Marcus Cake

What is offshore?

Approximately, 33-40% of the worlds financial assets and 50% of financial market transactions occur in offshore jurisdictions. This triggered a startling realisation. If we adjust the figures above for the assets held by individuals in onshore jurisdictions, we realise that the majority of non-individual financial assets are held in offshore jurisdictions. This is far from the everyday perception of offshore jurisdictions as being immoral or criminal. Offshore is a routine and major part of the international financial system.

Offshore, or “tax havens”, have been associated with no tax countries. Offshore includes low tax countries and major countries which offer preferential treatment for companies and individuals that locate within their borders.

Who?

This article will focus on the use of “offshore” by corporations.

If an individual chooses to be “resident” of a country, they are obliged to respect the laws of that country. Nearly all countries tax residents on their domestic income. Many also tax residents on their worldwide income and some tax income bought back to their country. Although some residents use offshore structures to minimise tax on their world wide income, this is problematic and will not be discussed here.

“Onshore” is generally a reference to countries which have higher tax rates and tax “residents” on their world wide income.

Offshore may be utilised for many different purposes. Extensive information on the use of offshore entities is available on the internet (click here for an example).

How?

Offshore entities may be utilised in the same way that onshore entities are administered. Offshore jurisdictions have online lodgement of documents and online banking. A corporate service provider will incorporate and assist in the annual administration of offshore entities. Jurisdictions can be cheap or expensive. Some corporate service providers are more expensive than others. A summary of initial and annual costs are available here.

Some corporate service providers have long histories, good reputations and global networks. Others may have been established yesterday. Offshore entities require specialist expertise. Many are unfamiliar with offshore and the purchase of these types of services from corporate service providers. If a customer is buying something for the first time, they will invariably pay more and may not get what they expected.

Offshore will only be worthwhile for those with a specific reason to structure offshore and a clear understanding of the costs, benefits and risks. The internet now means that everyday people can utilise “offshore”. Many corporate service providers provide extensive information on offshore on their web sites.

Where?

There are approximately 50 offshore jurisdictions. A list of these jurisdictions is available here. Each of these countries compete for the business of individuals and corporations by seeking to offer the best mix of corporations law, intellectual property protection, privacy, compliance cost, taxation and legal systems. A major source of revenue for these governments has become company registration fees and annual fees. This often provides a certain revenue in economies dependent on tourism. The choice of jurisdiction is determined by the purpose of the company and the attributes of each jurisdiction. There are, however, significant trends that may be ascertained. These trends include pharmaceutical holding companies in Switzerland, insurance companies in Bermuda, funds management companies in the Cayman Islands and banking in Singapore. Some jurisdictions offer the right mix of tax treaties with onshore countries, other maximise privacy and the protection of financial assets.

Additional information on legislation in offshore jurisdictions is available here. Each jurisdiction has different requirements regarding directors, company secretary, company records, meetings and other statutory requirements.
Why?

There are generic examples of the uses of offshore here. I will provide some specific examples.

Over the last five years, News Corporation has paid approximately 7% of its profits as taxation. Its competitors, primarily in the US, have paid 20-27%. The ability to operate your business with less expenses than your competitors is a source of competitive advantage. However, tax minimisation is not the only reason to utilise offshore. The increasing complexity of business and compliance cost of onshore jurisdictions is encouraging many to look to simpler jurisdictions. It is not only taxation laws that have become complex. Corporations law, state laws, stamp duty, occupational health and safety have all added to the costs of incorporating in an onshore jurisdiction. More laws are added, but rarely repealed. Offshore entities may just be simpler.

If you are growing a business, then listing on an offshore stock exchange is also cheaper and easier. However, due to the small local populations there is a lack of local equity analysts to provide equity research, lack of corporate advisers and lack of lack of critical mass of investors. A listing on an offshore exchange will probably not result in liquidity. This is quite a paradox given 40% of financial assets are offshore. The greater penetration of the internet is likely to result in more business activity in offshore markets and listings on offshore stock exchanges. The internet may offer a means for offshore stock exchanges to overcome geographic limitations to offer international companies liquidity. Onshore countries often do not offer local equity markets that can support growing companies. Perhaps, the internet and offshore exchanges could offer growing companies liquid capital markets where onshore equity markets do not.

Onshore reaction

In 1998, the OECD and other major economies began to work together to discourage “harmful tax competition”. Governments worldwide champion competition as means of increasing corporate efficiency and productivity to raise living standards. Of course, if tax competition results in a country not being able to provide basic services, tax competition would be immoral. However, taxation levels have trended upwards as government has passed more laws and become more involved in society. Tax competition would be beneficial if it encouraged governments to deliver services more efficiently and focus their efforts. Government often encourages competition as the means to improve efficiency and raise living standards. It seems unusual that tax competition is harmful, but all other forms of competition which almost always have short-term pain for longer term benefits are healthy.

