How Do Tax Havens Work?

According to the Tax Justice Network, up to 32 trillion dollars is stored away in tax havens throughout the world. Why do wealthy individuals and corporations hide money in such locations, and how do these tax havens work?  In this article by TaxClimate.com, we attempt to answer this question…

What is A Tax Haven?

While there is no single definition, a tax haven is typically a jurisdiction whose tax laws allow for favorable advantages to be used by foreign businesses and individuals. These advantages typically include:

  • Low or zero tax liability
  • Economically and politically stable environment
  • Privacy and confidentiality, since little to no financial information is shared with foreign tax authorities

There are 3 main types of Tax Havens:

  1. Primary Tax haven – This is where funds are ultimately stored. Typically, an offshore subsidiary of a company will hold intellectual property rights and then license these rights back to the parent company, transferring income in the process.
  2. Semi Tax Haven – A region where goods are produced with the intention of selling them outside the region it is produced. Typically, this is done by offering incentives like free trade zones, flexible labor laws and territorial only taxation.
  3. Conduit Tax haven – This is a location where sales from a parent company are redirected through. The purchase of goods produced in a semi-tax haven is marked up by the conduit tax haven, and then sold to the parent company.

Through the use of these tax havens, corporations are able to legally avoid or minimize their tax obligations. This is referred to as “tax avoidance” or “tax planning”.

How Do Tax Havens Work?

Corporations make tax havens work to their advantage by using the following principles:

 

  • Tax Residency – by claiming tax residency in a tax haven, their income is taxed at a lower rate or 0%, depending on the location. For wealthy individuals, this means avoiding taxes on their personal income such as inheritance tax, capital gains tax and their salaries. For corporations, this also means lowering their corporate tax burden.
  • Holding Assets – By setting up an offshore company or trust in a low tax jurisdiction, wealthy individuals or corporations can hold their investment assets in a lower tax country. The goal of this is to move ownership/tax residency of these assets away from a high tax country, so that they are no longer taxable at the higher rate.
  • Trading Companies – For businesses that are not restricted by a physical location, they may set-up their company in a tax haven to minimize their tax liability. Examples of such businesses include Internet services and financial service companies.
  • Confidentiality – The issuing of bearer shares allows the anonymous ownership of companies.

Examples of Countries and Regions that are known Tax Havens

  • Luxembourg
  • Switzerland
  • Bermuda
  • Cayman Islands
  • British Virgin Islands

As we’ve learned, wealthy individuals and corporations utilize tax havens to take advantage of lax regulations and tax rates. While tax avoidance/tax planning is legal, it is important to obtain professional advice to ensure you remain compliant with your home country’s tax laws.