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October 10, 2007
Tax Analysts Offshore Project
by Martin A. Sullivan

Full Text Published by Tax Analysts®


Document originally published in Tax Notes Today
on October 10, 2007.

This article introduces the Tax Analysts Offshore Project. The goal of the project is to quantify the amount of offshore tax evasion by individuals. (We will address aggressive tax avoidance by multinational corporations another day.) Because of the difference in financial services and data available in each jurisdiction, the plan is to examine one jurisdiction at a time, starting with the jurisdictions with the best data.

They hate the label, but because they impose little tax and provide a lot of secrecy, most offshore financial centers are tax havens. Their stated policy is to discourage tax evasion, but their actions speak louder than their words. In effect, they have laid out a large welcome mat for foreign investors who want to evade employment, income, and estate tax in their home countries.

They are small, but their financial and legal sectors generate huge numbers. In the Cayman Islands, banks have accumulated more than $1.5 trillion in deposits. Luxembourg has more than $2.3 trillion of assets in mutual funds. In Switzerland, bankers manage more than $4 trillion in assets for clients. And in the British Virgin Islands (population 25,552), there are 774,573 corporations.

What are dramatic figures like these really telling us about tax evasion?

There's no easy answer. The first thing to note is that there are often gaping holes in coverage in the data on offshore finance. For example, in the Cayman Islands, the monetary authority does not report dollar amounts on nonbank activity. That leaves Cayman's huge investment and hedge fund industry off the official radar. And in most jurisdictions there is little or no information about wealth managed through shell corporations and private trust arrangements. This problem means available data can tend to understate the scope of tax evasion.

However, data are often presented so that offshore financial services appear more significant than they really are. Tax haven regulators, who never miss an opportunity to promote their jurisdictions, have no interest in dispelling any statistical false impressions. In the highly competitive marketplace for offshore financial services, puffed-up numbers can heighten a jurisdiction's perceived prominence. So double-counting is routinely ignored, for example, when a local hedge fund is held by a local fund of funds or a local trust holds deposits in a local bank.

But even if there were neither gaps nor double-counting, we are still left with the enormous task of interpretation. The figures cited above give those unschooled in the subtleties of offshore finance the impression of tax evasion on a scale larger than it really is. Reporters and television producers who want to make news are glad to use official statistics like those. But a lot of offshore financial activity is not related to tax evasion. As we shall see, a recurring issue in our attempt to assess tax evasion is disentangling evasion from nonevasion financial activities. Sometimes the strategy will be to directly identify and estimate evasion-related activity. Sometimes the approach will be to gather information on all financial activity in a given jurisdiction and subtract the portion that does not involve tax evasion.

Incidentally, despite impressions we get from films and mystery novels, offshore tax evasion is not confined to small island and mountain countries. Offshore-style tax evasion is an issue in New York and London just as much as it is in Andorra or the Bahamas. For example, the United States — like other leading industrial countries — does not tax bank deposit interest paid to foreigners (or those individuals who claim to be foreigners). Moreover, U.S. banks paying interest to nonresidents (except Canadian residents) do not report information about interest paid to either the IRS or foreign tax authorities. So non-U.S. residents can readily use U.S. banks to evade taxes in their home country. In this project, we are not tackling tax evasion facilitated by financial institutions in industrialized countries — at least, not initially. With large countries, it is difficult to separate offshore activity from normal domestic business activity. This approach is not meant to divert attention from the considerable problem of cross-border evasion in financial centers of developed countries.

Data Sources

The often severe shortcomings of the data make a quantitative assessment of offshore tax evasion a daunting task. But there are good reasons to believe that our efforts can significantly increase our understanding. The available data are often flawed, but plentiful, particularly when compared with what was available a decade ago. And, as best we can tell, tax researchers have not taken full advantage of what's out there.

One established but still growing source of information on offshore financial services is the Bank for International Settlements (BIS). Located in Basel, Switzerland, the BIS was founded in 1930 to coordinate reparation payments imposed on Germany by the Treaty of Versailles. It has since evolved into an international institution that fosters central bank cooperation — a sort of "bank for central banks." Since the early 1970s, the BIS has collected data on external (that is, cross-border) loans and deposits. Currently the data's scope includes about 40 jurisdictions. For several of those — including Bermuda, Guernsey, Jersey, Panama, and the Isle of Man — data have been available from the BIS only since after 2000.

