Thirty years ago, one of the world’s largest offshore financial centres was the island of Curaçao in the Netherlands Antilles.
The Netherlands Antilles was the domicile for George Soros’s hedge funds as well as for corporate entities used widely by non-Americans to hold US real estate and other assets.
Most importantly, however, the Antilles was the home of the subsidiary finance corporations that were used by virtually every major American corporation as part of a structure to access the cheap foreign investment capital of the Eurobond markets.
This arrangement benefited both the Antilles and the United States. As is generally the case in the leading OFCs today, the financial services industry contributed significantly to the Antilles total government revenues. At the same time, foreign debt investment in US corporations expanded dramatically. Despite the mutually beneficial nature of Netherlands Antilles’ finance transactions, however, the United States cancelled the tax treaty that facilitated such transactions and the Antilles’ financial sector all but evaporated within a few years.
A brief review of the history of the Antilles’ offshore financial sector offers some answers:
- The Antilles’ financial services sector was the fortuitous product of three unrelated events. First, the construction of major oil refineries in Curaçao and Aruba to process Venezuelan crude oil in the early 1900s gave the islands a small but significant population of professionals that included accountants, lawyers, and civil law notaries. This nascent professional sector expanded significantly, along with the Antilles international reputation, when, following the German invasion of the Netherlands in World War II, a significant number of Dutch companies transferred their statutory seats to the Antilles as permitted by the law of the Dutch Kingdom.
- Unsuccessful efforts to retain Indonesia as part of the Dutch Kingdom following World War II led the Netherlands to offer the Antilles a significant degree of sovereignty over internal matters, including taxation. During the 1950s, at the urging of an entrepreneurial civil law notary named Anton Smeets (who later founded CITCO, the worldwide financial services giant), the Antilles government took advantage of its newfound autonomy to pass legislation creating a ‘ring-fenced’ tax regime in the Antilles that afforded special tax status to foreign-owned corporations that were domiciled in the Antilles but derived most of their income elsewhere. This regime encouraged the formation of passive Antilles investment entities that were largely exempt from Antilles taxation on the income they earned.
- Following World War II, the United States extended to the Netherlands Antilles the tax treaty it had previously negotiated with the Netherlands. Although the US extension of tax treaties to overseas territories of its treaty partners after World War II was rather routine, the treaty’s exemption of US source interest payments from the otherwise applicable 30 per cent US withholding tax combined with the Antilles’ ring-fenced tax regime made the jurisdiction a highly desirable location for entities receiving interest payments from the United States.
These three events set the stage for the Antilles’ offshore financial sector success. When US balance of payments deficits in the 1960s led the American government to encourage US multinationals to raise debt financing outside the United States for their foreign operations, American firms learned how to access the Eurobond market through finance subsidiaries created in the Antilles. When interest rates in the Eurobond markets later dipped below US rates, Eurobond financing became an appealing option for funding domestic as well as foreign operations, exponentially increasing the number of Antillean finance subsidiaries and driving significant growth both in the financial sector and the related sectors it supported. By the late 1970s, billions of dollars in corporate Eurobonds were being issued through the Antilles annually, saving US borrowers an estimated two to three per cent in interest costs.
As Antillean financial services firms became more sophisticated and their offshore customers grew more comfortable with the jurisdiction, new lines of business developed. For foreign investors, Antillean companies became popular vehicles for holding US real estate. Bearer shares in such entities provided investors anonymity and allowed the transfer of real estate assets without the transfer of title records in the United States. Moreover, the Antilles’ low-tax regime for foreign-owned companies attracted early hedge funds and captive insurance companies that were able to operate as Antilles corporate entities with only minor inconvenience. Notably, however, the Antilles did not lift its requirement that legal documents be filed in Dutch and it did not adopt laws that facilitated the formation and development of these new businesses. By failing to innovate in these markets, the Antilles eventually lost its initial advantaged position in both the hedge fund and captive insurance industries.
By the late 1970s, the Treasury Department, which had assumed oversight of tax treaty negotiations, became concerned that the United States-Netherlands Antilles tax treaty was subject to ‘treaty shopping’ – that is, it was being used by individuals and entities not physically resident in either country and for whom its benefits were not intended. As the treaty became what many within Treasury called a ‘treaty with the world’, US tax revenue losses mounted; US government estimates indicated that as much as US$100m per year in tax revenue was lost as a result of the treaty. Moreover, if the United States’ 30 per cent withholding tax on interest payments could be avoided merely by creating an Antillean entity to receive the payments, Treasury would have difficulty persuading foreign governments to sign tax treaty’s that included the expansive information exchange provisions it sought. Finally, US law enforcement officials also grew concerned about their inability to penetrate Antilles entities holding US real estate, and worried that proceeds of criminal enterprises were being laundered. Thus, the utility of a financial engineering strategy that had been acceptable to the United States a decade earlier was overshadowed by other US policy concerns and the United States attempted to renegotiate its tax treaty with the Netherlands Antilles.
Failing to sense the shift in the US’s cost-benefit analysis of the treaty, the Antilles government would not offer concessions sufficient to satisfy Treasury negotiators and the United States unilaterally terminated the treaty in July, 1987. (In response to an uproar in the bond market when US borrowers realised they would have to ‘gross-up’ their interest payments to cover the withholding tax on previously issued bonds, the United States hastily grandfathered outstanding bonds.) Despite a number of efforts to develop new offshore financial products, the Antilles has never found another market niche to rival the finance subsidiaries.
Lessons for OFCs
Our research suggests two key lessons from the Antilles experience that today’s offshore leaders should bear in mind as the United States, the OECD and the European Union ramp up their efforts to regulate the offshore financial industry.
- Offshore jurisdictions prosper when their products and services are perceived by onshore interests as offering mutual benefits. The US Treasury department encouraged Antilles finance subsidiaries for years, as their use was seen as a solution to an American balance of payments deficit. But the growth of any particular product can create interest group opposition within the onshore jurisdiction. In the case of the Antilles, the rampant growth of the finance subsidiary business resulted in the salutary effects of Eurobond market access being outweighed by new policy concerns (treaty shopping, tax revenue losses, money laundering). Ensuring that onshore governments continue to benefit sufficiently from offshore transactions and that they realise the magnitude of that benefit is thus critical to the survival OFCs. The public sector and the financial industry must work together to keep the jurisdiction’s laws competitive and to represent the jurisdiction’s interests with onshore governments and in international fora.
- OFCs must continue to identify and develop new offshore opportunities. The Antilles had a thriving offshore industry, lost it in an instant and has yet to restore its vitality. In large part, this reflects the Antilles’ singular dependence on a tax treaty that was particularly vulnerable to unilateral cancellation. Because the Antilles had not successfully developed new financial products or services, the treaty cancellation proved devastating. Virtually every line of business in the offshore world depends on the arbitrage of differences in onshore and offshore legal regimes. To survive, industry and government in OFCs must cooperate to encourage flexibility and innovation in the expansion of offshore financial products and services where these differences exist.
It is axiomatic that those who cannot learn from history are doomed to repeat it. These are turbulent times for OFCs, and the leaders of offshore jurisdictions would do well to remember the lessons of the rise and fall of the Netherlands Antilles.
This article is drawn from Craig M. Boise & Andrew P. Morriss, Change, Dependency & Regime Plasticity in Offshore Financial Intermediation: The Saga of the Netherlands Antilles, Texas International Law Journal (forthcoming 2009) available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1368489