When Christopher Columbus left in search of the New World, he was looking for routes for developing trade and commerce for Queen Isabella of Spain. A noble motive indeed! But times have changed. When the explorers of the New World leave their shores now, they are often looking for routes to new tax havens. Their motive is to avoid paying taxes.

In a world wherein levying taxes are compared to the plucking of a goose, there is no shortage of demand for tax havens. But before you even think of searching for a tax haven, read on to find out what tax havens are and why you should be careful.

The Smoke Screen

Tax havens have been around for quite some time, with some historians even mentioning their existence in the form of isolated islands during the time of the ancient Greeks. The oldest tax havens of our times include Liechtenstein, Switzerland, and Panama—each of which is believed to date back to the 1920s.

But even after so many years of existence, there is no universal definition of a tax haven. The Organization of Economic Cooperation and Development (OECD)—a Paris-based group of 37 developed countries—uses the three key attributes below for identifying whether a jurisdiction is a tax haven.

1. No or Only Nominal Taxes 

First and foremost, tax havens impose no or only nominal taxes. The tax structure varies from country to country, but all tax havens offer themselves as a place where non-residents can escape high taxes by putting their assets or businesses in that jurisdiction. Different tax havens are popular for rebates on different kinds of taxes. But this attribute alone is insufficient to identify a tax haven. Many well-regulated countries offer tax incentives for attracting outside investment but are not classified as tax havens. This leads to the second attribute of a tax haven.

2. Lack of Effective Exchange of Information

Tax havens zealously protect personal financial information. Most tax havens have formal law or administrative practices that prevent scrutiny by foreign tax authorities. There is no or minimal sharing of information with foreign tax authorities.

3. Lack of Transparency

In a tax haven, there is always more than meets the eye. The legislative, legal, and administrative machinery of a tax haven is opaque. There are always chances of behind-closed-doors secret rulings or negotiated tax rates that fail the test of transparency.

But that's not all. Apart from the aforesaid three attributes, the United States Government Accountability Office (GAO) has listed two additional attributes of a tax haven.

4. Local Presence Not Required

Tax havens typically do not require outside entities to have a substantial local presence. Such a concession could lead to interesting situations. For example, a 2008 Government Accountability Office report found that one building in the Cayman Islands housed 18,857 mostly international companies.

This suggests that you can claim tax benefits by merely hanging your nameplate in a tax haven. There is no need for actually producing goods or services or conducting trade or commerce within the boundaries of the country. For all practical purposes, tax evaders may continue their business in Florida while claiming to be residents of the Bahamas when it comes to paying taxes.

5. Marketing Tax Havens

In the end, tax havens are all about marketing. They promote themselves as offshore financial centers. Many are also considered to be important international financial centers.

Socioeconomic Factors

Other than lower taxes and secrecy, there are several other socioeconomic factors that make a particular destination a popular tax haven:

  1. Political and economic stability. Without political and economic stability, no amount of tax inducement can bring outside investors. Switzerland, for example, became famous for its political and economic stability.
  2. Lack of exchange controls. Putting assets in a country subject to exchange controls could be dangerous for outside investors.
  3. Treaties. Many tax havens like Mauritius have become popular due to loopholes in multiple tax avoidance treaties signed with different jurisdictions. Some are becoming less popular due to various information-sharing treaties signed with different governments.​​​​​​​
  4. Banking, professional, and support service. Destinations like Switzerland and Austria, although not strictly tax havens, are nevertheless popular for offshore banking services and a safe destination for assets.​​​​​​​
  5. Location. Location is always an important factor in the popularity of certain destinations. The Bahamas has been a popular offshore destination for U.S. corporations due to its proximity to Florida.

Popular Tax Havens​​​​

Andorra Located in Western Europe between France and Spain in the Pyrenees Mountains. No gift, inheritance or
capital transfer tax.
The Bahamas Located off the southeast coast of Florida. No personal income tax, capitals gains tax or inheritance tax.
Belize Located in Central America on the Caribbean sea between Mexico and Guatemala. No capital gains tax.
Bermuda Located east of North Carolina in the Atlantic Ocean. No income tax, capital gains tax, capital transfer tax.
The British Virgin Islands Located 60 miles southeast of Puerto Rico in the Carribean. No capital gains tax, capital transfer tax. Famous destination among offshore companies.
The Cayman Islands Located in the western Caribbean just south of Cuba. Famous offshore banking center.
The Channel Islands Located 40 miles north of France and 110 miles south of UK in the English channel. Non-residents are not taxed on foreign income.
The Cook Islands Located between Samoa to the west and French Polynesia to the east in the south Pacific. Famous for bank confidentiality.
Hong Kong Located south of mainland China on the South China Sea. No taxes on capital tax. Other taxes are also low.
The Isle of Man Located between Ireland and England in the Irish Sea. No corporation tax, capital gains tax, inheritance tax or wealth tax.
Mauritius Located in the Indian Ocean east of Madagascar. A low tax heaven.
Liechtenstein Located in western Europe bordered by Switzerland and Austria. Famous for low taxes.
Monaco Located in western Europe on the French coast of the Mediterranean sea. No personal income tax or capital gains tax.
Panama Located between the North Pacific Ocean and the Carribean sea. No tax on foreign source income.
Switzerland Located in western Europe. Famous for offshore banking and lower taxes.
St. Kitts and Nevis Located west of Antigua in the Lesser Antilles of the Caribbean Sea. Up to a 15-year tax holiday as an investment incentive. Bank secrecy.

Tax Haven or Trap?

With mounting pressure from international organizations like OECD and the G-20, tax havens may find it difficult to sustain their carefree existence. Growing numbers of Tax Information Exchange Agreements (TIEAs) and Mutual Legal Assistance Treaties (MLAT) between tax havens and other countries like the U.S. would take away tax havens' competitive advantage.

TIEA makes it compulsory to share tax information between signatories and MLAT requires co-operation in matters of legal enforcement and criminal investigations. To make matters worse, some of the tax havens have had to deal with the trouble of their own making. Investors thinking of using tax havens and offshore banking locations should take note of the Liechtenstein banking scandal that shook the world in 2008.

This scandal came to light when Germany initiated a series of tax investigations based on bank account information sold by a bank technician. Many citizens of Germany who took advantage of a Liechtenstein-based trust structure for evading tax in Germany found themselves in a noose. The leaked data also put tax evaders in the U.S., the UK, France, and many other countries at risk for tax investigations.

More recently, the Panama leak has sparked renewed interest and investigations into offshore companies.

The Bottom Line

The existence of tax havens has many effects. At one level, the lower taxes or no taxes in one country put pressure on other countries for keeping their taxes low. This is good for taxpayers in the short term, but the secrecy and opacity associated with some of the tax havens may encourage money laundering or other illegal activities that can harm the world economy in the long term. The crackdown on tax evaders in some countries shows that taxpayers need to tread with caution.