Uncovering the Damage of Offshore Banking and Tax Havens
By Nicholas Shaxson
Palgrave Macmillan Copyright © 2011 Nicholas Shaxson
All rights reserved.
WELCOME TO NOWHERE
An Introduction to Offshore
THE OFFSHORE WORLD IS ALL AROUND US. Over half of world trade passes, at least on paper, through tax havens. Over half of all bank assets, and a third of foreign direct investment by multinational corporations, are routed offshore. Some 85 percent of international banking and bond issuance takes place in the so-called Euromarkets, a stateless offshore zone that we shall soon explore. Nearly every multinational corporation uses tax havens, and their largest users—by far—are on Wall Street.
Tax havens don't just offer an escape from tax. They also provide wealthy and powerful elites with secrecy and all manner of ways to shrug off the laws and duties that come along with living in and obtaining benefits from society—taxes, prudent financial regulation, criminal laws, inheritance rules, and many others. Offering these escape routes is the tax havens' core line of business. It is what they do.
Before getting into the real story of offshore, this chapter will lay some basic groundwork for understanding tax havens, offering a few essential principles, some brief history, and a short overview of where the tax havens are located.
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Nobody agrees exactly what a tax haven is, but I will offer a loose description here: It is a place that seeks to attract money by offering politically stable facilities to help people or entities get around the rules, laws, and regulations of jurisdictions elsewhere. This definition is quite broad, compared to some others, and I have chosen it for two main reasons. First, I aim to challenge a common idea that it is perfectly OK for one jurisdiction to exercise its sovereign right to get rich by undermining the sovereign laws and rules of other places. Second, I am offering a lens through which to view the history of the modern world. This definition will help me show how the offshore system is not just a colorful appendage at the fringes of the global economy but rather lies at its very center.
I should also make a short point here about some confusion in the language. When I say "offshore," I obviously am not referring to offshore oil drilling. I am also not talking about "offshoring," which is what happens when a company moves a manufacturing plant or, say, a call center from the United States to India or China, perhaps to save on labor costs. When I say "offshore," I am talking about the artificial movement or use of money across borders, and about the jurisdictions, commonly known as tax havens, that host and facilitate this activity. Once the money has escaped offshore, it is reclassified in an accountant's ledger and it assumes a different identity—and that means, very often, that the forces of law and order will never find it.
A number of features help us spot tax havens. Here are some important ones.
First, as my colleagues have found through painstaking research, all tax havens offer secrecy, in various forms. The term secrecy jurisdiction emerged in the United States in the late 1990s, and in this book I will use it interchangeably with tax haven. I will call the whole global structure of these places, and the private infrastructure that services them, the offshore system.
Another common marker for tax havens is very low or zero taxes, of course. People and corporations use them to escape tax, legally or illegally. Secrecy jurisdictions also have very large financial services industries in comparison to the size of the local economy. These places also routinely "ring-fence" their own economies from the facilities they offer to protect themselves from their own offshore tricks. So they might, for example, offer a zero tax rate to nonresidents who park their money there but tax local residents fully. This ring-fencing is a tacit admission that what they do is harmful.
Various other telltale signs exist. Tax havens usually deny what they are and strenuously assert that they are clean. Search for "We are not a tax haven" on the Internet or "We are a transparent, well regulated, and cooperative jurisdiction," and see what comes up. Each has its own way of addressing the critics: In the Cayman Islands, for example, accusations of lax regulation after scandals are routinely dismissed as media stereotypes that do not correspond to objective reality.
But there is one feature of a secrecy jurisdiction that stands out above all: that local politics is captured by financial interests from elsewhere (sometimes these financial interests are criminal interests). This is why I include "politically stable" in my definition: Meaningful opposition to the offshore business model will have been neutered in a serious tax haven, so that such irritants as local politics cannot interrupt the business of making money. And here lies one of the great offshore paradoxes: These zones of ultra-freedom for financial interests are so often repressive places, viciously intolerant of criticism. The offshore world is steeped in a pervasive inverted morality: Turning a blind eye to crime and corruption has become good business practice: a way of attracting money; while alerting forces of law and order to wrong-doing has become the punishable offense. Here in the tax havens, rugged individualism has morphed into a disregard, even a contempt, for democracy and for societies at large.
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One of the first things to understand about offshore business is that it is, at heart, about artificially manipulating paper trails of money across borders. To get an idea of how artificial it can be, consider the banana.
A bunch of bananas typically takes two routes into your home: a real route and an artificial offshore paper trail. On the first route a Honduran worker, say, is employed by Big Banana, a U.S. multinational I've just invented, to pick the bananas, which are then packaged and shipped to Britain, sold to a supermarket, and sold on to a customer.
