UK: Offshore Financial Centres

The growth of offshore financial centres (OFCs) is the gold rush of the last decade. It is estimated that more than $1000 billion is now held in offshore funds and that the number of funds is 15 times larger than in the mid-1980s¹. But the continuing prosperity of OFCs has been threatened by scrutiny from onshore countries and their agencies. The onslaught has been prompted by observations that OFCs have increased the incidence of money laundering and exposure to global financial risks and that an important source of wealth is being diverted from onshore countries, who have substantial spending commitments, to ‘bolt-holes or tax havens’, whose spending commitments in comparison are minuscule. This latter trend has, the allegation runs, encouraged investors to escape their liabilities in their home countries by investing through OFCs, which in turn means that those investors benefit from the public spending in their home countries and yet pay no financial contribution towards it. In consequence, trade and investment patterns are being distorted, the tax base of onshore countries is being eroded, and international tax evasion is encouraged.

The industrialised economies have voiced concerns through their agencies, which in turn are paving the way for changes. The expediency and force with which the changes have been proposed and are to be implemented reflects today’s financial climate; as personal and corporate wealth grows with economic expansion (emerging predominantly in the form of globalisation and e-commerce) so does the volume of available investment. Onshore countries are also well aware that OFCs are a lost source of revenue – to which they no longer wish to turn a blind eye.

At the forefront of this campaign is the Organisation for Economic Co-operation and Development (OECD) which has resolved to stamp out harmful tax practices. In addition, OFCs are being cornered by other G-7 driven agencies like the Financial Action Task Force (FATF), focusing on anti-money laundering, and the Financial Stability Forum (FSF), concerned with the impact of OFC activity on the stability of international financial markets. This ‘cartel’ of agencies of the industrialised economies has sparked much anger amongst the OFCs.

OFCs, many of which are traditionally small islands, have achieved worldwide recognition and status as significant players in the financial investment business world. They have tapped into a lucrative source of income by acting as OFCs which has boosted their domestic economies over years when their other sources of income have been under threat. It therefore comes as no surprise that they have objected to being handed down edicts by their onshore counterparts.

This article looks at the rationales behind the OECD, FATF and FSF projects but will focus on the more controversial actions of the OECD. It will then consider the plight of the OFCs in the current climate – (i) whether the international pressure will mean a total eradication of their legitimate use and (ii) whether they have a place in the developed world today. In particular this article looks at the recent dialogue initiative and how, if at all, this can help balance the interests of the onshore and offshore worlds.

The OECD, comprising 29 member countries, has reported on numerous occasions that globalisation and the removal of exchange controls and other barriers to the free movement of capital, whilst enhancing economic development, have also encouraged the proliferation of harmful tax practices. New opportunities have been opened up for individuals and enterprises to engage in illegal activities, such as hardcore cartels, bribery, money laundering and tax abuses, which distort trade and investment flows. On the point on tax abuses, it has specifically argued that the coinciding of national or territorial tax with global trade, which is no longer confined to territory, releases the temptation for beneficiaries of a country’s stability, infrastructure and public services to exploit the mobility of capital and thus avoid paying their share of the country’s taxes. Even law-abiding businesses are concerned that these opportunities can skew the competitive environment unfairly in favour of the tax abuser and against the business that plays by the rules.

The OECD project on harmful tax practices which began in 1996 led to the adoption by the OECD Council (Switzerland and Luxembourg abstaining) in April 1998 of a report and guidelines on harmful tax practices, entitled Harmful Tax Competition: An Emerging Global Issue. The Report concluded that tax competition is harmful unless it is transparent, non-discriminatory, and aimed at attracting real activities.

It set out the criteria for harmful tax practices as being low/no/nominal effective tax coupled with:

1. Lack of effective exchange of information; or
2. Lack of transparency; or
3. Ring-fencing (where there is a substantial domestic economy)² or attraction of investment without substantial activities (where the offshore sector dominates the economy).

On 26 June 2000, the OECD published a further report listing 47 preferential tax regimes in the OECD area, which it considered harmful, and 35 OFCs which fell within the criteria above by engaging in harmful tax practices and did not have a significant tax base of income beneficially owned by its own residents.

The OECD has backed down from its original tough stance in that it now accepts that OFC governments are free to choose the tax regimes that they wish to set in their own jurisdictions. Nevertheless it has relentlessly pursued its threat of economic sanctions against those countries which do not agree to raise levels of financial disclosure and improve co-operation, in adherence to the principles of non-discrimination, transparency and effective exchange of information by July 2001. It wants those countries to set out a timetable by the end of 2001 for dismantling their most ‘harmful’ tax practices so that by the end of 2003 the OFCs will co-operate with tax authorities in other countries investigating tax crimes, leading by the end of 2005 to an effective exchange of information on all tax matters.

