Off-Shore Finance

Origins

The Second World War was entering its final stage as the attendees of the Bretton Woods conference convened to determine the post war financial order of the world. The influx of money into the United States due to World War I and the loans of the yet unfinished World War 2 made the US hold close to half of all gold reserves world wide. This made them yield considerable power money wise entering the negotiations in a world in which all currencies had a gold peg.

Among the impossible trinity (pick two out of three) of stable exchange rates, economic sovereignty and free capital, the representatives of the attending nations decided to impose capital controls on its citizens in favour of stable currencies and macro-economic sovereignty. This essentially restricted banks to only do business in their respective countries as money could not leave a country on a whim or at all.

This was a severe blow to the bankers in the City of London which had been accustomed to banking in the economic sphere of the British empire. It put the City of London into a comatose state as there wasn’t enough business to do for the banks which had previously serviced the financial needs in an empire encompassing close to a quarter of the worlds populations at its peak.

Fortunately for the British banking establishment, the Bank of England was more supporter than regulator as everybody knew everybody else in the upper echelons of British society. The attendance of exclusive private schools and the shared reminiscence of the might of the British empire instilled a sense of entitlement that the internationally agreed upon laws did not apply to them.

Thus when the USD from the Soviet foreign banks started to being lent out by British banks, the British regulators were happy that international banking had returned to England. These dollars that circulated outside the control of the Federal Reserve that was responsible for them were called EuroDollars. In 1963 the first EuroBonds were sold which were unregulated bearer bonds. Now bearer bonds are the perfect tool for tax evasion and money laundering. Essentially the are like an ultra valuable dollar bill with a worth of whatever the issuer thinks fits his needs. No record is kept of their purchase or sale as they are unregulated. Thus you can buy them in one part of the onshore financial system, cross any border you want with the piece of ultra valuable unregulated paper, and sell it somewhere else.

The money for the exploding EuroBonds market came from all the hidden money stashed away in the Swiss bank vaults. If you have money in numbered bank accounts in Switzerland you’re definitely happy that your money is safe. But at the same it could be working for you, being lent out to other people.

The German banker Siegmund Warburg and Scottish war hero Ian Fraser organized a quite dizzying setup to ensure that the bonds they were issuing skirted around every possible regulation and went through every imaginable loop hole. Often these financial products used different quirks in different European countries to their advantage to remain as unregulated as possible, something called regulatory arbitrage.

The first EuroBonds by Siegmund Warburg were formally issued in Schiphol airport in the Netherlands. They paid their interest in Luxembourg, free of charge. They were listed on the London Stock Exchange. And the borrower was officially the Italian Autostrade, an Italian state motorway company, while it was in fact the Italian IRI state holding company. All while being a bearer bond as it was registered and regulated nowhere.

From there the EuroMarkets exploded in all directions right under the pathetic nose of the Bank of England which was actively doing nothing, happy that business was flowing again in London. Business, which economists and politicians had prudently and wisely restricted through capital controls to shield the real economy from financial crashes.

In 1960 the EuroMarket which were mostly USD sloshing outside the US was worth 1 Billion, ten years later in 1970 it was already 46 Billion USD. In 1971 Nixon abolished the Gold standard which effectively initiated the decline of Bretton Woods. Together with the shift towards a more neoliberal stance, capital control were revoked starting in 1973 and by 1979 effectively all capital controls were gone. By 1980 the EuroMarket had thus ballooned to 500 Billion, and surging to 2.6 Trillion in 1988. It should be noted that EuroMarket quickly came to encompass any freely movable currency besides the USD that one could think of. So in 1997 the EuroMarket centered on London represented 90% of all international loans TI92.

Wealth in Off Shore Finance System

It is difficult to estimate the amount of wealth that is stored in the offshore financial center as the purpose of offshore is to remain hidden and untraceable. Gabriel Zucman estimates it to be around 8% of all wealth. The way he proceeds is to analyze the liabilities-holdings gap when comparing international statistical data on wealth. If you had a secret bank account you would most likely want your money to do something, like be invested in stocks. It turns out that 1/3 of the American stock market is held by Swiss bank accounts.

