Wednesday, March 10, 2010Fair Play, Fair Competition

KPMGThe Reality of Offshore Financial Centers

Offshore financial centers are often misunderstood. Even the term ‘offshore’ can be misleading and ambiguous. Perhaps more accurately, many offshore financial centers are low-cost, tax-neutral jurisdictions which specialize in providing legal and institutional infrastructure for companies, primarily in financial services, to efficiently and cost-effectively structure their affairs.

Why then the concern? Many concerns may reflect an out-of-date perception of offshore centers. In the past, admittedly, a number of common characteristics of offshore centers made them susceptible to abuses such as money laundering and tax evasion. Light touch regulation, lack of transparency over beneficial ownership of assets and low or non-existent domestic tax rates combined to create the potential for abuse.

Being a global financial center in the modern environment, however, requires critical mass and a scale of infrastructure that, for both fiscal and reputational reasons, precludes taking on questionable business. Over the last 20 years, initiatives such as those mounted by the OECD’s Financial Action Task Force (FATF) have ensured the implementation of internationally accepted standards to combat abuse of the financial system.

In a series of reports since 2000, the FATF has named some two dozen countries as uncooperative in the fight against money laundering – including many ‘onshore’ jurisdictions such as Egypt and Hungary. However, progress in securing commitments to implement the OECD’s standards of transparency and exchange of information has been substantial. Standards of regulation and transparency in offshore centers often stand comparison with many of the best of traditional centers. In the UK, for example, the split capital investment trust scandal of the late 1990s was first exposed by the Guernsey Financial Services Commission. As of May 2009, no jurisdiction – onshore or offshore – is currently listed as an uncooperative tax haven, although the OECD still lists a number of countries which have yet to comply with international tax standards in full.

Many offshore centers do indeed offer advantageous tax treatments to companies, such as hedge funds and insurers, which invest outside their jurisdictions. But this is true of many other countries as well; aspects of the tax systems of countries such as the US and UK are also structured to give favorable treatment to certain classes of companies or individuals. Labeling individual countries as tax havens can be unhelpful: many national jurisdictions frame their domestic tax policies in part to compete with international rivals.

The increasing sophistication of international tax regimes means that location in an offshore center rarely offers absolute tax advantages. Instead, many offshore centers are generally tax neutral, imposing no additional tax burdens on companies, whose profits are taxed in the normal way when they are repatriated.

Offshore financial centers meet a clear demand from institutions and professional investors who are looking for innovative and alternative investments offering a different risk profile with the prospects of enhanced returns. At a time of depressed returns in conventional markets and asset classes, such investments can play a valuable role in creating a balanced portfolio with the potential for long-term growth, safeguarding the savings and pensions of millions of consumers around the world. Innovation in offshore centers is bringing new asset classes into structured markets and products of which sophisticated investors can take advantage.

Many collective investment vehicles, such as mutual funds and unit trusts, find it advantageous to be headquartered offshore to facilitate international distribution. Offshore centers can offer protection against political risk in onshore domiciles and prevent confiscation of assets and preserve legitimate wealth. Some offshore jurisdictions are also often chosen because they have stricter and more sophisticated controls and regulations than the territories in which the companies operate, and by cross-border joint venture operations seeking a neutral jurisdiction. It is interesting that the US government often stipulates that overseas recipients of loans set up offshore vehicles if domestic law is inadequate.

Against this background, the apparently growing criticism of offshore centers in recent months is unfortunate. Much of it has been stimulated by the G20 London Summit’s search to explain the current financial crisis, and frame new regulation to try to prevent a recurrence. Some G20 members appear to have taken the opportunity to push for greater regulation of hedge funds and, by extension, to encourage a further crackdown on the offshore centers where many of them are headquartered. Whether many of these moves have potentially protectionist motivations which seek to insulate their proponents from fair competition is another debate.

Offshore jurisdictions are seeking to compete in their own right as global financial centers on an equivalent basis. Instead of seeking to limit the competitiveness of offshore financial centers, the international community should perhaps accept the necessity of competing with them on level terms. Many offshore centers offer a distinctive and complementary value proposition, with benefits for professional and institutional investors which eventually feed through to retail customers. They are increasingly integrated into the global financial community, to the point where it makes little sense to regard them as a separate category.

In their own right, many offshore centers play a major role in a number of global financial sectors: to give some examples, the reinsurance industry in Bermuda and the hedge fund industry in the Cayman Islands are so well-developed that they are some of the most successful in the world.

We welcome a review of whether the current regulatory framework for offshore centers is suitable in the post-crisis environment. However, mis-informed or disproportionate regulation may be to the disadvantage of the global economy.

Oyster Publications Inc, PO box 3369, Road Town Tortola, British Virgin Islands, VG1110