“Where there is an income tax, the just man will pay more and the unjust less on the same amount of income.” Plato


The flow of income is as follows: An enterprise generates income, then the income is received by the individual. In the end, the individual consumes the income. Income temporarily not consumed accumulates into wealth (capital). If only consumption were taxed, the state would not get paid until the income is consumed. If only income received by the individual were taxed, the state would not get money until income is distributed to the individual. However, wealthy owners are able to delay the date of income reception. On the other hand, if the state taxes income through several steps, people are less aware of the real amount they pay overall: “The art of taxation consists in so plucking the goose as to get the most feathers with the least hissing.” Jean Baptist Colbert.

A tax haven is not a state, but a special legislation that is applicable in a jurisdiction (territory of a state) sometimes only for a specific type of income (e.g. interest).

Even in hardcore tax haven countries, the tax haven legislation is often ring-fenced, that is it applies only to companies that are allowed to operate solely abroad, which is why they are called offshore companies. On the other hand, developed OECD countries operate tax haven legislation as well: USA, Belgium, the Netherlands, Switzerland, etc. So the category of tax haven is rather blurred, and there are very few countries without some tax haven structures. However, the relative proportion of the revenue of a particular country from this kind of legislation varies widely.

A national enterprise operates within the territory of the host state. Its income is generated within one company. On the other hand, a multinational enterprise is a group of companies that operate in several states simultaneously and its income is generated in several different companies (subsidiaries).

Nation states use their sovereignty to enact legislation aimed at gaining revenue at the expense of other nation states and multinational enterprises that operate internationally are able to take advantage of these tax haven rules, that is they divide and conquer.



The majority of the world economy is governed by multinational enterprises, so the majority of the world’s income is also generated by them. This income is the target of nation states. Multinational companies have emerged from international investment and trade, as capital can be used more efficiently on a worldwide scale. However, for international investment to be more efficient than domestic, some additional things are needed.

Firstly, the investor needs an investment treaty in which the capital importing country guarantees that the investment will not be expropriated, and also guarantees the free transfer of the investor’s funds from the capital importing country back to the capital exporting country.

Secondly, the investor should be able to bring back the goods manufactured into the capital exporting country free of tax, so customs duties need to be abolished between the country of production and that of consumption.

Thirdly, the investor needs a double taxation treaty that ensures that income generated by the foreign investment is not double taxed by both the country of residence (capital exporting country) and the country the income is sourced from (capital importing country).


International taxing rights are currently allocated as follows: Active or business income is taxable in the country where the activity that generates the income takes place, that is, where the income is sourced from. However, active income from international transportation is taxable where the transportation company is resident.  

Passive or capital income is taxable in the country where the owner of the capital is resident. Passive (capital) income includes:

Double taxation treaties reinforce the residence-source allocation. However, the source country is also allowed to tax passive income even if there is a treaty in force. The actual allocation of taxing rights depends on the power relations of the particular treaty partners. Capital-exporting developed countries prefer the OECD model treaty, which is more favorable to residence, while capital-importing developing countries prefer the UN model treaty, which is more favorable to source. Within the European Union, residence-based taxation of passive income is ensured by directives: the parent-subsidiary directive (dividend), fusion directive (capital gains), and interest-royalty directive.

“The avoidance of taxes is the only intellectual pursuit that carries any reward.“ John Maynard Keynes


Company residence is based upon the place of management or the place of incorporation of the enterprise. In consequence, corporations can change their taxable presence by relocating their place of management (e.g. they can migrate company headquarters from the UK to Ireland) or they can have their management in a high-tax country and incorporate the company in a low-tax country (tax haven). The latter are the well-known offshore letter-box companies (known as international business corporations) located in offshore financial centers (e.g. the Cayman Islands, Switzerland, Hong Kong, etc). By transferring company residence in a tax haven the passive (capital) income of the company (interest, dividends and capital gains, royalties, rent) and the active (business) income from international transportation is shifted to the tax haven jurisdiction at the same time. In addition, the multinational group can shift income (profit) by transferring business risk to its subsidiary that is resident in a tax haven jurisdiction. The profit arising from the risk remains with the risk bearing tax haven company. However, the transfer of risk is senseless within a group of dependent companies. After all, the ultimate risk of loss is borne by the whole group, as they have a common goal to survive and expand, therefore the profit from risk should also be attributed to the whole group.

