The main message emerging from Panama Papers, Paradise Papers, and the like, is that it is the rich, powerful and famous who make use of and benefit from tax havens.

And yet, the same law that these individuals and companies use to lower their taxes applies for every citizen and company of the country. Thus, in principle, every individual and company could make use of these methods. Yet, I get the impression they do not. Why?

A potential reason could be the price charged to set up and maintain these services. If setting up an off-shore scheme in a tax haven is costly, only those benefiting considerably from it can afford that service. However, you can imagine that, in a world where firms are competing with each other, these costs would be driven down, leading to some of these providers offering a standarised, low-cost service which can be used by many people. The benefit here emerges not from a high mark up but from quantity. As far as I know, these services are not widely available for the majority of companies and taxpayers.

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    "you can imagine that, in a world where firms are competing with each other, these costs would be driven down" There's more to competition than cost, since few businesses want to compete on cost. They'd rather differentiate themselves so as to keep prices high. (A lot of people would benefit from an introductory course in Economics.) – RonJohn Nov 8 '17 at 12:57
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    @luchonacho there certainly are barriers to entry in the legal and accounting trades. And "high" is always relative: some lawyers can "get away with" charging $1000 per hour and others can't. – RonJohn Nov 8 '17 at 14:54
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    The bottom ~80% of Americans don't pay much in (net) taxes/premiums to the federal government. If you are paying around 0% (plus or minus a few percentage points), you don't need a tax shelter to hide it. – Lan Nov 8 '17 at 15:00
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    The fundamental premise of this question is that everyone has the same access to tax shelters and the same laws apply to all. This is a false premise, because these things are not true. Laws regarding corporations have no application to individuals. Taxes on investment income do not apply to people without investment income, and so forth. – barbecue Nov 8 '17 at 18:16
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    @Fattie: Your response assumes every country has identical tax rates and taxing strategies. I can assure you they do not. I can also assure you that companies like Apple don't go to the trouble of taking some or all of their profits overseas unless there are tangible savings realized. – Robert Harvey Nov 8 '17 at 23:32
up vote 59 down vote accepted

I believe that an understanding of the taxation system can help to understand our place in it, and how that impacts each of our personal finances. I will try to remain unbiased here but this is a somewhat subjective question, so please bear with me if you disagree on any point.

Tax savings can occur for many reasons.

Some of these tax savings are well-advertised, and can be used by many people, such as tax credits for mass-transit passes which exists in some countries. But some of these tax savings are things you never heard of before, until it winds up on the news.

Why do some people seem to get tax savings that you and I cannot get, and why do those people always seem to have so much more money than us? A simplistic answer can show this in three parts: (1) The source of one's income; (2) Transaction costs; and (3) "tax loopholes".

1. Source of one's income

Tax savings occur proportionately to one's income, and if the savings apply to investment income, they occur proportionately to one's wealth. If someone living paycheck to paycheck with a minimal amount in a bank account "saves tax on investment income", they might reduce their taxable interest from $50 to $0. That's because they simply don't have any other investment income to reduce. All of their income comes in the form of employment, which is typically very hard to save taxes on. Most governments have a very firm grasp on the taxation of employment income, because it is a huge proportion of income in the country (and therefore has the largest amount of tax associated), and because it is very straightforward (work for someone = employment income). A more cynical person than I might point out that investment income is earned by the very wealthy, who can afford to lobby for politicians to pass favourable investment income laws.

2. Transaction costs

Even very straightforward tax saving opportunities may cost money to enable. The simplest example would be: if a tax saving opportunity is so complicated that an average person can't understand it themselves, then an accountant, lawyer, or banker will need to be the one to explain it. And that can cost you money. If your tax isn't so much to begin with, then the transaction costs to achieve the tax savings could be higher than the tax savings themselves. For example, most countries have tax savings / deferrals if you start a corporation. These rules typically exist to promote investment in the local economy. But someone who earns $10k in a side-business might not be able to afford the $3k in incorporation costs just to save $2k in taxes. The more income and wealth you have, the more these transaction costs become worthwhile.

3. "Tax Loopholes"

I'm going to generally define "tax loopholes" for the purposes of this answer as something where a somewhat arbitrary situation allows for taxes that a layman would consider unfair or unexpected. This often occurs with good intentions but poor legislation - the government tries to provide a benefit to a deserving group or to promote an activity, but ends up allowing another group to take advantage.

