In the aftermath of an historic global economic crisis, forensic investigations have led us to appreciate more acutely than ever the dangers posed by secrecy jurisdictions to the overall stability of world markets. Before September 15, 2008, the infamous day that Lehman Brothers stunned the world by filing its petition for bankruptcy, only certain development experts, anti-corruption advocates, and specialized law enforcement experts devoted much energy to this problem. Some had warned us that the use of secrecy jurisdictions could undermine the entire global economy. In an American Interest essay that appeared in early August 2008, for example, Raymond Baker, John Christensen and Nicholas Shaxson focused on the dangers posed by offshore facilitation of “dirty money” flows, stating that “the current subprime and evolving credit crunch are . . . the leading edge of a deep, destabilizing global economic crisis.”1 Indeed, a few observers—Robert Schiller and Richard Sylla among them—had been warning about the perils of secrecy jurisdictions, among other dangers, since the aftermath of the Black Monday stock market crash of October 1987. But few paid them much attention.
In the larger sense, then, opacity worked not just to help corporations make money but to deflect attention away from how they went about it. Now that a variety of recent investigations have shed light on different ways in which the use of secrecy jurisdictions played a major role in the financial meltdown—from AIG’s massive offshore booking of toxic commercial instruments to Goldman Sachs’s $57 billion subprime Altius III Funding, Ltd. Cayman Islands-registered scheme. Interest in the issue has now, not surprisingly, expanded.
It is not clear, however, whether the increased interest will result in a better legal regime. In recent months the nation’s political institutions have focused attention on domestic financial regulation reform—on Wall Street. But there is only, at best, an oblique relationship between what Congress has envisioned and argued over in pending legislation, which is limited almost entirely to the domestic sphere, and the broader international problem of secrecy jurisdictions. We will not solve this problem if reform efforts stop at our nation’s borders. The U.S. government must address the broader, borderless issue of anonymous corporations and beneficial ownership, decreasing the benefits that can be gained from using offshore secrecy jurisdictions and increasing the transparency of corporate profits and payments.
It remains to be seen, however, whether the domestic reform effort will accelerate or depress efforts to get at the deeper, insidious problem of corporate opacity and secrecy jurisdictions. This essay describes the current state of play, principally in the United States, with respect to legislative efforts to get a better grip on the problem. The first thing we must realize as we begin, however, is that despite the renewed focus on the link between financial transparency and economic stability, opacity is still spreading. The most recent example of this phenomenon is provided courtesy of China.
The New Hong Kong Flu
Hong Kong recently introduced measures to allow anyone, anywhere in the world, to form a Hong Kong company in a matter of minutes using an online system. While online corporate formation is now common throughout the world and arguably necessary for efficiency in a global economy, there are very few legitimate reasons why anyone needs to create a company in less than a day. While press articles have focused on the speed factor, the bigger issue is that a Hong Kong corporation can be completely anonymous.2
Hong Kong’s incorporation documents require the incorporator to list the directors and a corporate secretary for any new entity, but in practice those people can be nominees or agents who have no ties to the “beneficial owners”, namely those who actually own or control the company. Agency companies exist in which the employees’ only function is to “serve” on the boards of anonymous companies and file required paperwork as deadlines arise. Even worse, the directors don’t have to be human beings; they can be other companies that in turn have other companies or agents as directors. It is easy to see how those wishing to remain anonymous can readily create a long and convoluted chain of obfuscation to frustrate the best efforts of law enforcement and tax collectors.
The risk here is that a completely anonymous company can be set up in Hong Kong in a matter of minutes, a bank account can be set up in the name of that anonymous company, and the real flesh-and-blood beneficial owners of the company can transfer their tax evading, human trafficking, drug-related and other illicit proceeds to that Hong Kong account in less than a day. This is an excellent option to have in hand when you get wind that law enforcement or the tax man is about to knock on your door or the door of someone associated with you.
