¶ … Offshore Financial Centres and Their Effects on Global Economy
The past 3 decades or so have witnessed the proliferation of offshore financial centres that have drawn both criticism and praise for their cumulative effect on the global economy. These offshore financial networks included 36 jurisdictions by the end of the 1970s that involved three main types of geographical locations, inland enclave states, coastal enclave states and island states. The enclave states have established a global pattern of so-called satellite clusters that are compatible with four main business time zones with linkages to the major global and regional capital markets. The Western Hemisphere is generally served through the New York epicenter by the Caribbean and the Central American Basin; European enclaves, coastal enclaves and independent islands are included in the London epicenter; the Asian-Pacific region and Oceania are served within the Tokyo time zone by Hong Kong, Singapore, Vanuatu and Nauru and the final cluster is comprised of Persian Gulf jurisdictions providing service to Middle Eastern oil countries. Although official definitions vary, at the basic level, offshore financial centres provide financial services by banks and other agents to non-residents including the borrowing of money from non-residents and lending to non-residents. This can take the form of lending to corporates and other financial institutions, funded by liabilities to offices of the lending bank elsewhere, or to market participants. Although most of the financial services provided by offshore financial centres are legitimate, the tax advantages, privacy, lower banking costs and more relaxed regulatory systems that characterize offshore financial centres have also been exploited by organized crime and terrorist organizations. The purpose of this study was to provide a comprehensive and critical review of the relevant literature concerning offshore financial centres and their effect on the global economy, guided by the research question, "Is the demand for financial services going to increase or decrease the importance of offshore financial centres in the global financial market?" A summary of the study's findings and relevant conclusions are presented in the study's concluding chapter.
Contents
Chapter 1: Introduction
Statement of the Problem
Purpose of Study
Research Questions
Importance of Study
Scope of Study
Rationale of Study
Overview of Study
Definition of Key Terms
Chapter 2: Review of Related Literature
Chapter 3: Analysis and Discussion
Chapter 5: Summary and Conclusions
A Comprehensive Study of Offshore Financial Centres and Their Effects on Global Economy
Only the little people pay taxes. -- Leona Helmsley, 1989
Chapter 1: Introduction
Critics of offshore financial centres would likely suggest that the epigraph above indicates that Ms. Helmsley would have made a good "poster child" for the offshore financial services industry, while proponents would likely counter that the global economy absolutely needs such offshore financial services in order to grow. Despite the controversy and a modest reduction in the total number of offshore financial centres following the passage of the U.S.A. PATRIOT Act, there has been overall continued growth in the offshore financial services sector since 1936 that has resulted in hundreds of offshore financial centres (OFCs) being concentrated in several geographic regions of the world. These OFCs are typically located in small, low-tax jurisdictions that specialize in the provision of corporate and commercial services to non-resident customers (Suss & Williams 2002). The growth in offshore financial centres has been due in large part to several of the same reasons around the world. These centres feature specific tax advantages, enhanced privacy, lower banking costs and more relaxed regulatory systems than their onshore counterparts (Masciandaro 2004). According to an analysis conducted by KPMG (2010), one of the largest professional services firms in the world and one of the Big Four auditors, although they continue to focus on the same types of financial services, offshore financial centres must remain sufficiently flexible and agile to respond to rapidly changing conditions in the global economy.
Based on the evidence to date, offshore financial centres appear to be increasing in popularity for many of the same reasons (Offshore Financial Centres 2008). For example, offshore financial centres provide a viable alternative for banks that are competing in regions of the world where the emerging market economics are highly regulated, for example. A good indication of this can be seen in the amount of cross-border assets being exchanged through offshore financial centres (Offshore Financial Centres 2008). Besides the U.K. And the low countries of Belgium-Luxembourg (but including the Netherlands), total transnational exchanges with emerging countries increased from 58.5% in 1991 to a record of 67% in 1997 and as of year-end June 1999, receded to about 56% (Offshore Financial Centres 2008). This significant reduction in emerging economy exchanges may be attributable to a wave if consolidations that occurred in the Japanese banking systems during the late 20th century, together with the Asian monetary crisis that occurred shortly thereafter, resulting in a sharp decline in offshore financial services activity in Hong Kong (Offshore Financial Centres 2000). Since that time, the industry has experienced consistent growth in terms of the number of such centres as well as the amount of money that passes through them to the point where more than half of the global monetary supplies are handled at some point by offshore financial centres, an issue that directly relates to the problem examined by this study which is discussed further below.
Statement of the Problem
One of the recurring themes that quickly emerges from a review of the literature concerning offshore financial centres is their dual-edged qualities. On the one hand, offshore financial centres have been demonstrated time and again to be an essential component in successful multinational corporate business by facilitating financing and insurance requirements, as well as mitigating risk and by providing the foreign exchange services required between banks and commercial customers (Rose 2006). On the other hand, the same attributes that make offshore financial centres attractive for legitimate businesses are also highly attractive to organized criminal and terrorist organizations. Indeed, in popular context, offshore financial centres have become virtually synonymous with money laundering and tax evasion, and for good reason. Offshore financial centres have been exploited by these criminal groups with the assistance of collusion from some unscrupulous banking officials in ways that make their detection difficult or impossible, and regulating this industry has been challenging to say the least. In response to the illegal activities that have characterized the offshore financial services sector in the past, a wide range of initiatives sponsored by the international community have been implemented in recent years, including an OECD initiative designed to address the effects of harmful tax competition, the G7's Financial Action Task Force and the FSF, UNODC, the EU and international Non-Governmental Organisations (NGOs) (Rose 2006). These and other regulatory and law enforcement agencies around the world are actively involved in searching for better ways of monitoring and regulating the offshore financial services sector to identify criminal activity and reduce the prevalence of these practices in the future (Dwyer 2009). By and large, the overwhelming majority of offshore financial centres have been compliant with these initiatives and have implemented the OECD program targeting harmful tax practices (Dwyler 2009). Notwithstanding the increased costs of doing business represented by compliance with these initiatives (not to mention the lost illicit revenues that have been attained in the past), these trends in increased oversight are expected to continue to response to corresponding growth in the offshore financial services sector (Dwyer 2009). Although it might be possible to improve domestic tax receipts through the elimination of offshore financial centres, the impact on the global corporate community would be more than offset any gains realized through such a draconian measure (Dwyer 2009). Therefore, identifying the specific impacts that offshore financial centres have on the global economy represents a timely and important enterprise, a need that directly relates to the purpose of the study which is described below.
Purpose of Study
The overarching purpose of this study was to deliver a comprehensive and critical review of the relevant literature concerning offshore financial centres and their effect on the global economy. In support of this purpose, the study was guided by the research question below.
Research Question
Despite international restrictions on some of the offshore businesses, the research question that will guided this study was, "Is the demand for financial services going to increase or decrease the importance of offshore financial centres in the global financial market?"
Importance of Study
This type of study is important for a number of reasons. For instance, a 2008 updated report from the IMF emphasized that, "In recent years, there has been increased recognition of the need to improve understanding of the activities of offshore financial centers. Some offshore financial centres have captured a significant part of global financial flows, and their linkages with other financial centers creates the potential for their activities to affect financial stability in many countries" (Offshore financial centres: IMF Staff Assessments 2008, p. 1). Indeed, by definition, offshore financial centres are popular with the international banking community specifically because there are fewer restrictions involved, more lenient regulatory policies, and lower taxes than their mainstream banking industry counterparts; however, offshore financial centres do not have the same fundamental interests in protecting their depositors as their onshore counterparts because most of their depositors are non-residents who are located in other countries (Edwards 1999).
Because the home country is not required to reimburse foreign depositors for losses, there is no corresponding financial penalty for lax supervision; there is, though, a benefit to the country with lenient regulatory policies because of increased revenues generated and the employment opportunities these services provide (Edwards 1999). Furthermore, banks seeking to conduct multinational business are attracted to countries where incorporation laws and the regulatory framework offer less regulatory oversight (Edwards 1999). The quid pro quo nature of offshore financial services is clearly indicated by Edwards's observation that, "Multinational banks provide the offshore financial centre with increased tax revenue and employment for its citizens. Because the benefits outweigh the costs, offshore financial centres have a powerful incentive to maintain lenient regulatory policies. As a result, multinational banks incorporated in an offshore financial center successfully avoid supervision by an effective home country regulator" (1999, p. 1267). Given the scope of the offshore financial services sector at present and predictions for continued growth in the future, this type of study is clearly important by establishing an overview and "snapshot" of the industry as it exists today, as well as benchmarks that can be used for future comparisons.
Scope of Study
Based on the nature of the offshore financial services sector, the scope of the study extended to its global implications, with a specific focus on its effects on taxation and the global economy.
Rationale of Study
The research will show that notwithstanding their exploitation by criminal elements and terrorist organizations, offshore financial centres are not expected to go away anytime soon. The importance of the legitimate financial transactions that take place in offshore financial centres to the global economy make them an important addition to the international community and restrictions on the industry or its outright eliminated (if that was even possible) would have dire consequences for the global economy. According to Mckee, Garner and Mckee, "Through the activities they house, [offshore financial centres] are actually facilitators of various international activities. Indeed it appears as though the leading participants in the global economy, whether corporate or public, are in need of various services provided by or through offshore financial centers" (2000, p. 3). In this environment where each positive is balanced by a corresponding negative, identifying opportunities to eliminate the abuse of offshore financial centres by criminals and terrorists while improving their ability to provide vital legitimate financial services to the international community represents a timely and valuable enterprise.
