Emerging Trends In International Finance Centres' Legislation

E (Ben) Bendelow
President Emeritus and Chairman of the European Branch Chair of The Offshore Institute
Chairman of Basel Holdings Limited

When I was asked to write this article about emerging trends in International Finance Centres’ (“IFCs”) legislation, I was very struck by the quotation attributed to Einstein “many think they know the answers but very few know the questions“! I therefore spent some time pondering what are the real issues that are driving the trends in IFCs’ legislation, and hence financial products? I decided that the only way to come to a useful answer was to try to analyse the underlying economic forces, which the legislation is attempting to satisfy.

I felt that the best way to do this was to examine the historical context of IFCs, which have evolved from Offshore Financial Centres (“OFCs”), which in turn evolved from Tax Havens. So the fundamental question is why did tax havens evolve? Obviously any state requires revenue and the way that revenue is raised in most developed countries is by means of a taxation system but, with any system of law, there will, of course, be particular circumstances which will enable the outcome of the business events in question to be so structured as to yield a different result than perhaps the legislators originally envisaged. Hence the gradual emergence of tax havens in the early 1960s as the major industrial economies of the world recovered from the Second World War, and cross-border business really took off.

This period was followed by a “golden era” when very few powerful multilateral inter-governmental organisations (viz UN, OECD, WTO, EU, etc) really existed. In these circumstances it was relatively easy for the international businessman to aggressively plan his affairs. At the same time highly technical financially engineered products were developed, and these depended to some extent on bespoke legislation, which was more and more available in so-called OFCs.

However, in the last 25 years most leading OFCs have matured into IFCs and are in truth providers of financial services across a very broad spectrum. Nowadays international financial services really represent the arbitrage of legal systems to obtain some desired economic benefit. For those who are unfamiliar with the term “arbitrage”, this is an economic term and is typically used to define the use of some market imperfection, such as a timing advantage about a product or company, which the investor exploits to radically out-perform the market. So in modern international financial services, the international practitioner typically arbitrages some imperfection or differences in legislation between jurisdictions to legally improve the economic benefits for his clients.

If we take a look at estate planning for the high net worth individual, there are now a number of techniques to satisfy the dynamic and ever-changing demands of this type of individual. For example, if we consider the following factors when dealing with a wealthy person in their mid to late-40s, it is clear that an international estate plan need to be developed, because:

  1. Individuals are now becoming wealthier much earlier in their lives.
  2. Individuals now have greatly enhanced life expectancy.
  3. Government provision for pensions and health care is clearly going to be problematic in the next 50 years.
  4. The world is becoming extremely litigious and it is no longer prudent for a wealthy persons in their 40s and 50s to hold the title to their wealth in a non-diversified manner.
  5. Individuals and their children are becoming more and more multi-resident, which can have a particularly difficult impact on inheritance and other forms of taxation.

Given these factors, IFCs need to be able to provide solutions, which are typically not exclusively taxation driven but rely on bespoke legislation relating to the diversification of title of assets into such vehicles as investment holding companies, foundations, discretionary trusts, purpose trusts, limited partnerships, etc, etc. In addition to legal ownership diversification, there are a variety of new types of investment media available, such as private mutual funds, insurance products, etc.

What is true of the individual is also true of the corporate world. Many corporations are now operating on a truly global scale, with employees being freely transferred within an organisation from country to country. Similarly, they have operations in and generate revenue from many different countries and in many differing forms. As a consequence of the factors noted above, a number of specialist products have been developed, such as securitisation structures, multi-national pension schemes, and specialist treasury management products.

In summary, therefore, IFC products look at minimising the cost of:

  1. Taxation of all sorts
  2. Regulatory costs
  3. Combating political/economic uncertainty
  4. Providing unique legislative products
  5. Capital raising

As will be seen from the above analysis, the IFCs provide a varying necessary range of services to the world’s economy, and the services in question are very broadly based and are no longer focused principally on taxation. A whole portfolio of intellectual products and skills to satisfy market requirements has been developed. Most of the leading IFCs are highly regulated (indeed more highly regulated that many national finance centres). The big advantage is that IFCs are very nimble in producing legislative solutions because they are typically politically cohesive and have relatively limited domestic legislative programmes to find time to legislate for.

Having completed this analysis of what IFCs actually do and how they do it, we need to look at how some of the national governments and their multi-national organs have been reacting to the activities of the IFCs.

Clearly if there was no competition between jurisdictions to produce attractive legislation, which generally improves economic activity, then there would be no difficulty. However, the perception of most national governments is that the activities of the IFCs are not a “zero sum game”. In other words, they see themselves as merely losing revenue through, for example, taxation reduction, rather than the world’s economy benefiting from the much more efficient generation of wealth through the use of the special tools provided by the IFCs. Their reaction has been, through the OECD and EU, to put it mildly, adverse!