For example in Canada, there existed until a few years ago tax saving rules about passing on wealth to children at lower tax rates, only when a close family member is near-death [setting up a 'testamentary trust' between a grandparent and a grandchild could in some circumstances allow that trust to be created with additional 'tax brackets', meaning more income would be taxed at a less-than top tax rate before being distributed to the grandchildren].

The rules were put in place with the idea that "oh gee, a family member has died, and the dang ol' family is grieving so hard they can't distribute the wealth to the next generation for a few months on account of all the crying. We should make it so that the estate is taxed like a person, and if they earn only a little income, they have a low tax rate, and they only get taxed at the full rate if they have a lot of income". Seems reasonable enough, but if a family is ready to pass on wealth at the same time as someone is nudging the bucket with their foot, a morbid discussion with your lawyer and accountant could set your children up for life with forever reduced taxes on massive inheritances.


Examples:

Panama / Paradise leaks

In the case of the Panama / Paradise leaks, tax savings are due to all 3 of the above: Those who have massive wealth (and therefore earn the majority of their income from investments instead of employment) can afford the transaction costs associated with taking advantage of specific "tax loopholes". The simplest example of which is just that income earned in a foreign country might have a lower tax rate than income earned domestically. This is often a result of "cracks" in the foreign tax treaties between countries, which exist generally to promote business between countries and prevent double-taxing individuals who need activity in both countries for whatever reason.

Apple loophole

Take for example the "Apple loophole". Apple has operations around the world. Some activity occurs in low-tax jurisdictions. Apple reports a high percentage of the value of R&D as being associated with those jurisdictions. Those branches in low-tax jurisdictions charge the high-tax branches (such as the US) with fees for use of their valuable research. So much of Apple's income is reported in those foreign jurisdictions. It won't be taxed in the US until Apple "repatriates" the cash back to the US. Until then, the cash sits in the foreign jurisdiction, accruing less tax. This and similar rules can be used by individuals wealthy enough to hold corporations in foreign jurisdictions with low tax rates. How each particular rule / "loophole" works will depend on the nature of a specific case - tax law is complex, and the rules between countries are even more so.

These foreign tax loopholes are closing every year. It is getting harder and harder to hide money offshore, and it is getting less and less likely that you will be able to find a country with juuuust the right loopholes for your own offshore wealth. These types of news leaks will only help to expedite those changes.

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    Let me put it this way. Even if not cost-effective, could the cornershop set up as a multinational, operating as a subsidiary of a company in Jersey? – luchonacho Nov 8 '17 at 15:50
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    Let us continue this discussion in chat. – Grade 'Eh' Bacon Nov 8 '17 at 15:51
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    You should also note that the tax-authorities stille have to believe your story. Or as in the case of Apple vs EU not fine you with 12 bn. € because they don´t follow your R&D sceme ... – Daniel Nov 8 '17 at 16:09
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    @reirab it is not just a cost. Apple's R&D also creates value, say technology used in an iPhone. Lets say the newly developed iPhone Y costs $100 but with R&D developed parts that when added up have a value of $90. Let's handwave away all costs of marketing, production, etc. For each $100 iPhone Y sale in the USA, they need to pay taxes on $100. However, if instead Apple Ireland charges Apple USA $90 for the tech in the iPhone Y, the amount taxed can be reduced to paying USA taxes on $10 and Ireland taxes on $90. If Ireland has lower taxes, that results in a huge amount of savings. – iheanyi Nov 8 '17 at 17:48
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    Re "...investment income is earned by the very wealthy...": Not just by the very wealthy. There are a lot of low to middle income people who invest, especially if you include IRA & 401k plans. It's just that you hear a lot more about the "one paycheck away from disaster" types - unless of course you read books like "The Millionaire Next Door" :-) – jamesqf Nov 9 '17 at 6:44

Your "average company and taxpayer" generally wouldn't have significant off-shore/foreign income. In the U.S., for example, even if you have your employer deposit all of your salary to an account at a foreign bank, they would still report it to the IRS as income.

Removing the money from your home country isn't what gets it out of being taxed, it's that the money was never in your home country.

