In Defence of Offshore

Drawing attention from the real problems by villainising offshore regimes

MATTHEW FEARGRIEVE, PARTNER, MOURANT DU FEU & JEUNE

The annus horribilis of 2008 brought home to offshore financial centres big and small the fact that they were as vulnerable as ever to the bully tactics that bruised economic powers tend to deploy after they have taken a knock. Hence the protestations of Obama and Brown (echoed in quick succession by Sarkozy, Merkel and others) about tax havens and the need to teach them a lesson. The anti-offshore rhetoric mounted in the lead-up to the G20 Summit in April 2009, with reform of offshore jurisdictions being promised in many quarters.

The outcome? Why, an OECD list of course, this time ranking countries according to the extent to which they had implemented the OECD’s tax information exchange standard. Those countries having at least 12 tax information exchange agreements (TIEAs) compliant with the OECD standard were considered to have `substantially implemented´ it, whilst those countries falling short of 12 but otherwise showing willing were considered to have `committed´ to it. Then there were those countries that had not demonstrated any commitment to it. In effect, the OECD had white-, grey- and black-listed the selected countries. The US, UK, France and Germany were amongst the inhabitants of the white list, alongside some surprise entrants like China, Russia and South Africa (one can only guess the backstage political wrangling it must have taken to get them there). The black list of baddies was populated by Costa Rica, Uruguay, Malaysia and the Philippines. The grey list of dawdlers, split intriguingly between what the OECD asserted were `tax havens´ and `other financial centres´, included the world’s leading offshore hedge fund domiciles, the Cayman Islands and the British Virgin Islands.

At the time of the G20 Summit, there was a real anxiety that offshore financial centres (OFCs) should be part of a global solution to a global crisis and not permitted to remain aloof, and this anxiety found expression in traditionally the easiest means of exerting pressure on OFCs: compliance in matters relating to sharing of tax information. Fair enough? Well, almost. The exercise tellingly ignored two basic truths: first, that OFCs were not central to the financial crisis; secondly, that many of the OFCs being impugned already had in place significant TIEAs and other forms of cooperation treaties. More significantly, the exercise was tangential to the central thrust of the G20 Summit, namely that financial institutions (including hedge funds) needed better regulation.

In this departure one may detect the real agenda of the OECD’s political masters. Their financial services regulators have failed. Global recession has ensued. GDP and tax revenues have fallen, and growth is either negative or weak. OFCs are perceived as boltholes in which taxable monies can be secreted by wealthy individuals and institutions. Stigmatising them as ‘tax havens’ is both an easy piece of scapegoatism and a vote-winner for economically and politically embattled governments. This response relies on some flawed premises. This article looks at four of them.

1. OFCs are objectionable because they are low- or zero- tax jurisdictions
Why should OFCs not enjoy the same tax sovereignty prized by larger nations?

2. OFCs facilitate tax evasion
A White House press statement issued in May 2009 exemplifies the sort of tendentious rhetoric traditionally directed at OFCs, particularly in downturns: “Some countries make it easy for US taxpayers to evade or avoid US taxes by withholding information about US-held accounts or giving favourable tax treatment to shell corporations created just to avoid taxes: in the Cayman Islands, one address alone houses 18,857 corporations”.

Note the oblique reference to US tax enforcement. The reality is that OFCs do not aid or abet those who find ways of getting around domestic tax laws, nor do they obstruct or prevent the charging of taxes outside their territories. They are, however, entitled to presume that domestic anti-evasion laws in other countries are effective. Nonetheless, OFCs assist other countries in enforcing their own laws by agreeing with them to share information relating to criminal or civil tax matters, and by providing other means of assistance. Many were doing this well before the OECD drew up its list. The Cayman Islands have been doing this with the US for years.

The reference to shell corporations is pure political rhetoric, and cannot conceal the inconvenient truth that the registering of legal entities in OFCs is no materially different from the functionality provided by certain tax efficient states to the rest of the US, like Delaware (home to some 600,000 brass plate corporations and pervasive secrecy practices).

