How uneven regulation and financial innovation fuel tax abuse

Every year, governments around the world lose between $100bn to $560bn to tax abuse, or what is known as aggressive tax planning (ATP) in the corporate sector. Historically, most of these estimates have been accounted for by trade-related practices of tax abuse.

This has left the vast and evolving area of financially enabled ATP practices overlooked. And yet the amount of tax avoidance perpetrated by the use of sophisticated financial structures has reached $100bn a year in the US alone. As part of a grant by the EU’s Horizon 2020 research and innovation programme, we set out to investigate whether the same applies to Europe. 

Adding opacity

Generally, financial derivatives help to shroud transactions in layers of opacity and conceal the identity of the assets, the type of income and the purpose or timing of a transaction. Derivatives are also uniquely dynamic and notoriously hard to regulate. In particular, synthetic instruments – derivatives constructed out of other derivatives – are an example of a product that can evolve despite, or rather in response to, the rollout of new regulations. Synthetic structures especially complicate the taxation approach needed, a process that is difficult even when applied to most basic economic operations. 

One popular tool used historically in the US – but now more widely offered in Europe too – is a derivative structure known as a total return swap (TRS). TRSs work by swapping a set rate for a payment based on the performance of an underlying asset. The asset, in turn, normally includes both the income it makes and the capital gain it accrues.

From a tax perspective, TRSs enable a double whammy. First, parties to the TRS can claim that the money received constitutes capital gain rather than investment income; in most jurisdictions, this results in a lower rate of taxation. Second, the firm may round profits through offshore entities using TRS structures, in exchange for a fee, which in turn can be tax deductible. 

Regulatory response

The financial crisis of 2007 to 2009, as well as scandals such as the Panama Papers or the Paradise dossier, shed some light onto swap-centred arrangements of tax abuse. But the attention of the regulators has been uneven. Here, just like in many other areas of financial regulation, authorities in the US have been faster, sharper and more effective than their EU counterparts in identifying and regulating ATP generally. Part of post-2009 regulations in the US now target the derivatives-enabled gaming of the system, which has made the deployment of TRS structures more difficult.

Europe seems to be falling behind in the regulatory cycle. There has been at least one attempt to dispute a TRS-based tax scheme involving a Swiss bank. In the UK, the problem is known – although so far not much has been done about it. Despite the global campaign against tax havens, many jurisdictions maintain regimes that keep gains from securities disposal tax-free.

In addition, as the system adapts to the tighter post-2009 rules, new opportunities for regulatory avoidance enabled by products such as TRS are being discovered. Worryingly, it seems that the regulatory gap between the US and the EU is encouraging further use of sophisticated financial innovation not only for tax avoidance, but also for other types of regulatory arbitrage throughout Europe. 

New battle lines

In Europe, the use of TRS structures has expanded in the market for investment-grade and high-yield corporate debt. Between 2013 and 2017, the monthly trading volume for euro- and dollar-denominated additional Tier 1 bonds – that is, equity debt designed to take first loss in case of distress – has increased fourfold to $12bn. In parts of the financial market, TRS structures are being used to bypass post-2009 leverage and funding rules.

It appears therefore, that as progress is being made in the areas of tax justice with initiatives such as the Organisation for Economic Co-operation and Development’s base erosion and profit shifting, or BEPS, and project-by-project and country-by-country reporting, a great new battle is opening up between the financial industry and the regulators, which is likely to centre on financial innovations and financial engineering that enable tax and regulatory abuse.

To be able to deal with this upcoming fight, European regulators will need to bring themselves up to speed with recent and ongoing developments in this rapidly changing industry – and rethink the siloed approach to business regulation that has been a structural challenge for the EU. 

Anastasia Nesvetailova is director of the City Political Economy Research Centre at London's City University and Ronen Palan is professor of international politics at City University.