Tax Havens Essay ⋆ Business Essay Examples ⋆ EssayEmpire

Since World War II, a number of small jurisdictions have become “offshore financial centers” (OFCs), or “tax havens.” Initially dubbed “tax havens” because they were associated primarily with opportunities for individuals and firms to lower their domestic tax bills by moving assets to jurisdictions that had low or zero tax rates, many of the offshore jurisdictions have branched out into providing highly specialized and sophisticated financial services. Although there are periodic disputes between relatively high tax jurisdictions, such as the United States, Canada, France, and Germany, and the offshore financial center jurisdictions, the offshore jurisdictions now play an indispensable role in the world economy and are unlikely to disappear.

Offshore financial centers are numerous. Anguilla, Aruba, the Bahamas, Barbados, Bermuda, Belize, the British Virgin Islands, the Cayman Islands, the Cook Islands, Cyprus, Dubai, Gibraltar, Guernsey, Ireland, the Isle of Man, Jersey, Liechtenstein, Luxembourg, Mauritius, Monaco, Montserrat, Nevis, Panama, Singapore, Switzerland, and Turks and Caicos all have significant offshore financial activity and other jurisdictions, from Mongolia to Native Americans in the United States, are investigating the feasibility of creating offshore sectors.

OFC jurisdictions share a number of characteristics. First, they are generally relatively small jurisdictions. Second, they are generally wealthy; several are among the top 20 gross domestic product (GDP) per capita jurisdictions each year. Third, successful OFCs are stable politically, giving investors confidence. The major difference between the activities in an OFC and the activities that take place in many onshore jurisdictions is that money invested in an OFC is generally later reinvested elsewhere, while onshore jurisdictions offer substantial domestic investment opportunities for foreign investors.

For example, money from outside the United States is regularly invested in American chartered companies and banks in New York. Just as OFCs do, the United States routinely reduces and even sometimes eliminates taxes on such investments as an incentive for foreign investors to put their money in the United States. Indeed, within the United States, Delaware plays a role with respect to corporate charters, and Vermont plays one with respect to insurance companies that are virtually identical to the roles of the Cayman Islands and Bermuda with respect to the United States as a whole.

The Growth Of Offshore Financial Centers

The growth of OFCs began in North America, with the Bahamas, and in Europe, with the Channel Islands (Guernsey and Jersey) and the Isle of Man. Prohibition in the United States had brought great wealth to the Bahamas, which had become a center for smuggling alcohol into the United States. After the end of Prohibition, the Bahamian business sector looked for new opportunities. In 1934, Canadian mining magnate Harry Oakes moved to the Bahamas to escape a Canadian tax rate of 85 percent, and the colonial government soon began a campaign to lure other wealthy individuals to relocate to the islands. After the war, the Bahamas launched an ambitious tourism and business development program, which included establishing the Freeport complex with lucrative tax concessions and other steps that made the country a popular destination for tax exiles. The colony’s access to both dollars from American tourists and pounds sterling through its ties to Britain also made it a favored business location for those attempting to avoid Britain’s postwar capital and exchange controls. By 1960, the islands were the largest dollar earner in the entire British Empire.

British OFCs

As decolonization gathered steam, the ruling clique of “Bay Street Boys” lost control of the Bahamian government just as independence became inevitable. After a bribery scandal further eroded the former colonial elite’s political clout, Prime Minister Lynden Pindling threatened to reduce the availability of work permits for expatriates in the financial sector. This prompted a rapid relocation of a large number of bank and trust companies to the Cayman Islands, one of Britain’s few remaining Caribbean colonies.

Capitalizing on the Bahamas’ mistake, Cayman quickly passed additional legislation to promote the offshore financial industry. Britain acquiesced in its Caribbean colonies’ move into international finance because the British government recognized the lack of alternative development strategies for the small islands. The three islands that make up the Cayman Islands, for example, total only 100 square miles and have virtually no arable land and no natural resources. Cayman’s maintenance of its ties with Britain (it remains a British Overseas Territory) is in part due to the value of retaining a final appeal from the courts to the British Privy Council as a means of reassuring investors.

In Europe, the Channel Islands occupied an important jurisdictional niche. Not part of Britain but separate possessions of the British Crown, the islands had originally been part of the English monarchy’s continental possessions. Devastated by German occupation during World War II, the Channel Islands used tax incentives to lure investment for rebuilding.

Similarly, the Isle of Man had its own jurisdictional status, again through the Crown rather than through Parliament. While not devastated by the war, the Isle of Man faced an economic crisis of its own after the war and needed a development strategy. Taking advantage of their separate legal status, the islands offered wealthy Britons relief from the extremely high postwar income and estate tax regimes.