Overview of Study
This study used a four-chapter format to achieve the above-stated research purpose. chapter one introduced the topic under consideration, a statement of the problem, the purpose and importance of the study, as well as its scope and rationale. Chapter two provides a critical review of the relevant and peer-reviewed literature, and chapter three provides an analysis and discussion of the findings that emerged from the review of the literature. Chapter four presents the study's conclusions and a summary of the research.
Definitions of Key Terms
Definitions of the key terms, abbreviations and acronyms that were used in this study are presented in Table 1 below.
Table 1
Definitions of Key Terms
Key Term
Definition
CDD
Customer due diligence
BCP
Basel Core Principles
FATF
Financial Action Task Force
FIU
Financial intelligence unit
FSF
Financial Stability Forum
IFC
International Finance Corporation
IMF
International Monetary Fund
KYC
Know your customer
MIGA
Multilateral Investment Guarantee Agency
OECD
Organization for Economic Cooperation and Development
OFC
Offshore financial centre
WBG
World Bank Group
Chapter 2: Review of Related Literature
Background and Overview
Although there is no universal definition of offshore financial centre, a number of such definitions have been offered over the years. According to Mauer, "There is a significant literature on the dimensions and definitions of the offshore finance industry. The first definitional quandary is whether offshore refers to a place or series of places on the one hand, or a phenomenon of financial flows on the other hand" (2008, p. 155). The legal definition provided by Black's Law Dictionary (1999) indicates that offshore transactions are financial dealings that occur outside of a given country. A more useful definition, though, is provided by the International Monetary Fund (IMF) which reports that, "Offshore finance is, at its simplest, the provision of financial services by banks and other agents to non-residents. These services include the borrowing of money from non-residents and lending to non-residents. This can take the form of lending to corporates and other financial institutions, funded by liabilities to offices of the lending bank elsewhere, or to market participants" (Offshore financial centers 2000, p. 2). There are some other ways to formally distinguish offshore financial centres as well. For example, an offshore financial centre is an area officially designated by the IMF as being a place where the following types of activity take place: offshore banking, investment, incorporation, company formation, foundation formation, trust formation, insurance and other vehicles of wealth preservation and asset protection; the criteria required to be placed on the official list maintained by the IMF are as follows:
1. Have relatively large numbers of financial institutions engaged primarily in business with non-residents; and,
2. Have financial systems with external assets and liabilities out of proportion to domestic financial intermediation designed to finance domestic economies (Mauer 2008).
Offshore financial centres must provide some or all of the following services:
1. Low or zero taxation;
2. Moderate or light financial regulation;
3. Banking anonymity (Definition of Offshore Financial Centers 2011).
The IMF also reports that offshore financial institutions can also assume the form of accepting deposits from individuals and taking those proceeds and investing them in other financial markets (Offshore financial centers, 2000). Some regions of the world appear to attract more of this type of business than others. For instance, according to Stessens (2000), numerous Caribbean jurisdictions are frequently identified as both secret and tax havens; however, this type of identification can also be applied to financial services centres located in Andorra, Malta, Channel Islands, Liechtenstein, Monaco, Madeira, Gibraltar, Switzerland and Luxemburg, countries and territories that are also described as being offshore financial centres; these jurisdictions are also categorized as being "fiscal havens" by the U.S. Internal Revenue Service (Stessens 2000). "In the context of financial transactions," Stessens adds, "the term 'offshore' refers to transactions which take place between non-residents. An offshore bank can be defined as a financial institution which is legally domiciled in one jurisdiction, but conducts business solely with non-residents" (2000, p. 93). Other formal definitions of offshore financial centres have been offered by authorities such as Jao, who reports that, "By general agreement, an 'offshore financial centre' or, more narrowly, an 'offshore banking center' is a center where the host country accords preferential treatment to banks and other financial institutions in terms of taxation, regulatory restrictions, prudential supervision, and so on, provided that such banks and financial institutions deal only with nonresidents and in foreign currencies and are thus effectively insulated from the host country's domestic financial sector" (2001, p. 45). According to Stessens, though, "By this definition 'offshore transactions' can take place in any jurisdiction, but as a result of their fiscal and secrecy rules, some jurisdictions attract a very high number of offshore transactions and offshore banks and have thereby become known as offshore financial centres" (2000, p. 93).
Clearly, though, there is sufficient evidence available that indicates money launderers frequently use offshore financial centres to conceal the proceeds of criminal activities or legitimate earnings to avoid taxation on their revenuel. As Stessens observes, "In both instances they are likely to benefit from the secrecy rules and from the inertia of local law enforcement or fiscal authorities or their refusal to reply to requests for information" (2000, p. 93). Efforts to address the illegal activities that have taken place in offshore financial centres have been hampered by the increasing internationalization of the money laundering enterprise, and a broad-based and sustained effort is required by the international community in order to be effective at all (Stessens 2000). According to Stessens, "Strictly national interventions are likely to result only in a geographical shift of the phenomenon. Because of the increasing globalisation of the financial world, the proceeds of crime which have been deposited within one jurisdiction where the rules on the prevention of money laundering are less strict can penetrate into the financial system of other countries as well" (2000, p. 93). These jurisdictions fall within the global payments system but operate largely without any restrictions; to the extent that these jurisdictions avoid such restriction, they will continue to attract criminal and terrorist elements who want to take advantage of these lax banking systems (Stessens 2000).
Based on these foregoing definitions, it is clear that so-called "offshore transactions" can actually be conducted in any jurisdiction, but based on their specific fiscal and secrecy rules, some jurisdictions attract a very high number of offshore transactions and offshore banks and have thereby become known as offshore financial centres. In this regard, Stessens advises that, "It is of course evident that money launderers often use offshore financial centers to stash away the proceeds of criminal activities or legitimate earnings to dodge taxes on their capital. In both instances they are likely to benefit from the secrecy rules and from the inertia of local law enforcement or fiscal authorities or their refusal to reply to requests for information" (2000, p. 93). This point is also made by Schiffrin and Bisat who report, "Offshore financial centres have become synonymous with banking secrecy and tax evasion. In today's open and global financial world, characterized by a high mobility of funds and the rapid development of new payment technologies, the tools for laundering the proceeds of serious crimes as well as the means for anonymous protection of illegal assets in certain countries or territories make them even more attractive for money laundering" (2004, p. 231).
Current debates concerning the true nature of offshore financial centres tend to focus on the following series of questions:
1. Whether offshore is a consequence of the system of state sovereignty or a consequence or a cause of global financial liberalization;
2. Whether offshore is an effect of the law or an effect of markets and inherent structural tendencies in capitalism;
3. Whether offshore is part of a long-term story about conflicts among elites in offshore jurisdictions, linked to local development efforts, or delinked from national (ist) aspirations in those jurisdictions; or,
4. Whether offshore is an index of a new postmodern political geography (Mauer 2008, p. 158).
In reality, any jurisdiction can serve as a tax haven for commercial enterprises and individuals that are located in more highly regulated venues provided that it features lower tax rates or more favorable secrecy laws. As a result, a number of such jurisdictions have specifically designated tax havens that offer different rules for non-residents, as well as a high degree of bank deposit and/or corporate ownership secrecy (Rawlings 2005). Proponents of offshore financial centres would most likely emphasise the positive aspects of such jurisdictions by pointing to the opportunities for tax, estate, and corporate planning they offer rather than tax evasion or money laundering activities which these jurisdictions also attract.
In spite of their use by criminal elements, the fact remains that offshore financial centres are an important element in the conduct of multinational corporate business today, providing trade financing, insurance, pension administration, as well as more sophisticated financial instruments such as derivatives and hedge fund investment guidance (Mauer 2008). From a fundamental perspective, offshore financial centres offer valuable risk mitigation services as well as real-time guidance concerning the movement of resources as well providing for the efficient processing of foreign exchange between corporations and banks (Mauer 2008). Moreover, at other levels, offshore financial centres provide the opportunity for individuals and corporations to manage income streams from different jurisdictions without being forced to deal with double-taxation issues (Mauer 2008). As a result, the management of such potentially costly taxation regimens means that offshore financial centres represent an important form of asset protection for those entities that require such services, and the mitigation of risk through the techniques used by offshore financial centres are widely recognized as being sound business practice (Rawlings 2005). Nevertheless, the potential always exists for offshore financial centres to engage in illegal practices that are intended to camouflage the true source of profits and cloud the distinction from revenues that are generated through legitimate trade and those monies received as a payment of some type (Mauer 2008). Not surprisingly, these same types of activities can make the application of relevant taxation laws difficult or even impossible. The cumulative effect of these offshore financial services activities on taxation is discussed further below.
