Business

Death By Taxes

By Richard Teather

Low-tax jurisdictions such as the Turks & Caicos Islands are under attack again. Like the movie vampire that never quite dies, the European Union’s “Savings Tax Directive” appears to have come back to life, and is apparently due to come into force on July 1, 2005.

The Savings Tax Directive
The Savings Tax Directive is the widely-reported process by which the high-tax governments of Europe are hoping to stop their citizens from sheltering their savings in low-tax countries like the Turks & Caicos Islands. If the plan comes into effect, then affected countries will have to either charge tax on all interest payments to EU residents (and pay it over to the EU governments) or automatically report the amount of interest paid to the recipient’s national tax authority so that they can tax it themselves.

Automatic reporting would make it easy for the investor’s home authority to impose tax, but would run against the tradition in many countries of protecting investors through client confidentiality and banking secrecy.

Taxing interest payments to EU residents might therefore appear at first sight to be more attractive, but the EU clearly sees this as merely a temporary measure. The rates demanded are 15% for the first three years of operation of the system, 20% (the international norm for tax deductions from bank interest) for the next three years but a clearly punitive 35% thereafter. Tax will be deducted from interest payments by the payer (whether a bank or other entity), and 3/4 of the tax must be paid to the investor’s home government.

EU tax havens
The European Commission (the EU’s bureaucracy) has been pushing for such a scheme for 15 years, but the process was held up primarily by two members of the EU that effectively act as on-shore tax havens.
The first, Luxembourg, has for its size a massive financial services sector, fuelled by its tax exemptions for interest payments; it is therefore unwilling to agree to anything that would risk losing any of this business. Indeed it was the loss of tax revenue to the German government through its citizens putting their money into Luxembourg banks (a process made easier by the removal of border controls in the EU and by the introduction of the Euro) that arguably started this whole process.

The other tax haven is the UK, whose massive $3 trillion Eurobond market is tax-free. (This allows mainly US and Japanese companies to raise money more cheaply by paying interest to investors without deducting tax.) The existence of this market in London brings much wealth to the UK, particularly highly paid financial sector jobs, associated legal and accountancy work and rents and taxes paid by banks and traders.

For both of these countries therefore, the Savings Tax Directive would damage their national economies. Both the Luxembourg bank deposits and the London Eurobond market are attractive primarily because they are tax-free. It is true that both countries also have reasonably efficient banking and dealing sectors, but no more than many other jurisdictions. If tax had to be imposed because of the EU then there would be no particular reason for this activity to stay in either country. Indeed the Eurobond market used to be in New York, and only moved to London in 1964 when the USA started levying tax on bond interest.

In the European Union, tax measures can only be imposed by unanimous agreement of all Member State governments, which means that Luxembourg and the UK could, and did, veto any moves to introduce the savings directive. However after several years of strong pressure they extracted valuable concessions (including an exemption from the new rules for existing Eurobonds) and finally gave way.

What has this to do with the Turks & Caicos Islands?
One of the strongest arguments used by the UK and Luxembourg was that the Savings Tax Directive would do only harm, not good — if all savings within the EU were taxed, then investors would simply move their money outside. The EU would therefore lose valuable financial sector business and the related income, but without collecting any more tax. Bank deposits are clearly mobile, and although the Eurobond market seems more permanent it has moved once already (from New York) because of tax and would presumably be ready to move again.

The agreement between the EU member governments therefore made the Savings Tax Directive conditional on its rules also being accepted by various non-EU countries, to ensure that there was nowhere for these markets to move to. Specifically it must cover:

* The main non-EU European tax havens: Switzerland, Liechtenstein, San Marino, Monaco and Andorra;

* “Dependent or associated territories” of EU members: the Channel Islands, Isle of Man, the Dutch Antilles and Aruba, and the UK’s dependencies in the Caribbean (including the Turks & Caicos Islands).

The EU has no formal jurisdiction over these countries, but they were clearly chosen because the EU felt that it could pressure them into agreeing to its demands, either due to geographic proximity or political or economic ties. The Turks & Caicos Islands accepted the inevitable and agreed to sign up to the EUÕs proposals on January 26, 2004, after pressure from the UK Treasury that even the UK’s Foreign & Commonwealth Office regarded as excessive.