The Stop Tax Haven Abuse Act in the US, co-sponsored by Obama in 2007 and now being championed by Senator Carl Levin, is making its way through Congress in the form of a bill. In recent drafts, the bill:

• gives the US Treasury powers to penalise jurisdictions it deems are impeding US tax enforcement.
• requires additional filings from financial institutions and withholding agents in relation to US persons with connections to any one of 34 `Offshore Secrecy Jurisdictions´ (the list includes most of the key OFCs worldwide); the Treasury may add jurisdictions with `secrecy laws´ that are deemed to impede the IRS from obtaining information.
• contains a requirement (clearly in need of clarification) for US persons to provide the IRS with information relating to interests in passive foreign investment companies.
• treats non-US companies as domestic corporations if the management and control of the company occurs primarily in the US; this would generally include offshore investment funds whose shares are regularly traded on an established securities market or those with aggregate gross assets of $50 million or more (including assets under management). Management and control will be deemed to occur in the US if substantially all senior management responsible for investment decisions are located in the US. These provisions, which would come into effect two years following the Act becoming law, could subject many offshore funds managed in the US to be subject to US corporate income tax on their net income.
• abolished (in earlier drafts) the check the box election that offshore funds are permitted to make for the benefit of US non-taxable investors; this change, however, has been omitted from the latest draft of the bill.

These provisions are examples of the US exercising its tax sovereignty in such a way as to alter the extent to which US tax payers may, under US law, benefit from the tax efficiencies provided by OFCs. There is some evidence that the Bill is losing momentum, with policymakers unsure as to how to proceed. An alternative Bill has been proposed by Senator Max Baucus (chairman of the Senate Finance Committee, and a leading Democrat), which avoids the notion of secrecy jurisdictions and which is generally perceived more favourably by the US financial services industry.

Since April, there have been mercifully few tax-specific attacks directed from the EU on offshore jurisdictions. The focus on this side of the Atlantic has been largely on reform of financial services regulation. Not surprising, given that the EU includes Ireland, Luxembourg, Malta and Gibraltar, all offshore financial centres in their ownright. In the UK, Gordon Brown’s initial enthusiasm for following Obama’s lead on getting tough with tax havens was quickly quelled by the curious symbiosis that exists between the UK and its Overseas Territories and Crown Dependencies, which include the Channel Islands, the Isle of Man, the Cayman Islands, the British Virgin Islands and Bermuda. A retired civil servant was commissioned at the end of 2008 to conduct a review of these islands, focussing on their financial supervision and transparency; one could be forgiven for thinking that the UK government has kicked the issue of tax havens into the long grass.

The knee-jerk phase that preceded the G20 Summit appears to be over, and the true functionality of OFCs seems once again to be impressing itself in the collective political consciousness (at least on this side of the Pond): low- or zero- tax jurisdictions exist quite legitimately, and facilitate international transactions and the formation of tax transparent pooling vehicles (and in so doing help to lubricate the flow of capital around the word) by levying low or zero-rate taxes.

3. OFCs are non-transparent secrecy jurisdictions
The notion that all OFCs are shrouded in secrecy is wide of the mark. Many have long standing tax information sharing and other cooperation treaties with a number of countries. The ability to assist and cooperate with other countries on civil and criminal tax matters is often hardwired into the constitutions of their financial services regulators.

Cayman, home to the majority of the world’s offshore hedge funds, is a case in point. In 2007 the US General Accounting Office opined that US users of Cayman were motivated by the jurisdiction’s legal stability and well established support infrastructure and skills base, rather than a blatant desire to evade US tax. The report challenged the popular image in the US of Cayman being a secrecy jurisdiction, emphasising the fact that the islands had several information-sharing protocols with the US and have been consistently cooperative in sharing information with US authorities. The categorisation of Cayman in the Stop Tax Haven Abuse Act as an `Offshore Secrecy Jurisdiction´ is particularly unfair in this light.

