The fight against tax avoidance and tax evasion has often been compared to a whack-a-mole game, while the players make continued efforts to update regulations, the moles constantly search for new loopholes to bypass them.

What caused the emergence of tax avoidance schemes? How did we arrive at this point? What efforts are being made in the European Union to counter them? And what is the impact of new regulations on individuals and businesses in the European Union?

Introduction

Fighting tax avoidance has become a never-ending process of introducing new legislation immediately met with new schemes or loopholes, as shell companies are frequently used to wire money outside the local jurisdictions. Even so, despite the challenges of tracking money beyond the borders of the European Union, progress is still being made and integration between EU member states has helped in attaining the upper hand on the fight against tax evasion. Ultimately, the objective is to track money effectively to link assets with their owners and to verify that the proper taxes are paid in an effort that includes not only addressing tax evasion but also the fight against criminal activities like drug trafficking, organized crime operations, and even terrorism.

The OECD Model:

To understand the current situation it is useful to look back at 1963, when the Organisation for Economic Co-operation and Development (OECD) was expanding its scope beyond Western Europe to include other developed countries. Since 1992, members of the organisation have taken part in creating the “Model Tax Convention on Income and on Capital”, a treaty which initially focused on avoiding double taxation between nations and providing a common legal framework for bilateral agreements that regulated taxation in multiple countries. Since then the treaty has grown to a staggering size, with more than 2600 pages, and it now includes the positions of states outside the OECD.

The increased cooperation and shared information on taxes among nations has made it more difficult to hide money effectively while prompting tax avoiders to move funds through countries unaffected by such agreements. For them, the scheme is rather simple from a superficial view: transfer money to nations with favourable taxation laws, anonymize it by passing through bank accounts in nations with strong bank secrecy laws (like Switzerland), and finally return the money to the original owners through nations that do not withhold taxes on cross border payments (like Ireland, the Netherlands, and Luxembourg).

Since the 1992 agreement, the creation of financial technologies and online transactions has favoured the exponential growth of such schemes. On the other hand financial regulations have lagged behind in the integration of the international financial sector, with the emergence of grey areas. With large multinational corporations making use of those grey areas to increase their profit margins and competitiveness, several ‘tax haven’ countries have become progressively reliant on such schemes for their own national spending, and they became major financial centres thanks to their relaxed regulations.

A Turning Point: The Panama, Paradise, and Pandora Papers:

Such symbiotic relationships between tax havens and corporations have favoured the use of shell companies (companies which exist only on paper with no offices or employees) by generating specialized agencies to set them up. Despite its secrecy, the scheme was eventually brought into the limelight in April 2016 with the release of the Panama Papers, a leak of 2.6 terabytes worth in documents exposing details of offshore financial accounts spanning more than four decades, detailing the involvement of numerous politicians and major corporations.

Many individuals were apprehended with the ensuing investigations caused by the Papers, both for simple tax evasion and for other crimes. By simply considering the financial activity detailed in the Papers, Europol declared that it had found more than three thousands matches with criminal activities which included more than five hundred related to Eastern European criminal gangs, 99 related to drug trafficking, and more than one hundred related to Islamic terrorism investigations.

Yet, despite the incredible amount of data and its subsequent impact, it is worth remembering that the Panama Papers only revealed the client information of a single offshore financial service agency: Mossack Fonseca–only the fourth largest in the world providing such services. In fact, by November 2017, a similar leak rocked the financial world, this time named the Paradise Papers. In 2021 an even bigger leak was published, named the Pandora Papers, overtaking the Panama Papers as the biggest leak of reserved documents ever.

In many respects, 2016 changed the game. Before then the existence of tax avoidance schemes was known but public opinion seemed not as concerned with the issue as it has proven to be in the last seven years.

However, the Panama Papers put in evidence that the necessity for reforms to tackle the issue was overdue. Though attempts to subdue the problem were made prior to 2016, such as when the US Obama administration publicly addressed the matter by getting some tax havens to provide additional information, the issue remained far from being solved. Still, absence of effective solutions are not primarily due to a lack of resolve by the political leadership, but it is instead caused by the inherent nature of the problem which requires full international cooperation and commitment.

New Momentum: The Anti-Corruption Summit of 2016:

As mentioned beforehand, the Panama Papers indeed represented a shift in pace for addressing tax avoidance and tax evasion. With high-profile names involved, that process finally reached the public eye. It gained the political will and traction it needed to adjust regulations at both the national and international level. This was made evident during the UK’s hosting of the Anti-Corruption Summit in May 2016, just a month after the Pandora Papers’ release. Ironically, the Pandora Papers even forced David Cameron (at the time Prime Minister of the United Kingdom) to admit that he had received at least £30,000 thanks to his father’s investments mentioned in some of the documents.

