Panama Papers Shine Spotlight on Tax Havens

Leaked documents have revealed that international tax havens play a larger role than previously understood, and will likely raise pressure for more transparency in global finance, says CFR expert Edward Alden.

April 08, 2016

Interview
To help readers better understand the nuances of foreign policy, CFR staff writers and Consulting Editor Bernard Gwertzman conduct in-depth interviews with a wide range of international experts, as well as newsmakers.

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A group of news organizations this week published a trove of leaked documents, known as the “Panama Papers,” that show how political leaders around the world have secretly used companies in the Caribbean and elsewhere to avoid paying taxes. While the disclosures have already led to the temporary resignation of the Icelandic prime minister, in the United States they have come at a time when the Obama administration is attempting to limit corporate offshoring to low-tax jurisdictions. U.S. corporations have been able to avoid paying taxes on more than $2 trillion in profits, says CFR Senior Fellow Edward Alden, author of the book How America Stacks Up. The leaks will only increase pressure on governments to act, as they reveal the "vast, semi-regulated global market in which cash is moving around," he says.  

 Protests in Iceland over Panama Papers Icelandic demonstrators protest on April 4, 2016, after leaked ’Panama Papers’ documents revealed the Prime Minister’s links to offshore tax havens. (Photo: Stigtryggur Johannsson/Reuters)

The Panama Papers leaks center on Mossack Fonseca, a law firm based in Panama. What exactly do they do for their clients?

Basically, they help their clients set up shell companies that they can use to move assets, cash, to various parts of the world. And mostly, these are set up in low-tax or no-tax jurisdictions. In many cases, companies will use shell companies for completely legitimate purposes. Most of the alleged behavior that has been disclosed in the leaks is not illegal. There are lots of legal ways to avoid taxes by moving profits to other jurisdictions. So that kind of maneuvering is not unusual.

These shell companies are structured so that it’s very difficult for outsiders, including national tax authorities, to identify the owners of the company. The companies will have a name, they might have a post office box in the British Virgin Islands or somewhere else in the Caribbean, but very little information to allow you to identify which individuals are actually connected with those accounts. The significance of the leak is this massive email trail has made it possible to tie some very prominent individuals, including political leaders, to these offshore accounts.

In most cases we still don’t know exactly what was being done with those accounts, and how many might have broken laws. A lot of that is still coming out.

What, then, is the major significance of the leaks?

They suggest that the problem is much bigger than is generally understood. We have certainly known that companies, including American companies, report much of their profits in various low-tax jurisdictions around the world—be it a country like Ireland, where the corporate tax rate is just 12 percent, or smaller countries like Liechtenstein or a number of Caribbean countries, where there’s little or no tax.

“The scale of the Panama Papers is beyond anything that we have seen before. It will give a lot of impetus to efforts to crack down on the use of these sorts of entities as a tax avoidance strategy.”

There have also been revelations in the past about political leaders engaged in various corrupt activities, amassing large amounts of cash, and then moving it to offshore accounts. The Senate Select Permanent Subcommittee on Investigations did a big investigation into this several years ago.

But I think the scale of the Panama Papers is beyond anything that we have seen before. It will give a lot of impetus to efforts to crack down on the use of these sorts of entities as part of a tax avoidance strategy. The Europeans are particularly hawkish on this. And we’ve seen some indications the Obama administration is getting much more serious on this front too.

As you mention, a lot of this is legal. How can regulation separate out the legitimate purposes from unlawful activities like money laundering and terrorist financing, especially given the secrecy involved?

Where we’re going to see a lot more focus is on transparency. That is, requiring countries to make available—at least to tax authorities, not necessarily to the public—the owners of these shell companies.

The U.S. Treasury Department has announced that it’s getting far more serious about this, in part because the United States does not have clean hands. States like Delaware have strict secrecy laws that make it difficult to identify the beneficial owners of some companies. The Treasury Department wants to make sure that banks in the United States know, before they do business with any of these corporate entities, that they know the names of the owners.

Meanwhile, the Europeans and the Americans are going to put a lot more pressure on Panama. Panama is one of the countries that has been holding out from OECD [the Organization for Economic Cooperation and Development] efforts to require more information sharing. The Obama administration also tried to make greater financial transparency a condition of approving the U.S. free trade agreement with Panama in 2011, but these revelations indicate that not much progress has been made.

On the question of distinguishing legitimate from illegitimate activities, some of the Mossack Fonseca leaks show attempts to evade U.S. sanctions against countries like Iran or North Korea. That clearly will be of interest to criminal authorities in the United States. To the extent you can identify that sort of behavior, there’s going to be an effort to crack down on it.

The harder question is the issue of where corporations report and book profits. The current rules say that, by and large, you ought to be reporting profits in the places where you’re earning them, not moving them around the world willy-nilly to low-tax jurisdictions. Those are much harder rules to enforce. But there too, the first stage is transparency, actually knowing what companies are doing and where the profits are being reported.

How do the Panama Papers leaks tie into the broader debate in the United States over corporate ’offshoring’? Are these symptoms of a larger problem?

I think they are, in part. So far the biggest story in the Panama Papers is the links to a number of political leaders and the questions that that raises about corruption. But underlying that is the fact that there is this vast, semi-regulated global market in which cash is moving around in lots of different ways. And that is part of the broader tax reform debate in the United States.

