First, let's classify countries geographically. If you look at a map of the world and then look at the tax rates of most countries, the small countries -- typically islands -- have low to non-existent tax rates. The reason is actually pretty simple: they have small populations and small geographic areas. Hence, their need for tax revenue is greatly reduced (they don't have a social safety net to pay for and they don't have a great deal of infrastructure needs). This is why the islands in the Caribbean have become tax havens -- a development made far easier because of electronic banking. And when low tax rates are combined with bank-secrecy laws, an entire industry is now born -- offshore banking.
The creation of these tax havens led to a new type of international tax structure utilized by most major multi-national companies: the hub and spoke system. The "hub" is typically a company incorporated on one of these island nations which receives incoming payments and stores them in bank accounts. The "spokes" are payments from higher tax countries to these small islands, usually in the form of dividend payments, interest payments, royalty payments or payments based on some type of transfer pricing structure.
However, this structure can run into trouble when it comes to cross-border payments -- payments that move from one country to the other. Typically, the country where the payment is coming from has a fairly hefty tax at the border, largely because this is the last time that jurisdiction will get a bite at the apple. Hence, companies look for ways to lower the tax bite on these cross-border payments.
This is where the concept of tax treaties comes in. A tax treaty is signed by two countries for several reasons, one of which is to provide a maximum rate of taxation on cross border tax flows. For example, a tax treaty between two countries will state that the most country X can tax a cross border dividend payment is 5%. The purpose of signing these treaties is to create certainty for taxpayers (they have a fairly clear idea up front of what the tax rates will be) while increasing cross border transactions (lower taxes can increase capital flows). The first model tax treaty was written by the OECD and published in 1963. Several revisions have followed. The US also has a model tax treaty as does the UN. However, there are really very few meaningful differences between the three; the OECD is still considered the model treaty from an international planning perspective. (If you're interested, I have a power point presentation on tax treaties here and a video presentation on tax treaties here).
Now --suppose the following:
- we could form a small island country
- with a small population
- that had an extensive tax treaty network (to make cross border transfer payment easier),
- a low rate of corporate taxation (10%),
- a first world governmental structure (for political stability), and
- that was located next to a large region that was also one of the most populated areas with a high standard of living?
And that is how Cyprus became an international banking center.