Offshore financial centres are commonly labelled “tax havens” due to the misconception that they are used solely to avoid or evade tax. As a result of this misconception, during the first tranche of the global financial crisis, world leaders came out on the attack against OFCs, arguing that they are inherently bad and have to be stopped in order to protect dwindling government tax revenue.
OFCs have fought back with arguments in support of their jurisdictions. This article focuses on the practical reasons why OFCs are used in international business, highlighting that the use of OFCs is not simply tax-driven. Tax is just one of many reasons why structures utilise products from OFCs. The authors argue that OFCs are not simply “tax havens”, but are a positive, unstoppable force.
OFCs in a modern global economy
There is a misunderstanding in the general community about the function of OFCs. While it now may be accepted that OFCs were not responsible for the global financial crisis, most people believe that OFCs are simply utilised for, sometimes shady, tax reasons.
This view is incorrect. There are a number of important commercial reasons why OFCs are used in practice – with tax but one reason. In different parts of the world, for different kinds of businesses, and for different types of transactions and deals, OFCs are used for different reasons.
How OFCs are used in practice
In this section, we set out some of the main reasons, based on our experience of advising companies and individuals across the globe, why OFCs are used.
Offshore companies are commonly used as joint venture vehicles when there are investors from different jurisdictions coming together to fund a project. This could be, for example, an energy project in Latin America, a technology project in Asia or a mining project in Africa.
If the project is in Chile, for instance, and there are four joint venturers with one being Chilean, the three other joint venturers may prefer to use an offshore company as the joint venture vehicle through which funds are invested and the project managed, to avoid what has been referred to as a “home court advantage” for the Chilean investor.
The use of offshore entities also provides flexibility for the joint venturers in relation to the rules that will govern the joint venture company and its participants. If the joint venturers were to incorporate a company in the jurisdiction where the joint venture project is located, there is a risk that the jurisdiction’s rules may be overly restrictive, complex and costly to comply with on a day-to-day basis.
The BVI is perhaps the most common offshore jurisdiction that is used for joint venture companies as, through the BVI Business Companies Act 2004, it offers perhaps the greatest amount of flexibility for joint venture companies. In the BVI, there is generally no requirement for annual general meetings or to have an auditor; no need for resident directors; no particular form in which accounts need to be prepared and companies are provided with a great deal of discretion in terms of how they can distribute profits (other than the need to satisfy a solvency test).
Cost and ease of use
In close to all transactions that we see, cost and ease of use is a central reason why one or more offshore entities have been chosen. All of the main OFCs (eg Bermuda, BVI, Cayman, Guernsey, Isle of Man, Jersey, Mauritius, Seychelles) are very competitive when it comes to the price involved in setting up a company or other vehicle, as well as for ongoing maintenance fees.
This is very important given that a large number of OFCs are set up as special purpose vehicles for particular projects or as holding companies, rather than being ongoing operating vehicles.
Thus, it is attractive to keep costs as low as possible.
Relationship with, and access to, regulators
A key characteristic of the leading OFCs is that they are relatively small islands, with a small population that works together as a close-knit community. This is an attractive feature of OFCs because it means that regulators are much easier to contact, and generally much more open to being contacted, than their counterparts in the major onshore financial markets.
Businesses see this is an advantage as even if their key personnel are not on the ground in the relevant OFC, their advisers typically are there and thus can organise meetings with regulators, often at short notice, to discuss proposed transactions which may require the approval of the regulator or an exemption from a certain regulatory requirement, possible changes to the existing law and also ideas for new legislative initiatives.
Access to financial markets
Another common reason for using an offshore entity is to enable certain businesses to more effectively raise finance in leading financial markets (eg New York, London). Businesses that are located and incorporated in an emerging economy or politically unstable jurisdiction may have good prospects and solid fundamentals, but often do not obtain the level of finance they need.
As investors in the leading markets are familiar with the main OFCs as they are regularly used for debt and equity capital raisings in these markets, using an offshore entity to connect with investors in the leading markets is a simple way to overcome what may have otherwise been a major problem for the company.
It is for this reason that OFCs are becoming very popular in Latin America, for example, with businesses in emerging Latin American economies needing access to global capital in order to expand.
In our practice, we regularly see BVI companies being incorporated by Latin American businesses (and to a lesser extent Asian businesses) as an SPV to raise equity finance in the US market through a so-called “Rule 144A offering”. Rule 144A of the US Securities Act of 1933 allows entities to raise finance in the US by way of a private placement, with no registration or licensing with the US Securities & Exchange Commission required if the shares are placed with an investment bank or broker-dealer who then concurrently sell the shares to “qualified institutional buyers” (who generally must have at least $100 million under management).