Let’s assume a British person has hid wealth in Switzerland and tasked his Swiss bank to buy stocks in the US. What American statisticians see is that American stock is held by foreigners, which is marked as a liability. In Switzerland nothing is recorded, as the bank is merely holding the stocks not owning them. In the UK, no assets are recorded as the British persons wants his stock ownership to be kept secret.

Now normally the assets and liabilities should cancel each other out, as something being owned by a foreigner in one country should pop up as the property of that foreigner in his home country. But there is a massive hole valued at 7.6 trillion USD, which represents 8% of the global wealth, which is unaccounted for.

Another example is Luxembourg as the second largest incorporater of mutual funds. The regulators in Luxembourg say that 3.5 trillion USD are owned via shares in Luxembourg. But when you scour the statistics worldwide, one can only find 1.5 trillion USD officially registered in Luxembourg which means that 2 trillion USD are unaccounted for, held by people who do not want to claim their ownership of mutual fund shares.

Secrecy Jurisdictions

When people think about offshore finance and tax havens, they usually think of rich people not wanting to pay taxes. This is most certainly true but above all these offshore financial centers are secrecy jurisdictions, in which nobody knows what’s actually happening. A side effect is that if you don’t know that somebody parked his or her wealth somewhere, then you also can’t tax it. Another big draw for offshore centers is their prevalent deregulation, to the point of regulatory castration, in a laissez-faire approach to economics with which most economic historians will strongly disagree.

The way the rich, powerful, crooked or greedy (or any combination thereof) like to secure, hide and defend their wealth is through three main tools: trusts in the Anglo-Saxon sphere, foundations and shell companies.

• Trusts

Trusts are a patriarchic quirk of British law dating back to the dark ages. Back then, when a men went on the crusades, he obviously wasn’t home to defend his estate and property. And because women weren’t allowed to hold land, he signed his property over to a friend who remained back in England. The crusader would be the trust settlor, the friend staying in England the trustee and the wife and kids of the crusader were the beneficiaries. Thus the ownership was signed over to the trustee with the clear purpose that the trustee manages the property and assets in a way to benefit the beneficiaries.

Nowadays, trusts have lost their patriarchic purpose but now serve the nefarious purpose of hiding and defending secret wealth. The main purpose of a trust in our time is to protect wealth from taxation, regulators and creditors. They are created through the legal fiction of separating ownership from control.

For that reason they are for example very popular with rich Muslims. Islam declares having a mortgage and an insurance policy as haram, as planning out for the future goes against Allah’s divine plan and him taking care of you as a pious Muslim.

Besides cultural sensibilities, the sparsity of law and regulation make trusts very popular for wealth management. They are not taxed as entities, but are taxed where the trustee is registered. In a peculiar twist, offshore financial centers offer 0% tax rate on trusts and consequentially on trustees.

Since the trustee is the legally liable person of the assets parked in the trust, creditors and regulators who might be after the trust settlor’s assets can’t touch the assets as the settlor has ceded ownership to the trustee. And if you want to be really cautious, you can insert the OFC speciality of ‘flee clauses’ into a trust agreement. Should anybody come knocking on a trustee’s door or should more favourable terms be viable elsewhere, the trust can change legal registration in the blink of an eye.

English law foresaw the restriction on perpetuity, as they did not want assets accumulating in trusts. Over time, these accumulating assets could possibly give the trust structure outsized economic might and increase social inequality. Thus they were limited to 99 years to prevent economic dynasties. Guess what the offshore centers did: they abolished these rules. But Wyoming and South Dakota did the same thing, so it’s not only the Brits.