The Effect of Offshore Financial Centres on Taxation
Given the high stakes that are involved, the importance of applying appropriate tax laws on monies passing through offshore financial centres is clearly a high priority. A recent report from the World Bank's International Finance Corporation (IFC) notes that private sector projects in which the World Bank Group (WBG) invests through the IFC and Multilateral Investment Guarantee Agency (MIGA) should be subject to appropriate and transparent taxation by host countries (Offshore Financial Centers and Tax Evasion in World Bank Operations.2010). Likewise, sponsor home countries should possess the ability to collect appropriate taxes, and the countries must remain in compliance with requirements to report income generated from proceeds from any initiative (Offshore Financial Centers and Tax Evasion in World Bank Operations.2010). More stringent safeguards have been implemented in recent years with the primary objective of assuring the reporting of all such transactions (Offshore Financial Centers and Tax Evasion in World Bank Operations.2010). At present, the WBG primarily responses to the issue of offshore financial centres and tax evasion by engagement with its member countries and through coordination of its activities in collaboration with other international organizations and civil societies (Offshore Financial Centers and Tax Evasion in World Bank Operations.2010). The main framework for the engagement by the WBG with member states and coordination with others is the strengthening of tax systems, improved due diligence in private sector investment operations as well as domestic resource mobilization (Offshore Financial Centers and Tax Evasion in World Bank Operations.2010).
The strategy used by the WBG to address tax evasion and to help assure the appropriate use of public resources to date has largely focused on strengthening tax systems and applying anti-corruption efforts in developing nations. These efforts are in the process of being further amplified to provide support for nations in order to comply with recommendations from international organizations concerning ways to improve tax transparency, thereby facilitating their participation in the broader effort to address tax practices that fall outside of legitimate avenues (Offshore Financial Centers and Tax Evasion in World Bank Operations.2010). Because of the public resources they have been entrusted with, the World Bank Group regards any level of tax evasion in any transaction as being unacceptable. In response to this need to ensure all transactions are legitimate, the WBG applies due diligence in order to ensure that the structures that it invested in are selected for legitimate purposes and are not engaged in tax evasive practices, tax abuse, or other illicit purposes (Offshore Financial Centers and Tax Evasion in World Bank Operations.2010).
It should be noted, though, that there are no provisions in place that would prevent the World Bank Group from engaging in transactions with offshore financial centres provided that all of the partners involved comply with controlling legislation and regulations and a high degree of integrity is maintained throughout (Offshore Financial Centers and Tax Evasion in World Bank Operations.2010). In this regard, the World Bank Group reports that, "For example, jurisdictions may be used to avoid double taxation of investments in developing countries, or may provide legal infrastructure that a given host country lacks. However, a lack of transparency and inability to exchange information on the part of some jurisdictions can provide an environment that facilitates cross-border tax evasion, fraud, money laundering, and other illegal activities" (Offshore Financial Centers and Tax Evasion in World Bank Operations 2010, p. 4). In order to ensure that all aspects of a transaction are in fact legitimate, the World Bank Group's IFC and MIGA more closely scrutinize any projects that involve offshore financial centres in an effort to ensure the legitimacy of the structures that are being proposed (Offshore Financial Centers and Tax Evasion in World Bank Operations.2010).
As noted above, although much of the financial activity conducted in offshore financial centres is conducted for lawful purposes, a common theme in the literature is how some individuals and criminal enterprises are taking advantage of these offshore financial institutions to avoid taxation in their own countries. For example, Shelley reports that, "The ability to deposit large sums in offshore bank accounts that are outside the scrutiny of governments has reduced risks and permitted illicit capital to grow without taxation. Outside the regulations of the world's major financial systems they enjoy a competitive advantage for their capital that permits higher profits" (p. 605). The attractiveness of offshore financial centres, particularly for certain individuals and commercial enterprises in need of such services, is based in large part on their lenient tax regulations that permit non-residents to avoid taxation on their capital (Shelley 1998).
Offshore financial centres therefore provide both the opportunity and means for individuals and corporations so inclined to do so to use international capital in ways that are unlawful in their more heavily regulated countries of origin. Indeed, the absence of regulation is what makes offshore financial centres highly desirable for money launderers because they are cloaked in secrecy, provide a haven from onerous taxes as well as the capability to easily transfer capital. To date, the International Monetary Fund has identified more than a dozen major offshore financial geographic centres (see map at Figure 2); significant numbers of these institutions are situated in the Caribbean, Southeast Asia and Europe near other major financial centers (Shelley 1998). A good example of this can be found in the Cayman Islands where there are 550 banks for a total population of just 30,000 citizens, and only 17 of these 550 banks maintain a brick-and-mortar presence in this jurisdiction with 533 banks conducting the vast majority of their transactions using telecommunications of some sort (Shelley 1998). In fact, based on estimates from the United Nations Drug Control Programme, Shelley reports that "more than half of the world's stock of money transits through offshore centers," with about U.S. $2 trillion of private wealth -- 20% of the world total -- invested there" (emphasis added) (p. 605).
Likewise, a recent report from Jennings cites the need for offshore financial centres because they are essential for the health of the global economy. In this regard, Jennings notes that, "Whether G-20 leaders choose to recognize it or not, the Cayman Islands and other well-regulated offshore jurisdictions are key players in the international financial community, ideally placed to play a part in a solution to the present economic difficulties" (2009, p. 2). These observations indicate that offshore financial centres do in fact have an enormous impact on the global economy, but in both positive and negative ways and the balance between the two varying over time, depending on who is asking and who is being asked -- and the dual-edged nature of offshore financial centres is thus made abundantly clear. At one extreme are world leaders who place the blame for the ongoing global economic crisis squarely on offshore financial centres. For example, in a speech to the U.S. Congress, British Prime Minister Gordon Brown asked, "How much safer would everybody's savings be if the whole world finally came together to outlaw shadow-banking systems and offshore tax havens?" (quoted in Jennings 2009, p. 2).
The dichotomous nature of the offshore financial services sector as representing an important asset for legitimate business purposes as well as illicit ones is also cited as a reason the sector is so difficult to oversee and regulate. The assertion by Prime Minister Brown and other political leaders that offshore financial centres were to blame for the global financial crisis are misplaced, though, and Jennings specifically points to the results of a recent U.K. Financial Services Authority report that identified the real culprits involved in the financial crisis who it turns out are among their most vocal critics. According to Jennings, "The answer to the prime minister's question is simple: banning offshore centers won't make a blind bit of difference in making financial markets safer or less volatile, and in fact could make things worse. A recent report from the Financial Services Authority, the U.K. regulator, explicitly noted that offshore financial centers were not the cause of the global financial crisis. Instead, the report blamed inadequate regulation of banks in London and New York. Bashing offshore banking is just a convenient smokescreen for the shortcomings of 'onshore' oversight" (2009, p. 3). By referring to the legitimate business transactions using negative umbrella terms such as "shadow-banks" and "tax havens" in their criticisms of OFCs, onshore regulators and politicians are apparently seeking to divert the blame away from themselves as far as possible, and offshore seems to be as far as they can get. For instance, Jennings reports that, "The nature of business undertaken offshore is easily misrepresented, too. For example, my firm's office building, Ugland House in George Town, Grand Cayman, has drawn attention because it provides registered office services to over 18,000 companies. U.S. President Barack Obama, during his election campaign, referred to Ugland House as 'either the biggest building or the biggest tax scam in the world.' This elicited cheers from the audience but overlooked the fact that there are many such places all over the world, including onshore jurisdictions" (2009, p. 3). By lumping Ugland House with all offshore financial centres in the minds of the public, politicians and others have succeeded in painting this financial services sector with a very broad brush that is inherently unfair and for the most part unjustified. As Jennings points out, "Ugland House simply provides companies with a registered office address as required by local law, a law similar to that of every U.S. state. A single building in Delaware, for example, provides a registered office for over 200,000 companies. A well-researched report by the U.S. Government Accountability Office, the congressional watchdog, fully acknowledged Ugland House's registered office function and has helped to confirm the reality" (2009, p. 3).
In reality, offshore financial centres do provide a number of valuable business and financial services that positively affect the global economy in significant ways. Because these financial services are their core competencies, many OFCs are well situated to provide the financial expertise needed by private individuals and even major corporations. For instance, Jennings reports that:
Cayman Islands companies help American businesses, and fund managers in particular, compete for and service an international client base. International businesses with stakeholders from several countries frequently have to choose where to incorporate a business without giving any one stakeholder a 'home field advantage.' Also, many international investors will not invest directly in a U.S. company for a variety of good business, tax and legal reasons, such as class action litigation risk. Cayman solves these problems by enabling businesses and investors from around the world to form an entity in a neutral jurisdiction with stable political and judicial institutions, a deep reserve of local professionals, and a legal system that safeguards the rights of creditors and investors (Jennings 2009, 3).
While the financial services needs of every individual and corporate entity will be unique in some way, the broad range of expert financial services assistance being provided by legitimate offshore financial centres has profound implications for the global economy in multifaceted and interrelated ways that make precise calculations difficult but the extent of this impact can be readily discerned from just the activity taking place in the Cayman Islands and the United States. For instance, Jennings reports that, "Cayman Islands companies engage in a range of cross-border business transactions. For example, they help Boeing sell aircrafts to emerging-market airlines; enable U.S. corporations to access global markets more competitively; enable banks to make secured loans to finance power projects in developing countries; and help hedge fund managers to attract international investors. These transactions support thousands of jobs and ultimately generate taxable business activities in the United States and other G-20 countries" (Jennings 2009, p. 3).
