The place of offshore financial centers in an increasingly anti-tax haven world

This weekend I came across an interesting special report (“a place in the sun”) published on the Economist latest issue, which is dedicated to offshore financial centers. The report is a good reading for any international tax advisor because it provides some valuable insights into the policy and regulatory framework of offshore financial centers in an increasingly integrated global economy.

In the last decade, several important efforts were made to increase the scrutiny of offshore centers namely focusing on the necessity to counter money laundering, improve regulation on the financial services and reduce the (tax) advantage of using the so-called tax havens. For example, the OECD reports on Harmful Tax Competition, Towards Global Tax Co-operation and Improving Access to Bank Information for Tax Purposes were important tools because they laid down the principles of the reaction of onshore jurisdictions against those offshore centers. The aim of these initiatives was to counter distorting effects of harmful tax competition, by tackling certain practices with respect to mobile activities that (apparently) eroded the tax bases of other countries (i.e. country of the principal investor). The initiatives were also directed to find ways to improve international co-operation with respect to the exchange of information for tax purposes (which was sometimes in the possession of financial institutions).

According to the IMF definition, an offshore financial centers is a jurisdiction that (i) has a large number of financial institutions; (ii) where most transactions involve non-residents, (iii) where most institutions are controlled by non-residents, (iv) where the assets and liabilities are out of proportion to the domestic economy; and (v) where there is a very low or zero taxation, relaxed financial regulation and bank secrecy. There are multiple possible uses of OFC (i.e. offshore banking, captive insurance companies, establishing special purpose vehicles and asset management and protection) and some of them addressed in the report of the Economist.

It is interesting to note that, the OECD initially identified, in the framework of its project on harmful practices, 47 jurisdictions as tax havens. Nevertheless, 33 jurisdictions made in the meantime commitments to transparency and effective exchange of information and are now considered co-operative jurisdictions. There are only a few that remain unco-operative tax havens.

With the overwhelming increase of assets held by OFC in the 80’s and 90’s (according to the IMF cross-border assets held by OFC reached a level of US$4.6 trillion at end-June 1999) it was more than natural that other initiatives at the international level pursued the other (non-tax) elements of the OFC. For example, the Financial Action Task Force (FATF) was established to help protect financial systems from money-laundering and counter-terrorist financing systems. The FATF’s Non-Cooperative Countries and Territories process can be considered a success since the 23 jurisdictions that were listed as NCCTs in 2000 and 2001 are no longer on listed. Another initiative is the one headed by the Financial Stability Forum (FSF) which has been arguing for OFC to meet international financial markets standards and address problem areas, such as effective cross-border cooperation, information exchange and adequacy of supervisory resources.

Notwithstanding, it was visible throughout this process that there was a great variety in regulatory standards and infrastructure between the major international financial centers and other (less transparent) financial centers, where supervision was simply non-existent. As such, increased attention has been directed in the last years into reinforcing transparency and effective exchange of information for tax purposes. In that regard, the OECD Global Forum has just published a report, "Tax Co-operation: Towards a Level Playing Field – 2006 Assessment by the Global Forum on Taxation", which surveys 82 OECD and non-OECD countries and jurisdictions. This report undertakes a factual review on the legal and administrative frameworks in the areas of the existence of mechanisms for exchange of information, access to bank information and access and availability to ownership, identity and accounting information. This work is related to the wider initiative of developing a Model Agreement on Exchange of Information on Tax Matters, which is now being used by countries such as the United States (U.S.) as the basis for negotiating bilateral agreements.

For example, Article 5 (exchange of information upon request) of that Model provides that only in very few instances will the competent authority, receiving the information request, be able to circumvent the legal obligation of providing the tax-related information. The country receiving a must then provide the information, when it relates to a particular examination, inquiry or investigation in the other Country, even if the requested country does not need the information for its own tax purposes (i.e. because it has more lax rules). The rule (in connection with Art. 7) includes, nevertheless, certain safeguards (e.g. non-disclosure of trade or business secrets) as to when information requests may be refused. It is important to note that bank secrecy cannot be considered a part of public policy and therefore used as an excuse not to exchange information.

This already indicates a significant amount of pressure that can be used against the use of OFC through the conclusion of this bilateral exchange of information agreements. For example the U.S. has concluded in recent years such type of agreements with jurisdictions such as Aruba, Jersey, Isle Of Man, Guernsey, Netherlands Antilles, British Virgin Islands, Bahamas, Antigua and Barbuda and the Cayman Islands.

The recent cooperation commitments by tax havens for effective exchange of information may thus appear to constitute a “light in the end of the tunnel” for the countries that initiated the process against harmful tax measures back in 1996. As mentioned in the Economist report, the OECD prefers now to differentiate between well and poorly regulated financial centers rather than onshore or offshore and the focus has apparently shifted from (the lack of) tax to more regulatory issues. In fact, the OECD appears now to consider that “low or no taxes on their own do not constitute a harmful tax practice”.

Perhaps it is only under this stricter OFC regulatory framework, that one may understand a title in the Economist such as “Tax havens are an unavoidable part of globalisation and, ultimately, a healthy one”. Nevertheless, the issue is far from unquestionable and some of the points raised in the report deserve further reflection.

For example, the mention that “tax competition nowadays is mostly about big countries competing with each other” is an important reference. Recent years have brought increased tax competition even between jurisdictions once tagged as “high tax jurisdictions”. The difficulty today is that some traditional European jurisdictions instead of providing low corporate taxes such as Ireland (12.5%) are introducing exemptions at the level of the tax base, such as notional interest deduction in Belgium or the patent box in the Netherlands which ultimately may also have an impact in diverting of shifting certain mobile activities such as intra-group financing or licensing activities. This is one reason why in my view it is harder to frame the tax competition, when we are dealing with the so-called “big countries”. It is therefore not a surprise that the EU Code of Conduct on business taxation, which consists of a commitment not to introduce new harmful measures (standstill mechanism) and to revise existing tax measures deemed to be harmful (rollback mechanism) has lost slightly its political momentum.

Another highlight of the report is the reference to a recent study entitled Do Tax Havens Divert Economic Activity?, where economists found that tax havens boosted economic activity in nearby non-havens rather than diverting it. These references may have the benefit of re-launching the debate as to the role and place of OFC and their possible unintended or positive consequences.

In conclusion, after reading the whole report one remains with the overall impression that under the premise that tax competition may bring benefits, the role of the well run and regulated OFCs in tax evasion is perhaps being slightly dramatized. Nevertheless, one has first to listen to the interview and read the articles before taking conclusions!

Past posts on related subjects:
Corporate Tax Avoidance: The Case of Abusive Tax Shelters
Is Switzerland under enough pressure from Europe institutions to clamp tax competition?
“Benefits or evils” of Tax Competition
“Tax harmonisation is not on the agenda, nor will it be.”
Subsidy to the Celtic tiger or just healthy tax competition?