Addressing Offshore Corporate Tax Evasion - Essay Example

? Final paper draft Addressing Offshore Corporate Tax Evasion In partial fulfillment of the requirements for Submitted by Your College Your College Location The DATE Abstract Tax evasion and tax avoidance are two sides of the same coin, both denying governments of needed revenue. Tax evasion is the illegal concealment or avoidance of a tax, while tax avoidance is the legal effort to arrange the affairs of the entity in such a way as to minimize taxes. For individuals, there is no way to legally avoid taxes in an offshore environment. However, there exist numerous opportunities for juristic entities such as corporations, foundations and trusts to avoid taxation by operating in multiple, carefully chosen jurisdictions using carefully chosen techniques designed to minimize taxes. This report identifies various methods of tax avoidance by multinational corporations and other entities and makes policy recommendations with respect to closing these loopholes and level the playing field between competing businesses and tax jurisdictions. Outline Introduction Offshore Tax Evasion and Avoidance Tax Havens Corporate Tax Avoidance Methods Use of Tax Havens Debt Allocation Earnings Stripping Transfer Pricing Contract Manufacturing Hybrid Entities Hybrid Instruments Magnitude of Losses Policy Issues Repeal of Deferral Partial Abolition of Deferral Formula Aportionment Splitting Foreign Tax Credits Recommendations and Conclusions. Introduction Offshore tax avoidance has greatly increased in the last decade. Multiple multinational corporations; banks and even individuals have shifted their tax responsibilities and eliminated tax in their domestic businesses (Owens, 2007). Tax avoidance resulted in reduced government revenue and reduced domestic businesses activity, as big multinationals were rewarded for their financial manipulation instead of innovation, job creation or productive investment. Lack of transparency by various governments has greatly facilitated offshore tax avoidance. Poor preparation at the policy level in countering tax abuse has resulted in many multinationals and individuals relocating their “tax home” to a tax haven. As mentioned by Sullivan (2008, p. 726), use of offshore accounts poses a threat to sovereign governments as companies use havens like Cayman Islands and Bahamas to evade tax. Global integration of financial markets and the improved communication and information technologies has made the creation of these offshore accounts and shell companies easy. Globalization, coupled with lack of transparency among various countries (which is vital in tackling tax abuse) has increased the incidence of tax evasion and avoidance at both the individual and corporate level. In the new era of banking without borders, corporations and wealthy individuals are free to transfer their capital abroad and channel it to passive investments in offshore jurisdictions. This makes it possible for them to evade paying income taxes. Offshore tax havens are countries that engage in “tax competition” with the high-tax regimes. As mentioned by Sullivan (2007, p. 329), offshore tax evasion and avoidance has put sustainable and responsible businesses at a competitive disadvantage as their competitors avoid taxation by the use of tax haven structures and strategies. Tax evasion deprives countries of revenue and this limits the development and modernization of infrastructure, which is vital for a strong economy. Offshore tax evasion According to Owens (2007), international tax evasion is categorized into corporations’ tax evasion and individuals’ tax evasion; it can also be categorized into legal tax avoidance and illegal tax evasion, depending on whether the tax avoidance is broadly or narrowly defined. International tax evasion could also be distinguished by the measures taken or measures that could be used in reducing the subsequent loss. Government revenue losses arising from individual tax avoidance are usually associated with the use of narrowly defined tax haven, corporate tax evasion and avoidance arise in both broadly and narrowly defined tax havens and could also be legal or illegal. Tax evasion results from lack of adequate information, poor remedies including lack of adequate enforcement resources, incentives and sanctions that are well designed to improve sharing of information (Owens, 2007). Tax havens As mentioned by Gravelle (2009), tax havens is characterized by features like low or no taxes, ineffective information exchange, lack of requirements in substantial activities and lack of transparency in taxation. There are a number of formal tax evasions, Organization for Economic Cooperation and Development (OECD) created various tax havens in the year 2000, in effort to ensure that firms that were incorporated in the tax havens were treated as domestic companies in the United States. Low tax jurisdictions are in some countries like Switzerland and Ireland are recognized as tax havens but under OECD they are not recognized as tax havens (Sullivan, 2008, p. 724). Scandals like the Swiss Bank UBS and the Liechtenstein Global Trust Group gave rise to legal actions in United States