Cyprus: Offshore Financial Centres - Recent Developments

The last half of the 20^th century saw significant developments in the world financial system. Restrictions on trade and capital flows were relaxed, technology made rapid advances and the different parts of the global economy became more closely linked.

Offshore financial centres (OFCs) benefited greatly from these events and from the increased cooperation and competition which followed, and some became major centres of economic activity for multinational enterprises. A British report in 1998 estimated that the amount invested offshore then exceeded $6 trillion, more than the GDP of every nation except the United States of America.

What made OFCs so attractive? The main reason was their tax advantages, for both businesses and high net worth individuals, but they also offered confidentiality and political stability for financial activities, shielded from unwelcome regulation by geography and/or legislation. In addition, many of them offer the pleasant prospect of sun-kissed islands with beaches shaded by palm trees and washed by azure seas.

Just as attractive and successful human beings often become targets of criticism and complaint (usually based on jealousy!), so OFCs found themselves under attack. They were charged with introducing practices designed to encourage non-compliance with the tax laws of other countries. More specifically, they were accused of allowing themselves to be used to hide drug money, for tax fraud, for the circumvention of foreign inheritance laws and for money laundering and the promotion of corruption in general, with the implied assumption that all the money they held came there illegally.

In 1998 the OECD issued its report entitled Harmful Tax Competition: An Emerging Global Issue. It focused on geographically mobile activities such as financial and other services, it identified factors that could undermine the integrity and fairness of tax systems and it listed the following four criteria to determine the harmful aspects of a particular jurisdiction and identify it as a so-called tax haven:

• No, or nominal, taxes and no, or low, effective tax rates
• Lack of effective exchange of information
• Lack of transparency
• No substantial activities and/or ring fencing

The concern of the OECD with tax competition might not have been entirely unconnected with the preoccupation of the EU with tax harmonization. But whereas the EU, as a common market, needs a common rate of tax with only minor local variations, there was no justification for the OECD to use harmonization as a synonym for uniformity and try to impose such uniformity on the whole world.

Two of the then 29 member countries of the OECD abstained from the 1998 report – Luxembourg and Switzerland. Two countries small in size and population but vast in terms of financial activity and influence. In 1996 Luxembourg accounted for more than half the world’s offshore mutual funds. The range and depth of the financial deposits in Swiss banks is legendary, as is the secrecy that surrounds them.

Two years later, a change could be detected in the OECD’s progress report in 2000 entitled Towards Global Tax Cooperation: Progress in Identifying and Eliminating Harmful Tax Practices. It identified 47 potentially harmful preferential tax regimes in OECD member countries and listed 35 jurisdictions found to meet the tax haven criteria, but it also proposed a process whereby tax havens could commit themselves to eliminate harmful tax practices. Comparison of the titles of the 1998 and 2000 reports confirms that the emphasis had moved from harmful competition to harmful practice.

Before the 2000 report was issued, six jurisdictions – Bermuda, Cayman Islands, Cyprus, Malta, Mauritius and San Marino – had committed themselves to eliminate any harmful tax practices by the end of 2005. After the report was issued, five more jurisdictions - Aruba, Bahrain, Isle of Man, Netherlands Antilles and Seychelles – made similar commitments, to make a total of 11 so-called ‘committed jurisdictions’.

Since the 2000 report several multilateral discussions have taken place. There was a joint OECD-Commonwealth meeting in Barbados in January 2001, a Pacific region conference in Tokyo and a gathering of jurisdictions from Europe, the Middle East and OECD member countries in Paris in February 2001 and a joint OECD-Pacific Islands Forum meeting in Fiji in April 2001. It seems that these discussions, and some dialogues between OECD members and the tax haven jurisdictions, led to a better understanding by the OECD of the concerns of those jurisdictions about the commitment process and participation in the harmful tax practices work.

