With criticism of Caribbean IFCs leading to calls for further draconian legislative efforts, Paul Byles examines how IFCs can weather this regulatory storm.
Over the past two decades various international initiatives or outright ‘pressures’ have pushed IFCs to make changes to their infrastructure of laws and policies that relate to financial regulation or cross border cooperation. For the most part IFCs have managed to meet, and in some cases exceed, the various standards and maintained a fairy successful financial services sectors. But today’s challenges are of a different nature and for possibly the first time in a few decades we are faced with the legitimate question of IFCs future viability beyond the next decade or so.
To understand how today’s challenges differ from earlier ones, we need to take a brief glance at how various external pressures and the criticisms leveled at IFCs has evolved over the years.
It All Starts, And Ends, With ‘Tax’
Real external pressures on IFCS did not surface until the late 1990s, when they started to experience significant levels of economic success. This, coupled with statistical reports demonstrating the level and nature of capital flows between OECD economies and smaller IFCs and increasing fiscal challenges in Europe and elsewhere, attracted attention from policymakers in OECD based countries.
The primary criticism of IFCs was that they either encouraged or were outright involved in, tax evasion. IFCs responded by arguing that they cooperated with requests from authorities that were not ‘fishing expeditions’ and that the services they offered were legally sound (which was true and hard to argue with).
During the late 1990s/early 2000s, the criticism focused very heavily on regulation. Reviews by the IMF and FATF suggested that several IFCs had weak regulatory infrastructures that made then vulnerable to money laundering or did not fully comply with various international regulatory standards. Many IFCs responded by making the changes to their regulatory infrastructures. During this period many OECD based countries also did the same.
The external pressures soon focused almost exclusively on tax information sharing (also referred to as ‘cross border cooperation’) with the advent of the OECD’s global forum. This resulted in many IFCs engaging in formal tax information exchange agreements (TIEAs) with literally dozens of countries. The basic idea was that if countries shared information regarding citizens suspected of tax evasion this would reduce the practice.
But the original concern relating to dwindling revenues or increasing fiscal challenges particularly onshore, remained and therefore even with the proliferation of hundreds of new TIEAs, and significantly enhanced regulatory and anti money laundering regimes globally, the debate came full circle back to the ‘T’ word again.
Since 2013 the OECD has been involved in a project known as Base Erosion and Profit Shifting (BEPs). In summary, this project researched and identified the legitimate/legal ways in which international firms were utlising IFCs for the purposes of minimising their tax burdens. The project does not appear to suggest that any of these strategies were illegal. Instead the focus on BEPs is more business like: to identify the loopholes created in OECD based onshore economies and to put in pace agreed initiatives within the G20 countries to close these loopholes.
The OECD BEPS initiative is a significant concern because it targets the legitimate structuring that is utilised to help make multinational firms globally competitive. This initiative is far more serious than any regulatory enhancements of the past. This is not a new regulatory standard that simply requires changes to domestic legislation and hundreds of millions of dollars in resources by IFC governments. And neither is it a straight forward blacklist that they can either ridicule or respond to with new measures to get de-listed. BEPs is targeted at the very product offering, attempting to remove the tax efficiency of typical offshore structures. It doesn’t simply aim to change the rules or move the goalposts. It threatens to end the ‘game’ entirely.
Over the past five years in particular, we have witnessed a significant increase in the reluctance of US based banks to provide banking services to banks based in IFCs. The focus of this new pressure tend to be on those banks that are not subsidiaries or branches of the larger international banks, many of latter tending to be among the major US based correspondent banks.
The recent challenges to correspondent banking relationships is based on the idea that certain types of sectors and services should be viewed as being high risk and relates partially to the so called ‘Operation Choke Point’. This was a US Department of Justice initiative launched in 2013 which identified several areas of industry as being high risk for fraud and money laundering and discouraged banks from offering services to these sectors.
Subsequently the FDIC clarified that they expect a risk-based approach from US banks and not necessarily a severing of ties with all sectors. But it is appears that the practice of cutting ties with banks based in certain jurisdictions and certainly those regarded as ‘tax havens’ etc. continues among the US banks.
This presents a unique challenge in that:
Individual US based banks are telling their IFC banking clients that the reasons for severing ties with them is due to pressures from the US regulators and the need for the US based banks to avoid heavy fines and sanctions.
On the other hand, the US regulators have stated that they expect the banks to take a ‘risk based’ approach and have not directed banks to sever ties with any specific type of entity/sector.
