How do Tax Havens make money?

Swiss banks, etc.. why do they do what they do?

Feb 12, 2021

“Oh, I just love tax season”, said no one ever.

Well, every ordinary Joe and his uncle looks worried as the tax season comes barging in! And why not? After all, who would love to part with the hard-earned money? Ain’t the Government supposed to be our guardians — finance our life without expecting much in return! Umm.. the bitter truth being told, people get too literal when it comes to the meaning of ‘Government Servant’! And that’s why they fail to realize the financial burden on the Government to keep moving the trains, running the schools, protecting the borders, continuing the vaccination drive, building infrastructure and what not!

Needless to say, people start looking for leeway to evade taxes! And one such arrangement, widely popular among the rich boys, is routing the wealth to Tax Havens. Well, you must have at-least, in the daily chai pe charcha, come across the likes of Swiss banks? Yeah, that’s just one fish in the pool. Eh? Aren’t aware? Worry not, let me help you out.

What are Tax Havens?

For the uninitiated — Tax Havens (or formally put — Offshore Financial Centres) are countries or places with low or no corporate taxes, that allow outsiders to easily set up businesses there. To name a few: Switzerland, the Bahamas, Bermuda, the British Virgin Islands, the Cayman Islands, Mauritius, Panama, Netherlands, etc.

Here’s how you could identify one —

Minimal or negligible income tax
Limited public disclosure about companies and their owners
Lack of transparency in information exchange
No substantial activities

Well, you’ll agree with me.. the above-mentioned factors are facilitators for such a framework to exist, isn’t it? Rich boys and companies could have all the black money (untaxed income) and have it routed to these tax havens, irrespective of whether this money is earned legally or illegally through criminal activities. Most of it is done by investing in shell companies that exist only in papers or investing in asset classes like real estate, yachts and other luxury stuff. If some estimates are to be believed —

Wealth parked in Tax Havens could exceed $21-32 trillion.
About 10% of the total global output is parked in these Tax Havens.
The cost to governments, in lost revenue, exceeds $800 billion a year.

…and that’s grossly huge! Who bears the brunt, you ask? Well, it’s us, the honest fellows!

For your note.. using an offshore account isn’t exactly illegal, but not declaring this to local tax authorities is (illegal).

(Here's one such story of tax avoidance through tax havens involving Tiger Global and Flipkart by Finshots — “Don't underestimate the taxman”)

Anyway, did it ever occur to you, that… if tax revenues are the Government’s principal source of income and Tax Haven nations have negligible taxes, how do they run and manage their country? Never thought? Eh, there’s much more than what meets the eye. And I’ll clear the clutter for you, my friend…

How the hell do Tax Havens make money?

Just think about this.. why would a nation choose to be a Tax Haven, if it’s nothing to gain out of it? Hmm? What do you think these nations earn? Well, money, it is. Let me tell you how…

Fees, in lieu of taxes

Tax Havens provide services to rich goons from foreign countries. But why would they do it for free? No, they won’t. In fact, these nations levy high license and service fees in exchange for the minimal tax structure and secrecy services they provide (i.e. for keeping their mouth shut). Bribe or fees, call it whatever you wish, but that’s how it works. Not only that, they also charge a thick amount in the form of annual renewal charges — think Insurance, you pay the annual premium and, in turn, they insure you. So, all of this provides a source of recurring fixed income for Tax Haven nations.

Tax holidays, but not vacations ;-)

…on a lighter note. Well, there isn’t a complete absence of taxes, the way people perceive it to be. Generally, these Tax Havens levy high custom/import duties and sales tax on goods and services to cover their lost revenues from corporate & income tax. So, that comes in to compensate their exchequer.

Moreover, you get the benefit of lowered taxes only if you use their offshore structures, otherwise, you’ll be liable to pay tax. For example: suppose country T is a Tax Haven nation. You live in another foreign country and want to launder your money by investing in some other country S. You can do that by indirectly routing it through an international business company in country T, and you don’t have to pay any tax to country T (other than fees and charges). But if you choose to move into country T and genuinely set up a business there, you’ll have to cough up all sorts of taxes like import tax for stuff you bring in, sales tax, income tax, etc. Hope you’ve got an idea why it’s not exactly a vacation tho ;-)

Triggered spending and investment

See, when the rich guys from foreign countries save on taxes, they might be tempted to spend on stuff that they wouldn’t have otherwise done. Like: real estate or yachts or precious gems, etc. These stuff, of course, bring in taxes and other revenues for Tax Haven nations.

