Economics of Offshore Locations

THE OFFSHORE ECONOMIC  experiment is about capitalism. The offshore locations were created as a reaction to the world in the midst of an anti-industrial revolution. This revolution created the ‘nobility’ of being a victim and trashed individual achievement in favour of groups. It was the world as seen by Ayn Rand. The individual entrepreneur was doing battle against the bureaucracies, regulators and government dependent companies. Elements of free western nations were actively and openly embracing socialism, collectivism and communism. At that time Lenin, Marx and Galbraith were credible and passengers actually dressed up to fly on airplanes. Today, our younger professionals have no recollection of these times.

There were also race and labour riots. Whole sections of modern industrialised cities were being burned to the ground. Political assignations were commonplace. They were troubled times.

It was against this backdrop that the British Overseas Territories of Cayman and the British Virgin Islands were nurtured into offshore financial centres. Offshore financial services were selected as a way to deal both with the political climate, by providing a safe haven for assets, as well as to defray some of the cost of administration. The financial service model that was developed relied heavily upon Swiss financial philosophy.

There also happened to be a great natural client base nearby; the rich of the United States. The fi nancial service sector in the US was fat with cash and interest rates were low. The great fi nancial innovation of the time was the inducement to bank where they gave away.

Four slice toasters instead of the old two slice toasters. Tax rates in the industrialised world were complex and punitive with tax rates as high as 90 per cent. Even the Rolling Stones at this time had run afoul of the tax man and become tax fugitives. The attractiveness was simple; a complex domestic tax code allowed for a great deal of international ‘tax structuring’ whereby a smart and aggressive executive or entrepreneur could pay almost nothing in taxes and secure the funds away from great domestic uncertainty.

In the 1980s the primary leaders in offshore innovation were the Cayman Islands, the British Virgin Islands and Hong Kong. They had reacted to and profited from the stabilisation of the social and political environment and the concurrent development of the global economy. Many new jurisdictions also adopted similar legislation with niche ideas having varying degrees of success.

The successful jurisdictions focused on developing offshore legislation, to make use of their jurisdiction’s straightforward regulations and tax codes. This legislation focused on offering an alternative to the burdensome and costly financial market regulation in the US and Europe. The innovation and competition from the international financial community was not dealt with through European and US innovation but rather through legislative and regulatory ‘protective measures’. During this time, in the US, small securities broker dealers were regulated out of business and the US mutual fund industry lobbied to insure that US citizens had to buy only US mutual funds. The impact was dramatic. According to a study on small business capital formation conducted by the US SEC, the cost of raising equity for a small business had risen from 23 to 28 cents on each dollar raised.

The 80s and 90s were also a time that the more unsavoury elements of society learned that the privacy and efficacious financial centres could be of use to them too. This time, while a time of great innovation, was also a time of reputational damage.

The 1990s were also the beginning of the recognition by Europe, and less so the US, of the impact offshore financial centres had on their economies. The FAFT and OECD began their campaign against ‘Harmful Tax Competition’ and the NCCT ‘blacklist’. What this was about was tax revenue recognition and the ability of a country to properly tax their citizens and corporations. Getting the NCCT countries to comply was a struggle, but all of this changed on 11 September 2001 when the modern world was struck by a bomb from the third world. This campaign against ‘Harmful Tax Jurisdictions’ was dropped and the regulations were forwarded under the guise of anti-terrorism.

The reason for being offshore financial centres has always been about capitalism. It is about keeping the capital that you have created. It is about allowing that capital to work as hard as it can. It has been about the freedom to re-deploy the capital to where it will be most effective and not dealing with currency controls or where you can or cannot invest. It is about creating a near borderless society where merit and its reward can be deployed and flow freely to its highest and best use. Today, the competitive jurisdictions have focused on specialty niche products, the legislation to support those products and the corresponding freedom of capital.

