Hae Min Lim
Tax Havens: Why Do They Exist and Continue to Thrive?
Conglomerates are increasingly setting up paper companies in tax havens such as the Cayman Islands, stirring controversy that they may be aiming at creating secret funds or avoiding paying taxes.
According to an analysis of the country’s top 40 conglomerates by Chaebul.com, a research firm on large businesses, the number of their subsidiaries in the world’s 10 major tax havens stood at 86 as of the last year, up almost 60 percent from a year ago.
In order to find out why such companies are using tax havens for tax planning, this paper will focus on the structure of tax havens and their wide use. In addition, it will point out the problems and following regulations.
- Tax Haven
A tax haven is a state, country or territory where certain taxes are levied at a low or zero rate. The Organisation for Economic Co-operation and Development (OECD) identifies three key factors in considering whether a jurisdiction is a tax haven:
Tax havens impose nil or only nominal taxes (generally or in special circumstances) and offer themselves, or are perceived to offer themselves, as a place to be used by non-residents to escape high taxes in their country of residence.
Tax havens typically have laws or administrative practices under which businesses and individuals can benefit from strict rules and other protections against scrutiny by foreign tax authorities. This prevents the transmittance of information about taxpayers who are benefiting from the low tax jurisdiction.
A lack of transparency in the operation of the legislative, legal or administrative provisions is another factor used to identify tax havens. The OECD is arguing that laws should be applied openly and consistently, and that information needed by foreign tax authorities to determine a taxpayer’s situation should be available.
Corporations, in order to achieve effective tax avoidance, use multiple types of tax havens.
- Primary tax havens: the location where financial capital winds up. Subsidiary shell companies there obtain rights to collect profits from corporate intellectual property (IP) by transfers from their parent.
- Semi-tax havens: locations that produce goods for sale primarily outside of their territorial boundaries and have flexible regulations to encourage job growth, such as free trade zones, territorial-only taxation, and similar inducements.
- Conduit tax havens: locations where income from sales, primarily made outside their boundaries, is collected, and then distributed. Semi-tax havens are reimbursed for actual product costs, perhaps with a commodity markup. The remaining profits are transferred to the primary tax haven, because it holds rights to profits due to the corporate IP. By matching outflow to income they do not retain capital and their role, while crucial, remains invisible.
Large multinational corporations may have dozens of such tax haven entities interacting with each other. Each haven can claim that it does not satisfy definitions that attempt to place all tax havens into a single class. Even increased transparency does not change the effectiveness of corporate tax avoidance.
- Tax Haven Locations
The U.S. National Bureau of Economic Research has suggested that roughly 15% of the countries in the world are tax havens, that these countries tend to be small and affluent, and that better governed and regulated countries are more likely to become tax havens, and be successful if they become one.
Other sovereign countries that have such low tax rates and lax regulation that they can be considered semi-tax havens are:
Non-sovereign jurisdictions commonly labeled as tax havens include:
[Tax Haven Map]
The 10 tax havens Korean Conglomerates use are the Cayman Islands, Panama, British Virgin Islands, Marshall Islands, Bermuda, Labuan, Mauritius, Cyprus, Switzerland, and Barbados. Among these, the Cayman Islands have 41 companies, with the number more than doubling from 18 of the previous year. Located in the western Caribbean Sea, the British overseas territory comprises Grand Cayman, Cayman Brac and Little Cayman. The government is known to levy no income, corporate or capital gains taxes.
SK Group had eight companies there in 2012, but set up 21 more last year. Hyundai Group set up two companies there last year, and Daelim Group also opened one. They seem to have turned their eyes to the Cayman Islands after a bombshell statement by the International Consortium of Investigative Journalists last year, which claimed to have obtained more than 2.5 million documents showing secret bank accounts in the Virgin Islands.
The famous tax haven hit the spotlight in Korea as well, with 15 paper companies of Korean conglomerates having been registered there as of last year. According to Chaebul.com, the conglomerates have 15 paper companies in Panama, and four in Bermuda. It said the authorities must strengthen its scrutiny on the overseas paper companies set up by top conglomerates as they can be used as channels for tax evasion and other irregular practices in breach of the foreign exchange regulations.
