International Tax Avoidance using tax havens and loopholes in DTAA

EGMP-22 Business Law Project

This project discusses the issue of tax havens and how they are used by International companies to evade taxes from an Indian perspective.

Submitted By
Arun kumar G Arvind Srinath Ashok Giri Ramaprasad Alwa B Ravichandran Iyer Sudhakar Reddy EGMP -22 IIM Bangalore

1/15/2012

Contents
1. 2. 3. 4. 5. Introduction .................................................................................................................................... 2 Major provisions of the DTAAs that India has entered with different countries ........................ 2 Policies of different tax havens that make them attractive for different type of operations .... 3 Implications of Tax Haven operations using DTAA for India ........................................................ 4 Methods used by companies in DTAA countries to evade taxes ................................................. 4

6. Actions taken by various governments and international organizations to curb the menace of tax avoidance under DTAA .................................................................................................................... 5 7. Future of Tax Havens and DTAA .................................................................................................... 6

References .............................................................................................................................................. 7

1. Introduction
Tax Haven According to Investopedia, a tax haven is a country that offers foreign individuals and businesses little or no tax liability in a politically and economically stable environment. Tax havens also provide little or no financial information to foreign tax authorities. Individuals and businesses that do not reside a tax haven can take advantage of these countries' tax regimes to avoid paying taxes in their home countries. Tax havens do not require that an individual reside in or a business operate out of that country in order to benefit from its tax policies. The Organization for Economic Development and Cooperation (1998) dened the features of tax havens as no or low taxes, lack of effective information exchange and transparency, and no requirement for substantial activity. DTAA Double Tax Avoidance Agreements (DTAA) are created so that a resident of a country (home country), who has an income in a second country (contracting country) as a result of business or job, is not taxed for the income in the home country if he has already paid tax on the income in the contracting country. The provisions of the agreement are applicable to corporations as well. While the law is created to avoid double taxing citizens and hence to help grow the economies, several loopholes in the agreements allow Companies and HNIs to use tax havens to route money and avoid paying tax on income neither at the contracting country nor at the home country.

2. Major provisions of the DTAAs that India has entered with different countries
A typical DTA Agreement between India and another country covers only residents of India and the other contracting country who has entered into the agreement with India. A person who is not resident either of India or of the other contracting country cannot claim any benefit under the said DTA Agreement. Such agreement generally provides that the laws of the two contracting states will govern the taxation of income in respective states except when express provision to the contrary is made in the agreement.

a. Taxation of Business profits: Imposition of tax on a foreign enterprise is done only if it has a
Permanent Establishment (PE) in the contracting state. If a permanent establishment has been created, the profit may be taxed in the other state only to the extent that is attributable to that establishment. Tax is computed by treating the PE as a distinct and independent enterprise. If a resident of India becomes liable to pay tax either directly or by deduction in the other country in respect of income from any source, he shall be allowed credit against the Indian tax payable in respect of such income in an amount not exceeding the tax borne by him in the other country on that portion of the income which is taxed in the said other country. The same benefit is available to the resident of the other Country, on income taxed in India. In respect of incomes on which taxes are either exempted or reduced, the country of residence will not take the exempted income into account while determining the tax to be imposed on the rest of the income. Income from immovable property: Income from immovable property will be taxed in the contracting state in which the property is situated.

b.

c.

Taxation of income from Air and Shipping Transport : Income derived from the operation of Air transport in international traffic by an enterprise of one contracting state will not be taxed in the other contracting state. Income earned from the operation of ships in international traffic, will be taxed in the contracting state where the place of effective management of enterprise is situated. Taxation of Income from Associated Enterprise: In order to plug loop holes for tax evasion, a separate article in DTA agreement provides for taxing the notional income deemed to arise on account of an enterprise of one contracting state participating directly/indirectly in the management of another enterprise in the other contracting state or where some persons participate directly or indirectly in both the enterprises under conditions different from those existing between the independent enterprises. Taxation of dividend income: Dividend paid by a company resident of India to a resident of another contracting state will be taxed at that contracting state. However, the Indian company has to pay Dividend distribution Tax (DDT). Taxation of interest income: Both the contracting states have the right to tax interest income. Taxation of Income from Royalties: taxation of Royalties varies from agreement with one country to another. It can be taxed either or both contracting states depending on the agreement with the specific country. Taxation of Capital Gains: Income from capital gains is taxed in the state where the asset is located.

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e.

f. g.