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    Isn't it not declaring the foreign income that gets it out of being taxed? – DJohnM Nov 8 '17 at 14:14
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    And, for US citizens (whether residing in the US or not) and US tax residents, not declaring all foreign income on the income tax return is a crime since the taxpayer signs the return as being true and complete under penalty of perjury. Furthermore, the existence of these accounts must also be revealed to the US Treasury under FBAR regulations, regardless of whether there was any income received in the accounts or not. – Dilip Sarwate Nov 8 '17 at 14:37
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    @luchonacho the corner store is physically located, and doing business, in its home country. – yoozer8 Nov 8 '17 at 14:43
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    @DJohnM Sometimes it can be perfectly legal according to the letter of the law to not report that income. For example, if you own a foreign corporation doing business in another country, you might not pay tax in your home country until you receive dividends from it. There are many many other examples of rules which create similar outcomes. – Grade 'Eh' Bacon Nov 8 '17 at 14:50
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    @Dilip Sarwate: But the relevant question is when does it become income to you? E.g. you're a US taxpayer who owns a foreign corporation which makes profits, but doesn't pay out dividends, so you haven't made income from it. – jamesqf Nov 8 '17 at 17:55

In a nutshell, there are significant entrance hurdles, legally and especially financially. The fixed cost and effort to get it set up is high (although later, the proportional cost and efforts are negligible).
Therefore, this is only of interest for taxable amounts of seven digits or more - which most people don’t reach.

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    I am not a lawyer, but I think in most cases, yes. You will need to be willing to jump through significant hoops, for example, instead of having a job with a salary in the US, you would have a company in the Cayman Islands, which does the work you’re supposed to do and gets paid for it. You yourself would physically execute the work as an employee of your own company, and officially live on the Cayman Islands, and get a small salary from your company there. Obviously you would need a living address, and a company in the Cayman Islands, plus authorization to live there and so on. – Aganju Nov 8 '17 at 17:55
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    This. Tax havens/loopholes/etc. are essentially just a regressive tax. Once you make enough to afford to be able to use them, you can greatly lower your tax rate. – R.. Nov 8 '17 at 18:13
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    @Aganju Even if you are considered a resident of the Cayman islands for Cayman tax purposes, you can still be considered a resident of the US for US tax purposes. Not only that, but the work being completed in the US means you would be taxed in the US [unless you work remotely and lie about the fact that you are sitting in the Cayman's while you do so]. Not only that, but US citizens are taxed by the US on all income from all sources, regardless of where they live [though they get credit for taxes paid elsewhere]. – Grade 'Eh' Bacon Nov 8 '17 at 18:31
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    But your income is small, as I wrote, and the company’s profit goes not to you but in a trust fund. This is only level 1. Specialist will get you to level 5 or 10. – Aganju Nov 8 '17 at 18:43
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    @Fattie If you are an employee of a Cayman company working in the US (legally, of course), your living expenses such as rent, car mileage, per diem, are reimbursed by the employer, which is not the employee's taxable income and at the same time reduces the tax base of the employer. Just an example of how it might work. You might also be an employee of a US (Delaware) company fully owned by the Cayman company etc. – mustaccio Nov 9 '17 at 14:43

Ditto @GradeEhBacon, but let me add a couple of comments:

  1. Ignorance of the law. There might be all sorts of tax savings that you or I could take but that we don't because we don't know about them. And that doesn't mean that we're stupid. US tax code is now over 73,000 pages long. Who knows what's in there?

But more relevantly:

  1. GradeEhBacon mentioned transaction costs. Yes. Many tax shelters require setting up accounts, doing paperwork, etc. Often you have to get a lawyer or accountant to do this right. If the tax shelter could save you $1 million a year in taxes, it makes sense to pay a lawyer $10,000 to set it up right. If it could save you $100 a year in taxes, paying $10,000 to set it up would be foolish. In some cases the tax savings would be so small that it wouldn't be worth the investment of spending $20 on a FedEx package to ship the paperwork.

  2. Inconvenience. Arguably this is a special case of transaction costs: the cost of your time. Suppose I knew that a certain tax shelter would save me $100 a year in taxes, but it would take me 20 hours a year to do the paperwork or whatever to manage it. I probably wouldn't bother, because my free time is worth more than $5 an hour to me. If the payoff was bigger or if I was poorer, I might be willing.

  3. Complexity. Perhaps a special case of 3. If the rules to manage the tax shelter are complicated, it may not be worth the trouble. You have to spend a bunch of time, and if you do it wrong, you may get audited and slapped with fines and penalties. Even if you do it right, a shelter might increase your chance of being audited, and thus create uncertainty and anxiety. I've never intentionally cheated on my taxes, but every year when I do my taxes I worry, What if I make an honest mistake but the government decides that it's attempted fraud and nails me to the wall?

