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IMF report heavily criticises the OECD’s tax consensus

IMF logoThe IMF has a major new Policy Paper out entitled Spillovers in International Taxation, looking at the effects that one country’s tax rules and practices can have on others.

Reading between the lines, this report constitutes a major attack on tax havens. “Spillovers” in international tax are all about tax haven activity, particularly when those spillovers are deliberately crafted. It also savages a significant part of the prevailing OECD tax consensus that has dominated international tax for the last century or so.

This is a really important document, and though it focuses on developing countries it has important implications for European countries as they consider the urgent matters of tax reform.

We are delighted to see the IMF convincingly takes the side of developing countries: not only taking sides in big current political fights (such as India vs. Vodafone)

but peppering the report with suggestions how developing countries can fight against all the erosion.

This makes a really refreshing change from the standard (often well-justified) stories about IMF programmes laying waste to developing countries.

The IMF says the aim of this exercise – which, by the way, is clearly written and should be palatable to interested non-experts – is to complement the OECD’s BEPS (Base Erosion and Profit Shifting) project to help countries protect themselves from tax abuses, by looking at the spillovers. However, buried deep in the text are some devastating criticisms of BEPS too – notably that it doesn’t properly address crucial issues of unfairness towards developing countries. The report notes:

“New results reported here confirm that spillover effects on corporate tax bases and rates are significant and sizable. . . . Spillovers are especially marked and important for developing countries. . . . The amounts at stake in a single tax planning case now quite routinely run into tens or hundreds of millions of dollars.”

And, in terms of the tax base (that is, which part of cross-border income that developing countries get to tax), there’s some startling quantification:

“The spillover base effect is largest for developing countries. Compared to OECD countries, the base spillovers from others’ tax rates are two to three times larger, and statistically more significant. . . . The apparent revenue loss from spillovers. . .  is also largest for developing countries.”

Our emphasis added. Wow. And we’d agree with the next bit, of course:

“The institutional framework for addressing international tax spillovers is weak. As the strength and pervasiveness of tax spillovers become increasingly apparent, the case for an inclusive and less piecemeal approach to international tax cooperation grows.”

That may be a gentle dig at the OECD, for not being ambitious enough. And there’s plenty more: the IMF notes.

“[a] concern sometimes expressed that the system allocates too little tax base to developing countries”

In other words, considering all the different bits and pieces of income that flow from a cross-border investment from a rich country to a poor one, most of them get taxed by the rich country, leaving relatively little on the table for the poor country. What a surprise. And it notes the harmful effects of tax ‘competition':

“The pervasiveness of the tax incentives that the IMF and others have long stressed as significantly undermining revenue in developing countries may to a large extent be a spillover reaction to policies pursued in other countries: a clear instance of tax competition.”

Tax competition is the widely used term; but Tax Wars is the less economically illiterate term. The IMF also notes that – unlike the global trade system – the tax system is an uncoordinated and pretty disastrous hodge-podge. It contains an interesting statistical nugget: “the increased importance of intra-firm transactions (about 42 percent of the value of U.S. goods trade in 2012″ (consistent with the idea that about half of world trade happens inside multinational corporations)

The IMF report takes a swing or two at the OECD’s BEPS process. For instance, in a section on tax treaties which allocate taxing rights among countries, the IMF notes that not only are the OECD models (that are generally the basis for these treaties) skewed in favour of richer countries, as we and other have often remarked, but it also adds:

“At issue here are deeper notions as to the ‘fair’ international allocation of tax revenue and powers across countries (which current initiatives do not address).”

That is a small sentence buried in the text, but it’s devastating. And the IMF notes that defending the OECD consensus may even end up not serving the self-interest of OECD countries:

“Arrangements that seem to contradict broad perceptions of fairness, even if those are imperfectly articulated, may increasingly give rise to unilateral domestic measures to change them—with a consequent risk of uncoordinated defensive measures even further undermining the coherence of the international tax system.”

Treaty reform, it seems is essential, as it notes in its key messages for developing countries:

IMF messages developing

The “sign treaties only with considerable caution” reminds us of a recent fiery intervention by Lee Sheppard, in which she urges developing counties not to sign these kinds of tax treaties.

Now here’s something else that’s fascinating. The IMF appears to be taking India’s side in its recent tax tussle with Vodafone. Get a load of this:

“The tax treatment of gains on indirect transfers of interests in assets is a controversial issue—and one of particular importance to many developing countries.”

This is where a multinational has an asset in a developing country, and that asset rises in value. It wants to sell the asset – but if it just sells it straight, it may have to pay capital gains tax on those gains. So instead the multinational sets up a shell company in a tax haven, to own the asset. This time it merely sells the shell company (which owns the asset). The sale is recorded in the tax haven, which doesn’t tax capital gains. Bingo! Wealth is transferred from a poor country to wealthy shareholders of the multinational.

This is exactly the issue in the India-Vodafone fight – which the IMF explicitly mentions, along with billion-dollar cases in Mauritania and Mozambique (p70). And the IMF’s conclusion on this?

“The laws of many developing countries need strengthening if they are to tax gains on such indirect transfers.”

Go get ‘em!

On the crucial issue of the OECD’s Arm’s Length Method (otherwise known as the Arm’s Length Principle, or ALP), which we and many others have criticised extensively, the IMF recognises that it is badly broken though it does not fully endorse a move towards the main alternative, unitary taxation with formula apportionment (FA). Such an approach would tackle many of the existing problems, it argues, but would introduce new difficulties – and would not necessarily shift tax bases towards developing countries. Yet it adds:

“this approach, rather than one based on ALP, is so common at subnational level—indeed there seems to be no subnational CIT that does not use some form of FA—suggests that it has at least some merit in taxing firms operating across highly integrated economies.”

(That bit in bold is our emphasis, because we (or at least today’s TJN blogger) didn’t know that.)

Whether or not developing countries would benefit from application of formula approaches internationally, the IMF notes that it depends on which kind of formula were applied:

Formula developing

The IMF urges ‘closer study’ of partial approaches based on formula apportionment, however, including hybrid approaches and ‘profit split’ methods which involve allocating taxable income between countries on a formula basis, but at a transaction level rather than at the level of the multinational group.

To finish, here’s another little bomblet:

“[it has been argued that] low tax and conduit countries can improve the efficiency with which capital is allocated. These considerations generate heated dispute, but remain essentially uninformed by empirical knowledge.”

It is almost funny how the IMF savages some of the tax havens’ central arguments in their self-defence (see more here). The 2006 paper they cite in this respect (Desai, Foley and Hines) and earlier iteration by Hines in particular have become totemic for tax havens in their defence. “Uninformed by empirical knowledge” is perhaps as damning a statement as you will get from the scrupulously polite IMF.

There is plenty more in this report, but these are probably the main points, tax justice-wise.

To summarise: the IMF seems to be carving out new space in this arena with more time for the interests of developing countries, in some contrast to the OECD – which is, after all, a club of rich countries, and experience shows tends ultimately to bat for the interests of its member states.

A welcome addition to the literature.

Endnote: this article is cross-posted (in adapted form) with the Tax Justice Network and Financial Transparency Coalition blogs.

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Switzerland fights to curb scope of global transparency moves

Circle The Wagons

Switzerland: clinging to old secrecy practices as the world moves forwards

Cross-posted with the Tax Justice Blog.

The Swiss Federal Council on Wednesday issued a statement making it all too clear what it thinks “the new global standard for the automatic exchange of information in tax matters” should look like. This concerns the OECD’s ongoing project to create a new framework for international financial transparency, which we’ve written about before: while we found shortcomings, we welcomed the project overall. The OECD is expected to finalise its global standard in June.

The Swiss position is a direct threat to global moves on transparency. A private tax adviser tells TJN:

“My view is that they are trying to wriggle out of it.”

The Swiss statement is yet more evidence of what has been called a “circle the wagons” strategy: when under pressure from a world that’s moving forward, give ground only inch by inch, if at all; hold on to secrecy where possible – and particularly exploit the weaknesses of weaker and more vulnerable countries.