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3. Policies of different tax havens that make them attractive for different type of operations a. Mauritius Route: Article 13(4) of the DTAA with Mauritius specifies that gains other than
from the alienation of immovable property or gains from the alienation of movable property forming part of the business property of a permanent establishment which an enterprise of a Contracting State has in the other Contracting State or of movable property pertaining to a fixed base available to a resident of a Contracting State in the other Contracting State for the purpose of performing independent personal services, including such gains from the alienation of such a permanent establishment (alone or together with the whole enterprise) or of such a fixed base, may be taxed only in Mauritius. Article 13(4) means that acquisition of other capital assets such as shares in Indian companies by companies in Mauritius is only taxable in Mauritius and not in India. This article of treaty is very attractive to investors since Mauritius doesnt have capital gains tax. It has led to many companies setting up faade establishments in Mauritius to channel their investments in Indian (in the form of shares) and repatriate the capital gains without paying any tax. This process followed by companies is generally termed as Mauritius route. b. Cayman Islands & Bermuda: Besides high level of secrecy, there is no corporate tax for holding companies. This makes those countries attractive to create a holding company which in turn will form another company in Mauritius. The capital gain earned by the Mauritian company (which is not taxed in India or Mauritius due to the DTAA) is channelled back to their holding companies, in effect not paying taxes in any of the three countries. This method only defers tax, because once the money is brought back to the origin country (mostly the US), the tax has to be paid on the profit. However, there is a practice to give interest free loans to citizens to other countries by such holding companies, which is in a way paying back of profits without paying taxes. c. Cyprus & Luxembourg: Similar to Cayman Islands & Bermuda, Cyprus too has very minimal formalities to setup offshore corporations and there is no capital gains tax, withholding, or dividend tax for income earned by offshore corporations. Luxembourg, though has a 10% tax

rate, however, the authorities are very lax in tax collection. Also, No tax on bank interest, investment dividends, or capital gains for non-residents.

4. Implications of Tax Haven operations using DTAA for India a. Loss of corporate tax collections: According to a November 2010 report by US-based
research and advisory body Global Financial Integrity (GFI), India has lost $213 billion from 1948 to 2008 in illicit financial flows through loopholes in DTAA with different countries. An example of tax loss is the Vodafone Essar case where Vodafone gained control over Hutchinson India through an intricate deal spanning multiple tax haven operations which gave Hutchinson a huge capital tax gain without paying a tax for it in India. However, tax authorities caught up and Vodafone ended up with a huge capital gains tax liability

b. Round tripping of money: This route is taken by Indian residents or companies to channel
money from India back into India as FDI and avail the tax and other benefits given to FDI investments. Example is the TATA stake in Idea cellular which was held through a Mauritian shell company. Between April 1996 and 2008/09, over $1.6 billion has been sent to the British Virgin Islands; $5.4 billion to Channel Island; $4.67 billion to Cyprus; $6.1 billion to Mauritius; $10.7 billion to The Netherlands; and $14.38 billion to Singapore. Its very unlikely that Indian companies are investing such large sums in the native economies in these locationswhich means the money is either being used to invest further in overseas operations, or is finding its way back to India through other routes.

c. Funding of illegal activities: Complex multi-jurisdictional financial transactions have become

the venues for the merger of terrorist finance with other mobile capital. The investigation on sources of funds for September 2001 attack on WTC has pointed to multiple channels that involve the tax havens. India, which also suffers from terrorism, can be easily assumed to be facing the issue of terrorism financing through tax havens due to the DTAAs with these tax havens. Tax havens are also used for stashing away profits earned from Narcotics trade and fund the trade. Due to their high levels of secrecy laws and sophisticated banking and communications, the tax havens allow a narcotics dealer to move money through the tax haven and cleanse the money. For e.g. a dealer can use a courier to manually deposit cash in a Cayman Islands bank, transfer it to Mauritius and bring the money as clean money to India as investment.

d. Lack of corporate transparency: Corporate veil in transactions involving DTAA countries is a

big problem for India. For example, the Russian-owned, Switzerland-based Bycell had its 2G licence cancelled by the Department of Telecommunications after Revenue and Home Ministry officials expressed concerns over lack of clarity in its funding. Two of Bycells promoter companies were based in Panama, which does not share information with India. In another instance the tax sleuths have traced back the ownership of IPL teams such as Rajasthan Royals, Kings Punjab, and Kolkata Knight Riders to shell companies potentially owned by Indians; however they are still not able to unearth the connections completely due to secrecy laws of the DTAA countries.

5. Methods used by companies in DTAA countries to evade taxes a. Allocation of debt and earnings stripping: A common prot-shifting method is to borrow
more in high-tax jurisdictions and less in low-tax jurisdictions. For example, a foreign parent company may lend to its Indian subsidiary or an unrelated foreign borrower that is not subject to Indian tax on interest income might lend to an Indian rm. The Indian firm then

claim tax deduction by reducing its earnings by showing the high interest paid to the lender. The lender, which normally is a parent company located in a low tax regime, enjoys high interest and low tax.

b. Transfer pricing: Another method used to evade taxes using provisions in DTAA is transfer
pricing. This is achieved by the pricing mechanism of goods and services sold between related companies in different tax jurisdictions. To properly reect income, prices of goods and services sold by related companies should be the same as prices that would be paid by unrelated parties. By lowering the price of goods and services sold by parents and affiliates in high-tax jurisdictions and raising the prices of their purchases, income can be shifted from the high-tax jurisdiction. Firms such as IBM, that have huge workforce in India, are using this method to avoid paying taxes for its operations in India.

c. Contract Manufacturing: This involves the contracting of a manufacturing firm in a high tax
jurisdiction by a firm in a low tax jurisdiction to manufacture and sell a product in the high tax country. The contracting firm will then sell the product in the high tax jurisdiction and repatriate profits to the low tax country. Cross Crediting and Sourcing: Income from a low-tax country can escape taxes because of cross-crediting: the use of excess foreign taxes paid in one jurisdiction or on one type of income to offset tax on other income in high tax jurisdiction.

d.

