This article was originally published by Financial Times.
The release of the Panama Papers has made vivid the role played by tax havens in hiding illicit gains. But the rapid growth in offshore centres in recent decades has been built on more than secrecy.
Amid the unsavoury revelations about authoritarian leaders and their intimates abusing offshore accounts provided by Panama’s Mossack Fonseca law firm, many financiers are springing to the defence of an industry they view as an essential cog in a world of increasingly cross-border trade and investment.
Alongside their misuses, they argue, offshore funds and shell companies also allow multinationals and individuals to manage a welter of tax issues from multiple jurisdictions where they operate. In some cases, they simply provide stability in an uncertain world.
“The international financial services industry plays a vital and largely positive role in the global economy,” said Nigel Green, chief executive of deVere Group, an international advisory firm.
James Quarmby, a wealth structuring expert at law firm Stephenson Harwood, agreed.
“Everyone has gone a bit over the top. They have gone too far. The point we need to remember is just because some naughty people have used offshore for money laundering and tax evasion, it doesn’t mean that everyone is using offshore companies for money laundering and tax evasion,” said Mr Quarmby, who called offshore finance centres “the grease on the wheels in international trade”.
For good or ill, tax havens have mushroomed in the era of globalisation in which the world’s economies have become ever more closely integrated.
They averaged 3.3 per cent annual per capita real GDP growth from 1982-1999, whereas the world averaged just 1.4 per cent annual growth over the same period, according to research by Jim Hines of the University of Michigan.
Demand for offshore services is intensifying. Boston Consulting Group last year reported that private wealth booked in offshore centres grew by 7 per cent in 2014 to reach $11tn.
“Current political and economic tensions, such as those in the Middle East and Latin America, continue to drive the demand for offshore domiciles that offer high levels of stability,” the firm said.
Fears of being targeted by kidnappers or fears that a government could expropriate assets are powerful reasons for using tax havens — as well as the desire to evade taxes or hide illicit wealth. But they also serve other legitimate purposes in the international financial tax system, say analysts and executives.
Capital Economics, a consultancy that examined the reasons why the British island of Jersey had become the custodian of an estimated £1.2tn of wealth in 2013, noted the importance of tax neutrality: An offshore centre with a zero corporate tax rate ensures that investors drawn from multiple jurisdictions are not exposed to double taxation, and only pay taxes that are due in their home countries.
It also highlighted the importance of “bespoke” regulation that allowed specific sectors to avoid the unintended inefficiencies of “catch-all” regulation of larger jurisdictions.
The flexibility of small offshore centres has allowed them to specialise. A 2009 report commissioned by the Treasury into the Crown Dependencies and Overseas Territories noted that many of them had “developed important niche positions in international financial markets”.
For example, the Cayman Islands are the world’s leading centre for hedge funds and also a significant wholesale banking centre, with high volumes of overnight banking business from the US.
The fallout from the data leak revealing widespread use of offshore financial centres by the rich and powerful is spreading
Meanwhile, Bermuda is the largest base for the “captive insurance” industry, where a company sets up its own insurance arm. It is also widely used by US multinationals to notionally “park” profits that may eventually be repatriated to the US.
More than $1tn of cash has been booked offshore, even if the money is actually held in US banks or Treasury bonds.
More generally, offshore investment hubs play a big role in global investment.
Unctad, an arm of the UN, reports that some 30 per cent of cross-border corporate investments have been routed through offshore “conduits” before reaching their destination, and this trend sharply accelerated during the second half of the 2000s.
In 2012, the British Virgin Islands were the fifth largest recipient of foreign direct investment globally with inflows at $72bn, higher than those of the UK, which has an economy almost 3,000 times larger.
A big reason is that investment flows in and out of China are mostly routed through offshore centres to benefit from more efficient incorporation and listing procedures, according to Professor Jason Sharman of Griffith university in Australia.
“Ease of incorporation, the ability to reduce capital and issue different classes of shares, the reliance on tried and tested legal concepts and systems, the flexibility of corporate structures and the tax-neutral treatment of investment from different sources all argue in favour of using international financial centres to invest in China,” Mr Sharman said.
But investment is also often routed through offshore centres to save tax. Unctad reported last year that an estimated $100bn a year of tax revenues were lost by developing countries as a result of offshore investment hubs.
“Not only do they cause economic and financial damage to countries, they also raise a basic issue of fairness,” it concluded.
It called for urgent action against tax avoidance but also warned that “the risk of negative effects on investment flows, especially to developing countries, must also be considered carefully”.
Cracking down too heavily might deter necessary investment for development that might otherwise have taken place, it said.
It said that even the World Bank and other development finance institutions used offshore investment hubs, in a sign they have come to play “a systemic role in international investment flows”.
As Mr Quarmby said: “They are way more necessary than people grasp.
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