Tax Havens
Tax havens are countries with very low, or nil, tax rates on some or all forms of income. These rates are usually accompanied by accommodating financial institutions and other arrangements favourable to tax avoidance or evasion activities. The growth of tax havens has matched the growth of international trade and developments in communication technology. You can divide tax havens into three categories:

1. The zero tax haven
2. The low tax haven
3. The tax haven that imposes tax at normal rates but grants preferential treatment to certain activities

The first two categories usually consist of small economies - often former British colonies or dependencies - that make up for the absence of direct taxation by the use of indirect taxes.

Ireland is an example of the third category, with its manufacturing incentives under which a special low rate of tax applies to manufacturing operations located there.

Tax havens have been criticised on the basis that they’re used for depositing the proceeds of criminal activities and they allow the wealthy to conceal the true extent of their fortunes from the communities in which they live. It seems, however, there is little evidence to support these allegations. In the preface to his book on tax havens, Milton Grundy, an offshore taxation expert, states:

The general view I have gathered is that tax havens must cause some loss to fiscal authorities throughout the world, but there must also be some truth in the proposition that a good deal of business is done via tax havens which, if the parties were contemplating a net after-tax return, would not get done at all.

Users of tax havens may well be seeking privacy as well as financial or fiscal benefit.

Relief from double taxation
Many countries offer relief from double taxation for the foreign taxes paid on a unilateral basis. There are several theoretical methods that can be used to achieve this. The country of residence may allow a deduction from taxable profits for the amount of foreign tax paid, on the basis that it is essentially a cost of obtaining those profits.

Alternatively the country of residence may adopt the source principle, and exempt the foreign profits from tax altogether, on the basis that tax has already been paid in the other country.

Finally, the country of residence may adopt the residence basis and reserve the right to tax the foreign profits, but allow a reduction in tax liability equivalent to the foreign tax paid.

The Organisation for Economic Co-operation and Development (OECD) is a group of 30 countries sharing a commitment to democratic government and the market economy. The OECD Model Convention deals with the question of relief from double taxation as follows: for some items of income or capital, the Model Convention gives an exclusive right to tax to one of the contracting states and the relevant article states that the income of capital shall be taxable only in a contracting state. The state in which the exclusive right to tax is vested is normally the state of which the taxpayer is a resident. In this situation, no double taxation arises.

For other items of income or capital, however, the right to tax is not exclusive, and the relevant article then states that the income or capital in question may be taxed in the contracting state of which the taxpayer is not resident. In such a case there may be double taxation, in which case the state of residence must give relief so as to avoid the double taxation.

Article 23 of the OECD Model Convention presents two alternative methods of relieving any double taxation that remains after the application of the income allocation provisions of the treaty. The methods are exemption and credit, and which method is actually used will depend on the agreement between the particular countries involved, some preferring the exemption method, others the credit method.

Under the exemption method, the country of residence relinquishes its right to tax income that has been taxed according to the treaty in the other country, the country of source.

Whether or not this is advantageous will obviously depend on the respective tax rates of the two countries. Under the credit method, the country of residence reserves its right to tax income allocated to the country of source, but will allow credit for the tax paid overseas in calculating the ultimate liability.

In the method of credit adopted by the OECD model, the amount of credit that is allowed for foreign tax is limited to a maximum of the amount of tax that would have been paid if the profits were earned in the country of residence.

The position is slightly more complicated when the foreign profits take the form of dividends from a foreign company in which a resident company holds shares. Dividends may then be subject to a withholding tax when they are remitted to the shareholder. Under an exemption system, payment of a withholding tax may be sufficient for the dividends to be exempt from tax in the country of residence of the shareholder.

Under a credit system, the question arises as to whether only the withholding tax will be credited, or whether recognition is also given to the tax on profits paid by the foreign country. In many countries that adopt a credit system - including the UK and the US - credit is allowed for the underlying tax (the tax paid by the foreign company on its profits from which the dividends are paid) - but only for substantial shareholdings, that is, non-portfolio investments

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Content last updated: 31/01/2006