Thursday, August 25, 2016

After Brexit

The U.K.’s decision to leave the EU marks a historic shift in the nation’s relationship not only with Europe but with the world. In the short-term, there will be costs to Brexit, as a result especially of changes to the rules governing trade between individuals and businesses in the U.K. and their counterparts in other nations. In the longer term, however, Brexit presents an opportunity for the U.K. to re-establish itself as a cosmopolitan, classical liberal democracy governed by the rule of law and more open to trade with the outside world. If it takes that path, then its prospects are brighter than they would have been in an over-regulated, increasingly protectionist EU.

For Britain formally to begin the process of leaving the EU, it must – according to Article 50 of the Lisbon Treaty – notify the EU of that decision. The terms and date of exit will then be determined by agreement – but by default will occur two years after notification. Actually invoking Article 50 almost certainly will require an Act of Parliament. While some U.K. politicians have talked of Parliament rejecting the referendum result, it seems more likely that Parliament will pass such an Act and grant (perhaps limited) negotiating authority to the government over the terms of Brexit.

The U.K. government has established an “Brexit Department” to develop the exit strategy. That department, headed by David Davis, must now grapple with the complex task of identifying the best way to disentangle the U.K. from the EU. Key questions to be addressed include: What should be Britain’s trade policy? How should immigration be reformed? And which British regulations required by the EU should be kept and which scrapped? To make matters worse (or at least more confusing), these questions are not necessarily independent of one another.

Taking trade first: At present, the U.K. is part of the EU customs union and practically all trade policy decisions are made on an EU-wide basis. Currently, all trade in goods, services and capital between the U.K. and other EU member states is tariff free. This preferential treatment for trade within the EU boosted trade and created a tendency for transactions to remain within the customs union. However, trade with the EU as a share of all British trade has declined from about 55 percent in 1999 to 45 percent in 2015.

The increasing importance of trade outside the EU has in part been driven by the rapid growth of Asian economies, which was in turn driven in part by unilateral trade liberalization on their part. Britain could potentially benefit enormously by following that route – which in many respects would be a return to the free trade era of the late 19th Century. Unilaterally removing external restrictions on imports of goods, services and capital would be both the simplest and in many respects the best policy, since it can be undertaken without the need for any intergovernmental negotiation. It would ensure that consumers and producers in the U.K. had access to these inputs at the lowest possible cost. This would drive stronger domestic competition, resulting in higher rates of innovation and growth.

A second, largely complementary, option is for the U.K. to revert to independent membership of the World Trade Organization. The advantage of the WTO is that it limits the tariffs and other restrictions other members can impose on British exporters. However, this should not be seen as an alternative to unilateralism.

A third option, which again is largely complementary to both unilateralism and membership of the WTO, is to join the European Free Trade Association (EFTA). This association, which currently comprises Norway, Iceland, Lichtenstein and Switzerland, imposes no tariffs on goods traded between them. Apart from the immediate benefits of mutual free trade, joining EFTA would signal Britain’s continued commitment to trade and comity with other European nations – and perhaps encourage other EU members considering withdrawal to embrace an arrangement based on trade rather than political patronage. Membership of EFTA would also bring the U.K. automatic membership of the 27 free trade agreements EFTA has negotiated for its members.

If Britain were to join EFTA, it might also have the option of joining the European Economic Area (EEA), which currently comprises three of the EFTA nations, Norway, Iceland and Lichtenstein. Under EEA rules, the U.K. would maintain the “four freedoms”: free movement of goods, services, capital and people across all EU and EEA states. But that would effectively leave Britain with almost the same EU migration policy that has become so contentious with many in the Leave camp. Unlike the EU, the EEA permits an emergency brake on immigration, which has been invoked by Lichtenstein, but this might not be sufficient.

Moreover, EEA members are also required to comply with EU regulations related to these four freedoms – without having any say in the content of those regulations. Given that a key reason for the U.K. leaving the EU is the lack of transparency and accountability of the EU’s decision-making processes – and the arbitrary, capricious and economically sclerotic regulations that have resulted – EEA membership looks like a less than ideal option.

However, as Roland Smith has argued, it may be the option that is most acceptable to the establishment.

A fourth option would be for Britain to seek to negotiate trade agreements with various other nations, including Canada, Australia, the United States, China and India. However, there is a danger that such negotiations could become very protracted, so again this option should be considered subordinate to unilateral liberalization. Also, to minimize the complexity of such negotiations, it might be best if Britain were to identity a basic set of principles that could be applied to all potential partners in free trade.

Turning to the question of immigration: If the U.K. does not choose the EEA route or if it is not permitted to join the EEA, it will have to establish rules for nationals of other EU member states currently living in the U.K. The simplest and most logical solution would be to grant any EU national living and working in the U.K. at a specified date, perhaps the date on which Brexit becomes final, permanent leave to remain. But obviously there is then the question of how to determine which future potential immigrants to permit.

There are many potential alternative immigration policies. The libertarian in me wants to advocate for totally open migration but that would be even less politically acceptable in the current U.K. than joining the EEA. So, some kind of restricted migration policy is, I think, inevitable. One way to do this would be to adopt an employment-based system of some kind. Sweden has arguably the best such system; it permits anyone with a qualifying job to migrate – removing much of the uncertainty, delay and cost of the kind of employment-based visa process now in place in the U.K.

But there is a fundamental problem with all employment-based immigration systems, namely that they require immigrants to have a job prior to migration. This imposes high costs on both the firms seeking to employ migrants, which typically bear the cost of visa applications, and on immigrants, who must find jobs in foreign countries, go through selection processes, etc.

An alternative system, proposed by the late Nobel-Prize winning economist Gary Becker is to sell the right to migrate. This idea has the advantage that it does not require a person to have a job prior to migration, nor does it impose arbitrary restrictions based on current location, academic qualifications, or family relationships. The main problem with this system is the difficulty knowing the “correct” price: too high and Britain would suffer from a lack of skilled labor (read: the cost of plumbing would rise unacceptably); too low and there might be a flood of migrants, leading to the same concerns that have been raised by the current opponents of open migration.

An additional problem with selling the right to migrate is that it does not accommodate those who might otherwise be permitted to immigrate on compassionate grounds, such as asylum seekers, refugees or family members. So, accommodation would have to be made for these people.

Last but by no means least, Britain will have to find a way to decide which of the thousands of regulations that derive from EU legislation to keep and which to discard. Britain has on several occasions sought to cut red tape, establishing various Parliamentary committees charged with deregulating the economy. Last year, Parliament passed a new Deregulation Act that again sought to reduce some of the red tape that has become so burdensome. But all of these changes were piecemeal and none could to stem the tide of EU legislation.
Previous attempts at deregulation also simply didn’t have sufficient teeth. One solution would be automatically to sunset all EU-derived regulations at the date the EU exits the EU – which will be two years after it invokes Article 50. During those two years, parliament could investigate the need for those regulations and prioritize the re-instantiation of any deemed, on net, to be desirable. By making deregulation the default and imposing a limited timeframe, parliament will be forced to prioritize more effectively than has previously been the case.

Of particular significance to readers of Cayman Financial Review will be the treatment of financial regulation, especially that which governs firms offering financial services across the EU under the so-called “passport” arrangements. If the U.K. were to join the EEA, the passport arrangement would remain in place for all financial services. Unsurprisingly, the City of London is now lobbying heavily for the EEA option.

If Britain does not join the EEA, the U.K. government will clearly seek a mutually agreeable alternative solution. Under the incoming Markets in Financial Instruments Regulation, many – but not all – of the rights of “passport” holders can be applied to non-EU firms, so it is likely that an important element of the Brexit negotiations will focus on ensuring these rights do apply to financial firms in the U.K.

One of the financial “passport” rights that does not extend to non-EU (or EEA) based firms is for UCITS (Undertakings for Collective Investment in Transferable Securities), a key requisite of which is that they be domiciled in an EU member state. The U.K., which is currently domicile for 12.7 percent of UCITS assets, will almost certainly seek to ensure that U.K.-domiciled UCITS funds continue to qualify. If the U.K. does not obtain such agreement, then U.K.-based fund managers will be required to domicile any UCITS they sell in an EU jurisdiction. However, as long as they continue to comply with necessary provisions of the UCITS regulation, U.K. fund managers will still be able to manage the funds from the U.K.

After the Brexit vote, Britain’s current relationship with the EU is untenable and must change. But that change should be an improvement on the status quo. A looser arrangement, based on open trade with the EU and all other nations, an immigration policy that is more rational and humane, and the removal of many of the arbitrary and capricious regulations developed by bureaucrats in Brussels could lead to a much freer society. That would be a good thing for the people of Britain. It might also set an example for the rest of Europe.

The shape of the international financial services industry post-Panama Papers: a view from Anguilla

The data leak from the Panamanian law firm, Mossack Fonseca (MossFon), styled by the media as the Panama Papers, has been discussed, dissected and reported on ad nauseam over the past few months, and the issue will remain in the headlines for the foreseeable future.

The purpose of this article is to lay out some thoughts as to the long-term impact this episode will have on the industry in terms of the structure of service providers, marketing, strategy and general matters.

 

The beginning of the end of the high-profile multi-jurisdictional players

The targeting of Mossack Fonseca was probably not by coincidence or chance. The International Consortium of Investigative Journalists and other left-wing organizations which abhor tax competition presumably targeted the larger and more high-profile firms such as Mossack Fonseca. This latest episode follows what happened in the LuxLeaks case, the LGT affair in Liechtenstein and the BVI leaks which focused on Portcullis TrustNet and Commonwealth Trust Limited. In all these cases, the targets of the leak were high-profile service providers with multiple offices around the world.

What this means is that no large, high-profile player is safe from the potential of being a target and that includes the large trust and corporate services companies and the major international financial services center (IFC) law firms. This also means that clients of these firms are at risk of having their information compromised. That includes the few who may be engaged in nefarious activities as well as the majority of clients who are totally in compliance with the laws of the IFCs and their own home countries. It is my view that no client is immune from this risk and no large high-profile player can sleep well at night as long as the ICIJ and its friends in the media are active in this project.

I suspect strongly that many other large players will soon discover that despite their best IT/computer data systems, they too may be hacked either from inside or outside by the ICIJ. Or they may be hacked by persons or groups who will pass on the information to the ICIJ, and both they and their clients will pay a high price. Hacking becomes even more of a probability and not just a possibility especially if and when state actors become involved. It is now clear that the concentration of vast amounts of information on clients in one central location is a recipe for disaster.

Profile, notoriety and media coverage, while beneficial to firms in other industries, is an albatross in the private-client, wealth-management sector where the use of IFCs is involved and should be avoided as much as is practical. The higher the profile a company formation agent, trust company or IFC law firm has, the greater the target it becomes and the higher the chances of it being attacked. As a consequence, legitimate clients who wish to make use of these jurisdictions for legal tax and estate planning are best advised to seek out boutique, small, niche and competent service providers to work with. While this is no guarantee, the chances of keeping one’s information private are greater than in the case where a client works with a larger, more well-known service provider.

The tragedy of all these leaks is that clients who played by the rules are now being lumped into the mix with others who may not have.

 

Politically exposed persons (PEPs) should not be clients of any IFC service provider without continued monitoring at appropriate fee levels

Any service provider accepting a PEP without extensive due diligence both at inception and on a regular basis post-establishment of the business relationship is courting disaster. The Financial Action Task Force (FATF) defines a PEP as “ as an individual who is or has been entrusted with a prominent public function.”

The FATF states: “Due to their position and influence, it is recognized that many PEPs are in positions that potentially can be abused for the purpose of committing money laundering offences and related predicate offences, including corruption and bribery, as well as conducting activity related to terrorist financing. This has been confirmed by analysis and case studies. The potential risks associated with PEPs justify the application of additional anti-money laundering/counter-terrorist financing (AML/CFT) preventive measures with respect to business relationships with PEPs. To address these risks, FATF Recommendations 12 and 22 require countries to ensure that financial institutions and designated non-financial businesses and professions implement measures to prevent the misuse of the financial system and non-financial businesses and professions by PEPs, and to detect such potential abuse if and when it occurs.”

The Panama Papers leak makes it clear that a PEP is not only high risk but is likely to bring the service provider itself into disrepute if it is later discovered that said service provider worked with this person without ensuring that all the proper due diligence and monitoring, including after the relationship was established. A service provider who breaches this cardinal rule will rue the day that he/she got involved with a PEP.

PEPs are more likely than most to be involved in corruption, looting state assets, taking bribes, and using friends, families and cronies to provide cover for them. Thus, to take one on as a client requires extensive background checks and monitoring and the charging of fees commensurate with the risk involved. In this new era, a general blanket rule against accepting any PEPs would be ideal but if a service provider wants, needs or chooses to work with one, then proper fees must be charged and KYC controls established and implemented.

It is worth noting that the FATF has specifically said that: “These requirements [the aforementioned recommendations for enhanced customer due diligence] are preventive (not criminal) in nature, and should not be interpreted as stigmatizing PEPs as being involved in criminal activity. Refusing a business relationship with a PEP simply based on the determination that the client is a PEP is contrary to the letter and spirit of Recommendation 12.”

The great challenge, of course, is finding PEPs that are clean and then providing them with services where the costs do not exceed the revenue.

 

The end of the cheap and cheerful IFC structure has arrived: Be prepared to lose clients or to lose your license

The new world that is dawning upon us dictates that quality and service will be directly linked to costs. Intermediaries who are often unlicensed and clients who do not understand the role of service providers in the IFCs will soon learn that one gets what one pays for. Cheap and cheerful structures are no longer possible. This is because of the increasing know-your-customer (KYC) obligations being imposed by regulators and governments on service providers and the AML/CFT rules which have to be complied with. Service providers will also learn that one cannot and will not be able to compete on cost and low-price jurisdictions like Belize, Nevis, Seychelles and Samoa will learn this also. It is only a matter of time before the less onerous AML/KYC regimes catch up with both the service providers and jurisdictions as a result of the changing landscape. Reputational damage will impact both greatly and clients would be advised to take the necessary steps to protect themselves from now.

Services providers who do not adjust their fees to cover these increased costs will eventually be forced out of business. This will be both from a lack of financial resources to meet the new compliance regimes and administrative penalties that regulators such as the Financial Services Commission in Anguilla will impose. Said service providers may also have their licenses revoked or suspended and worse yet, may be prosecuted criminally. The Commission in Anguilla recently wrote to all service providers noting that continued breaches of the AML/KYC rules will result in the imposition of administrative penalties and criminal referrals for prosecution under the Proceeds of Crime Act.

Service providers will therefore have a choice: either increase fees to cover compliance costs, which will of course risk losing clients to others who choose not to increase fees or to other jurisdictions like those mentioned above, or risk losing their licenses. It is not an easy one to make but it is the reality in my opinion in the post-Panama Papers world.

All this will occur while states like Delaware in the United State will continue to offer the formation of companies without licensing the registered office providers or requiring them to conduct or hold any KYC information.

The company formation situation in the U.S. will of course pose challenges for the rest of the world. IFC service providers have no choice, until pressure is brought to bear on U.S. domiciles to change their practices, but to compete on this uneven playing field and do the best we can.

 

The use of nominee directors/shareholders is dead except if they are part of the service provider or another regulated person

Service providers probably should not provide services for any entity, especially registered agent/office services, for a company which has a nominee as a shareholder or director. This is unless that nominee entity or person is an employee of or owned by the service provider. Even in such a scenario, the service provider should have full control over the structure and all bank accounts. The service provider should question closely why the ultimate beneficial owner does not wish to operate the company in his or her own personal capacity.

However, what is not sensible in this new era, in my opinion, is for a service provider, say in Anguilla, to provide registered agent/office services in the following scenario: The company is incorporated on instructions from an unlicensed intermediary in the U.K. and owned by someone from Uzbekistan who uses two people in Cyprus as nominee shareholder and director with a bank account in Latvia.

This, with the greatest of respect, is a ridiculous structure which no longer passes the smell test. It is not one which should be encouraged, especially where neither the intermediary nor the nominees are licensed and regulated elsewhere. The obvious question is why doesn’t the ultimate beneficial owner who is from Uzbekistan want to be director and shareholder of his company? If the answer is not one that is cogent and even if it is cogent, granted the myriad of players and risks involved as a result of this and the geographical spread, then careful thought should be given to accepting this structure or remaining as registered agent/office if it comes into being post-incorporation.

The service provider has to focus his mind on these questions.

How am I going to exercise proper monitoring as required under the AML regime to ensure that the structure is not being used for money laundering or terrorist financing?

Given the complicated nature of the structure, the players involved and the fact that I don’t have access to bank statement information or the daily operational activities of the company, should I take on this structure?

Given this, the obvious action to take is not to provide any services for this company, in my opinion. I would even suggest that the use of corporate shareholders and directors owned by the same beneficial owner as the company being incorporated itself, in this new era of transparency, should be avoided unless it is absolutely necessary. Again, the necessary fees need to be charged to cover the increased KYC operational costs involved in conducting due diligence and securing information on corporate entities, etc.

 

Intermediaries need to be licensed

In addition to always arguing about fees and trying to beat service providers down on price, the major problem with many intermediaries, from a service provider perspective, is that they live and function in jurisdictions where the provision of company formation or trustee services is not licensed and regulated in the same manner as is done in the IFCs. As a consequence, these intermediaries neither understand nor appreciate the regulatory and legal regimes under which IFC service providers operate. Service providers have to protect themselves so that they are not held criminally liable for dropping the ball and failing to do what the law says they should do on a daily basis – that is to monitor the activities of all companies and trusts to which they provide services.

To solve this problem of perspective and AML/KYC compliance, it would be best if intermediaries secured their own licenses to be their own registered agent/office in the IFC jurisdictions. This is because the intermediaries are closer to the direct client than the registered agent several thousand miles away. This can be accomplished using a separate office space with dedicated staff so mind and management is done locally, thus adding substance to the jurisdiction, or through a brass-plated operation using the business office space of another agent who already has those facilities in place.

 

Conclusion

The impact of the Panama Papers has just started to be felt globally and in the financial services industry. The fallout from this leak and the many others to come will continue and even more long-term and consequential effects will follow. It is best then for those of us in the industry to seek to adapt our business models and operational practices to the new reality and seek not only to survive but to flourish.

Cayman’s tax transparency regime as it currently stands: A practical guide

The Cayman Islands are at the forefront of the global move towards tax transparency and cooperation in international tax matters. Since 2001, the Cayman Islands has signed 36 Tax Information Exchange Agreements (TIEAs) with various countries, 29 of which have already come into force. A further 15 are in the process of being negotiated. The Tax Information Authority Law applies for the purpose of giving effect to the terms of a scheduled Agreement/TIEA for the provision of information for tax purposes.

In 2015, the Cayman Islands joined more than 90 other countries by committing to the exchange of information for tax purposes on an automatic basis. Cayman is in the process of implementing the OECD Common Reporting Standard, with the first automatic information exchange due to take place in September 2017. In April 2016, the Cayman Islands government also committed to the provision to revenue and law enforcement authorities of information on the beneficial ownership of companies and other structures and signed a protocol with the government of the United Kingdom in respect of the sharing of beneficial ownership information which is due to come into effect no later than June 30, 2017. This will allow, for example, reporting of all companies in which a given individual has a significant interest, even though the companies may be managed by different service providers.

This article deals with the regime as it stands now in this ever evolving area of law and regulation and provides a brief background of the important things you need to know.

 

The TIEA regime

The TIEAs permit revenue authorities of other countries to make requests of the Cayman Islands for information relevant to the determination, assessment and collection of taxes in the requesting jurisdiction. Under the TIA Law, the request is made to the Cayman Islands Tax Information Authority (CITIA), which will usually then need to obtain the information from third parties, such as banks and service providers. For that purpose, having satisfied itself that the request complies with the relevant TIEA and the TIA Law, it may issue a notice in writing to any person requiring the production of documents or information.

Persons who receive a notice are required to comply with the notice within the time specified by the authority, usually 21 days. Failure to comply, without lawful excuse, is an offence liable on summary conviction to a fine of $10,000 and to imprisonment for two years.

