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

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

Carson Wen

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Harsh reality: IFCs on the back foot

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

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

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

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

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

Positive futures for IFCs

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

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

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

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

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

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

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

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

Need for a nurturing domestic IFC environment

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

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

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

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

Lotta Moberg

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

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

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

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

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

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

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

Quarterly Review

CFR

Premier McLaughlin leads new 13-member coalition government

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

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

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

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

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

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

Cayman beneficial ownership laws take effect

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

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

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

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

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

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

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

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

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

Company formations bounce back

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

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

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

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

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

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

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

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

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

Report: BVI firms hold $1.5T in assets

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

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

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

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

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

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

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

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

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

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

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

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

OECD tax chief: Cayman must get the narrative right

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

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

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

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

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

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

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

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

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

Offshore centers must play long game

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

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

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

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

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

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

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

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

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

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

The offshore future is bright

CFR

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

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

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

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

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

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

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

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

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

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

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

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

Putting Venezuela on the path to prosperity

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

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

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

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

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

Chile as a model for inspiration

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

Enter the Chilean model.

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

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

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

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

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

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

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

And what was the result?

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

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

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

Reforms that Venezuela must make

So what can Venezuela learn from this experience?

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

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

They can do so by pursuing the following landmark reforms:

Eliminate price controls

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

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

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

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

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

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

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

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

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

Eliminate capital and currency controls

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

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

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

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

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

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

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

Constitutional reform

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

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

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

Privatization of the oil industry

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

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

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

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

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

Conclusion

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

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

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

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

Known to me

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

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

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

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

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

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

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

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

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

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

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

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

Taxation in the global economy: Balancing competitiveness and solvency

Figure 2

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

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

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

Table 1

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

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

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

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

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

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

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

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

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

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

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

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

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

Figure 1
Figure 2

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

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

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

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

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

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

ENDNOTES

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

Fake economic news

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

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

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

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

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

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

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

Whither free trade?

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

Whatever happened to free trade?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Whither free trade?

And so, we return to the original question.

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

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

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

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

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

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

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

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

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

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

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

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

Entrepreneurial transfer pricing – embracing the arm’s length principle

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

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

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

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

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

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

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

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

Responding to BEPS – keep calm and fight against bad regulations

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

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

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

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

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

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

Antigua and Dominica make changes to diplomatic passports as proper regulation of citizenship-by-investment continues to be an issue for the Caribbean

In 2017, Antigua and Barbuda and Dominica have made changes to the operation of diplomatic passports while the St. Kitts government continues to debate proper regulation of Citizenship-by-Investment (CBI). As the popularity of CBI has continued, so has the criticism of the vetting, transparency, and governance issues arising out of the programs.

Diplomatic passports

Although the granting of diplomatic passports is a separate activity/product from CBI, in fact the two have linked because the problems associated with the operation of diplomatic passports coincide with the governments that have CBI.

Antigua and Barbuda

On March 1, 2017, Gaston Brown, the prime minister of Antigua and Barbuda, announced that his cabinet is implementing a new policy on diplomatic representation and accreditation.

The new policy is based on recommendations prepared by Sir Ronald Sanders, ambassador of Antigua and Barbuda to the U.S.

The new procedures provide enhanced integrity and standing of diplomatic and other passports by requiring more rigorous appointment procedures, including expanded due diligence and monitoring practices.

On February 7, 2017, the announcement by the Antigua and Barbuda cabinet stated that in March 2017, when new electronic passports, containing biometric data, would be ready for use, the government would recall all existing diplomatic and official passports, except those held by (i) the governor-general and spouse, (ii) the prime minister and spouse, (iii) ministers of the government and spouses, (iv) diplomats accredited by formal government to other states and international and regional organizations, and their spouses and dependent children.

Thereafter, the government will issue and monitor diplomatic and official passports in accordance with the following guidelines: categories of entitlement for diplomatic passports (e.g., governor general, prime minister, cabinet ministers, president of Senate, speaker of the House of Representatives, ambassadors, and ambassadors-at-large or special envoys); and categories of entitlement for official passports (e.g., members of the Senate and the House of Representatives, senior public servants, including permanent secretaries).

Appointment of non-national ambassadors-at-large, special envoys and honorary consuls. They will be granted on a limited basis to increase the global reach of the state. The cabinet must appoint non-national ambassadors-at-large, special envoys and honorary consuls only in circumstances where such appointments will further the goals of the state or bring added value to Antigua and Barbuda’s international or bilateral relationship with countries. To manage the risks associated with these appointments, the appointment will be for a maximum of two years, subject to renewal upon satisfactory performance.

Non-national persons considered for appoints as ambassadors-at-large, special envoys and honorary consuls must: (a) be of good reputation and proven competence; (b) not have any criminal record; (c) possess the skills necessary to function in the designated role; and (d) submit to rigorous and satisfactory due diligence checks.

Applicants for the above-three positions must submit all necessary information and documentation for enhanced due diligence process; provide an outline of planned activities for their task, emphasizing their capacity to bring benefits to Antigua and Barbuda; and deliver annual reports on the progress made including recommendations for improvements.

Applicants for these three positions must provide: police certificates from countries of residence and birth, and declarations on source of funds and disclosure of business activities.
The government will evaluate non-national ambassadors-at-large, special envoys and honorary consuls on a yearly basis to determine effectiveness of representation. If an appointee envoy does not fulfill the goals for which his/her appointment was made and is judged not to have brought any added value to the state, the government must terminate the appointment.

A review committee will be appointed to determine the performance, including any risks to the state’s reputation or otherwise, by non-nationals appointed as ambassadors-at-large, special envoys and honorary consuls. The committee must be non-political and will compromise five senior persons drawn from the existing public service (or retired persons with relevant experience), including law enforcement agencies, and will make recommendations to the cabinet on the continuance or termination of the appointments.

The appointments of all diplomats, including nationals, will be ended should they be found by a court to have committed a serious crime or should it be established that they have abused their diplomatic status to infringe the laws of Antigua and Barbuda or any state abroad.

With effect from the implementation of its new electronic passports, in March 2017, or at the effective date, the government will provide a list of all holders of Antigua and Barbuda diplomatic and official passports to those countries with which it has formal diplomatic relations.

On January 27, 2017, Xiao Jianhua, a 45-year old China-born billionaire who is a Canadian citizen and an Antiguan and Barbudan ambassador, was taken in a wheelchair from a luxury Hong Kong hotel with his head covered and eventually brought to China, apparently to cooperate in a corruption investigation.

Dominica

On January 1, 2017, a CBS 60 Minutes program on “Citizenship by Investment” or CBI by several Caribbean islands, including Dominica, featured alleged abuses in issuing diplomatic passports, including the fact that several of Dominican diplomats have been arrested or are persons of ill repute. Critics called for the enactment of a Foreign Service Act in Parliament to govern the appointment of diplomats and others in Dominica’s diplomatic service and the appointment of a Commission of Inquiry, presided over by a distinguished Caribbean jurist to fully and comprehensively audit and investigate the CBI program and diplomatic appointments in controversy and report its findings to the Dominican public. One critic, Gabriel J. Christian, a Dominican and attorney in the Washington, D.C. area, observed that the Canadian government has imposed visa restrictions on Dominica after some 66 Chinese bearing Dominica passports were intercepted in Canada in 1999. He also alleged that news about one of Dominica’s diplomat appointees Macau based Lap Seng’s (Mr. Wu) involvement in illegal activity was aired on ABC News in 1997.

Another critic referred to the arrest and return to Iran on January 16, 2017 of Dominican diplomat, Alireza Zibahalat Monfared. Monfared has been accused of involvement in a sanctions-busting scheme (U.S. and U.S. sanctions against Iran oil industry) in which he worked closely with another Iranian who was sentenced to death last year for embezzling the Iranian government of some $2.8 billion. Monfared allegedly participated in a group helping Iran to evade UN and U.S. sanctions.

According to Christian, the Commission of Inquiry should report on: the numbers of passports issued under the program from inception; the names of all passport agents and full disclosure of their contracts of service; a complete audit of monies earned under the current administration from the passport/CBI program and the appointment of diplomats; the location of all monies earned and the manner of expenditure of such monies; an audit of all diplomatic positions granted, public disclosure of the names of all persons given diplomatic passports, and whether any monies were paid to the government or its agents/assigns for such diplomatic passports or positions; government officers, ministers and agents should give testimony under oath; the parliamentary opposition must have a member on the five person commission and the commission should include a member of the Dominican government, a local non-partisan professional and a qualified forensic audit from a Commonwealth country or the U.S.; and the Commission of Inquiry should be held in public, and in camera, in the Dominican parliament.

On February 27, 2017, Dominica’s Prime Minister Roosevelt Skerrit expressed his regret “at the unfortunate turn of events with respect to a few persons holding diplomatic passports becoming persons of interest to foreign countries and external security organizations” and acknowledged that such incidents have shown the need for improvement. Skerrit accused the opposition of conducting a “concerted and orchestrated campaign against the citizenship by investment program” which, he said, led to “incidents of looting, burning and other forms of vandalism, instigated by irresponsible politicians.”

Mr. Skerrit said the interim policy would be as follows:

  • All non-nationals under consideration for diplomatic and consular appointments will undergo the same due diligence requirements as persons applying for citizenship under the CBI program of Dominica.
  • A prospective appointee must meet and fulfill the requirements of the Dominican government and also must be approved by an internationally rated and recognized global security agency that would conduct the requisite due diligence exercise.
  • A prospective appointee must not have a criminal record, be of good reputation and proven competence, and possess the requisite skills required to operate in the designated role.
  • Where applicable, declarations must be made on sources of funds and disclosure of business activities of the proposed appointees.
  • All future consular and diplomatic appointments shall be for a period of no more than three years at any one appointment.
  • The Dominican government will undergo a more rigorous monitoring of all appointees to  ensure that these persons are doing an effective job for the country and that they continue to be held in high regard by their peers and in the country in which they are representing Dominica’s interests.

Skerrit’s announcement is in response to the cascading criticism and the call for a Commission of Inquiry. It remains to be seen whether his announcement will be sufficient to squelch the growing criticism.

