Pressure on tax havens

The process initiated by the Organisation for Economic Co- operation and Development (OECD) to end ``harmful tax practices'' around the world could ultimately have an impact on the controversial 'Mauritius' route that foreign institutional investors and others take for investment in India. Following the OECD action, the issue now is not if India will ever be more strict in permitting investor funds to take advantage of the double tax avoidance treaty between India and Mauritius but when the latter itself will change its tax policies to prevent funds based in the West from routing their investments through the island nation.

In 1998 the OECD started identifying ``harmful tax regimes'' among its 21 member-countries as well as the ``tax havens'' elsewhere in the world. The objective was to initiate a global process by which a country's tax rates would stop being the ``dominant'' factor in decisions about where to park investment funds. (The absence of a capital gains tax in Mauritius is surely the dominant factor influencing many India-oriented funds to establish name-plate companies in that country.) The obvious reason for this concern is the erosion in revenue that follows tax competition between countries.

While it is interesting that the OECD is trying to end certain preferential tax regimes among its members, more relevant for India is the attempts it is making to end zero or very low tax rates elsewhere - which is how the innumerable tax havens which seem to dot the oceans more than anywhere else attract legal and illegal funds for transit investment. The OECD has just published a list of 35 such tax havens - which include Andorra (continental Europe), St. Kitts in the Caribbean, Seychelles in the Indian Ocean and Vanuatu in the Pacific. These are tax havens which are yet to commit themselves to a phase-out of their identified harmful tax practices and Mauritius is not on the list. But there is a commitment by some tax havens to ``co-operate'' with the OECD and modify their regimes by 2005 at the latest.

These co-operating tax havens have not been identified by the OECD but separately the ministers of the OECD member-countries have welcomed the promise by Bermuda, the Cayman Islands, Cyprus, Malta, Mauritius and San Marino to eliminate their harmful tax practices.

The OECD identifies a tax haven based on whether or not it ``has no nominal taxation on financial or other service income and offers or is perceived to offer itself as a place where non- residents can escape tax in their country of residence.'' These are the features of the Mauritius tax regime which attract funds that seek to invest in India. Specifically, four criteria are used to demarcate tax havens: ``(1) There is no or nominal tax on the relevant income (from geographically mobile financial and other service activities); (2) There is no effective exchange of information with respect to the regime; (3) The jurisdiction's regimes lack transparency or their application is not apparent or there is inadequate regulatory supervision or financial disclosure and (4) The jurisdiction facilitates the establishment of foreign-owned entities without the need for a local substantive presence or prohibits these entities from having any commercial impact on the economy.'' (Towards Global Tax Co- operation, OECD, June 2000).

The Mauritius tax regime would meet the first and last of these criteria and should therefore be in line for change. If that does happen by 2005, investment funds could lose much of the incentive to locate themselves there and channel their resources to India. While all this is a long way off, two questions are relevant. What locus standi does the OECD have to enforce a change in tax regimes? And how will tax havens cope with loss of what for some countries is a major source of revenue?

The OECD is not a multilateral organisation, it is only a rich- country (increasingly a middle-income country) body. The rules it frames cannot be forced on non-members like Mauritius. The OECD has proposed that countries take certain 'defensive' measures against those tax havens which do not co-operate. These include imposing a withholding tax, renegotiating tax avoidance agreements and the like. That may be a workable tactic for a rich country member of the OECD, but what of a non-member like India whose Government has shown that it is not terribly keen on any acting against misuse of its double taxation avoidance agreement with Mauritius?

If that makes a change in the tax laws of all havens unlikely - notwithstanding their governments' commitment to modify them by 2005 - there is also the matter of compensation. Tax havens are almost always small nations, for which even registration charges and the minimal local presence of foreign investors constitute considerable revenue.

The OECD suggests some kind of international compensation mechanism, but unless there is some certainty about their losses being covered it is hard to see many tax havens giving up their present source of revenue.

CRR

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