The OECD Approach To Tax Competition
3 April 2000
There are four independent but related international initiatives in varying stages of development that deal with tax competition; that of the Finance Ministers of the G-7, the United Nations, the European Union and the Organisation of Economic Co-operation ("OECD"}. It is the OECD Report referred to earlier this morning which is the most extreme in its aspirations and to which I respond this morning on behalf of the Dependent Territories
As we have heard this morning, the fundamental assumption of the OECD Report is that in a global free market capital and labour are increasingly mobile. Thus capital and labour may be attracted away from countries with high tax burdens to countries with a low tax burden. In the absence of any reduction in public spending there will be an increasing burden on the less mobile labour and capital remaining in the high tax country. For that reason the OECD Report objects to countries which "specifically target" mobile capital by operating as a tax haven or a preferential tax regime. The OECD proposes to introduce economic sanctions against a list of jurisdictions to be published in June 2000. One problem that the OECD Report never satisfactorily answers is how you define an intention to "specifically target".
That notwithstanding, what the OECD have threatened to do is attack those jurisdictions whose approach to public finance spending is different from that of the OECD countries.. Historically, only the Government or state in any jurisdiction has the authority to tax… It is a purely sovereign power. Whilst the definition of "sovereignty" is undergoing a radical recharacterisation for those Member Countries of the European Union, no such recharacterisation should or can be applied to jurisdictions that have not agreed by one treaty or another to do so. The fact that the tax haven country's system of taxation is indirect should not of itself be any ground whatsoever for comment in a non-arbitrary or non-discriminatory system.
To support its case, the OECD Report makes unsupportable statements which it represents as fact. For example, at paragraph 26:
"the Committee recognises that there are no particular reasons why any two countries should have the same level and structure of taxation. Although differences in tax levels and structures may have implications for other countries, these are essentially political decisions for national Governments. Depending on the decisions taken, levels of tax may be high or low relative to other states and the composition of the tax burdens may vary."
So far so good. At this point the Report seems to concede, the self-evident proposition, that a jurisdiction should be free to design its own tax system as a matter of its sovereignty.
However, the paragraph goes on to state:
"Countries should remain free to design their own tax systems as long as they abide by internationally accepted standards in so doing".
This also appears eminently reasonable until it is recognised that there is no internationally recognised standard for designing a tax system or a tax rate. That point notwithstanding, countries failing to meet the "standard" will apparently be subject to coercive measures by the OECD.
At various points the OECD Report talks about the distortive effect of trade and investment patterns caused by tax havens or preferential tax regimes. Yet there is no reference whatsoever in the Report to the major distortions in international markets which are, of course, Government subsidies. The Report does not talk about the Common Agricultural Policy or how precisely you build an Airbus. Further, the question of whether it is taxation that causes distortion is highly arguable, although the OECD argument rests entirely on this assumption. In a tax free world, market forces would drive economic decision making. It is as arguable that it is the introduction of taxation that causes the distortion not the introduction of lower rates of taxation or different systems of taxation.
The OECD Report is further flawed in that it then fails to provide any objective definition of "harmful" in relation to a "distortion" caused by a lower rate of tax. The fascinating questions of: lower than what rate? and how much lower? are not considered worthy of comment. Harmful means harmful. Beauty, or more accurately, the absence of beauty is in the eye of the beholder.
Thus, rather than an application of the Rule of Law which recognises that tax is a creature of statute and that you are either within the terms of the statute, in which case what you are doing is lawful avoidance, or outside of the terms of the statue, in which case what you are doing is tax evasion, we have a subjective analysis as to the intention behind legislation which now becomes the test for determining whether or not the jurisdiction in question is responsible for "harmful" tax competition. This approach is unknown to the English or US common law systems which are characterised by consistent legislative interpretation. It seems a retrograde step to have the OECD Report suggest that jurisdictions be subject to sanction on the basis of a system which relies on a subjective analysis of intention of their legislation. Further, in paragraph 54, the Report talks of "preventing tax avoidance" as if this were the current standard. But it is not the standard in the United States. It is not, and should not be, given that the general anti-avoidance provision has been shelved, the standard in the United Kingdom. The concept of unlawful tax avoidance and tax escape are civil law concepts which are not even in effect uniformly across the OECD countries. They are essentially European in genesis. The test, absent an objective system and regulatory mechanism to apply it, seems again subjective in nature. The test can only be that a transaction has resulted in less tax being paid than would otherwise have been paid. A general anti-avoidance provision of that type exists in Canada and has proved highly ineffective.
The application of this subjective thinking is carried through in paragraph 79 of the Report which states:
"many harmful preferential tax regimes are designed in a way that allow tax payers to derive benefits from the regime while engaging in operations that are purely tax driven and involve no substantial activities."
But the marketplace will determine whether the transaction works and whether the activity is substantial. It is for the onshore jurisdiction to apply tests of what is and what is not substantial for tax purposes; for example, the United Kingdom with its mind and management test has very specific rules for the tax residence of companies. Similarly the United States with its highly sophisticated controlled foreign company legislation will dictate whether the offshore corporation, the subsidiary of the US parent, is or is not taxable in relation to its earnings regardless of where that subsidiary is incorporated.
To derive momentum, the OECD Report provides a very narrow perspective which seeks to characterise capital flows to and through financial centres as being exclusively undertaken by individuals involved in personal tax evasion. No doubt to a greater or lesser extent this occurs but it occurs onshore as well as offshore. No more double standards please. In fact, tax evasion itself is comparatively easy to deal with and I will turn to the solution in a moment. But as a general proposition the OECD Report fails to appreciate at all the important role of the financial centre in managing and accessing international capital markets and reinvesting the proceeds in the EU and OECD jurisdictions. Let me give you four examples.