Citizenship-by-Investment developments in St. Kitts concern vetting issues

On May 23, 2017, Labour parliamentarian Konris Maynard was ordered to leave parliament on the heels of a debate between the Speaker of the National Assembly Michael Perkins and opposition leader, former prime minister Denzil Douglas over comments Douglas made about a certain Chinese economic citizen of the federation. The speaker had told Maynard to sit down when he tried to make a point of order during a presentation by Prime Minister Timothy Harris.

Following a statement by China suggesting that CBI recipient, Chinese national Ren Biao, had become a citizen of St. Kitts by using illicitly obtained funds, P.M. Harris said that the government is hoping it will be able to strengthen other components of the economy significantly enough over a period of time so that it can phase out the country’s CBI. He made the observation while explaining his government’s efforts to ensure that the CBI program does not attract tainted funds.

On May 9, 2017, Harris, who is accused of harboring fugitive Ren, said he inherited a bad situation from the prior Douglas administration. Harris said the Douglas administration granted Ren citizenship even though Interpol informed the prior administration of Ren’s pending arrival in St. Kitts and Nevis in July 2014. Harris observed that the passports in question did not have the country of origin field, despite earlier warnings from the U.S. government.

In March, Harris stated records provided by the Canadian bank Note Company showed that some 15,197 regular passports, 91 diplomatic and 39 official passports were issued without the country of birth field by the Douglas administration. Harris said his administration has decided to deactivate all passports issued by the former government without the country.

In 2014, Canada revoked the visa waiver that holders of St Kitts and Nevis passports, citing concerns about the issue of passports and identity management practices with the CBI program.

Analysis

The Xiao disappearance also calls attention to the issue of extradition and alternatives and their interaction with international human rights as well as the need for better regulation of both CBI and diplomatic passports. In this regard on September 6, 2016, at the G20 summit in Hangzhou a resolution provides for the Chinese to start an institute about anti-corruption and the need for other countries to cooperate in returning persons suspected of corruption and deny their entry into their countries. The G20 has committed to continue the G20 Denial of Entry Experts Network. In this regard, consistent with national legal systems, the G20 will work on cross-border cooperation and information sharing between law enforcement and anti-corruption agencies and judicial authorities. Increasingly, the G20 and international organizations are likely to increase their demands for better regulation of CBI programs.

Assuming CARICOM members want to preserve as much of their sovereignty as possible, and considering the implications for CARICOM in the context of the single market, CARICOM itself should act to require better regulation of both diplomatic passports and CBI. Failure of the countries with CBI programs and CARICOM to regulate is likely to result in increased pressure from the G7, G20, OECD, and countries, such as China, to act or face potential countermeasures.

The deteriorating investment climate in South Africa

In 1994 South Africa, led by its iconic first democratic president Nelson Mandela, was the darling of the world. Investors flocked to the newly free country.

It is now 23 years later. And it is not looking good. Data from the South African Reserve Bank shows that foreign direct investment to South Africa reached a record level of ZAR 80.1 billion in 2013, declined somewhat to ZAR 62.6 billion in 2014, and then plummeted to ZAR 22.6 billion in 2015. After a brief and slight recovery by 38 percent in 2016, prospects for 2017 are bleak.

Transparency International’s 2013 global Corruption Perception Index shows that South Africa has dropped 34 places since 2001, with half the decline of 17 places occurring since 2009. South Africa is currently ranked at number 72 out of 175 countries and heading downwards.

Conventional wisdom has it that the South African government has been “captured” by a family of extremely wealthy Indian businessmen, the Guptas, who have been accused of controlling even the appointment of cabinet ministers.

In March 2017, President Zuma dismissed Finance Minister Pravin Gordhan, generally regarded as a prudent and thrifty finance minister, and replaced him with a Zuma (or Gupta) loyalist. This caused panic in the markets. Rating agencies Fitch and Standard and Poor downgraded South Africa’s sovereign credit rating to junk status.

In the latest quarter, the economy posted a negative growth rate, effectively constituting a recession.

How has it come to this?

The meltdown has been years in the making

For instance, compare South Africa’s performance since 1994, when all was meant to change for the better, with a selection of average peers selected purely on the basis of per capita GDP (Costa Rica, Algeria, Serbia, Macedonia, Columbia, Mongolia, Tunisia, Ecuador, Dominican Republic, China, Jordan, Peru, Sri Lanka and Albania): Per capita growth in this peer group is more than three times that of South Africa, and average unemployment less than half. And these are a random selection, not top-performers.

There are a number of individual items in the World Economic Forum’s Global Competitiveness Report 20162017 where South Africa’s ranking is worse than 130 out of 138 countries rated. These include:

  • Business costs of crime and violence: 133
  • Quality of education system: 134
  • Quality of math and science education: 138
  • Cooperation in labour-employer relations: 138
  • Hiring and firing practices: 135
  • Flexibility of wage determination: 135

South Africa’s investment climate is becoming progressively less investor-friendly. The following figures from the Fraser Institute’s Economic Freedom of the World Index, that measures economic freedom by country, show the movement of the measurement of South Africa’s economic freedom since 1970. (See chart right)

In the years leading up to 1995, the economic system was not free. The high-water mark of freedom was in 2000, when South Africa scored 7.09 (compared to countries like Singapore, Hong Kong and New Zealand at just below 9 out of 10). But since 2000, South Africa’s rating has gradually declined from 7.09 to where it stands today, at 6.64.

Clearly and significantly South Africa is moving in the wrong direction. Its economic freedom ranking in the world (out of 159 countries today) declined from 42 in 2000, to 71 in 2005, to 87 in 2010, to 93 in 2013, to where it is now, in 105th place.

My view is that South Africa’s particularly poor economic showing is due to the fact that, instead of building a free economy since 1994, it has nurtured a culture of rent-seeking – that is, set up structures enabling citizens to get benefits from the system without giving commensurate production in return. That has unfortunately had a devastating effect on the investment climate by undermining productivity of the workforce.

Nothing illustrates this as graphically as the phenomenon of welfare payments. By law, the South African government has since the advent of democracy in 1994 progressively paid increasing amounts by way of social welfare grants to the unemployed.

In its May 2016 report “South Africa: A new growth strategy”, the South African Institute of Race Relations (SAIRR), a think-tank, tellingly observed: “… the number of people on social grants now exceeds the number of people in employment. In 2001, before the major roll out of child support grants occurred, there were 312 employed people for every 100 on social grants. Now there are only 86 people with jobs for every 100 people on social grants.”

In a 2014 opinion piece, Johann Redelinghuys, a partner at international leadership consulting firm Heidrick & Struggles, pointed out that: “By 2012, according to Frans Cronje of the Institute of Race Relations – quoting from his publication ‘Our next ten years’ – a number of black households were saying that welfare is almost as important as employment. This would suggest that we may be approaching the point seen in some socialist economies where the comforts of welfare payments may make it less attractive to go out and find a job.”

An obvious litmus test for the investment climate of a country is its level of entrepreneurial activity. SA fails this test hands-down. A comparison of the percentages of the population intending to start a business in South Africa with the other African countries cited in the Global Entrepreneurship Monitor 2016/17 Global Report (GEM Report), shows that 49.5 percent of the population in those countries intend starting a business. In South Africa the figure is 10.1 percent.

South Africa’s welfare-state mentality of dependency and entitlement undoubtedly has a role to play in this unimpressive outcome. There are about 17 million welfare recipients in South Africa – about 30 per cent of the population. We are talking here of a massive injection of cash for no productive work in return. South Africa spends $396.27 per capita per year on welfare. Burkina Faso spends $20.35 per person per year and Uganda, recently named the most entrepreneurial country in the world, a puny $11.10. These figures are typical in Africa, and so low that clearly there is strong motivation to work or start a business in those countries.

The inference is irresistible that the helping hand of government has helped douse the entrepreneurial fire in South Africa. That hampers wealth creation and dampens consumer demand, which is damaging to investment prospects.

According to the South African national budget for 2017/18, welfare comprises about 11.5 per cent and free government housing 12.5 per cent of total expenses. Public-service salaries and remuneration amount to 35 per cent of the budget. Between 2000 and 2012, a quiet, insidious revolution took place in South Africa, in that unproductive government employment rose by approximately 46 per cent, while private-sector employment barely increased. The ratio of private to government workers declined from 5.5:1 to 3.9:1 over this period. While private-sector employment stagnated, government employment increased by 850,000 jobs.

All these unproductive, rent-seeking expenses have helped push South Africa’s government spending to about 32 percent of GDP. It should be about 20 percent in order to compete with its most successful peers in GDP per capita terms – such as China, Peru and Sri Lanka – whose average per capita income growth is more than seven times that of South Africa, and unemployment more than five times lower. Labour law must be added to this mix.

Compulsory cost increases due to minimum wages, strikes and union negotiations depress the ability of the economy to absorb labour. This means that employment growth does no longer keeps pace with whatever economic growth may occur. After the Labour Relations Act of 1956 became applicable to black workers in 1979, private, non-agricultural employment started declining relative to growth of GDP. In other words, private-sector labour-absorption capacity suffered a near-fatal blow from which South Africa has never recovered.

Under the labor law, employment, once obtained, is not easily lost on account of low productivity. There are difficult procedures for employers to follow in order to dismiss employees for poor performance. In addition, strike law encourages work stoppages in order to get pay increases, which are typically not accompanied by higher productivity.

As elsewhere the world, trade union density retards employment growth. In the graph below, the block to the left of the vertical axis expresses union density, defined as a percentage of the economically active population. The right-hand side of the vertical axis shows the formal employment growth or decline. It is uncanny how the two curves run in parallel.

In 2011, Adcorp (a labor brokerage) reported that since the introduction of the new Labour Relations Act in 1996, after-inflation wages had increased by 28.8 per cent, nearly triple the increase in the preceding 25 years. Per unit of productivity, real wages increased in that period at an average annual rate of 7.6 per cent, or 200 per cent in total. Due to the wage-push effect of labour laws, workers have been compensated way above the level of their productivity – a textbook case of rent-seeking. Constraints on job creation does nothing to encourage investors looking for flourishing consumer markets.