Labuan, a tax haven located in Malaysia, has two paper companies set up by Daelim Group and one by SK Group. Switzerland also has paper companies set up by Samsung Group and GS Group. Among these conglomerates, SK is the most active, operating 35 companies in tax havens. It had 24 of them set up last year. Lotte Group followed SK with 13 companies, Hyundai Heavy Industries has five, while Hyundai Group and Daelim has four each. Samsung, Hyundai Automotive Group, LG, CJ, and E Land Group have three companies each.
Tax havens have been criticized because they often result in the accumulation of idle cash which is expensive and inefficient for companies to repatriate. The tax shelter benefits result in a tax incidence disadvantaging the poor. Many tax havens are thought to have connections to fraud, money laundering and terrorism. While investigations on tax haven abuses have been ongoing, there have been few convictions. Lobbying pertaining to tax havens and associated transfer pricing has also been criticized.
- Incentives for Nations to Become Tax Havens
There are several reasons for a nation to become a tax haven. Some nations may find they do not need to charge as much as some industrialized countries in order for them to be earning sufficient income for their annual budget. Some may offer a lower tax rate to larger corporations, in exchange for the companies locating a division of their parent company in the host country and employing some of the local population. Other domiciles find this as a way to encourage conglomerates from industrialized nations to transfer needed skills to the local population. Yet still, some countries simply find it costly to compete in many other sectors with industrialized nations and have found that a low tax rate mixed with a little self-promotion can go a long way to attracting foreign companies.
- Regulation Measures
In order to prevent tax evasions through illegal methods, NTS made public the names of people who failed to report overseas financial accounts worth 5 billion won ($4.5 million). The agency added that they would face criminal charges for attempting to evade taxes from year 2014. To encourage tip-offs on failure to pay taxes, the NTS has increased the reward tenfold to 1 billion won this year.
1) Actual Taxation under the Framework Act on National Taxes
Article 14 (Actual Taxation)
(1) If any ownership of an income, profit, property, act or transaction which is subject to taxation, is just nominal, and there is other person to whom such income, etc., belongs, the other person shall be liable to pay taxes and tax-related Acts shall apply, accordingly.
(2) The provisions pertaining to the computation of tax base in the tax-related Acts shall be applied to a real income, profit, property, act or transaction, regardless of its title of form.
(3) Where it is recognized as a method of receiving unjust benefit pursuant to this Act or tax-related Acts, such as an indirect method through a third party or a method of involving two or more activities or transactions, this Act or tax-related Acts shall apply as if the relevant parties have made a direct transaction or have conducted an activity or transaction in succession, according to the economic substance of such activity or transaction.
Under this regulation, principles of real taxation functions as anti tax avoidance rule; however, it does not thoroughly prevent tax avoidance.
2) Beneficial Ownership
Beneficial Owner is a legal term where specific property rights (“use and title”) in equity belong to a person even though the legal title of the property belongs to another person. This often relates where the legal title owner has implied trustee duties to the beneficial owner. Beneficial Ownership is related to real taxation principle as the core substance for taxation.
The fact that the specific level of tax rate varies from taxpayer to taxpayer makes it important to determine to whom an economic activity is substantially attributable for taxation purpose. In this regard the substantial attribution doctrine should be considered initially for the purpose of the application of domestic tax laws in Korea. Along with the above doctrine the beneficial ownership concept has to be applied to a non-resident taxpayer from a country with which a tax treaty is concluded. A routine tax treaty has provisions that the preferential tax rates stipulated within may be applied to a non-resident from the counter-party country only if he is a beneficial owner of the pertinent income. Such restriction is put on interest income, dividend income and royalty income.
The concept of beneficial ownership is not defined in any official laws or regulations of sovereign countries or international organizations though particles of its meaning may be found sporadically in tax court decisions or tax authorities’ opinions. The difficulties originating from such uncertainty are increased by the intertwining between the beneficial ownership concept and the substantial attribution doctrine.
- Regulations in Other Countries
U.S. Legislation: Foreign Account Tax Compliance Act
The Foreign Account Tax Compliance Act (FATCA) was passed by the US Congress to stop the outflow of money from the country into tax haven bank accounts. With the strong backing of the Obama administration, the Congress drafted the FATCA legislation and added it into the Hiring Incentives to Restore Employment Act (HIRE) signed into law by President Obama in March 2010.
