Manuel Romera. Professor. IE Business School
30 June 2014
The real problem with so-called tax havens is not a question of tax competition, but rather the lack of both transparency and control of criminal activity in these territories.
The level of tax evasion in Spain, and on average in Europe, represents 23% of GDP according to the report “Closing the European Tax Gap”, while the average cost of global tax evasion stands on average at 5.1% of world GDP, according to “Tax Justice”. In order to provide a better idea of the magnitude of these figures, consider that fact that the black economy in Spain could fund 85% of the country’s public healthcare sector.
A tax haven is a geographic territory with a tax system designed to exploit world demand for opportunities to avoid or evade tax. The key characteristics of a tax haven are therefore low rates of tax, little transparency, and a focus on non-residents.
In order to provide a pragmatic point of view, let’s take a look at some of the main practices of tax havens and how countries that are not tax havens try to prevent potential tax earnings from ending up in them:
1. Thin capitalization: This is when a head office places very few of its own resources but a great deal of its debt in a subsidiary company located in a country with a high level of taxation. The deductible interests reduce profits to a minimum resulting in a low level of corporate tax. It is even possible to achieve double the amount of deduction for interests, depending on where the debt originates from.
In order to counteract this practice, European law introduced the parent – subsidiary directive, which limits the ratio of debt to a company’s own resources. Any debt above this limit is considered to be capital for deductibility purposes.
2. Location of asset ownership: This is a way of transmitting high-value assets to countries with low tax rates. Normally, in this case, ownership of the asset is passed onto an instrumental company based in a tax haven, in which the owner is simulated using a front man or similar who serves as a fictitious owner. In order to combat this practice, countries try to establish that fraud is being committed, given that all legal contracts are designed exclusively to achieve lower levels of tax and have no real mercantile purpose.
3. Abuse of holding regimes: This practice consists of placing the head office of the business group in an EU country for the sole purpose of securing an abnormally favorable tax treatment.
It is not easy for countries with less favorable tax regimes to combat this practice, given that firms are free to set up wherever they want to within the EU. Nevertheless, international agreements and EU regulations are now trying to oblige companies that place their head office in a particular country to prove that they have an economic background in the country in question, that is to say, they have material and human resources there, and do not simply use it as a front for tax purposes.
4. Transfer pricing: This is when companies attribute convenient prices to the sale and purchase of intra-group goods and services with a view to placing the corresponding tax bases in tax havens with the lowest rates of tax. In order to combat this practice there are now different legislations that oblige companies to specify how they have calculated their costs and margins and the tax system they use for their subsidiaries.
Tax havens have always existed because countries have always competed to get income, savings and investments. The fact that the number of tax havens has grown over the last few decades is the result of growing tax pressure in many countries, which consider it more important to provide social services than to offer a competitive tax rate (which could be the subject of a whole other discussion). However we have to assume that the negative connotations of tax havens are their lack of transparency and criminal activities rather than tax competition in itself, and that is how the OEDC Work Group sees it too. There is a thin line, which is frankly very difficult to analyze, between tax optimization or tax avoidance, which is legal in theory and even recommendable, and tax evasion used to commit the kind of crimes it is so often associated with, which is totally reprehensible. What is indisputable, however, is that according to the “Observatory on Corporate Reponsibility”, IBEX 35 companies increased their presence in tax havens by 6.8% last year, and 94% of them have companies domiciled in such places.