Back to the Future

Legal Week
25 October 2001

After a rigorous three-year process, in July the Cayman Islands emerged with a clear understanding on the Organisation for Co-operation and Development's (OECD's) Harmful Tax Competition initiative, its zero tax regime intact, and its money laundering legislation tweaked by the Financial Action Task Force (FATF) to spectacular levels of probity requiring the application of Know Your Client due diligence to UK standards.
In the light of this, two often repeated myths  should have been laid to rest firmly. As to 'bank secrecy', the accord reached with the OECD ensured that there would be tax transparency with regard to criminal tax matters in the first tax year following 31 December, 2003 and with regard to civil matters, in the first tax year following 31 December, 2005 pursuant to bilateral treaties to be negotiated on a country-by-country basis.

The form of these treaties is still under negotiation, but this accord sends a message that the Cayman Islands is not an appropriate jurisdiction for trust or corporate structures that involve assets related to civil or criminal tax evasion.

As to 'money laundering', it may have been argued before the FATF process that the Mutual Legal Assistance Treaty with the US, ratified in 1990, provided adequate deterrent to any such activity in the Cayman Islands.

Pure tax offences were excluded from that treaty, but the US Department of Justice had specific gateway access to any client files involving drugs trafficking, fraud, failing to make appropriate reports in respect of currency transfers, insider trading and fraudulent security practices. It was open to the US Government to extend the range of offences at any time by exchange of letters. No request to extend the treaty following the terrorist attacks on the US has, as yet, been received.

The Mutual Legal Assistance Treaty was little used by the Department of Justice in the 11 years following its ratification. Nevertheless, the FATF took a different approach by placing a significant obligation on the financial service provider, not just with regard to source of funds and suspicious transaction reporting, but requiring that a chain be established either directly or through an appropriate intermediary organisation or institution in an FATF-approved jurisdiction to the ultimate owner for bank accounts and all securities.

These requirements were imposed on professionals across a range of transactions and applied specifically to all forms of regulated and licensed entities in the Cayman Islands.

Suspicious transaction reporting along UK-style lines was rendered mandatory and applied to all professionals with none of the convenient distinctions applied in certain Continental European jurisdictions.

The FATF review process, which involved on-site inspection of the Cayman Islands Monetary Authority and the Financial Reporting Unit was thorough. The FATF concluded that the 40 original Vienna principles and the 29 additional principles were met and the Cayman Islands  had effective anti-money laundering legislation, and the systems to operate it effectively, which met the new world standards for cross border co-operation and transparency.

With that undertaken by July 2001, Cayman Islands professionals faced up to the task of applying the new regulations and guidance notes to the pre-existing book of business, which had to be completed by December 31, 2002.

The Cayman Islands Government had drawn a line in the sand on the principle of transparency and government policy was that the Cayman Islands should concentrate on the legitimate right to privacy as it relates to international capital flows in the areas that have formed the foundation of the Cayman Islands financial industry; mutual and hedge funds; structured finance and asset financing; private equity and joint venture transactions; insurance; banking; and properly structured trust arrangements for private clients.

This seemed to be the right direction, and transparency the right bargaining chip given that the Cayman Islands maintained its tax neutrality; a position indirectly supported by the US Treasury when it withdrew support for the wider tax harmonisation goals of the OECD initiative by re-establishing the importance of tax competition.

But now the line in the sand looks like it is being re-drawn. In the wake of 11 September, the US anti-money laundering legislation needs to be upgraded. Conventional definitions of money laundering will need to be re-evaluated. A framework based on the assumption that terrorist networks are necessarily funded by proceeds of criminal activity is simplistic. The amounts required to fund terrorists appear to be very small, so they may not appear to be 'suspicious.'

The current definitions of money laundering and the application of anti-money laundering legislation and regulation in the changed circumstances require careful re-thinking.

But what is emerging from the US legislative process appears to be retrograde. The new Senate Bill that deals with money laundering and anti-terrorism legislation introduces the following tests that the Treasury Secretary should consider when making a finding that grounds exist for concluding that a jurisdiction is of 'primary money laundering concern':
1) The extent to which the jurisdiction offers 'bank secrecy or special tax or regulatory advantages to non-residents or non-domiciliaries of such jurisdiction'. Whether this was specifically aimed at the UK and Ireland is unclear, but it would certainly catch both these and a number of offshore jurisdictions. Why terrorism should be legislatively linked to tax competition is unclear.
2) Another subjective test, 'the substance and quality of administration of that jurisdiction's bank supervisory and counter money laundering laws', remains difficult to prove a negative. Statistical 'aberrations' in suspicious activity reporting could be an indication of the absence of activity about which one should be suspicious.
3) 'The relationship between the volume of financial transactions occurring in the jurisdiction and the size of the jurisdiction's economy'. This old chestnut is an OECD favourite and targets offshore centres that provide financial services. It corresponds directly with the 'lack of substantial activity' test of the OECD Harmful Tax Competition report. Again, it appears to contradict Treasury Secretary O'Neill's position for the US Treasury on tax competition.
4) 'The extent to which the jurisdiction is characterised as a 'tax haven' or offshore banking or secrecy haven by credible international organisations or multi-lateral expert groups.' When the OECD initially compiled its list of 47 tax havens, it admitted it had relied on anecdotal evidence, but the OECD is regarded as a credible international organisation. This test re-introduces the application of the 'low or no rate of tax test' that comprised one of the OECD's four-point tax haven tests in its earlier report.
5) 'Whether the US has a mutual legal assistance treaty with that jurisdiction, and the experience of US law enforcement officials, regulatory officials and tax administrators in obtaining information about transactions originating in or routed through or to such jurisdiction.' Surely the appropriate test and a sufficient test on its own?
6) 'The extent to which that jurisdiction is characterised by high levels of official and institutional corruption.' A subjective analysis from which it seems that the US in defining indicia is learning from the European book.

The reader may be forgiven for concluding that the subjective nature of the determinations required and the unfortunate linkage between, on the one hand, direct and indirect systems or low levels of taxation and, on the other, money laundering, appear to hark back to the worst aspects of the OECD paper on Harmful Tax Competition. The House and Senate Bills on US anti-money laundering have not been reconciled and have not moved to the President for signature.

In the current climate, it seems reasonable to suppose that some distinct, well-established and proper principles may be overridden. It also seems right to conclude that those jurisdictions that remain on OECD and FATF blacklists may find that the temperature is about to heat up. Fortunately, the Cayman Islands is on neither.