In November 2001 the OECD issued another progress report, entitled The OECD’s Project on Harmful Tax Practices, in which it stated (paragraph 26):

‘Some Member countries, as well as some tax havens, have expressed concerns regarding the application of the no substantial activities criterion, the application of a framework of coordinated defensive measures to tax havens as of 31 July 2001 and the time frame for developing implementation plans.’

The report went on to say that, in the light of the discussions with the jurisdictions, the OECD’s Committee on Fiscal Affairs had concluded that the no substantive activities and ring fencing criterion should no longer be used (paragraph 27), and that commitments would be sought only in relation to the effective exchange of information and transparency criteria, to determine whether or not a jurisdiction is considered to be an uncooperative tax haven (paragraph 28). It also said that the ‘committed jurisdictions’ could review their commitments in respect of the no substantial activity criterion (paragraph 29).

In paragraphs 32 and 33 the Committee said that it ‘recognizes that the potential application of a framework of coordinated defensive measures to tax havens prior to their potential application to OECD member countries raises concerns regarding a level playing field between member countries and tax havens’ and ‘has decided that the time for making commitments will be extended to 28 February 2002’.

The use of the phrase ‘level playing field’ lifted the lid on the discontent which has been seething for some time beneath the apparently tranquil surface of the operations of the OECD steamroller.

Belgium and Portugal abstained from the 2001 report. Luxembourg recalled its abstention from the 1998 report which also applied to the 2001 report, regretting that the latter was further away from the goal of combating harmful tax competition with respect to the location of economic activities. Switzerland noted that its 1998 abstention applied to any follow-up work done since 1998.

As well as the four abstentions out of its current membership of 30, the OECD had earlier had to contend with the statement made by Mr. Paul O’Neill, the US Treasury Secretary, on 10 May 2001. Mr. O’Neill said:

‘…I share many of the serious concerns that have been expressed recently about the direction of the OECD initiative. I am troubled by the underlying premise that low tax rates are somehow suspect and by the notion that any country, or group of countries, should interfere in any other country’s decision about how to structure its own tax system. I am also concerned about the potentially unfair treatment of some non-OECD countries. The United States does not support efforts to dictate to any country what its own tax rates or tax system should be, and will not participate in any initiative to harmonize world tax systems. The United States simply has no interest in stifling the competition that forces governments – like businesses – to create efficiencies…’.

Faced with such an unequivocal declaration of opposition from the US, any programme of sanctions to try to enforce harmonization of tax systems throughout the world would surely have been doomed from the start. The volte-face by the OECD is confirmed by the press notice accompanying the 2001 report which said that the OECD ‘seeks to encourage an environment in which free and fair tax competition can take place in order to assist in achieving its overall aims to foster economic growth and development worldwide.’

Far from being a global issue, emerging or otherwise, there is a widely held view – obviously shared by the United States – that tax competition is not merely harmless but is positively beneficial. There is a strong argument, that it has made a notable contribution to the substantial wealth created during the last half century and should be enabled, indeed encouraged, to continue. The challenge of the twenty first century must be to share wealth more equitably among all the nations of the world, particularly in the taxation of e-commerce.

The 2000 and 2001 progress reports from the OECD are evidence of some back-pedalling and of a progressive and desirable shift away from an overbearing and dictatorial approach in favour of more openness and tolerance towards the so-called tax havens, working cooperatively with them and emphasizing evolutionary change through dialogue and consensus. The removal of the no substantial activities and ring fencing criterion and the more relaxed timetables for the making of commitments and the development of plans to implement those commitments must be welcomed, but there are still dangers in the desire of the OECD to collect tax-relevant information.

