The sensational leak of the Panama Papers has created significant international controversy with names of both the wealthy and famous being linked to entities established in tax havens—jurisdictions known for preferential tax regimes.

As expected (or intended), the leak has initiated a wide range of regulatory investigations that are now underway across much of the world. The investigations are mounted to evaluate whether the named individuals have actually committed criminal offences, such as money laundering or tax evasion; because merely conducting business in a tax haven is not illegal. In fact, there are numerous legitimate reasons to do so, including the provision of certain organizational and tax advantages for companies, funds, trusts, and individuals.

A tax haven is generally defined as a country, state, or territory that offers foreign individuals and businesses little or no tax liability in a politically and economically stable environment. Many also offer much needed privacy for sensitive transactions, and in some cases strict confidentiality—they may provide little or no financial information to foreign tax authorities. Tax havens allow individuals to reside elsewhere, while operating out of the tax haven in order to benefit from its tax policies and privacy laws. The fact that some individuals choose to exploit the confidential nature of tax havens to conceal assets, launder money, or evade paying a fair share of tax in their home countries is, however, a crime. As such, law enforcement around the world has stepped up efforts to contain the criminal use of tax havens, where the consequences of a conviction can result in hefty regulatory fines or prison sentences.

Notwithstanding the criminal connotations of financial secrecy and tax avoidance typically associated with the term “tax haven,” the label is not necessarily accurate. For example, some tax havens have no statutory bank secrecy and many have agreed, or at least acknowledged their intent, to implement tax information exchange protocols recommended by the Organization for Economic Co-operation and Development (OECD) and endorsed by the Group of Twenty (G-20) and the European Union (EU). Known as the Common Reporting Standards, or CRS, the agreement establishes a standard of transparency in the exchange of information between committed countries. Essentially, it allows foreign countries to investigate suspected tax evasion in signatory jurisdictions.

Starting an offshore business without proper understanding of the legal and regulatory obligations can cause a serious risk for any investor. Consulting legal counsel on company formation, tax, and international banking issues, when considering offshore investment, is advised. This article looks further into key issues, briefly discusses the disclosure obligations of taxpayers, and offers tips on how to manage regulatory investigations, should they arise.

Bane of our times: Tax evasion, not tax havens

Tax evasion is a crime in all jurisdictions. Diverting focus away from that fact and placing Panama under scrutiny, alone, is short sighted. Panama is just the tip of the iceberg. Wherever there exists a promise of iron clad confidentiality, criminals may be found stashing illicit gains or evading taxes.

There are currently 98 identified offshore jurisdictions—tax havens—which range from Andorra in the Catalan region of Europe to Vanuatu, a Pacific island nation, and from Delaware, USA, to many Caribbean countries and territories. Although certain countries, states, and territories are cooperative in exchanging tax information when law enforcement inquires are made, with so much offshore finance taking place around the world, it is highly probable that many jurisdictions other than Panama are holding illicit funds but have not yet been exposed. In fact, some of the previous leaks such as the Cayman Islands tax leak in 2013 and the great HSBC leak reveal that the problem of tax evasion is not exclusive to any one jurisdiction or type of entity. That the electronic documents stolen from the Panama-based law firm, Mossack Fonseca, name several current or former heads of state from developed economies, and even more people linked to current or former world leaders and governments, it is safe to say that the use of offshore financial centers is widespread.

The implications of the leak are also relevant to financial institutions. The Panama Papers names some well-known international banks that facilitated the establishment of offshore companies as part of their wealth management services for clients in Panama. This alone is not a problem, however, it is incumbent on financial institutions to have adequate preventive measures in place, such as suspicious transaction reporting to prevent fraud. In this regard, it is important to note that Panama has taken significant actions to improve its financial transparency over the past two years. The intergovernmental Financial Action Task Force has even applauded its progress in combating money laundering and other kinds of fraud.

From the perspective of Panamanians, Panama is one of the most favorable—and oldest—offshore jurisdictions in the world. Dating back to the 1920s, it is particularly well known for its role in the financial services sector, which includes offshore banking and ship registration. In fact, Panama is one of those exceptions mentioned earlier that does not meet the OECD’s 1998 definition of a tax haven. As defined by the OECD, a tax haven possesses these traits: (1) no or nominal tax on the relevant income; (2) lack of effective exchange of information; (3) lack of transparency; and (4) no substantial activities. To be clear, Panama has no special regime differentiating between locals and foreigners. It imposes tax on activities performed in Panama, and provides certain tax benefits to both national and foreigners alike, if the activities are performed abroad.

