No news in the Pandora Papers: A reflection on the evolution of tax havens

12.2021

Recently, a number of documents have been published revealing the names of well-known individuals from the worlds of sports, business, art, and various other sectors who, in the past, have had some connection to the so-called tax havens. In reality, this is not something new. On the contrary, for an expert in international tax law, it feels like watching the same film for the tenth time.

Below are some comments to help understand what the media is talking about:

Firstly, there is no clear definition of what constitutes a tax haven. Traditionally, it referred to a small country with few inhabitants, an underdeveloped economy, and low productivity. These were typically countries with little more than agriculture, fishing, and perhaps some tourism—isolated from the main capital and investment routes. Few knew they even existed, and they had no taxes because they simply did not need them.

This changed in the late 1960s. During this time, the United States experienced a steady and significant increase in direct taxes—intended to fund President Lyndon B. Johnson’s Great Society, the Vietnam War, and the Apollo moon landing—taxing the profits of both individuals and corporations (Einkommensteuer and Körperschaftsteuer). Prior to this, not only in the US, but also in almost all high-productivity countries (industrialised nations), tax systems had been primarily based on duties on imports and consumption. However, in the 1960s, the concept of the welfare state began to emerge, and this could only be achieved with an increase in tax burdens. A Sozialstaat (welfare state) means a Steuerstaat (tax state).

It was at this point that tax havens began to offer a product that would prove immensely successful: the accumulation of wealth and income from citizens of "rich" countries within the banking systems of these small, low-tax jurisdictions (which, in turn, were integrated into the banking systems of wealthier nations, as these tax havens did not develop alternative banking structures). To achieve this, they offered two major advantages: 1) Zero or near-zero taxes on accumulated wealth within their borders; and 2) A guarantee of non-disclosure of this information to the tax authorities of the "rich countries" requiring such data.

This secrecy was crucial, as the tax systems of industrialised countries are based on the taxation of worldwide income or wealth. In practice, for a resident in Germany, Spain, or the US, owning assets or earning income generated in such a jurisdiction was of no use if it had to be reported to their home country's tax authorities. This resulted in the application of the tax rates of the country of residence, with deductions, where applicable, for foreign taxes paid (the principle of Capital Export Neutrality).

In response to these offers from tax havens, anti-abuse legislation was enacted in the US in the 1960s to prevent income and profits from being shifted to these jurisdictions (new concepts like Controlled Foreign Corporation (CFC) rules and thin capitalisation emerged). This legislation was adopted by Germany in 1973 through the Aussensteuergesetz (Foreign Tax Act) and by Spain in the 1990s.

Over the years, the methods for hiding wealth became increasingly complex, but the underlying product remained the same: to create the illusion that economic activity in these jurisdictions was legitimate. This was based on one of the key principles of international tax law, which holds that business activity should only be taxed in the country where it is actually conducted. In this way, owners of assets or income did not have to declare them in their home country. To achieve this, many fictitious documents were created in these countries, making it appear as though the economic reality matched the paper trail. In some cases, no documents were created at all, and even the names of business owners were not known to the authorities of these jurisdictions.

For many years, tax authorities in industrialised countries did not take action, primarily because politically, it was not seen as a priority. The money locked away in these jurisdictions was ultimately invested in industrialised countries. It should also be noted that using these countries was not prohibited, although it was often clear that there was some degree of bad faith involved in these transactions. By the late 1980s, there were some shifts in policy, but initially, they were focused on combating money laundering, particularly in relation to criminal activities such as drug trafficking (as famously stated by Tom Cruise in the film The Firm: "If you want to chase organised crime, follow the money and the lawyers").

It wasn’t until the late 1990s that major changes began in Europe, culminating in the 2003 Zinsrichtlinie (Interest Directive). For the first time, an automatic and spontaneous exchange of tax information between national tax administrations within the EU was established, albeit limited to capital income from bank deposits (and it would take around ten years for it to become fully operational). Mario Monti, President of the European Commission at the time, famously remarked: "The climate is changing."

The most significant changes have occurred in the past 15 years. For the first time, the United States demanded that Switzerland—an exceptional tax haven that does not fit the typical description—provide a list of US citizens holding assets in Swiss banks. The US tax system applies two criteria for taxation: residence and nationality (a unique feature, unlike most other countries). This means that, in the US, taxes are not only based on where a person resides but also on their nationality. Consequently, it is common for individuals to buy foreign nationalities to escape US taxation, often renouncing US citizenship.

Switzerland initially refused to provide this information, prompting the US to issue an ultimatum: “Either you provide the information we demand, or you will be permanently excluded from access to the US capital markets, and you will not be able to conduct business in our country. You will become a pariah state in the business world.” Switzerland capitulated without hesitation. Following this, with political support from the OECD and alongside the developments within the EU to expand the automatic information exchange system, a "blacklist" of "non-cooperative" states began to be compiled. Slowly, these jurisdictions began to change (as in the case of Andorra), and this shift allowed Spanish courts to prosecute Spanish tax evaders, as they could now challenge the presumption of innocence with evidence from Andorra and similar jurisdictions. This was previously not possible.

Recent changes have been driven in two key directions: 1) The pursuit of political corruption, specifically targeting illicit wealth accumulated by former government officials in many countries; and 2) The dismantling of the façade of economic activity in many businesses based in tax havens. This is the case with figures such as Lionel Messi, Juan Falcones (author of The Cathedral of the Sea), Imanol Arias, and many others across various countries. This is what is referred to as the principle of "substance over form". In tax law, what matters is not the appearance but the reality.

The information now published in the Pandora Papers, though not the first of its kind in the past decade (with some even originating from confidential data stolen from Swiss banks), pertains to transactions carried out many years ago, but now the names of the individuals involved are made public. It is similar to the Stasi files. Many of those involved may regret their actions, but, under pressure from their environments, they proceeded with these operations.

There remains one area yet to be fully addressed in either social or judicial terms: the role of legal advisors in these operations. Most of these advisors are based in industrialised countries (legal advice in tax havens is often non-existent or rudimentary, and they simply collect fees from decisions made in offices located in industrialised countries).

As for the Pandora Papers themselves, being documents obtained illegally, they cannot be used to convict any taxpayer in Spain. However, what is undeniable is that tax havens are no longer as fashionable as they once were. This change, however, remains in its early stages, and it is unclear in which direction it will evolve in the future.

++ Article originally published in German in the magazine “Economía” in October 2021, issued by the German Chamber of Commerce in Spain ++