Ayadi arbak financial centres in europe; a new positioning in the global financial market post crisis (2014)

Titles include: Mario Anolli, Elena Beccalli and Tommaso Giordani editors RETAIL CREDIT RISK MANAGEMENT Rym Ayadi and Emrah Arbak FINANCIAL CENTRES IN EUROPE A New Positioning in the Glo

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Titles include:

Mario Anolli, Elena Beccalli and Tommaso Giordani (editors)

RETAIL CREDIT RISK MANAGEMENT

Rym Ayadi and Emrah Arbak

FINANCIAL CENTRES IN EUROPE

A New Positioning in the Global Financial Market Post-crisis

Rym Ayadi and Sami Mouley

MONETARY POLICIES, BANKING SYSTEMS, REGULATORY CONVERGENCE, EFFICIENCY AND GROWTH IN THE MEDITERRANEAN

Caner Bakir

BANK BEHAVIOUR AND RESILIENCE

The Effect of Structures, Institutions and Agents

Alessandro Carretta and Gianluca Mattarocci (editors)

ASSET PRICING, REAL ESTATE AND PUBLIC FINANCE OVER THE CRISIS.Dimitris N Chorafas

BASEL III, THE DEVIL AND GLOBAL BANKING

Dimitris N Chorafas

HOUSEHOLD FINANCE

Adrift in a Sea of Red Ink

Dimitris N Chorafas

SOVEREIGN DEBT CRISIS

The New Normal and the Newly Poor

Stefano Cosma and Elisabetta Gualandri (editors)

THE ITALIAN BANKING SYSTEM

Impact of the Crisis and Future Perspectives

Joseph Falzon (editor)

BANK PERFORMANCE, RISK AND SECURITISATION

Joseph Falzon (editor)

BANK STABILITY, SOVEREIGN DEBT AND DERIVATIVES

Juan Fernández de Guevara Radoselovics and José Pastor Monsálvez (editors)

CRISIS, RISK AND STABILITY IN FINANCIAL MARKETS

Franco Fiordelisi and Ornella Ricci (editors)

BANCASSURANCE IN EUROPE

Past, Present and Future

Josanco Floreani and Maurizio Polato

THE ECONOMICS OF THE GLOBAL STOCK EXCHANGE INDUSTRY

Jill M Hendrickson

FINANCIAL CRISIS

The United States in the Early Twenty-First Century

Otto Hieronymi and Constantine Stephanou (editors)

INTERNATIONAL DEBT

Economic, Financial, Monetary, Political and Regulatory Aspects

Paola Leone and Gianfranco A Vento (editors)

CREDIT GUARANTEE INSTITUTIONS AND SME FINANCE

Essays on Crises, Capital Flows, FDI and Exchange Rate

Gabriel Tortella and José Luis García Ruiz

SPANISH MONEY AND BANKING

A History

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A New Positioning in the Global Financial Market Post-Crisis

Rym Ayadi and Emrah Arbak

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v

4.4 Changes in global regulatory frameworks 77

Amendment of European Savings Tax Directive

Amendment of Mutual Assistance Directive

2.4 Asset profi les of administrators in major

3.2 Number of DTCs and TIEAs in force compliant with

4.4 Change in banks’ external liabilities by counterparty,

4.8 Variability in GFCI rankings – top 40 Centres

6.1 Contribution of fi nancial and business sectors to

3.3 Information sources on benefi cial ownership of

1

Introduction

Financial centres are in constant evolution in order to accommodate

an increasingly integrated global economy and an ever more lenging environment As domiciles for a range of financial services, these jurisdictions, which serve as intermediaries between mostly non-resident clients and international and local financial institu-tions, big or small, have grown over the last decades as a direct result

chal-of the increasing importance chal-of financial markets across the globe Traditionally, many of the smaller financial centres have been iden-tified as ‘offshore’; this term refers mainly to the low-tax, flexibly licensed and less onerous regulatory regimes that have characterized some jurisdictions The term has also been used to refer to centres with strict confidentiality laws, in some cases, and to the ability for institutions or corporate structures to operate through a centre without a substantial physical presence in it The centres defined

by these characteristics have been used by international financial players and by investors and individuals to accommodate their financial and corporate needs

Before the eruption of the 2007/2009 financial crisis, efforts had been made by large financial jurisdictions, and also a number of smaller ones, to improve transparency, information exchange about taxation matters, and the quality and outreach of financial regu-lations Efforts were also made, at a moderate speed, to promote global coordination and cooperation in regulation, supervision and taxation The financial crisis was a turning point; indeed the risks posed by an increasingly globalized financial system have impelled policymakers across the globe into speeding up their moves to close

the gaps in global regulation and taxation These global policy ments have subsequently driven all jurisdictions to adapt their regu-latory and taxation frameworks to respond to market changes and increasing levels of risks

The political pressure to implement these reforms has increased exceptionally strongly, especially in relation to some of the jurisdic-tions on the perimeters of the onshore nations which spearheaded the regulatory reforms This led to an intensification of the efforts

to enhance tax information exchange and coordination in dealing with tax practices harmful to the established financial centres At the same time, most of the advanced economies increased their public expenditure to counter the impact of the crisis on their economies and financial markets This in turn led to fiscal concerns, in some cases intensifying some of the existing pressures arising from an aging population and increasing trends in public expenditure Another challenge for financial centres has been the shifting of global wealth and economic activities, which are moving increas-ingly from the traditionally affluent Western countries to certain emerging economies The access advantages provided by some of the regional centres in and around these emerging markets have given them a first-mover advantage over the Western financial centres The level of competition is likely to increase substantially in the coming years, provided that these markets continue to maintain their trend growth in economic activity and wealth

