Death to Parking ‘Gray’ and ‘Black’ Money Offshore

Non-payment of tax has become a national sport in many countries, for example, it is estimated that in China the unreported household income equates to as much at 30 per cent of GNP. In Greece, which imposes a 'notional' income tax on luxuries, such as swimming pools - less than one per cent of all pools are reported[i] and 9,793 tax audits from the beginning of the year have resulted in 496,306 violations! 

From time immemorial people have been trying to protect their hard earned wealth from confiscation. To this end, post World War II, while tax rates were relatively low and tax collection was unsophisticated, a string of ‘offshore financial centres’ developed. At first they were tax havens that attracted great wealth - wealth that was legitimately earned, but that evaded tax.

Times have changed - both tax rates and the ability to detect un-taxed income have increased. Crime has become international, and pools of funds from illegal activities have been amassed offshore. However, fundamentally tax systems have remained static, while the demand for revenue in developed countries to support social welfare states has become insatiable. It was therefore inevitable that developed countries would seek to end certain practices in offshore centres.

We believe that the end is in sight for the type of offshore centres that have catered to those seeking to avoid their client’s home country tax - but that there is a bright future for offshore centres that become centres of excellence, are transparent and ‘play by the rules.’

The Tax System

Historically, those who have money want to keep it protected both from outright theft as well as confiscatory taxation. The history of mankind has been dominated by wars to conquer other peoples and take from them whatever is precious and revolutions by a population fed up with oppressive taxation. This pattern has repeated itself right through to today.

The rise of the ‘offshore’ tax haven, as we know it, coincides with both war and revolution. At the beginning of World War II individuals and corporations sought to use jurisdictions that were safe from the Nazis to protect their assets. Money was stashed in Zurich, London and New York in the hope that if some did survive the war, they would have something with which they could rebuild their lives. Dutch companies reincorporated in the Netherlands Antilles, for example, so they could continue operations without being subject to the US’s ‘trading with the enemy’ statute.

After World War II, as the industrial nations utilised the income tax system to finance welfare and other socialist policies, the perceived need to avoid tax became all the greater.

Post-World War II, many countries, such as Britain and the United States encouraged the use of tax havens, and many island jurisdictions sought a piece of the growing international financial services business.
Life is messy and the international financial services business is no different. Legitimate tax avoidance got mixed up with tax evasion and proceeds from illegitimate business. After all, money is fungible. Tax, which we all agree is necessary to fund the legitimate operations of government for the benefit of all, was used as a means to satisfy the voracious appetite of government to fund political goals and programmes.

The result of this combination has led us to where we are today. What was once legitimate tax avoidance is now considered tax evasion. The income tax system, which has been used by many countries over the past century, has failed the industrial world and the welfare states. But the industrial countries lack the political will to change. The blame for this failure must fall on somebody - and for now it falls on the non-industrial offshore tax havens and financial centres.
The past six decades have seen a proliferation of offshore tax havens and financial centres. Whether a large industrial country or a small island jurisdiction, they offered ‘no questions asked’ corporate formation, cloaked in the anonymity of barer shares, nominee directors and bank secrecy.

Many of the island jurisdictions scrambled to enact legislation (mostly drafted by or on the advice of British or American lawyers) to attract offshore business - since every country, after all, is offshore to some other country. Where there was a lack of local talent in a developing jurisdiction, expatriates, frequently from Britain or Canada, obtained work permits and residency and provided the experience and expertise needed. This enabled otherwise second world countries to compete for top-tier business.

The benefit to these developing countries was the creation of both private and government jobs, with the additional sources of revenue facilitating the building of infrastructure as well as increasing living standards and quality of life.

The industrial nations that were financial centres (eg, England, Switzerland and the US) and the developing island jurisdictions were now, for the first time in history, in competition for business.

In the 1960s becoming an offshore centre frequently led to the establishment of core expertise, such as accountancy and legal, mutual funds management, and insurance administration and risk management. In 1978 the Queen of England made William Walker, a Cayman Island attorney a member of the Most Excellent Order of the British Empire, for his work in developing Cayman as an offshore centre.

By the 1980s some offshore centres were reportedly generating more than one-quarter of their entire gross national product from their offshore service sector. Unfortunately much of the growth in the offshore industry came from the ‘dark side’ - including dictators who looted their country, criminals, and even major corporations that had gone astray.
With social welfare programmes, particularly in Western Europe and the United States, craving revenue to support their social agenda, tax rates exploded. Many wealthy individuals and corporations sought ‘shelter’ offshore - not only from tax, but from prying eyes.

At first, it was perfectly legal. In the early 1960s a US citizen could escape tax by establishing an irrevocable ‘foreign situs trust’. As more revenue escaped the fisc, developed countries began to enact a plethora of laws intended to capture the offshore revenue that was escaping, such as the ‘foreign controlled company’ laws - which taxed earnings of certain closely controlled foreign companies. Some taxpayers relented, and paid the tax. Others, figuring, “I will never get caught,” continued to establish offshore accounts, trusts and companies - flagrantly violating their home country’s tax laws, and there were many jurisdictions that were ready to help them.

