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A place in the sun

A special report onoffshore financeFebruary 24th 2007

O�shore �nancial centres are booming, thanks to their easy-going taxregimes. But the best of them are more than tax havens: they are goodfor the global �nancial system, argues Joanne Ramos

they will have to support in retirement.Such countries have launched a raft of ini-tiatives to strengthen the international �-nancial system against the undesirableside-e�ects of �nancial globalisation: �-nancial crime, �nancial contagion and taxevasion. The idea is to prod �nancial cen-tres worldwide to adopt international bestpractice on bank supervision, the collec-tion of �nancial information and the en-forcement of money-laundering rules.

One group has become the object ofspecial scrutiny: o�shore �nancial centres(OFCs). These are typically small jurisdic-tions, such as Macau, Bermuda, Liechten-stein or Guernsey, that make their livingmainly by attracting overseas �nancialcapital. What they o�er foreign businessesand well-heeled individuals is low or notaxes, political stability, business-friendlyregulation and laws, and above all discre-tion. Big, rich countries see OFCs as theweak link in the global �nancial chain.

In the past OFCs have indeed permittedvarious dodgy doings. Critics think theirdependence on foreign capital encouragesthem to turn a blind eye to crime and cor-porate fraud within their borders. SaniAbacha of Nigeria, Mohammed Suhartoof Indonesia and Ferdinand Marcos of thePhilippines are just a few of the corruptleaders who have looted their countries,helped by the secrecy o�ered not just bycertain tax havens but also by some on-shore �nancial centres, a point often ig-

What it takes to succeedNot only low taxes but a great deal besides.Page 3

On or o�?It’s a matter of degree. Page 5

Moving piecesGlobal companies have plenty of latitude tominimise their tax bills. Page 7

Rich pickingsHow to defeat tax cheats. Page 9

Unintended consequencesThe less obvious uses of tax havens. Page 11

All together nowCrooked OFCs have to be kept down, but goodones must be allowed to �ourish. Page 13

The Economist February 24th 2007 A special report on o�shore �nance 1

1

Places in the sun

IF THE deal over North Korea’s nuclear-weapons programme holds, Kim Jong Il

may be able to indulge his penchant for�ne wines and Hollywood blockbustersagain. Banks around the world had sev-ered ties with North Korea after Americalast September blacklisted a Macau bankaccused of doing business with the hermitkingdom, making foreign money tighterfor the Great Leader. But a move towardsmore normal relations with Americacould help restore the �ow.

The �nancial system is modern war-fare’s newest front. In a globalised econ-omy money moves instantly and anony-mously across borders. This can bene�tterrorists, drug tra�ckers and rogue na-tions in need of cash. Keeping such cus-tomers out of the world’s sprawling �nan-cial system is becoming ever harder.

Financial regulators have another bigconcern. Footloose capital transmits notjust tainted money but �nancial crises too.The huge growth in the use of esoteric de-rivatives and the rise of hedge funds havemade it increasingly di�cult to under-stand where �nancial risk lies, partly be-cause much of it is hidden away on islandswith variable supervision.

But the most vexing problem thathighly mobile �nancial �ows pose for gov-ernments is that when they cross bordersthey may take tax revenues with them.This is particularly serious for rich Westerncountries with ageing populations that

Also in this section

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An audio interview with the author is at

AcknowledgmentsParticular thanks for their help in the preparation of thisspecial report go to Paul Oosterhuis of Skadden, Arps,Slate, Meagher & Flom; Svein Andresen of the FinancialStability Forum; Alain Damais of the Financial Action TaskForce; Barry Johnston of the IMF; Michel Aujean of theEuropean Commission; and Yoshi Kawai of the Interna-tional Association of Insurance Supervisors

www.economist.com/specialreports

A list of sources is at

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2 A special report on o�shore �nance The Economist February 24th 2007

2 nored by the OFCs’ critics. Some of themoney used for the terrorist attacks of Sep-tember 11th 2001 was funnelled throughDubai, which has recently set itself up as a�nancial centre. The accounting scams atEnron, Parmalat and Tyco were made eas-ier by complicated �nancial structuresbased in OFCs (though, again, also in on-shore centres such as Delaware).

Tax warsBut the most obvious use of OFCs is toavoid taxes. Many successful o�shore ju-risdictions keep on the right side of thelaw, and many of the world’s richest peo-ple and its biggest and most reputablecompanies use them quite legally to mini-mise their tax liability. But the onshoreworld takes a hostile view of them. O�-shore tax havens have �declared economicwar on honest US taxpayers�, says CarlLevin, an American senator. He points to astudy suggesting that America loses up to$70 billion a year to tax havens.

The Tax Justice Network, a not-for-pro-�t group that is harshly critical of OFCs,reckons that global tax revenues lost toOFCs exceed $255 billion a year, althoughnot everybody believes it. Canadians werealarmed by a government report showingthat Canadian direct investment in OFCsincreased eightfold between 1990 and2003, to C$88 billion ($75 billion)�a �fth ofall Canadian direct investment abroad.The bulk of this was in �nancial services,mostly in a few Caribbean countries.

Business in OFCs is booming, and as agroup these jurisdictions no longer sit atthe fringes of the global economy. O�-shore holdings now run to $5 trillion-7 tril-lion, �ve times as much as two decadesago, and make up perhaps 6-8% of world-wide wealth under management, accord-ing to Je�rey Owens, head of �scal a�airsat the OECD. Cayman, a trio of islands inthe Caribbean, is the world’s �fth-largestbanking centre, with $1.4 trillion in assets.The British Virgin Islands (BVI) are home toalmost 700,000 o�shore companies.

All this has been very good for theOFCs’ economies. Between 1982 and 2003they grew at an annual average rate perperson of 2.8%, over twice as fast as theworld as a whole (1.2%), according to astudy by James Hines of the University ofMichigan. Individual OFCs have doneeven better. Bermuda is the richest countryin the world, with a GDP per person esti-mated at almost $70,000, compared with$43,500 for America (see chart 1). On aver-age, the citizens of Cayman, Jersey, Guern-sey and the BVI are richer than those in

most of Europe, Canada and Japan. Thishas encouraged other countries with smalldomestic markets to set up �nancial cen-tres of their own to pull in o�shoremoney�most spectacularly Dubai butalso Kuwait, Saudi Arabia, Shanghai andeven Sudan’s Khartoum, not so far fromwar-ravaged Darfur.

Globalisation has vastly increased theopportunities for such business. As com-panies become ever more multinational,they �nd it easier to shift their activitiesand pro�ts across borders and into OFCs.As the well-to-do lead increasingly peripa-tetic lives, with jobs far from home, man-sions scattered across continents and in-vestments around the world, they cankeep and manage their wealth anywhere.Financial liberalisation�the eliminationof capital controls and the like�has madeall of this easier. So has the internet, whichallows money to be shifted around theworld quickly, cheaply and anonymously.

The growth in global �nancial serviceshas helped too. Financial services are in es-sence the business of managing data. �It iszeros and ones,� says Urs Rohner, the chiefoperating o�cer of Credit Suisse, a Swissbank, adding that �in no other industry doyou see the impact of globalisation asenormously and dramatically as in �-nance.� This is because these zeros andones can be traded, structured, lent andsold anywhere. Pro�ts can be booked al-most anywhere, too, and are increasingly

being shifted to OFCs. The growing importance of the �nan-

cial-services industry in many economiesmeans that a greater chunk of pro�ts�andtax liabilities�are easily moved o�shore. Apaper published last year by Alan Auer-bach of the University of California atBerkeley found that whereas in 1983 �nan-cial corporations accounted for only about5% of all corporate-tax revenues in Amer-ica, between 1991 and 2003 they made uproughly a quarter.

The taxman also has to worry aboutnon-�nancial companies that are actinglike �nancial ones. The main pro�t enginefor General Electric, a large American con-glomerate that makes everything from jetengines to plastics, is its �nance division.Non-�nancial companies run pensionfunds and stock-option plans for their em-ployees across the world, manage theircorporate treasuries in myriad currenciesand increasingly employ esoteric �nancialproducts such as derivatives to hedge risksand raise money. All of these activities canbe set up in OFCs and often are, supportedby an army of lawyers, accountants and in-vestment bankers.

Parasites or pioneers?OFCs are often portrayed as �nancial para-sites that survive by diverting tax andother revenues from �real� economies, of-fering a haven for tax cheats and money-launderers. Some of this undoubtedlygoes on�but it goes on in big onshoreeconomies as well.

Businessmen and wealthy individualsinsist that OFCs can play a legitimate rolein reducing tax liabilities. The businesscommunity in particular argues that in a�ercely competitive global economywhere national tax regimes can varywidely, minimising tax payments is acompetitive necessity and OFCs are onesolution. OFCs themselves insist that theyare specialist �nancial centres and have farmore to o�er than just low taxes.