More importantly, perhaps, is the fact that although these offshore financial centres are a so-called "tax haven" in that they help banking customers avoid double taxation, they do not help their customers avoid taxation in their home jurisdictions. In this regard, Jennings points out that, "The fact that Cayman is tax-neutral does not affect the obligation of the stakeholders in these transactions to pay tax in their home jurisdictions" (2009, p. 4). The Cayman government remains committed to combating tax evasion and has taken steps to improve transparency requirements; furthermore, the country has become a signatory to a number of agreements with the United States and other countries to promote collaborative reporting and financial measures as well. For instance, Cayman has:
1. Entered into a number of Tax Information Exchange Agreements with other governments (these include several unilateral agreements);
2. Shared tax information with U.S. authorities; and,
3. Adopted the E.U. Savings Directive in 2004 that provides for automatic reporting of accounts established by E.U. citizens (Jennings 2009).
Moreover, Cayman has established a proven track record of cooperation and compliance with these voluntary agreements. The U.S. GAO report confirmed, for example, that "Cayman has won plaudits from U.S. federal agencies, including the Internal Revenue Service, for its timely cooperation with information requests" (Jennings 2009, p. 4). In fact, Jennings absolutely bristles with righteous indignation when it comes to the types of negative connotations implied by President Obama's characterization of Ugland House and even counteracted the U.S. On its own track record. For instance, according to Jennings, "Cayman operates a well-regulated financial system. Bernard Madoff, for example, could not have run his Ponzi scheme from Cayman, where local regulation requires investment managers to use an approved and registered auditor. Also, Cayman's anti-money laundering laws are recognized by the Financial Action Task Force as more compliant with international standards than those of the U.K. And by the International Monetary Fund for promoting a 'strong compliance culture'" (2009, p. 4). Indeed, rather than causing the global economic crisis, Jennings argues that offshore financial centres have helped to minimize its overall impact and have hastened the global economy's recovery in the process. As an example of this, Jennings notes that Cayman provides an essential avenue for inward investment into the world's major economies, which of course includes the U.S. In support of this assertion, Jennings cites
U.S. Treasury figures that show Cayman investment funds are the third largest holders of U.S. debt, both public and private. According to Jennings, "Cayman investment funds are already lining up to play a role in the economic recovery by attracting international institutional investors to investment funds that will support economically productive ventures, including many in G-20 economies. For example, several funds registered at Ugland House have been established to acquire so-called 'toxic assets' for international investors in the manner advocated very recently by the U.S. Treasury secretary, thus helping banks onshore to resume much-needed lending" (2009, p. 5). The emotional-laden speeches by Prime Minister Brown and President Obama -- among others -- have skewed the analysis of the impact of offshore financial centres away from their legitimate contribution to the more nefarious aspects of the industry, a feature that Jennings resents in particular. For example, Jennings concludes that, "While overheated political rhetoric drowns out reasoned discussions on the uses of offshore centers, those who understand international economics value the role that they play. U.S. senators and G-20 leaders must beware of unexpected and unintended consequences of sweeping anti-offshore legislation that risks inhibiting the flow of capital into the U.S. And Europe at a time when it is needed most to support businesses and jobs" (2009, p. 5).
Likewise, Mckee et al. also suggest that there are in fact two sides to the offshore financial centre coin and the negative aspects tend to overshadow their legitimate contributions. In this regard, Mckee et al. note that, "Historically offshore financial centers have been seen as a mixed blessing for those concerned with international finance and its affect upon the world economy. Financial professionals and economists have often seemed to be overly concerned with various questionable activities that have rightly or wrongly been presumed to be accommodated in the offshore centers" (p. 3). Conventional economists typically assess the effects of offshore financial centres in terms of the combination of benefits to the tax revenue base of offshore jurisdictions vs. The damage they do to onshore jurisdictions; however, this analysis is misguided from the outset because of the rationale that is being used to compare and judge the variables that are involved which are highly subjective in many cases. For instance, Perry and Mauer note that the analytical methods used by conventional economists are "based on the erroneous assumption that offshore financial centres make money from foreign direct investment, or from taxes on corporate earnings. Economists also measure the impact that offshore financial services have on tax revenues 'at home,' in the onshore jurisdiction from which offshore money originates. They rarely examine the phenomenon of offshore finance from the point-of-view of the countries offering the services, or ask what it means to a country to be a tax haven" (2003, p. 85). Moreover, the multiplier effect means that any original infusion of autonomous money will be increased two- or three-fold as these funds are spent and re-spent in the offshore financial centre-hosting country. Furthermore, the revenues that are being generated by many of the Caribbean-region offshore financial centres are based on the fees they assess for their financial services rather than any taxes imposed on these funds. As an example, Perry and Mauer cite the case of the British Virgin Islands (BVI) where the laws stipulate that individuals and corporations qualify to establish a so-called "international business company" (IBC) that is based on the BVI with a onetime fee of $300 being charged; the IBC can remain active so long as an annual licensing fee of $300 is paid (Perry & Mauer 2003). The revenues that are generated through these types of corporations of convenience are significant. According to Perry and Mauer, "Such IBCs usually exist for a short time only, generally for the duration of a particular transaction a company wishes to conduct 'offshore,' and are then dissolved" (2003, p. 86). In fact, the frequency of these types of transactions has meant that the fees that are being generated account for almost half of the BVI government's revenues each year, surpassing even tourism. In this regard, Perry and Mauer conclude that, "Dissolutions are announced in the local newspapers, whose back three or four pages are always full of 'voluntary liquidation' notices. Many IBCs come into and go out of existence during the course of a week, and so the revenue generated from fees can become considerable. In 1992, out of a total British Virgin Islands government revenue of U.S. $54 million, the offshore financial services sector contributed U.S. $21 million, outstripping tourism for the first time in the islands' history" (2003, p. 86).
There are a number of offshore financial service enclaves that are currently available to interested parties of every ilk, legitimate and otherwise. For instance, the Cayman Islands are free of direct taxation and provide "the ability to accumulate profits free of tax and, for branches or subsidiaries of parent companies elsewhere, the ability to repatriate profits at most advantageous times. There are no exchange controls, thus permitting the movement of capital in and out, as well as the holding of accounts in any major currency" (Mckee et al. 2000, p. 31). In fact, some types of offshore financial services are considered entirely legitimate. In this regard, Frank observes, "After all, such places can sometimes have a function that isn't simply mischievous. Who can blame those Argentines who foresaw possible financial unrest and parked their life savings outside of the country before disaster struck in 2001? Or those businesspeople in countries with poor legal systems and unstable banks who choose to conduct their deals through more reliable offshore institutions?" (2005, p. 44). Indeed, a number of financial services companies have offshore branches that are used as a component of their legitimate money management practices that are designed to avoid inappropriate taxation on short-term holdings, to provide customers with interest-bearing overnight sweep accounts, and for transacting Euro currency exchanges (Connolly 2003).
Moreover, some offshore financial centres are considered an essential part of global commerce when they are properly administered and regulated for less than obvious reasons. For example, Elizur and Malkin (2000) note that, "In many countries assets must be hidden offshore against kidnapping and extortion, rapacious governments, or simply as part of estate planning. Offshore banks protect the money of businessmen in countries where no one, including a bank's own management, ever really knows how sound it is" (p. 17). As noted throughout the literature, though, these legitimate and lawful purposes for offshore financial services can also provide a front for criminal activities, and some major U.S. And foreign banks have established offshore branches specifically for their clients that want to avoid the regulations and laws as well as unwanted attention from law enforcement authorities in their own countries (Connolly 2003). As Perry and Maurer point out, the line between legitimate and acceptable business practices and illicit ones becomes particularly difficult to draw in these cases: "The offshore financial services sector provides one case of putting procedural norms and accountancy techniques to new purposes. Offshore finance points up the limits of the accounting rituals by so nicely demonstrating that the line between shady and sound dealings is incredibly difficult to draw" (2003, p. 84). These offshore financial centres provide both affluent clients and criminal enterprises alike with the avenue they require to avoid taxes as well as to facilitate international financial fraud, market manipulation, theft of intellectual property, illegal arms dealing, and drug smuggling (Connolly 2003). Human rights activists groups have estimated that at least $50 billion a year is exploited from developing nations through some offshore financial centres (Elizur & Malkin 2001).
According to Mckee et al., the burgeoning offshore financial services network included 36 jurisdictions by the end of the 1970s. These authors identify three types of geographical locations: (a) inland enclave states, (b) coastal enclave states and (c) island states (Mckee et al. 2000). These types of enclave states have tended to conglomerate in a global pattern of what McKee et al. term "satellite clusters" that are comparable with four main business time zones that correspond to major global/regional capital markets:
1. The Western Hemisphere was served through the New York epicenter by the Caribbean and the Central American Basin.
2. European enclaves, coastal enclaves and independent islands were included in the London epicenter.
3. The Asian-Pacific region and Oceania were served within the Tokyo time zone by Hong Kong, Singapore, Vanuatu and Nauru.
4. The final cluster was composed of Persian Gulf jurisdictions providing service to Middle Eastern oil countries (Mckee et al. 2000, p. 5).
Other authorities, though, suggest offshore financial centres represent more of a "Bermuda Triangle" that is used primarily by money launderers, financial fraud, and tax avoidance purposes. For instance, Lozano and Maingot (2004) maintain that the "ultimate objective of the criminal is to enjoy his gains, perhaps in a tropical haven, more likely within the same geographic milieu in which his criminal enterprise operates" (p. 92). Depending on their geographic location and preference, then, offshore financial services customers have a wide range of choices for offshore financial services. In this regard, Appendix a provides a list of countries, territories, and jurisdictions with offshore financial centers according to their respective area of geographic coverage. There are also a number of tax enclaves located in the Caribbean region as shown at Appendix B. In all locations, offshore financial centres are experiencing steady growth in their balance sheets as shown in Figure 1 below.