Hong Kong represents the new face of an old problem, and it is a problem that involves the United States as well as other countries. The Financial Action Task Force (FATF) is an international body formed almost entirely by the countries that also form the Organization for Economic Cooperation and Development (OECD) to create international policies and recommendations to combat money laundering. The FATF has justifiably criticized America’s failure to address the gaping hole in accountability that makes it much easier for people all over the world to park their illicit money in U.S. banks. Indeed, the world’s leading perpetrator of financial opacity, according to the Financial Secrecy Index of the Tax Justice Network, is the United States, exemplified by the state of Delaware. Before the U.S. government can do much of anything about Hong Kong or secrecy jurisdictions in the Cayman Islands, Gibraltar, Jersey and elsewhere, it needs to clean up its act at home.
To that end Senator Carl Levin (D-MI) introduced the Incorporation Transparency and Law Enforcement Assistance Act (the Incorporation Transparency Act) in March 2009. This act would require that the state agencies responsible for incorporating companies also collect beneficial ownership information about the people who own and control companies formed in the United States. Delaware alone incorporated 121,628 new entities in 2008.3 Delaware collects no information with respect to who runs these companies. Many of them are not owned or controlled by Americans. The risks inherent in this lack of transparency, and therefore accountability, are truly staggering.
The Incorporation Transparency Act has faced some significant criticism. Efforts to make corporate beneficial ownership transparent have been roundly opposed by the National Association of Secretaries of State and the Chamber of Commerce of the United States of America, which fear that requiring beneficial ownership information in the corporate formation process for U.S. corporations will reduce sharply the number of companies formed here.4 These critics forget, however, that low standards attract low quality. What kind of business do we want to attract to America? The kind for which it is more important to be anonymous and unaccountable than to have access to the largest economy in the world? To be sure, a demand for legal accountability would probably reduce the number of companies incorporated in states like Delaware, Nevada and Wyoming, and thus reduce the income they receive from incorporation fees and filings, but that is revenue raised at the going rate for the price of anonymity. The rest of us, meanwhile, pay the much higher price of more transnational tax evasion, crime, terrorism and economic instability.
Other critics have argued that beneficial ownership information is already collected by financial institutions under the Bank Secrecy Act and can be obtained by law enforcement under subpoena. Thus, they say, collecting the information at the stage of entity formation is superfluous. This is an argument that perfectly suits the word “disingenuous”, for those who make it know very well that, for all practical purposes, accurate information about those intent on breaking the law is hard to come by and cannot be quickly or effectively acquired by subpoena.5 It is true that, for every account that a financial institution opens, that institution is required by law to conduct investigative questioning necessary to identify each individual “who has a level of control over, or entitlement to, the funds or assets in the account that, as a practical matter, enables the individual, directly or indirectly, to control, manage or direct the account.”6 Many institutions have tried to dig deep and question their clients thoroughly in order to determine beneficial ownership, but they are seldom trained investigators. Other institutions have simply weighed the cost to their business of digging too deep, that cost being a loss of capital from dodgy customers and penalties for non-compliance, against the benefit of increased capital due to lax compliance. Those who wish to evade the law’s requirement can easily do so. Bank workers should not be the persons ultimately responsible for supplying correct and complete information; the beneficial owners themselves ought to be legally obliged to do so the moment they form a company.
Current law also creates bizarre inefficiencies. As things stand now, every financial institution with which a company has an account must go through equivalent processes of discovery. It makes more sense to collect this information just once, upon incorporation: An incorporator should be required to certify that all information is true, complete and correct, and to provide copies of identification cards or passports as appropriate. In addition to being a law enforcement tool, this beneficial ownership data could provide financial institutions yet another tool for assessing risk.
