The Big Squeeze
The world is experiencing its fifth year of financial crisis. While some countries (mainly BRIC) are recovering nicely, Europe, the US and Africa are mired in a financial quagmire. We witness mass anxiety in many countries such as Egypt, Tunisia, Libya and others where the Google revolutions were driven by unemployed youth. In Greece and Spain mass riots occur because of budget cuts and in the US the Tea Party movement with its misdirected anger has taken over Congress.
After a negative GDP growth of 9% in 2009, Russia is recovering well from the crisis. Its GDP is projected to grow around 5% in 2011 and its unemployment rate is around 6%. The recent rise in oil prices to the $100 per barrel range has allowed Russia to balance its budget and to generate a budget surplus. Russia is in good fiscal condition with low debt and huge currency reserves.
Eleven years ago Russia’s tax system was a major deterrent to foreign investors with an effective rate of over 80% on the Net Profits Tax and a Personal Income Tax rate of 32%. Tax evasion was rampant. In 2000 and 2001 Russia completely reformed its Tax System, a 13% Flat Tax was implemented on personal income and a 24% (reduced to 20% in 2008) Net Profits Tax rate was established. The result was increased tax revenues and a reduction of tax evasion.
Russia’s tax system is still evolving and issues such as Transfer Pricing and consolidated tax returns are currently being discussed in the Duma. Recently, Russia signed a new Protocol on its treaty with Cyprus which allows Russian tax authorities to request information about the beneficial owner of Cypriot companies owned by Russians. It also requires that taxes on the gains of Cypriot companies holding Russian real estate be taxed in the country where the real estate is located. This change to the Cyprus Treaty was done by using the OECD Model Treaty and by threatening to blacklist Cyprus if it didn’t cooperate. Many Russian companies have left Cyprus, and other countries such as Luxemburg and Sweden are actively recruiting Russian clients.
The US economy is another story, the 2010 budget deficit was 1.3 trillion dollars and the Congressional Budget Office projects a cumulative deficit of 7.2 trillion dollars by 2021. Moody’s is already suggesting that it might downgrade the US AAA credit rating and speculators are buying Credit Default Swaps on US debt. The European debt crisis, oil price increase, and a continuing housing downturn, threaten a very fragile recovery in the US. The US deficit was generated from a number of factors such as the Bush tax cuts, lack of financial regulation that contributed to the crisis and two wars.
US tax reform is at the heart of any budget deficit discussions. 1.1 trillion dollars in tax benefits are given annually to individuals and corporations. These tax breaks not only increase the deficit, but cause tax rates to be too high. Instead of promoting economic growth and competiveness, the current tax code presents individuals with perverse economic incentives instead of a level playing field. The Deficit Commission concluded that the current individual tax system is hopelessly confusing and complicated, this causes many taxpayers to underreport their income and taxes, hoping to avoid the audit lottery.
Last year I wrote an article in PASSPORT (Nowhere to Hide, March 2010) describing the tax inequities suffered by US ex-pats. I demonstrated how a US ex-pat might pay significantly more in tax than an ex-pat from the UK simply because he was taxed based on citizenship rather than residence. This kind of situation causes many US citizens to renounce their citizenship.
The United States is the only major industrialized economy that taxes its corporations on a worldwide basis. The US also allows MNCs to defer tax on foreign income until it is repatriated. Combined with the 35% corporate tax rate US corporations have many incentives to indulge in exotic tax planning. Many US MNCs incorporate in Bermuda using what is called a tax inversion to avoid US taxes. Google uses a tax structure known as a “Dutch Sandwich” to shuttle a majority of its foreign profits from Ireland to the Netherlands and then to Bermuda, where there is no tax. Google saves over one billion dollars a year with this scheme and its effective tax rate in 2009 was 2.4%. The list of US companies using exotic tax schemes is huge. Boeing uses 38 tax haven subsidiaries to reduce its 2010 effective tax rate to 0.3% General Electric’s effective tax rate is 14% and Yahoo’s is 7% and Carnival Cruise Lines has a 1.3% effective tax rate largely because it structures the ownership of its ships through Panama.
The Deficit Commission recommends that the US corporate rate be reduced to 23% and that many tax loopholes be eliminated. In addition it recommends that MNCs be taxed on a territorial system rather than a worldwide system. These changes are designed to make US MNCs more competitive in the global marketplace.
One of the more innovative discussions on US tax reform is whether to adopt a Value Added Tax similar to the VAT that is used in more than a 150 countries. Serious proposals on VAT also suggest that an exemption of $100,000 per family be allowed for individual income tax and the corporate rate be lowered to 15%. The 15% rate would solve many of the corporate tax issues and make the US a tax haven in this regard. This plan would also eliminate 100 million of the 140 million income tax returns and would free more than 150 million Americans from ever having to deal with the IRS.
Is this a realistic proposal or will the US continue on the path it has been on for many years where US multinationals spend huge amounts of money to run circles around the IRS? Perhaps the US will follow Churchill’s axiom when he said “the Americans will always do the right thing after they have exhausted all other possibilities.”
In “Nowhere to Hide” I also wrote about the UBS case and how the IRS forced the Swiss bank to provide the names of 4400 US citizens who were account holders (under US law these individuals are required to report these accounts to the IRS). Since that time the IRS has data-mined the list and secured 177 indictments and 156 guilty pleas, all of which involving millions of dollars in taxes and penalties. The IRS has also established a Whistle Blower office from which it has received thousands of referrals concerning unreported foreign bank accounts. Credit Suisse has recently been indicted on charges similar to UBS. Recently, Wikileaks released the names of 2000 US citizens who hold foreign bank accounts, which the IRS is likely to pursue.
The IRS has offered an amnesty program to those US citizens who have not reported their foreign bank accounts. Essentially, for those who voluntarily report their foreign bank account by August 31, 2011 they will only be subject to a 25% penalty on their bank balance and a 12% penalty if their balance is less than $75,000.
The G20 is using the OECD to pursue tax evasion in a number of ways. First the OECD is requiring that Tax Haven jurisdictions sign Tax Information Exchange Agreements. As of March 2011 457 TIEAs have been signed. The G20 recently announced a comprehensive list of disclosure rules for Tax Havens and also declared that “The era of Banking Secrecy is over.” The Big Squeeze is on and it is getting tighter every year.