The legal advantage of trusts is that the law defines trusts as ‘a fidicuary relationship with respect to property’. Importantly, such a relationship can be defined in any way possible, allowing for multitudes of special arrangement. But even more importantly, the beneficiaries and the trust itself is nowhere recorded. So you can theoretically move 5 billion USD into an offshore trust, name your kids the beneficiaries and the tax men wouldn’t even know. This obscurity and outright secrecy makes trusts so appealing.

But at the same time there is the thorny issue of the trustee which you have to pick carefully. When offshore centers tried to vie for Asian ultra hight net worth (UHNW) individuals, they quickly realized that most Asian patriarchs were loath to relinquish control over their companies to a trustee.

Thus the British Virgin Islands VISTA structures were developed. The Virgin Islands Special Trust Act (VISTA) removed any duties, obligations and liabilities from the trustee. See, normally the trustee is liable for the successful managing of the assets put into the trust. This includes running an entire company, if the settlor so chose to park an entire company in the trust. With VISTA, the trustee only role is to be a placeholder for the owner of the company, while it is run by the settlor. Another innovation, if you want to call it that, was the creation of the protector role which allows the protector chosen by the settlor to remove and reassign trustee roles. While not really necessary for wealth managers of UHNWI’s as they are usually professionals, it does give more power to the settlor.

The Cayman Islands Special Trust Alternative Regime (STAR) innovated by removing the constraint of having people being the sole beneficiaries of a trust. STAR trusts expanded the purpose of a trust to literally anything, increasing the beneficiaries wealth or even political goals.

• Foundations

Foundations are popular for a similar reasons as VISTA and STAR trusts as they give the creator a lot of leeway. They are predominantly used by rich people from BRICS (the emerging markets Brazil, Russia, India, China and South Africa) countries, where wealth generation has been immense, but the formation of general trust not so much. Similar to Asian rich people from low trust countries, they also loathe the idea of relinquishing control to strangers. But with foundations, the founder has signatory authority on the foundation’s bank accounts, giving him full control. For example, Panama has developed itself into the center for Latin American wealth management, as Latin Americans have experienced much political unrest and have high force inheritance laws. Thus they want to protect their wealth without ceding control.

According to the Merriam-Webster dictionary, a foundation is ‘funds given for the permanent support of an institution’ or ‘an organization or institution established by endowment with provision for future maintenance’. Funnily enough, the definition goes on citing directly an offshore wealth management technique by naming ‘a trust administered by a foundation’ as an example. While most people attribute philanthropic ideals to a foundation, by law it is just assets and money given for the support of a specific cause for future generations. So in reality the purpose of a foundation can be anything the founder wants it to be.

A big advantage of foundations in terms of maintaining control is that the founder can be both beneficiary of the foundation and be the director of the council of the foundation. Coupled with the signatory authority, the founder can have maximum control over what happens with and inside a foundation. Also, assets can be moved in and out of a foundation, making it a flexible asset protection structure. Additionally, a foundation can open bank accounts and go into contracts. Compared to trusts which are a British common law structure and aren’t recognized by civil law, foundations are universally accepted.

The downside compared to trusts is that they have to be registered as a legal person, making them more visible than trusts. But Panama and the Seychelles already offer foundations with nominee founders such that the names of the real founders are in the dark again. Due to the public registration, administrative costs of foundations are higher, as bylaws and articles have to be formulated and they are usually audited. Also, transferring wealth into foundations can be taxed in most onshore countries and as a legal person a foundation can be sued and go bankrupt.

• Shell Companies

Compared to trusts, which are only recognized in common law countries, and foundations which have to hold up to public/governmental scrutiny, companies are universally recognized as legal entities. Similarly to foundations they can exist in perpetuity.

As the US have vigorously defended their spot on the top of the Financial Secrecy Index, shell companies can be bought for as little as 250 USD in states like Nevada, Wyoming and Delaware. In the more advanced secrecy jurisdictions they come with the extra flavour of nominee directors, which keep the beneficial owner’s name off the records. For the registration, these secrecy jurisdictions don’t require identification, but the company does require directors. So the nominee directors serve as directors for the shell company while doing absolutely nothing in terms of real managing of the company. There is a story of a 23 year old fast food cook who was the nominee director of a New Zealand company. The 20 USD he was paid were quite nice until international prosecutors knocked on his door, asking him why he was the director of an arms smuggling company.