The Incorporation Transparency Act would require that the same definition of “beneficial owner” under the Bank Secrecy Act be used to determine who the beneficial owners of U.S. companies are. Ironically (from the financial institutions’ perspective), some have argued that this definition is too vague and cannot be implemented. Even the U.S. Treasury has jumped on that bandwagon, arguing for a more precise definition. Now, as long as coming up with such a definition does not delay or subvert the legislative process, such an exercise could be useful. Any workable definition of beneficial ownership that retains two essential elements—an element of control and an element of ownership—will suffice for most purposes. But one wonders what is really motivating the demand for precision, and if “more precise” is in practice a synonym for “watered down.”
As things stand now, U.S. policy is schizophrenic on the issue of what level of diligence financial institutions need to undertake with respect to beneficial ownership. There is one standard for domestic use and another for foreign use. This schizophrenia came about because Congress recently passed a law intended to identify accounts held by U.S. “persons” abroad (meaning corporate entities as well as individuals). This new legislation, the Foreign Account Tax Compliance Act, or FATCA, will come into force in 2013. FATCA requires that every non-U.S. financial institution that wants access to U.S. markets must sign an agreement with the U.S. Treasury that they will either report to the IRS financial information with respect to all accounts that have one or more “substantial United States owners” (as well as identification information with respect to those owners), or withhold on behalf of the United States 30 percent of all withholdable payments made to such accounts. A “substantial United States owner” is either a U.S. “person” who owns, directly or indirectly, more than 10 percent of the stock of a corporation, or more than 10 percent of the profits or capital interest of a partnership, or a U.S. “person” treated as an owner of a portion of a trust under U.S. law.
In short, the U.S. government now requires that foreign financial institutions identify U.S. beneficial owners and remit that information to the U.S. government, but it does not require that domestic financial institutions send the identification information of foreign beneficial owners to their governments (or even collect that information in the United States for security purposes). In other words, it’s wrong for foreign institutions to help U.S. citizens avoid and evade taxes, but it’s okay for U.S. institutions to help non-U.S. nationals avoid and evade taxes in their countries. This is absurd, but it could soon get even worse: If critics of the Incorporation Transparency Act get their way by watering down the legislation, then we will have a third definition of beneficial owner used for incorporation. Clearly, the U.S. government needs to review all current laws in light of proposed legislation and take a more integrated approach to the subject.
Making Sure Tax Avoidance
and Evasion Don’t Pay
Tax avoidance and evasion are the primary reasons offshore secrecy jurisdictions were created. They exist to provide a safe haven for corrupt and otherwise illegal funds to flow worldwide. It follows that the most effective way to reduce their viability is to get at their motivating source by making tax avoidance and evasion as difficult and punitive as possible. Would-be users of secrecy jurisdictions will not value them very much if the odds of their getting caught and clobbered in the process are sharply increased.
FATCA is a significant step forward in this regard. In addition to the reporting requirements noted above, it closes certain offshore taxation loopholes previously permitted by U.S. law concerning foreign trusts, dividends paid to non-U.S. persons and certain portfolio interest exemptions. It also requires expanded reporting with respect to persons working with passive foreign investment companies and when new foreign corporations are created. There is even a provision that increases penalties for underpayment. Tackling the issue of anonymous incorporation would help, too. But much more can be done in this area.
Senator Levin and Representative Lloyd Doggett (D-TX) introduced a critical, broad-based piece of legislation last year called the Stop Tax Haven Abuse Act (STHA). The STHA contains a raft of provisions aimed at both corporate and individual taxpayers that would make certain secrecy jurisdiction-related activities illegal, require additional reporting with respect to funds held offshore, and address the incentives driving the professional sectors that promote tax avoidance and evasion schemes.
First, the STHA creates what lawyers call certain rebuttable presumptions in favor of the IRS in cases where a person is found to have accounts offshore in secrecy jurisdictions. In short, if you have an account offshore, the STHA would allow the IRS to presume that the account held more than $10,000 (and therefore should have been reported); that any person who formed, transferred assets to, was a beneficiary of, or received money or property from an offshore entity is in control of that entity; and that funds received from offshore are taxable and any funds being sent offshore have not yet been taxed.
