With the groundbreaking release of the Panama Papers and the subsequent global uproar, you’re not alone if you find yourself wondering: Just what is a tax haven?
The massive leak of millions of papers from the database of a Panamanian law firm, Mossack Fonseca, detailed dozens of global politicians and associates purportedly using offshore tax havens to hide assets. All told, the names of 12 current or former world leaders were found in the document dump. Iceland’s prime minister resigned just days after the release, and several other heads-of-state are now in the hot seat.
What is a tax haven? Simply put, a tax haven is generally a country with a low rate – or even a zero rate – of income tax, says Narelle MacKenzie, a tax consultant in San Diego. The Cayman Islands, Bermuda and the Bahamas each boast a zero percent rate for corporate taxes.
Who typically uses tax havens? Companies and high net-worth individuals disproportionately use tax havens in an attempt to lower their tax burdens. “The top corporate statutory tax rate in the United States is 35 percent, which is substantially higher than the average 2015 worldwide tax rate of 22.9 percent, though some countries favor much lower tax rates,” says Susan Albring, associate professor of accounting at Syracuse University’s Martin J. Whitman School of Management. When you take in billions in revenue, as some companies do, cutting the tax rate by even 1 percent is a veritable financial windfall. Still, there’s more than enough incentive for individuals to seek out low-tax jurisdictions, too.
“Other than the country of Eritrea in Africa, (the U.S.) is the only country that taxes its citizens no matter where they live,” says Nuri Katz, president of Apex Capital Partners, a global advisory firm. For instance, a Canadian working in Brazil would pay taxes only to Brazil, he says. But an American working in Brazil would pay taxes to Brazil and would have to file in the U.S.
That system creates an incentive for Americans to lower or defer taxes through offshore avenues.
Using tax havens to your advantage isn’t illegal. Mark Matthews, formerly chief of criminal investigations for the Internal Revenue Service and now an attorney at Caplin & Drysdale in the District of Columbia, says tax havens are legal for “the vast majority of economic and financial activity.”
Although the term “tax haven” is arguably a dirty phrase nowadays, there are certainly legitimate uses of them.
For instance, a U.S. citizen who owns a construction company in Cypress would have a large tax bill if the company paid him dividends directly, Katz says. But if the construction company was instead owned by a firm headquartered in the Cayman Islands, “then fees of all sorts, like dividends, royalties and other fees could legally be paid to that Caymans company from Cyprus with no tax.”
It’s when you don’t report your ownership of these foreign companies that you can get into big trouble.
Historically, accurate reporting has been tough to enforce. Famously secretive Swiss banks, for instance, weren’t required to give up their clients’ names to the U.S. government. The banking secrecy afforded by tax havens has facilitated “financial crimes like tax evasion, money laundering and Foreign Corrupt Practices Act violations,” Matthews says.
Consequences can be stiff for offenders. In 2010, Congress passed the Foreign Account Tax Compliance Act, or FATCA, making tax-haven shenanigans far more difficult.
“FATCA basically forces all banks around the world to report financial information to the American government,” regarding any Americans with interests in foreign accounts, Katz says.
Depending on the crime, prison sentences can range from 5 to 20 years. But if you earned the money legally, there’s “generally an IRS disclosure program available to avoid prosecution and publicity, although with likely stiff financial penalties,” Matthews says.
“The government is also interested in third parties such as bankers, advisors and the like who come forward to cooperate even if they may have helped Americans hide money,” Matthew says.
There’s an odd consequence of these stricter rules. The term “tax haven” is ultimately relative. A desirable tax haven for a citizen of one country might not be such an appealing option for a citizen of another, due to differing tax rates and treaties. New standards from the Organization for Economic Co-operation and Development take further aim at tax havens by introducing stricter financial reporting requirements between countries.
But the U.S. isn’t required to furnish names of non-U.S. citizens with accounts in America to their country of origin.
The new standards could encourage “foreigners to stash more money in America by keeping secrets from other governments,” Katz says.
Essentially, the U.S. is itself becoming a tax haven of sorts.
The bottom line on tax havens? Simply put, people use them to pay less taxes. Sometimes they’re used criminally, most of the time they aren’t. Illegally shielding assets in today’s day and age is an ill-advised, Herculean task, and becoming more difficult by the day to pull off.
Consult an appropriate tax lawyer if you’re thinking about legally setting up offshore financial accounts. And definitely consult a lawyer if you’ve already done it the other way … because the Feds may be ringing your doorbell very soon.