The five technology trends that will change insurance for good and for better

The modern insurance industry evolved out of London, where business was done in person, contracts and insurance policies were written on paper, and pricing was more subjective than objective. Roll forward 330 years and much of the industry really is not that different. A recent Willis Towers Watson report showed 74 percent of respondents felt the industry had failed to show leadership in digital innovation; remarkable for such a massive global industry.

When Saxon was started in 2011, our vision was clear: use technology to create a better customer experience. We have found that by developing buy online, e-signatures, e-approvals and pricing algorithms, we have simultaneously been able to drive down processing times, and increase customer satisfaction. We are far from perfect still, but our adoption rate of new technology, and the Saxon culture mean that every day we get better and stronger. What is exciting from our point of view, is that the industry is at a tipping point, and the big winner will be the consumer. Here are five technology trends that we are embracing because we believe they are going to contribute to an insurance revolution:

Artificial intelligence

AI has a bad reputation. To many, it conjures up images of mass job losses, robotic “customer service” and infuriatingly limited options. Actually, if it is used wisely, the reverse should be true. AI should allow the 70 percent of transactions that are simple – in insurance, think adding a driver to a vehicle policy or claiming for a lost piece of jewelry – to be processed instantaneously through a medium like Whatsapp, Facebook Messenger or even Siri.

Could AI lead to job losses? Absolutely. But only if we do not adapt. AI will force the human workforce to find a way to provide added value. This could be through delivering a heightened customer experience, being empowered to make discretionary service decisions, or creating a deeper connection and thus driving loyalty.

To the contrary of popular opinion, AI will lead to a much greater customer experience if done correctly. And insurance is a frontrunner in adopting it. Just google “Lemonade” to see the stir they are creating in the market, and all the copycats that are emerging – many of them established, traditional players.


Used by military forces for over a decade, the private sector is embracing their use exponentially since the FAA relaxed their rules in 2016 in terms of their commercial use. The insurance industry has shown a particularly keen interest in drones for several reasons, but the two main ones are:

  1. It is much cheaper to send a drone to inspect a high building than a person. From the shorter inspection time, to the fewer workmen’s compensation claims, drones save money.
  2. Post disaster claims inspections can now be conducted within hours of an event. Images of the damage caused by Hurricanes Harvey and Irma were taken very soon after the winds died down. This allows insurers to assess total damage far more quickly than traditional methods. The most advanced insurers are even overlaying real-time images with their policyholders’ information to pro-actively evaluate the extent of damage, and in many cases, offer settlement amounts before a claim is even made.

As for Saxon, as we have developed our own drone program, we have identified another use case: as a verification tool. We have already had examples where we’ve identified customers who had noted on their application form by mistake that they had, for example, a standing seam roof when in actual fact it was shingle. Having inspected the house with our drone, we were able to identify the error and rectified it up front. Without that inspection, in the event of a claim for roof damage following a hurricane, it is likely that any claim would be denied.

Big data

It is a painful process applying for insurance. Even with the ease of doing it online, there are still a lot of questions, and all for a product that, while important, is not that exciting. The question, therefore: is there enough available public data that means the way insurance is distributed can be radically improved? Quite probably, yes, but it is about getting comfortable with data sharing and access. Admiral, a U.K. insurer, was trialing a program whereby it was scraping Facebook data and looking for a link between people’s Facebook accounts – frequency of access, time of use, language employed – to develop a pricing and underwriting model. The project ended when Facebook got cold feet. But sooner or later a similar model will gain traction – and should make the process of buying insurance a breeze.

An alternative distribution model would be a pay-as-you-go model. Using car insurance as an example, the two key factors in determining the cost are 1) how much you drive and 2) the way you drive. An app on your phone that captures and transmits driver behavior information can accurately assess both factors, and would allow you to consume insurance as you would electricity. Or better yet, embed the technology in the vehicle and include in the lease cost.

The same Willis Towers Watson survey mentioned earlier, also shows 94 percent of respondents believe that distribution will be the area most radically improved by technology over the next five years. Big data will be central to this.


The insurance industry can be extremely inefficient. The chain of insurance often goes like this: Consumer – agent/broker – Insurer – broker – reinsurer – broker – reinsurer.

If we conservatively assume that each layer is costing the consumer 10-15 percent on top of the pure insurance cost, then it is safe to assume we are paying about twice as much as we would do in a perfectly efficient market. This is one of the reasons why Saxon is committed to being 100 percent direct to the consumer for our products. Incidentally, we have also cut out the broker between us and reinsurers too.

So, one obvious solution to this inefficient market is peer-to-peer insurance. Just like Uber has erased the inefficiencies of the taxi industry, or Airbnb has become so popular as a source for accommodation, the time is ripe for P2P insurance for certain segments of the industry. In fact, Lemonade originally launched as a P2P insurer, but had not prepared the market well enough, so retreated from that brand position.

No doubt that consumer confidence is critical to success – trusting that someone will pay to repair your house takes a bigger leap of faith than trusting someone will pick you up on time – but it is not hard to imagine a set-up that would provide the required level of confidence.

Self-driving cars

Tesla recently came out and said it would look to include lifetime insurance costs in the purchase price of one of their vehicles, such is the confidence they have in the autonomous driving and collision avoidance technology of their vehicles. Whether or not this is marketing ploy by Tesla to get some column inches, the academic point is extremely valid. At what point, can insurance products switch to becoming warranty products? In the case of a fully autonomous, self-driving vehicle, surely if an accident occurs then it is a product defect? And while this is likely to be backed at an aggregate level by some sort of insurance product, from the consumer’s perspective it would be embedded in the purchase price, and remove the need to buy car insurance annually.

If this is a near reality for car insurance, then it is easy to see how fire-proof homes, or unbreakable phones, will require a new approach to the old way of insuring.

Insurance is a hugely important product and industry, but the reality is no one particularly enjoys buying insurance, reading policy documents or arguing about claims. The good news is that an insurance revolution is occurring, forced by disruptors entering the market, and everything that has not changed in hundreds of years is being critically examined under the new light of consumer experience. There are a lot of reasons to be optimistic.

So while Saxon does not quite have the R&D budget to be a global investor in developing these trends, we will continue to be one of the first to adopt new technologies as long as they are beneficial to our customers.

Semantic traps in tax policy

Tax avoidance. Aggressive tax planning. Harmful taxation. Treaty shopping. Rule Shopping. Law Shopping. Abuse of tax treaty. Abuse of tax law. Secrecy jurisdictions. Black money.

If someone had the patience to read the tons of documentation written on tax policy by the Organization for Economic Cooperation and Development (OECD) or other international organizations, such as the International Monetary Fund or the United Nations, he would see how these texts are full of unreadable words, locutions, acronyms, slogans and definitions. All these papers are well-written, very elegant in their sophisticated terminology, convincing.

Nevertheless, going more in depth with the reading, one realizes that they are only empty shells, beautiful words with no meaning.

The rush for increasing the sophistication level of tax policy language is not left to chance but it is a deliberate strategy by policy-makers to corrupt the meaning of words in order to convince governments, politicians and naive citizens that the global economy is unjust, entrepreneurs are evaders, multi-national companies spend time designing tax strategies to minimize the amount of taxes to pay, and so on. Once they have convinced the reader that the world is unequal, the solution comes naturally: fight corruption through anti-avoidance rules, squeeze taxpayers (mostly capital-owners), and give more money to the state so that bureaucrats can increase public spending for welfare programs, for whatever that means.

Nevertheless, these institutions know that, to achieve their goals, they must convince the greatest number of countries to follow their recommendations. Suppose, in fact, only few countries decide to follow them, while all the others do not. The former would lose all tax revenues, thanks to the freedom to move capitals and tax bases to other jurisdictions, and the latter would host all the taxpayers escaped from the jurisdictions which levy high taxes.

This is a typical equilibrium achieved under a Tiebout competition. To achieve it, a co-ordination of tax regimes is required. This is why these organizations launched a campaign against tax competition, preaching the benefits of “tax harmonization,” a semantic trap meaning that all jurisdictions should adopt the same tax policy, tax rates, tax bases and tax rules.

A semantic trap in the tax policy is recognizable by the distorted use of the adjectives associated with nouns. The idea which stands behind the trap’s creator is to transform an adjective having a neutral connotation into one with a negative meaning. For example, the OECD’s “aggressive tax planning locution,” used by the organization to convince governments they have to join an international convention to tackle the fiscal planning made by multinational corporations and wealthy people, an “emerging global issue,” as they call it.

The OECD moves from the assumption that tax competition can be harmful. It does not say that it is harmful per se but that it can be harmful when it becomes detrimental for government’s revenues because it leads to a sub-optimal provision of public goods. This is a subtle but fundamental difference. Professor Michael Devereux (Oxford University), one of the leading OECD economists and a great supporter of tax harmonization, defines “harmful tax competition” as “the uncooperative setting of source-based taxes on corporate income where the country is constrained by the tax setting behavior of other countries.” In a free-market perspective, competition is always and necessarily an uncooperative game, as market forces always constrain players to behave in order to achieve better results than other players but the goodness of competition stays just in this. Otherwise, it would not be a competition. Therefore, it seems quite paradoxical that supporters of “harmful tax competition” transform a good feature into a negative one. The result is that someone is entitled to decide when behaviors of those who harm the competition (the tax planners) become unacceptable from a social perspective. In other words, according to this view, tax competition, theoretically seen as a good, is subjected to a moralization process which ends with the condemnation some behaviors. Almost never the OECD said tax competition can be beneficial for people and companies, while empirical evidence shows that this is true. It has always highlighted, and often created, only the side effects of tax competition. Over time, they have hinted that “harmful tax competition” leads to a race to the bottom, fueled by a continued fall in corporate tax rates to attract tax bases, undertaken by the use of tax planning and profit shifting activities.

According to the OECD, jurisdictions with low tax regimes are not seen as best practice in terms of effective and efficient tax administration, but as pirates that subtract tax revenues from other jurisdictions. But since they realize that defining what harmful tax competition really means is not an easy task, they have been forced to introduce an ad-hoc language to identify the subjects who harm the competition. Categorizing institutions and finding a culprit is always the most effective way to reach the goal. So, the OECD started to group states into categories: country with preferential regimes, tax havens, and non-member economies.

Then, it established criteria for identifying each of them. “Preferential regimes” and “tax havens” are other two semantic traps. Just pay attention to how the OECD’s definition of the word “havens” is used to connote a jurisdiction “characterized by having only nominal or no taxes, impeding the free exchange of information on taxpayers with other governments through administrative practices or laws, non-transparency, and a lack of substantial activities” as the enemy of the poor and the haunt of the world’s criminals. The idea that low taxes, small governments, privacy and private property’s defense could be values worthy to be defended does not deserve to be considered.

Another example of semantic trap is the “tax avoidance” locution. According to the Cambridge dictionary, this term means “the reduction, by legal methods, of the amount of tax that a person or company pays.” Moving from this definition, the OECD believed it was its duty to limit the taxpayers’ freedom to find legal methods to minimize their tax burden. The organization’s website devotes an entire section to the tax avoidance issue, in which it notes that “OECD is at the forefront of efforts to improve international tax co-operation between governments to counter international tax avoidance and evasion.” By doing so, tax avoidance is raised to the same level of tax evasion, among the activities which must be tackled. Not because it is illegal, but because it is considered dangerous for governments’ public finances. This is the contradiction: fighting a legal behavior in order to build a more legal world. This violent incursion into the sphere of taxpayers’ personal rights is not only tolerated by the OECD but, even worse, encouraged.

But how can you convince people that something legal must be punished? Through morality. Morality is not justice or legality. In policy-making, morality is only an arbitrary vision of an issue, through which what is “legal” may become an “undesirable legality” and, for this reason, should be punished. With a sophisticated language used to sweeten the pill, the institution has produced a great deal of papers, presented at many conferences around the world, and paid officials to lobby governments in order to convince that tax legality is undesirable. The “undesirable legality” weakens justice and legality, because it erases one of the main characteristics of the two: certainty. The tax planner who legally takes an action to minimize a tax burden must fears that a tax administration can always decide that this behavior must be punished.

This is pure arbitration. The same is used by the OECD when it compiles the “black list” of what it calls “uncooperative tax havens,” according to some criteria it has freely established. Jurisdictions which do not respect transparency and exchange of information requirements are blacklisted. Financial privacy is not a right for the OECD.

In conclusion, we should always pay attention when we read the policy papers and “recommendations” by international organizations because behind any word there is a hidden intent to achieve a moral goal, which most of the time aims to reduce the economic freedom of individuals.

Most common semantic traps used in tax policy

Tax avoidance: the use of legal methods to modify an individual’s financial situation to lower the amount of income tax owed. This is generally accomplished by claiming the permissible deductions and credits [Investopedia]. It differs from tax evasion, which uses illegal methods, such as underreporting income to avoid paying taxes.

After-tax hedging: taking opposite positions for an amount which takes into account the tax treatment of the results from those positions (gains or losses) so that, on an after-tax basis, the risk associated with one position is neutralized by the results from the opposite position. [OECD]

Tax Planning: Set of planning activities undertaken by a taxpayer to minimize tax liability through the best use of all available allowances, deductions, exclusions, exemptions, etc., to reduce income and/or capital gains.

Aggressive Tax Planning: conceptually elusive

Harmful tax competition: Commission communication “a package to tackle harmful tax competition in the United Europe”, discussion initiated by the Commission at the informal meeting in Verona, 1996. From the reading of the text it appears clearly what EU officials wanted to achieve by introducing the slogan “harmful competition”: a needed “coordinated action at European level to tackle harmful competition in order to help achieve certain objectives such as reducing distortions in the single markets, preventing excessive losses of tax revenue or getting tax structures to develop in a more emplyment friendly way”. [conclusions of the Ecofin Council Meeting on 1 December 1997 concerning taxation policy]

The criteria for identifying potentially harmful measures include:

  1. an effective level of taxation which is significantly lower than the general level of taxation in the country concerned;
  2. tax benefits reserved for non-residents;
  3. tax incentives for activities which are isolated from the domestic economy and therefore have no impact on the national tax base;
  4. granting of tax advantages even in the absence of any real economic activity;
  5. the basis of profit determination for companies in a multinational group departs from internationally accepted rules, in particular those approved by the OECD;
  6. lack of transparency.

In a report of November 1999 the Group identified 66 tax measures with harmful features (40 in EU Member States, 3 in Gibraltar and 23 in dependent or associated territories). Following the 1998 report “Harmful Tax Competition: An Emerging Global Issue” the OECD created the “Forum on Harmful Tax Practices” focussed on three areas: Harmful tax practices in Member Countries; Tax havens; Involving non-OECD economies. In the framework of its work on Base Erosion and Profit Shifting (BEPS) the OECD has agreed on recommendations on a number of issues in October 2015 including: Hybrid mismatch arrangements (Action 2); Transparency of rulings (Action 5); Patent boxes (Action 5)

Treaty Shopping: abusive practice of structuring a multinational business to take advantage of more favorable tax treaties available in certain jurisdictions. The search of the most favorable treaty from the tax regime perspective by the subject who abuses.

Rule Shopping: abusive practice consisting in a behavior finalized to making applicable a provision more favorable to the foreign source income, that would not be applicable, otherwise.

Both the Treaty and Rule Shopping belong to the more general Law Shopping.

Abuse of Tax Treaty: improper behavior by a State to suspend or extinct a treaty (Vienna Convention on the Law of Treaties).

It represents a variant of the Abuse of law semantic trap, meant as a subjective right exerted by a single in a contrary manner with respect to the aim recognized or protected by the law.

Hybrid Mismatch Arrangements: arrangements exploiting differences in the tax treatment of instruments, entities or transfers between two or more countries

Related semantic traps:

Hybrid entities: Entities that are treated as transparent for tax purposes in one country and as non-transparent in another country
Hybrid instruments: Instruments which are treated differently for tax purposes in the countries involved, most prominently as debt in one country and as equity in another country.

Hybrid transfers: Arrangements that are treated as transfer of ownership of an asset for one country’s tax purposes but not for tax purposes of another country, which generally sees a collateralised loan.
(see: OECD, Hybrid Mismatch Arrangements – Tax Policy and Compliance Issues, March 2012)

Base erosion and profit shifting (BEPS): tax avoidance strategies that exploit gaps and mismatches in tax rules to artificially shift profits to low or no-tax locations. The BEPS package provides 15 Actions that equip governments with the domestic and international instruments needed to tackle BEPS

Transfer pricing: transactions involving intangibles; contractual arrangements, including the contractual allocation of risks and corresponding profits, which are not supported by the activities actually carried out; the level of return to funding provided by a capital-rich MNE group member, where that return does not correspond to the level of activity undertaken by the funding company; and other high-risk areas. (OECD, Aligning Transfer Pricing Outcomes with Value Creation, Actions 8-10 – 2015 Final Reports)

The future of money: How cryptocurrencies with real backing will become the ultimate disruptive technology

The world has been plagued by endless fluctuating exchange rates between countries and persistent and highly variable rates of inflation ever since the major countries of the world began to erode the gold standard during the twentieth century as a direct result of having to finance major wars. Transactions costs, using cash, credit or debit cards, check or wire transfers, are all unnecessarily high. These problems have undermined saving, investment, and trade – all of which have reduced GDP growth, employment and real wage growth.

The solution is to move to a world of privately created money with real backing, such as a basket of commodities, or one or more metals, such as gold, silver or aluminum – which would be exchanged in digital form through the use of blockchains. The innovative blockchain software technology enabled the creation of cryptocurrencies, such as Bitcoin and Ethereum.

The use of the blockchain solves the problem of double spending and, through the use of encryption, protects financial privacy while verifying the transaction in close to real time. The actual transaction cost can be negligible, and national borders are irrelevant. The problem with existing cryptocurrencies is that, even though the developers have found mechanisms to limit the total amount of currency issued, there is no benchmark or real basis for actual value and hence the prices have fluctuated very wildly. In contrast, even though the U.S. dollar, like all major currencies, is what is called a fiat currency with no specific backing (i.e., the U.S. gold reserves are only a tiny fraction of the total money supply), but the government does have the ability to acquire resources through taxation. That is, the value of the U.S. dollar is based on the correct belief that the government has sufficient coercive power to tax real assets.

Private parties could move to the use of gold, aluminum or other commodities as a benchmark and backing for money without government permission. Prices for all other commodities, goods and services could be listed in troy ounces of gold, pounds or kilos of aluminum rather than US dollars, euros, U.K. pound sterling, Japanese yen, or any other central bank-issued fiat money. Nobel Laureate, F. A. Hayek, in his classic, “Denationalization of money – the argument refined,” published in 1974, clearly explained why it was preferable and practical to have non-government issued money, with competitive suppliers. There is no more reason for the government to have a monopoly on money than there is for government to have a monopoly on the production of toasters. Historically, many private parties minted gold, silver and copper coins, which were fully interchangeable with government-minted coins of the same weight. The only need for government to be involved with the production and quantity of money is to designate what is legal tender for the payment of taxes and government payments to others. If the dollar is defined for U.S. government purposes as, for instance, 1/1000 of a troy ounce of gold or one kilo of aluminum, it matters not as to who minted the coins or supplied the metal as long as it meets the defined standard. The technical hurdles for implementing Hayek’s concept for private money no longer exist as result of the Internet and blockchain.

Gold, for many good reasons, has served as the most commonly used commodity standard for money. Ever since being adopted by the U.K. in 1821, as well as by Germany, France and the U.S. in the 1870s, gold has served the global economy well. It became, in essence, the world currency, thereby eliminating the chaos of multiple fluctuating foreign exchange rates. Goods and services, all around the world, were denominated in gold. And given the cost of mining new gold, persistent inflation did not occur. This was an economic golden age in which the world economy grew rapidly.

There are many arguments for going back to gold; but for several practical reasons, it is very difficult. The dollar’s peg to gold at $35 per ounce was officially (and abruptly) abandoned in 1971, and in 1976 the U.S. dollar officially became a fiat currency. But even after the 3,000 percent rise of gold versus the dollar in the 46 years that followed, the money supplies of all nations vastly exceed their gold supplies, even at the current price for gold. It is unpalatable, politically, for central banks to now re-peg their currencies to gold at whatever high rate is feasible and give up the power to control their money supply. The re-adoption of a global gold standard would also restrict governments from running large and persistent deficits.