Despite this, or perhaps thanks to it, the summit achieved ambitious international commitments which are still being implemented to this day, raising further vital media attention on the topic. Tracking the process of these commitments is possible on: https://www.anticorruptionpledgetracker.com/explore-regions/

Nevertheless, the convention still suffered from one of the biggest difficulties in fighting tax avoidance, the very same that limited past efforts: limited international cooperation. With only 43 countries present, vast areas of the globe were not affected by the ambitious agreements achieved at the summit, making it possible for tax evasion to simply change route and still, with some additional difficulties, anonymize the process. What is more, even the summit’s participating EU members failed to present a united body of statements and commitments. This diversity in regulations has led to great difficulty in implementing practices that are effective on the international stage.

Even though 2016 was 7 years ago, new legislation has taken time to find traction, requiring cooperation of all countries to reach full effectiveness. Though progress was indeed accomplished, the relative achievements in the immediate aftermath was too little to make a real difference. Furthermore, it is not as though regulations were not in place prior to the Panama Papers. Take the EU for example: in 2011 it had passed a directive on an administrative cooperation in the field of taxation and in 2015, the Anti-Money Laundering Directive was already in its fourth incarnation. In 2013, even the OECD had launched a tax plan to address base erosion and profit shifting (also known as BEPS). This shows how the world was and still is in the process of implementing an effective solution to this problem, but after 2016 this process greatly picked up pace.

The EU’s Renewed Fight Against Tax Evasion and Avoidance:

Following the various leaks, it became evident that such regulations would not be enough, prompting some countries like Germany and France to individually updating their regulations on the use of shell companies. Still, despite strict new regulations, they continued to be relatively ineffective since transferring money to other EU countries allowed to then move it to a shell company in a fairly simple way. The evident need for pan-EU policies to address shell companies led to establishment of the Unshell initiative along with a renewal of the ATAD (Anti Tax Avoidance Directive), passed in 2016. Of course, considering tax haven countries often have a vested interest in preventing full transparency in such matters, other lines of attack have been put in place, targeting those facilitating tax evasion and creating the SAFE initiative (Securing the Activity Framework of Enablers)

Following some changes and extensive discussions, the latest version of the regulation is finally in the process of being approved, with its introduction planned for January 2024. The new regulation will use a number of metrics to identify shell companies in order to prevent their misuse. At any given time it will use data from the last two years to evaluate companies. Considering that it was just approved it is unlikely that businesses will have enough time to be in line with the new regulations before January 2024, so this date is likely to be postponed. Even so, change is coming, and for businesses that are at risk of following short of the requirement thresholds, this will mean serious consequences.

As outlined in the regulations, thresholds will be installed to measure a company’s likelihood of being a shell company: the type of revenue, the cross-border nature of the business, and the management and administration.

In more detail, businesses will thus have to comply to the following criteria: no more than 75% of a company’s revenue should derive from passive income (like dividends, royalties, insurances, rent, etc.), no more than 60% of the value of a company’s transactions should occur between borders, and management and administration should not be outsourced to a third party.

Companies that will not pass those criteria will be considered shell companies or they will have to contest this decision by providing additional documentation. If they are unable to do that financial institutions like banks and investors will be banned from interacting with the company. 

The Consequences: Are Such Policies Worth It?

Unsurprisingly, the EU’s measures have received their fair share of criticism. The reality for businesses is that failing even one of these thresholds may lead to judicial action taken against them through a new concept called the ‘presumption of substance’. Therefore, if a company does not pass all three thresholds, the EU may consider it a shell company. Though this presumption can of course be challenged in court, it would inevitably bring some additional costs primarily affecting small businesses. Moreover, penalties for being considered a shell company can be very harsh, possibly leading to the business’s prohibition to have relations with financial institutions, such as using services offered by a bank.

By prohibiting a company from accessing credit as a penalty of being considered a shell company, a business might rapidly become insolvent. All international businesses will have to be wary of these new regulations, and even if this won’t directly affect the average consumer it may force smaller businesses to employ advisors in order to ensure compliance. The regulation will therefore likely lead to an increase in operational costs. It is improbable that this will have a big impact on large companies but it may implicate higher costs on small businesses, leading to more difficulty in conducting business both inside and outside of the EU; an example being small businesses operating in the UK and the EU.

Conclusion

The question remains if such a reduction in tax avoidance will be beneficial enough to justify these upcoming difficulties. Considering that billions of euros are flowing tax-free and being smuggled out of the EU, the potential definitely exists for the regulation to be considered ‘worth it’. The real answer to the question depends on how effective such new measures by the EU prove to be. Much of that will depend on the implementation by single states, but what we can say for certain is that the fight against tax avoidance will not come to a definite close in its response. We can only hope that these measures will be a step forward in the establishment of a more balanced playing field among businesses and individual taxpayers.