In the weeds of Congress’s deliberations on tax reform is a provision that could help balance relations with one of the United States’s most significant trade partners — Bermuda.
The international trade regime has no shortage of cheaters and free-riders. But Bermuda stands in a league of its own in its use of tax loopholes to rob the United States of investment and jobs. How the House and Senate resolve their differences over the so-called “Bermuda Loophole” could help address a trade imbalance exacerbated by three decades of misguided tax laws.
In a report published late last year, Oxfam gave Bermuda the dubious distinction of being the world’s worst corporate tax haven. This was before the leak of the Paradise Papers, which revealed that major corporations like Apple and Nike were avoiding taxes through Bermuda-based subsidiaries.
The issue is not simply that Bermuda has no corporate income or withholding taxes, or that it refuses to participate in an array of multilateral transparency initiatives. The problem, in many ways, is the byproduct perverse incentives in the U.S. tax code that transnational corporations and the government of Bermuda are only too happy to exploit.
The migration of the U.S. insurance market provides a case in point. Bermuda has not levied direct taxes on corporate profits since 1966. It was not until the U.S. tax reform legislation of 1986, however, that the United States witnessed a flight of its insurance companies to the island. This was a period when offshore financial centers were on the rise and tax havens, in Ronen Palan’s words, were becoming “the heart of globalization.”
An unintended consequence of the 1986 tax reform was that it enabled foreign-based insurance companies to avoid taxes by shifting their profits from U.S.-based businesses to foreign affiliates abroad. Bermuda-based insurers are now paying an effective rate of less than 10%.
Since the loophole was created nearly three decades ago, the share of U.S.-based insurers in the U.S. insurance market has declined from 85% to 27%. Those that remain are largely older companies whose other tax requirements preclude an offshore strategy.
What’s more, by avoiding U.S. taxes, foreign insurers, mostly based in Bermuda, gain an advantage in raising capital to buy out U.S. insurance companies, thus leading to an exodus of businesses and high-paying jobs from the United States. Compared to 15% in 1989, 60% of the top reinsurers by premium are now foreign-owned, and in recent years, foreign companies have accounted for almost every acquisition of an American insurer.
What should in theory produce better goods and services for consumers does nothing of the sort in the real world. Foreign insurers simply lack the market share necessary to orchestrate a unilateral price increase in insurance markets.
A 2017 report from the insurance journal Dowling & Partners found that foreign-owned groups play a minuscule role in catastrophic coverage of U.S. coastal markets. The study determined that closing the Insurance Tax Haven Loophole would have no meaningful impact on the catastrophe market, which is based largely in Bermuda.
This is not surprising. As the largest reinsurance market, insurers want to do business in the United States. A tax on reinsurance profits ceded to foreign affiliates is hardly enough to deter foreign insurers when their U.S.-based competitors are paying the same rates. Nor would it impact capacity in the market given that affiliate reinsurance, unlike third party reinsurance, is simply a tax avoidance mechanism that does little to actually shift risk to unrelated parties.
What the loophole does do is shrink the market for tax-exempt financing, depriving states from funding for local infrastructure. When foreign insurers engage in “income stripping,” they do not buy tax-exempt municipal bonds. This, among other reasons, is why the United States would lose an estimated $10 billon over the next decade if the loophole isn’t closed. It’s one of many examples that vindicate former Treasury Secretary Larry Summers’s assessment that corporate tax shelters are “the most serious compliance issue threatening the American tax system.”
Little wonder that 85% of Americans are frustrated by corporate tax loopholes.
None of this matters to Washington’s free trade zealots. The same wonks who created this mess in the first place now maintain that closing the Bermuda Loophole would amount to “special interest trade protectionism in the tax code.”
Never mind that closing the loophole would not privilege American companies. It would simply level the playing field to ensure that U.S. and foreign-based insurers are subject to equal tax treatment. And it would do so in a way that is entirely consistent with U.S. tax treaties and trade obligations.
The good news is that the Senate Finance Committee included in the initial draft of its tax proposal strong language to close the loophole. Whether this proposal makes it through the negotiating process, however, remains to be seen. Similar language on the House side was watered down by the time of the final vote.
Fixing the imbalances produced by tax havens in Bermuda and elsewhere will be a long process requiring far-reaching legislation.
Closing the Bermuda Loophole, however, is an important step—one that will focus attention on an issue that Congress has ignored for far too long.