In theory, there is no reason why private parties cannot issue gold coins. There are many private minters who currently do. The problem arises if these gold sellers call their coins money, because it then falls under government regulation, and the U.S. Treasury has been aggressive in shutting down private issuers of gold money (both coin and digital gold money). It should be noted that under Section 8 of the Constitution, Congress has the power to coin money; however, it does not specify that only Congress should have this power.

The U.S. government places a capital gains tax on any gain in the price of gold coins and bullion versus the U.S. dollar, even when the fall of the dollar is solely due to inflation. The price of gold has also been much more volatile than aluminum and a number of other commodities over the past thirty years. The volatility is due to the fact that the price of gold is very much influenced by world events and the actions of governments – such as gold sales and purchases – who own a major share (18 percent) of the outstanding world stock of gold. Relatively small sales or purchases of gold by governments can greatly affect the price of gold, since, like all commodities, it trades at the margin.

There are many alternatives to gold, including a variety of commodity baskets, but my favorite is aluminum. As unlikely as it may seem, an aluminum-based money overcomes several of the problems with gold. Like gold, most of the aluminum ever produced is still in use today (more than 90 percent of the gold ever produced and more than 75 percent of the aluminum). These two metals do not disappear with endless recycling and environmental degradation (they do not “rust”), unlike virtually all other metals. A high and growing percentage of aluminum is recycled because approximately 40 percent of the cost of primary aluminum production is energy, yet it is only five percent of the cost of recycled aluminum, so there is a strong incentive for recycling.

As unlikely as it may seem, an aluminum-based money overcomes several of the problems with gold.

In the past, gold had the attraction that a tiny amount was of great value, so it was easy to carry around and useful for high-value coins. This advantage disappears in the digital age, and, in fact, can be a disadvantage. Because of its high value to weight, gold is easily stolen, which makes it costly to store. It is much more difficult to steal a significant value of aluminum because of its low value to weight. If aluminum becomes widely used as a global monetary standard, issuers of aluminum-backed money would need to demonstrate that they have possession of – or at least ability to procure within a short period of time – the necessary aluminum to fulfill redemptions. Issuers of aluminum money would likely be aluminum producers, banks, other financial institutions and even major owners of aluminum, such as airlines (the planes).

Global standards would need to be established for issuers, and perhaps insurance might be required. Given that aluminum coins would be digital, each one could be traced back to a specific issuer in case of a redemption problem. The risk would be low – one issuer might possibly have a problem, but not all would.

Aluminum is the most versatile and useful of all metals, in that it can be substituted for most other metals at some price, as well as many plastics, wood, etc. Over the last 30 years, aluminum has had far less price volatility than gold and, as noted above, all other major metals and most commodities. Its price volatility should continue to decline as the stock of existing aluminum grows relative to new production of primary aluminum. The cost of producing secondary aluminum will always be less than that of producing primary aluminum because of the energy cost differential. This imposes a natural limit on how much primary producers can charge.

At the moment, the Chinese have more than half the world’s primary production capacity; but even so, they cannot “corner” the market because of the huge global stock of secondary aluminum, equal to about 15 times yearly primary output, and there are many aluminum producers in many countries who can ramp up production. Aluminum accounts for about 7 percent of the earth’s crust, so no country can obtain a lock on the raw material, most notably bauxite. If the Chinese government decided to adopt aluminum as their official currency backing, others around the world would be wary that they might engage in price manipulation, which they could do to either bankrupt competitors or impose a temporary artificial scarcity. The Chinese would be smart if they let private entrepreneurs create aluminum-backed currencies and then legalize them for domestic use and even for government purposes. This would give them total independence from the U.S. Federal Reserve, which neither China or any other country now has.

The. U.S. government benefits from having the dollar as the world reserve currency. It is not only the Chinese who resent this system, but many other countries, such as the Swiss, who have lost some of their monetary and regulatory independence to the Fed. It is only a matter of time before some countries figure out that they can use the new technologies to regain their monetary freedom. The U.S. and other major governments will not like the competition.

It will be very difficult for them to know who is spending and receiving cryptocurrencies with or without real backing, because of the cost of trying to break the encryption for each largely invisible transaction.

The problem of cryptocurrencies without a real anchor is well recognized, so there will be many attempts to find the most acceptable backing – gold, aluminum, commodity baskets or whatever. (Note: We have already established considerable intellectual property protections for the aluminum-backed cryptocurrency concept and its implementation. Others are working on gold, etc. As always, the market will ultimately determine success.)

The classical gold standard using coins and/or bullion for transactions provided a great deal of financial privacy for the users, particularly if they did not use banks. The new cryptocurrencies have the potential to provide the same level of privacy, because the networks are peer-to-peer, rather than having the money run through a bank or other financial institution.

Governments will, of course, try to ban/monitor/regulate/tax cryptocurrencies, but it is a battle they are likely to ultimately lose in the same way new technologies have been almost fatally disruptive for traditional book stores, video rental shops, film cameras, newspapers, etc. Private cryptocurrencies with real backing are likely to become the ultimate disruptive technology and finally free people from government monetary tyranny.

Escaping the international tax cartel through technology


In 1800, average income per capita across the world was around $1,200 (in 2017 dollars). In Europe, it was around $2,000 and in Ottoman Egypt about the same. In the South Indian kingdom of Mysore, it was higher: around $3,500 – similar to that of Europe’s richest economy, the Netherlands. Much has changed since then – mostly for the better.

During the 19th century and into the 20th century, many European countries (and most notably the U.K., the Netherlands, Germany, Switzerland, France, Denmark and Sweden) grew rapidly, as did the U.S., Australia, and Argentina. After the Second World War, some countries returned to growth, while others, including much of Latin America, China, India, and the Soviet Union, stagnated. Japan, South Korea, Taiwan and Hong Kong began growing rapidly. In Africa, many newly-independent countries floundered. And in the past 30 years, China, especially, and India to a lesser extent have experienced rapid growth. Meanwhile, growth in Europe, Japan and the U.S. has been lackluster.

Wherever it has occurred, sustained growth has been the result of innovation, which has resulted in the production of more and better goods and services using fewer inputs. Underpinning this innovation has been competition, which has incentivized entrepreneurs to specialize and to develop new products and production processes in order to create profits. By contrast, where competition has been stymied, usually by some combination of regulation, trade restrictions, and/or distortionary taxes and subsidies, incumbent producers have grown complacent and innovation and growth has stagnated.

Competition and specialization is not inherently constrained by national borders. International trade in goods and services has enhanced the process. Countries that have been more open to such trade have generally experienced more rapid growth as a result. China’s recent growth has in no small part been facilitated by unilateral reductions in trade restrictions, which have reduced the cost of inputs, such as energy (e.g., coal from Indonesia and Australia), enabling producers to leverage other inputs (notably low-cost local labor) and compete with producers facing higher input costs, resulting in a dynamic and innovative manufacturing industry.

The benefits of free trade are not limited to goods. When capital can more freely move across borders, competition ensures that entrepreneurs are able to finance worthwhile investments at lower cost. This is especially true for smaller economies, including most countries in the early stages of growth, where the pool of capital is often very limited.
Development economists recognized the need for capital in the 1950s, but this was interpreted by many as a justification for government subsidies, while private capital, driven by the profit motive, was often seen as “harmful.” The ensuing combination of “aid” (i.e., capital provided by foreign governments and allocated by domestic governments, usually to politically connected companies) and restrictions on private investment and lending inhibited competition and innovation, contributing to the slow rates of growth in much of Africa and South Asia.

By contrast, the emergence of offshore financial centers has been a boon to economies across the world. By offering a well-regulated, tax-neutral environment in which capital can flow freely to its most highly valued uses, these centers have provided an important lubricant to the wheels of innovation and growth.

In addition, by withholding capital from the grubby hands of the governments of over-taxed and over-regulated countries, OFCs help entrepreneurs in those countries who might otherwise be subject to even more onerous taxes and regulations.

As Richard Teather notes in this issue, critics claim that offshore financial centers such as Cayman are engaging in “harmful” tax competition. These dissembling bureaucrats are only able to make such claims by inverting the meaning of “harmful,” so that it applies to OFCs that are well regulated and successful, but doesn’t apply to countries, such as Nauru, that are poorly regulated and unsuccessful. In other words, the EU and its buddies at the (Paris-based) OECD just don’t like it that OFCs threaten the business model (if one can call it that) of their bloated, protectionist member governments. (This point is driven further in this issue by Emanuele Canegrati, who explains the true meaning of various terms used to attack OFCs.)

At one level, OFCs could be viewed as a “technology” that has enabled capital to circumvent harmful government restrictions. In the past decade, a new type of technology has begun to play a similar role. Cryptography, used for thousands of years to send coded messages, has been transformed by the development of modern algorithms and rapid computer processing, enabling safer communication and storage of information. And now it is being used to store and transfer capital.

For more than 50 years, payment networks have used encrypted messaging to authenticate transfers of funds. However, until recently there was no safe and reliable digital equivalent of cash. As a result, anyone seeking to move large amounts of capital from one place to another either had to use a payment network that was subject to government reporting and oversight, or convert the funds into physical assets (cash, bearer bonds, diamonds, gold, etc.).

In the 1990s, several companies created digital “cash” in the form of encrypted tokens. But these risked the digital equivalent of counterfeiting, known as the “double spending” problem: in the absence of a means of identifying the uniqueness of each token, there is a risk that it could be spent twice (or more). Issuers initially attempted to solve the problem through centralized authentication systems but these were expensive and faced a risk that the authentication system itself would be hacked. (Other solutions were considered, such as affiliating individual tokens with the biometric information of their holders, thereby ensuring that only the legitimate holder of a token could spend it; but they were not implemented, probably due to cost.)

Then, in 2008, an anonymous cryptographer (or group of cryptographers) known as “Satoshi Nakamoto” published a paper describing a possible solution involving the use of distributed ledgers. Specifically, Nakamoto envisaged the creation of a new digital currency, Bitcoin, whose tokens would be identified by accretions of unique blocks of code and authenticated during each transaction against the ledger (i.e., all other blocks, which are held on all nodes of the network). The authentication process requires a computer to solve a complex algorithm and its solution generates a new token (or a fee, when all tokens are issued). Although Bitcoin was the first such currency to be created and remains the most popular (as of this writing, the total value of Bitcoins in circulation is $62 billion), many others have followed.

While transactions into and out of Bitcoin are readily observable, transactions made with Bitcoin – and other blockchain based currencies – may be made anonymously. As such, they have become a popular means of moving capital away from the prying eyes of government. But that feature has attracted the attention of government officials, who have sought to regulate Bitcoin exchanges or even, as in China, ban them.

One potential problem faced by current blockchain based currencies is their fiat nature, which means that they have no intrinsic value. If Bitcoin were to become a dominant medium of exchange, that problem might disappear. But as Richard Rahn notes, there may be a simpler and more effective solution: create a new blockchain-based currency backed by real assets, such as aluminum or a basket of metals (or other widely tradable and non-perishable commodities).

In the meantime, Singapore has announced that it intends to “tokenize” its currency using a private Etherium-based blockchain, which could improve the speed and reduce the cost of large Singapore-dollar denominated transactions. And the Bank of England has also been looking into the use of blockchain for digitizing the Pound, as have the central banks of Canada, Japan and Russia.

Blockchains are now being developed and used for many purposes beyond currencies, as several authors in this issue highlight. Ron Quaranta explains that some of these involve private blockchains, the purpose of which is to mimic the authentication advantages of a public blockchain while avoiding the potential for disclosure of elements of the transaction.
In many cases, new blockchain based businesses raise funds through “initial coin offerings” (ICOs). These share features of crowdfunding, in that the project only proceeds if sufficient funding is obtained (and if it is not, then the funds raised are returned). But unlike most crowd-funding sites, the purchasers of tokens issued during the offering effectively become shareholders in the project. As Brian Knight and Andrea O’Sullivan note, ICOs raise a host of regulatory issues, from AML/KYC requirements to compliance with securities rules.

One of the earliest ICOs was for Etherium, a blockchain-based smart contract system. The tokens issued during the Etherium ICO were sold in 2014 at an issue price of $0.4 and currently trade at around $250. Smart contracts offer huge potential for disintermediating financial services. The extent and speed with which this process will occur is open for debate, but occur it will.

Therein lies both opportunity and threat for OFCs: opportunity to be at the forefront of the blockchain revolution, by creating an appropriately light touch regulatory framework that enables the operation of exchanges and smart contract-based services (from fund management to insurance) that attracts business away from the less responsive regimes elsewhere. A threat lies in the potential for some of the core activities currently provided by professionals in IFCs to be replaced by robots.

External regulatory developments continue to plague Caribbean financial centers

Caribbean international financial service jurisdictions must continue to deal with several external factors as they conduct business. Many of these developments pose challenges to their successful operation. This article will focus on four of the developments: efforts to hold enablers criminally liable; the OECD’s Multilateral Instrument (MLI); automatic exchange of information; and the use of blacklists.

I. Efforts to hold enablers criminally liable

In the last five years, tax authorities and prosecutors in the United States and several EU countries have prosecuted banks and other intermediaries for their roles in conspiring and/or assisting taxpayers to commit tax crimes. The French, Belgian and German prosecutors have all brought cases against Swiss banks. Although long an important international financial services jurisdiction, the United Kingdom government has been at the forefront of initiatives to change the conduct of tax intermediaries or enablers.

The U.S. Department of Justice has been the leader of efforts to prosecute. In May 2014, Credit Suisse pleaded guilty to conspiring to aid and assist U.S. taxpayers in filing false returns and was sentenced in November 2014 to pay $2.6 billion in fines and restitution.

In December 2014, Bank Leumi, an international bank based in Israel, entered into a deferred prosecution agreement after the bank admitted to conspiring from at least 2000 until early 2011 to aid and assist U.S. taxpayers to prepare and present false tax returns by hiding income and assets in offshore bank accounts in Israel and other locations around the world.

Under the terms of the deferred prosecution agreement, Bank Leumi paid the United States a total of $270 million (in U.S. currency) and continues to cooperate with respect to civil and criminal tax investigations.

In February 2016, the Justice Department entered into a deferred prosecution agreement with Bank Julius Baer, which admitted to conspiring with and knowingly assisting U.S. accountholders to hide billions of dollars in offshore accounts and evade U.S. taxes. As part of the deferred prosecution agreement, Julius Baer agreed to pay $547 million (in U.S. currency), including restitution for tax loss arising from the undeclared U.S. related accounts, disgorgement of gross fees paid with respect to these accounts, and a fine for its illegal conduct. In addition to the deferred prosecution agreement, two Julius Baer bankers, both of whom had been fugitives since 2011, pleaded guilty to conspiracy to defraud the IRS, to evade federal income taxes and to file false federal income tax returns.

On Dec. 29, 2016, the U.S. Department of Justice announced that it had reached final resolutions with banks that have met the requirements of the Swiss Bank Program. The Program provided a path for Swiss banks to resolve potential criminal liabilities in the United States, and to cooperate in the Department’s ongoing investigations of the use of foreign bank accounts to commit tax evasion. The Program also provided a path for those Swiss banks that were not engaged in wrongful acts but nonetheless wanted a resolution of their status. Banks already under criminal investigation related to their Swiss-banking activities and all individuals were expressly excluded from the Program.

On April 27, 2017, the Criminal Finances Act 2017 received royal assent in the United Kingdom. It became effective in September 2017. It contains several provisions that will significantly alter the investigation and enforcement of corporate crime in the U.K. and establishes a new offense for tax professionals, such as solicitors and accountants, rendering tax advice.

The law contains two new offenses for failure-to-prevent: the failure to prevent facilitation of domestic tax evasion and the failure to prevent facilitation of foreign tax evasion. If a person who is “associated with” a relevant body commits a foreign or U.K. tax facilitation evasion offense, the relevant body will be vicariously liable. The law defines an “associated person” to include an employee, agent or any other person performing services on behalf of the relevant body. The Director of Public Prosecutions or Director of the Serious Fraud Office (SFO) must approve a prosecution.

Section 45 criminalizes: (i) being knowingly concerned in, or acting with a view to, the fraudulent evasion of tax by another person, and (ii) aiding, abetting, counselling or procuring the commission of a tax evasion offense.

Section 46 criminalizes a “foreign tax evasion facilitation offense,” meaning non-U.K. tax evasion by a U.K. company. It applies where the relevant entity has a nexus with the U.K., and it consists of conduct which (i) amounts to an offense under the law of a foreign country; (b) relates to the commission by another persons of a foreign tax evasion offense under that law; and (ii) would, if the foreign tax evasion offense were a U.K. tax evasion offense, amount to a U.K. tax evasion facilitation offense. Hence, the act must fulfill a dual criminality test.

The Act provides for a reasonable prevention procedures defense, which emulates Section 7(2) of the Bribery Act 2010. According to the HMRC draft guidance, “if a relevant body can demonstrate that it has put in place a system of reasonable prevention procedures that identifies and mitigates its tax evasion facilitation risks, then prosecution is unlikely as it will be able to raise a defense.” Under Section 47(1) and (2), the Chancellor of the Exchequer (“the Chancellor”) must prepare and publish guidance about procedures that relevant bodies can put in place to prevent persons acting in the capacity of an associated person from committing U.K. tax evasion facilitation offenses or foreign tax evasion facilitation offenses and may from time to time prepare and publish new or revised guidance to add to or replace existing guidance.

The implications of legislation criminalizing acts of the enablers who participate in structuring and tax planning are that intermediaries, especially in countries such as Switzerland and the U.K., are increasingly wary of creative, proactive planning advice that may run afoul of the laws of foreign countries, especially since such violations can involve criminal sanctions, including imprisonment, huge fines and loss of reputation. The prosecution of banks is causing banks and financial institutions, including ones in the United States, to inquire of law firms and fiduciaries for their own anti-money laundering due diligence policies. Already, the EU’s proposed anti-money laundering directive would also extend the definition of the covered financial institutions and products, so that a very large number of persons will soon be covered.

II. Automatic exchange of information (AEOI)

The Common Reporting Standard (CRS), developed in response to the G20 request and approved by the OECD Council on July 15, 2014, calls on jurisdictions to obtain information from their financial institutions and automatically exchange that information with other jurisdictions on an annual basis. It sets out the financial account information to be exchanged, the financial institutions required to report, the different types of accounts and taxpayers covered, as well as common due diligence procedures to be followed by financial institutions.
Now that the last details for the OECD’s common transmission system to facilitate the exchange of data gathered under the automatic information exchange standard have been finalized, data will start flowing between early adopter countries in September 2017.

In the second week of August, the common transmission system was launched at OECD headquarters in Paris, with 136 delegates representing 57 jurisdictions present. The Global Forum will also focus on getting the rest of its members to commit to the CRS, according to Bhatia, who noted that of the 145 members, only 43 have not yet followed suit. The impact of the CRS, along with the U.K. equivalent regime (commonly referred to as UK CDOT) that is in place between the U.K. and the 10 Crown Dependencies (CDs) and Overseas Territories (OTs), and FATCA, has been to raise financial regulatory costs significantly, especially since many small jurisdictions had to invest in studying FATCA, UK CDOT and the CRS, enact laws and regulations, conclude agreements (e.g., FATCA Intergovernmental agreements, CoE/OECD Convention on Mutual Administrative Assistance in Tax Matters), and purchase and develop software to make the exchanges.

Some jurisdictions, such as the Bahamas, had to make additional expenditures. The Bahamas does not even have a Commission of Inland Revenue, since it does not have an income tax. Some jurisdictions that have prioritized and marketed financial confidentiality as an attribute of their international financial services. The AEOI deprives the jurisdictions of the attribute. Another implication of the AEOI is that Caribbean jurisdictions are subject to evaluations of their compliance with AEOI, which requires substantial preparation and follow-up work.

The most important implication is that the most important competitor on trusts and wealth management – the U.S. – has not signed the CRS and there are no prospects that it will sign it in the next few years. Because of its superpower status, none of international organizations, such as the OECD, or informal groups, such as the Financial Action Task Force, will dare put the U.S. or states on the blacklist or take countermeasures against them, even though wealth structures and fiduciary firms are flooding into Delaware, Nevada, South Dakota and Wyoming to take advantage of the anonymity afforded by the knowledge that the U.S. is not and will not be part of the CRS and hence the names of beneficial owners will remain unreported. The U.S. advantage is helped by lack of entity transparency laws in the U.S. and comparatively light reporting on luxury real estate, although recent FinCEN regulation now requires reporting in some metropolitan and border areas for certain luxury purchases. As a result of the advantages of the U.S. states and the lack of a level playing field in the implementation of the AEOI, the small Caribbean jurisdictions will continue to lose market shares to the United States.