Against this unsettled backdrop, this book aims to assess to what extent the increasing international cooperation in regulation and taxation could help financial centres in Europe to better respond to risks and opportunities facing them in the future At the same time, the book aims to identify other challenges faced by the jurisdictions

in the upcoming years

A representative sample of small jurisdictions, mainly in Europe, was chosen as a basis of the study, comprising:

The book does not aim to undertake an overall assessment, nor is

it an analytical critique of any particular jurisdiction; these tasks are amply carried out by other international organizations and standard-setters, such as the International Monetary Fund (IMF), World Bank (WB), Financial Action Task Force (FATF), and the Organisation for Economic Co-operation and Development (OECD) Instead, the book endeavours to give an understanding of the conditions and factors that have contributed to the current standing

of these jurisdictions, with the ultimate aim of shedding light on the future opportunities and challenges facing them The assessments of the international organizations are nevertheless used for the purpose

of understanding their underlying strengths and weaknesses Chapter 2 begins with an overview of the evolving nature and the role of the selected jurisdictions The perception of these jurisdictions

is often shaped by political and academic debate; while some argue that these financial centres serve the purpose of attracting finan-cial flows to their neighbouring onshore economies, others claim that they serve as a safe haven for criminal and illegitimate activity The academic literature has also tended to provide a divergent view, finding evidence for increased avoidance or evasion activity in some cases, while highlighting the positive spillovers to surrounding economies in others

Chapter 3 turns to a discussion of compliance and the responses of the financial centres in the light of the development of international

standards As the evidence summarized clearly shows, most selected financial centres have implemented international standards However

it is possible to distinguish between early movers from others In particular, some of these jurisdictions appear to have taken – at least

in some cases – a more proactive approach, possibly in a deliberate effort to avoid such conditions and remain at the front of the pack Others have been more response-driven, implementing change only after the revelation of highly publicized events and damaging disclosures

Chapter 4 turns to the risks and opportunities awaiting the selected financial centres in the upcoming years and decades The chapter includes a discussion of the regulatory changes in most developed countries, especially the changes originating from the EU, amidst calls for enhanced global coordination, which were height-ened during the financial crisis It also identifies the deteriorating fiscal positions of larger advanced countries as another key determi-nant of increasing international pressure to close global regulatory and taxation gaps The rise of new economic powerhouses such as China is also likely to challenge the business models and change the competition among the financial centres worldwide

The main idea that emerges from the discussions in that chapter is that increasing attention paid to all jurisdictions (not just to a select few), gives them an opportunity to comply with the international standards and practices without losing business to the growing competition The shifting of global wealth and economic activity towards emerging economies can represent a further opportunity for the more reputable jurisdictions that will likely benefit from serving

as a bridge between investment opportunities in Europe and the wealthy investors in the emerging markets In short, the book argues for the authorities of the European financial centres to create these opportunities by striding forwards in a framework of cooperation

generally, several developed countries, most notably the UK, mented tax hikes in 1960s and early 1970s, especially on corporate income and investment earnings These developments led financial institutions and businesses to look for alternative venues, to conduct their transactions elsewhere

The universal use and acceptability of the US dollar in international business and financial transactions quickly led to the emergence of an

Thanks to its historical position as a global trade centre and its touch regulatory stance towards external financial transactions, the City of London sprung up as the leading market for dollars outside the US by the mid-1960s Other centres followed suit by introducing regulatory and fiscal regimes to facilitate the operation of foreign banks By the end of the 1960s, Singapore launched its own alterna-tive for the Asian market, the ‘Asian Dollar Market’ (ADM)

In the meantime, a number of financial centres in Europe, including Switzerland, Luxembourg, the Channel Islands and the Isle

of Man, attracted the deposits of non-residents, encouraged either by

bank secrecy laws in the case of Switzerland, or by favourable tax regimes in the case of the Channel Islands and the Isle of Man Other jurisdictions closer to the US, such as the Bahamas and the Cayman Islands, also introduced regulatory regimes that made it easier for US-based banks to incorporate banking facilities on the islands, providing regulatory and fiscal advantages to the parent institutions

by overcoming the interest rate ceilings and other restrictions on banking products

By the 1980s, most industrialized countries retracted the Depression-era regulations that had triggered the development of these jurisdictions Reserve requirements, interest rate ceilings and more generally capital controls were rolled back, in exchange for more liberal policies that saw the rapid globalization of financial activities and markets Meanwhile, the US and Japan developed their own foreign banking facilities, effectively providing more competition to the existing offshore jurisdictions The US estab-lished its International Banking Facilities (IBFs) in 1981, which were allowed to receive deposits from and provide loans to non-residents or other IBFs These banking units were exempt from reserve requirements and depositary insurance premiums, and were subject to a separate fiscal regime In a similar vein, Japan introduced the Japanese Offshore Market (JOM) in 1986, with similar characteristics

The deregulation wave of the 1980s and 1990s did not lead to a collapse of offshore jurisdictions Most of them, especially those located around the US and Europe, used their first-mover advan-tage to became more specialized in certain activities, such as captive insurance, protected-cell companies, special-purpose entities and other vehicles Businesses and institutions in larger financial centres continued working with these centres due to regulatory flexibili-ties, know-how and familiarity Meanwhile, tax advantages became increasingly important, particularly for high net worth people and foreigners living in the neighbouring onshore economies, who increasingly used these jurisdictions to safeguard their assets without subjecting them to high taxes, and for international companies and investors who sought stable, secure, efficient, tax-neutral and regula-tory flexible jurisdictions Legal separation and the strength of legal systems also gained in importance, and became instrumental to the growth of the fiduciary sector in these centres

