Over the past two decades, various international cross-border and regulatory initiatives have been the catalyst for significant changes to the regulatory framework of international financial centers in the Caribbean. The extent of the changes has led to legitimate questions regarding the future viability of international financial centers. Ultimately, the impact is largely answered by the extent to which they can continue, in effect, to serve as the tax enforcement arm of other countries and bear the cost of introducing and maintaining financial regulatory standards.
Tax enforcement (a.k.a. ‘cross-border cooperation’)
The various initiatives that have impacted international financial centers fall into two categories: those that focus on global regulatory standards and those that are aimed at minimizing tax evasion and tax avoidance.
Following the rapid introduction of hundreds of tax information exchange agreements modeled after a template created by the OECD, international financial centers were soon ushered into the more significant automatic exchange of information regime.
Foreign Account Tax Compliance (FATCA) requires automatic reporting of certain information on U.S. or U.K. persons as defined by those respective countries’ FATCA regulations. FATCA has been in full swing with the first reports already submitted and now the more widely applicable Common Reporting Standard (CRS) has been introduced in most IFCs.
The Common Reporting Standard is global FATCA, with the only notable exception being that the United States is not a party to CRS and will continue its tax enforcement efforts via FATCA.
For the most part, the main Caribbean IFCs such as Bermuda, Cayman Islands and the British Virgin Islands have handled FATCA and CRS well as they have put the required infrastructure in place and local institutions are already reporting under the regimes, with CRS reporting about to start soon.
These two initiatives have two major consequences for IFCs. First, there will likely soon be an expectation that jurisdictions demonstrate periodically the extent of their financial services industries compliance with the FATCA and CRS requirements. This will mean not only demonstrating that they have the necessary laws and regulations in place but more importantly that their institutions are reporting in accordance with the procedures and have the necessary internal systems to be able to identify and report these accounts.
Assessing compliance will increase further operational costs on both the individual institutions and the various competent authorities as both groups of stakeholders will need to devote resources towards tax inspections and internal audits of systems and procedures.
The second and more important impact of these two initiatives is that IFCs are now headed toward serving as the tax enforcement arms of other countries. To continue to refer to these various initiatives innocently as cross-border cooperation or information exchange misses, or dodges, the larger issue: OECD countries now have a mechanism to assist them in finding out more about whether any of their citizens are illegally avoiding their tax obligations. What is to stop them from further tweaking these initiatives? Broadening the criteria on which information can be exchanged, introducing compliance aspects for individual accounts, putting country audits in place, reducing reporting thresholds, and widening the scope of reach are all possible further tweaks that might be expected in the medium to long term.
All of these potential changes would pose huge resource constraints on IFCs. The possibility of these further adjustments which can be in response to any number of domestic policy challenges facing OECD countries means that, in effect, an IFC’s tax regime will be acting similarly to that of a tax office of the OECD country. Naturally, if OECD-based leaders perceived that their tax revenues are low, they will look to increase their revenues by focusing on enforcement and collection. In addition to focusing on their respective domestic tax offices, OECD authorities will rightly feel that they have leverage to make adjustments to the protocols in place with IFCs as part of their efforts.
IFCs don’t have access to resources to cope with these ad-hoc changes and these external shocks can be potentially damaging unless the respective IFC can adequately make its case on legal, political and financial grounds.
Has the dust settled on regulatory standards?
IFCs are also subjected to various global regulatory standards. Under this umbrella, there are two clear categories: those standards that focus on financial regulation and those that focus on the fight against money laundering and terrorist financing.
Financial regulatory standards include those aimed at improving regulation of the various industry subsectors; investment funds, banks, trusts, insurance companies, etc.
There are well established global standards in each of these areas with corporate services still being the least developed of the group. But, nonetheless, the standards are widely accepted by all countries, whether IFC or OECD based. These standards include the Basel Core Principles for Effective Banking Supervision, IOSCO Objectives and Principles for the investments sector, and the IAIS Insurance Core Principles for insurance industry.
Periodical reviews by the International Monetary Fund helped to bring many countries on board in terms of complying with these standards and there are very few countries now that are not at least reasonably compliant with the standards. In addition, according to objective reviews by the IMF several years ago, many established IFCs are in line or in some cases ranked higher than some OECD countries in several of these areas of industry regulation.
The dust seems to have settled in respect to these global regulatory standards and it is expected that they will likely be tweaked occasionally but are otherwise very stable.
Generally, these standards tend not to be reviewed or amended materially unless there is a major financial collapse, which tend to calls for sweeping reforms.
The same cannot be said of standards aimed at fighting money laundering and terrorism. Reviews by the FATF and in case of the Caribbean-based IFCs, the CFATF, has meant many changes to the legislation over the years. Many IFCs are now subjected to periodically follow-up reviews and the Cayman Islands is expecting its review shortly.
Going forward, IFCs should be able to weather the storm on such reviews and, while there are always recommendations for changes to their regimes, it is not expected that these changes will have a significant impact in terms of cost of implementation or in terms of the success of their business models. For the most part, most IFCs would be happy to decline business that refuse to comply with the standards because these types of risk being caught (money laundering fraud and terrorist financing) are legitimate threats to their businesses.
As a direct result of pressure from the U.K. and other countries, many IFCs have introduced a central registry of beneficial ownership of companies or a mechanism that has an equivalent function. In some cases, the IFCs’ implementation falls shy of the call for a “public” registry, although in all cases IFCs have implemented or are in the process of putting in place a central registry where ownership searches can be made by certain authorities as defined within the legislation.
The difference between this final initiative and the others mentioned above is that there is not true global standard for such a registry.
The main concern relating to the central registry equivalent is that if not handled with ultra care, it potentially signals to legitimate IFC clients that the right to financial privacy is all but gone. There are many valid reasons why clients will not wish to have their ownership information easily accessible to the public. This last initiative may have a negative impact on IFCs, depending on the mechanism chosen to comply. If clients feel that their information is accessible to the public without any protections, then clearly this will have a negative impact on business. But if they can be assured that there are protocols in place and that so called “fishing expeditions” will not be permitted, then this initiative is unlikely to have much of an impact outside the obvious need for businesses to incur further costs to implement the systems.
Are IFCs’ future secured?
In terms of financial regulation and global standards the IFCs seemed to have handle this very well as most established IFCs are as compliant as other OECD-based countries. And aside from occasional changes based on industry developments such as the new capital requirement within the Basel banking standards, it is not expected that these initiatives would pose any harm to IFCs.
With respect to the tax initiatives, the primary concern must the extent to which IFCs have become an extension of the tax enforcement departments of other countries. Questions regarding sovereignty and fair-trade practices aside, clearly this poses a major resource threat to IFCs. It’s not a matter of whether IFCs are willing to assist in the fight against tax evasion, as they have clearly demonstrated they are ready to do just that. But they do not have the financial resources to implement changes to their regimes for this purpose unless funding is received directly from the countries that are asking for such changes. When faced with the earlier prospect of U.S. FATCA, some businesses based in IFCs chose to avoid American clients completely; but with CRS, which includes clients from all over the world, that approach is not practical. It therefore remains a question of incurring the costs to comply or shutting down the businesses entirely.
The same dilemma faces governments in IFCs. Either they are willing to incur the costs of potential expensive changes, including regular inspections and audits, etc., or they cannot. In the short term, they will be able to avoid the dilemma, as there are not pressures as yet to introduce even further changes. But when that does surface, likely in the medium term, there will be some serious decisions to be made.
Most IFCs will survive in the short term. Some are likely to survive in the medium term but only those willing to take a more strategic approach to their existing business models are likely to survive in the longer term.