The international financial services industry is facing increasing pressures and demands for change mainly driven by external forces from the international community. These pressures are well-known and pose a threat to international financial services centres (IFCs). They include data-leaks, which continue to cast the industry in a negative light, the work of the Organisation for Economic Cooperation and Development (OECD) through its Base Erosion and Profit Shifting (BEPS) project, attacks on the legitimacy of legal-planning strategies and moves to criminalise tax mitigation, the push for public registers of beneficial ownership of structures by the UK and EU along with increasing compliance costs and lower profit margins.
The purpose of this article is not to lament the current situation but to propose ideas and solutions for survival. The jurisdictions and service providers who adapt to the changing circumstances are the ones most likely to prosper over the long run in my opinion.
In my opinion, the first thing that both jurisdictions and service providers need to do as a result of the new environment is to de-risk. As banks, especially correspondent banks are doing, jurisdictions and service providers need to engage in a de-risking exercise to ensure that clients are above board and transparent. Those who aren’t need to be shown the door. Jurisdictions can de-risk through the enactment and enforcement of new and current AML/CFT laws to ensure that service providers get rid of and do not accept clients who, through their structures, are showing that they do not understand the changing landscape and thus pose a very great risk for money laundering and terrorist financing.
The days of the client being always right are over. In fact, the client is rarely right because he (and here I use the pronoun to refer to both genders) may not understand that the structure that he has, through its mere existence and design, may be deemed by the regulators and service providers to be at great risk for use in illegal activities. This is not to say that the client’s intentions are nefarious and thus he will engage in illegal activity, but rather it should be made clear that this type of client with that type of structure is no longer welcome either in the jurisdiction or by the service provider. We in the industry must become more selective in our clients. The onus is on us to select clients to some extent and not just have clients select us. That is a hard concept to accept and requires a paradigm shift but, in my opinion, it will have to be done at some point.
As a consequence, in this new paradigm, politically exposed persons may become persona non grata. Any service provider accepting a PEP without extensive due diligence both at inception and on a regular basis post-establishment of the business relationship is courting disaster.
The Panama Papers leak makes it clear that a PEP is not only high risk but is likely to bring the service provider and jurisdiction itself into disrepute if it is later discovered that said service provider worked with this person without ensuring that all the proper due diligence and monitoring, including after the relationship was established, was done. A service provider who breaches this cardinal rule will rue the day that he got involved with a PEP.
PEPs are more likely than most to be involved in corruption, looting state assets, taking bribes and using friends, families and cronies to provide cover for them. Thus, to take one on as a client requires extensive background checks and monitoring and the charging of fees commensurate with the risk involved. In this new era, a general blanket rule against accepting any PEPs would be ideal but if a service provider wants, needs or chooses to work with one, then proper fees must be charged and KYC controls established and implemented. Panama as a jurisdiction and Mossack Fonseca as a service provider are both learning the lessons of dealing with PEPs the hard way unfortunately. I hope that this example will lead others to take a different course or action.
Jurisdictions, clients and service providers will need to become more compliant and transparent. Given the move towards beneficial ownership registers and EU/UK/OECD pressures, there is no longer any room for secrecy and, unfortunately, legitimate client confidentiality is also under intense threat. These attacks will not stop but transparency is a means to keep ahead of these pressures.
Service providers may need to consolidate/merge to create economies of scale to address compliance and cyber-security costs. The latter, post Panama Papers, will become an increasingly important factor in the decision-making matrix when it comes to selecting service providers and jurisdictions to domicile entities in.
The new world that is dawning upon us dictates that quality and service will be directly linked to costs. Intermediaries, who are often unlicensed, and clients, who do not understand the role of service providers in the IFCs, will soon learn that one gets what one pays for. Cheap and cheerful structures are no longer possible and jurisdictions which promote and facilitate these entities, will go the way of the dinosaurs. This is because of the increasing KYC obligations being imposed by regulators and governments on service providers and the AML/CFT rules which must be complied with.
Service providers will also learn that one cannot and will not be able to compete on price, and low-price jurisdictions like Belize, Nevis, Seychelles and Samoa will learn this also. It is only a matter of time before the lax AML/KYC regimes catch up with both the service providers and jurisdictions as a result of the changing landscape. Reputational damage will impact both greatly and clients would be advised to take the necessary steps to protect themselves now.