Another source of data is the IMF. The 1990s ushered in new international efforts to collect data on cross-border holdings of debt and equity securities. For this purpose the IMF established the Coordinated Portfolio Investment Survey (CPIS). The first survey recorded the foreign security holdings of 29 countries as of December 31, 1997. Since 2001 the IMF has conducted the CPIS annually. The most recent data available provide year-end 2005 figures for 73 countries.

Last, but not least important for the publication of data, are the official institutions of the offshore centers themselves. During the last decade, the posting on the World Wide Web of financial statistics by authorities of a growing number of jurisdictions has greatly expanded the availability of information that until recently was effectively inaccessible.

Nonevasion Activities

Sometimes commentators leave the impression that all financial activity in the tax havens is shady business. Let's take a moment now to quickly review some big pieces of the offshore puzzle that have little or nothing to do with tax evasion. This discussion is a first pass at answering the oft-heard question: "What business do people have in tax havens other than tax evasion?"

One booming area of business for some offshore financial centers is the repackaging of loans and debt (e.g., mortgages, credit card debt) into marketable securities. These securitizations use a variety of legal structures often referred to as "special purpose vehicles" (SPVs). Besides reduced regulatory requirements in offshore jurisdictions, sellers of new securities want to avoid subjecting SPVs to entity-level taxes or subjecting interest paid by the entities to withholding taxes. This is most easily accomplished in the "tax neutral" environments provided by offshore financial centers. The tax motives here are primarily to avoid double taxation rather than tax evasion. A lot of securitization takes place on the island of Jersey, for example, so we must take care not to ascribe data reflecting SPV assets to assets involved in tax evasion.

Another component of offshore finance that looms large in the statistics is cross-border lending between banks or between affiliates of a single bank. For example, a U.S. bank may route a loan to a German corporation through its Cayman subsidiary. Booking loans in the Cayman Islands reduce regulatory requirements and allow coordination of international activity in a tax-neutral environment. And there may be opportunity to shift profits out of high-tax Germany and the United States to the no-tax Cayman Islands. That last possibility is an issue of corporate taxation (not a subject of this study) and, in any case, is not tax evasion but merely avoidance. Huge numbers of interbank loans move through offshore centers like the Bahamas and the Cayman Islands.

A captive insurance company is a closely held subsidiary of a single or small number of onshore businesses. The primary purpose of a captive is to insure risk incurred by its owner(s). In the 1990s, the IRS had a number of court disputes with U.S. corporations about their offshore captives, and there have been cases in which small businesses have used captive insurance structures to park offshore assets. In general, however, data reflecting offshore activity by captive insurers are not related to individual tax evasion. Bermuda, the Cayman Islands, and Guernsey are examples of offshore captive insurance centers.

Offshore jurisdictions often tout their fund administration business. A fund administrator provides all the back- and middle-office support, including coordinating audit, tax, and compliance reporting, so fund managers can focus on managing clients and the investment portfolio. Ireland is a leading fund administration center. From an economic development standpoint, offshore centers' focus on administration is well placed because those services can generate steady employment for the local workforce and thus provide more economic benefit than "brass plate" businesses with no physical presence. However, because fund administration — like the outsourcing of any service — can be performed in any jurisdiction and is not dependent on tax rules, it is not central to our examination of offshore tax evasion.

Offshore Trusts and Funds

Aside from offshore activities that might fool us into overstating the size of offshore tax evasion, there are two lines of financial business that have nontax reasons for being offshore but at the same time provide opportunities for tax evasion.