As companies are profit oriented organizations and income tax decreases their profit, the goal of the multinational company group is to generate less income in high tax countries and more in low tax countries. To achieve this goal, the multinational enterprise locates low risk activities operating with leased equipment, licensed intellectual property and financed by loan capital in high tax countries. At the same time risk, equity capital, ownership of intellectual property and equipment are located in low tax countries.

The active (business) income of the multinational subsidiary that is resident in the non tax haven state can be reduced by transfer pricing, when it sells products or services to another group member that is resident in a tax haven below market price and purchases products or services over market price. In this way, the profit is shifted to the tax haven, because in the case of international trade (reinvoicing) the activity that generates the income usually takes place where the subsidiary is resident.

To sum up all the above, the multinational group is able to allocate its income by allocating assets/capital and risks and in addition by transfer pricing the products and services that are produced by the group. This means that the value of the income allocated to a particular nation state is the sovereign decision of the multinational enterprise.


The high tax country that provides extensive public services to its citizens can apply the following methods to at least slow down the outflow of income and with it the tax revenue.

If the company resident in a low tax jurisdiction is proven to be managed by people resident in the non tax haven country, the company residence and with it the passive (capital) income can be shifted back to the high tax jurisdiction. However, these tax haven companies are many times managed by nominee directors that are resident in the tax haven country, therefore it is very difficult for the non tax haven state to prove the effective place of management.

The non tax haven state can levy a so-called withholding tax on dividend income paid out by the local subsidiary to its parent company that is resident in a tax haven jurisdiction. In addition, the non tax haven state can apply withholding tax on the interest, royalty and rent that reduce the income of the company resident domestically. As an alternative, the non tax haven state can render these costs non-deductible from the income tax base of the resident company.

If however the high tax jurisdiction has a double taxation treaty with another state, then passive income (dividends interests, royalties, rent) is taxable at residence. Within the European Union, the directives on parent-subsidiary, interest-royalty, and fusion have the same effect. Multinational companies are able to take advantage of these directives and double taxation treaties by channeling passive income through so-called conduit companies that are resident in EU member states, or countries that have a double taxation treaty with the high tax jurisdiction. The income is directed via the conduit company to the so-called beneficial owner company resident in a tax haven free of withholding tax. This structure is known as treaty or directive shopping, as the beneficial owner of the income uses the intermediary state only to benefit from its double taxation treaty or EU membership. States can avoid this kind of tax avoidance by denying treaty/directive benefits if they manage to prove that the beneficial owner of the income is not the company resident in the treaty-partner country or another EU member state.

One of the main attacks launched by international corporations against domestic income comprises interest charged by one group member that is resident in a tax haven to another group member company resident in a high tax jurisdiction. The multinational group puts its capital into a group member company (subsidiary) located in a tax haven, while the subsidiary located in a high tax country is financed by debt borrowed from the low taxed subsidiary. In this way, the income of the thin-capitalized group member is shifted to the thick-capitalized subsidiary resident in the tax haven. The defense made by the high tax state is known as the thin-capitalization rule, which means that the nation state does not allow interest to be deducted above a certain limit if the subsidiary is financed excessively by debt.

Against transfer pricing developed OECD countries fight by applying the so-called arm’s length principle, that is the state compares the prices of intercompany sales/purchases to the prices that have evolved between independent companies (market price). After establishing the arms’ length (market) price, the state adds the difference (positive or negative) to the income of the resident company.