While additional reforms need to be implemented by Panama to meet the highest standards of law enforcement and policy making, this need is not exclusive. Other offshore jurisdictions in the world are more lax. Yet, with governments increased focus on tax evasion, investors should bear in mind that one cannot hide ill gotten gains or tax liabilities behind any jurisdiction without accepting the fact that they are at risk for not only paying hefty fines, but also incarceration should they be caught and convicted.

The inherent risk of tax havens: Avoidance vs. evasion

The Panama Papers have shown that it is critical to comply with legal and regulatory obligations for taxation and demonstrate proper disclosure as required by law. In this context, it is important to recognize the difference between tax evasion and tax avoidance. Tax evasion constitutes an act outside the law and tax avoidance is considered an act within the law. An example of tax evasion in the U.S. is when an individual hides income in a foreign bank account in a manner that is clearly not allowed by U.S. tax law. In this case, the taxpayer is a tax evader. Tax avoidance, however, can be simply described as arranging one’s affairs to minimize taxes in a manner that is consistent with the law.

The distinction between tax avoidance and tax evasion, however, is not clear cut and can be notoriously fuzzy. Furthermore, the OECD in its fight against harmful tax practices has not sought to draw any clear or marked difference between evasion and avoidance, and has actually clarified that both can be treated as one homogenous subject. The ultimate test of whether offshore tax planning is legal should be based on what the home country legislation says about it and how it will be interpreted by the courts. It is, therefore, critical for taypayers to have a clear understanding of tax law in their home countries and seek advice from a tax attorney to preclude any illegal behavior on the tax front.

Disclose voluntarily: Concealment tactics under attack

The concealment of financial information from taxing authorities facilitates only illegal activities—tax evasion—not necessarily tax avoidance. But, if the Panama Paper scandal has taught anything, it is to fully disclose financial details, including any offshore investments, to tax authorities. While many investments in Panama may have been completely legal for avoidance purposes, the leak exposed some worrisome links to other prohibited activities. For example, one British company reportedly used a secret offshore finance company to help North Korea expand its nuclear weapons program. This use clearly defies sanctions against North Korea held by countries such as the EU and U.S., among others.

Through the use of tax havens, it can be possible to hide the true owner of money and assets, conceal the source of the money, and avoid paying any tax. If any of these apply, the best course of action is to make a voluntary disclosure to the tax authorities. Voluntary disclosure may lead to reduced fines and possibly mitigate any criminal liabilities in certain instances. As a general rule, the sooner one discloses potentially illegal offshore operations, the better. Forthright and timely disclosures are always critical to minimize risks and possible legal ramifications.

Under investigation: Everyone is suspect

The  individuals named in the Panama Papers should expect amplified scrutiny and investigation given the current circumstances. Many countries have already started investigations into those named in Panama Papers. Unfortunately, even those operating within a legal framework can be suspected of illegal operations initiated in Panama, including legitimate investors. The investigations are, by default, attempting to determine whether there is any evidence of tax evasion or other violations of law. Therefore, all offshore investors—even beyond Panama—should be prepared to address the background and nature of their operations, eventually.

A company or individual under investigation will be required to provide financial information and records related to the offshore business. Information technology equipment, such as computers, laptops, and company servers may also be examined. It is therefore advisable for any one doing business offshore to conduct a review of their affairs and have a strategy in place to deal with an investigation. While there may be reasons to proactively engage with a regulatory body in advance of an investigation as mentioned above, one should always seek advice from a legal counsel before proceeding. Your counsel can determine the subject of inquiry, conduct a compliance audit, and also advise on any available legal remedies.

Plugging the leak: What does the future hold?

Although the long term impact on Panama as a desirable offshore jurisdiction is yet to be seen, the potential for illegal activity within any offshore financial center is generally acknowledged, world-wide. There is even speculation that the Panama Papers will mark the end of offshore investments. This seems highly unlikely, however, as offshore investments have existed for nearly 100 years and have been particularly ideal for certain types of entities such as insurance and re-insurance companies. And we can expect that more offshore jurisdictions will make changes to their legal frameworks to become compliant with the international standards of good governance, including the implementation of the CRS.

Fifty-five countries, states, and territories have committed to the first exchange of information under CRS in 2017, with 47 having passed specific legislation for implementation, as of April 18, 2016. For investors, this means that regulatory investigations, including on-site inspections and audits, will increase. Therefore, a sound understanding of tax law and the implications of illegal activities should be known. Equally important is to be prepared to answer any enquiries from regulators and ensure all corporate and financial records are well ordered and easily accessible for inspection. Advance disclosure of one’s offshore operations may also be advised. Financial institutions can minimize risks through preventive measures. Needless to say, in the event of a regulatory investigation, legal advice should be immediately obtained.