Offshore Banking Basics

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By L. Burke Files

So often we view those people with offshore accounts as “suspicious” by definition.  But any good investigator must deal not only with the transaction but with the motivation behind the transaction.  Many people, even upstanding US citizens, have moved trusts and investments overseas to protect them from taxation, the machinations of greedy heirs, or confiscation due to litigation.  This article can be used as a primer on why there are offshore financial centers and how they are used for legitimate business reasons.

The leading offshore centers vary widely in the volume of business they do, their level of sophistication, their market penetration, and the breadth of services they provide.  The Cayman Islands has perhaps the most advanced operation, having edged past the Bahamas in recent years.  Panama’s operation is one of the oldest, but over the years it has fallen victim to political instability and the wrath of the US government.  The Netherlands Antilles operation, another old veteran, has also become a casualty of US displeasure.  Its upstart neighbor, Aruba, is now vying for the same business.  Barbados and the British Virgin Islands have recently scored notable successes.  Anguilla and the Turks and Caicos Islands hope to emulate the business of their successful British neighbors.

Most of these places are small, rather isolated, tropical islands where the pace of life is, as the tourist brochures like to say, unhurried.  While this is no doubt an admirable quality, leisure is not always conducive to success in business.  Nevertheless, these nine jurisdictions account for bank deposits totaling well over $500 billion, roughly half of all the world’s merchant shipping registrations and thousands of offshore companies.

The Cayman Islands and the Bahamas rank among the world’s leading international banking centers in terms of size, alongside or ahead of countries such as Switzerland and West Germany. The Caymans and Barbados are also two of the world’s leading offshore insurance centers.  Panama hopes to become the world’s largest center for ship registration this year, and the Bahamas’ ship registry is larger than those of India, Brazil or South Korea.

It should be remembered that most of the financial business conducted in these financial centers exists on paper only.  Transactions and decisions are usually made in the great cities of the world and instructions are relayed offshore.  There, lawyers, accountants, bankers and bureaucrats take care of the paperwork and occasionally act as hosts to visiting clients.  Most new business comes in the form of referrals.  Nevertheless, these activities have resulted in an avalanche of fees to professionals and governments in these regions, and there is no sign of any decreased demand for their services.

It is small wonder that there is keen competition for the business.  Apart from tourism, most of these territories have no visible means of support. Lacking natural resources, capital, and manpower, they generally have no significant agricultural or industrial base and, therefore, are dependent on the outside world for most supplies.

Offshore businesses generate foreign exchange, tax revenues and employment, as well as indirect benefits such as tourism.  Offshore businesses offer the opportunity for economic diversification and are far more profitable than tourism, once the necessary infrastructure is in place, because they require less manpower and less foreign exchange spending.  Moreover, even a moderate degree of success can have a large economic impact in the smaller islands.

The Need

The need for offshore financial services arises from restrictive jurisdictions and from numerous other reasons.  For example:

1. An individual wishes to escape from onerous or capricious restrictions imposed by a government.

2. Business owners wish to allow corporate diversification into activities not permitted within their country.

3. Companies or individuals wish to avoid foreign exchange controls.

4. Companies or individuals wish to avoid restrictions on foreign investments.

5. Moslem countries prohibit the payment of interest in Moslem countries.

6. Financial asset holders wish to guard against high inflation in other countries.

7. Owners of wealth wish to provide a stable mechanism to transfer their wealth to heirs without taxation and to be free of the constant rule and tax changes in certain high tax and high regulation jurisdictions.

8. Asset owners need a safe haven against political upheaval and wars.

9. Companies or individual citizens may need a properly, established contractual intermediary for profit capture away from high tax and high regulation jurisdictions. The need and the desire for these types of services is evident in the phenomenal growth rate of offshore institutions during the last 10 years.

The Industry and Trends

Since the second world war, the demand for offshore financial services has grown rapidly as a result of higher taxation and expanding regulations in many industrialized nations, as well as political instability in some emerging nations.  The rise of multinational companies, whose primary allegiance is to shareholders rather than to any particular country, the expansion of world trade and cross-border investment, and the increase in both personal and corporate wealth have all helped to stimulate this growth.  The growth in offshore financial services has been assisted by revolutionary advances in technology and communications, which have helped erase the barriers of time and location for even the most remote parts of the world.

Until recently, offshore financial centers were commonly described as “tax havens,” a term that many offshore depositors disliked because it suggested that they help people circumvent the laws of high tax countries.  But the term accurately reflects the genesis of the business and remains a condition of its continued existence.  No offshore financial center could hope to survive if it imposed any significant levels of taxation.