However, in the author’s opinion, the establishment of the market or arm’s length price is practically impossible at present due to the following main causes (among many others).

The first main problem is that the bulk of world trade takes place among multinational groups, so there is practically no arm’s length price which can be applied between related (group) companies. The markets typically dominated by multinationals (e.g. banking, pharmaceutical, automotive, telecommunication, computer industry, etc.) do not have a large number of independent participants.

The second main problem is that one of the main goals of market competition is the establishment of prices, so the correct market (arm’s length) price cannot be established, cost effectively, by way of calculation. The result of calculation, therefore, will be a broad range of prices which is more than sufficient for the multinational to locate the income where it is optimal.

The third main problem is that if the market profit is attributed to all dependent group companies, a residual profit will arise in consequence of the fact that the aggregated (whole) income of the multinational group exceeds that of the group of independent companies. This is mainly due to centralized management and economies of scale.

Furthermore, multinational companies can easily opt out of the arm’s length system, as the rule only applies to transactions between related enterprises. Two unrelated multinational groups doing business with one another could therefore swap profits in different jurisdictions by selling to each other above market price in one country and buying from each other above market price in another country. Or the multinational company could insert a formally unrelated conduit company into the supply chain.

As stated above, nation states are currently unprotected against transfer pricing. The largest transfer price battle (dispute) to date was fought between the U.S. tax authority, the IRS (Internal Revenue Service), and the multinational pharmaceuticals giant GlaxoSmithKline. The dispute was resolved by a settlement agreement, GlaxoSmithKline paid $5.2 billion, which was essentially a peace treaty.

The multinational enterprise, which is an international group of companies, is able to construct artificial intercompany transactions (e.g. treaty shopping, see above) for the purpose of reducing the income of high tax jurisdictions. The high tax state can declare these artificial transactions invalid if their sole or main purpose is to obtain undue tax benefits (so-called substance-over-form or abuse of rights doctrine). The problem is that tax authorities operate nationally, so they do not have an overview of the whole chain of international transactions. This is a situation similar to the story of the blind men and the elephant, when several blind men are asked to determine what an elephant looks like by touching different parts of the elephant's body. As all the blind men touch a different part, they are in complete disagreement, even though they are touching the same thing. This is similar to the national tax inspectors working separately.

In contrast, the multinational group’s aggregated real income published on the stock exchange is audited internationally, by international audit firms known as the Big 4, in order to see the big picture, the whole set of transactions. Sometimes, however, even international audit is insufficient as revealed by the accounting scandals of Enron, WorldCom and Parmalat, to name just a few. On the other hand, in the case of national tax audits, the chance of identifying the real transactions is close to zero. But even if the international transactions are real transactions and not artificially created, they are extremely difficult to audit nationally.

The multinational enterprise which has succeeded in shifting profit to a tax haven is at the same time faced with a problem. The multinational group is structured hierarchically, that is a parent company, which is usually located in a high tax jurisdiction, owns all the subsidiaries resident in various states. The profit which is shifted to tax havens generates a loss for the parent company listed on the stock exchange. The multinational organization needs to report profit on the stock exchange, but at the same time wants to declare loss to the tax authority. The magic that resolves this contradiction is called a consolidated financial statement following the accounting standards of US GAAP or IFRS (EU). In a consolidated financial statement the income of the non tax haven parent company and that of the tax haven subsidiary are published together. The accounting standards do not require a country by country report on the income, so the average investor is not even aware of where the company profits are allocated [1]. Nation states have responded to this trick by inventing the controlled foreign corporation rule. In applying this legislation, the high tax jurisdiction adds the retained earning (income not paid out as dividend) of the subsidiary resident in a tax haven to the income of the domestic corporation the parent company. In this way, the shifted profit becomes taxable by the non tax haven country where the parent company is resident.

