TAX NEUTRALS STILL NEED TAX TREATIES
In March, Guernsey reached an agreement with Malta. The following month Guernsey announced the conclusion of treaty negotiations with Hong Kong and plans for talks with Liechtenstein and Luxembourg. What we are seeing is the creation of a strategic financial network. Guernsey recognizes that signing DTTs with any jurisdiction delivers limited long-term benefits, so it is aligning itself with a carefully selected group of “mid-shore” locations that are perceived as a bridge between the onshore and offshore worlds.
As cross-border structures become more complex and multi-layered, an increasing number of transactions will be routed through Hong Kong and Singapore in Asia and through Malta, Luxembourg and Cyprus in Europe. A tax neutral jurisdiction needs to build relationships with these players in order to stay relevant.
Guernsey is not the only offshore financial center to seize the initiative. Barbados and Panama saw their DTTs with Luxembourg come into effect at the start of this year as did an agreement between the United Arab Emirates (UAE) and Cyprus. Jersey and the Isle of Man have signed treaties with Malta in recent years, while Jersey and Seychelles are awaiting ratification of agreements with Luxembourg.
The key issue is that DTTs offer a lot more to tax neutral jurisdictions than TIEAs. Double taxation treaties address information exchange but also offer a variety of other financial benefits. TIEAs, by comparison, amount to little more than an agreement to serve as an outpost for foreign revenue authorities. In this sense, a DTT with a mid-shore financial center is particularly desirable because it solidifies a trading relationship. For those managing offshore structures, just the tax breaks on passive income – capital gains, interest, dividends, royalties and so on – offered through DTTs are compelling.
Qualification for treaty benefits rests on establishing a sufficient level of substance in the jurisdiction so that regulators have no reason to suspect a company exists solely to leverage these benefits. The potential impact of this on a local economy is significant.
Regulators look unfavorably on companies that, among other things, have limited business activities in the jurisdiction or operate on a scale that doesn’t tally with the amount of income being generated. It is therefore necessary to set up a local office, hire staff and retain service providers, lawyers and accountants to support the structure.
Tax neutral locations that rely heavily on financial services to spur GDP growth need this extra economic activity. They also need to appreciate the role they are increasingly being called upon to play in offshore structures. Guernsey, in seeking DTTs with Luxembourg and Hong Kong, is trying to secure its future in Europe and Asia as a piece of the fund management puzzle rather than its focal point. As an important private equity fund jurisdiction, an alliance with Luxembourg offers access to the euro zone and an easier time navigating the EU Alternative Investment Fund Manager Directive. Hong Kong, meanwhile, is the destination of choice for fund managers targeting rapid growth in Asia.
Put more broadly, a tax neutral jurisdiction can coexist effectively with a mid-shore location, provided it lays the groundwork. As an example, fund managers holding assets in India or China through investment holding companies in BVI or Cayman Islands will eventually want to realize their gains and return proceeds to investors worldwide in a financially efficient manner. If these structures include mid-shore jurisdictions, such as Hong Kong and Singapore, then investors have greater certainty about how their investment gains will be taxed. Without DTTs with a mid-shore jurisdictions, fund managers will look for certainty elsewhere and could result in certain jurisdictions being cut out of the loop.
In five to 10 years, OIL expects Hong Kong and Singapore to supplant BVI and Cayman as the most important jurisdictions, but it is not a zero-sum game. BVI and Cayman are so well-established that their influence is unlikely to fade, and steps can be taken to consolidate their market positions. Much the same applies to second-tier tax neutral locations such as Mauritius, Seychelles and Samoa. First, they must satisfy the global investment community that they are able to meet transparency requirements. Second, they should forge strategic alliances with mid-shore financial centers, initially through DTTs.
The naysayers who are skeptical that tax neutral jurisdictions have anything to offer potential DTT partners should think again. Some mid-shore jurisdictions are already taking the lead. A carefully assembled network of tax treaties is equally crucial to the long-term sustainability of the financial sectors in mid-shore jurisdictions.