Another advantage is that companies can open bank accounts and that credit cards can be given out on those accounts. Barclays, a British bank, had to admit that close to 19% of its credit cards were linked to bank accounts in tax havens registered to shell companies. Thus, presumably, the beneficial owners moved their wealth into tax havens, set up a shell company with a bank account, and then used a credit card on the shell company’s bank account to go shopping.

Some jurisdictions even offer bearer shares which is a stupendous money laundering tool. The transactions of bearer shares are recorded nowhere and the person who is the bearer of the share is the owner of it. But legally, the owner of those bearer shares can say under oath that as long as he’s not physically holding the share in his hand, that he’s not the owner of the company. So imagine a company laundering money and the police comes asking the supposed owner of the company, who’s exerting control over the company via bearer shares, whether he owns the company or not. Then the owner, who’s doing money laundering, can say ‘No’ and thats legally valid. Offshore is a weird world.

Shell companies are hid behind the lawyer-client privilege as a lawyer is used as the front man. This adds another lawyer of obfuscation since the name of the true owner of a shell company can’t be divulged by force. Thus, if the police comes knocking, the lawyer is protected from having to name the true owner of the company as it would violate the lawyer-client confidentiality.

Often, wealth and companies are placed in a trust-company structure. The company allows maximum flexibility and access to the parked wealth by offering credit cards and being able to move assets in and out of the company. The shares of the company are then put into a trust with a nominee. Thus the owner of the wealth and the onshore corporation can do whatever he or she wants. But in case the tax authority wants to inquire who all this wealth belongs to, the trust arrangement legally separates the settlor from is assets. Similarly, creditors can’t access the company assets as they belong to the trust and not the settlor.

• Limited Liability Partnerships

Your business interests can also be incorporated into a Limited Liability Partnership which are ‘tax transparent’. First of all, partnerships are subject to far less scrutiny than real companies, as only the partners have money in them. Thus only the partners money is involved and not the publics. Stock companies are more transparent as the public can invest in them so they are held to more stringent standards. Thus partnerships are in general more opaque as nobody but the partners have their money in them. But traditionally, partners were also on the hook should something go awry. Also, partnerships are taxed on a per partner basis, such that any profits or losses the partnerships accrues is passed directly onto the partners. Thus profits and losses are directly taxed with the individual partners, making the tax transparent.

Limited Liability Partnerships (LLP) were created on behest of the big four accounting firms on the Isle of Jersey as they wanted to have the cake and eat it too. So they wanted the opaqueness and maximal profit of a partnership with the protection of a separate legal entity which would be on the hook instead of the partners. In a normal partnership, if the business decisions go sour, the partners are on the hook as their share of the partnership makes them legally responsible. For example, if an accounting firm screws up while auditing and the audited company goes belly up, the partners of the accounting firm would be directly responsible for possible law suits by damaged share holders of stock companies. Partnerships would ensure that the partners of the accounting firm would have skin in the game thus forcing them to be stringent. Limited Liability Partnerships do away with such precautions and the accounting firms can happily screw up without fearing the repercussions: fees for me, losses for the public. Hurray.

Advantages of Tax Havens

Whereas the creation of the EuroMarket served the purpose of moving money into a less regulated sphere where it could generate more profits free from capital controls, the origin of tax havens is more muddled. Ostensibly, their original purpose was the provision of low tax and preferential tax regimes, but early on they put an increased emphasis on secrecy for individuals. Meyer Lansky had deep ties to the Bahamas and used them to launder money for the mob. Many of the trust regulations were aimed at people hiding their wealth as much from their families as from the tax authorities. In general, tax havens offered secrecy jurisdiction perks, of which tax evasion was a natural consequence since you can’t tax what you can’t see.

