What Is a Tax Haven?

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DEFINITION
A tax haven is a country that imposes low or no tax rates on foreign taxpayers. Tax havens also often limit the information about these taxpayers that they are willing to share with other countries.

A tax haven is a country that imposes low or no tax rates on foreign taxpayers. Tax havens also often limit the information about these taxpayers that they are willing to share with other countries.

Learn more about tax havens and why some taxpayers choose to do business in them.

Key Takeaways

  • A tax haven is a country with low or no taxes, often with a high level of financial secrecy to protect foreign taxpayers.
  • Tax havens cost governments hundreds of billions of dollars of lost tax revenue every year.
  • To combat tax evasion through tax havens, taxpayers with income or assets overseas must disclose foreign activities to the IRS.
  • The Tax Cuts and Jobs Act, which took effect in 2018, requires U.S. corporations with foreign subsidiaries to pay a one-time transition tax as though they had repatriated profits from foreign subsidiaries to the parent corporation.

Definition and Example of a Tax Haven

A tax haven is a country that charges foreign taxpayers low or no taxes. These countries also do not openly share financial information about taxpayers’ activities with the taxpayers’ home countries.

Taxpayers, corporations, and mutual funds may choose to work through tax havens—often through subsidiaries—or hold their bank accounts there. This allows these individuals and groups to avoid paying taxes in their home country.

For example, the Cayman Islands imposes no income tax on individuals or corporations. It is considered one of the most financially secretive nations in the world.

As a result, the Cayman Islands is a popular tax haven used by many U.S.-based corporations. The profits these corporations report that they earn through their Cayman Islands subsidiaries are equal to 20 times the Cayman Islands’ own gross domestic product.

How Tax Havens Work

In general, income earned by a U.S.-based corporation’s foreign subsidiaries is not subject to federal income tax. It is only taxed once the income is repatriated to the United States via a dividend to the parent corporation.

This means that corporations based in the United States can form subsidiaries in tax havens. As the profits earned in these subsidiaries remain in the tax haven, the corporations can avoid paying U.S. income taxes on them.

There are both legal and illegal ways to use tax havens to avoid or defer paying income tax.

Avoiding taxes by keeping subsidiaries’ profits overseas is legal. But some taxpayers may attempt to hide assets and even income overseas. This is more likely to happen in tax havens that don’t often share information with foreign taxpayers’ home countries.

This type of fraud could be as simple as putting undisclosed cash in a bank account in a tax haven. Or it could be as complex as setting up a web of domestic trusts formed in the United States and foreign trusts formed in a tax haven to hide your business income.

Criticism of Tax Havens

Tax havens cost governments around the world over $483 billion in lost tax revenue every year, according to one estimate. Taxpayers’ use of them poses a significant problem to the countries that need that revenue, including the United States.

To combat taxpayers evading taxes by operating in tax havens, the Internal Revenue Service (IRS) has imposed certain disclosure requirements on taxpayers with assets or income abroad.

Examples of these disclosures include:

The Tax Cuts and Jobs Act, passed in 2017, took tax haven enforcement a step further by imposing a one-time transition tax on unrepatriated earnings of foreign subsidiaries.

This law required United States corporations with profits in overseas subsidiaries to pay a one-time 15.5% tax on profits held in cash and a one-time 8% tax on profits held in liquid assets. Corporations were given the option to pay the tax all at once or in parts over eight years.

Combating tax evasion through the use of tax havens is not only an issue in the United States. In fact, in 2009 the Organization for Economic Cooperation and Development (OECD) founded the Global Forum on Transparency and Exchange of Information for Tax Purposes. The forum’s goal is to increase cross-border transparency and end cross-border tax evasion. Much of this work involves tax havens.

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