Switzerland gives way
It was widely thought that the agreement to the Savings Tax Directive by the UK and Luxembourg, and its acceptance by the smaller low-tax jurisdictions, was an irrelevance because the process was conditional on Switzerland also agreeing. The Swiss government was thought to be unlikely to ever agree to anything that might damage its international banking sector.

However, the Swiss were put under intolerable pressure, particularly by Germany (which was losing the most under the old system through its citizens investing in Luxembourg banks) introducing excessive customs checks and administrative inconveniences in an attempt to practically close the Swiss border. (The Spanish have been using similar tactics against Gibraltar.)

Finally in June 2004, the Swiss government, after extracting other concessions from the European Union, agreed to sign up to the Directive.

Is the Directive now final?
The Swiss government has agreed to comply with the Savings Tax Directive, agreements from the other European tax havens are said to be “forthcoming,” and it is claimed that “all matters of substance” with the dependent and associated territories have been resolved. However the agreement by the Turks & Caicos Islands is of course dependent on the Savings Tax Directive coming into effect, and this is still not certain.

Firstly, although the Swiss government has agreed to the EU’s demands, this still needs to be ratified by the Swiss federal Parliament. It shows the EU’s attitude to democracy that they regard this as an administrative inconvenience, but the Swiss have been exerting their independence strongly recently and may well reject the proposal (although other elements of the deal, demanded by the Swiss negotiators as a condition of their acceptance, are valuable).

Secondly, although at the time of writing the full details of the European Council’s decision are not yet available, it appears that the Directive will still not come into effect until the Council of the EU agrees that the agreements with Switzerland and the other low-tax jurisdictions are satisfactory. This may sound like merely a technical process, but the way that the EU works means that this will be, in effect, a final political decision on whether to go ahead with the Directive. If they disagree with the general principle, then governments are quite capable of voting against overwhelming evidence that the conditions have been met.

The final acceptance by the Council is therefore far from certain, especially as it needs the unanimous agreement of the representative from each of the member governments, which now includes the 10 new members from eastern Europe. Some of these, such as Estonia, have celebrated their escape from communism by repositioning themselves as low-tax industrial centres and may be unwilling to allow the EU to reverse this policy by imposing Europe-wide taxes.

Level playing field
Furthermore, the agreement by the Turks & Caicos Islands is conditional on Switzerland, Liechtenstein, San Marino, Monaco and Andorra adopting “substantially the same terms.” Once the EU’s agreements with these countries are finalised and published, then they will be subject to close scrutiny from the other low-tax jurisdictions to ensure that the European tax havens have not been given a better deal.

Impact of the Savings Tax Directive
Even if the Directive does come into force it is unlikely to destroy the offshore finance industry, even in those jurisdictions that have been pressured to implement it.

Firstly, of course, it only affects investors who are resident in the EU; deposits from USA and other residents will not be affected.

However even for EU investors, the Directive is full of holes and should be easily avoidable; indeed the Swiss have dubbed it the “fools’ tax” because only those who do not take proper advice will be harmed by it. It is of course impossible to give firm advice at this stage, but there seem to be two main methods of avoiding the impact of the Directive:

To begin with, the bank or other person paying interest is under no obligation to investigate whether or not the person to whom interest is paid is actually the beneficial owner. For example, if a bank in the Turks & Caicos Islands pays interest to a trustee based in a jurisdiction not subject to the EU’s rules, then the bank will not have to deduct tax from that payment unless it is actually informed by the trustee that the beneficiary of the trust is an EU resident.

Secondly, the Directive only applies to interest, not to dividends. An EU investor can therefore set up a company in the Turks & Caicos Islands and invest share capital into it. That share capital can then be deposited by the company into a bank, but provided the company is tax resident in the Turks & Caicos Islands the recipient of the interest earned (the company) will not be an EU resident and so the Directive will not apply. The EU resident individual investor will receive dividends from the company, not interest, and so again the Directive will not apply.

This second restricted application of the Directive may well prove to enable EU investors to effectively deposit money in Turks & Caicos banks through some form of redeemable preference share, giving a return commercially equivalent to a bank deposit but legally a dividend that will escape the Directive.

The future for low-tax jurisdictions
Despite the claims of the European Commission, the Savings Tax Directive is still not certain and it appears that even if it does come into force next summer it will be relatively easy to avoid.
However this is not the only assault on low-tax jurisdictions. Various other international bodies, including the United Nations, have begun processes to try to impose minimum levels of tax on savings and business activities, but the most serious after the EU is the Organisation for Economic Co-operation and Development (OECD).

