Offshore Financial Centres (OFCs) & Global Regulatory Efforts

 Uses of Offshore Financial Centers (OFCs)

OFCs can be used for legitimate reasons, taking advantage of: (1) lower explicit taxation and consequentially increased after tax profit; (2) simpler prudential regulatory frameworks that reduce implicit taxation; (3) minimum formalities for incorporation; (4) the existence of adequate legal frameworks that safeguard the integrity of principal-agent relations; (5) the proximity to major economies, or to countries attracting capital inflows; (6) the reputation of specific OFCs, and the specialist services provided; (7) freedom from exchange controls; and (8) a means for safeguarding assets from the impact of litigation etc.

 

Offshore banking licenses. A multinational corporation sets up an offshore bank to handle its foreign exchange operations or to facilitate financing of an international joint venture. An onshore bank establishes a wholly owned subsidiary in an OFC to provide offshore fund administration services (e.g., fully integrated global custody, fund accounting, fund administration, and transfer agent services). The owner of a regulated onshore bank establishes a sister "parallel" bank in an OFC. The attractions of the OFC may include no capital tax, no withholding tax on dividends or interest, no tax on transfers, no corporation tax, no capital gains tax, no exchange controls, light regulation and supervision, less stringent reporting requirements, and less stringent trading restrictions.

Offshore corporations or international business corporations (IBCs). IBCs are limited liability vehicles registered in an OFC. They may be used to own and operate businesses, issue shares, bonds, or raise capital in other ways. They can be used to create complex financial structures. IBCs may be set up with one director only. In some cases, residents of the OFC host country may act as nominee directors to conceal the identity of the true company directors. In some OFCs, bearer share certificates may be used. In other OFCs, registered share certificates are used, but no public registry of shareholders is maintained. In many OFCs, the costs of setting up IBCs are minimal and they are generally exempt from all taxes. IBCs are a popular vehicle for managing investment funds.

Insurance companies. A commercial corporation establishes a captive insurance company in an OFC to manage risk and minimize taxes. An onshore insurance company establishes a subsidiary in an OFC to reinsure certain risks underwritten by the parent and reduce overall reserve and capital requirements. An onshore reinsurance company incorporates a subsidiary in an OFC to reinsure catastrophic risks. The attractions of an OFC in these circumstances include favorable income/withholding/capital tax regime and low or weakly enforced actuarial reserve requirements and capital standards.

Special purpose vehicles. One of the most rapidly growing uses of OFCs is the use of special purpose vehicles (SPV) to engage in financial activities in a more favorable tax environment. An onshore corporation establishes an IBC in an offshore center to engage in a specific activity. The issuance of asset-backed securities is the most frequently cited activity of SPVs. The onshore corporation may assign a set of assets to the offshore SPV (e.g., a portfolio of mortgages, loans credit card receivables). The SPV then offers a variety of securities to investors based on the underlying assets. The SPV, and hence the onshore parent, benefit from the favorable tax treatment in the OFC. Financial institutions also make use of SPVs to take advantage of less restrictive regulations on their activities. Banks, in particular, use them to raise Tier I capital in the lower tax environments of OFCs. SPVs are also set up by non-bank financial institutions to take advantage of more liberal netting rules than faced in home countries, reducing their capital requirements.

Tax planning. Wealthy individuals make use of favorable tax environments in, and tax treaties with, OFCs, often involving offshore companies, trusts, and foundations. There is also a range of schemes that, while legally defensible, rely on complexity and ambiguity, often involving types of trusts not available in the client's country of residence. Multinational companies route activities through low tax OFCs to minimize their total tax bill through transfer pricing, i.e., goods may be made onshore but invoices are issues offshore by an IBC owned by the multinational, moving onshore profits to low tax regimes.

Tax evasion and money laundering. There are also individuals and enterprises who rely on banking secrecy to avoid declaring assets and income to the relevant tax authorities. Those moving money gained from illegal transaction also seek maximum secrecy from tax and criminal investigation.

Asset management and protection. Wealthy individuals and enterprises in countries with weak economies and fragile banking systems may want to keep assets overseas to protect them against the collapse of their domestic currencies and domestic banks, and outside the reach of existing or potential exchange controls. If these individuals also seek confidentiality, then an account in an OFC is often the vehicle of choice. In some cases, fear of wholesale seizures of legitimately acquired assets is also a motive for going offshore. In this case, confidentiality is very important. Also, many individuals facing unlimited liability in their home jurisdictions seek to restructure ownership of their assets through offshore trusts to protect those assets from onshore lawsuits. Some offshore jurisdictions have legislation in place that protects those who transfer property to a personal trust from forced inheritance provisions in the home countries.

