The world’s financial infrastructure remains in flux. The United States’ FATCA, Britain’s “son of FATCA,” France’s “mini-FATCA,” the dozens of intergovernmental agreements (IGAs) being entered into by governments around the world with the U.S., and calls by many EU member states for IGA-like agreements of their own are changing the rules of international financial transactions.
NYU’s John Blank and Virginia’s Ruth Mason argue in a recent Tax Notes article that, taken together, these agreements and laws offer “an aspirational new global standard for automatic exchange of information.” Let’s hope not.
Moreover, at the same time, we’ve witnessed politicians around the world demanding that businesses and individuals who have legally structured their affairs to minimize tax burdens pay more than they are obligated to do by tax laws in the name of “fairness.”
For example, U.K. Prime Minister David Cameron rejected the notion that being “within the law” was sufficient criteria for judging the validity of a business arrangement; he said that while “really aggressive tax avoidance” might be legal, it would not be “playing fair.” This is an extraordinary abandonment of the rule of law. If we can’t count on Britain to stand up for the law, it seems to me that the future is indeed grim.
All this regulatory activity and political pressure is going to be a boon for lawyers and accountants, but what does it mean for the global economy? Much of the discussion of international financial transactions revolves around these types of arguments about “unfair competition” and “distortions” introduced into financial and legal arrangements by jurisdictions with tax structures that differ from developed world norms.
These are not new claims. Offshore critic Ronen Palan argued in 1999 that what sets offshore finance apart is that “it drives economic activities into jurisdictions they should not have been in the first place.” More generally, critics contend that the existence of these jurisdictions “distort[s] the relocation policies of international capital.”
These arguments rest on a profound misunderstanding of how financial transactions occur. A series of incorrect assumptions about money, business, finance and government underlie them. These assumptions are disguised by often over-heated rhetoric and pseudo-scientific or completely unscientific calculations.
There are undoubtedly a few safe deposit boxes stuffed with cash and diamonds in Switzerland and other OFCs, although I’d wager there are probably more in New York, London and Paris than in any offshore bank. But money is not sitting idle in bank accounts in Cayman, Switzerland or Singapore. Indeed, among the silliest of the claims made by the Tax Justice Network in The Price of Offshore-Revisited is that the ill-gotten gains of criminals and dictators are invested in low-yield CDs.
Even if the depositor is uninterested in a return on his investment, the bank certainly wants to earn a return. Money deposited in OFC bank accounts, like money in any bank account anywhere, is used by the bank to earn a return by investing it. Some small fraction of money in an OFC bank might end up invested locally, but OFC economies are too small to provide sufficient investment opportunities for the money in their banks. Instead, the money is aggregated and lent on – often into the jurisdictions where politicians complain the most loudly about OFCs.
So, if they aren’t the equivalent of a mattress for tax evaders to hide money under, what are OFCs doing? They are a vital part of the international financial system providing three key services.
Rule of law. One of the most critical services provided by OFCs is the rule of law. All too many jurisdictions around the world lack the basic legal infrastructure to enable investment in anything but the most fleeting of economic opportunities. Without access to a competent, unbiased judiciary, serious regulatory bodies that prevent fraud, or modern, well-crafted laws and regulations, economies cannot grow. Sadly, many governments do not provide these basic components of the rule of law. Structuring an investment through a jurisdiction that does provide them can solve this problem.
This is not a hypothetical issue for far too much of the world’s population. Not only do corrupt governments fail to offer their citizens legal systems that work, but even where corruption is not an issue, less sophisticated legal systems may not enable creating business structures that appeal to foreign investors.
For example, EU pension funds are restricted in the types of investments they can make. OFCs like the Cayman Islands have created regulatory measures that meet those criteria, including the creation of the Cayman Islands Stock Exchange. Without the availability of an OFC-based structure, many developing country investments would be unable to access these important sources of funds. In whose interest is it to cut the world’s poor off from these sources of investment?
