How Do Tax Havens Work?
A Guide to Understanding International Tax Avoidance and Evasion
Oct 10, 2009
A tax haven is a low-tax country or territory where individuals or corporations shift their income to avoid the taxes of their home location. Tax avoidance involves using legal means to reduce one’s taxes, while tax evasion involves illegal methods for the same purpose. A U.S. Senate subcommittee has estimated that revenue losses from tax havens and abuses total upwards of $100 billion per year.
Tax Evasion
By channeling investments or passive income (e.g. interest) through foreign entities, some individuals evade taxes illegally by not reporting these assets or income on their tax returns. The U.S. estimates these tax revenues losses as being between $40 and $70 billion per year. Estimates of losses due to profit shifting by corporations to tax havens run between $10 billion and $60 billion.
Where Tax Havens Are Located
According to the OECD, the world’s most common tax havens are located in Caribbean, Europe, and Pacific in locations near large developed countries. Up to 50 countries are considered on a regular basis to have characteristics of tax havens. Major countries such as the United States, the United Kingdom, the Netherlands, Denmark, Hungary Iceland, Israel, Portugal, and Canada can be considered tax havens depending on the situation and context.
Corporate Tax Avoidance
Common methods for corporations avoiding tax and shifting profits artificially to low-tax countries have included:
- Allocating debt to tax havens: borrowing more in high-tax countries than low-tax ones using subsidiaries or foreign entities.
- Transfer pricing: changing the prices of goods and services sold to company affiliates to shift income from high-tax jurisdictions. Similarly, companies have transferred intellectual property or intangible assets to tax havens.
- Contract manufacturing: using another company as a contractor to manufacture goods to avoid high tax rates.
- Check-the-box provisions: these provisions allow corporations to be considered entities in one country and not in another. For example, a corporation can be recognized as a hybrid entity together with a subsidiary from a low-tax country and thus avoid paying taxes.
- Cross crediting: using excess foreign taxes paid in another country to offset U.S. taxes through foreign tax credits. Since companies can defer the process of repatriation of income to their benefit, the Government Accountability Office estimates that American multinational corporations pay virtually zero tax to the U.S. government on foreign source income.
Individual Tax Avoidance and Evasion
Individuals commonly avoid and evade taxes through use of the Internet, which facilitates online transactions. Tax avoidance is typically undertaken by individuals using U.S. rules that do not impose withholding taxes on certain types of income, including interest and capital gains. This is advanced further by limited tax reporting between countries on income, interest, and corporations registered in tax havens.
By purchasing investments directly from foreign countries (e.g. stocks, bonds) or placing money in foreign banks accounts and not reporting income, some individuals evade tax (illegal under U.S. tax law). Some individuals also set up shell corporations or trusts in foreign countries to evade tax on investments by taking advantage of exemptions on interest income and capital gains for non-residents in the U.S., for example.
Proposed U.S. Legislation Regarding Tax Havens
Current Obama administration proposals on tax havens address both individual and corporate tax evasion. The proposals include restrictions on foreign tax credits, hybrid entities, and check-the-box provisions. Specifically for individuals, additional reporting of personal information, new withholding rates on payments, and new penalties for non-reporting are proposed.
The new provisions, if enacted, are expected to earn $210 billion for the U.S. federal government in the fiscal years 2010 to 2019.
Further Reading
Diamond, John W. and George Zodrow, eds. Fundamental Tax Reform: Issues, Choices and Implications (2008). Cambridge: MIT Press.
Gravelle, Jane G. Tax Havens: International Tax Avoidance and Evasion (July 9, 2009). Congressional Research Service.
Government Accountability Office. U.S. Multinational Corporations: Effective Tax Rates are Correlated With Where Income Is Reported (August 2008). GAO-08-950.
Organisation for Economic Co-operation and Development (OECD). A Progress Report on the Jurisdictions Surveyed by the OECD Global Forum in Implementing the Internationally Agreed Tax Standard (October 6, 2009).
The White House, Office of the Press Secretary. "Leveling the Playing Field: Curbing Tax Havens and Removing Tax Incentives for Shifting Jobs Overseas" (May 4, 2009).
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