The Cayman Islands seems to be riding through its own version of the 'perfect storm'. It has faced the challenges of the OECD and successfully made it to the White List as a transparent jurisdiction, in signing 13 tax treaties with other jurisdictions. It even found a seat as a member of the OECD's Steering group for future reform. President Obama used to speak of the Islands regularly, although not fondly, clearly convinced that the Islands were responsible for his country's financial woes, until the healthcare albatross seemed to unavoidably divert his attentions, if only for a while. Then there's the unkind and unfavourable onshore press that followed suit; the Islands moved from being forced to defend their status as a tax neutral jurisdiction to protesting inaccurate stories circulated in the press that the UK might be forced to bailout the Islands (raising the eyebrows of UK citizens already burdened by a rapidly downward spiraling economy and increasing unemployment).
A somewhat beleaguered but determined Cayman Islands, has remained resolute that it will remain a key player in the financial industry and it will not introduce direct taxation to the Islands. Notwithstanding a then immediate need to increase its borrowing, Cayman refused to introduce direct taxation to the Islands, in spite of less of a push and more of a shove from the UK to get the Islands to implement direct taxation. The private sector in the Islands, accustomed to a close working relationship with the Cayman Government, made it clear that direct taxation would have an immediate negative impact on the industry. There was a collective sigh of relief in the Islands on the announcement at the end of September 2009, after days of deliberation with the UK, that no direct taxation would be imposed by the Cayman Government. Perhaps because the reality is that its locals already do pay substantial indirect taxation. It is a 'tax' system of sorts that some might argue is a fairer system as each pays according to what he or she consumes, as opposed to paying taxes based on one's earnings and ultimately paying for others who are not earning.
Moody's however seemed to have concisely (and perhaps accurately) summarized Cayman's current situation in early September whilst standing behind the Islands Aa3 rating:-
"The outlook on the ratings remains stable......For the first time in the territory's history, the government made an explicit request to the UK Foreign and Commonwealth Office (FCO) in order to increase its debt levels," said Alessandra Alecci, Vice President-Senior Analyst in Moody's Sovereign Risk Group. In addressing the Islands need to increase its borrowing Alecci identified the reasons behind the Islands challenges as "falling revenues due to a drop in tourism and other services' income and higher expenditures associated with a one-off ambitious capital expenditure program." However she went on to state that "Given the Islands' long history of fiscal prudence, Moody's views the significant widening of the central government deficit during 2004/2005 (when the costs associated with Hurricane Ivan were incurred) and subsequently as being more the result of extraordinary circumstances than a fundamental policy shift away from fiscal conservatism".
No one can argue that these are extraordinary times that we are all living and working in. No country, it seems, has been left unscathed by the global recession. The UK and the US are facing staggering deficits and soaring unemployment exacerbated by the recession. The announcement in early October that unemployment in the US had been underestimated and 10% unemployment would be likely1, showed the continuing erosion of the US economy notwithstanding unprecedented bailout money pumped into the economy. And perhaps even more worrying is the US' unhealthily heavy dependency on China and Japan to continue to buy US bonds in order to sustain the US ballooning debt. Tiger Management founder and Chairman Julian Robertson told CNBC in an interview, "The US is too dependent on Japan and China buying up the country's debt and could face severe economic problems if that stops.... It's almost Armageddon if the Japanese and Chinese don't buy our debt. I don't know where we could get the money. I think we've let ourselves get in a terrible situation and I think we ought to try and get out of it."2
A similar September article echoed the resounding theme emerging amongst the experts; "If China were to succeed at dethroning the dollar as the world's reserve currency the potential implications are severe, even apocalyptic. The U.S. dollar goes into freefall for the simple reason that if no country has to hold dollars any longer, they won't. Instead, thanks to the ragged state of the U.S. government's finances, many countries will dump greenbacks as fast as they can, which will only put additional pressure on an already-strained U.S. financial system, which in turn will further damage our economy".3 One can understand the unease of the onshore industry, when it appears it is being forced to take direction from, what seems to be, a rudderless ship, particularly when the direction seems harmful to industry rather than productive. Given the times, there is little room for more error.
The Financial Times4 wrote an article in October on the position of the Cayman Islands economy, which deserves special mention here in that the article concludes that there are 'intriguing implications' for the western world. The said article refers to the Islands previous strong economic health but, is now contending with a slowdown in revenue due to public spending etc. There is other curious information in the article which is surprisingly speculative, if not outright inaccurate (such as suggesting that 'advisers' had raised the 'once taboo concept of corporate tax'. This has never been raised in any forum in the Cayman Islands, it has never been raised with or by the Cayman financial industry, and remains as taboo as ever). However, the article does raise some inescapable truths that are thought provoking and brings home the irony of the entire situation (perhaps even some perspective). It states that 'most other western nations are also beset by ballooning spending – and a shrinking pool of tax revenues. (The UK has a net revenue to debt level of 115 per cent, according to the Institute for Fiscal Studies, or twice that of the Caymans)'.
However, for Cayman, Moody's noted the important difference with its economy; in the face of the global economic challenges, this would be the first time that the Islands had reached borrowing levels that required the UK's approval. To be clear, notwithstanding misleading spin that was played in certain otherwise credible UK publications referring to 'UK bailout'; the Cayman Islands were not borrowing from the UK, but, borrowing from banks already lined up and willing to lend, subject to required approval from the UK.