Offshore entities are also regularly used to raise finance by listing on a major stock exchange. The Hong Kong Stock Exchange, Singapore Stock Exchange, London Stock Exchange (and its Alternative Investment Market, or AIM), New York Stock Exchange and NASDAQ are commonly used for listings using an offshore company.
Securitisation refers to the process where rights to an income stream due to a person (being the originator) are repackaged and then sold through securities. The benefit for the originator is that it receives early access to that income stream.
Notwithstanding the recent global financial crisis which many attributed to major banks in the US and parts of Europe engaging in complicated securitisation arrangements involving sub-prime/low-doc home mortgages, it is recognised that securitisation continues to have an important role. Both before and after the global financial crisis, the Cayman Islands have become one of the main jurisdictions used for the incorporation of SPVs to facilitate a securitisation arrangement. We also regularly see BVI as the domicile of choice.
In the typical securitisation arrangement where a bank is the originator, the bank will set up a separate SPV (the issuer) to transfer a portfolio, or pool, of its assets. The issuer is designed to be bankruptcy remote so that the assets cannot be distributed to the originator’s creditors if the originator collapses.
To provide for complete separation between the originator and the SPV issuer, it is common that a purpose trust be established to hold the shares in the issuer. A purpose trust departs from the traditional position at general law that a trust must either have one or more beneficiaries or be set up for a charitable reason, by allowing a trust to be created for a particular purpose (the purpose being simply to hold the shares in the issuer).
A purpose trust is a creature of the offshore world, thus making the use of OFCs a central component of securitisations worldwide. For example, each of Bermuda, BVI and Cayman have established rules in place facilitating the establishment of purpose trusts.
OFCs are also very important for mutual funds. Mutual funds are investment vehicles in which money from different investors is pooled and then can be invested in a variety of different ways. Mutual funds are generally characterised as being either an open-ended fund, where securities in the fund are bought (redeemed) and sold by the fund on a regular basis, or a closed-ended fund, where the securities are usually only issued once by the fund, and then not redeemed until the fund liquidates.
The Cayman Islands is far and away the market leader when it comes to offshore mutual funds, with their now being approximately 10,000 funds domiciled in Cayman. The BVI is the second largest offshore jurisdiction for funds, with there now being close to 3,000 funds registered in the jurisdiction.
Like for equity and debt capital market deals, using a Cayman or BVI-domiciled fund can be important to take advantage of “group think”. The path of investing in a Cayman fund has not only been followed, but generally followed with success, over the years and provides a better chance of raising money and gaining new investors in key financial markets than by using, say, an Iranian fund or Brazilian fund.
Offshore funds are also typically used in a master-feeder fund structure, which are common in the US. With a master-feeder arrangement, there will usually be both a domestic, US feeder fund (for US investors) which is structured as a limited partnership (so as to be a flow through entity for US tax purposes), and a feeder fund domiciled offshore to accommodate foreign investors from parts of the world outside the US.
The sole purpose of the feeder funds is to raise money to distribute to the master fund, which is also usually domiciled offshore, with the master fund pooling this money and making a series of investments with a view to profit.
Having a US-domiciled feeder fund appeals to US investors as if these investors participated in an offshore feeder fund, the fund could be characterised as a “passive foreign investment company” which would then subject them to very complicated and strict guidelines set by the US Internal Revenue Service. The non-US, offshore feeder fund appeals to foreign investors who are wanting to participate but do not necessarily want to be exposed to the US tax system. Without the option of utilising an offshore feeder fund, US-based fund managers could be severely restricted in attracting investors outside the US.
The master fund is domiciled offshore for the same reason of attracting foreign investors, in addition to the usual cost and regulatory benefits that flow from using an offshore entity.
OFCs are far from being a threat to the healthy, effective functioning of the world economy. There is a rich tapestry of reasons why OFCs are used, and reasons which show that OFCs are both fundamentally important and central to the transactions that are driving global business. The examples raised above highlight this.
OFCs are not about tax scams, shadow banking and shady individuals. OFCs touch upon every type of business, and upon, every type of transaction, in every part of the world. OFCS really are an unstoppable force.
* Michael J. Burns is Managing Partner of the British Virgin Islands office of Appleby; James McConvill is a Consultant with Appleby in the British Virgin Islands and a member of Victoria University Law School in Melbourne, Australia. Some of the points made in this article are explored at greater length in the earlier article: Michael J. Burns and James McConvill, “An Unstoppable Force: The Offshore World in a Modern Global Economy” (2011) 7 Hastings Business Law Journal 205.