The Road about to be Travelled

May, 2011

A recent in development in European Court of Justice shone a thin beacon of sanity that, for a moment, bathed all financial centres in a positive glow. Hopefully, this will portend further similar developments and will thereby assist in refuting the misstatements, the half-truths and the omissions that pass for political comment in relation to the offshore financial world.

The event in question was the statement by Advocate General Niilo Jääskinen in the proceedings in the ECJ who advised the Courts Judges to rule in favour of the Gibraltar corporate taxation regime proposed in 2002 which sought to introduce a selective low 10% rate of tax. The EU Commission had attempted to argue that this rate structure constituted unlawful tax competition, the much-recited argument of the extreme left wing, high tax proponents, Tax for Justice. The EU Commission argument failed but the precise nature of that argument is of interest. The Commission had argued that at the lower corporate tax rate constituted a scheme of State Aid on the grounds that the tax rate was incompatible with the Internal Market because it was "regionally selective" in that it constituted a tax regime distinct from that of the United Kingdom to which Gibraltar was subject constitutionally and "materially selective" in that it was "inherently discriminately" since the proposed tax regime would result in offshore companies in Gibraltar not being taxed at all. The decision will be at a surprise to many.

From a more distant perspective, this decision will help to clarify the focus of what has become the fundamental issue. And it is the issue that in fact aligns Dublin and the Cayman Islands, on the same set of OECD cross hairs. The issue plain and simple is that of tax competition.

Before a chorus of "Hardly" drowns us out, let us endeavour to look through the layers of mischaraterisation to the actual facts at which point the truth of the matter should become more compelling. It is surprising how simple it is to undertake this particular analysis; testimony to the fact, no doubt, that if sufficient "tax haven" and "tax evasion" mud is slung, enough of it will stick to confuse the even the scholarly observer. The facts are, that the Cayman Islands does not even meet the OECD’s own test for a tax haven nor, and notwithstanding, the facility with which that expression is conflated with the expression "tax evasion", is it a jurisdiction in which the latter can be practiced, at least with any reasonable prospect of success. The indicia laid down by the OECD in their effort to define a Tax Haven in the 1998 report "Tax Competition – An Emerging Global Issue", required four factors to be evident, (i) a low or nominal rates of taxation, (ii) a lack of administrative and judicial transparency, (iii) bank secrecy, and (iv) a lack of substantial presence. Ignoring for a moment the highly subjective nature of these so called criteria, the simple fact is that the Cayman Islands has full pro-active tax reporting under the European Union Savings Directive with all 28 European Union Treasuries, has a sufficient number of bilateral Tax Information Exchange Agreements in the OECD approved form to ensure the gold standard otherwise known as "White Listing" and has regulator to regulator disclosure being a full IOSCO member.

In practical terms however, the position is a good deal more certain that that since the Cayman Islands financial services industry began to move away from the bank secrecy model in the mid 1980's leaving tax evasion to the more skilled exponents of the black arts in Switzerland and Liechtenstein (although in fairness, they too are now undergoing their own epiphany; one more swiftly than the other).

The Cayman Islands having then moved seamlessly through the transparency process, it is surprising that the truth deniers are able to maintain their criticism. But at the least then in the light of the foregoing the real agenda comes into focus and that must relate not to transparency nor tax evasion but to tax avoidance, that is to say, the real concern of the OECD and particularly in the light of the unmanageable deficits which the US and the European Nations are currently facing (one way or another) can be laid fairly and squarely within the first of the four indicia from which the Report takes it title. The issue plain and simple is tax competition albeit perfectly lawful tax competition on the basis of all current law and regulation.

The position of the Cayman Islands on this point is philosophically the most pure since its indirect system of taxation has operated for over 200 years and it cannot be said that it was designed with the intention of attracting capital flows. Nonetheless, the decision of the ECJ will also be welcome in Dublin where the politicians have fought a magnificent rear-guard action in fending off the Franco German assault on the 12% corporate tax rate and the more so notwithstanding, the seemingly precarious nature of their hold on the field of political combat.

