Rethinking Risk: Why Small Is Beautiful In The Fight Against Cross-border Tax Crime

But how big a risk do small IFCs pose?

Evasion Is One End Of The Tax Loss Spectrum

Tax evasion is the criminal activity where individuals, businesses or other legal persons deliberately omit, conceal or misrepresent information in order to reduce their tax liabilities, or intentionally fail to pay their due taxes without appropriate cause. There are three key points of contact between a taxpayer and the authorities when taxes can be evaded:

1. Taxes can be evaded by failing to register with the appropriate authorities as a taxpayer, declare activities subject to taxation or file all the required documentation.
2. Taxpayers can deliberately reduce the tax they owe by miscalculating or under-reporting their liabilities.
3. Taxpayers can fail to pay any or all of their liabilities.

Evasion is only one of many ways in which a government may not receive payment of the full taxes they would calculate as owing to them. There is a ladder of activities that may be undertaken by taxpayers to reduce their liabilities – from legitimate ‘tax planning’ through ‘legal interpretation’ and ‘avoidance’ to concealment and misrepresentation; ‘evasion’ is only potentially relevant in the latter. Moreover, the same tax-losing activity, such as a taxpayer understating earnings in annual returns, can be evasion if intentional or, if not, simply human error.

When authorities have attempted to size the scale of tax evasion, especially in developed economies, they have found it to be only a fraction of lost revenues. For example, the United Kingdom’s tax authority estimates that only 13 per cent of the £35.8 billion of taxes due in 2021/22 that were not paid were evaded – whereas ‘error’ and ‘failure to take reasonable care’ on the part of taxpayers (both individuals and businesses) accounted for 45 per cent.


Despite The Political Imperative, No One Has Done The Maths

Sadly, nobody has a good sense of the scale of tax evasion globally. The detail and thoroughness of HMRC’s tax gap reporting is rare, if not unique, among its peers (and even it is far from perfect). The paucity of data and the poor quality of analysis, especially across the major economies, is surprising given the level of political interest in addressing the problem.

Based on the thin evidence available and some chunky assumptions, we wouldn’t be surprised if the global combined tax gap was in the order of US$4 trillion in 2023, with up to US$500 billion (equivalent to 0.5 per cent of world GDP) accounted for by tax evasion. The amounts facilitated by or mediated through small international finance centres will be a proportion of these. But, when you consider the various contributors to the tax gap, it is difficult to see how IFCs can contribute to anything other than a small proportion.

Tax Is Lost Mostly Through High Volume But Low Value Activities

Again, the detail of the HMRC tax analysis paints a helpful picture (albeit of the overall tax gap and not evasion specifically).

Small businesses underpaying domestic taxes are the bulk of HM Treasury’s lost revenues. Of the estimated £35.8 billion tax gap in 2021/22, £20.2 billion is attributed to enterprises with turnover below £10 million and fewer than twenty employees. These are not the typical clients of the small IFCs in, for example, the Crown Dependencies and the United Kingdom Overseas Territories.

Over one third of the tax gap relates to revenues lost from the country’s main taxes on personal earnings and wealth: income tax, national insurance and capital gains tax, with the self-assessment regime for these contributing £7.8 billion to the total. The 800,000-or-so wealthy British residents with incomes of £200,000 or more or assets equal to or above £2 million accounted for £1.7 billion of the tax gap.

The HMRC analysis shows that tax is lost in Britain predominantly from parts of the regime where there are high volumes of lower value and less-well monitored activity. High-volume-low-value transactional markets simply aren’t where the IFCs operate, so it would be odd to presume they are responsible for large chunks of the tax gap or evasion.

 




Informal Economy Limits Developing Nations’ Tax Receipts.

It’s not just the large Western economies like the United Kingdom that suffer tax losses.

Our estimate of global tax evasion also covers developing countries, and especially the taxes unreported and unrecovered from the informal economy. The prevalence of cash and unbanked transactions makes it difficult for authorities, even if they were well-resourced, to capture the full tax due on all activity. Indeed, even relatively well-industrialised nations, such as China, India and Russia, face these problems.

Out of a potential US$540 billion of global tax evasion, we would suspect US$230 billion of it will relate to developing nations or those with a large informal economy, with little of this having any logical route to IFCs.

Of Course, There Is Some Risk Of Tax Evasion Through Small IFCs

Although the evidence points clearly to the bulk of tax evasion being low-value-high-volume and purely domestic in nature, there remains some scope for small IFCs to facilitate it or mediate its proceeds.

The proportion of evaded taxes that are transferred and laundered in a jurisdiction other than where the original crime was perpetrated will be small. But the nature of foreign-facilitated tax crime will likely be different to that carried out only domestically.

There is some direct risk that even the most robust small IFCs are used to launder the proceeds of tax evasion elsewhere. The source of these proceeds can be legitimate activities such as would be the case if legally earned income is not reported to the tax authorities.

Presumably the objective is to hide the proceeds from authorities in the original jurisdiction in which the income was earned. It is true that in the past, some jurisdictions may have turned their backs on their global responsibilities by turning a blind eye to unsavoury behaviour in order to secure business. But we also know the attitudes and behaviours of governments, regulators and the financial services industry in the more reputable and robust centres, including many of the Crown Dependencies and Overseas Territories (CDOTs), and those attitudes and behaviours firmly reject attempts to evade tax within their jurisdictions. The many exchange of information agreements in place with international partners, and the rigour of centres’ ‘Know Your Customer’ legislation and procedures leave little room for wannabe-tax evaders to fly under the radar.