The OECD’s Committee on Fiscal Affairs has identified some measures that would assist countries moving towards those standards. These measures include: eliminating anonymous accounts and requiring records to be kept on bank customers and beneficial owners of accounts, shares and trusts; audited or filed financial accounts and introducing measures that ease exchanges of information for tax investigations undertaken by authorities of other states. The OECD emphasises that the measures are to be applied throughout member and non member countries. But while the OECD claims that its members are committed to eliminating identified harmful features by April 2003, in contrast to its approach to the OFCs, this has notably not been backed up by any threat of sanctions against those members who fail to comply.

OFCs have been angered by, what some would describe as, the authoritarian way in which the OECD began its crusade. It was seen as outrageous that the OECD had dared to sidestep the sovereignty of OFC governments and exercise extra-territorial jurisdiction by dictating a set of standards and requirements without offering any consultation or dialogue with OFC governments. The whole OECD exercise was indeed questionable for its legality, propriety and sense of proportionality.

Some commentators have seen the OECD’s conduct as arbitrary and, ironically, rather opaque itself. For Jersey it came as a shock that their name was registered on the blacklist. In their defence, initiatives such as the Edwards Report³, FATF and FSF have reported that Jersey is co-operative and well regulated. The Edwards Report concluded that Jersey had an appropriate arsenal of financial regulation and had more effective money-laundering legislation than many countries that were members of the FATF or the European Union. The FATF, by placing Jersey in the premier list of jurisdictions in its investigation into identifying countries which failed to co-operate in the international fight against money laundering, endorsed that view. The FSF further described Jersey as having a good legal infrastructure and supervisory practices with good staffing levels. The OECD in contrast, whilst advocating transparency on the one hand, provided no explanation for Jersey’s inclusion on the blacklist despite its impressive record.

This example sits uneasily with the omission of Switzerland and Luxembourg from the blacklist. Both member states openly opposed and abstained from approving the OECD 1998 Report. Both are also major competitors for offshore business. Switzerland has been the subject of scandal in recent times – having been exposed as a haven for funds which were wrongfully appropriated during the Nazi regime and notorious for its high levels of privacy, which are still in place. Luxembourg was criticised during the BCCI and Banco Ambrosiano cases. Yet the OECD appears to have dismissed this dissent from within as de minimus.

The anti-money laundering campaign has been a powerful medium by which onshore governments have pressed for regulation of OFCs. On 22 June 2000, the FATF published a report entitled Review to Identify Non-Cooperative Countries or Territories, in which it identified a number of OFCs as ‘non-co-operative’ in the money laundering clampdown⁴. As at 1 February 2001, the list remains unchanged even though all bar one of the jurisdictions have introduced or are about to introduce anti-money laundering legislation and regulations⁵.

Money-laundering is a worldwide problem, not wholly exclusive to OFCs. In the examination of the financial affairs of kleptocrats such as Slobodan Milosevic and Sani Abacha, the OECD has pointed to substantial flows of capital which have passed through the financial centres of Western Europe. Moreover, it has acknowledged that several billion US Dollars of Russian monies, thought to be of doubtful origin, have passed through US Banks and this has yet to result in a money-laundering prosecution in the US. Indeed the US National Money Laundering Strategy for 2000 has recognised that a ‘substantial portion’ of money laundering in the world likely takes place in the US.

In effect, it is arguable that double standards are being applied as between onshore countries and OFCs. For example, the U.K. a leading voice in the OECD initiative, revealed in March this year that 23 banks in the UK had handled some $1.3 billion of Abacha’s money and of these 15 had ‘significant control weaknesses’. Despite repeated requests from the Nigerian Government to freeze funds held in British accounts and repatriate looted funds, no action has yet been taken. Meanwhile, in contrast, the Jersey Financial Services Commission (JFSC) has uncovered more than £100 million of funds connected to Abacha. The JFSC found bank accounts used by associates of Abacha at five of Jersey’s 500-plus financial institutions. The JFSC has said that it is prepared to name and shame the banks that have harboured laundered money connected to Abacha.

Another example, also noteworthy, is the wrongful appropriation of $4 billion by Milosevic during the Yugoslavian civil war. Although much of the money is believed to have gone to Cyprus, the paper trail suggests the involvement of Germany, Greece, and even the UK all FATF members. So far, governments and central banks in the West – apart from Cypriot authorities - have not leapt to co-operate with Belgrade’s investigations.