The main argument against OFCs isthat by allowing companies and a�uentindividuals to avoid taxes, they sap tax rev-enues from �real� countries, limiting thosecountries’ ability to pay for public servicesand forcing them to tax less mobile factorssuch as labour, housing and consumption.The big risk is that �globalisation is per-ceived to be rigged against the average citi-zen,� says David Rosenbloom, formerlythe international tax counsel at the Trea-sury Department in America.

Critics also worry that OFCs do not su-pervise business within their borders

1The very rich list

Source: CIA World Factbook *2004 †2005 ‡2003

Top economies by GDP per person2006 estimate, $’000

0 10 20 30 40 50 60 70

Bermuda*

Luxembourg

Equatorial Guinea†

United Arab Emirates

Norway

Guernsey†

Cayman Islands*

Ireland

United States

Jersey‡

British Virgin Islands*

Iceland

Denmark

Hong Kong

Canada

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The Economist February 24th 2007 A special report on o�shore �nance 3

2 tightly enough, which gives crooks anopportunity to enter the global �nancialsystem and could allow sloppy practicesthat might spark wider �nancial crises.Certainly, as many OFCs themselves willadmit, only a couple of decades ago regu-lation in many o�shore jurisdictions leftmuch to be desired and bad money foundits way in with the good. OFCs argue thatthis has changed and their supervision isnow at least as good as onshore, some-times better.

Libertarians say that tax, regulatoryand other competition is healthy becauseit keeps bigger countries’ governmentsfrom getting bloated. Others argue thatOFCs may be an inevitable concomitant ofglobalisation. �Even if today’s OFCs weresomehow stamped out, something likethem would pop up to take their place,�says Mihir Desai of Harvard BusinessSchool. Some academics have found signsthat OFCs have unplanned positive e�ects,spurring growth and competitiveness innearby onshore economies.

Should anything be done about OFCs?Countries try to discourage investment intax havens through the tax code and pourresources into tracking down tax cheats.But this is a Sisyphean task�close one reg-ulatory loophole and lawyers will openanother; convince one OFC to co-operatein the �ght against tax evasion or �nancialcrime and another will take its place.

International organisations havelaunched various initiatives to try to getOFCs to tighten supervision, co-operatemore with foreign governments to catch

tax cheats and, at least in Europe, eliminate�harmful� tax practices. OFCs think suchinitiatives are designed to force them outof business. The countries that set thesestandards �are an oligopoly trying to keepout smaller competitors. They are bothplayers and referees in the game. How canthey be objective?�, asks Richard Hay, alawyer in Britain who represents OFCs.

What is clear is that globalisation haschanged the rules of the game. It has pro-duced many bene�ts for rich countries,but has also provided more opportunitiesfor tax leakage, which explains their anxi-ety over OFCs.

OFCs, for their part, have by and largedone well out of globalisation. Two de-

cades ago, they were mainly passive repos-itories of the cash of large companies, richindividuals and rogues. Some jurisdic-tions still ply this trade today and shouldbe put out of business. But the best ofthem�for example, Jersey and Bermuda�have become sophisticated, well-run �-nancial centres in their own right, with ex-pertise in certain niches such as insuranceor structured �nance.

This special report will argue that al-though international initiatives aimed atreducing �nancial crime are welcome, thebroader concern over OFCs is overblown.Well-run jurisdictions of all sorts, whethernominally on- or o�shore, are good for theglobal �nancial system. 7

THE Jersey cow, a small, honey-brownbovine that is prized by farmers for the

abundance of buttery, high-fat milk it pro-duces, is one of the fastest-growing breedsin the world. From its origins in Jersey, arocky island 14 miles (22km) o� of thewestern coast of France, it now wanders�elds in over 100 countries from South Af-rica to Latin America. It is Jersey’s mostfamous export. But the island’s real cashcow is �nancial services. Jersey’s 46 banks,1,055 investment funds and over 200 trustsadminister over £700 billion in assets onthe island. In St Helier, Jersey’s capital,they compete for o�ce space with more

than two dozen law �rms, 50 accountancyout�ts and 20 insurance companies.

Jersey’s transformation into an OFC

was not part of a grand plan. After the sec-ond world war Jersey’s low taxes attractedthe bank deposits of British expatriates liv-ing in the former colonies. The island’smaximum rate of income tax of 20% hadremained untouched since 1940 when itwas set by the German occupiers.

But tax was only the beginning. Jerseyused its role as a low-tax repository of cashto build up a sophisticated private-bank-ing and trust business. More recently it hasmoved into the corporate business�struc-

tured �nance, the administration of invest-ment funds, the management of companyshare plans and the like.

Other OFCs developed in similar ways.Many of them are small territories thatwere once part of Britain (a number ofthem are still dependencies). Often theyhad a history of low or no taxes long be-fore they began to attract the deposits ofBritish expatriates and others. As money�owed in, the cleverer ones began to diver-sify into more sophisticated businesses.They also began to promote themselves asbroad �nancial centres, not just bankingones. This suited Britain, because it meant

What it takes to succeed

Not only low taxes but a great deal besides

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4 A special report on o�shore �nance The Economist February 24th 2007

2 its protectorates could become self-su�-cient. It also suited the jurisdictions them-selves. Financial services are lucrative andprovide a much more stable income thancrops and �ckle tourists. Mauritius hopedto diversify away from sugar, textiles andtourism and attract skilled labour when itlaunched itself as a �nancial centre in1992. Barbados, a poor country reliant onsugar, received help from the IMF andother agencies when it established its �-nancial industry in the 1970s.

Given the attractions, why are there noteven more OFCs? After all, cutting taxes toattract foreign capital seems an easy wayout of poverty. A study published last De-cember by Mr Hines and DhammikaDharmapala of the University of Michi-gan looked at 209 countries and territories,including 33 tax havens, to see why somejurisdictions become tax havens and oth-ers do not. Those that do, they found, areoverwhelmingly small, wealthy and, espe-cially, well governed, with sound legal in-stitutions, low levels of corruption andchecks and balances on government.Badly run jurisdictions cannot attract or re-tain foreign capital, so many do not eventry. Slashing tax rates is not nearly enough.

This may explain why the British em-pire spawned so many successful OFCs.These jurisdictions inherited strong legaland governmental institutions that reas-sured investors. Lingering ties to Britainprobably helped, too. The appeals processin the BVI and Jersey, among other OFCs,ends up in Britain. Other jurisdictions thathave tight cultural or linguistic ties tonearby large �nancial centres also bene�tfrom a ready clientele happy to do busi-ness in a familiar place. Liechtenstein, forinstance, does well out of being perchednext to Switzerland and using the Swissfranc as its currency.

Whiter than whiteBeing a successful OFC is tougher than itused to be. The best-run of them competenot only with o�shore rivals but also, incertain industries, with onshore ones. Ber-muda’s biggest competitors in captive in-surance (of which more below) are Ver-mont and South Carolina.

The costs of running OFCs have also in-creased. Complying with the raft of inter-national standards for �nancial servicesintroduced since the late 1990s involves alot of e�ort. And as standards rise, more isexpected of the public companies that useOFCs as well. They must not only makepro�ts, but be good corporate citizens too:paying bosses enough but not too much,

for instance, making sure their operationsin poor countries are run ethically (nochild labour, no sweatshops) and steeringclear of shady jurisdictions. So OFCs thatare careless about their reputation may�nd themselves shunned by the big, listedmultinationals that are their lifeblood.

OFCs complain that the bar is sethigher for them than for their onshorecounterparts. When Stanley Works, anAmerican toolmaker, announced in 2002that it was moving its headquarters to Ber-muda, it caused a furore. Along with other�rms that had moved to tax havens, in-cluding Tyco and Ingersoll Rand, it was pil-loried as �unpatriotic�, even though it wasacting entirely legally. Partly as a result,new American captive-insurance busi-nesses now often stay onshore. A regulatorin Europe comments: �Tax havens have tobe whiter than white. It is the only way toshake o� their bad reputation�whichsome of them deserved not too long ago.�

Being whiter than white does not comecheap. Introducing anti-money-launder-ing and other regulations, bee�ng up banksupervision and tracking down �nancialcrooks takes money and expertise. A paperpublished last August by the Common-wealth Secretariat, a group of 53 formermembers of the British Empire, estimatedthat in 2002-05 the direct cost of new regu-lations for Barbados was $45m and forMauritius $40m�big numbers for tiny is-lands with small budgets. The indirect hitcould be even bigger. For example, thenumber of o�shore banks in Vanuatuplummeted to 7 from 37 in a year after newrules required banks to open a permanento�ce with at least one full-time employeeon the island. The paper concludes that for

these three jurisdictions, �the costs in-volved in meeting the new standards haveexceededidenti�able short- to medium-term bene�ts.�

The start-up costs for new OFCs are alsomuch higher than they used to be. As oneregulator in a tax haven explains, in the olddays jurisdictions were able to build a criti-cal mass of business before turning theirattention to legal and regulatory struc-tures. Many OFCs that opened their doorsin the 1960s and 1970s have put in placeanti-money-laundering systems only inthe past few years, for instance. Thismeans that some bad money came in withthe good that had to be �ushed out later.