There has been a significant increase in the receipt of notices from the CITIA in recent times, along with a significant decrease in the level of information provided by the authority to the recipient. There is also only one decided case in the Cayman Islands where the release of confidential information has been challenged – two other cases have been commenced in the last 12 months – so there is little authority on which a recipient and its advisors can turn in determining a recipient’s right to information and obligation to disclose.

 

When can CITIA issue a notice?

A request must have been made to the CITIA by the competent authority of the relevant country in compliance with a relevant TIEA. The TIEAs signed by different countries follow an OECD model and are broadly similar, although they are some important differences. They require the requesting authority to provide certain information to the Cayman Tax Information Authority, including the identity of the person under examination, grounds for believing the information is foreseeably relevant to tax matters in the relevant country, and grounds for believing the information is in the possession and control of someone in the Cayman Islands. The Cayman authority must determine whether the request is in compliance with the relevant TIEA and, if it is determined that there is compliance, execute the request in accordance with the relevant TIEA and the TIA Law.

If the CITIA considers it necessary to obtain specified information from any person to comply with the request, it must issue a notice in writing requiring the production of such information, which is listed in a schedule to the notice. In the case of information required for criminal proceedings in the territory of the requesting authority, the Tax Information Authority must first apply to a judge for an order to produce such information.

 

Is the recipient of a notice entitled to the information in the request?

The TIA Law currently contains no provision that entitles the recipient of the notice to the information in the request. However, in the only decision in the Cayman Islands challenging the disclosure of confidential information under the TIA Law, the court ordered disclosure of the request and any related documents as an interim order to a judicial review application.1

Similarly, in numerous decisions in Bermuda, the court has found that both fairness and justice require that the recipient should be entitled to see the request, to the extent that its contents are relevant to the question of whether the requirements of the law were satisfied.2 In a recent decision, the Court of Appeal for Bermuda,3 a jurisdiction which requires the tax authority to obtain a production order from the court, held that there was a fundamental right to disclosure of the material upon which an ex parte order was based and a right of that importance can only be abrogated by “crystal clear” statutory provisions. The statute in Bermuda was amended following the Court of Appeal decision but it remains to be seen whether the most recent amendments are sufficiently “crystal clear” to abrogate a recipient’s fundamental right to automatic disclosure.

While it is untested in Cayman – other than in the application for judicial review referred to above – these cases suggest that a recipient should be entitled to the information in the request to enable it to determine whether there has been compliance with the TIA Law and the relevant TIEA before complying. Although the TIA law provides extensive indemnities from civil suit for anyone providing information to the CITIA, a service provider that simply complies with what proves to be an obviously invalid request without seeking the information necessary to check its validity could well find itself facing at least embarrassment with its client, possible reputational damage and, in an extreme case, even claims.

 

Do you have to comply with the notice?

You are required to comply with a notice issued by the CITIA. Failure to comply, without lawful excuse, is an offense liable on summary conviction to a fine of $10,000 and to imprisonment for two years. Compliance is deemed not to be an offense under the Confidential Relationships (Preservation) Law.

However, you should seek legal advice about your obligation to comply in any of the following instances: (i) you do not hold the documents referred to in the notice; (ii) you protest that the terms of the notice are too wide or its requirements too onerous or expensive; (iii) you dispute that the notice was served on the correct entity; (iv) you assert that the information requested could not be relevant to a tax enquiry; or (v) you assert the information is (or could be) subject to legal privilege.

 

What information do you have to provide?

Nothing in the TIA Law requires the provision of information in relation to a taxation matter that arose prior to the date of commencement of the TIA Law, except where the terms of a TIEA otherwise so provide. This is important to note, as the obligation to produce will depend upon which country made the request and which TIEA applies. For example, a request from the United States can relate to information and documents without regard to the taxable period to which the request relates, i.e. from any date. By contrast, a request from Argentina can only relate to taxable periods beginning, at the earliest, after the date the TIEA between Argentina and the Cayman Islands came into force, i.e., Aug. 31, 2012. The position is different for each of the 36 countries with agreements in force and the CITIA does not always disclose the jurisdiction which made the request in the notice.

If the notice requires the production of information relating to a time period outside the scope of the relevant TIEA, then there is no requirement to provide the information. More importantly, the information should not be provided as there is a risk that such disclosure would not be protected by the TIA Law and, therefore, in breach of the Confidential Relationships (Preservation) Law. The information requested must also be foreseeably relevant to tax matters in the requesting country. “Fishing expeditions” are not permitted and, although the Tax Information Authority should decline to assist where the request is not made in conformity with a TIEA, that is unfortunately not always the case, as proven in the MH Investments decision.

 

Can you tell your client about the notice?

The particulars of and all matters relating to a request must be treated as confidential, and no person who is notified of a request may disclose the fact of the receipt of such request or any of the particulars required or documents produced or information supplied to any other person, except that person’s attorney and such other persons as the CITIA may authorize. This provision is also binding on the attorney of any person to whom the above applies as if he were that person. A person who contravenes this requirement commits an offense and is liable on summary conviction to a fine of $1,000 and to imprisonment for six months.

The consequence of this if you are a service provider is that you cannot tell your client about the notice. The problem with not being able to tell your client about the notice is that you may not be able to find out whether your client is even a taxpayer or has any dealings in the jurisdiction of the requesting authority and, therefore, whether you are responding to a valid request.

In Jersey, for example, the relevant authority is required, except in excluding circumstances, to send a copy of the third party notice to the taxpayer to whom a third party notice relates. There is no similar provision in the Cayman legislation. A taxpayer will often not know that a service provider has disclosed documents to the CITIA, which then forwards them to the requesting authority, until some time after the production.

 

Notification to individuals

An individual who is the subject of a request for information solely in relation to a matter which is not a criminal matter, must if his whereabouts or address in the Cayman Islands is made known to the Tax Information Authority, be served with a notice by the CITIA advising of the existence of a request specifying that individual, the jurisdiction making the request and the general nature of the information sought. An individual so notified may within fifteen days from the date of receipt of the notice, make a written submission to the CITIA specifying the grounds which he wishes the authority to consider in making its determination as to whether or not the request is in compliance with the TIA Law, including any assertions that the information requested is subject to legal privilege.

This only applies to natural persons. It does not apply to corporations. Although, if the taxpayer under investigation is an individual, a corporation served with a notice may want to check that the Tax Information Authority has served notice on the relevant individual and given them an opportunity to challenge the request before complying. Again, this does not always happen as evidenced in the MH Investments decision.

 

Restrictions on use of information provided

All information provided and received by CITIA and the requesting authority must be kept confidential, and can only be disclosed to persons or authorities officially concerned with the administration and enforcement of the laws concerning taxes. The requesting authority shall not, without the prior written consent of the CITIA, transmit or use information or evidence provided under the TIA Law for the purposes, investigations or proceedings other than those within the scope of the TIEA. Before the CITIA gives such consent, it must apply to a judge for directions.

 

Conclusion

Although there is not a lot of scope to challenge a notice issued by the Tax Information Authority, service providers may want to be careful that they do more than just blindly comply. If the notice is found to be defective, they could be the subject of, at best, well-founded complaints by their clients, potentially leading to loss of business.

Individuals who wish to avail themselves of the limited right to be informed, or at least have a basis for challenge when it is ignored, may wish to provide the authority with an address in the Cayman Islands at which they can be served with notice. Perhaps the strangest feature of the system, based as it is on OECD principles and relatively standard treaties, is how differently countries have implemented it. There is surely scope for a more consistent approach to an international issue.

 

What the future looks like

Even with automatic exchange being introduced, it is anticipated that requests under the TIA Law will increase rather than decrease. When it is implemented, foreign authorities will automatically be provided with information about their taxpaying citizens that they may not already have, for example, entities at which funds are held and the sum held. That will then give the foreign authority a basis for making a request to the CITIA so that the foreign authority can fully investigate any matters of interests.

The same applies to the provision of beneficial ownership information, which will operate outside of the TIEA regime. Limited information will be provided under the beneficial ownership protocol, but it will give foreign authorities a sufficient basis to then make a request under the TIA law for further information for matters of interest. The Cayman Islands government has committed to ensuring that those interested in or connected with the entities concerned are not informed that a search for beneficial ownership information is in progress or has been conducted. For the time being, the same does not apply in relation to notices under the TIA Law and the Tax Information Authority is still required to notify individuals who are the subject of an investigation that a request has been made.

The Cayman Islands government has also committed to participation in the development of a new global standard for the exchange of beneficial ownership information. However, as Premier Alden McLaughlin pointed out at the recent anti-corruption summit in London, a global standard requires the participation of all major countries. Since some of those do not yet even ask for the necessary information, far less ensure that it is verified and recorded, as Cayman has been doing for many years, there is clearly some way to go before this can become a reality. But in the current climate it would be unwise to expect anything other than continual movement in that direction.

 

ENDNOTES

  1. M.H. Investments & Anor v The Cayman Islands Tax Information Authority (Unreported decision of Quin J, 24 January 2013 in Cause No. G391/2012) and (Unreported decision of Quin J, 30 August 2013 in Cause No. G391/2012). See Appleby article: Cayman Decision on Tax Information Exchange: Transparency undermined or rule of law upheld?
  2. See Lewis & Ness v Minister of Finance [2004] Bda L.R. 66 and more recently, Minister of Finance v AD [2014] SC (Bda) 10 Civ (27 January 2015
  3. The Minister of Finance v AD [2015] CA (Bda) 18 Civ (12 June 2015)

Cayman’s maritime industry poised for growth – but let’s take a measured approach

At the beginning of May, I was invited to participate as a speaker at the Cayman Islands Shipping Summit held during the first annual Cayman Maritime Week, an event which signifies an important broadening of Cayman’s economy as the islands look to generate an increase in business within our maritime industry.

This attempt at building on the existing three pillars of our economy – financial services, tourism and real estate – is important as far as real estate is concerned because any broadening of our service offering here in the Cayman Islands means an increased potential for new visitors who may enjoy these islands and ultimately want to call Cayman home, either full time or at least for part of the year. It will attract new segments of the population from differing areas of the world, everyone a possible new resident and a home owner in the making.

However, I believe that the broadening of any industry needs to be tempered by measured reflection and discussion as to the ultimate benefits for the islands. In particular, I was asked to speak on a panel discussing the development of the dock to enable the berthing of cruise ships.

Firstly, let me state that I have never disagreed with developing the cruise ship port. I am in favor of the development so long as it is done in a manner that does not harm the environment and is truly necessary, because it is a huge investment for such a small island as Grand Cayman. We should ensure that, as a result of any new development, our visitors, whether they are cruise ship or stayover visitors, should get a great experience when they arrive here. This will then make it more likely that they will return as repeat visitors, or even residents down the line. At the same time, any development of the port should not negatively impact the rest of us, residents and stayover visitors alike, especially as far as congestion is concerned.

In addition, I note a report by Business Research & Economic Advisors (BREA) called “Grand Cayman Cruise Berthing Facility: Potential Impact on Cruise Passenger Onshore Visitation and Spending,” prepared for the Ministry of District Administration, Tourism and Transport.
This report states that the Cayman Islands is the fifth-largest cruise destination in the Caribbean and yet it is the only destination without a cruise berthing pier. The report states that, over the period 2009 to 2014, all the other destinations have seen growth in their cruise tourism product while Cayman has experienced a small decline. I think it is interesting to note that we still remain in the top five, and I attribute this very much to the safety and security which this jurisdiction offers our cruise ship visitors.

Unlike in other jurisdictions where cruisers are often quite segregated from the local community, when they alight, our cruise ship visitors are able to fully integrate within the Cayman community in our shops, restaurants, bars, beaches or attractions, and feel safe and secure – a very important selling point for Cayman.

I also believe we must carefully consider the wisdom of investing in such developments when the cruise industry is extremely cyclical with regards to benefits for the local economy, effectively creating jobs very much on a part-time basis, according to the schedules of the cruise ships.

Stayover visitors are a particularly important commodity for Cayman. They have been proven to put considerably more back into the economy per person than cruise ship visitors. Thus, to ensure they in particular have a brilliant time while they are here is an important point not to be ignored.

In my mind, we should be focusing on lengthening and strengthening our airport runway to make it easier for people from Europe to get here, as well as ensuring our overnight visitors enjoy a fantastic overall experience.

 

Creative thinking

Dovetailing into this discussion of the expansion of our maritime industries, I believe the issue of providing moorings for mega yachts ought to be intrinsically woven into any discussion of the expansion of our port. Wooing very high net worth individuals to our shores with proper mooring facilities should be a high priority, because they can give back to the economy in so many ways, including the payment of fuel taxes, mooring fees, staffing, not to mention their spending once they come ashore. In turn, they too might then appreciate the fantastic lifestyle that the Cayman Islands affords its residents and then look to buying property themselves.

Unlike the Eastern Caribbean, where island-hopping is a popular pastime for yachters as they pass with ease from one island to another thanks to their close proximity, the Cayman Islands is isolated out in the Western Caribbean. So excellent mooring facilities need to be developed to attract these types of individuals to our shores.

Cayman’s real estate industry is currently buzzing with new development and truly excellent offerings for such wealthy individuals. While inventory continues to wane along the most popular, exclusive and therefore highly desirable Seven Mile Beach corridor, some incredible family homes are available in family-centric, exclusive places such as Crystal Harbour and Cypress Point, while several developers are creating some excellent brand new properties in the South Sound area. The islands have a great deal to offer investors and I believe it is vital that we are creative and inventive in finding ways to attract them as residents.

Quarterly review

Tax transparency

Beneficial ownership: Government says US must sign first

The Cayman Islands will not adopt a mechanism for the exchange of beneficial ownership data that is not implemented by the United States, according to government.

Confirming that Cayman’s position had not changed after the Anti-Corruption Summit hosted by the U.K. in May, Premier Alden McLaughlin called for a level playing field in terms of financial transparency and stated that a standard without U.S. participation “is not a global standard.”
Cayman’s participation in the summit was predicated on it joining an initiative for the automatic exchange of beneficial ownership data. This initiative of 40 countries aims to develop a global standard for the automatic exchange of beneficial ownership data between law enforcement agencies and tax authorities of the partner countries.

Premier McLaughlin said government fully supports access to beneficial ownership data by foreign law enforcement agencies to help detect and prosecute corruption, tax evasion and other serious crimes. However, Cayman has not agreed to a specific method of exchanging this information but will take part in the discussions that will lead to the development of such a mechanism.

Cayman has agreed to implement the standard once all G-20 countries, OECD member states and all other U.K. overseas territories and Crown dependencies agree to it.

During the summit, government extended an offer to grant countries participating in the conference the same type of access to its beneficial ownership data that it has negotiated with the U.K.

From June 2017, U.K. authorities will have expedited access to information on who truly owns Cayman-registered companies and other entities, through a centralized platform which has not yet been developed, at the Department for International Tax Cooperation. However, the data is exchanged only on the basis of individual requests rather than the wholesale automatic exchange of all beneficial ownership data that the global standard aims for.

In addition, Cayman will replace its Confidential Relationships (Preservation) Law, which often has been characterized as a “secrecy law,” with a Confidential Information Disclosure Law.

Government has also passed legislation completely abolishing the use of bearer shares, which could be used to conceal the beneficial owner of an entity. Bearer shares had already been immobilized since 2000.

The anti-corruption conference has passed the responsibility for the development of the global beneficial ownership standard on to the Financial Action Task Force and the Organization for Economic Cooperation and Development.

The development of a global standard is expected to take years.

Even when implemented, it is far from certain that all OECD and G-20 countries, and in particular the United States, are going to adopt it.

 

Financial services

About 100 companies linked to Cayman in Panama Papers

The Cayman Islands plays only a minor role in the offshore data leak involving the Panamanian law firm Mossack Fonseca.

Of the 214,000 offshore companies set up by the firm, none was incorporated in the Cayman Islands and only 104 had a link to Cayman. In almost all of these cases, the companies, although incorporated elsewhere, provided a Cayman Islands contact address or were set up on the instruction of a Cayman-based intermediary.

About a third of the companies are still active.

An online database of entities, officers and intermediaries linked to the Panama Papers release, published by the International Consortium of Investigative Journalists, does not include files containing phone numbers, bank account information, financial transactions or passports for privacy reasons.

As a result, the database does not always reveal the beneficial owners of the entities, but more commonly shows only a corporate service provider or parent company.

However, the now-published data includes all of the 214,000 offshore companies established or administered by Mossack Fonseca between 1977 and 2015. In addition, the database contains about 14,000 intermediaries, such as law firms, banks and trust services providers who directed the Panama law firm to establish entities on behalf of their clients.

A search of the Cayman-linked entities, officers and intermediaries revealed the typical assortment of banks and trust services providers, investment entities and corporate directors that can be expected in a corporate database of offshore companies.

In addition to 104 entities connected with the Cayman Islands, there were 32 Cayman intermediaries linked to entities set up by Mossack Fonseca. Cayman companies, service providers and individuals are named about 600 times as officers of entities created by the Panama law firm.

In the international context, this means Cayman’s role in the Panama Papers is relatively benign as far as volume is concerned. Mossack Fonseca worked with intermediaries in more than 100 countries.

 

Cayman mergers and acquisitions activity highest in five years

The Cayman Islands reached a five-year high in the number of local mergers and acquisitions in 2015.

Deals involving entities registered in Cayman accounted for about a third of the overall deal volume and more than a quarter of the transaction value in major offshore financial centers analyzed by offshore law firm Appleby.

“For four years now, we have seen the Cayman Islands ranked as the most popular destination for investors seeking to acquire offshore assets,” said Simon Raftopoulos, a Cayman-based partner and member of the firm’s Corporate Finance and Private Equity teams. “With nearly 1,000 deals recorded in 2015, Cayman had another standout year and was a significant contributor to a robust year for transactional activity in the offshore markets by all key metrics – deal value, deal volume and average deal size.”

Cayman attracted 974 deals in 2015, worth a cumulative US$125 billion, a 14 percent increase in deal value over 2014. Both the number of deals and the average deal size of US$129 million were 7 percent higher than in the previous year, the Appleby’s Offshore-i report found.

Two of the 10 largest transactions of 2015 involved Cayman-incorporated companies as targets. In one notable institutional buyout, Qihoo 360 Technology, a software publishing business incorporated in Cayman, was sold to True Thrive, a consortium of investors also incorporated in Cayman, for $9.3 billion.

This deal reflected the trend of large transactions emerging in the information and communications space, Appleby said.

The total cumulative value of offshore M&A deals across all offshore jurisdictions measured in the report in 2015 increased 56 percent over the previous year, with average deal value topping highs not seen since 2007.

Three of the largest quarterly periods of the last decade occurred in 2015 and contributed to a cumulative deal value of US$442 billion across offshore jurisdictions. The year also saw an impressive nine megadeals worth in excess of US$5 billion each and more than US$150 billion when combined, Appleby reported.

Moreover, there were 75 deals each worth more than $1 billion last year, compared with 52 recorded in 2014.

As a result, the annual average deal size reached a record high of $149 million. The previous high set in 2007 stood at $99 million.

“The offshore markets are thriving and enjoying some of the best deal activity ever witnessed,” said Frances Woo, managing partner of Appleby’s Hong Kong office. “Offshore saw more value than the Middle East, Africa, Eastern Europe, South and Central America combined. Although 2016 remains fraught with uncertainty and challenges at the macroeconomic level could slow global deal activity, we are quietly optimistic that such good news will continue in 2016.”

The majority of M&A deals, about 30 percent, involved insurance and financial service companies (883 deals), followed by manufacturing with 610 deals; IT and telecoms (287); construction (233); and mining and quarrying (192).

The Cayman Islands also led offshore financial centers in the number of initial public offerings involving offshore-incorporated companies, despite an overall drop in the number of offshore IPOs in 2015.

Cayman-incorporated entities accounted for 45 out of a total 82 IPOs of offshore companies last year.

 

Percentage of Cayman-based hedge funds declining

The percentage of hedge fund launches domiciled in the Cayman Islands has declined slightly in recent years, according to a report on key trends in hedge funds in 2015 by data provider Eurekahedge.

