Most modern medicine would be impossible without anesthesia. It supports a wide-variety of medical procedures that help people live healthier lives while typically posing no harm to patients when administered according to well-established standards. Yet according to the U.S. National Institute for General Medical Sciences, until recently the medical profession “knew very little about how anesthetics work”.
It may seem strange that a critical element of an important part of modern life can be so poorly understood by the professionals who oversee it. However, that happens more commonly than you may think. Medicine offers one example. Tax policy offers another.
Tax neutrality is a vital component of the 21st century global economy. When administered as policy that adheres to global standards for transparency and cross-border exchange of information, it enables the free flow of international investment capital and financing which benefits both developed and developing countries. Yet, international tax policymakers too often advance initiatives which fail to recognise the benefits tax neutrality provides and the safeguards it enables – and, as a result, threaten both.
Tax Treaties: Common Use, Risk of Abuse
Tax neutrality is the lesser known of the two main tools to mitigate the risk of double taxation on cross-border trade or investments among two or more differing tax regimes. The more well-known and commonly used tool to address double taxation is double tax treaties. More than 3,000 bilateral income tax treaties are currently in effect. Almost all EU members attempt to remove the obstacle of juridical double taxation through use of double tax treaties. In fact, some EU Member States have in excess of 70 double taxation agreements or treaties.
But while double tax treaties offer a widely accepted path to reduce or eliminate double taxation, they also come with risks. Double tax treaties are by nature complex and less transparent, and therefore sometimes pose a risk of abuse for tax evasion or aggressive tax avoidance. According to the European Commission, “some companies avoid taxes by ‘treaty shopping’ i.e. by setting up artificial structures to gain access to the most beneficial tax treatment under various tax agreements with other Member States or third countries”. This practice is widespread enough that the EU has had to take measures to combat the abuse.
These concerns indicate that concluding a double tax treaty to reduce or eliminate double taxation on cross-border investment can actually give rise to the rerouting of investment and income flows. Abuse of these treaties may also potentially increase incentives for base erosion and profit shifting, rather than increasing the overall investments made. Despite these risks, international policymakers tend to use the international network of double tax treaties as the baseline for new policymaking because it’s the system they know.
Tax Neutrality: A Concept for Funds Administered for a Jurisdiction
There is another tool that provides the same or better benefits with enhanced protection against abuse: tax neutrality. While poorly understood by international policymakers as jurisdiction-wide tax policy, tax neutrality is already understood and embraced worldwide for Collective Investment Vehicles.
Most countries treat income from Collective Investment Vehicles differently from corporate profits for tax purposes, promoting investment and reducing double taxation by applying the concept of tax neutrality on the investments. The income of a fund itself is effectively exempt from taxation, but individual investors are still required to pay tax on the proceeds from their investments. In the US, for example, funds are structured as “pass throughs” or “transparent” entities (LLCs, partnerships, etc.). In Canada, funds are often structured as “transparent limited partnerships”, In Japan, collective investment trusts are effectively tax exempt. In each instance, investment is promoted while double taxation is avoided through the use of tax neutrality.
The Cayman Islands has taken this concept of tax neutrality and applied it jurisdiction-wide as a cornerstone of the country’s tax regime. The Cayman Islands does not levy a corporate income tax. Instead, it operates an indirect tax regime which raises government revenue through fees and consumption taxes. As with the fund structures described above, Cayman’s policy of pure tax neutrality means investors in Cayman-domiciled investment vehicles are still subject to their home jurisdiction’s tax requirements, but Cayman just does not add an additional layer of taxation.
Tax Neutrality: Benefits and Protections
Cayman Islands’ tax neutrality may be different from the standard use of double tax treaties to reduce or eliminate double taxation, but it meets the same criteria and provides the same – or better – benefits and protections. The OECD Model Tax Convention on Income and Capital gives guidance on the use of double tax treaties to address the burden of double taxation on cross border economic activities. However, it also recognises alternative tax policy models for addressing (i) double taxation; (ii) tax conflict mediation; and (iii) tax information sharing to protect against tax evasion and aggressive tax avoidance. The Cayman Islands’ tax neutral regime uniquely meets the criteria of such an alternative tax policy model.
Cayman’s policy of tax neutrality removes any need for the jurisdiction to maintain tax treaties because there is no tax conflict to address and no risk of double taxation. In addition, cross-border economic transactions between the Cayman Islands and other countries do not require tax treaties for the purpose of administrative assistance (such as the ability to exchange tax information). The Cayman Islands meets this need through numerous bilateral tax information exchange agreements (TIEAs) as well as the Multilateral Convention on Mutual Administrative Assistance in Tax Matters through extension by the United Kingdom.