In the years leading up to the time of writing in early 2013, but especially following the first phase of the global financial crisis of 2007/2009, the traditional advantages of financial centres have been subject to scrutiny Legal advantages such as secrecy and confiden-tiality have become increasingly questioned as sources of risk, while legal certainty has become, perhaps more than ever, an important pull factor Global cooperation efforts have aimed at harmonizing the regulatory frameworks, aiming to overcome some of the more detrimental aspects of regulatory arbitrage The palette of tax advan-tages has also been contested amidst deteriorating fiscal balances in many economies and coordinated international efforts to diminish harmful tax competition Lastly, with the expansion of economic and financial globalization to emerging economies, financial centres that provide access to those markets as gateways have prospered and are indeed expected to do so, especially with the emergence of the Chinese yuan as an international currency

While the advantages offered by financial centres have been changing, so have the scope and depth of the activities provided by these jurisdictions

2.1 Legal advantages

Historically, financial centres have used various bank secrecy and confidentiality laws in order to attract capital inflows and high net worth individuals Both aspects continue to be important legal advantages that these traditional centres offer However, the prac-tices have come under increasing scrutiny in recent years, with the revelation of a number of highly publicized cases involving Swiss and Liechtenstein banks These events have shown that bank secrecy could be highly vulnerable to illegitimate uses, tax evasion

in particular

Thanks mostly to the efforts of the OECD, a substantial part of these concerns have been addressed Under the OECD’s Model Tax Convention (MTC), last reviewed in 2005, jurisdictions are to enter into bilateral agreements that provide for information exchange in all tax-related matters, without seeking the presence of any ‘domestic tax interest’ or without applying strict criminality standards as a prereq-

2009 many jurisdictions (such as Andorra, Gibraltar, Luxembourg,

Malta, and Switzerland) could respond to queries regarding only criminal offences and not civil matters Moreover, the definition of criminal matters was kept narrow This was particularly the case in Switzerland, where information exchange applied only to fraudulent tax-related conduct deemed to be an offence under the laws of both requesting and requested states (‘dual criminality’)

Many of the selected jurisdictions have initiated information exchange agreements to comply with the revised guidelines As depicted in Table 2.1, Cyprus (2008), Hong Kong (2010), and Singapore (2010) have eliminated the presence of domestic tax interest as a prereq-

Liechtenstein (2010), Luxembourg (2009) and Malta (2008) have duced laws to allow their tax authorities to exchange information in all tax-related matters, including both civil and criminal cases

In many cases, the amendments have resulted in full or near full compliance with the OECD’s 2005 guidelines However, close examination reveals that several jurisdictions continue to lag behind

In particular, Liechtenstein has failed so far to introduce information exchange agreements with its key trade partners, most notably its neighbours Austria and Switzerland Although committed to imple-ment the OECD’s standards, more than 60 per cent of Luxembourg’s international tax agreements fail to contain a provision that enables authorities to exchange banking information Lastly, most of Switzerland’s agreements continue to prohibit access to tax-related information in civil matters, and apply the dual criminality requi-

of the agreements that fail to meet the OECD standards were signed prior to legal amendments, which are expected to be revised in the upcoming years

There is also concern that the improved standards may continue

to undermine information exchange, since the procedures rely on the ability to garner prior evidence In line with the current stand-ards set by the OECD, many of the selected jurisdictions require a formal request from the foreign authorities, providing sufficient substantiation regarding the suspected wrong-doing and the correct

procedures is to prevent requesting parties to engage in ‘fishing ditions’ to collect information that is unrelated to tax matters In practice, however, the requesting authorities may not have sufficient

Dual crim inality

Criminal matters only

Liechtenstein √* X x x* Expanded scope to civil matters (2009); no agreements with key partners

Luxembourg √* X x x Granted access to bank info (2009); many existing agreements

incompliant

Switzerland √* X √* √* Dual crim eliminated (2010); many existing agreements incompliant

Notes: The figures were compiled from a critical assessment of the OECD’s annual Tax Co-operation reports and the peer reviews in the

Exchange of Tax Information Portal, which were conducted within the second half of 2011 and first half of 2012 Apart from specific legal structures, the assessments for limited or conditional access rely on the share of international agreements that meet the OECD standards The table depicts the ease of access to bank information only under bilateral international tax agreements such as Tax Information Exchange Agreements (TIEAs) or Double Tax Conventions (DTCs).

Sources: OECD, Exchange of Tax Information Portal, http://www.eoi-tax.org; OECD (2008; 2009; 2010)

prior knowledge or evidence Moreover, the OECD’s standards do not clearly identify the criteria for refusals on the grounds of inadequate evidence In consequence, it is likely that the existing standards will

be revised further in the upcoming years, to address the potentially contingent and discretionary nature of the information exchange procedures in place 7

Figure 2.1 Legal strength in key financial centres, 2010

Notes: The legal strength, or rule of law, measure captures the extent to which

indi-viduals have confidence in and abide by the rules of the society, covering strength of contract enforcement, property rights, quality of courts and the legal procedures The figures are based on governance perceptions as reported by a wide variety of survey respondents, ranging from non-governmental organizations and commercial service providers to public authorities worldwide

Luxembourg

Switzerland

IrelandSingaporeGermany

Liechtenstein

United States

Hong KongFranceMalta

AndorraCyprusBermuda

Cayman Islands

No of std dev from global norm

United Kingdom

While confidentiality and secrecy provisions are being increasingly scrutinized, a more positive factor of the legal systems of financial centres is the strength of institutions Indeed, recent evidence shows that jurisdictions with strong contract enforcement and property rights are more successful in attracting capital inflows (Alfaro, 2008)

In particular, poorly governed jurisdictions face more difficulties in attracting capital inflows even if they offer other legal, regulatory and taxes (Dharmapala and Hines, 2007)

