How do Tax Havens make money with negligible tax liability?

Tax Havens. Tourist spots cum business centers or sometimes a group of small, negligible islands which hold a major chunk of world’s money!

It is an entity that is the most loved by high net worth individuals and businesses who would like to do, let’s diplomatically say ‘TAX SAVINGS?’

It is also an entity that is most loathed by the Governments around the world (Not necessarily by government officials and politicians in some cases. You know what I mean) due to the stiff tax competition.

In order to understand how tax havens make money, one should understand what exactly they are and about its legality.

What exactly are tax havens?

Tax Havens are nations that have a zero or negligible tax percentage on the deposits/investments. The banks and financial policies of these countries offer attractive, minimal tax rates compared to other countries. This factor draws the citizens and businesses of other countries to deposit their money or do businesses in these tax havens. This reduces the tax burden of these individuals and hence saves more money.

The legality of tax havens

Tax havens and their existence aren’t illegal. It is legal by the National sovereignty of each country. The financial institutions of these countries possess the legal right to offer lower tax rates. They do this to attract deposits or investments which are used for the economic development of tax havens.

The term ‘tax haven’ has a negative connotation that arose due to the governments and politicians of non tax havens. The tax competition put up by these tax havens erodes the tax base of the government and the power of politicians in non tax havens. So, they openly hate the existence of tax havens.

The question of legality only arises in the means of transporting the money earned in non tax haven country to tax havens. E.g. Through hawala transactions, money laundering etc. People launder the black money or illegally earned money from non tax havens to tax havens.

People have found thousands of ways to manipulate the finances and transport the money to tax havens. On the other hand, curbing money laundering is not an easy task. This is also the reason why the government enforcement agencies in non tax havens hate the very idea of tax havens. Because they believe the very nature of tax havens motivates money laundering.

How is it beneficial to tax havens? How do they make money with negligible taxes?

No country or territory would be a tax haven if there no advantages in being it. No place would like to be a tax haven with a loss. They are not magic money churners. A country opts to be a tax haven to draw capital or investments from other countries for its economic development.

Sometimes it is also done for political reasons.

Some of the following ways are in which they make money even with negligible tax returns.

• Additional economic activity generated by large foreign investment. With large investments, there can be allied sources of economy generation that will benefit the country.

• Tourism – To lure and entertain the investors/depositors, tax havens are made fancy places and tourist attractions. These luxury tourism opportunities for the rich generate immense economy to the tax havens. E.g. Hong Kong.

• Wealth funds

• Other ancillary taxes like VAT, Property tax, consumer spending and employment opportunities

Why can’t other countries become a tax haven?

Well, not all countries can become tax havens. If that’s possible for countries to lower taxes, then there is no exclusivity and hence there are no tax havens.

It is reported that about 15% of the countries in the world are tax havens now. Like 30 countries roughly in a count of 200. Only a few of the rest 170 countries can even think to become a tax haven. For which they have to possess a very special set of favorable situations and they are

1. A tax haven aspirer should have very strong Rule of Law and established history of it. A ‘political stability’ is the most desired fact of becoming a tax haven. Nobody wants to put their money in a country that can topple anytime.

2. For investors or depositors to trust the country, it should showcase long documented cases of financial and transactional security.

3. A tax haven is preferred to have relatively a very small population and geography. Depositors believe that countries with a large population would force the tax haven government to inhibit the outflow of the incoming money. But there are well-established tax havens that have a huge population with favorable tax haven laws. E.g. Switzerland, USA (Some states) etc

4. A tax haven should have a strong military force or military alliance to keep itself from being conquered by another country. For e.g., Switzerland has a strong military, and Luxembourg is a member of NATO. Numerous overseas territories or island groups which serve as tax havens have their defense needs served by the UK.

These are some of the requisites or preferences to be tax haven. The idea of being a tax haven does not work for all countries, even fulfilling the above mentioned. It depends on the mass psychology, trust factor and understanding of the investors and depositors about the territory.

And hence, the territory should be able to generate that kind of trust.