Vive la différence

So what does it take to be different? The laws of the offshore locations must be sufficiently different from a given country of origin of a client, to invite a professional to recommend an offshore location. It gives that jurisdiction a value or utility that is attractive. Differentiation is the most important item, by far. It is through a differential use that a change in utility occurs between one jurisdiction and another. It is that change in utility that attracts commerce to offshore financial centres. One of the key fallacies many professionals and regulators alike chose is sameness. “Let’s make this law the same as the US or European law, or regulating an offshore jurisdiction like it was New York or London,” kills the differentiation. For example if the trust laws are the same inj urisdiction A and jurisdiction B, you only compete on price.

The laws and regulations must also be sufficiently different from the domestic domicile of potential clients. Since most clients come from North America and Europe, we need to be different than North America and Europe. Many an offshore location has withered shortly after laws were passed that were to “bring a location up to world standards”.

Location, location, location…

People wish to deal in their own language. Further, people are social creatures and like to meet those people with whom they are going to conduct business. Even though the Caribbean IBCs are some of the most cost-efficient and flexible in the world, Asians pay a premium to work in their own language with professionals in Hong Kong and Singapore.

The law

Common law jurisdictions are the favoured. The disincentives are when it takes two and three years to settle even the most simple of commercial disputes. Further, even justa simple foreclosure in some locations can take two to three years. Alternative dispute resolution legislation or conventions may be the next choice for many locations.

Ask the expert

Most of the offshore locations pass laws and draft regulations with the help of international experts. What is often lacking is a suffi ciently deep pool of experts and support people in that jurisdiction. For example when a company requires annual audits and none of the local accountants are accepting new assignments because they are too busy, this can cause a real problem for those who need the audit.

Transparency

The transparency of the professional community is important when a client checks the history and licenses of a given service provider. The regulatory bodies must be responsive to this transparency. I always check with local authorities to see if a company is registered and properly licensed. Some jurisdictions respond on the phone or in a day or two for a small fee. Other jurisdictions have never responded to an inquiry even after many months of attempts to make an inquiry.

Privacy

Privacy is a key ingredient in many of the selection features of an offshore location. Known wealth in many countries can make you a kidnap or litigation target. A recent study in the difference of yield between offshore fi xed deposit funds and US based fi x deposit funds was 1.75 per cent. That is, offshore funds retuned 1.75 per cent less on average. Thus, the great ‘privacy’ issue shows that people will only sacrifice a little for ‘just privacy.’ There is much more to an offshore location than just privacy.

Conclusion

The economics of successful offshore financial centres allows for the creation and preservation of capital under formal property recognition systems. It is precisely the creation of these metarights (access to the rights of property rights) that allows one not to be subject to the whim of extralegal entanglements, created when irrational bureaucratic looters seize power. The economics of offshore financial centres permits the commercial individual to resist the suffering under the tyranny of the status quo of their home country.

L. Burke Files DDP CACM
Mr. Files is an international financial investigator and due diligence expert who has run cases in over 130 countries and has visited over 100 countries. Mr. Files has tackled investigations running from a few hundred thousand dollars to over 20 billion. Along the way, he became familiar with the knowledge of what people need to do, for due diligence, preventing corruption, and to avoid helping criminals launder money. He brings this experience of hands-on investigating and problem-solving experience to his lectures on Due Diligence, AML, and Anti-Corruption. Prior to founding FE&E, Inc., he served as the Director of Corporate Finance for American National an investment bank focused on development stage venture capital. He was also employed by Oppenheimer/Rouse as a commodities specialist trading customer accounts in Agri-Business, 24-hour gold and silver, and foreign currencies. Mr. Files has authored six books, and many white papers and articles. He has been quoted in major publications including The Guardian, The Financial Times, Forbes, US Newsweek, and more. He is the author of the award-winning book Due Diligence For The Financial Professional 2nd Edition. Mr. Files serves on the board of directors for several private companies, funds, and non-profits. The companies include Unicus Research a specialty advisory service for fund managers and family offices, SGS Glazing a specialty glazing design and estimating firm, and NSI a premium spirits company.