Dr Walid Hejazi

Offshore financial centres (OFCs) are incredibly misunderstood. The abuse of these jurisdictions by individuals or organisations to hide income or assets from legitimate tax authorities has resulted in a negative view of all such jurisdictions. Let's be clear: the use of these jurisdictions by any organisation to avoid paying taxes that should be paid is illegal - and such organisations should be prosecuted. But as in the case of purely domestic scenarios, the taxpayer has the right to arrange business affairs in such a way as to minimise the tax burden by legal means. There will always be those international investors that use creative ways to reduce taxes owed to the legitimate tax authority - in that sense, OFCs are no different.

The use of OFCs for illegitimate purposes is minimised when there are agreements on transparency and exchange of information between such jurisdictions and home economies. As is clear from the Organisation for Economic Co-operation and Development's (OECD) most recent list, many (but not all) jurisdictions have in fact moved in that direction. Examples of jurisdictions that have implemented the OECD's international tax standards include Barbados, Jersey, Mauritius and the US Virgin Islands, and more recently Bermuda, the British Virgin Islands and the Cayman Islands. Examples of those that have agreed in principle to effect the OECD's international tax standards include the Bahamas, Belize, Liechtenstein, Panama and Singapore.

FDI and ofcs

Over the past two decades, foreign direct investment (FDI) has become an increasingly important channel of global integration. When businesses have a foreign presence, this opens foreign markets to further exports from the home market. The world has seen an explosion in the levels of FDI. From the $704bn in 1980, the total amount of FDI in all of the world's economies grew to a staggering $15000bn by 2007, a global FDI increase by a factor of more than 20.

The vast majority of this FDI is located in the world's wealthiest (OECD) economies. What is interesting, though, is the important role played by OFCs, low-tax jurisdictions that are home to more than $2000bn in capital. It is this capital that has become the target of many governments hoping to fill their coffers by taxing these pools of wealth.

OFCs and FDI benefits

Much of the empirical evidence documenting the benefits of FDI relate to multinationals investing directly into a host economy from a home economy: for example, a US multinational investing directly into China. A careful look at the data, though, reveals that these global investment strategies are not as straightforward.

Multinationals often do not invest directly into the host market, but rather use a conduit jurisdiction, an OFC, to access these global markets. The extent of FDI invested in OFCs that flows through to third markets varies by jurisdiction, but is typically a very large share.

The US had $2800bn invested into the global economy in 2007. Of this, 11% was invested through OFCs, amounting to $300bn. In 2007, Canada had more than $500bn invested into the global economy. A full 20% of this, $127bn, was invested into OFCs.

Even China has been relying heavily on OFCs. More than 20% of all FDI that goes into China flows through OFCs, the largest being Hong Kong, a fact that will surprise few.

What may be a surprise, though, is that a full 15% of all FDI into China goes through the British Virgin Islands, which was only recently listed by the OECD as a jurisdiction that has substantially implemented the internationally agreed tax standard.

The Big Debate

The question becomes, are the use of such OFCs 'good' for the home economy where the investment originates, the host economy in which the investment is ultimately made, or is it good just for the OFC and the organisation involved in the investment?

This is where my latest research comes into play. On the whole, the public debate is far too narrow, and concludes that simply because the use of OFCs provides a tax advantage to businesses using them, then they must be bad for the economy and for the average citizen. This public debate often goes on to conclude that the use of these OFCs results in a loss in tax revenue to the home economy.

It is further argued that if there is a crackdown on OFCs, then the investments located there will return to the home country, thus increasing the tax base and hence improving government finances. My research shows that these arguments are too narrowly focused, and are wrong. As in the case of any policy discussion, when decisions are made based on an incomplete assessment of the issues, sub-optimal decisions will be made.

When a multinational uses an OFC to access the global economy, the OFC experiences a tax advantage that is tantamount to a reduction in its cost of capital. As a result, the multinational is able to move into foreign markets, especially those which are less familiar and more risky (such as emerging markets). Since multinationals from all major economies have access to the use of OFCs, they all have access to these structures, which extends to them reduced costs of capital.

In many situations, the income that is earned globally is allowed to flow back to the home country at very low tax rates. In the case of Canada, for example, when the global income flows back to Canada through a Barbados affiliate, that income is taxed at a very low rate in Barbados, and not taxed upon repatriation to Canada. However, when that repatriated income is paid to shareholders, either in terms of dividends or capital gains (as retained earnings accumulate), these payouts are taxable. Therefore the initial loss in tax revenue associated with not taxing the income when repatriated is offset by the increased income tax paid by shareholders when the income is paid out. The flow of income to shareholders is necessarily higher having used an OFC relative to having not. Moreover, since the multinational is more competitive in the global economy, exports from the home country to the host economy increase, as do head office functions, all of which contribute to employment, investment and the enhancement of tax revenue.

These theories have been tested using the gravity model for international trade, which is estimated using Canadian and US trade and FDI relationships with the global economy.

The analysis shows that outward FDI - that is, a home country's FDI into a foreign host economy - contributes to home country's exports to that host economy. This result, notably the complementarity between international exports and outward FDI, is long-standing. The new research being reviewed here, though, considers whether this complementarity result continues to hold when the multinational invests in a foreign market, but uses a conduit (an OFC). That is, does US investment into Brazil, for example, generate more US exports from the US to Brazil, whether the US company uses a conduit or not.

The result of new research shows that when US multinationals use an OFC as a conduit into foreign markets, exports generated as a result are larger than those which are generated when the multinational invests in that host economy directly. This result is in no way a surprise because having used the OFC as a conduit, the multinational is more competitive and hence does better in the foreign market than had it not. Therefore, the complementarity, or stimulation of exports from the home to the host, will be necessarily larger.

A more detailed analysis reveals another interesting result. The OECD released a list in April 2009 that classified countries into three categories: jurisdictions that have substantially implemented the internationally agreed tax standard; jurisdictions that have committed to the standard, but have not yet substantially implemented them; and jurisdictions that have not committed to such standard.

Analysis demonstrates that FDI going through the first category has a larger impact on host-country trade in comparison with countries that have not (second and third categories). The exchange of information that jurisdictions have substantially put into effect reduces the likelihood of illegitimate or single transactional purposes, while making those jurisdictions more likely to be used as a bona fide conduit into the global economy in order to enable competitiveness.

Formulating policy

There are many policy-makers that are using OFCs as scapegoats for deteriorating fiscal balances at home. It is argued that if the income generated in the global economy and repatriated through OFCs were taxed, fiscal balances would improve. This is a short-sighted view, and is incorrect.

If policy-makers were to tax the use of OFCs as conduits into the global economy, the impact on the competitiveness of each country's respective multinationals would diminish - and this effect would be magnified if the policy change were not effected across all countries. Therefore, the profitability and the activities of the multinationals in the global economy would be diminished.

A government policy that restricted the use of OFCs would significantly hurt the competitiveness of multinational companies and would reduce government tax revenue, not increase it. Reduced use of OFCs will hurt countries and their citizens, not help them.

Dr Walid Hejazi is professor of international competitiveness at the Rotman School of Management, University of Toronto, Canada