Among them were: (1) that the eldest daughter of Ferdinand Marcos, former President of the Philippines, is a beneficiary of an offshore trust now being investigated for the purpose of recovering wealth stolen by the Marcos family; and (2) that Mongolia's Deputy Speaker set up an offshore company and a million-dollar Swiss bank account, a disclosure that led to his confession of an "ethics failure" and dismissal. Now let's examine the usefulness of offshore centers and the likely impact of the ICIJ story in the coming months and years.
Three Legs of a Stool.
The late Peter Drucker, the father of modern-day management, was a leading influence in the economic miracle of Japan that witnessed a nation shattered by World War II become the world's third largest economy. Drucker's mind extended well beyond management principles. Author of 39 books, he wrote on how to create a "new society" that functions well.
He believed three kinds of organizations were required: public sector, private sector and social sector. In the public sector national, regional and local bodies do the work of government. In the private sector businesses meet the needs and wants of citizens through voluntary exchanges in a profit-driven market economy. In the social sector, what Drucker dubbed the "third sector," the health and welfare needs of the citizens not fully met by the public or private sectors are served by nonprofit organizations. He pictured these sectors as three legs of a stool. Each must be effective and strong for the whole society to enjoy health, peace and prosperity. Where do offshore centers fit in this picture?
What Does Offshore Mean?
In the literal sense "offshore" refers to a jurisdiction other than one's own residence. Because taxation has for ages been linked to residency, historically there has been an incentive to move wealth outside of one's own country to avoid or reduce the tax burden. The first modern example of a nation that developed a reputation for attracting foreign capital was Switzerland in the wake of World War I, fueled in part by its privacy laws in banking. The century that followed gave rise to a number of competing offshore jurisdictions, culminating in a boom of new entrants during the last 20 years.
Offshore jurisdictions are often called "tax havens" by the press. Offshore financial centers appear to prefer the name "international financial centers" (IFCs), especially in comparison to the term "tax havens," which they view as unfairly negative. While the name "IFC" may be an improvement from a public image standpoint, it undoubtedly creates confusion for the uninformed citizen who might assume that IFCs include New York City, London and Shanghai. Usually, that assumption would be incorrect.
Admittedly, IFCs are difficult to define. The lines between onshore and offshore are increasingly blurry. Nevertheless, there is a general consensus on the identity of the world's most popular IFCs. The list includes the British Virgin Islands (BVI), Cayman Islands, Channel Islands, Bahamas, Bermuda, Switzerland, Singapore and Hong Kong. One organization critical of IFCs, the Tax Justice Network, estimates that IFCs hold as much as US$32 trillion in financial assets. That is more than half of all household wealth in the U.S. and double that of China. IFCs are also employed by many of the world's most famous brands like Apple, Coca-Cola and Microsoft. Though most people may have no real understanding of IFCs, these relatively small jurisdictions have profound significance in today's world.
The Extraordinary Benefits of IFCs.
What the general public rarely receives from the news media is an honest portrayal of the substantial benefits that IFCs bring to the global economy, developing countries in particular. China, for example, has waged the most successful war on poverty in human history. Since the death of Chairman Mao the welcome extended to foreign investors by the Middle Kingdom is seen as the key factor in raising living standards. The World Bank says that "foreign direct investment remains one of the most important tools in the fight against poverty." (Klein, Aaron and Hadjimichael: 2001) Foreign capital deployed in the mainland came predominantly from Hong Kong and the BVI. According to a 2010 World Bank report, China attracted one fifth of the foreign direct investment made to all developing countries during the last decade. No doubt China's comfort with IFCs contributed to this remarkable attraction of capital.
As the gears of the private sector begin to turn in developing markets, IFCs are the necessary lubricant. Emerging markets often lack essential ingredients to access capital: (1) political stability, (2) a sound and independent legal and regulatory framework, and (3) first-class financial, legal and accounting services. IFCs offer these essentials plus a tax-neutral platform. While tax incentives may have caused much of the early growth in IFCs, tax benefits have and will continue to diminish in importance relative to these other advantages. Thus, we see that one leg of Drucker's stool, the private sector, depends heavily on IFCs to build and sustain efficient markets.
IFCs also serve the interests of the public sector. Those who equate good government with big government may disagree. In our mobile, instantly informed world, IFCs empower citizens and capital to choose their jurisdiction, limiting the monopoly power of the public sector and creating competition among governments. Arguably, those governments that govern most fairly and efficiently do best in attracting people, businesses and wealth. In other words, IFCs are a check on unwarranted growth in the public sector.