that garnered great attention from countries representing the international banking sector. At hand was international tax issues related to information reporting and possible individual tax evasions. Many countries are identified to be tax havens or at least they have some aspects that are linked with tax havens that they have overlooked, these include major countries like UK, United States, Denmark, Canada, Portugal, Hungary Iceland, Netherlands and Israel. These countries allow companies to reduce their taxes on capital gains and dividends from their subsidiaries, which has a wide impact on tax reduction. Countries with corporate tax rates below 20% are seen as potential locations for domicile. Companies then receive [shift] their incomes to in a low-tax regime in order to save. These countries include Ireland, the Slovak Republic, Iceland and Poland (Gravelle, 2009, p. 5). Tax havens significantly impact revenue collection efforts of high-tax regimes. The United States, for example, estimated that the use of tax havens caused losses of tax revenue in the range of $43 billion to $123 billion in 2009, from both individuals and corporations. Such losses of revenue impedes the growth of a strong economy by reducing available funds for development of modern infrastructure, improvement of agricultural activities, improvement of commerce, energy, small businesses, justice, national science and environmental protection (Sullivan, 2007, p. 331). Corporate Tax Avoidance Methods Use of tax havens With respect to the United States, multinationals incomes from their overseas subsidiaries are not taxed until the revenue is repatriated to the parent company in U.S. as Dividends. However, anti-abuse rules of subpart F allow taxation of related and passive income from wholly owned overseas affiliates and subsidiaries, including controlled foreign corporations (International Taxation, 2008). The net repatriated income is taxed less credits for any foreign income taxes actually paid. When a country establishes operations overseas, that part of company is not subject to taxation because it is treated as a branch of the company rather than a separate entity. In this way, all overseas branch income is treated as part of the parent company’s income. A company with such subsidiaries may engage in financial manipulation and enjoy tax evasion through its overseas operations, inasmuch as the foreign tax credit given to the multinationals is theoretical and does not offset tax in the host country (Gravelle 2009, p. 7). Multinationals with subsidiaries operating in high tax countries may receive excess tax credits to cover United States tax liability, offsetting lower tax credits given to those multinationals whose foreign affiliates are operating in low-tax countries. Foreign operations provide multinationals a means of reducing their tax burdens. Most multinationals and banks in the U.S. employ teams of accountants and lawyers to help them establish tax havens that will maximize the firm’s profit, which can be perceived as giving them an unfair competitive advantage (Jacobs & Duke, 2006, p. 56). Tax havens have been termed unethical in that they favor irresponsible firms over ethical firms, big companies over small and multinational companies over domestic firms. Debt allocation and stripping of earnings Firms may also evade tax by shifting their profits from high-tax countries to low-tax countries as long as such shifts will be possible and will not affect other aspects of firm. One method used by firms to shift profits involves increasing borrowing from high capital jurisdictions and reducing borrowing in the low-tax jurisdictions. This shift of debt moves debt to high tax regimes and equity to low tax regimes. Another practice involves earnings stripping, whereby the company’s debt to other firms and any unrelated debts are not taxed to the recipient. In the context of multinationals, a parent company in US lends to the subsidiary in US or a foreign borrower who is not subject to US tax lends to a firm in US. The current US tax rule tackles earnings stripping and deductions; the rule applies allocation of United States parent company interest to limit the company on foreign tax credit (Gravelle, 2009, p. 8). Lack of allocation rule is set to address deferrals allows US parent companies to operate foreign affiliates in low tax jurisdiction with equity finance taking all interest as deduction on the overall company debt. It is hard to evaluate the earning stripping by parent companies from other countries operating foreign subsidiaries in U.S. since the firms entire accounts are unavailable. Transfer pricing Companies also shift their profits via transfer pricing: Companies reduce prices charged by the parent company and the subsidiaries in high-tax countries and increase prices charged in low-tax countries. By raising the purchase prices of their commodities, company shifts income. Transfer pricing is also reflected in the intangibles like the intellectual properties where a patent built up in U.S. is given license to a subsidiary in low-tax country like Ireland shifting the income where the payment or royalty is less than the license true value. As