The Love That Dare Not Speak Its Name

How Offshore Companies Can Level the Tax Playing Field for Developing Countries and are Finance Ministers' Secret Best Friend

Just the term ‘offshore entity’ sounds shady. Secret meetings in astute bank vaults in the Swiss Alps or dropping off suitcases stuffed with cash to some sun-drenched speck in the Caribbean from a seaplane. But, and hear us out on this one, not all offshore entities are bad. One of the main uses of an offshore entity is to not be taxed twice when investing outside your home country. A major job creating element absent from Low- and Middle-Income Countries (LMIC) is investment. Quietly and counterintuitively, the much-maligned offshore entity is a key element of creating broad-based sustainable economic growth.

In a rich man’s world…

In the global race to attract investment, it’s a dog-eat-dog world. Countries will try all the tricks in the book to get people and companies to invest. Golden visas are popular (although frowned upon by the EU), Special Economic Zones continue to multiply, recent years have seen an arms race of state subsidies across the globe. US Treasury Secretary Janet L. Yellen was recently in China to try and get them to go easy on their green energy subsidies, so the US’s own green energy subsidiaries wouldn’t just get cancelled out.

Now imagine you are the finance minister of an emerging economy. You can’t offer the trillion-dollar subsidies lavished by your rich world peers. Your counterparts over at the ministry of education are still busy building the world class universities that OECD countries boast about (and your citizens apply for scholarships to attend). The ministry of transport and infrastructure hasn’t quite finished all those roads, rail, airports, and ports you need. The ministry of land is working on simplifying the land tenure situation; but it’s still not great. The myriad interlocking institutions and infrastructure elements that are present in countries that attract the most inbound investments take decades to build. There are also few shortcuts to building effective state capacity. Luckily, you have a friend or two overseas.

Places such as Hong Kong or Mauritius tax the profits of companies that are registered in their jurisdictions at low or even zero percent. It might not seem immediately obvious why the fiscal arrangements of often very small countries would matter to you as a reformist Minister of Finance of a LMIC. You want investment, you want factories built, call centres operative, and garments being sewn. Much of this investment needs to come from abroad. As the reformist minister you’ve pressed the flesh at Davos. You’ve spoken up the opportunities and the chequebooks are out. Typically speaking those who invest wish to one day realise profits. This is where those little low and tax-free countries can help.

The winner takes it all…

A double taxation agreement (DTA) is a deal between two countries that helps prevent income from being taxed twice. It sets rules on which country can tax certain types of income, making taxes simpler and fairer for people and businesses. For example, if two countries have a DTA they may agree that dividends paid, and taxed, in one country are not taxed as income in the second country. If no such agreement exists between the two countries, both countries will tax the same money. To explain, let's compare three scenarios where 100,000 USD in profits are generated a subsidiary company:

1. A UK company 100% owed by an Italian company who operate under a full DTA. 

2. A company in Ghana similarly owed by an Italian company who wants to remit profits back to Italy.

3. The same Ghanaian company except this time remitting profits to its parent company incorporated in a zero-tax jurisdiction.

In the first scenario – the UK company with a full DTA – the corporate tax paid would be 21,710 USD (the UK’s corporate tax rate on 100,000 USD profit is 21.71%). Italy’s corporate tax rate is 24% so the Italian parent company would be credited the tax already paid (21,710 USD) but have to shell out the remaining 2,290 USD (to make it up to 24,000 USD). The parent company would be left with 76,000 after all taxes are paid.

But in scenario two, with the Ghanaian company remitting to Italy without any DTA in place, the profits would be taxed three times. Once in Ghana at 25% corporate tax (25,000 USD), then a 5% Withholding Tax on the profit dividend sent out (3,750 USD), and the money that makes it to Italy would be taxed as income at 26%. This leaves the Italian company with 52,725 USD of their original 100,000 USD. The effective tax rate of investing in Ghana becomes a stonking 47.275%.  

However, if the Ghanian company is registered in a zero-tax jurisdiction (our third scenario), they would still pay the full 25,000 USD in corporate tax as well as the 5% WHT tax on dividends to the Ghanian government. But their offshore company in a zero-tax jurisdiction would then pay, well, zero tax. Meaning the final after-tax income is 71,250 USD which is not a million miles off what an Italian company investing in the UK would pay as well.

Money money money…

Unfortunately, LMICs do not have many DTAs in place. Whilst the countries that make up the OCED almost all have DTAs with each other (and a bunch more besides), Tanzania has nine DTAs in total, Benin just four. DTAs take time and resources to negotiate. And obviously individual investors cannot negotiate one on a country’s behalf. If you are an investor from a country without a DTA you will face an effective tax rate of as much as 45+% on your African adventure. However, if you set up a company is a low tax jurisdiction and then invest, you’ll still pay tax twice (once in the ‘host’ country, once in your ‘home’ country). Just the second time around it will be zero or a low single figure amount.

Abuses do and will continue to exist. Companies will engage in underhanded transfer pricing (in short finding creative ways to stack the ‘host’ company with costs, whilst the offshore company shows all the profit). A matryoshka doll of companies within companies can obscure ultimate beneficial ownership. Some jurisdictions may be less enthusiastic about enforcing laws than others allowing ill-gotten gains an entry point into the global economy. These practices are illegal and immoral, and many shadowy corners of international finance are in desperate need of a burst of sunlight. But these ills can be tackled. Even Switzerland’s famously opaque banking system was eventually cracked open by reformist Swiss politicians such as Eveline Widmer-Schlumpf and others.

Emerging economies need investment. Their economies often have some of the highest growth rates in the world. However, the litany of issues that make emerging economies less than optimally desirable places to invest is long. Offshore entities and low tax jurisdictions go some way to leveling the tax playing field. They are no panacea and often deserve the opprobrium cast their way. But there is a reason why it is the finance ministers of the G20 and the OCED who are the most vocal in their denunciations. Offshore entities are LMIC finance ministers’ secret best friend.