Meanwhile, trumpet to domestic and international media and anyone who will believe them how, ahem, clean, well-regulated and transparent the historic haven for thieves and abusers has suddenly become!

The Swiss statement says, for instance:

  • Negotiations on the automatic exchange of information with other selected countries are to be examined. In an initial phase, priority would be given to the introduction of the automatic exchange of information with countries with which there are close economic and political ties and which, if appropriate, provide their taxpayers with sufficient scope for regularisation and which are considered to be important and promising in terms of their market potential for Switzerland’s finance industry.
  • The introduction of the automatic exchange of information with foreign countries would be conducted by means of separate bilateral agreements with the partner countries. Moreover, implementing legislation would be required in national law. Existing legislation excludes the automatic exchange of information.”

Our emphasis added (thanks to Koen Roovers for bringing this up). The private adviser notes:

“They are trying to choose who to exchange with, and under what conditions. The OECD system was not set up so that countries can add whatever riders they like onto it. They [the Swiss] want to turn this to their advantage, maybe to even move backwards from where they are now.”

As we have noted, multilateral negotiations with intransigents like Switzerland are always more fruitful, but Switzerland wants to make sure it has maximum leverage over vulnerable developing countries.

The Swiss statement goes further. It insists that:

  1. the exchanged information should be used solely for the agreed purpose (TJN: that’s an effort to keep the scope of transparency as narrow as possible; only let information be used for tax investigations, but – please! – not for corruption, embezzelement, and so on),
  2. the information should be reciprocal, i.e. should flow in both directions, (TJN: as we’ve noted, this ‘reciprocity’ is unnecessary and unfair for many poorer countries)
  3. data protection must be ensured and (TJN: a motherhood-and-apple-pie statement that in itself is fair enough but can be abused to restrict the scope of information exchange drastically)
  4. the beneficial owners of trusts and other financial constructs should also be identified. (OK, as far as it goes)
  5. Moreover, the Federal Council stated that, where appropriate, the issues of regularisation of the past and market access are to be incorporated into negotiations on the automatic exchange of information. (playing hardball: hanging on to secrecy for past assets, trying to gain advantage wherever possible.)

Mark Herkenrath of Alliance Sud in Switzerland adds:

“The Swiss government will stick to a bilateral approach to AIE and engage in “cherry picking”. That is, it will try to exclude developing countries from AIE for as long as possible – despite opposition by various NGOs and Left-wing members of parliament and a lively debate within the federal administration (I do not think the Swiss development agency SDC is in favor of excluding developing countries from AIE).

The problem is that the Swiss government is not expecting any external resistance to this strategy of cherry picking. Neither the OECD nor the G20 have made a clear statement in favor of a multilateral approach to AIE. Nor have they asked for the inclusion of developing countries in such a multilateral approach. Nor have LIC/LDC governments made it clear that they wish to be included.”

Koen Roovers of the Financial Transparency Coalition summarises:

“This is the moment where Switzerland, likely with the silent support of other rich nations, show what all this is really about: countries with which there are close economic and political ties will cooperate to not hurt each other economically (or in any case less), but that less fortunate populations of the world won’t benefit from this international drive against large-scale tax evasion.

Meanwhile, they have created great spin and to some extent, were rehabilitated by mainstream media stating that ‘Switzerland (& Singapore) joining the ministerial agreement meant the end of banking secrecy’.

He is quite right: the credulous nature of so many media reports about Switzerland is breathtaking. He adds:

“In April, the Swiss development cooperation agency published a briefing calling for “systemic inclusion of the issue developing countries in Switzerland’s internal strategy work in the field of automatic exchange of information and effective implementation of the multilateral OECD Convention on Mutual Administrative Assistance in Tax Matters.”

It seems that voice hasn’t been taken on board when the federal government communicated its position yesterday.”

Indeed. Switzerland isn’t the only country to lack such joined-up thinking, of course.

Endnote: Switzerland currently holds the top position in our Financial Secrecy Index.


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Why Russia no longer fears the West. It’s the offshore, stupid

PutinCross-posted with the Tax Justice Blog:

If there’s one story you read today make it this one, from Politico Magazine. It’s triggered by the crisis in Ukraine, but it’s been a long time coming.

The point of this short story is clear: Western leaders are waking up to the fact that Russia no longer fears or even respects them. Why? Well:

“Russia thinks the West is no longer a crusading alliance. Russia thinks the West is now all about the money.” Read the rest of this entry »


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Show trial of Swiss whistleblower Elmer now in 9th year

Cross-posted with the new Tax Justice Network blog.

This month a Swiss court fought back against efforts by the United States to tackle criminal activity and tax its wealthy citizens properly. As Worldwide Tax Daily reports:

“A Swiss court on January 6 held that Switzerland’s Federal Tax Administration

Elmer copyright free

Rudolf Elmer in Mauritius

(FTA) “unlawfully granted” a U.S. request for client data from private banking group Julius Baer, saying it did not meet the requirements for an administrative assistance request under the Switzerland-U.S. income tax treaty.”

This is the latest episode in a long-running saga which began in 2008 when Swiss bankers were caught red-handed trying to flog tax evasion schemes to wealthy U.S. taxpayers – and the U.S.  responded with a crackdown, As a result, the two countries began working on new information-sharing protocols between the two countries that have had the effect of penetrating Swiss banking secrecy – though only up to a point, and only for the U.S.

As this episode unfolds, it’s worth remembering the long-running and fascinating case of Rudolf Elmer, former Chief Operating Officer with the Cayman affilate of the high-society Swiss bank Julius Baer. Elmer became fed up with what he was seeing and was involved in – and blew the whistle, first in 2005. He began by telling the Swiss tax authorities of tax evasion by Swiss taxpayers, and later provided information to Wikileaks and the world’s media.

This is not just yet another story of human rights abuses by a secrecy jurisdiction against someone who would challenge the  financial establishment. It touches on deep contradictions at the heart of the Swiss model of offshore finance. As tax expert (and TJN Senior Adviser) Professor Sol Picciotto says:

“His story casts fascinating light into the `offshore’ system, constructed by lawyers and other professionals, which has been central to the emergence of transnational corporate capitalism.”

The main legal charge against Elmer is that he breached Swiss banking secrecy laws which make it a criminal offence to reveal secrets obtained as an official of a bank. The main part of Elmer’s defence is that the information (which he admits he revealed) came from an affiliate of Julius Baer in the Cayman Islands, which is separate from its Swiss parent and therefore not governed by Swiss law.

Switzerland’s efforts to use Swiss laws to go after secrets revealed elsewhere contradicts the underpinnings of Switzerland’s own liberal use of offshore principles to help corporate and other tax cheats. For example, the Swiss tax authorities claim that profits earned by foreign affiliates (such as in the Cayman Islands) cannot be taxed in Switzerland, under the widely used ‘separate entity’ principle. As Picciotto notes:

“That is the essence of Elmer’s case, and is why the prosecutors are finding it hard to nail him.”

Since the first whistleblowing in 2005 he and his family have been hounded by the Swiss judicial authorities – which we would argue are ‘captured’ by the financial services industry: a classic feature of the so-called Finance Curse that afflicts finance-dependent economies. Of Elmer’s 28 encounters with the courts, 27 decisions have gone against him, and he has been imprisoned twice: once for 187 days, and once for 30 days, under an archaic Swiss law that allows lengthy spells of detention for police interrogation. In a twist reminiscent of the Soviet era, Elmer said Zurich prosecutors requested psychological evaluation of him in 2009 and in 2011 but he declined to cooperate – mainly to avoid the risk of ending up in a mental institution. Elmer’s long-suffering wife, would you believe it, is still under investigation for assisting in the breaking of Swiss banking secrecy.

Elmer also argues that the prosecution’s case is full of errors and inconsistencies. He told us, via separate emails, in the past a few days:

“At the moment the judges of the High Court of Zurich have to find me guilty. They have invested too much in the matter and cannot lose face! If I do not win – which is likely – I might have to take the entire case to the European Court of Human Rights.
. . .
We can demonstrate that the law has been bent and stretched, in order to serve the bank and not to lose face. This is about politics in the courtroom, and not about the law of a democratic society.
. . .
The case is an opportunity to show that a secrecy jurisdiction needs a morally corrupt judicial system in order to survive.”

