The Paradise Papers: Is there a Future for Financial Centres?

The name chosen by the International Consortium of Investigative Journalists (ICIJ) to describe the cache of 13 million documents stolen from various sources including the offshore law firm, Appleby, instantly relays the message the group intends to send; The Paradise Papers – secret paradise islands stashing the cash of the rich, famous and powerful – an irresistible lure for the world’s media.

The story taps into a public mood of retribution for the individuals and institutions which were the perceived cause of the global financial crisis and the ensuing period of austerity. For ordinary people there is a need for someone to blame – initially it was the bankers, perhaps with some degree of justification, and now it's the 'tax dodgers' and the rich generally. There is a beguiling fantasy that, if only 'we the people' could access all that cash stashed in secretive offshore islands, then we could end austerity. The usual NGOs, such as the Tax Justice Network, help promulgate the myth that the international finance centres (IFCs) using secret accounts and trusts, help the rich and powerful to evade taxes that could be spent on public services. They are egged on by the EU and politicians who believe in the 'big state' and feel threatened by tax competition. In effect, IFCs are being bullied by the big countries.

Ironically, it is precisely because of bullies that IFCs were created in the first place. In 1930s’ Germany the National Socialist government started its campaign of intimidation and discrimination against its own citizens, most of them Jews, but also other minorities. Understandably fearful of their money being confiscated, many of the wealthier citizens in question started to move their money out of Germany and most of it ended up in neighbouring Switzerland, which offered banking of the most private kind, underpinned by strict banking secrecy laws. Whilst you can argue that the Swiss bankers saw an opportunity here, it is also true to say that they offered a lifeline to the people concerned, as even a hint of disclosure could have led to the execution of the account holders.

Some years later, when the Second World War was beginning to build momentum, the Dutch government, fearful of being overrun by the Nazis, decided to take some radical and – as it turns out – brilliantly perspicacious action. The government proposed that those Dutch multi-nationals that we all know so well, such as electrical giant Philips, relocate their headquarters and their cash reserves to Curacao, a distant Dutch possession in the South Caribbean Sea – about as far away from the Nazis as was geographically possible. In order to sweeten the pill, the government offered a very attractive corporate tax regime – and so the world’s first tax haven was born.

The terms ‘banking secrecy’ and ‘tax haven’ now have negative associations  but it is important to realise that the development of these features was not motivated because of a desire to avoid tax - that was at best a marginal issue – but instead because of a strong need for safety, security and stability.

Thankfully, the world is no longer at war, but this desire for safety, security and stability still drives individuals and businesses to use IFCs. That may sound fanciful, given the examples of IFCs being used to evade tax and, whilst it is true that tax evasion factors into the equation, the reality is that most tax evasion happens at home in the so-called grey economy. Looking at our domestic environment, the tax gap in the UK is the lowest it has ever been – at 6 per cent or £34bn – which is evidence that HMRC has done really well in its anti-avoidance efforts. The tax gap is broken down into categories and HMRC estimates that £5.2bn is attributable to tax evasion.  HMRC acknowledges that the vast majority of the tax evasion that goes on is domestic, through the so-called black economy. So, even if we are generous and say that 20 per cent of the evasion takes place offshore, that would yield an additional £1bn per annum. That is hardly enough the stop austerity, as the Shadow Chancellor, John McDonnell, claimed in a recent radio interview. To put this in perspective, Labour's spending promises would amount to an additional expenditure of £60bn per annum (according to the FT) which is 60 times more than he could recover from stopping offshore tax evasion

Despite the press stories to the contrary, the truth is that the major IFCs are extremely well regulated and have been so for many years – it is far harder to set up a company in Jersey than in the UK, for instance, because of its rigorous ‘know your client’ rules. All the major IFCs comply with international rules on money laundering, tax information exchange and corporate governance. The press also obsesses over ‘secrecy’ in the IFCs and yet a bank account in the British Virgin Islands, Jersey or Panama is no more secret than a bank account in the UK. There is also disclosure to law enforcement agencies of the beneficial ownership of companies in all the major IFCs.  None of the IFCs have a publically accessible register, but then nor does any other country, except the UK. 

Most people use companies in IFCs for quite mundane, non-tax reasons. If you are trading or investing internationally, an offshore company is an essential building block for your business. One huge attraction is the excellent legal systems and experienced professionals in the legal, fiduciary and corporate governance sectors. Experienced business people will tell you that there are certain emerging markets where, under no circumstances, would you want to resolve an investors' dispute. You would much rather resolve it in a Cayman court, for instance, where you could be sure of a fair fight.

Furthermore, try listing a company from one of the more challenging African countries on the London Stock Exchange. It is really difficult. However, there are dozens of British Virgin Islands, Cayman and Jersey companies listed, which demonstrates that their standards of corporate governance, due diligence and investor protection are extremely high.

Another reason for using an IFC is the bilateral treaties that many of them have entered. Mauritius, for instance, has excellent treaties with India and as a consequence is now the world's most important financial getaway to the subcontinent. Hong Kong, for similar reasons, is the gateway into China and a huge amount of trade passes through the territory as a consequence. Barbados, which is part of Caricom, is the gateway into the Caribbean nations and has a very useful treaty network.

The other criticism in the press is the fact that many IFCs have zero or low rates of corporation tax and jumps to the conclusion that those businesses are therefore avoiding all tax. This is simply not true, as virtually every country in which an offshore company would wish to trade or invest will impose taxes on locally-sourced profits, normally enforced by way of withholding taxes (anything up to 35 per cent) on dividends, royalties, rents, interest and other payments abroad. That's one layer of tax.

In addition, the home jurisdiction of the shareholder of the offshore company will invariably tax that income, either when it reaches the offshore company (using ‘controlled foreign corporation’ rules), or when it is extracted by way of dividend. That's the second layer of tax. So what the IFC does is ensure that either there is no third layer of tax or, if there is, that it's as modest as possible.

IFCs are a vital part of our globalised world and without them international trade and investment would seriously suffer, global GDP would decline and the world would be a poorer place. Globalisation has led to the largest and fastest reduction in global poverty that has ever been seen in the history of humankind, and that could not have been achieved without the pivotal contribution from the IFCs.

It is important also to remember that the IFCs themselves are entitled to earn a living and, in many cases, without a finance industry, there would be no employment for local citizens, leading to the destruction of local communities as working age people leave to seek employment elsewhere.

The reality is that IFCs deliver tangible benefits to the world economy through increased investment and production, which in turn leads to higher profits. Ironically, those profits translate into higher tax revenues when they are repatriated.  This should not be forgotten when people clamour for the ‘tax havens’ to be closed down.

James Quarmby
Partner, Head of Private Wealth Team