These days new OFCs must invest inregulation, legislation and enforcement upfront. That explains why some of thenewer ones are wealthy countries that cana�ord to do this. Dubai, for example, hasspent billions of dollars setting up the legaland supervisory systems to underpin itsnew �nancial centre. A big chunk of thismoney was spent on hiring regulators,mostly from Britain.

Some countries have decided that allthis is more trouble than it is worth. Tonga,Niue and Nauru, three miniscule islands inthe Paci�c Ocean, have quit o�shore bank-ing to avoid the cost of meeting interna-tional standards, as, in e�ect, have theCook Islands.

Getting down to businessSo what does it take to run a successfulOFC? First and foremost, you need a taxsystem that foreign capital �nds attractivebut still pays the bills. The model that mostOFCs choose keeps corporate taxes low ordoes away with them entirely but makes

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The Economist February 24th 2007 A special report on o�shore �nance 5

2 up for this through a combination of indi-rect taxes and fees, which are in any eventeasier to collect.

Regulation, too, is critical. It must be�necessary, appropriate and proportionaland bene�ts [must] outweigh costs,� as-serts Timothy Ridley, chairman of theCayman Islands Monetary Authority.That applies not only to OFCs but also tobig �nancial centres such as New York andLondon. The job is never easy, but a risk-based supervision regime, which mostOFCs use, is more manageable in small ju-risdictions because supervisors tend toknow most of the movers and shakers.

Moreover, in such places regulators tend tobe easy to reach and take the gripes of thebusiness community seriously. Regulatorsin Singapore, for instance, habitually con-sult local businesspeople to see how theycan improve co-operation. Their clientssay this is not just public relations. �Theyare willing to listen and change. They arenot rigid like regulators in Japan and Ko-rea,� says one banker at a British �rm.

In the nature of things regulation insmall OFCs can also be simpler than in bigcountries. In America, for instance, a na-tional insurer may �nd itself being regu-lated by each of the 50 states. In Bermuda,

by contrast, �you can focus simply on run-ning a sound business and makingmoney�not on red tape,� says Karole DillBarkley, an insurance consultant.

More importantly, many OFCs are in-volved mainly in wholesale rather than re-tail business. Of the Cayman Islands’ $1.3trillion in bank deposits, 93% are interbankbookings, not personal or corporate ac-counts. The 8,000-plus hedge funds domi-ciled in Cayman cater only to rich, sophis-ticated investors able to look out forthemselves, so regulators do not have toworry about protecting widows and or-phans and can streamline procedures. In

WHAT exactly is an o�shore �nancialcentre? At its broadest, it is any �-

nancial centre that takes in a large chunkof foreign funds�in other words, almostevery �nancial capital in the world. Muchof the business conducted in places suchas New York, London or Hong Kong isfrom outside America, Britain or China.

Britain is arguably one of the biggestpersonal-tax havens in the world. So-called �resident non-domiciles��peoplewho live in Britain but claim domicileabroad�do not have to pay tax on o�-shore income. America, for its part, soaksup huge amounts of o�shore cash be-cause it taxes little of the money held inits banks by non-resident foreigners. For-eigners’ bank deposits in America add upto $2.5 trillion, well over twice as much asthose in Switzerland.

But as most people understand theterm, �OFC� means a smaller jurisdictionwhere the lion’s share of the institutionsare controlled by non-residents andmany of them are in the �nancial sectoror set up for �nancial reasons. The vol-ume of business conducted by these �-nancial institutions often far outstrips theneeds of the local economy.

When OFCs combine all these attri-butes with a low- or no-tax regime theyare tagged as �tax havens�, especially ifthey also have strict banking-secrecyrules, light supervision and a slack gripon business within their borders. Pan-ama, for instance, still allows bearershares that can be anonymously owned

and traded. The Financial Stability Forum (FSF), a

group that monitors threats to the global�nancial system, has put together a list of42 jurisdictions that it de�nes as OFCs.The OECD in 2000 compiled a narrowerlist of 35 tax havens. There is a great dealof overlap between the two.

Dividing the world into onshore ando�shore �nancial centres is di�cult be-cause �it is a matter of degree, not sub-stance,� says one European bank reg-ulator. For example, many peopleconsider Bermuda an OFC, but it ispacked with actuaries pricing reinsur-ance risks. Jersey, where the �nancial sec-tor accounts for over half of all taxrevenues, is home to a sophisticatedbanking industry, co-operates with othergovernments on tax matters and requiresbanks and other licensed institutions tohave a �real presence� on the island.

More confusingly, some jurisdictionsstraddle both categories. One example isLuxembourg, a tiny country sandwichedbetween Belgium, France and Germanyand one of Europe’s most important �-nancial centres. A founder-member ofthe EU, Luxembourg is considered a well-managed, soundly regulated �nancialcentre with real expertise. It is home tomore than 2,200 investment funds withalmost 1.8 trillion under management. Itis also the euro zone’s biggest private-banking centre. The �nancial-services in-dustry contributes a third of Luxem-bourg’s output and, including its indirect

contribution (accountants, lawyers andthe like), supplies around 40% of Luxem-bourg’s tax take.

Luxembourg is sometimes lumpedwith tax havens because of various scan-dals involving companies based there, in-cluding the notorious BCCI and, morerecently, Clearstream. But although Lux-embourg got most of the bad press, BCCI

was operated out of London and Clear-stream is mainly a French a�air.

Ireland and Singapore are big inmanufacturing but also have thriving �-nancial centres that cater to o�shore busi-ness. Singapore has strict rules onbanking secrecy and does not considerforeign tax evasion a crime. Some peopleconsider Switzerland as a tax haven be-cause of its low tax rates and its fabledbanking secrecy.

But onshore economies can be opaquetoo. A report issued by a governmentagency in America last April found thatfew states collect information on the trueowners of companies set up within theirborders. Delaware and Nevada are par-ticularly lax.

Mr Owens at the OECD prefers to dif-ferentiate between well and poorly regu-lated �nancial centres rather thanonshore or o�shore ones. Well-regulatedcentres co-operate with foreign tax andother authorities and have sound super-vision; poorly regulated ones hide behindsecrecy. Low or no taxes on their own,says Mr Owens, do not constitute a harm-ful tax practice.

It’s a matter of degreeOn or o�?

6 A special report on o�shore �nance The Economist February 24th 2007

2 the BVI hedge funds can be set up and reg-istered within a couple of days.

The two pillars of Bermuda’s insuranceindustry�captive insurance and reinsur-ance�also cater to sophisticated busi-nesses only. Captives are set up by compa-nies (or groups of them) to lower theirinsurance bills by covering predictablerisks themselves. British Airways, for in-stance, until recently had a captive in Ber-muda that insured its aviation and otherrisks. Because no third parties are in-volved, regulators in Bermuda apply alighter touch. Reinsurers underwrite partof the risks of other insurance companies.They are subject to stricter disclosure rulesin Bermuda because, under many con-tracts, unrelated third parties are at risk.

One way OFCs maintain a light touch isto involve auditors and other service pro-viders in regulation. Jeremy Cox, the su-pervisor of Bermuda’s insurance industry,describes the island’s way of doing thingsas �practical regulation that tries to use theexperience of industry�. Bermuda alsoputs some of the regulatory onus on inde-pendent auditors, who must sign o� oninsurers’ annual �lings and con�rm thatthey meet minimum liquidity and pro�t-ability standards.

In Cayman all regulated or licensedprofessions�including lawyers, auditors,fund administrators and auditors, insur-ance providers and service providers fortrusts�are required to blow the whistle ifthey suspect that something untoward isgoing on. This is separate from the money-laundering rules.

Jack be nimble, Jack be quickFor all OFCs one of the advantages of be-ing small and predominantly reliant onthe �nance industry is that they canchange existing rules and laws quickly toreact to new opportunities. Inevitably thistakes much longer in big, diversi�ed econ-omies, where any change in the status quoinvolves di�cult negotiations among anassortment of interest groups.

