In this article we will discuss about the meaning and types of off-shore financial centres.
Meaning of Offshore Financial Centres:
Offshore financial centres play a critical role in the international financial system. They provide finance, insurance, broking, holding-company and head-office services, and exist because the economic benefits outweigh their costs.
In a global economy, there will be bona fide business reasons for setting up a business in any country, including a low tax one. These dealings can be genuine and profits allocated to them commensurate with the economic value they add. Their role may include a wide range of business objectives.
i. They allow businesses to reduce costs and increase revenues through centralised group services within a multinational enterprise.
ii. They assist in the efficient and effective movement of capital and resources and provide opportunities for global investment.
iii. They provide facilities to manage financial affairs confidentially and ensure legal protection from unjustified claims through trusts.
iv. They permit the use of intermediary entities to overcome cumbersome regulations at home (and host) country.
v. They provide flexibility in legal systems (“legal arbitrage”) to develop quick legislative solutions to meet specific market needs.
vi. They provide tax-neutral services and assist in international tax planning. Etc.
The fast changing global environment demands that multinational enterprises remain flexible to take advantage of the business opportunities, wherever they arise, at an acceptable cost.
Due to various, domestic constraints, many onshore jurisdictions are unable to keep pace with these new demands, and have indirectly encouraged (he growth of relatively smaller offshore centres that provide new and innovative business services quickly or/and at lower costs. Their flexible tax systems, fewer regulations, greater confidentiality and opportunities for cost savings make them attractive to global businesses.
Tax mitigation is frequently not the key factor in the use of offshore financial centres. Many jurisdictions are used as “regulation havens” to avoid, besides confiscatory tax regimes, onerous controls (e.g. exchange controls) and legal claims (e.g. asset protection trusts). Moreover, several offshore centres provide “secrecy havens”.
However, the impact of taxes still plays an important role. Cross-border transactions usually lead to higher tax costs since they involve more than one tax jurisdiction. The use of offshore centres helps reduce this tax liability. Many financial centres offer zero tax or special tax regimes as “tax havens”.
Both traditional and non-traditional offshore financial centres may act as tax havens.
They may be broadly divided into three main categories for tax purposes:
(i) Traditional offshore centres with nil or very low tax on corporate or business income and few or no treaties (“base havens”).
(ii) Traditional offshore centres with reasonable domestic tax rates but with special tax regimes that allow the use of their treaty network for offshore activities, (“treaty havens”).
(iii) Non-traditional offshore (e.g. onshore) centres with special incentives or benefits that may be exploited for a particular international transaction or activity to gain a tax or non-tax advantage for offshore activities, often with the help of tax treaties (“special concession havens”).
The role of offshore financial centres is often found either as a base haven, or as a treaty haven. An effective international structure may need a “conduit” company for tax minimization in a treaty country and a “base” company for capital accumulation in a low or nil tax offshore centre.
The conduit company focuses on the treaty advantages that are obtained from the source country, whereas the base company minimizes the taxes in an intermediary country of residence. Base and treaty havens may also be located in high- tax countries that provide special legislation for offshore activities.
Types of Offshore Financial Centres:
a. Base Havens:
Base havens are offshore financial centres with nil or very low corporate taxes, no withholding taxes, and no or, at best, a few tax treaties. Often, they charge a “fee in lieu of taxes” or a flat rate tax, irrespective of the actual turnover or profits.
There are generally no exchange controls or currency restrictions, and a high level of banking and commercial secrecy is provided. The lack of tax treaties reduces the possibilities of exchange of information under the treaty provisions. Their primary use is to collect and accumulate income in a tax-free or low-tax environment.
Base companies are useful for the administration of income generating assets, and for group financial management. They may also engage in service-type activities, such as copyright owning, group management and regional co-ordination services, overseas commercial or professional activities, re-invoicing, insurance or shipping services, etc.
Base havens may also serve as a central or bulk purchasing company, or as a trading company. They may not be suitable for certain activities due to lack of skilled labour force, unsuitable communication facilities or inadequate business infrastructure. Many of the smaller centres also suffer from potential political and economic uncertainties, and weak regulatory systems.
The role of a base company as a holding or finance company is usually limited since it lacks a treaty network. For example, a group finance company needs treaty provisions to reduce the interest withholding tax in the source country. Low or nil tax base havens with no tax treaties may still be useful in situations when the income from the subsidiaries is tax-exempt in the host country.