Elmer’s whistleblowing is in its ninth year now, and they still haven’t dropped it. A truly independent judiciary, it seems, would have stopped trying to flog this horse long ago. But they haven’t: the campaign of intimidation continues, and there are still two cases pending against him.

As an aside, Switzerland’s decision to probe another Swiss banker who has provided information to U.S. tax authorities may be, as a recent article noted, designed as:

“a message to bankers: Keep quiet or else.”

It’s not just the Swiss authorities that seem to be in the pocket of the offshore banks. Much of the Swiss media seems substantially ‘captured’ too. While the rest of the world has focused on the big story: the exposure of large-scale criminality by wealthy élites around the world, much of the Swiss media has responded instead by focusing on questioning or smearing the whistleblower, with accusations (among many other things) that he is a ‘thief and a blackmailer“.

But it is the big story that interests us. Here’s the whistleblower support site Liberté Info, with some interesting questions posed in a recent letter to the Zurich High Court:

  1. Why has the prosecution not performed a criminal investigation of Julius Baer Bank & Co. AG, Zurich on the facts provided by Mr Elmer, information which has been widely published and is publicly available on the internet?
  2. Why have the judges of the High Court, who do have the lead in this matter, not requested that such a criminal investigation be performed in order to evaluate the entire case and to understand whether Mr Elmer had good reasons to make this information public?
  3. Why have the assets of (a Mexican drug lord) and other alleged criminals, which have been exposed in this case, not been investigated by Zurich’s authorities?

One can only wonder.

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Netherlands admits shame in being tax haven, pledges limited reforms

Cross-posted with the Tax Justice Blog:

We have long criticised the Netherlands for being a particularly important European tax haven helping multinational companies escape taxation. As, increasingly, have many others in Europe, the United States, and elsewhere. We recently noted, too, how some developing countries have been kicking back at some of the abuses that have been perpetrated upon them with the help of the Netherlands and other tax havens.

We are now delighted to see a Financial Times interview Netherlands’ deputy finance minister, Frans Weekers, making an admission that his government is uncomfortable with, and perhaps even ashamed of, the Netherlands’ role in this pernicious trade. The Financial Times reports:

“A proposal by the Netherlands to renegotiate its tax treaties with 23 least-developed countries marks a turning point for a country that has until now deflected accusations that it is a key player in tax avoidance by multinational corporations.

The initiative, which comes as the G20 meeting in St. Petersburg is putting tax harmonisation issues high on the agenda, is the most concrete move yet by the Netherlands to address the criticisms. Tax justice advocates say the country’s network of treaties with over 90 countries makes it a nexus for tax avoidance, allowing multinationals to reroute their profits through Dutch “letterbox companies” that do no real business in the Netherlands and exist largely for tax purposes.”

This comes in the context and the spirit of today’s G20 leaders’ declaration, which includes a statement that:

“We call on member countries to examine how our own domestic laws contribute to BEPS [TJN: Base Erosion and Profit Shifting, OECD-speak for corporate tax dodging] and to ensure that international and our own tax rules do not allow or encourage multinational enterprises to reduce overall taxes paid by artificially shifting profits to low-tax jurisdictions.”

There are big lacunae to be addressed in the Dutch plans, however. The FT article describes an official Dutch report presented last week, which seeks to insert new anti-fraud provisions in their tax treaties with the 23 countries; will pass on information to tax authorities in developing countries; and will ‘crack down’ on letterbox companies. In a brief email to TJN, Lee Sheppard of Tax Analysts spoke of the Dutch

“promises to put more ‘substance’ in shell companies MNCs [Multinational Corporations] use. Turns out the “substance” ain’t gonna be much.”

Despite the disappointments in the detail (as is so often the case with shiny-looking tax justice-styled reforms, or world leaders’ statements on these kinds of issues) the broad new public statement by the Dutch authorities is greatly welcome. The headline announcement is of great political significance, and an official admission that the tax justice movement, in the Netherlands and elsewhere, has had a point all along.

Today’s blogger remembers a tax justice meeting in Amsterdam a few years ago when a top Dutch tax official gave a horribly patronising presentation, seeking to pooh-pooh a seminal report by our excellent Dutch NGO colleagues at SOMO. Times, they are a-changin’.

“Over the past 10 years the trend has been for the number of letterbox companies in the Netherlands to keep growing. I want to turn that trend around,” Mr Weekers said. “I see the Netherlands being portrayed in a bad light. I don’t want to be portrayed in a bad light.

The Dutch move stems from a government-commissioned report over the summer which, for the first time, agreed with tax-justice groups that developing countries miss out on substantial tax revenues because of their treaties with the Netherlands.”

Here is a clear and public admission by the Netherlands government that this tax haven activity is causing great harm around the world. Or, to put it more succinctly, Tax Havens Cause Poverty.

Which, of course, immediately raises the next question: why stop at 23 countries? And why stop at these limited measures?

The logic points inexorably in one direction: the Netherlands should work towards rolling up this whole sordid industry and starting to compete on the basis of genuine business activity.

We urge other nations engaged in this shameful trade – such as Ireland, Luxembourg, Switzerland, Belgium, the United Kingdom and others – to take note. We applaud the Netherlands for making what must have been -at least as far as it goes – a politically difficult move.

For those with a Financial Times subscription, there is a whole lot more in the FT story.

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Press Release: response to OECD Action Plan on corporate tax avoidance

From the Tax Justice Network blog, a response to the OECD’s Action Plan on corporate tax avoidance. Now updated, with full commentary below.

The OECD has now published its long-awaited Action Plan on how to deal with corporate tax avoidance. Our response is below. It is broadly in line with a briefing yesterday as a curtain-raiser to this report.


Taxing multinational corporations: OECD chooses a path strewn with obstacles, headed in the wrong direction.

TJN’s Response to the OECD’s Action Plan on “Base Erosion and Profit Shifting”

July 19th, 2013

The OECD this morning published its long-awaited Action Plan to tackle corporate tax avoidance, which has seen the likes of Starbucks, Google, General Electric, Vodafone, Apple, Amazon and many others avoid billions in taxes.

Having carefully examined the Plan, which the OECD sent us under embargo on Wednesday, we have not changed our overall assessment we published on July 17th.

  • The Action Plan proposes the design of a series of piecemeal patches. These patches are generally to be welcomed, as immediate remedies to the gaping holes in the broken international tax system.
  • After a year’s work, the OECD has only identified the issues on which work is needed; developing actual proposals will be a far more arduous task, and the timetables of up to two years are likely to prove optimistic.
  • This approach is fraught with political obstacles. Although many of the envisaged measures are welcome, the overall approach would ultimately entrench the current broken system.
  • The OECD’s recommendations are not binding, and would require many governments to reverse their policies, in the face of determined opposition from business, and from the influential armies of accountants and lawyers who greatly benefit from designing tax avoidance schemes.
  • If governments did adopt the recommendations, this would intensify tax conflicts as each nation seeks to ‘grab’ as much cross-border income as possible for tax purposes. An already highly complex system will also become still more convoluted. Coordination will be extremely difficult, and the OECD’s ambitious idea for a multilateral convention is more likely to take twenty years than two.
  • The OECD should open the door to an approach that many tax experts agree is superior: unitary taxation, where multinationals are taxed not according to the tax haven-friendly, inefficient and distorted economic forms that their accountants and lawyers contort them into – but instead according to the genuine economic substance of what they do and where they do it.
  • The OECD experts have for years stubbornly clung to the outdated principles of a system devised 80 years ago, and have sought to close down any debate on this alternative, which would effectively cut tax havens out of the international tax system and restore countries’ abilities to tax multinational corporations. They claim that unitary taxation is not politically feasible.
  • We demonstrate below why unitary taxation is more politically feasible than the OECD’s approach, if governments are serious about taxing multinational corporations. It can be introduced gradually, starting with a transparency requirement, then expanded, building on years of accepted practice.

