Panama Papers and Political Peril
What do Pakistani Prime Minister Nawaz Sharif, Spanish Minister of Industry, Energy and Tourism José Manuel Soria, Icelandic Prime Minister Sigmundur Gunnlaugsson, UK Prime Minister David Cameron, and Russian leader Vladimir Putin have in common? They are all government officials under pressure, after being linked to foreign tax havens in the "Panama Papers." The so-called Panama Papers are more than 11 million confidential documents stolen from Mossack Fonseca — a Panamanian law firm specializing in setting up shell corporations and trusts as tax havens — and leaked to the world press over the past 14 months.
Soria and Gunnlaugsson have already resigned, while as of this writing, Sharif left Pakistan for a medical procedure, raising doubts about his return. British Prime Minister David Cameron has fended off questions about his ownership interest in an offshore trust which he sold before becoming Prime Minister, and Russian President Vladimir Putin has also faced questions about indirect connections through friends and associates.
All these high-profile imbroglios have one other thing in common: they do not appear at this point to be illegal. The hypocrisy of tax avoidance practices can bring down politicians and prominent figures, but to many millionaires and billionaires, the outing of their overseas investments in shell corporations is merely a public relations annoyance. That can change if the public outcry is such that it promotes reforms in worldwide tax laws. Such changes may end up being the true legacy of the Panama Papers.
Shining a Light on the Problem
The revelations from the Panama Papers are the result of months of painstaking work by the International Consortium of Investigative Journalists (ICIJ). With individuals from a vast number of countries being implicated in the papers, it took a coordinated network of worldwide journalists to do the investigative work needed to connect the dots properly. Over 214,000 offshore entities were studied, encompassing over 15,600 shell corporations and 200 different countries and territories.
ICIJ confirmed what we already knew — that wealthy and powerful individuals take advantage of offshore shell corporations to hide their true wealth for a number of reasons. Even so, the magnitude of the findings was eye opening.
The real enablers, if not the driving forces, are the banks that are the direct connections to wealthy clients. The ICIJ analysis shows that Mossack Fonseca worked with over 14,000 different banks, law firms, and other middlemen to manage wealth through offshore companies, with some of the biggest banks as major players. HSBC and its affiliates are responsible for over 2,300 such companies, while UBS added another 1,100. Participation of the larger international banks should come as no surprise — they are likely to have more wealthy clients seeking tax havens.
Drawing the Lines of Responsibility
It is important to emphasize that there is nothing inherently wrong with setting up overseas corporations. You are welcome to take advantage of every tax advantage offered by overseas corporations, and businesses have plenty of legitimate reasons for setting up overseas entities. What is wrong is the use of such corporations in order to engage in illegal activities, such as laundering money or avoiding taxes through concealing your ownership share.
If you properly declare your overseas wealth to the right authorities — in the US that is the IRS, generally through Form 8938 as required by the Foreign Account Tax Compliance Act (FATCA) — your taxes are correctly assessed and all is well as long as you pay that tax. If the amount of tax is legal but inadequate in the eyes of government or the rules make tax fraud very difficult to enforce, it is up to the government to change the tax laws. Momentum is building to do just that, given worldwide reaction to the Panama Papers combined with the wave of Bernie Sanders-induced populism.
Where does the blame for the current situation lie? The individual dodging taxes by underreporting true wealth is clearly at fault, but identifying the dodgers is difficult based on the structures set up by the law firms and banks involved. If there is evidence that a bank or law firm knows the overseas entity is being used for illegal purposes, they clearly share culpability — but to what level are banks or incorporators like Mossack Fonseca required to monitor the activity of their clients? If the goal is to close off tax havens, the current level is clearly insufficient.
Regulators worldwide hope to seize on this opportunity to crack down on tax avoidance through offshore shell companies. The Organization for Economic Co-operation and Development (OECD) recently called a meeting of tax officials from multiple nations to seek a common response. Officials from Britain, Germany, France, Italy, and Spain announced new rules to take effect in January 2017 designed to be a "hammer blow against those that would illegally evade taxes and hide their wealth in the dark corners of the financial system."
Where is the US in this effort? It is not leading the way, as one might expect. Keep in mind that Delaware, Wyoming, and Nevada have reputations as low-tax homes for corporations. Even within the European announcement there were rifts, according to The Guardian, who reported that the other participants were pushing Britain to extend the rules to all trusts instead of only those that "generate tax consequences." China and Russia are also said to be against the rules announced in Europe, and other G20 countries have yet to sign on.
The fact is that many governments have self-interest in preserving certain aspects of tax havens. As a result, assembling worldwide agreement on how to deal with them is a daunting task indeed. A USA Today editorial by Pulitzer Prize-winning journalist David Cay Johnston suggests a two-fold approach for US compliance: require disclosure of true ownership of shell companies using the Commerce Clause as justification, and shift the efforts of the Justice Department from fining banks and bankers to prosecuting them. The first recommendation is likely to occur; the second seems unlikely —although it certainly would be effective.
The very wealthy will always manage to find ways to take greater advantage of legal tax loopholes than the rest of us, and such loopholes will never be completely closed. However, illegal activity is an entirely different matter, and we welcome legislation that improves the transparency of ownership of offshore entities. Take advantage of lower tax rates if you want, but do not try to avoid taxes entirely.
It remains to be seen if the flood of information released by the Panama Papers can sustain enough momentum to effect long-term change in offshore corporations and trusts. Expect a tremendous fight from those involved in secretive dealings, but expect that fight to be mostly held behind the scenes. It will require cooperative effort and persistence to overcome the power of nearly $22 trillion in hidden assets.
We are also concerned that subsequent reforms will have difficulty balancing focus and effectiveness. Legislation to control loopholes for the wealthy can cause collateral damage for the rest of us, especially by the time the legislation is sliced, diced, and shredded by lawyers and special interest groups. We hope that legislators and regulators will find suitable transparency rules and penalties that improve tax compliance without damaging legitimate estate-planning trust mechanisms. A legislative scalpel may be preferable to a regulatory hammer.