The Cayman Government in early October adjusted its revenue measures with increased fees and duties across all sectors. The Government is still addressing further cuts in expenditure to generate what it describes as a 'small surplus' in revenue at the end of the 2009/2010 financial year. The Leader of Government Business declared that he would not be looking for 'one red cent' from the UK and the representative from one of the private sector associations commented to the British Press, 'If we wanted lectures on how to manage our economy, the FCO would be the last body on earth we would approach!'5 Yes, it is all quite ironic!
What can only be described as a standoff between the UK and the Cayman Islands on taxation for the Islands, brought home the challenges that seem unique to Cayman; finding a level playing field as a small territory leading the way in an important global industry. The Islands' continued firm grip as a leader in the hedge fund industry, has pitched it squarely against its not-so-loving mother England, as a competing financial centre and, yes dare I say it, as a tax haven (as England itself has direct taxation but, also has lower taxation incentive laws to attract persons and entities from other jurisdictions, England would not have the benefit of being described as a 'tax neutral' territory, such as the Cayman Islands). But, the same is true for Delaware in the United States.
In what might seem to be an effort to avoid the obvious poor administration of onshore regulation (and perhaps not so much insufficient regulation) there has been much finger pointing and a form of 'McCarthyism' at its best. The latest target being the hedge fund industry, which somehow also seems to be 'scapegoated' as a catalyst for the global economic woes. The result; the EU Directive for Alternative Investment Fund Managers (Directive), designed to 'regulate' alternative investments (those cynics amongst us would say that this would stand to reason since Cayman is home to over 80% of the world's hedge funds). But, the severe backlash to the Directive has been raging since April this year. Lord Myners of Truro, financial services secretary to the UK Treasury was quoted in September as saying that there is 'no doubt, there will be a directive' but, at the same time acknowledging that the form of Directive before them will be amended because it is 'inadequate'. However, most are of the view that if the Directive moves forward in any form similar to the current draft, the UK will be severely impacted. Lord Myners made an interesting observation in his address, noting that people have argued that it is only by closing the EU market to all who do not meet equivalence tests that managers could be incentivized to move to the EU. Although he rejects the argument as being false, it is still a rather telling statement; although the Directive is purported to improve regulation, the true aim appears to be a desperate bid to drive business to the EU, a cartel of sorts. This would perhaps explain why so much attention is being given to the hedge fund industry in spite of the fact that all agree there is no indication that it played a role in the world's economic woes. To thicken the plot, the EU Commissioner for Internal Market and Services, Charley McCreevy has since admitted that "Most commentators agree that alternative investments such as hedge funds and private equity were not the primary causes of the crisis. There has been however strong political pressure from all sides of the outgoing European Parliament for more regulation in this area".6
But, those in the industry warn that it might well have the opposite effect than that which the EU is hoping for. The International Fund Investment's research department7 interviewed UK based alternative fund managers and their consultants earlier this summer, as well as institutional investors and family offices to get their views on domiciliation on the heels of the Directive and the recent income tax increases. Ultimately, when asked if they will relocate their funds as a result of the Directive, most interviewed indicated that it is the rules, resources, reputation and regulatory infrastructure that are the critical factors in domicile satisfaction – not so much that they are in the EU. The fact that the Cayman Islands has as strong an infrastructure to support the investment fund industry as most notable onshore jurisdictions, has kept the Cayman Islands at the pinnacle of success in the hedge fund industry to date. When asked to rate the service they receive from their offshore service providers, the report showed that auditors came top, lawyers came second and administrators came last. The fact that the Cayman Islands continues to host almost all of the top accounting firms and more leading law firms than most of its competitor offshore jurisdictions, allows Cayman to continue to be favourably viewed for domiciliation of funds. The fund managers have made the point that EU based funds will be 'expensive and time consuming' and most predict the failure of the draft Directive. The Directive is viewed as an effort to force fund managers to work in a jurisdiction that is less user friendly, with less efficiency, less flexibility and more set up costs and overall expenses than setting up in the Cayman Islands which is known for striking the right balance with effective and appropriate legislation. NO ONE interviewed was looking to relocate their funds voluntarily and most said they would not, even if they were required to relocate themselves to another jurisdiction.
The industry might well prove that it will continue to abide by the general principles of any free trade market; it will gravitate to where they can consistently find the best quality service providers with effective regulation but, user friendly legislation. The EU and the US current efforts to force business back into their jurisdictions, even with tax haven legislation of their own and a high-handed approach to business, will ultimately require them to thwart capitalism and fair market trade, which is interesting considering the principles on which the UK and the US have been built over the centuries, as these are the fundamental basics of a democratic society.
As a result the continued use of the Cayman Islands in the hedge fund industry in spite of all of the challenges remains. While incorporation of funds are down due to the economy, Cayman still holds it's percentile of fund incorporations globally as its fundamentals of doing business have fortunately not changed. Hence Moody's observation that there has been no "fundamental policy shift away from fiscal conservatism" and the Islands are sending a clear message that they remain open for business. The Government of the Islands has shown the sort of 'moxie' that will be crucial to the Islands continued success; it has consulted with the private sector to determine the best course of action to move forward, determining the fee increases, immediate cuts in Government spending and the determination not to impose direct taxation. Perhaps this is democracy and capitalism at its best.
1.NPR 2nd October 2009
2.CNBC 24th September 2009
3. 'China Begins its Move Away from US Dollar', 4th September 2009, The Market Man.
4.Financial Times (UK) 5th October 2009
5.Guardian.co.uk, 'Cayman has no need of British Help', 16th September 2009.
6.Institute of Chartered Accountants In Ireland (ICAI) Financial Services Breakfast Seminar, Dublin, 26th June 2009
7.An Industry in Transformation, 2009
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