Substance over form:

How international financial centers can survive in the age of automatic exchange of information and transparency

This year marked a turning point for international financial centers (IFCs), especially those that are British Overseas Territories (BOTs) and Crown Dependencies (CDs), in terms of the future landscape on which they will compete, cooperate and provide their services. 

It also presaged the end, in my opinion, of form over substance which, in many cases, has characterized the manner in which some of these IFCs have operated to date through the use of shell companies with little substance in the jurisdiction of incorporation or trust structures which are, in effect, managed from the onshore jurisdiction with the actual trustee in the IFC, a mere figurehead who does what he/she is told to do and is paid fees which are risible and evidence that the actual management and administration of the structure are not taking place therein.

For some time now, many of us in Anguilla have argued that secrecy and opaqueness no longer can be the main reasons for using IFCs, especially those in the Caribbean. The erosion of financial privacy is regrettable for many reasons, including the safety and security of persecuted people around the world, but that battle is largely lost.

This doesn’t mean, however an end to our business in the offshore world. Many IFCs have enough intellectual capacity and the necessary skills-sets and favorable economic climates within their borders to move up the value food-chain. It has also been a pet peeve of mine since being in private industry as opposed to regulation where I started my career in this sector, to witness the gimmicks which clients request and service providers assent to in structuring their affairs to take advantage of the low tax regimes and financial intermediation that IFCs offer.

The use of general powers of attorney granted to the shareholder or ultimate beneficial owner by the nominee director, the use of nominee directors who exercise no independent judgment or decision-making akin to the trust structures which I referenced earlier and thus are paid little, and mobile bearer shares to hide and or confuse beneficial ownership, are just some of these practices which, if not dead in the water, will soon die, as the landscape changes.

Not only were these practices risky in some respects, despite being common in all IFCs and favorite requests of many clients especially citizens of the former Soviet Union, Eastern Europeans and Asians, but they also added little, in my opinion, to the credibility of the structure and to the jurisdiction.

With the G8 summit in Northern Ireland in June, which was presaged by U.K. Prime Minister David Cameron’s May 20 letter to the leaders of the overseas territories and Crown dependencies, and the announcements and actions which followed, secrecy and opaqueness went out the window.
Cameron’s decision to force these jurisdictions to enter into Foreign Account Tax Compliance Act (FATCA) compliant intergovernmental agreements (IGAs) with the U.S., agree to join the pilot program for the automatic exchange of information with a few EU member states including the U.K., France and others, otherwise termed “son of FATCA”, and have the OECD Multilateral Convention on Mutual Assistance in Tax Matters extended to the overseas territories and Crown dependencies, while publishing action plans to move towards a registry of beneficial ownership information of companies, trusts and other structures domiciled within their borders, meant in effect that the rules of the game had changed and these IFCs would now need to compete on a different playing field, within a new paradigm in which automatic exchange of information and transparency are the norm.

While it is clear that the British overseas territories and Crown dependencies will be the first to be affected by these developments, persons in the independent IFCs like the Bahamas, Belize, Nevis and others should not take solace in this fact since the trend will eventually reach their shores. Regulatory arbitrage in their favor is unlikely to last very long given the zeal with which the powerful high-tax governments are pursuing their anti-tax competition agenda. Mid-shore jurisdictions like Singapore and Hong Kong may benefit in the long run in some respects, especially Hong Kong given its favored status as a Special Administrative Region of China. Singapore is likely to face greater pressure but given its size, strategic position in Asia surrounded by emerging economies like Indonesia and Malaysia, it is likely to fare much better than the smaller IFCs spread out in the Caribbean, part of Europe and Indian Ocean.

The criticism of companies domiciled in IFCs has always been that they are shell structures. No activity takes place in the jurisdiction, no accounts are mandated for audit and onward submission to a revenue authority, no mind and management takes place in situ whether by having a resident director, as was once the case in some jurisdictions for at least licensed entities, or a requirement to hold board meetings therein. In effect, the only link the company often has with the jurisdiction is that the latter is the seat of its domicile and each year the company pays the local registered agent a fee to maintain it is good standing thus ensuring its existence.

This situation allows hypocrites like the current occupant of the White House to say in 2008 that Ugland House in the Cayman Islands was either the “biggest building or biggest tax scam on record” to the cheers of his left-wing political base and foreign friends which unfortunately and ironically include the vast majority of the professionals who work in the sector in IFCs, with a straight face, while conveniently ignoring 1209 North Orange Street in Delaware which has 285,000 companies and happens to [be in] the state of his equally economically untutored vice president.

However, despite the sheer scale of the double standard which smacks of modern day colonialism and mercantilism, the fact remains that this thinking has and continues to shape the debate and landscape. The only way in which IFCs can overcome this and serve clients’ needs is to move towards ensuring that more substance, mind and management, and actual business activity, take place within their geographical confines. In other words, not only should the situs/seat of the company be in the IFC but so should its actual operations whether through dedicated staff and or management conducting their activities locally or at least holding regular meetings therein to strengthen the link between the company and the jurisdiction.