  4. Qualification. Again, as others have noted, tax shelters aren't generally, "if you fill out this form and check box (d) you get 50% off on your taxes". The shelters exist because the government decided that it would be unfair to impose taxes in this particular situation, or that giving a tax break encourages investment, or some other worthy goal. (Sometimes that worthy goal is "pay off my campaign contributors", but that's another subject.) The rules may have unintended loopholes, but any truly gaping ones tend to get plugged. So if, say, they say that you get a special tax break for investing in medical research, you can't just declare that your cigarette and whiskey purchases are medical research and claim the tax break. Or you talked about off-shore tax havens. The idea here is that the US government cannot tax income earned in another country and that has never even entered the US. If you make $10 in France and deposit it in a French bank account and spend it in France, the US can't tax that. So American companies sometimes set up bank accounts outside the US to hold income earned outside the US, so they don't have to bring it into the US and pay the high US tax rate. (US corporate taxes are now the highest of any industrialized country.) You could, I suppose, open an account in the Caymans and deposit the income you earned from your US job there. But if the money was earned in the US, working at a factory or office in the US, by a person living in the US, the IRS is not going to accept that this is foreign income.

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    “US corporate taxes are now the highest of any inustrialized country” - complete nonsense made up from thin air (by the POTUS), and anyone that wants to know can easily verify it’s false. – Aganju Nov 9 '17 at 21:36
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    @Aganju Here is a list of world nations that includes their corporate tax rates. en.wikipedia.org/wiki/List_of_countries_by_tax_rates The US, at 35%, is the highest of any industrialized country. It may be that there is some measure by which US corporate taxes are NOT the highest, but that's certainly the plain reading of charts like this, so I don't see how you can say that such a claim is "nonsense". This statement was most certainly not invented by Mr Trump; people were talking about this long before Trump became interested in the subject. – Jay Nov 9 '17 at 22:21
  • @Jay UAE at 55% seems to me to be higher than USA at 35% + 0-12%. Also, the USA is not alone at 35%; one can certainly argue about the "industrialized" part for several of those, but I count seven other countries at a 35% corporate tax rate. There's also e.g. American Samoa with a range of 15%-44%. – a CVn Nov 13 '17 at 9:58
  • Keep in mind the rate actually paid is not the same as the base income tax number because of deprecation, deductions, required contributions to employees social security etc. The US makes writing off loses and expenses much easier than other countries. – Aaron Harun Nov 13 '17 at 15:00
  • @AaronHarun True, and when you calculate the actual amount of taxes paid the US is not the highest ... but it's still up there. – Jay Nov 21 '17 at 17:12

Tax-free bonds

There are tax free bonds in the United States. They are for things like public housing and other urban projects. They are tax free for everyone but only rich people buy them. Why?

The issue is that the tax free nature of the bond is included in its yield. So rather than yielding say a 5% return, they figure that the owner is getting 20% off due to not paying taxes. As a result, they only give a 4% return but are as risky as a 5% return investment. Net result, only rich people invest in tax free bonds. "Rich" is defined here to mean people paying a 20% tax on long term investment returns.

Itemized deductions

Or take the State and Local Tax (SALT) deduction, which has been in the news recently. Again, it is technically open to everyone. But there is also a standard deduction that is open to everyone. For the typical family, state and local taxes might be 5% of income. So for a family making $100k a year, that's $5k. The same family can take a $13k or so standard deduction instead of itemizing. So why would they take the smaller deduction?

As a practical matter, two groups take the SALT deduction. People rich enough to pay more than $13k in state and local taxes and people who also take the mortgage interest deduction. So it helps a lot of people who are rich quite a bit. And it helps a few middle class people some.

But if you are lower middle class with a $30k mortgage on a tiny house and paying 4% interest, then that's only $1200 a year. Add in property taxes of $3000 and SALT of $2.8k and that's only $7k. Even if the person gives $3k to charity, the $13k deduction is a lot better and requires less paperwork.

Contrast that with someone who has $500k mortgage at 3.6% interest. That's $18k in interest alone. Add in a SALT of $7k and property taxes of $50k, and there's $75k of itemized deductions, much better than $13k. Now a $7k donation to charity is entirely deductible. And even after the mortgage interest deduction goes away, the other $64k remains.

