Will tax havens fall apart?

Last Updated: Fri, Apr 19, 2013 04:43 hrs

The heading of this article is adapted from Nigerian author Chinua Achebe's widely acclaimed novel Things Fall Apart. Achebe passed away a few weeks ago, on March 21, and hence his writings come to mind. He had borrowed this title from W B Yeats' apocalyptic poem "The Second Coming", written in 1919. Yeats was perhaps influenced by the meaningless carnage of the First World War, the fratricidal Russian revolution and foreboding about the future. The following lines from this oft-quoted poem rang true at the time of the financial sector meltdown in 2007-08:

"Things fall apart; the centre cannot hold...
The best lack all conviction, while the worst
Are full of passionate intensity."

Are these words of any relevance with the spotlight again on tax havens and shadow banking? This article takes stock of recent government statements about their determination to fight tax evasion and tax avoidance, and the Financial Stability Board's (FSB's) efforts to formulate norms aimed at reducing the incidence of shadow banking (as mandated by the G20).

In the first week of April 2013, it was reported that a Washington-based International Consortium of Investigative Journalists (ICIJ) had obtained access to emails and other documents relating to accounts located in offshore financial centres (OFCs). It seems that 2.5 million files from 120,000 offshore and trust companies covering almost 30 years of such activity and involving more than 170 countries were examined. It was mentioned that 612 Indians were among those named. In the same week, Jerome Cahuzac, the French budget minister, admitted to having a secret Swiss bank account for 20 years and had to resign.

The prompt reaction at senior government levels calling for action was refreshing. On April 4, 2013, the German finance minister welcomed the ICIJ revelations, saying that it would "increase the pressure" on tax evaders. On April 10, France announced that it was setting up a special prosecutor to investigate and pursue cases involving tax evasion and fraud and that France would work to eliminate tax havens around the world. On April 12, the finance ministers of the six major European countries - Germany, France, UK, Italy, Spain and Poland - agreed to push for greater transparency. The French finance minister was reported to have said: "Nobody can deny that bank secrecy is outdated ... we need an efficient system to tackle [tax] evasion strategies."

Earlier, the 16 February edition of The Economist carried a special report on offshore finance. According to this report, the Boston Consulting Group estimates the total volume of funds in tax havens to be around $8 trillion. McKinsey believes that the amounts invested in tax-free jurisdictions could add up to $21 trillion. This special report suggests there are about 50-60 tax havens around the world that are located in the Caribbean (Bermuda, British Virgin Islands, Cayman Islands), parts of the United States (Delaware state), Europe (Cyprus, Liechtenstein, Luxembourg, Switzerland) and the Indian and Pacific Oceans (Mauritius, Seychelles, Singapore). The names of internationally recognised banks or companies that warehouse huge volumes of funds in tax havens were not listed in this report.

Tax havens, with their minuscule to zero tax rates and strict confidentiality, enable individual fortunes to be hidden from external financial sector regulators and tax authorities. Accounts are also held in the names of private firms, and it is practically impossible to establish individual ownership by disentangling the complex web of cross-holdings that stretch across several tax havens.

OFCs invariably argue that tax arbitrage is legitimate; and that tax avoidance is legal in their jurisdictions while tax evasion is not. In practice, it is impractical to expect that external tax authorities would be able to provide the information required for OFCs to distinguish whether it is a case of tax avoidance or evasion. Assuming that the protestations of tax havens are valid and that they only facilitate tax avoidance, these OFCs should have no difficulty in sharing information about their clients with external regulatory authorities. Consequently, if G20 countries are serious about reducing tax evasion and the accumulation of ill-gotten gains in tax havens, OFCs could be threatened with economic sanctions if they are not adequately transparent and responsive. In fact, if there is political will, the threat could include potential restrictions in regular air and shipping links.

Tax havens can be centres for shadow banking activities, which cause systemic risks to build up outside regulatory purview. The November 2012 FSB consultative document titled "Strengthening Oversight and Regulation of Shadow Banking" identifies the risks in shadow banking as: (i) use of repos to create short-term, money-like liabilities and facilitation of credit outside the banking system; (ii) securities lending cash collateral reinvestment estimated to stand at over $1 trillion (could lead to systemic risks since it involves maturity and liquidity transformation). The following risks affect both shadow banking and regular banking: (i) tendency of secured lending to be pro-cyclical; (ii) fire sale of collateral securities; (iii) re-hypothecation of unencumbered assets; (iv) interconnectedness stemming from chains of transactions involving reuse of collateral (risk of financial contagion and opacity); (v) inadequate collateral practices (the risk is that regular mark-to-market practices are not followed). A fuller discussion and examination of the technical issues related to shadow banking is outside the purview of this article. Suffice it to say that banking activities in tax havens need to be made more transparent to external regulators.

In India it has been reported that the Cobrapost allegations and ICIJ revelations are to be investigated. It may make future wrongdoing less likely if the results of the investigations were to be placed in the public domain.

The principal difficulty with obtaining fuller disclosure from OFCs is that tax havens are under the administrative supervision of developed countries or are located in independent states. They are in stiff competition with each other to attract funds by keeping taxes at minimal levels. Further, legal structures have been set up in tax havens to disallow any disclosure unless the requesting side provides full details of alleged wrongdoing.

On balance, despite several recent high-level official statements, it would be wishful thinking to expect that tax havens will soon become fully transparent or fall apart. However, the current environment of mounting antipathy in developed countries towards tax evasion and tax avoidance could enable us to restrict clandestine capital outflows from India by working in concert with other G20 members.

More from Sify: