should the struggle against tax havens consist of? Traditionally tax havens differentiated between residents and non-residents; they have tended to tax, sometimes heavily, their own citizens and local businesses, while offering low taxation to non-residents. The EU business directive has put paid to that, with the result that all countries in the EU, as well dependencies of EU countries must treat residents and non-residents the same way for tax purposes. Once this battle is won, the next great issue is that of opacity. Tax havens have created systems and regulations that help to hide the true owner of assets deposited in their domains. As long as secrecy is maintained, potential tax avoiders and evaders, as well as money launderers are likely to try to take advantage of these countries to hide their assets. The key issue, therefore, is now secrecy, and more generally, opacity. We need an internationally agreed code of conduct that ensures transparency of ownership and traceability of assets to their ultimate owners.
Raymond W. Baker, Capitalism's Achilles' Heel: Dirty Money, and How to Renew the Free-Market System, (London: Wiley, 2005)
Vincent P. Belotsky, 'The Prevention of Tax Havens via Income Tax Treaties', California Western International Law Journal 17 (1987) 43-62
Dhammika A. Dharmapala & James R. Hines, 'Which Countries Become Tax Havens?' NBER Working Paper No. W12802 (2006)
Charles R. Irish, 'Tax Havens', Vanderbildt Journal of Transnational Law (1982) 449-510
Roman Kuenzler, 'Les paradis fiscaux', (University of Genéve, Master thesis, 2007)
Ronen Palan, Richard Murphy and Christian Chavagneux, Tax Havens: How Globalization Really Works, (Ithaca: Cornell University Press, 2010)
Sol Picciotto, International Business Taxation, (London: Weidenfeld and Nicolson, 1992)
Jason C. Sharman, 'South Pacific tax havens: From leaders in the race to the bottom to laggards in the race to the top?' Accounting Forum 29 (2005) 311-323
Jason C. Sharman, Havens in a Storm: The Struggle for Global Tax Regulation. (Ithaca: Cornell UP, 2006)
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