Figure 1. Offshore Financial Centres' Balances Sheets: 2001-2009
Note:
1. Sovereign Caribbean includes 8 countries: Antigua and Barbuda, the Bahamas, Barbados, Belize, Dominica, Grenada, St. Kitts and Nevis, St. Vincent and the Grenadines.
2. Caribbean non-sovereign includes six regions: Aruba, Bermuda, British Virgin Islands, Cayman Islands, Netherland Antilles, Turks and Caicos.
Source: Shipke 2011
Based on his analysis of offshore financial centres, Shipke found that the Caribbean accounts for a large share of the global total (see geographic distribution of offshore financial centres in Figure 2 below). According to Shipke, Caribbean offshore financial centres:
1. Assets and liabilities of the 40 reporting Offshore financial centres are about U.S.$2.7 trillion and U.S.$3.2 trillion respectively (8% of world cross-border holdings);
2. The wider Caribbean held about 60% of the estimated balance sheets managed of Offshore financial centres;
3. Within the Caribbean, non-sovereign jurisdictions account for the largest stock OFC assets/liabilities;
4. Barbados and the Bahamas are the most important countries (Shipke 2011, p. 6).
Figure 2. Geographic Distribution of Offshore Financial Centres
Source: http://rpmedia.ask.com/
According to Rahn (2004), all major offshore financial centers such as the Cayman Islands and Bermuda as well as other large financial centers such as Switzerland, the U.K. And the United States feature above-board legal systems and competent administrators. Moreover, legitimate investors can benefit from the reasonable banking privacy regulations that exist in these jurisdictions, and more money is actually "laundered" in New York and London than in offshore financial centres such as Cayman (Rahn 2004). This author suggests that Cayman and its offshore banking competitors provide a place for large companies and financial institutions can consolidate their funds in electronic form without being taxed or subject to unnecessary costly regulation while they are reinvested in legitimate financial dealings around the world (Rahn 2004).
In fact, the majority of the approximately $1 trillion that is transacted through Cayman offshore financial centres is subsequently invested in the United States in ways that are beneficial to honest private investors and pensioners as well. For instance, Rahn emphasizes that, "The money is owned by the millions of people who are investors in both American and foreign companies and who, for the most part, are unaware their retirement incomes are being both protected and enhanced because part of their investments are continuously being repackaged in Cayman as they go off to higher and better uses" (2004, p. 16). Offshore financial centres in these regions provide both legitimate and valuable services for their international financial services customers as well as providing local residents with meaningful employment. In this regard, Rahn (2004) concludes that sustained economic growth can only be achieved when capital is invested in those activities and enterprises that provide the highest after tax risk adjusted rate of return: "Places like Cayman provide highly efficient and low-cost environments for institutions to acquire and invest capital, protected by the rule of law. This is why most of the world's big banks operate in Cayman, as well as hundreds of insurance companies and thousands of institutional mutual and hedge funds" (Rahn, 2004, p. 16). Likewise, Garner, McKee and McKee (2002) report that Singapore has become one of the world's three largest offshore financial centers. "As regional and global political and business environments have changed over the years, Singapore has become ever more attractive to multinational companies and cross-border investors. The country provides generous tax incentives in a solid business infrastructure" (p. 40). Some of the other benefits of offshore financial centres to the global and regional economies include the following:
1. Income from direct employment;
2. Benefits via spillovers to other sectors in the economy including other services (such as tourism) and infrastructure (e.g. telecommunication and transportation);
3. Government revenue from taxes and fees (Shipke 2011, p. 7).
Notwithstanding these benefits, the fact remains that offshore financial centres in some jurisdictions have been used for unlawful purposes, and in the post-September 11, 2001 environment, many of the legislative initiatives designed to counter these practices have focused on the potential connection between money-laundering practices in these jurisdictions and terrorist activities at home and abroad, and these are discussed further below.
Relevant Legislation and Regulatory Oversight of Offshore Financial Centres
The need for effective regulatory oversight of offshore financial centres has become especially pronounced in recent years due in large part to the proliferation of these tax havens and their potential misuse by criminal and terrorist organizations. In this regard, Cortright, Lopez and Gerber emphasize that, "One of the most important battles in the war against financial crime is the campaign to rein in offshore financial havens. The existence of unregulated financial centers is a major obstacle to the enforcement of financial sanctions and laws against money laundering" (2002, p. 109). These authors also cite the relative lack of transparency that characterizes many offshore financial centres: "In the United States and other Organization for Economic Cooperation and Development (OECD) countries, banks generally comply with government regulations and oversight laws. In jurisdictions such as the Cayman Islands, the Bahamas, and Cyprus, however, banks are intentionally structured to avoid regulation and legal scrutiny. These offshore centers operate as havens not only for avoiding or minimizing taxes but for sheltering illicit profits" (Cortright et al. 2002, p. 109). Offshore financial centres are also a refuge for political leaders seeking to avoid international sanctions and the scale of the offshore banking business is enormous (Cortright et al. 2002). In response, Maurer reports that the 10-year period between 1996 and 2006 witnessed intensified global efforts to regulate offshore finance, with numerous influential groups lining up against them. For example, the United Nations, the OECD, the Financial Action Task Force (FATF), the Financial Stability Forum (FSF), the International Monetary Fund (IMF), the European Union, and various non-governmental organizations including Christian Aid, Oxfam, and the newly formed Tax Justice Network (TJN) all published reports and statements encouraging a cessation of the financial services abuses that were taking place in offshore financial centres (Cortright et al. 2002). Countering these negative campaign efforts, though, the Society for Trust and Estate Practitioners, the leaders of Caribbean countries, the Commonwealth Secretariat, and lobbying groups such as the U.S.-based Heritage Foundation, the Cato Institute and the recently created Center for Freedom and Prosperity and the International Trade and Investment Organization all came out in vigorous support of offshore financial centres and blasted these attempts to regulate the global economy (Maurer 2008).
In 1996, the U.S. government estimated that 20% of the mutual funds in the world are transacted at some point offshore financial centres with a great deal of the transaction occurring in the Cayman Islands and the amount involved are staggering: "Grand Cayman Island is home to a huge offshore banking industry, serving as the address of record for more than 26,000 companies with banking assets exceeding a staggering $670 billion" (Cortright et al. 2002, p. 109). The problems that characterize offshore financial centres have increased in recent years, due in large part to the same forces that are driving globalization and advances in electronic banking technology. As an example of this process, a number of Pacific Island nations established rogue banking operations and jurisdictions such as Nauru, Niue, and Vanuatu became favored addresses for those seeking to avoid financial scrutiny during the 1990s; moreover, "Much of the capital spirited out of Russia in recent years, for example, went to accounts in Nauru" (Cortright et al. 2002, p. 109).
In response to these trends, a number of governmental and private concerns have been introduced in recent years in response to the growth of offshore financial centres the common purpose of overseeing an industry that has historically been largely unregulated. In this regard, Zagaris (1999) reports that the following initiatives have been undertaken by the international community to this end:
1. Multilateral organizations have been created to develop anti-money laundering standards, mechanisms, and institutions;
2. The United Nations pioneered the 1988 Vienna Convention Against the Trafficking in Illegal Narcotic and Psychotropic Substances contains the requirements to criminalize money laundering and immobilize the assets of persons involved in illegal narcotics trafficking;
3. In 1989, the G-7 Economic Summit Group established the Financial Action Task Force (FATF), which operates out of the Office of Economic Cooperation and Development (OECD) headquarters in Paris.(4) FATF has issued a set of forty recommendations (Forty Recommendations) that concern legal requirements, financial and banking controls, and external affairs and issues an annual report that provides an overview of progress and problems in international anti-money laundering;
4. The G-10 Basle Group of Central Banks has actively provided guidelines for central bank supervisors and regulatory controls and on September 23, 1997, the Basle Group issued guidelines on supervision;
5. Regionally, the Council of Europe's 1991 Convention on Laundering, Search, Seizure and Confiscation of Assets has become the major international convention that obligates signatory governments to cooperate against anti-money laundering from all serious crimes;
6. The European Union, as a signatory to the 1988 Vienna Drug Convention and due to its own actions to combat financial crimes against the Communities, issued a 1991 Anti-Money Laundering Directive and recently promulgated initiative against cybercrimes (Zagaris, 1999).
The battle against exploitation of offshore financial centres, though, resembles a real war, with each measure being taken by the international community to better regulate these industries being met with countermeasures by criminal and terrorist enterprises. According to the FATF, money laundering methods and techniques change in response to developing counter-measures. In response, the FATF has identified increasingly sophisticated combinations of techniques, such as the increased use of legal persons to disguise the true ownership and control of illegal proceeds, and an increased use of professionals to provide advice and assistance in laundering criminal funds. These factors, combined with the experience gained through the FATF's Non-Cooperative Countries and Territories process, and a number of national and international initiatives, led the FATF to review and revise the Forty Recommendations and nine subsequent recommendations into a new comprehensive framework for combating money laundering and terrorist financing. The FATF has called upon all countries to take the necessary steps to bring their national systems for combating money laundering and terrorist financing into compliance with the new FATF Recommendations, and to effectively implement these measures (FATF 40 recommendations 2004).
