The OECD Observer
January 1999, No. 215

 

Overcoming Fiscal Borders in the Global Economy
By Grace L. Perez-Navarro

 

Tax authorities run the risk of being left at the border while the rest of the world reaps the benefits of globalisation. One important way of empowering them to combat international tax avoidance and evasion is to improve the cross-border exchange of information.

The OECD has long advocated the progressive liberalisation of trade and financial markets as a means of stimulating economic growth and improving living standards around the globe. Substantial progress has been made towards that goal. However, the increased opportunities for business to operate globally have in turn expanded the opportunities for taxpayers to avoid or evade tax at the international level. National borders may in many ways be disappearing, but they still broadly define the area within which governments can act to administer their national tax laws. Indeed, most countries would consider it a violation of their sovereignty if their borders were crossed by foreign tax authorities to administer their own tax laws.

Fiscal borders pose a serious problem for tax authorities. They simply cannot carry out their work without information about a taxpayer’s income-producing activities, including those that take place abroad. They cannot always rely on domestic sources of information to determine and collect tax, particularly where cross-border transactions are concerned. As a result, tax authorities need some means of gathering information internationally in an increasingly globalised world.

 

A Growing Problem

The scope of international tax avoidance and evasion is always difficult to measure. As one tax administrator quipped, ‘if we could measure it, we could tax it.’ Nevertheless, most experts agree that the problem is substantial and growing. A recently issued report commissioned by the United Nations Office for Drug Control and Crime Prevention suggests that the size of the tax evasion problem is some multiple of the amount of the proceeds of all types of crime.1 One of the authors of the report, Jack A. Blum, recently testified before the US House of Representatives that ‘most of the world’s money laundering in offshore centres involves tax evasion.’ In its annual report for 1995-96, the multilateral Financial Action Task Force, based in Paris, estimates the size of the money laundering problem to amount to hundreds of billions of dollars annually. If most of this money involves tax evasion, governments and citizens alike should be concerned.

The problem is getting worse. This has been suggested by the increase in certain types of cross-border activity, such as in the foreign assets and liabilities held by deposit money banks in OECD countries, as shown in the charts.

The tremendous increase in foreign assets and liabilities in the United Kingdom is particularly intriguing. This figure is likely to represent the substantial growth of financial activity in the City of London but it also represents the growth of activity in UK dependencies such as the Cayman Islands. Undoubtedly, the growth of both the foreign assets and liabilities held by deposit money banks is significant, though it does not by itself point to a rise in international tax avoidance and evasion. In fact, most of the increase in foreign assets and liabilities held by deposit money banks is likely to represent legitimate commercial activity which has been properly declared for tax purposes. Nevertheless, operating through foreign banks can present opportunities for tax avoidance and evasion, particularly if tax authorities do not have access to the information they require. That is why exchange of information between tax authorities is so vital.

Since its adoption in 1963, the OECD’s Model Tax Convention on Income and Capital has included a provision to permit tax authorities to exchange information. The convention generally allocates primary taxing rights to the taxpayer’s country of residence, which means the tax authority of one country will often require information from another country. Today, over 225 treaties between OECD member countries and over 1,500 world-wide are based on the model convention. More detailed provisions for exchange of information were developed jointly by the OECD and the Council of Europe in the Convention on Mutual Assistance in Tax Matters.

 

How Exchange of Information Works

Most countries have laws that protect the confidentiality of information that tax authorities have gathered about a particular taxpayer. In fact, tax authorities are normally subject to some of the most stringent confidentiality requirements imposed on government departments. As a result, one country generally cannot provide information about a taxpayer to another country without a legal instrument that permits such disclosure. Historically, exchange of information generally has been carried out by OECD member countries under bilateral tax treaties which contain provisions based on Article 26 of the Model Tax Convention. The OECD/Council of Europe Convention also provides for exchange of information, but offers the added benefit of permitting it on a multilateral basis. Furthermore, that convention provides for exchange of information with respect to direct and indirect taxes, while the scope of most bilateral tax treaties is limited to direct tax matters, such as income taxes.

There are three main ways that countries send information to each other: after a specific request, by automatic exchange or spontaneous exchange. The most important is the first one. Under both the Model Convention and the OECD/Council of Europe Convention, countries are expected to rely on their domestic sources before making a specific request to a treaty partner. The request has to be precise (details about the taxpayer in question, the fiscal year, the transactions under scrutiny, the relevance of the information being sought). Speculative requests without specific justification—so-called fishing expeditions—are prohibited. All of these requirements are designed to prevent countries from overburdening each other with demands and to ensure that taxpayer information is disclosed only when necessary.

The second means of sharing information is through automatic exchange. This mainly concerns information about routine, periodic payments, such as interest and dividends paid to non-residents which may be taxable in the taxpayer’s country of residence. This type of exchange is growing in importance, particularly as countries improve their ability to match the information received with details about their own taxpayers. It may also benefit taxpayers by reducing their compliance costs.

The third type, the spontaneous exchange of information, typically happens in the course of an audit when one tax authority uncovers details which it thinks may be of interest to its counterpart in another country (usually the taxpayer’s country of residence). More general information may also be exchanged between tax authorities. For example, tax authorities may wish to share their experiences in dealing with issues that arise in a particular industry, such as insurance or oil. Some countries also permit authorised representatives of one country to visit the other for information gathering purposes.

