How the rich avoid tax and stay rich

June 2, 2017

French economist Thomas Piketty argued in his bestselling book Capital in the Twenty-First Century that capitalism arose from feudalism and is in many ways reverting to it.

In the medieval period the king’s armies were supplied by the barons who press-ganged their peasants but had to also fight themselves. To avoid having to fight, the practice of “sub-infeudation” arose, by which barons, as tenants of the king who owned all the land, sub-let or leased part of their land to a tenant who was then responsible for providing the king with taxes and soldiers. It was an early form of tax avoidance.

In the early 12th century English King Henry I invented Equity as a device to allow the Lord Chancellor, as agent of the King, to decide cases in court as he chose, even if this meant overriding statute law. Equity was used by the barons to evade their feudal obligations by creating a use, the father of the modern trust, whereby the real owner of land and the apparent owner could be different people and only the apparent owner — the one on the paperwork — carried the feudal war and tax burdens.

King Henry VIII abolished the use in the mid-16th century. But it was quickly replaced by the “use upon the use”, which became the modern trust. Trusts are used widely today to hide true ownership and thus evade taxes and to protect family capital from inheritance taxes, capital gains tax and public inspection.

Trust me, I’m a lawyer

A trust works by separating the benefits of ownership, which belong to the beneficiaries, from the control of the trust funds, which are in the hands of the trustee.

In a discretionary trust the trustee decides how much the beneficiaries get, and that arrangement means the beneficiaries are not liable for the full amount of income and capital gains tax. Both the trustee and the beneficiaries can be companies.

A company is kind of trust with directors acting as trustees and the shareholders taking the role of beneficiaries. Shareholders can be other companies or trusts and shareholders cannot be sued for the company’s failure to pay its debts. Companies pay lower rates of income tax than humans and can be bought and sold quite easily.

The primary purpose of a company is to allow shareholders to make money while protecting them from business risks through their limited liability for the company’s debts. Companies are thus vehicles of legal privilege.

Banks require loans to small firms to be secured and guaranteed, but larger firms borrow on less onerous terms. When a bank makes a new loan, it literally creates money. It is under no obligation to lend less than its customers deposit. In fact money owed to the bank is considered by the bank as an asset.

Premium clients are helped to relocate their funds to tax havens. Tax havens and central European banks allow “number only” bank accounts, but the initial depositor must sign and prove their identity and is the only one who can withdraw money unless a deed of transfer is completed. Trustees can do this for their beneficiaries.

International tax evasion

International tax evasion by large corporations usually involves transfer pricing. For example, A sells items costing it $5 million in Britain to customers in the European Union at profit of $3 million, which should be taxed at 25% in Britain.

A uses invoices from its British Virgin Islands (BVI) office for every major customer or has that office charge the British company $5 million in management fees, commissions or consultancy.

A pays no tax at all in the BVI because the entire business was conducted outside the BVI. The British tax office cannot prove the BVI invoices are empty shells and cannot set them aside. The Australian Tax Office (ATO) could do so here because it has the necessary powers but does not use them unless the evidence of fraud is beyond reasonable doubt.

In group C, company A is in a high tax country and B is in a tax haven. A eliminates its taxable profits by receiving a loan from B, the interest on which equals the amount of the profit. But the loan is only on paper, not a real cash transfer.

A shows no profit, B shows income from interest but, being in a tax haven, it pays no tax on it. Group C’s international profits are artificially raised by tax avoidance which is illegal in Australia but not in most other countries. 

Still in group C, A sells product to D for distribution and sale to countries round the world. A produces accounting entries that show only small profits from the sales to D, by appearing to sell at cost plus a tiny margin. D makes a large actual profit on its sales accordingly but it is in a low tax country so it leaves the figures alone. The ATO can overturn such artificial transfer pricing but is not obliged to do so.

Money laundering consists of disguising and rendering untraceable the sources of bank deposits. It is now widely used for tax evasion by the rich and by multinational corporations. Any tightening of rules in one jurisdiction causes a flight of capital into looser regimes of which BVI and Nauru are currently the loosest of all.

Tax mercantilism

Mercantilism, to which we are arguably returning under US President Donald Trump, is the pursuit of national commercial interests through the use of monopoly powers and the breach of trade treaties.

Tax is a national interest. Small countries compete to make their banks as attractive as possible to high-wealth people and firms with negligible taxes and easy secrecy around assets. OECD coordination of measures to combat tax havens through its Financial Action Task Force is, at best, a work in progress.

Regulation is one thing, but enforcement is another and corruption affects both.

Agency theory says principals can mitigate the self-serving actions of their agents, delegates and employees by giving incentives to align their interests, such as through stock options.

The top nine drug companies in the US in 2000 produced US$155 billion in profits and paid their executives between US$3 million and US$17 million each, plus between US$11 million and US$73 million in stock options. The effect of stock options is to link their remuneration to the share price so their financial interests align with those of the shareholders.

A trustee can be considered the secret agent of the beneficiaries. Agency is essential to secrecy.

Secrecy is even today thought to be essential to appropriation of public property by private interests. Secrecy is a precondition of rich people’s asset conservation.

Transparency regulations are weakly and sporadically enforced, sometimes only to punish political enemies.

As long as small countries are allowed notional economic sovereignty by the G8 countries, there will always be tax havens and relatively secret bank accounts. The rulers of most countries have a direct and material interest in continuing the laundry business.

Economic criminals should have their assets sequestered into a public trust and the trust managed to improve infrastructure, health, education and to promote the community.

Class war is a real war, not a dinner party.

[Gabriel Donleavy is Professor of Accounting at University of New England.]

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