The second route—the accountants' paper trail—is different. When a banana is picked in Honduras and shipped to Britain and sold, where are the final profits generated? In Honduras? In the British supermarket? In the multinational's U.S. head office? And how do you work this out? How much do the corporation's management expertise, or the brand name, or the insurance, or the accounting business, contribute to profits and costs? Which country ought to tax each component of the final profit? Nobody can say for sure, so the accountants can, up to a point, decide for themselves.
Here, in simple form, is what they might do. They advise Big Banana to run its purchasing network from, say, the Cayman Islands, and put a financial services subsidiary in Luxembourg. The Big Banana brand might be parked in Ireland; its shipping subsidiary in the Isle of Man; it might locate certain parts of its "management expertise" in Jersey, and its insurance arm in Bermuda. All are tax havens.
Next, each part of this multinational charges the other parts for the services they provide. So Big Banana's Luxembourg finance subsidiary might lend money to Big Banana Honduras, then charge that Latin American subsidiary $10 million per year in interest payments for that loan. The Honduran subsidiary will deduct this $10 million from its local profits, cutting or wiping out its local profits (and consequently its tax bill) there. The Luxembourg finance subsidiary, however, will record this $10 million as income—but because Luxembourg is a tax haven, it pays no taxes on this. With a wave of an accountant's wand, a hefty tax bill has disappeared. Who is to say that the $10 million charged by Big Banana Luxembourg is the real going rate—or just an accountant's invention? Quite often it is hard to tell, although sometimes these prices are adjusted so aggressively that they lose all sense of reality: A kilo of toilet paper from China has been sold for $4,121.81, a liter of apple juice has been sold out of Israel at $2,052, and a ballpoint pen has been recorded leaving Trinidad valued at $8,500.
Though most examples are far less blatant than this, the cumulative total of these shenanigans is vast. About two-thirds of global cross-border world trade happens inside multinational corporations. And it is poor countries in particular, with their underpaid tax officials, that always lose out to multinationals' aggressive, highly paid accountants.
What Big Banana has done here is transfer pricing (or mispricing), a common offshore trick that U.S. Senator Carl Levin calls "the corporate equivalent of the secret offshore accounts of individual tax dodgers." The general idea is that by adjusting its internal prices a multinational can shift profits offshore, where they pay little or no tax, and shift the costs onshore, where they are deducted against tax. In the banana example, tax revenue has been drained out of a poor country and into a tax haven and funneled through to the wealthy owners of a multinational corporation. In October 2010 a Bloomberg reporter explained how Google Inc. cut its taxes by $3.1 billion in the previous three years through transfer pricing games known by names such as the "Double Irish" and "Dutch Sandwich," ending up with an overseas tax rate of 2.4 percent. The problem is getting worse. Microsoft's tax bill has been falling sharply, for similar reasons. Cisco is at it. They are all at it. Transfer pricing alone cost the United States an estimated $60 billion a year9—and that is just one form of the offshore tax game.
Worldly readers may still shrug and tell themselves that this is just part of the ugly flipside of living in a rich nation. If they do, in their reluctantly cynical way, they are suckers—for they are victims, too. The tax bill is cut not only in Honduras but in Britain and America too. The annual report of a real banana company listed in New York notes: "The company currently does not generate U.S. federal taxable income. The company's taxable earnings are substantially from foreign operations being taxed in jurisdictions at a net effective rate lower than the U.S. statutory rate." (Rough translation: We don't currently pay U.S. taxes because we use tax havens.)
This may be quite legal—but when it happens, small businesses and ordinary folk must step in to pay the taxes that multinationals have escaped. "Small businesses are the lifeblood of local economies," said Frank Knapp, member of a new group formed in 2010 called Business and Investors Against Tax Haven Abuse. "We pay our fair share of taxes, shop locally, support our schools, and actually generate most of the new jobs. So why do we have to subsidize multinationals that use offshore tax havens to avoid paying taxes?"
Multinationals, it has to be said, find it hard to cut their taxes to zero because governments take countermeasures. But it is a battle the governments are losing. The U.S. Government Accountability Office reported in 2008 that two-thirds of American and foreign companies doing business in the United States avoided income tax obligations to the federal government in the years 1998–2005, despite corporate sales totaling $2.5 trillion. Not only this, but the corporate transfer pricing abuses that I have just described are just one of several forms of tax abuse. Subsequent studies suggest the problem is getting worse.