Source: Financial Stability Forum's Working Group on Offshore Financial Centers Report (April 2000).

Significance of  Offshore Finance

While incomplete, and with the limitations discussed below, the available statistics nonetheless indicate that offshore banking is a very sizeable activity. Staff calculations based on BIS data suggest that for selected OFCs, on balance sheet OFC cross-border assets reached a level of US$4.6 trillion at end-June 1999 (about 50 percent of total cross-border assets), of which US$0.9 trillion in the Caribbean, US$1 trillion in Asia, and most of the remaining US$2.7 trillion accounted for by the IFCs, namely London, the U.S. IBFs, and the JOM.

History of offshore  Business

The maintenance of historic and distortionary regulations on the financial sectors of industrial countries during the 1960s and 1970s was a major contributing factor to the growth of offshore banking and the proliferation of OFCs. Specifically, the emergence of the offshore interbank market during the 1960s and 1970s, mainly in Europe—hence the eurodollar, can be traced to the imposition of reserve requirements, interest rate ceilings, restrictions on the range of financial products that supervised institutions could offer, capital controls, and high effective taxation in many OECD countries.

In Asia, offshore interbank markets began to develop after 1968 when Singapore launched the Asian Dollar Market (ADM) and introduced the Asian Currency Units (ACUs). The ADM was an alternative to the London eurodollar market, and the ACU regime enabled mainly foreign banks to engage in international transactions under a favorable tax and regulatory environment.

In Europe, Luxembourg began attracting investors from Germany, France and Belgium in the early 1970s due to low income tax rates, the lack of withholding taxes for nonresidents on interest and dividend income, and banking secrecy rules. The Channel Islands and the Isle of Man provided similar opportunities. In the Middle East, Bahrain began to serve as a collection center for the region's oil surpluses during the mid 1970s, after passing banking laws and providing tax incentives to facilitate the incorporation of offshore banks. In the Western Hemisphere, the Bahamas and later the Cayman Islands provided similar facilities. Following this initial success, a number of other small countries tried to attract this business. Many had little success, because they were unable to offer any advantage over the more established centers. This did, however, lead some late arrivals to appeal to the less legitimate side of the business.

By the end of the 1990s, the attractions of offshore banking seemed to be changing for the financial institutions of industrial countries as reserve requirements, interest rate controls and capital controls diminished in importance, while tax advantages remain powerful. Also, some major industrial countries began to make similar incentives available on their home territory. For example, the U.S. established in 1981, in major U.S. cities, the so-called International Banking Facilities (IBFs). Later, Japan allowed the creation of the Japanese Offshore Market (JOM) with similar characteristics. At the same time, supervisory authorities, and to some extent tax authorities, were adopting the principle of consolidation which reduced the incentives for banks to carry on business outside their principal jurisdiction. As a result, the relative advantage of OFCs for conventional banking has become less attractive to industrial countries, although the tax advantages for asset management appear to have grown in importance. In fact, reported bank intermediation on the balance sheet in IFCs has declined over the period 1992-1999, thus contributing to the overall decline in the share of bank cross-border assets intermediated through OFCs from 56 percent of total bank cross-border assets in 1992 to about 50 percent of total bank cross-border assets at end-June 1999 (Chart 1).

The Offshore Finance Activity

Banking activity in OFCs is now predominantly carried out by branches and affiliates of banks incorporated elsewhere, mainly in major countries, but also in larger emerging market economies. Since the failure of BCCI and Meridian Bank it has become difficult for a bank incorporated in a jurisdiction with limited domestic markets to carry on business in other countries. Supervisors now require banks wishing to open branches and affiliates to demonstrate a capacity for their home supervisor to exert consolidated supervision, which it is almost impossible to do for a bank whose business is almost entirely outside the home country's jurisdiction.

The physical presence of establishments of foreign banks in OFCs varies. In some centers they may originate and, in some cases, fund the business carried on their books. But in other cases, they may have a very limited physical presence and the business decisions may all be taken elsewhere. Such establishments are sometimes known as "shell" branches. There has been a tendency in the more successful OFCs for the amount of local value added to grow, as these OFCs have acquired the ability to supply specialist capabilities and skills. Offshore activities may also take place through so-called parallel-owned banks, that is, banks that are not subsidiaries of a bank in the onshore center, but have the same owners or controllers. Effective consolidated supervision is more difficult in such cases.