A further form of rent-seeking is affirmative action legislation in the form of so-called black economic empowerment (BEE) and employment equity. The former in effect requires businesses to have prescribed ratios of black shareholders and suppliers, the latter certain prescribed ratios of black employees in all levels of management. In a survey of European Union businesses in 2014, 90.2 per cent of respondents identified BEE (including employment equity) as a barrier to investment in South Africa, second only to the volatility of the rand, in particular the legal obligation of ‘employing and retaining “black” employees with required skill levels’ (89.9 per cent).

South Africa’s education system is one of the poorest in the world. In the World Economic Forum’s Global Competitiveness Report 2016-2017 the quality of South Africa’s education system was rated 2.3 out of a possible 5, and ranked 134 out of 138. In terms of maths and science education, it came in last, at 138. In a league table compiled by the OECD, South Africa’s education system was recently rated 75th out of 76 countries assessed.

The main reason is that the government has sought to impose a one-size-fits-all government-run centralized education system on one of the most diverse societies in the world. Coupled with this is the South African Democratic Teachers’ Union, the ANC-aligned teachers’ union, that has in some cases taken over the management of schools, and has successfully resisted the evaluation, promotion and remuneration of teachers on the basis of merit. So education itself has become a massive rent-seeking scheme. Resultant skills shortages are a direct impediment in the way of future investments.

The golden thread that runs through all these structures ostensibly put in place to redress the disadvantages of apartheid, is that they enable people to get something for nothing.

Together they are, sadly, assured to destroy productivity, and with that much hope for future investment growth. The bitter irony is the counter-productivity of these structures, as they harm the very victims of apartheid that they ostensibly aim to help, ultimately by driving away domestic and foreign investment. Nothing short of a change of government and structural reform of seismic proportions will fix that.

The unravelling of the General Motors restructuring: Claims beyond the limits of bankruptcy

CFR

Bankruptcy law offers distressed businesses tremendous power to force a reduction or restructuring of debts both large and small, but it has distinct limits, which recent events have thrown into the spotlight. Potential investors in the business or assets of reorganizing retailers, such as Sears, and manufacturing companies, such as General Motors, should take particular note.

Sometimes the limits are procedural, as in the rule in U.S. chapter 11 reorganization proceedings that allows debtors to keep favorable leases and reject unfavorable ones, with limited damages. The snafu is that, for nonresidential real estate leases in particular, debtors have only a maximum of seven months to make the decision with respect to all such leases or face automatic deemed rejection. Particularly for the wave of retail store bankruptcies that have arisen over the past several months, this limitation spells potential doom for reorganizing the network of far-flung storefront leases that is vital to larger, national retail chains. Such debtors frequently cannot make effective decisions as to which of their hundreds of storefront leases to retain, and they thus face losing all of them within only a few months.

More fundamental is a limitation on the types of debts that can be affected by a bankruptcy process. This limitation was and is front and center in the gargantuan and unprecedented reorganization of General Motors. For debtors facing large personal injury and environmental burdens, it may render any attempt at a restructuring futile or undo a seemingly successful one.

Bankruptcy laws worldwide generally limit their haircutting effect only to debts existing as of the date the debtor’s bankruptcy proceedings commenced. Later debts likely qualify for payment in full as claims arising either in connection with the administration of the insolvent estate or in the operation of the restructured entity. Thus, anchoring debts to a point in time before case opening is an important and sometimes less than straightforward task.

For loans and other contractual obligations, an agreement usually defines the amount of any claim, and even a known claim that has not crystalized can be assigned to the pre-commencement period and administered in bankruptcy in most of the world. Contingent claims that depend on the occurrence of a future, post-commencement event might be discounted for the likelihood of the contingency occurring in the future, but most modern bankruptcy laws draw such contingent claims within the scope of their coverage.

A key sticking point, however, involves unliquidated claims and especially latent and undiscoverable claims. Personal injury claims and environmental liabilities are perhaps the most salient examples. If the debtor has manufactured a dangerously defective product, or emitted hazardous waste, and it has injured identifiable victims, those victims certainly have claims, but they are unliquidated; that is, the value or amount of those claims will remain unknown until both liability and damages have been adjudicated. One could estimate these claims, as sometimes is done for contingent contract claims, but in bankruptcy systems that derive from English law, the concept of “provability” might exclude unliquidated tort (delictual) claims from the bankruptcy process entirely. In Australia, for example, unliquidated damages from personal injury claims are specifically excluded from administration in bankruptcy proceedings; a judgment establishing the claim amount must be signed before the commencement of the bankruptcy case for such claims to be “provable.”

U.S. bankruptcy law, in contrast, explicitly encompasses unliquidated claims, but General Motors’ case shows that some claims nonetheless remain outside the wide embrace of bankruptcy law. GM’s restructuring occurred over a period of just over one month in mid-2009. Nearly five years later, GM launched a massive recall of cars due to a major operational problem, a defect in ignition switches that could cause its vehicles to turn off unexpectedly and become uncontrollable while traveling at high speed. When owners of cars produced prior to the restructuring sued GM for personal injuries and economic loss due to this ignition switch defect, GM asserted that it was insulated from these claims by operation of the bankruptcy case.

For victims of accidents that occurred before the restructuring, and for all then-owners of vehicles devalued by the later-revealed latent defect, the Second Circuit Court of Appeals in New York held in July 2016 that these claims could be properly impaired in GM’s bankruptcy case. Indeed, even claims from accidents that occurred after the bankruptcy case could be properly impaired in advance as contingent claims, so long as the victims of those claims had a relationship with GM and the defective vehicle before the case closed. For future purchasers of used GM cars, however, who had no pre-bankruptcy relationship with GM, their claims for injuries and economic loss could not be reached by GM’s bankruptcy case because these claimants were unknown and unknowable at the time, and they could not be deprived of their rights without some process that was simply unavailable to them.

Unfortunately for GM, another procedural snafu revived even the old-owners’ claims. While the Second Circuit acknowledged that latent, future product liability claims can be addressed under U.S. bankruptcy law as contingent, the claimants are entitled to notice of the existence of the defect and potential claim, at least if the debtor knows about it. The Second Circuit approved a lower court finding that GM knew or should have known about the ignition switch defect, it therefore could have reasonably identified the owners of the affected vehicles, so it was required to provide these potential claimants with specific notice.

GM had not done this; therefore, these claims were not cut off by the bankruptcy case for lack of due process. In April 2017, the U.S. Supreme Court refused to review this ruling, leaving the GM restructuring potentially in ruins as billions of dollars of potential tort liability is unleashed on GM anew.

In evaluating the potential for bankruptcy to right the ship of a distressed manufacturer, account must be taken of the limits of bankruptcy’s remedial power. Some modern bankruptcy laws leave all unliquidated tort/delict claims unaffected, and even in the more liberal U.S. regime, the rights of unknown and unknowable future victims may well be beyond the reach of a restructuring. Bankruptcy law is powerful, but it has limits.

The Colón Free Trade Zone – regional distribution center for the Americas

Panama has long been recognized as an avenue for trade since the 16th century when Inca gold and silver filled the Spanish treasury by way of the galleons that sailed from Portobelo harbor on the Caribbean side of the isthmus on their way to Cadiz. The English privateers who sailed the coasts of the Caribbean coasts, such as Drake and Morgan, have obtained mythic status and rumors of Spanish wrecks off the coast abound. Portobelo was also the site of a twice annual fair that attracted visitors from throughout the region to trade in goods newly arrived from Spain, as well as goods produced in each of the countries. But the decline of the Spanish empire in the 17th century and the subsequent revolutionary wars in the early part of the 18th century meant that Panama was a sleepy backwater of Gran Colombia, as the new nation was known.

However, the discovery of gold in 1849 in California attracted the development of the Panama Railroad that shortened the trek from the east coast of the U.S. to San Francisco. The first successful land bridge between the oceans was an enormously profitable project in the New York exchanges. Later, Ferdinand De Lesseps, fresh from his successful construction of the Suez Canal, came to repeat his exploits in the jungles of Panama in 1880, but fate deemed his efforts should meet with colossal failure that broke the French treasury, along with Monsieur De Lesseps’ sanity. Yellow fever and malaria decimated the work force and ultimately forced the bankruptcy of the effort. It would not be until the end of the century that, as a result of investigations carried out in Cuba by Dr. Walter Reed and Dr. Carlos Finlay, the mosquito was identified as the vector between the virus and the infection.

The delays in the arrival of the Pacific fleet during the Spanish American War spurred Theodore Roosevelt’s efforts to build a canal but his overtures were spurned by the politicians in Bogota who were leery of Uncle Sam’s designs on the area. The frustrations by the isthmian business interests in the face of the capital’s resistance to the plans created the nascent revolutionary movement that culminated in a declaration of independence from Colombia in 1903.

One of the first acts by the young nation were dollarization and a signing of a treaty by the new government with the U.S. bequeathing in perpetuity a narrow strip of land on either side of the canal that became the Panama Canal Zone. A massive public health effort was carried out as the first stage of the construction program to safeguard the lives of the canal construction workers.

The successful construction of the canal meant the colossal project was inaugurated on August 1914, just as the First World War broke out in Europe. The canal was operated by the U.S. government as a federal dependency up until the implementation of the Torrijos-Carter treaties on 1977. Radical student movements during the early sixties caused serious riots in both Panama City and Colón and marked the end of the perpetuity aspect of the treaty and the beginning of Panamanian politicians’ search for alternatives to having a U.S. colony in the middle of the country. Omar Torrijos, the military strongman, capitalized on the post-colonial tide sweeping the world to obtain the gradual return of Canal Zone territories with a final handover slated for December 31, 1999. The Canal Zone was a federal institution that also harbored more than 10 bases manned by all of the U.S. military services.

The post-Second World War era in Colon, on the Atlantic terminus of the Panama Canal, was one of a severe downturn in economic activity as a result of the cessation of hostilities. The booming nightlife that hosted scores of soldiers moving across theaters of conflict seeking a respite from the horrors of war had shut down and the city fathers were desperately seeking an alternative model to boost growth in the Caribbean hamlet. The hiring of an American consultant was propitious as his insight with regard to the U.S. Free Trade Zone law of 1936 seemed to fit the bill with developing an additional element to the passing of goods through the canal. The law was signed and took effect in 1948 but really took a few years to gather the traction necessary to attract customers to this innovative project.