Also, the directors of shell companies incorporated in Tax Haven nations might have to pay a visit, once in a while, for regulatory purposes, and obviously, they’ll stay in elite suite rooms, eat in premium fine dining restaurants, travel in luxury saloon cars and explore the country. Undeniably, this gives a boost to the Hospitality and Tourism sector, bringing in more revenue for their Government.

So, these rich guys keep pouring in money into Tax Haven nations and thus, there’s ample inflow of FDIs (Foreign Direct Investment), which allows those nations to get easy access to capital as well as to build up their coffers for use in case of emergency. Foreign corporate investment in banks and other financial institutions also enables a good financial framework, and a free and open foreign exchange management mechanism. Also, bonds (or debt) issued by the Government of Tax Haven nations can be underwritten or subscribed (purchased) by foreign banks, which provides funds for public investments and economic developments.

In a way, Tax Haven nations get their national financial security insured by big countries like the US, as bureaucrats from these countries have to keep the banks afloat for their accounts to continue running.

Reduced burden on Government spending

Well, if: X-Y=Z, how do you maximize Z? Either by increasing X or decreasing Y, isn’t it? The same works for Tax Haven nations. Fees and investments bring in revenues(X), whereas some expenditure(Y) is cut down as the rich guys take it on themselves. Think for example, Construction. When the rich goons wanna show the existence of their (shell) companies, they’ll build buildings, like the big ones. But these will be of no use to them, hence, they’ll rent it out to these nations, probably at cheap rates. So, these nations get access to commercial buildings without having to cough up much from their Capital Expenditure budget. There are many other facilities that these nations get a hold of, without really spending.

Employment booster

To give shape to a giant tax-savvy and secrecy mechanism, Tax Haven nations would need lawyers, accountants and tax experts, in really good numbers. Banks and other financial institutions will require CXOs, managers, clerks, data entry operators and other client-facing personnel. So, there would be ample employment opportunities for the citizens of these nations, which would indirectly give a boost to their education sector as well. Think about this — as more citizens get educated, more of them will get employed, their standard of living will improve, they’ll spend more, they’ll invest more, they’ll pay taxes, and increased savings & investments also brings in more revenue for the Government.

Now that you know how these Tax Havens make money, here’re some facts.

Let the numbers speak —

A publication from the National Bureau of Economic Research depicts that Tax Havens are actually adequately funded, here’s one evidence:
…you see, the ratio of government spending to GDP or tax revenue to GDP of these nations stood approx. at par with the world as a whole. So, it wouldn’t be unfair to say that these nations do, actually, make sufficient money.
You won’t believe it, but the top three Tax Havens for India (Singapore, Netherlands and Mauritius) account for 59% of cumulative FDI equity inflows and 55% cumulative FDI equity outflows! Consider the top 10, and the inflows could go as high as 87% ..as per data released on inflows (2000-2019) by the DIPP and data on outflows (2012-2018) by the RBI — both reported by Business Today. Well, now it’s not difficult to imagine what could be a major factor behind the increasing economic disparity (between rich and poor) in India!

The bottom line

There’s a quote by Denis Healey —

“The difference between tax avoidance and tax evasion is the thickness of a prison wall.”

However, it’s high time we bring tax avoidance under the legal scanner. Misuse of the existing legal system for personal benefit is, undeniably, a criminal offence. And for that, there is something called the General Anti-Avoidance Rule (GAAR) that spots no difference between tax avoidance and tax evasion. However, criticisms of it being too stringent have dragged on for long, and thus it needs a revision. There are a number of other proposals by experts, like digital sales tax, which could go a long way in curbing tax avoidance. Well, let’s just leave it to our law-makers and policy-makers to do the best they can.

However, there is a need for the Government to restore citizens’ belief on its fiscal policy (taxes and how they’re spent). Judicious government spending and transparency of records is the necessity. Only then, probably, a few more citizens will regain faith and we can make our tax structure more inclusive and acceptable (at-least more than the current 2 percent!) These reforms may bring about psychological and moral changes, which take time, but they do work eventually.

Anyways..

What else, in your opinion, could discourage tax avoidance?

…I would really love to hear your views.

Gen Z's Words

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