Thanks to its nimbleness, Singaporehas been able to score a number of suc-cesses against Hong Kong, its slower-mov-ing rival. New trust laws in Singapore thatcame into e�ect a year ago have promptedHong Kong to re-examine its own. Singa-pore was also ahead of Hong Kong in pass-ing legislation on real-estate investmenttrusts (REITs), a relatively new investmentclass in Asia that has been growing rap-idly, fuelled by the local property boom.�We are small in a big world. We survivebecause we stay ahead of the region,� says

Kelvin Chan, a former government o�cialwho is now with the Partners Group, aSwiss private-equity �rm. �In this, beingsmall is our strength.�

Luxembourg manages to move quicklyeven though it is part of the EU and mustcomply with all EU directives, which havebecome increasingly onerous over theyears. Luxembourg dominates the marketfor a type of investment fund called UCIT,similar to mutual funds, that complieswith sti� requirements so that it can besold freely throughout Europe. This is be-cause it was the �rst country to incorporatethe UCIT directive into law in the 1980s.

Being quick on one’s feet is importantfor OFCs not only because competition is�erce but because many o�shore productsare easily commoditised. There is nothingparticularly special about a Cayman-dom-iciled hedge fund, for instance; indeedmore o�shore hedge funds are domiciledthere than anywhere else, and lawyershave so much practice that they canquickly set up another one. Hedge-fundmanagers themselves look for safety innumbers. �You go there because everyoneelse does,� says one New York investor.BVI companies are popular in Asia formuch the same reason: they are familiar,they work, and everybody else uses them.

OFCs with critical mass and expertisein certain niches often act as subcon-tractors for �nancial institutions in big on-shore centres in the same region. Invest-ment bankers in London, for instance,often work with bankers in Jersey on merg-ers and acquisitions. Bankers and lawyersin Cayman work with the lawyers ofAmerican multinationals on structured-�-nance transactions.

Such expertise helps OFCs to beat o�the competition. Bermuda’s reinsurancemarket is �ourishing because it relies on anetwork of brokers, underwriters and ac-tuaries that would be hard to replicate. Bycontrast, fund administration�in essence,the back-o�ce work for investmentfunds�which thrives in Dublin, Jersey,Luxembourg, the Isle of Man and else-where, has become commoditised for run-of-the-mill equity funds. This is one reasonwhy so many OFCs are �ghting overhedge-fund business. Administering thesefunds requires expertise in areas such asvaluing illiquid instruments and complexsecurities such as derivatives, so marginsare fatter and clients tend to stick around.

But small jurisdictions sometimes �ndit di�cult to attract and retain the people toprovide the expertise. OFCs in balmy cli-mates or close to onshore economies dobetter than tiny islands �oating in the mid-dle of the South Paci�c. Proximity to �real�economies makes it easier to lure those ex-perts (almost always expatriates), and cli-ents also like the convenience of being inthe same time zone as their OFC and talk-ing to people in their own language.

Some islands are running out of space.Jersey, for instance, imposes strict housingrestrictions. Bermuda is facing evengreater strains on its capacity. Householdsare limited to owning one car to cut downon tra�c, so a�uent businessmen can beseen zipping to work on motorscooters.Getting permanent residency in Bermudais di�cult and house prices are vertigi-nous, not least because unlike most otherOFCs Bermuda is the home base of manyhuge global businesses with large num-bers of employees.

The in�ux of well-paid expatriates whodrive up the cost of living can cause ten-sions with the local population. Kurt Tib-betts, a government minister in Cayman,says his government works on preservingsocial harmony by pouring money intoeducation. Bermuda quietly pursues a�r-mative-action policies that give locals �rstrefusal of any jobs before expatriates canbe considered. For the leading OFCs, suc-cess comes with its own headaches. 7

1

The Economist February 24th 2007 A special report on o�shore �nance 7

IT WAS as if America had swallowedSweden. Since George Bush signed into

law a one-o� tax amnesty in 2004 thatslashed corporate-tax rates from 35% to justover 5%, American companies have repa-triated close to $350 billion in previouslyuntaxed foreign pro�ts, according to esti-mates by JPMorgan, a bank�just shy ofSweden’s annual output. P�zer, a drugscompany, alone brought home an eye-popping $38 billion. Well over $150 billionof American companies’ foreign pro�tsstill sit o�shore.

Companies the world over are increas-ingly global. They are also facing ever�ercer competition at home and abroad,which makes them increasingly sensitiveto costs�including the costs of regulationand tax. That is good for OFCs, often thelow-cost middlemen of international �-nancial transactions.

The way companies use OFCs haschanged over the years. A few decadesago, before the telecoms revolution madeit easy to shu�e money around the globe,companies used OFCs primarily becausethey had less onerous �nancial rules. Thelinks between banks in Cayman and thosein America, for instance, are rooted in along-standing American rule barringbanks from paying interest on commercialchequing accounts. To get around this,many American banks set up �sweep ac-counts� that electronically funnel moneyto Cayman for an interest-earning over-night stay before being swept back home.�Cayman takes advantage of a legitimateloophole�and the �nancial system isnone the weaker for it,� says one regulatorin Europe.

Luxembourg got established as a �nan-cial centre four decades ago partly becauseit had looser lending rules than other Euro-pean countries such as Germany, says Fer-nand Grulms of the Luxembourg BankersAssociation. A Luxembourg subsidiary ofa German bank could make over twice asmany loans for the same amount of equityas its parent. Scandinavian banks weredrawn to Luxembourg because they coulddeal in foreign currency there, which at thetime was prohibited at home.

Regulation still matters. In Europemany countries, including Germany,

France and Italy, until recently did not al-low onshore hedge funds, says Tom Whe-lan of Greenwich Alternative Investments.That gave o�shore hedge funds a chance toestablish themselves. In America three-quarters of onshore hedge funds have o�-shore clones, mainly because hedge fundswith foreign investors, who are not re-quired to pay taxes on their hedge-fund in-vestments in America, would still need to�le America’s unwieldy tax returns if theyinvested onshore.

These days the main attraction of OFCsfor companies is the prospect of lower taxbills. Because of �erce global competition,being as tax e�cient as possible is just asimportant as keeping down labour costsand overheads, which often entails a dif-ferent kind of o�shoring.

In extreme cases companies havemoved their headquarters to a tax havento slash tax bills. In America new ruleswere introduced a few years ago to stopsuch �corporate inversions�, and have re-cently been tightened further. But a clutchof British insurers, including Hiscox andOmega Underwriting, have recentlymoved to Bermuda to minimise tax.

Most companies have gone for a half-way house, staying put but using OFCs tocut their tax bills. To understand how thisis done, a quick tax tutorial is in order.

Broadly speaking, countries opt for oneof two kinds of tax system. The �rst taxescompanies and people on their world-wide income, irrespective of where it wasearned. This method is used by America,Britain and Japan, among many others. Toavoid double taxation, a company receivesa credit for the taxes it pays to foreign gov-ernments up to the amount it would havepaid had it remained at home.

The second, simpler method, called the�territorial� or �exemption� system, taxesonly pro�ts earned in the home country.This system is used by the vast majority ofOECD countries, including France, Canadaand Switzerland. For example, Francewould tax Total, the energy company, onthe pro�ts it earns in France but not onthose it earns inVenezuela or Kazakhstan.

For companies taxed under the world-wide system, the most straightforwardway to use OFCs to minimise taxes is tosend money o�shore and keep it there, asP�zer did. This is because countries thattax companies on worldwide pro�ts donot present the tax bill for foreign pro�tsuntil these have been repatriated.

There are four other main ways inwhich companies can use OFCs to avoidtax, regardless of where they are based andwhat tax regime they fall under. The �rstthree do not worry the taxman; the fourth

Moving pieces

Global companies have plenty of latitude to minimise their tax bills

8 A special report on o�shore �nance The Economist February 24th 2007

2 gives him sleepless nights. The �rst of the less worrying sort in-

volves moving a physical business�suchas a manufacturing plant�to a tax havenand then attributing as much pro�t to it aspossible. Ireland is a prime example of thisstrategy in action. The second is setting upa company in a tax haven to tap its favour-able tax-treaty network. Mr Owens of theOECD notes that the vast majority of for-eign direct investment in India over thepast decade has been channelled throughnearby Mauritius because of its tax treatywith India. Cyprus’s tax treaty with Russiamakes it a favourite for companies invest-ing in that country.

A third involves companies setting upin OFCs that are �tax neutral��that is, themain attraction is avoiding extra layers oftax rather than avoiding tax bills. For ex-ample, an American mortgage-lendermight sell a chunk of its mortgages, and themortgage payments that go with it, to aCayman company. This company wouldnot make any pro�ts; it would simply re-package the streams of mortgage pay-ments into bonds and sell these to inves-tors. In Cayman it would not be taxed, butonshore it might have been.

The taxman’s nightmareThe strategy that gives the taxman night-mares involves shifting pro�ts from high-tax to low-tax jurisdictions. This is done ei-ther by transferring a company’s �nancialrisk (and its potential future pro�ts) to anOFC, or by exploiting the ambiguities oftransfer-pricing rules which govern howmultinationals divide up their pro�tsamong the countries they operate in.

