When Google established its international tax scheme, it followed a path well worn by other multinational companies. The company booked its sales from outside the U.S. at its international headquarters in Ireland. Most of that profit was then sent on to the Netherlands, largely free of tax. From there, the money went on to a well-known tax haven, the sunny islands of Bermuda. By the time the technology giant parked its money there, it had reduced its foreign tax bill to the low single digits. The scheme, known in tax avoidance circles as the “Double Irish” with a “Dutch Sandwich,” helped Google save billions in taxes. Last year, for example, Google registered $4 billion in sales in the United Kingdom, but only paid $10 million in taxes in that European country.

Multinationals and the rich alike have long utilized tax havens from the Cayman Islands to Singapore — territories that collect low or no taxes on international businesses — to hide money and avoid hefty tax bills. Apple, Facebook and Pfizer have all purportedly employed a version of the “Double Irish.” And a study released by the Tax Justice Network in July found that wealthy individuals have stashed between $21 trillion and $32 trillion in offshore accounts. The lower sum is the size of the Japanese and U.S. economies combined. What’s more, analysts see growth in the hedge fund industry, which means more business for tax havens.

But the industry is also under growing scrutiny. Governments, tired of seeing companies skirt tax bills (although it is legal), are cracking down on offshore banks, forcing more transparency into the process. And tax havens themselves have a problem: Not enough tax revenue. Years of failing to levy a corporate and, in many cases, sales and income taxes, have left tax havens with huge debts. For the first time, many of the tried and true places to sock away cash are turning toward new taxes or fees that target foreign money.

“Many tax havens are facing a period of acute budgetary pressure: The Cayman Islands for example has been instructed by the U.K. government, which is responsible for Cayman debts, to impose new taxes,” says John Christensen, director of the Tax Justice Network.

In considering new taxes and fees, the tax havens play a tricky game of balancing the lifeblood of their financial services-based economies against the need to address structural deficits. “These countries have established their reputations and … investors feel comfortable there because they won’t be changing policies,” notes Michael Knoll, co-director of the Center for Tax Law and Policyat the University of Pennsylvania Law School. “If you even appear that you are likely to change course, that could be very dangerous.”

A Double-Edge Sword

The impressive range of companies registered in the Cayman Islands would lead one to believe it’s rolling in cash. Among them are well-known companies like Procter & Gamble, Intel, pieces of Mitt Romney’s Bain Capital and more than 90,000 other companies, hedge funds and investment vehicles. Even the owners of the famed English football club Manchester United chose the British territory when it raised $233 million in an IPO this year.

For companies, the lure is obvious: the Cayman Islands, a set of three small islands in the Caribbean Sea, collects no income, capital gains or other taxes. In fact, after paying a few thousand dollars to register and a few thousands more in annual registration and franchise fees, the government touches very little of the $1.6 trillion that firms and individuals have parked in the tax haven. While government officials and activists have argued the morality of the practice, utilizing tax havens is perfectly legal. Companies also have an obligation to shareholders to minimize tax bills as part of a larger strategy to maximize profits.

It’s no surprise then that the number of companies and hedge funds seeking out tax shelters is on the rise. A report by offshore legal advisors Appleby Group found a 13% increase in registrations in the Cayman Islands and a 10% growth in the British Virgin Islands in the first half of 2012 and a 20% increase in registrations in the Seychelles, located off the eastern coast of Africa, since 2010.

“For hedge funds, we’re seeing an expansion in the industry that we haven’t seen in years,” says Andrew Schneider, president and chief executive of Global Hedge Fund Advisors. Schneider estimates that the industry is growing by between 20% and 30%, which he calls “a double-edge sword. It means more growth for the sector but it also runs the risk of having more unqualified people attempting to manage funds.”

That’s good news for territories like the Cayman Islands, which are seeing more business thrown at the financial services sector, an area that has become key to its economy. But governments in the Cayman Islands and a number of the other most popular tax havens are suffering under growing debts, the product of years of levying hardly any taxes.

The Cayman Islands has seen a decade of rapid debt growth, from around $143 million to roughly $600 million. Ireland, from which companies are able to route profits earned in Europe, has a debt-to-GDP ratio of nearly 105%. Singapore is not far behind at around 101%. In the Seychelles, debt is 83% of GDP.

High debt-to-GDP ratios are not exclusive to tax havens. Even the U.S. struggles with a debt that’s larger than the size of its economy. And the debt travails of European countries like Greece and Portugal have become well known.

But carrying such debt can be detrimental to economic growth. A Harvard University study found countries with debt loads that exceeded 90% of GDP historically have grown more than 1 percentage point more slowly than countries with smaller debts.