Further, there is a lack of consensus even among the worlds’ richest most powerful countries about what, for the purposes of fighting money laundering, should count as a crime. Although it may now be relatively easy to get OFCs to co-operate in tracking down revenue from the illegal drugs trade or terrorism, OFCs are likely to prove less helpful if the target is revenue from, for example, internet gambling - the subject of a recent U.S. Senate report. For why should the U.S.A. be able to decide that an online bet took place in the U.S.A., where it is illegal, with the result that any revenue generated by internet gambling constitutes criminal proceeds, just because the gambler used a computer in, say, Salt Lake City, when the company and server taking the bet are in an OFC where gambling is legal? The question of what counts a crime becomes even more acute when it comes to tax evasion or avoiding government imposed controls on capital movements, the two main reasons people have traditionally used OFCs. Should taxes evaded be treated by banks as the equivalent of profits from crime? Some critics suggest that the attack on money laundering is no more than a disguised attack on harmful tax practices by onshore countries aimed at OFCs, the OECD initiative by another name.

The Working Group behind the FSF Report⁶ undertook its review having engaged in a one day consultation with OFC representatives⁷ and a survey of supervisors from onshore and offshore jurisdictions. The Report acknowledged that OFCs, to date, had not been a major causal factor in the creation of systemic financial problems. However in light of national financial systems growing more interdependent, the Report identified that future problems in OFCs could have consequences for other financial centres. The Report stated:

The significant growth in assets and liabilities of institutions based in OFCs and the inter-bank nature of the offshore market, together with suspected growth in the off-balance sheet activities of the OFC-based institutions (about which inadequate data exist) increase the risk of contagion.⁸

The Report stated further that problems with OFCs could hinder market surveillance and law enforcement in onshore centres, thus posing a threat to the global financial system. Amongst the potential future problems the following were identified: inadequate disclosure rules; inadequate knowledge of activities of financial institutions based in OFCs; lack of resources; lack of co-operation with onshore supervisors and excessive secrecy laws⁹.

A number of international standards and codes of good practice were recommended, falling into the following three broad categories:

1. cross-border cooperation, information sharing, and confidentiality;
2. essential supervisory powers and practices; and
3. customer identification and record-keeping.

In monitoring OFCs’ adherence to these international standards, the Report delegated responsibility to the International Monetary Fund (IMF) with back-up provided by the FSF, notwithstanding that several OFCs are not members of the IMF, bringing into question the issue of proper consultation and participation in the process and the ability of OFCs to participate in the dialogue.

The OFCs, whilst eager to enter into a dialogue with the OECD, have constantly insisted on a level playing field. The first significant steps were achieved when the OECD engaged in regional consultations, in Barbados, on 8-9 January, and Tokyo, on 15-16 February, of this year.

On 10 January, the OECD announced that it had agreed with Commonwealth countries on the way forward to achieve global co-operation to counter harmful tax practices through dialogue based on shared support for the principles of transparency, non-discrimination and effective exchange of information on tax matters. In further pursuit of their dialogue, the agreement approved the creation of a small joint Working Group of representatives from the Commonwealth, Caricom, Pacific Island Forum and OECD countries and territories. Its task will be to examine how the mutually accepted principles can be put into practice and to continue the dialogue begun in Barbados. If successful, this could result in a new process in substitution for the process behind the OECD’s Collective Memorandum of Understanding (published in November last year). Yet the OECD continues to press individual OFCs for commitments rather than forge a multilateral agreement on reform.

The OECD has insisted that it is not seeking to force OFCs to change their rates of taxation. It is more concerned with their concessionary regimes and the level of transparency, in particular the rules on the exchange of information with other tax authorities. In a recent paper entitled Promoting Tax Competition¹⁰ the authors contended that the project did not attempt to harmonise tax structures, set minimum levels of taxation, adversely impact commercially motivated cross border investment flows, eliminate commercially useful structures, curtail legitimate tax planning, curtail privacy rights through the promotion of exchange of information or deny any government the right to determine its own tax practices. Indeed, the OECD believes that it has finally achieved a shared perspective with various communities that the project should:

• provide a level playing field in the tax area for cross border activities
• facilitate competition that is fair and transparent
• ensure that all taxpayers meet their tax obligations

Of the 35 jurisdictions that were named and shamed in the blacklist, some two thirds have already co-operated or indicated that they would do so¹¹. A final decision on sanctions is not to be taken until after the meeting of the G-7 finance ministers in July of this year. Countries which continue to fail to satisfy the OECD requirements by the 31 July deadline could see themselves subject to bans on financial dealings with OECD countries.