An example of a risk-transfer schemewould be a company set up in Luxem-bourg to �nance the research and develop-ment of a drug in high-tax Germany. Sucha manoeuvre could cut both ways. If thedrug were a success, pro�ts would bebooked in Luxembourg and taxed at a lowrate. But if the drug bombed, the companywould lose out on the higher tax losses itwould have been able to book had it kepteverything in Germany.

Financing companies of this type canbe set up to pay for all sorts of initiativesthat can later be credited with boostingpro�ts to be taxed o�shore�a big advertis-ing campaign, investment in technologyand the like. Companies can also structureloans between subsidiaries in high- andlow-tax countries to achieve the same end.

Another way to minimise taxes is toshift the risk of joint ventures or othertransactions o�shore. Companies based in

the BVI, for instance, are now the second-largest investors in mainland China afterHong Kong, says Robert Briant, a partner atConyers Dill & Pearman, a law �rm basedin Bermuda. Many of these investments in-volve joint ventures.

The second big stick in the corporatetreasurer’s tax-avoidance armoury istransfer pricing. Companies have a lot oflatitude in setting the price that subsidiar-ies charge each other for goods and ser-vices. This can shift pro�ts away from high-tax countries by attributing higher ex-penses and lower pro�ts to them. This isno small matter for tax authorities: anastonishing 60% of international tradetakes place within multinational �rms.

The question of where a companycreates value, and thus where its pro�tsshould be taxed, is tricky at the best oftimes. Companies are increasingly man-aged on regional or even global lines, notnational ones. It makes little sense to havea separate risk or research division each forFrance, Germany and Italy, for instance.And a large and growing chunk of thevalue companies create comes in the formof intangible assets such as patents orbrands. These are hard to value as well asexceedingly mobile.

Most countries calculate transfer priceson the basis of what two independentcompanies would pay on the open market.But many services and intangible assets,say a unique patent or a global brand, donot have a market price, so it is hard to esti-mate what they are worth. That leaves am-ple room for quibbling�and, say the taxauthorities, manipulation.

These schemes have deprived the tax-man of a lot of revenue. A government re-port published in 2004 found that 61% ofAmerican companies paid no federal in-come tax during the boom years of 1996-2000. Much of this was thanks to movingpro�ts�rather than actual business�to taxhavens, reckons Martin Sullivan, editor ofTax Analysts. He looked at Internal Reve-

nue Service data from 1998 to 2000 andfound that pro�ts before tax of subsidiar-ies of American companies during thisperiod grew by $64 billion, or 45%, to $208billion, with over half of this increase com-ing from low-tax countries, particularlyBermuda, the Bahamas, Denmark andCayman. The average e�ective tax rate onthe foreign pro�ts of American multina-tionals during this period dropped from24.2% to 20.8%.

Transfer pricing in particular is comingunder increasing scrutiny. Mark Everson,the IRS Commissioner, told a group of sen-ators last August that the challenges posedto the agency by transfer-pricing manipu-lation �are acute and ever growing. O�-shore abuses are a real problem.� A studyby Andrew Bernard of the Tuck School ofBusiness at Dartmouth, Bradford Jensen ofthe Institute for International Economicsand Peter Schott of Yale School of Manage-ment conservatively estimates that the IRS

loses at least $5.5 billion and maybe asmuch as $30 billion from the manipula-tion of transfer pricing each year.

Such numbers have made tax authori-ties in America, Canada and Britain morebelligerent. Late last year Merck, a drugscompany, disclosed that it is facing fourdisputes with American and Canadian taxauthorities that could cost it $5.6 billion inadditional taxes and interest. Anotherdrugs-maker, GlaxoSmithKline, last au-tumn settled a 16-year transfer-pricing dis-pute with the IRS for over $3 billion.

Some believe that the best way out forcompanies is to assign transfer prices ac-cording to a formula based on the numberof people and amount of property theyhave in each country. But in practice thisdoes not really make things easier, says Pe-ter Merrill of PricewaterhouseCoopers.For a start, there is no common tax base ina common currency across countries, sothere is no coherent pool of taxable pro�tsto allocate by such a formula. Intangibleproperty would still have to be valued.And the formula would probably notwork for companies involved in a range ofdi�erent businesses such as Toyota, whichapart from making cars is also involved inbusinesses such as housing, �nancial ser-vices and biotechnology.

The real problem is that globalisationhas rendered the current system of taxingmultinationals archaic. Taxation is basedon national boundaries, but companiesoperate across continents and can easilyshift money and physical assets around.Until tax systems re�ect that reality, thedi�culties will persist. 7

1

The Economist February 24th 2007 A special report on o�shore �nance 9

�IN THIS world nothing is certain butdeath and taxes,� Benjamin Franklin

famously proclaimed. But for the well-heeled and well-advised, only the grimreaper is a dead certainty. The privatebankers of the rich can �nd ways to struc-ture transactions that greatly reduce theirtax bills and sometimes eliminate them al-together. This often involves movingmoney o�shore.

According to Boston Consulting Group,o�shore private-banking assets total al-most $6 trillion. Some of this wealth isstashed o�shore for safe keeping by thewell-to-do from politically turbulent partsof the world. But most of it is there to mini-mise taxes�sometimes legally, often not.Most OFCs do not levy capital-gains or in-heritance taxes, nor taxes on passive in-come such as interest. Strict banking-se-crecy rules in some of them can shieldassets from the taxman as well as a�ordprotection from unscrupulous govern-ments. In a number of jurisdictions�in-cluding Switzerland, Luxembourg and Sin-gapore�not paying taxes owed to foreignauthorities is not a crime. Other OFCs, in-cluding many in the Caribbean, do nothave any laws against tax evasion becausethey impose no income taxes.

These bene�ts have persuaded someprosperous people to set up house insunny tax havens. Popular destinations in-clude Monaco, a city-state of two squarekilometres on the Riviera that Ringo Starrand Roger Moore call home; Switzerland,abode of Tina Turner and Boris Becker; An-dorra, squeezed between France and

Spain; and various Caribbean islands. Other jurisdictions are trying to elbow

into this business, not so much to draw taxexiles as to attract entrepreneurs whobring with them (taxable) businesses andbrainpower. Last year the Isle of Mancapped income tax at £100,000, in thehope of convincing London investmentmanagers of the charms of island living.Guernsey plans to impose a £200,000 cap.

Singapore is trying to edge out HongKong as a home for hedge-fund investorsand bankers by o�ering permanent resi-dency in two years or less and a low-tax,business-friendly environment, as well asa bit of fun. �One problem we face is thathedge-fund managers are young andlively,� a former government o�cial ex-plains, �and compared with Hong Kongwe are boring.� So Singapore has recentlyreversed a law that banned dancing onbar-tops, opened a slew of new bars andrestaurants and loosened restrictions onracy �lms.

Famous tax exiles make good head-lines, but there are relatively few of them.Most of the rich would rather stay put,moving only their assets to tax havens.One simple way to do this is to open abank account in an OFC that does not taxinterest payments. These are meant to bedisclosed to the taxman at home, but oftenare not. Tax dodgers can tap these fundsfrom afar by using debit and credit cards,although tax authorities are now crackingdown on this.

One way to get round this is by settingup a trust. This involves putting money,

property and other assets into an indepen-dent legal entity and designating someonereliable to manage it. Trusts had their ori-gins in the Crusades. Knights would assigntheir land and other possessions to atrusted friend to take care of their a�airsshould they die abroad.

TrustworthyThese days users of trusts have more mun-dane motives. If a trust is set up in a tax ha-ven, assets often accumulate in it free oftax as long as they remain o�shore. Moneycan also be passed on to heirs through thetrust, avoiding inheritance taxes. Andtrusts are a nifty way to protect assets froman angry spouse in the event of a divorce.Long popular in America and Britain, theyhave now caught on in Europe and,increasingly, Asia.

Another method by which the wealthycan squirrel some of their assets o�shore isby setting up a company. It is a particularlystraightforward way to hold disparate andworldwide assets�such as land, factoriesand investments�and transfer them toheirs or spouses, who can take a stake in-the company. Such companies can be rela-tively simple to set up. BVI, one of thecheapest places for doing this, gets a lot ofbusiness out of it.

The use of trusts and companies o�-shore can minimise some taxes�such asinheritance tax�and defer others, such asincome tax, until the money is broughthome. Both are standard tools in tax plan-ning for the a�uent. What has made themcontroversial is their lack of transparency.