The reason that these presumptions are so important is that they put the burden of proof on the beneficial owners and not on financial institutions or the government. As has already been noted, it is very difficult to get information about accounts in secrecy jurisdictions, regardless of whether those accounts are being used legitimately or illegitimately. If the STHA passes, the shoe would be on the other foot: If the IRS can prove that you or your company has an account in an offshore secrecy jurisdiction, it can presume that funds related to the account are taxable. As a taxpayer, you or your company would have the right to produce evidence that the funds are not taxable, but the STHA shifts the burden of proof from the government to the owner of the account.
Second, the STHA applies the “duck doctrine” to corporations that use offshore secrecy jurisdictions to reduce or eliminate tax liability while the majority of their staff and their headquarters are in the United States. In other words, if it looks like a duck (a U.S. corporation) and talks like a duck (has its staff and headquarters in the United States), then it’s a duck. The relevant STHA provision would require that any corporation that is publicly traded or has aggregate gross assets of $50 million or more and is managed and controlled by persons primarily resident in the United States be treated as a U.S. domestic corporation for tax purposes.
Third, the STHA contains provisions that will increase the level of caution that “tax structuring” practitioners apply when advising clients. Congress codified (albeit in the recent health care bill rather than FATCA) a legal doctrine called the “economic substance doctrine.” The doctrine essentially says that if there is no independent, profit-producing reason to set up corporations and accounts in a specific manner aside from reducing tax liability, then the transaction has no economic substance and the court will treat the superfluous entities as if they do not exist.
This codification is a large step forward, but unfortunately it only addresses liability after the fact, and it only affects the taxpayer, not the consultant who created the scheme in the first place. The STHA aims to fix those omissions. It includes provisions to dissuade the creation of tax schemes that approach the fuzzy gray line between tax evasion and tax avoidance. It increases the penalty to the practitioner of creating an abusive tax shelter from 50 percent of the practitioner’s gross income from the activity to 150 percent of the gross income. Those who aid and abet such schemes (lawyers, banks, investment firms and accountants working in concert) would also be subject to a disgorgement of 150 percent of the gross income received for such services. The STHA would prohibit fees earned on a contingency basis (a percentage of tax savings) for such services and would raise the level of certainty needed for an accountancy, legal or other firm to provide a letter of comfort to a client affirming that the tax structure complies with U.S. law.
Combined with the new provisions adopted via FATCA, these measures would significantly restrict the supply side of secrecy jurisdictions by reducing the ways in which secrecy jurisdictions can benefit a would-be taxpayer. Congress should pass them, without tampering with or weakening them, as soon as possible.
Transparency of Corporate
Profits and Payments
As things stand today, a company can create any number of subsidiaries in low- or no-tax secrecy jurisdictions and then transfer profits made in higher-tax locations to them. There are several ways to do this, but the main method involves the subsidiary charging artificially inflated prices for services or goods it provides to its parent company in the high-tax jurisdiction. This reduces profit in the high-tax jurisdiction and transfers it to the low-tax jurisdiction. Other methods include distorted pricing on stock trades and other capital transfers. Rules and regulations exist to determine appropriate transfers and transfer prices in a given situation, but, as one judge in the U.S. Ninth Circuit Court stated, “these regulations are hopelessly ambiguous.”7
The United States, with arguably the second-highest corporate tax rate in the world, loses tax revenue to such transactions but retains one of the highest standards of living on the planet. This sort of scam devastates developing economies, however, where one can find much of the manufacturing and processing of raw materials for goods sold in the United States and other consumer economies. In order to create the infrastructure and basic social services needed to move beyond subsistence living, developing economies need tax revenues from companies operating within their borders. Those companies should not be allowed to use fancy transfer pricing mechanisms to reduce the tax owed to these countries. (Dishonest local elites should not steal their society’s assets either, of course, but that is a separate issue.)