As shown in Figure 2.1, all of the financial centres included in the study are judged to have substantially stronger legal systems than the global average This is particularly the case for Luxembourg and Switzerland, which score the highest among the sampled coun-tries, surpassing even some of the onshore jurisdictions, such as the UK, Germany, the US, and France Indeed, the rule of law and legal certainty have been contributing factors to the development

of a large array of bankruptcy-remote financial products, private banking, fiduciary business, captive insurance, and estate planning

in these financial centres

2.2 Regulatory advantages

Regulatory advantages in the form of more flexible and less onerous regulations play a key role in the successes of many of financial centres Recent empirical research has confirmed that jurisdictions with fewer entry requirements, activity and owner-ship restrictions, and lower capital requirements tend to attract banking activity from more regulated jurisdictions (Houston et al., 2012) This should not be surprising As so often with legal and tax-related advantages, globally active financial institutions have the ability to pick and choose jurisdictions that provide a flexible regulatory environment, which may facilitate regulatory arbitrage opportunities

Regulatory arbitrage can have both positive and negative welfare effects On the one hand, the flow of activity to less regulated systems may improve market efficiency by allowing banks to overcome excessively (and unnecessarily) costly regulations Effectively, cross-border capital mobility can put an upper limit on the restrictions that regulators may impose on their domestic markets In a parallel manner, the ease with which capital can move internationally may

give regulators incentives to cooperate among one another and move towards a level playing field

On the other hand, there has been an increasing concern that most activities that take the form of regulatory arbitrage are harmful, undermining the ability of home state authorities to control and monitor risks In effect, financial institutions may use less regulated jurisdictions to lower their regulatory costs while increasing risks

Figure 2.2 Regulatory quality in key financial centres, 2010

Notes: The regulatory quality index captures the perceptions on the ability of

authori-ties in implementing sound policies and regulations that promote the development of the private sector The figures are based on governance perceptions as reported by a wide variety of survey respondents, ranging from non-governmental organizations and commercial service providers to public authorities worldwide.

Germany Liechtenstein

Malta United States

Cyprus Andorra Bermuda France Cayman Islands

No of std dev from global norm

and social costs to the taxpayers at home Moreover, if global eration efforts are undermined, for example due to highly diverging interests, regulatory competition could produce a harmful ‘regula-tory race to the bottom’ (Barth et al., 2006, p 68)

As in legal advantages, simply having more onerous regulations is not sufficient to attract inflows Indeed, the regulations in smaller financial centres have to be sounder For example, one would expect jurisdictions aiming to draw foreign business and capital to curb protective and unfair practices while supporting policies to foster inward investment, such as easing entry, lowering costs for starting business, reinforcing pro-competitive regulations and so forth Moreover, the regulators need to be responsive to the needs of the businesses while keeping a close eye on opportunities, with an ability

to quickly and effectively draft legislation and determine standards for the development of new areas

Figure 2.2 confirms that most of the selected financial centres have

a regulatory quality that outshines their onshore counterparts Most notably, the more global-oriented and well-diversified financial centres, such as Singapore, Hong Kong, Luxembourg, Ireland and Switzerland, have a greater regulatory quality than the German, US, and French systems Although the more regional-oriented jurisdictions that provide more focused and niche services, such as Cyprus, Andorra and Bermuda, are lower in comparison, they are nevertheless substantially above the global averages, and compare well with the French system

In terms of licensing, a number of jurisdictions have chosen to grant licences to well-known and reputable financial institutions that are based in international financial centres in the EU As of April

2011, the share of branch offices among all regulated banks in Jersey, Guernsey and Isle of Man were 53 per cent, 44 per cent, and 41 per cent, respectively In the Cayman Islands, the share was even higher, with branches representing nearly two-thirds of all licensed entities, mostly of European and American institutions In other jurisdic-tions, the share of branches was lower For example, in Luxembourg, only 26 per cent of all banks were branch offices of foreign banks

2.3 Tax advantages

Offshore jurisdictions provide a number of tax advantages which have helped earn them the name ‘tax haven’ Among the numerous

incentives, most jurisdictions have low or no taxes on corporate income, capital gains, and sales (Table 2.1) The governments of most

of the jurisdictions obtain their financing from personal income taxes, sales taxes (where applicable), excise duties, property taxes, levies on licensing, and in some cases stamp duties on purchase or transfer of real estate

In recent years, some of the sampled jurisdictions have put in place measures to increase their attractiveness in the face of tax policy changes in many major countries Examples include measures to attract high net worth individuals by imposing regressive marginal rates on incomes beyond a certain threshold (that is, a cap on tax liabilities) or granting specific residency licences that benefit from a low tax rate In many cases, similar incentives have also been put into place for corporations and individuals The UK taxes its ‘non-domi-ciled’ residents only on income earned in and wealth repatriated to the UK In many cases, the tax exemptions are granted to foreign-owned entities that have no economic activities in the jurisdiction Some of the initiatives have come under scrutiny due to public pres-sure or pressure from the EU (see discussion in Section 3.2)

A striking example of incentives is the Swiss ‘forfait tax’ or the

place in Switzerland for over a century Under the system, wealthy individuals can opt for the payment of a large annual lump sum

in lieu of their liabilities as a regular tax resident The lump sum is calculated according to the total amount of annual costs spent by the taxpayers in Switzerland, subject to a minimum To simplify matters, the expenses are assumed to be five times the notional rental value

of the taxpayer’s home A crucial condition is that those who opt for the scheme are not allowed to earn income from employment in Switzerland, and remain citizens of another country

The Swiss lump sum taxation schemes have received wide cism in recent years, both from neighbouring countries and from the Swiss public, due to fiscal concerns amidst the financial crisis At the federal level, parliamentary proposals were submitted to abolish or modify lump-sum taxation in 2009 and 2010 Moreover, in October

criti-2012 over 100,000 signatures were handed over to the Federal Chancellery to initiate a popular vote to abolish the lump-sum taxation If the Federal Chancellery approves it, the popular vote is likely to take place in 2014 Although the proposal has not yet been adopted at the national level, the Zurich (2010), Schaffhausen (2011),

