The OECD Observer
January 1999, No. 215

 

Curbing Harmful Tax Pratices
By Jeffrey Owens

 

The proliferation of harmful preferential tax regimes and tax havens is a growing concern for governments and business. Why? And what can be done about it?

In April 1998 the OECD published a report on harmful tax competition in response to a request by the OECD countries to ‘develop measures to counter the distorting effects of harmful tax competition on investment and financing decisions and the consequences for national tax bases’. The report was endorsed by OECD Ministers in May. The worry at the heart of the report is the rapid spread of preferential tax regimes in both OECD and non-OECD countries and tax havens. Liberalisation and globalisation have led a number of governments to adopt harmful preferential tax regimes, particularly offshore regimes, not so much to attract real foreign direct investment, but as predatory policies whose main purpose is to siphon off part of another country’s tax base.

During the past 15 years virtually every OECD country has adopted some type of preferential tax regime. Over the same period the number of tax havens has more than doubled. From 1985 to 1994 the value of investments into low tax jurisdictions in the Caribbean and south Pacific islands grew fivefold, to over $200bn. The tax haven business is no longer confined to the very rich and self-proclaimed havens can be found in almost every corner of the world.

The OECD’s position on preferential taxes is unambiguous. The existence of low or no income taxes is not in itself enough to constitute harmful tax competition. Rather, when low or no taxes are combined with other legislative or administrative features, such as ‘ring-fencing’, a lack of transparency, the absence of exchange of information, then harmful tax competition may arise. The OECD report provides a framework for identifying harmful regimes and suggests counter-measures for them.

Accordingly, harmonising tax rates across countries or installing minimum tax levels is not the aim. Countries must remain free to decide their own tax rates with checks and balances coming from competitive forces of the global marketplace and thereby encouraging countries to adopt ‘best practice’ policies on taxation.

 

Focus on Financial Services

The main focus of the OECD’s work is financial and other services. The reasons are simple: these are the activities which are the most geographically mobile and therefore sensitive to tax differentials. They form an important sector, driving much of today’s global economy. Tax havens located outside the OECD area and harmful preferential tax regimes in OECD countries are of particular interest for these activities.

The concept of ‘tax haven’ refers to tax jurisdictions which offer themselves as a place which non-residents can use to escape tax obligations in their countries of residence. A number of factors identify these havens, in particular the virtual absence of taxes, combined with minimum business presence requirements, and a lack of legislative and administrative transparency. Bank secrecy and other features preventing effective exchange of information are also discernible. Using these definitions, a list of jurisdictions identified as tax havens is expected to be published in October 1999. The list should help to form the basis for unilateral or collective counter-measures.

The concept of ‘harmful’ preferential tax regimes refers to low tax regimes—provided for either in the general tax legislation or as administrative measures—that are primarily tailored to tap into the tax bases of other countries. Characteristics of such regimes are their low effective taxes combined with ‘ring-fencing’, whereby they are partly or fully insulated from the domestic economy. There is often a lack of legislative and administrative transparency here too, as well as difficulties accessing information. The potentially harmful regimes in the OECD area tend to target banking, financing, insurance, location of headquarters, distribution and similar services, although of themselves these are legitimate commercial activities.

To deal with harmful preferential tax regimes, OECD countries have agreed to non-binding Guidelines for Dealing with Harmful Preferential Tax Regimes. They have undertaken to eliminate within five years of the adoption of the OECD’s report on harmful tax competition or, if a particular ‘grandfather clause’ applies, at the latest on 31 December 2005, the features of those preferential tax regimes identified as harmful under the Guidelines. Furthermore, the OECD has established a Forum on Harmful Tax Practices to discuss the implementation of the 19 Recommendations contained in the report.

Besides the tax haven list and the guidelines, both of which are of a multilateral character, recommendations are made on how the OECD countries might strengthen their domestic and bilateral measures against harmful tax practices. At the national level, OECD countries are encouraged to adopt Controlled Foreign Company or equivalent legislation. This generally enables the home country of the parent to exercise taxing rights over lowly taxed foreign subsidiaries that the parent controls. They are also encouraged to adhere to certain defined standards in providing tax rulings and to apply strictly the 1995 OECD Transfer Pricing Guidelines, which provide for internationally agreed upon standards for establishing prices on intra-group transactions.

Bilaterally, OECD countries are encouraged to intensify their exchange of information on tax havens and preferential tax regimes. A provision is being considered for the OECD’s Model Tax Convention to deny entities operating under harmful tax regimes access to certain or all of the convention’s benefits. Furthermore, the report asks countries to consider terminating any treaties they might have with tax havens.

Countries around the world are reaching a point where they can choose either to step up the tax competition race, damaging as it may be, or to help with international efforts to build some new rules for the game. It should not be forgotten that the world has already experienced its fair share of trade wars, and unbridled tax competition could be just as counter-productive, to put it mildly. While there is such a thing as healthy tax competition—for example, when it leads to curbs in excessive government spending—if it is left unfettered it would not only shift the tax burden from capital to labour (sometimes referred to as the ‘race to the bottom’), but investment decisions would become excessively driven by tax considerations. Mostly, a free-for-all would cause tension between countries as preferential tax regimes begin to bite into the tax systems of third countries.

International co-operation through a multilateral tax competition framework is the best way to ensure stability and the peaceful co-existence of different tax systems. In the longer term, the degree of success of the Guidelines and other OECD initiatives to combat harmful tax practices will, however, depend not only on the progress made by the OECD countries, but also on the ability to bring non-member countries into the process. Judging from the response by non-OECD countries at a series of regional informal tax competition seminars held last year in Mexico, Singapore and Turkey, it is clear that several non-OECD countries share the OECD concerns on these issues.

 

Tax Competition May Be Bad Economics

Another key challenge is to convince the markets that eliminating harmful tax practices makes economic sense. That will not be easy. On the face of it, less tax competition arguably means less money in the pocket of the taxpayer and more revenue to the authorities. However, too much tax competition leads to complex and costly anti-avoidance legislation, which in turn places an increased burden of compliance on taxpayers. It also leads the market to become distorted, since not all taxpayers have access to foreign avoidance opportunities.

Rising compliance costs on international operations may discourage small and medium-sized companies from expanding to certain countries. Moreover, co-operation in building international guidelines is important so that companies resident in countries with efficient anti-avoidance legislation do not see their competitiveness penalised compared with those based in countries where the anti-avoidance legislation is ineffective or not fully enforced. Fair tax competition depends on the establishment of a ‘level playing field’ for business without the costly effects of harmful tax practices and the resulting defensive measures. Both government and business will benefit if these goals can be achieved.

 

OECD Bibliography

Harmful Tax Competition: An Emerging Global Issue, 1998 (http://www.oecd.org/daf/fa/tax_comp/taxcomp.htm)

Steven Clark and Flip de Kam, ‘OECD Taxes Revisited’, The OECD Observer, No. 214, October/November 1998 (http://www.oecd.org/publications/observer/214/article9-eng.htm)

The OECD Model Tax Convention on Income and on Capital, 1997 (http://www.oecd.org/daf/fa/treaties/treaty.htm)