It is interesting to read about the history of the BVI (click here to read the History of the BVI Financial centre). This is a jurisdiction that endeavoured to do the “right thing” in the eighties and signed a tax treaty with the US government. A change of government resulted in the US reneging on the treaty which caused great financial difficulty for the BVI. The BVI accused the US of a “breach of faith”. Twenty years later, the BVI is one of the leading offshore jurisdictions with over 700,000 international business companies registered. The statutory requirements for BVI companies are summarised here. It is also one of the most respected. It has largely avoided the issues that confronted many offshore jurisdictions. This is largely a result of the fact that the BVI banking system may only be used by residents of the BVI, and not IBC’s.

There have been signficant changes in offshore jurisdictions as a result of pressure from onshore and increasing concerns about terrorism. The onshore jurisdictions have become more transparent, passed laws and been more vigilant to eliminate criminal activity. Most offshore countries will provide information in response to international enquiries where criminal or civil liability is alleged. They will generally not respond to “fishing expeditions” by onshore countries.

No-one could dispute the legitimate need to stop the flow of funds that finances terrorist activity. Many of the laws that are targeted to terrorist activity have broader implications. One such example is the definition of money laundering. Offshore jurisdictions have enacted “money laundering” legislation. The definition of money laundering has been extended as time has passed to the conversion of assets resulting from any illegal activity (including taxation), rather than just the proceeds of drug trafficking.

Pitfalls

Onshore economies are very familiar with offshore jurisdictions and have enacted legislation in an effort to preserve domestic tax bases. Domestic tax authorities can “attribute” the income of an offshore entity to a resident tax payers if certain criteria are met. These criteria include majority ownership of the entity, voting control or if the “management and control” of the entity rests with domestic taxpayers. “Attribution” does not apply to trading businesses operating in foreign jurisdictions. It is primarily targetted at individuals using offshore subsidiaries to hold financial assets.

The comments here are very simple for the purpose of effective communication. Specialist taxation advice can be very expensive. However, corporate service providers have standard products/structures for the most common situtations. They can also customise entities for more complex situations. They do, simply, work with offshore entities every day and their clients have similar objectives. These corporate service providers offer extensive information on their web sites which may significantly reduce the cost of domestic legal advice. One provider suggests that they can supply a tax proof offshore structure, but further examination is required and quality advice advisable.

Onshore jurisdictions treat tax evasion differently - a criminal offence punishable with jail, civil liability for unpaid tax, fines or lesser treatments. The laws are drafted to apply to as many possible situations to allow tax authorities to capture as much activity as possible. This may be quite reasonable given the resources that corporations utilise to structure their affairs. “Tax haven” cases are often widely publicised to discourage others. The result is much greater complexity in tax codes, demonisation of offshore activities and a lot of work for accountants. I understand that even everyday workers utilise accountants to prepare their tax returns. It is estimated that 60% of accountants in one jurisdiction are devoted to tax compliance. This expertise should be utilised to grow companies, build shareholder wealth or progress philanthropic activity.

A few thoughts

I actually wonder what proportion of a country’s tax base is derived from taxing world wide income. How much would a country realistically give up if it only taxed income which was repatriated to the home country? This is an increasingly common approach. What would it save in reduced complexity? How much capital would stay onshore rather than being sent offshore? Of course, domestic electorates may perceive this as unfair and an opportunity for the rich to get richer. Although, many domestic electorates have become increasingly capitalist or have a greater understanding of globalisation. For many countries, some changes to the tax system, even if necessary or prudent, would be political suicide. Opposition parties could easily exploit the unfairness of some changes.

Some eastern block countries have introduced flat tax systems based on revenue with minimal deductions. They are very simple systems. They are attracting significant business. On the surface the tax rates are lower, but it is calculated on a higher amount becase there are limited deductions. The actual tax revenue is similar to the onshore countries. These countries are becoming very popular because of their simplicity rather than lower tax rates

A “futurist” has made the following quote about the US tax system in his article The Coming Collapse of Income Tax:

“Within the next ten years the income tax system in the United States will be dismantled. A number of emerging new forces coupled with the universal dislike of the system will soon gain enough of a toehold to cause it to collapse. While a new tax system will need to simultaneously emerge in its wake, the exact form of the replacement system will depend on the political party in power at that time.”

These comments apply equally to all onshore jurisdictions. I do not believe the onshore tax systems will collapse. The futurist’s article provides ten specific reasons that the system will need to be restructured - only one of these reasons relates to offshore.

The offshore jurisdictions are, and will remain, a critical part of the financial system. The internet and standardisation of offshore “products” has made offshore accessible to all. The onshore economies may continue “enforce” existing laws which seek to tax residents on world wide income. They may engage in “tax competition” or restructure misunderstood and unworkable tax systems. Whatever happens, the internet is likely to play a significant role in facilitating change.