Rich pickings

How to defeat tax cheats

10 A special report on o�shore �nance The Economist February 24th 2007

2 Most jurisdictions, including America andBritain, do not regulate trusts. Bermuda,Cayman, Jersey and the BVI do�a point ofparticular pride for OFCs�but it is stillhard to get information on them. Compa-nies are an even bigger problem, as theycan be set up easily either onshore and o�-shore without much disclosure.

The number of people using thesemethods to minimise their tax bill is bur-geoning. One reason is that there are manymore rich people than there used to be. Ac-cording to Boston Consulting Group,global wealth in 2005 increased by 8% to$88.3 trillion and the number of million-aire households (those with over $1m inassets under management) reached 7.2m(see charts 2 and 3).

The fastest growth came in the develop-ing world�which arguably needs tax reve-nues even more than the rich countries do.Between 2000 and 2005 the number ofmillionaires in India and China increasedby over 15% a year, following by Brazil andRussia with 10%. Many wealthy people insuch countries deposit money abroad be-cause they fear tumult, or a grasping gov-ernment, at home. The rich in Hong Kong,itself a low-tax jurisdiction, move assetso�shore in part because they are wary ofthe Chinese government.

In developed countries OFCs are nolonger the exclusive preserve of the veryrich. The �mass a�uent� too�dentists,doctors, prosperous small businessmen�are placing money o�shore and putting abroader swath of the tax base at risk. Tech-nology has played a big part in this. Any-one who types the words �o�shore bankaccount� into an internet search enginewill score over 1.7m hits, many of them of-fering advice on how to set up o�shorebank accounts, trusts and companies, all at

reasonable rates. Electronic banking is pro-viding easier access to untaxed o�shorefunds. Promoters of tax havens are nowalso marketing their wares to a broader au-dience. Where once they advertised onlyin airline magazines handed out in �rst-class cabins, they have now embracedbusiness class and, on some airlines, eveneconomy class.

A�uent people these days also leadmore cosmopolitan lives. Expatriate em-ployees of multinational �rms are likely tomanage their �nancial a�airs o�shore,completely legitimately. So are owners ofoverseas holiday homes, who often de-posit the rent in o�shore bank accounts o�-shore without telling the taxman�de�-nitely illegal, but often hard to track down.

Taxman taxedAll of this makes the taxman’s job harder,particularly in countries with worldwidetax systems. American tax authoritieshave waged war on �abusive� tax shel-ters�complicated transactions with noeconomic purpose other than avoidingtax�and the bankers, lawyers and accoun-tants who sell them.

These are particularly damaging to gov-ernment revenues because they are oftenstandardised and sold to the wealthy bythe thousands. The government not onlyhas to unearth such inappropriate tax shel-ters but to convince the courts that even ifthey are technically legal they havepushed the boundaries too far.

America’s Internal Revenue Servicehas notched up some big wins. Its biggest,in August 2005, was in a court case againstKPMG, one of the world’s top four accoun-tancy �rms. The IRS accused KPMG of ped-dling a series of tax shelters to rich inves-tors, involving Cayman and other OFCs,which generated $11 billion in phoney taxlosses and deprived the government of at

least $2.5 billion in tax revenue. KPMG ad-mitted to criminal tax fraud and paid$456m in �nes. That sent a signal to tax ac-countants and lawyers everywhere towatch their step.

But rather than trying to bend the rules,many should-be taxpayers just hide.Given the current state of technology, thisis relatively simple to do because bank ac-counts can easily be set up over the in-ternet and used from afar. So the tax au-thorities have to go in through the backdoor. In 2000 the IRS convinced the Amer-ican courts to grant it access to the detailsof thousands of credit- and debit-card ac-counts linked to (untaxed) o�shore ac-counts in the Bahamas, Antigua and else-where, which allowed it to collect some$270m in tax.

The IRS hopes there will be even richerpickings to come. Last spring it won per-mission to inspect the records of custom-ers of PayPal, eBay’s online payment sys-tem, who have bank or payment-cardaccounts in tax havens. The IRS suspectsthat some of PayPal’s 100m accountsworldwide are being used to dodge taxesby using money in o�shore accounts tobuy goods online.

Britain’s Inland Revenue last year wona landmark case obliging Barclays, a Brit-ish high-street bank, to hand over the bankdetails of hundreds of thousands of o�-shore accounts held by British residents.The Revenue estimates that this couldyield up to £1.5 billion in unpaid taxes.Other British banks may hear from the tax-man soon.

The Australian tax authorities, too,have cracked down on the use of paymentcards to draw money from o�shore bankaccounts. They have reportedly found thatover A$10m a day is leaving Australia forJersey and Guernsey, the Caribbean andother OFCs.

British, American, Australian and Ca-nadian tax authorities hope to unearthmore such scams by joining forces. In 2004they set up the Joint International TaxShelter Information Centre (JITSIC) toshare information on abusive tax sheltersand their promoters. Critics complain thatsuch invigilation will eventually lead tothe establishment of a global super-copwith the power to pry, unchecked, intopeople’s private a�airs. They would prefertax amnesties to persuade people to repa-triate their money. But when this methodwas used by a handful of countries in con-tinental Europe, the result�the repatria-tion of about $200 billion�was generallyseen as disappointing. 7

2Far and wide

Source: Boston Consulting Group

*Free financial assets†Forecast

Number of dollar-millionaire* households, m

2000 05 10†0

2

4

6

8

10

12

North America

Europe

Asia Pacific

Middle East & Africa

Latin America

3Plenty to go round

Source: Boston Consulting Group

Wealth assets under managementBy region, 2005, %

North America37.6

Latin America3.2

Middle East & Africa3.2

Europe33.1

Asia Pacific23.0

Total:$88.3trn

1

The Economist February 24th 2007 A special report on o�shore �nance 11

FRANCE has always taken pride in its re-fusal to embrace the harsher aspects of

capitalism and globalisation�from its 35-hour work week to laws that make it di�-cult to sack employees. But in a globaleconomy no one can sit still. In a newyear’s speech to labour unions and com-panies in January, Jacques Chirac, France’spresident, called for cuts in France’s cor-porate-tax rate from 33% to 20%, and as lowas 10% for some companies. That is belowIreland’s 12.5%, at which the French haveoften sniped in the past.

Yet it is OFCs that are seen as tax rogues,for two reasons. First, they are seen to bespurring tax competition among coun-tries. True, some onshore economies aredoing much the same, but OFCs use taxesto attract mobile �nancial capital (and pro-�ts) without any �real� business underpin-ning it. Second, OFCs are thought to be aid-ing tax evasion, the unlawful avoidance oftax. These two issues are often confused.

The risk of tax competition is that itcould spiral out of control, starting a �raceto the bottom� as real economies cut taxrates on mobile capital and transfer the taxburden to labour and other immobile fac-tors in order to keep up with lower-taxcompetitors. This prompts other countriesto follow suit�and so on and downward.In the bleakest scenarios social-welfaremodels would crumble because govern-ments would be unable to pay for publicservices and there could be a backlash.

Poorer countries could also �nd itharder to compete on taxes, reinforcing theperception that globalisation is unfair. Arecent paper by Harry Garretsen and Jo-landa Peeters of the Central Bank of theNetherlands analysed annual data for 19OECD countries from 1981 to 2001 andfound that big, rich countries, such as Brit-ain and Germany, were better able to resisttax competition and maintain high cor-porate tax rates than smaller, poorer ones.It concluded that �if there is a race to thebottom, it seems that it is more real forsome countries than others.�

But for now that is still a big �if�. A stackof academic studies has documented thatforeign investment is sensitive to tax rates,and Mr Garretsen and Ms Peeters found intheir study that footlose capital did indeed

lead to tax competition. A 1% increase intheir measure of capital mobility was as-sociated with a 0.5% drop in e�ective cor-porate-tax rates.

But this competition does not seem tohave started a downward race. As a pro-portion of GDP, total tax revenues have in-creased steadily over the past 30 yearseven as statutory tax rates have fallen. Thisis true even in the EU, where drops in statu-tory tax rates have been particularly dra-matic. E�ective average corporate-tax rateshave also fallen (see chart 4). Yet accordingto a paper published last June by GaetanNicodeme of the Solvay Business Schoolin Brussels and the European Commis-sion, corporate-tax collections in Europe asa proportion of GDP have remained stableover the past decade, at around 3%. He saysthis may be because lower tax rates haveallowed countries to attract a large cor-porate-tax base.

Even if it does not cause a race to thebottom, tax competition is not necessarilybenign, says Michel Aujean of the Euro-pean Commission. Corporate pro�ts haveboomed in recent years and tax collectionhas followed. More companies are beingset up, so there are more to be taxed. And inmany countries cuts in statutory tax rateswere accompanied by measures thatclosed loopholes, thus broadening the taxbase. All this means that the numbers maynot be as reassuring as they seem to be.