The Colón Free Zone (CFZ) was the genesis of the Puerto Rican pharmaceutical industry as politicians there saw the success by pharma companies and their production efforts in the zone. Early Panamanian investors also saw the opportunity to offload cargo from the transiting vessels to build a buffer stock of inventory in the Free Zone, allowing for a shortening of the supply chain with relative speed to the traditional model of waiting for the production and dispatch of goods from the point of origin. Due to its central location in the Western Hemisphere, the Colón Free Trade Zone began to attract more and more traders who bridged the supply from China with the demand from small and medium merchants in the Central American, Caribbean and South American markets.

Few of the members of the board of directors of the Colón Chamber of Commerce in the late 40s would have believed how the object of their efforts has grown to become an important sector of the national economy after almost 70 years since its founding.

Today, the CFZ administers an operation that employs more than 25,000 direct jobs associated with the more than 2,400 business located there representing over 6 percent of the countries’ GDP. The CFZ has grown to encompass an area of more than 800 hectares of land around the city of Colon. Three of Panama’s five ocean ports are based on the Caribbean side, a scant few kilometers away from the zone. The Panama Railroad, now under the skilled administration of Kansas City Southern Railroad, has its Atlantic terminal a few meters away from a recently renovated airport which should soon begin to handle air cargo to and from neighboring cities.

The neighboring markets of Colombia and Venezuela have each in their own way, affected negatively in the exports from the free zone. In 2016, turnover exceeded US$10 billion in exports to the neighboring markets supplying a broad range of goods, such as pharmaceuticals, clothes, footwear, electronics, wine and spirits, perfumes and cosmetics, as well as a plethora of goods that supply the region’s demands.

The Venezuelan economic meltdown, coupled with the Colombian restrictions on trade that compete with domestic producers, have made the Panamanian economy a primary destination for the goods handled there as CFZ users have sought vertical integration to capture additional margins at the point of sale. Panama has become a shopping destination, with millions of passengers taking advantage of the excellent price advantages on a myriad of goods found in the country thanks to the Colón Free Trade Zone.

Venezuela has gone from being the main client of the zone to a fourth-place position as the Maduro government mismanaged the world’s largest oil reserve economy to the point that imported gasoline shortages have begun occurring in the formerly wealthy nation. Recent events would indicate that changes should soon arrive to that neighboring country but doubts about the speed of the recovery amongst the CFZ users should temper any optimism about a short-term economic rebound.

The value proposition of the CFZ is that of a midway point between the factory and the final point of consumption. Goods arrive primarily from Asia, the factory of the world and are shipped from multiple origins to the Free Zone to build a buffer stock of inventory to service the neighboring countries on a just needed basis, thereby reducing the new for higher inventory lessons under a longer lead-time scenario.

Multinational corporations have increasingly seen the benefits of bringing products produced around the world under one roof to service the more than 70 countries that can be accessed from the zone on a weekly basis by ocean and daily by air from the Hub of the Americas in the Tocumen Airport on the Pacific side. The Tocumen airport received more than 14 million passengers in 2016 and is increasingly an attractive alternative to connect with Europe and Asia with daily flights by the major airlines, including Lufthansa, Turkish, Air France, KLM, Iberia and Avianca, among others. Copa, the Panama flag carrier listed on the NYSE, boasts a fleet of more than 100 aircraft to service over 70 destinations on a daily basis, making Panama an interesting alternative for multinational corporations seeking regional headquarters conveniently located in the region.

More than 80 of the world’s largest multinationals have considered the CFZ an ideal location for storing goods and performing value-added services such as labeling, pricing, promotions and assembly of goods customized at the moment of sale for the destination location. This value-added operation provides the thousands of jobs that are sorely needed in a traditionally disadvantaged area of the country, with double the unemployment in the rest of the country. A large Chinese telecom operation in the CFZ builds custom-made telephone equipment for contracts in the region. Employing more than 100 technicians in two shifts, this operation highlights the changing nature of the zone with regards to speeding up the supply chain and offering customization at the last moment. A major U.S. footwear retailer receives all of its China product in the CFZ, allowing for a cross-dock operation to build outbound containers with product in the freshest mix possible as determined by point of sale information in the more than 500 stores throughout the region. A large U.S. computer company is bundling its various products into a combo pack designed for the requirements of each of the countries it services.

With last year’s news of the Panama Papers debacle, the offshore industry in Panama has attracted the attention of the multilateral agencies seeking greater worldwide controls on the tax haven status of the country. The OECD is reviewing the CFZ regime in light of the favorable treatment by Panama fiscal policy of profits on foreign trade. Panama’s territorial fiscal policy regarding offshore profits is seen as possible harm to the traditional confiscatory tax policies in the G20 nations. Will the review committees recognize that the CFZ has been a good thing for the country?

The CFZ is also facing a challenge by Chinese SEZs, such as Yiwu and Guangzhou, that have attracted the former free zone clients to buy direct from the producers in China, bypassing the free zone merchants. Can the CFZ maintain its relevancy in light of the above challenges? The current Panamanian government has contracted the services of various consultancies to survey the best minds globally to try and forecast the possible scenarios for not only the Colón Free Zone but the other special regimes that have emerged due to the Free Zone’s success. The example of the Panama Pacifico SEZ, a former U.S. Air Force base was the subject of a recent Forbes article1 highlighting the swords to plowshares aspect of that area.

Panama has recognized the benefits of the CFZ regime and proof of this are the rising number of SEZs that have popped up around the country. The Panama Canal administration has also recognized the potential of creating more space along the banks of the canal, permitting the construction of more logistics parks to house the increasing numbers of companies that are becoming aware of the potential Panama offers for the supply chain. The World Bank in 2016 recognized Panama’s efforts in maximizing its logistics potential by awarding the country the #1 position in its logistics index for Latin America (globally #40), ahead of Chile (#46), the perennial leader in economic development in the area.

Conservative estimates place logistics as a sector providing over 30 percent of GDP in the country. With the recent inauguration of the Panama Canal expansion project that allows for over 90 percent of the container fleet of the world to pass, the country is well positioned to continue building on its infrastructure investments and aspires to become a global hub along with other zones like Dubai, Singapore and Rotterdam.

ENDNOTES

1 https://www.forbes.com/sites/danalexander/2016/03/23/inside-the-most-audacious-real-estate-project-in-the-world/#16f97e4d196f

The who what why of Cayman’s beneficial ownership regime

CFR

A new era started on July 1, 2017, when Cayman’s beneficial ownership legislation came into effect. Both the design and messaging around the regime have aimed for “business as usual”: many commonly used Cayman vehicles will fall outside the headline obligations under the new laws, and in any event for the best part of two decades Cayman financial services providers have had to hold private information on the beneficial owners of their clients.

There are, however, details within the legislation that expand its coverage beyond the primary in-scope entities. Even persons who evidently fall within an exclusion may have proactive obligations to provide information, with criminal sanctions for failure to comply. The directors, managers and shareholders of every Cayman company must take the time to understand the classifications and obligations under the new regime. This is equally the case for all Cayman corporate services providers.

Background

It is worth briefly recollecting the purpose and history of this legislation. A combination of the post-financial crisis deficits in the U.K., the anti-offshore agenda of certain NGOs such as Oxfam, and anger and distrust in the general U.K. population about foreign ownership and the usage of structures by the wealthy to avoid paying their “fair share”, pushed beneficial ownership information to the top of the political agenda in the U.K. in time for David Cameron to make it a central plank of his chairmanship of the G8 in June 2013.

A subsequent G20 communique summarized the intention: “Companies should know who really owns them and tax collectors and law enforcers should be able to obtain this information.”

The U.K. enacted legislation in 2015 that created a public register of “Persons with Significant Control” for U.K. companies. There was then a flurry of activity ahead of the Anti-Corruption Summit in London in May 2016 that led to an Exchange of Notes between the U.K. and Cayman governments, in which the Cayman government, alongside other Overseas Territories and the Crown Dependencies, agreed to establish a centralized platform to assist U.K. law enforcement and tax authorities.

At that time, one key element of the debate was whether the details collected would be publicly available or not. The Cayman government successfully held the position that the information should be non-public until such time as public registers became the accepted international standard. A condition was that the Cayman information had to be almost instantaneously available to the U.K. authorities; the authorities had to be able easily to explore legitimate enquiries across multiple vehicles; and corporate services providers must not be alerted to any searches having taken place.

Cayman framework

Fast forward to 2017, and Cayman has delivered on its commitment in the Exchange of Notes to create a centralized platform of beneficial ownership information. The key legislation takes the form of amendments to the Companies Law and the LLC Law, in each case with accompanying regulations. The legislation has been supplemented with guidance notes.

An affected Cayman company must maintain a beneficial ownership register at its registered office. Once a month, each registered office provider is required to upload relevant information via an encrypted USB to a transfer server at the Ministry of Financial Services as the competent authority. This server operates as a secure search platform, accessible only by the ministry upon formal lawful request from a specified list of governmental authorities in the context of financial crime, money laundering, and regulatory or tax matters, including in response to a legitimate request from a jurisdiction which has entered into an agreement with the Cayman Islands government in respect of the sharing of beneficial ownership information. Currently this is limited to the U.K. To enhance the security of the data on the platform and to protect it from cyber-crime and hacking, the server is air-gapped, with no external connectivity.

Partnerships, including exempted limited partnerships, trusts and other bodies that are not legal persons are not covered by the legislation.

For all legal entities, classification is important as the legislation imposes different obligations on different categories of person.

In-scope companies

All Cayman LLCs and all companies incorporated in Cayman or registered by way of continuation in Cayman, including ordinary companies, exempted companies and exempted segregated portfolio companies are in-scope, unless they fall within an out-of-scope category as described below.

The types of companies that are expected to be in-scope include personal holding companies, private trading companies, joint venture companies, TopCos and subsidiaries in private corporate groups, small unregulated funds that are self-administered and managed by a non-regulated manager, some carry vehicles and private unlicensed Cayman businesses.