In this ‘good cop, bad cop’ scenario there is little transparency and ultimately no true source for the IFCs to attack the issue of losing their correspondent banking relationships.
There is now a real risk that many IFCs will lose their ability to offer true private banking services. If a bank can no longer accept funds from clients (because it can no longer place those funds at another bank), there is little point in maintaining a banking license. IFCs run the risk of ending up with only a few banks represented by the global banks in their jurisdictions. While some clients can transition to these banks, many may not wish to do so, potentially rendering ‘offshore banking’ obsolete as a product offering within the next decade. The loss of government revenues, jobs and negative impact on the GDPs of IFCs is a material risk particularly if the IFC has a heavy focus on banking services.
Public Registry of Beneficial Ownership
Some IFCs are recently being placed under pressure to introduce a central registry of beneficial ownership of companies which can be accessed publicly.
Those IFCs that are overseas territories of the UK such as the Cayman Islands, BVI and Bermuda among others, have come under pressure in the past year to introduce such a registry. Many have quite rightly taken a position that they will not introduce such a registry because; a) they already have an existing infrastructure that achieves the same result or b) such public registries are far from being a global standard and there would therefore not be a level playing field if the IFCs were to introduce them before other countries do so.
Thus far the arguments seemed to have delayed any serious pressures for public registries to be introduced. But this initiative presents another challenge to IFCs.
The main concern relating to the central registry equivalent is that if not handled with ultra care, it potentially signals to legitimate IFC clients that the right to financial privacy is all but gone. There are many valid reasons why clients will not wish to have their ownership information easily accessible to the public. If clients were to say redomicile or close their entities entirely, this would also have a major negative economic impact on IFCs.
FATCA and CRS
Both of the above initiatives focus on information sharing much along the lines of the pressures to introduce TIEAs. These challenges are not seen as significant because most IFCs have already put in place the necessary regimes and policies to enable information sharing. Established IFCs with regard to global standards are not at risk as they are generally not interested in clients seeking to evade taxes, the latter being the primary focus of these two initiatives. The main result of FATA and CRS is that it imposes further compliance and infrastructure costs on the private and public sectors in IFCs.
Where Do We Go From Here?
With the exception of FATCA/CRS, the difference between earlier challenges to IFCs and the recent ones is that earlier initiatives required costly but straight forward changes to legislation and regulatory regimes. As long as these changes were not a deterrent to good quality clients most IFCs were not concerned and in fact many IFCS continued to grow their financial services sectors and economies.
However the recent initiatives particularly BEPS, the public registry and correspondent banking leave little in the way of a ‘simple response’ from IFCs. These initiatives are a threat to the way of doing business and therefore can be viewed more pragmatically as an attack on the service offering rather than seeking to regulate bad behaviour.
The general thrust of these initiatives is to say to clients “don’t go offshore”. For years advocates of IFCs have argued that if onshore economies truly wanted to stop the activities offshore or in IFCs, they could do so by simply closing their onshore loopholes. In effect these recent initiatives threaten to do just that.
The future of IFCs beyond the next say seven to ten years relies on them invoking the type of strategic thinking and innovation which led to the creation of the majority of these financial centres during the past five decades.
It will require a true reassessment of the existing business model. The new business model will need to take the following factors into account:
Instantaneous information sharing between tax authorities
Continuous regulatory changes
Less or very difficult access to the US clearing system by independent private banks
A business model that requires significantly more visible value added to clients and less reliance on, or at least to accompany, tax engineering
Almost no recognition of the old debate on tax evasion versus tax avoidance as onshore government focus solely on the question of how to maximize their tax revenues irrespective of legality.
A blurring of the lines between regulatory and tax authorities as a direct result of OECD policymakers incorporating the concerns of their domestic treasury departments.
Whether the changes onshore lead to new market opportunities for IFCs.
The general conclusion is that only those IFCs willing to take a more strategic approach to their existing business models are likely to survive in the new era. It is very possible that new market opportunities are identified and many IFCs remain sustainable for another three or four decades, but this is unlikely to occur without concerted efforts to review and adjust the current model.
The simple answer to whether IFCs can survive the face of these challenges is that those willing to adjust might survive and those unwilling certainly won’t.
Paul Byles is Director of FTS, a Cayman Islands compliance and management consulting firm. He also serves as an independent director and consultant to financial services firms. He is an economist and former regulator who has worked in the offshore sector for over 25 years. He is author of the books ‘Inside Offshore’ and 'Introduction to Offshore Financial Services: A BVI text'.