Hence, governments in tax havens are considering raising taxes and fees that would target foreign investments. The minister of finance in the British Virgin Islands has proposed increased trade license fees, a requirement for foreign companies, as well as a scaled work permit fee that would charge higher-paid employees more. In the Cayman Islands, the prime minister has proposed increased registration fees for hedge funds, which would bring nearly $3 million more into government coffers. The Bahamas, which only has a debt-to-GDP ratio of 50%, is for the first time considering a sales tax and a corporate tax.

New taxes and fees could eventually drive business elsewhere. “The political logic of tax competition suggests that tax avoiders may well shift to other tax havens that charge lower fees and/or are not planning to introduce a tax on corporate profits,” Christensen notes.

Increased Scrutiny

In some circumstances, the British government is demanding that their overseas territories introduce the taxes because it is ultimately responsible for the debt of those territories and the U.K. itself is struggling with its own debt issues. That demand underscores a larger movement on the part of foreign governments to crack down on tax havens and the companies that use them — even though some of those countries themselves are home to well-known tax havens.

Knoll says that while reducing debt may be one of the reasons behind the proposed taxes and fees, governments like that of the U.S. and U.K. are probably more interested in recuperating missing taxes. “You look at the budgets of these [tax havens] and compare it to the tax revenue that a country like the U.S. is not collecting and [the budgets are] minimal,” by comparison, he notes.

Indeed, a 2011 California Public Interest Research Group study found that tax avoidance costs the U.S. government roughly $100 billion each year, an amount far larger than the debts tax havens have accumulated.

In November, British Parliament held hearings in which members interrogated executives from Amazon, Google and Starbucks for minimizing tax bills. In France, the tax collection agency sent Amazon a bill for back taxes in the amount of $252 million. And the Australian government sent Apple a bill for $29.5 million in back taxes. The companies have said they are only operating under the systems established by politicians and that they pay the required tax in each of the countries in which they operate.

The increased scrutiny could lead companies to turn to low-tax places, such as Ireland, which charges a corporate income tax of 12.5%, rather than no-tax environments. A member of the Bahamas ministry of finance who spoke anonymously because he was not permitted to speak on the record notes that even if the country established its first corporate tax, the effect would be minimal. “If they are paying a corporate tax here, they can go to the other jurisdictions and say, ‘look we are paying here. We are paying taxes,” he says.

What’s more, the fees that tax havens are considering incorporating are so small compared to the amount of assets stashed there, that there is unlikely to be an exodus of companies. “You’re talking very small amount that would be built into the cost of doing business,” says Schneider. “I don’t see it affecting the business.”

A Bigger Blow

What could be a bigger blow for tax havens are new accountability rules. Next year, one of the toughest U.S. requirements on foreign tax shelters will take affect. The Foreign Account Tax Compliance Act (FATCA), passed in 2010 as part of a larger bill, obligates foreignbanks and financial institutions to share information with the Internal Revenue Service.

Under the act, the foreign financial institutions are to share the name, address, taxpayer identification number, account balance and other information for each account holder with the IRS. The institutions have until June 30, 2013, to enter into an accord with the IRS. Avoiding an agreement altogether could be costly for the banks’ shareholders, which could be subject to a 30% U.S. tax on income earned on the accounts.

Analysts say the act helps push the system to more transparency, but it has its limitations. “FATCA is a huge step in the direction of making automatic tax information exchange the effective global standard, but it has the limitation of being a unilateral measure introduced by the U.S., even though it allows for reciprocity of exchange between treaty partners,” Christensen says. “It is now recognized that automatic information exchange is the effective global standard for curtailing tax evasion, and the next step is to make this standard a genuinely multilateral standard involving all countries.”

The British government appears poised to introduce its own version of FATCA, focusing on its territories and dependencies, such as the Isle of Man and Jersey. A draft plan of the legislation was leaked to the magazine International Tax Review. It shows that the U.K. government would demand the same levels of transparency that the U.S. demands under FATCA. “The move will deal an almost-fatal blow to tax evasion through the U.K.’s tax havens,” the magazine concluded.

The Cayman government, in a statement to Knowledge at Wharton, says it has worked in consultation with the financial services industry on new fees and taxes. The government shared by email drafts of the new rules with the industry before making them public. “For the 2012/2013 budget year, the government places a renewed emphasis on expenditure reductions, which have mitigated the revenue measures that are now in consideration,” the statement says. The government already backed away from a controversial plan to levy a 10% tax on expatriate workers after receiving criticism from within and abroad.

The balancing act in the Cayman Islands is indicative of a larger effort on the part of tax havens to raise new revenue while not threatening the business community they host. As Bruce Zagaris, an international tax lawyer for Berliner, Corcoran and Rowe LLP, a Washington-based law firm, puts it: “Every jurisdiction has to look on one hand at gaining more revenue and on the other hand continuing to attract investment that produce more jobs and more revenue.”