Oxfam, a not-for-pro�t group thatworks to alleviate poverty, says tax com-petition is already very real for poor coun-

tries. In a report published in 2000 it esti-mated that developing countries lose atleast $50 billion a year to tax havens, aboutthe same amount as rich countries doleout to poor ones in foreign aid.

John Christensen of the Tax Justice Net-work takes issue with the term �tax com-petition�. He says that �true competitionspurs productivity and e�ciency in themarket, while tax incentivisation�whichis what this is�only increases after-tax pro-�ts. The two are not the same.� He arguesthat the tax regimes of OFCs and their on-shore copycats distort economic decisions.

Many economists and businessmendisagree with Mr Christensen, arguing thatcompetition of any kind is a healthy, disci-plining force. �Tax competition is the onlyagent of productivity for governments�itis the only competition they have,� saysJacques de Saussure, a partner at Pictet &Cie, a Swiss private bank. But he agreesthat it can go too far, because the rich tendto be more mobile than the poor and canhire advisers to minimise their tax bills.

Complements or substitutes?Even those in favour of tax competitionseem to assume that tax havens take busi-ness (and hence taxable pro�ts) away fromonshore economies: that the amount ofeconomic activity in the world is �xed andthat a dollar booked in Guernsey is a dol-lar less for France. However, a wealth of ac-ademic research has shown that when acompany opens a plant abroad, demandin its home country gets a boost too: salesby the parent company grow and jobs andexports at home tend to rise. But does thisalso hold true if pro�ts are simply shiftedto tax havens?

A fascinating study published in 2006by Mr Hines of the University of Michiganand Mr Desai and Fritz Foley of HarvardBusiness School provides evidence that itdoes. Looking at data on American multi-national companies from 1982 to 1999, theeconomists found that tax havens boostedeconomic activity in nearby non-havensrather than diverting it.

They o�er two possible explanationsfor this surprising result. The �rst is that acompany’s subsidiaries in tax havens mayadd value by providing important inter-

Unintended consequences

The less obvious uses of tax havens

4More for less

Sources: OECD; Institute for Fiscal Studies *Unweighted average

Corporate-tax rates and revenuesin developed countries

1975 80 85 90 95 2000 05

2.0

2.5

3.0

3.5

4.0

20

25

30

35

40

Corporate taxes,% of GDP

Effective averagecorporate-tax rate*, %

12 A special report on o�shore �nance The Economist February 24th 2007

2 mediate inputs used by its operations else-where. The second, more interesting one isthat in helping multinational companieslower their e�ective tax rates�even if thisis done simply by pro�t-shifting�OFCscould make high-tax countries more at-tractive to foreign investors. So a relativelyhigh-tax country such as France might seea drop in foreign investment if nearby taxhavens went out of business, because for-eign companies would no longer be ableto use them to minimise French tax bills.

If true, this opens up the possibility thattax havens complement onshore jurisdic-tions rather than substituting for them,and that the interaction between the twoincreases total economic activity in theworld. If the pie gets bigger, then both taxhaven and onshore jurisdiction will bene-�t. An interesting side-e�ect may be thatonshore economies are able to maintainhigher general levels of income tax be-cause mobile capital, which is sensitive totax rates, will help itself to a lower e�ectivetax rate by using OFCs. �Tax havens arelike pressure valves,� says Mr Hines. �Thecompanies that might otherwise leave ahigh-tax country for a lower-tax home stayput because they can use tax havens tolighten their tax load.�

This could be the reason why govern-ments in onshore jurisdictions the worldover do little to stop the use of tax havens,even though they constantly complainabout them. British politicians, for in-stance, sometimes talk about scrappingtheir country’s rule on resident non-domi-ciles because it allows wealthy peopledomiciled abroad, often in tax havens, tolive in Britain tax-free. That would simulta-neously increase Britain’s tax take and seri-ously dent the o�shore business of nearbytax havens. Yet nothing is ever done, per-haps because doing away with the rulewould cause an exodus of wealthy and of-ten brainy residents that would hurt theeconomy more than the tax forgone. Simi-larly, America and others could quite eas-ily curb the use of tax havens by tighteningthose parts of the tax code that already pe-nalise the use of OFCs, but they choose notto do so.

In a paper published last spring, An-drew Rose of the Haas School of Businessat the University of California at Berkeleyand Mark Spiegel of the Federal ReserveBank of San Francisco argue that OFCsmay o�er other bene�ts too. They studiedthe banking sectors of 221 countries andterritories and found that the nearer acountry was to a tax haven, the more com-petitive and e�cient its banking system

appeared to be. �O�shore competitors cankeep onshore banking sectors on theirtoes,� explains Mr Spiegel. �They probablyfacilitate sleaze but can still have unin-tended positive e�ects.�

Laundry listThe sleaze factor is conspicuously absentfrom all these studies, which concentrateon the OFCs’ role as low-tax jurisdictions.But what if a low-tax OFC is shoddily regu-lated or its rules are opaque?

By de�nition there are no reliable �g-ures on money-laundering worldwide, be-cause its perpetrators try to make the pro-ceeds of �nancial crime indistinguishablefrom legitimate money. Michel Camdes-sus, a former managing director of theIMF, once estimated the amount of moneylaundered globally at 2-5% of world GDP.Based on world output in 2005, that wouldput the current �gure at about $2.1 trillion.This is a problem not just for tax havensbut also for some onshore �nancial cen-tres. Augusto Pinochet, the Chilean dicta-tor, hid millions of dollars with the help ofRiggs Bank, based in Washington, DC.

The proportion of illicit funds that is de-tected is minuscule, and would be even ti-nier without co-operation across borders.This is where criticism of OFCs is justi�ed.Some of them have rules that make it verydi�cult to exchange information with for-eign enforcement authorities. Others donot register the companies that set up ontheir shores, so could not provide such in-formation even if they wanted to. Caymandoes register its o�shore companies, ofwhich it has over 70,000, and willingly as-sists foreign law-enforcement agencies,but it does not require companies to dis-close their bene�cial owners, so the in-formation is not all that helpful.

Other �nancial centres that co-operateon money-laundering and other criminalinvestigations balk at sharing informationon tax matters. This includes not just OFCsbut onshore jurisdictions with strict bank-ing-privacy rules.

Jurisdictions that cling to secrecy rulesare �selling a shield against the laws of for-eign governments�, says Mr Merrill. �En-forcement is almost impossible whenfaced with this shield.� Indeed, althoughtax revenues have been on the upswing,the OECD’s Mr Owens insists that tax eva-sion is a real problem, and a growing one:Ireland, which some consider to be a taxhaven in its own right, last year recoveredalmost 1 billion in unreported tax reve-nues from banks in the Channel Islands.South Africa reckons it is losing 64 billionrand ($ 8.8 billion) a year to tax havens.Crackdowns on tax cheating in America,Britain, Canada and Australia have nettedbillions of dollars. Most of the cheats areindividuals who cannot argue that globalcompetition is driving them to it.

Mr Desai of Harvard is studying the ef-fect of OFCs on the corporate governanceof companies that use them. He reckonsthat they may facilitate corporate mis-deeds, even unwittingly, because unscru-pulous managers can use the often com-plex and opaque structures companies setup in tax havens for all sorts of dodgy do-ings. Mr Desai points out that Tyco and Par-malat both had thousands of subsidiarieso�shore which its managers used not onlyto reduce their tax bills but also to loot thecompany. Enron’s 700 companies in Cay-man allowed its corrupt bosses to mini-mise taxes but also manufacture earnings.�This is the underappreciated real cost ofOFCs, rather than lost tax revenues,� saysMr Desai. 7

1

The Economist February 24th 2007 A special report on o�shore �nance 13

SOMERSET MAUGHAM, a British novel-ist, once described Monaco, a tiny city-

state on the Mediterranean coast that of-fers sun, secrecy and minimal taxes to itsmany super-rich residents, as �a sunnyplace for shady people�. That used to betrue for many other OFCs as well. Forsome of them it still is. But things arechanging, even in free-wheeling Monaco.Prince Albert, who took the throne in 2005,has vowed to rid the country of its reputa-tion as a haven for tax cheats and crookedbusinessmen. In future, he said, his rulewould be guided by �morality, honestyand ethics�.

The city-state, one of just a handful ofjurisdictions still blacklisted by the OECD

for its tax practices, is belatedly followingother OFCs. Somewhat grudgingly, theyhave all been responding to internationalpressure that goes back to the early 1990s,when the G7 group of big, rich countriesstarted to debate the risks of �nancialglobalisation. This produced three sepa-rate but related international initiativeslaunched in the late 1990s.