In particular, the Isle of Man proved adept at marketing its thousand years of experience with common law trusts to European clients from civil law jurisdictions that lacked such entities. As more and more trusts were established on the Isle of Man, the financial services industries of accountants, investment advisers, and lawyers emerged to service them. As in the Caribbean, the British government tolerated the islands’ efforts because it recognized that without independent sources of income, the islands’ populations would become dependent on British transfer payments for survival.

Cayman’s development illustrates the transformation of the offshore financial sector from tax havens to OFCs. The earliest activities were company formations, to take advantage of the zero direct tax regime, and banking, to take advantage of confidentiality laws. Over time, however, Cayman developed a sophisticated business sector of its own, with virtually all of the world’s 50 largest banks maintaining a presence, as well as international accounting firms and law firms that included partners with English, Canadian, and other Commonwealth qualifications.

Cayman passed additional laws, taking advantage of demand in America for alternative insurance company structures in the 1980s, and becoming one of the leading locations of hedge funds in the 1990s. In part because of its small size, Cayman was able to quickly respond when it identified an opportunity for a new financial product, and its reputation for responsive and stable government gave investors the confidence necessary for the jurisdiction to succeed. The focus on offshore financial services has paid handsome dividends for Cayman and Caymanians. The islands went from a barter economy in 1960 to among the highest GDP per capita jurisdictions in the world today.

Regulation Of OFCs

OFCs have generally taken a quite different approach to financial sector regulation. Recognizing that customers for offshore transactions are generally sophisticated individual and institutional investors and corporate entities, OFCs’ regulatory bodies tend to not pay as much attention to disclosure requirements as do regulators in countries with large retail investment sectors, like the United States. Thus, where American regulators shape regulations to protect unsophisticated individual investors from assuming too much risk, OFC regulators focus instead on ensuring that customers have legitimate business purposes for making use of offshore entities. As a result, it is harder to open an individual bank account in most OFCs than it is in the United States or the European Union (EU). The benefit of this regulatory approach is that it dramatically lowers compliance costs for the regulated entities, reducing the cost of doing business.

OFCs have had their share of difficulties as well as successes. One problem stems from their portrayal as shady places where criminals lurk with briefcases full of cash from illicit enterprises. Dubbed the “Grisham Effect,” because novelist John Grisham used the Cayman Islands as a backdrop for such behavior in his crime novel The Firm, this reputation undercuts the leading OFCs’ efforts to establish reputations as carefully regulated jurisdictions where fraud is less likely than in the onshore world. As part of this effort, many OFCs work closely with international institutions like the International Monetary Fund (IMF) to ensure that their adoption of best practices standards is recognized. (The IMF conducts regular assessments of OFCs’ regulatory efforts.)

Despite these efforts, some OFCs have fallen victim to corruption. The chief minister and two other high government officials of the Turks and Caicos was arrested in the United States on drug charges in 2001, and Britain suspended the Montserrat government’s authority over banking regulation. More generally, the EU and the group of large countries that are members of the Organisation for Economic Cooperation and Development (OECD) have launched periodic attempts to restrict what they term harmful tax competition. Using the threat of sanctions and blacklists, the EU, OECD, and the United States have all succeeded in persuading most OFCs to adopt tax information exchange agreements. In addition, several European countries, led by Germany, have purchased stolen financial information from former bank employees in Lichtenstein and have used the information to launch tax evasion investigations into their citizens’ use of Lichtenstein business entities.

Bibliography:

Hoyt Barber, Tax Havens Today: The Benefits and Pitfalls of Banking and Investing Offshore (Wiley, 2007);
Michael Craton, A History of the Bahamas (Media Enterprises, 1986);
Mihir A. Desai et al., “The Demand for Tax Haven Operations,” Journal of Public Economics (v.90/3, 2006);
Mihir A. Desai et al., “Do Tax Havens Divert Economic Activity,” Journal of Public Economics (v.90/2, 2006);
Mark P. Hampton and Jason P. Abbot, eds., Offshore Financial Centers and Tax Havens (Ichor Business Books, 1999);
International Tax and Investment Organization, Towards a Level Playing Field: Regulating Corporate Vehicles in Cross-Border Transactions (International Tax and Investment Organization, 2002);
A. Johns and G. M. Le Marchant, Finance Centres: British Isle Offshore Development Since 1979 (Pinter, 1993);
Vassel Johnson, As I See It: How Cayman Became a Leading Financial Centre (Book Guild, 2001).

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