However, the controlled foreign corporation rule can be avoided as well:

The proposed solution against profit shifting of multinationals is the application of the so-called formulary apportionment method or unitary taxation, where the whole income of the multinational group is distributed among the countries where the group performs its activities using arbitrary weighting of different factors, such as payroll, assets, or sales [2]. However, this method does not differ substantially from the current system where multinationals allocate their own income arbitrarily, as we are faced with the same problem of how to allocate income truthfully among states. The ideal method would allocate to every state the real value of the income locally generated, as the public services rendered have contributed to the generation of the income, and therefore the state is entitled to its fair share in order to be able to provide the services continuously. But the real value is impossible to calculate in the absence of competition. On the other hand, applying formulary apportionment does not in itself prevent the possibility of abusing the new world accounting system. The value of income can also be manipulated in the formulary apportionment system, as multinationals could relocate certain factors (payroll, assets, sales, etc.) to where taxation is more favorable.

To sum up the above, the true allocation of income among states is not cost effectively feasible. Even if the multinational enterprise does not want to misuse the system, it cannot calculate the real income attributable to the subsidiary operating in a particular state. Even in the case of an ideal international taxation system where all states applied the same tax rate and there were no tax havens, it would be advantageous for the multinational enterprise to set off loss generated in one state against profit generated elsewhere. The artificial reduction of profit generated in one state reduces the tax revenue levied on the income, and so deprives the state of funds needed for the rendering of public services that have contributed to the generation of the profit. In the present international taxation system with different tax rates and tax havens, multinationals are even more tempted to shift profit to countries with more favorable tax regimes to “optimize” their tax burden.

Because all of the problems described above, the solution could be to introduce an international level of corporate income taxation, that is tax should be levied and audited internationally in a centralized manner. Furthermore public services which are consumed by international companies and which cannot be privatized, that is the coordinating functions of the state, should be provided internationally.

”Foreign aid might be defined as a transfer of money from poor people in rich countries to rich people in poor countries.” Douglas Casey

As described above, developed countries are able to defend themselves to a certain extent, but developing countries are far less protected against multinationals as they are obliged to enter into double taxation treaties with tax havens to attract foreign investment, or they do not even try to tax passive (capital) income at all. In the case of active (business) income, multinationals can easily shift profits by transfer pricing. In addition, developing countries usually lack the resources, expertise, methodology and infrastructure, to audit the transactions of multinational enterprises. As a result, profit is shifted out of the developing country unimpeded. In the absence of tax revenue, however, the developing country falls back on foreign aid and credit, and in consequence the government of the developing country comes under obligation to foreign donors and creditors that are mainly interested in getting hold of the resources of the developing country: raw materials, people (called human resources by multinationals), energy and environment [3].

Moreover, thanks to the controlled foreign corporation rule and anti-avoidance rules on transfer pricing applied by developed countries, income shifted to tax havens from developing countries can be subject to tax in developed countries. In this way, the tax revenue can be transferred from the developing country to the developed country.

However, as described above, the international taxation system has also been transformed in the case of developed countries. Multinational corporations shift their profits to tax havens, and as nation states are deprived of tax revenue, the money is loaned back to them by multinationals to enable them to provide public services. The traditional state-taxpayer relationship is therefore transformed into a debtor-creditor relationship. In addition, by reducing the tax revenue, the multinationals can force the nation states to reduce their public expenditures and to privatize public services.

So corporate income tax is avoided. In the next phase, the income will be received by the individual owner of the multinational group in the form of dividends or capital gains. After that, the individual will consume the income usually by purchasing a luxury villa, yacht and private jet.


“Rich bachelors should be heavily taxed. It is not fair that some men should be happier than others.“ Oscar Wilde

The parent company, which owns all multinational subsidiaries and which is listed on the stock exchange, is not owned by the individual (so-called high net worth individual or HNWI) directly, but by a personal holding company that is registered in a tax haven, usually an offshore financial center where dividends and capital gains are exempted from income tax.