III. Multilateral Instrument (MLI)

One Caribbean jurisdiction, Barbados, has developed its international financial services around building a tax treaty network. Counting the CARICOM double tax treaty, Barbados has 43 tax treaties in effect.

The OECD MLI, which is part of the OECD Base Erosion Profit Shifting initiative, will limit the tax planning opportunities. The MLI, titled the “Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting,” addresses treaty shopping and provides jurisdictions with the mechanisms to fight tax avoidance by multinational enterprises. In November 2016, the OECD adopted the MLI to provide signatories with a quick way to implement the treaty-related recommendations of the BEPS project, and held an MLI signing ceremony on June 7. As of Aug. 30, 2017, the OECD now has 70 signatories to its multilateral instrument (MLI), covering 71 jurisdictions, and is actively working with an additional 30 to 40 countries to get them ready for signature as soon as possible, according to an OECD adviser.

Given the fact that 99 countries have participated in the process and are likely to sign the MLI, it may amend a very large percentage of the world’s existing and future bilateral tax treaties so that they are consistent with BEPS treaty-based recommendations.

All signatories have adopted the default principal purpose test (PPT) and 12 jurisdictions will supplement the PPT with the MLI’s simplified limitation on benefits provision. The PPT and LOB provisions will make treaty shopping more difficult and limit the use of the Barbados tax treaty network.

IV. Blacklisting

A formidable challenge for Caribbean jurisdictions with international financial sectors has been the growing use of blacklists. In addition to the OECD, FATF, EU, and national blacklists, even subfederal units have blacklists. The G-7 and G-20 have endorsed and called on countries to use blacklists.

FATF Rule 19 states as follows: “Countries should be able to apply appropriate countermeasures when called upon to do so by the FATF. Countries should also be able to apply countermeasures independently of any call by the FATF to do so. Such countermeasures should be effective and proportionate to the risks.”

The EU has its own blacklists. On May 20, 2015, the EU adopted a new framework on AML/CFT. The new rules consist of: (a) Directive (EU) 2015/849 on the prevention of the use of the financial system for the purposes of money laundering or terrorist financing (the 4AMLD”); and (b) Regulation (EU) 2015/848 on information accompanying transfers of funds (“FTR”).

Art. 9(1) of 4AMLD states that third-country jurisdictions which have strategic deficiencies in their AML/CFT regimes and that pose significant threats to the financial system of the EU (“high-risk third countries”) must be identified in order to protect their proper functioning of the internal market. Art. 9(2) of the Directive authorizes the Commission to adopt delegated acts to identify those high-risk third countries, taking into account strategic deficiencies and laying down the criteria on which the Commission’s assessment is to be based.

Article 18(1) of the 4AMLD calls on obliged entities to apply enhanced customer due diligence measures when establishing business relationships or carrying out transactions with natural persons or legal entities established in listed countries.

On July 14, 2016, the European Commission adopted the Delegated Regulation (EU) 2016/1675, which for the first time identified high-risk third countries with strategic deficiencies. The Commission took into account the most recent FATF Public Statement, FATF documents (Improving Global AML/CFT Compliance: on-going process).
The Regulation has been in force since September 23, 2016.

In July 2016, G20 countries called on the Global Forum to devise objective criteria to identify jurisdictions that have not made sufficient progress toward a satisfactory level of implementation of the agreed international standards. These include those on Exchange of Information on Request (EOIR) and Automatic Exchange of Information (AEOI).
The OECD-hosted Global Forum on Transparency and Exchange of Information for Tax Purposes was asked to prepare a list of non-cooperative jurisdictions for the G20 Leaders’ Summit in Hamburg in July 2017.

Several countries have their own blacklists for tax and money laundering issues which apply primarily to IFCs. An example is Section 311 of the USA PATRIOT Act (Special Measures for Jurisdictions, Financial Institutions, or International Transactions of Primary Money Laundering Concern).

Section 311 of the USA PATRIOT Act provides the Secretary with a range of options that can be adapted to target specific money laundering and terrorist financing risks most effectively. These options provide the Treasury Department with a powerful and flexible regulatory tool to take actions to protect the U.S. financial system from specific threats.

An example of the application of Section 311 to a Caribbean jurisdiction concerning an international financial program is on May 20, 2014, the U.S. Department of the Treasury Financial Crimes Enforcement Network (FinCEN) issued an advisory to alert financial institutions that certain foreign individuals are abusing the Citizenship-by-Investment program to facilitate financial crime.

FinCEN said it was issuing the advisory to alert financial institutions that certain foreign individuals are abusing the St. Kitts and Nevis (SKN) Citizenship-by-Investment program to obtain SKN passports in order to engage in illicit financial activity. Financial institutions can mitigate exposure to the risk through customer due diligence, including risk-based identity verification consistent with existing customer identification program requirements.

Notwithstanding all of the tax and regulatory carve-outs the federal and state governments provide to attract foreign investment, seven U.S. states have enacted anti-tax haven legislation. The laws seek to expand the scope of state taxation to encompass income earned by foreign subsidiaries in countries that a state defines as tax haven jurisdictions.

Even though the Treasury includes states in TIEAs with Canada and Mexico and the Multilateral Convention on Administrative Assistance in Tax Matters, Treasury tells foreign jurisdictions that it has no authority to intervene in state taxation. Some states have issued blacklists based on lists that the OECD has not maintained for over a decade. These lists are arbitrary and non-manageable. States continue to develop new legislation even though the laws bring reduced business employment and investment, potential foreign retaliation, and constitutional challenges.

V. Analysis

A result of the continued application of new extraterritorial financial regulatory, compliance, and enforcement laws is a diminution of international tax planning, since providing international tax advice, especially creatively, is becoming an increasingly risky business.

Meanwhile, the costs of applying tax transparency, anti-money laundering, terrorist financing, economic sanctions and anti-corruption measures has imposed an inordinate burden on small jurisdictions, especially since they are subject to countermeasures if they do not have good scores when they are evaluated.

Unless Caribbean jurisdictions can force international organizations and informal groups using mutual evaluations and countermeasures to apply regulations on a level playing field, the Caribbean jurisdictions will have trouble meeting all the new international financial regulatory requirements. As long as the international financial community continues to be indifferent to proper governance and inclusion of a broad set of countries worldwide, and the Caribbean has no seat on the G-7, G-20, the OECD, the FATF and the EU, it will have difficulty meeting these requirements.

BVI workers relocate to Cayman after Hurricane Irma


Following the devastating destruction caused by Hurricane Irma and the disruption of essential services in the British Virgin Islands, numerous corporate services providers pulled their employees out of the territory with some of the staff to their firm’s sister offices in Cayman.

Richard Reading, a partner at Baker Tilly’s Cayman office, said about 15 to 20 financial services firms booked a jet to evacuate 250 employees. Other firms worked separately to help their workers leave.

He expected between 10 and 15 BVI employees to come to Cayman on a 60-day work permit exemption that allows them to continue carrying out BVI-related business.

Nick Bullmore, a partner with Carey Olsen’s branch in Cayman, said government had been very helpful in facilitating the relocation. He said his firm is moving between five and 10 of its employees and their families here.

“For what it’s worth, our government has done a fantastic job of facilitating these moves,” he said. “It is wonderful to be able to help our sister islands in their time of need. Even though it has now been 13 years since Ivan, we all still remember the generosity shown by others at that time.”

It is not clear how long it may be before the displaced workers can return to the BVI.

“It could take one month, six months, or a year,” Reading said. “It’s going to be a challenge to rebuild. It’s a hard place to build in.”

When Hurricane Ivan hit Cayman in 2004, BDO Managing Partner Glen Trenouth spent about three weeks in the BVI before returning to Cayman. His employees soon followed him, he said.

However, Trenouth said, he was able to find accommodations for himself and his employees. If the BVI cannot rebuild its infrastructure and housing, it would be pointless to send workers back, he said.

“They’d just be a burden on the territory,” he said. Eight BDO workers were expected to come to Cayman.

Meanwhile, the BVI Financial Services Commission announced that its Hong Kong-based BVI House Asia would be the point of contact for regulatory-related matters with the online portal back up and running.

BVI House Asia’s Elise Donovan insisted that the territory is open for business.
“Our financial services business was built to allow people to do BVI business from anywhere in the world, and to continue business regardless of the physical conditions in this jurisdiction,” Ms. Donovan said.

Record number of suspicious activity reports filed in 2015/16

A record number of suspicious activity reports of potential money laundering and other financial crimes were made in the Cayman Islands between July 1, 2015 and June 30, 2016 according to the Financial Reporting Authority.

The 620 SARs represented a 9 percent increase from 2014/15, and marked the fourth straight year the number of reports filed had increased, the Financial Reporting Authority stated in its annual report.

The authority noted that 124 of the cases resulted in information disclosures to the Royal Cayman Islands Police Service, 24 disclosures to the Cayman Islands Monetary Authority, 23 to other law enforcement authorities, and 22 to overseas financial investigation units.

The number of entities making those reports increased from 116 in 2014/15 to 140 in 2015/16, with the largest number of reports (266) coming from the banking sector.

Most of the reports involved suspected “suspicious activity” – typically reports on accounts showing activity that is out of line with the account holder’s expected level of income – while other reports suspected fraud, corruption, money laundering and “other” financial crimes.

There were 1,257 suspects identified in the reports, 796 of them being “natural persons” and 461 of them legal entities.

Most subjects of SARs came from Cayman – including 71 “natural persons” and 210 legal entities being suspected of wrongdoing. The jurisdiction with the second-most number of subjects was the U.S. (100 natural persons and 19 legal entities), followed by the U.K. (51 natural persons and nine legal entities). The other jurisdictions with more than 30 suspects of suspicious activity reports were Taiwan, Jamaica, Canada, the British Virgin Islands and Brazil.

The financial intelligence unit, whose international call sign is CAYFIN, said that the growing volume of SARs is likely due to the territory’s enhanced financial crime-tackling measures.

“The FRA has long held the view that the growing number of SARs is indicative of the vigilance of the reporting entities against money laundering and terrorist financing,” the Financial Reporting Authority stated. “The substantial number of cases in the past three fiscal years appears to have been influenced by due diligence reviews as a result of overseas tax, legal and regulatory updates coming into effect.”

While noting that Cayman has enhanced due diligence measures, the Financial Reporting Authority stated that the volume of reports has put “considerable strain” on its resources. The authority has “around” 12 staff, including one legal adviser.

Cayman and Bermuda captives outperform commercial insurers

Captive insurers domiciled in Bermuda and the Cayman Islands posted strong operating earnings and outperformed commercial insurance companies, rating agency A.M. Best reported in September.

A.M. Best’s report, “The Beat Goes On: Rated Bermuda & Cayman Captives Continue Their Strong Operating Performance,” noted that among the captives rated by the agency, “premium leverage ratios improved, as capital grew at a healthy rate of 8 percent, buoyed by strong operating earnings.”

The report highlighted that 2016 marked the fifth year of above-par operating results for captives with a total return on revenue of 23 percent, down from 24 percent in 2015.

“Underwriting results declined somewhat, to a combined ratio of 85.3 in 2016 from 80.0 the year before, but were well above the results posted by A.M. Best’s composite of U.S. commercial casualty insurers. In addition, the Bermuda and Cayman five-year [2012-2016] average combined ratio of 82.5 far exceeded the U.S. commercial casualty segment by more than 16 points,” the rating agency found.

A combined ratio of less than 100 indicates an underwriting profit, while a ratio of more than 100 means the insurer pays more in claims and expenses than it receives in premiums.
“The Bermuda and Cayman captives saw their net premiums earnings decrease for the first time in five years, to a modest 4.7 percent compared with a high single-digit growth that averaged 7 percent in the prior four years. This included a 10.1 percent growth in 2014, which was far greater than the premium growth reported by U.S. commercial casualty insurers over the same period,” A.M. Best said.

The rating agency noted that unlike traditional property and casualty insurers, captives are not pressured by stakeholders for returns on equity or revenue growth. In addition, extensive use of reinsurance allows captives to transfer a significant amount of catastrophe risk, resulting in less volatile results compared with traditional insurers.

“Bermuda and Cayman captives have posted strong, double-digit [return-on equity] despite difficult market conditions and challenges, with a five-year compound average growth rate of 13 percent for operating ROEs. Favorable reserve releases and limited catastrophe events are the two key contributors to their solid margins and strong ROEs,” A.M. Best stated.

The rating agency further predicted a healthy future for captive insurers “based on the success of the captive business model, the efficiencies gained from the use of alternative risk transfer and the benefits of increased risk awareness and loss control, as well as the ability to integrate sound risk management practices throughout the organization, all of which lead to operating results that outperform the commercial market.”

Trade body responds to criticism of CLOs

Collateralized loan obligations, securities backed by a pool of debt such as low-rated corporate bonds, have performed well this year but attracted criticism for it.

European CLO issuance for the year to date is higher than during the same period last year, when issuance was the highest since the financial crisis with 16.8 billion euros issued in 41 transactions. In the larger U.S. market, year-to-date CLO issuance of $71.2 billion is twice as high as in the same period in 2016, according to Bloomberg. The majority of CLOs are structured through the Cayman Islands.

Media reports have equated the resurgence of collateralized loan obligations to a new form of systemic risk, similar to the risks that materialized from the more complex collateralized debt obligations during the financial crisis. Given that most of the loans underlying CLOS have a low credit rating on their own, the criticism is specifically leveled at the triple-A ratings assigned to tranches of CLOs, indicating a minimal risk of default.

The Loan Syndication and Trading Association responded to the criticism in a statement, noting: “The suggestion that somehow the companies that CLOs lend to are unworthy because they are not investment grade seems troubling. After all, 70 percent of rated American companies are rated below BBB/Baa3; these are important and iconic American companies such as Burger King, Avis, American Airlines and Dell, as well as many innovative middle market companies.”

The comparison with collateralized debt obligations is unwarranted, the trade body noted, because the long-term loss rate on investment grade CDO notes is much higher at 34 percent – a figure that includes the performance during the financial crisis – than CLOs, which according to rating agency Moody’s only had long-term loss rate of 0.1 percent. The association also stated that there has never been a default on a CLO note that was rated AA or better according to Moody’s.

Not only have CLOs performed better than other asset backed securities, they were also much safer than corporate bonds, the LSTA said, citing cumulative default rates compiled by Wells Fargo in 2015. For instance, A and BBB-rated CLO note defaults were both less than 0.5 percent compared with 2 percent and 5 percent, respectively, for equivalently rated corporate bonds.

For BB-rated CLO notes and corporate bonds the difference is even larger: 2.26 percent compared with nearly 16 percent.

The LSTA also played down the correlation risk between by pointing out that CLOs must invest in loans to a diverse set of industries. For AA-rated CLO notes to be impaired, default rates of the underlying loans would have to be nearly seven times higher than during the financial crisis and for AAA-rated CLO notes there is no default rate high enough to cause losses, the LSTA said referring to research by Bank of America.

OECD report: Cayman remains ‘largely compliant’

Despite numerous government measures to bring Cayman in line with the tax transparency guidelines propagated by the Organisation for Economic Cooperation and Development, Cayman is still only deemed “largely compliant,” according to the latest OECD peer review report.

This is essentially the same result as the 2013 review of the way in which Cayman collects and exchanges tax information with other countries.

Although government has addressed the recommendations in the last peer review report, certain amendments, for example with regard to the availability of beneficial ownership information, were “too new to evaluate,” the latest assessment noted.

Cayman was rated “compliant” in seven and “largely compliant” in three of the 10 elements that made up the assessment.

“Cayman tested very well against this more rigorous set of standards, and this clearly demonstrates the high quality of our cooperation with our treaty partners,” said Minister of Financial Services Tara Rivers.

The new peer review follows a six-year process during which the Global Forum first assessed the legal and regulatory framework for tax information exchange and then the actual practices and procedures in 119 jurisdictions worldwide.

The Global Forum’s new review process combines the two elements with a focus on the ability of tax authorities to access beneficial ownership information of all legal entities and arrangements.

The latest report concluded the requirements to maintain beneficial ownership information are generally well implemented in practice. However, the new beneficial ownership requirements for 11,000 domestic companies, put in place in March 2017, remain untested.

During the review period, one company refused to provide information in response to a notice requesting information that was not held in the Cayman Islands. Although the Tax Information Authority referred the case to the Director of Public Prosecutions, the case was not pursued.

“Therefore, in those cases where information is not maintained in the Cayman Islands, the Cayman Islands should ensure that its enforcement powers are sufficiently exercised to ensure that it has access to all information in all cases,” the peer review stated.

A follow-up report on the steps taken to address the latest recommendations will be issued no later than June 2018, the OECD said.

Five facts about the BVI that shouldn’t have come as a surprise

The British Virgin Islands cover a geographical area of 152 square kilometers and are home to around 30,000 people – plus a major international business and finance center hosting more than 400,000 active incorporated business companies.

The level of financial and corporate activity on the islands appears incongruous to many audiences, and has prompted some campaigners and journalists to misguidedly brand the islands a “tax haven.” But the scale, success and economic contribution of international finance centers, like the BVI, should not be such a surprise – and nor should it be feared.
Our recent report, Creating value: The BVI’s global contribution, revealed five “surprising” facts about the jurisdiction that also demonstrate the global value of international finance centres.

Fact 1:

Despite its relatively small size, the BVI has a real, balanced and sustainable economy.

With levels of prosperity among the higher performers in the Caribbean and Latin America region, the territory has a remarkably balanced and sustainable economy underpinned by a thriving tourism sector as well as an innovative international business and finance center.

With more than one million visitors in 2016, tourism accounts for one in every four jobs in the BVI, and the international business and finance center one in 10. Half of all economic output derives from these two key sectors. The workforce is truly international, with roughly two-fifths employed on a work permit. A large majority of work permit employees are from the neighboring region, thus providing employment opportunities for those coming from nations with higher unemployment.

As a small economy, the BVI imports almost all the goods it consumes and many of its services. Spending on imports totaled roughly US$750 million in 2014, the majority of which were brought from the United States – supporting around 12,000 jobs there. But, with strong services exports, it ran an overall trade surplus in the order of US$45 million in the same year.

The BVI has maintained a sound fiscal position despite the impact of the global financial crisis. It is not a jurisdiction without taxes or with artificial taxes: it levies taxes on residents, visitors and locally operating companies in order to fund public services. It is, though, a tax neutral territory with a zero rate of tax on corporate profits. In addition to its general attractiveness for global investors, this ensures that any cross-border transactions mediated via the BVI are not at risk of double taxation.

Fact 2:

The BVI is home to a unique cluster of financial and professional services firms that form an international business and finance center.

In a world where national boundaries have ever decreasing significance to people and to businesses, it should come as no surprise that there is demand for services that facilitate efficient and secure cross-border transactions. Centers like the BVI have evolved to meet the needs of global businesses and investors, and internationally mobile individuals.

In Road Town, a cluster of specialist and expert firms has developed to help service the needs of those looking to carry out cross-border trade and investment and want the comfort of the jurisdiction’s well-regarded company law. The BVI’s international business and finance center employs 2,200 people directly and supports a further 3,000 jobs in the territory. More than two-thirds of all jobs in the center are held by “BVIslanders and Belongers” (i.e., those who are full citizens of or are constitutionally recognised to belong to the territory). It accounts for roughly one-third of the islands’ economic output and over three-fifths of government revenues.

Fact 3:

The ‘BVI Business Company’ is a widely used and dependable vehicle to facilitate cross-border trade, investment and business.

With its tax neutrality, a framework of common law, a highly regarded commercial court and ultimate right of appeal to the Judicial Committee of the Privy Council in London, the BVI has become a leading center specializing in the incorporation of vehicles for international business. The BVI provides legal structures through which companies, institutions and individuals across the world carry out cross-border trade and investment.

There are more than 400,000 active BVI Business Companies. Roughly two-fifths originate from Asia, while use by clients in ‘G7’ countries accounts for less than one-fifth. The assets held by these vehicles have an estimated worldwide value of US$1.5 trillion.

