The explosion of interest in the world's emerging markets in recent years has highlighted the important role of international financial centres (IFCs) in facilitating investment both into these markets as well as putting developing capital to work around the globe. At the same time, the global economy and international policymakers alike are becoming increasingly aware of the benefits that the presence and activities of IFCs - both small and large - provide to emerging market economies.
The link between the presence of IFCs and improved economic development in emerging nations is well established. A recent paper from Professor Jason Sharman of Griffith University ('International Financial Centres and Developing Countries: Providing Institutions for Growth and Poverty Alleviation') highlighted the experiences of China and India and demonstrated how IFCs have enhanced economic growth and reduced poverty in developing nations. This view runs in sharp contrast to the common misconception that IFCs erode wealth and prosperity in developing nations, but as the evidence demonstrates, IFCs have been critical to economic liberalisation and the reduction of poverty in the developing world.
Starting with China, which since 1978 has seen the most successful reduction in poverty in history, Professor Sharman notes that foreign investment flows - including an increasing amount of outbound investment from China - have been primarily routed through tax neutral IFCs. While it is no surprise that Hong Kong has been the greatest source of foreign investment into China, the British Virgin Islands has consistently been the second largest investor, while 10 times more Chinese outbound investment passes through Cayman Islands structures compared with the United States. He concludes that China's relative openness to IFCs has significantly contributed to higher growth and a reduction in poverty due to lower transaction costs and the more efficient use of capital.
By comparing the contrasting changes in poverty rates in Asia, where substantial IFCs such as Hong Kong and Singapore are located, with Africa, the role played by IFCs is striking. International poverty research by Sylvia LeRoy and Amela Karabegovic of the Fraser Institute showed that while the rate of poverty in China fell from 35.3 per cent to 2.5 per cent from 1970 to 2000, Africa experienced an increase in poverty from 35.1 per cent to 48.8 per cent. While IFCs in Asia have helped facilitate globalisation and financial intermediation, the absence of deep and sophisticated IFCs in Africa, with the exception of Mauritius, has left that region with limited access to efficient financial intermediation and liquidity, with business starved of development capital.
If any further evidence was required as to the importance China places on the IFCs which have served its economic development so well, then one only has to look at the manner in which China resisted any interference in Hong Kong's activities as a financial centre when assuming control in 1997. Furthermore, it was China that was prepared to derail consensus at the G-20 meeting in London in April 2009 to avoid Western interference and an international crackdown in the affairs of its local financial centres, particularly Hong Kong and Macau.
The network of relationships between the world's key emerging markets and the leading IFCs is primarily dictated by the historical presence of double taxation treaties, with China's relationship with Hong Kong a case in point. Here the tax treatment drops withholding tax to five per cent, making Hong Kong entities the favoured entry vehicle into China, while the Closer Economic Partnership Agreement (CEPA) which came into force in 2004 provides a host of additional advantages to Hong Kong companies entering China.
Typically, a Cayman Islands exempted company or BVI business company will be interposed upstream into a structure to allow the company to take advantage of the flexible corporate regime within these jurisdictions - for example, there are no requirements for BVI companies established since 2005 to have authorised capital, the absence of stamp tax for share transfers in Cayman or BVI which is payable in Hong Kong, while it is generally faster and less costly to establish companies in the Cayman Islands or BVI. Other notable differences include Cayman and BVI companies not being required to file annual audited accounts, as is required by Hong Kong companies. For all these reasons, business companies in the Cayman Islands, BVI, Bermuda and Jersey to some extent, feature strongly among the listings on the Hong Kong Stock Exchange.
On the private equity side the Cayman Islands exempted partnership is the preferred vehicle when looking to attract foreign capital to be deployed in China, while for inbound investment into China, the role of offshore funds has perhaps been overstated. More recently the trend has been for domestic RMB funds to be formed in order to invest in China. This development mirrors a similar situation in Japan some years ago when structured finance transactions were dominated by Cayman vehicles before domestic vehicles were adapted to meet the requirements of issuers and investors.
Turning to Russia and the Commonwealth of Independent States, the key IFC relationship here is Cyprus by virtue of the tax treaty with the former Soviet Union, which most of the former Soviet nations acceded to. In fact, Cyprus is the clear choice for Russia, the Ukraine and other CIS nations by some distance, however for certain transactions The Netherlands and Luxembourg are gaining favour. In any event, once again a BVI company will often be utilised at the top of the structure, with Russia and Kazakhstan very familiar with the BVI's flexible corporate regime. Elsewhere, the Cayman Islands, Jersey, Guernsey, Belize, Isle of Man and Panama all feature to a lesser extent, while Bermuda is a key jurisdiction for Russian aircraft registrations.