Multinational enterprises (MNE) are one of the financial players which use the preferential tax regimes of tax havens extensively. When people talk about tax evasion or tax avoidance, most of the lost tax revenues is due to multinationals not paying appropriate taxes. With the globalization of economies, many supply chains stretch across half the world. In fact 2/3 of all trade is done within multinationals as they move products and components over their supply chains.

The way multinationals cheat on governments tax revenue is through ‘transfer pricing’. Many multinationals have subsidiaries registered in different countries which sell components to each other as products move along the supply chain. Imagine that the iPhone is developed in a high tax country such as the US and sold by the sales department which is registered in a low tax country. The development division can sell the iPhone for a low price to the sales department thereby making only little profit in the high tax country. This creates a loss for the development division as R&D and production is expensive and they are selling the products cheaply. The sales department then sells the iPhone for the original price but as its registered in a low tax country such as Luxembourg or Ireland, there is only little tax on its profits. The mother company, Apple, thus pockets the difference in the tax rates.

Transfer pricing has led to some astonishing price mechanisms. Examples are water plastic seals from the Czech Republic to the parent company for 972.98 USD per unit, gloves from China for 4,121.81 USd a kilo and locks from France for 3,067.17 per Kilo. These import prices made the parent companies in the US overpay such they reduced their profits on which they could be taxed. Exports from the US were stupendously low as missiles exported to Israel were priced at 52.03 USD a piece, diamonds were exported to India at 13.45 USD carat, cameras were suddenly worth 7.44 USD when exported to Colombia and car seats were exported for a mere 1.66 USD to Belgium. So when the US parent company sold something, these were priced very low as it crossed the border to a subsidiary in another country. The parent company in the US made little profit which incurred little absolute taxes.

Google for example sold the IP of its search engine algorithm to an Irish subsidiary to which it pays licensing fees. The fees are costs for the US operations, thus diminishing the corporate tax rate, and increasing profits for the low tax Irish subsidiary. Similar schemes have led Ireland have trade surplus of 25% of its GDP which grossly distorts macro economic numbers.

Another aspect is the complete disregard for prudent finance and financial safeguards in offshore financial centers.

Safe for offshore financial centers, every country has capital requirements for banks. These capital requirements stipulate that a bank or financial institution has to keep a certain percentage of its assets as cash such that if the assets go bad, the financial corporation can offset the loss immediately with the cash reserves and is not endangered by the sudden loss.

But these cash requirements are understandably cumbersome for the financial companies as it is money they can’t put to use to generate profits. Offshore financial centers are attractive insofar as they reduce financial prudence to a minimum and require very little capital requirements.

This becomes interesting once we look at how credit increases the money supply. Most money is actually not printed by the central banks but generated through credit. A bank never actually has all the money of all the depositors on hand at all times but only has a little amount at its immediate disposal to fulfill the withdrawals of customers. Most of the money is tied up in long term loans and only because only a few customers withdraw all their money at once allows the bank to keep functioning with only little cash at hand. If all customers would withdraw their money all at once, due to a loss of faith in the bank safekeeping their wealth, we would have a bank run and the bank wouldn’t be able to pay out all its depositors and panic would ensue.

Lets assume that we have 100 USD, and the capital requirement $r$ is 10%. This means we have to keep 10% in cash at our bank and are allowed to loan out 90% to another financial player. The second party now has 90 USD and can in turn make loans to a third party with the remaining 81 USD once the 9 USD cash is kept. The third party now gets 81 USD and can give out 72.9 USD in a new loan after subtracting the 10% capital requirement. \(\begin{align} M_1 &= M_0 *(1-r) &&= 90 \\ M_2 &= M_1 * (1-r) = 100 * (1-r)^2 &&= 81 \\ M_3 &= M_2 * (1-r) = 100 * (1-r)^3 &&= 72.9 \\ M_4 &= \ldots \end{align}\) This forms a geometric series and if we were to continue to infinity, we’d get

With $r=10\%=0.1$ we increase the money supply tenfold but more importantly we create a chain of dependencies in terms of credit. By reducing the capital requirements we make every financial institution more susceptible to defaults, the chain along which the money bounces through the system longer and ultimately the entire system more fragile.