Professor Sol Picciotto, a Senior Adviser to the Tax Justice Network, said:

“The Action Plan contains some ambitious measures, which would produce some benefits if implemented. But its approach is like trying to plug holes in a sieve. The OECD has chosen a road that is strewn with obstacles, and leads in the wrong direction.

The OECD has missed this big opportunity to crack open the door to the big reform that the world’s citizens need. It is still open to countries to adopt their own versions of worldwide taxation of multinationals, and for other organizations such as the United Nations to take a lead in developing an effective worldwide system.”

Part 2: detailed commentary

The section below explores the OECD report in more detail.

The OECD Action Plan: the positives.

The Tax Justice Network supports the OECD’s efforts to strengthen international tax rules. The Action Plan is uneven, but in many respects ambitious. Some of its proposals would mean ending tax breaks that we have fought hard against, or introducing measures that we have supported. For example:

  • Strengthening so-called Controlled Foreign Corporation (CFC) rules. These have been eviscerated notably by the U.S.’ so-called “check-the-box” and pass-through rules, and by the UK’s move to a ‘territorial’ system in 2012, as a result of lobbying by multinational corporations and their advisers;
  • Limiting corporations’ ability to deduct interest and other payments made from affiliates in high-tax jurisdictions to related affiliates in low-tax or no-tax jurisdictions;
  • Ending arrangements that facilitate so-called treaty-shopping, such as the ‘Dutch Sandwich’, and other abuses of provisions in tax treaties;
  • Reforming the concept of “Permanent Establishment” and of attribution of profits, which are easily avoided by separating related functions.

A path strewn with obstacles, and leading ultimately in the wrong direction

Despite these positive recommendations, which if implemented would provide some relief for citizens who bear the economic brunt of corporate tax avoidance, the OECD report is build on a fatally flawed approach.

The OECD experts could have taken this unique political opportunity – on the back of widespread citizen protests and pressures from cash-strapped governments to tackle corporate tax avoidance – to set the world on the road towards a new and far better system. It does not do this, but instead aims to strengthen existing rules.

The fundamental flaw in the current system is that it tries to tax transnational corporations (TNCs) as if they were loose collections of separate entities operating independently in each country. This is a system built on a fiction: the OECD knows as well as anyone that these firms are not bunches of separate entities – but unified firms under central direction.

A tax system fit for the 21st Century would recognise this economic reality, and seek to tax them using a unitary approach. Most tax experts, even some at the OECD, recognise the clear superiority of the unitary approach.

Their main objection has been that such an approach would require a degree of political cooperation which would not be politically feasible. However, a gradual transition towards such a system is both possible and necessary, as we explained in our previous Briefing, and in a more detailed earlier report.

In our view, on the contrary, the OECD’s piecemeal approach is itself fraught with political obstacles, and is far less politically feasible as an approach, if we are serious about taxing TNCs effectively.

Recommendations are not binding; lobbyists will fight hard

Many of the measures that the OECD proposes to formulate would require states to reverse their international tax strategies, in the face of determined opposition not just from business, but also from the powerful firms of accountants and lawyers who find the current porous and complex system allows them to design highly lucrative tax avoidance schemes.

There will be many who will hope that while the OECD tries to flesh out these ideas into detailed provisions, the economic and political climate might change, fiscal pressures will abate, and press and public will lose interest in tax justice. We think this is unlikely.

More plausibly, cash-strapped governments will want to try to plug some of the holes in the leaky sieve of international taxation. Each will prioritise the measures that they think would least upset their own business lobbies. It will prove hard to persuade governments to repeal tax provisions that they believe attract business, even if these provisions harm other nations’ economies.

A recipe for conflict

To the extent that the OECD does succeed in persuading governments to follow its new recommendations, it faces an enormous task of coordination. If each state prioritises measures that give it a bigger slice of the tax pie, that is a recipe for international tax conflicts between nations. Some issues raised by countries have been ruled to fall outside BEPs project. These would add to the numerous conflicts that already bedevil the system. For example, India and other developing countries remain concerned about the limits current tax rules place on source taxation of foreign-based service providers.

Internet-based services: a growing headache

Many governments would like a quick solution to the problem to taxing internet-based companies. Google, for instance, has avoided large amounts of tax by selling its advertising through its affiliate in the tax haven of Ireland. The OECD is unlikely to deliver a good solution to this. One of the fifteen points in the Action Plan concerns the Digital Economy: it expects to deliver only an analysis in a year’s time, and even this deadline is unlikely to be met.

There are good reasons for this: the digital economy is not a distinct sector, but an important element in all business today, to a greater or lesser extent. Specific ways may be devised to tax some particular activities such as internet sales, but such partial and unilateral methods would produce imbalances and conflicts. In fact, the issues identified by the examples of Google, Apple and Amazon point to the more fundamental systemic flaws of the “separate entity” approach described above, which as we have pointed out the OECD does not propose to tackle head-on.

The OECD’s powers of persuasion

In its very tough task of coordination, the OECD’s only weapons are technical expertise and peer-pressure persuasion.

It proposes to use three methods.

First, at the most voluntaristic level, it will `revamp’ its Forum on `harmful tax practices’. This essentially entails using peer-pressure to persuade countries to remove tax breaks and preferential regimes.

Second, it will draw up revisions mainly of the Commentary to the Model Tax Treaty, and if necessary also to the actual model treaty articles. The treaty articles are legally binding, and the Commentary has significant legal effect in interpreting those provisions. But this effect only works if and when states actually renegotiate their existing bilateral tax treaties. With the best will in the world, this would take years.

Third, the Plan also proposes to formulate a multilateral treaty, which it hopes would override existing treaties. This poses complex legal problems, and a special group of international legal experts will be recruited for this delicate task. But such a multilateral treaty also would only come into force once ratified by individual states, and only among the states which do ratify it. We recall that in 1988 the OECD drew up, in conjunction with the Council of Europe, a multilateral convention on tax co-operation. This took over twenty years to gain more than a handful of ratifications.

Transfer pricing: a deeper and deeper hole

In our view, the OECD has chosen a road that is not only strewn with obstacles, but leads in the wrong direction. This can be seen most clearly, perhaps, with respect to the transfer pricing problem. Here, the OECD has dug itself progressively into a deeper and deeper hole by doggedly pursuing the fiction of “separate entity” and the “arm’s length method’, described above.

The Action Plan suggests that there is the beginning of a realisation of the need for a new approach, in mentioning that `special measures, either within or beyond the arm’s length principle, may be required’. This could potentially be construed as a possible tiny opening. However, it falls well short of the fundamental reorientation of approach that is required.

The OECD experts can be said to have done what could realistically be expected of them, given the political constraints. We had hoped for more, at least as regards transparency.

A road map to true reform

As we have pointed out, moving towards unitary taxation would not entail the sudden shock of a ‘big bang.’ It can be introduced gradually, building on existing practice. It involves three components, each of which can build on elements already existing in the current system.

A first, immediate step towards a unitary approach would be a transparency requirement, to require TNCs to submit to each relevant tax authority a Combined and Country-by-Country Report. This would outline the genuine economic substance of what the TNCs do and where they do it, and build on and enhance the already fast-emerging standard of Country by Country reporting.

This report should include global consolidated accounts, for which the OECD could and should develop a template. Action 13 of the Plan does seem to open up this possibility, and for this we must be grateful.

Second, tax authorities could use this information to apportion the global profits multinationals using appropriate allocation factors reflecting the economic substance of their activities around the world.

This can build on existing practice, in particular the so-called “profit-split” method already accepted by the OECD Transfer Pricing Guidelines, which aggregates the profits of related entities then apportions them according to so-called “allocation keys.” This is a narrower, transaction-level version of apportioning profits by formula.