The activities of the OECD, which is a private organisation owned by the richest economies in the world, has been particularly egregious. The OECD has attempted to produce a scientific excuse, based on economics, for the political determination of certain national governments to oppress the rights of the populations and governments of the IFCs. For example, if one looks at the definition of harmful tax competition in the OECD’s report on this matter, it is clear that the definition was manipulated so that only small, relatively weak, countries were affected because of the five factors that had to be present, according to the OECD, for harmful tax competition to be taking place. The last one was that “mobile financial services had to form a large proportion of the GDP of the territory concerned”. If this statement is examined by using any type of objective analysis it would be seen to be purely politically motivated. Principally because this definition ipso facto cannot apply to any OECD member, given that they have large diversified economies, it was clearly aimed at small and politically vulnerable countries with whom the OECD members trade.

As a result of this political determination, various regulatory reviews and reports on the IFCs have been produced, the net effect of which is going to place the governments of IFCs under renewed pressure to amend their domestic legal regimes to permit greater transparency. The general philosophy being developed seems to be that “confidentiality” is in but “secrecy” is out.

Other substantial changes taking place relate to e-commerce and securitisation structures. Clearly the ability to place a commercial web site in an offshore centre could be extremely fiscally beneficial in two regards:

  1. The possibility of avoiding sales taxes on the goods or services provided, and
  2. Sheltering the profits made by the site concerned.

Without doubt there are a number of fiscal and technical issue to be considered but e-commerce must constitute a “sunrise industry” for the offshore world.

A similar “sunrise industry” is the securitisation processes. This is the ability to turn future receivables into present day capital flows. Essentially, in this process assets are transferred to an “orphan” offshore structure (i.e. not owned by the corporate sponsor). Special purpose vehicles (“SPVs”) are formed to issue loan notes in the capital markets. These notes securitise (i.e. have attached to them in priority to other creditors) the receivables sold to the SPV by the sponsoring institution. The SPVs pay for the receivables out of the capital receipts of its own loan note issues. Clearly the ability to ensure that withholding taxes are not levied on long-term programmes is vital (a typical programme lasts 21 years). Here the continuing process of capital markets de-intermediaryisation is clearly benefited by the existence of IFCs.

Other interesting developments relate to novel legislative products, which are not typically available in onshore locations. For example, the development of Protected Cell Companies (PCCs), which are companies with a core of ordinary share capital, surrounded by a number of separately capitalised cells of preference share capital. The essential feature of a PCC is that individual cells can go bankrupt without affecting the solvency of the other cells, or indeed of the whole corporation.

PCCs have a number of interesting uses, such as an umbrella vehicle for mutual funds, where each cell represents a different type of investment media. Thus it is possible to migrate each individual investor’s funds from one cell to another without disposing of underlying assets, which are held to the order of each cell. Consequently, if Investor A wishes to realise his investment in Cell 100, which may be invested in Government Securities, he will instruct the managers to redeem his shares in Cell 100, and then re-invest the proceeds into Cell 101, the underlying investments in which may be blue chip equities. Conceptionally, the investor has merely re-ordered his investments in a single entity rather than moved from one legal personality to another.

There has been some criticism of the PCC structure along the lines that such an entity may confuse or mislead the public. However, this type of “ring-fenced” structure has in fact existed de facto for a number of years if one considers, for example, the Lloyds Insurance Market, where individual members can go bankrupt without the market itself sinking into insolvency.

Another interesting use for PCCs is to provide different types of insurance cover under one legal entity, although the claims attributable to any particular policy can only track through to the cell which was the issuer of the policy in question, rather than to the general assets of the company in question.

The PCC vehicle is yet another example of how legislative flexibility rather than taxation has been one of the driving forces behind this type of legislation. Similarly, flexibility has been exhibited in the light but appropriate regulatory regime often applied to banks created in IFCs, which are often formed for some special technical purpose. A number of IFCs cope with this requirement by issuing special restrictive licences, perhaps only permitting the bank in question to deal with other members of the same financial group.

Other interesting products recently developed include extremely flexible general company laws in a number of jurisdictions, which feature such elements as re-domiciliation, nil par value shares, incorporation in foreign languages, and very flexible accounting provisions.

In summary the international financial services world is changing. Because of pressure from onshore multi-national organisations regulation is going to promote greater transparency in regard to such matters as ownership of assets. In principle, what this probably means is that offshore regulators will be required to be more fully informed about transactions undertaken by professionals offshore. However, even when the required regulatory charges have been fully put in place by the major IFCs pressure from onshore multi-national organisations can be expected to continue.

What is really needed is a general World Trade Organisation agreement on competition in financial services. Without it, continued contradictory uncoordinated calls for change in IFCs can be expected. How IFCs collectively will respond these calls is difficult to predict but many are starting to say “where Switzerland goes, so do we”! In other words, pressurise us as much as you like but we will strive to maintain a level playing field with our competitors (i.e. Switzerland) until the end.

In the medium term, therefore, the smart money will be looking how Switzerland changes its regulatory regime to accommodate pressure from the EU, etc, while in the medium term Singapore should also be watched. What will be really interesting, however, is how the government of China acts in relation to the regulatory regime in Shanghai - ah, but that’s another story!