Foreign companies registered in Cayman are not in-scope companies, although they may be relevant legal entities and registrable persons, as explained below.

Out-of-scope companies

The following legal entities are out-of-scope:

  • companies listed on an approved stock exchange;
  • funds registered with CIMA under the Mutual Funds Law;
  • companies registered with CIMA as excluded persons under the Securities Investment Business Law, such as many Cayman-incorporated investment managers and investment advisers;
  • other licensed companies in Cayman such as banks, trust companies and insurance managers;
  • companies managed, arranged, administered, operated or promoted by an approved person as a special purpose vehicle, private equity fund, collective investment scheme or investment fund (a managed entity);
  • general partners of managed entities; and
  • subsidiaries of companies that fall within the above categories, i.e. companies whose out-of-scope parent(s) hold more than 75 percent of the shares or voting rights of the subsidiary, or the right to appoint and remove a majority of the board of the subsidiary; or companies which are themselves subsidiaries of such a subsidiary.

For the managed entity exemption, an “approved person” is a person or a subsidiary of a person that is (i) regulated, registered or licensed under a Cayman regulatory law or regulated in an approved jurisdiction, or (ii) listed on an approved stock exchange.

It is expected that there will be a lot of attention on the managed entity exemption, as terms such as “managed”, “administered” and “special purpose vehicle” are construed. Cayman investment funds that have delegated discretionary management to SEC registered investment advisers in the U.S. or FCA regulated managers in the U.K. will be exempt as managed entities. Other scenarios may not be so clear-cut. Companies that have appointed directors registered under the Directors Registration and Licensing Law will not, for that reason alone, qualify for the managed entity exemption.

Beneficial owners

Beneficial owners are individuals who, in respect of an in-scope company:

  • hold, directly or indirectly, more than 25 percent of the company’s shares;
  • hold, directly or indirectly, more than 25 percent of the voting rights of the company;
  • hold, directly or indirectly, the right to appoint or remove a majority of the company’s board of directors; or
  • have the absolute and unconditional legal right to exercise, or actually exercise, significant influence or control over the company.

The regulations provide details of what indirect ownership means.

Relevant legal entity

Relevant legal entities are legal entities incorporated, formed or registered, including by way of continuation or as a foreign company, in Cayman that would be beneficial owners if they were individuals.

Registrable person

Registrable persons in respect of a company are (i) beneficial owners, and (ii) relevant legal entities that hold an interest in the company or meet one of the ownership and control conditions directly in respect of the company and through which any beneficial owner or relevant legal entity indirectly owns an interest in the company.

The result is that, in practice, while there may be multiple relevant legal entities in respect of a Cayman company, only the relevant legal entities at the level immediately above the company will be registrable persons. Individuals, on the other hand, will be registrable persons, as beneficial owners, even where their interest in the underlying company is held indirectly through a majority interest in multiple entities.

Obligations

In-scope companies have the most extensive obligations. Each such company must:

  • engage a licensed Cayman corporate services provider (CSP) to maintain an adequate, accurate and current beneficial ownership register for the company at the company’s registered office in Cayman;
  • take reasonable steps to identify individual beneficial owners and relevant legal entities;
  • give notice to all beneficial owners and relevant legal entities requiring such persons to confirm their status as registrable persons and their registration details within one month of the notice;
  • provide to its CSP the required particulars of such registrable persons once those particulars have been confirmed;
  • instruct the CSP to enter the required details of registrable persons into the register, or a nil return; and
  • upon becoming aware of any change to the particulars of a registrable person stated in its register, give notice to the registrable person as soon as reasonably practicable requesting confirmation of the change.

Beneficial owners and relevant legal entities also have their own obligations. They must respond to any notice received from an in-scope company; if they are registrable persons, they must confirm or correct their details; and they must state whether or not they know the identity of a registrable person or any person likely to have that knowledge.

Registrable persons have a proactive obligation to notify an in-scope company that they are registrable persons, even where they have not received a notice from the company.

Similarly, registrable persons must proactively notify an in-scope company if they know of any change in their status or particulars.

So it is not the case that the board of directors of a Cayman company can determine that they are out of scope and automatically proceed as if the law does not apply to them. A regulated feeder fund that invests all of its assets in a regulated master fund, which itself invests in a portfolio of listed securities and financial instruments will be fully removed from the obligations in the legislation.

But if, for example, a Cayman private equity fund managed by a U.S. manager directly acquires a 30 percent stake in a Cayman company that owns a solar panel manufacturing business in China, the Cayman fund will be out of scope and will not itself have to maintain a beneficial ownership register. It will, however, be a registrable person in respect of that underlying Cayman company and must provide it with all necessary information, whether it is asked for such information or not.

Default

Companies and their directors who knowingly and wilfully breach the legislation commit criminal offences and may incur significant fines. Similarly, registrable persons who do not provide timely and complete information or knowingly make false statements commit an offence.

A company is also required to serve a defaulting registrable person with a restrictions notice, copied to the Cayman authorities, the effect of which is to freeze dealings in the relevant interests.

Conclusion

Cayman has a consistent strategy of meeting or exceeding global standards on transparency and international cooperation. Nevertheless, few in Cayman’s financial services industry considered the U.K.’s beneficial ownership drive to be necessary or desirable for Cayman.

Unlike the U.K. itself as well as the U.S. and all other G20 nations, Cayman has since 2001 required financial services providers to verify the identity of beneficial owners of Cayman companies: and at a more onerous 10 percent threshold.

In addition, Cayman’s largely institutional and regulated client base is an improbable harbour for the wrongdoers that the U.K. law enforcement authorities wish to target.

The new beneficial ownership regime therefore attempts to support the central aims of the initiative while safeguarding the privacy of legitimate transactions and seeking to minimise the impact for entities which are subject to alternative regulatory oversight. Clearly, however, the regime will increase the compliance burden in Cayman, even for entities that are ostensibly out of scope. Companies, their directors, individual beneficial owners and corporate services providers will all need to be alert to the new requirements.

Prepare for the rise of cryptocurrencies and blockchain technologies

I recently had the distinct pleasure of being on a panel discussion that revolved around the topic of de-risking of Caribbean banking sectors and the looming economic issues this will present. As I was building my arguments, my mind could not help but think of radical but reasonable solutions to this issue. Now, I would not wish to mislead the reader into thinking that blockchain technology is the immediate savior to all of the financial market problems one is met with in small open economies. There is, however, the need to explore the history and potential benefits in light of the rapid pace of innovation along with the huge cost savings and “sovereignty” brought about by the use of this de-centralized software. This is supported by the fact that although there may be about three cryptocurrencies that are household names (Bitcoin, Ethereum, Ripple), there are 754 in global circulation. It will certainly take some time before any of those will possibly provide the technology that can totally alleviate the de-risking problem we have. I will explain.

Bitcoin by now is the most familiar term coming out of the global financial technology (fintech) industry. It is indeed a name which is part of popular culture, even though most remain skeptical about it potential; understandably so. As the largest cryptocurrency by market value, approximately US$41 billion with 16.3 million coins in circulation, it is as much admired for the economic value it brings to investors as it is maligned for the anonymity it used to provide to transacting parties. The latter is no longer true due to the levels of oversight by financial intelligence units in developed economies. They have gone as far as Japan on April 1, 20171 in convincing governments that cryptocurrencies can be considered as a legal means of payment. This holds true especially where the authorities are able to sufficiently monitor transactions made through qualified money service businesses. This is not as inconceivable as one may think. One discerning glance online would reveal to the reader that after the famous crash of the Mt. Gox trading platform the green shoots became new standard bearers that to this day maintain know-your-customer best practices when they onboard new clients no matter where that customer resides. In contrast, some international business and “citizenship by investment” jurisdictions are at times still reputed to sidestep such regulations.

The “distributed” ledger technology behind any cryptocurrency, its blockchain, is even more compelling. The blockchain is a form of internet where the servers and databases are not owned and operated by large telecommunications companies but these are de-centralized and, like Napster, it is a peer-to-peer technology. It is basically not dependent on a middleman but resembles a marketplace where miners/producers (those who use their computers to run the cryptographic algorithms which reward them with tokens/coins on successful completion) and users (those who consume tokens for transactional purposes and, debatably, a store of wealth) transact directly with each other. This feature alone has the ability to help circumvent the major issues revolving around the move to de-risk banks which operate in the Caribbean once two events occur: the entry of additional market players, and widespread acceptance of the technology by governments and regulators.

Notwithstanding the current issues with scaling a small but growing system of computers, this ecosystem allows transactions to be verified since the blockchain software installed on the systems owned by users and producers are always approving legitimate transactions.

Your typical internet service company cannot do this in a cost-effective manner. A blockchain, in simple terms is a very secure and anonymous ledger that provides producers and consumers of the token the means, akin to the real time gross settlement (RTGS) and SWIFT transmission technologies in banking, to facilitate cryptocurrency transactions without the use of a middle man, like a central bank.2 Note that RTGS and SWIFT depend on a direct verification system used by a small number of counterparts. This currently leads to bottlenecks resulting in the throttling of transactions/wires especially within and from smaller financial jurisdictions.

Renowned venture capitalist, Fred Wilson of Union Square Ventures – on the back of participating in a $75 million round of financing for Coindesk, a news portal for all things involving cryptocurrencies – believes that the provision of technologies built on protocols, such as the blockchain, cannot just lessen the cost of financial transactions globally while eschewing the perennial financial middlemen such as central banks and commercial banks, but also allows the implementation of new kinds of ticketing solutions and marketplaces.3
To further understand this point, consider why huge players in finance and technology such as Goldman Sachs, JP Morgan and Microsoft, via the Enterprise Ethereum Alliance, publicly endorsed and are working with the Ethereum blockchain4 to further advance exchanges of value using blockchain technology just a matter of months ago.

Santander, a member of the alliance, went as far as to show how two counterparties can use Ethereum as settlement platform for a foreign exchange spot transaction. Again, this presents another potential use case in the region’s ongoing fight against de-risking. Now you may begin to question what value they must be seeing in a technology which seemingly promotes anonymity and could very well be a competing platform. But along with my earlier assertion that this is not as much of a worry as it once was, all coins and blockchains are not created equal. Several blockchains are created at an ever-increasing pace and seek to solve problems that the Bitcoin blockchain and protocol were not designed to deal with.