This competition for international financial services of all types brought with it, predictably, hostility from industrial countries, which believed that their country was losing business or sources of tax revenue while ‘offshore’ jurisdictions were gaining at their expense. It did not matter that the industrial country was also ‘offshore’ and actually doing the same thing.

The industrial countries formed their own guild - the OECD - and proceeded under the guise of economic cooperation and development to regulate the smaller ‘offshore’ nations out of business.
Then there was the gray area of offshore activity. This was from money earned though legitimate efforts, but then became ‘gray’, eg, tax was not paid, currency restrictions were violated, etc.   Although not paying tax and stashing away funds ‘offshore’ became a national sport in Europe, with Americans taking the silver metal - the offshore world was too hard to tackle, so it was ignored.

But as industrial countries’ income tax systems started to fail, something had to be done to keep the tax system working. It was easy to blame those secret and mysterious offshore places for the problems of the failing income tax system. So instead of sensibly changing to a workable tax system, the industrial countries using an income tax system declared that what was ‘gray’ money was now ‘black’ money. This change came about predominately due to the confluence of certain events.

Without question there is a very dark side to international financial services. Criminals earn money and need financial services. Clearly, straightforward criminal behaviour is not hard to define and for civilized people to agree upon as wrong. It is easy to agree that the hiding of proceeds from theft, fraud, looting, enslavement and transportation of women and children, drugs, facilitation of terrorism is unacceptable under any circumstances.

What is difficult to accept is the fact that such criminal activity predominately occurs within the OECD countries and other ‘onshore’ countries, yet the ‘offshore’ jurisdictions take the blame because they are used as conduits for funds which are routed from the ‘onshore’ through the ‘offshore’ and then back to the major ‘onshore’ banking and financial centres.

Through the mid1980s, one could form an English company, have its management based outside of the UK, and the company would still have the prestige of being an English company, but because tax followed the ‘seat of management’, which was outside of UK, it was not subject to tax.

In the early 1990s the US developed the ‘pass through’ LLC. A foreign person could form an LLC in Delaware or Nevada, elect to have it treated as a ‘pass through’ and for tax purposes it didn’t exist. As long as the LLC had no US sourced income, the LLC was not subject to US tax. Doesn’t it sound better to say your company is formed in Delaware, rather than in Isle De Tax Haven?

So if a zero tax rate could be achieved in two of the most financially stable and respected countries in the world, then the growth of offshore business must have been down to more than simply a zero tax rate.

What then was the attraction of offshore financial centres? It was often the lack of regulation, and the fact that many such jurisdictions turned a blind eye to the source and origin of the business that was being attracted.

To be fair, many offshore centres did evolve and become major players in the world of international finance and commerce. But others offer little more than the next island and there is little to differentiate one from another.

The Shifting Paradigm

There are a number of legitimate reasons for keeping funds in low tax jurisdictions; however tax evasion is no longer one of them. The risk-reward paradigm has shifted. For example, a US citizen who avoids paying tax on US$500,000 of income - hiding the funds offshore, saves perhaps US$175,000 in tax. The citizen has limited use of the funds, and if caught five years later, could owe more than US$400,000 in tax and penalties, and be subject to more than 10 years in prison.

In addition, there were almost two dozen people indicted or convicted from the USB fallout, and the Swiss have yet to begin to turn over information on the 4,450 persons that have been targeted. The IRS has now also reportedly begun to target HSBC clients.

The Change

 Five factors have converged into the perfect storm to bring about the end of offshore tax evasion:

(1) Greater need by developed countries for revenue to support their social programmes. Hence, the need to look for ‘low hanging fruit’ - that is, large stashes of untaxed revenue that is easy to find and get.

(2) Change in governmental attitude towards offshore tax evasion. At one time, offshore tax evasion was viewed as ‘someone else’s problem’. Eventually, developed countries became concerned that criminals were ‘laundering’ proceeds of crime offshore. At the turn of the millennium, we had the G-7, OECD, and other NGOs issuing black lists, and claiming that offshore centres were destroying the economic stability of the world. Then came 9/11, and with it a concern that offshore centres had become bastions of terrorist financing. More countries now view tax evasion as a universal criminal problem.

Accordingly, in the 1960s someone with an anstault in Liechtenstein was viewed as a crafty bon vivant. By 2002, the same person was viewed as a potential terrorist.

The change in attitude regarding tax evasion has lead to greater cooperation between countries, a growing string of ‘mutual legal assistance’ treaties, and a willingness to enforce foreign laws.

(3)Enhanced priority to deter offshore tax evasion. Many countries have turned to multinational approaches to stem tax evasion, and others are making it a top priority.

In 2010 the US had made ‘international tax compliance’ a major initiative. Further the IRS has established an audit group that will target very wealthy individuals.