The United States is one of the only countries that, in theory, taxes its corporations on income they earn anywhere in the world. But that tax only becomes payable if and when the profits are repatriated to the United States. Thus, U.S.-headquartered corporations leave most of the money they earn offshore, and try, to the extent that they can legally, to move U.S.-earned profits offshore. As a result there is more than $2 trillion in profits earned by U.S. corporations that has never been taxed.

That’s really the issue at the heart of the U.S. debate over corporate tax reform. The Republican approach is largely focused on how to make U.S. corporate tax rates more attractive so that companies will be less inclined to invest and move profits offshore. On the other side, most Democrats want the government to use regulations to crack down on what they see as abusive practices.

We saw the latter this week with the Treasury department’s decision to go after the Pfizer-Allergan merger. That $160 billion pharmaceutical industry merger was engineered by the U.S. company Pfizer in order to move its tax headquarters to Ireland, where the corporate tax rate is 12 percent, rather than the 35 percent in the United States. But the Treasury department announced new regulations that had the effect of killing that merger, showing that the administration is getting more aggressive in going after transactions done quite explicitly for the purpose of lowering companies’ tax burden.

Those Treasury regulations are being interpreted as targeting the Pfizer-Allergan merger, but are they going to change the way that U.S. corporations in general operate?

There are two elements to the regulations, and one was explicitly aimed at this merger. The administration is in effect saying that a corporate "inversion" [in which a larger U.S. company is taken over by a smaller foreign company in order to move its tax headquarters] has to look like a legitimate merger. The new Treasury rules made it impossible to do that in this case, by upping the requirements for a legitimate merger, and will make inversions very difficult in a lot of other cases.

More significantly, it could change the way foreign-owned corporations operate in the United States, with potential implications for long-established foreign investors in the United States like Volkswagen, Siemens, or Honda. Specifically, the administration wants to crack down on a practice known as earning stripping, in which companies can deduct a significant portion of their interest-payable on debt.

“If these Treasury rules act as a break on foreign investment, that’s something the administration’s going to have to take a pretty serious look at.”

What often happens when a foreign company takes over a U.S. company is that it will load up the U.S. company with debt, and then the U.S. subsidiary is allowed to write off that debt in its tax payment, so it significantly lowers its tax owed to the U.S. government. The new Obama administration regulations will significantly narrow the circumstances under which companies can do that.

Foreign companies in the United States have cried foul about this, saying that this is going to deter them from investing in the United States. This is, I think, an issue the Obama administration has to take seriously. The administration has made a priority of expanding foreign investment in the United States, launching the SelectUSA Initiative and holding annual summits to encourage companies to invest in the United States. If these Treasury rules act as a brake on foreign investment, that’s something the administration’s going to have to take a pretty serious look at.

How do U.S. regulations on tax havens compare with those of other developed countries, and how has international cooperation evolved on this?

As I mentioned, the United States is quite different because it’s got a worldwide tax system. Most countries have a territorial tax system in which their companies are charged tax only for profits earned within the country. And the United States also has a higher headline corporate tax rate, the 35 percent tax rate, than any other advanced economy. If you look at the various tax breaks that are available to U.S. companies, the actual tax rate they pay on the global earnings is quite similar to a lot of their competitors, but it does discourage companies from investing in the United States.

On the cooperation side, the OECD has led efforts to develop international cooperation among governments to share information, to set common standards, to try to crack down on companies that are seen as behaving in an abusive fashion. The European Union has recently gone after a number of companies, including Starbucks, Apple, and Google, over their tax practices.

The United States has been wary about these initiatives. During the Clinton administration, the United States was pretty enthusiastic. But the [George W.] Bush administration’s approach was that countries competing to lower corporate taxes is a good thing. Their thinking was, we don’t want to become part of international efforts to discourage lower taxes.

The Obama administration is more sympathetic, obviously, than the Bush administration was, but still somewhat wary of working too closely with the OECD. There’s the fear that a fair bit of this is targeted at U.S. companies, and that the result will be to raise the tax bills particularly for U.S. companies.

The British are in a similar situation. The UK is under a lot of pressure to crack down on the British Virgin Islands, which is a British territory that is home to a lot of these shell companies that were set up by Mossack Fonseca. The British have been quite reluctant on that front, not necessarily wanting to work with the rest of the European Union.

Can we expect this to become more of a campaign issue in the United States?

There is certainly a general anger against companies, like Pfizer, that try to do a merger in order to move their headquarters outside the United States. And President Obama has been very explicitly and publicly critical. He actually did a White House press conference to announce the new Treasury rules, which is something I’ve never seen before. These are usually quietly announced.

[Democratic presidential candidates] Hillary Clinton and Bernie Sanders have spoken out against the Pfizer merger. This is not new: Back in the 2004 election, John Kerry, who was the Democratic candidate at the time, referred to them as Benedict Arnold companies.

Beyond that, it gets much more complicated. There is a difficult balance between wanting U.S. companies to be competitive in the global economy, which means having a reasonable and fair tax burden, while also wanting to make sure that they’re not doing a lot of really aggressive tax planning to avoid paying taxes. And although the corporate share of overall U.S. tax revenue has dropped steadily for years—it’s half of what it was in the 1960s—that hasn’t entered the campaign discussion as much as this issue of particular companies trying to escape the United States.

This interview has been edited and condensed.

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