A company in the base haven is often structured as an intermediary entity that is either a subsidiary or as a parallel company with the same shareholders as the home or host country. It may also be owned by an offshore discretionary trust with the shareholders as beneficiaries. Such tax planning requires a certain amount of caution.
i. It must avoid “unplanned” tax residence under the domestic tax laws in either the home or host country due to the location of its management.
ii. The lack of treaties may expose even a minimal economic activity to host country taxation under an “effectively connected” or “business connection” rule, or other local source rules. Such short-term activity may be subject to tax, since the tax treaty protection of the “permanent establishment rule” will not be available.
iii. The profit accumulation in a base haven provides a tax deferral, until the amounts are paid to the home country. Thus, it may only defer, but not reduce, the taxes due to the home country, if they have to be remitted later. Several countries have controlled foreign corporation and transfer pricing rules to counter tax deferral.
Many base havens are colonies or ex-colonies of onshore jurisdictions (Examples: Netherlands, United Kingdom) and enjoy their political and economic protection.
b. Treaty Havens:
Treaty havens are offshore financial centres that permit nonresidents to use their tax treaties for resident intermediary entities, e.g. treaty shopping. The tax treaties with source countries provide for reduced or nil withholding tax on inbound income.
Normally, they exempt qualifying entities from corporate income taxes and capital gains, and then generally levy a nil or reduced withholding tax on outbound payments. As a result, they are useful as a tax-efficient location for intermediary or conduit companies that allow flow-through income in international tax planning through treaty shopping.
The intermediary structure using treaty havens can be either a direct conduit or a stepping-stone conduit. The direct conduit takes advantage of the treaty concessions granted to the intermediary entity by the host and home jurisdictions.
The stepping-stone conduit relies either on (i) a tax reduction through a counterbalancing expense, or (ii) the use of a related company in a base haven to extract the profits from the intermediary country through tax-deductible expenses. The erosion of the tax base leads to a reduced tax liability imposed at the regular corporate rate.
The use of an intermediary entity can provide several tax benefits.
i. It helps to minimize the total tax through the use of third-country treaties. For example, the treaty with an intermediary jurisdiction may provide more favourable treaty benefits, or grant them if there is no treaty between the host and home States.
ii. The use of an intermediary entity may help to change the nature or character of the income for tax purposes. For example, the interest or royalty receipts from a host country may be paid out as dividends or capital gains to the home country, or vice versa.
iii. The use of a treaty country as an intermediary may prevent the exposure to source taxes if the activities are not significant and do not form a permanent establishment.
iv. The profits may be extracted from a high-tax jurisdiction and accumulated in a base haven through stepping-stone conduits. Etc.
From the taxpayer’s viewpoint, treaty shopping reduces the overall foreign tax burden and allows tax arbitrage and accumulation of funds abroad. Several countries actively encourage the use of their treaty network for offshore business activities of nonresidents.
Although many of them tolerate, and even allow or encourage treaty shopping themselves, some of them have anti-treaty shopping measures to restrict the loss of their tax revenues through the unintended use of bilateral treaties by third country residents.
c. Special Concession Havens:
Many high-tax “onshore” countries act as tax havens and provide special tax regimes with exemptions or reliefs to attract businesses with certain types of international business activities. They also allow the use of their treaty network for treaty shopping. As mentioned earlier, some commentators call them non-traditional offshore jurisdictions.
A 2000 OECD Report describes the preferential tax regimes within its Member Countries.
i. Several countries have special provisions for holding, finance or licensing companies, usually with the benefits of their tax treaties. They also give preferential treatment for financial services, such as insurance, offshore banking, mutual funds management and leasing activities to nonresidents.
ii. Many countries encourage multinationals to set up service companies that pay a tax on income based on an agreed percentage of the expenses incurred by them in the country. Several countries offer co-ordination centre facilities for the operations of large multinational enterprises.
iii. Some countries provide companies set up by nonresidents for offshore use with full or partial confidentiality on details of their ownership and transactions.
The OECD Progress Report “Update on Progress in Member Countries” issued in 2006, mentions that most of the preferential tax regimes in the OECD Member States considered as harmful tax competition have now been either abolished or amended. Hence, the tax structures that are available today are presumably not harmful.
