Tax Havens pull up socks in ‘transparency’ era

The great ‘subprime’ crisis has had its share of fallouts over past 24 months; yet there is a silver lining emerging from under the dark clouds which has the world order gearing up for a brand new era of financial discipline and enhanced regulation. Ironically, one of the positives borne out of the recent economic upheaval has been staggering focus on ensuring robust transparency standards in tax matters.

Before delving further into how tax transparency and information exchange are critical for sorting financial disorder across economies, let me try and explain the concept of ‘money laundering’ and how the absence of strict standards in tax discipline have abated this menace. This also helps putting in perspective the role that the international tax policy, in tandem with other non-tax measures, plays in combating tax evasion, whether with or without aid of money laundering.

What’s the color of money!!

Money laundering is loosely used to describe ‘washing’ of unaccounted or illicitly sourced money through a cobweb of complex financial transactions, usually involving more than one jurisdiction. The objective of the process deployed to ‘clean’ the money is to hide either the ownership or the destination of such funds. A typical ‘laundering’ scheme could see three stages:

a) Placement stage – at this stage, the objective of stakeholders is to move the illicit funds away from source location; sources of such funds can be traced to ‘cash intensive’ illegal business (such as drug trafficking, smuggling, etc)

b) Layering stage – this is most crucial stage in the process, as money virtually changes its color through this stage. the objective is to conceal the ownership and mitigate audit trail by employing funds in complex financial dealings (in stocks, commodity and future brokers). Often the sheer volume of such transactions makes it difficult to trace the origin of funds. Layering can be done by placing funds with banks in tax efficient jurisdictions as it’s easier for stakeholders to ensure secrecy about the origin under ‘de facto’ banking secrecy norms.

c) Integration stage – In the final step, the ‘cleaned’ money is deployed for integration with the routine economy. Post integration, more often than not it becomes virtually difficult to distinguish between legal and illicit sources.

While the flow of funds to ‘launder’ the illicit funds may look easy to achieve, even more perplexing is the sheer size of this ‘industry’ itself; IMF estimates (June 2010) indicate that the aggregate size of money laundering worldwide is between 2 to 5% of global GDP, making it effectively the 3rd largest industry in the world. The size of Indian ‘parallel’ economy is equally disturbing; the unofficial international statistics indicate approximately USD 1.5 trillion of Indian wealth alone is stashed in offshore accounts; a public interest petition filed by the former law minister corroborates this estimate.

Ideally, therefore given the volume of stakes world economies would do well to unearth unaccounted money circulating in the ‘laundry’ web, and deploy the treasure to tide over their fiscal deficits.

Incidentally, last week I happened to address an international conference on ‘Prevention of Money Laundering and Terror Financing’ organised in collaboration with the Ministry of Finance, India and the federal Ministry of Finance, Germany. Taking a cue from the event, I would be correct in stating that world economies have already begun to deal with the money laundering menace in the national as well as international framework.

G-20 communiqué and crack down on tax havens

In April 2009, G20 released an official communiqué post its London summit G20 whiplashing on offshore tax havens. The summit, perhaps the first strategic international summit for President Obama post the crisis elicited more than ordinary expectations, and proclaimed ”era of banking secrecy is over”. The nine page communiqué announced IMF sanctions on tax havens unwilling to share information.

Following the G-20 summit and Global forum peer review, OECD published a report on implementation of internationally agreed standard on exchange of information for tax purposes. In 2009 report, four nations were identified in the black list, for not having committed to globally accepted transparency standards. As per the latest OECD reports (of November 2010), these four countries (Uruguay, Malaysia, Philippines and Costa Rica) have moved into White /Grey list for either having substantially implemented these standards or have at least committed to such implementation.