The point needs better illumination because not only are the mischaraterisations that dog the of the Cayman Islands unfair to a jurisdiction which had, at the height of the market, provided over US$3.6 trillion of assets under management for inward investment into the United States and, primarily, through the City of London, into Europe and manages some US$1.5 trillion in bank deposits and inter bank bookings, but the misunderstandings that result lead to flawed domestic policy. Sn. Sanders of Vermont apparently actually believes there to be US$100 billion "stashed" in offshore financial centres; flawed understanding leads to flawed domestic policy and a number of the provisions of the HIRE Act which are now making their way into regulation under FACTA will have the unintended consequence of disincentivising inward investment into the United States at the very point where US$0.50 of every dollar its government spends is borrowed money. Can no one in Dublin offer any sound advice to his or her colleagues in Washington on some of the trickier long-term aspects of that particular practice?

But even if we assume that the political truth deniers cannot defy the weight of fact and therefore, gravity, indefinitely, does this mean that it is about to be plain sailing for the offshore financial jurisdiction? I doubt it. If tax competition is indeed the philosophical core of the debate then we can anticipate continued public relations antagonism for whatever reason. And the most likely of these would be the fourth of the highly subjective OECD criteria in that Report, the lack of "substantial presence". But if ever there was a spectacularly audacious retro-engineered definition, this one must take the cake. That is to say, in endeavoring to define the financial industry of a geographically small offshore financial centre as "harmful", the soundest possible basis for doing so is to ignore in its entirety the sophistication of its legal system, the quality of its professional structure, its systems for governance, compliance and transparency, the trillions of dollars under management, managed in accordance with lawful and recognized structures that withstand the due diligence of the world's best investment bankers, lawyers and accountants and simply to argue that it is harmful because it is, "Well what shall we say? – Small". There is no doubt that the OECD has hit on something here. The geographical size constraint is going to require all our fiendish cunning to overcome and at first sight, it seems likely on that point, and particularly since for aesthetic reasons we are limited to a seven storey office height limitation, that we are doomed here to fail the OECD test. On the other hand, who was it exactly who established the principle that a properly structured international transaction is in some way illegitimate unless much like a car manufacturing plant, or former car manufacturing plant, in Sn. Levin's beloved home state of Michigan, there are 5,000 people working under but one roof.

The well-structured international financial transaction may have a company in one jurisdiction, a prime broker in another, investors in a third an investment manager in a fourth and an administrator in a fifth. This structure may have withstood due diligence, have hundreds of millions, if not billions, of dollars invested in it, be audited annually and meet every test required of the financial market place with respect to its operation and function and yet would necessarily fail the OECD "substantial presence" test. This is fascinating engineering. But what meaning does this definition have in the real world of international capital flows?

And yet, no lesser personage than President Obama picks up the same point when he speaks of 12,000 companies in one building. Certainly, he cannot be referring to those companies undertaking tax evasion because you would need to be certifiably insane to make that suggestion in the light of the crystal clear transparency that prevails in the Cayman Islands. It can only be the lack of "substantial presence" that gives rise to his suggestion of a "tax scam", thereby lending indirect support to the OECD principle.

Fortunately, "substantial presence" is not, even by the OECD quadruple test, the sole indicia of a tax haven but the Cayman Islands most clearly should now do more not only from the perspective of its own economy but in terms of deflecting spurious reasoning to boost that percentage of each transaction which is managed and administered in the Islands For those reasons alone, the Administration’s more enlightened proposals on immigration reform will prove critical to the ongoing debate. Without reformed immigration policy sufficient professionals cannot be attracted or housed in the Islands to better clothe the local financial industry with the indicia of substance. The OECD are unlikely to go a away on this point and the question of whether or not the Cayman Islands people embrace these changes will have a good deal to do with how well the road ahead is travelled.