The salient recommendations from the 40 originally promulgated by the FATF are set forth below, followed by supporting rationale and/or steps that will be required for compliance.
Recommendation No. 1:
Countries should criminalise money laundering on the basis of the United Nations Convention against Illicit Traffic in Narcotic Drugs and Psychotropic Substances, 1988 (the Vienna Convention) and the United Nations Convention against Transnational Organized Crime, 2000 (the Palermo Convention).
Supporting Rationale/Steps Required:
Countries should apply the crime of money laundering to all serious offences, with a view to including the widest range of predicate offences. Predicate offences may be described by reference to all offences, or to a threshold linked either to a category of serious offences or to the penalty of imprisonment applicable to the predicate offence (threshold approach), or to a list of predicate offences, or a combination of these approaches. Where countries apply a threshold approach, predicate offences should at a minimum comprise all offences that fall within the category of serious offences under their national law or should include offences which are punishable by a maximum penalty of more than one year's imprisonment or for those countries that have a minimum threshold for offences in their legal system, predicate offences should comprise all offences, which are punished by a minimum penalty of more than six months imprisonment. Whichever approach is adopted, each country should at a minimum include a range of offences within each of the designated categories of offences3. Predicate offences for money laundering should extend to conduct that occurred in another country, which constitutes an offence in that country, and which would have constituted a predicate offence had it occurred domestically. Countries may provide that the only prerequisite is that the conduct would have constituted a predicate offence had it occurred domestically. Countries may provide that the offence of money laundering does not apply to persons who committed the predicate offence, where this is required by fundamental principles of their domestic law.
Recommendation No. 2:
Countries should ensure that:
(a) the intent and knowledge required to prove the offence of money laundering is consistent with the standards set forth in the Vienna and Palermo Conventions, including the concept that such mental state may be inferred from objective factual circumstances.
(b) Criminal liability, and, where that is not possible, civil or administrative liability, should apply to legal persons. This should not preclude parallel criminal, civil or administrative proceedings with respect to legal persons in countries in which such forms of liability are available. Legal persons should be subject to effective, proportionate and dissuasive sanctions. Such measures should be without prejudice to the criminal liability of individuals.
Recommendation No. 3:
Countries should adopt measures similar to those set forth in the Vienna and Palermo Conventions, including legislative measures, to enable their competent authorities to confiscate property laundered, proceeds from money laundering or predicate offences, instrumentalities used in or intended for use in the commission of these offences, or property of corresponding value, without prejudicing the rights of bona fide third parties.
Such measures should include the authority to:
(a) identify, trace and evaluate property which is subject to confiscation;
(b) carry out provisional measures, such as freezing and seizing, to prevent any dealing, transfer or disposal of such property;
(c) take steps that will prevent or void actions that prejudice the State's ability to recover property that is subject to confiscation; and (d) take any appropriate investigative measures.
Supporting Rationale/Steps Required:
Countries may consider adopting measures that allow such proceeds or instrumentalities to be confiscated without requiring a criminal conviction, or which require an offender to demonstrate the lawful origin of the property alleged to be liable to confiscation, to the extent that such a requirement is consistent with the principles of their domestic law.
Recommendation No. 4:
Countries should ensure that financial institution secrecy laws do not inhibit implementation of the FATF Recommendations
Recommendation No. 5:
Financial institutions should not keep anonymous accounts or accounts in obviously fictitious names.
Supporting Rationale/Steps Required:
Financial institutions should undertake customer due diligence measures, including identifying and verifying the identity of their customers, when:
(a) Establishing business relations;
(b) Carrying out occasional transactions:
(i) above the applicable designated threshold; or (ii) that are wire transfers in the circumstances covered by the Interpretative Note to Special Recommendation VII;
(c) There is a suspicion of money laundering or terrorist financing; or,
(d) the financial institution has doubts about the veracity or adequacy of previously obtained customer identification data.
Recommendation No. 8:
Financial institutions should pay special attention to any money laundering threats that may arise from new or developing technologies that might favour anonymity, and take measures, if needed, to prevent their use in money laundering schemes.
Supporting Rationale/Steps Required:
In particular, financial institutions should have policies and procedures in place to address any specific risks associated with non-face-to-face business relationships or transactions.
Recommendation No. 9:
Countries may permit financial institutions to rely on intermediaries or other third parties to perform elements (a) -- (c) of the customer due diligence (CDD) process or to introduce business, provided that the criteria set out below are met. Where such reliance is permitted, the ultimate responsibility for customer identification and verification remains with the financial institution relying on the third party.
Supporting Rationale/Steps Required:
The criteria that should be met are as follows:
(a) a financial institution relying upon a third party should immediately obtain the necessary information concerning elements (a) -- (c) of the CDD process. Financial institutions should take adequate steps to satisfy themselves that copies of identification data and other relevant documentation relating to the CDD requirements will be made available from the third party upon request without delay.
(b) the financial institution should satisfy itself that the third party is regulated and supervised for, and has measures in place to comply with CDD requirements in line with Recommendations 5 and 10.
Recommendation No. 10:
Financial institutions should maintain, for at least five years, all necessary records on transactions, both domestic or international, to enable them to comply swiftly with information requests from the competent authorities. Such records must be sufficient to permit reconstruction of individual transactions (including the amounts and types of currency involved if any) so as to provide, if necessary, evidence for prosecution of criminal activity.
Supporting Rationale/Steps Required:
Financial institutions should keep records on the identification data obtained through the customer due diligence process (e.g. copies or records of official identification documents like passports, identity cards, driving licenses or similar documents), account files and business correspondence for at least five years after the business relationship is ended. The identification data and transaction records should be available to domestic competent authorities upon appropriate authority.
Recommendation No. 13:
If a financial institution suspects or has reasonable grounds to suspect that funds are the proceeds of a criminal activity, or are related to terrorist financing, it should be required, directly by law or regulation, to report promptly its suspicions to the financial intelligence unit (FIU).
Recommendation No. 15:
Financial institutions should develop programmes against money laundering and terrorist financing.
Supporting Rationale/Steps Required:
These programmes should include:
a) the development of internal policies, procedures and controls, including appropriate compliance management arrangements, and adequate screening procedures to ensure high standards when hiring employees.
b) an ongoing employee training programme.
c) an audit function to test the system.
Recommendation No. 17:
Countries should ensure that effective, proportionate and dissuasive sanctions, whether criminal, civil or administrative, are available to deal with natural or legal persons covered by these Recommendations that fail to comply with anti-money laundering or terrorist financing requirements.
Recommendation No. 18:
Countries should not approve the establishment or accept the continued operation of shell banks. Supporting Rationale/Steps Required:
Financial institutions should refuse to enter into, or continue, a correspondent banking relationship with shell banks. Financial institutions should also guard against establishing relations with respondent foreign financial institutions that permit their accounts to be used by shell banks.
Recommendation No. 19:
Countries should consider the feasibility and utility of a system where banks and other financial institutions and intermediaries would report all domestic and international currency transactions above a fixed amount, to a national central agency with a computerised data base, available to competent authorities for use in money laundering or terrorist financing cases, subject to strict safeguards to ensure proper use of the information.
Recommendation No. 20:
Countries should consider applying the FATF Recommendations to businesses and professions, other than designated non-financial businesses and professions, that pose a money laundering or terrorist financing risk.
Supporting Rationale/Steps Required:
Countries should further encourage the development of modern and secure techniques of money management that are less vulnerable to money laundering.
Recommendation No. 21:
Financial institutions should give special attention to business relationships and transactions with persons, including companies and financial institutions, from countries which do not or insufficiently apply the FATF Recommendations. Whenever these transactions have no apparent economic or visible lawful purpose, their background and purpose should, as far as possible, be examined, the findings established in writing, and be available to help competent authorities.
Supporting Rationale/Steps Required:
Where such a country continues not to apply or insufficiently applies the FATF Recommendations, countries should be able to apply appropriate countermeasures.
Recommendation No. 22:
Financial institutions should ensure that the principles applicable to financial institutions, which are mentioned above are also applied to branches and majority owned subsidiaries located abroad, especially in countries which do not or insufficiently apply the FATF Recommendations, to the extent that local applicable laws and regulations permit.
Supporting Rationale/Steps Required:
When local applicable laws and regulations prohibit this implementation, competent authorities in the country of the parent institution should be informed by the financial institutions that they cannot apply the FATF Recommendations.
Recommendation No. 23:
Countries should ensure that financial institutions are subject to adequate regulation and supervision and are effectively implementing the FATF Recommendations. Competent authorities should take the necessary legal or regulatory measures to prevent criminals or their associates from holding or being the beneficial owner of a significant or controlling interest or holding a management function in a financial institution.
Supporting Rationale/Steps Required:
For financial institutions subject to the [Basel] Core Principles, the regulatory and supervisory measures that apply for prudential purposes and which are also relevant to money laundering, should apply in a similar manner for anti-money laundering and terrorist financing purposes. Other financial institutions should be licensed or registered and appropriately regulated, and subject to supervision or oversight for anti-money laundering purposes, having regard to the risk of money laundering or terrorist financing in that sector. At a minimum, businesses providing a service of money or value transfer, or of money or currency changing should be licensed or registered, and subject to effective systems for monitoring and ensuring compliance with national requirements to combat money laundering and terrorist financing.
