The rise of financial centres does not happen in a manner one might expect to see in the movies. It is not about laundering money, drug-dealing or terrorist financing. It is not even about tax evasion. It would be incorrect to say that none of these activities happen in offshore financial centres but, without a doubt, the vast majority of these activities also occur in developed Western markets.
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The role of financial centres has been to facilitate the expansion of business activity globally. The past several decades have seen liberalisation policies in many emerging markets, which opened them up to the global economy. This, coupled with significant advances in information technology, reductions in communications costs and innovations in transportation, has resulted in a surge in globalisation. At the same time, there has been growth and expansion of global regulations and oversight, stemming from renowned bodies such as the Organisation for Economic Co-operation and Development (OECD) and the G-20.
Flow of capital
While much of the media’s focus has been on the surge in global trade – imports and exports – what underlies the world’s globalisation efforts is the movement of capital; that is, investments by multinational corporations. In 1980, the world’s stock of outward foreign direct investment (FDI) stood at $549bn. By 2011, this figure exceeded $21,000bn, some 35 times the 1980 level. In contrast, exports in 1980 stood at $2400bn, and had grown to $22,400bn by 2011, an almost ten-fold increase.
Investment strategies by multinationals have been shown to support, or complement, home country exports to the FDI destination country. This complementary result is robust across many academic studies. Put differently, one cannot think of trade without thinking of underlying investment strategies. In today’s global economy, these two strategies essentially go hand in hand. When one digs into this data, what becomes clear is that a large and increasing share of these investments is, in fact, moving through offshore financial centres (OFCs).
That is, rather than invest directly in countries in Asia, South America or eastern Europe, multinationals set up global hubs or holding companies in OFCs, which they use as conduits into the global economy. The reason for such complicated global structures is that the multinational is able to achieve a lower level of taxation on its global operations; it does not, for instance, have to pay taxes more than once on the same revenue stream. The upside for the corporation is that it is more efficient and competitive globally.
It must be highlighted also that there are significant benefits to both the home and host economies of these corporations as well. When used as conduits to the global economy, the use of OFCs is a win-win for the key stakeholders – for the corporation, the source country of the investment and the ultimate destination country.
Tax loss myth
There is a misplaced emphasis on the potential loss in tax revenue associated with the use of OFCs. The following calculation may be helpful in illuminating this point. The Canadian economy has more than $500bn invested globally, with about $100bn going through OFCs. Assume, for simplicity, that these investments would generate a 10% income flow which would generate an annual income flow of about $10bn. Assuming a tax rate of 30%, that would make $3bn in potential tax revenue. The Canadian government may have looked at these offshore centres and thought that if they could tax the income flow off of all of that capital, they could generate $3bn.
It is a shortsighted viewpoint, and it is wrong for the following reason. The analysis that I have done demonstrates clearly the following point: when Canadian companies use OFCs, the money does not stay in the OFC. Canadian companies that are using these jurisdictions as conduits into the global economy are more efficient and more productive as a result of the tax advantage that comes with the use of these conduits.
So when a Canadian company goes, for example, to Brazil, eastern Europe, China or India, if they go there directly the taxes that they face are higher than the taxes that they would face had they gone through an offshore jurisdiction such as the Cayman Islands, which promotes a 0% rate of tax, or Barbados, with its extensive portfolio of double taxation agreements.
Many stakeholders focus on the initial tax that is lost; that is revenue that the government could have obtained. But the point that must be made, and that has to be made clearly, is that if Canadian companies were not allowed to use these jurisdictions as conduits into the global economy, their tax burden would be significantly higher and they would not be able to compete with multinationals from other OECD countries, which have access to essentially the same financing structures.
With that enhanced global competitiveness comes enhanced global jobs in Canada, enhanced exports, employment and capital formation. So, the initial tax loss must be balanced against the benefits that come from having Canadian companies that are more efficient in the global economy. The same theory can be applied to companies from all developed countries, and increasingly developing countries.
Under surveillance
Another concern relates to activities undertaken in these jurisdictions that cannot be monitored by OECD countries. There must be a distinction made between tax evasion and tax minimisation strategies. The former is illegal and must not be tolerated. The latter can be done in a completely legal way. In a domestic context, the tax authority can both monitor and audit in a bid to limit the extent of tax evasion – but even here, the estimates of the lost tax revenues domestically swamp any potential revenue that can ever hoped to be generated from OFC investments. However, OECD jurisdictions have sought transparency and exchange of information for these jurisdictions.
If Canadian companies were not allowed to use these jurisdictions as conduits into the global economy, their tax burden would be significantly higherquote
Many jurisdictions have made commitments to the OECD to implement transparency and effective exchange of information for tax purposes. As an example, to quote from the OECD website, “Barbados will not be included in the list because it has longstanding information exchange arrangements with other countries, which are found by its treaty partners to operate in an effective manner. Barbados is also willing to enter into tax information exchange arrangements with those OECD member countries with which it currently does not have such arrangements. Barbados has in place established procedures with respect to transparency. Moreover, recent legislative changes made by Barbados have enhanced the transparency of its tax and regulatory rules.”
OFCs are concerned that OECD countries will go on fishing trips, simply trawling for information. As such, the requests must have specific information so as not to invade the privacy of investors in OFCs. And as such, the evidence of how successful these efforts have been is mixed. Nevertheless, it can be stated that when OECD countries approach OFCs with detailed requests with specific information, with valid grounds, co-operation is forthcoming.
Distinct roles
An International Monetary Fund (IMF) report published in 2010, Cross-border Investment in Small International Financial Centres, estimated that small OFCs accounted for about 8.5% of world cross-border holdings, with a small group a countries accounting for the vast bulk of these holdings. According to this IMF study, key players are the Bahamas, Bermuda, the Cayman Islands, the UK Channel Islands (Guernsey, Jersey, and the Isle of Man), the British Virgin Islands and the Netherlands Antilles. However, it is the Cayman Islands which is largest among this group, accounting for about half of the total international balance sheet.
There are several financial services that are provided by financial centres, including international banking, insurance, asset management, mutual funds and structured finance. Among the countries reviewed in the IMF report, only the Cayman Islands provides all of these services on a significant scale. This is important because if it were the case that these OFCs ‘did nothing’ and were unregulated, then each OFC would nominally provide all these services, with the functions undertaken elsewhere. In contrast to this, each OFC specialises in a set of niche tasks.
Taken together, the group of small financial centres is important across several lines of production of financial services. These include international banking, insurance, collective investment schemes, asset management, trusts and structured finance, with the mix of activities varying across the individual countries in line with scale and the level of specialisation. In general, the small financial centres perform niche tasks that correspond to the production of intermediate financial services.
Walid Hejazi is a professor at the Rotman School of Management, University of Toronto.
