Hiding funds through unreported accounts, shell companies, transfer pricing, corporate inversions and other practices presents a high cost to national treasuries. Governments are now taking steps to combat the problem.
A recent estimate put the figure at a staggering $7.5 trillion deposited in offshore tax havens. Of this total, roughly 80% or $6 trillion is never reported or taxed. Individuals or corporations that cannot or will not take such measures are often taxed at a higher rate to make up the shortfall. This exacerbates the skewed distribution of wealth that is receiving an increasing amount of attention, e.g. in the 2016 US presidential race.
Shell Companies Allow for Anonymity
One reason for the small number of US firms mentioned in the Panama Papers is that there are American states like Delaware, which permit the incorporation of shell companies. Whether in Delaware, the Cayman Islands, or other tax havens, the point of these companies is to hide the identities of people or corporations that actually own them. Those named as corporate officers are employees of the banks holding the assets and sometimes even these people assume fictitious identities.
Besides tax evasion, shell companies can be used to hold funds for terrorists, organized crime, and other nefarious purposes. They can also be used to buy assets like real estate, not only to launder funds but also to insulate properties from any code enforcement violations through court action.
Alternative Practices for Tax Evasion
Transfer pricing and tax manipulating loans are alternative practices used by companies to avoid taxation. Transfer pricing used to transfer supplies or assets between companies frequently favor subsidiaries in low corporate tax regions. The practice enhances profits there while lowering profits of corporate entities in high-tax regions.
Loans facilitated by tax haven banks are another means of lowering tax obligations. One method is for an American or European company to send funds to a shell account in a tax haven bank. The bank, for a fee, will declare some of these funds as their own and then make them available for a loan to a subsidiary in that tax haven. The subsidiary can then deduct the interest on the loan for additional tax savings.
US corporate effective tax rates fell from 29% in 2000 to 17% in 2013.
Corporate inversions have been another means of avoiding taxes. This practice takes advantage of a tax loophole that permits American firms to buy foreign firms, then move their headquarters to the foreign company to enjoy a lower tax rate. Burger King’s purchase of Tim Horton’s in Canada allowed the newly Canadian-based, merged firm to save millions in taxes. Pfizer’s planned 0 billion acquisition of Allergan, an Irish firm, was called off after the Justice Department changed tax rules that would have prevented tax savings through an inversion.
Fighting Tax Evasion Has Entered the Policy Agenda and Risen Fast
The electoral support received by Donald Trump and Bernie Sanders, the popularization of scholarship by economists Thomas Piketty and Gabriel Zucman, the Panama Papers, and the devaluation of blue collar workers have fused to place income distributions issues high on the policy agenda.
The political risk for companies employing tax evasion strategies could be substantial. They should forecast some loss to future profits on their balance sheets in case of the loss of tax avoidance options. The threat is perhaps larger to consulting firms who charge billions advising companies how to use these strategies optimally. A loss of many of these options could pose a threat to their core competency. The likely loss of power of business-friendly conservatives, either through a Trump restructuring of Republican ideology or a large Democratic win, could accelerate stricter regulations by the US.
Bernie Sanders is winning electoral support by promising action against tax evasion.
Proposed International Initiatives to Combat Tax Evasion
In 2010, Congress passed the Foreign Account Tax Compliance Act (FACTA). The act requires foreign banks to automatically provide the IRS with information about accounts held by American nationals. In practice, it simply replicates what’s required of US banks. It ensures that all sorts of bank income, such as interest income, dividends, and capital gains are reported to the IRS. The law also requires sanctions against non-reporting banks amounting to a tax of 30% on all dividends and interest paid to them by the US
Despite initial protests, Chinese authorities began to praise automatic reporting by 2013. If a law similar to FACTA was passed in China, it would help identify and recoup funds sent out of China by the sorts of Chinese citizens being challenged by President Xi’s push against corruption. In 2013, some successes by the US program led the OECD to recognize the need for universal, automatic data collection and coordination of cross-border taxation. High-income countries and major havens like Luxembourg, Switzerland, and Singapore have announced support for the program, denoted BEPS (Base Erosion and Profit Shifting).
FACTA’s effectiveness is somewhat doubtful. Since many accounts are shell accounts with undisclosed nationalities, some bankers simply don’t acknowledge many American clients. This has led the IRS to employ other measures, including multi-million dollar payments to bank employees who inform on their banks. Large banks like UBS, Credit Suisse and HSBC have been charged with violations but faced relatively minor sanctions. A fine of $1.2 billion was imposed on HSBC for violating separate anti-laundering laws and not reporting accounts by drug cartels in its US subsidiaries.
There is also a movement for a multilateral central global financial register of all accounts as the ultimate transparency solution. Some of this is already done between the EU and other countries, but it is a long way from being universal.
The Obama administration’s 2016 initiatives against money laundering have not passed Congress, but instead, it has imposed certain regulations in the executive branch. More recently, Treasury passed regulations preventing serial inversions and moving profits to newly acquired foreign firms. The overall effort is still in infancy but should advance with supportive international leaders and public support.