Cayman has seen its global share decrease from 26.7 percent for funds launched in 2010 to 25 percent for funds launched as of February 2016. In 2015, only 15 percent of new funds were domiciled in the Cayman Islands.

Meanwhile, the United States has grown its share from 33.8 percent for funds launched in 2010 to 58.3 percent for funds launched as of February 2016. In 2015, nearly half of all new funds (48.4 percent) were domiciled in the United States.

Both Luxembourg and Ireland also took a larger portion of new fund launches, the data provider reported. Luxembourg increased its share as a domicile for new funds from 12.9 percent in 2010 to 16.7 percent in 2016, while Ireland doubled its domiciliation share from 7.3 percent in 2010 to 14.6 percent in 2015.

The United States, the Cayman Islands, Luxembourg and Ireland together account for 82 percent of the world’s hedge funds as of February 2016.

 

Cayman Finance, government sign new agreement

Cayman Finance has signed a new memorandum of understanding with the Cayman Islands government “to enhance the already close working relationship that Cayman’s financial services industry has with government,” Cayman Finance said.

The first MoU between Cayman Finance and the Ministry was signed in 2013.

“Our signing of the new MoU with Cayman Finance is significant because it marks the importance we all place on the private and public sectors working together to enhance, support and protect the industry,” said Minister for Financial Services Wayne Panton.

“It speaks volumes about the unity with which we approach the issues facing our industry today.”

Cayman Finance CEO Jude Scott agreed, stating that the new agreement “augments government’s support for Cayman Finance and enhances the relationship with regard to the joint marketing of the jurisdiction, facilitating industry consultations and tackling international initiatives.”

The memorandum of understanding also provides the ministry with a seat on the Cayman Finance board.

What is tax avoidance?

There seems to be a fair amount of confusion in the public discourse between the idea of tax avoidance and that of tax evasion. These phenomena are different, and they require distinct responses from the writers and the administrators of the tax law system. We can observe the efforts to address them in the ongoing coordination efforts unfolding at the international level under the guidance of the OECD.

taxesIf a taxpayer engages in tax planning, or fails to do something (such as declaring an amount as income), and as a result pays little or no tax, is this clearly a problem that the tax system ought to fix? It depends on the reasons for the outcome. The common law principle is well known: Taxpayers are free to arrange their affairs to reduce taxation, and there is no duty to pay more than the law requires. Because of this foundational principle, the relevant inquiry is: What does the law require? This question cannot be answered simply by consulting the relevant legal texts. Instead it requires an examination of the architecture of rulemaking, implementation and enforcement.

There are any number of perspectives to consider in such a reflective exercise, including the spirit of the law as a whole and the intent of the lawmakers. Central to these inquiries are the roles played by two functions that are critical to every legal regime, namely: the detection of and response to relevant behaviours by administrators.

Detection and response are necessary factors for determining what constitutes sanctioned behavior. A taxpayer often pays a lower tax in one scenario than she would in another. In order to know whether and how the tax system should respond to the differential between the taxpayer’s outcome and any number of counterfactual outcomes requires as a threshold the ability to both detect the factual and construct the counterfactuals. Failing to detect that such a differential has occurred necessarily means failing to respond to the differential, and therefore raises the potential that taxpayers systemically violate the law.

Fixing information asymmetries to solve the detection threshold is what drives the OECD’s work on information gathering and exchange among countries. The goal of these efforts, most forcefully playing out in the context of the “common reporting standard” and appearing throughout the base erosion and profit shifting (BEPS) initiative, is to resolve informational asymmetries faced by tax administrators. Armed with the relevant facts about their taxpayers, tax administrators will be better able to detect deviations from the rules.

However, having information, even perfect information, does not reveal the definition of tax avoidance, since we have not identified the counterfactuals. Consider, for example, the taxpayer that engages in a series of transactions using various legal structures and mechanisms, and claims to owe a given amount of tax as a result. Even a tax administration equipped with perfect information about the taxpayer’s behaviour does not immediately reassess the taxpayer for a different amount of tax. Instead, the administrator faces a choice: Should it investigate and reassess the taxpayer, or not? It seems clear that the tax administration certainly should not pursue the taxpayer if it is clear that the taxpayer would prevail in the challenge.

To take an extremely oversimplified example, the tax administration should not (and most likely would not) investigate and reassess a taxpayer who successfully reduced or eliminated her tax burden by placing approved investments in tax-favored instruments, such as a government-sponsored registered retirement savings plan. To pursue such a taxpayer where the taxpayer’s behavior was clearly contemplated and indeed encouraged by the relevant legal text would be to waste resources.

One could therefore protest that investing in such tax-favored savings plans should not be seen as tax avoidance at all, since the tax system explicitly provides that the given behavior is not subject to tax. The action was by definition tax compliant, not tax-avoiding. But even if we can accept this idea, it is subjectively unsatisfying to apply the same logic to the taxpayer engaged in complex cross-border legal gymnastics to exploit highly technical rules with the assistance of an army of tax advisers.

There seems to be a world of difference between “straightforward” tax planning that is explicitly offered to “regular” taxpayers by their governments, and the ongoing public narrative about the convoluted undertakings of sophisticated taxpayers, involving offshore structures and transactions. The OECD work on country-by-country reporting seems clearly intended to address the public perception surrounding this gulf.

We can interrogate this space by considering the reasons why certain actions that are clearly known to tax administrations are nevertheless allowed to stand, other than for the reason that pursuit would certainly result in the taxpayer prevailing. This is a broad range of cases, and a voluminous one: A tax administration might choose not to pursue a given taxpayer or transaction for any number of reasons. Some of these are more palatable to the public than others.

For instance, lack of administrative capacity and resources likely top the list of reasons why a tax administration might not pursue actions that appear inconsistent with the law. This is a problem prominent in, but not limited to, lower income countries. But even in richer countries, administrative resources are scarce and decision-makers must triage their efforts strategically to meet economic, social and political goals. Waxing and waning of public reaction is one reason why administrators might direct resources to problems that are disproportionate to the revenues at stake.

Similarly, tax administrations may decline to pursue a given taxpayer or issue based on litigation risk – the chance of losing a contested assessment even where the government’s position seems stronger or more plausible than that of the taxpayer. This cost-benefit analysis can understandably be an unsatisfactory response to a public angered by the apparent unfairness of well-resourced and well-advised taxpayers. But it is a systemic problem that has little or nothing to do with the tax administrators’ access to information about the taxpayers’ behavior.

Finally, and significantly for the characterization of a taxpayer’s behavior as tax compliant or the opposite, a tax administration may decide not to pursue a given taxpayer or transaction following a calculation about how the actions of this type of taxpayer affect the economy as a whole, or (more sinisterly) the political fortunes of lawmakers. No amount of information disclosure or exchange resolves these issues. For this reason, much of the OECD’s work on BEPS involving information gathering and exchange is not a solution to a problem but a way to generate another round of bargaining on changes to the rules going forward.

Information asymmetry between taxpayers and tax administrations has played a role in confusing the public discourse about the distinction between tax avoidance and evasion. It is thus understandable that increased information gathering and exchange on a global basis have become key to many governments’ efforts to bolster the integrity of their tax systems. It seems likely that resolving this problem will not resolve all confusion and finally help the public understand how to identify and what to do about tax avoidance. However, it may help refocus public debate on what sort of tax policy is acceptable in a world of globally mobile capital.

Alina Mungiu-Pippidi: ‘The Quest for Good Governance: How Societies Develop Control of Corruption’

Corruption is a major factor impeding economic development and growth, good governance and the rule of law. Efforts to illuminate or at least greatly reduce it have not enjoyed limited success. We need a better understanding of what facilitates it and what discourages it. “The Quest for Good Governance” (Cambridge University Press) by Alina Mungiu-Pippidi, uniquely attempts to pull together and link research and experience across disciplines, historical timeframes and geographic boundaries in the search for answers to these questions. It distills current understanding of some of the key lessons we have and have not learned over the last two decades in the global anti-corruption and democratization arena.

Mungiu-Pippidi is a well-known political scientist, journalist and academic who hails from Romania. She has broad-ranging experience in this field, including having taught at the Hertie School of Governance in Berlin for many years and having authored or co-led a number of important governance and anti-corruption research studies. She cut her corruption teeth during her revolutionary days following the fall of the Berlin Wall in 1989.

In her fascinating walk down the governance and anti-corruption lanes spanning four continents, she attempts to frame complex issues within country context and to quantify through data, research and case studies – perhaps as well as anyone has done so far – some of the underlying reasons for anti-corruption progress in eight selected countries. She notes, according to most surveys and research, that these are among only a dozen or so countries that seem to have had some measureable success over the last several decades.

She begins by defining what corruption is, saying that “people grant a far broader meaning to what pollsters call corruption than lawyers do…. The general population when asked to assess corruption offers its assessment of its society’s capacity to enforce public integrity and fairness, rather than reporting on individual experiences of corruption as legally defined in criminal codes.”

Her empirically tested factors influencing the extent of corruption in a country include those creating “opportunities,” such as governmental red tape, lack of transparency, concentration of power, large amounts of discretionary funds, and foreign aid, and those imposing “constraints,” such as an independent judiciary, independent media, active civil society and demanding voters.

Her selected “contemporary achievers” are: Estonia, Taiwan, Slovenia, South Korea, Chile, Botswana, Uruguay and Georgia. While summing-up the gist of her book in a sentence does not do her monumental work justice, her overall cross-country findings and policy recommendations in essence point to the need for developing countries to reduce rent-seeking opportunities in government, to make wholesale reform of the civil service a high priority and to provide more support for broader multi-stakeholder collective action. After reading her book, I think few would argue with these propositions.

However, as it often the case in the development world, the real on-the-ground questions are how to implement these difficult objectives in practice and how to sequence and link them up with other important inter-related reforms – all within specific country context.

These questions could have been more succinctly presented and debated in “Quest,” particularly for those less familiar with research in this emerging field of study. Perhaps it would have been worthwhile just for Mungiu-Pippidi to remind us that world history has taught us there is no magic formula for good governance. That said, she does help make a strong case for making anti-corruption reforms in developing countries more strategically focused on the fundamentals and then helpfully proceeds to identify some that seem to have worked in select countries.

 

Global lessons learned

As someone who has worked in this area for many years, including in a number of the countries covered in this book, I wish that Mungiu-Pippidi’s information-rich chapters had placed a little more emphasis on what we still don’t know from the limited research and experience we now have in our collective knowledge banks.  One important lesson I’ve learned over the last 25 years or so, sometimes the hard way, is that one should be very humble and quick to point out that it is virtually impossible to truly quantify the myriad reasons for success on the governance, rule of law or anti-corruption fronts, given that there are so many elements and combustible and often hidden forces at play in any project of reform and development. It is also very important to always remind oneself that we are still only in the embryonic stages of anti-corruption research.

Another lesson learned is that the countries that have made the most democratic and anti-corruption progress are generally those that have linked anti-corruption reforms to elements of economic and rule of law reform. Mungiu-Pippidi rightly points out that few judicial reform programs promoting judicial independence have been successful or had an impact on corruption, given that the judiciary is often just as corrupt as other key institutions in many developing countries.

There are many other ways to promote a rule of law culture that would have been worth referencing in her book. For example, some countries, like Georgia, have had some anti-corruption success through both presidential leadership and civil society action.

Together they promoted and supported, often with donor support, multiple goals and reforms, including policies and programs designed to promote accountability by strengthening independent media and parliament, supporting reform advocacy groups like the Georgia Young Lawyers Association, by undertaking fundamental reform of the prosecutors office and the traffic police, through regulatory streamlining and by implementing key provisions of the United Nations Convention Against Corruption. I would argue that all of these reforms, in addition to reform of the civil service, resulted in collective action that made all the difference in reforming what some saw as a failed hopelessly corrupt state.

Even though there is a risk that her valuable, thought-provoking research may be misread or misused by some, I broadly agree with Mungiu-Pippidi’s general research findings and policy recommendations and hope that her interdisciplinary approach to research and prioritizing reforms represents the future wave of anti-corruption, rule of law and governance research that is so much needed.

While her ambitious cross-cutting and cross-border methodology advances and helps focus the global debate, I believe even she would admit that the art of defining, measuring and analyzing corruption and governance is at best only half way home and has a long way to go. This includes the new mixed, and some would argue still somewhat limited and untested, methodology she employed to select the eight countries she writes about, which admirably attempts to integrate theory, history, case studies and quantitative evidence.

She notes the country selection process was largely guided by the World Bank’s widely-used annual World-Wide Governance Indicators (WGI), which began in 1996, and that the anti-corruption analysis for the eight countries was shaped in large part by the anti-corruption indicators, which represent many but certainly not all key elements of governance. While the WGI is well respected by many and it is a useful tool for trying to gauge progress or failure and program impact, it does have its critics both within and outside the World Bank. Even the authors of the WGI caution that the indicators are based exclusively on perception surveys only and that while they are useful for research and debate purposes, they also underscore the inherent difficulties of measuring or assessing the quality or integrity of governance with data. While most believe the WGI has proven useful for broad cross-country comparative research and awareness raising purposes, many, including myself, believe it is time to develop sub-national indicators and indexes as well. Right now, much of the data used in the WGI is obtained mainly in the capitals of countries, which obviously does not represent potentially significant in-country variations.

There is an emerging consensus that the WGI must be continually refined and expanded as we learn more and as we strive to explore new ways to promote transparency, accountability and competition within the public and private sectors.

For the careful or ever-questioning reader or student, these research gaps or shortcomings should raise important questions as to whether and what other key governance or reform initiatives might have also played an important role in a country’s governance success. I’m sure any number of lawyers, bankers, law enforcement officials and economists, as well as those who are working in other reform fields such as financial and regulatory reform, also see some of the missing analytical gaps in her broad but not quite broad enough interdisciplinary analysis.

While a daring and laudable methodological achievement in itself, Mungiu-Pippidi’s country selections, conclusions and policy recommendations would have benefited if her methodology had been more succinctly expressed and the research conclusions more carefully qualified or narrowly focused. While she does note that she intentionally chose to focus on democratic and not authoritarian success story countries for purposes of the book, she does not clearly distinguish how she intellectually distinguished various elements of governance, such as rule of law, from those directly related to corruption and a wide range of other important elements of good governance.

In the final analysis, as someone who has worked on as many programs related to rule of law as anti-corruption or governance, I found myself questioning whether she has not given short academic and applied research shrift to important governance elements related to rule of law and other governance elements in both her country analysis and policy recommendations

In short, I would suggest that those reading her fact/data-filled book read and keep the title and theme of her prior path-breaking global study in mind, since it is Quest’s birthmother. This report, titled, “Contextual Choices in Fighting Corruption: Lessons Learned” (NORAD 2013), found above all else that big picture country context, public access to information and interdisciplinary analysis matters. It is a study well worth reading and thinking about.

Contextual Choices contains ten useful global lessons learned that were reached by consensus among a team of academics and practitioners representing many disciplines and countries. One rule of law observation made in Contextual Choices rings particularly loudly to my way of thinking and experience, namely:

“… most anti-corruption interventions in most developing countries fail because they are attempted in societies that lack the rule of law.”

Somehow this truism unfortunately gets lost in the details in Mungiu-Pippidi’s analysis and policy conclusions in this latest book. This is an important ever-present footnote to keep in mind when reading Quest, since it is widely acknowledged that all eight selected countries have made progress in promoting a rule of law culture as well as directly attacking institutional corruption. Even in city-states that lean democratic or autocratic, such as Hong Kong and Singapore, it is widely acknowledged that anti-corruption success was in part attributable to high priority efforts to promote a rule of law culture. Not many countries have gone down the rule of law path and those that have, such as Georgia and virtually all of the country studies in “Quest,” lend support to the idea that this fundamental reform is inextricably linked to other governance and anti-corruption reforms.

I think, if pressed, Mungiu-Pippidi would acknowledge that because addressing systemic corruption and problems related to governance, not to mention the rule of law, is dependent on so many known and unknown inter-related factors, that prioritizing and linking-up the issues within holistic country context is what seems to make the most difference. That said, her research findings and policy prescriptions are without question all supported by as credible research as now exists and are worthy of a grand global debate. Everyone would learn something by reading “Quest.”

Do we need central banks?

All of us alive today have lived in the age of central banks – notably the U.S. Federal Reserve, the Bank of England, the Bank of Japan and, more recently, the European Central Bank. At first, it may seem absurd to even contemplate a world without them, but there is a good case to be made that they are unraveling.

At various times in our lives, we realize that we are in the midst of a storm of change but have little idea of where it will lead – the Internet being a classic case. Two decades ago, many of us understood the world was going to change because of it, but few conceived the shape of the change. Now, it is almost impossible to conceive a world without the Internet.

This essay is different than what you may normally expect to see in the Cayman Financial Review. I rarely use personal pronouns in my writings, but members of the CFR editorial board have been in intense debate in recent years with each other and other professional colleagues as to where central banks, banking, monetary policy, and even the concept of money itself are headed. Thus, I thought it might be of interest to CFR readers to provide you with a window into some of these debate issues – as a way of, perhaps, stimulating your own thought stemming from the current monetary storm.

The first central banks were created in Amsterdam and Stockholm in the early 1600s. The early central banks were largely utilized to assist in financing government operations. The Bank of England was formed as a private company in the late 1700s to help the government raise funds for financing the wars that England was engaged in at the time. By the mid-19th century, the Bank of England (misnamed because it is the central bank of the U.K., not just England) became totally government owned and had the monopoly on the issue of bank notes (currency).

The U.S. did not have a central bank until the Federal Reserve came into existence in 1913. Under the gold standard, which most major nations were using up to the advent of the WWI, there was not a necessity for money policy. Recessions used to be called “panics,” which tended to short in duration and self-correcting. There developed a widespread belief that panics could be mitigated if there was a central bank to serve as the lender of last resort for commercial banks, which would prevent a cascading series of bank failures – which could lead to a depression – hence the Fed.

The role of central banks has been changing over the years, and particularly in the last eight years. In addition to being a lender of last resort, most central banks issue the currency and try to maintain its value, which is a continuous problem once a currency is unhinged from something real, such as gold. Most central banks also have bank regulatory functions, such as requiring certain capital and reporting standards. In recent years, these bank regulatory functions have grown – particularly at the Fed as a result of the passage of the Dodd-Frank bill, stemming from the financial crisis of 2008-09.

For a number of decades, the Fed had a dual mandate which was to insure the value of the currency and promote policies that would lead to full employment.  The fact that these goals could be contradictory was most often conveniently ignored. During the last half of the 20th century, the conventional wisdom was that the Fed could achieve these goals by controlling the rate of interest and the money supply. As those of you who took a course in macroeconomics or money and banking may recall, the Fed had three primary tools for achieving its goals. The first was what are known as “open market operations” whereby the Fed buys and sells government bonds in the secondary market often on a daily basis. The second was the “discount rate” or the rate of interest the Fed charged banks for short-term loans. The third was the reserve requirements whereby the Fed determined the percent of assets that the bank had to keep in reserve.

The Fed has a very poor record in maintaining price stability, as shown by the fact that the dollar is equal to about 1/24 of what it was back in 1913. The Fed also has a poor record of maintaining a counter-cyclical economic policy to promote full employment. It is unrealistic to assume that the governors of the Fed are smarter than the collective wisdom in markets, which is why they so often get it wrong.

bankAfter 2008, the Fed and the other major central banks began a program, known as quantitative easing (buying and holding government bonds), with one of its goals to make it easier for businesses to obtain low-cost capital, for job growth and expansion. In effect, the bond purchases have enabled governments to fund their ever-increasing debt burdens at artificially low rates of interest. It has also made it possible for big and very creditworthy borrowers to obtain cheap credit. The ones who have lost out are savers, who are now facing very low or even negative rates – which is the same as a massive tax increase on their returns from savings – and small and entrepreneurial businesses. Increasing numbers of observers believe that the Fed bond buying program is contractionary rather than expansive.

Jerry L. Jordan, the former president of the Federal Reserve Bank of Cleveland and a member of President Reagan’s Council of Economic Advisors, has been arguing that the Fed’s traditional tools have been become impotent. In a new paper for the Cato Journal (volume 26, number 2), Jordan states: “Commercial banks are no longer resource constrained, the historical linkage between the central bank balance sheet (the monetary base) and the outstanding money supply has been broken. […] Without the ability to influence the supply of money, central bank open market operations have no influence on the rate of inflation.