But the OECD onslaught has already impacted on OFC activities. For example, the first eleven months of last year saw registration of international business companies fall 20% in St Vincent. Antigua’s offshore banking business has also suffered and now the country hosts 18 banks as opposed to 78 just less than 2 years ago. Time will tell if this is just a panic reaction to the initial heavy handedness of the OECD or whether the OFCs are facing a collapse in business.

On the face of it, OFC governments in the main are striving hard to be seen to be unaffected by pressure from the OECD. Many inner circles, however, see that the only way to move forward is together with the OECD. The Bahamas has banned anonymous ownership of its 100,000 international business companies – shelters that have been identified as cover for money laundering. Barbados is looking at possible changes to its tax legislation to achieve convergence between lower rates for its offshore sector and higher ones for onshore businesses. Dominica now requires offshore banks to have a physical presence on the island and that the institutions secure government approval for changes in shareholders, directors and senior staff. The Isle of Man has come up with its own rescue package in order to avoid an exodus of capital. It has offered information exchange with foreign countries under double taxation agreements and has undertaken to remove the contentious practice of ‘ring fencing’, under which non-residents benefit from tax advantages not made available to residents. Guernsey is contemplating a similar change.

There is growing concern (and possibly relief) that the OECD initiative may run out of fuel. Major financial centres such as the City of London have expressed fears that they will bear the brunt of the clampdown on OFCs. Firstly, it would cut off a source of funds that provides around £150 billion for banks operating in the UK. Secondly, a campaign that targets confidentiality and discreet business, one main reason why clients prefer OFCs in the first place, could rebound on the City. One view put forward by an official of the British Bankers’ Association is that if the UK is seen to condone supplying information about individuals and companies, even when there is no suggestion of tax evasion, these people and entities could think that confidentiality is being compromised and as a result this may drive business away from London. The influential lobby of the City’s financial institutions may therefore relax the vigour of the Government’s support of the OECD initiative. But flawed though the OECD, FATF and FSF initiatives may be, their rationales remain credible. And OFCs depend upon foreign jurisdictions in that they rely on access to foreign clients, networks and markets. They cannot therefore isolate themselves from the foreign pressure linked with such clients, networks and markets. One commentator has noted that:

The opportunity to participate in the markets of other countries implies some minimum standards of behaviour in order to justify access - a constructive response to the reasonable concerns of onshore countries is essential for any OFC, unless it is prepared to unplug from the international grid¹².

The current debate is unlikely to mark the end of OFCs. It has shifted expectations, and has generated healthy competition among OFCs trying to win over business by creating products and enhancing professional services to satisfy the needs of a growing and increasingly sophisticated clientele. One law firm in the Cayman Islands predicts that there will be fewer jurisdictions in the future that do well. The winners will be those that can show good regulation and transparency, and which come down hard on laundered money and tax evasion.

OFCs are also rising to the new challenges brought about by the advent of e-commerce. Some have already begun to put an infrastructure in place. The OECD argues that Internet banks are a dangerous haven for money laundering and therefore ought to face tighter regulatory controls. Fraudsters and money launderers are able to hide behind the anonymity of the Internet to create false identities and siphon the proceeds of crime. So far there is not much evidence that such people are exploiting the internet but, according to one New York bank regulator, there is, for example, growing concern about a Mondex smartcard in use in Europe which allows money to be transferred without leaving an electronic trail. But online businesses are more able to benefit from the low or zero tax rates than more traditional companies. They are mobile, and can serve a global market from anywhere with the right telecoms connections. For example, in the UK, with legislation being introduced in vital areas of intellectual property and commerce, giving legal status to electronic signature, and the Regulation of Investigatory Powers Act coming into force on the UK mainland, internet service providers may look to offset millions of pounds in compliance costs by putting their servers offshore.

On the other hand, the most important concern for OFCs is the apparent lack of a level playing field. OFCs are being asked to adhere to onerous standards and requirements which are not currently universally followed in onshore countries. All industrialised nations offer tax incentives of one kind or another and OFCs have legitimate fears that they are being forced into embarking upon rigorous regulatory and fiscal programmes which are not mirrored by all onshore jurisdictions and that this could lead to investors taking their business to mainland centres causing a loss of revenue, investment and employment in the OFCs.

Clearly, OFCs which need to harmonise their two-tier tax regimes and give up their so-called ‘brass plate’ company structures¹³ will have to make sacrifices to appease the OECD. The OECD, in turn, must reciprocate on the new culture that it preaches to OFCs. If it is to achieve progress in its endeavours to fight against harmful tax practices, it must be prepared to act as firmly with its own members as it has with OFCs to maintain the respect of the OFCs and avoid causing serious damage to their economies. This will need to be reviewed in the future dialogue initiative.