Appenzell-Ausserhoden (2012), Landschaft (2012) and Stadt (2014) cantons abolished their lump sum taxation schemes Similar arrangements to attract high-income or wealthy individ-uals exist in other jurisdictions (Table 2.2) In particular, Gibraltar, Guernsey, and Isle of Man have tax caps that limit the tax liabili-

foreign income of wealthy immigrants, where consent by authorities

low-tax regimes for foreign high net worth individuals, returning migrants, and highly qualified expatriates 11

Figure 2.3 shows the tax rates applicable to corporate income Low corporate taxes are arguably the most visible fiscal benefits provided

Figure 2.3 Corporate tax rates, as of June 2012

Sources: PricewaterhouseCoopers, Worldwide Tax Summaries, 2011/12; OECD, Exchange

MaltaFranceGermanyMonacoLuxembourgUnited Kingdom

SwitzerlandSingaporeHong KongIrelandJerseyIsle of ManGuernseyGibraltar

Andorra Cyprus

Bermuda

10

221717131010101010

262933333335

00

Islands Cayman

Incentives for

high income

persons*

Corporate income tax (top marg

rate) (%)

Personal income tax (top marg

rate) (%)

Capital gains taxation

VAT or sales tax (top rate) (%)

Payroll cont

(top rate, employee) (%)

Payroll cont (top rate, employer) (%)

Notes: * The tax incentives for the rich are often in the form of regressive tax rates, either as a strict cap on tax liability or declining marginal

tax rates, both of which are applicable to incomes above a certain threshold level ** Certain tax caps on social security and payroll tions are applicable † Applicable only to local income of non-residents

contribu-Sources: PricewaterhouseCoopers, Worldwide Tax Summaries, 2011/12; OECD, Exchange of Tax Information Portal, http://www.eoi-tax.org;

to businesses worldwide Most of the offshore jurisdictions have tax rates that are in the vicinity of 10 to 20 per cent of corporate income, which is lower than those of all of the major developed countries depicted Indeed, in the sample of jurisdictions considered in the study, only Luxembourg, Malta and Monaco have corporate tax rates above 25 per cent

The low-tax schemes in some of the financial centres have been challenged in recent years Many of the European jurisdictions have increased the existing taxes or introduced new ones, mostly

in response to lower economic activity and the ensuing challenges

in public finances amidst the financial crisis In particular, Andorra introduced in 2011/12 a personal income tax applicable to non-residents on their local incomes, as well as a VAT system (replacing

income tax rate to 35 per cent, up from 30 per cent, and raised the VAT rate to 17 per cent, up from 15 per cent Further reforms

of the tax system are likely to be undertaken in the near future

as part of the bailout package announced in March 2013 Ireland, whose public finances were hit particularly hard, has introduced

a number of adjustments, most notably by increasing the capital gains tax from 25 per cent to 30 per cent and introducing a ‘domi-cile levy’ that could as much as double the tax liabilities of high income of domiciled (but not necessarily resident) individuals The Isle of Man, alongside the UK, increased its VAT rate to 20 per cent

in 2011 (up from 17.5 per cent) Luxembourg introduced a one-time crisis contribution of 0.8 per cent in 2011 on all personal incomes, and increased the top income tax rates and solidarity surtax to 4 per cent in 2012 (up from 2.5 per cent)

2.4 Evolving scope of activities

To a large extent, financial centres have to ensure some form of tax neutrality, which serves as a price advantage for clients in larger and already established centres While regulations have to be less onerous, they nevertheless have to minimize risks to the jurisdiction itself, including (but not limited to) reputational damages A well-established legal system, which ensures the best protection of private rights, is a key ingredient for any financial centre Finally, many

centres have taken a step forward by ensuring private information is protected by developing strict secrecy and confidentiality rules The discussion below highlights how the presence of different sets

of factors has led to the development and success of certain business lines over time The development of private banks, for example, has relied extensively on a strong tradition in legal rights and secrecy While confidentiality has for decades been beneficial in attracting business, it has also been a risk factor, allowing private banks and trusts to be used for illegitimate uses

Although the discussion relates to a variety of activities as well as factors for development and success, one theme remains constant: both the financial centres and the activities operating through them are changing, driven partly by the increasingly complex demands of the clients and the increasing integration of global markets Another key determinant of evolution, however, has been the reputational risks and international efforts, perhaps more so in certain types of activities than others

Banking services

One of the key developments since the early nineties has been the changing nature of banking in offshore jurisdictions Banks that are incorporated in onshore jurisdictions establish offshore affiliates for

a number of reasons The latter often serve as a place of tion for transactions conducted in other countries The international transactions routed through these jurisdictions may also be subject

registra-to a combination of less onerous regularegistra-tory requirements, lower taxes and legal protection in the form of bank secrecy, or ring-fencing of assets for regulatory purposes, as in the case for off-balance sheet activities

The very development of the international finance centres in the 1960s can be seen as a clear consequence of increased regulatory pressures and incentives to seek regulatory arbitrage For example, London and Luxembourg allowed the US-based institutions to raise Eurocurrency deposits and to handle foreign exchange operations through their affiliates, outside the scope of US law and regulations

As of the end of 2011, over US$1 trillion of deposits have been held in

‘sweep’ accounts that pay interest in large US banks’ Cayman Island branches due to regulatory restrictions that restrict interest paid on overnight accounts in the US

From late 1990s, a number of the sampled financial centres started serving as a true branch or subsidiary of their parent banks

A key example is the growing importance of the ‘upstream banking’ model, which is the key banking activity in a number of jurisdic-tions, most notably the Crown Dependencies (Guernsey, Jersey and the Isle of Man)