Cost-effective business structuring. Business entities are costly to create and maintain. Jurisdictions that specialize in legal regimes that lower those costs can lower transactions costs and so facilitate more transactions, creating wealth. OFCs do this in two dimensions. First, they have regulatory regimes focused on particular problems. For example, offshore entities in the Cayman Islands are not unregulated, as some OFC critics like to claim. Rather, these entities are regulated in a way that takes into account the way they are used in the global economy. If an entity is not marketed to retail investors, costly measures aimed at protecting retail investors can be omitted without harming anyone.
Of course, advocates of more aggressive regulation tend to fall conspicuously quiet when asked to explain how well those regulations work in practice. Plenty of European and U.S. investors lost money with Bernie Madoff, who had to turn himself in to the SEC to get arrested despite repeated, detailed submissions describing Madoff’s fraud made to that agency by Harry Markopolos. Worse, Madoff was not even running a sophisticated fraud – just a garden variety Ponzi scheme. Since Dickens wrote about such frauds in Martin Chuzzelwit (1844) and Little Dorrit (1857), it shouldn’t have been that difficult for the SEC attorneys who ignored Markopolos’ submissions to grasp the problem.
Second, OFCs have developed specialized business entities that serve particular needs at lower costs. Segregated portfolio companies and business trusts are just two examples of ways in which OFCs have innovated to reduce transactions costs. OFC critics like to suggest that such entities must be being used for some nefarious purpose. But there is nothing nefarious in organizing a captive insurance company or creating a special purpose vehicle to enable financing of a capital equipment purchase.
Now, people who don’t understand or don’t like competition, such as the Tax Justice Network, like to hint that there is something illegitimate about using a business structure in one jurisdiction to do business in another. TJN is at least consistent, criticizing Delaware and Nevada as well as OFCs.
President Obama needs to have a chat with Vice President Biden, formerly a senator from Delaware, or Senate Majority Leader Harry Reid (D. Nev.) about the merits of jurisdictional competition. Or, perhaps, he has – Obama has not offered any criticism of Delaware’s or Nevada’s corporate registries, despite their significant lack of transparency. More importantly, what the anti-competitive crowd fails, or refuses, to understand is that jurisdictional competition is vital to generating improvements in the law that produce economic growth.
Organizing a business using an OFC makes doing business less costly – and not just because of taxes. Suppose a business needs to finance a major piece of equipment. Using a special purpose vehicle to make the ownership of the equipment bankruptcy remote from the operating business can lower financing costs.
Or perhaps a hospital wants to create its own insurance company so that it can craft its own coverage policy for doctors that practice there. A captive insurance company organized in a jurisdiction with regulations designed to facilitate such structures, and regulators who understand their operation, reduce the cost of such a strategy.
Tax neutrality. When bringing together investors from multiple jurisdictions, a zero-direct tax or low-direct tax jurisdiction makes it cheaper to aggregate money into an investment vehicle. David Cameron or Barack Obama might not like it, but they ought to love it. Cameron should be excited because international business structuring, using overseas territories, crown dependencies and former British colonies is a great deal of what goes on in the City.
Not only do all those professionals pay considerable U.K. tax on their earnings, but the concentration of all that talent in London is responsible for driving up London property values (and stamp tax receipts) and filling London business hotels and restaurants. And Obama should be rolling out the welcome mat for international investors, since it is their money – often coming to the U.S. via an OFC – that is propping up the anemic economic growth rates he’s presided over. Any money earned in the United States is, of course, subject to tax in the United States.
As we rebuild the world’s financial infrastructure, I hope we will not destroy the ability of jurisdictions to compete with one another in the provision of these important services since it is competition that pushes all jurisdictions, not just OFCs, to improve. For the last ten years, I have taught a law school class that brings U.S. law and business students to the Cayman Islands in March to learn first hand about how to do business offshore.
Inevitably, when I mention this course, the response is a knowing smirk, particularly if all the listener knows about Cayman and OFCs comes from John Grisham’s The Firm. My students develop quite a different understanding. Dozens of Caymanian lawyers, government officials, accountants, insurance executives and others have spoken to my students over the last decade. My students leave with a changed impression of OFCs and Cayman, as well as useful business contacts and a tan. We need to get the word out about what really goes on in OFCs or we risk losing an important part of the global financial system.
It is not too late, but it will be soon.