BVI Business Companies are much more than just a piece of paper, and are used in everything from global corporate group structuring through company listings and international joint ventures to succession planning and family wealth management. Even the so-called “shell companies,” which hold assets without active operations, have economic and legal substance and are vital to the efficient operation of an increasingly globalized business world.

Their importance in international investment flows is evident from data on foreign direct investment. According to the United Nations, the BVI was the ninth largest recipient of foreign direct investment, and the seventh largest source of outward flows in 2015.

Major respected companies worldwide use BVI Business Companies to manage their cross-border activities. The BVI is home to part of the group structure of more than 140 major businesses listed on the London, New York or Hong Kong main stock exchanges. In addition, BVI Business Companies are used by major international development banks, including the World Bank’s International Finance Corporation and the European Bank for Reconstruction and Development, to help fund projects around the world.

Fact 4:

The BVI is a sound and reliable center which has worked harder than many bigger nations to meet international standards, and not some supposed tax haven.

There is little to be gained for those seeking to launder ill-gotten gains, or evade or avoid other countries’ taxes, through the use of BVI Business Companies.

There are no banking secrecy laws and, anyway, the BVI has a relatively small banking sector which is focused on serving domestic customers. There simply isn’t cash stashed on the islands.

The territory has a good record of compliance with the Financial Action Task Force’s recommendations. The BVI has met 40 of their 49 requirements for combating money laundering, terrorist financing and the financing of nuclear arms proliferation. This compares favorably to many much bigger nations, such as France, the Netherlands and Luxembourg with 38, 35 and 22 compliant or largely compliant recommendations met, respectively.

Indeed, the BVI is ahead of the United Kingdom, which has met 37 recommendations, and the United States’ 39.

And, the BVI works with tax authorities worldwide to help them crack down on evasion by their taxpayers. The territory was an early adopter of the Common Reporting Standard for the automatic exchange of tax information and exchanges information under the United States Foreign Accounts Tax Compliance Act. It has adopted and implemented the European Union Directive on the Taxation of Savings Income and currently has signed 28 tax information exchange agreements, putting it ahead of many big name international finance centres on this measure of transparency, including Switzerland and Ireland with ten and 25 signed tax information exchange agreements respectively. The BVI is also part of the Multilateral Convention on Mutual Administrative Assistance in Tax Matters, which provides a platform for the exchange of information with over 90 countries worldwide.

Fact 5:

Through its direct employment, trade and, most importantly, facilitation of cross-border business, the BVI supports jobs, prosperity and government revenues worldwide.

It is all too easy to assume that what appears to be the surreal and remote world of international finance makes no difference to the real lives of employees, voters, families and businesspeople. But these substantial cross-border investments provide the underlying finance that enables real world economic investment in homes, factories, hospitals, railways, broadband, machinery, entrepreneurs, etc. – or they provide the essential liquidity for the secondary markets that underpin and provide confidence in these primary real world investments.

We estimate conservatively that BVI Business Companies hold US$1.5 trillion of assets. These holdings reflect cross-border investment in the widest variety of physical, corporate and financial assets – and support material levels of employment, prosperity and tax receipts across the globe.

It is, of course, impossible to know with any certainty how many jobs result from any specific dollar of investment – but we can make reasonable and cautious estimates of the orders of magnitude involved. Our analysis indicates that the investment mediated by the BVI supports around 2.2 million jobs worldwide, with China (including Hong Kong) accounting for nearly two-fifths of them – and one-fifth in Europe. The economic activity and incomes generated by 2.2 million jobs worldwide will likely contribute over US$15 billion annually to government coffers worldwide.

It shouldn’t be a surprise that international finance centers, like the BVI, play an important and positive role in an increasingly globalized world economy. But too few politicians, opinion makers or journalists in larger “onshore” nations understand this. Understandably, they are easily swayed by the inaccurate and poorly-evidenced but vocal and passionate rhetoric of campaigners.

The facts of international finance are poorly understood and narrowly communicated. This isn’t the fault of the media in London, politicians in Washington or officials in Brussels; it is the responsibility of those in the international financial centres themselves. It is time to get vocal and passionate about the global contribution of IFCs.

Using the Netherlands in international tax planning

On May 4, 2009, the Obama administration published a plan to curb tax avoidance that included the following statements:

  • In 2004, the most recent year for which data is available, U.S. multinational corporations paid about $16 billion of U.S. tax on approximately $700 billion of foreign active earnings – an effective U.S. tax rate of about 2.3 percent.
  • A January 2009 GAO report found that of the 100 largest U.S. corporations, 83 have subsidiaries in tax havens.
  • Nearly one-third of all foreign profits reported by U.S. corporations in 2003 came from just three small, low-tax countries: Bermuda, the Netherlands and Ireland.

Being accused of being a tax haven prompted outrage from the Dutch government and the U.S. government withdrew the accusation. But the question remains: Is the Netherlands a tax haven? To answer this question, we shall use Wikipedia’s definition: “A tax haven is a jurisdiction that offers favorable tax or other conditions to its taxpayers as relative to other jurisdictions.” In this article, we shall show that in this particular case Obama was right: The Netherlands was and still is a tax haven, not for the ordinary Dutchman, but most certainly for internationally operating companies. Trillions flow through the Netherlands each year thanks to its favorable tax climate. There is a good reason why 80 of the 100 largest companies in the world have a holding company here.

The following figures are from 2009, the year Obama published his paper. The Netherlands headed the IMF’s world rankings for direct foreign investment. Its total incoming investments amounted to no less than $3,000 billion, while its outgoing investments totaled $3,700 billion. These figures represent 377 percent and 465 percent respectively of Dutch gross national product (GNP). By comparison, the United States, a country with a national income of over $14,000 billion, occupied second place on the IMF rankings with incoming investments of $2,300 billion dollars and outgoing investments of $3,500 billion (16 and 25 percent of GNP respectively). In other words, the ratio of GNP to foreign investment was 20 times higher in the Netherlands than it was in the U.S.

Below, we shall briefly describe a few of the tax benefits the Netherlands has to offer.

The Dutch participation exemption

Subject to meeting the conditions for the participation exemption, a Dutch company or branch of a foreign company is exempt from Dutch tax on all benefits connected with a qualifying shareholding, including capital gains, cash dividends, dividends in kind, bonus shares, hidden profit distributions, and currency exchange results. Under certain conditions, some categories of profit participating loans may qualify as well.

The participation exemption will apply to a shareholding in a company if the holding is at least 5 percent of the investee’s capital, provided the conditions are met. As a general rule, the participation exemption is applicable as long as the participation is not held as a portfolio investment. The intention of the parent company, which can be based on particular facts and circumstances, is decisive. Regardless of the company’s intention, the participation exemption also is applicable if the sufficient tax test (i.e. the income is subject to a real profit tax of at least 10 percent) or the asset test (i.e. the subsidiary’s assets do not usually consist of more than 50 percent of portfolio investments) is met.

Dutch dividend withholding tax

Dividends paid by a Dutch BV to its shareholder(s) are generally subject to a 15 percent dividend withholding tax. The withholding tax rate can, however, in most cases be reduced, often to zero, by virtue of tax treaties, the EU Parent-Subsidiary Directive, or other forms of tax planning.

Tax treaty benefits

The Netherlands has concluded tax treaties with more than 80 countries. These tax treaties:

  • Reduce, often to zero, the rate of (withholding) tax on interest, dividends, and royalties paid by a resident of one country to residents of the other country.
  • Avoid capital gains tax in the country where a subsidiary is located when a shareholder in the other country sells its shares.
  • Avoid dual residency issues.
  • Limit tax of one country on business income of a resident of the other country to that income from a permanent establishment in the first country.
  • Define circumstances in which income of individuals resident in one country will be taxed in the other country, including salary, self-employment, pension, and other income.
  • Provide procedural frameworks for enforcement and dispute resolution.
  • Encourage cross-border trade efficiency.
  • Provide certainty for taxpayers in their international dealings.

The EU tax exemption for dividends

The EU Parent-Subsidiary Directive (PSD) provides for tax exemption for cross-border dividends paid between related companies located in different EU member states. Member states are obliged to put the PSD into practice through their national laws, so that companies based in the EU’s single market of 28 member states can operate on an equal footing, regardless of where they are established.

The PSD provides for a zero percent withholding tax rate for qualifying dividends paid by a subsidiary in one EU member state to a parent company in another EU member state.

Therefore, dividends paid to a Dutch holding company by EU subsidiaries can qualify for a zero percent withholding tax rate in the country where the subsidiary is located.

Furthermore, the PSD in principle prohibits the levying of any corporate income tax on the dividend income of the parent company. For interest and royalties a similar directive applies.

Withholding tax on interest and royalties

The Netherlands does not levy a withholding tax on interest payments or royalty payments. However, interest payments to a foreign corporate or individual shareholder may become subject to Dutch income tax under limited circumstances. Interest on hybrid loans can be subject to Dutch dividend withholding tax. However, in most cases double tax treaties or the EU Interest and Royalties Directive will limit this right to tax or, more often, prevent the Netherlands from exercising this right to tax altogether. On the basis of the EU Interest and Royalties Directive, a zero percent withholding tax rate applies for qualifying royalties and interest payments between qualifying associated corporations established in the EU. A corporation is considered associated if it has cross holdings of at least 25 percent or a third corporation has a direct minimum holding of 25 percent in two other EU corporations.

Innovation Box

Another interesting feature of the Dutch tax system is the special tax treatment of intellectual property or intangibles. Under the so-called Innovation Box regime, profits derived from intangibles that qualify for the Innovation Box regime are taxed at an effective rate of 5 percent, instead of the marginal rate of 25 percent. The Innovation Box applies to intangibles that are developed by a Dutch taxpayer and are new to that taxpayer.

The regime distinguishes between “small” and “large” taxpayers. For the small taxpayers (consolidated group turnover of a maximum of 50 million euros and a gross income from intangible assets of less than 7.5 million euros per year) an R&D certificate gives access to the Innovation Box, as well as entitlement to a payroll tax subsidy for technical innovation performed by company employees working in the Netherlands. R&D certificates are issued by the Netherlands Enterprise Agency (RVO). Large taxpayers only have access to the Innovation Box if, in addition to an R&D certificate, they also own (an exclusive license for) the intangibles.

The scheme involves administrative obligations. The taxpayer has to keep records which show the technical innovations that have been produced. Following approval by the European Code of Conduct group, the Organization for Economic Cooperation and Development (OECD) also concluded that the Dutch innovation box regime does not produce any harmful tax competition.

Tax rulings APA/ATR practice

In the Netherlands, it is possible to obtain certainty on the tax consequences of activities in advance. Depending on the intended activities and/or intended structure, you can either obtain an Advance Pricing Agreement (APA) or an Advance Tax Ruling (ATR).

An APA provides certainty in advance regarding transfer pricing issues. Typical issues to be governed by APA agreements are the prices which are charged within a group of related companies for services rendered or goods delivered.

An ATR provides certainty in advance regarding the tax consequences of certain international structures and/ or transactions. An ATR can be requested for:

  • The existence of a permanent establishment in the Netherlands.
  • The application of the participation exemption for intermediate holding companies or top holding companies.
  • International structures in which hybrid financing forms or hybrid legal forms are involved.

The European Court of Justice habitually strikes down anti-avoidance rules

By setting up a (holding) company in the Netherlands, an EU member state, one can benefit from a great many favorable tax decisions of the European Court of Justice (ECJ). The ECJ has created a doctrine limiting the ability of EU member states to police tax avoidance, effectively making Europe more open to tax avoidance. The effect of the doctrine can best be understood by considering President Obama’s 2009 proposal to curb international tax avoidance. In its press release announcing international tax reforms, the White House stated with disapproval that “nearly one-third of all foreign profits reported by U.S. corporations in 2003 came from just three small, low-tax countries: Bermuda, the Netherlands, and Ireland.” The rules that the White House proposes strengthening are just the types of anti-avoidance rules that the European Court of Justice is striking down. Because of the ECJ’s anti-avoidance doctrine, EU member states cannot pass rules that would prevent tax avoidance in the Netherlands and Ireland – both EU member states themselves – unless they apply only to “wholly artificial arrangements.” The ECJ has made clear that far fewer transactions can be prohibited in the EU than member states would like.

A famous example of the use of Netherlands in international tax structures is the Rolling Stones. Records released in the Netherlands show that the band’s tax bill on their earnings of $450 million was $7.2 million dollars or approximately 1.6 percent. The Stones have used a structure in the Netherlands for all their royalties since 1972. A simplified example of such a structure looks as follows:

In this example, royalties paid by the Dutch Royalty Company to the foreign shareholders are not subject to any Dutch withholding tax on royalties. The paid royalties are tax deductible in the Netherlands from the royalty income received from subsidiaries. Any profits from subsidiaries can be paid out as dividends to the Dutch parent, usually at a zero percent rate, due to the participation exemption, the EU parent subsidiary directive or a tax treaty.
The foreign shareholder of the Dutch Royalty Company can be a company or foundation in a tax haven which will therefore not be taxed on its royalty income. Alternatively, it can be situated in a jurisdiction with a preferential treatment for royalty income, a jurisdiction which has concluded a tax treaty with the Netherlands, or a member state of the EU, in which case the Parent Subsidiary Directive reduces the Dutch withholding tax on dividends to zero.
The above example shows that the Netherlands can provide a valuable role in international structures, especially those involving intellectual property.

This article only provides a very basic description of Dutch tax laws. Always consult a qualified tax advisor before implementing any strategy discussed herein.

In the interests of justice

While local schools, some businesses and many professionals have been on a lengthy summer hiatus, the same cannot be said for the local judiciary. The Grand Court of the Cayman Islands has continued to hear and determine a wide range of matters, many of which are of particular significance to the local financial services industry. The directions and judicial guidance flowing from the courthouse pays heed to the court’s overriding objective – which is to deal with cases in a just, expeditious, and economical way – and the court has delivered important new guidance by way of practice directions and judgments about the proper conduct not only of proceedings before it, but of industry professionals generally.

Practice and procedure for winding up petitions

As those in the financial services industry well know, the filing of winding up petitions can be a contentious process, given the risk that petitions may be presented to the court improperly and the fact of their filing subsequently widely published (usually online, to great fanfare). In order to more clearly prescribe what is expected by the court at the time of filing such proceedings, the Grand Court has recently released Practice Direction No. 4 of 2017.

Noting that “the filing of a petition to wind up a company if publicized can cause irreparable harm to its reputation, even if the petition is ultimately dismissed for lack of merit,” the Practice Direction requires that, prior to filing any winding up petition, the petitioner’s attorney must apply in writing to the Grand Court Financial Services Division’s registrar to have the proceeding assigned to a judge and to fix a hearing date. A creditor’s petition must not be filed or entered upon the Register of Writs and Actions unless and until these matters have been attended to and, if the assigned judge makes an order restricting the filing or publication of the petition, it may not be entered on the register until further order of the court. Similarly, a contributory’s petition must not be published on the register until the judge has fixed a date for hearing the summons or as otherwise directed by the judge, and a winding up petition presented by the Cayman Islands Monetary Authority must be only be published on the register if the judge has so directed.

Primeo, Ponzi Schemes, and the Privy Council

The winding up of the Primeo Fund (in official liquidation), stemming from the global financial crisis of 2008 and ongoing for many years now, has continued to generate judgments of note and both the Grand Court and the Privy Council have released new decisions over recent months. Primeo, a Cayman Islands investment fund, was established and managed by Bank Austria and, to its great misfortune and ultimate demise, had invested with the now infamous multi-billion dollar Ponzi scheme known as Bernard L. Madoff Investment Securities LLC. New developments include judgments in the following proceedings arising out of the liquidation of Primeo:

  • In Pearson v Primeo Fund (in Official Liquidation), the Privy Council brought to a conclusion the lengthy dispute between Hearld Fund SPC (in official liquidation) and Primeo regarding the redemption of shares. Herald, an open-ended investment fund, had invested the majority of its funds in Madoff. Primeo subsequently invested in Herald, which meant that Primeo became an indirect victim of the Madoff fraud when it was finally exposed in December 2008. Herald had accepted a number of investors’ redemption requests immediately prior to the collapse of Madoff, but had not paid out the redemption proceeds. Herald argued that all investors unpaid at the relevant date ranked as ordinary shareholders and should be paid pari passu. On behalf of the redeemed investors, Primeo argued that the amounts owed were actually simple debts and the investors should rank in the liquidation as ordinary creditors, above the unredeemed investors. The Privy Council dismissed Herald’s appeal, confirming the earlier decisions of the Cayman Islands Court of Appeal and the Grand Court to the effect that an investor who has properly redeemed its shares, but has not been paid, will be a creditor of the company in respect of its redemption proceeds. Accordingly, its claim will rank ahead of the remaining investors in the liquidation of the company, albeit behind those of “ordinary” creditors.
  • In Primeo Fund (in Official Liquidation) v Bank of Bermuda (Cayman) Ltd (“BBCL”) and HSBC Securities Services (Luxembourg) S.A (“HSSL”) Justice Andrew Jones QC considered, and ultimately dismissed, a separate claim by Primeo for damages of approximately US$2 billion against Primeo’s custodian and administrator. Against a background of very complex facts and involved legal arguments, Primeo had alleged, among other things, that HSSL had breached its contractual duties concerning the appointment and supervision of Madoff as its sub-custodian. Primeo also alleged that BBCL had breached its obligations in connection with the maintenance of Primeo’s books and records, and in determining the NAV per share each month. Essentially, Primeo’s position was that, had BBCL and HSSL met their obligations in their respective roles, Primeo would have withdrawn its investments with Madoff and taken its business elsewhere – well before the collapse of Madoff as a Ponzi scheme and unscathed from the fallout. While such a brief summary does not do the judgment or the expansive legal arguments justice, the court ultimately found the defendants had breached their duties to Primeo in respect of their acts and omissions. However, as Primeo had failed to establish the relevant causal link between those acts and omissions and the losses it had allegedly suffered, the judge found that Primeo had suffered no relevant loss. Primeo’s claims were dismissed not only on this basis, but also because of other issues in Primeo’s case including the fact that certain of its claims were time-barred and others were barred pursuant to the rule against reflective loss (in that the Court had found Primeo was attempting to pursue claims that were more properly the claims of BBCL and HSSL). Describing Primeo as largely “the author of its own misfortune,” Justice Jones noted that the relatively high risk of fraud or error inherent in Madoff’s model must have been “manifestly obvious to all concerned” and gave general guidance as to the professional and legal standards applicable to fund directors, administrators, custodians, auditors, and investment advisors. Pending any appeal, the judgment is recommended reading for this group of professionals, particularly those who deal with abnormal or high-risk investment structures.

The evolution of fair value appraisals

In addition to the steady stream of winding up petitions that populate the court’s weekly cause list, litigation arising from mergers and acquisitions continues to be allocated significant hearing time. Via a further suite of judgments released in the last quarter, the Grand Court has been fine-tuning its guidance in respect of the proper operation of the statutory fair value appraisal regime found at section 238 of the Companies Law (2016 Revision), and the applicability of the Grand Court Rules (GCR) to that regime. Two recent examples of the continued evolution of the regime can be seen in litigation involving Qunar Cayman Islands Limited, a Cayman Islands company that had been listed on the Nasdaq but the subject of a “take private” transaction pursuant to which it was to enter into a merger with another company:

  • In the matter of Qunar Cayman Islands Limited, Justice Raj Parker considered the appropriate approach to directions for the proper conduct of fair value appraisal actions before the court. Eight shareholders of Qunar forming four groups (collectively, “the dissenters”) objected to the merger and sought to have the fair value of their shares assessed pursuant to the statutory regime. In terms of the proper conduct of the appraisal process, Justice Parker ordered that one expert should be instructed jointly and severally for all four groups of dissenters, and one expert for Qunar. Further, to assist the parties’ respective experts with their valuation exercise, Qunar was ordered to give discovery by uploading all documents relevant to fair value to an electronic data room and pursuant to a list of documents in the form prescribed by the GCR. The judge did not rule out the possibility of discovery being ordered from dissenting shareholders in these types of proceedings, but made it clear that such an order would only be made in a very rare exceptional case (and not in those particular proceedings). While the fair value assessment continues before the court, this particular interlocutory judgment should in practice give rise to a consensus as to the usual order for directions applicable to the majority of such actions and ought to result in a more speedy resolution of such cases without the need for protracted argument.
  • In a judgment from a related interlocutory application, Re Qunar Cayman Islands Limited Justice Ingrid Mangatal confirmed that the court has the power to award interim payments in appraisal litigation and, more specifically, to make an award in the amount of the company’s fair value offer to shareholders pursuant to section 238(8) of the Companies Law. This ruling is consistent with the approach previously adopted by Justice Charles Quin in Quihoo 360 Technology Co. Ltd and gives dissenting shareholders to a company merger assurance that, pending a determination of the fair value of a company’s shares, they have a mechanism (by virtue of GCR Order 29, Rule 12(c)) to challenge their deprivation of the price of their shares. Essentially, the judgment confirms that the court will be ready to mitigate the hardship or prejudice that could be suffered in the period between the commencement of the statutory appraisal proceedings and the ultimate determination of fair value, by making an interim payment of the merger consideration to the dissenters (effectively bringing them into the same position as the non-dissenting shareholders who will have already received the same amount of merger consideration). A “just sum” to be paid as an interim payment will be predicated on the basis of what the company has said is the fair value in the lead up to the commencement of the proceedings (being the merger consideration). The decision is an important one that will impact on other similar applications before the court, and bring more clarity to the parties’ rights and obligations in fair value proceedings.