Ethereum, for example, takes the concept of the peer-to-peer network and basically infers that creating a token (Ether) is not enough: a network has greater value than transmitting digital currencies. And although these tokens may have value in some form or another, the best case may very well be using a token as it was originally intended: as a form of receipt.

Another system, Ripple, produces a token that is designed to exchange value only but has become rather appealing to global banks due to a design which is tackling the issue of scalability first, so as more banks potentially join the network, there should be no bottlenecks. And whereas Bitcoin and Ethereum focus on total transparency of transactions, even if the parties are perceived as anonymous, i.e public blockchains, the creators of Ripple sought to ensure that banks can create their own controlled private blockchain technology where they could control transparency. All coins are not created equal.

Consider an email sent between two individuals for a moment. An email typically contains data that is easily seen by the two individuals. These individuals, without much effort can find who sent it, who received it, the title, and the time sent. But there is additional metadata about the servers which the delivered the email; the devices and browsers used to send the email; and the IP address from which the email was sent that is not as obvious to both persons. Cryptocurrencies can have metadata attached in a similar fashion.

So you can see more than just the cryptographic hash (think a unique sequence of randomly sorted numbers and letters) that is your coin. The metadata that can be embedded into each token will have information about the senders. It extends to something as including, in the token, the terms and conditions under which the token or in this case receipt was transferred. And taking into consideration that there must have been some agreement in order for said token to have been transferred, one can look at this token as a form of a contract: a smart contract. And it is these smart contracts – a contract that within seconds is verified and recognized across a blockchain – that can lead not just to even more efficient financial sectors but e-governments, law firms, small businesses etc.

Imagine never having to go into a land registry again because your there is a verifiable record of your deed on the blockchain and you can be verified as the owner simply because the government, using a blockchain, issued you a unique token that displays to all in the network that you and the government came to agreement on your title. Bottlenecks be gone.

Ethereum also provides software developers with access to two previously very centralized resources: finance and software platforms to sell apps. One must always remember that a blockchain is just a de-centralized form of the internet and then the notion that, in the case of Ethereum, software developers can build apps to achieve any level of functionality to be sold to and to utilize the available computing resources provided by producers and consumers on the platform may not be so far-fetched. Successful Ethereum projects such as Golem provide great examples of the effectiveness of a decentralized market for apps which also can utilize the markets computing resources.

The cost of doing business online is definitely about to fall further. Financing for these projects is now easier thanks to the concept of Initial Coin Offerings (ICOs) which are very similar to an IPO. This is done under the premise that you can, using Ethereum, create a token which you may distribute to potential investors who are willing to part with their ether in exchange for that token. And since ether is easily exchangeable to bitcoin via the several cryptocurrency exchanges online, these businesses can surely finance their operations – especially if they are Japanese. The opportunities are endless for businesses worldwide, small and large.

On March 9, 2017, the Monetary Authority of Singapore (MAS) announced that they had completed Phase One of a monumental project, Project Ubin. This is an ongoing effort via the use of Ethereum, to digitise the Singaporean Dollar5. The MAS is open sourcing their findings so that Singapore’s burgeoning fintech community can contribute to its development. I am still left to wonder why we have not begun using the available legal and technological resources in a similar manner to leap frog emerging economies in this space. The future is now.

ENDNOTES

  1. http://www.coindesk.com/japan-bitcoin-law-effect-tomorrow
  2. See https://blockchain.info to get a sense of how vibrant this technology is.
  3. See http://www.coindesk.com/fred-wilson-blockchain-applications-still-biggest-opportunity-bitcoin/.
  4. http://fortune.com/2017/02/28/ethereum-jpmorgan-microsoft-alliance/
  5. http://www.mas.gov.sg/Singapore-Financial-Centre/Smart-Financial-Centre/Project-Ubin.aspx

Grey matters

The Conundrum of Hedge Fund Definition

Hossein Nabilou

EUROPEAN COMPANY AND FINANCIAL LAW REVIEW

Forthcoming available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2846097

Abstract:
This article attempts to define hedge funds and to distinguish them from a variety of similar investment funds. After reviewing the hedge fund definition in the U.S. and the EU, this article argues that the current regulatory framework, which defines hedge funds by reference to what they are not rather than to what they are, is prone to regulatory arbitrage. Even in the presence of a statutory definition, due to the ineluctable indeterminacy of language and regulatory arbitrage problems, borderline issues will persist, which makes statutory definitions of hedge funds neither possible nor desirable. Therefore, regulators should avoid the temptation of proposing such statutory definitions. Instead, they should rely on regulatory discretion within a broad principles-based regulatory framework to do so. For such a principles-based regulatory regime to work, regulators should rely on a functional definition of hedge funds. Accordingly, this Article defines hedge funds as privately organized investment vehicles with a specific fee structure, not widely available to the public, aimed at generating absolute returns irrespective of market movements (Alpha) through active trading and making use of a variety of trading strategies. This functional definition is likely to help address regulatory problems that might originate from statutory definitions of hedge funds.

CFR Comment:
These two pieces by a professor from Luxembourg highlight issues in hedge fund regulation and reasons why regulators on both sides of the Atlantic may take up changes going forward.

 

How Countries Should Share Tax Information

Arthur J. Cockfield

(November 30, 2016) available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2877838

Abstract:
There are increasing policy concerns that aggressive international tax avoidance and offshore tax evasion significantly reduce government revenues. In particular, for some low-income countries the amount of capital flight (where elites move and hide monies offshore in tax havens) exceeds foreign aid. Governments struggle to enforce their tax laws to constrain these actions, but are inhibited by a lack of information concerning international capital flows. The main international policy response to these developments has been to promote global financial transparency through heightened cross-border exchanges of tax information. The paper discusses elements of optimal cross-border tax information exchange laws and policies by focusing on three key challenges: information quality, taxpayer privacy, and enforcement. Relatedly, the paper discusses how the exchange of automatic ‘big tax data’ combined with data analytics can help address the challenges.

CFR Comment:
The remedy for the failure of information exchange to yield all the benefits claimed for it will surely be requirements of yet more information exchange. Here is an opening salvo in that battle.

 

Closing the Hedge Fund Loophole: The SEC as the Primary Regulator of Systemic Risk

Cary Martin Shelby

BOSTON COLLEGE LAW REVIEW, 58, forthcoming, available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2869150

Abstract:
The 2008 financial crisis sparked a flurry of regulatory activity and enforcement in an attempt to reign in activity by banks, but other institutions have also been identified as potentially threatening to the stability of the financial markets. In particular, several empirical studies have revealed that systemic risk can be created and transmitted by hedge funds, which are private investment funds that have historically evaded regulation under the federal securities laws. In response to the risk created by hedge funds, Congress granted the Financial Stability Oversight Council (“FSOC”) authority under the Dodd-Frank Act of 2010 to designate hedge funds as Systemically Important Financial Institutions (“SIFIs”). Such a designation would automatically result in stringent capital constraints and limitations on liquidity risk on these nonbank institutions. However, in the over six years since FSOC has been granted this authority, it has failed to identify even one hedge fund as a SIFI. The council has encountered a variety of challenges such as criticisms to systemic risk studies sanctioned by FSOC, and massive resistance to the SIFI designation process by numerous industry participants. If this designation were applied to hedge funds it would severely limit the abilities of hedge fund advisers to pursue certain strategies. For these reasons, it is highly unlikely that FSOC will designate a hedge fund as a SIFI. The inability of FSOC to regulate systemically harmful funds is particularly troubling because several post-financial crisis studies have revealed that systemic risk can still be created and transmitted by hedge funds. Given FSOC’s inability to close this hedge fund loophole, this Article argues that Congress should explore appointing the SEC as the primary regulator of systemically harmful funds because; (1) the transparency framework inherent in the federal securities laws can supply a more effective means for mitigating systemic risk than the prudential framework currently mandated for SIFIs, and (2) appointing the SEC in this regard would reduce the fragmentation of our current regulatory structure which has been extended and complicated by the creation of FSOC. While the federal securities laws are typically used to promote investor protection, this Article posits that enhancing transparency to hedge fund counterparties and investors can decrease systemic risk by empowering such market participants to better protect themselves against risk. Enhancing protection in this manner could in-turn weed out systemically harmful funds from the marketplace, without imposing the severe capital constraints that would be mandated under FSOC’s model. With respect to reducing the fragmentation of our current regulatory structure, this Article argues that lawmakers should dedicate resources to reforming our existing agencies instead of creating additional layers of ineffective regulation that could lead to repeated failures, undue complexities, and wasted resources.

CFR Comment:
Sometimes it seems like the magic words to justify a new regulatory measure are “systematically important”. Here they are invoked to bring the SEC into the picture to remedy the FSOC’s failings. While a debate over whether the incoming Trump Administration will seek Dodd-Frank repeal is in the news, watching for things like this to sneak into any “repeal” or “reform” measure is worth doing.

 

A Catharsis for U.S. Trust Law: American Reflections on the Panama Papers

Reid K. Weisbord

COLUMBIA LAW REVIEW ONLINE, 116: 93-107 (2016) available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2856042

Abstract:
In April 2016, a massive leak of confidential legal documents, now known as the “Panama Papers,” attracted international scrutiny and condemnation of offshore asset protection trust arrangements. Such trusts are legal to create but notoriously susceptible to abuse by wrongdoers seeking to hide assets from the peering eyes of tax collectors and creditors. The Panama Papers offer compelling evidence of something long suspected but difficult to prove for lack of transparency ‒ even though asset-offshoring techniques may be used for legitimate purposes, they are, in fact, too often abused as a cover for criminal activity and tax evasion. In response to the leak, the U.S. Department of Justice and several foreign law enforcement agencies opened investigations into the financial improprieties uncovered by the Panama Papers. However, before criticizing offshore trust havens for capitalizing on fraudulent behavior at the expense of nonresident claimants, U.S. state lawmakers should first reflect upon the recent wave of domestic trust legislation authorizing similar conduct here at home. This article is a patriotic catharsis lamenting the recent trend of U.S. trust law to sanitize some of the most controversial and widely abused offshore trust practices and urges lawmakers to take steps toward its reversal. Three aspects of U.S. trust law, in particular, have authorized asset protection techniques similar to those permitted in offshore trust havens: (1) self-settled asset protection trusts, (2) nonresident tax shelters, and (3) trust secrecy. The article concludes with a discussion of existing federal law protections against domestic trust abuse and recommendations for reform.

