The shocking loot of Punjab National Bank (PNB) to the tune of about Rs 11,400 crore by diamond merchants, Nirav Modi and Mehul Choksey, has brought back tax havens into public discussion. According to news reports, the income-tax department has extended its investigation to major tax havens such as Jersey, Bahamas, Cyprus, Singapore and Mauritius, to trace the shell companies used by Modi and Choksey to transfer funds to and from India.
Tax havens, also called “offshore financial centres” (OFC), are an important offshoot of the global growth of finance capital after the 1970s.
What is an OFC? It is very difficult to precisely define the term. An OFC is a site that hosts financial activities outside the regulatory reach of, or beyond the jurisdictions of national economies. Thanks to such regulatory immunity, the OFCs have become a greatly preferred instrument for the rich and powerful of the world to hide their earnings and wealth from tax authorities.
As financial markets were increasingly liberalised after the 1970s, inc-omes and wealth have al-so been increasingly generated outside the boundaries of economies. Let us consider the United States. Less than 15 per cent of the US's corporate profits were generated abroad in the 1970s, which grew to about 35 per cent by 2013. More than 50 per cent of these foreign profits of US companies are reportedly stored in OFCs. Further, about 20 per cent of all profits of US companies are also estimated to be stored in OFCs. Globally, about eight per cent of the financial wealth is supposed to be held in OFCs. The number of tax havens has also grown with the growth of financial liberalisation and generation of wealth abroad. If there were about 32 OFCs in 1977, there were 72 OFCs by the mid-2000s. Typically, conduit companies are set up in these OFCs and multinational transactions between two high-tax jurisdictions are routed through these companies. As a result, a major share of the profits gets reported in the tax haven.
Shell companies registered in the tax havens are also used to hide the real ownership of assets or firms. Recently, the release of the Panama papers revealed to us the depth of this problem. For instance, a person Q residing in Mumbai wants to invest dirty money in the purchase of a luxury property in a way that the identity of the owner is not revealed. He would contact a law firm in Panama, such as Mossack Fonseca. This law firm, though dealing with thousands of such deals, is most likely to operate out of a dingy outlet in a small street in Panama City. A limited liability company (LLC) is floated, which would be legally buying the luxury property for Q. There are many locations in the world where these LLCs can be based; Delaware in the US has long been notorious for hosting tho-usands of such fake firms. Because the firm does no business in Dela-ware, no account statements need to be given to authorities there, including ownership details. Only the name of a member is required, which actually could be yet another company, or a foundation floated elsewhere similarly. This foundation may be based in Panama. The legal owner of this foundation, again, will not be Q but an employee of Mossack Fonseca, who would give an authorisation to Q to purchase the luxury property. Given the complex intertwining of the transaction, it is expected that Q's identity is never revealed to tax authorities in Mumbai.
The increasing generation of profits abroad has had another implication. As a rule, taxes are paid in countries where profits are made and not in countries where the owners reside. Further, the principle of “arm's length pricing” in taxation implies that each subsidiary of MNCs compute profits of their own and are legally treated as unrelated entities. It is here that “transfer pricing” becomes a major issue for tax authorities to tackle.
In transfer pricing, the attempt is to shift the taxable income from a jurisdiction/country of higher tax rates to another jurisdiction/country of lower tax rates. Yet another instrument used by companies to drain wealth out of India is the participatory notes (PN) route. Typically, a PN is a derivative instrument issued to overseas investors by registered Foreign Institutional Investors (FII) against underlying Indian securities. The FIIs would act as the investment managers of their clients, who would hold sub-accounts with the FII. Investments would be made by the FIIs on behalf of the clients. As a result, the clients need not register with the market regulator in India, i.e., the Sebi and their identity remains anonymous.
In other words, OFCs, transfer pricing and PNs are all instruments used by tax evaders in the globalised world of production and finance to not pay legitimate taxes in home countries. The OFCs are often thought of as small island nations, mainly in the Pacific. While many small island nations are an integral part of this global chain, there are many other locations too that are equally complicit. The cases of London City and of Switzerland are well known. In fact, the term "Swiss banks" has attained some notoriety in public discussions within India. However, facts suggest that such a discussion may be miles behind what is the reality. According to close observers, Switzerland is no longer a safe or trusted destination for black income holders, as the secrecy provisions in Swiss banks have been whittled down. India has entered into an agreement with Switzerland for automatic exchange of information on transa-ctions and assets of Indian citizens (though after 2019). As a result, black incomes from India have been increasingly moving into new OFCs like Singapore and Dubai. In these centres, black incomes are not held as deposits (as in Swiss banks) but as funds managed through structured companies or trusts.
There are two important points here in conclusion. First, the rise of OFCs has been an integral part of the way globalised finance has reconfigured the interface bet-ween tax officials and big business. The enormity of the evasion that has followed the rise of OFCs is such that it constitutes a major threat to the economic sovereignty of countries. Secondly, what is required is indeed a global exercise to reduce the use of OFCs to evade tax.
(The writer is a Professor with the TISS. He is also the editor of Note-Bandi: Demonetization and India's Elusive Chase for Black Money)