The OECD “Harmful Tax Competition” initiative
The OECD’s campaign against low-tax jurisdictions began in 1998 with the publication of its paper “Harmful Tax Competition — an emerging global issue.” The Organisation’s members are the governments of the leading industrialised countries, primarily Europe, the USA and Canada, Japan, and Australia and New Zealand, but the main drivers of this particular process are again the high-tax European governments.

Tax Competition is the process by which countries compete to attract investment by lowering their tax rates, and the OECD accepts that it has had very beneficial effects in forcing governments to give more thought to the effect of their tax policies on investors. Indeed, the 1998 paper stated that: “liberalisation of cross-border trade and investment has been the single most powerful driving force behind economic growth and rising living standards.”

However some governments clearly feel that things have gone too far, and want to restrict international investment in order to protect their ability to raise taxes. As the first part of this initiative, and to minimise accusations of bias, the OECD attempted to define harmful tax regimes, giving four “key factors”:

1. No or low effective tax rates;

2. “Ring-fencing” (i.e. the low tax applies primarily to foreign investment);

3. Lack of transparency (i.e. the nature of the tax reductions are hidden); and

4. Lack of effective exchange of information.

The last factor, lack of information exchange, is similar to the EU’s desire to force low-tax jurisdictions to report all payments made to EU residents to their home tax authority so that they can be taxed.

Resistance to the OECD
The OECD intended to force non-members to comply with its demands by imposing sanctions on non-compliant countries. However it was met by organised opposition from the low-tax jurisdictions, particularly from the Caribbean states which have seen their economies threatened. Antigua & Barbuda has been a leading voice in the opposition to the OECD, and the government of the Cayman Islands has recently spoken out against the “interventionist high-tax” approach of the EU.

Almost all of the low-tax jurisdictions conceded to the OECD’s demands to publicly commit to removing all “harmful” aspects from their tax systems, but mostly on the explicit condition that they would do so only when all other countries, including the OECD members themselves, had done the same. The commitment by the Turks & Caicos Islands, signed on March 8, 2002, demands as a condition that “those jurisdictions, including OECD member countries . . . that fail . . . to satisfy the standards of the 1998 Report will be the subject of [sanctions].”

The OECD process is still on-going, but this insistence by the low-tax jurisdictions on a level playing field is difficult for the OECD to either reject or satisfy. Rejection of demands for fair play would be a clearly unfair move (accusations of neo-colonialism have already been made) and damaging politically, but many of the OECD’s members (including again, Switzerland and Luxembourg) are unwilling to dismantle their own valuable tax regimes.

Interestingly, Liechtenstein, under the close protection of OECD member Switzerland, is one of only five jurisdictions to have completely refused to comply with the OECD’s demands, suggesting that Switzerland will not allow the process to go too far.

The OECD members have carried out a review of their own harmful tax practices, and claim that they have removed or rendered harmless almost all of them. However this review has ignored many of the more important regimes, and is open to strong accusations of favouritism with OECD members being treated more leniently than non-members.

One of the many regimes that were not examined was the UK’s “non-domicile” exemption. This effectively allows foreign nationals to live in the UK, being tax-resident almost indefinitely, but remain exempted from tax on their overseas income. Not only does this clearly come within the OECD’s definition of a harmful tax regime (being a ring-fenced and largely hidden system that allows a low effective tax rate), it is also harmful in the OECD’s sense of actually distorting economic activity. Indeed it is incredibly successful; a recent study suggested that of the UK residents with annual income over £100,000, half of them were non-UK nationals likely to be benefiting from this exemption. The UK gains from this regime by attracting wealthy individuals and their spending, and despite numerous reviews it shows no sign of removing this exemption.

The low-tax jurisdictions are therefore in a strong position against the OECD, provided they keep insisting on the “level playing field” of fair treatment for OECD members and non-members. The danger is that the OECD is trying to separate out information exchange; most of the OECD members are willing to introduce this if they can then insist that the non-members do the same. The low-tax jurisdictions must resist this move and insist that the whole package needs to be implemented before a level playing field is in place. In other words, that the OECD members must genuinely dismantle all of their harmful tax regimes before information exchange is imposed. As many of the OECD members are clearly unwilling to do this, the OECD process can be lost in the sand for many years, possibly indefinitely.

In addition, the current USA government is not fully supportive of these moves by the OECD. This should make OECD sanctions, should any be imposed, less effective.

