Tax Heavens and their Impact on Indian Economy

Context: Union Finance Minister said cryptocurrencies, drug mafias, tax havens and cyber intrusions posed major threats to the global financial ecosystem and a global collaborative effort was needed to counter such challenges.

What are Tax Havens?

• A Tax Haven, in short, can be defined as a country/place/jurisdiction where the rate of taxation is very low. This low rate of taxation usually varies from 2% to sometimes as low as 0.02%.
• Usually, countries engage in upholding such a low rate of taxation in order to increase foreign investment as well as the cash flow in their economy.
• By charging a very minimal amount of tax, it encourages big multinational corporations and firms to incorporate themselves in these countries, which in turn, helps in the development of their economy.
  • This practice of multinational corporations of shifting their profits from high-tax jurisdictions to low-tax jurisdictions (tax havens) is known as Base Erosion and Profit Shifting (BEPS).

Tax Haven Criteria by OECD

• The Organization for Economic Co-operation and Development (OECD) identifies four key factors in considering whether a jurisdiction is a tax haven. They include:
  • Whether the jurisdiction imposes no or only nominal taxes.
  • Whether there is a lack of transparency.
  • Whether there are laws or administrative practices that prevent the effective exchange of information for tax purposes with other governments.
  • Whether there is an absence of a requirement that the activity be substantial.
• Various Types of Tax Havens:
  • Pure Havens: Income or Capital gains are not charged at all (example – Bermuda, Cayman Islands, Vanuatu etc.)
  • Tax Havens where the state-approved rate of taxation is low due to the implementation of tax agreements between different countries regarding double taxation (example – Liechtenstein, Switzerland, Republic of Ireland etc.)
  • Tax Havens where taxpayers are exempted from paying taxes for cross-border transactions (example – Costa Rica, The Philippines, Panama etc.)
  • Tax Havens that engage in a preferential treatment towards offshore and holding companies (example – Austria, Luxembourg, Thailand etc.)
  • Tax Havens that offer exemptions for industries that have been made for the development of exports (example – Ireland, Madeira in Portugal etc.)
  • Tax Havens that provide financial benefits and privileges to companies classified as ‘Offshore Companies’ (example – Bahamas, Antigua & Barbuda, British Virgin Islands etc.)
  • Tax Havens that provide specific benefits to banking companies or financial companies which engage in offshore activities (example – Anguilla, Grenada, Jamaica etc.)

Working of Tax Havens

• The working of tax havens involves several methods and strategies that individuals and corporations use to reduce their tax burdens or hide their wealth.
• Offshore Accounts: Individuals and companies open bank accounts in tax haven jurisdictions, where they can hold and manage their assets. These offshore accounts offer confidentiality and may be subject to lower or zero tax rates.
• Shell Companies: Establishing shell companies (also known as “letterbox” companies) in tax havens is a common practice. These companies often exist only on paper and serve as a legal entity to hold assets or conduct business transactions while obscuring the actual owners.
• Transfer Pricing: Multinational corporations can manipulate transfer pricing by artificially inflating or deflating prices for goods and services between subsidiaries in different countries. This allows them to shift profits to low-tax jurisdictions.
• Double Taxation Treaties: Tax havens often have double taxation treaties with other countries. These treaties can be used strategically to minimize or eliminate tax liabilities by taking advantage of loopholes and mismatches in tax laws.
• Intellectual Property Shifting: Corporations can transfer intellectual property rights, such as patents, trademarks, and copyrights, to subsidiaries in tax havens. They then charge royalties and licensing fees to shift profits to low-tax jurisdictions.
• Treaty Shopping: Treaty Shopping is a method of tax avoidance, whereby a third party takes advantage of a taxation treaty entered by two countries in order to reduce their tax liability on the income deriving from those countries.

