What Does the Future Hold for IFCs?

“Little else is required to carry a state to the highest degree of opulence from the lowest barbarism”, claimed Adam Smith, “than peace, easy taxes and a tolerable administration of justice”. 

Viewed from the Isle of Man, one might quibble as to whether bucket-and-spade tourism counts as barbarism. Or, for that matter, whether soya lattes and artisan food shops constitute the highest degree of opulence. But consistent gains in GDP per capita show that the principle holds, and it is a formula that has stood the world’s international financial centres (IFCs) in good stead for nigh on 50 years. 

Nevertheless, the years since the global financial crisis have seen a level of opprobrium cast upon IFCs that is unprecedented in its sustained nature and its breadth of political support at the highest level; across nations, political parties and supra-national bodies. Few would have foreseen the day when a Conservative British prime minister would be calling for the G8 group of large capitalist economies to take urgent action against global businesses for complying with their own tax laws. 

In this febrile political atmosphere it is not unreasonable to ask what future do IFCs have? What tactics should they adopt in the face of this onslaught? What new products and services can they seek to bring to market?  Which ones will survive and what will they look like in 10 years’ time?

It would be easy to aver that we have been here before. Banking failures in the ’80s led to metro-lite financial services regulation and, certainly in the Crown Dependencies, a coupling of their regulatory approach and momentum with that of onshore jurisdictions. This no doubt frustrated business developers in the IFCs, but it has provided a ready riposte to allegations of regulatory short-comings. The developed nations’ expectation that transparency as to the identity of the users of IFCs would bring an end to financial crime may have been misplaced.  It did, however, spawn the FATF recommendations and the client due diligence process that everyone now regards as a fact of life. Most IFCs have also emerged unscathed from the white/grey/black list process as regards bi-lateral tax information exchange. 

But this time it feels different. Yes, there are significant incentives for political elites in western economies to cast IFCs as villains in order both to deflect attention from their own short-comings and, perhaps more significantly, to play to the general anti-IFC sentiments among their electorates in their home countries. This is an understandable imperative. Whilst it is one that there is little that IFCs can do to counter, it does permit some succour.

Political priorities change with the weather; so do the issues of the day, as perceived by the general public and echoed through the popular press. One can expect focus to shift in due course, giving IFCs and their users some breathing space. Of more concern to IFCs is the possibility that the consensus on free markets as drivers of global economic development has broken down; that the elite good really believe that they know best and that, insofar as private enterprise should be allowed to participate, it should only be on terms set by a clique of global leaders as being most likely to maximise their domestic tax-take. This would be a major problem for IFCs, which need at least tacit acceptance that tax (including the cost of compliance) is a burden, a yoke on investment and that tax competition (at least as regards global capital flows) is a good thing.

There has been an apparent shift since the financial crisis towards an implicit popular belief in a command economy. Ronald Reagan famously asserted that the most terrifying phrase in the English language was “I’m from the government and I’m here to help”... Few people now seem to share that view. Despite the unprecedented levels of intervention in the economy (monetary policy, infrastructure spending etc), there are further calls that the governments of developed nations should “do more to help the economy”.  In the post-war era, Friedrich Hayek, the economist much loved by the late Margaret Thatcher, warned of the dangers of sleep-walking down the “road to serfdom” as a result of socialist policies.  With little fanfare, the government’s involvement in western economies has spiralled out of control; even under governments with ostensibly pro-market sentiments, the level of state control of the economy (well over 50 per cent of GDP in many cases) has reached levels of which inter-war dictators could only dream. 

Most startlingly, this has not occurred in the face of opposition from the populace.  It has not even arisen from complacency or inattention. Seemingly, it has been positively welcomed by many, if not most, who are happy to rely upon the state for education, opportunity, health, livelihood, care in old age and direction as to what they may and may not enjoy. In light of this, perhaps it is not surprising that there is an emerging moral movement asserting that it is the moral obligation of the individual and the body corporate to pay the ‘right amount of tax’ to the courageous state, which obviously knows far better what to do with the funds than anyone else.

Leaving aside the pertinent questions as to what is the ‘right’ amount of tax, and to whom it should be paid by a multi-national business, if this is the case then will there be future demand for the products and services of IFCs? In the absence of a fundamental change in the nature of the corporate entity, the motive to minimise the tax burden on any company – and thus maximise the returns on capital for investors - exists and will continue to exist. 

And it is a very good that that it does exist. The state is made up of individuals whose only role is to pass laws, to tax and to spend.  Past experience suggests that they will tax and spend to the greatest degree possible unless restrained and, in the absence of suitable checks, they will have no incentive to do so efficiently, as they are spending ‘other people’s money’. The idea of individuals or companies being brow-beaten into paying more tax than they have to is a scary prospect. The requirement to pass laws to introduce new or greater taxes, or to borrow more money if they overspend, is a least some check on government action in that it raises the threat of electoral defeat.  But if people can be bullied into handing over loot voluntarily, then this threat abates.  It could thus be argued to be a moral obligation of the citizen to avoid paying more tax than legally required and thus hold the state to account.

It is to be hoped that the cult of the state will abate in due course. One could reasonably expect that the evidence of the overall beneficial effects of free markets and free movement of capital would prevail in due course.  That their key role in dragging millions of people from destitution to the luxuries of three square meals a day, in tackling genuine public health issues and in stabilising problem states would be recognised.  Until this time, whilst the motives for international tax structuring may subsist, the opportunities for IFCs to add value may be limited. Taken to its natural conclusion, the benefits of free markets and restrained and predictable fiscal policies might be expected to lead major developed economies to adopt simple, flat corporate tax structures thus obviating the need for IFCs. The prevailing public mood and bloated exchequers make this a remote contingency, however.