Tax evasion is probably one of the oldest pastimes known to man, and there is no doubt that offshore financial centers are sometimes used for this purpose.  But many offshore activities could more accurately be described as tax planning, using legal mechanisms to reduce or eliminate taxes on income, wealth, profits and inheritance or to accumulate tax-free income offshore, pending repatriation to a taxable jurisdiction.

Such arrangements are often used when the income or assets in question are international in nature.  For example, an author or inventor who receives royalties from many countries may have them paid into an offshore account until the funds are needed at home.  International mutual funds may be registered offshore to minimize regulation and boost investor returns.  International traders may operate through offshore businesses to increase trading profits, and owners of foreign capital assets may incorporate offshore to avoid capital gains taxes when the assets are sold.  In many cases, some tax is ultimately paid in the home country, but offshore strategies can help minimize the tax burden or permit repatriation at an economically more favorable time.

Tax minimization is not the only reason for using an offshore financial center.  Freedom from regulation is another major attraction as individuals and businesses seek to escape what they regard as onerous, unreasonable, or capricious restrictions imposed by politicians.  It is no coincidence that banking, insurance, and ship registration are three of the main pillars of offshore business.  They are among the most heavily regulated industries in developed countries.  Again, offshore financial centers provide legal mechanisms through which these businesses can avoid very costly and time-consuming regulations in certain circumstances.

Sometimes, establishing offshore operations can also allow diversification into activities not permitted at home; or it can provide a more level playing field if a company is subject to heavy regulation in its own country while its foreign competitors are not.  A prime example is the use of foreign jurisdictions by United States and Japanese banks to engage in securities and insurance businesses, which are prohibited at home.

More generally, offshore financial centers are often used to avoid foreign exchange and capital controls, restrictions on foreign investment, and other domestic constraints, such as the prohibition against interest payments in some Muslim countries.  In the past, capital controls in the United States were a major factor behind the initial growth of the enormous Euro-dollar market and its offshore tributaries.  Similar restraints are still a fact of life in many countries, which attempt to limit the inflow of foreign exchange and the outflow of capital for domestic political reasons, even if such limitations undermine the operations of local businesses.  The result is usually a flourishing black market and increased reliance on offshore financial centers.

Another source of demand for offshore services has been the need for a “safe haven.”  Upheavals in Europe before the first and second world wars stimulated the movement of assets and holding companies to neutral and offshore locations.  Political crises and economic realignments have also made wealthy Europeans nervous at times.  For example, it is a fact that one well-known European company transferred a substantial amount of assets offshore a few years ago, fearing that its union would make unacceptable demands after a swing to the left in local elections.

Today, the greatest need for a “safe haven” is probably felt by the more affluent citizens of many countries.  Having accumulated some liquid capital, their principal investment goal is to preserve and protect their savings, often from rampant inflation, corruption, and government incompetence at home.  Investing the funds abroad through offshore financial centers accomplishes their investment objectives.  This phenomenon, usually known as “capital flight,” stems from the collapse of confidence in governments, institutions, and currencies due to political instability and economic disarray or uncertainty.  By all accounts, the amount of capital flight from foreign countries held in offshore banks is vast.

Offshore banks are improving their image by:

1. Locating in countries with a good or improving reputation as real offshore financial centers with viable legal and regulatory systems. (eg. British, Swiss, Dutch).

2. Engaging in legitimate local and international transactions with individuals and firms of good reputation.

3. Assisting in local and international development projects and small business loans.

4. Assisting in the development and education of local personnel and civic minded persons.

5. Engaging in image building advertising in local and international financial publications.

6. Offering courteous and competent services to customers and regulatory authorities.

7. Having as shareholders advisors, employees, and individuals of competence with good reputations.

8. Lastly, and importantly, maintaining a very strong and conservative financial structure.

Adam Smith’s economic theory of jurisdictions with a competitive advantage holds true.  The offshore financial centers exist because capital flows from where it is heavily taxed, controlled or constrained to areas where it can work its hardest for its owners.

L. Burke Files is a P.I. specializing in financial investigations and research.  He lives and works in the Phoenix metropolitan area and may be reached at (602) 838-1728.

* Ranked by deposit banks’ foreign liabilities at mid-1988 Source: IMF (International Monetary Fund,  NYC)

  THE WORLD’S LEADING CAPTIVE INSURANCE CENTERS

* Ranked by estimated number of captives domiciled there

Source:  Captive Insurance Company Directory 1994, a Tillighast  publication (Stamford, Connecticut).

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