They still include holding company regimes using treaty shopping techniques. According to Jeffrey Owens (Director – Centre for Tax Treaty and Administration, OECD), the changes have “in many cases, encouraged governments to reformulate them, usually by way of the very sophisticated use of holding regimes, trusts, consolidation regimes and tax administration of rules”.
Some of the major special concession havens today include:
The United States is probably among the world’s largest beneficiaries of global competition for offshore activities. Each US state has its own corporate laws. Most of them act as a secrecy haven and keep little or no information on companies registered under their corporate laws. The US federal government cannot impose its law on the states because of the division of powers under the US Constitution.
Nearly all US states provide legislation for a single member Limited Liability Company (“LLC”). It is estimated that there are over 3.7 million US-registered LLCs (2007). A single member LLC owned wholly by a foreign nonresident for offshore (non-US) activities is a disregarded entity for federal tax purposes and is wholly tax-exempt.
The company can be operated and managed worldwide confidentially. As there is no federal or state taxation, there is no reporting requirement to any tax authority. Under US domestic law, it is unlawful to disclose information on an individual’s business activities to a foreign government without a treaty.
The United States has also been excused from the provisions under the EU Savings Directive, as applicable to other non-EU countries.
The United States also provides special tax concessions to nonresidents on US bank interest and capital gains. Nonresident foreigners can invest in the United States in US stocks and bonds and pay little or no tax.
Their fully tax-exempt status makes the United States a tax haven for foreigners. It is estimated that nonresident foreigners have invested more than USD 11 trillion in the United States, including USD 7 trillion in financial markets.
According to some commentators, nil taxation, minimal regulation and secrecy makes the United States the best tax haven in the world for non US citizens and nonresidents.
London is the largest and one of the oldest offshore financial centres in the world. Although it is not considered as an offshore centre in a narrow sense, financial services constitute a sizeable percentage of the UK’s invisible exports.
In 1998, 7% of UK GDP was derived from the financial service activities of the City of London. The City of London is a well-regulated and respected financial centre through its wide range of financial institutions and related expert service providers.
The United Kingdom also provides a very favourable tax regime to encourage offshore business activities and transactions. For example, it is a major centre for international headquarters companies in Europe and a base for holding companies and other offshore financial activities.
Its tax rules and wide treaty network actively encourage treaty shopping to minimize foreign taxes and allow effectively tax neutral flow-through income. Some of the other tax planning structures involve the use of trusts, limited partnerships and limited liability partnerships, and provision of fiduciary activities for nonresidents.
The United Kingdom is also an offshore centre for non-domiciled resident individuals who are taxed on certain income earned abroad on a remittance basis.
Switzerland has widely promoted itself as a tax-efficient offshore financial centre with a pro-business fiscal policy. It is a low-taxed jurisdiction due to its split taxation at varying rates among the federal, cantonal and municipal governments and the generous tax incentives for offshore business activities. Switzerland provides several structures for offshore tax planning using tax-beneficial holding and domiciliary companies.
Switzerland is also a tax haven for foreigners, particularly high net worth individuals. They can live in Switzerland and pay a low negotiated lump sum tax. The bank secrecy law makes it an attractive “secrecy haven”. It is estimated that Swiss banks hold significant amounts of foreign private wealth.
In Switzerland, tax evasion is a financial crime. However, it only applies where Swiss financial companies are directly involved in evading foreign taxes. It is best known for its long tradition of banking secrecy and strict client confidentiality.
It follows the principle of dual criminality for access to bank information. Under dual criminality requirement, the activity must be a criminal offence in the requested country under its domestic law.
The Netherlands is probably one of the leading financial centres for tax planning in the world. Like the United Kingdom, it has extensively used domestic fiscal measures and its wide tax treaty network to attract offshore financial business activities.
They include its participation exemption rule, advance tax rulings, and several special structures to achieve low effective tax rates for flow-though income of nonresidents. The Netherlands also does not have many anti-avoidance measures to discourage offshore activities.
Although some of its preferential tax regimes have been abolished or amended as potentially harmful regimes under the OECD and EU initiatives, the Netherlands still remains an attractive offshore jurisdiction for tax planners.