Recommendation No. 25:
The competent authorities should establish guidelines, and provide feedback which will assist financial institutions and designated non-financial businesses and professions in applying national measures to combat money laundering and terrorist financing, and in particular, in detecting and reporting suspicious transactions (FATF 40 Recommendations 2003).
Largely in response to the terrorist attacks of September 11, 2001 (they were promulgated just one month following these attacks), the 40 recommendations developed by the FATF have since been supplemented by nine additional recommendations to combat terrorist financing by offshore financial centres which are set forth below.
Recommendation No. 1:
Ratification and implementation of UN instruments: Each country should take immediate steps to ratify and to implement fully the 1999 United Nations International Convention for the Suppression of the Financing of Terrorism. Countries should also immediately implement the United Nations resolutions relating to the prevention and suppression of the financing of terrorist acts, particularly United Nations Security Council Resolution 1373.
Recommendation No. 2:
Criminalising the financing of terrorism and associated money laundering: Each country should criminalise the financing of terrorism, terrorist acts and terrorist organisations. Countries should ensure that such offences are designated as money laundering predicate offences.
Recommendation No 3: Freezing and confiscating terrorist assets
: Each country should implement measures to freeze without delay funds or other assets of terrorists, those who finance terrorism and terrorist organisations in accordance with the United Nations resolutions relating to the prevention and suppression of the financing of terrorist acts. Each country should also adopt and implement measures, including legislative ones, which would enable the competent authorities to seize and confiscate property that is the proceeds of, or used in, or intended or allocated for use in, the financing of terrorism, terrorist acts or terrorist organisations
Recommendation No. 4: Reporting suspicious transactions related to terrorism: If financial institutions, or other businesses or entities subject to anti-money laundering obligations, suspect or have reasonable grounds to suspect that funds are linked or related to, or are to be used for terrorism, terrorist acts or by terrorist organisations, they should be required to report promptly their suspicions to the competent authorities.
Recommendation No. 5: International Co-operation: Each country should afford another country, on the basis of a treaty, arrangement or other mechanism for mutual legal assistance or information exchange, the greatest possible measure of assistance in connection with criminal, civil enforcement, and administrative investigations, inquiries and proceedings relating to the financing of terrorism, terrorist acts and terrorist organisations. Countries should also take all possible measures to ensure that they do not provide safe havens for individuals charged with the financing of terrorism, terrorist acts or terrorist organisations, and should have procedures in place to extradite, where possible, such individuals.
Recommendation No. 6: Alternative Remittance: Each country should take measures to ensure that persons or legal entities, including agents, that provide a service for the transmission of money or value, including transmission through an informal money or value transfer system or network, should be licensed or registered and subject to all the FATF Recommendations that apply to banks and non-bank financial institutions. Each country should ensure that persons or legal entities that carry out this service illegally are subject to administrative, civil or criminal sanctions.
Recommendation No. 7: Wire transfers:
Countries should take measures to require financial institutions, including money remitters, to include accurate and meaningful originator information (name, address and account number) on funds transfers and related messages that are sent, and the information should remain with the transfer or related message through the payment chain. Countries should take measures to ensure that financial institutions, including money remitters, conduct enhanced scrutiny of and monitor for suspicious activity funds transfers which do not contain complete originator information (name, address and account number).
Recommendation No. 8: Non-profit organisations: Countries should review the adequacy of laws and regulations that relate to entities that can be abused for the financing of terrorism. Non-profit organisations are particularly vulnerable, and countries should ensure that they cannot be misused:
(i) by terrorist organisations posing as legitimate entities;
(ii) to exploit legitimate entities as conduits for terrorist financing, including for the purpose of escaping asset freezing measures; and,
(iii) to conceal or obscure the clandestine diversion of funds intended for legitimate purposes to terrorist organisations.
Recommendation No. 9: Cash Couriers:
Countries should have measures in place to detect the physical cross-border transportation of currency and bearer negotiable instruments, including a declaration system or other disclosure obligation. Countries should ensure that their competent authorities have the legal authority to stop or restrain currency or bearer negotiable instruments that are suspected to be related to terrorist financing or money laundering, or that are falsely declared or disclosed. Countries should ensure that effective, proportionate and dissuasive sanctions are available to deal with persons who make false declaration(s) or disclosure(s). In cases where the currency or bearer negotiable instruments are related to terrorist financing or money laundering, countries should also adopt measures, including legislative ones consistent with Recommendation 3 and Special Recommendation III, which would enable the confiscation of such currency or instruments (FATF IX Special Recommendations 2001).
Proponents of such increased oversight of offshore financial centres maintain in an era of sophisticated telecommunications, regulatory initiatives will ultimately remain largely ineffective because of the ability of electronic funds to be easily transferred to largely unregulated offshore financial centres. According to Hellener, though, "The likelihood of a wide-scale geographical displacement of this kind from leading financial centers is not strong, given the dependence of financiers on services provided by world cities, as well as their trust in the safety of existing clearing systems and the political stability of the host governments involved" (2002, p. 387). While it would be foolhardy to suggest that no illegal activities take place in offshore financial centres, Hellener and like-minded authorities believe that the legitimate business purposes conducted by these centres far outweighs the illicit activities that may be conducted. In this regard, Hellener advises, "Moreover, even if financial activity did flee to offshore locations, it would still be subject to the regulatory initiatives of powerful states. Offshore financial centers, after all, exist in political jurisdictions that can be subjected to strong pressures by leading states. Such pressures have been increasingly used, for example, to encourage offshore financial centers to introduce anti-money laundering regulations, and have met with considerable success" (2002, p. 387). This characterization may be overstated given that the full extent of illegal activities taking place in offshore financial centres may not be known with precision, but it does appear reasonable to suggest that trends over the past two decades or so all indicate that more regulation and oversight of offshore financial centres is taking place today, and these issues are discussed further below.
Oversight of Offshore Financial Centres
Offshore financial centres are an important cog in the global payments system but remain largely free of the same types of oversight that is in place in their onshore counterparts, making detection and reporting of transactions an essential element in their oversight. For instance, according to Lozano and Maingot, "So long as this is the case, cash exports will tend to go to these countries for integration into the financial system there and return by means of wire transfers. This means that detection of the outflow of cash becomes especially important when internal avenues have been blocked" (p. 94). This point is also made by the IMF's analysis, "Prospects and Policy Changes" (2000), in which the point is made that, "A major issue over the medium term is the appropriate recent moves to increase scrutiny of offshore financial centers, as the financial industry is an important part of the regional economy, particularly for the Bahamas (where 20% of employment is associated with financial services), St. Vincent, and St. Kitts and Nevis" (p. 1). Furthermore, the Internal Revenue Service (IRS) in particular has established a lengthy history of conducting investigations of offshore financial activities in an effort to penetrate the veil of secrecy through the use of informants (Stessons, 2000). In addition, and as noted above, the increased scrutiny has apparently paid off, and Cayman has voluntarily entered into agreements with the IRS and the U.S. Justice Department to exchange information concerning suspected criminals, tax evaders and terrorist organizations. "If you are a crook, it is not wise to try to open an account in well-run jurisdictions like Cayman and Switzerland, because neither the banks nor the governments will protect you," Rahn adds (2004, p. 16). These are clearly positive trends for an important global financial services industry that has suffered from criminal abuses and negative publicity for a number of years.
The pressure exerted on the offshore financial centres to comply with more rigorous anti-money laundering standards has continued to product positive results in recent years as well (Offshore Financial Centres: International Narcotics Control Strategy Report 2004). For instance, since the establishment of the Financial Action Task Force's (FATF) Non-Cooperative Countries and Territories (NCCT) initiative in 2000, FATF has identified 23 jurisdictions as being NCCTs, with 16 of these being offshore financial centres or jurisdictions that provide those types of financial services that are typically associated with these types of centres (Offshore Financial Centres: International Narcotics Control Strategy Report 2004). Other positive signs can be discerned from the progress being made even more recently. For instance, as of December 31, 2003, there were just nine NCCT jurisdictions remaining on the FATF list, and just three of these were providing offshore financial services (Cook Islands, Guatemala and Nauru) and all of these jurisdictions had achieved substantive progress in resolving previous deficiencies identified by the FATF:
1. The Cook Islands established a financial intelligence unit;
2. Guatemala strengthened its licensing, registration and regulatory procedures for its offshore banks; and,
Nauru reportedly canceled the licenses of its nearly 400 shell banks (Offshore Financial Centres: International Narcotics Control Strategy Report 2004).
The effects of the oft-scorned USA PATRIOT Act ("the Act") have also been influential in increasing the oversight of some offshore financial centres. For instance, the provision of the Act that prohibits direct or indirect transactions between U.S. financial institutions and foreign shell banks was a primary reason that Nauru decided to revoke the licenses of shell banks in its jurisdiction and was a key reason for the decrease in the number of offshore banks in recent years (Offshore Financial Centres: International Narcotics Control Strategy Report 2004). As with the other facets of OFCs, though, the picture that emerges from an analysis of ongoing oversight initiatives is mixed, with some authorities suggesting that the problem of the illegal practices that have been predominate in offshore financial centres remain, while others argue that the problem has been overstated in the past and current oversight efforts have produced positive and meaningful results.