  • 1
    $50k of property taxes on a $500k home seems overly contrived as an example. – iheanyi Nov 11 '17 at 0:15

And yet, the same law that these individuals and companies use to lower their taxes applies for every citizen and company of the country. Thus, in principle, every individual and company could make use of these methods. Clearly, they do not. Why?

Misconception number 1. How did you conclude they do not? Because NY Times didn't spend time doing an expose' on your plumber?

The Panama Papers and the Paradise Papers contain the files from merely three companies that help in this large industry. This is a story about poor IT policies of three companies.

A potential reason could be the price charged to set up and maintain these services.

This is a significant deterrent.

The costs of forming offshore entities are perpetuated by the expensive lawyers, registered agents and incompetent government representatives in these tiny jurisdictions. (For what its worth, even most United States are pretty incompetent at these administrative processes. Really only a few financial centers and a few exceptions have it all streamlined.)

These are scale problems primarily.

The incompetence of different nation/state's public sectors will make you realize everything you take for granted.

The main message emerging from Panama Papers, Paradise Papers, and the like, is that it is the rich, powerful and famous who make use of and benefit from tax havens.

But not exclusively for tax purposes.

Newspapers, and even the organization leaking this information, is driving clicks to a gullible and impressionable public. I've talked with ICIJ (who release and push the discussion on the Panama/Paradise Papers), they really do believe in their "tax expose'" angle, but lack any consideration of how business work.

'Tax Haven'. These are sovereign nations with due process with democratically elected legislatures who looked at their budget and realized they don't need to fund their government via passive taxes. Their governments offer a good and service that people want, and it provides enough revenues to their governments.

Many of these jurisdictions have well evolved corporate laws for fast evolving business models.

For example, The Segregated Portfolio Company in the British Virgin Islands is more well defined and supported by clearer case law and is more useful entity than a Series LLC in the few United States that support it.

There are at least a dozen reasons why someone would use a "tax haven", where only one of them is "tax".

Many of the Financial intermediaries in the business, have extraordinary high requirements for opening an account. For example to open an account in Credit Suisse one will need 1 million US dollars.

  • Sure, but is the cost of setting up such accounts that high? You would "expect" that competition will make these financial intermediaries to fight for more and more customers (individuals/firms), expanding such market to other customers with less income. – luchonacho Nov 9 '17 at 9:39

However, if you are employed by a company that exists in a tax haven and your services are provided to an employer by that tax haven company, it is the tax haven company that gets paid, not you. Under various schemes that company need not pay you at all. For example it may make you a loan which is not taxed (ie you don't pay tax on a loan, just as you don't pay tax on the money lent you by a mortgage company). You are bound by the terms of the loan agreement to repay that loan at a rate that the company finds acceptable. Indeed the company may find eventually that it is simply convenient to write off the loan as unrecoverable. if the owners/officers of he company write off your loans, how much tax will you have paid on the money you have had as loans? The taxman can of course state that this was simply set up to avoid tax (which is illegal) so you should have a balancing scheme to show that that the loans were taken to supplement income,just as one might take a bank loan / mortgage, not replace it entirely as a tax scam. Hiring tax counsel to provide this adequate proof to HMRC has a price. Frequently this kind of loophole exists because the number of people using it were sufficiently low not to warrant policing ( if the policing costs more than the tax recovered, then it is more efficient to ignore it) or because at some stage the scheme has been perfectly legal (as in the old offshore'education' trust recommended by the government a few decades ago). When Gordon Brown set out a 75% tax rate (for his possibly ideological reasons rather than financially based ones)for those who had these accounts , he encountered opposition from MPs who were going to be caught up paying high tax bills for what was effctively retrospective taxation, so there was a built in 'loophole' to allow the funds to be returned without undue penalty. If you think that is morally wrong, consider what the response would be if a future Chancellor was to declare all IAs the work of the devil and claim that retrospective tax would need to be paid on all ISA transactions over the last few decades.eg: tot up all the dividends and capital gains made on an ISA in any year and pay 40% tax on all of them, even if that took the ISA into negative territory because the value today was low/ underperfoming. Yet this has been sggested as a way of filling in the hole in the budget on the grounds that anyone with an ISA can be represented as 'rich' to a selected party of voters.

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    Not familiar with the US specifically, but in general forgiven loans would count as income (to the person being forgiven), and potentially so would loans below market rate. – not_a_comcast_employee Nov 9 '17 at 0:36

protected by Ganesh Sittampalam Nov 9 '17 at 7:31

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