This approach, as currently used, aggregates profits only at the level of bilateral transacting entities – whereas in reality TNCs use more complex cross-linkages among multiple affiliates. It would not be such a great stretch to extend this practice from the level of transacting entities to the combined whole. Indeed, there is already considerable experience in some sectors in applying formulaic profit apportionment, especially in the finance sector, e.g. where a trading book is transferred between offices in different time-zones over 24 hours. Formula apportionment of such profits has been done for 20 years through Advance Price Agreement (APAs) with banks. If firms such as Apple, Amazon, Google and Starbucks really do want to pay a fair level of taxes wherever they do business, they too could enter into APAs and agree an appropriate apportionment.

The experience of using profit split and APAs could be combined with proper research to determine appropriate apportionment formulae. Some degree of divergence of formulae is likely, but this is acceptable.

Some argue that states would simply aim to weight the factor which produces the biggest ‘tax grab’ for themselves – and that therefore it will be impossible for there ever to be full global agreement on a formula: and so, they argue, the whole approach is politically impossible.

But this is quite wrong, for several reasons.

First, full convergence is not necessary. Differing formulae could certainly lead to some overlaps between different countries’ tax systems – but as explained above this already happens under the current system, and the problem is likely to be less under unitary taxation.

Second, states won’t just go for the biggest possible tax grab – because they need also to consider the effects that this would have on inward investment. This is likely to lead to a more balanced approach towards designing a formula, and to encourage convergence. A balance between production and consumption factors seems best. In the US, the trend among states using unitary taxation has been for convergence (towards emphasising the sales factor.)

Some also argue that firms could still reorganise themselves to minimise their taxes.

This is true but it would happen to a dramatically lesser degree, and in a very different way. It is far harder for a firm to relocate physical assets, workers and sales to other countries than it is for them to shift artificial profits under the current system. And if they chose to divest some operations to truly independent third parties, they would lose the profits of synergy and scale. It is hard to imagine a company like Apple being willing to transfer to a truly independent wholesaler in a low-tax country a significant slice of its profits. Relocation of real activities may well occur, but this is very different from the artificial shifting of profits to largely paper affiliates that happens under current rules.

States would remain free to choose their own marginal tax rates. So countries could compete to attract genuine investment rather than formation of paper entities aimed at subverting the taxes of other countries.

Unitary Tax would therefore eliminate harmful tax competition, while allowing countries to make genuine choices between attracting investment in production and generating revenues from corporate taxation. Such a system would of course not be perfect, but aligning tax rules more closely to the economic reality of integrated firms operating in liberalized world markets would make it simpler and more effective.

The third important element of reform would involve a procedure for resolving disagreements and conflicts between states. Such a system already exists in the OECD’s Mutual Agreement Procedure (MAP) but it could be improved, as explained above, and extended to include negotiation of APAs.

Currently, the MAP is very secretive, and decisions often involving hundreds of millions or even billions of dollars are not published. The secrecy of both MAP processes and APAs greatly increases the power of frequent actors in these processes, i.e. the international tax and accounting firms – to the great detriment of the system as a whole.

Publication of both would be a great step towards a system which could both provide and more importantly be seen to deliver a fair international allocation of tax.

Not just the OECD.

A new approach to international tax in any case should not come from the OECD alone.

Although they propose to include at least seven of the eight non-OECD members of the G20, this still excludes the vast majority especially of developing countries. A more inclusive forum is needed. The United Nations Tax Committee should be the appropriate body – but it is hampered by lack of resources and bureaucratic problems. Nevertheless, if sympathetic governments could supply it with special funding, it could initiate a special project, following up its rewrite of the Transfer Pricing Manual which was published this year.

The IMF’s Tax Policy Department could also play a role, given its expertise. Indeed, the IMF last month recognised that there is considerable interest in a unitary taxation approach:

“such schemes—including their impact on developing countries—deserve a more thorough and realistic assessment.”

We hope that the OECD would also contribute to such a broader initiative to study and develop a new approach, even while it pursues its task of repairing the leaky sieve. The Tax Justice Network will continue its own work, and would be be happy to contribute to any initiatives aimed at restoring the integrity and efficacy of the international tax system.

Media enquiries

Please contact Professor Sol Picciotto:

Skype: Sol.picciotto


Phone +34-943-579800

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Swiss bankers confess that their UK tax deal has failed

Adapted from the Tax Justice blog.

The Swiss Bankers’ Association has this morning admitted that its UK-Swiss bilateral tax-and-secrecy deal, which we have condemned from the start, has failed. This is of enormous importance, given that Italy is considering (again) the possibility of signing such a deal.

The deal, under a Swiss-designed model sometimes known as “Rubik,” is supposed to take a large capital chunk (and ongoing withholding tax payments) from the untaxed assets of UK residents who have been criminally evading tax via Swiss banks, in exchange for their being allowed to keep their tax affairs secret. Switzerland would pay the UK a one-off upfront payment of SFr 500 million – about £320 million or $500 million, and then, politicians promised, Britain would reap £4-7 billion, mostly from the hefty chunk being taken out of the capital in the Swiss accounts.

We said from the beginning that because of the giant loopholes in the deal — some of them deliberately inserted — they would raise only a small fraction of what they had promised. We sent our analysis to the Swiss Bankers’ Association, to the Swiss and UK tax authorities, and to private practitioners – and apart from this underwhelming response, none of them demonstrated to us how we had got it wrong. For a short discussion of our original analysis and the response from others, see this Guardian story – or the full analysis here.

Now a few days ago the UK balanced its budget with a promise of £3.2 billion from the Swiss tax deal. We showed how that was a fictional budget-balancing exercise, based on unrealistic projections.

Now, finally, we have been proved right. A new press release from the SBA says:

“First indications from selected banks in Switzerland show that there are fewer untaxed UK assets in Switzerland than had been previously assumed.

The possibility can therefore not be ruled out that either none or only a small part of the banks’ guarantee payment of CHF 500 million will be recovered.”

That is a devastating confession. This is very far from the £4-7 billion that the UK politicians have been promising.

The Swiss “withholding tax” model is now effectively dead. Dave Hartnett, David Gauke and the government that sanctioned this deal must now hang their heads in shame.

There are, admittedly, a couple of other details in the SBA’s statement today. Notably this paragraph:

“First indications from selected banks in Switzerland show that there are fewer untaxed UK assets in Switzerland than had been previously assumed. This is mainly due to the fact that many clients have resident non-domiciled status. These clients are not liable to taxation in the UK and thus do not fall under the Agreement. Furthermore, numerous UK clients have opted for voluntary disclosure, which comes as no surprise given the latest developments in Switzerland with regard to the announced adoption of a global standard for the automatic exchange of information.”

Now the Swiss Bankers’ Association has a long track record of obfuscation and secrecy, so we need to take this unproved, unsourced assertion with a cupful of salt. This is spin.

And this statement, to be honest, is ridiculous. For one thing, what on earth were those projection-makers in the UK thinking if they did not consider the assets of the so-called non-doms (who are resident in the UK but who don’t pay tax (or even have to report) their non-UK income? Did they somehow “forget” to factor them in? We asked them for the basis for their original projections, and they never provided any kind of detailed analysis. This statement is nonsense. (And if a “non-dom” doesn’t have to report their non-UK sourced income, then we wonder what is the point of then hiding their foreign assets in a Swiss bank?)

The second part of the statement, that some UK “clients” have opted for voluntary disclosure, may contain some truth. They may have transferred assets via the very generous (though technically much tighter) Liechtenstein Disclosure Facility, for instance – but this deal would have had almost no impact on the rate of those voluntary disclosures, because it is, as we demonstrated, child’s play to escape. If people with secret Swiss stashes wanted to disclose voluntarily they were going to do so, perhaps out of moral scruples or whatever. But there was no ‘pressure’ from the UK-Swiss tax deal to do so. Put your Swiss account into an insurance wrapper or discretionary trust or Liechtenstein foundation — or, more dramatically, put it in an account in Singapore – and you are home free.

What they don’t seem to want to admit is that there are “fewer untaxed UK assets in Switzerland” because so many of those assets, which from an economic point of view are assets that UK taxpayers have the power to enjoy, have been shifted outside the scope of the deal through becoming assets that are not, legally speaking, connected to a UK taxpayer. Many if not most of those assets achieved that trick by becoming what one might call ‘ownerless’ assets.