Services providers who do not adjust their fees to cover these increased costs will eventually be forced out of business. This will be both from a lack of financial resources to meet the new compliance regimes and administrative penalties that regulators such as the Financial Services Commission in Anguilla will impose. Said service providers may also have their licenses revoked or suspended and worse yet, may be prosecuted criminally. The Commission in Anguilla wrote to all service providers at the end of March 2016, noting that continued breaches of the AML/KYC rules will result in the imposition of administrative penalties and criminal referrals for prosecution under the Proceeds of Crime Act.
Service providers will therefore have a choice: either increase fees to cover compliance costs, which will of course risk losing clients to others who choose not to increase fees or to other jurisdictions like those mentioned above, or risk losing their licenses. It is not an easy call to make but it is the reality in my opinion in this new era.
Service providers probably should not provide services for any entity, especially registered agent/office services, for a company which has a nominee as a shareholder or director. This is unless that nominee entity or person is an employee of or owned by the service provider. Even in such a scenario, the service provider should have full control over the structure and all bank accounts. The service provider should question closely why the ultimate beneficial owner does not wish to operate the company in his or her own personal capacity. Jurisdictions, which facilitate these types of structures without having local persons who are subject to regulation executing these functions, will face problems in years to come as well.
What is not sensible in this new era, in my opinion, is for a service provider say in Anguilla, to provide registered agent/office services in the following scenario:
The company is incorporated on instructions from an unlicensed intermediary in the UK and owned by someone from Uzbekistan, which uses two people in Cyprus as nominee shareholder and director, which has a bank account in Latvia and does business in former Soviet countries.
This, with the greatest of respect, is a ridiculous structure, which no longer passes the ‘smell test’. It is not one which should be encouraged especially where neither the intermediary nor the nominees are licensed and regulated elsewhere. The obvious question is why doesn’t the ultimate beneficial owner who is from Uzbekistan want to be director and shareholder of his company? If the answer is not one that is cogent or even if it is cogent, granted the myriad of players and risks involved as a result of this and the geographical spread, then careful thought should be given to accepting this structure or remaining as registered agent/office if it comes into being post-incorporation.
The service provider must focus his mind on these questions.
1. How am I going to exercise proper monitoring as required under the AML regime to ensure that the structure is not being used for money laundering or terrorist financing?
2. Given the complicated nature of the structure, the players involved and the fact that I don’t have access to bank statement information or the daily operational activities of the company should I take on this structure?
Granted this scenario, in my opinion, the obvious action to take is not to provide any services for this company. I would even suggest that the use of corporate shareholders and directors owned by the same beneficial owner as the company being incorporated itself, in this new era of transparency, should be avoided unless it is absolutely necessary. Again, the necessary fees need to be charged to cover the increased KYC operational costs involved in conducting due diligence and securing information on corporate entities etc.
I say all of this to drive home the point that these sorts of structures are no longer acceptable and the service providers as well as the jurisdictions which encourage and facilitate them are putting themselves at risk and failing to adapt to a changing environment. However, where the mind and management of such structures is based in the IFC whether provided by local human directors or expatriate beneficial owners who live in these centres, then the risks are reduced and a greater nexus with the IFC is established. It is to this concept and the impetus behind it that I now turn.
Recent proposed changes announced in April 2016 by the OECD because of the BEPS project regarding the international taxation rules related to transfer pricing and permanent establishment, will soon make it clear that the right to impose taxation on multinational companies will be linked to the jurisdiction where the economic activity of the company takes place and value is created, as opposed to the seat of the company’s domicile. This will mean that jurisdictions that wish to survive in this new era will need to innovate by creating new products and services but most importantly, if these services are to be taxed within IFCs at zero or low rates, substance/economic activity/value creation must occur there and not outside their geographical confines.
This will involve encouraging multinational companies that want to take advantage of low taxes to move away from playing structuring games, such as the Irish sandwich, but to establish subsidiaries with mind and management, bricks and mortar on the ground in the IFCs. The new rules will work much better for companies that are developing intellectual property and therefore, the movers and shakers in this area must be able to show a physical nexus if they wish to ensure that the ideas they create and companies they form do not fall within high tax jurisdictions if this is their goal.
The pressures facing IFCs are known and well-documented. The issue is how to survive in this new environment. My submission is that the jurisdictions and service providers who will stand the test of time are those that focus less on playing the game under the old rules of secrecy, form, gimmickry and low costs, and more on creating actual economic activity/value via having substance on the ground and being transparent.