The report has gone some way to dispel the popular image in the US of Cayman as a secrecy jurisdiction into which US individuals and corporates can salt away tax dollars. A great deal of ignorance still persists though, and the recent populist rhetoric of politicians and press alike makes that much clear. The hope offshore is that Obama’s views towards Cayman and other OFCs will be tempered by the counsel of advisors and industry insiders. For the moment, there is some uncertainty about the administration’s priorities, and OFCs – particularly those in Obama’s back yard – remain alert to the need to respond pro-actively to political developments in the US.

The effect of the OECD initiative in April is what can fairly be described as a scramble by the majority of grey listed financial centres to sign TIEAs that meet the OECD’s standard. There is an added impetus for these OFCs, together with certain white listed OFCs, to sign agreements with EU member states because of the third country provisions of the draft EU Directive on alternative investment fund managers, which will prevent non-EU funds from being sold into EU member states unless the fund’s domicile has TIEAs with those states. For a variety of reasons, then, offshore is steadily becoming more transparent.

4. OFCs are inadequately regulated
The `tax haven´ tag is particularly insidious because it can be made to denote poor regulation as well as dubious tax status.

In the field of fund regulation, offshore regulators work from the basic principle that the onshore manager, not the offshore fund, is the source of financial and operational risk. The corollary of this is that the offshore regulator effectively piggy backs on the regulatory oversight (by the Securities &Exchange Commission, the Financial Services Authority, etc.) of the manager onshore, leaving the fund subject to the offshore regulator’s own regime. That regime is appropriate to ensure oversight of the offshore fund, for what it is – a tax transparent pooling vehicle – and is correspondingly different from the onshore regulation of the manager. There have been cries for increased regulation of both managers and funds. But increased regulation of the fund offshore is not the direct result of increased regulation of the manager onshore. Offshore fund and onshore manager are different animals, and different regulatory regimes are required for each.

Given its primary focus on regulation of the manager, the draft EU Directive on Alternative Investment Fund Managers broadly upholds the distinction between the separate functionality of the manager and the fund. The focus of its third country provisions (applicable to funds domiciled outside the EU) on OECD tax standard compliance is somewhat tangential to this, and one suspects that the principles of tax transparency, which the draft ostensibly upholds, have been hijacked by those EU countries opposed to Anglo Saxon capitalism (for which read those countries with no meaningful hedge fund industry of their own) wishing to curtail the private placement in their territories of hedge funds, most of which are domiciled outside the EU. The final form of the draft is still a case of wait-and-see for the alternative fund industry, both onshore and off.

The leading offshore jurisdictions regard robust regulatory oversight and compliance with international standards on anti-corruption and money laundering, including those espoused by the IMF, as being central to their role of international financial centres. In the eyes of the IMF, the anti money laundering laws (AML) currently in place offshore frequently exceed the measures enacted by EU countries (the UK and France among them) and the US.

The Cayman Islands have been mentioned several times in this piece because most offshore hedge funds are regulated there and because their regulatory and AML regime is exemplary of the integrity of the leading offshore jurisdictions. The islands have signed their 12th OECD compliant TIEA, and have been rewarded with white list membership (complementing the islands’ IOSCO membership achieved earlier this year). Any euphoric feeling that this may be an indication of the political tide beginning to turn must be tempered with an awareness that the beast is a moveable one (or, in OECD parlance, that the threshold of 12 agreements is a `dynamic´ one). It remains to be seen what additional hoops the world’s leading offshore hedge fund domicile – together with other offshore jurisdictions – may have to jump through. Political pressure is not a new sensation for OFCs, but there is no room for complacency. They must continue to respond to the dual imperatives of keeping in step with political and regulatory developments onshore and ensuring that managers and investors remain aware of the continuing benefits (effective regulatory oversight being one of them) of using offshore.

Matthew Feargrieve is a Cayman Islands attorney-at-law and a partner in offshore law firm Mourant du Feu & Jeune. Based in London, he advises managers and investors in the UK, Europe and Middle East on all aspects of Cayman Islands law and regulation applying to the formation and operation of alternative funds and management companies.