The most obviously egregious provision in the provision in this respect relates to so-called discretionary trusts. For anyone wanting to understand international tax evasion and avoidance, these creatures are worth understanding. Recently we quoted a practitioner in Jersey as saying that:

“Something like 90% of Jersey trusts we draft are fully discretionary ones.”

And we have heard those kinds of figures from other sources too. This is bread-and-butter stuff: see that blog for a brief explanation of how discretionary trusts work. In our original analysis, we noted that Article 2h of the UK-Swiss tax deal said:

“An individual resident in the United Kingdom is not considered to be a relevant person . . . if it is not possible to ascertain the beneficial ownership of such assets, e.g. due to the discretionary nature of the arrangement.”

Our emphasis added. That loophole explicitly carved out for discretionary trusts is a flag planted squarely in the agreement saying ‘escape me here.’ What reason can there be for this kind of deliberately inserted escape route? The only reason we can think of is that it was put there to protect people – not just from prosecution, but also from the inconvenient matter of having to cough up the money. And we know that whistleblowers had provided information on Swiss bank accounts to the UK authorities, so there were undoubtedly people to protect.

This is a truly sordid tale. And now there is a multi-billion dollar hole in the UK’s budget to explain.

Why would the SBA put that particular spin on the reasons for the failure of its deal? We think that the reason is likely to be because of the Amendments to the EU Savings Tax Directive, which does quite effectively tackle the problem of ‘ownerless assets.’ To oversimplify: by saying that the asset is deemed not to have been given away into the structure until a distribution to a beneficiary has happened.) These amendments are powerful tools for tracking down assets, and represent a threat to Swiss banking secrecy; they have been playing long and hard, in alliance with Luxembourg and Austria, to derail the progress of these Amendments. To confess that these kinds of loopholes are the reason for the deal’s failure is tantamount to an admission that the EU’s project, which is a mechanism for delivering automatic information exchange to the 43 jurisdictions covered, is far superior to the Swiss withholding model. (For a look at what is at stake here, take a look at this article by Itai Grinberg last year.)

We will end with an apt tweet from a UK tax expert. It kind of speaks for itself, revealing much about the where power and influence lies.


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Tax justice and a short history of the decline of corporate responsibility

Also cross-posted with the Tax Justice Network blog.

The U.S. site Remapping Debate is carrying a long article entitled Citizens without obligations? which looks at changes in corporate citizenship over the years.

“In an effort to find out whether American corporations are the kind of “citizens” that believe that they have national obligations, Remapping Debate contacted the representatives of more than 80 corporations.

Most had no comment, a striking finding in and of itself. And among the corporate representatives who did comment, most were unwilling to say that their corporation had any obligations to the United States, let alone to define any such obligations with specificity. “

Although this article focuses on the United States, it seems likely that if similar conclusions would be reached in many other countries. Richard Sylla, economics professor at the Stern School of Business at New York University (NYU), commented on the findings:

“It’s revealing that the benefits they cite are so self-serving. It shows that they think of themselves as opportunistic entities, not participatory members of society.”

BakanReaders of the book The Corporation, by the Canadian law professor Joel Bakan, from which the above image is drawn, would hardly be surprised to hear this. As his book summary notes:

“The corporation lies, steals and kills without remorse and without hesitation when it serves the interests of its shareholders to do so. It obeys the law only when the costs of crime exceed the profits. Corporate social responsibility is impossible except insofar as it is insincere.”

That book, though several years old now, is still well worth reading.

But there is still plenty more to be said.

A box early in the story published by Remapping the Debate, entitled “When obligations went with benefits,” notes that for most relevant history, U.S. corporations were perceived by both the public and by corporate executives themselves as having a broad range of obligations — including national obligations — that competed with the goals of making profit or creating value for shareholders. This is obviously central to any tax justice agenda: a narrow “shareholder value” approach to corporate responsibility would see managers fighting aggressively to dodge taxes and shirk other responsibilities, while a ‘stakeholder value’ approach would see a far more balanced responsible approach.

The article also refers to a 2013 paper by Gomory and Richard Sylla, entitled The American Corporation, which says:

“The most recent era is marked by a shift away from a stakeholder view of corporate interests and purposes to one dominated by profit and shareholder-value maximization.”

Remapping Debate continues:

“The idea that a corporation exists solely to make money is actually quite new,” explained Ralph Gomory, a professor of management at New York University. The broader sense of corporate responsibility was starkly apparent during World War II, when many U.S. companies dramatically changed their operations to aid the war effort, Gomory said, but it also extended through the 1950s, 1960s, and 1970s. “Even in the early ’80s, you would be more likely to hear a CEO talking about his responsibilities to the country or to his employees than his duty to the shareholders.”

Gomory cites main reasons for the erosion in corporate responsibility, starting in the 1970s: the end of the Cold War and the onset of rapid globalization; the alignment of the interests of corporate executives with shareholders through stock-based compensation; and an ideological shift in economics and business schools towards the idea that the purpose of a corporation was the maximize shareholder value.  Milton Friedman’s 1970 article in New York magazine, entitled “The Social Responsibility of Business is to Increase its Profits,” reflected the changes that were underway.

“Businessmen [who] speak eloquently about the “social responsibilities of business in a free-enterprise system,” Friedman wrote, “are unwitting puppets of the intellectual forces that have been undermining the basis of a free society these past decades.”

Though experience has revealed Friedman’s arguments to be fatally flawed, his was an influential argument at the time.

But despite the profound ideological shift that took place, our recent blog on this subject confirms, in fact, that corporations do in fact still have official responsibilities to society, beyond a narrow focus on delivering returns for shareholders. It cites Lynn Stout,  Distinguished Professor of Corporate and Business Law at Cornell Law School, as saying:

“The ideology of shareholder value maximization lacks any solid foundation in corporate law, corporate economics, or the empirical evidence. Contrary to what many believe, U.S. corporate law does not impose any enforceable legal duty on corporate directors or executives of public corporations to maximize profits or share price.”

More specifically, in the UK, directors are required to have regard to the long-term consequences of their decisions, the interests of employees, relationships with suppliers and customers, the impact of corporate activities on the community and the environment, the company’s reputation for high standards of business conduct and the need for fairness between different members of the company.

Remapping Debate quotes William Lazonick, a leading business thinker at the University of Massachusetts, Lowell.

“Up until the 1980s, CEOs were extremely reluctant to shut down factories and lay off a large number of workers,” Lazonick said. “Mass layoffs were actually seen as a serious abnegation of corporate responsibility. It was understood that the company had a responsibility to it workers, and that if it failed, soci- ety at large would be on the hook for that failure.”

It also cites Margaret Blair, a law professor at Vanderbilt University, who notes that in the period from World War II to the 1980s, it was far less common to see corporate executives lobbying the government for special rights and benefits, including lower taxes.

“It was accepted that, if the United States was going to be a powerful economy and have a high quality of living, then the corporate sector needed to do its part to supply financial resources to the government,” she said. “There was no sense of it being the corporations versus the government. It was much more about everybody being in it together.

And, we hasten to add, that period was one of high, broad-based economic growth. One can see the change in two statements from the U.S. Business Roundtable, cited by Sylla and Gomory. The first, from 1981, states that corporations have a responsibility to “each of the corporations constituents.” It continues:

“Responsibility to all these constituents in toto constitutes responsibility to society…Business and society have a symbiotic relationship: The long term viability of the corporation depends upon its responsibility to the society of which it is a part. And the well-being of society depends upon profit- able and responsible business enterprises.”

By 1997, the Business Roundtable’s position had changed to:

“The principal objective of a business enterprise . . . is to generate economic returns to its owners,” that is, its shareholders.”

This has been accompanied by a rise in corporations’ sense of entitlement, without corresponding obligations: a classic recipe for (among many other things) tax-dodging:

“Sylla said the fact that many American corporations see themselves as entitled to the benefits of citizenship — without incurring reciprocal obligations — is reflective of a fundamental disjunction between how individual and corporate citizenship are perceived.