The first is the formation of offshore trusts by onshore investors. These trusts are often marketed as providing "asset protection" from domestic lawsuits and unreasonable spouses. As explained by attorneys Jay Adkisson and Chris Riser in their 2007 book Asset Protection: Concepts and Strategies for Protecting Your Wealth, this feature of foreign trusts is oversold. Comparable and often superior asset protection can be achieved through the use of domestic trusts. But it is usually the case in offshore jurisdictions that the identities of the settlor (the person contributing funds) and the beneficiaries of an offshore trust are shielded from disclosure to onshore authorities. That allows the beneficial owners to hide ownership of all types of assets and evade paying tax on income from those assets in their home country. For our study of offshore evasion, to the extent we are able to observe offshore fiduciaries holding assets on behalf of their clients, those assets will be considered potential tax evasion assets even though asset protection may also be a motive or even the primary motive for using offshore trusts.

The second line of financial business in which nontax and nonevasion factors play a large or major role in the decision to locate offshore is the fund business: offshore domiciling of mutual funds, hedge funds, and private equity funds. (For brevity's sake, we refer to all of them here as mutual funds.) Certainly, light regulation and lower costs are a major factor for establishing a fund offshore. It is also easier to avoid entity-level tax on the fund if, as is the case in most offshore centers, there is no tax. However, although it is rarely the topic of open discussion (because it is illegal), another advantage of domiciling offshore — perhaps we should call it an incidental advantage — is that a fund domiciled offshore even when it is managed from onshore can avoid reporting information to onshore tax authorities. U.S. investors in offshore mutual funds are easily able to hide assets and income when foreign funds file no information returns with the IRS. If foreign funds do not allow U.S investors, a U.S. investor can invest indirectly through a foreign corporation or trust.

So while there is no doubt that offshore mutual funds would still exist in an evasion-free world, their existence — like the existence of banks in tax havens — provides U.S. investors with greater opportunities to hide income and assets from the IRS. While a large portion of those assets are held by institutional investors (for example, pension funds, university endowments, and other mutual funds), and those investors are not suspected of being involved in evasion (although it should be noted that in the case of U.S. tax-exempts holding leveraged hedge funds, investors are skirting U.S. tax laws by investing offshore), individual investors both large ("high-net worth") and small ("retail") can avoid home country taxation just as well as if they were invested in an offshore bank.

Feedback

The Tax Analysts Offshore Project will provide data and interpretation of data on a number of offshore jurisdictions commonly associated with tax evasion. On the provision of data we will endeavor to be exhaustive. On interpreting data, however, we can only begin the conversation. As our data presentation unfolds, please send your comments to offshoreproject@tax.org and join us in our offshore explorations.

References

      Bank for International Settlements, Guidelines to the International Locational Banking Statistics, Nov. 2006.

      Bank for International Settlements, "Preliminary International Banking Statistics, First Quarter 2007," Table 3A (available at http://www.bis.org/statistics/bankstats.htm).

      British Virgin Islands Financial Services Commission, "Financial Services Commission — Statistical Bulletin #5," Dec. 2006 (available at http://www.bvifsc.vg).

      European Fund and Asset Management Association, "Quarterly Statistical Release, June 2007," Table 3 (available at http://www.efama.org/60Statistics).

      International Monetary Fund, "Report on the Measurement of International Capital Flows" (the Godeaux Report), Sept. 1992.

      International Monetary Fund, Portfolio Investment: Coordinated Portfolio Investment Survey Guide, 2d. ed., May 2002.

      Jay Adkisson and Chris Riser, Asset Protection: Concepts and Strategies for Protecting Your Wealth, McGraw-Hill, 2007.

      Liz Dixon, "Financial Flows via Offshore Financial Centers as Part of the International Financial System," Bank of England Financial Stability Review, June 2001.

      Marshall J. Langer, "Harmful Tax Competition: Who Are the Real Tax Havens?" Tax Notes Int'l, Dec. 18, 2000, p. 2831.

      Swiss Bankers Association, "The World of Swiss Banking 2007," English edition, p. 3 (available at http://www.swissbanking.org).

Appendix:
Peeling Through the Layers

This appendix outlines some important concepts central to quantifying offshore tax evasion.

Modern financial markets are usually characterized by multiple layers of intermediation — in the form of both instruments and institutions — between ultimate savers and ultimate investors. An essential feature of offshore tax evasion is using existing layers (for example, Swiss private banks, Cayman hedge funds) and adding new layers (offshore trusts and corporations) to help conceal the layer itself or block discovery of the relationship between assets and their beneficial owners from tax authorities.