As the political climate changes and western economic fortunes repair slightly, we can therefore expect better regulated IFCs to resume their role, rather like the good bacteria of the global financial system, in assisting the efficient uptake of nutrition from the digestive transit of international capital flows. Just as most people don’t much like to contemplate the teeming bacteria in their gut, when challenged they will still acknowledge the useful purpose they serve. Grudging acceptance when prompted is probably the best that IFCs can hope for.

What will the re-emerging successful IFC look like? What features will it exhibit and what tactics can it employ in the meantime?  Undifferentiated ‘me too’ products have been a feature of the offshore landscape for many years; captives, hedge funds, trust structures, light-touch corporate vehicles etc. In a buoyant financial environment and with fewer external pressures, it was possible for IFCs to maintain a large portfolio of products at limited embedded cost. The most successful, such as Cayman hedge funds and BVI holding companies have flourished and will probably continue to do so, but going forward this is unlikely to work for many IFCs. 

Markets will become more fragmented and IFCs will need to decide where to deploy their resources, depending on which markets they target (both sectorally and geographically). Products that may work in one market will not be suitable for others. This might suggest damaging competition between IFCs, but this may not be the outcome.  Indeed, amongst those that succeed in creating compelling solutions it may drive more co-operation in order to offer multi-IFC solutions to global businesses dealing in different markets. It also seems inevitable that the barriers to entry to the offshore environment, ie, the threshold wealth or transactional value required in order to justify an offshore component, will rise.

In some cases, and particularly in the traditional regulated sectors, this is going to mean even greater levels of scrutiny and regulation in order to gain acceptance in key markets. Examples of this can already be seen. In the world of insurance, the gestation of Solvency II has been troubled, but Bermuda has committed to an equivalent regime.  This is a major commitment in terms of initial and on-going resources.  It is not a regime that can be readily replicated by any other IFC. If it succeeds in the retention of existing business or the attraction of new business, then the costs will be justified and will be an effective barrier to entry for other players. 

Similarly, in the funds arena, Jersey and Guernsey have trailed the introduction of AIFMD compliant regulations in order to seek to take advantage of the availability (not even guaranteed, as of yet) of ‘passporting’ into EU member states. Again, if successful, the potential upside is significant, but the costs of introducing and maintaining such a regime will be significant.

Both tactics represent a commitment to the EU marketplace that embodies a number of potential risks and rewards. The ability to deal with a single agglomeration of many states, together making up the world’s largest economic area, is obviously attractive.  But the prevailing mood within it towards IFCs is not propitious and the reality of joint action in that forum has been cruelly exposed by the Euro crisis.  Furthermore, the EU does include states that are themselves IFCs and potential competitors. Embracing the EU may also mean adopting a posture that turns a shoulder towards other markets.  Whilst it may not be intended to look cold, and may not actually be unattractive to the analytical customer from elsewhere, he may not bother to approach and may be concerned as to a general rising tide of cost associated with a step-up in regulation in those jurisdictions.

Other IFCs are more obviously focusing on newer markets. Some of the most exciting are in Africa, and here the Indian Ocean IFCs are well-placed to take advantage.  Clearly the focus will be on resources, infrastructure and more general investment activity, but the more generic nature of the products to be used does not mean that the African continent can be treated as a single market. The signs are that the IFCs will need to look at the region on a country-by-country basis in order to shape their products. Both Mauritius and the Seychelles have created corporate regimes with simple corporate taxing regimes in order to operate within double taxation agreements.

Some developing nations, such as Zambia, are flexing their muscles about keeping more of the taxation benefits of resources for themselves.  It would be short-sighted of any such nation, desperate for development capital, to create a regime that deterred international capital flows, but it seems that they are minded to use the current environment to negotiate better deals. IFCs who wish to do business in these countries will need to be willing to come to the table to thrash them out.

The opportunities for IFCs with greater room for growth and infrastructure may lie in affiliations with technology-based industries that do not need large bases in any of their major markets. The Isle of Man has done exceptionally well in attracting e-gaming and related businesses. Other opportunities of this nature will arise.

All IFCs that want to be in a position to thrive in the new economy need to deal with the supra-national demands for transparency and avoid sanctions. They need to identify their target markets and strike the deals that will get acceptance for their products.  They also need to avoid the diseases that have afflicted larger economies.  A number of IFCs have allowed their public finances to become distorted, their state sectors too large and their private sectors encumbered by regulation. IFCs need stable public finances to avoid the need for outside assistance. Many will also need supply-side reforms to ensure that their private sectors can be flexible and able to attract the talent needed to deliver services in a more complicated world.

On the face of it the biggest threat to IFCs appears to be the hurricane of regulation, pressure for disclosure and moralising over tax avoidance. Rather, like the wrapped-up traveller in Aesop’s fable, the greater long term threat to IFCs may be the sun-lit uplands of low, flat and simple corporate tax regime in the major economies.  The warmth of the beating sun might be more likely to persuade the multi-national business to give up the cloak of offshore, but (fortunately for the IFCs) the vast appetite of the major economies to consume tax revenues makes it look like political suicide for anyone to suggest it.

Appleby
Bermuda, British Virgin Islands, Cayman Islands, Guernsey, Hong Kong, Isle of Man, Jersey, Mauritius, Seychelles and Shanghai.