“We’ve determined that a corporation is legally like a person in lots of ways,” Sylla said. “They have rights, including the right to free speech, and they enjoy an array of benefits. Don’t most of us think that those rights and benefits come attached to obligations? When they say they don’t have any national obligations, it shows we have a double standard.”

Quite so. One for our corporate responsibility page.

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Derivatives WMD: lobbyists seeking to remove ‘burdensome’ safety catches

I wrote this originally on the Tax Justice Network blog.

This important blog is fairly long, so we preface it with a short summary.


The Wild-West $600 trillion unregulated global market in financial derivatives, implicated in numerous financial disasters before, during and since the hottest phase of the global financial crisis in 2008/9, now potentially faces some welcome (if very belated) new regulation in the U.S., Europe and elsewhere. Last week, for instance, the U.S. became the first country in the world to require mandatory clearing of many derivatives contracts, a crucial protection for citizens.

The U.S. Dodd-Frank financial reform bill of 2010, currently the leader in this particular area, envisages that if a derivatives trade has a “direct and significant connection” to the U.S. economy — in other words, if risky derivatives trading activity could turn around and bite U.S. taxpayers — then the U.S. should be able to regulate it whether it is nominally located in the U.S., in the City of London or in the Cayman Islands. We at TJN fully support that as a generally useful principle, for all regulators worldwide.

But financial lobbyists and others are now battling to stop this, so that transactions by U.S. companies that are conducted overseas are exempted from the rules. They argue that it is ‘burdensome’ for global banks in one jurisdiction to have to comply with regulation emanating from another jurisdiction, and they want to get all foreign transactions exempted from regulation. If they succeed, this would constitute a basic and gigantic offshore escape route which would kill effective regulation of this industry, lead to yet another race to the bottom on financial regulation, and strike at the very foundations of global financial reform. The stakes are high.

Worryingly, Michel Barnier, the European Commissioner for Internal Market and Services, and several European and other finance ministers, appear to have sided with the financial lobbyists, and want financial regulation to stop at national borders.

The core question to consider here is: whose priorities are most important here? Should one put the interests of financial stability and the general public first? Or is it more important to make life more convenient for global banks?

We urge any groups and people interested in financial stability issues to take an interest in these crucial issues.

Full blog

From the Washington Post on Saturday:

“Pop quiz: What do the following financial crises — AIG, Lehman Brothers, Citigroup off-balance sheet SIVs, Bear Stearns, Long-Term Capital Management, and the “London Whale” of JP Morgan — all have in common?”

One thing they have in common, of course, is that these are names for some of the worst financial disasters that have hit the world in recent years. But there’s something else they have in common too. The article cites Gary Gensler of the U.S. Commodity Futures Trading Commission (CFTC), one of few U.S. regulators to have tenaciously tried to rein in many Wall Street abuses:

“According to a speech given by Gensler earlier this month, they all involved exposures to derivatives across countries.

And, in more detail:

“AIG Financial products was run out of London as a branch of a French-registered bank. The U.S. Lehman Brothers Holdings guaranteed 130,000 outstanding swaps contracts from their London affiliate. Citigroup’s off-balance sheet financial instruments were launched from London and incorporated in the Cayman Islands. The two Bear Stearns hedge funds that collapsed, precipitating the firm’s failure and the taxpayer rescue, were incorporated in the Cayman Islands [TJN: and let's not forget the role of Wild West offshore Ireland in that particular debacle]. Long Term Capital Management’s swaps were booked in a Cayman Islands affiliate (that according to Gensler, who was with Treasury at the time of their 1990s collapse, was basically a P.O. Box). And, as the name stipulates, the London Whale trades of JPMorgan Chase were in London.”

Our emphasis added. We have written about this before.

Some time before the crisis, derivatives were accurately described by Warren Buffett as ‘financial weapons of mass destruction (WMDs)’ – and so it turned out. Key to the mess was Wall Street’s ability to escape regulation it didn’t like by going elsewhere to conduct the trades in jurisdictions (such as London) with laxer regulation.

Our emphasis added, again: those two words ‘escape’ and ‘elsewhere’ are close to being definitional for us at TJN. This is quintessentially offshore business.

This gigantic business is currently putting Europe and the rest of the world at grave financial risk – as if there wasn’t enough to worry about. The Washington Post continues:

“As Marcus Stanley, of Americans for Financial Reform [AFR], notes to Erika Eichelberger of Mother Jones, “Wall Street banks routinely transact more than half their derivatives through foreign subsidiaries. [TJN: Bloomberg analysis last year discovered that 62 percent of Goldman Sachs' and 77 percent of Morgan Stanley's derivatives operations were foreign.]

How big is this issue? Well, according to a recent letter by [tax justice hero] Carl Levin, Elizabeth Warren, Sherrod Brown and three other U.S. senators, the four largest U.S. commercial bank derivatives dealers alone, accounting for 93 percent of the $223 trillion notional value of the U.S. bank derivatives market (note: that is trillion, not billion), had over 3,300 foreign subsidiaries.

Now the U.S. 2010 Dodd-Frank financial reform bill has an excellent and potent ‘extraterritorial’ aspect: a principle that is one of the most powerful generic tools available in global financial regulation. Put simply, Congress granted authority to the CFTC (which regulates around 90 percent of U.S. derivatives markets) to oversee all derivatives transactions if they have a ‘direct and significant connection’ to the U.S. economy — whether those transactions are nominally located in the U.S. or in  Cayman or in London. This stands to reason: if derivatives cowboys in London are putting U.S. taxpayers at risk, or vice versa, then the home country should be able to regulate that business, wherever it is.

And of course this is not purely a U.S. matter. Far from it.

For one thing, Wall Street is the biggest part of global markets in financial derivatives, and the financial crisis has shows us that in our interconnected world, one big country’s problems soon become everyone else’s problems. More importantly, there is an essential principle at stake here: that when risky trading activities happen, any country that is seriously at risk from these financial WMDs should not be rendered powerless to regulate to make them safer. The possibility of cross-border regulation is an essential, foundational principle that is worth defending to the last. And, perhaps still more importantly: giving individual countries free rein to regulate as they see fit, without concern for the impacts on other jurisdictions, is a tried and tested recipe for a race to the bottom: where the laxest jurisdictions get the most business, and others then face incentives and pressures to relax their regulation just to keep up in this dangerous race. At TJN we have seen this deadly dynamic again and again and again: on tax, on secrecy, on financial regulation, and otherwise.

So for Dodd-Frank to succeed, this potential for “extraterritorial” reach is absolutely essential: a foundation stone of the whole exercise.

And now comes the problem.

The ‘extraterritorial’ aspect of Dodd-Frank is now under serious threat, from two main quarters. First, Wall Street and assorted hangers-on in the United States are powerfully attacking the principle. As Marcus Stanley of AFR writes in U.S. News:

“On Monday, the U.S. became the first country in the world to require mandatory clearing of many derivatives contracts, a crucial protection in these previously unregulated markets.

But even as this crucial protection takes effect, Wall Street is mobilizing to create a back door escape route. Its goal is to prevent U.S. regulation of derivatives transactions by U.S. companies that are conducted overseas. This loophole could strike at the foundations of financial reform.

. . .

It would create an incentive for global banks to transact their business through whatever jurisdiction has the weakest regulations – a “regulatory haven” to match the tax havens that international corporations already use.

. . .

If they succeed, entities nominally based in foreign countries but active in U.S. derivatives markets will not have to comply with U.S. derivatives rules. This could potentially include foreign subsidiaries of U.S. banks, the numerous U.S. hedge funds incorporated in places like the Cayman Islands and subsidiaries of major foreign banks that are major dealers in the U.S. markets”

(Read the rest of that article for more details, or see this.)

But, worryingly and more surprisingly, it’s not just U.S. lobbyists who are trying to undermine this crucial aspect of Dodd-Frank.

