Panama Papers: Was Mossack Fonseca within its legal rights to keep mum?

The leak of documents from Panamanian law firm Mossack Fonseca has set the cat among the pigeons around the world, from the Kremlin to Downing Street and Beijing.

A major question to emerge from the Panama Papers revelations is: Is setting up firms in offshore tax havens legal?

It is legal and even common for companies to establish commercial entities in different jurisdictions for a variety of legitimate reasons. These include cross-border mergers and acquisitions, estate planning, restructurings, bankruptcy and for reasons of personal safety.

It could also be done to pool the investment capital from investors residing in different jurisdictions who want a neutral legal and tax regime that does not benefit or disadvantage any one investor.

What does South African law say about this practice? Under this country’s law, there are different types of residents – for example, a “resident” as defined in terms of the so-called physical presence test, and an “ordinary resident” as defined in terms of common law.

One of the key tests of physical presence is having a local office and staff members to answer phone calls and so on. This has resulted in the mushrooming of virtual offices globally.

If a foreign company renders professional services to a South African company, it is important that the foreign entity considers whether this will result in it creating a permanent establishment in South Africa.

Where this occurs, under the provisions of a double taxation agreement concluded with another country, South Africa will be entitled to subject that foreign entity to tax on the profits of its South African operations.

Currently, the corporate tax rate is 28% of taxable income derived from a company’s South African branch. The distribution of profits by local branches of foreign companies is not subject to the normal 15% dividend withholding tax. There is no further tax payable on the remittance of South African branch profits offshore. These profits will have been taxed in South Africa. Nonresidents are subject to capital gains tax at an effective rate of 18.6%.

Bad practice
In Panama, the standard corporate tax rate is 25% of net income and the standard “branch” tax rate is 25%, with an additional 10% imposed after “branch tax” income.

Businesses in Panama are regulated by several oversight and enforcement agencies. Furthermore, firms are expected to comply with international protocols such as the Financial Action Task Force on money laundering and, more recently, the United States’s Foreign Account Tax Compliance Act, to try to ensure that the companies being incorporated in foreign countries are not being used for tax evasion, money laundering, terror financing or other illicit purposes.

In addition, the country’s lawyers are required to know the client and have enough information to identify him or her. “Knowing your customer” includes verifying the identity of the client and the beneficial owner during the due diligence process before starting to work with them.

Therefore, when one of the directors of Mossack Fonseca said that he could not possibly know all 300 000 of the firm’s clients and that he just set up the companies and did not know what they do as individual businesses, it painted the values of his practice in a bad light.

The practice of law is not a processing plant. You cannot just process documents for people you are not in a relationship with.

Moreover, lawyers must also comply with the following client due diligence requirements: retaining records for at least five years, reporting transactions that arouse suspicion, reporting any cash transactions that exceed the stipulated threshold, monitoring transactions on a weekly basis, and monitoring account holders’ transactions on a biannual basis.

In any event, the new obligation imposed on all legal entities by Panama’s amended Commercial Code – to keep updated share registers for nominal shares, subject to penalties for noncompliance – is sufficient to ensure the availability of ownership information.

One may conclude that legal entities in Panama are obliged to comply with “know your client” policies and client due diligence measures to verify the identity of clients or beneficial owners. This is to help authorities ensure that foreign companies are subject to Panama’s tax laws.

Mossack Fonseca was legally and practically limited in its ability to regulate the use of companies it was incorporating or providing services to, considering the sheer number of companies involved. However, the law firm was obliged to gather all the necessary information from its clients and report unorthodox-looking transactions.

One needs to emphasise that the only legal obligation on the law firm is to know the identity of its clients and to report any illegal activity. There is no obligation to report that “Mr so-and-so” registered a company in Panama. To expect this type of reporting obligation from lawyers would stifle proper tax structuring, and would compromise the constitutional principles of the “right to trade” and the “right to privacy”.

The leaking of the Panama documents may be embarrassing and have political consequences in some countries, as happened when the prime minister of Iceland was forced to resign – but it was absolutely not illegal, unless criminal activities were committed with the full awareness of the law firm in question.


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