By Krishnamurthy Subramanian From IST Economic Times

To demonstrate his government’s commitment to bringing back black money, finance minister Arun Jaitley must list in his Budget proposals on Monday the tax havens with which the government plans to sign Tax Information Exchange Agreements (TIEA) in the next few years. While such a list of countries may not seem to merit attention in a Budget speech, economic research suggests that TIEAs can generate substantial benefits for the Indian economy.

Even though close to a thousand TIEAs have been signed by various countries, only a small number involve India. By providing such a proposed list, the government opens itself to aperformance evaluation on its efforts to counter black money.

There can’t be a better way for the finance minister to credibly commit that he can walk the talk about bringing back black money.

Since 2012-13, more than Rs 31,000 crore has been invested by Indians in Singapore. The Netherlands is another favourite tax haven with Rs 11,330 crore capital invested in 2013-14.

It is surprising how little is known about the types of firms that use tax-haven subsidiaries and their underlying motives.

Research conducted by Insead’s Morten Bennedsen and University of Michigan’s Stefan Zeume (‘Corporate Tax Havens and Shareholder Value’, March 2015, working paper) now fills this gap using evidence from a novel data set covering 13,639 publicly listed companies from 52 countries and their 1,64,000-odd domestic and foreign subsidiaries.

ATIEA is a bilateral agreement between countries to exchange information relevant in civil or criminal tax investigations against individuals or firms. Importantly, TIEAs don’t change the tax rules in either of the involved countries.

The most obvious motive for establishing subsidiaries in tax havens is to minimise overall tax payments. Multinationals often use transfer-pricing to underreport income in India and shift profits to countries with zero or low tax rates.

However, the government cannot lift the corporate veil and establish audit trails in many of these transactions when tax havens do not share information. Also, multinationals can reduce their tax bill by establishing subsidiaries in tax havens.

Typically, firms pursue little operational activities in tax havens. Yet, they can obtain significant tax reductions by transferring intangible assets such as patents, licences, brands or goodwill to these locations. Because operational subsidiaries and the parent firm would pay taxes for using these assets if the subsidiary is set up in a high tax environment, firms reduce their tax bill significantly by sending the subsidiary in a tax haven.

Besides this tax motive, companies establish subsidiaries in tax havens to avoid shareholder scrutiny. Recall that Enron CFO Andrew Fastow created a staggering 892 offshore subsidiaries, 692 of which were created in the Cayman Islands alone. Of course, this network of subsidiaries allowed Enron to avoid paying taxes. However, in the court cases after the Enron collapse, it was also revealed that Fastow and his friends were able to transfer considerable resources to companies they controlled outside Enron.

Tax havens are typically very opaque. As a result, it may be hard for shareholders to clearly monitor how a firm’s assets are being used in these territories. The controlling managers may have an interest in piling cash in tax havens to finance future activities beyond what shareholders find optimal.

Firms hold cash in havens and use it for inefficient acquisitions. Such firms can also transfer resources out of the corporation through third parties. These are often non-transparent for non-controlling owners. Stealing and tunnelling away resources from shareholders to controlling managers is easier in environments that lack transparency.

TIEAs make the actual transfers of cash and assets costlier to insiders and more transparent to headquarter country tax authorities during tax investigations. Thus, it becomes more difficult and costly for controlling owners and promoters to use havens to hide or steal cash.

The implementation of a TIEA increases average shareholder value by 3% on average. Because these gains to shareholders result from increased transparency about the use of funds by promoters and corporate insiders, they do generate societal benefits above and beyond those accruing to shareholders.

To achieve tangible success in reducing the influence of black money in the economy, we have to recognise that corporates respond to the implementation of a TIEA with one tax haven by engaging in haven-hopping. They move their subsidiaries strategically from places that entered TIEAs to those that did not. Because of firms engaging in haven-hopping, it is critical for the government to plug all the loopholes by undertaking TIEAs with all the major tax havens.

In fact, because of haven-hopping, the effect of undertaking TIEAs on black money will be quite non-linear with the first few TIEAs having no impact, as firms switch to other available havens. Conversely, once all the major tax havens are all brought under the ambit of TIEAs, the impact on black money will start showing.

The writer is associate professor of finance, Indian School of Business
IMAGE: blackmoney-BCCL

For more on this story go to: http://blogs.economictimes.indiatimes.com/et-commentary/retrieving-black-money-stairway-to-tax-havens/