Even in the third sector - civil society - IFCs display their worth. The cover story from the Spring 2013 issue of Asia Outbound outlines the appeal of IFC-based foundations. As venture philanthropy goes global, IFCs become ideal storehouses, especially for philanthropists in developing regions. Most plan to support causes within their own homelands eventually. Yet, in the face of domestic economic or political uncertainty, they prefer access to sophisticated financial markets and the wealth safety of IFCs for their charitable accounts. IFCs also supply tools for social ventures where businesses are run for profit, and profits are devoted not to private investors but to social welfare. In China and in other emerging markets, IFCs will help enable the third leg of the stool to one day match the public and private sectors in strength and effectiveness.
Tax Avoidance and Evasion.
The most common charge leveled against IFCs is that they harbor tax cheats. This was true in the past, and abuses still persist. Financial crimes are part of the human condition and not confined to the offshore world. Though not always apparent, it is important to recognize the distinction between legitimate tax avoidance by proper planning versus unlawful tax evasion. Because of recent trends in the international tax environment, IFCs that countenance tax evasion and criminal abuses will find themselves without a seat in the global marketplace. Instead, it will be IFCs that are committed to tax and regulatory compliance that will prosper and lead the industry.
IFCs are also accused of threatening the world's corporate tax revenues. Some argue that legitimate tax avoidance by use of IFCs will drive the nations' corporate tax rates down in a desperate "race to the bottom." This viewpoint is championed by the European Union's Organisation for Economic Co-operation and Development (OECD). Reports of "letterbox companies" in the Netherlands and "IP boxes" in Switzerland breed such fears. Still, the OECD and other groups are exerting pressure on low tax jurisdictions to collaborate and cooperate rather than compete on tax policy among the family of nations.
Secrecy and Transparency.
The most serious claim facing IFCs relates to any involvement with global terrorism, money laundering, drug trafficking or other forms of corruption. Over the past decade, the threat of further acts of terrorism has turned the political will in favor of financial transparency in lieu of privacy rights. The OECD's Global Forum on Transparency and Exchange of Information for Tax Purposes has successfully promoted the widespread acceptance of Tax Information Exchange Agreements (TIEAs). In 2010 the U.S. adopted the Foreign Account Tax Compliance Act (FATCA) to stem the flow of tax evasion by U.S. citizens living abroad. According to Bahamas Islands Info, their Minister of Finance calls FATCA the "most significant matter facing the international financial services industry today." He adds: "The global paradigm is shifting to an expectation of transparency globally." Without the advent of the Information Age in this generation, FATCA and other information reporting structures would not be feasible.
The era of secrecy that hides evil practices in dark corners of the world is coming to an end. Though most of the transparency provisions are aimed at improving tax compliance, they will surely make life more difficult for would-be terrorists and money launderers. But for the new regulatory standards to produce solid results, IFCs must be vigilant in compliance. A 2012 research study by three professors, including Jason Sharman of Griffith University, suggests that compliance with "know your customer" anti-money laundering standards fashioned to prevent the use of anonymous shell companies is "patchy," and the transparency system is "compromised." In defense of IFCs the study points out that they outperform their onshore counterparts, especially (and ironically) the United States. Even so, regulatory observance among IFCs must and will get better.
Public Image and the Future of IFCs.
Without question, the public image of IFCs has suffered this year from news of offshore leaks and the banking crisis in Cyprus. Somehow the ICIJ peeked behind the curtains of 120,000 offshore companies and trusts. Even though this was done illicitly and in violation of obligations of confidentiality, these leaks should produce positive long-term results for IFCs. First, this attention will further motivate IFCs to adopt, and adhere to, even stricter standards of tax and other regulatory reporting requirements. This industry will continue to develop and mature, now even more quickly. Second, anyone considering using IFCs to further their corrupt schemes is now on notice that the light of transparency will shine brighter than ever. Third, this unwelcome development for IFCs actually provides a platform for them to educate the public about the global marketplace and refute the caricatures of IFCs painted by their opponents. Among the best at doing so is the BVI's Elise Donovan, who said, "We see it as an opportunity to put the record straight and present the facts on the legitimate and vital role centres like the BVI play in maintaining a stable and efficient global economy." (BVI IFC Newsletter April 2013)
The offshore waters have been choppy this year. But the IFC ship is resilient and powerful. It has its compass bearings set right. And it's moving steadily toward calmer seas ahead.