The source could also be illegitimate, such as income earned from criminal activity like drug dealing. It is not impossible that criminals would look to move the money to an offshore jurisdiction, but why would this be any more likely done through a small IFC? The very same legislation, information sharing and due diligence processes that identify potential tax evasion in the CDOTs will pick up illicit earnings, too.


The Risk For IFCs Comes From Dealing With Shades Of Grey

The bigger (albeit still small) risk for the robust IFCs relates to business carried out on cross-border structures where the tax implications are not black and white. Where tax avoidance involves compliance with the law, aggressive tax avoidance aims to adhere to the letter of the law while undermining its intent. There’s a risk that IFCs could be utilised for attempted aggressive tax avoidance, potentially perceived as evasion in the original jurisdiction. Such schemes may operate at the edge of legal permissibility from the start. Equally, schemes that initially comply with the law but violate its spirit may be outlawed by legislative or tax code changes. The evolving nature of the boundary between avoidance and evasion underscores the ongoing risk.


Offshore Industry Has No Appetite For Risky Business – Nor Do The Governments

Small IFCs, especially those in the CDOTs, typically serve the needs of sophisticated institutional cross-border investors globally, which also means carrying on a material share of business with higher business risks. But that does not mean IFCs will work with tax evaders. Politicians in these jurisdictions have consistently communicated their stance against fostering business activities linked to foreign tax evasion or aggressive avoidance. In similar fashion, anti-tax evasion measures and anti-money laundering directives have been implemented to ensure a diligent and risk-aware approach is adopted by governments, relevant agencies, and financial service providers. Recognising the financial sector’s importance to IFCs’ local economies, jobs and tax revenues, there is a firm commitment to safeguarding their reputations, with no willingness to compromise their standing.

Offshores should not be considered standalone jurisdictions – it’s not uncommon for there to be multifaceted operations across various IFCs, with multiple IFCs being involved in the same transaction. As globally recognised brands, facilitating tax evasion would tarnish a financial service provider’s standing not only in the specific offshore centre involved but potentially across multiple jurisdictions. In the world of offshore finance, a shift towards a global compliance mindset has become essential. Businesses need to recognise that adherence to regulatory standards extends beyond individual jurisdictions to encompass their entire range of offshore operations. On the flip side, for IFCs, the consequence of financial misconduct transcends borders, impacting the collective reputation of finance centres globally. Instances of misconduct are shared concerns, highlighting the joint responsibility for maintaining integrity and ethical standards.

In this landscape, caution prevails, emphasising the commitment of IFCs to maintain a reputation for integrity and responsible financial practices, even in high-risk scenarios. This proactive response is part of the ongoing evolution of offshore financial centres, where a commitment to robust regulatory frameworks and ethical conduct underscores their dedication to transparency and accountability. The narrative surrounding so-called tax havens, often shaped by historical perceptions, is being reshaped by the tangible efforts of IFCs to align with global standards. As these centres adapt to changing expectations, they play a pivotal role in fostering a secure and compliant international financial environment.

Plenty Of Opportunities For Tax Criminals To Be Caught

Throughout the lifecycle of a financial product in a small IFC, there are various touchpoints between a potential tax evader and financial services providers, regulatory bodies, professional services firms and government departments. At each of these stages, there is the opportunity for tax evasion to be identified and the business to be rejected, reported to the relevant authorities, and the relationship terminated.

Given the intricate and sizable nature of financial structures in offshore jurisdictions, a collaborative approach involving multiple on-island service providers is often necessary. It's a coordinated effort rather than a solo act, emphasising the importance of collaboration in navigating the complexities of offshore finance. For instance, a structure managed by a trust and corporate services provider may have received guidance from an accountant or tax expert, established with the support of a law firm, be banked on the island, and be audited. Each of these service providers has its own rigorous onboarding, monitoring, and review procedures. Many are under the purview of regulatory bodies within the jurisdiction, which closely supervise their activities.

Why Would A Tax Evader Take A Risk In The CDOTs When There Are Less Stringent Regimes Elsewhere?

A tax evader’s choice of jurisdiction in which they attempt to launder money is presumably guided by previous experience and their understanding of how the financial services sectors in different jurisdictions work.

Anyone with a real understanding of the CDOTs, and knowledge of their zero-tolerance approach to financial crime, would undoubtably factor this into their decision on which jurisdiction to use. When comparing the layers of due diligence and hoops they would be required to jump through with alternative financial centres, attempting to launder money in the Crown Dependencies and Overseas Territories seems like a sure-fire way to get found out.  

Zarea Kamil
Zarea Kamill is a Researcher and Analyst at Pragmatix Advisory, where she works on a wide variety of projects, focusing on analysis and modelling. Since joining the team in summer 2023, she has been analysing regulatory and supervisory data related to the AML regime of an international finance centre. Zarea holds a BSc in Political Economy from King’s College London. A Malaysian national, she is fluent in Bahasa Melayu as well as English.

Rebecca Munro
With a focus on islands and IFCs, Rebecca works on a wide variety of Pragmatix Advisory projects, especially those with a social, economic or public policy dimension. She is an active member of her community on the Isle of Mull. She led the first successful community purchase of land, the Isle of Ulva, under new Scottish legislation and has spearheaded the building of new affordable homes for islanders. Rebecca holds a first-class honours degree in politics, philosophy and economics from the Open University, which she earned while owning and managing her own hospitality business.