This layering creates a dual problem for statisticians. On one hand, it is often difficult to identify quantifiable amounts associated with each layer. For example, what amount of investment flows through British Virgin Island corporations or Panamanian trusts?

On the other hand, when we are lucky enough to be able to get hard numbers on any of these layers, it is often difficult to tell whether the corresponding investments have already been associated with another layer. This leaves open the possibility for double-counting. For example, offshore insurance companies may have investments in offshore mutual funds. Mutual funds may invest in other mutual funds.

The figure is a simplified view of the layers of financial instruments, financial intermediaries, and legal structures that separate ultimate sources and uses of investment funds. In some cases, all of these layers (or more) may play a role between ultimate saver and ultimate investment, and in some cases only a few may. Moreover, for each investment made by any investor, almost any combination is possible.


Layers of Financial Intermediation and Ownership




Some layers may be offshore, and some may be onshore. And, especially in the case of willful evasion, layers in several different offshore jurisdictions will be employed. It is worth noting that often only one layer of secrecy is necessary for successful tax evasion. Only one broken link in the chain of information is needed - - for example, if a U.S. resident makes a deposit in a Cayman Islands bank, and, absent a criminal investigation, the Cayman bank does not share information with the Cayman authorities or the U.S. government. As another example, an offshore corporation owned by a U.S. resident may invest in U.S. securities. In both cases, only one part of the chain from saving to investment is offshore. In both cases, evasion is straightforward because there is no withholding tax at the source and no information reporting to the IRS. Extra layers just add insurance to maintaining privacy, especially as laws and practices change over time.

Double-counting often occurs in official data when a country adds together two layers in its borders of the same vertical flow of funds. Double-counting can also occur across borders when inconsistent methods are used. For example, if a Swiss fiduciary holds an account in a Jersey bank, we should not attribute the dollar amount of holdings in both Switzerland and Jersey to evasion activity. That figure makes it obvious that double-counting must be avoided when trying to estimate the amount of funds involved in offshore evasion.


___________________________________________________________________

SIDEBAR: The Varieties of Offshore Evasion


Mr. Jones is a small-business man living in the United States who has just closed a deal and made $1.5 million. He decides he wants to "invest offshore" to avoid U.S. income taxes.

An important threshold decision for Jones is whether he will begin his career as a tax evader by hiding his $1.5 million or just the investment income it generates.

In the first case, he may simply not report his income to the IRS. Or, if it is not so easy to cook the company books, he may establish an offshore corporation that charges the domestic business $1.5 million for "consulting services." That zeroes out his U.S. income and at the same time gets his money out of the country. Assuming his tax rate is 33.3 percent, he has in either case cheated Uncle Sam out of $500,000 and has $1.5 million ready to invest offshore. Assuming he invests in offshore assets that earn 10 percent, his first-year investment income is $150,000. If that investment income goes unreported, he stiffs the U.S. government another $50,000.

In the alternative case, he reports his $1.5 million of income on his Form 1040, pays Uncle Sam $500,000, and has $1 million available for offshore investment. Assuming he invests in offshore assets that earn 10 percent, his first-year investment income is $100,000. And if that goes unreported, he stiffs the U.S. government out of $33,333.

As simple as this example is, it allows us to identify several important concepts surrounding offshore tax evasion: the distinction between evasion of tax on investment capital and investment income — or, in terms we will use in this study, the difference between "front end" and "back end" tax evasion. In the first case above, Mr. Jones engaged in both front- and back-end tax evasion. In the second, it was just back-end.

Some could argue that front-end evasion is not really offshore but domestic evasion. Certainly there is a case to be made for that. But for most purposes, it would be foolish to make a big distinction between the two because they often come as a package deal.

Second is the distinction between evasion in which the initial investment is from legal activities and evasion in which the initial investment is from criminal activities. That may make a world of difference to law enforcement officials, but in the data and in offshore jurisdictions, it is hard to separate the two, and — from a tax policy perspective — it is unclear why we should want to.