Announced changes in the federal rate therefore have no implications for economic activity or inflation.” Jordan and others argue that the above mentioned traditional tools of the Fed are broken and are unlikely to work again. Many traditional Fed advocates argue that the tools can and should be revived. Time will tell.

By way of background, one of our colleagues, Dr. Warren Coats, did his dissertation under Milton Friedman. Coats then spent many years at the IMF, having major responsibility for its SDR program, and setting up many currency boards in the former communist countries of central Asia and Eastern Europe.  Coats then retired from the IMF and joined me on the board of the Cayman Islands Monetary Authority. Coats and I were privileged to have known, not only the late Milton Friedman, but also the legendary economist/philosopher, F. A. Hayek and Robert Mundell, all of whom were Nobel Laureates, as well as many other serious thinkers on issues revolving around money.

Back in 1976, Hayek wrote a classic little book, called “Denationalization of Money,” in which he argued that there was no reason for the government to have a monopoly on money, and if it were left up to private competition we would have better money. As an example at the time, he thought, perhaps, commodity baskets could serve as a superior store of value and unit of account (money functions).  Many of us have come up with proposals over the years as to what such baskets might look like. Again, our colleague Coats has spent some number of years developing a basket-type concept which he calls the “real SDR.”

There are many advocates of returning to a gold standard, which is feasible provided that the initial price of gold vs. the dollar is set at a reasonable market value. The government could announce that at a certain point in the future; for instance, noon GMT on April 1, 2017, the government would set the price of the gold in dollars based on the free market price of gold at that moment. Futures markets in gold would have plenty of time to take in global opinion by those willing to put their money, rather than just their opinions, on the line, adjust, and ultimately converge as the date approaches. Under a gold standard, the government would need to be prepared to buy and sell gold at the set dollar-gold price. There is extensive literature on the pros and cons of returning to a gold standard, which I will not repeat here but is available on the Internet – other than to again note it is possible and may or may not be better than the current Fed-created money – but the debate is useful.

A major impediment to the development of private currencies has been the insistence of the U.S. Treasury to treat the change in price of a commodity or any other private money like Bitcoin as a capital gain or loss – which is lunacy, given that the paperwork to record all such changes would be almost impossible and the fact that the Treasury would gain no net tax revenue – because trading in commodities is essentially a zero-sum game where profits and losses cancel each other out over the long run. I wrote an article, published back in 1981 in the Wall Street Journal, making the case to remove the capital gains tax from commodity trading. Despite the fact that no one made a sensible case against my argument, this destructive tax is still with us.

John Tamny, political editor at Forbes, editor of Real Clear Markets, and a senior fellow at the Reason Foundation, has just published a very well-written and entertaining book, “Who Needs the Fed?” Tamny’s book is a sharp critique of the performance of the Fed, where he argues by analogy that if any business went from failure to failure as the Fed has done, it would have long ago disappeared. Tamny believes if the Fed was totally abolished, without the government setting up some institution to carry on some of the current responsibilities, the future of the U.S. economy would be no worse. Others, even many “free market” economists, who though also being very critical of the Fed, disagree about how many of its functions can be successfully privatized. The book is a constructive addition to the debate and has the virtue of being far more interesting than the more technical books on the subject.

It is arguable whether or not the major central banks have a coherent plan as to how they will unwind their balance sheets of the trillions of dollars they have added, primarily in government bonds. There is likely to be an increased political outcry against them as the situation worsens. What comes next is worth the debate.

The ‘useful purpose’ of offshore financial centers

Recently, 355 economists signed a letter co-ordinated by Oxfam arguing that tax havens have “no useful purpose.” There is a history in the U.K. of letters being signed by more than 350 economists who make outlandish claims and, in doing so, undermine their own reputations. Back in March 1981, 364 economists wrote to The Times to object to the policies of the then-Conservative government which was trying to get government borrowing under control. The 364 argued, among other things, that “present policies will deepen the depression.” This proved rather embarrassing when the economy came out of depression literally in the month the letter was drafted. Similarly, the claim that tax havens have “no useful purpose” is so over the top that it is difficult to take the correspondents seriously. Nevertheless, at least for a day, it remained at the top of the U.K. news agenda.

Rather oddly, over half the signatories to the tax havens letter came from Italy or Spain, with well over one-third from Italy alone. And the signatories included people who work for the UN which, in effect, acts as a tax haven for its employees. So, perhaps we should not take too much notice of the precise number of signatories.

But, it has to be said, that there were a few luminaries among the signatories of the tax havens letter. In particular, whenever Angus Deaton, winner of last year’s Nobel Prize for economics, says something, one should sit up and take notice. His views on foreign aid are a very wise contribution to the debate and he has a very acute understanding of the problems caused by corruption and the need to develop functioning tax systems in poor countries. But, on this occasion, I believe he is wide of the mark.

 

So, what useful purpose do tax havens serve?

Offshore centers allow companies and investment funds to operate internationally without having to abide by several different sets of rules and, in the process, paying more tax than ought to be due. This is important. If, for example, a property fund is being managed in which there are investors from all round the world, some of them might be tax exempt, such as charities and pension funds in the U.K., and the other investors might pay widely varying rates of tax levied according to completely different principles depending on where they live.

International tax treaties just cannot deal with the complexities that are involved in such situations. The simplest approach for all concerned is to base the investment fund in a tax haven and allow the investors to pay the tax that is due in the investors’ own jurisdictions. If tax havens were not used, it would be very difficult to manage many pooled funds which allow investors to access a wide range of international investments in a way that reduces risk and ensures the efficient allocation of capital across the world. Investment markets would become parochial once again and everybody would lose.

It should be noted that there is no avoidance of tax here. Certainly, tax havens often allow those who should not pay tax – such as pension funds in the U.K. and charities – to avoid paying tax that is not due. Furthermore, they allow investors to simply pay the tax that is due in their place of residence, as is right and just. Indeed, if the recently released Panama papers demonstrated anything, it was that tax havens are much more benign than people think they are. For all the furore over David Cameron, for example, the fact is that he paid all the tax which was due to the British government on the offshore investments which he held.

 

Tax havens also simplify complex international corporate relationships.

There are 19,000 pairs of countries in the world and devising consistent taxation arrangements between every possible pair would be fearsomely difficult. Double taxation treaties and other international agreements simply cannot cover every eventuality. Offshore centers allow complex multinational businesses to do business efficiently, especially across countries with very different tax rules.

For example, if a U.K. firm wishes to do business in Nigeria, it may well choose to set up a subsidiary in the Cayman Islands which will, in turn, own the Nigerian arm of the business. Relationships can then be simplified – the Cayman Islands would need to have appropriate agreements with other countries, but it would not be necessary for every pair of countries in the world to have agreements with each other. Perhaps more importantly, it might be helpful for the Nigerian and U.K. partners to establish a subsidiary in a ‘neutral’ territory. This would also avoid the potential for double taxation if the U.K. firm wished to repatriate profits from Nigeria.

And the idea that tax havens are shady and corrupt places where people wish to hide economic activity is completely wrong. Indeed, the opposite is the case. Switzerland and Luxembourg which come high on the list of tax havens, are in 7th and 10th place in Transparency International’s Corruption Perceptions Index. Italy, from where one-third of the signatories come, is 61st. When it comes to money laundering, Switzerland ranks among the better countries in the world while Luxembourg is rather average, ranking close to Japan. Italy is a shocking 98th – perhaps the Italian economists should have written to their own government.

flagAnd this leads us, perhaps, to the most interesting aspect of this debate. One of the reasons groups such as Christian Aid and Oxfam have got involved in this debate is that they believe that large corporations are avoiding tax in shady places instead of paying it to the governments of developing countries which could use the revenue to reduce poverty.

In fact, tax havens are normally well-governed – they have to be in order to attract business. Most corporations and financial institutions do not like doing business in places that have a reputation for poor governance.

A typical example cited by NGOs is that a company in a poor country will establish a subsidiary in a country such as Switzerland and transfer products between the subsidiaries using transfer prices that reduce profits in the poor country and raise profits in Switzerland. The fact that nearly all the examples cited relate not to complex intellectual property but to goods and services that have reasonably objective values at the intermediate stage of production suggests that the problem lies not with the tax haven but with governance in the country in which the company is operating. Firms are able to distort transfer pricing because of the lack of competence in the country in which they are operating.

Interestingly, Oxfam uses Malawi as a case study. It argues that, if it were not for money sheltered in tax havens, there would be more money to spend on healthcare for Malawians.

Malawi is a country beset by problems. Aid was suspended in 2013 due to public looting on a horrendous scale and government spending is an incredible 50 percent of national income.

Malawi’s problem is not that its government is too small in relation to its economy; it is that it is too big and also dysfunctional. Malawi languishes at 112 in the Corruption Perceptions Index. If too many Malawians are holding money in Switzerland and not paying tax in Malawi, the fault lies with the Malawi government and not the Swiss government.

The process of globalization, of which the internationalization of finance is part, has brought enormous benefits to the world’s poorest people. There have been bigger reductions in the number of poor people in the last 30 years than in the whole of the previous 6,000 years put together. The World Bank announced at the end of last year that, for the first time in recorded history, the share of the global population living in extreme poverty – defined as below $1.90 in daily disposable income – had dropped below 10 percent, down from 44 percent 35 years ago. At the same time, by any reasonable measure world inequality has fallen too.

We take this for granted. Anti-tax-haven campaigners cannot see the wood for the trees. The huge reduction in world poverty did not happen because of the efforts of NGOs, but largely because of the greater integration of a number of countries into the rest of world economy. Poverty will not fall still further by undermining the tax havens that have helped this process of international integration, but by encouraging better policy in those countries in which a large proportion of the world’s poor live. Such countries tend to have high trade barriers, stifling regulation and are beset by corruption.

Contrary to the claims made by the 355 economists and activists, tax havens do serve many useful purposes. Economic and legal institutions are still inadequate in many places, while international governance, such as the international tax system, remains imperfect and can stifle international investment. Offshore financial centers can help alleviate these problems and ensure that less-developed countries can benefit from the inflow of foreign capital – which is normally scarce relative to such countries’ labor resources. The stable and relatively transparent regimes in offshore centers help compensate for the rather less stable regimes in the countries in which the end investment usually takes place.

Indeed, it is interesting that NGOs are the first to complain about lack of competition and the cartelistic characteristics of big business. Yet there can be little worse than a tax cartel. Tax havens help ensure that governments provide reasonable environments in which to do business whilst not charging penal tax rates. They keep governments on their toes. If one country starts to exploit business or exploit investors, tax havens can provide a conduit that can circumvent such exploitation.

NGOs also tend to have few constructive views on fundamental reforms of the tax system. Such is their desire to see the world’s problems solved by levying more tax and giving more power to governments that they tend to avoid any thought of simplifying the tax system and reducing the tax burden. But, there is a simple solution to many of the perceived problems of tax havens. We should stop taxing corporations on the basis of their profits in the country in which profits are made. The owners of companies should be taxed in their country of residence according to the capital gains and income they receive from their shareholdings. In other words, equities should be taxed in the same way as bonds. If countries in which a company operates wish to levy additional taxes – such as land value taxes on business property – that would be a separate matter and such taxes could not be avoided via tax havens.

Of course, some individuals will try to hide their money in tax havens so that it escapes the attention of tax authorities altogether. But, it is the responsibility of governments to collect taxes from their own people. If some governments are not capable of doing so, that is a problem that needs to be solved. What we should not do is respond by excoriating offshore financial centers.

Now that it is clear the U.S. will not ‘reciprocate’ on FATCA, will ‘partner’ countries wise up?

As I have warned for several years now, “partner” governments signing legally defective Foreign Account Tax Compliance Act (FATCA) intergovernmental agreements under promises from the U.S. Treasury Department that the U.S. would provide reciprocal information from domestic American institutions was at best a long shot, more likely just a deception. Almost three years ago, in July 2013, Florida Congressman Bill Posey made it clear requests for legislative authority to provide “reciprocity” were dead on arrival.

Yet foreign governments have continued to deceive themselves – or their publics, or both – that American participation in a global GATCA, or intergovernmental automatic exchange of information, disclosure of corporate beneficial ownership, and a common reporting standards regime, probably under OECD auspices, were just around the corner.

Well, it is not. Period. Full stop.

With Senators Rand Paul’s and Mike Lee’s stalwart block of tax treaty provisions as backdoor mechanisms for securing the Obama Administration’s sought-for authority, the matter is deader than ever here in Washington.

Belatedly, some elements abroad are waking up to the fact they have been had. They have only themselves to blame, really. Not only were they warned by this writer time and again, they at least should have had the common sense, and an elementary understanding of our non-parliamentary Constitutional system, to know that Treasury’s promises had no legal authority and were worthless. But so intimidated were they by America’s mighty threat of FATCA sanctions or deceived by the siren-song of the compliance industry that “there is no alternative” to an inevitable, and for the industry, highly lucrative, acquiescence to Washington’s demands, or perhaps slavering with the sheer greedy lust of an expected tax revenue bonanza if only they would throw their citizens’ privacy concerns under the bus, our so-called “partners” – more properly called satellites – meekly handed over the keys of their financial institutions to the IRS (not to mention, to the NSA, CIA, etc.)

But still, our “partners” now pronounce themselves shocked that “the Yanks” are not keeping their promises. Since the “Panama Papers” story broke, foreign officials have accused the United States of acting as a tax haven as well as permitting states like Delaware, Nevada and Wyoming not to disclose beneficial ownership of corporations. There have been calls to blacklist the United States, and even (from the Greens/EFA group in the European Parliament) to apply sanctions against us. Cayman Premier Alden McLaughlin has called for a level playing field in terms of financial transparency and stated that a standard without U.S. participation “is not a global standard.”

Good luck with that.

At this point, as our foreign partners finally notice the raw deal they have gotten, they have three choices:

  1. Keep beating their collective heads against the wall, futilely demanding that IGA reciprocity promises be honored, that American states disclose “beneficial ownership,” that the U.S. sign on to the so-called Protocol amending the Multilateral Convention on Mutual Administrative Assistance in Tax Matters, along with a follow-up competent authority agreement, etc.
  2. Accept that Washington will treat international information exchange like we treated the League of Nations or the International Criminal Court: Those lesser, not-fully-sovereign countries will comply with whatever we dictate to them, and we will ignore their requests to us.
  3. Finally admit to themselves that FATCA, GATCA, AEOI, CRS, and the rest of the whole rotten OECD-Obama scheme was a bad idea to start with. They must then tell Treasury they will not comply with FATCA and will pull out of arrangements that violate state sovereignty and personal privacy – and if Treasury does attempt to impose illegal sanctions for FATCA non-compliance, determined resistance and asymmetrical responses will follow. Granted, small countries like, say, Cayman, are in a weak position to defend themselves directly, though they could support anti-FATCA efforts inside the United States, which they have not. Other countries do have significant options. For example, Canada and the United Kingdom are in a strong enough financial relationship vis-à-vis the U.S. to tell Treasury that any FATCA “withholding” to their institutions will be met dollar-for-dollar with withholding from transfers to the U.S. Or Canada could inform the U.S. that an equal sum of FATCA withholding would be imposed in added fees on American air carriers transiting Canadian airspace on Atlantic flights.

The bottom line is this: If there’s a will to resist, the means will be found. But if partners continue to cower as they have thus far, they deserve whatever they get. Based on past performance, I remain skeptical that they will summon the wherewithal actually to stand up for themselves. But the successful Brexit vote gives even this most hardened cynic pause and renewed hope in the spirit of liberty.

Meanwhile, at least the sense of unfairness and the need to do something about it appear to be growing. The following is a survey by country of reactions to the accurate perception that FATCA is an unfair, one-way street, especially for “Accidental Americans,” who are local citizens who for a variety of reasons are considered “U.S. persons” for tax purposes by the U.S. (The survey is sourced from Jude Ryan on the Accidental Americans group on Facebook.)

flag-franceFrance: The Assemblée Nationale has set up a fact-finding mission to investigate the extraterritorial reach of U.S. laws and in particular the invidious position French “Accidental Americans” find themselves in. Several recent events have highlighted the propensity of the U.S. courts and the U.S. administration to purport to impose sanctions against foreign corporations and foreign individuals in respect of events occurring outside of U.S. territory. Based on the feedback of a wide array of experts, the fact finding mission will attempt to define the contours of U.S. extraterritoriality, exhaustively identify all cases of extraterritorial application of U.S. laws, assess their impact and, in particular, their impact on fair competition and the economic losses suffered by French companies as a result, and to study ways in which to counter such practices both at a national and European level. The mission hopes that its findings will lead to concrete implementation measures. A hearing of French Accidental Americans was held on June 8, 2016, and at which issues raised by FATCA and the U.S. practices of Citizenship Based Taxation, particularly as regards Accidental Americans were discussed. The mission questioned and heard testimony from five Accidental Americans. Also, French Parliamentarian Seybah Dagoma wrote to the President François Hollande’s office drawing his attention to the issues faced by French citizens who are also Accidental Americans. In her letter, Dagoma denounced the unintended consequences of FATCA, the absurdity of Citizenship Based Taxation, the extraterritorial reach of U.S. laws and the living nightmare French Accidental Americans and their families are enduring.

flag-italyItaly: Massimiliano Fedriga, leader of the parliamentary Lega Nord group, recently posed a question to the Italian government regarding the situation of Accidental Americans and, in particular, how the Italian government proposes to safeguard Italian citizens caught up in this mess, in addition to questions regarding infringement of Italian sovereignty, compliance costs and related matters.

flag-canadaCanada: In Canada, the Alliance for the Defence of Canadian Sovereignty has initiated a lawsuit against the government of Canada legislation that enables the FATCA IGA “agreement” between Canada and the United States. The defendants in the lawsuit are Canada’s attorney general and revenue minister. The plaintiffs are two women from Ontario, Canada, both born in the United States, but who left the U.S. at an early age and have no meaningful ties with U.S. – yet they are deemed by the U.S. to be “tax citizens.” The plaintiffs claim that the legislation violates Canada’s Charter of Rights and Freedoms, Constitution, and its sovereignty as a nation. The trial is likely to take place in Canada Federal Court later in 2016. Plans are also afoot to mount a legal challenge in the U.S. courts to the U.S. practice of Citizenship Based Taxation.

flag-isrealIsrael: Two actions are ongoing in Israel. The first is an appeal to Israel’s Supreme Court, contesting the right of banks to transfer information pertaining to local accounts of dual citizens to the IRS. If this appeal is successful, the problems of accidentals will also be solved. The second revolves around banking problems faced by the many small charities popular in Israel’s ultra-Orthodox communities. These charities rely on foreign donations. Requiring them to report on all donators will effectively ruin them. This issue is being discussed by the finance committee in the Israeli parliament. This committee also promised to discuss the Accidental Americans issue.

It still remains to be seen where these efforts will amount to anything serious. Likewise, even if they are, it is essential they are directed not towards pulling the U.S. into the financial fishbowl – which I repeat again for the record, just will not happen – but for scuttling it entirely. In that regard, it is belatedly time to create what never has existed from the time FATCA was launched in 2010: a dedicated, funded Washington-based lobby and media effort to repeal this misbegotten, wasteful, invasive, and dysfunctional law.

What the taxman sees

That turmoil will be occurring in a world where there is already significant upheaval on the horizon from the OECD’s Base Erosion and Profit Shifting (BEPS) initiative and the growth of the bureaucracy needed to implement the various FATCA and FATCA-like measures being adopted around the world. The Panama Papers, also discussed by several authors in this issue, are provoking calls for even more regulatory efforts aimed at international business structures.

To make sense of all this, consider adding to your August holiday reading Yale anthropologist James C. Scott’s books, ‘Seeing Like a State: How Certain Schemes to Improve the Human Condition Have Failed’ (Yale 1998), and ‘The Art of Not Being Governed: An Anarchist History of Upland Southeast Asia’ (Yale 2009). Here’s why they are relevant.

