Future of offshore financial centres: the tax question

FATCA and its progeny have spawned a raft of intergovernmental agreements (IGAs) promising transparency to tax authorities around the world. Not to be outdone, prime minster David Cameron is pushing for beneficial ownership registries for the UK, the Crown Dependencies and the Overseas Territories.

New York University’s John Blank and [University of] Virginia’s Ruth Mason argue in a recent Tax Notes article that, taken together, these agreements and laws offer ‘an aspirational new global standard for automatic exchange of information.’ Does this mean the end of offshore financial centres?
No. Critics of offshore financial centres (OFCs), like US senator Carl Levin, the Tax Justice Network, and Oxfam, might wish it were so but the demand for offshore financial services will continue for three reasons.

First, jurisdictions like Bermuda, the Cayman Islands, Guernsey, Hong Kong, and Jersey exist for many reasons unrelated to tax avoidance.
There are certainly tax reasons for some offshore transactions by entities and individuals – as the recent raft of efforts by US corporations to merge with UK and Irish companies demonstrates – but there are also many such transactions that do not turn on tax issues.

For example, Harvard’s non-profit hospital must put its medical malpractice insurer in the Caymans for non-tax reasons since Harvard is exempt from US income taxes.
Second, international trade is facilitated by tax-neutral platforms for aggregating capital – and that capital often flows into the same jurisdictions that are passing laws like FATCA and talking about creating public registries.

For example, Jersey Finance recently published a report by Capital Economics that showed that investment through Jersey into the UK produced £2.3bn in tax revenues each year and supported 180,000 British jobs.

Not surprisingly, Cameron rejected the ‘tax haven’ label for the Crown Dependencies and Overseas Territories in remarks in parliament in June.
Similarly, the US benefits from the billions of dollars of non-resident foreigners’ deposits – $6.7bn (£4bn) in Miami alone, according to one estimate – the interest on which is not taxable under US law.

As OFCs do a better job of documenting those benefits, which they will be able to do as the push for transparency yields new data on financial flows, onshore politicians like Cameron will become more cautious about choking off important sources of investment.

Rule of law

Third, there are many countries around the world where the rule of law is absent or where business law is underdeveloped. Access to jurisdictions that offer sophisticated and honest courts, certainty of legal interpretation, and up-to-date statutory and regulatory frameworks enables businesses to invest in those countries despite the investment targets’ legal systems’ flaws.

For example, considerable investment in to China goes through the British Virgin Islands and Hong Kong while a large amount of investment into African economies flows through Jersey. Investors use these offshore jurisdictions in part because they offer more sophisticated legal systems and better courts. BVI has both respected regulators and an efficient administrative system; Hong Kong’s courts are among the world’s best; Jersey has hundreds of years of precedent behind its trusts law.

These types of advantages both give investors confidence in their legal advisors’ predictions of how possible disputes will be resolved and that unanticipated problems will be able to be addressed fairly.

These smaller jurisdictions are specialists in law and can outcompete larger jurisdictions precisely because they are small enough that winning international investors’ business matters to the local economy. It is no accident that advances in law concerning subjects as diverse as insurance, investment funds, and trusts come from smaller jurisdictions.

The same is true of competition within the US. For example, Delaware’s corporate law is widely regarded as the best in the US and its judges are acknowledged to be among the most sophisticated and respected on corporate law issues.

Winning and keeping the corporate services business matters to Delaware’s economy, and so to its government, in a way that it could never matter to the vastly larger California economy or government. The same is true of OFCs relative to larger economies.

Developing economies

This is critically important to investment in developing economies, which desperately need inbound investment. Suppose a group of investors from multiple countries are seeking to structure an investment into a developing economy.

These investors need to create a vehicle that shares the risks and rewards of their investments, that provides a governing structure that enables them to adjust their business strategy to unforeseen events, and that creates a forum in which to resolve any future disagreements.

This in turn requires a well-developed business law framework governing the type of entity they choose for their venture and an honest, sophisticated court whose decisions are reasonably predictable. In many respects, the role of an OFC in such a transaction is to export the rule of law to places where it does not yet exist by providing rules and decision makers capable of addressing these issues. Moreover, investors want the level of comfort a serious regulator provides.

To meet investor demand, successful OFCs are engaged in upgrading their regulatory capacity, not reducing it.

 

This blog is an extract from an article originally published in Accountancy Live.

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