According to the upstream model, the branches and subsidiaries

of large international banks collect liabilities from customers and legal persons either residing in the financial centre (such as local residents, fiduciary businesses and other financial institutions) or those residing elsewhere (such as expatriates or ‘non-domiciled’ foreigners residing in neighbouring countries) The funds are then lent to the parent institutions In addition to some retail-oriented services, many of the banks in small financial centres provide private banking and wealth management services to domestic and foreign high net worth individuals These services tend to be more exclusive and customized, responding to not only the financial but also the advisory needs of the banks’ wealthy clients

Most of the private banking and wealth management activities are conducted through offshore entities that are integrated into larger financial conglomerates This is, for example, the case for top players such as UBS Global Wealth Management, Credit Suisse Private Banking, Bank of America Global Wealth and Investment Management, Morgan Stanley Global Wealth Management Group, HSBC Global Private Banking and so on For these institutions, the private banking and wealth management arms generally fulfil

a more advisory-oriented role for the clients, which translate into lower risks for the upstreaming institution In turn, the relatively smaller players, such as Pictet, Julius Bär and Lombard Odier, tend to focus predominantly on discretionary management services, which tend to be more risky but are expected to generate greater expected yields for the institution

Traditionally, the European centres have had a clear nance in global banking and wealth management, owing largely to legal and regulatory certainty, economic stability, capital openness and tax neutrality The Swiss banks are clear leaders in the private banking sector, owing to Switzerland’s long tradition of confiden-tiality and client privacy Indeed, despite outflows amidst pressure

predomi-on secrecy and political tensipredomi-ons in 2009, the Swiss private banks

managed nearly half of the assets under management for the largest global players (Birchler et al., 2011)

With the rise of emerging economies, many of Asia’s financial centres serve as a means for channelling external funds towards local uses in destination countries, as in the case of Hong Kong and Singapore Accumulated expertise and familiarity with the destina-tion countries is one of the key reasons why banking businesses have come to be concentrated in these centres Access to local or regional markets is another reason, a key advantage enjoyed by Hong Kong, Shenzhen, Shanghai and Beijing

Meanwhile, as wealth generation moves towards emerging mies, the potential for economic and fiscal overhang in Europe (and the US) are leading to a fundamental shift of focus in wealth manage-ment As will be discussed in detail below, several Asian and Middle Eastern centres have now caught up with their European counter-parts Perhaps more strikingly, a survey of wealth managers across the globe hints that Singapore may overtake Switzerland as the top global private banking financial centre as early as 2013 (PwC, 2011)

Retail funds

A number of the financial centres have become domiciles and place

of administration of retail funds in recent years, owing mostly to their tax neutrality, accumulated know-how, access advantages and regulatory and political adhesion with the onshore economies The leading fund domiciles and administration jurisdictions within the EU are Luxembourg and Ireland The smaller jurisdictions are less likely to have substantial management or brokering activities, since these roles are often operated through global financial centres, including most notably London and New York (See Box 2.1 for details on the structure of funds.)

Box 2.1 Structure of funds

The structure of a fund depends above all on the regulations and fiscal

laws of where it is registered, that is, its place of domicile Domiciliation

in tax-neutral locations is attractive, since the fund can avoid paying taxes

on capital gains In this manner, taxes are due only when the earnings are repatriated to investors, wherever they may reside The regulatory frame-work of a jurisdiction also matters for the choice of domicile Laws in most onshore jurisdictions require retail funds to be domiciled domestically,

but for alternative funds, such as hedge funds or private equity funds, domiciliation is not subject to such requirements As a consequence, the so-called ‘specialist’, ‘professional’ or ‘expert’ fund vehicles that are

in place in most offshore jurisdictions provide advantages by offering a lighter regulatory touch

Most funds have a distributed global structure Fund management is

naturally the key separable activity A large proportion of fund ment activity is based in the US (mostly in New York), while London takes second place Smaller jurisdictions appear to be making constant but modest gains in attracting the managers of funds of hedge funds The market share of total number of such funds managed from offshore jurisdictions was 14 per cent in 2007 (Eurokahedge, 2008)

The structure of a fund includes a number of support functions, such

as prime brokerage, fund administration and custody Prime brokers

provide securities lending, leveraged trade executions and cash ment services to hedge funds, and operate mainly from the brokerage arms

manage-of large investment banks in London and New York Of growing

impor-tance in small financial centres are fund administrators , who provide

independent pricing and accounting services for the fund’s portfolio, advice on compliance with local laws, and other ‘back office’ functions These services are increasingly provided from smaller jurisdictions, with lower costs arising from lower taxes, cheaper office space or lower cost of labour, and with state-of the-art communication infrastructure and ease

of access comparable to global centres Within the EU, Dublin has become

a principal administration centre, while Luxembourg is also becoming a key challenger

The regulations in most centres require domiciled funds to be administered in the same jurisdiction, which could lead to positive spillovers for other institutions in the jurisdiction Similarly, a fund’s

custodians , which undertake the depository function of safeguarding

the fund’s assets, often have to be located where the fund is domiciled

or administered The same can be said of auditors , whose services form

an integral part of the regulatory framework applicable to alternative funds

Across the globe, the extent to which foreign-domiciled retail funds can be made available for domestic distribution depends heavily on the regulations of the home country Some of the major developed economies, such as the US or Canada, are acknowledged as ‘closed fund countries’, meaning that only domestically domiciled funds are available for sale to retail investors (Khorana et al., 2009) The legislation in the EU allows the cross-border sale of funds domiciled within the EU, as long as they establish themselves as Undertakings

for Collective Investments in Transferable Securities (UCITS) These

‘single-passport’ rules have given Ireland and Luxembourg serious comparative advantages Other smaller financial centres that are EU members may also appear as contenders in the upcoming years, such

as Malta in UCITS-compliant hedge funds, and Cyprus in UCITS administration

Funds that are domiciled outside the EU can be marketed within the EU, but only if bilateral arrangements exist between the domi-cile country and the target country Such agreements currently exist between the dependent or associated territories of the UK and some other member states, notably the UK and the Netherlands These arrangements give some jurisdictions, such as the Crown Dependencies, a potential role as retail fund domiciles Despite these arrangements, the level of retail fund activity (including domicili-ation) is relatively low, and is likely to stay low in the upcoming years due to competition from EU-based financial centres such as Luxembourg and Ireland, and potentially Malta and Cyprus