International Policy Initiatives

Table 3 provides a synoptic description of the many ongoing initiatives—some of which are more fully discussed below, aimed at curbing OFC involvement in lax financial regulation, tax evasion, and financial crime. While cross-border and offshore banking have been at the core of the Basel Committee's work since the mid-1970s, OFCs have more recently become a major target of the FATF and OECD because some of them are increasingly viewed as offering opportunities for money-laundering and tax evasion, as well as raising obstacles to anti-corruption investigations.

Offshore Issues: Synopsis of International Policy Initiatives
Organization	Sub-Group/Working Party	Topic	Key Deliverable(s)
Asia-Pacific Group on Money Laundering	n/a	Workshops on the misuse of OFCs.	Ongoing.
Basel Committee	Basel Committee and Offshore Group of Banking Supervisors	Supervision of cross-border banking.	Survey on implementation of the 1996 Report.
CFATF	Sub-group of FATF working with Caribbean jurisdictions	Mutual evaluation process in the Caribbean.	Ongoing.
European Union	Multi-Disciplinary Group against organized Crimes	Cross-border investigation and cooperation.	Ongoing.
FATF(*)	Ad Hoc Group on non-cooperative jurisdictions	Identifying detrimental practices and non-cooperative jurisdictions.	List of non-cooperative jurisdictions published on June 22, 2000.
Financial Stability Forum(*)	Working Group on Offshore Financial Centers	Potential effects of OFCs on global financial stability. Compliance with international regulatory standards, notably cross-border cooperation.	Report adopted end-March 2000.
G-7	Finance Ministers' Working Group on financial crimes	Cross-border cooperation between law enforcement and regulators.	Ten key principles.
	Financial Experts Group	Transparency and regulatory cooperation.	n/a
IOSCO	Working Party 4 Implementation Committee	Detect under-regulated and un-cooperative jurisdictions.	Follow-up work on the report prepared in 1997.
New Zealand Government	Pacific Roadshow	International and regional dimensions of financial crimes and risks for the South Pacific forum countries.	Report on visits to 13 Pacific countries to warn of financial crimes and misuse of OFCs.
OECD	Committee on Fiscal Affairs (*)	Tax competition.	1998 Report on harmful tax competition.
	Forum on Harmful Tax Compet.	Tax havens.	List of tax havens by June 2000
Offshore Group of Banking Supervisors (OGBS)	n/a	Working closely with the Basel Committee to evaluate OGBS members' compliance with Basel's Core Principles.	Survey on implementation of the 1996 report.
Offshore Group of Insurance Supervisors	n/a	Development of various standards.	Self-assessments.
Registrar of Offshore Financial and Banking Services	Created in 1998 to provide Pacific regional grouping	Envisages to focus attention of regional centers on internal standards.	n/a
U.K. Government	Edwards Report	Financial regulation in the Crown Dependencies.	Follow-up work on the report prepared in 1998.
	KPMG Report	Financial regulation in the overseas territories.	Report expected by July 2000.
United Nations	Offshore Forum (ODCCP)(*)	Develop minimum performance standards for OFCs	Standards to be finalized by March 2000.
Legenda: CFATF = Caribbean Financial Action Task Force; FATF = Financial Action Task Force; IOSCO = International Organization of Securities Commissions; ODCCP = U.N. Office for Drug Control and Crime Prevention. (*) Denotes IMF participation

Source: IMF

IMF Review of OFCs

The Financial Stability Forum's Working Group on Offshore Financial Centers was set up to review the uses and activities of OFCs and their significance for global financial stability. Those OFCs with weaknesses in financial supervision, cross-border cooperation, and transparency were felt to allow financial market participants to engage in regulatory arbitrage, undermining efforts to strengthen the global financial system. The FSF considers that the key to addressing most of the problems with these OFCs is through the adoption and implementation of international standards, particularly in cross-border cooperation. The FSF has identified the relevant international standards whose implementation would address these issues, is considering mechanisms for assessing compliance in the implementation of the standards, and is looking at appropriate incentives to enhance such compliance. The FSF has also asked the Fund to take on the main responsibility for conducting these assessments, drawing in expertise from supervisory agencies and elsewhere.

The Basel Committee on Banking Supervision has been actively promoting more effective cooperation between "home" and "host" supervisors for many years. Cross-border banking issues were at the core of the "Basel Concordat" of 1975; the Concordat was revised in 1983 to take account of the growing need for consolidated supervision of international banking groups. That work was given further impetus by the collapse of the Bank of Credit and Commerce International (BCCI) in 1991, which led to the publication in 1992 by the Basel Committee of the Minimum Standards—see Box 2. Subsequently, in 1996, a Working Group on Cross-Border Banking was established, composed of members of the Basel Committee and the Offshore Group of Banking Supervisors. This group prepared a report (the "1996 Report") including 29 recommendations to address a number of practical problems that had arisen in the implementation of the 1992 Minimum Standards. None of this work is specific to OFCs, although the problems involved in establishing the relative responsibilities and effective cooperation between home and host supervisors arises particularly with supervisors in OFCs. Finally, in 1997, the Basel Committee issued its Core Principles for Effective Banking Supervision, providing, inter alia, a comprehensive framework for effective consolidated supervision which is also appropriate for offshore banking activities.