The US Justice Department recently stated that: “Professionals, including bankers, who promote fraudulent offshore tax schemes against the United States will be held accountable.”

Recently the US has indicted several lawyers and trust company officials in connection with sheltering money in Switzerland. So not only will it be harder for individuals to seek to hide their funds, but those who assist in the hiding and sheltering of funds, may themselves become targets of criminal charges. This will lead to less trustworthy and less sophisticated professionals willing to help the few clients who still want to venture into offshore concealment of earnings.

(4) Computerisation - makes it possible with greater ease to track the flow of money.   Fifty years ago there were few credit cards, and ‘cash was king’. It was impossible to detect spending, and the concept of a ‘life style audit’ to determine if a taxpayer was living beyond their means was not yet perfected.

Today, it is virtually impossible to travel and live without a credit card, which leaves a detailed trail of an individual’s whereabouts and spending habits. And if someone tries too hard to conceal their spending, they are likely to be running afoul of money laundering rules - concealing the nature or origin of funds.

Computerisation also makes it easier for a whistle blower to provide data to revenue authorities on hundreds if not thousands of taxpayers.

(5) Finally, the cost-benefit to revenue agencies expending funds to track tax cheats has generated substantial recoveries. Hence stopping offshore evasion has become profitable.

With the greater likelihood of detection, and the enhanced burden of getting caught, fewer and fewer people will seek the shelter in the offshore world.

What is the Future?

There is a lesson for the offshore industry in buggy whips. A buggy whip is a horsewhip with a long stiff shaft and a relatively short lash used for driving a horse harnessed to a buggy or other small open carriage. At the turn of the 20^th century it was a thriving business, at least until the introduction of the automobile. Then the industry died. It is cited in economic classes as an example of a niche industry ceasing to exist because the need for its product disappeared.

Buggy whip manufacturers thought they were in the business of making buggy whips. In 1910 had buggy whip manufacturers concluded that they were in the business of creating ‘transportation accessories’, they would be thriving today.[ii]

The offshore world has changed in the past decade. What was the standard modus operandi of ‘tax havens’ is no longer viable.

With the end near for many of the offshore centres, what does the future have in store for them?

• Much of the ‘dirty money’ has already migrated to the major nations, for two reasons (safety and investment opportunities), and what is left offshore, will continue to flow from the more respected offshore jurisdictions.

• Some of the offshore centres will fade into infamy due to a lack of business. Those are the ‘me too’ jurisdictions, with little unique to offer, and who did not focus on ‘service’.

• Some centres will succeed and continue to grow - those will be the jurisdictions, that: (a) conduct business with the highest standards and compliance with international norms, (b) have become or are already ‘centres of excellence’ - develop reputations in providing top flight quality/services that are unique or with special expertise, and (c) remember that clients are customers, and customers are king - and provide the best of ‘white glove’ service.

• There is a place in the offshore world for legitimate business and tax planning for clients from developed countries, including the United States.

• There will always be a handful of jurisdictions that pursue the ‘race to the bottom’ and will continue to seek the nefarious.

Coming in from the Cold

It is impossible to legally, and without a likelihood of getting caught, spend even a modest portion of an offshore stash. Even if the founder does not touch the money - what are the children going to do? Inherit an illegal situation? The children will face the same problems - tax evasion and an inability to use the money.        

“What if... I’ve a ‘stash of cash’ offshore, that was never reported?” First, be cautious of any scheme to ‘clean’ the money, eg, pay management fees, for virtually all of these types of plans will constitute money laundering or some other type of financial crime. Then come clean. Most countries have some type of amnesty or disclosure programme that will avoid criminal sanctions. Even if you do not want to come clean for your self, do so for your children!

There is a very bright future for the offshore centres that learn from the errors of the past, implement transparent and best practices, develop products and expertise, and combined it all with the service attitude of a five-star hotel.

In the end, offshore financial centres will become what they once were, and always should have been: service centres that cater to the legitimate needs of rich individuals and companies with multi-national businesses.

 

* Mr Fisher is based in Beverly Hills, California. He is a member of the California Bar, and the Honourable Society of Lincoln's Inn (London [student bencher]). Mr Fisher is a graduate of the University of Southern California (BA), Southwestern University (JD), and the University of Cambridge (LLB with honours).

Denis A Kleinfeld is an attorney based in Miami, Florida. He is a graduate of the University of Illinois (BS. in Accountancy, 1967) and is registered with the university as a Certified Public Accountant, with his JD from Loyola University of Chicago.

Mr AJ Fisher resides in Beverly Hills. He is a graduate of the University of Michigan (BA - Econ/Comm 2004), Emory University (JD - 2007, MBA - 2008), and is a member of the California Bar.

 

[i] Greek tax inspectors are using Google Earth to locate homes with pools.

[ii] See, the seminal article entitled: “Marketing Myopia” by Prof Theodore Levitt, Harvard Business Review, July-August 1960.