Questioning Consent Orders

Interim payments in section 238 proceedings were also the subject of a recent judgment issued by Justice Nicholas Segal, but with a twist. In In the matter of Trina Solar Limited the court was asked to consider an application by the company to set aside a consent order it had agreed with a group of dissenting shareholders pursuant to which the company would make an interim payment of the merger consideration to them. While the consent order had been executed by the parties and approved by the judge, certain stakeholders in the company later refused to approve the payment of the agreed amounts – largely on the basis that they had become aware of the debate before the court in Qunar and in another case about the court’s jurisdiction to make interim payment orders in section 238 cases. No payment was made in the amount or by the deadline specified in the consent order, and the dissenting shareholders then filed a winding up petition against the company. The company sought from the court, among other things, a declaration that the consent order was defective or invalid, and orders striking out the winding up petition. It argued that the consent order had been made without jurisdiction because no summons or evidence had been filed in support of it as required by the GCR.

The court held that the consent order was binding on the parties when made, and was considered to be valid and in full force and effect regardless of the existence of a summons or supporting evidence. Interim payments were duly made by the company in accordance with these findings. Acknowledging this, and in a second judgment published on Aug. 25, 2017, Justice Segal confirmed that while the dissenting shareholders acted reasonably in presenting a winding-up petition after the company failed to make the payment provided for in the consent order the petition could not be pursued in the light of the fact that the interim payments had subsequently been made. However, the Court ordered that the costs of the petition, and of the application to set aside the consent order, were to be paid by the company.

Future judgments

A number of further cases of significance to financial services industry professionals are currently queued not only before the Financial Services Division of the court, but also the Cayman Islands Court of Appeal and the Privy Council. Industry professionals can therefore expect fresh guidance, and a continued expansion of local jurisprudence, before the year is out.

BVI banking on remedy for struggling financial sector: Bank of Asia could turn around declining incorporation rates

At a business conference in the British Virgin Islands in January 2016, Hong Kong-based businessman Carson Wen and his then-partner, Chad Holm, publicly presented for the first time a proposed solution to a problem that has vexed the territory for years: The inability of BVI-registered companies to open bank accounts.

Carson Wen

While most major international financial institutions are reluctant to take on the reputational risk of doing business with offshore entities, Wen and Holm said that they were planning to start a bank that would be dedicated to doing just that.

At the time of the presentation on what is now known as the Bank of Asia, the BVI was suffering through years of sluggish incorporation rates, which are seen as a bellwether for the health of the territory’s financial services industry.

But about four months later, those sluggish numbers began to truly nosedive in the wake of the Panama Papers – a trove of more than 11.5 million documents leaked from the Panama-based law firm Mossack Fonseca that allegedly include evidence that Virgin Islands-based companies were used for money laundering and other nefarious activities.

Industry professionals blamed the reputational damage the Panama Papers inflicted on the BVI as the major reason for it suffering the worst year for new company incorporations since at least 2003, when the territory’s financial regulator began releasing quarterly statistics.

But the Panama Papers did more than make companies shy away from incorporating in the BVI; they also exacerbated a problem that has plagued the jurisdiction for years by making international banks even warier to open accounts for entities registered there.

Indeed, months after the Panama Papers stories first broke in April 2016, at least 11 trust firms were notified by three international banks that they would not be able to operate bank accounts with them, according to documents leaked to the BVI press at the time.

Management for those trust firms painted the banks’ decision as a knee-jerk reaction to the Panama Papers, as well as the result of an overall decreased appetite to do business in jurisdictions like the BVI, which are perceived as high-risk.

This growing trend – known as ‘de-risking’ – has left the territory scrambling for a solution to fill the growing void left by the major international banks, and BVI officials are now counting on the Bank of Asia to be that solution.

“There is a long-term retrenchment by Western financial institutions. They are risk adverse, have weak balance sheets, and are hampered by cumbersome regulations. Many see this decline accelerating in coming years… In a fast moving business environment, neither the BVI nor its clients can afford to wait,” said the territory’s Premier, Orlando Smith. “This is where the Bank of Asia can step in and play an important role.”

When the bank was first presented in January 2016, Holm touted it as an institution that could transform the BVI’s financial services industry.

With a BVI-based bank catering to BVI-registered companies, the jurisdiction would transform from a place through which “money just moves from point A to point B and happens to touch, to a financial centre where real deposits stick on the island,” Holm said at the time.

According to Bank of Asia officials, making the BVI a jurisdiction where companies can park their cash would be a value-added service that could help stop the haemorrhaging the territory has experienced since the mid-2000s, when it had around 800,000 companies incorporated there.

“We expect that the number of [business companies] annually will increase to the level of previous years as more new accounts will be opened,” said Bank of Asia President Joycelyn Murraine, a former managing director of Scotiabank’s BVI branch.

Wen told the Cayman Financial Review that he expects the bank to be open by the fourth quarter of this year.

When it launches, Bank of Asia will initially only offer traditional banking services, such as deposit-taking and lending, to the roughly 400,000 companies registered in the BVI – specifically, to about 200,000 companies with ties to Asia, he said.

But eventually, Wen envisions the bank becoming an institution that offers wealth and investment management services.

Unlike typical commercial banks, the Bank of Asia will operate almost exclusively on an online platform, which officials say will keep costs low and allow the employment of “cutting-edge technology” to ensure the bank does business only with legitimate customers.

But the development of this platform has been one of the contributing factors to the delays in opening the institution – the original target launch date was the third quarter of 2016 – according to Bank of Asia officials.

Murraine said IT professionals are putting the finishing touches on the bank’s “proprietary platform,” as well as other technology that will ensure the bank follows know-your-client rules and other regulations.

“Wen is adamant in ensuring that the bank’s compliance and regulatory infrastructure is a robust one, and second to none. Therefore, a lot of time is spent on developing the systems,” said Murraine.

Bank of Asia has also suffered other setbacks, including a falling-out between Wen and Holm – leading to a legal dispute between the former partners in both the Hong Kong High Court and the BVI High Court.

Wen sued Holm and two other businesspeople last October, claiming that they tried to undercut him and set up their own competing bank, according to court documents.
Along with monetary compensation, Wen is seeking an order from the Hong Kong High Court for the defendants to delete any documents and materials relating to Bank of Asia, according to his claim form.

Wen’s claim form contains few details – it makes general allegations that his former partners breached their fiduciary duties, breached their duties of care, and acted in conflict of interest against him – and he has declined to elaborate other than to say that the defendants’ actions contributed to the delays in Bank of Asia’s opening.

Holm, for his part, denies Wen’s allegations against him, and filed a counterclaim in Hong Kong for wrongful termination, seeking more than $25 million in damages.

Holm also filed a lawsuit against Wen in the BVI High Court in January, claiming that Wen breached a contract with him. According to Holm, Wen did not follow through on an agreement to have Holm made a roughly 22 percent shareholder of Bank of Asia.

While both cases are ongoing, Wen called Holm’s lawsuits “frivolous,” and said they will not affect Bank of Asia’s new target date for opening.

The lawsuits did not hamper Wen’s efforts to raise capital for Bank of Asia, with the bank finalizing an agreement in April to sell about 31 percent of its shares to the Bermuda-based firm V1 Group Limited for $30.8 million – after the territory’s financial regulator lowered Bank of Asia’s capital requirement from $100 million to $38 million, which was a precondition for the sale.

The V1 Group’s agreement to purchase the $30.8 million of shares also stipulates that if Bank of Asia does not begin operating by Sept. 27, Wen’s firm Sancus Financial would have to give it another 10 percent stake in the bank at no cost – an event that would give the V1 Group the plurality of shares in the bank.

Officials have not commented on the implications missing the Sept. 27 deadline would have for the bank’s operations, but Wen said he is confident Bank of Asia will have a “soft opening” by then, and will be fully operational in early Q4.

BVI officials are hoping that the bank will open sooner, rather than later, in order to turn around a slide in incorporation rates that has lasted since the 2007 global financial crisis, and has picked up pace over the last year.

“In a fast-moving business environment, neither the BVI nor its clients can afford to wait,” said Smith.

Confidence, not confidentiality, is the key to a healthy future for IFCs

Whether or not it could fairly be said anymore that a career offshore, rather than simply a career-building stint offshore, is to take the road “less traveled” is an interesting issue. But that is very much secondary to whether doing either amounts to career suicide in these days of increased, and increasing, economic, political and social turbulence. Not in the least, I say, and in fact entirely the opposite, as explained below.

That my view is non-partisan in terms of favoring a specific jurisdiction simply reflects the extent to which I have been – and am still – fortunate to work across multiple international financial center (IFC) jurisdictions. It also explains why I do not discuss specific statutory initiatives around implementation of transparency and information exchange. We all know they exist and are only to grow.

Harsh reality: IFCs on the back foot

The “new normal” of transparency and international cooperation continue to change the face of, and challenge traditional economic drivers for, IFCs. Those jurisdictions risk losing out as they expend precious energy – private and governmental – on defensive strategies in doomed “David and Goliath” fights with onshore governments and the organizations they fund, such as the OECD and FATF.

Much ink has been spilt on the so-called Panama Papers debacle (really, truly, the Mossack Fonseca Papers, if anything at all) and their fallout. If the onshore world was suspicious of IFCs before – we all know they were – then this data theft was the perfect storm of information around high-profile onshore customers and salacious details of pseudonyms being used for scheduled meetings. Just read the self-congratulatory language on the OCED website about its part in the groundswell of populist feeling against IFCs.

Data breaches are just plain bad for business – the examples are legion and include Target in 2013 and Ashley Madison in 2015. Post-hack, the latter perhaps unsurprisingly changed its strapline from “life is short, have an affair” to “find your moment.” Oddly, it did not add, in parenthesis, “and just hope that details of that moment are not hacked and sent to your spouse /significant other.”

Perversely, though, as confidentiality erodes within the IFC world, the overwhelming pressure to maintain it actually decreases. Put another way, if you are no longer selling confidentiality as your lead brand, you can therefore afford to worry somewhat less about confidentiality being compromised. Hold-out jurisdictions with inflexible confidentiality regimes have a broken business model and should rethink quickly before such a system gets the type of damaging publicity that the onshore world would love to give it.

There is no denying the existence of major challenges: there is plenty of empirical evidence that incorporations are down in the IFC best known for that market, and elsewhere new hedge fund business is losing ground to U.S. fund formation.

Positive futures for IFCs

Enough, already, as I said before the attendees of the Caribbean STEP Conference in May in Cayman where I pointed out that an industry survey put 77 percent of those polled expecting a functioning network of tax information exchange agreements by 2020.

Far from ignoring the challenges IFCs and those who work in them face, I am simply urging others proactively to chase opportunities. The world owes none of us a living. There is a tremendous pool of professional talent ready to service the many aspects of this increasingly turbulent, uncertain (and taxed) world and for which IFCs and those who work in them are ideally situated. Whether on the wealth management and fiduciary management side, or M&A closings on deals of eye-popping value involving smaller amounts of red tape, IFCs have plenty to be upbeat about.

As a disputes lawyer, I am well aware that successful businessmen and women from Russia, other parts of Eastern Europe and elsewhere often fill the lists in the Commercial Courts of the “Big 3” jurisdictions in the region. The major threat there is the high standard (and it is getting higher all the time) of one’s opposition. Is that really something to be downbeat about? Hardly. Instead, it simply reinforces the marketing message that there is a robust infrastructure around dispute resolution.

The arbitrage in skills outside of the main IFCs is reducing but the simple fact is that not all IFC jurisdiction can realistically expect to become an international arbitration center. Those jurisdictions with proportionately more tourism-related construction and development have realized the need for modern and cooperative insolvency regimes and are doing something about it as harsh lessons have been learned. Inability, under local law, to recognize a U.S. Chapter 11 filing aimed at debtor-in-possession refinancing may be a short-term vote winner, but has had immediate adverse effect in terms of credit agency sovereign debt ratings and likely contributed towards the high cost paid by the same political leader in the medium term.

Who better than those with experience of both “worlds” to take wholesome advantage of the increasing overlap between the IFCs and onshore as international business see more blurring of those lines. To an increasing extent, offshore litigation can be around issues such as an IFC response to an onshore requesting authority for offshore tax information. Would that work area have developed absent the increasing onshore pressure for transparency? Clearly (no pun intended) not.

The point is a simple one: the myriad issues and problems for clients, as thrown up by the ever-changing global economy, are as much of an opportunity as a threat for supporting professionals so long as we are ready to grapple with the unknown.

A siege mentality does none of us any good, whilst also squandering opportunity. Globally, change is the new constant and it is no different onshore. For the last more than seven years, I have worked within a predominantly U.S. organization with an office presence on both coasts of the U.S., as well as in other major onshore financial centers. We are also in two of the “Big 3” (the third being one in which I lived and worked for several years). Major U.S. government initiatives such as those in respect of the Swiss banks and voluntary disclosure of non-compliant account holders placed a spotlight on the need to explain in the onshore context the legitimate business model of IFCs at the same time as turning the world upside down for countless onshore providers.

In that scenario, my organization was ideally placed to help. Obviously, I am not suggesting that every firm is capable of, or even aspires to, a cross-border litigating offering. Also, and tempting as it is, schadenfreude should come second to commercial opportunity being pursued: across all disciplines the professionals spread across the IFCs either have already, or at least should aim to acquire, the type of pan-jurisdictional skillsets and knowledge to leave them well placed to assist clients and potential future clients in scenarios impacting or impacted by onshore issues.

Need for a nurturing domestic IFC environment

Expat 101: the golden rule of harmonious non-Islander existence, or a least one of them, is to stay off the topic of politics. In many, if not all, of these jurisdictions the imbalance of overall population and electorate continues to grow.

The vast majority of expatriates and expatriate-owned businesses are sensitive to that and understand the need to earn the trust of local government. But that social contract has a counterparty. All of the population deserve the opportunity (not the right) to feel valued. For those jurisdictions looking to put behind them public corruption trials for members of former governments, the watchword is transparency. Get that right and in every good sense of the word, the IFCs will continue to be a “target” for the well-trained professional. The IFCs only stand to benefit from continuing to provide a warm welcome.

Book Review: ‘The Political Economy of Special Economic Zones: Concentrating Economic Development’ by Lotta Moberg

Special economic zones (SEZs) with variations known as free ports, free cities, etc have been created in more than 130 countries over the last half century, and to date some 3,000 plus have been formed. Special economic zones typically have no or low tariffs, low tax rates and light regulations. They range in size from entire cities, like Hong Kong, to single buildings. There have been many successes but even more failures. Lotta Moberg is a very smart international economist, who has studied the pros and cons of SEZs in detail. She presents a very balanced analysis of what works and what does not – and what lessons are to be learned.

Lotta Moberg

In the early 1990s, I chaired an economic transition team in Bulgaria as it attempted to transform itself from a communist to a free market, democratic country. Suggestions were made at the time for the creation of a special economic zone to serve as a model of how a free market economy should work, in the same way that Hong Kong served as a model for China and their many subsequent SEZs. Most Bulgarians at the time were enthusiastic about the creation of a special economic zone, but they could not agree among themselves of where it should be located, with several different regions vying for it. The result was they checkmated each other and nothing was done at the time.

What struck me is the widespread recognition that free trade, free markets, private property protections along with low taxes and regulations were good, hence the support for the concept of a SEZ but not for the whole country as I once suggested out of frustration. Bulgaria now has several limited special economic zones.

In her book, Moberg gives a brief history of SEZs going back to ancient Greece, but then concentrates on modern era SEZs which really started with the rise of export processing zones. These zones were most often fenced off areas, engaged in light manufacturing, and without residential components. Most were focused on developing export industries. Some zones have evolved into major free ports, such as one in Dubai, which is the ninth largest port in the world. Other zones are as small as single factory zones. Some zones are clear additions to local economies, creating more jobs at higher wages; other zones do not justify their costs, particularly when governments have built the infrastructure and the most productive workers are drawn from the rest of the economy into the zone.

Like all forms of economic organization and structure, SEZs have both costs and benefits. Being a former academic, Moberg is comfortable in the language of cost-benefit analysis even though not all her readers may be. She is careful to cite evidence and provide data to support her arguments. The bottom line is she clearly demonstrates properly designed and managed SEZs can have great benefits, or impose disproportionate costs on an economy. There is also no simple answer about which activities are appropriate for a SEZ or how big it should be. Every case is individual, which helps explain the great disparities in outcomes.

Those who create SEZs need to determine where they should be created, but are plagued by not knowing beforehand which activities are going to be the most viable for the zone, and what are the proper incentives that need to be created for the zone to fulfill its potential. The inherent intellectual conflict is with the idea that central planners know best of how to create a free market center.
Moberg is at times a bit cynical about the motivations for creating SEZs which she notes: “when the status quo of protectionism is under threat.” She concludes they are better than the status quo if the alternative is no reform. The book is well balanced between giving concrete and interesting case studies; India, China, the Dominican Republic, Dubai, Saudi Arabia, etc. and relevant economic theories behind the zones.

Again, her conclusions are mixed as to whether the SEZs served as examples of reform for the entire country, as has been largely done in China, or just served as opportunity for the well connected to avoid taxes and regulations in order to increase their own wealth at the expense of the country. Even though a number of SEZs have spurred more general economic reform, there is not much evidence that they have done much to foster general political change. SEZs may help reform in the Arab countries by allowing the use of the British created common law which governs almost all the world’s financial centers, and allowing the full utilization of the skills of women. There are several experiments going on in the world with various types of SEZs at the moment, including the free cities project in Honduras, where I serve on the best practices board. In sum, Moberg is modestly optimistic about the future of SEZs, but coldly realistic about the past and potential failures.

For those who wish to obtain an overall understanding of the potential and pitfalls of SEZs, as well as understanding of the multiple types and past successes and failures, this relatively thin volume provides the best overall description and analysis produced to date.

Quarterly Review


Premier McLaughlin leads new 13-member coalition government

The May 24 general election in the Cayman Islands brought about days of political scrambling as 19 elected lawmakers sought to form a government.

The Progressives won seven seats but also suffered the crucial loss of three former government ministers. Meanwhile, the Cayman Democratic Party was limited to winning just three seats. The remaining members of the Legislative Assembly are independent candidates.

After a week of negotiations, a new coalition government was formed led by Premier Alden McLaughlin, who will be premier for the second consecutive term. The “government of national unity” features seven Progressives party members, three Cayman Democratic Party members and three independent politicians.

CDP Party Leader McKeeva Bush was sworn in as Speaker of the House.

The former Education and Labor Minister Tara Rivers is now minister for Financial Services.

Former KPMG managing partner Roy McTaggart is the new finance minister.

Cayman beneficial ownership laws take effect

On July 1, the Cayman Islands began to operate under new laws that will introduce a technology-based system to enhance its existing regime of maintaining and exchanging information about the true owners of Cayman-registered entities.

The system is aimed at improving the speed of providing beneficial ownership information to U.K. law enforcement authorities.

Because of data security concerns, especially hacking, the ministry of financial services has opted for a so-called “air-gapped platform” that is not connected to the internet or any other network, but hosted offline. The system will require financial services providers to maintain their own beneficial ownership registers and upload the information once a month to an encrypted flash drive, which has to physically be taken to the Government Administration Building.