Indeed, effective consolidated supervision is one of the more difficult aspects of supervision to implement in practice. For this reason, it is generally weakly implemented in many countries, according to a recent study by the staff,¹⁷ which shows that most of the countries so far assessed were rated non-compliant or materially non-compliant with regard to Core Principle 20 dealing with consolidated supervision. Indeed, out of these countries for which consolidated supervision was relevant, only 28 percent were rated fully or largely compliant, with 72 percent found seriously wanting. One contribution to this weakness is the absence of consolidated accounting and reporting, together with differences in accounting standards. Supervisory coordination is shown to be another vital element, somewhat better implemented but still weak in many instances.

Recommendations for action following the 1998 Basel Committee's survey to assess implementation of the Core Principles are currently being considered by the Basel Committee. The Committee is now considering, against the evidence from implementation, how far the gaps referred to above and any others should lead to an updating and/or fine-tuning of the 29 recommendations of the 1996 Report.

The Financial Action Task Force (FATF) was established to help protect financial systems from criminal use for the laundering of the proceeds of drug related and other serious crime.¹⁸ More recently, the emphasis has been on the extension of the FATF's work to crimes other than those associated with drugs, including some fiscal crimes. The FATF's 40 recommendations have come to be recognized as a statement of best practice in the combat against money-laundering. The Task Force has also encouraged the formation of regional groups, the first of which was the Caribbean Financial Action Task Force (CFATF), and which includes the major OFCs in that region. The CFATF has also published a list of 19 recommendations in addition to the FATF's 40, many of which deal with aspects germane to business in OFCs. A similar group has been established in the South Pacific. The FATF's Ad Hoc Group on Non-Cooperative Jurisdictions was established in 1998 to develop a common process for FATF members to evaluate whether jurisdictions are cooperating with FATF anti-money laundering initiatives. This work was finalized on June 22, 2000, when the FATF published a report which included a list of 15 non-cooperative jurisdictions.

The U.N. Offshore Forum is a 1999 initiative of the U.N.'s Office for Drug Control and Crime Prevention to deny criminals access to OFCs for the purpose of laundering the proceeds of criminal activities. The Forum's program seeks political commitment from OFCs towards the adoption of minimum performance standards.  In return, the Forum will provide technical assistance that will aid OFCs in coming into compliance with the standards. The Forum's program was set out to the global financial community in March 2000 during its Plenary Meeting in the Cayman Islands.

The OECD Committee on Fiscal Affairs (CFA) has established the Forum on Harmful Tax Competition under the aegis of the G-7, which, since the Birmingham Summit of May 1998, placed a greater emphasis on the need to step up international cooperation to enhance the effectiveness of attempts to prevent the erosion of the ability of major countries' tax authorities to tax the income and capital of their residents. The OECD's Forum was created as the result of the OECD May 1998 report on Harmful Tax Competition and it was assigned responsibility, inter alia, for undertaking an ongoing evaluation of existing and proposed preferential tax regimes in OECD member and non-member countries, and examining whether particular jurisdictions constitute tax havens. The OECD has informed some 49 jurisdictions that they are considered to be "tax havens." They will be classified in three categories according to their willingness to cooperate with OECD countries' tax authorities: a group of "non-cooperative" OFCs against whom sanctions may be taken; a second group which are committed to "reform," but where such reforms have not been set in train; and a third group which are in the process of implementing reforms. The names of those falling in the first two categories are expected to be published.

There have also been assessments and surveys other than those carried out by recognized international bodies. For example, the U.K. authorities have published a review of the offshore business of the Channel Islands and the Isle of Man, which provides considerable information on the nature of the business carried out in those jurisdictions. The U.K. authorities are also sponsoring a study by KPMG of the main overseas dependent territories which provide facilities for offshore business. The work is expected to be completed by mid-2000 and the results will published.

All these international initiatives aimed at OFCs relate in various ways to the Fund's heightened focus on assessments of financial stability, including under multilateral and bilateral surveillance, and more recently notably through the implementation of the joint Bank-Fund Financial Sector Assessment Program (FSAP). These issues are, inter alia, discussed in a companion Policy paper. issued by IMF

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