In this objective the OECD is supported, even outrun, by the United States. In his statement of 10 May 2001 Mr. O’Neill also referred to ‘…the core element that is our common goal: the need for countries to be able to obtain specific information from other countries upon request in order to prevent the illegal evasion of their tax laws by the dishonest few.’ This need for information has been reinforced by the events of 11 September 2001 and the consequent natural desire of the United States to protect itself from a more uncertain environment, although that desire in turn engenders the risk of a less level playing field, less competition and more intervention. The US Patriot Act 2001, which became law on 26 October 2001, subjects to special scrutiny foreign jurisdictions, financial institutions and international transactions that provide opportunities for criminal abuse, and the Secretary of the Treasury is empowered to take special measures against them if they are a primary money laundering concern. The focus of the legislation, on the identification of foreign account holders and the control of correspondent banking, implies that money laundering is essentially a foreign problem and seems to presume that the fault lies with OFCs.

Certain OFCs have already taken significant steps to remedy any shortcomings; the following are examples:

• The Netherlands Antilles are abolishing their offshore regime and replacing it with a new fiscal framework which will facilitate the expansion of tax treaties.
• The Bahamas enacted much supervisory legislation in 2000. It has been given Qualified Jurisdiction status by the US with whom it expects to enter into a tax information agreement. It has been removed from the FATF list and it has met the FSF requirements.
• The Cayman Islands concluded a tax information agreement with the US in November 2001 as part of its obligations as a ‘committed jurisdiction’. The renegotiation of all its tax treaties by the US to include tax information agreements is likely to continue.
• As part of its preparations for membership of the EU, Cyprus has published a package of radical tax reforms that is being considered by the House of Representatives. It includes the abolition of the preferential tax treatment of international business companies and the imposition of a uniform 10 per cent corporate tax rate for all companies, whether local or international.
• Its strategic position at the crossroads of Europe, Asia, the Middle East and Africa has always given Cyprus an important role as a regional and international business centre. In 1999 foreign exchange earnings from international business activities amounted to CYP 234 million or 4.7 per cent of GDP.
• Cyprus is determined to maintain and enhance its international business role and is playing a full part in all the efforts to eliminate harmful tax practices. It has kept records of beneficial ownership for some time, it was one of the first ‘committed jurisdictions’ and it was not on the FATF blacklist.

The FATF has already expanded its mission beyond money laundering, and will now also focus its energy and expertise on the worldwide effort to combat terrorist financing.

How can the collection of tax-relevant information be reconciled with the individual and corporate right to privacy and confidentiality? Nowadays it is generally accepted that this right must be curtailed if fraud and crime are to be effectively detected and deterred, if not prevented. But if information must be collected, a balance must be struck and, perhaps more importantly, some method needs to be found to ensure that the recipient of the information can be trusted with it and that it is not misused and does not fall into the wrong hands. The cry uttered by Juvenal in his Satires ‘Sed quis custodiet ipsos custodes ?’ should be an ever-present warning.

After all, are not many of the OECD member countries tax havens themselves? As recently as January 2002 the World Trade Organization (WTO) found that massive export tax breaks for companies like General Electric, Boeing and Microsoft amounted to illegal export subsidies. It is also questionable whether some of the EU tax regimes comply fully with WTO rules. Surely export tax breaks and subsidies are just as harmful as low direct taxes and special treatment of international business companies?

The quotations at the head of this article are intended to be a reminder that, whereas evasion of tax remains illegal, as do all the operations associated with evasion, avoidance of tax is, and always has been, an entirely lawful activity. OFCs provide individuals and companies with opportunities lawfully to avoid or postpone the payment of taxes, as well as a tax-neutral forum for residents of different countries to do business together. They are also a source of funds for banks and investment houses operating in major financial centres.

OFCs which are well-regulated and actively opposed to all forms of money laundering, terrorist financing and tax evasion should be allowed, indeed encouraged, to operate in a climate of open competition.

It is time for the OECD and EU pots to stop calling the OFC kettles black or, to use another proverb, for those in the OECD and EU glasshouses to stop throwing stones. The only sensible and constructive way forward is for all jurisdictions, large and small, OECD members or not, to cooperate fully on equal terms and by means of absolute transparency and effective exchange of information to eliminate harmful tax practices, with a view to achieving a genuinely level playing field for all on which to transact honest business.