Scott has four big ideas that shape his analysis of why ambitious development plans in Southeast Asia fail (Seeing) and how various tribes escaped incorporation into precolonial and colonial states in the same region (Not Being Governed). First, he argues that the fundamental need of a state is to render people “legible” to it, enabling them to be taxed.

Second, in making people legible, states change the nature of the activities people engage in, their culture, and their society as a whole. Third, the social engineering states attempt in the course of making people legible is due to a “high modernist ideology” that uncritically applies scientific and technical models to societies. Finally, combining that ideology with a state with significant coercive power tends to lead to bad results.

Although I am not sure Scott, who styles himself an anarchist and disavows any connections with libertarian authors like Friedrich Hayek, would agree with the analogy, the OECD’s BEPS proposal seems like a grand example of applying a high modernist ideology to people’s activities in a way that is likely to lead to disasters. And the project of pinning down every transaction using information exchange, beneficial ownership registers, etc, looks a great deal like a legibility project.

Here’s how Scott describes the need to get people to create “state-accessible product” that can then yield state revenue in precolonial Southeast Asia. There states preferred people to grow irrigated rice rather than live in the hills as subsistence farmers, hunters and gatherers. As Scott describes it in ‘The Art of Not Being Governed’: “State-accessible product and gross domestic product are not simply different; they are, in many respects, at odds with each other. Successful state-building is directed toward the maximization of the state-accessible product. It profits the ruler not at all if his nominal subjects flourish, say, by foraging, hunting or shifting agriculture at too great a distance from the court. It similarly profits the ruler little if his subjects grow a diverse suite of crops of different maturation or crops that spoil quickly and are therefore hard to assess, collect and store. Given a choice between patterns of subsistence that are relatively unfavorable to the cultivator but which yield a greater return in manpower or grain to the state and those patterns that benefit the cultivator but deprive the state, the ruler will choose the former every time. The ruler, then, maximizes the state-accessible product, if necessary, at the expense of the overall wealth of the realm and its subjects.”  (pp. 73-74)

It is not too much of a stretch to apply this analysis to efforts to curb tax avoidance by businesses and individuals. The BEPS project itself is a massive effort at legibility. The failure of the OECD or the governments endorsing its project to engage in any serious cost-benefit analysis of the project reflects not simple carelessness but a preference for legibility over any possible benefits of not burdening the world economy with the compliance costs of BEPS (higher growth rates, for example).

Similarly, just as Prussian authorities changed that country’s forests from diverse ecosystems to organized, regimented monocultures by focusing on counting the valuable trees and rewarding those managers who increased the legible products, so our tax codes have induced behavior. Songwriters like U2 shift their copyright holdings to the Netherlands not because the Dutch are musical aficionados but because the tax system makes it profitable to do so. BEPS and other efforts to restructure tax systems globally are likely to have large impacts. For example, BEPS is likely to make firms less entrepreneurial in their international businesses by raising the cost of doing business globally. In turn, this will make firms less likely to lend in developing countries where financial regulations are less developed. It will make firms more likely to adopt costly and bureaucratic systems that document compliance efforts. The result will be a global financial architecture that is a version of the U.S. Transportation Security Administration – a costly, inconvenient system with few benefits and many costs.

Scott defines “high modernism” as “a particularly sweeping vision of how the benefits of technical and scientific progress might be applied – usually through the state – in every field of human activity.” (State, p. 90) This approach is taken equally by those on the left and the right. It is tempered by the belief that there is a private sphere into which the state may not intrude, the belief that the economy is too complex to be managed, and the existence of “working, representative institutions through which a resistant society could make its influence known.” (p. 102)

BEPS makes clear that the OECD has lost any notion that the world economy is too complex for it to manage or that there is a sphere of life into which it may not intrude. Moreover, the OECD is itself the perfect example of an institution that is unrestrained by any institutions. Unaccountable, sequestered in its Paris headquarters, and with a staff drawing tax-free salaries, it is undemocratic, unrepresentative and disconnected from the world economy. The rebellion of British voters against the EU as evidenced by the Brexit vote suggests there is a limit to which people are willing to cede control of their lives to unaccountable institutions.

Looking at the world the way states do can help us understand why they do what they do. As the quest for legibility drives states towards imposing ever higher costs on the world economy, the challenge is developing ways to create vehicles that are resistant to high modernism.

Liquidity and Cayman funds

Prior to investing in a Cayman Islands-based investment fund, it is customary for a proposed investor to ask the Cayman fund’s directors or investment manager to confirm the liquidity terms of the Cayman fund. By “liquidity,” the investor is referring to the possibility and frequency that the Cayman fund’s shares may be redeemed.

Follow-up requests from the incoming investor include confirmations of when redemption proceeds may be paid to the investor; whether the investor becomes a creditor in respect of the redemption proceeds as of the redemption date; and whether the payment of redemption proceeds may be suspended by the board of directors of the relevant Cayman fund.

In order to answer some of these queries, it is useful to observe some of the provisions of the Companies Law of the Cayman Islands and the judgment passed down by the Judicial Committee of the Privy Council of England in the Cayman case of Culross Global SPC Limited v Strategic Turnaround Master Partnership Limited.

 

Redemptions under the Companies Law

Section 37(1) of the Companies Law states that:
“Subject to this section, a company limited by shares or limited by guarantee and having a share capital may, if authorised to do so by its articles of association, issue shares which are to be redeemed or are liable to be redeemed at the option of the company or the shareholder and, for the avoidance of doubt, it shall be lawful for the rights attaching to any shares to be varied, subject to the provisions of the company’s articles of association, so as to provide that such shares are to be or are liable to be so redeemed.”

Section 37(2) goes on to say:
“Subject to this section, a company limited by shares or limited by guarantee and having a share capital may, if authorised to do so by its articles of association, purchase its own shares, including any redeemable shares.”

Lastly, section 37(3) states:
“(a) No share may be redeemed or purchased unless it is fully paid.
(b)  A company may not redeem or purchase any of its shares if, as a result of the redemption or purchase, there would no longer be any issued shares of the company other than shares held as treasury shares.
(c)  Redemption or purchase of shares may be effected in such manner and upon such terms as may be authorised by or pursuant to the company’s articles of association.
(d) If the articles of association do not authorise the manner and terms of the purchase, a company shall not purchase any of its own shares unless the manner and terms of purchase have first been authorised by a resolution of the company.”

Having looked at what is required under the Companies Law to permit a redemption of shares, it is now useful to examine what was determined under Strategic Turnaround regarding the effective date of a redemption and when redeeming investors become creditors of a Cayman fund.

 

Strategic Turnaround:  When a redeeming investor is deemed to exit a Cayman fund

In delivering the opinion of the Privy Council in Strategic Turnaround, Lord Mance stated that it is a basic principle of company law that capital subscribed to a company may not be returned to shareholders otherwise than as prescribed by statute.

In this regard, reference was made by Lord Mance to above-mentioned sections 37(1) and 37(3)(c) of the Cayman Companies Law. In a nutshell:
If authorized to do so by its articles of association, a Cayman fund may issue shares which are to be redeemed or are liable to be redeemed at the option of the company or the shareholder.

The manner in which any redemption may be effected must be authorized by or pursuant to the articles of association.

Accordingly, if (i) a Cayman fund is authorized by its articles of association to issue redeemable shares, (ii) the Cayman fund issues redeemable shares pursuant to the authority in the articles of association, (iii) redeemable shares are redeemable at the option of the company or the shareholder, and (iv) the articles of association describe the authorized manner and the terms upon which any redemption may be effected, then the board of directors of the Cayman fund must ensure that the redemption is effected in the manner authorized by the articles of association.

Once a redemption is effected in the manner authorized by the articles of association, the redeemed investor will become a creditor of the Cayman fund.

 

Strategic Turnaround:  Suspending payment of redemption proceeds after the redemption date

In practice, an investor in a Cayman fund may find himself in a position where his shares were validly redeemed in the manner authorized by the articles of association, the redemption proceeds remain unpaid for a period and the board of directors of the relevant Cayman fund indicate its intention to suspend the payment of redemption proceeds during the said period. This ability to suspend redemption proceeds was discussed by the Privy Council in Strategic Turnaround.

The Privy Council took the view that:

  • the issue depends upon the construction of the articles of association, read with other documents as may be incorporated or referred to therein, and
  • any power to withhold payment of redemption proceeds must be authorized by or pursuant to the articles of association.

It is consistent with the Privy Council’s view that, if the offering document of a Cayman fund contains a statement that the Cayman fund’s board of directors may suspend the payment of redemption proceeds and such description embraces powers which go beyond those set out in the Cayman fund’s articles of association – for example, where the articles of association contain no such power to suspend the payment of redemption proceeds – the description in the offering document of a Cayman fund will be of no legal effect as against investors.

 

Conclusion

The opinion delivered by the Privy Council in the Strategic Turnaround case highlights the importance for lawyers to properly draft a Cayman fund’s articles of association. Bearing this in mind, clients should be wary of any offer to them to utilize any “template” articles of association, which may not provide the Cayman fund’s board of directors with the appropriate powers or flexibility.

Why the current investment climate favors Cayman captives

The sun shines on the Cayman Islands – that’s a given. But it also shines on Cayman’s captive insurance industry, despite record global yields. Within a week of the Brexit vote on June 23, global yields hit record lows on stimulus bets. It felt like only yesterday that we were gawking at a 10-year U.S. Treasury yielding just 2.19 percent, but that was in January. Fast forward six months and the 30-year U.S. Treasury yielded 2.19 percent and the 10-year reached a record low at that time of 1.378 percent.

Most Cayman captives are U.S. dollar denominated and managed according to conservative investment mandates – i.e., they hold a lot of low-yielding U.S. dollar denominated bonds. Negative interest rates would clearly cause for a lot of pain – thankfully, that’s not expected in the United States. Cayman employs internationally accepted best practices and a risk-based approach with favorable insurance regulation that can allow for a greater level of investment management flexibility, when compared to other jurisdictions. With low yields likely to persist, this flexibility, innovative money management solutions found locally, and low costs are more important than ever.

For captive insurance companies, the “captive life cycle” tends to drive investment policy. The captive typically starts by holding deposit-type products (cash) while insurance premiums flow in and the company gains an understanding of its expected claims. Once the captive has built up an asset base, they will then tend to look at fixed income solutions (bonds) that offer yield, some safety and liquidity. As the captive starts to build up surplus funds, they should consider adding modest exposure to equities to further enhance portfolio returns and diversification.

graph-equilibriumLow-interest rates and expectations for below average returns are causing captives to consider diversification opportunities into other areas, namely dividend paying equities and capital protected structured notes. Capital protected or buffered structured notes, issued by high-quality banks, are not understood as well as they should be by captive owners and captive managers in general. Structured notes can add value in the current investment environment, as they can offer the risk and return profile of both bonds and stocks, which can be a logical next step for captives investing in low yielding bonds with potentially higher inflation in the future.

 

The investment climate matters for captives

The combination of sluggish growth and too-low inflation has the world’s major central banks responding with highly accommodative monetary policies. Negative interest rates and full-fledged quantitative-easing programs are now the norm in Europe and Japan, but we have not seen significant pick-ups in economic activity or inflation in those regions. It appears that monetary stimulus is becoming less effective, leading us to question whether central banks are running out of options for generating meaningful growth. Of the world’s major developed economies, only the U.S. seems fit enough to warrant a tightening of monetary conditions. However, given the U.K.’s recent vote to exit the European Union, and other upcoming geopolitical pressures, any tightening is now likely to be put on hold for a while longer.

Our base case scenario is one where the economy is able to work its way through the many challenges and avoid a global recession. In this scenario, economic growth should be sufficient to allow for a modest increase in interest rates over time. Even if distributed over a long period of time, rising rates will act as a headwind to fixed-income returns. Our total-return expectations for bonds are either negative or in the low single digits over the year ahead – it does not take much to produce negative fixed-income total returns as long as coupon income stays so low. Our asset mix continues to favor equities as our forecast of slow growth and low inflation should be supportive of further gains in stocks.

In my opinion, as Brexit scenarios come into view, it is a good idea to take a step back from recent wild market swings and put the risks into perspective. Rather than beating a hasty retreat, equity investors should reconfigure portfolios. Great Britain’s limited position within the global economy should contain any Brexit fallout. While the U.K. is the fifth-largest economy in the world, it represented only 3.9 percent of global GDP in 2015. Just 3.8 percent of U.S. exports and 2.6 percent of Chinese exports flow to the U.K. The U.S. also has less exposure to the EU (ex-U.K.) than one might assume, with 14.3 percent of exports going to the region.

The S&P 500 is highly dependent on domestic revenue. S&P 500 sales attributed to the U.K. averaged a mere 1.2 percent of total sales from 2012 to 2014 and sales to Europe ex-U.K. averaged only 6.7 percent, according to Standard & Poor’s. If we incorporate foreign sales for companies that do not break out data by country or region (referred to as “foreign non-attributed” in the chart), the above figures probably would not even double. Moreover, should Brexit negotiations become protracted – not a given – U.S. sales to the region would not disappear, they would just be lower. If the U.K. slides into a recession and continental Europe’s growth rate slips, the hit to the global economy and S&P 500 earnings should be manageable, in our assessment.

The expectation that short-term interest rates may remain lower for longer is being reflected in long-term bond yields. The yield on the U.S. 10-year Treasury has traded below 2 percent over the past quarter, something that has occurred only twice in the past 146 years – in 2012 during the European debt crisis and at the onset of the Second World War. Our expectation is that bond yields will rise from these unusually low levels over time, but current economic conditions likely do not foreshadow a sharp upward adjustment in the near term.

graph-geographySupporting the need for higher U.S. short-term rates have been labor-market improvement and firming inflation. The U.S. unemployment rate has fallen considerably since the financial crisis to a level where rate hikes would have been well-advanced by now in a more robust economic recovery. The Fed, however, has preferred to err on the side of caution with respect to raising rates given that the economic recovery is progressing more slowly than it expected and that there’s little evidence of an overheating economy. In this context, the pace of fed funds rate hikes is likely to be gentle – not likely until 2017.

 

Inflation will drive the future Fed rate path

Investor complacency is not surprising. Seven straight years of economic recovery following the financial crisis and efforts by central banks to bolster the economy through asset purchases and negative interest rates have so far failed to stop inflation from falling, so it is no wonder that investors have turned so sanguine about the inflation outlook.

Let us recall that inflation is the main variable driving the performance of bond markets. Over the past 50 years, the U.S. inflation experience can be divided into two distinct periods.

Between the mid-1960s and the early 1980s, inflation soared to double-digit levels and required a deep recession to bring it under control. This painful period was followed by the “Great Disinflation,” a 30-year period over which the yield on the 10-year U.S. Treasury bond fell as low as 1.4 percent in 2012 from its high of 15 percent in 1982. During this period, a 10-year Treasury bond delivered an average annual return of 8 percent, according to Citigroup. We do not expect a repeat of these superb returns since they would likely require decades of outright deflation.

In our opinion, the clear and present risk of higher U.S. inflation outweighs investor fears of another financial crisis. We expect the U.S. business cycle to last a bit longer, as household and bank balance sheets are in much better shape after six years of repair. The employment figures are also looking up, with 13 million jobs created since the financial crisis. With the U.S. economy near full employment, some inflation is likely to emerge, especially given that deflation did not surface in the core goods-and-services basket when economic activity was weak and the unemployment rate was high after the 2008 crisis.

 

Why captives should consider Cayman

The annual captive insurance forum held each year in Cayman currently hosts more than 1,400 conference-goers, the largest of its kind. Over 30 separate topics are discussed, and the forum hosts almost 100 speakers. Many of these delegates bring their families on holiday and pack the hotels and condos on Seven Mile Beach, in late November and early December each year. Cayman is an enjoyable place for investors to visit. Frankly, the size of the conference facilities and the country’s airline capacity are the containment factors.

With careful government supervision, backed by a stable political environment and solid professional support services, Cayman has become the second largest offshore insurance domicile in the world. As of September 30, 2015 the total number of captives domiciled in Cayman was 742, with total premiums of US$12.5 billion and total assets of $58 billion under the Cayman Islands Monetary Authority’s supervision. Cayman remains the leading jurisdiction for healthcare captives, with 34 percent of the domicile’s captives falling into this classification; however, Cayman captives are diverse, and span across many industries and lines of insurance coverage.

It is not uncommon to hear misconceptions that small domains, such as the Cayman Islands, would find it difficult to match the level of financial sophistication offered by other finance centers such as London, New York, Zurich or even Singapore. Being a major financial hub, Cayman can and does offer the same level of service. Local money managers for instance have access to the same quality information and investment opportunities, while branches of global entities rely on the same centralized research expertise as branches in larger financial centers. Given the sizable overweight to conservative, low-yielding investment grade bonds, Cayman’s captive industry continues to deal with low interest rates and will for much longer.

Improving mind and management in the same country as the captive, there is a role for locally based investment managers, who have the sophistication to navigate this investment climate by presenting cost efficient solutions and alternatives.

Brexit and the Cayman Islands

The relationship between the European Union and the Cayman Islands has an interesting history. When faced with the prospect of the extension of the first EU Savings Directive in 2003, the Cayman Islands went so far as to mount a legal challenge, only to be advised by the EU’s Court of First Instance that while the EU had no power to directly or indirectly extend the EUSD to the Cayman Islands, if the United Kingdom chose to so do, as it had indicated that it would, this was entirely a matter for the U.K. and the terms of its constitutional relationship with the Cayman Islands.1  Consequently, when the U.K. threatened to leverage its superiority in this relationship and to issue an Order in Council, the Cayman Islands was left with little option but to enact its own legislation giving effect to the objectives of the EUSD.

Superficially, one might be tempted to interpret the outcome of the U.K.’s Brexit referendum as a liberating force, potentially freeing the Cayman Islands and the other United Kingdom Overseas Territories from the reach of the EU. This narrow view, however, ignores, amongst other things, that many of the EU’s objectives are shared by other international organizations with whom the Cayman Islands will continue to engage. Having initially resisted the first foray into the sharing of tax information that was the EUSD, the Cayman Islands has latterly embraced the OECD’s global agenda in this regard and a policy of active engagement has, for the most part, proved beneficial for the Cayman Islands. Certainly, it would be naive to think that any impending departure from the EU by the U.K. will herald mass renegotiations of the many tax information exchange agreements entered into by the Cayman Islands in recent years, or a reneging by the Cayman Islands of its commitment to adopt the OECD’s biggest and boldest tax sharing initiative to date, the common reporting standard.

A more considered analysis of the decision of the EU Court of First Instance reveals that the judgment is instructive as to the nuances of the relationship between the Cayman Islands and the EU and the U.K.’s crucial role as the intermediary between the two. At a time when the playbook appears to have been tossed away and there is massive uncertainty as to what the U.K. will do next in terms of Brexit, let alone what effect this may have on the U.K. overseas territories, any instruction is most welcome. So, if there is a lesson still to be learnt from the approach taken by the EU court, it is that the Cayman Islands can be impacted by the U.K.’s interests as manifested in the U.K.’s interactions with the EU.

Even though the British electorate voted to leave the EU, the U.K. will continue to have some sort of relationship with the EU. Negotiations between the U.K. and the EU will, at some stage, have to take place. At this juncture, it is difficult to predict how these negotiations will pan out, given that there are so many different variables to contend with at present. The premier of the Cayman Islands is therefore right to make contact with the U.K. and to seek assurances in an effort to avoid precisely the sort of unilateral action by the U.K. that committed the Cayman Islands to the EUSD without prior consultation. In response, the U.K.’s overseas territories minister has indicated that the outcome of the referendum does not change the constitutional relationship between the U.K. and the overseas territories. That may very well be the intention, but the Cayman Islands should be under no illusion that its interests are anywhere near the top of the U.K.’s list of non-negotiables.

The Cayman Islands cannot therefore afford to rest on its laurels. Events are unfolding rapidly since the Brexit referendum and with each successive turn there may well be ramifications for the Cayman Islands to consider. One such event is the debate surrounding whether the prime minister can use prerogative powers to trigger the U.K.’s departure from the EU under Article 50 of the Lisbon Treaty, or whether such action requires pre-approval by parliament. This is evidently a critical consideration for the U.K. as it figures out what to do next after the Brexit vote, although its relevance to the Cayman Islands has largely gone unnoticed.

