Offshore tax havens: How do they work? What can be done about them?

Another massive leak of information from a tax haven law firm – dubbed the Paradise Papers – has shone a spotlight on the questionable ways in which wealthy individuals and big companies structure their finances.

But how do tax havens actually work? Can they ever be legitimately used? Exactly how big is the problem? And what can governments actually do about it?

How do tax havens actually work?

There are actually multiple ways tax havens facilitate tax avoidance, and it’s important to grasp the differences.

One of the primary methods is corporate profit-shifting.

This is where a multinational company registers its headquarters in a low-corporation tax jurisdiction and then books its profits there, rather than in the country in which it actually makes its sales.

This is what firms such as Google and Facebook have been doing in order to lower their global corporation tax bills.

But what about personal taxes?

An individual could simply become a resident of a low-tax country in order to pay a lower rate of tax on their income.

This is what racing drivers and globe-trotting sportspeople generally do.

But there are also ways in which individuals can remain living in a non-tax haven, such as the UK, and still benefit from tax havens.

If an individual keeps their assets in a trust in an offshore tax haven they can legally avoid paying capital gains in the country in which they are resident.

What is a trust?

This is where an individual puts their assets “in trust” to be managed by nominally independent third parties (or “trustees”) for the benefit of named beneficiaries, which can include the individual who put the assets into trust in the first place.

The income can be paid out by the third parties to the beneficiaries regularly, or sporadically, depending on the decisions made by the third parties.

Once it is received by the beneficiaries, the income is subject to income tax. But while it is in the trust the assets are not subject to capital gains and the income on the investments is not taxed.

A major tax advantage is that the beneficiary of a trust is also not subject to inheritance tax on the value of the assets when the person who put the assets into trust for them dies.

So who are these trustees?

They can be local officials in the tax haven, or partners in a local law firm, or accountancy firm, appointed by the individual who put their assets into trust.

Given the likelihood of those trustees being influenced by the previous owner of the assets when it comes to income disbursements the scope for abuse of the arrangement is obvious.

But aren’t there legitimate uses of tax havens?

Historically, mutual investment funds, which attract investors from around the world, have registered themselves offshore to avoid the risk of double taxation of their surpluses.

This isn’t necessarily a problem so long as the beneficiaries of the fund do pay income tax on the money they receive from the fund in their home country.

When it comes to off-shore trusts, some argue that they are necessary to safeguard the privacy of beneficiaries. There are some circumstances where one can imagine this is a legitimate argument.

Yet the problem is that privacy can be so easily abused to facilitate illegal personal tax evasion and other crimes such as money-laundering.

How big is the problem?

Corporate tax avoidance is significant.

At the end of 2016 the giant US technology companies alone were estimated by Moody’s Investors Service to have $1.84 trillion (£1.4 trillion) of cash held offshore.

This is essentially profits that firms such as Apple, Microsoft and Google registered outside the US, and most of which is piled up in tax havens.

But personal tax avoidance is bigger.

The calculations of the economist Gabriel Zucman – analysing discrepancies in countries’ national accounts – suggest that around $7.6 trillion, or 8 per cent of global wealth, is held offshore. That’s up 25 per cent over the past five years. Not all of that money will be held off-shore in order to dodge tax in a morally questionable way. But it’s fair to assume that a large proportion of it is.

The Tax Justice Network campaign group estimates that corporate tax avoidance costs governments $500bn a year, while personal tax avoidance costs $200bn a year.

Didn’t David Cameron promise to clamp down on all of this?

The previous Prime Minister did implement a series of “automatic exchange of information” agreements between the UK and the tax authorities of various tax havens designed to prevent the possibility of evasion.

But campaign groups say that this effort was a lot less impressive as a crackdown than the fanfare suggested.

And the new system hinges on an unrealistic level of cooperation from law firms and accountants in tax havens. Cameron also actually fought a proposal from the European Union that there should be public transparency over the beneficiaries of offshore trusts.

The previous government’s “diverted profits tax”, designed to curb corporate tax avoidance by the likes of Google, was also grossly over-sold by ministers as a viable solution to multinational profit shifting.

So what needs to be done?

On corporation tax avoidance, there are broadly two potential solutions.

One would be for governments around the world to collaborate and agree to tax a multinational’s profits on the basis of a fair international formula, based on their sales, investments and employee numbers in various countries.

This would effectively shut down tax havens, where no substantive economic corporate activity actually takes place.

The other solution is for governments to unilaterally tax a multinational’s revenues, while making allowance for its local costs, investments and exports.

This was something that US Republicans were pressing for earlier this year, although the plan has now been ditched.

And on personal tax?

Here a major part of the solution is to go down the route that David Cameron blocked: to demand full and public transparency on the beneficiaries of offshore trusts.

Acting in concert, the governments of the EU could bring serious pressure on many tax havens to comply.

Many tax havens such as the Cayman Islands and Bermuda are also British crown dependencies, giving the UK Government itself considerable leverage if it chose to exert it.