There, the information about the true owners of Cayman-based companies and other entities will be uploaded via a dedicated, secured transfer terminal.

As such, the system provides a secure mechanism for sharing beneficial ownership information on Cayman’s exempt, limited liability, and non-resident companies with the U.K.

As with all of Cayman’s international cooperation mechanisms, only competent authorities will be able to exchange beneficial ownership information.

In Cayman, the beneficial ownership competent authority is the minister of Financial Services, who will delegate authority to the Financial Crime Unit, which will receive requests from U.K. law enforcement.

The Financial Crime Unit must verify that any request is part of an ongoing investigation and that the alleged offense is also a criminal offense under Cayman Islands law, to prevent so-called “fishing expeditions” or wholesale requests for data.

The information that is provided in response to legitimate requests includes the names, addresses, dates of birth, passports or other identification documents, as well as the dates when each individual became or ceased to be a beneficial owner. The General Registry will hold the beneficial ownership data and the search platform.

Company formations bounce back

New company registrations in the Cayman Islands have bounced back in 2017, after a dip last year.

May 2017 saw the largest number of company formations in a single month since the financial crisis with 1,174, according to statistics provided by the Cayman Islands General Registry.

During the first five months of this year, 5,243 new company registrations represented an increase of 8.9 percent over the same period in 2016.

Last year, the number of active companies registered in the Cayman Islands briefly breached the 100,000-mark before dropping back to 96,259 after the end of the year. This was mainly because the record high of 102,369 active companies in Sept. 2016 included nearly 8,500 companies that at the time were set to be struck off the register.

In addition, company terminations jumped 16.9 percent to 14,101 from 12,062 in 2015. In 2014, there were only 7,321 company terminations.

Interest in Cayman Islands offshore companies, however, is undiminished. Despite a 3 percent decline in new formations last year, 2016 was still the second strongest year since 2008.

In contrast, in the British Virgin Islands, the leader in offshore company formations, new company registrations have been continuously declining. While the financial crisis caused the initial fall, more recently, fallout from the Panama Papers has been blamed for the decline in company formations, which dropped by half from more than 64,000 in 2012 to just over 31,700 last year.

Meanwhile, the growth in Cayman Islands partnerships continued unabated last year as the number of active partnerships on the register increased by 12 percent to 20,122.

The first five months of 2017 were the most successful period for new partnership formations so far, the statistics show, as 1,516 registrations outpaced 454 terminations.
Trust registrations, which experienced small declines in recent years, recorded the first growth quarter at the end of 2016. After five successive quarters of 1 to 2 percent falls in the number of active trusts on the register, the final quarter of 2016 showed a 4 percent increase to 1,855.

Report: BVI firms hold $1.5T in assets

An economic impact report commissioned by BVI Finance concluded that the British Virgin Islands brings a substantial net benefit to governments worldwide.

The report “Creating value: The BVI’s global contribution” by consulting firm Capital Economics found that the 417,000 companies registered in the islands hold about $1.5 trillion in assets globally.

Many of the companies are registered in the BVI to facilitate cross-border trade and investment. For instance, more than 140 corporations listed on the stock markets in London, New York and Hong Kong maintain a subsidiary in the BVI. About a quarter of the companies’ assets represent investment vehicles, whereas family wealth and property holdings make up about 5 percent each.

The investment flows mediated by the BVI support around 2.2 million jobs worldwide, the report noted, especially in Asia, where about 40 percent of the assets held by BVI companies are located. European clients represent about 20 percent of BVI companies. The U.K. alone constitutes 12 percent of the value of BVI companies, both in terms of the location of the ultimate beneficial owner and the location of the assets.

“The scale of the BVI’s global contribution to investment and jobs sheds a new light on the debate around its impact on the tax receipts of other nations,” Capital Economics stated, and concluded, “The BVI is a substantial net benefit to governments worldwide.”

Like the Cayman Islands, the BVI stresses that it is not a tax haven but rather a tax-neutral jurisdiction, which does not reduce or eliminate any tax liability in other jurisdictions.

The report argued that the BVI is not a material center for corporate profit shifting.

Multinational companies that seek to optimize their tax position would look to conduct any “profit shifting” through jurisdictions that gave them protection from double taxation, and where they would be exempt from withholding charges, Capital Economics said. But, “The BVI offers little protection to businesses from so-called ‘double taxation’ in another jurisdiction or from ‘withholding taxes’ elsewhere. Multinational companies that use their transfer pricing arrangements to shift profits into the jurisdiction will not be sheltered from taxes due elsewhere.”

This is in stark contrast to European jurisdictions like the Netherlands, which maintains a large number of double taxation treaties that reduce withholding taxes for income from dividends, interests and royalties, or low tax jurisdictions like Luxembourg and Ireland, which offer low tax rates on intra-group interest payments or royalties from intellectual property. These mechanisms are much more suitable for the shifting of profits to low tax locations to avoid taxation.

Capital Economics believes that BVI companies could be used to avoid up to $750 million of tax each year.

“To put this in context, the United Kingdom tax authorities estimate their annual ‘tax gap’ at US$59 billion alone – so any leakage through the BVI is immaterial against other sources of tax loss,” the report said. “Moreover, our estimate of the theoretical maximum amount of tax avoided assumes that the only and every use of a BVI Business Company is tax avoidance. In reality, we believe the actual number will be a small fraction of this.”

At the same time, investment flows channeled through BVI vehicles would bring substantial net benefits to governments onshore. For instance, the report estimates that the tax supported by employment related to investments mediated by BVI companies is $15.7 billion, far outweighing the potential tax loss onshore from deferred tax payments or the avoidance of property transaction taxes.

OECD tax chief: Cayman must get the narrative right

Cayman will remain a successful offshore financial center if it changes the message it has sent out to the world over the past decades, according to Pascal Saint-Amans, director of the Centre for Tax Policy and Administration at the OECD.

“You need to get the narrative right, and the narrative will be right if it is based on substance,” he told delegates at a tax transparency conference hosted by the Cayman Islands Ministry of Financial Services in April.

Cayman needs to explain what is happening in the jurisdiction, but, he added, “you need to understand the outside perspective that is full of suspicion about how there can be so much business in such a small jurisdiction without any substance.”

Politicians and industry representatives should stop with the narrative used 20 years ago that offshore centers lower the cost of capital by allowing tax avoidance. Yes, tax avoidance reduces the cost of capital, but it also deprives countries of taxes that they are entitled to, he noted.

The head of tax at the OECD believes Cayman already has a good narrative if it focuses on properly dealing with any past misconduct and developing a good strategy for making beneficial ownership data available and accessible.

Legacy issues exist even in the most advanced jurisdictions, and the U.S. Department of Justice together with public pressure from campaigners and whistleblowers should make the business community focus on past conduct, Saint-Amans said.

The next big thing ahead will be the issue of beneficial ownership, he predicted, but acknowledged the public availability of information on who truly owns Cayman-based companies and other entities raises privacy concerns.

“It is true, there is an issue of privacy and that is why privacy is at top of the OECD priority list.” The same applies to the automatic exchange of tax information.

The countries that want more transparency will need success stories to demonstrate that the system works, the OECD tax chief said, and claimed that it was also in the interest of offshore centers to stop further leaks of client data.

Offshore centers must play long game

Offshore financial centers should focus on simplifying their business and having economic substance in their jurisdiction to thrive. “Having warm bodies in cool offices making real decisions,” is part of what Tim Ridley calls the long game that offshore centers must play to survive.

In his lecture at the annual STEP Caribbean conference in Cayman in May, the former Maples and Calder partner and Monetary Authority chairman said the Organisation for Economic Co-operation and Development’s initiative to tackle the erosion of tax bases and profit shifting and the latest offshore blacklist from the European Union both include actual economic activity criteria. One way to demonstrate substance in the wealth management industry is to have fully staffed family offices offshore.

This would bring the obvious direct and indirect economic benefits for offshore centers that do not suffer from overcrowding, have good office and residential property available at reasonable prices, good accessibility, weather and general infrastructure.

But to take advantage of this potential business, Ridley said, offshore financial centers must put in place the necessary and simple “package” that can be promoted internationally by the public and private sectors and encourage potential candidates to relocate.

Offshore centers must be particularly vigilant in ensuring that they have the right home-base infrastructure, such as stable political and economic environment, a welcoming immigration regime, the appropriate financial laws and structures, top quality courts and judges that are particularly important in the trust area, tax neutrality and quality professional services.

Ridley’s second point, simplifying the business, may seem counterintuitive at first, he said. In a world where tax information is exchanged automatically between countries through the common reporting standard developed by the OECD, reporting may result “in conflicting or confusing reporting from different jurisdictions up the ownership chain.”

One school of thought therefore argues for concentration of entities and activities in a single reporting jurisdiction, whereas another favors no reporting under common reporting standard with critical family members moving to the jurisdiction where their offshore structure is domiciled.

With global wealth creation still on the upswing, wealth creators are becoming more global.

The best jurisdiction for “some of the critical cogs in the structure” may be onshore, offshore or a combination of the two, he said.

Critically, Ridley said, offshore centers must find the right balance between legitimate privacy rights and the proper needs of law, regulatory and tax enforcement.

The offshore future is bright


During a recent STEP Caribbean conference in Grand Cayman, Tim Ridley, past chairman of the Cayman Islands Monetary Authority, listed the attributes that will make or break international financial centers in the coming years: adequate infrastructure, stable political and economic environment, welcoming immigration policies, strong legal and judicial systems, tax neutrality and quality of professional services.

Mr. Ridley was presenting a general comment to professionals of several offshore centers as a guidance for positioning their respective jurisdictions in a world which is being shaped by wider disclosure and exchange of information, as well as pressure from onshore governments and multinational bodies to address profit shifting and tax base erosion.

The focus already is and will become more relevant on substance, meaning doing business and making decisions locally in the offshore center. This presents a major challenge as well as huge opportunity for offshore centers to move up from their previous model of name plates and shell companies into a new world of substance and efficiency in provision of professional services.

The Cayman Islands has already achieved great progress in attracting and creating conditions for professionals and their families to relocate and enjoy fulfilling lives in our country.

Directors and ultimate beneficial owners are the next target and Cayman is in great position to attract them as well.

The Kimpton Seafire, Cayman International School and Camana Bay: Cayman’s infrastructure is receiving major improvements with new roads, expansions at the port and airport and, eventually, a permanent solution for waste management. But what really makes a place attractive for high-net-worth families and their financial advisors is not only the “hard infrastructure” but also the places where they go to relax, enjoy and, why not, learn and get educated. Having first-class hotels and restaurants, shopping and leisure communities and sports and learning centers is playing an essential role in making Cayman desirable to live in, not just to visit from time to time.

Location, location, location: we live in an interconnected world but geography still matters. The reason is not so much related to physical distance (nowadays rendered less important by all the electronic means of communication), but “time distance,” as being able to have all partners of a deal participating in the same meeting or a conference call makes for better decision making. Cayman’s location is convenient to all markets in North, Central and South America, as well as Central and Western Europe. With an associated office in Hong Kong or Singapore, any structure based in Cayman can cover the whole world and provide professional services in any time zone.

Sitting at the grown-ups table: the Cayman Islands government and the private sector made a conscious decision to face the difficulties instead of burying their heads in the sand and wait or hope for the problems to disappear. Cayman representatives have been part of every relevant committee, discussion, conference or working group managing, at a minimum, to understand the issues and how they could affect our industry but more often than not, being able to contribute to make new regulatory requirements proportional, consistent and not overly burdensome. This ability of shaping the discussion and to find the more efficient solutions for the success of the global economy is a hallmark of Cayman’s international presence and why it is frequently said that Cayman “punches above its weight.”

Diversified and strong industries: Cayman is the world’s capital of the offshore investment funds with around 90 percent of all hedge funds being registered here; the second largest jurisdiction for captive insurance, an industry that provides global support to areas as diverse as agriculture, tourism, protection against natural disasters and infrastructure investment and development; our maritime registry is widely recognized as first class and preferred by professionals and customers who trust our laws and court system; almost every airplane financing deal signed around the world involves professionals and entities based in Cayman, for the same legal and professional reasons; this list could go on and on, demonstrating the wide range and attractiveness of our jurisdiction.

Welcoming business environment: As I write this article I am returning from a week of business meetings in Amsterdam, where the pressure of BEPS and the calls for local substance are also being felt and forcing the industry and government to re-examine their priorities and work to preserve their place in the international financial world by adjusting their business model. Although the Netherlands has one of the most successful economies in Europe, Dutch regulators and the legal and financial industries are busy re-examining and re-evaluating their laws and regulations to keep their structures and entities relevant and applicable to the new requirements of the financial industry. As much as the Cayman Islands has been a voice for sanity and moderation in discussions related to financial regulation, the lesson to be learned is that complacency is your worst enemy and that we in Cayman should also be constantly questioning what we should do better tomorrow.

Borrowing the great words of Churchill when rallying his nation around the mission of resisting a long-term war, this is not the end of the business model for a well-established and reputable offshore financial center like the Cayman Islands, not even the beginning of the end, but it could be the end of its “fledging humble beginnings” and the opportunity to consolidate its graduation into a new world where local decision making, strong operations and substance will be the norm and it will not matter if a business is located onshore or offshore as long as it is in the right jurisdiction. And Cayman will be right.

Eduardo D’Angelo P Silva has been president of the Cayman Islands Bankers Association and Chairman of Cayman Finance. He is presently a director of JP Integra Group, a provider of private wealth solutions.

Putting Venezuela on the path to prosperity

Demonstrators hold signs and Venezuelan flags during a protest outside of the Goldman Sachs headquarters in New York in May. Photo: Bloomberg.

With the current Maduro regime on the ropes due to increased discontent and unrest from all sectors of Venezuelan society, many analysts are beginning to ponder about what lies ahead for Venezuela’s future.

A country that has not only coped with nearly two decades of destructive socialist polices under the helm of Hugo Chávez and his successor Nicolás Maduro, it has also experimented with socialist policies of varying degrees for the past five decades.

To fully recover from these detrimental policies, Venezuela will have to implement substantial market-based reforms. It is no secret that Venezuela is experiencing a brain drain of sorts, where estimates of nearly 2 million Venezuelans have fled the country in search of greener pastures.

With so much instability at the political and social level, it will be difficult to convince Venezuelans to return to their country. Thus, there is an urgent need for reforms that will make Venezuela sufficiently attractive for foreign investors and Venezuelan expatriates alike to come back to and help rebuild the country from the ground up.

Chile as a model for inspiration

Luckily, there is a Latin American country that Venezuela could look to as a reasonable model of economic recovery in times of political and economic crisis.

Enter the Chilean model.

Just like Venezuela, Chile had the misfortune of confronting a socialist regime that brought it to the point of economic collapse in the 1970s. Long lines for basic goods and services, hyperinflation, growing black markets, and social instability were the norm in Chile under Salvador Allende.

In 1973, the military stepped in to prevent further harm from Allende’s socialist policies.

But even in his first years of power, military dictator Augusto Pinochet maintained many of the previous economic controls ushered in by Allende’s government. The Chilean economy would continue to sputter with inflation and exploding public debt spiraling out of control.

Luckily, a group of economists trained at the University of Chicago, better known as the “Chicago Boys” stepped into the scene and would serve as advisors to the Pinochet regime.

Cooler heads would eventually prevail as Pinochet turned economic matters over to the Chicago Boys.

Once behind the steering wheel, the Chicago Boys did not play around the margin.

They did away with all price and exchange controls, liberalized industries that were completely nationalized under Allende, cut spending, slashed tariffs, and implemented a revolutionary social security reform that turned Chilean workers into capitalists.

And what was the result?

Chile boasted a sustained growth rate of 4.3 percent from 1983 and onwards. As of today, Chile is the most economically and politically stable country in Latin America all thanks to these far-reaching reforms.

While the authoritarian nature of the Pinochet regime should be condemned, this regime at the very least allowed the reforms that gave Chile a strong dose of economic liberty. Such unprecedented degree of economic freedom not only allowed for substantial economic growth, but it also paved the way for the democratization of Chilean society.

The period of prosperity allowed for the development of a robust civil society that helped oust Pinochet from power in 1988 during a plebiscite. This was a watershed moment in Latin American history, as Chile would be buttressed by one of the most stable constitutional orders in the region’s history.

Reforms that Venezuela must make

So what can Venezuela learn from this experience?

The reality is that “shock therapy” is not only necessary to revitalize the Venezuelan economy in the short-term, but also to create a sustainable institutional foundation for the country in the long-term.

Venezuelan policymakers simply cannot beat around the bush and pursue half-measures. They must be willing to make the hard call and strike at the root of Venezuela’s institutional ills.

They can do so by pursuing the following landmark reforms:

Eliminate price controls

The rampant scarcity of basic goods that Venezuela has gained a lot of notoriety for in recent years is no mere coincidence. It is the logical result of Hugo Chávez’s and Nicolás Maduro’s price control policies.

These policies originated in 2002, when Hugo Chávez implemented series of interventionist measures that aimed to stem capital flight following a failed coup attempt against his government. These measures consisted of expropriation of key industries, exchange controls, and price controls.

Thanks to the flow of petrodollars brought about by high oil prices in the mid-2000s, Venezuelan businesses had considerable wiggle room in importing basic goods and raw materials as a short-term, fallback measure.

However, when oil prices started to fall, harsh economic realities emerged. Scarcity would soon become the norm in Venezuela because of stringent exchange controls that did not allow for the free entry of dollars into the economy combined with a burdensome price control regime that prevented the price system from functioning properly.

Once high levels of inflation became a factor, Venezuela’s socialist government would double down in its price control efforts. By passing the Fair Prices Act in 2014, the Venezuelan government aimed to tame shortages by banning profit margins over 30 percent and tightening price ceilings on basic goods.

The Fair Prices Act has only aggravated Venezuela’s shortage crisis, practically leaving it in a state of famine. The Venezuelan government has followed up these polices with even more interventionism through the establishment of CLAPS, local supply and production committees, that ration food in a way that favors government supporters.

Simply put, when the government establishes an artificial price ceiling for goods and services, it will increase the demand for said good or service.

Therein lies the problem; supply does not adjust accordingly to meet this demand under price controls. Consequently, shortages emerge, as more consumers demand the good while suppliers have no incentive to keep up with demand because of the artificially low price.

To solve Venezuela’s scarcity crisis, policymakers must immediately abolish all price controls so that prices can reach their natural equilibrium and allow for resources to be allocated efficiently. A transitional government can begin by abolishing the Fair Prices Act, and then continue hacking away at remaining price controls.

Eliminate capital and currency controls

Another legacy of Hugo Chávez’s economic authoritarianism is Venezuela’s byzantine system of exchange rates. If the black-market rate is included, Venezuela currently has a total of four different exchange rates. Established to supposedly strengthen the Bolívar and prevent capital flight, Venezuela’s exchange controls have done considerable damage to the Venezuelan economy.

Hugo Chávez created The Commission for the Administration of Currency Exchange (CADIVI) in 2003 for with the aim of stemming capital flight by limiting the amount of foreign currency Venezuelans can buy or use in daily transactions.

This system would later morph into CENCOEX (the National Center for Foreign Trade) and other variants such as SIMADI and SICAD.

Akin to the effects of price controls, exchange controls have forced multiple multinational corporations, such as Ford to shut down operations in Venezuela because of dollar shortages.

These controls have also affected the airline industry, where there is now a shortage of plane tickets.

Due to these perverse controls, the border town of Cúcuta, Colombia has become the go-to airport for many Venezuelans that must travel by bus just to find an airport that has tickets available. More than just a form of financial control, currency and capital controls represent a form of social control. At their very essence, these heavy-handed policies are designed to limit Venezuelans’ travel options and keep them locked in.

Venezuelan policymakers must work to repeal the “organic laws” that established these controls. Markets must be allowed to function freely in order for dollars to flow back into the economy and international companies to restore their normal operations in the country.

Constitutional reform

From its ratification in 1999, the Constitution of the 5th Republic was based on faulty institutional premises. This constitution granted the state far-reaching powers, and legitimized Venezuela’s despotic regime. The power of socialism of the 21st century lies in its facade of democratic and institutional legitimacy.

Operating under the guise of democracy, 21st-century socialist regimes are viewed as legitimate in the eyes of the international public. Even the Venezuelan government’s most tyrannical actions are respected by international bodies due to their “legal” status.