Before we can fix this problem we need to grasp the extent of it, but this is currently impossible because multinational corporations report their profits as though the parent company and all of its subsidiaries are one. There is no way to determine how much profit a given subsidiary declared and how much that subsidiary paid in taxes. Thus we must work to change international accounting standards to require a multinational to report its profits and taxes on an entity-by-entity basis, or at least a country-by-country basis. This shouldn’t pose an undue burden on corporations. The data, after all, already exist; one must already have an accounting of individual profits and losses before one can aggregate them.
Congress is currently considering a piece of legislation that would begin the movement toward such transparency. The Energy Security Through Transparency Act (ESTTA), sponsored by Senators Dick Lugar (R-IN) and Benjamin Cardin (D-MD), mandates that all companies working in the extractive industries (oil, mineral mining, natural gas) that are required to report to the Securities and Exchange Commission include details of their payments to governments in their reporting. These payments may come in the form of direct taxation, licensing fees, up-front and ongoing contractual payments and other types. Such reporting would disproportionately benefit developing countries, where the extractive industries carry out most of their work.
The mandatory reporting of amounts paid to other governments would increase accountability on a variety of levels. First, investors will be able to see more clearly where and how their investment is being used, allowing them to better gauge the level of their risk in volatile locations. Second, the citizens of a given country can see how much money their government receives in payment for a nation’s natural resources. If the amount is high and the citizens’ social services are not, they will more readily be able to hold their government accountable. Likewise if the amount is low, they will demand to know why. Citizens will also be able to see a corporation’s contribution to the local government and economy and judge for themselves whether it is doing enough.
ESTTA is not a comprehensive solution for the problem, however. It will not force corporations to disclose where the undeclared profits are being transferred or kept. In terms of combating the overall problem of shifting funds to low-tax jurisdictions to avoid corporate taxes, ESTTA will merely turn the light on so we can see the problems more clearly. Additional measures will be needed to address specific issues, but ESTTA is a start, and it too deserves to become law.
Secrecy jurisdictions are magnets for illicit funds and facilitators of illegal and often dangerous activities. They support capital flight out of developing countries, transnational crime, terrorism and massive tax evasion that unfairly burdens ordinary citizens, and as we now know, they imperil the stability of the U.S. and international financial systems. In short, they are a manifest threat to U.S. national interests. We therefore must reform not only the laws pertaining to banking secrecy but also related laws concerning anonymous corporations and accounting rules that allow for non-transparent transfers of funds within corporate families. We must understand the problem not only as an integrated one but also as one that must involve both domestic and international parties.
The legislation described here that is now pending in Congress represents an important start to solving several problems. Thus it is crucial that the legislation aimed at Wall Street, as important as it may be, not take the wind out of the sails of this larger effort. Yet the attentive American public, which has been deluged with information about how to rein in Wall Street’s excesses, knows practically nothing about these other measures, and this lack of knowledge could be a problem. The President’s use of the bully pulpit and the power of a free press are the best instruments available to offset the incessant self-interested lobbying of the financial industry. So far, these instruments have been mute. It’s time they made some noise.
2See Martin Vaughan, “Hong Kong Plan Raises Tax Concerns”, Wall Street Journal, April 1, 2010.
3Delaware Division of Corporations, 2008 Annual Report (2008).
4Letter from R. Bruce Josten, Executive Vice President of Government Affairs, Chamber of Commerce of the United States of America, to Senator Joseph Lieberman, Chairman, and Senator Susan Collins, Ranking Member, of the Committee on Homeland Security and Government Affairs (October 1, 2009) (on file with the author).
5Note the examples brought by Robert M. Morgenthau, “Tax Evasion Nation”, The American Interest (September/October 2008).
6The definition of beneficial owner can be found at 31 CFR 103.175(b).
7MarketWatch, “Appeals court reverses high-profile Xilinx tax decision”, March 23, 2010.