Ireland has successfully used tax competition under its fiscal regime to encourage cross- border trade and investment. Besides having one of the lowest corporate tax rates, at 12.5%, in the European Union, it has the benefits of the various EC Directives and a wide tax treaty network.
In addition, Ireland provides several incentives, special economic zones and reduced taxes on passive income to attract offshore capital. Ireland has also implemented the EC UCITS Directive.
Dublin IFSC is popular with financial services, particularly for funds listed on the Irish stock exchange, captive insurance, securitization SPVs and aircraft leasing and finance. Ireland is widely used as a holding company base as well as for holding intellectual property rights. It is also an attractive location for manufacturing activities within the European Union.
Singapore today is a major offshore financial centre in the Asia-Pacific region. Its rapid growth since the 1970s is due partly to its fiscal policies that encourage the business activities of nonresidents in Singapore.
It also recognizes that as a small island economy it needs an open society to attract international professional expertise. Like Hong Kong, Singapore is the regional headquarters base in Asia for a large number of multinationals enterprises.
One of the key factors contributing to the growth of Singapore as an offshore centre is its business friendly tax regime. The authorities are responsive to international needs and trends and react quickly to adopt necessary fiscal and non-fiscal measures to be competitive.
It is a low-tax country that offers a wide range of tax incentives and tax treaty benefits to nonresidents. Moreover, it actively encourages treaty shopping as a holding and headquarter companies base. While tax avoidance by residents is strictly monitored, there are very few anti-avoidance rules that affect offshore business activities.
The financial institutions in Singapore are regulated and well supervised. However, Singapore offers banking secrecy since it denies exchange of tax information unless it has domestic tax interest.
Domestic interest requires that the information is provided only if it is in the domestic interest of the requested State. Banks are not permitted to disclose client information under Singapore law, except for official investigations into domestic tax violations, money laundering, corruption, kidnapping, etc.
Singapore was not listed as a tax haven in the OECD’s Harmful Tax Project. Moreover, it is not required to disclose or withhold tax on interest payments to EU residents under the EU Savings Directive. Singapore is an excellent example of tax competition as a tool for economic growth.
Tax competition, unless harmful (as defined), is widely practised in many other countries that provide financial services to nonresidents. They attract nonresidents to carry on offshore activities in their country and provide favourable tax terms to them through holding companies and similar preferential regimes.
The 2006 OECD Update Report lists them as Austria, Belgium, Denmark, France, Germany, Greece, Iceland, Ireland, Luxembourg, Netherlands, Portugal and Spain.
Some less known special havens include:
(i) Brunei established an international financial centre in July 2000. It provides for tax- exempt companies that can be limited by shares, guarantee, shares and guarantee, or duration. The law also allows the set-up of dedicated cell companies, limited partnerships, international trusts and offshore banks. Brunei is targeting the Islamic investment market, estimated at around USD 1 trillion.
(ii) Campione on Lake Lugano in Italy provides tax-exemption from Italian taxes on foreign-source income of resident foreigners. Campione economically belongs to Switzerland, but is subject to Italian law. There are no personal or corporate taxes and no municipal taxes. Italian-sourced income and Italian nationals are excluded from this privileged status.
(iii) Ceuta and Melilla are two small Spanish enclaves on the Moroccan coast in Africa. Their tax rate is half the regular Spanish rate. As part of Spain, they benefit from Spanish tax treaties.
(iv) In June 2000, Botswana in Southern Africa launched its International Financial Services Centre as a base for regional financial services and collective investment schemes. The tax rate is fixed at 15% guaranteed until 2020 with no taxes on payments to nonresidents.
(v) Sri Lanka exempts foreign writers, artists and retired persons (“persons of goodwill”) from domestic income and wealth taxes and estate duties for five years (or more), and exempts their foreign income from taxation.
Under the resident guest scheme in Sri Lanka, persons who remit a minimum of USD 150,000 for themselves and USD 25,000 for each dependant can obtain a residence visa for up to five years.
Many countries permit the use of their domestic tax system and tax treaties by nonresidents and compete for their offshore activities provided they benefit their economy and do not materially erode their own domestic tax base.
Preferential tax regimes in many OECD countries have been abolished or amended, where they are deemed harmful to other Member Countries, but tax competition is not discouraged. Countries are free to have whatever kind of tax structure they think appropriate to their own economic circumstances including not having any tax at all.