CFR Comment:
An interesting call for changes in U.S. trust law to block use of offshore trusts to avoid U.S. taxes.

 

Global Developments in Trust Arbitration

S.I. Strong

ARBITRATION OF TRUST DISPUTES: ISSUES IN NATIONAL AND INTERNATIONAL LAW (Oxford University Press, 2016) available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2848029

Abstract:
Over the last few decades, arbitration has become increasingly popular in a wide variety of contexts and jurisdictions. However, up until recently, one field ‒ trust law ‒ has stood apart and resisted the pull toward arbitration. Over the last few years, this tradition has begun to change. Indeed, an increasing number of jurisdictions have begun to embrace the arbitration of internal trust disputes, meaning disputes involving trustees and beneficiaries and relating to the inner workings of the trust. Although trust arbitration has received support from numerous courts, legislatures and commentators, the procedure is still in its infancy, and numerous questions exist about the use, scope and validity of arbitration provisions found in trusts. This chapter describes the key issues in the area of trust arbitration as a matter of both national and international law and introduces the work of other contributors to a new volume of collected essays on trust arbitration. Both the chapter and the book in which it is found consider trust arbitration from both a trust law and arbitration law perspective, which is critical to a proper understanding of the issues at stake. The chapter and the book also discuss trust arbitration as a matter of domestic and international law, thereby recognizing the differences in national approaches to trust arbitration while also respecting the importance of offshore jurisdictions in trust law and practice. Trust arbitration is a new and exciting area of law, practice and scholarship, and one that will be growing rapidly in the coming years. This chapter provides an important introduction to the comparative, international and interdisciplinary issues that arise when settlors seek to require arbitration of trust-related disputes through inclusion of an arbitration provision in a trust.

CFR Comment:
An introduction to an important trend. Jurisdictions that focus on trusts need to be thinking ahead to how they will adjust.

 

Culprits or Bystanders? Offshore Jurisdictions and the Global Financial Crisis

Daniel Haberly & Dariusz Wojcik

(November 21, 2016) available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2870744

Abstract:
Questions have been raised regarding the role of low-tax offshore jurisdictions in the global financial crisis, based largely on evidence that many problematic asset-backed securities were issued from or listed in the Cayman Islands, Jersey, Ireland, and other ‘offshore’ sites. However, there has not been a systematic investigation of the offshore geography of crisis-implicated securitization. Here the authors fill this gap by constructing the first comprehensive jurisdictional map of the largest pre-crisis Asset-Backed Commercial Paper (ABCP) programs, and examining the rationale for and impacts of this geography in detail. They show that offshore jurisdictions were disproportionately involved in producing the most unstable ABCP classes. However, this is difficult to explain in terms of the traditional role of offshore banking centers as sites for direct avoidance of onshore regulation and transparency. Rather, they propose a Minskian model of pre-crisis offshore ABCP production, wherein these jurisdictions specialized in alleviating incidental institutional frictions (e.g. double taxation) hindering onshore financial innovation. In this context, they could sometimes be legitimately described as improving the institutional ‘efficiency’ of financial markets; however, by facilitating the endogenous evolutionary instability of these markets, this apparently innocuous service had profoundly negative effects. This normative disconnect poses a conundrum for offshore reform.

CFR Comment:
Useful data and some great visualizations, although some tough sledding in the text for those not up on Hyman Minksy’s theoretical frameworks.

 

Finally, two papers look at the impact of moving transactions offshore.

 

Offshoring and Audit Reviewer Effectiveness

Frank D. Hodge & Kim Ikuta

(November 3, 2016) available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2864011

Abstract:
In order to reduce costs, audit firms have begun transferring audit tasks to offshore locations in countries such as India. Consequently, new audit associates no longer perform these tasks. They are, however, asked to review them. If gaining experience completing audit tasks is an important building block to effectively reviewing those tasks, then offshoring may negatively impact future audits. Using an experiment, the authors investigate this concern and find that auditors who lack experience completing relatively complex audit tasks are less effective during the review phase of an audit than are auditors who have experience completing the tasks. They also find that a simple training exercise does not eliminate this problem. The results highlight a potentially hidden cost of offshoring, one with important implications for audit firm training if offshoring trends continue.

CFR Comment:
This brief paper raises an important question, one which accounting regulators might want to consider in thinking about who should be able to sign off on audits.

 

Domestic Financial Markets and Offshore Bond Financing

José María Serena & Ramon Moreno

BIS QUARTERLY REVIEW (September 2016) available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2842333.

Abstract:
Firms in emerging market economies markedly increased their issuance of bonds in offshore markets after the great financial crisis. By contrast, increases in offshore bond issuance by firms in advanced economies were more muted. An empirical analysis suggests that the less developed state of financial markets in emerging economies may have encouraged firms there to step up their offshore bond issuance as external financing costs fell. Firms appear to use the proceeds of offshore bonds to boost their holdings of short-term assets. This may raise financial stability concerns.

CFR Comment:
An excellent empirical investigation of the impact of multijurisdictional financing.

 

 

OECD Watch

The Organisation for Economic Cooperation and Development (OECD) has gradually carved for itself a central role in global tax matters over the last two decades. Today, its many initiatives impact global economic activity in a variety of ways. OECD Watch summarizes and analyzes the organization’s recent activities relating to international finance and tax matters.

Base Erosion and Profit Shifting

The OECD held a signing ceremony for the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent BEPS on June 7. According to the OECD, “The MLI offers concrete solutions for governments to close the gaps in existing international tax rules by transposing results from the OECD/G20 BEPS Project into bilateral tax treaties worldwide.” A total of 76 countries signed or formally expressed their intention to sign, including Canada, China, France, Germany, Hong Kong, Sweden and the United Kingdom, among others. Notably absent from the list is the United States.

Additional guidance was released for the implementation of country-by-country reporting (BEPS Action 13). It addressed five specific issues: “the definition of revenues; the accounting principles/standards for determining the existence of and membership in a group; the definition of total consolidated group revenue; the treatment of major shareholdings; and the definition of related party for purposes of completing Table 1 of the CbC report.”

Automatic exchange – more jurisdictions succumb

The OECD celebrated the signing of six additional competent authority agreements between Hong Kong and the following jurisdictions: Belgium, Canada, Guernsey, the Netherlands, Italy and Mexico. These added to their existing agreements with Japan, Korea and the United Kingdom, and moves the territory toward fulfilling its pledge to implement the automatic exchange of financial account information.

Panama deposited its instrument of ratification for the Convention on Mutual Administrative Assistance in Tax Matters, which entered into force July 1. Guatemala also ratified, while the United Arab Emirates, Kuwait, and Lebanon signed the convention, bringing the number of signatories to 111 jurisdictions. The Bahamas formally indicated an intention to sign, as well.
The OECD also released new guidance for implementing the Common Reporting Standard. It included a new series of CRS-related Frequently Asked Questions, and a second edition of the Standard for Automatic Exchange of Financial Account Information in Tax Matters. The new edition expands on the CRS XML Schema User Guide and “sets out additional technical guidance on the handling of corrections and cancellations within the CRS XML Schema, as well as a revised and expanded set of correction examples.”

Economic surveys

The OECD released economic surveys for Spain, Japan and Colombia. For Spain, low yields from the nation’s VAT were lamented, and increases in excise taxes on tobacco and alcohol were called for, as well as for fuel and other “environmental taxes.” The report callously waved away the impact of higher energy prices on the poor by simply noting that they “do not raise particularly strong distributional concerns.” In other words, the fixation on inequality led the authors to conclude that harm to the poor doesn’t matter so long as policies harm the rich just as well.

In Japan, the report called for raises to the minimum wage, higher consumption taxes, and new “environmentally-related taxes.” For Colombia, the report called for the lowering of taxes on wages, but urged collection of more revenue overall to fund increased spending on infrastructure and social programs.

Embracing class warfare to push big government

In a disturbingly honest statement highlighting the OECD’s big government agenda, Secretary-General Angel Gurría called for the “shake up” of globalization and the liberal international order that has brought unprecedented prosperity to the world and lifted billions out of poverty.

“Too many things are not working for too many people,” he says. Among them are “rising inequalities of income, wealth and opportunities.” But he really gives away the game when he admits that one of the problems to be solved is “limited progressivity of our tax systems.” Such an astonishing counterfactual represents a full-throated embrace of class warfare.

Highlighting this disturbing trend is a new OECD report called Bridging the Gap: Inclusive Growth 2017 Update Report. It criticizes “the ‘grow first, distribute later’ assumption that has characterized the economic paradigm until recently,” and claims that “inequalities tear at the fabric of our societies.” Much of the report could have come straight from the campaign speeches of socialists like Bernie Sanders and Jeremy Corbyn, especially its conclusion that “fiscal policy is the key mechanism for redistributing market incomes,” and recommendations for additional welfare spending to be paid for through increases of the double taxation on savings and investment.

Other areas of concern

At the behest of the Task Force on Tax Crime and Other Crimes, the OECD delivered a report on “Technology Tools to Tackle Tax Evasion and Tax Fraud.” It primarily serves an informational purpose by reporting what policies different countries have implemented to reduce certain kinds of tax evasion and fraud. Particularly noteworthy, and troubling, are two sections on the cash and sharing economies. The report ominously notes that while they are “not types of tax evasion and fraud themselves,” the cash and sharing economies “can facilitate it.” More worrisome, it noted without criticism the effort of some countries to limit cash usage or outright ban transactions above certain thresholds.