The Financial Stability Forum (FSF) wasput in charge of monitoring the systemicrisks posed to the increasingly interlinkedworld �nancial system. The Financial Ac-tion Task Force (FATF) was set up to �nd away to keep money-launderers out of the�nancial system (terrorist �nancing wasadded after the attacks of September 11th2001). The OECD launched its �harmful-tax initiative� to get rid of unhealthy taxcompetition and prod jurisdictions intohelping foreign tax authorities with theirinvestigations.

OFCs were not the only target, but theyreceived special scrutiny because the FSF

and the FATF worried that they mightprove the weakest link in the global �nan-cial system. The FSF paid particular atten-tion to the banking system. Internationalprinciples for banking regulation had al-ready been set out by the Basel Accord in1988. They were based, among otherthings, on the idea of �consolidated super-vision� in which a bank’s home supervi-sor took responsibility for monitoring therisks of the entire bank. This called for co-operation from host regulators. ManyOFCs fell far short of this requirement.

The FATF drew up 40 standards forkeeping money-launderers out of the �-nancial system, including a ban on shellbanks and a requirement that jurisdictionsmust know the true owners of all compa-nies set up within their borders. Like theFSF, the FATF found that supervisors inOFCs often lacked expertise, good in-formation and the mechanisms (andsometimes also the will) to exchange it.

Both bodies decided, separately, thatthe way to prod OFCs into action was toname and shame them. In 2000 the FSF

blacklisted 42 OFCs and the FATF 23 �non-co-operative countries and territories�, in-cluding the Bahamas, Israel and Russia.Countries on these lists were often barredfrom doing business with banks and other�nancial institutions in the rich world ormade subject to much more onerous dis-closure requirements.

The IMF was put in charge of checkingon the progress that OFCs and other big �-nancial centres had made in meeting inter-national standards. In a recent study itfound that, on average, supervisory stan-dards in OFCs were �superior to those ofother jurisdictions�. OFCs met 80% of thestandards on co-operation and disclosurerelated to bank and insurance regulation,

though they still had further to go on anti-money-laundering measures. The FSF’sworries are now largely about newer risks,such as the rapid growth of derivativesand hedge funds in OFCs.

By and large, good progress has beenmade. The FSF withdrew its list in 2005,though it set up a group to continue moni-toring OFCs. The FATF recently removedMyanmar, the last country on its blacklist.

Caring, sharingBut on the vexing issue of taxation, pro-gress has been slow. The OECD’s �harm-ful-tax� project, launched in 1996, coveredsome of the same ground as its sister initia-tives. It aimed to get jurisdictions to collectbetter information and to share it with for-eign tax authorities when necessary.

But four of the OECD’s members�Swit-zerland, Belgium, Austria and Luxem-bourg�would not sign on to the project be-cause they would have to give up theirbanking-secrecy rules, which do not allowthe exchange of information about foreigntax evasion. The Bush administration alsocomplained that the project would sti�etax competition, so the focus was nar-rowed to better information-gathering andexchange.

In 2000 the OECD blacklisted 35 tax ha-vens. Only �ve of them still remain on thelist: Andorra, Liberia, Liechtenstein, Mar-shall Islands and Monaco. Only two coun-tries, Guatemala and Nauru, have no legalsystem for the exchange of tax informa-tion, although they are working on it.

But the real measure of success for theOECD project is progress on Tax Informa-tion Exchange Agreements (TIEAs)�bilat-eral agreements between tax havens andbigger countries to help each other on taxmatters. The OECD sees these agreementsas the answer to the problem of tax-dodg-ing. America has signed over a dozenTIEAs, most of them with OFCs in its back-yard, mainly because these tax havens de-pend so heavily on their big neighbourthat they are bound to comply. But onlythree other TIEAs have gone through in thedecade since the project was launched�al-though dozens are said to be in the works.

Europe has fared little better. In 1999the EU launched a code of conduct aimed

All together now

Crooked OFCs have to be kept down, but good ones must be allowed to �ourish

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at �harmful� tax measures, using the samede�nition as the OECD’s. The code was ex-tended to EU members’ dependencies, soit covered tax havens such as Jersey,Guernsey and Cayman. Jurisdictions duti-fully abolished their �harmful� preferen-tial tax regimes�but some simply ex-tended the same low rates to everyone.Such moves technically comply with thecode of conduct, but the EU is watchingthem warily.

The EU’s savings directive, designed tosquash tax evasion by individuals withinEurope, took e�ect in 2005 after a decadeof wrangling, but has proved something ofa �op. The original plan was to get EU

members and their dependencies auto-matically to exchange information on sav-ings kept in their banks by citizens of otherEuropean countries. But once again theusual suspects�Luxembourg, Belgium,Austria and Switzerland (not an EU mem-ber but included in the savings directive)�would not budge. Under a compromise,countries could either exchange tax in-formation or deduct a withholding tax onthe o�shore accounts of EU members andremit it in bulk to the investors’ home taxauthorities. Most member states chose toexchange information; most European taxhavens went for the withholding tax.

So far, the countries that opted to with-hold taxes have remitted a paltry 210m.The directive de�ned �savings� so nar-rowly that it was easy to �nd ways aroundit. The interest on bonds is subject to the di-rective, for instance, but dividends onshares, bond-like insurance products or in-come from derivatives are not.

Compared with the glacial progress oninitiatives to counter tax avoidance, inter-national projects on �nancial crime andbank regulation have done rather well.This is because most governments agreethat money-laundering and �nancialmeltdowns are best avoided. Many OFCshave co-operated in these initiatives, andthe rest will have to come round�if onlybecause they would lose their livelihoodsif, say, a terrorist attack in America were �-nanced through one of their banks.

The problem with getting agreementon tax matters is that the interests of bigcountries are not aligned�indeed there isvigorous competition on tax. This is whythere is no international standard on taxevasion or tax competition along the linesof international standards on bank regula-tion or �ghting �nancial crime. For exam-ple, Britain convinced the EU to exempt theeurodollar market, which thrives in Lon-don, from the de�nition of �savings� un-

der the savings directive because it did notwant to lose this business. Switzerlandand Luxembourg fear�not withoutcause�that giving up banking secrecywould hit their private-banking business.

Where big countries do seem to be ableto agree is in objecting to small tax havensthat make life easy for cheats, particularlyindividuals. For multinational companiesthe picture is mixed. They are proli�c usersof OFCs, and their home countries gener-ally do little to stop them. The moststraightforward way to do so would be totighten up controlled-foreign-corporation(CFC) rules. Under these rules companieswith subsidiaries in tax havens are taxedmore heavily, making the use of OFCs lessattractive. Every country has such rules,but detailed provisions vary.

If big countries were to make theserules more stringent, they would deprivetax havens of a lot of business�but theythemselves would get hurt too as theircompanies lost competitiveness againstforeign rivals. So they do a bit of sabre-ratt-ling but mostly let their companies use taxhavens to suit their needs.

Here to stayThe trouble with trying to curb the use oftax havens by companies is that tax sys-tems are based on national boundaries,but multinational companies increasinglyare not. Companies are in business to max-imise pro�t, so they will base themselvesin the lowest-cost and lowest-tax jurisdic-tions. Tinkering with transfer-pricing rulesor CFC rules will not solve the problem.

Taxing individuals poses less of a di-lemma. Individuals do not face globalcompetition. They have to pay taxes in

their home countries in return for the ser-vies provided by government. If anindividual feels his tax burden is unfair, hecan vote for tax-cutting politicians or go tolive in a less heavily taxed country�or, ifhe does not mind breaking the law, he canhide his money abroad.

Some experts believe that the only wayof reconciling a system of national tax re-gimes with a global economy is to harmo-nise tax systems across borders. But this isnot going to happen soon. Singapore,Hong Kong and other o�shore jurisdic-tions are outside the scope of the OECD’stax project. They also show little interest ingetting involved with the EU’s e�orts.Given the trouble the EU had introducingeven a watered-down savings directive,broader tax co-ordination seems out of thequestion for now. Nor is it necessarily de-sirable, because a healthy dose of compe-tition is good for the �nancial system.

The best bet is, �rst, for countries bothonshore and o�shore to exchange tax in-formation and target cheats�individualsand corrupt companies seeking obscurityo�shore�that harm the �nancial system.

Second, rich countries should look inthe mirror. A recent World Bank studyshowed that cutting tax rates and simplify-ing tax systems can greatly reduce the inci-dence of tax evasion. Doing so wouldmake tax havens less attractive.

But until and unless these things hap-pen, OFCs are here to stay. That may be nobad thing. The small, unsuccessful onesare already being driven out. Those that re-main should be monitored more closely.But the well-run, nimble ones will con-tinue to thrive because they have some-thing to o�er in a globalised world. 7

Future special reportsCountries and regionsAmerica’s South March 3rd The future of the EU March 17th China and its role in Asia March 31stBrazil April 14th

Business, �nance, economics and ideasTelecoms April 28thCities May 5th