Firstly up to 10 per cent of the world's new aircraft product is financed through the Cayman Islands. This is not tax driven, rather if you are Boeing or Airbus and you are financing the sale of your product you would rather not have it owned by a Chinese corporation subject to Chinese law should there be a default. Better then to place the owning vehicle in a tax neutral efficient jurisdiction such as the Cayman Islands with a sensible legal system should it come to enforcing your rights.
Secondly, if you are structuring a mutual fund that is to attract multi-jurisdictional investment you would prejudice any one investor against another if you located in any specific taxable jurisdiction. Again, what you require as the jurisdiction for the investment pool is a tax neutral, fiscally efficient jurisdiction which does not add a further layer of taxation to the transaction. The investors, in any event, will be taxed in accordance with the laws of their jurisdiction of domicile or incorporation.
Thirdly, if you are a major onshore corporation and you wish to reduce your cost of borrowing and do not, therefore, wish to rely on bank or quasi bank funding, you can do so by accessing the international capital flows through a structured finance product. There may also be ancillary regulatory benefits in doing so, in terms of off balance sheet structuring. Again, the point is that you require a tax neutral, fiscally efficient jurisdiction that does not add a second layer of taxation.
Fourthly, if you look at offshore insurance which is very popular in both Bermuda and the Cayman Islands you find the attraction has very little to do with onshore tax benefits which have been removed by onshore legislation in most cases, rather you require a more sophisticated regulatory regime which does not apply inappropriate levels of regulation designed to protect the retail market when, in fact, what you are establishing is an institutional product marketed to institutions by way of private placement . This, in effect, is a regulatory arbitrage.
What then is the way forward? In his paper delivered at Jesus College, Cambridge on 14th September, 1998 Mr Jonathan Winer, Deputy Assistant Secretary of State for the US Department of Narcotics and Law Enforcement argued that from the regulatory perspective and perspective of the drive against money laundering and criminal activity the distinction made under the laws of most offshore jurisdictions, in the relevant Mutual Legal Assistance Treaties, as between defined criminal activity on the one hand and tax evasion on the other hand, could no longer be supported. In his view by amending the Mutual Legal Assistance Treaties to (a) add tax evasion to the list of predicate offences for money laundering; and (b) to include tax evasion amongst the grounds for elimination of bank secrecy, the offshore jurisdictions would meet the new standard, at least insofar as the United States is concerned. Whether this principle is universally acceptable is one thing, but as an objective standard it is coherent. It certainly seems to have been accepted as a solution by the Treasury in the recent Paper referred to today, although it should be noted that somewhat worryingly the Treasury Paper tends to use the expressions "tax evasion" and "tax avoidance" synonymously as if to say there is no difference between the two..
But if tax evasion is to become the basis of the new standard for international co-operation then it seems necessary to conclude that any offshore jurisdiction that wishes to encourage or tacitly acquiesce in fraudulent tax evasion in the future must be regarded as an endangered species. Again, if tax evasion is the basis of the new standard then the OECD Report references to low taxes and non-substantial activity as two of the four indicia of the definition of a tax haven are, I would submit, irrelevant. The legitimate and supportable objective of an OECD country, or indeed an EU country, should be no more than to seek meaningful assistance from any jurisdiction whether onshore or offshore in circumstances where its own national or citizen has evaded its domestic obligation to pay tax. It seems also right to say given the current international standard and the problems of the definition of the OECD Report that the bright line should properly be drawn at the level of exchange of information in relation to tax evasion and not mere avoidance. To go further raises serious questions about the legitimate right to privacy.
If tax evasion is indeed the basis for the new standard then I have three concluding points. The first is that the authors of the OECD Report should redefine their vocabulary and their objectives. However close they may be socially, ideologically or geographically to Brussels, the common law jurisdictions of the OECD are unlikely to accept in the foreseeable future the criminalisation of tax escape or tax avoidance.
Secondly, the approach thus far of the OECD provides no confidence that an objective analysis has or will be made as to the distinctions between the legislative frameworks of the offshore jurisdictions or between the offshore jurisdictions and the onshore jurisdictions. The picture that is painted that onshore is good and offshore is bad is ludicrously simplistic. The tax haven "tests" in the OECD Report appear to give no credit whatsoever to the jurisdictions such as the Cayman Islands, Bermuda, Jersey or Guernsey that may be regarded as substantially in compliance with the Financial Action Task force and Caribbean Financial Action Taskforce Recommendations and the Vienna Convention on money laundering. To that effect the OECD Report appears to operate in a manner contrary to the initiatives of the British Government, which through either the Foreign and Commonwealth Office or the Foreign Office has, in respect of the Crown Dependencies and the Dependent Territories, insisted on legislation which includes within its ambit a "suspicious transaction" reporting requirement in relation to all crimes. This legislation exceeds in its ambit the legislation which exists in the Continental European jurisdictions and arguably the US. This legislation mirrors effectively the provisions of the English Criminal Justice Act 1993 in relation to money laundering and criminal activities.
The OECD would do as well to ensure that legislation of this sort is, in effect, in all OECD countries with regard to suspicious transaction reporting before seeking to apply coercive sanctions across the board against the offshore jurisdictions. No double standards please.
Thirdly in threatening the capital bases of the better regulated offshore jurisdictions by the imposition of sanctions or other coercive measures, the OECD threatens to induce capital flight to less well regulated centres of Asia and elsewhere. There is a great deal of available office space in Singapore, Hong Kong and Shanghai. This would appear to be in direct conflict with the initiatives of the British Government in respect of the British Dependencies and Crown Dependencies and as a policy runs the risk of setting back the advances established in the fight against crime particularly in the area of money laundering and criminal activity as it was traditionally understood before anyone sought to include within that definition the issue of tax matters.
Anthony Travers, OBE