mentioned by Barber (2006, p. 57), intangibles like new inventions and new drugs are incomparable in price and this challenges the policing of transfer pricing. In U.S., advertising of new brands is tax deductible; investments in other intangibles except buildings and capital equipment in U.S. also have tax credit since they are treated as for research and development. The overall treatment of these activities gives an effective low or zero tax rates for the total intangible investments creating an avenue for tax avoidance since the tax deductions offset the possible future taxes that would be charged on return on investment (Barber, 2006, p. 59). Contract manufacturing Some subsidiaries are established in low-tax countries that are deemed undesirable to manufacture and market the products. Such multinationals engage in profit shifting whereby the subsidiary approaches another firm in a country where there is high tax rates to manufacture products and sell for them as a contract manufacturer, the contract manufacturer produces the product at cost plus fixed mark-up. The arrangements are made such that the contract qualifies for exception from the subpart F taxes (OECD-CTPA, 2006, p. 9). Hybrid instruments and hybrid entities Firms are also able to use what has been referred to as check-the-box provisions. These are provisions aimed at simplifying the question as to whether a company is a partnership or a corporation. Check-the-box provisions are applied in foreign operations by use of disregarded entity rules that lead to hybrid entities: Entities recognized as multinationals in one country but not as multinational entities in another country (Barber, 2006, p. 62). A U.S. based company can open subsidiaries in low-tax countries and lend to them in high-tax countries, allowing the subsidiary to enjoy significant deductible interest expense. The subsidiaries in high-tax countries are treated as separate corporations and such operations enable the companies to avoid subpart F taxes by receiving different treatment in foreign countries and in United states. Hybrid instruments comprise of instruments that are treated as equity in one country and as debt in another country. Magnitude of loss of tax revenue from corporate tax avoidance There is no single estimate of the cost incurred through international corporate tax avoidance; however, many countries incur a significant cost due to tax avoidance by corporate entities. The estimate of potential revenue lost through shifting of profits by multinational corporations differs across time and countries, with estimates from some countries as high as sixty billion dollars. Between the period 2000 and 2003, corporate tax revenue in United States fell from $207 billions to $132 billion. The amount of corporate income tax revenue lost through tax evasion increased during this period as companies increasingly established overseas operations. A rough estimate given by Joint Committee of Taxation in United States in 2008 was eleven billion dollars; this was deemed a rough estimate since it could be understated or overstated because profit-shifting activities vary considerably (Gravelle, 2009, p. 20). Policy options to address profit shifting One of the challenges faced in addressing offshore tax evasion in most countries, particularly in the United States, is that most of the methods used by both corporations and individuals to avoid taxes are legal (or at least appear to be legal). Use of legal methods makes it difficult for United States tax authorities to address offshore tax avoidance in any other way other than by adjusting tax law. There is no international cooperation in the efforts to fight offshore tax evasions or avoidance except at the OECD level. In general, countries such as the U.S. do not share trade or business information on a multilateral base and this makes it so easy for tax evasions to occur at the individual level (Meinzer, 2008, p. 16). Efforts to enhance international cooperation are playing a great role in fighting individual tax evasion and various ways to address offshore tax evasions are under way. These include the repeal of deferral income and other changes in international tax rules. Extensive change in international tax rules It is important that significant changes be made in the international tax rules including restrictions in the allocation of capital gains and income, and deferrals (Meinzer, 2008, p. 25). Repeal deferral Repeal of deferral would help eliminate the rewards that companies enjoy from profit shifting. The repeal of deferral means foreign subsidiaries should be subject to the current tax on the subsidiary’s income while they continue to enjoy foreign tax credits. Repeal deferral is feared since corporations would probably go for incorporations in countries that allow deferral; mergers would also be used to counter the policy measure (Meinzer, 2008, p. 18). However, most companies would hardly opt for the merger option since it involves radical changes in organizations, which are costly and may not be undertaken by corporate to gain small tax benefits. Another option is direct portfolio investment like individual purchase of shares stock, which