Impact That Tax Havens Have on The Indian Economy 

• Reduced Tax Revenue: The use of tax havens allows individuals and corporations to reduce their tax liability in India, leading to a decrease in tax revenue for the Indian government.
  • The reduced tax base due to tax havens can distort the government’s plans for economic growth and development.
  • According to IMF, tax havens collectively cost governments around the world between $500 billion and $600 billion a year in lost corporate tax revenue.
• Affects Tax system Equity: Tax evasion by the usage of Tax Havens also dismantles the equity attribute of any tax system.
  • In India, specifically, reduction of their tax liability by many leads to an increase in the rates of taxes as charged by the government for every assessment year (for the purpose of increasing its revenue) and the burden of that unfortunately ends up falling upon the honest taxpayers.
  • As a consequence of this, even the taxpayers who always pay their taxes honestly end up engaging in practices such as tax evasion in order to reduce an already incremental burden.
• Black Money: Traditionally, tax havens have been used for Tax Evasion and to store Black Money.
  • A Bank of Italy calculation reveals India’s share in tax havens globally to be $152-181 billion or Rs. 10 lakh crores.
  • India is ranked eighth in the world in black money generation by the Global Financial Integrity Report.
• Increased Income Inequality: Tax havens contribute to income inequality by concentrating economic power in the hands of a few.
• Administrative Burden: Base Erosion and Profit Shifting through the usage of Tax Havens leads to an unnecessary consumption of time, effort and energy on behalf of the Indian tax authority.
  • The Indian tax authorities must constantly engage themselves in developing various policies for the purpose of countering the intricate mechanisms that corporations use in order to shift their profits for the purpose of reducing their tax liability.
• Unethical Activities: Tax evasion through tax havens often involves unethical activities such as bribery, forgery, and intimidation.
  • These activities create a significant impact on the social and moralistic values of the Indian society.
• Inflation and Economic Imbalances: The influx of funds into the economy from tax evasion can lead to inflation, which negatively affects the poorer sections of society by making necessities more expensive.

Regulatory Mechanisms Adopted by The Government of India

• BEPS Action Plan: To limit the practices of Base Erosion and Profit Shifting (BEPS), the OECD introduced the BEPS Action Plan, approved by all members of the G20 (including India). It includes the following 15 action plans (see the image).
• Equalization Levy: India has also successfully implemented the Equalization Levy to all business transactions irrespective of a corporation’s Permanent Establishment (PE).
  • As a result of this, any corporation that has incorporated itself in a tax haven but engages in regular transactions with entities in India will be charged a fee (Equalization Levy) for doing the same.
  • Many other countries have followed India’s footsteps and have implemented the Equalisation Levy for business transactions.
• GAAR (General Anti-Avoidance Rules): India also adopted the GAAR (General Anti-Avoidance Rules) via the Finance Act of 2012.
  • However, due to various problems, GAAR was implemented as late as the 2018-19 financial year and finds itself in Chapter X-A of the Income Tax Act, 1961 of India.
    • GAAR is a concept which generally empowers the Revenue Authority in a country to deny tax benefit of transactions or arrangements which do not have any commercial substance and the only purpose of such a transaction is achieving the tax benefit.

• Treaty Shopping: India has, furthermore, enabled itself to tackle the issue of Treaty-Shopping.
  • Especially with regards to the India-Mauritius DTAA, Indian authorities can now tax Mauritius residents upon their transactions (to and from India) based on their own personal discretion.
  • This has, positively, limited the practice of third-party corporations to incorporate themselves in Mauritius to conduct tax-free business in India.
• Tax Information Exchange Agreements (TIEA): India has also put severe restrictions upon the practice of storage of money received in the form of illicit/illegitimate gains (“Black Money”) in tax havens by entering TIEA with several tax havens.
  • A TIEA provides India with the power to gather information from these havens upon requests relating to a criminal or civil tax-related investigation.
  • India has entered TIEAs with several tax havens such as Bahamas (2011), Bermuda (2011), Liberia (2012) and Belize (2014).

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