FATCA requires a broad scope of foreign financial institutions (FFI)– banks, stock brokers, hedge funds, pension funds, insurance companies, and trusts – to report directly to the Internal Revenue Service (IRS) all clients who are U.S. persons. Starting January 2014, FATCA requires FFIs to provide annual reports to the IRS on the name and address of each U.S. client, as well as the largest account balance in the year and total debits and credits of any account owned by a U.S. person. If an institution does not comply, the U.S. will impose a 30% withholding tax on all its transactions concerning U.S. securities, including the proceeds of sale of securities.
In addition, FATCA requires any foreign company not listed on a stock exchange or any foreign partnership which has 10% U.S. ownership to report to the IRS the name and tax identification number (TIN) of any U.S. owner. FATCA also requires U.S. citizens and green card holders with foreign financial assets in excess of $50,000 to complete a new Form 8938 to be filed with the 1040 tax return, starting from the fiscal year 2010. The delay is indicative of a controversy over the feasibility of implementing the legislation as evidenced in this paper from the Peterson Institute for International Economics.
An unintended consequence of FATCA and its cost of compliance for non-US banks is that some non-US banks are refusing to serve American investors. Concerns have also been expressed that, because FATCA operates by imposing withholding taxes on U.S. investments, this will drive foreign financial institutions (particularly hedge funds) away from investing in the U.S. and thereby reduce liquidity and capital inflow into the US. Since this regulation has been enforced, persons who are subject to such conditions, need to be in compliance.
Although tax havens can be great locations for corporations to invest their money with a much lower tax rate compared to Korea, the NTS is investigating tax haven users to find loopholes and prevent illegal tax evasion. As mentioned above, the NTS uses the method of real taxation by levying tax on beneficial ownership. In this sense, substance over form principle is strictly followed and observed.
Prior to consideration of a tax haven, it is good to understand the relevant procedures and steps. One has to make sure that he is not using an unauthorized offshore account. A majority of tax havens are verified and sound, with only a few exceptions. A person has to make sure that he or she doesn’t pay high taxes by considering unauthorized tax havens
Another important point to consider about tax havens is to discuss the issue with a tax specialist before starting to make use of a tax haven, and it is crucial to verify that a person is not making any false decisions who is about to start the tax haven at low prices.
Tax havens are popular among businesses globally for their zero or low tax rates and, in some cases, the lack of transparency in making financial data public. According to an official at the National Tax Service, tax authorities are closely watching such increases, but an investigation is rarely launched unless there is a hint of wrongdoing.
The Bank of Korea and financial regulators are currently looking into alleged violations of a foreign-exchange law involving conglomerate executives, after a civic group last year disclosed the names of nearly 20 Koreans suspected of having evaded taxes by creating paper companies in the British Virgin Islands, Singapore and Switzerland. The Korean government has also pledged to deal sternly with white-collar crime. Therefore, issues regarding tax havens are becoming important in the business world.
 Ja-Young Yoon, Paper firms in tax havens up 60 percent, http://koreatimes.co.kr/www/news/biz/2014/06/602_158790.html
 Gio Wiederhold, Valuing Intellectual Capital, Multinationals and Tax havens; Management for Professionals, Springer Verlag, (2013)
 Ja-Young Yoon, Paper firms in tax havens up 60 percent, http://koreatimes.co.kr/www/news/biz/2014/06/602_158790.html
 Treasury and IRS Issue Guidance Outlining Phased Implementation of FATCA Beginning in 2013, U.S. Internal Revenue Service (2011), http://www.irs.gov/uac/Treasury-and-IRS-Issue-Guidance-Outlining-Phased-Implementation-of-FATCA-Beginning-in-2013
 U.S. Internal Revenue Service, For most individual taxpayers, this means they will start filing Form 8938 with their 2011 income tax return to be filed this coming tax filing season, (January 25, 2012), http://www.irs.gov/Businesses/Corporations/Do-I-need-to-file-Form-8938,-%E2%80%9CStatement-of-Specified-Foreign-Financial-Assets%E2%80%9D%3F