6. Actions taken by various governments and international organizations to curb the menace of tax avoidance under DTAA
a. Tax Information Exchange Agreements (TIEA): TIEA is a model agreement on exchange of tax information developed by the OECD with the purpose of promoting international cooperation in tax matters through information exchange and curb harmful tax practices. India, through its Central Board of Direct Taxes, has signed with about 62 jurisdictions and is working on agreements with about 10 countries to enable information exchange on tax malpractices by firms and persons operating in India. b. Peer review and white list: The OECD has published a list of jurisdictions have adopted global standards on transparency and exchange of information, set by the OECD. This list includes the white list and the black list. Another step taken by the OECD countries is a regular peer review of the countries in the white list to ensure that they comply with the norms setup for information exchange. c. Global pressure on tax havens: Global bodies are putting pressure on tax havens like Switzerland and Luxembourg, by putting them on OECD grey list and issuing threats of sanctions, to change opaque laws and share information that will help countries like India trace huge sums of black money stashed abroad. Recently, following global pressure, the Swiss authorities made it easier for foreign governments to hunt tax cheats by lowering the threshold for the amount of information foreign tax agencies must provide in order to gain help from Swiss banks. d. Individual countries passing regulations: Countries such as the US are passing their own legislations for combating the tax avoidance. For example, UBS agreed to share information on 4450 secret accounts of Americans with the bank used to hide money under the Foreign Account Tax Compliance Act (FACTA). In India too, pressure is on the central government to enact legislation that would bring transparency to the bank accounts held by Indians abroad. e. Revision of DTAAs: Countries such as Germany & UK led other countries to sign revised DTAA with Switzerland and other countries. India too has a revised DTAA with Switzerland, Mauritius, Australia, Philippines, and Nepal etc.., and is working on revising the DTAA with other Tax havens. f. Offensive action: 2008 Liechtenstein tax affair is a series of tax investigations in numerous countries whose governments suspect that some of their citizens may have evaded tax

obligations by using banks and trusts in Liechtenstein. This offensive action was started by Germany after it unearthed tax evasion by top executives in the country and obtained a CD with information on account holders in LGT bank in Liechtenstein. Several governments have since started investigations into potential tax evasion using Liechtenstein and other noncooperative jurisdictions such as Monaco and Andorra.

7. Future of Tax Havens and DTAA

Tax havens and DTAA are here to stay. Though the latest developments and the actions by OECD and different countries have brought in transparency in place of opacity, it has opened doors for the tax havens to compete for investments legitimately by offering a low tax opportunity. Now many countries and companies offer tax saving instruments that take advantage of business models supported by tax regimes of former grey list countries. For e.g. after Switzerland altered its secrecy laws to comply with the OECD TIEA rules, money started pouring in through legitimate channels to take advantage of its low tax regime. The same applies to former grey list countries such as Liechtenstein, Andorra, and Monaco etc.., This is helped in part by the rising tax regimes in countries such as the UK and the US fuelled by the financial crisis. As far DTAA is concerned, these agreements will stay, with harmful clauses removed through negotiations between different contracting countries. For example in India, the accounting system is getting overhauled with the implementation of International Financial Reporting Standards (IFRS). Also, the Direct Tax Code (DTC) is getting updated with provisions such as General Anti-Avoidance Rules (GAAR) and the Controlled Foreign Corporation (CFC) that would allow India to override treaties and provide taxmen with the means to plug existing loopholes. Other countries, including Canada, Australia, Italy, UK and South Africa, have already taken such steps to discourage corporates from using loopholes in the DTAAs and using tax havens to evade taxes. DTAAs are a necessity to make International commerce attractive by making tax regimes transparent and efficient.

References
1. Tax Havens: International Tax Avoidance and Evasion - Jane G. Gravelle - National Tax Journal 2. Treasure Islands: Outlook Magazine Oct 15 2011 3. Tax and terrorism: a new partnership? - M. Michelle Gallant - Journal of Financial Crime 4. http://www.investopedia.com/terms/t/taxhaven.asp#axzz1jVnE843g 5. http://www.fool.co.uk/news/investing/2010/10/21/the-future-for-tax-havens.aspx 6. http://en.wikipedia.org/wiki/2008_Liechtenstein_tax_affair 7. http://online.wsj.com/article/SB10001424052748704409004576145940166986186.html 8. http://www.oecd.org/document/7/0,3746,en_2649_33767_38312839_1_1_1_1,00.html 9. http://www.forum4finance.com/2010/04/14/cbdt-move-towards-curbing-tax-evasion/