Alternative funds

While retail funds are less likely to locate within non-EU based jurisdictions, financial centres close to Europe are likely to play an increased role as hedge fund domiciles A primary reason for this potential development is that the regulations in these jurisdictions are often less onerous than in onshore jurisdictions, subjecting the funds to fewer restrictions on marketing, accredited investors, share restrictions, and redemptions (Aragon et al., 2011) However, the EU rules, the so-called Alternative Investment Fund Managers Directive (AIFMD) will in all likelihood challenge these notions

A second reason is the typical application of no (or very low) rate income taxes on earnings Apart from allowing non-residents

corpo-of onshore economies to avoid taxation by seeking investments in offshore jurisdictions, the low-tax regimes also reduce the potential

of double taxation and allow the deferral of taxation until the ings are distributed The ability to defer taxes, furthermore, gives the funds the ability to filter short-term investors without having to resort to ‘lock-up’ rules on investor redemptions (Aragon, 2007) Globally, more than half of hedge funds are domiciled in offshore jurisdictions, with the British Virgin Islands and the Cayman Islands

earn-being by far the most popular domiciles (IFSL, 2010) This is largely due to the differences in the regulatory environment and investment strategies between the two types of vehicles While retail funds are subject to strict regulatory requirements, hedge funds are compar-atively lightly regulated, and are only available to high net worth individuals or institutional investors who meet the funds’ minimum investment requirements Since these investors are often consid-ered to be sufficiently sophisticated to assess the risks or wealthy enough to bear them, hedge funds have often been less burdened by regulations

Box 2.2 Master-feeder funds

Investment funds are often composed as master-feeder structures Such

structures effectively channel a number of ‘feeder funds’ into a single central vehicle, called the ‘master fund’ By pooling investments in a tax-neutral jurisdiction, these structures allow the related funds to meet qual-ifications, based on asset size An additional benefit is the economies of scale arising from running a single fund rather than a number of parallel structures

Several costs also arise due to the master-feeder structure The pooled structure implies that the actions of one feeder may have an impact on smaller funds For example, when one of the feeder funds decides to pull its investments back, there will be dire consequences for other feeders More generally, a major risk is when the interests of various feeders are contradictory In these cases, the magnitude of the problem may be manageable in jurisdictions that provide good protection for investors and creditors

One recent problem underlines the risks associated with the feeder structure and the importance of a sound legal system Marking the onset of the global financial crisis, the embattled US investment bank Bear Stearns filed in the Cayman Islands to liquidate two collapsing hedge funds in early August 2007 The two funds left investors with potential losses of up to US$1.6 billion (€1.16 billion) due to subprime investments

master-A US bankruptcy court in New York refused to recognize the Cayman liquidation process, on the grounds that the fund did not have its centre

of main interest (COMI) in the islands, as it was recognized as an exempt company The bank then attempted to push the fund into out-of-court liquidation A group of investors challenged this move, and won a case

in the Grand Court of the Cayman Islands on February 2008 to stop the liquidation process altogether and to investigate the causes of the funds’ downfall

A distinction has to be made between single hedge funds and ‘fund

of hedge funds’, including those involving a master-feeder structure

at this point (see Box 2.2) The funds of funds have lower minimum investment requirements, as they seek a diversification strategy by holding shares in hedge funds and private equity funds These funds cater to a broader class of risk-averse investors, and may in some cases

be marketed to retail investors According to estimates of IFSL (2010), funds of hedge funds’ assets represent an increasing share of the total hedge fund assets, growing from 18 per cent in 1999 to 40 per cent

in 2008, although dropping back to 30 per cent in the midst of the financial crisis in 2009

The collapse of several hedge funds, the Madoff scandal, the drying-up of liquidity in the midst of the 2007/9 financial crisis, and the regulatory changes in the EU have all led investors to look for alternative investment vehicles with more transparency and regula-tion The result has been the birth of highly-regulated hedge funds

or funds of hedge funds that are UCITS-III compliant, that is, the

‘Newcits’

Faced with severe restrictions on leverage and investment egies, the prevailing wisdom in finance theory would suggest that the Newcits would underperform against their regulation-

funds is likely to remain limited, the recent net inflows have increased, including those from Asia and Latin America, attesting

to the growth potential of the regulated alternative funds in the upcoming years 14

Another feature that requires attention is how hedge funds are structured A significant proportion of the world’s hedge funds are domiciled and often administered in offshore jurisdictions However, most of the management activities are conducted in major international centres, with funds managed from New York and London representing around two-thirds of the global hedge fund assets (IFSL, 2010) A critical examination of various sources suggests that the share of funds managed from offshore jurisdic-tions remains small but has exhibited some modest growth over

these funds that are managed offshore are funds of hedge funds

Many of the leading hedge funds across the globe are administered from offshore financial centres For example, Figure 2.4 shows that a clear majority of funds administered in the Crown Dependencies are alternative funds, comprising mostly hedge funds, funds of hedge funds, private equity funds and property funds Historically, other jurisdictions, such the Cayman Islands, Bermuda, and the British Virgin Islands, have served predominantly as third-party hedge fund administration domiciles In contrast, the administration of retail funds and their regulated cousins are often conducted onshore, mainly due to regulatory provisions that require more complex valuation processes and appropriately developed systems, as well as access to experience and skilled staff These factors imply that the rapid growth of the alternative funds industry, potential growth of regulated Newcits, and calls for increased transparency may change the funds scene in many financial centres