Certainly, there are offshore financial centres that are well regulated and have the regulatory and oversight mechanisms in place that are needed for transparent and timely exchange reporting, but these centres are mainly located in the larger and more affluent jurisdictions the provide offshore financial services. The fact that these OFCs are well regulated is related to their established track record of voluntary compliance with FATF recommendations and the Basel Core Principles, making them attractive to legitimate businesses and individuals. Here again, though, the very same features that make OFCs attractive to legitimate businesses can be easily used or misused by criminal and terrorist organizations, as well as otherwise-legitimate businesses that may want to skirt a particularly troublesome law or two in their financial dealings. In this regard, the International Narcotics Control Strategy Report emphasizes that, "The primary attraction of the offshore sector remains the frequent existence of legal frameworks designed to obscure the identity of beneficial owners, to promote regulatory and supervisory arbitrage, and to provide mitigation or evasion of home-country tax regimes. In the majority of offshore financial centres a wide range of regulations normally imposed on onshore banks are not applicable" (2004, p. 5). In a number of offshore financial centres, it is possible to create legal "banks" that have little or no capital, that can be formally registered and ownership assigned to nominee directors -- all over the Internet with no face-to-face, "know your customer" provisions in place. The International Narcotics Control Strategy report also points out that, "Often, there are few, if any, disclosure requirements and bank transactions are free of exchange and interest rate restrictions" (Offshore Financial Centres: International Narcotics Control Strategy Report 2004, p. 5).
Furthermore, depending on their jurisdiction, some offshore financial centres also provide their customers services to create and sustain various legal entities including the aforementioned international business companies, as well as others such as trusts, exempt companies, investment funds and insurance companies (Offshore Financial Centres: International Narcotics Control Strategy Report 2004). While these otherwise-legal entities sound benign enough, the convoluted ways that corporations bent on avoiding (or breaking) the law as well as criminal and terrorist organizations can use these legal entity forms to cloud their identities and conceal the proceeds of their financial dealings make them particularly challenging for law enforcement authorities around the world. In this regard, the International Narcotics Control Strategy Report adds that, "To maintain the anonymity of the true beneficial owner of these entities, many are formed with nominee directors, nominee officeholders and nominee shareholders. When combined with the use of bearer shares (shares that do not name the owner, rather, ownership is based on physical possession) and 'mini-trusts') instruments used to further insulate the beneficial owner while bridging the ownership and management of the corporate entity), IBCs can present impenetrable barriers to law enforcement" (emphasis added) (Offshore Financial Centres: International Narcotics Control Strategy Report 2004, p. 5). Adding further fuel to the arguments against some of the services provided by offshore financial centres is the clear-cut example of the sale of passports in a quid pro quo exchange for investment in their home country. According to the International Narcotics Control Strategy Report, "The continued selling of 'economic citizenship,' (passports sold to foreigners who promises to invest in the country) if improperly controlled, creates yet another impediment to law enforcement., as frequently the purchaser of such as a passport can also purchase a new name on the new passport" (Offshore Financial Centres: International Narcotics Control Strategy Report 2004). These "legal" avenues to gaining access to legitimate documents that can clearly be abused by criminals and terrorist organizations makes the need for increased oversight of this area vitally important, and efforts to eliminate it practice altogether should become a priority for the international community's global war on terrorism.
Since 2002, the International Monetary Fund (IMF) has conducted assessments of nearly 40 offshore financial sectors, a representative sampling of which is presented at Appendix D.A progress report on the ongoing assessments that was completed in July 2003 found that, by and large, supervisory and regulatory regimes in the assessed jurisdiction require further strengthening to comply with the Basel Core Principles. In a number of jurisdictions, deficiencies were also identified in the technical skills required to provide effective supervision of compliance, and there remains a need for more comprehensive anti-money laundering/counterterrorist financing rules. In addition, there was a general lack of expertise with complex financial instruments identified in the assessed jurisdictions.
The IMF also found that while regulation of banks in the offshore financial centres is generally stronger than the regulation of insurance sectors; likewise, in the securities sector, a majority (approximately 66%) of the OFCs assessed by the IMF had implemented adequate principles relating to information sharing and cross-border cooperation (Offshore Financial Centers, the Assessment Program: A Progress Report and the Future of the Program 2003).
Based on this comprehensive analysis of compliance and capability levels within the assessed OFCs, the IMF concluded that many of the assessed offshore financial centres lacked effective compliance programs, but these needs were most commonly related to a lack of adequate legislation or the resources needed to implement and administer corrective actions. The IMF study also concludes that compliance with recommendations regarding terrorist financing is weaker than that regarding money laundering recommendations (Offshore Financial Centers, the Assessment Program: A Progress Report and the Future of the Program 2003). Besides this benchmark study, the IMF also periodically assesses offshore financial centres' compliance with the 25 Basel Core Principles set forth in Appendix C.
Some indication of recent progress and the remaining constraints in developing more effective oversight of offshore financial centres can be discerned from the most recent assessments of the various offshore financial centre jurisdictions conducted by the IMF based on compliance with the Basel Core Principles which are presented at Appendix D. As can be seen from the IMF assessments at Appendix D, a great deal of progress has been made in recent years in aligning business practices in these offshore financial centres with the Basel Core Principles and best industry practices; however, in most cases, the IMF also identified additional requirements that were needed by these centres to fully implement their recommendations and in a few cases, the need for major overhauls and revisions of existing regulatory legislation. In most cases, the same types of problems continue to be identified by the IMF during their assessments of OFC jurisdictions, including a lack of expertise and resources. These issues have assumed new relevance and importance in recent years based in large part on innovations in telecommunications that have made it far easier for offshore financial centres to be used for illicit purposes. As the global use of the Internet continues to increase, so too has the ability of criminals to instantaneously transfer funds, providing further opportunities for poorly regulated offshore financial centres to increase their customer bases; further, the Internet also provides terrorists and criminal organizations alike with yet more opportunities to conceal their identities and the proceeds of their illegal transactions, making law enforcement efforts especially challenging (Offshore Financial Centres: International Narcotics Control Strategy Report 2004).
The Internet has also provided yet another way for money to be more easily laundered. According to the International Narcotics Control Strategy Report, "Internet gaming executed via the use of credit cards and offshore banks represents yet another powerful vehicle for criminals to launder funds from illicit sources as well as to evade taxes. Virtual casinos can be extremely profitable for governments that sell the licenses but that exert inadequate controls, and may, in fact, share in the operator's profits" (2004, p. 6). As if international law enforcement authorities did not have enough to be concerned with in the provision of oversight to OFCs, the World Wide Web has created an entirely new way that offshore financial centres can engage in elaborate schemes to further their legitimate -- and illegitimate -- business interests. The problem appears to be on the increase as well. For instance, the Report found that, "In 2003, 30 offshore financial centres were observed on the Internet as having virtual gambling sites, more than doubling the number of offshore financial centres reported to have Internet gambling sites in 2002. These sites represent a particularly difficult problem for law enforcement, as the Internet server frequently is located in a country other than the country that has licensed the website" (Offshore Financial Centres: International Narcotics Control Strategy Report 2004, p. 6). One of the more important findings to emerge from the literature concerned the effects of existing oversight and regulatory mechanisms in combating money laundering over the long-term. This finding suggests that current methods may not prevent all misuse of OFCs, they are at least making it more difficult. Although it may be a simple matter for criminals, terrorists or others to transfer funds to offshore financial centres, getting it back again in a form that is equal to its original value is another matter altogether. For instance, according to Cortright et al., "It may be easy for a criminal or political pariah to move assets to offshore financial havens, but attempting to use those assets in the future can be difficult. Funds that are stashed away in Pacific or Caribbean islands eventually have to reenter the financial mainstream if they are to have maximum use value. The most important commodities and manufactured goods are traded in hard currency, often in dollars" (2002, p. 111). Because there are a number of oversight mechanisms in place in the major onshore financial centers, when they rejoin the mainstream global economy, they are once again vulnerable to law enforcement involvement. In this regard, Cortright and his associates note that, "These transactions are cleared through banks in New York and other major financial centers, exposing them to regulation and potential interdiction. Attempting to use sheltered assets thus involves risk. This fact suggests that, although financial sanctions may not be able to prevent the flight of assets to safe havens, they may nonetheless prevent or make more difficult the use of those assets in the future" (2002, p. 111). There have also been stronger efforts made to improve the transparency of banking operations in OFCs in recent years, and for improved cooperation with international law enforcement agencies (Cortright et al. 2002). In fact, a significant component of this ongoing effort has been the amplification of the FATF mandates (Cortright et al. 2002). Following the axiom that in order to improve something it must first be measured, the Offshore Group of Banking Supervisors and the FATF cooperated in assessing compliance levels among its membership with respect to the Vienna Convention as well as anti-drug drug money laundering laws. The findings that resulted from the June 2000 FATF report included more than two dozen jurisdictions that were found to be "non-cooperative" or "deficient" in their banking regulation practices (Cortright et al. 2002). According to these authorities, "The finance ministers of the G7 countries subsequently advised their domestic financial institutions to be wary of transactions with banks in these jurisdictions. They also warned that enforcement measures might be forthcoming if the listed jurisdictions did not cooperate with international efforts to prevent financial crime" (Cortright et al. 2002, p. 111).
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