At the heart of this debate is the royal prerogative and the extent to which these discretionary powers are subject to parliamentary oversight and supervision by the courts. One only need consult with the Chagos Islanders, who were forcibly removed from their homes in the British Indian Ocean Territory under prerogative powers and who were unsuccessful in their attempts to challenge the exercise of this prerogative in the courts2, to appreciate the seriousness of the issue at hand. Closer to home, the suspension and amendment of the Turks and Caicos Constitution by the U.K. in 2009, on one view, effectively extended the royal prerogative by revesting wide discretionary legislative and executive powers in the governor at the expense of the locally elected officials.

As a U.K. overseas territory and ultimately subservient to the U.K., the Cayman Islands does indeed have an interest in what might otherwise be viewed as an obscure point of U.K. constitutional law. The fact that this may not have been immediately apparent should also serve to put the Cayman Islands on notice as to the need to be ever vigilant in its monitoring of Brexit developments. To this end, the Cayman Islands should consider mirroring the U.K.’s establishment of a bespoke Brexit unit, so that it is as prepared as it can be for every eventuality in what promises to be an on-going Brexit saga.

 

ENDNOTES

  1. Government of the Cayman Islands v Commission of the European Communities 2003 CILR 91.
  2. R (Bancoult) v Secretary of State for Foreign and Commonwealth Affairs (2008) UKHL 61.

Why Russia will continue to disappoint

Russia has more natural resources than any other country – perhaps as much as 30 percent of the world’s total – and a well-educated population. So, why is it not rich?

The short answer is that it is still plagued by high levels of corruption and lacks the institutions to take good ideas and turn them into globally competitive products.  When is the last time you were in a store and saw a product “made in Russia,” like those made in China, Japan, South Korea, and Brazil, etc.?

russian-thumbs-downRussia consistently runs a positive balance of trade, but its exports are primarily oil, gas, metals, wood, other natural resources, and military products. As a result, its GDP goes through wild swings based on international commodity prices. The Russian economy grew rapidly from 1999 to 2008, in large part due to the global demand for commodities, and in particular oil and gas. But in the last couple of years, the Russian economy has been in a deep recession because of the drop in the price of oil and economic sanctions imposed as punishment for its military adventurism.

Russia also has an on-going demographic problem with a flat or even falling population, estimated to be about 144 million. During the boom times in the early 2000s, Russia attracted many immigrants from the former Soviet Republics which largely offset the declining native Russian work force due to a low birth rate. But as the economy fell into recession, the number of immigrants has greatly declined.  Russia females, on average, live about ten years longer than their male counterparts, largely because of widespread alcoholism and smoking by Russian males. Yet, women have a retirement age of 55 while men can retire only at age 60. These low retirement ages drive many of the most productive workers out of the labor force, which adds to the costs of dependency.

In the early 1990s, during the transition period, I was an economic advisor to several senior Russian government officials, including the first non-communist prime minister, the late Yegor Gaidar. Subsequently, several of us set up joint ventures with Russia entities, in part to teach them how a real capitalist economy operates.  Because of on-going problems with the Russian physical and legal infrastructure, and because of the pervasive corruption, we ended up moving our operations, including our most skilled Russian scientists, to the U.S. in one of our companies.  In another joint venture, we ended up selling the business to our Russian partners because of their inability to follow international legal, management and accounting standards. Russia has made considerable progress in the rule of law and property rights protections since those early days of transition, but corruption is still very widespread, which has the same effect as a tax on the productive and honest. Russia ranks 119th out of 166 countries on the Transparency International global corruption index. By contrast, neighboring Finland ranks number 2, and the U.S. number 16. On the World Bank measure of ease of doing business, Russia now ranks 51, while the U.S. is number 7, and Singapore has the top spot of number 1, out of 189 countries.

Russian universities produce one of the highest numbers of engineers and scientists, and yet they create relatively few world-beating high-tech companies.  During the communist period, there was no way for a Russian scientist with a transformative idea to create a company to turn that idea into products that millions would buy. Those who came up with new ideas would receive an “authors’ certificate” rather than a patent. “Authors” were provided with a 50 ruble payment, but no royalties or ownership of the idea, no matter how important. At the time, there could be as many as four “authors” for any new idea – each of whom would receive the 50 rubles. As one would logically expect, most authors’ certificates had four authors – the person who thought of the idea plus three of his or her family or friends.

Even in a country like the U.S., it is not easy for an innovative patent holder to obtain the capital and build the structure of a new enterprise around the idea, or even license it. And the U.S. has more venture capital firms and the developed infrastructure than anywhere else for taking new ideas and turning them into goods and services people want. Other developed countries, such as Switzerland, realize that their future prosperity is dependent on innovation. The Swiss MIT, called ETH, where Albert Einstein and many other scientific Nobel Prize winners studied, has a program to help its students and faculty create new enterprises from their ideas.

It takes some time for a culture to change from a top-down government directed society to a bottom-up entrepreneurial society. Russia continues to export capital, for reasons of both safety and opportunity, and export many of its best and brightest scientists and engineers. The Russians, of course, are well aware of the problem, but they still default to centralized planning in attempting to create a Russian Silicon Valley, as they are now doing in the city of Skolkovo. The communists during the USSR days also set up several science cities which were of little use.

Despite the limited Russian success in creating an entrepreneurial culture and institutions, they do produce world-class technology in a few areas, most of it military related. Their large rocket engines are arguably the best in the world, and the U.S. has been dependent on these engines for the last few years. They are also able to produce highly sophisticated military aircraft and submarines – no small achievement. Before the collapse of the Soviet Union, the Russians and Ukrainians were the second largest producer of civilian aircraft in the world, but that industry almost died with the USSR. Their airframes were very rugged, but their avionics and engine efficiency was a generation behind that of the West. They largely missed the opportunity to form joint ventures with foreign companies to provide state-of-the-art avionics and engines combined with Russian airframes. So they are just now, a quarter of a century later, trying to rebuild a civilian aviation industry which will be tough given the global competition.

Russia has a relatively small and highly manageable government debt-to-GDP ratio unlike all of the major developed countries. Russia also wisely went to a low 13 percent rate flat income tax system a decade and a half ago. They also have a relatively low corporate tax rate of a flat 20 percent. But their sales tax rate at 18 percent and social security tax rate of 30 percent are very high. On the positive side, they have kept government spending under control and in most years run a surplus.

Russia also set up national reserve funds during the period of high commodity prices, to cushion the periods of low commodity prices. The rate of depletion of these funds and their considerable foreign exchange holdings will depend on domestic political pressures to spend on an added social safety net, and whether or not there is a major recovery in oil prices. Given the advances in fracking technology and the new discoveries of major oil and gas fields throughout the world, it is unlikely that oil and gas prices will return to the levels whereby Russia can again accumulate surpluses and also have sufficient funds to invest in new gas and oil infrastructure. As would be expected, it is reported that there has been underinvestment in oil and gas expansion and replacement, and increased mismanagement since the oil and gas companies were largely renationalized a decade ago.

Over the long run, commodity prices tend to fall relative to other prices, as production technologies improve. Russia relies primarily on commodities for its income, and to date has been largely unsuccessful in broadening the economic base of the economy. So the open question is, where are the sources of growth for the next couple of decades?

In 1992, the ruble had collapsed, and the currency was almost worthless. Yet, I was amazed that the subways continued to run, and the electricity remained on. The workers who provided these basic services continued to show up at work, even though they could buy very little with their paychecks. There were virtually no riots in the streets as would be expected in most places. Instead, the Russians faced this extreme hardship with quiet desperation. Women stood for long hours outside of the subway stations trying to sell a pair of boots or a frying pan in order to buy some food which was in very short supply. Within weeks, spontaneous free markets began to emerge – even though, after 70 years of communism, virtually no one had any experience with a market economy. The economy was dollarized with considerable help from the U.S. and the European countries – but it was the individual perseverance of the Russian people that enabled them to get through several very tough years.

Real incomes are now several times higher than they were at the end of the communist period, and poverty has been greatly reduced. Russia has enough going for it – incredible quantities of raw materials, a highly educated work force, and a functioning market economy, which should keep it as a slowly growing middle-income economy over the next few decades. But Russia is also unlikely to experience the high growth rates of the 1999-2008 period because they give little indication that they are going to seriously deal with the corruption and the lack of the rule of law, and create the venture capital institutions and markets that are necessary.

Russia will likely continue to disappoint, not because it will become an economic disaster, but because it ought to be high-growth developed country. Yet, it is unlikely to make those few remaining steps to fulfill its potential.

Politicians and the Panama Papers

The recent Panama Papers leak has brought tax havens to the forefront of public policy discussions. Naturally, many individuals and supranational entities have advocated for more stringent regulations on tax havens and tougher Anti-Money Laundering (AML) programs in response to these revelations. Entities such as the Organization for Economic Co-operation and Development (OECD) have spearheaded this push to penalize tax havens.

The OECD has used the recent release of the Panama Papers to not only condemn Panama for its tax haven status, but has also doubled down in its efforts to impose more onerous rules on money laundering and tax evasion. Interestingly, organizations such as the Financial Action Task Force (FATF) recently removed Panama from its grey list of countries that did not have adequate measures that impede money laundering and dirty money practices.

Like the OECD, the FATF is not very keen on the idea of tax competition but it is rather telling that it decided to remove Panama from its list of suspicious countries. This is no isolated incident, as countless other offshore jurisdictions such as the Cayman Islands have actually beefed up their laws against dirty money over the past few years. Ironically, these much maligned offshore sites have stricter due AML measures than many OECD countries.

So what is truly at stake in the recent response to the Panama Papers? This article will seek to analyze what PEPs are; which notable politicians were involved in the Panama Papers; whether or not expanding current PEPs and Anti-Money Laundering (AML) measures are effective forms of policy; and the political implications of the Panama Papers.

 

What are PEPs?

The FATF, which was established in 1989 by the G7, has led the push against money laundering around the world. Over the years, FATF has developed a “politically exposed person” (PEP) standard as a way to combat money laundering and terrorist financing at the highest echelons of government.

In short, a PEP is an individual – a government official or their family members or close associates – who could use their public office for ill-gotten gains or be at greater risk for corruption or terrorist financing. The standards for determining what constitutes a PEP are not universal, but there is general consensus among countries that the 2003 FATF standard is the norm for the financial services industry.

 

List of PEPS involved in the Panama Papers

The following politicians have become targets of controversy because of information in the Panama Papers:

David Cameron

Former British Prime Minister David Cameron had criticized complex offshore structures for not operating in a fair manner in 2013. In an ironic twist of fate, the Panama Papers would later reveal details of the offshore trust, Blairmore Holding, Inc., that his father Ian Cameron established in 1982. While Cameron did hold shares in Blairmore in the past, he claimed to have sold his shares before becoming prime minister. Nevertheless, he has received significant criticism for his dealings in the offshore trust by opposition leaders. More fuel has been added to the fire as new details have emerged that implicate fellow Conservative Party members in offshore activities.

Rafael Correa

In response to the Panama Papers, President of Ecuador Rafael Correa proposed an ethical pact to reject candidates in upcoming elections that hold money in tax havens. At first glance, this response seemed natural given Rafael Correa’s penchant for populist economic policies. However, new developments emerged from the Panama Papers in which Correa and his estranged brother Fabrcio Correa were reported to have bought Orlion S.A., an offshore company, in 2006. To add more intrigue into the mix, Orlion S.A. was under investigation in 2012, during Correa’s presidency, by the Panamanian government for the alleged embezzlement of state funds.

Sigmundur Davíð Gunnlaugsson

Sigmundur Davíð Gunnlaugsson involvement in Wintris, a foreign company and a creditor of failed Icelandic banks, is one of the most notable political revelations of the Panama Papers. Prior to his resignation as prime minister, Gunnlaugsson was a major player in Icelandic politics who ascended the ranks as chairman of the Progressive Party, eventually becoming prime minister in 2013. The Panama Papers shed light on his activity with Wintris, in which he owned a 50 percent share when he entered office in 2009. Eight months after entering office, he would sell his share to his wife for $1. Although Gunnlaugsson broke no laws, his failure to disclose his share in Wintris did not sit well with Icelandic voters. After widespread protests and pressure from political opponents, Sigmundur Davíð’s resigned from the office of prime minister on April 5, 2016.

 

Understanding the anti-tax haven motives

What the Panama Papers have demonstrated is that politicians are very involved in offshore activities. According to WikiData, politicians were the most cited occupation group in the Panama Papers. There is nothing inherently wrong in using offshore services, but these recent findings show a degree of hypocrisy on the part of some politicians. Many politicians are quick to lambast tax havens when they themselves or their colleagues use these services.

Moreover, there is an elephant in the living room that is frequently ignored – the fiscal predicament of many OECD countries. The majority of the OECD countries are characterized by generous welfare states. While the benefits of a welfare state make for good politics in the short term, they are very expensive to maintain in the long-term. Coupled with demographic realities, welfare states will find themselves on unsustainable paths after years of lavish spending put them on the verge of potential bankruptcy.

History has shown that when countries are in fiscal dire straits they will look to find a scapegoat domestically or abroad as a pretext for increased taxation. In this case, tax havens are the political class’s new target.

 

Policy effects of PEP and AML measures

Given the fact that so many political figures were exposed by the Panama Papers, perhaps the real lesson is that FATF and other bureaucracies should focus on reforms that will make it harder for politicians to misuse their power to loot their nations.

Though it is important to be realistic about what can be achieved. If politicians are comfortable with stealing public funds, it is very unlikely additional rules and regulations will have much impact, whether those policies come from FATF or elsewhere.

Alternatively, FATF can devise rules for financial institutions that arguably would be effective, such as mandatory disclosure of all assets owned by politicians, their families, and close associates, combined with prohibition of foreign financial accounts for those individuals. But such dramatic steps surely would face an uphill battle since FATF bureaucrats know that their (tax-free) salaries are dependent on approval by governments.

In any event, AML measures that make criminal actions more expensive for politicians would, on paper, make looting less likely.

But it would be very important for the rules to be narrowly targeted on politicians and the people close to them. Extending such rules to the broader population would necessitate a gross misallocation of resources. Economics has demonstrated repeatedly that policies often produce unintended consequences that deviate substantially from the lawmakers’ original intent. AML laws that require individuals and companies to complete extensive amounts of paperwork, for instance, result in increased costs that inhibit the effective functioning of the financial sector.

This dynamic is most visible in developing countries, where banking is at times cost prohibitive for many individuals. According to a 2014 World Bank report, 62 percent of adults worldwide have accounts at banks and other financial institutions. That being said, there still exists wide disparities in banking accessibility between the developed world and the developing world.

The 2014 World Bank report sheds light on how documentation requirements are a significant barrier to account ownership, with 18 percent of adults citing these types of requirements as a hindrance to account ownership. By the same token, 23 percent of adults cited costs as another barrier to setting up bank accounts.

Generally speaking, these high costs can largely be attributed to the regulatory expenses incurred by banks due to the anti-money laundering requirements. In turn, financial institutions pass the burden on to consumers through higher costs and fees. FATF has even recognized this unintended consequence and has tried to implement safeguards that promote more financial inclusion.

 

Panama Papers: Qui bono?

Who benefits from the recent release of the Panama Papers? It has become clear that not only multinational organizations such as the OECD have benefitted, but also populist politicians on the far left have gained much traction with the release of the Panama Papers. Politicians such as Jeremy Corbyn in the United Kingdom, Bernie Sanders in the United States, and Pablo Iglesias in Spain have unsurprisingly railed against the latest revelations from the Panama Papers. Their respective calling cards are their perceived independence from the “establishment” political left and right.

In reaction to the Panama Papers, Iglesias has called for an international tax collection agency to prevent tax evasion. Iglesias has had choice words for Spanish political elites, viewing them as the ruling “caste” that is supposedly fostering corruption and economic inequality. The Panama Papers has provided Iglesias and his party Podemos (We Can) the ideal springboard to pick up steam throughout Spain.

Similarly, Jeremy Corbyn, the Leader of the Labour Party in Great Britain, has capitalized on the release of the Panama Papers to attack the then-Prime Minister David Cameron for his involvement in offshore activities. The case that the Panama Papers brought to light did not reveal criminal action on Cameron’s part. Nevertheless, Corbyn has made sure to score points by demonstrating the purported corruption of Cameron and his Tory colleagues.

Bernie Sanders has long advocated for measures that would impede tax reduction practices. Five years ago, Sanders made his voice heard when he stood up against the U.S.-Panama Trade Promotion Agreement, where he claimed in a speech before Congress that large corporations evade $100 billion in U.S. taxes through the use of “abusive” and “illegal” offshore accounts based in Panama. Fast forward to the present, Sanders has advocated for an immediate repeal of the Panama Free Trade Agreement and has vowed to prosecute banks, corporations and individuals who hold money illegally in offshore accounts.

Although, it remains to be seen whether Corbyn, Sanders or Iglesias will make further political headway in their respective careers, they have undoubtedly used the recent Panama Papers controversy to advance their populist platforms. Politics has demonstrated that even when certain policy prescriptions are deemed to be too radical for the general public, political posturing by certain political gadflies can gradually shift the proverbial Overton Window of public opinion towards their pet policies.

 

Conclusion

It is ironic that politicians and international bureaucracies are using the Panama Papers as an excuse to impose higher burdens on the private sector when the only real revelation from the stolen documents was that politicians were the biggest users of offshore structures. And unlike private sector users, who generally utilize companies, trusts and other structures for legitimate purposes, it is far more likely that politicians were seeking to hide ill-gotten gains.

All in all, AML measures should be focused on elected officials and other figures that hold national office. In theory, public officeholders are agents of their respective political jurisdiction, thus must be held to higher standards of conduct in all spheres of their lives. It stands to reason that any individual that pursues public office must cede a certain degree of privacy.

However, AML standards that are applied to the general populace may turn out to be costly for countless individuals. Developing countries are often the forgotten man in these discussions as they do not necessarily have the luxury of having cost-effective banking services at their disposal.

The world would be better off with a vibrant system of tax competition among countries in which citizens are treated as customers and nations are incentivized to compete with each other to acquire the most productive individuals across the globe. In the end, simplified tax laws that emphasize territorial taxation through consumption taxes on all economic activity realized within a country’s borders, would be a more cost-effective manner of reducing the incentive for tax evasion and the circulation of dirty money.

Regulate virtual currencies?

Should virtual currencies be regulated and if so, how? This question has been explored extensively even before Bitcoin and other crypto-currencies emerged. It has been the subject of regulatory and legislative hearings, judicial deliberations and calls for information from national and state governments and numerous industry groups.

So far, it is a split decision. The issue, however, should be much more settled than it appears to be. Across the spectrum of virtual or digital currency businesses should, and in most cases can, be regulated in the same way as their counterparts in traditional payment transaction models.

For many years, public policy concerning the movement of money has been implemented through legislation and regulation to protect consumers, provide safety and soundness, and prevent money laundering and terrorist financing. The years of experience and multitude of debates that led to this regulation should not be ignored simply to accommodate new technologies, which in many ways allow us to perform the same old functions simply in a new way.

With virtual currencies it is important to look past the “cool” aspects of the technology and instead focus on the actual function being performed. Virtual currencies facilitate value transfer between persons – natural or legal – whether locally and globally, in the same manner and for the same reasons as fiat currencies. In fact, transferring value just like fiat currency is the very argument virtual currency advocates use in promoting adoption.

They simply point out its greater efficiency for making payment. The opportunity to prey on a consumer or finance illegal activity, however, is no different between fiat and virtual currency although the properties of certain virtual currency might make it easier, especially considering the systems have inherent anonymity or pseudo-anonymity characteristics. And, even where virtual currencies businesses are regulated, a potentially large regulatory gap exists. The customer may transfer the crypto-currency to another wallet not held with the regulated business, where the ability to have customer identification review and verification, and transaction monitoring is close to impossible.