Figure 2.4 Asset profiles of administrators in major European jurisdictions,

2008

Notes: Results are based on responses from 63 companies providing administration

serv-ices in Europe, representing about 70 per cent of the total assets under administration

Source: Deloitte, Fund Administrators in Europe Survey, November 2008

Insurance

Owing to the early development of various regulatory and legal structures, some jurisdictions have developed sizeable international insurance activity, mainly comprising life, re-insurance and captive insurance companies Bermuda is a clear leader in the latter two sectors globally, while other centres have made strides in the life insurance sector

Arguably the most predominant offshore insurance product, captives are insurance or re-insurance entities that are owned directly

or indirectly by their parent companies, with the aim of providing

used to provide coverage for more predictable risks Examples include employee benefit plans, liability insurance, vehicle insurance, prop-erty insurance, transit risks etc While many countries do not distin-guish between captive insurance and regular insurance undertakings

in their legal frameworks, some of the offshore and onshore tions have come to recognize the specificities of captive insurance The idea of a captive was first developed in 1960s in the US as an attempt for large corporations to insure their own risks using subsid-

undertakings equivalently, over time most of the captives moved

to offshore jurisdictions, first to Bermuda in late 1970s and then to other centres, including the Cayman Islands, Vermont, Guernsey, Hawaii, and the Isle of Man The introduction of the protected cell company (PCC) structure in Guernsey in 1997, soon copied in other jurisdictions, has allowed different firms to own individual cells under a single corporate structure, achieving cost savings through economies of scale

According to the literature, captives provide a number of tial benefits to the parent companies, including cost advantages (that is, reducing transaction costs in risk management and control), informational advantages (provided that the captive and the parent are under the same management), tax advantages (that is, deduct-ibility of premiums), and an efficient coverage for international firms

are devised when the onshore options do not adequately provide these benefits (that is, when regulatory or fiscal rules are not suffi-ciently preferential)

Structured finance

Offshore jurisdictions are increasingly active in the structured finance processes, especially in the structuring and setup of special purpose vehicles (SPVs) for secured borrowing In most cases, the SPVs are used to issue notes or borrow from financial institutions under loan agreements, all secured by assets held by the vehicle The assets generate cash flows which are used to make payments to note-holders or creditors In addition to setting up and running SPVs, institutions in offshore jurisdictions may also be engaged directly

in the process of securitization, or the process of transforming assets (such as a pool of loans) into securities

As in other financial services provided by these jurisdictions, tax neutrality is high among the reasons for choosing to be offshore It pays for SPVs to be domiciled in jurisdictions with low or no corpo-rate income taxation, which reduces the costs associated with the cash flows received by the vehicle To a lesser extent, payments to note-holders or creditors are not subject to withholding taxes in most jurisdictions, potentially reducing the tax bill for entities that run these vehicles

Apart from the tax benefits, the offshore jurisdictions also offer comparative regulatory benefits The capitalization rules appli-cable to the SPVs are often more favourable in these centres than

in onshore locations Moreover, the issuance of notes is often not subject to a regulatory consent requirement

Trusts and fiduciary services

In legal terms, a trust is formed when the absolute owner of an asset, often called the settlor, transfers the legal ownership to a trustee Despite the transmission of ownership, the trustee cannot presume any beneficial ownership of the assets Instead, the party can only manage and administer the assets, all for the benefit

of third parties, that is the beneficiaries, which may include the settlor or any other parties The identities of the beneficiaries and the permitted transactions in managing and administering the assets, as well as the trustee’s fiduciary duties towards the beneficiaries, are specified by a detailed contract (called the trust deed) between the settlor and the trustee prior to the transfer of ownership

Under international standards put forth by the Financial Action Task Force (FATF), a trust or company service provider (TCSP) is defined as an entity or individual who acts as a trustee or a director

of a trustee company TCSPs are in some cases subsidiaries of cial institutions, law firms, or accountancy firms However, in many cases, at least in the case of offshore jurisdictions, they are a single person or a stand-alone entity

Trusts and TCSPs have emerged to respond to various situations, in many cases as a formal means for succession planning when family structures may be complicated after the death, marriage or divorce of the settlor In commercial transactions, trusts have emerged where there is concern that the parties may not live up to their contractual obligations TCSPs provide a variety of business services to facilitate the establishment and administration of legal entities, including forming companies and legal persons, acting as a directors or partner for the entity, providing registered offices, and acting as a nominee shareholder 19

One of the most defining characteristics of trusts is their relative opaqueness and their potential for ‘illegitimate’ uses More specifi-cally, in many jurisdictions the ultimate beneficiaries, sources of assets, and objectives of the entity are not adequately identifiable,

in many cases owing to the nature of a trust relationship However, the severed relationship between the ultimate beneficiaries and the trust makes the latter particularly vulnerable to aggressive tax abuse and criminal uses 20

The main weakness regarding trusts and TCSPs relates to the ease with which the resident of an onshore jurisdiction can use the enti-ties beyond their intended use, including most notably for illegiti-mate purposes An increasing number of jurisdictions require trusts and TCSPs to register or obtain licensing with financial authorities as well as subjecting them to strict know-your-customer rules However, under the current information exchange coordination mecha-nisms, the taxable receipts of foreign residents may go unnoticed Indeed, as discussed above, the OECD’s efforts to identify offences

on an ‘ on-demand’ basis could have a limited effectiveness if the tax authorities in the home countries have trouble in identifying the wrong-doing themselves

At the same time, given that exclusivity is a defining characteristic

of trusts and TCSPs, it would be unrealistic to expect public sure provisions or automatic information exchange regimes to be put

disclo-in place for these entities any time soon Meanwhile, the disclo-increased need to shore up tax revenues has led to an increasing number of high-profile whistleblowing cases surfacing – a trend which is likely

to continue 21