What Venezuela needs is true constitutional reform. Policymakers must push for reforms that can transform Venezuela’s political system into a system of market-preserving federalism which fosters competition among administrative units below the federal level. A genuinely federalist system grants states and municipalities a strong degree of autonomy, so that they can vie access to labor and capital.

Privatization of the oil industry

Venezuela became one of the richest countries in Latin America thanks to a hands-off government policy when it came to managing its oil sector. From the 1920s to the 1970s, Venezuela experienced unprecedented economic growth thanks to its relatively free market economy. Unfortunately, the government decided to nationalize the petroleum industry in 1975. The nationalization of Venezuela’s petroleum sector fundamentally changed the relationship of the Venezuelan state with civil society.

Instead of Venezuelans paying taxes to the government in exchange for the protection of property and similar freedoms, the Venezuelan state would take on a patrimonial role by bribing its citizens with a plethora of handouts in order to maintain its legitimacy.

Rather than buying off their citizens with generous subsidies, countries based on more liberal frameworks of governance have their subjects pay taxes, and in return, these governments provide basic public services that protect the life, liberty, and property of their citizens. The state is not the proprietor, thus giving the citizens a strong check against state abuse should the government overstep its boundaries.

In an ideal world, the state oil company, PDVSA (Petroleum of Venezuela) would be fully privatized. But due to political constraints, a more realistic alternative would be to carry out gradual privatization measures that liberalize state control of PDVSA and develop a sovereign wealth fund in the Norwegian mold. This will not only make Venezuela’s petroleum sector more dynamic on an international scale, but it will also de-politicize the sector by keeping politicians hands off of petroleum revenues to finance unsustainable government largess. This will set the stage for a complete privatization of Venezuela’s oil industry.

Regardless of the political circumstances and opportunities available, Venezuelan policymakers should have the privatization of PDVSA as their long-term goal.


All in all, Venezuela will need its very own Chicago Boys if it wants to not only get out of its current crisis, but also create a stable institutional foundation that promotes economic growth.

The challenges ahead are daunting and will require strong political leadership to effectively tackle them. The harsh reality is that the country needs a facelift when it comes to its economic and political institutions.

A strong dose of capitalist reforms is paramount. The good news is that Venezuela has a regional model in Chile to look towards for inspiration. By emulating the Chilean model, Venezuela can move forward and undo the horrific legacy of Hugo Chavez’s socialist policies.

Now, it’s just a matter of the opposition taking power in Venezuela and having the political courage to follow through with tough reforms to right Venezuela’s economic ship.

Known to me

Unfortunately, being a man or woman of your word is not an acceptable regulatory standard for compliance.

Gone are the days when it was acceptable to confirm the identity of a new client by a director or senior colleague simply scribbling the words “known to me personally” on a file cover or due diligence checklist, without providing a shred of documentation.

The level of comfort that such personal introductions provided to a recipient, have since been outweighed by all the risks to its business operations, of failing to properly identify a customer, its affiliations or its source of funds. It is clear from regulatory guidance, that any such personal introduction should never replace the obligation to properly identify someone and run verification procedures on their data.

Relevant financial businesses are able to rely on due diligence which they have previously collected and where the information at hand is still considered to be reliable and up to date. Nonetheless, the standard remains that businesses should identify their customers and verify their identity using independent and reliable source documents.

In the Cayman Islands, the regulatory standards for the prevention and detection of money laundering and countering the financing of terrorism, though providing a certain level of flexibility, require, inter alia, (i) the obtaining of satisfactory evidence of the identity of an applicant for relevant financial business and (ii) the verification of that data at the earliest possible point after contact is made. There is scope to tailor the due diligence requests based on the type of customer, proposed transaction or nature or length of the business relationship.

The reality is, however, that the rainmakers are not always impressed by compliance demands and would prefer not to go out to clients to request further or better due diligence particulars, and in some cases, any at all. The concern is that a transaction that is time sensitive could be delayed, or a potential client could be “spooked” by the additional or “burdensome” due diligence requests. This is a well-known tension between the compliance function and the operations departments. It is remarkable that when those same requests are made of the rainmakers, they comply without utterance.

Since we are operating in a risk-based regulatory environment, what often follows is a lively debate on what constitutes taking reasonable measures to establish and/or verify someone’s identity, in light of regulatory guidance. Sectoral and industry best practices are to be considered in the analysis of what due diligence could suffice, and whatever decision is made should be clearly documented, and made subject to internal review.

Any reliance on introductions to personal clients, should always be premised on the basis that the standards of the AML/CFT regulations are being met. Accepting the assertion that someone is personally known requires the recipient to be satisfied that the introducer has obtained satisfactory evidence of the identity of the person being introduced, and further, that the evidence of such identification is being maintained in a compliant manner. If that is not the case, the introduction should not be relied upon. This is equally true under the eligible introducer’s regime.

The minimum documentation that should be held for a personal client is satisfactory evidence of (i) full name/names used; (ii) correct permanent address; (iii) date and place of birth; (iv) nationality; (v) occupation; (vi) nature of transaction/business and (vii) the source of funds.

With those three words, “known to me”, the introducer is essentially giving an assurance on all of the above. Do you really know someone’s true identity, their affiliations or their source of funds? The source is not the bank account or trust fund that the money may originate from. It is the transaction or series of transactions or occurrences that caused that bank account or trust fund to contain money in the first place. Do you know what they are?

In the wake of the publication of the National Risk Assessment report, the Cayman Islands Monetary Authority (CIMA), has stepped up its efforts to test the veracity of AML/CFT programs through offsite measures. Coupled with this is CIMA’s development of, and consultation on, revised data accessibility and record retention expectations. This signals that those conducting relevant financial business should expect a higher level of scrutiny from CIMA on AML/CFT matters and, ultimately, enforcement action including for failure to take appropriate measures to conduct due diligence on their customers to properly identify them, and potentially for failure to retain source documents and data, as required.

There is convergence in the customer due diligence space with the compliance obligations to CIMA for AML/CFT, the Tax Information Authority in respect of the automatic exchange of information and more recently the registrar of companies in respect of the beneficial ownership registers. It would appear that now is as good a time as any for businesses subject to one or more of these regulatory obligations, to take a step back and to determine how compliance can be achieved in a smarter and more efficient manner.

Taxation in the global economy: Balancing competitiveness and solvency

Figure 2

It seems the Administration is using economic growth like magic beans – the cheap solution to all our problems. But there is no golden goose at the top of the tax cut beanstalk, just mountains of debt,” reads a statement released from Maya MacGuineas, president of the nonpartisan Committee for a Responsible Federal Budget. “Instead of banking on fantasy growth rates to offset debt-financed tax cuts, we should be pursuing sustainable economic growth to lift incomes and reduce budget deficits.”

According to Bloomberg’s ‘Tracking Tax Runaways’ report, 57 corporations left the U.S. for more tax-friendly jurisdictions in the last 20 years1. Ireland, with a corporate income tax rate of 12.5 percent, tops the list of recipient countries for U.S. companies that shift their place of incorporation to another country. President Trump’s proposal to slash the corporate income tax to 15 percent aims to reverse this trend by making America competitive again.

The rest of the developed world anxiously awaits what will happen to America’s corporate tax structure, because the highest corporate tax rate in the developed world has been benefitting other nations’ economies for years. Since the mid-1990s, while some OECD (Organization for Economic Co-operation and Development) countries gradually reduced their corporate tax rates, America’s corporate rates remained relatively unchanged. As a result, large American employers left America for lower-tax jurisdictions2 – average corporate taxes in the rest of the OECD are nearly 10 percent lower.3 Table 1 documents that five corporations with a total net income of $2.3 billion shifted their place of incorporation to another country in 2016 alone.

Table 1

Unlike Maya MacGuineas, most economists – myself included – recognize that U.S. President Donald Trump’s proposed sharp decrease in the overall tax burden would increase U.S. competitiveness and grow the size of the U.S. economy. This is because competitive tax cuts would trigger large inflows of capital that would boost productivity. However, most experts are reluctant to publicly support the plan due to worries about fiscal solvency. One concern is that slashing the corporate tax rate to 15 percent would boost the deficit so much that the tax cut would be short-lived.

On April 25, the Washington D.C.-based Tax Foundation estimated that in order for the proposed corporate income tax cut to be self-financing, it would have to raise the U.S. average growth rate from 1.9 percent to 2.8 percent.

Most experts believe this type of growth is unlikely since productivity has sharply declined in most industrialized economies. In the United States, per-person gross domestic product rose by an average of 2.2 percent a year from 1947 through 2000, but growth has been much lower since. While weak productivity and fewer workers are hits to the “supply” side of the economy, former Secretary of the U.S. Treasury Lawrence Summers4, who re-introduced the world to the concept of secular stagnation, provided evidence that a shortage of demand is also a major part of the problem.

Regardless, when confronted with low productivity, the case against expansionary policy does not seem logical. Whether supply will create new demand or demand will lead to a supply boost – as Secretary Summers suggests – one thing remains certain: productivity growth will not return to its golden age with tax rates that penalize both supply and demand.

Tax policy, such as cutting the corporate tax rate, influences saving and investment decisions which in turn affect labor market outcomes – employment, wages, and aggregate welfare. In increasingly interconnected markets, the effects of policies in one country can have implications for the rest of the world. Globalization, reductions in institutional barriers to international investment, and trade agreements have contributed to increased levels of capital mobility across countries with large differences in factor taxes. One example was the creation of a unified financial market in Europe that caused a large increase in international capital mobility across countries with uneven tax structures. It soon became clear to Europe’s political class – concerned about fiscal solvency – that containing capital flight had to become a priority.

Capital flight refers to a large-scale exodus of financial assets and capital. Corporations and high-income individuals often move their assets to countries with a lower tax burden when the benefit from moving assets abroad exceeds its cost. The flow of mobile factors of production from a high-tax to a low-tax state directly reduces the tax base in the high-tax jurisdiction. In addition, the relocation of mobile factors – labor and capital – can also reduce overall factor income in the high-tax country, thus further eroding its tax base.

For most countries, curbing capital flight implies either a tax race to the bottom or tax harmonization. Tax competition exists when governments are encouraged to lower the fiscal burden to either encourage the inflow or discourage the exodus of production factors.

Tax harmonization refers to making the tax burden identical across borders, usually by increasing tax rates in all jurisdictions.

When capital is perfectly mobile and there are no tax differentials, investors will continue to shift capital between sectors of the world economy until the marginal productivity of capital in each sector is equal to the world return. At equilibrium, the international allocation of capital is efficient because resources are directed towards the location where they create the most value.

However, if tax differentials exist between countries, resources will continue to be shifted only to the point where after-tax rates of return are equalized to the world return. Pre-tax rates of return will remain un-equalized, and thus so too will the marginal productivity of capital in different sectors of the world economy. Tax differentials thus disrupt the optimal allocation of resources, and reduce economic efficiency. Through lower and converging tax rates, tax competition represents an opportunity to enhance global productivity and aggregate welfare.

For example, in the 1980s, the United Kingdom (U.K.) – which previously had higher taxes on capital income and lower income tax rates on labor than France – lowered its tax rates on capital income and barely changed its labor income tax due to concerns about competitiveness. On the other hand, countries in Continental Europe (CE) barely changed their taxes on capital income and increased labor income taxes sharply because of concerns about fiscal solvency. These changes led to productivity gains and an amelioration of living standards in the U.K. relative to CE. (Mendoza and Tesar, 2005)5.

The U.K. clearly benefited from the capital tax cuts. Capital flows from CE to U.K. made labor more productive in the U.K., grew its tax base, thus explaining why fiscal solvency in the U.K. did not require large increases in other taxes. On the other hand, capital flight from CE made labor less productive in CE, shrinking its tax base. Large increases in labor income tax rates only exacerbated the problem since labor supply responded negatively to higher effective tax rates. While tax competition proved to be welfare-improving for the U.K., it was immiserating for CE.

By the late 1980’s Britain’s average growth rate had reached 5 percent. For the general election of 1987 Margaret Thatcher’s party boasted that “Britain’s Great Again. Don’t let Labour wreck it.” Although the share of real gross domestic product (GDP) paid in taxes – a measure of the tax burden – decreased in the U.K. (see, Figure 1), yearly tax revenues per capita grew faster in the U.K. (see, Figure 2), averaging 8 percent annual growth in the 80s and 90s compared to 6 percent in France.

Figure 1
Figure 2

In OECD countries, the expected decline in tax revenues never occurred in countries that cut taxes on capital income.6 Instead, a significant increase was recorded. (Simmons, 2006)7. In the U.S., Mertens and Ravn (2013)8 provides more evidence of the dynamic effects of capital and corporate tax cuts. The authors of this study find that personal income tax cuts lowered tax revenues while corporate income tax cuts did not, because of a very elastic response of the tax base.

Economists Andrew Mountford and Harald Uhlig investigate the effect of unexpected fiscal policy changes, such as tax cuts and spending hikes, in a paper entitled: “What are the Effects of Fiscal Policy Shocks?”9 Mountford and Uhlig analyze how changes in government tax revenues and spending affect important economic indicators like GDP, consumption and private investment. They use U.S. data from 1955 to 2000 and control for business cycles, which are normal, reoccurring fluctuations in economic activity.

Mountford and Uhlig find that deficit-financed tax cuts outperform both balanced-budget and deficit-spending approaches in improving GDP. Deficit-financed-tax-cuts deliver up to five dollars of additional GDP per 1 dollar of decline in government revenue caused by the tax cuts. Deficit-financed-tax-cuts stimulate output, consumption and investment significantly, with the effect peaking three to five years after the policy change. While some tax cuts may not immediately pay for themselves, growth effects coupled with government spending restraint are guaranteed to deliver solvency.

Unfortunately, fallacious claims suggesting that a tax race to the bottom leads to insolvency still dominate the policy debate. Competitive tax cuts grow the tax base, which in turn reduces the marginal cost of public funds. (Razin and Sadka, 1989)10. As a result, funding for government programs can increase via non-distortionary means in a more competitive low tax regime.

Fiscal solvency is a symptom of tax competitiveness while insolvency indicates a lack thereof. The bulk of evidence suggests that corporate tax cuts grow the tax base and improve aggregate welfare. This is precisely why good tax policy in a global economy begins with improving competitiveness. Mark Twain famously said: “history does not repeat itself but it often rhymes,” and a corporate income tax cut – one that rhymes with the Thatcher tax cuts – should foster an economic environment conducive to fiscal solvency – ceteris paribus.

The author can be reached for comments at The views presented here are solely those of the author. They may or may not reflect the views of The Buckeye Institute.


  2. Ibid.
  4. Gauti B. Eggertsson & Neil R. Mehrotra & Lawrence H. Summers, 2016. “Secular Stagnation in the Open Economy,” American Economic Review, vol 106(5), pages 503-507.
  5. Mendoza, E. and Tesar L. (2005). “Why hasn’t tax competition triggered a race to the bottom? Some quantitative lessons from the EU.” Journal of Monetary Economics, 52, 163-204.
  6. OECD (2017), Tax revenue (indicator). doi: 10.1787/d98b8cf5-en (Accessed on 02 May 2017)
  7. Simmons, R. (2006). “Does recent empirical evidence support the existence of international corporate tax competition?” Journal of International Accounting, Auditing and Taxation. 16-31.
  8. Mertens, K. and Ravn M. (2013). “The Dynamic Effects of Personal and Corporate Income Tax Changes in the United States.” American Economic Review, 103(4): 1212-47.
  9. Mountford, A. and Uhlig, H. (2009). “What are the effects of fiscal policy shocks?” Journal of Applied Econometrics, 24: 960–992. doi:10.1002/jae.1079
  10. Razin, A and Sadka, E. (1989). “Integration of the international capital markets: the size of government and tax coordination.” National Bureau of Economic Research, working paper #2863

Fake economic news

Fake news is the name given primarily to political news that is not true. Unfortunately, much economic news is also not true, because the data is so poor or the sources, most often government bureaucrats, have a vested interest in misreporting. In this issue of the Cayman Financial Review, Lawrence Hunter describes the problem of what are often called free trade agreements are nothing of the sort. In another article, Professor Urska Velikonja describes how the Securities and Exchange Commission and other government agencies misrepresent their own performance.

Recently, I was in Kiev, Ukraine, and observed many new, attractive high-rise apartment and office buildings and considerable on-going construction. If you read the official statistics about the Ukrainian economy, you would believe the place is economically stagnant, or worse. The country has a low-level war with Russia and by all accounts has massive corruption; yet, real economic progress is taking place. From the end of the Cold War, I have visited Ukraine every few years in conjunction with some economic program or conference. As noted, the official numbers about the Ukrainian economy from various international and U.S. government agencies show almost no rise in the standard of living over the last thirty years, but those of us who have observed what is actually happening on the ground know that the numbers have been wrong. I asked some of the Ukrainian economists I was meeting with for their explanation of the disparity. They all agreed that more than 50 percent of the Ukrainian economy is part of the “shadow economy,” meaning that the numbers were not being reported, nor taxes being paid on much of the activity.

During the Cold War, the CIA and other government agencies reported a much higher standard of living than was true for the Soviet Union and Eastern Europe. As chief economist of the U.S. Chamber of Commerce in the 1980s, I was a consumer of the data for policy reasons, but had been given a “heads up” by colleagues at the National Security Council that they believed the official numbers were wide of the mark. The folks at the CIA and elsewhere had a vested interest in exaggerating the economic threat from the communist countries. They also tended to rely too much on the “official” numbers as reported by these countries. For instance, the Bulgarian government would report that bread cost x cents per loaf, but in fact few loaves of bread were available at that price and so most consumers had to rely on the black markets to obtain bread – at a much higher price – and this real-world data was often not adequately factored into the CIA estimates. The quality of most goods and services was also much lower than in the capitalist countries, and these quality differences were also not adequately made part of the official economic estimates.

Government agencies, whether domestic or international have a vested interest in overstating the ability to repay the debt of those to whom they have extended loans. Like banks, they have an obligation to report potential bad debts but often fail to do so because of the political embarrassment that it might cause. Note: The Greek government keeps obtaining debt forbearance from its international creditors on the basis of promises to cut spending and raise more tax revenue, which never fully occurs for reasons any objective observer well understands.

In the article “Behind the SEC’s Enforcement Statistics,” Professor Velikonja of the Georgetown University Law Center, exposes how the SEC selectively uses statistics to make its performance seem much better than it is. “The most widely-used performance indicators that the SEC uses are the number of enforcement actions filed and the amount of monetary penalties imposed. Neither measures what it is supposed to measure – the increase in investor protection and/or capital market efficiency – both are unreliable: they are used inconsistently from year to year and can be manipulated.” Many government agencies use flawed statistics to make their performance look better than it is in order to obtain larger budgets and more power.

Lawrence Hunter had several senior economic policy positions in both the executive and legislative branches of the U.S. government, and well understands the difference between what gets labeled as free-trade agreements and the reality. Free trade has been economic orthodoxy since the late 18th and early 19th centuries, when its benefits were best described by Adam Smith and David Ricardo. As Hunter notes: “The case for free trade broadly defined holds that people should be free to trade freely among themselves for goods and services without government intervention and restrictions, both among their own countrymen and with people of foreign nations. Under this arrangement, people will tend to produce and export those goods in which they excel and to import those goods in which they and their fellow countrymen do not excel.” Before World War I, free trade flourished, but Hunter argues it has been in retreat ever since. “The rebirth of free trade was extinguished with the introduction of government-managed trade, the history of which is charted by the litany of alphabet efforts of politicians and bureaucrats to substitute their own rules for the working of free markets – NAFTA, CAFTA, WTO, and the TPP, to name a few. Bizarrely, all of these acts of destruction were committed in the name of open markets and free trade.”

The irony is that President Trump had a point in his criticism of the existing “free trade” agreements, without seeming to understand that the solution was real free trade.
Fake economic news is largely a product of self-interested government bureaucrats and others spinning information to make their agencies or themselves look as if their only objective is the “public interest.” Fake news is also a product of the real problems associated with obtaining accurate data because of incompetence or the plain difficulty of obtaining reliable numbers. Trade numbers, for example, contain massive errors due both to definitional problems and inconsistent data collection procedures. Many economic numbers are nothing more than approximations or even guesses, so users beware.

Whither free trade?

To answer the question, “Whither free trade?” it is necessary first to answer the prior question: “Whatever happened to free trade?”

Whatever happened to free trade?