The report also noted that “the challenge of the sharing economy that means it can facilitate tax fraud and evasion is that it can be more difficult to identify the existence of business activity.” As the sharing economy continues to grow, the concern must be that it is likely to receive greater scrutiny from tax agents. This report could presage future OECD efforts post-BEPS. And another report, “Investing in Climate, Investing in Growth,” provides yet another avenue through which the OECD may choose to pursue its big government agenda – by embracing climate change activism.

U.S. pushback

Following the education efforts of a coalition of free market and taxpayer protection organizations, led by the Center for Freedom and Prosperity, about how the OECD works against the interests of U.S. taxpayers, the Trump administration indicated a willingness to curtail OECD funding.

In the administration’s proposed budget for 2018, international organizations receive a significant 31 percent cut from current levels. The budget calls for an inter-agency review to determine from which organizations those cuts are to come, with a command to “give priority to organizations that most directly support U.S. national security interests…and American prosperity.”

How the review treats the OECD, which has long worked against U.S. economic interests, will be worth watching, along with whether the U.S. Congress follows the path laid out by the administration, and how the OECD responds should a significant portion of its funding be threatened in response to its increasingly politicized and anti-growth agenda.

Protecting personal data – are employers prepared?

CFR

The new Data Protection Law, gazetted in June, will regulate the future processing of all personal data in the Cayman Islands. Employers should take steps now to ensure that they understand their obligations under the new law; that they have in place policies and procedures to ensure the proper protection of employee personal data under their control and to give themselves flexibility to monitor an employee’s use of email, the internet and other devices where necessary.

Employers in Cayman need to get it right – reputations and criminal liability will soon be at stake.

The new law

Drafted around a set of internationally recognized privacy principles, the Data Protection Law 2017 (DPL) provides a framework of rights and duties designed to give individuals greater control over their personal data. Personal data is defined widely to include any data which enables an individual to be identified. Personal data relating to employees must be processed fairly and lawfully and used for a legitimate purpose that has been notified to the employee in advance. Employee data holdings should not be excessive in relation to the purposes for which they are collected and should be securely purged once those purposes have been fulfilled.

An important aspect of employee data is that it almost invariably includes “sensitive personal data” such as information about an individual’s health and ethnic background. Sensitive personal data is subject to enhanced privacy protection under the DPL and therefore requires careful handling.

Protection of employee data by the employer is required throughout the employment relationship. Employers often start collecting personal data before the formal employment relationship commences, through data provided by job applicants in application forms and resumes. The collection of data then continues during the course of the individual’s employment through performance reviews and an employer’s payroll, pension and health insurance obligations. Even after the employment relationship ends, employers will often need to retain data holdings for former employees to comply with pension or other legal requirements.

The DPL gives employees the right to access personal data held about them and to request that any inaccurate data is corrected or deleted. Employers will need to have policies and procedures in place to manage these requests. The new law also obliges employers to cease processing personal data once the purposes for which that data has been collected have been exhausted. Prescribed data retention periods are not set out in the DPL but an analysis will need to be undertaken to determine how long employee data should be kept for.

Similarly, it will be important to evaluate how personal data can be securely deleted once the purposes for holding it have been fulfilled.

Data protection policies

Under the DPL, the employer is required to set out the purposes for which employee personal data is being collected and details of whom that data may be shared with. Employees must also be informed of any countries or territories outside the Cayman Islands to which their personal data may be transferred. Recommended best practice is for this information to be set out in a separate privacy notice which can be provided to the employee and signed at the same time as the employment contract, as the DPL requires a data subject to provide “a clear affirmative action” to signify consent. If the privacy policy changes over time, and in particular if personal data is to be processed for any new purposes, this processing can only be undertaken if fresh consent is obtained from the employee.

The purpose of an employee data protection policy is to set out the conditions under which the employer will process personal data and ensure that everyone in the business is aware of their individual responsibilities and the employer’s expectations regarding privacy. If an individual suffers damage caused by an employer’s breach of its obligations under the DPL, he or she could potentially bring claims for breach of contract, constructive dismissal and any distress suffered. The individual could also report the matter to the Information Commissioner, the regulatory body responsible for enforcing the new law.

Ideally, the policy should identify a compliance manager who is responsible for reviewing, implementing and monitoring compliance with the policy. The policy should also briefly set out the measures taken by the employer to ensure that there are appropriate security measures in place to safeguard employee data and address how this will be protected if the employer intends to transfer employee data outside the Cayman Islands.

The need for a privacy policy also extends to the collection of data in the online environment, for example where an individual provides personal information when completing a job application online. The organization must ensure that the form includes a privacy policy either as part of its text or by means of a hyperlink on the form which can be reviewed by the applicant before the form is submitted. Similarly, information about a job applicant may also be collected through the use of cookies. If organizations deploy online tracking devices on their websites which collect personal data, data subjects must be made aware of the kinds of personal data the organization is collecting and the purposes for which that data is to be used.

The Information Commissioner has extensive investigative powers which include the power to enter onto premises and to require the furnishing of information and the production of documents. Following an investigation, if the Commissioner finds that a data user has contravened a requirement of the DPL he may serve an enforcement notice on the data controller directing it to take the steps necessary to remedy the contravention. Refusal to comply or failure to comply with an order is an offence. Employers may be liable on conviction to a fine of $100,000 or imprisonment for a term of 5 years, or both. The Commissioner may also issue a monetary penalty order requiring the data controller to pay a monetary penalty of an amount up to $250,000 and has the power to “name and shame” data controllers for breaches of the DPL.

Employee monitoring

There is no general prohibition against an employer undertaking surveillance of employees in the Cayman Islands. An employer has a right to direct its employees’ work activities and for that reason the employer has a right to reasonably monitor such activities. However, any collection, use and storage of personal data must comply with the DPL.

A forward-thinking employer can put itself in a strong position to check and investigate facts for legitimate business reasons, including investigating grievances and poor performance or misconduct, by having a clear and easily accessible employee monitoring or technology use policy. In particular, the policy should explain that the use of the employer’s IT systems, including email, internet, telephones and mobile devices, may be monitored from time to time and employees should have no expectation of privacy when using those devices. Employers should also include a contractual right to monitor within the employment contract.

Before deciding whether to undertake employee monitoring, employers are recommended to consider:
a) an assessment of the risks that employee monitoring seeks to manage and the benefits to be derived from applying it to those risks, having regard to the purposes that relate to the business functions or activities of the employer;
b) alternatives to employee monitoring and a consideration of the range of options open to the employer that may be equally cost effective and practical in their application, yet less privacy intrusive; and
c) the accountability of the employer. It is the responsibility of the employer to implement privacy compliant data management practices in the handling of personal data obtained from employee monitoring.

CCTV surveillance and accessing employee emails will be permissible, provided the employer has carried out an assessment that such monitoring is necessary and that monitoring is conducted openly and in accordance with the monitoring policy. Employers should share the evaluation process they undertake with their employees. Such a gesture indicates the transparency of the process and informs employees of the rationale behind the monitoring. When considering whether collection was carried out by unfair means, the Information Commissioner is likely to look for evidence that an evaluation has been undertaken.

An employer that wishes to conduct covert monitoring of its employees must have a legitimate purpose which would be prejudiced by giving notification to the employees of the purpose of that monitoring. A good example would be the prevention or detection of crime or serious misconduct.

Recommended best practice would be for the employer to consider the range of options available to them before conducting covert monitoring and assess the potential impact such monitoring would have on the privacy rights of its employees. Where covert monitoring is carried out, the employer should keep detailed records of the discussions that led to that decision, in case those actions need to be explained and justified to the Information Commissioner at a later date.

Cyber crime

For many employers, payroll processing and other back-office functions are now mostly digitized and are often delegated to external service providers. In an age where highly sensitive information can be exchanged at the touch of a button, data protection issues must be considered before any transfers of employee data are made to third parties. These transfers also leave employers vulnerable to cyber-attacks as criminals can easily identify and exploit weak links in the flow of information between an organization and its external providers. There is no substitute for proper due diligence on the systems, policies and procedures of those providers to ensure that personal data is handled appropriately and securely. Regular physical audits and independent testing of a service provider’s controls would also be advisable.

Contractual provisions should be put in place between the employer, as the data controller, and the third-party service provider, as data processor, to ensure that any employee personal data is processed only for authorized purposes, that all data is stored and transmitted securely and that disaster recovery practices are in place in the event of a data breach. Essentially, the contract should require the data processor to level-up its policies and procedures for handling personal data to ensure compliance with the DPL. Use of subcontractors by the service provider should be prohibited without the prior approval of the employer. Employee data that may have been anonymised or aggregated by the employer before being transferred will still require careful handling. The rise of social media and the increase in online public data sources means cyber criminals are now easily able to “re-identify” individuals by combining that information with the anonymised or aggregated datasets.

The attraction of flexible working has led to a growth in the popularity of “bring-your-own-device” (BYOD) policies. While some organizations are issuing smartphones and tablets for employees, other employees may be using their personal devices for business purposes without approval. Where BYOD is offered, a careful balance needs to be struck between employee satisfaction and protecting personal data. Organizations should put in place a clear BYOD strategy that sets out minimum do’s and don’ts for using a device. There should be a clear segregation of enterprise data which should at all times be under the control of the employer. Data should be encrypted and the employer should have the ability to remotely access, monitor and wipe the data and prevent data access from third party apps.

Data breaches that impact employee records present a particular threat due to the sensitive nature of the information held about employees. When employee data is targeted, it can have a significant, longer-term impact than simply a stolen credit card number, which can be easily rectified with the card issuer.

Loss of usernames and passwords is also a concern because this type of data can be used to overcome authentication-based workarounds to access other confidential information held by the employer. When employee data is breached, organizations need to work quickly to protect their employees and account for any lost company information. In the event of a data breach, the DPL requires the employer to notify both the Information Commissioner and the affected employee and provide details of the breach within five days.

Protecting personal data is now business critical for employers in Cayman. Even if monetary losses are not sustained as a result of personal data being mishandled, the reputational damage to an organisation following a breach of the new law could be devastating.

Kathryn Rowe is a Senior Associate specializing in contentious and non-contentious employment work. Peter Colegate is a Senior Associate specializing in data privacy, technology regulation and FinTech. Kathryn and Peter are both based in Appleby’s Cayman Islands office.