We have now seen an unholy alliance formed between Michel Barnier, European Commissioner for internal market and services, and George Osborne, UK Chancellor; Switzerland’s Eveline Widmer-Schlumpf; and several other finance ministers. They, too, want to stop Dodd-Frank at the U.S. borders. In a letter sent to U.S. Treasury Secretary Jacob Lew on April 18th, they stated that:

“we hold the view that as a principle, local regulations should not be extended beyond national borders.”

This is the classic recipe for a race to the bottom. Can we trust Switzerland, one of history’s top racers-to-the-bottom, to ensure that their derivatives regulations do not create enough of loopholes to lure lots of derivatives business? Of course not. London’s history in this respect makes it equally untrustworthy.

While Barnier may have made some useful moves on financial regulation in other areas, this letter goes in exactly, precisely the wrong direction. The justifications that the signatories of the letter for wanting regulation to stop at national borders include:

  • If this happens, derivatives markets will recede into localised and “less efficient” structures.
  • The simultaneous application of multiple rules to cross-border activity will result in conflicting, inconsistent or duplicative requirements on market participants, constituting “burdensome regulatory conditions.”
  • (subtext: who do these Americans think they are?)

Now those complaints will carry a lot of weight especially among those who worry a lot about ‘burdensome’ regulations being applied to this market. For sure, extraterritorial regulation has the potential to make specific regulatory compliance issues more complex. But against this, weigh some other considerations.

First, this is not a story about the United States bullying other jurisdictions, although on the surface it could look that way. This is a case of weary, embattled, outgunned financial regulators facing up to enormously powerful financial interests, under heavy fire, to try and protect their citizens as best they can.

Second, if one is worried about efficiency and complexity, one should consider the complexity and inefficiency (not to mention injustice and disruption) that would result from more gigantic bailouts.

The right approach, of course, is to put financial stability and the fate of ordinary taxpayers around the world at the first order of priority, and the convenience of global banks in complying with regulation after that.

Given this big picture, some important details now need to be taken into account.

Dodd-Frank guidance does envision a role for what is known as ‘substituted compliance’, which would exempt foreign activity from falling under a home country’s rules — just so long as the home country (in this case the U.S.) deems the foreign rules to be good enough and equivalent to its own. In other words, instead of having regulators reaching into other jurisdictions to regulate risky activities, you effectively have regulators handing out certificates of good conduct to other jurisdictions and trusting them to regulate properly.

All this sounds like a good idea in theory – and indeed ‘substituted compliance’ may be a principle worth taking on board, as a co-operative end goal.

But if carried out too early, and in the wrong way, it could be a total disaster.

It is essential that this ‘substituted compliance’ only happens once both the requirements and the enforcement of the foreign regime’s derivatives protections are genuinely equivalent and good enough to be able to hand over to that foreign regulator. This approach, among other things, gives foreign regulators powerful incentives to shape up and put genuinely strong regulation in place, so as to get their hard-earned certificate of good conduct. This is a race-to-the-top incentive. This ‘strong version’ of substituted compliance puts the interests of taxpayers and societies first, and the interests of global banks second.

But a weak version of ‘substituted compliance’ would put the interests of global banks first and protect them from ‘burdensome’ financial regulation, where jurisdictions generally trust each other to regulate at home, as they see fit, and perhaps a few of the most egregious recalcitrants get slapped on the wrist or even have their certificates of trustworthiness temporarily withdrawn. This would be an appalling, race-to-the-bottom outcome.

So what is the approach reflecteded in the April 18th letter sent to U.S. Treasury Secretary Lew by Barnier and the finance ministers?

The letter does accept ‘substituted compliance’ as a general principle, which on the face of it is not necessarily in conflict with Dodd-Frank.

But the question now is: are the ministers angling for a weak version of ‘substituted compliance’, or a strong version? Well, the letter states, in part:

“as a principle, local regulations should not be extended beyond national borders. We expect any deviations from this principle to be narrow, and to exist only where there is a clear and specific justification.”

This looks exactly like the weak version, or something perhaps just as bad: a recipe for waiting until all jurisdictions are up to scratch before anyone does anything at all. That could be a recipe for waiting interminably, while the financial derivatives orgy continues unabated. (And there are other things, highlighted in the FT, that are worrying about the letter.)

We urge all organisations in Europe that have an interest in global financial stability to get up to speed on these crucial issues. A good place to start is here.

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New report into the UK’s Overseas Territories and developing countries

Cross-posted with the Tax Justice Blog and the Treasure Islands blog.

Christian Aid and the IF campaign have a very important and topical new report available, entitled Invested interests: the UK’s Overseas Territories’ hidden role in developing countries.

It is becoming increasingly recognised that huge amounts of investment in and out of developing countries is being routed via tax havens. Former UN Secretary-General Kofi Annan has remarked, accurately:

“When foreign investors make extensive use of offshore companies, shell companies and tax havens, they weaken disclosure standards and undermine the efforts of reformers in Africa to promote transparency. Such practices also facilitate tax evasion and, in some countries, corruption, draining Africa of resources that should be deployed against poverty and vulnerability’.”

Many of the world’s most important tax havens – between a third and a half, depending on how it is measured – are British Crown Dependencies or Overseas Territories, partly independent from Britain, but also closely linked to the UK via a web of constitutional links.

The crucial part to know here is that Britain has complete power to disallow the offshore secrecy (and other) legislation that these places put in place. In a very important section entitled The UK’s role, it notes:

“In the most recent White Paper on the BOT [British Overseas Territories] it was confirmed that ‘[As] a matter of constitutional law the UK Parliament has unlimited power to legislate for the territories’.

The UK has hitherto chosen not to intervene, in almost every case – but there are isolated cases, not related to offshore secrecy, where the UK has forced the islands’ hands.

So it is wonderful that influential organisations are now starting, for the first time (spurred in part by long-running work by TJN and by books such as Treasure Islands) to take a long hard look at Britain’s role in development. The new report notes that it:

“attempts, for the first time, to quantify the role that tax havens to which the UK is constitutionally linked play in facilitating the flow of FDI into developing countries, dwarfing that of the BRICS nations.”

Anything like this is, as we have noted in our own research, an exercise in night vision, so precision is hard to get. But this is a very useful piece of new research.  And it’s topical too, as the report’s author Joseph Stead notes:

“The UK as G8 chair has never been in a stronger position to end the grave injustices caused by tax havens – if the UK  succeeds in putting its own house in order first. The Prime Minister must do everything he can to get UK havens agreed on a tax deal before he arrives in Northern Ireland, so he can push the G8 to end the tax scandal.”

Quite so.

There is an absolute ton of useful information in here. We will merely scratch the surface, and highlight a few fascinating details, such as this one:

Three of 14 British Overseas Territories, in particular the British Virgin Islands (BVI), Cayman Islands and Bermuda emerge as among the biggest global sources of FDI. Together with the Crown Dependencies of Jersey, Guernsey and the Isle of Man, they were in 2011 the largest provider of FDI to the developing world

. . . and this remarkable fact is backed up by an equally remarkable table:

We’ve seen isolated information on this before — such as in this French report, for instance — which was surprising enough, but we’ve never seen the data collated like this.

In short, tax havens are conduits for a large share of foreign direct investment around the world – but the share is much bigger when just developing countries are considered. Nearly half the investment from the highly secretive British Virgin Islands, for instance, goes to developing countries, and outward FDI from the BVI was equivalent to over 860 times (NB, that’s not 860 percent, but 860 times!) the BVI’s GDP. (By comparison, the UK has a ratio of around 1:1 and the US around 0.2:1.) That is astonishing.

The report outlines a number of reasons why the tax havens may be so important, ranging from a desire for a more secure legal environment to the more nefarious round-tripping, tax dodging and corruption. Secrecy automatically facilitates and promotes these.

The report notes that the IMF and others have been woefully lax in collecting data on this; the report’s authors had to go to individual countries to find out the totals. Shame on them. The OECD, it says, has the overwhelming role in designing international the corporate tax system – but this is highly problematic given that while the OECD is a club of rich countries, it is the poorer countries that are disproportionately the victims of this. Much more transparency is obviously needed too.

An extremely useful overall contribution to the literature.


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