has marked substantial growth. However, direct investment may be driven by portfolio diversification and not necessarily tax avoidance. The government can take repeal deferral as a policy option followed by the evaluation of mergers and direct investment portfolios. This would help in examining whether they are a result of the policy adopted. Partial abolition of deferral The United States can eliminate deferral for specified tax havens, or in countries where tax rates are below the tax rates of the U.S., deferrals can be eliminated by specified proportion. Deferral can be eliminated for companies that manufacture or produce goods for export or purchase outsourced goods for import into U.S (Sharman, 2006, p. 49). Partial abolition of deferral could also be made on production of commodities that are exported. Partial deferral would help address challenges associated with leveraging and transfer pricing without terminating deferral entirely. It would be very critical to define tax haven under these mentioned circumstances. Formula apportionment Formula apportionment is a possibility to address profit shifting, but this would mean a major change in international tax system. Apportionment means the income generated by the subsidiaries would be apportioned to the jurisdictions involved, depending on the share combination of assets, sales, and employment. Formula apportionment has been used in U.S by many states and it is used in some Canadian provinces (Gravelle, 2009, p. 24). The challenge in using formula apportionment is lack of practical rule in intangible assets. Where the capital is not tangible, real distortions would arise in capital allocation; it is difficult or impossible to estimate the amount of intangible investment made by a company. Splitting foreign tax credit from income Rules may be adopted whereby legal entities are required to be characterized consistently in United States and in countries where subsidiaries are established. Splitting tax credit for income from foreign operations would help eliminate the use of hybrid instruments, hybrid entities and the subsequent inconsistencies in the treatment of taxable income (Jacobs & Duke, 2006, p. 21). Recommendations and conclusion International cooperation would help establish the magnitude of taxation subsidiaries are subjected to in host countries, thereby assisting the allocation of appropriate foreign tax credit. As an example, the U.S. should apply for participation in the European multilateral agreement on tax administration to enhanced shared information (Gravelle, 2009, p. 21). The U.S. should also participate in the amendment of international tax rules to ensure that repeal deferrals are eliminated where necessary, either partially or in total. Formula apportionment would also ensure multinationals do not take allocated tax credits as a gain, but rather pay the required tax. Demand for the provision of offshore facilities has considerably increased following high rate of capital flows across the borders and the improved communication and information technologies. Use of internet banking in business transactions has also facilitated individual tax evasions. Modern business facilities require the government of U.S. to put in place the appropriate policy measures to address the ever-increasing tax evasion at corporate and at individual level. The other important policy issue that United States has to tackle is tax havens; they have to come up with a way of handling tax havens in order to reduce tax evasion (Sullivan, 2007, p. 337). Such measures would enable government to collect enough revenue to sustain modern infrastructure, improve commerce, agriculture and other important economic sectors. References Barber, H. (2006). Tax havens today: the benefits and pitfalls of banking and investing offshore. Author John Wiley and Sons. Gravelle, J. (2009). Tax Havens: International Tax Avoidance and Evasion. Retrieved on 23 February 2010, from: http://www.drandreassimon.com/Site/About_Me_files/CRS2.pdf International Taxation. (2008). Large U.S. Corporations and Federal Contractors with Subsidiaries in Jurisdictions Listed as Tax Havens or Financial Privacy Jurisdictions; U.S. General Accounting Office; GAO-09-157. Retrieved on 23 February 2010, from: http://www.gao.gov/new.items/d09157.pdf Jacobs, V., & Duke, R. (2006). Offshore Tax Strategies. Prairie Village: Offshore Press, Inc. Meinzer, M. (2008). Unilateral Measures Against Offshore Tax Evasion: The Example of the Argentinean Corporate Supervisory Board (Inspeccion General de Justicia, IGJ). Munich: GRIN Verlag. OECD-CTPA. (2006). The OECD's Project on Harmful Tax Practices: 2006 Update on Progress in Member Countries. Paris: Organization for Economic Cooperation and development. Owens, J. (2007). Offshore Tax Evasion. Retrieved on 23 February 2010, from: http://www.theglobalist.com/storyid.aspx?StoryId=6212 Sharman, J. (2006). Havens in a Storm. The Struggle for Global Tax Regulation. Ithaca, Cornell U.P. Sullivan, M. (2007). Lessons from the Last War on Tax Havens, Tax Notes, July 30, pp. 327-337. Sullivan, M. (2008). Extraordinary Profitability in Low-Tax Countries, Tax Notes, August 25, pp. 724-727. Read More