Paradise lost?

Milton Grundy reports on what offshore jurisdictions have to offer now that tighter regulations have come into force

A couple of years ago, it looked as though the offshore world would shortly cease to exist. The Organisation for Economic Cooperation and Development (OECD) Report, more noted for its bellicose tone than its intellectual quality, demanded an end to “ring-fencing” – the provision to non-residents of privileges not available to residents. Unfortunately, this is essentially what most of the offshore jurisdictions have to offer, although they point out that the onshore jurisdictions offer it too. A non-resident in the UK can establish an interest in possession trust free of capital gains tax and free of income tax on its foreign income; in the US, a non-resident alien can have a limited liability company free of tax on its foreign income.
There was a lot of huffing and puffing, complicated by the anti-money laundering initiative directed by the Financial Action Task Force and of which, it seemed to the offshore jurisdictions, they were especially, and unfairly, the target. The hubbub has died down, the ring-fencing concept has been quietly dropped, and the Enron affair has put an end to the notion that financial malpractice is mostly to be found offshore. The major onshore countries have settled for powers to obtain information, and the offshore jurisdictions are saying that it is business as usual.
But what business is it? Barristers lead a very protected life. Nobody asks me my opinion about changing a trunk-full of £50 notes into euros, but common sense tells me that there must still be Italians with bank accounts in Chiasso and South Americans with accounts in Florida, and that the origins of these funds would not bear too close an examination. I need no crystal ball to say that this business will have to go, and will doubtless go painfully for many of the depositors. And for the rest? We are in an area where statistics are notoriously few, but there are signs that the future of offshore business belongs to an altogether more serious and demanding world.
So, what about statistics? The Society of Trust and Estate Practitioners has nearly 500 members in Jersey, more than 150 in the Bahamas and many more in other offshore jurisdictions – they must be doing something. And the last volume of the Journal of the International Tax Planning Association has 364 pages, most of the text discussing offshore matters. The OFC Report stated that the Cayman Islands had become the fifth largest banking centre in the world. That is amazing given that the islands are so small that years ago – before the airport had Radar – planes travelling to the islands carried enough petrol to get back to Miami, just in case the pilot could not find them. Clearly, something, whether good or bad, is going on offshore, even if the public does not know much about it.
Speaking simply impressionistically – and forgetting the various cheats and frauds who, mercifully, seem to be on the way out, the offshore world now seems to be engaged as much in tax deferral as in tax avoidance. The border between the two is a narrow one. If someone buys a freehold reversion to a lease with a trifling ground rent, they can expect to be richer every year, but they will pay no tax until they sell. That is deferral. But if when they sell they are resident in Monte Carlo – though they may have to stay away for more than five years – that is avoidance.
Consider the case of a joint venture between an American, a British, and a Japanese company. None of them want to be involved in the tax regime of either of the other two; they therefore decide to establish the joint vehicle in the Bahamas. So long as they can negotiate the controlled foreign companies rules applicable to each, the tax they defer can be used as working capital in the business, but at the end of the day, the benefit of the re-investment will come to each of them as a dividend or as a capital gains on disposal, and be taxable accordingly. A UK-resident individual may do the same thing, if he can show a commercial reason for doing so.
Again, an offshore trust made by a UK-resident settlor for his children and grandchildren can accumulate income, though not capital gains, tax-free, however this is only tax-free for the time being, the tax charge crystallises when the beneficiaries receive the money. If by that time one or more of the beneficiaries have become resident elsewhere, deferral becomes avoidance. Similarly, a receipt from an offshore company of, for example, remuneration or a profit share, may be dependant on the happening of a future and uncertain event – the ultimate recipient may not be taxable on an uncertain sum, but, if they are resident in the year in which the uncertainty ceases, a tax liability will arise. This is a case of deferral. If, on the other hand, the recipient is then non-resident, he may avoid the tax charge, but this then becomes a case of avoidance.
It seems that true avoidance is an exceptional, and generally unplanned, result of an offshore transaction, and that the offshore jurisdictions function mostly as a kind of warehouse for profits that are not going to be taxed this year, but that will probably be taxed in the future. Why do the major industrial powers not put a stop to this? A hunch is that it is because the onshore world benefits hugely from this deferral: the modern economy has an immense appetite for capital to be invested, and the facilities offered by the offshore jurisdictions allow the re-investment of gross returns instead of net returns.
If the onshore governments were to ask my advice on putting an end to offshore tax deferral (not that they will), I would point to the way that the US put an end to the Netherlands Antilles as a route for paying gross interest to foreign lenders; by abolishing the withholding tax on such interest, Antilles structures immediately became otiose.
But should onshore governments bring deferral onshore? Rules permitting tax on domestic trust income and gains to be postponed until the beneficiary is in a position to spend them on champagne and chorus girls, could – if my analysis is correct – go a long way towards putting the offshore world out of business.
Milton Grundy is head of Gray's Inn Tax Chambers