TIEAs champion cause of transparency

In a related development post the G-20 summit, certain jurisdictions (Switzerland, Liechtenstein, Luxembourg, and Austria) offered to relax their banking secrecy norms to exchange tax information with Revenue authorities of other jurisdictions. In an unprecedented development in the history of Swiss Banking industry, UBS agreed to share client data with the US IRS in a tax probe, triggering of a debate on client confidentially and information secrecy norms.

To deal with growing focus on information exchange and overcome the organic difficulty in information exchange, the countries have come to realise the importance of Tax Information Exchange Agreement (TIEAs).

TIEAs are bilateral agreements intended for use where a Double Taxation Avoidance Agreement (DTAAs) is considered inadequate for exchange of information. TIEAs though narrower in scope than DTAAs, are comprehensive on the subject and lay down detailed guidance. The 2002 OECD Model Agreement on Exchange of Information on Tax Matters serves as base document for negotiation between countries. In 2009, the model agreement was endorsed by most key jurisdictions including by nations who have traditionally sought waiver under banking secrecy norms and client confidentiality norms.

For the record, the UN has incorporated the Model in its Model Tax Convention; this has relevance in context of the Indian tax treaties as majority of Indian DTAAs are modelled on UN Model Convention alone.

There are certain inherent limitations, however; obvious impediment is the tax administration’s reluctance to share resident taxpayers’ data with foreign governments. Most governments on the pretext of ‘de facto banking secrecy’ do not permit access to information from their financial institutions and banks. Such hurdles shall surely limit governments’ ability to implement these standards.

To quote an instance, in the most curious development in wake of the economic crisis, governments of the US and Switzerland had inked TEIA for disclosure of American taxpayers’ details by Swiss authorities to establish tax evasion by the US IRS. In fact, the US IRS initiated the probe against key Swiss banks including UBS to force disclosure of taxpayers’ information. However, until late 2009 the Swiss government had declined to ‘share information’ with foreign agencies.

The skeptic in me had anticipated in the May 8th column that an over-drive for information sharing could lead to an environment of ‘over regulation’ and may hurt credibility of information exchange process.

It appears my anticipation was not over the board, as we saw the US IRS recently abandoned legal push to force the Swiss bank UBS to disclose taxpayers details; the move came on the back of US dropping criminal charges (a month ago) against the bank after an 18-month probation for selling offshore tax evasion services. Presumably, the disclosure thus far made by Swiss government and banks would have helped the US IRS arrive at the comprise solution. The US IRS’ move however translates as caution for other governments to avoid environment of ‘over regulation’.

Indian pace with global movement

In the global movement to combat the might of ‘parallel’ economy, India has not lagged much behind indeed. The legislative amendments to the Indian Income-tax law empowering the Government to sign agreements with non-sovereign states and well though-out rush to sign TEIA are indicative of the government’s endeavors and the pace India is keeping with the global standards. Unreported statistics (September 2010) indicate that Government is negotiating limited tax treaties with 11 non-sovereign states, and TIEAs with more than 20 prioritized countries. Needless to mention although that hurdles to implementation of such bilateral agreements are yet to be witnessed.

Besides, the impending tax reforms (the New Tax code) would institute more checks in the domestic legislation to combat the crime of tax evasion [in the form of a general anti-avoidance rules, Controlled foreign corporation regime, treaty override in cases where GAAR applies].

To conclude, therefore if I have to paint a clearer picture of the evolving landscape post ‘subprime’ disaster, I would think that institutionalizing robust standards for transparency as means of reliable governance in tax matter alone would require attitudinal shift across economies. Whilst the international framework [such as OECD Forum on Transparency & Exchange of information, Financial Action Task Force (FATF)] could provide spark to the movement, sustaining the same would require unilateral behavioral alignment by each individual economy including India. At the same time taking a cue from the recent move by the US IRS, it is important to realise that the current context shall require a judicious balance between realities of sustaining economic activities across borders and need for ‘just’ adequate regulations to be put in place. An over-drive to ‘regulate’ could indeed do more harm than relieve economies of pangs of ‘post crisis’ wounds.