The Model Convention and the OECD/Council of Europe Convention both require the protection of the exchanged information from disclosure. It must be treated as secret and may only be disclosed to persons and authorities, such as judicial bodies, involved in the assessment, collection, and enforcement of the taxes covered by the applicable convention. This condition aims to protect the rights of taxpayers. In fact, the OECD/Council of Europe Convention requires that taxpayers be notified before information is exchanged about them.

part from limiting disclosure, the obligation to exchange information at all is qualified under both conventions. First, to provide information a party is not expected to take measures that might go beyond its own internal laws and administrative practices or those of the requesting party. Second, a party is not required to give information that is normally unobtainable under either its laws or procedures or those of the requesting party. Thus, a lack of reciprocity may remove the obligation to exchange information. Third, there is no obligation to provide details that would disclose any trade, business, industrial, commercial or professional secret, or whose disclosure would run contrary to public policy. This allows governments to protect commercial and public interests where appropriate.

 

Eliminating the Barriers to Effective Exchange

Despite the sound substantive legal framework of the Model Tax Convention and the OECD/Council of Europe Convention, improvements could be made in the implementation of the exchange of information provisions. Progress could be made by expanding tax administrators’ domestic access to information. Another aim should be to enhance the quality of information available. New technologies could be exploited further and better use made of existing mechanisms for information exchange.

As noted above, the extent to which exchange takes place under the provisions of the Model Convention and the OECD/Council of Europe Convention generally depends on the domestic laws of the countries involved. Thus, if the laws of the countries provide minimal or cumbersome access to information for tax purposes, the exchange of information provisions will not be effective. For this reason, countries should re-evaluate any internal legal barriers to obtaining information which, due to the reciprocity provisions of tax treaties, might also prevent them from receiving information from elsewhere. After all, countries cannot expect to receive information from treaty partners that they themselves cannot provide.

The quality of information available domestically could also be improved to facilitate better international exchange. A primary area for action is to establish reliable mechanisms for verifying the identity of individuals undertaking transactions and to require the maintenance of adequate records of that information. The most obvious example of where such verification and record maintenance practices could be improved is in the banking sector. Much progress has already been made, mainly as a result of efforts to prevent and detect money laundering, but a few countries continue to have inadequate systems of customer identification.

Commercial secrecy also poses problems for tax administrators. A common practice in international tax evasion schemes is to incorporate multiple layers of entities in jurisdictions with strict commercial secrecy provisions. Tax administrators have to peel away at the layers in a bid to uncover the true originators of the transaction. More transparency in corporate ownership would make life more difficult for tax evaders and make things a little easier for the authorities.

One of the major complaints about existing procedures for exchange of information is that they take too long. Greater use of new communications technologies could radically change that. Moreover, some countries have expressed frustration at not being able to match the information received automatically with their taxpayers’ information. To help get over this problem, the OECD has recommended that countries encourage non-resident recipients of income to disclose their resident country tax identification numbers (TINs). All but five OECD member countries currently use TINs.

Another important way of making progress would be to have more countries ratify the OECD/Council of Europe Convention. So far, only Denmark, Finland, Iceland, the Netherlands, Norway, Poland, Sweden and the United States have ratified. Belgium has signed but has yet to ratify it.

 

The Cost of Inadequate Information Exchange

If exchange of tax information is not improved to meet the demands of the global economy and rising cross-border activity, governments and their citizens may suffer a number of adverse consequences.

First, most governments depend heavily on tax revenues as a means of providing public services to their residents. If they cannot counter international tax avoidance and evasion and this results in a reduction of tax revenues, governments may be forced to cut the public services they provide, shift more of the tax burden to less mobile factors of production, such as labour and immovable property, while possibly increasing their public deficits.

Second, the playing field for taxpayers will remain distorted because compliant taxpayers will have lower net incomes than those who are not. As a result ‘good’ taxpayers will bear a heavier share of the tax burden, which in effect depends to some extent on the ability to avoid or evade taxes, rather than on the democratically decided fiscal policy.

Third, improving the exchange of information would help to reduce the costs that tax administrations incur in their attempts to uncover schemes of cross-border avoidance and evasion. The savings would allow tax administrations to devote more of their resources to improving their service to taxpayers.

Finally, public confidence in the fairness of their tax system would be undermined if by simply crossing the border (physically or electronically) some taxpayers could avoid or evade taxes with little fear of being detected or caught. A better international exchange of information can help governments overcome fiscal borders to ensure continued confidence in the fairness of the tax system.

 

OECD Bibliography

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

Joint OECD/Council of Europe Convention on Mutual Assistance in Tax Matters, 1995

Tax Information Exchange between OECD Member Countries: A Survey of Current Practices, 1994 (http://www.oecd.org/scripts/publications/bookshop/redirect.asp?231994033P1)

Taxpayers’ Rights and Obligations: A Survey of the Legal Situation in OECD Countries, 1990

International Tax Avoidance and Evasion: Four Related Studies, 1987. (http://www.oecd.org/daf/fa/EVASION/EVASION.HTM)