Tax Neutral, but Transparency Positive
The commitment to information sharing that both double tax treaties and tax neutrality are designed to support is not limited to TIEAs. Cayman also has adopted automatic exchange of tax information with relevant authorities in other countries. Under the OECD’s Common Reporting Standard (CRS), which has been implemented in the Cayman Islands, Cayman proactively shares tax information with over 100 other governments, which includes the UK and all EU Member Countries – a level of transparency which essentially assists them in the collection of their own taxes, regardless of what their unique tax laws are.
These information exchange agreements reflect a commitment to transparency. Tax neutral jurisdictions like Cayman support a level of transparency that arguably make them better at combatting tax evasion and aggressive tax avoidance than those that rely on the often opaque system of double tax treaties.
The Cayman Islands is a transparent, cooperative jurisdiction that already meets or exceeds the full range of globally-accepted standards for transparency and cross-border cooperation with law enforcement and tax authorities. The OECD’s Global Forum in 2017 assessed Cayman to be “largely compliant” with the international standard for transparency and exchange of information, the same rating given Germany, Canada and Australia.
The Cayman Islands has also had a world class verified ownership regime in place for more than 15 years. All companies established in the Cayman Islands must be formed using a licensed and regulated Cayman Islands corporate service provider. There is no ability for the general public to form Cayman Islands companies online. The information in the Cayman Islands ownership regime is collected and verified by these licensed and regulated Cayman Islands corporate service providers under existing anti-money laundering and know-your-customer laws and regulations and that information forms part of the Cayman Islands’ current enhanced information exchange arrangements with the UK.
A Hypocratic Oath for Tax Policy: First Do No Harm
While Cayman’s tax neutral policy is responsible and transparent, there are a few things it is not. It is not harmful to different kinds of investors because it maintains the same headline tax rates and effective tax rates, unlike most jurisdictions who operate double tax treaties. Cayman’s tax policy treats all investors fairly rather than using more favourable rates to create winners and losers in the marketplace.
Cayman’s tax neutrality is also not harmful to other jurisdictions. It does not inhibit the ability for other jurisdictions to tax the income of their citizens as they choose. In fact, as noted above, Cayman enables better tax collection by other jurisdictions through the automatic exchange of tax data. In addition, the OECD has completed a review of the Cayman Islands’ domestic legal framework that includes economic substance legislation and found that the Cayman Islands’ tax neutral regime is not harmful and meets all economic substance requirements. [OECD Harmful Tax Practices – Peer Review Results; Inclusive Framework on BEPS – Action 5, Jul 2019]
Finally, pure tax neutrality is not a policy that supports harmful base-shifting to evade or avoid taxes. This kind of aggressive tax avoidance requires a legal mechanism – usually in the form of terms of a double tax treaty. As noted above, the Cayman Islands’ tax neutral regime does not require double tax treaties and therefore has no legal mechanism to allow base-shifting.
Misguided Policies Based on Misunderstood Taxation
Despite the clear benefits and absence of harm from the Cayman Islands’ policy of tax neutrality, international policymakers continue to undermine it with proposals that seem based on a misunderstanding of how it works and why it is important. Proposed policies that focus only on the Cayman Islands’ and other jurisdictions’ lack of a corporate income tax threaten to significantly diminish the valuable role they play in the global economy.
Consider what would happen if the Cayman Islands was forced to end its policy of tax neutrality and introduce direct corporate tax on the profits of, for example, Cayman Islands’ collective investment vehicles – or, as under the OECD’s Pillar 2 initiative, other jurisdictions were allowed to tax those funds themselves. These new taxes would impose a double-digit reduction in the returns to investors in those vehicles, many of which are private and government pension funds. That would quickly and directly translate into cuts in payments to pensioners, whose monthly cheques would be reduced by the cost of new and unnecessary taxes.
Tax neutrality is a powerful tool to boost the health of the global financial system. As the Cayman Islands’ pure tax neutral regime shows, when used on compliance with global standards it can be operated with clear transparency and even stronger safeguards than the traditional double tax treaties. Before developing new rules that may inadvertently threaten the value this system provides to investors of all sizes around the world, international policymakers should better learn how this tax neutrality works and how it can help them achieve the goal of a robust, fair global taxation system.
Jude is well respected locally and globally having spoken internationally on financial services topics and featured on a number of occasions in international media. He retired as an Audit Partner in 2008 after spending over 23 years with Ernst & Young. As the Global CEO of Maples and Calder, he took an active role in the strategic growth and development of the firm. Jude has extensive experience within the Cayman Islands financial services industry, having served on various Cayman Islands Government and private sector committees. He has served as the CEO of Cayman Finance since 2014.