Offshore finance centres are appealing to the financial system as transactions are done in almost complete darkness due to the lack of oversight. Additionally, extremely restrained regulation basically results in little financial prudence i.e. very low capital requirements.

This results in a ballooning amount of EuroDollars created in this offshore market and an almost impenetrable interdependence between financial institutions. It is thus no wonder that the offshore markets were a great amplifier, conduit and cause of the financial crises.

Another problem in offshore financial markets is the proliferation of special purpose vehicles (SPV) that are created by their parent companies. The sole purpose of these subsidiary legal entities is to separate the risk of ventures in the SPV from the parent company. The assets do not appear on the balance sheet of the parent company and SPV’s have their own assets, liabilities and financial statements, yet the business decisions are made by the parent company. Upon creation, the rules and purpose of these vehicles are clearly defined and it receives funding from investors to buy the agreed-upon assets in its creation document. The lendors to the SPV can buy bonds or shares of the SPV and the worth of the SPV is defined by the assets it bought from the raised funds. Mostly, SPVs are used for securitization, such that interest payments far into the future can be monetized into a lump sum that the originator of the security can book now.

Enron used special purpose vehicles (SPV) in the Bahamas to offload debt. They sold their debt to specifically designed SPV’s, such that their debt was offloaded into the Caribbean ocean. Since their financial statements were separate from Enron itself, the parent company in Houston could claim to be in superb financial health.

Similarly, Northern Rock used the Granite SPV to offload mortgages into the offshore world and clean its balance sheet. The Granite SPV eventually grew to 50 billion USD but was hidden from regulators as the position did not occur on the balance sheet. The creation of SPVs in offshore financial markets is so popular due to their laxer regulation.

This is also the reason why the Bahamas claim to have 75% of the worlds hedge funds incorporated within their jurisdiction. Long-Term Capital Management for example was incorporated in the Bahamas and executed their massively leveraged investment strategy from there. AIG Financial Products that almost tanked the insurance giant all on its own by selling Credit Default Swaps to everybody asking was located in the City of London. These are just a few examples in which the non-existent regulation of offshore financial markets have resulted in massive collateral damage to society.

Advantages for Tax Havens

Tax havens themselves earn little through taxes as they have reduced them to basically zero or at least to a miniscule rate. Instead they use indirect taxation through the paying of fees and the support of a specialized work force which they can tax more. In bona-fide tax havens which specialize in company, trust and foundation registration, yearly fees are required which make up for the lost revenue.

It is important to note that tax havens often sell out their sovereignty at the expense of their own citizens. Many of them levy taxes on their citizens, while non-residents and their financial products are exempt from almost all taxes. Instead, they make money by taxing the lawyers, accountants and other financial services professionals.

Yet, this is exactly a problem as tax havens rely disproportionally on a single industry which makes them increasingly susceptible to sudden changes in regulatory framework of other countries. The poverty rate of Luxembourg has increased twofold as any redistributional policy is prevented on purpose. The spoils of the offshore financial services industry thus accrue in the hands of a small and often non-resident work force while the main population suffers from the cuts in basic services and increasing house prices and costs of living. The Crown Dependency of Jersey is another example where the local population is suffering disproportionately.

The small size of most tax havens gives the local governments little to work with. Would you build a huge production plant in a country with a demand of just 500.000 people? In case of the Bahamas, the only thing they have beyond offshore financial services is sugar which is hardly a future proof or otherwise lucrative source of income for the country. The small size also increases the probability that the country is ruled by an oligarchic or plutocratic elite which can utilize the proposed deregulation and offshoring as they make the rules.

Additionally, offshore finance requires little capital as you only need a good internet or phone connection and a mailbox which can be claimed as a headquarter by 2.000 to 12.000 offshore companies. Give or take.