Doing this would avoid following the “too cute by half” tax mitigation strategy which Apple used, legally I might add, in using an Irish company which only link to Ireland was its domicile while having mind and management in California and which in effect allowed it not to pay Irish tax based on Ireland’s definition of a tax resident company and U.S. taxes based on the American definition of what qualifies a company for paying its taxes. The negative publicity which Apple and other companies like Google and Starbucks took as a result of aggressive tax mitigation strategies cannot be quantified, but the extent to which it has caused lawmakers in various countries to react can be seen in the recent moves by Ireland to change its laws so that so-called “stateless companies” using Irish company law as the law of its domicile will be subjected to Irish taxes as of January 1, 2015, if the legislation is enacted in its current guise.

One good example of this move to substance over form is the development of the Cayman Enterprise City (CEC) which epitomizes what IFCs need to do. The concept is simple in its construction and marries well the benefits of a low tax jurisdiction with the need for substance on the ground. Clients wishing to take advantage of its benefits incorporate a Cayman company, which itself is tax neutral since the Cayman Islands have no corporate, capital gains, income or sales taxes, and uses office space within the CEC to actively manage and operate the company with mind and management physically within the jurisdiction. They are therefore able to gain the tax benefits of using a Cayman company without the gimmicks mentioned earlier and can stand before their home-based revenue authorities, depending of course on their citizenship, and say that the company which they own is domiciled, managed and operated from the Cayman Islands; here is its registered office address which is an actual physical space; here are its employees who are mainly Caymanians and therefore this company is outside its remit.

While CEC is the product of a government created special economic zone which also receives other benefits such as exemption from import duties and the granting of five year visas in five days, some would argue that such a legislative framework is not necessary for IFCs to create substance within their geographical sphere.

One such proponent of this perspective is Lynwood Bell of the Span-Hansa Group in Anguilla. Bell believes and some of us concur, that all jurisdictions with tax neutral regimes, flexible immigration rules and a friendly business climate, through the active efforts of the local professional advisers, could and should encourage clients to come offshore physically and start their business there. Over the years, he has done so for over 20 of his clients without any legislative framework existing in Anguilla. However, industry professionals in Anguilla are actively working on an economic residency program which will involve some legislative activity on the part of the Anguillian government to create a carve-out within its Immigration and Passport Control Act to allow for and further encourage this along the lines of the recently created regime in the Turks and Caicos Islands.

Bell is also the creator of two other concepts designed to encourage and create substance within Anguilla and which could easily be copied by other IFCs. They are the certificate of intellectual property residence and the certificate of economic purpose. While the concepts when fully understood are not earth-shattering, they are attempts to prove substance and purpose through the use of documents and documented activities which are taking place within the jurisdiction backed by recognition from the Companies Registry. While Bell is satisfied that they work fine as are, others in the industry locally, based on feedback from elements of the international community, are seeking ways to give legislative backing to these concepts which will be “works in progress” for some time. Irrespective of this, along with moves to encourage clients to take up economic residence, Anguilla as a jurisdiction is seeking to also create substance within its borders.

Bell is of the view that had firms like Apple made use of tax neutral jurisdictions like Cayman and Anguilla, the negative fall-out which they received could have been avoided, especially if some elements of substance, such as regular board meetings being held in situ, had been established. Apple would have been able to legitimately claim that they pay local, zero-rated corporate taxes, which is not the case in Ireland where Apple fell into a lacuna between Irish tax laws and those of the U.S. where its operations are mainly based and mind and management occurs. 

He also argues that jurisdictions that have a tax information exchange agreement (TIEA) with Canada such as Anguilla and Cayman are ideal to take advantage of the exempt surplus and participation exemption rules of Canada’s tax regime through encouraging Canadian companies to incorporate and operate subsidiaries from these IFCs as they have been doing for several years in Barbados as a result of its double taxation agreement with Canada. 

Whether or not this can be mirrored as a result of the TIEA, especially in Cayman and in light of the recent ruling in M.H. Investments and J.A. Investments v The Cayman Islands Tax Information Authority, I concur with Bell on the broader point and agree that such potential opportunities strengthen the arguments for companies, even those with revenue levels and operations way below that of multinationals, to seek to ensure that their activities are structured in a way where substance trumps form.

In a presentation made to the Society of Trust and Estate Practitioners (STEP) branch in Johannesburg, South Africa, in September of this year, I posited that in this changed landscape, the test that each client will face is this: Can he or she stand before his/her tax authority and say truthfully that the trust of which he/she is a settlor or beneficiary is not controlled by him/her? Or is the company of which he/she is the ultimate beneficial owner not managed and controlled by him/her but is indeed controlled in the IFC by the registered agent or company administrator? If the client cannot answer these questions truthfully, then he/she is likely to be in trouble with his/her revenue authorities and the service provider would have done the client a disservice.

It is my opinion that if the client adopts an approach which focuses on ensuring that there is substance over form, he/she would be able to indeed answer in the affirmative to the test set out above and the service provider would have indeed provided a good service as opposed to doing the client a disservice. This would thus ensure not only his/her own survival in the industry but the future of the IFCs in general.

Cayman Enterprise City