Why are these attacks being launched?

“highly efficient and low-cost environments . . . protected by the rule of law”
(description of low-tax jurisdictions by the Cayman leader of Government Business, July 2004)

Jurisdictions such as the Turks & Caicos Islands are clearly valuable in international investment. By providing such an environment, they make international capital markets more efficient and in many cases make international pooling of capital possible when it would otherwise be prevented by a lack of co-ordination of cross-border tax and investment regulations. By doing this they increase the amount of available international investment capital, help it to go to the places where it will do most good, and therefore increase jobs and the global standard of living.

Furthermore, as most of the low-tax jurisdictions have very little industrial base (due to geographical constraints), most of this investment and these benefits end up back in the OECD countries themselves. Even the OECD itself accepts this — its 2001 Progress Report on its initiative against tax competition states:
“The more open and competitive environment of the last decades has had many positive effects on tax systems, including the reduction of tax rates and broadening of tax bases which have characterized tax reforms over the last 15 years. In part these developments can be seen as a result of competitive forces that have encouraged countries to make their tax systems more attractive to investors. In addition to lowering overall tax rates, a competitive environment can promote greater efficiency in government expenditure programs.”

Although this is a process that is beneficial to their citizens, it is not one that is attractive to governments themselves. Faced with the choice of making their activities more efficient or increasing taxes, most governments would find it much easier to raise tax.

In Europe at the moment, politicians are feeling trapped by electorates who are unwilling to pay any more tax but want better public services for what they do pay. In the UK for example, government advisers now believe that tax levels above 43% of GDP (only just above the current levels) will seriously damage their electoral prospects.

With nearly half the nation’s wealth, one would have thought that governments should be able to provide a few half-decent hospitals. However most of this money is creamed off by the politicians’ various client groups, whether those who have become dependent on welfare payments or the armies of middle managers who have a stranglehold on the inefficient state services. In the rest of Europe the problem is even worse, with even less reform and crippling unfunded pension liabilities.

What the politicians would like to do is soak the “rich” for a little more tax money, raising more funds without directly affecting any electorally significant group. Of course high taxes on savings income damages investment, reduces economic activity and jobs and ultimately makes the whole country poorer, but it is still a very tempting short-term target. Their problem is that since the last time this was tried in the 1970s, capital has become much more mobile and now can easily shelter in tax havens. Raising taxes on the rich would simply move money offshore rather than increase the government’s revenue.
European governments have therefore given in to the temptation for a short-term solution. Whatever the long-term effects on the economy, they would rather muzzle the tax havens to leave themselves free to raise taxes on investment capital.

Conclusions
Low-tax and lightly-regulated jurisdictions like the Turks & Caicos Islands play a beneficial role of the world economy. Not only do they improve the efficiency of international capital markets, and therefore increase investment and jobs all around the world, but they also force other governments to use their tax revenues more efficiently.

High-tax governments resent this and would rather stamp out such jurisdictions, leaving themselves free to raise taxes whatever the cost to the economy and long-term detriment to their citizens.

The EU’s Savings Tax Directive is a current danger to low-tax jurisdictions. Although it is still not yet final and should be possible to avoid in its current state, it may well be pushed through and later extended.

The OECD’s process is currently less of a worry, having been slowed down by the concerted insistence by non-members on a level playing-field. However this needs to be maintained. Non-members must insist on the whole package being taken forward together and resist the current OECD moves to drive through information exchange on its own while effectively dropping those parts that would harm its own members. A change in government in the USA could also give new force to the OECD. The process was started under the Clinton government and lost speed when the Bush administration signalled a lack of enthusiasm.

Overall, there needs to be continued co-operation between low-tax jurisdictions like the Turks & Caicos Islands and their friends and supporters in Europe and the USA. It is important for all of us that the European governments do not win this fight, not just to preserve the sovereignty of small nations but also for the sake of investment and the global economy.

Richard Teather BA (Oxon) ACA is Director of the Centre for Finance & Tax Research, Bournemouth University, UK, in which role he writes and speaks regularly across Europe in support of international tax competition. He previously worked in private practice, advising multinational businesses on tax law, which gives him a deeper understanding of the role of low-tax jurisdictions in the world economy that is not shared by many of his fellow academics. He can be contacted via e-mail at rteather@teather.me.uk or through his website www.teather.me.uk.



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