Transfer mispricing is one of the most important reasons that multinationals are multinationals and why they usually grow faster than smaller competitors. Anyone worried about the power of global multinationals should pay attention to tax havens.
It is not just your bananas, of course. Much of the food you eat will most likely have taken a similarly twisted route into your home. The water in your tap may have traveled on a similarly ghostly paper pathway en route to your bathtub. Your television, its component parts, and many of the programs it shows also likely took offshore routes into your living room. The offshore world envelops us.
All these offshore games make markets profoundly inefficient. Wealth has been transferred from poor taxpayers to rich shareholders—but nobody has produced a better or cheaper banana here. These are untargeted government subsidies for multinationals, courtesy of the tax havens, and they don't make multinationals more productive. When corporate managers focus on tax dodging they take their eyes off what they do best—making better goods and delivering them more cheaply to market. Add to that the time and billions wasted paying expensive accountants and lawyers to conjure up these schemes. And then there is the secrecy. A fundamental building block of modern economic theory is transparency: Markets work best when two sides to a contract have access to equal information. Treasure Islands explores a system that works directly and aggressively against transparency. Offshore secrecy shifts control over information and the power that flows from it toward the insiders, helping them take the cream and use the system to shift the costs and risks onto the rest of society.
David Ricardo's theory of comparative advantage elegantly describes principles that lead different jurisdictions to specialize in certain things: fine wines from France, cheap manufactures from China, and computers from the United States. But when we find that the British Virgin Islands, with fewer than twenty-five thousand inhabitants, hosts over eight hundred thousand companies, or that more than 40 percent of foreign direct investment into India comes from Mauritius, Ricardo's theory loses its traction. Companies and capital migrate not to where they are most productive but to where they can get the best tax break. There is nothing "efficient" about any of this.
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The world contains about 60 secrecy jurisdictions, or tax havens, which can be divided roughly into four groups: a set of continental European havens, a British zone of influence centered on the City of London and loosely shaped around parts of Britain's former empire, a zone of influence focused on the United States, and a fourth category holding unclassified oddities like Somalia and Uruguay.
The European havens got going properly from the First World War, as governments raised taxes to pay for their war costs. Switzerland's famous secrecy law, making violation of banking secrecy a criminal offense for the first time, was enacted in 1934 in response to a French tax evasion scandal, though Geneva bankers had sheltered the secret money of European elites since at least the eighteenth century. Picturesque, little-known Luxembourg, specializing since 1929 in certain kinds of offshore corporations, is among the world's biggest tax havens today: Well over $2.5 trillion is parked offshore in Luxembourg. In March 2010 South Korean intelligence officials indicated that North Korea's "Dear Leader" Kim Jong-Il had stashed some $4 billion in Europe—profit from the sale of nuclear technology and drugs, insurance fraud, counterfeiting, and projects using forced labor; Luxembourg, they said, is a favored destination for the money.
The Netherlands is another major European tax haven. In 2006, while the Irish musician Bono browbeat Western taxpayers to boost aid to Africa, his band, U2, shifted its financial empire to the Netherlands to cut its own tax bills. Austria and Belgium are also important European havens of banking secrecy, though Belgium softened its laws in 2009. A couple of other small European micro-state havens are worth noting, including Monaco and Andorra, with occasional cameo roles from odd places like the Portuguese Islands of Madeira, which was central to a major Nigerian bribery scandal involving the U.S. oil service company Halliburton that resulted in the second largest fine ever paid in a prosecution under the Foreign Corrupt Practices Act.
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The second offshore group, accounting for about half the world's secrecy jurisdictions, is the biggest. This is a layered hub-and-spoke array of tax havens, centered on the City of London, which mostly emerged from the ashes of the British empire. As I will show, it is no coincidence that the City of London, once the capital of the greatest empire the world has known, is the center of the most important part of the global offshore system.
The City's offshore network has three main layers. Its inner ring consists of Britain's three Crown Dependencies: the nearby islands of Jersey, Guernsey, and the Isle of Man. The authoritative U.S. publication Tax Analysts estimated conservatively in 2007 that just these three havens hosted about $1 trillion of potentially tax- evading assets. At a reasonable annual rate of return of 7 percent and a top income tax rate of 40 percent, the tax evaded on those could be almost $30 billion per year—and income tax evasion is just one of several forms of offshore tax and financial losses. Other losses, which I will explain below, are far bigger. (Continues...)
Excerpted from Treasure Islands by Nicholas Shaxson. Copyright © 2011 Nicholas Shaxson. Excerpted by permission of Palgrave Macmillan.
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