In the U.S., the federal government determined that transferring virtual currency should be subject to regulation in the same way as transferring fiat currency. The U.S. government first laid down this principle in a 2008 plea settlement with e-gold Ltd. requiring the digital currency system to register as a money service business and seek money transmission licenses in states where such licenses were required. This position was enunciated by the government after a federal court had determined that money transmission can occur even if it does not deal in currency. That decision by the court was the key factor that lead to the plea. The 2013 guidance from FinCEN effectively ratified this position by “clarifying” that businesses transferring or exchanging virtual currency were money services businesses for purposes of the Bank Secrecy Act.

Many jurisdictions in the U.S. and outside the U.S. require either registration or licensure with statutes that are broad enough to consider any medium of exchange. It is likely in the U.S. that more states could bring these systems under regulatory control by accepting the FinCEN guidance and/or the court precedence. In other situations, where the medium of exchange is specifically defined as national currency, a simple expansion of the definition of “money” or “monetary value” or “funds” could open the way for existing rules to be applied. For example, a number of states define money in money transmission as sovereign currency, or the legal tender of a country. In the EU, “funds” are considered fiat currency. Expand “funds” or “money” to include virtual or digital currencies in which they are a digital representation of monetary value that can be used in replacement of, converted into, redeemed for, or exchanged for fiat currency; and existing regulation could apply nearly everywhere.

Two arguments are most often presented for not regulating virtual currencies or at least minimizing regulations. First, these new payment mechanisms are so unique, traditional guidelines do not apply and therefore special considerations need to be developed. This uniqueness may exist to some extent with the technology, but in terms of moving value, it is more perception than reality. In order to be in line with public policy intent, regulations should be implemented and enforced in the same manner as with “traditional” money transmitters.

Second, it is argued that enforcing regulations for these new virtual currency related businesses would stifle innovation. This argument has merit, but it has the same merit for any new ideas, not just those dealing with virtual currencies. It is always a good idea to ensure that any regulation while achieving the objectives presented by legislation be enacted in a way to reduce any adverse effect on the generation and implementation of innovative concepts. This argument is applicable across the board, not solely with virtual currencies.

This lack of regulatory control around emerging virtual currency-related businesses also creates an uneven playing field for traditional banks and money services businesses putting them at an increasing competitive disadvantage. Proper compliance involves substantial efforts to obtain licenses/approval, as well as ongoing efforts to maintain compliant systems, are plagued with time delays to market, geographic constraints and significant costs. Virtual currency-related businesses that do not adhere or are not held accountable to existing regulations obviously are not burdened with these delays, constraints or costs. Even the few virtual currency start-ups that try to follow regulatory guidelines are severely handicapped, if not entirely crippled, in their efforts to develop customers, revenue or investment when compared to less compliant virtual currency-related businesses which simply start without regulatory controls.

Not ensuring virtual currency-related businesses adhere to the same regulatory guidelines as traditional systems puts at risk the very objectives the regulations are designed to meet and the persons they are intended to protect. Persons wanting to defraud consumers or move money for illegal activity can much more easily accomplish their objectives by avoiding regulated entities and using those who make no effort to comply.

However, this is not to say that many of the current and emerging virtual currency-related businesses cannot operate, or are not already operating, within a regulatory compliant framework of money services businesses or other types of financial services companies. In fact, there are some that do. In order for a virtual currency-related business to meet these standards it must:

  • Conduct customer identification review and verification proactively on all users of their system or service.
  • Have knowledge of both counterparties to a transaction with which their system or service is involved.
  • Maintain an adequate and sufficient level of transaction monitoring; have in place processes and procedures to detect, report, and prevent illegal and illicit activity.

The market needs to take a step back, unwind from the technology, and apply what legislators and public policy makers intended. The bigger picture for application of this intent should prevail, not the details of a specific regulation. When viewing this larger picture, the question and answer become clearer. Where money and monetary value can be interpreted to include a broad national money substitute, apply existing rules. Where the definitions are narrow, simply expand them within existing law.

Grey matters

The first wave of ‘Panama Papers’ scholarship
Not surprisingly, the public availability of portions of the Panama Papers and the impact of the disclosures worldwide have attracted academic attention. Four of the first wave of academic papers are worth a look.

The Value of Offshore Secrets – Evidence from the Panama Papers
James O’Donovan, Hannes F. Wagner and Stefan Zeume (April 27, 2016)
available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2771095.

Abstract:
The authors use the data leak of the Panama Papers on April 3, 2016 to study whether and how the use of offshore vehicles affects valuation around the world. The data leak made transparent the operations of more than 214,000 shell companies incorporated in tax havens by Panama-based law firm Mossack Fonseca. The Panama Papers implicate a wide range of firms, politicians, and other individuals around the globe to have used secret offshore vehicles. Allegations include tax evasion, financing corruption, money laundering, violation of sanctions, and hiding other activities. The authors find that, around the world, the data leak erased an unprecedented risk-adjusted US$230 billion in market capitalization among 1,105 firms with exposure to the revelations of the Panama Papers. Firms with subsidiaries in Panama, the British Virgin Islands, the Bahamas, or the Seychelles – representing 90 percent of the tax havens used by Mossack Fonseca – experienced an average drop in firm value of 0.5 percent – 0.6 percent around the data leak. They also find that firms operating in perceivably corrupt countries – particularly in those where high-ranked government officials were implicated by name in the leaked data – suffered a similar decline in firm value. Further, firms operating both in Mossack Fonseca’s primary tax havens and in countries with implicated politicians experienced the largest negative abnormal returns. For instance, firms linked to Mossack Fonseca’s tax havens and operating in Iceland experienced negative abnormal returns of -1.4 percent; the data leak revealed that Iceland’s prime minister failed to disclose beneficial interest in a British Virgin Islands incorporated shell company. Overall, their estimates suggest that investors perceive the leak to destroy some of the value generated from offshore activity.

CFR comment:
Using stock market data from firms traded in 73 countries, this study looks at the impact on firm value of the April 2016 leak of the Panama Papers data. They also plan to expand the paper to include more detailed data, bringing in additional analysis of individual firms, individuals, countries, and politicians. This is a clever use of event study methodology to see whether there is an impact from large-scale data leaks. As the analysis is extended, it will get more interesting. This is a project worth following.

 

Wealth Management, Tax Evasion and Money Laundering:
The Panama Papers Case Study
Ehi Eric Esoimeme, (April 27, 2016)
available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2790543

Abstract:
Purpose: This paper aims to discuss the various anti-money laundering programs that banks are required to put in place, to mitigate the tax evasion and money laundering risks in wealth management.
Design/Methodology/Approach: This paper uses the “Panama Papers” revelations to illustrate the vulnerability of private banks to money laundering. Private banks are banks, or operational units within banks, which specialize in providing financial services to wealthy individuals. These services are often referred to as wealth management services.
Findings: This paper determined that effective implementation is the key to lifting the veil of secrecy once and for all and eradicating tax evasion. Rather than create new laws and policies, efforts should focus on supporting effective implementation, and promoting enhanced cross-border and inter-agency co-operation on tax and financial crimes.
Research Limitations: This paper will focus on one aspect of our banking system – wealth management – that may be particularly attractive to criminals who want to launder money.
Originality/Value: While most articles are focused on the money laundering/tax evasion risks posed by offshore locations, this article is focused on domestic banks that allow funds to be transferred to offshore locations.

CFR comment:
This brief paper uses examples from the Panama Papers to argue that better enforcement of existing laws and practices would have prevented the abuses identified. Compliance officers may find it useful as a source of examples for training employees.

 

Disclosure of Beneficial Ownership after the Panama Papers
Mark Fenwick & Erik P. M. Vermeulen
Lex Research Topics in Corporate Law & Economics Working Paper No. 2016-3 (May 8, 2016), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2777152

Abstract:
The publication of the so-called “Panama Papers” has focused public interest on how elaborate corporate structures and offshore tax havens can be used by politicians, celebrities and other elites to conceal their beneficial ownership of companies and obscure their personal assets. Rather than taking the Panama Papers as an indication of the need for more and stricter disclosure and reporting rules, however, this paper advocates an alternative approach. The authors begin by acknowledging that many companies are currently experiencing “disclosure and reporting fatigue,” in which the constant demand for “more” and “better” transparency and reporting is having the unintended effect of promoting indifference or evasiveness. Disclosure and reporting is widely perceived as an obligation to be fulfilled and not as an opportunity to add value to a firm.
This is confirmed by the findings of an empirical study that examines how disclosure rules operate in practice across various jurisdictions. The key takeaway of this empirical study is that – even in those jurisdictions that have a robust disclosure regime – the majority of firms engage in “grudging” or “boilerplate” compliance in which ownership and control structures are not adequately revealed in an accessible way and – perhaps more importantly – the impact of these ownership and control structures on the governance of a company are obscured.
Rather than focus on introducing more stringent and mandatory disclosure rules, the paper advocates an approach based on the current communication strategy of a minority of firms in the sample. Interestingly, a small number of firms engage in what the authors characterize as “open communication” in which information on control structures and its effect on governance are presented in a direct, accessible and highly personalized manner. Such firms seem to recognize the commercial and other strategic benefits to be gained from open communication, and the paper explores the implications of such an approach for both business and regulators.

CFR comment:
Using a sample of 2014 annual reports from 280 listed firms in 14 jurisdictions (the top 20 in each jurisdiction by market capitalization), this paper examined the disclosure of beneficial ownership information in each. Based on this analysis, it concludes that “for the vast majority of firms, we do not really know what is going on” in all types of firms (public, family-controlled, state-owned). The authors then suggest a strategy by which firms can effectively communicate beneficial ownership information in a way that is understandable and useful. They also suggest that rules-based approaches produce “an unhealthy standardization” of information that “may actually obscure control issues” and reveals little information. Both regulators considering how to handle beneficial ownership disclosure and professionals advising firms will find this paper of interest.

 

Following the Money: Lessons from the Panama Papers, Part 1: Tip of the Iceberg
Lawrence J. Trautman, (May 23, 2016)
available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2783503

Abstract:
Widely known as the “Panama Papers,” the world’s largest whistleblower case to date consists of 11.5 million documents and involves a year-long effort by the International Consortium of Investigative Journalists to expose a global pattern of crime and corruption where millions of documents capture heads of state, criminals and celebrities using secret hideaways in tax havens. Involving the scrutiny by over 400 journalists worldwide, these documents reveal the offshore holdings of at least several hundred politicians and public officials, including the prime ministers of Iceland and Pakistan, the president of Ukraine, and the king of Saudi Arabia. More than 214,000 offshore entities appear in the leak, connected to people in more than 200 countries and territories.
Since these disclosures became public, national security implications already include abrupt regime change, and probable future political instability. It appears likely that important revelations obtained from these data will continue to be forthcoming for years to come. Presented here is Part 1 of what may ultimately constitute numerous-installment coverage of this important inquiry into the illicit wealth derived from bribery, corruption, and tax evasion. This article proceeds as follows. First, disclosures regarding the treasure trove of documents from the Panama-based law firm Mossack Fonseca are reviewed. Second, is a discussion of the impact and cost of bribery and corruption to the global community. Third, the paper defines and briefly explores issues surrounding “tax evasion.” Fourth, the impact of social media and technological change on transparency is discussed. Next, a few thoughts about implications for future research are offered.

CFR comment:
This lengthy paper summarizes some of the initial impacts of the Panama Papers. Those looking for a quick guide to the story will find many references here documenting the evolution of the story. It also provides a summary guide to many of the issues raised by the Panama Papers.

 

Although not directly on the Panama Papers, four other recent papers tackle issues that relate to them.

Big Data and Tax Haven Secrecy
Arthur J. Cockfield, Florida Tax Review, Vol. 18, pp. 483-539 (2016)
available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2757268

Abstract:
While there is now significant literature in law, politics, economics, and other disciplines that examines tax havens, there is little information on what tax haven intermediaries – so-called offshore service providers – actually do to facilitate offshore evasion, international money laundering, and the financing of global terrorism. To provide insight into this secret world of tax havens, this article relies on the author’s study of big data derived from the financial data leak obtained by the International Consortium for Investigative Journalists (ICIJ). A hypothetical involving Breaking Bad’s Walter White is used to explain how offshore service providers facilitate global financial crimes. A transaction cost perspective assists in understanding the information and incentive problems revealed by the ICIJ data leak, including how tax haven secrecy enables elites in nondemocratic countries to transfer their monies for ultimate investment in stable democratic countries. The approach also emphasizes how, even in a world of perfect information, political incentives persist that thwart cooperative efforts to inhibit global financial crimes.

CFR comment:
This thorough article argues for additional measures to prevent tax avoidance and tax evasion. Although the author (a professor at Queen’s University in Canada) is highly critical of offshore financial centers, it presents a thoughtful analysis of the barriers to implementing measures to restrict OFCs. Policy makers and professionals in OFCs should read it to understand the challenges they are likely to face in the future.

 

The Relationship between Offshore Evasion and ‘Aggressive’ Tax Avoidance Arrangements: The HSBC Case
Iulia Nicolescu, Financial Regulation International (Informa Law), (March 18, 2016)
available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2757636

Abstract:
This paper critically analyses the relationship between tax evasion and ‘aggressive’ tax avoidance with a view to arguing their equivalence from a moral perspective. This is supported by factual similarities in the offshore financial sector, notably their mutual employment of confidentiality-bound trusts and other special purpose vehicles (SPVs). Taking the HSBC case as an example, the research is prompted by the recent debate surrounding the ambiguity of tax avoiding practices of major international banks and MNEs. At international level, regulatory response has translated into the OECD’s Base Erosion Profit Shifting (BEPS) Project and the Common Reporting Standard (CRS) for automatic exchange of information (AEOI). In the U.K., the introduction of a new ‘offshore tax evasion’ offence is currently being proposed by the HMRC. The paper first considers the taxonomy of tax avoidance, arguing the equivalence of ‘aggressive’ tax avoidance with evasion from a moral and regulatory perspective. The second section compares offshore evasion with aggressive tax avoidance arrangements and discusses the case of HSBC. The final section concludes with a consideration of the effectiveness of anti-evasion and avoidance measures.

CFR comment:
This paper by a researcher at the University of Warwick in the U.K. argues that “aggressive” tax avoidance is equivalent to tax evasion. This is an argument that will be welcomed by, among others, French and German tax authorities. Those who work to reduce taxes for clients would do well to familiarize themselves with the argument since it is one they will be hearing in the future from revenue authorities.

 

Italian and Swiss Voluntary Disclosure Policies: A Critical Comparative Analysis
Davide Marchesini Mascheroni,  (May 13, 2016)
available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2779811

Abstract:
The fight against offshore evasion is increasingly becoming a global current topic of fair taxation, specially following the international agreements on automatic exchange of information in tax matters entering into force in the near future. In particular, how to design a voluntary disclosure program, complementing and reinforcing one’s own tax compliance strategy, represents one of the main issues being discussed today into the international tax environment.
A growing number of internal legislators have been drafting their own rules on voluntary disclosure, trying to find a meeting point between the need to provide sufficient incentives for non-compliant taxpayers to come forward and the will not to reward a non-compliant conduct.
This article compares the key features of two targeted strategies, different from each other, adopted into the Italian and Swiss legislations and highlights the reasons behind both approaches, trying also to deliver new arguments on eventual inferences in the short term arising from the end of the era of banking secrecy.

CFR comment:
This brief paper describes and compares the Italian and Swiss approaches to voluntary disclosure programs for taxpayers. Since such programs are likely to recur, it provides useful assessments of the reasons for the two programs’ successes and missteps.

 

Bank Secrecy in Offshore Centres and Capital Flows: Does Blacklisting Matter?
Olga Balakina, Angelo D’Andrea, & Donato Masciandaro
BAFFI CAREFIN Centre Research Paper No. 2016-20 (May 1, 2016) available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2777380

Abstract:
This study analyses cross-border capital flows in order to verify the existence and direction of the effect of the soft regulation promoted by international organizations against banking secrecy which characterized the so called tax and financial heavens. This effect is called in the literature ‘stigma effect’ but both the existence and the direction of the stigma effect are far from being obvious. The international capital flows can simply neglect the relevance of the blacklisting, or worst, the attractiveness of banking secrecy can produce a race to the bottom: The desire to elude more transparent regulation can sensibly influence the capital movements. The authors test whether being included and later excluded from the FATF blacklist is an effective measure that influences countries’ cross-border capital flows. Using annual panel data for the period 1996-2014, they apply their framework to 126 countries worldwide. They find evidence that in general the stigma effect does not exist.

CFR comment:
Governments and multilateral organizations seem unable to resist blacklists as a policy tool to coerce other jurisdictions to adopt regulations that the listing governments and organizations want adopted. This paper suggests that there is little impact on capital flows from being on a blacklist. In a rational world, this ought to lead to a reduction in the use of blacklists.

 

Cables, Sharks and Servers: Technology and the Geography of the Foreign Exchange Market
Barry Eichengreen, Romain Lafarguette and Arnaud Mehl
ECB Working Paper No. 1889 (April 25, 2016) available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2769922

Abstract:
The authors analyze the impact of technology on production and trade in services, focusing on the foreign exchange market. They identify exogenous technological changes by the connection of countries to submarine fiber-optic cables used for electronic trading, but which were not laid for purposes related to the foreign exchange market. The authors estimate the impact of cable connections on the share of offshore foreign exchange transactions. Cable connections between local markets and matching servers in the major financial centers lower the fixed costs of trading currencies and increase the share of currency trades occurring onshore. At the same time, however, they attenuate the effect of standard spatial frictions such as distance, local market liquidity, and restrictive regulations that otherwise prevent transactions from moving to the major financial centers. The authors’ estimates suggest that the second effect dominates. Technology dampens the impact of spatial frictions by up to 80 percent and increases, in net terms, the share of offshore trading by 21 percentage points. Technology also has economically important implications for the distribution of foreign exchange transactions across financial centers, boosting the share in global turnover of London, the world’s largest trading venue, by as much as one-third.

CFR comment:
As a rule of thumb, anything economist Barry Eichengreen writes is worth reading. He is one of the most important analysts of money writing today. This paper, coauthored with analysts from the ECB, is a clever exploitation of data on foreign exchange transactions and the investment in undersea cables. Their results are likely to matter for understanding how markets are likely to develop for trading in RMB or euros. Well worth a read for anyone affected by foreign exchange trading.

 

Not everyone is writing about the Panama Papers or policy measures aimed at OFCs. Two other recent papers provide food for thought about key areas of international finance: foreign exchange markets and securitization.

Development Financing during a Crisis: Securitization of Future Receivables
Suhas Laxman Ketkar and Dilip Ratha
World Bank Policy Research Working Paper No. 2582 (April 2001) available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=632651

Abstract:
Market placements backed by future receivables can allow public and private sector entities in a developing country to escape the sovereign credit ceiling and raise lower-cost financing from international capital markets. If planned and executed ahead of time, such transactions can sustain external financing even during a crisis.
Mexico’s Telmex undertook the first future-flow securitization transaction in 1987. From then through 1999, the principal credit rating agencies rated more than 200 transactions totaling $47.3 billion. Studying several sources, Ketkar and Ratha draw conclusions about the rationale for using this asset class, the size of its unrealized potential, and the main constraints on its growth.
Typically the borrowing entity (the originator) sells its future product (receivable) directly or indirectly to an offshore special purpose vehicle (SPV), which issues the debt instrument. Designated international customers make their payments for the exports directly to an offshore collection account managed by a trustee. The collection agent makes principal and interest payments to investors and pays the rest to the originator. This transaction structure allows many investment-grade borrowers in developing countries to pierce the sovereign credit ceiling and get longer-term financing at significantly lower interest costs. The investment-grade rating attracts a wider group of investors. And establishing a credit history for the borrower makes it easier for it to access capital markets later, at lower costs.
This asset class is attractive for investors – especially buy-and-hold investors, such as insurance companies – because of its good credit rating and stellar performance in good and bad times. Defaults in this asset class are rare, despite frequent liquidity crises in developing countries.
Latin American issuers (Argentina, Brazil, Mexico, and Venezuela) dominate this market. Nearly half the dollar amounts raised are backed by receivables on oil and gas. Recent transactions have involved receivables on credit cards, telephones, workers’ remittances, taxes, and exports.
The potential for securing future receivables is several times the current level ($10 billion annually). The greatest potential lies outside Latin America, in Eastern Europe and Central Asia (fuel and mineral exports), the Middle East (oil), and South Asia (remittances, credit card vouchers, and telephone receivables).
One constraint on growth is the paucity of good collateral in developing countries. Crude oil may be better collateral than refined petroleum. Agricultural commodities are harder to securitize.
Another constraint: the dearth of high-quality issuers in developing countries. Securitization deals are complex, with high preparation costs and long lead times. The ideal candidates are investment-grade entities (in terms of local currency) in sub-investment-grade countries (in terms of foreign currency).
Establishing indigenous rating agencies can slash out-of-pocket costs. Developing standardized templates for certain types of securitizations might help. A master trust arrangement can reduce constraints on size. Multilateral institutions might consider providing seed money and technical assistance for contingent private credit facilities.
This paper – a product of the Economic Policy and Prospects Group – is part of a larger effort in the group to monitor capital flows to developing countries. The study was funded by the Bank’s Research Support Budget under the research project “Innovative Mechanisms for Raising Development Finance – Future-Flow Securitization.”