It died between World War I and World War II. It flickered to life again after World War II only to be snuffed out, smothered by a monstrous web of governmental rules, regulations and restrictions that shackle markets and impede the free exchange of goods and services – both domestically within sovereign nations and internationally among them.

The rebirth of free trade was extinguished with the introduction of government-managed trade, the history of which is charted by the litany of alphabet efforts of politicians and bureaucrats to substitute their own rules for the working of free markets – NAFTA, CAFTA, WTO and the TPP, to name a few. Bizarrely, all of these acts of destruction were committed in the name of open markets and free trade.

Prior to World War II, it is safe to say, beggar-thy-neighbor, protectionist practices significantly hobbled the free exchange of goods in world trade. Most notoriously, the Smoot-Hawley Act in the United States led to contagion effects throughout the world and, ultimately, a world-wide depression. In 1976, economist Allan Meltzer noted that the decline in U.S. food exports and falling agricultural prices contributed significantly to bank failures in 1930 and 1931, triggering subsequent bank failures and eventually monetary collapse.

In the aftermath of WWII, international bureaucracies, such as the General Agreement on Tariffs and Trade (GATT), were established to set rules that would lower trade barriers by restricting protectionist trade policies and decreasing discriminatory tariffs. While the GATT regime clearly produced an improvement in the world trade environment, it nevertheless laid the predicate for what was to follow with managed trade. From GATT forward, there was a concerted effort by managed-trade bureaucrats to pass themselves off as committed “free traders.”

By 1997, Fordham University and Manhattan College adjunct professor Robert Batemarco was able to connect the dots between the burgeoning welfare state, creeping government control of domestic economies and international restraints on trade and exchange:
“…government restrictions on international trade are of a piece with domestic restrictions on competition. They share the same goal: To redistribute income from the many to government’s chosen few and to substitute its own preferred allocation of resources for that of the market. Indeed, by restricting trade with foreigners, governments close off an important means of mitigating the impact of their domestic restrictions. This is what John T. Flynn had in mind when he said, ‘The first condition of a planned economy is that it be a closed economy.’”

At the heart of government planning and economic engineering, both domestic and internationally, is what public choice economists call rent seeking: Schemes conjured up by interested parties petitioning governments to protect themselves against competition and pursuing an advantage for themselves against all would be competitors; and, efforts by bureaucrats and politicians to build bureaucratic empires and increase their power at the expense of economic growth and prosperity – evidenced, for example, by anti-dumping rules, labor laws and harmonization, right down to and including harmonization of nations’ tax and monetary policy.

As this neo-Mercantilism takes its toll, especially on the poorest individuals and nations striving to better themselves, and economic engineering goes array, as it always does, the usual reaction sets in. Politicians and bureaucrats double down on their misguided policies in an effort to use government to mitigate the damage their meddling created in the first place: More planning, more economic engineering, more grasping for power, more rules and regulations, more efforts to stunt competition, more preferential treatment and greater centralization and uniformity – again, all sold as ersatz “free-market solutions,” to create jobs and stimulate economic growth. In fact, these policies do not foster trade and commerce; they encumber them.

When the failure of government-managed trade becomes so obvious it cannot be ignored, desperation sets in. One desperate solution has been so-called “free trade zones,” which turns out to be little more than a kind of second-order managed trade solution for economic basket cases created by governments’ first-order attempts to manage economies and trade. As early as 1995, Columbia University professor Jagdish Bhagwati explained the Orwellian manner in which this version of second-order managed trade was being sold with the trappings of “free trade” while simultaneously, and contradictorily, being touted as the solution to the shortcomings of free trade: “…it is time that we realized that the phrase Free Trade Areas [FTAs] is Orwellian newspeak. It lulls us, indeed editorialists and columnists and politicians, into focusing only on the fact that trade barriers are lowered for members to the exclusion of the fact that, implicitly, the barriers are raised (relatively) for nonmembers.

FTAs are therefore two-faced: they embody both free trade and protection. The reason is that they are inherently preferential and discriminatory. Perhaps, as economists interested in the quality of public policy discourse, we should take a pledge to rename the FTAs henceforth as PTAs (i.e. preferential trade areas).”

More preferable still would be a pledge by politicians and professors alike to rename “free trade agreements” henceforth as “managed trade agreements,” the very antithesis of authentic free trade.

Thus, most of the bad that free trade gets blamed for – job loss, declining wages, hollowing out of domestic manufacturing, out-sourcing, offshoring and the like – ultimately can be laid at the doorstop of government-managed trade and domestic economic engineering, i.e., mercantilism. History demonstrates unambiguously that mercantilism leads to favoritism, inefficiency, reduced prosperity and tyrannical government.

There is tragic irony in the invasive, creeping-and-climbing, Kudzu-like growth of over-grasping, gargantuan governments strangling all in their path. What a tragic turn of events this is, in light of the fact that the rampant spread of overweening bureaucratic states, posing as democracies, emerged at the fall of communism and the end of the Cold War – a point in history at which humanity was presented with the opportunity to achieve liberty, peace and prosperity through the time-tested means of free markets and free trade.

The discovery of the virtues of free trade go back to the late 18th and early 19th centuries in the writings of Adam Smith, David Ricardo and James Mill, father of John Stuart Mill. The case for free trade broadly defined holds that people should be free to trade freely among themselves for goods and services without government intervention and restrictions, both among their own countrymen and with people in foreign nations. Under this arrangement, people will tend to produce and export those goods in which they excel and to import those goods in which they and their fellow countrymen do not excel. This was termed the Law of Comparative Advantage by Ricardo.

Since Ricardo first postulated the Law of Comparative Advantage two centuries ago, free trade practices consistently have demonstrated their ability to allocate resources most efficiently, i.e., to put the factors of production to their most productive use, increase productivity and, thereby, raise standards of living by maximizing economic growth. And yet, the politicians and bureaucrats in charge around the world have ignored this track record of success in favor of wooly-headed Keynesian economic theories based on a collectivist ideology and unconfirmed assumptions of market failure and instability that require constant government management of trade and commerce.

Today, we are seeing the accelerated advance of a global version of what Alexis de Tocqueville some 175 years ago dubbed a “sole tutelary,” a central political authority in which: “Power is absolute, minute, regular, provident and mild…the sole agent and the only arbiter of [citizens’] happiness…[and] after having thus successively taken each member of the community in its powerful grasp and fashioned him at will, the supreme power then extends its arm over the whole community. It covers the surface of society with a network of small, complicated rules, minute and uniform, through which the most original minds and the most energetic characters cannot penetrate, to rise above the crowd. The will of man is not shattered, but softened, bent, and guided; men are seldom forced by it to act, but they are constantly restrained from acting. Such a power does not destroy, but it prevents existence; it does not tyrannize, but it compresses, enervates, extinguishes, and stupefies a people, till each nation is reduced to nothing better than a flock of timid and industrious animals, of which the government is the shepherd.”

This hydra-headed, bureaucratic Leviathan now extends its reach globally, beyond sovereign boundaries, in part through unelected international agencies, such as the World Trade Organization and misnamed “free-trade” agreements.

Whither free trade?

And so, we return to the original question.

The prevailing and continuing trend toward increasing government control of every facet of life, including trading with people in foreign nations as one sees fit, appears irreversible by any normal democratic political means. Short of an economic crackup, there appears to be no practical, incremental means by which to reverse the status quo, which, to quote former President Ronald Reagan, “is Latin for the mess we’re in.”

But, my opinion is just that: my personal judgment. I could be wrong. Therefore, it may serve some useful purpose to lay out systematically what authentic free trade would consist of and how it could work in a world recovering from the almost certain catastrophe that awaits us along the course the world is traveling. Perhaps at this point, the necessity for rapid economic growth would overcome inertia and compel people to accept the obvious: Free markets and free trade work; government intervention and planning do not.

Here is a partial outline of proposed free trade policy and related tax policy necessary to make free trade viable. It is incomplete as it omits other economic reforms necessary to remove other government interference into the domestic marketplace to make it possible for domestic manufacturers to compete with the manufacturers of other countries. Neither does the outline address currency and monetary policy, all of which are topics for another day.

  1. Pull out of all existing trade deals and trade organizations such as the WTO and NAFTA.
  2. Repeal the income tax (both personal and corporate) and replace it with a comprehensive and neutral national retail sales tax along with a uniform and non-discriminatory, border-adjusted, destination-based cash flow tax on businesses.
  3. Enact a law providing for the government to enter into binding bilateral free trade agreements with its trade partners providing that both partners submit trade disputes between the two nations to an arbitration board agreed upon in advance by both partners. If a trade partner refuses to abide by an adverse ruling of the arbitration board, the alternative schedule of tariffs discussed in #5 below automatically would be triggered.
  4. All bilateral trade agreements would be of the same standard form specified in law, stipulating that both parties would refrain from erecting tax and non-tax barriers to trade and committing not to engage in any form of discriminatory and unfair trade practices. The language should be general and “constitutional” in nature and not subject to negotiation between the parties prior to signing.
  5. Establish an alternative, non-discriminatory and neutral schedule of tariffs to be levied on the imports of countries not a party to a bilateral agreement and to be triggered against a bilateral trade partner’s imports if and only if there is an adverse ruling from the trade arbitration board that cannot be resolved between the two countries.

This outline falls short of the simplicity and elegance of the original American Free Trade Agreement among the original 13 American states, i.e., the U.S. Constitution, whereby the Framers mandated free trade among all the states in the union. The arrangement is spelled out in Article I, Section 9, of the Constitution: “No tax or duty shall be laid on articles exported from any state. No preference shall be given by any regulation of commerce or revenue to the ports of one State over those of another: nor shall vessels bound to, or from, one State, be obliged to enter, clear, or pay duties in another.”

There is a reason for the added complexity of the outline suggested above: The American states are bound together in a constitutional system and subject to federal law and the authority of federal courts for any breaches of the Constitution; U.S. trading partners are not.

So, the question arises: How are disputes between bilateral trading partners not covered by some larger constitutional document to be resolved? This quandary, in fact, has been the overriding impetus behind the burgeoning rules and bureaucracies in multilateral trade organizations such as the WTO. The solution to compliance and dispute resolution among trading partners within these multilateral trading organizations usually is for members of the organization to cede a part of their national sovereignty to the bureaucratic organization. Little wonder, a growing number of people rightly perceive these international organizations as the vanguard of global government.

Much is left undone by the foregoing outline, in two areas in particular. First, no lasting prosperity can be hoped for until monetary reform is undertaken and sound money restored. This may be taken care of the hard way in the natural course of events as the world economy cracks under current interventionist policies, and people come to realize the necessity of sound money.

Second, to expand on Robert Batemarco’s observation above, the trend toward collectivization in virtually every nation around the world is a strong impetus toward global centralization and global government, as the WTO illustrates. It is, therefore, absolutely necessary to reverse the trend toward collectivization.

As I point out in Taxed to Death; How the Income Tax & IRS Harm Everyone in America, the process of collectivization the United States was: A counter-revolution against the precepts of the original American Revolution; a counter-revolution that came to be characterized by everything the Founding Fathers feared most and had attempted to guard against: unbridled, majoritarian democracy, central planning, unrestricted direct taxation, unconstrained government spending and unrestrained borrowing, a debauched currency printed without restraint and disconnected from any real backing, unbounded government meddling and intervention into every facet of daily life and commerce, vast social engineering and empire building.

It is bad enough that free trade continues to give way to globally managed trade by quasi-government bureaucracies. It is even more concerning to see another dangerous trend developing. Increasingly, nations are imposing trade sanctions to achieve foreign policy objectives, especially by large, powerful nations such as the United States. Tit-for-tat, retaliatory trade wars are bad enough; once trade becomes weaponized in a delirious attempt to impose the empire’s desires on the rest of the world, trade wars can easily turn into shooting wars. We are well advised, therefore, to remain mindful of the old dictum that “when goods don’t cross borders, soldiers will.”

Lawrence Hunter is a senior fellow at the Institute for Global Economic Growth

Entrepreneurial transfer pricing – embracing the arm’s length principle

By publicizing exaggerated tax gap estimates and demonizing tax avoidance schemes based on allegedly abusive transfer pricing schemes, governments and advocates of big-government are aggressively promoting their tax grabbing agenda. To be sure, the Organisation for Economic Cooperation and Development cannot be regarded as a champion of tax competition. However, just as there is no harm in acknowledging that the economists at the OECD occasionally generate sensible statistics and reports, it is worthwhile to be aware of policy issues on which the influence of the OECD is, at least on balance, positive. A case in point is to be seen in the realm of transfer pricing. While the European Commission, the European Parliament as well as high tax jurisdictions are keen on utilizing transfer pricing regulation for curbing tax competition, the OECD adopted a more moderate stance. The OECD has certainly facilitated stricter transfer pricing regulations in the context of the Base Erosion Profit Shifting (BEPS) project, but the actions and policies of the EU, specifically the state aid infringement procedures as well as the promotion of the Common Consolidated Corporate Tax Base (CCCTB), are likely to be much more detrimental to tax competition and are thus much more worrisome.

Specifically, the OECD’s effort to preserve the arm’s length principle as the leading paradigm of transfer pricing is positive. Why? Because the arm’s length principle allows entrepreneurs to sustain alignment between their transfer pricing system and their business processes as well as their strategic objectives, including minimization of the tax bill. Embracing an entrepreneurial approach to transfer pricing will go a long way towards minimizing tax risks as long as the arm’s length principle prevails. Emphasizing the entrepreneurial perspective on transfer pricing further seems suitable to counter the stigmatization of transfer pricing as a vehicle for tax avoidance – which in turn would contribute to dispelling the myth that formulary apportionment (CCCTB) is somehow a sensible idea.

The BEPS project – supporting the modernization of the arm’s length principle makes business sense

After reports on increasing tax gaps resulting from tax avoidance and tax evasion were propelled into the limelight, the OECD responded to mounting political pressures by embarking on a comprehensive revision of its international transfer pricing guidelines. While not legally binding, it is important to understand that the OECD transfer pricing guidelines are a widely accepted reference for tax authorities and taxpayers around the globe. The Leitmotiv of revising the guidelines was to “modernize” the paradigm of international transfer pricing, the so-called arm’s length principle.

Pursuant to the arm’s length principle, multinational enterprises are required to price their intercompany transactions by utilizing prices agreed between unrelated third parties (market prices) as a reference. Identifying sufficiently comparable third-party transactions is one of the main challenges for transfer pricing professionals. Transfer pricing is not an exact science and often transfer prices are set by multinationals within a broad range of comparable prices. From an entrepreneurial point of view this is absolutely sensible. A range of prices reflects differences in terms of market conditions, bargaining positions and other phenomena to be observed in a market economy. As such, utilizing a range of prices as a reference for transfer pricing rather than a single price, is hardly an artificial or sinister approach concocted by tax advisors. Entrepreneurs will often utilize a respective range in order further their strategic objectives, e.g. ensuring a sensible incentive structure for distribution entities.

Critics of the arm’s length principle lament that MNEs systematically abuse transfer pricing by setting transfer prices that favor subsidiaries located in low tax countries. The criticism is, however, misguided, as setting transfer prices within a range of reference prices seldom offers an enticing lever to shift profits. It should also be noted that tax authorities are notoriously suspicious of the benchmark studies, which are utilized by taxpayers to determine and defend arm’s length ranges, and do not hesitate to attack respective studies. In other words, it is plainly implausible to portray transfer pricing as a main pressure point of tax avoidance (let alone tax evasion). It is largely uncontested that aggressive tax avoidance schemes are based on legal elements and elaborate tax structuring, such as hybrid mismatches etc., rather than on systematic mispricing.

In the context of the BEPS project, the OECD has clarified that the measuring-rod of the effectiveness of the arm’s length principle is to be seen in the extent to which the transfer prices set by an MNE will result in a profit allocation that reflects the value contributions by the transacting parties. While there will be an inevitable time gap prior to the reforms impacting the tax gap calculations, there can hardly be any doubt that the reforms are indeed suitable to reach the target of the BEPS project, namely aligning the place of value creation with the place of taxation.

In any case, the solution proposed by the critics of the arm’s length principle, namely adopting a system based on formulary apportionment (such as the CCCTB), would constitute a drastically misguided paradigm shift. Under a system based on formulary apportionment, the allocation of profits would be based on a notion of a “fair” distribution of profits according to an arbitrary formula. Applying a global formula would not only constitute a milestone towards greater tax harmonization, i.e. coupling the introduction of CCCTB with compulsory ‘minimal tax rates.’ It would also constitute a delinking of transfer pricing from business processes. A political formula, irrespective of its calibration, can never be aligned with the business processes of an individual MNE. Furthermore, a formula, from which intangibles are absent, is obviously conceptually ill-suited to result in a profit allocation that reflects the value contributions by the transacting parties. Instead of a market-based profit allocation, a tax system based on formulary apportionment would reflect a planned economy.

Responding to BEPS – keep calm and fight against bad regulations

While there is no magic bullet available to taxpayers, a viable strategy for minimizing transfer pricing related tax risks in a post-BEPS world, is to pay closer attention to documenting the economic substance of cross-border transaction. Instead of compiling mind numbingly extensive documents, however, taxpayers should focus on explaining the value contributions made by the individual transacting parties by conducting a value chain analysis. In the process, the tax department, which in most cases will be assigned the responsibility for compiling transfer pricing documentation, should talk to the senior management as well as to the controlling and accounting departments. It needs to be ensured that the analysis is consistent with the business processes. Having a respective documentation in place, will alleviate the imbued suspicion of tax auditors and facilitate smoother tax audit proceedings. Often it will pay dividends to compile documents, such as cost center reports, invoices etc., to be utilized as a “back-up” during tax audits. Additional information about internal planning data and market information will often prove invaluable for substantiating that the pricing adopted for transactions with related parties is identical to the pricing adopted with unrelated third-parties.

Admittedly, the outlined approach is “transfer pricing 101.” Efficient transfer pricing does not require fancy structuring and glossy reports. Adopting an entrepreneurial approach, i.e. not confining transfer pricing to the tax department, will align the business perspective with an effective implementation of the arm’s length principle. A healthy and legitimate dose of tax optimization will and should naturally remain feasible. All tax authorities must remain obliged to judge the transfer prices of each MNE based on the arm’s length principle and limit their taxation to the arm’s length profits earned by entities within their jurisdiction. In other words, tax authorities will have to keep competing for their tax base instead of colluding about apportioning global income amongst each other according to some convenient (tax maximizing) formula.

Allocating profits to entities that lack economic substance will, however, become increasingly difficult. While diluting the principle that residual profits are to be allocated to the legal owners of the underlying intangible is far from unproblematic, the revised transfer pricing guidelines by and large offer an acceptable mechanism. By focusing on a more holistic evaluation of the value contributions by the transacting parties, the guidance is compatible with an entrepreneurial approach to transfer pricing (i.e. even applying bargaining theory seem feasible ).

Despite the positive sentiments exuded thus far, MNEs will have to remain vigilant and fight bad regulations. One of the toughest battles against tax-grabbing tax authorities will have to be fought with respect to the taxation of intangibles. It must be ensured that the discretionary powers of tax authorities in implementing the “modernized” arm’s length principle remain limited. Most importantly, tax authorities must continue to bear the burden of proof. The latest discussion draft of the OECD in respect to the transfer pricing issues of hard to value intangibles gives rise to grave concerns. Its main feature is that tax authorities are issued a carte blanche for utilizing hindsight. Where, for example, the actual income of a transaction turns out to be significantly higher than the anticipated income on which the pricing was based, then this will be regarded as “presumptive evidence” that the projected income used in the original valuation should have been higher.

In case the taxpayer adopts a policy based on an entrepreneurial approach to transfer pricing, he would be able to document that the assumptions made at the time of anticipating future earnings were in fact commensurate with best practices for decision-making under uncertainty. The discretionary powers of the tax authorities must be limited, by obliging them to conclusively demonstrate that the underlying assumption of the analysis conducted by the taxpayer deviated from arm’s length conditions. Unfortunately, the discussion draft does not reflect an appropriate restrain on discretionary powers.

Hopefully, the business community will actively participate in the discussion, making it clear that a sensible regulation cannot be based on scapegoating MNEs. In turn, MNEs should engage in a critical dialogue and not snub the OECD’s efforts in the realm of transfer pricing. As long as the threat of a CCCTB is on the table, it certainly would not hurt to adopt a more proactive stance on defending the arm’s length principle.