Statistical Illusions

The distinctions are not just of academic interest. Different statistics and reports on tax evasion will use different combinations of these concepts. For example, one widely cited estimate of tax evasion looks at just back-end evasion. The Tax Justice Network estimates that $11.5 trillion is invested offshore and that those assets on average earn a return of 7.5 percent. The group also estimates that the resulting $860 billion of taxable income should be taxed at 30 percent, resulting in worldwide tax evasion totaling an estimated $255 billion annually. But notice that is only back-end evasion. (Tax Justice Network, "The Price of Offshore," Mar. 2005.)

In recent testimony before the Senate Finance Committee, Prof. Reuven Avi-Yonah of the University of Michigan Law School used a similar method. He started with a rough estimate of $1.5 trillion of offshore assets held by U.S. residents, and then assumed an average rate of return of 10 percent and a tax rate of 33.3 percent to arrive at his $50 billion figure for the annual revenue loss from international tax evasion by U.S. residents. He did not factor any front-end evasion into his calculation.

In contrast, press releases on prosecutions for offshore tax evasion will include both front- and back-end evasion (as well as interest and penalties).

 Example of Offshore Investor With $1.5 Million of Earnings
 
                (33.3% tax rate; 10% rate of return)
 
    All figures are onshore tax revenue in thousands of dollars,
 
         except the last column, which shows offshore assets
 
                       in millions of dollars.
 -----------------------------------------------------------------------------
                                     
Tax Saving From Evasion
                         -----------------------------------------------------
                                             
Unreported
 
                                Unreported  Investment
 
Case                            Earnings    Income       Total
 -----------------------------------------------------------------------------

 (1) Legal Earnings Unreported     $500        $50        $550
 (2) Illegal Earnings Unreported   $500        $50        $550
 (3) Earnings Reported               $0        $33         $33
 Also Note:
 (4) All Income Reported             $0         $0          $0

 -----------------------------------------------------------------------------
                           
[Table continued]
 -----------------------------------------------------------------------------
                                     
Measurement of Offshore Evasion:
 
                                         Four Different Views
                         -----------------------------------------------------
                                                                     
Data
 
                                `Tax         IRS                   (assets)
 
                                Justice      `Tax      DOJ Press     (in
 
Case                            Network'     Gap'       Release    millions)
 -----------------------------------------------------------------------------

 (1) Legal Earnings Unreported      $50       $550     $550 + i&p*     $1.5
 (2) Illegal Earnings Unreported    $50        $50     $550 + i&p      $1.5
 (3) Earnings Reported              $33        $33      $33 + i&p      $1.0
 Also Note:
 (4) All Income Reported            $33         $0          -          $1.0

 -----------------------------------------------------------------------------

 *"i&p" = interest and penalties.

Meanwhile, the IRS does not include the illegal sector of the economy in its estimates of the tax gap.

Other Types of Evasion

Two other types of offshore evasion deserve further mention. The first is offshore estate tax evasion. In addition to income taxes, estate and gift taxes can be avoided by wealthy individuals by placing assets offshore and hiding their existence from domestic tax authorities. Of course, that requires cooperation on the part of the recipients of those funds — who, if they are not complacent with evasion, could end up paying tax, interest, and penalties to tax authorities.

The second type of offshore tax evasion is the holding of onshore assets through offshore structures. For example, a U.S. resident could avoid U.S. withholding tax and U.S. information reporting by purchasing U.S. debt securities through an offshore corporation. Notice that in this case there are unlikely to be any statistical data on the "offshore" assets held in this manner.

Conclusion

How far should the definition of offshore tax evasion extend? Should front-end evasion be included? Should evasion of income from illegal activities be included? Should estate tax evasion and phony foreign holding of U.S. assets be included? There is no one correct answer to these questions.

Because of these conceptual issues, inherent complexity, and data shortcomings, the Tax Analysts Offshore Project will initially focus its attention on identifying offshore assets for which, primarily because of lack of information reporting to onshore tax authorities, the potential for evasion is high. We will call them "Potential Tax Evasion Assets" (PTEA). In general, PTEA will be calculated by identifying assets in offshore sectors and then subtracting the portion of those unlikely to play a role in individual tax evasion.


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