What now for the Crown Dependencies?

November 16th, 2010

I reported yesterday that the zero / 10 tax regimes adopted by all three of the Crown Dependencies have failed the test set by the European Commission for compliance with the EU Code of Conduct for Business Taxation (Guernsey has failed by default).

There are those who do, of course, wish to ignore the news and that is their prerogative. I admit that this is a leak, but one which I’m entirely confident is right. Failure on three out of five counts is a dramatic rejection of the deliberately abusive structure of zero / 10. It is also a resounding slap for those who think that getting round obligations is acceptable. The tax avoiders of the Crown Dependencies thought they could do this. It has been shown that they cannot. They have failed, as I understand it from what I have been told because of non-compliance with the following tests:

  1. Whether advantages are accorded only to non-residents or in respect of transactions carried out with non-residents;
  2. Whether advantages are ring-fenced from the domestic market, so they do not affect the national tax base;
  3. Whether advantages are granted even without any real economic activity and substantial economic presence within the Member State offering such tax advantages;

I predicted each of these in 2005.

Why the Crown Dependencies have failed

It is very obvious that if a company trading in Jersey is not taxed if it is owned by non-residents but is forced to distribute dividends that are taxed if it is owned by a Jersey resident person that there are clear tax advantages provided to non-residents. The failure of the first test was so predictable it is amazing that anyone in any of the Crown Dependencies, or in London, thought that they could get away with this abuse by arguing that the discrimination existed in personal tax, not business tax, which was the defence they used.

It has to follow on the same logic that test two also fails: the only reason for enforced distribution must have been to protect the national tax base by solely charging the domestic market to tax when the international market was not charged.

The third is a little more complex I suspect, and requires consideration of another issue – which is in the preamble test for the Code – which seeks to determine whether the rate of tax offered to business is itself harmful because it is seriously out of line with the overall tax rate in a jurisdiction. Since the claimed headline rate of tax in Jersey is 0% then clearly that is out of line when he prevailing income tax rate, which is 20% on most forms of income. This, I think, has to be born in mind when assessing the impact of the failure. It is not just the specific tests that have, I suspect, given rise to this rejection of the Crown Dependencies’ tax systems. For the specific tests to be undertaken there had to be a significant and deliberate tax differential to indicate the presence of abuse. That means I think that the 0% tax rate is itself under review and considered abusive. If true this is much more serious than the Crown Dependencies currently anticipate, and very welcome.

How does this impact on the third test? Well, if a 0% tax rate is offered to non-residents then it is very obvious that some activity without any real economic substance or presence will be recorded in the Crown Dependencies even though no real activity actually is undertaken there. This means that the 0% tax rate is, in itself, now part of the review, in my opinion. I cannot see how else the third test failed.

What does this mean for the Crown Dependencies?

First, and most obviously, zero / 10 is dead.

Second, and probably as importantly, confidence in the economic judgement of these locations will be severely dented. After all, if they cannot deliver a legal tax system when what business claims it needs is certainty, why should anyone take the risk of locating transactions in their jurisdictions again?

Thirdly, any new tax system in these islands must remove all differentials between the local population and those who seek to use these locations for tax abuse. A consistent tax rate must be applied to business transactions, and that consistency must overflow into any personal tax system. In other words, the tax base for business and personal transactions must be similar. It is, I think, very obvious that the argument that they can be different has now been rejected by the Code of Conduct group. The decisions that have been reached would not have been possible if that were not the case.

There are some immediate advantages in this for the islands. Some glaring anomalies, such as UK high Street stores trading being untaxed in St Helier, St Peter Port and Douglas when their locally owned competition is taxed must go. But since there is no prospect, whatsoever, that Jersey or Guernsey could balance their budgets without imposing a positive local rate of tax on companies this does imply that a consistent positive rate of tax will be applied to all profits arising in Jersey and Guernsey from now on. If, as I suspect, the UK continues to chip away at the Isle of Man’s VAT subsidy the same will be true there too.

This means, at the very least, that a territorial basis for taxation will be adopted in the Crown Dependencies, with all income arising in these places being subject to local taxation. But, remember, that these places do currently apply a residence basis of taxation to their warm blooded populations. To be consistent, and avoid the risk of abuse falling foul of the Code, a territorial basis might also be necessary with regard to the human population of these islands as well, especially if the corporate tax rate is lower than the income tax rate. That would have massive impact: the local population could easily ship income out of the local tax base if this were introduced. I think this may be a major constraint on the potential for a territorial basis for tax, at least with differential tax rates.

And there are, in any event, other risks. Take for example the recent trend for UK quoted companies to be incorporated in Jersey but be tax resident in a location such as Ireland or Switzerland. The assumption here was that the Jersey company would avoid all tax: that is not so obviously the case if a territorial system were to apply. The immediate of certainty which was the underpinning of these arrangements will have been blown apart.

And then there is something more significant still: if it were possible under a territorial taxation arrangements for a Crown Dependency company to still enjoy a 0% tax rate, which would be a significantly different rate from the standard rate of tax in the Crown Dependencies then the preamble test inherent in the Code of Conduct, which suggests that if there are major differential tax rates available to non-resident companies the existence of abuse does prima facie exist, will continue to be a problem, indicating that the Code may not be complied with if a territorial basis for tax is created with this deliberate intention of offering 0% tax to some companies.

I think there is a real chance this will be the case, and this shatters the complacent assumption in the Crown Dependencies that territorial tax will solve all their problems because none of the tax abuse they promote supposedly takes place on the islands – all of it, in the mysterious make believe world of the secrecy jurisdiction, supposedly taking place “elsewhere” (a concept I explain here).

Finally, territorial tax will, in any event, increase pressure on the Crown Dependencies to exchange information with other tax authorities. The simple fact is that if a company incorporated in one these places claims to have no trade arising in that place then its trade must be somewhere else. The Crown Dependencies would in that case be beholden to determine where that other place is and, I think, exchange information with it. If they did not then the opportunities for abuse would be enormous, and they would be deliberately facilitating it.

None of this puts the Crown Dependencies in a pretty situation. But I am not going to get upset about that. This is a problem of their own making, and one that they could have avoided if only they had been willing to listen.

Written by Richard Murphy

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