The personal holding company is owned by a trust (common law) or private foundation (civil law), also registered in a tax haven. The trust (foundation) is a legal person that has no legal owners. The assets of the trust are owned by the trust itself, and the individual (HNWI) is formally just a beneficial owner who is entitled to the benefits of assets held by the trust. What is more, the benefits from the assets (income) are not received directly by the beneficial owner, but the luxury goods (villa, yacht, jet) are owned by an offshore company (owned by the trust) registered in a tax haven, and the individual only uses the goods instead of purchasing them directly. In this way, the value of income received by the individual is even further reduced. In addition, the yacht and private jet used by the individual are registered in a tax haven as well, therefore consumption tax is avoided at the same time.

The trust is also suitable for avoiding inheritance or estate tax, as in the case of death, only the beneficial owner of the property is changed rather than the legal owner. In addition, the wealth of the trust cannot be seized in the form of enforced tax collection.

”Real rich people figure out how to dodge taxes.” George W. Bush

Although the HNWI receives a limited amount of income directly, personal income tax is still not avoided totally.


Income received by an individual from any state in the world is allowed to be taxed by the state of which he or she holds citizenship (USA), or the state where the individual is resident. In the absence of citizenship or residence, states are only allowed to tax the income of individuals originating from their territory, but not their worldwide income. As HNWIs are freely able to relocate their income wherever they want through companies and trusts, they only have to worry about being taxed based on citizenship or residence.

One way to avoid residence-based taxation is to reside in a state where there is no personal income tax (e.g. Monaco). This is known as tax exile and the HNWIs are called tax refugees. The other method is when the HNWI resides nowhere, that is, if he or she lives in a state only temporarily and does not become a permanent resident. These are known as PTs (perpetual traveler/permanent tourist/prior taxpayer).

To avoid citizenship-based taxation, typically in the case of US citizens, the HNWI has to travel perpetually, or has to find a state where there is no personal income tax and which does not have a Tax Information Exchange Agreement with the state of citizenship (USA and Monaco have a TIEA), or has to renounce citizenship.

The most important thing, however, is that HNWIs consume only a minor portion of their income so their income accumulates into wealth. This wealth is invested in securities and the securities are owned indirectly through foreign companies and trusts. As a result, the HNWIs are free to live in their home countries because tax authorities are not aware of the real income (wealth) of the individuals, as has been fully demonstrated by the recent 2008 Liechtenstein tax affair and the UBS tax case.


If the HNWI is not resident in the state, or no longer a citizen of the state (USA), then the state can do nothing. If however the HNWI is a resident or a citizen, then the state can also apply the controlled foreign corporation rule to individuals, and try to tax the undistributed income of the foreign personal holding company owned directly by the individual. The tax information needed can be obtained by the state if there is a double taxation treaty with an information exchange clause or a tax information exchange agreement between the state of residence/citizenship and the state where the personal holdings are located. Within the European Union, tax information exchange is provided for by directives. But information exchange is really only useful if it occurs automatically, otherwise it is very burdensome for the tax authority to request information on a case by case basis, and in the majority of cases the tax authority is totally unaware of the wealth deposited abroad [4]. Currently the major international automatic tax information exchange agreement is the European Union Savings Directive, which is applied not only within the EU, but also in five non-member European countries (e.g. Switzerland, Liechtenstein, Monaco). Dependent or associated territories of ten member states (e.g. Cayman Islands) also apply the system. However, the savings directive applies only to individuals and only to income from interest.

Secondly, information exchange is only useful if the individual owns wealth directly, but personal holding companies registered in tax haven secrecy jurisdictions are in many cases owned by nominees, in addition, a large part of the wealth is owned by trusts and private foundations that have no legal owners.

In the case of personal income tax the overall solution could also be to introduce an international level of taxation to solve the problems described above, and in addition, to provide for social equality on an international scale. Personal income tax should be levied internationally in a centralized manner and public services consumed by world citizens should be provided internationally as well, that is services should be paid for by the central government and they should be provided by participants of the international market.

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