The enhanced flexibility of the BVI corporate regime is attractive to Russia, in particular the permissive financial assistance regime. There are no restrictions in the BVI for a company providing financial assistance to any person in connection with an acquisition of its shares, which negates any concerns that such a transaction would be invalid under common law. The flexible and low cost corporate regime in the BVI also means that the constitutional documents of a BVI company can be adapted to create an enhanced bespoke corporate governance structure, to give effect to agreements reached between joint venture partners and to build in sophisticated creditor protections.
The Russian market has matured significantly over the past decade, in line with the greater use and application of IFC structures. Ten years or so ago, Russia utilised IFCs for simple holding companies, however, these entities have now grown significantly. Today, the BVI and other offshore jurisdictions are used by Russian corporate and financial institutions for sophisticated cross border financing transactions and for listing companies on international stock exchanges.
In addition to holding company work, BVI companies are extremely popular for joint venture transactions because of their inherent flexibility – as opposed to the prescriptive regime which applies when adopting a joint venture structure utilising a Russian company. BVI companies are also typically used in Russia as acquisition vehicles for corporate M&A transactions, as well as in finance deals for local Russian banks and international financial institutions. On the investment funds and private equity side, Russian use of offshore vehicles slowed down significantly during the global financial crisis, however, this stream of work is coming back in line with the recovery in financial markets.
In South East Asia, the creditor friendly nature of BVI and Cayman companies make these jurisdictions attractive for Indonesia-related financing for international financial institutions, while Cayman and BVI companies feature strongly in Vietnam, Malaysia and Thailand.
There has historically been significant FDI into India from Mauritius as foreign investors have sought to utilise the favourable double taxation treaty between Mauritius and India. For US investors seeking to deploy capital into India there has been a number of Cayman Islands investment funds established with an India focus, which have then in turn established Mauritius subsidiaries for investment into India. Cyprus, meanwhile, has a double taxation treaty with Ireland that is used in some financing transactions into India. One particular area where Walkers is anticipating substantial future growth is in aircraft finance, with Ireland a favoured jurisdiction for aircraft financings for Indian airlines, just as it has become for China. Earlier this year, Indian low cost airline IndiGo placed the world's largest Airbus order worth US$15.6 billion.
Looking at Latin America and Brazil in particular, the favoured IFC domiciles are outside of the traditional ‘offshore’ jurisdictions, with Delaware, Ireland, Austria and Luxembourg featuring the most commonly, in part due to Brazil's 'blacklist' of IFCs which charge less than 20 per cent corporate tax. The traditional offshore jurisdictions still come into play, however, particularly on the private equity side where a Cayman Islands exempted limited partnership is often used as the investment vehicle which sits above wholly owned subsidiaries established in Delaware to invest in Brazilian assets.
So too in the context of capital markets and structured finance transactions, Cayman's position historically as the favoured offshore jurisdiction for the establishment of finance subsidiaries and incorporation of issuing vehicles by a number of Latin American corporations and financial institutions, including Brazil, has been well documented. With appropriate planning, there is also growing potential for the use of Cayman Islands structures for high net worth individuals with assets outside of Brazil for estate planning purposes.
Brazilian managers who want to gain access to international investors recognise that sophisticated investors are comfortable investing through funds established in the Cayman Islands. All the traditional advantages apply, such as the speed and ease of establishment, comfort with the robust regulatory framework, which provides no unnecessary impediments to business, the common law regime, the presence of leading service providers and the familiarity of the product which has led the market for so many years. Currently the main IFC competitors for Cayman in funds work are Ireland and Luxembourg, with Ireland – which does not feature on Brazil's blacklist - becoming increasing popular for Brazilian asset managers and banks, particularly when European investors are targeted. The most significant move to date was Banco do Brasil's establishment of its Qualifying Investor Funds in Ireland with assets under management now around US$10 billion.
With the increasing number of funds created with a Brazilian investment focus, as well as the other emerging markets, there continues to be an increasing need for Cayman structures. Brazil's blacklist, however, remains a significant barrier to entry that requires additional analysis to ensure that the ultimate structure is tax efficient for all concerned. Whether Brazil should open the gates to greater foreign investment to meet the current demand for infrastructure projects is an interesting dilemma for policymakers, with inflation such a concern at this time. One thing that is clear, however, is that Brazil's blacklist and the inefficiencies it presents in terms of raising capital reduces the flow of capital into Brazil and arguably slows down the rate of growth in its domestic economy and increases the rate of unemployment.
For the world's IFCs, looking to service the emerging markets that have now already emerged, as well as the next generation to come, the challenge remains to identify the areas where they can best assist companies and financial institutions in the developing world.