CFR comment:
OFCs excel at securitization. This paper’s analysis of the barriers to securitizing developing country cash flows points to opportunities – fixing these barriers would increase the availability of securitizations for businesses in developing economies. First movers in finding such solutions ought to benefit. Ready, set, go.

 

 

The EU’s democratic deficit

Following the end of World War II, Western European leaders set out to create pan-European institutions that would assure future peace and prosperity on the continent. Those goals were to be accomplished through an ever closer union among European nations. Unfortunately for the founders of modern Europe, such a union never enjoyed broad public support. Thus, even as the EU grew in power and importance, public support for further European integration ebbed away. This lack of support for the EU institutions and growing clamor for the repatriation of powers back to the nation states is at the heart of Europe’s problem with “democratic deficit.”

 

What is the “democratic deficit”?

In today’s political discourse, democracy is often understood as majoritarian decision-making. That view of democracy is problematic, for, as history shows, majorities too can be tyrannical. Majoritarian rule, therefore, needs to be constrained by separation of powers, checks and balances, constitutional guarantees, etc.

But the term “democracy” has another important meaning – the ability of the electorate to choose and replace the government through free and fair elections. The choice, however, needs to be a meaningful one. What is the point of being able to choose between two or more candidates, if none of them can effect specific policy changes? What is the point of having a vote if the real decisions-makers are unelected, unknown and unaccountable?
Over the years, EU member states have ceded a large number of policy areas or “competences” to the Byzantine bureaucracy in Brussels. Some, including trade and monetary policies, have been ceded completely, in which case elected public officials at the national level have no choice but to implement decisions made in Brussels. Some, including transport and energy policies, have been ceded partially, in which case elected public officials at the national level are limited in their ability to influence decisions made in Brussels. In both cases, the voters’ ability to effect changes of policy through their elected representatives and to hold those representatives responsible in free and fair elections is rendered meaningless.

The problem of the “democratic deficit” is compounded by two inconvenient facts. First, the nation-state remains the basic building block of international, including European, relations. The European states have been evolving separately and, often, in competition with one another for hundreds, sometimes thousands, of years. The Greeks were first unified in the 4th century BC. A relative newcomer, England was first unified over a thousand years ago.

Both have developed a set of unique institutions. The British concept of parliamentary sovereignty, for example, does not exist on the continent.

Second, a pan-European demos does not exist. For a vast majority of European peoples, being a “European” remains a geographical, not a political, distinction. Thus, while European travelers to the United States may say that they are from “Europe,” in Europe they almost always refer to themselves as being from Britain, France, Germany, etc. That is likely to continue, because most people’s identities are not formed by attachment to abstract principles, such as liberty, equality and fraternity, but by cultural, religious, historical and linguistic ties.

Bearing those points in mind, it is crucial to realize that the EU is undemocratic not by accident, but by design. The proponents of “an ever closer union” understand that there is no public support for anything resembling the United States of Europe. Jean-Claude Juncker, the current president of the EU Commission, summed up the decision-making process in Brussels thusly, “We decide on something, leave it lying around and wait and see what happens. If no one kicks up a fuss, because most people don’t understand what has been decided, we continue step by step until there is no turning back.”

Similarly, Valery Giscard d’Estaing, the French former president who presided over the drafting of the European Constitution in the early 2000s, said that “public opinion will be led to accept, without realizing it, provisions that nobody dared to present directly.” When the French and the Dutch rebelled and voted against the EU Constitution in their 2005 referenda, they were ignored and the EU Constitution, relabeled as the Lisbon Treaty, was adopted nevertheless.

Is it any surprise, therefore, that while the EU Commission and the EU Parliament grew in power and importance, the European peoples’ interest and participation in EU institutions have steadily declined? When the first election for the European Parliament was held in 1979, for example, 62 percent of eligible voters cast their vote. In every subsequent election, voter turnout has declined. It reached a nadir, 42.61 percent, in 2014.

 

Rise of populist parties

Unwittingly, the EU has become a driving force behind the rise of populist parties in Europe. These parties come from across the political spectrum – from the far left to the far right. Often, they have nothing in common, except for their opposition to further European integration and a desire, at the very minimum, to repatriate some of the EU powers back to nation states. They are present in all EU countries and hold, remarkably, one third of all seats in the European Parliament.

While some of these parties are more respectable than others, the EU often paints them with the same brush. Thus, people who happen to believe that the EU is a threat to liberal values, such as democratic accountability, are often treated with as much disdain as people who happen to believe in authoritarianism.

Consider the former vice president of the EU Commission, Margot Wallstrom. While visiting the Czech city of Terezin, which used to be a site of a Nazi concentration camp during World War II, Wallstrom linked the rejection of the EU Constitution to the return of the Holocaust. As she said, “They [opponents of the EU Constitution] want the European Union to go back to the old purely intergovernmental way of doing things. I say those people should come to Terezin and see where that old road leads.”

So, what are the reasons for the rise of populism in Europe? First, many Europeans, but especially the citizens of ancient and well-functioning democracies such as Denmark, Holland and Great Britain, resent the democratic deficit. They feel that far too many decisions impacting their lives are being made in Brussels by people who are unelected, unknown and unaccountable. This feeling is not as strong in the East, where democratic accountability is recent and deeply imperfect, but it is growing in countries such as the Czech Republic and Hungary.

Second, many Europeans see the EU as having failed in some of its core competences, including monetary and immigration policies. The westerners do not wish to continue “subsidizing” the inefficient south, while the easterners reject immigration from Africa and the Middle East. Calls for “solidarity” between European countries are resented and, increasingly, rejected. In the absence of a pan-European demos, citizens of Germany cannot understand why they should pay to bail out the Greeks and citizens of Hungary cannot understand why they should take in some of the non-EU immigrants who were on their way to Germany.

Third, many Europeans feel a general sense of malaise and decline. To be fair, the blame for Europe’s woes does not rest with the EU alone. The national governments are also to blame. A growing number of Europeans are frustrated by the failure of the EU establishment and of the mainstream political parties at home to address serious problems, including low growth and high unemployment, and increasing immigration and rising debt. By voting for populist parties, they are lashing out against the “establishment.”

deficit

Is EU reform possible?

The piecemeal amalgamation of twenty-eight distinct cultures, polities, economies, and histories may well have continued in spite of a growing public distrust of the EU institutions, had the EU lived up to its own rhetoric and delivered prosperity and stability to the European continent. Regrettably, it has failed to deliver either.

Many thoughtful commentators have recognized the need for EU reforms. Many believe that such reform should include at least some repatriation of EU powers back to the nation states. Unfortunately, past experience with EU reform does not augur well for the future.
In 2000, for example, the Lisbon Agenda committed the EU to becoming “the most competitive and dynamic knowledge-based economy in the world capable of sustainable economic growth with more and better jobs and greater social cohesion” by 2010. Nothing was done to undo decades of EU over-regulation and the Lisbon Agenda was declared a failure in 2009.

The Lisbon Agenda was replaced by a reform program called Europe 2020. “In a changing world,” the former EU Commission President Jose Manuel Barroso wrote in its preface in 2010, “we want the EU to become a smart, sustainable and inclusive economy. These three mutually reinforcing priorities should help the EU and the Member States deliver high levels of employment, productivity and social cohesion.” With four years to go, there is still no sign of “high levels of employment, productivity and social cohesion” or reforms that would bring that happy state of Europe about.

Amazingly, the EU has shown itself incapable of serious reform even when faced with possible disintegration. Former Prime Minister David Cameron’s desire to “fundamentally change” Great Britain’s relationship with the EU met with stubborn refusal in Brussels to consider anything but cosmetic modifications to existing treaties. Considering that the EU refused to reform with the British referendum on EU membership hanging, so to speak, over its head, what’s the likelihood that the EU will reform now that the U.K. has voted to exit the EU?

The real problem for those who wish to see EU reforms is that the EU establishment has a strong incentive to centralize, rather than decentralize decision-making in Brussels. Quite aside from the ideological commitment of the EU bureaucrats to the creation of a United States of Europe, which they may or may not believe in, centralization of power is in their interest. It increases their power and resources.

In their desire to empower themselves, the EU bureaucrats are helped by the Court of Justice of the European Union, which interprets EU laws and regulations in a way that maximizes the centralization of decision-making in Brussels. The ECJ has been a called the “driving force of both market integration and political integration” and is increasingly criticized for not simply interpreting the law, but fulfilling a political program of an “ever closer union.” That is a far cry from the common understanding of the role of the judiciary in a free society – to impartially interpret the law rather than drive the process of political change.

 

Europe’s greatest achievement?

It is often claimed that the EU expansion into ex-communist countries was one of its greatest accomplishments. As one author notes, “the prospect of European integration created pressure to reform Eastern European economies and strengthen the rule of law.”

That is partially true. In Slovakia, for example, the prospect of the EU membership certainly played a part in defeating an authoritarian and protectionist government, and replacing it with one committed to democratic and economic reforms. In the economically free Estonia, on the other hand, EU membership meant re-imposition of tariffs and a consequent decline in economic freedom.

Still, there is no denying that all ex-communist members of the EU enjoy a higher degree of political freedom than non-EU ex-communist countries, such as Serbia, Montenegro, Macedonia and Ukraine, let alone the politically unfree Belarus. Electoral shenanigans are rare and governments come and go in accordance with the will of the people. That is, after all, why they were admitted into the EU in the first place.

But, when it comes to the creation of “liberal democracy,” the picture is, at best, mixed. In general, the rule of law has improved and corruption declined in ex-communist countries during the EU accession talks. Unfortunately, these salutary trends have stalled since the ex-communist countries entered the EU. Indeed, some evidence suggests that disbursement of Structural and Cohesion funds has exacerbated ex-communist countries’ problem with corruption.

Last, but not least, consider the impact of EU regulations on ex-communist countries. Productivity across the EU differs widely. In 2015, for example, GDP per capita in Luxembourg, the EU’s richest state, was 14.9 times higher than that in Bulgaria, the EU’s poorest state. In contrast, GDP per capita in North Dakota, which is America’s richest state, is only slightly more than 2.1 times higher than that in Mississippi, America’s poorest state.

By definition, regulations emanating from Brussels must be applied equally throughout the EU. Unavoidably, regulations that add to the cost of production have a more deleterious effect on less productive ex-communist countries than on more productive Western European nations. Eastern countries are growing increasingly resentful of regulations, which are often made to enhance the already high standards that exist in the West and which are often meant to protect the interests of Western producers.

 

Conclusion

I started my career as a believer in the European integration process. Over time, I started to see the costs as well as the benefits of the EU. Later, I have come to believe that the costs of EU membership far outweigh its benefits. While this was a gradual process, one event convinced me that the EU has become pernicious and must be stopped. That event was the EU’s handling of the French and Dutch referenda on the EU Constitution in 2005.

After the people of France and Holland rejected it in their respective referenda, the EU establishment relabeled the EU Constitution as the Lisbon Treaty and adopted it nonetheless. This act of supreme arrogance convinced me that the EU establishment held the people of Europe in utter contempt and that it would stop at nothing in order to pursue its agenda of an “ever closer union.” It showed me that the EU bureaucrats see themselves as a class of wise experts who know how society ought to be organized. The memories of my childhood behind the Iron Curtain flooded back.

And that brings me to my final point: does an “enlightened” class of technocrats have a right to make people free or happy or, simply, better off? There is no guarantee that, if the EU implodes, the people of Europe will make the “right” choices. I can just as well imagine Prime Minister Boris Johnson’s Great Britain becoming a global free trade superpower and President Marine Le Pen’s France hunkering down behind a wall of protective tariffs. But, I would rather see individual nation states make “wrong” choices than to see Europe as a whole suffer a massive systemic failure.

And I fear that Europe is on the road to a systemic failure. Large parts of Europe suffer from low growth, high unemployment, rising deficits and stratospheric debts. To make matters worse, tensions between the people of Europe are rising. Some feel that they are being forced to adopt policies they do not like, while others feel that they have to subsidize people with whom they have nothing in common. The EU has become a large pressure cooker with no safety valve. The EU could turn down the heat by repatriating many of its competences back to the nation states. That, alas, is not in its nature. As such, the EU risks blowing up in an uncontrolled way. If that happens, everyone will lose.

Trustees and divorce

Recent developments in the case law of onshore jurisdictions like England and Hong Kong have only highlighted for trustees the very difficult position they can find themselves in when a beneficiary or settlor is involved in a divorce.

Divorcing beneficiaries have long been problematic for on and offshore trustees but it is the so-called “big money” divorces exemplified by cases like the Poon1 divorce in Hong Kong and Charman2  in England that grab the headlines, publicized in the media rightly or wrongly, either as one spouse going to extraordinary lengths to avoid their financial obligations or where one of the spouses is making what seems to us lesser mortals to be outrageous financial demands.

So what would the position be in the Cayman Islands if a trustee here was pitched into the middle of a divorce involving beneficiaries? So far, there has only been one reported case here on trusts and divorce, the case of Re B Trust also involving a Hong Kong-based family. The settlor and his wife were divorcing; both were beneficiaries, along with their three children aged 19, 17 and 12, of a Cayman Islands STAR trust.

Not surprisingly perhaps bearing in mind the nature of a STAR trust, the trust in issue had a wide exclusive jurisdiction clause in favor of the Cayman Islands courts which was according to the judge, “emphatic” in its terms. This was not a discretionary trust. The fund was split into two; one part holding ‘controlled companies’ over which a ‘designated beneficiary’, in this case the wife, had investment control and the other, the ‘distribution fund’, over which the trustee had power to apply the income and capital for the benefit of the beneficiaries.

The asset holding structure was this: The trustee held all of the shares in a Cayman company which in turn held all the shares of another Cayman company plus an investment portfolio held in Singapore. Both the parent and subsidiary were “controlled companies.”

The subsidiary held all but one of the shares in a Hong Kong company which in turn held a residential property in Hong Kong which housed the wife and children and represented the greater share of the value of the underlying assets in the trust. The trustee held the other share in the Hong Kong company subject to the trusts of the distribution fund.

The wife applied to vary the trust so that 40 percent of the shares in the parent and Hong Kong companies were divided between husband and wife and the remaining 60 percent of each remain in the trust for the benefit of their children. The Hong Kong court ordered the trustee to be joined as a party.

The trustee did not submit to the jurisdiction but instead, the couple’s eldest child, who was also an enforcer of the trust, applied in Hong Kong to be joined to the variation application. The trustee, perhaps not surprisingly, made an application to court in the Cayman Islands for directions.

The court directed the trustee not to submit to the jurisdiction holding that the trustee’s primary duty is to administer the trust according to its terms unless otherwise ordered by the court in the Cayman Islands. Submitting to the jurisdiction would risk putting the trustee in a position where its duty to the beneficiaries would conflict with its duty to comply with an order of the overseas court. The overseas court order would be made primarily with the fair division of marital assets in mind, not the wider interests of the beneficiaries or beneficial class.

weddingThe judge held that Cayman’s “firewall” provisions reflect what he described as the “overarching rules” consistent with the inclusion of an express governing law and exclusive jurisdiction clause, that in those circumstances, a trust governed by the laws of the Cayman Islands can only be varied by a Cayman Islands court in accordance with Cayman Islands law.

Now, this case on its facts is regarded by many as providing the clearest possible guidance to Cayman Islands trustees who are caught in this conundrum, certainly as far as submitting to the jurisdiction of an overseas divorce court is concerned.

I would however exhort trustees to look at the particular facts of each individual case before forming a view. The court in Re B found that a trustee must “jealously guard” its independence.  Although the court directed that the trustee should not submit to the jurisdiction and that it would not enforce any variation order that the Hong Kong court made against the trustee, it did also find that the trustee should not set its face forever against whatever order the matrimonial court may hand down at the end of the divorce. The judge cited with approval the “impeccable attitude” of the trustee in A v A v St George’s Trustees in considering the court’s order in light of what it thinks is the right decision for the beneficiaries as a whole.

The court here may therefore have been more supportive of a decision by the trustee to assist the husband meet a financial order, in the same way as the Jersey Royal Court in the most recent stage in the Poon divorce involving the trustees of the Otto Poon Family Trust.

The court there in an initial directions application3, endorsed the trustee’s decision to submit to the jurisdiction of the Hong Kong court and participate in the divorce proceedings there, finding that given the nature and location of the trust assets, it was in the best interests of the beneficiaries of the trust for the trustee to do so. Most of the trust assets were located in Hong Kong and for the most part, the trading companies lower down the structure were run from there, too. The trustee was therefore in a cleft stick – it could stay out of the divorce and refuse to comply with any order the court made – but it could not prevent enforcement against the trust assets located in Hong Kong. The trustee therefore decided that it was in the best interests of the beneficiaries for it to appear in the Hong Kong court to try to protect their interests and the Jersey Royal Court approved that course of action.

Subsequently, in a second application for directions4 after the divorce was concluded, the Jersey Royal Court blessed the trustee’s decision to assist the settlor in meeting the financial order made on his divorce. The court also blessed the trustee’s decision to exclude the wife as a beneficiary after receiving substantial payments from the trust.

The contrasting decisions of the Hong Kong and Jersey courts highlight one of the thorny issues which the trustee has to grapple with in this situation. The Hong Kong court criticized the trustee for the position it took in the divorce as appearing to be partisan in favor of the husband.

When a trustee tries to protect the trust assets for the beneficiaries, the trustee will inevitably find itself in an opposing position to the spouse who argues the trust assets should be a resource available on the division of marital wealth on divorce. The trustee’s position is not necessarily wrong or partisan but it could be perceived by the matrimonial court and the opposing spouse, as siding with the other spouse.

This is another example of the inherent tension between the family courts trying to achieve justice between two divorcing parties, and the trustee’s very different focus in trying to balance the wider interests of all of the beneficiaries. This should not, however, prevent the trustee from considering the position fully and seeking directions from its home court at the appropriate juncture. However, when a trustee tries to protect the trust assets for the benefit of the beneficiaries, who may or may not include both husband and wife but will nevertheless include other people, the trustee may find itself in a position opposing the spouse who argues that the trust should be varied or its assets should be a resource available on the division of marital wealth on divorce.

In summary, on divorce in England and in Hong Kong, it is clear from recent cases that both husband and wife will share the wealth generated during the marriage, even if some or most of it is held in trust. The matrimonial court will undertake an inquisitorial role into the couple’s finances and will calculate the division of their wealth from a starting point of equality5, subject to certain special circumstances which are outside the parameters of this article.

Trustees therefore have to take great care if they find themselves unwittingly pitched in to a divorce involving beneficiaries. They should consider carefully with their advisors the terms on which the trust was settled and by whom, who the beneficiaries are, the nature of the assets held in the trust and where they are located. All are factors to be taken into account before the trustee decides what steps to take next in the best interests of the beneficiaries.

 

ENDNOTES

  1. Kan Lai Kwan v Poon Lok to Otto, FACV 20 and 21/2013
  2. [2006] 1 WLR 1053
  3. [2011] JRC 167
  4. [2014] JRC 254A
  5. White v White [2000] UKHL 54