Tax Havens and the High Seas

Reem El-Mehalawi

Vol. 41 Associate Editor

As the world becomes more globalized and connected, it is especially important to develop laws that will prevent global enterprises from being subject to double taxation. If every state were to tax a portion of a certain company’s profits, the sum of those portions might exceed the total income of the enterprise.[1] This can be an especially serious problem for shipping enterprises—their profits are generally quite modest, and taxation in developing countries can be quite high.[2] The Problem of Tax Havens for Shipping Companies Countries have widely agreed to combat double taxation by using residence- and source-based income taxation schemes.[3] Both the United Nations (UN) and the Organization for Economic Cooperation and Development (OECD) model tax treaties recommend that countries give taxing rights of business profits to a company’s state of residence.[4] An exception is made for profits derived from permanent establishment in a contracting state.[5] This is not an effective way to tax shipping enterprises. A shipping company’s income is said to be earned on the high seas, and not in the various countries in which it operates.[6] The problem with resident- and source-based taxation is that shipping companies can pay virtually no taxes by using the very same laws that protect them from being taxed twice.[7] Companies incorporate and “reside” in tax havens like Panama and Liberia where their tax rates are effectively zero.[8] One striking example of this is Carnival Cruises. The company mainly provides cruises from the United States to various other countries. But it is incorporated in Panama. Under resident-based taxation, Carnival Cruises does not owe US taxes. The company has paid virtually no taxes since 1997.[9] The most effective response to these kinds of problems will be an international one.[10] Individual countries cannot fill the gaps in international tax law on their own.[11] The OECD’s & UN’s Inadequate Response In response to tax havens, the OECD and UN model tax treaties recommend that profits be taxed only in the place of effective management, rather than in the country of residence.[12] This, however, didn’t solve the problem. The model articles don’t define what a “place of effective management” is.[13] Previous commentary suggests that it is the place where key decisions are made and where the most senior persons meet.[14] But under this definition, Carnival Cruises can continue to avoid paying taxes by having the board of directors meet in Panama a few times a year.[15] This is especially true considering the ease with which a person or group of people can communicate electronically and travel internationally for meetings.[16] It is no longer necessary for individuals to live in the same country in order to run a business.[17] The UN and OECD need to define what exactly is meant by a place of effective management so that it is not so easy for companies to “manage” themselves from tax havens. A myriad of potential solutions could refine the concept. Toward a Better Solution One solution would tie the place of effect management to the state with the strongest economic nexus to the enterprise.[18] This would include factors such as the location of the headquarters, the place of incorporation, where the directors reside, and relative importance of the functions performed in the state.[19] This is by no means an exhaustive list of factors that could be taken into consideration.[20] However, it is essential that the test not be too ambiguous. States need to prioritize the factors that are most important to the inquiry in order to implement an effective cross-jurisdictional test. The UN and OECD could even establish a hierarchy of the factors, as is done to establish individual residency.[21] Another potential solution would replace the place of effective management test entirely with the strongest economic nexus test.[22] The extent to which an enterprise is using capital, labor, and enterprise in a state can be used to determine its economic connection to that state.[23] This would make tax evasion much more difficult. The UN and OECD need to take the lead in proposing comprehensive reforms to existing tax treaties. Countries have struggled to combat tax evasion on their own.[24] Only an international solution can effectively

[1] United Nations Department of Economic and Social Affairs, Model Double Taxation Convention Between Developed and Developing Countries (2011),  https://www.un.org/esa/ffd/wp-content/uploads/2014/09/UN_Model_2011_Update.pdf at 162-63. [2] Id. [3] OECD Draft for Public Comment, The Impact of the Communications Revolution on the Application of “Place of Effective Management” as a Tie Breaker Rule (2001), http://www.oecd.org/tax/treaties/1923328.pdf at 3. [4] UN, supra note 1, at 12; OECD, Model Tax Convention on Income and on Capital (2014), https://read.oecd-ilibrary.org/taxation/model-tax-convention-on-income-and-on-capital-condensed-version-2014_mtc_cond-2014-en#page1 at 28. [5] UN, supra note 1, at 12; OECD, supra note 4, at 28. [6] UN, supra note 1, at 164. [7] See Pat Garofalo, The Company That Ran the Cruise From Hell Pays Almost No Income Tax, ThinkProgress (Feb. 15, 2013),  https://thinkprogress.org/the-company-that-ran-the-cruise-from-hell-pays-almost-no-income-tax-b234ef54e936/. [8] See Cynthia Blum, U.S. Taxation of Shipping: Anchored to a Flawed Policy, 33 J. Mar. L. & Com. 461, 479-80 (2002). [9] Id.; Garofalo supra note 7. [10] See OECD, Ending Offshore Profit Shifting, http://www.oecd.org/about/impact/combatinginternationaltaxavoidance.htm. [11] Id. [12] UN, supra note 1, at 14; OECD, supra note 4, at 29. [13] OECD Draft, supra note 3, at 4. [14] Id. [15] Place of Effective Management Recommendations on Guidelines to be Issued, Deloitte (2015), https://www2.deloitte.com/content/dam/Deloitte/in/Documents/tax/in-tax-place-of-effective-management-noexp.pdf at 12; See Reuven Avi Yonah, The International Tax Dodge: What can be done?, The American Prospect (2016). [16] OECD Draft, supra note 3, at 8. [17] Id. [18] See Id. [19] Id. at 12. [20] See Id. [21] OECD Draft, supra note 3, at 13. [22] See Id. [23] See Id. [24] See Joe Meyers, Which Countries Are Worst Affected by Tax Avoidance, World Economic Forum (Apr. 12, 2017), https://www.weforum.org/agenda/2017/04/which-countries-are-worst-affected-by-tax-avoidance/. The views expressed in this post represent the views of the post’s author only.