Plans for governments to exchange tax information were thrown into disarray at negotiations in June 2003 over the European Union Savings Tax Directive. Despite the EU's commitment to information exchange as the ultimate objective of its plans for policing tax compliance, Switzerland — drawn into the debate — insisted on preserving its banking secrecy. The result: The EU granted a temporary, possibly permanent, exemption from information exchange obligations to Switzerland, then conceded the same treatment to EU members Luxembourg, Austria and Belgium.

All the states involved in this tussle are members of the Organisation for Economic Cooperation and Development — the same group that was threatening non-member jurisdictions with draconian sanctions if they did not commit to the parallel program for information exchange being pursued by the OECD, a Paris-based club of 30 nations, with membership restricted to the principal developed countries of the world.

Now, with the European nations' resistance casting doubt on OECD assurances that its members would adhere to information exchange standards;1 it is inconceivable that the OECD would sanction non-member jurisdictions. There also is an understandable temptation for smaller offshore jurisdictions to rescind commitments on tax information exchange they made to the OECD.

The OECD's program for tax information exchange is in jeopardy. But its vision of a world with nowhere to hide money is too important to fail. Eventually there must be information exchange in an interdependent world. Small jurisdictions that prove insensitive to the need to assist larger countries — on which their ability to do business depends — risk damaging confrontations.

Despite concerns over how it's handled the process, the OECD deserves credit for pioneering work toward greater cooperation in a global world. The EU also has contributed to policy design, although its proposal for automatic provision of data is intrusive and indiscriminate. The OECD's approach — information exchange on request — strikes a better balance between the needs of law enforcement and an individual's right to privacy.

Unfortunately, the OECD's initial engagements in 1998 with non-member jurisdictions were clumsy and aggressive. Still, constructive dialogue between the OECD and offshore centers was gaining momentum in 2001 and 2002. Then the June 2003 EU fiasco hit. Because threats can no longer secure the additional cooperation that OECD needs at this stage, a new process for change is needed. It is now essential to give offshore centers a positive stake in devising the global regime for tax information exchange.

OFFSHORE CENTERS

No longer the fiscal pirates depicted in John Grisham's thriller The Firm, small offshore jurisdictions have grown up. As little as five years ago most were marginal players, operating on the periphery of the world financial system. Although initially reluctant, offshore centers have engaged with agencies such as the OECD, the Financial Action Task Force (FATF) and the International Monetary Fund (IMF) to adopt global standards for regulation. Increasingly, they've been drawn into mainstream global finance.

I mean “offshore center” in a conventional sense — to describe the smaller international financial centers such as Bermuda, Cayman and Jersey. In reality, though, offshore is more appropriately defined not by a financial center's size, but rather by whether its financial services are provided to clients who live outside its jurisdiction. Tax-free facilities for cross-border financial services to attract non-resident clients (such as no taxes on bank deposits, investment management or bonds) are common both in small and in major, developed countries.2 London, New York and Tokyo control, between them, nearly 60 percent of the global market for offshore services. Taking into account the additional activity in other OECD member states, OECD jurisdictions control 80 percent of the international market for offshore services.3

To be effective, regulatory initiatives must take into account that tax-free facilities and regulatory concessions exist to attract offshore clients in both large and small centers.4 Without a common standard, shady business will simply move to poorly regulated centers. Recognizing this possibility, OECD and the Financial Action Task Force (a G-7 chartered body established in 1989 to fight money laundering) have insisted that non-members join their tax information exchange programs.

Offshore centers have made significant adjustments in their financial services regimes to engage in the global fight against money laundering and terrorism. Indeed, the FATF's work in these areas with small offshore centers since early 2000 has been so successful that the regulatory regimes in many of these centers now exceed the standards of those in large, industrialized nations.5 For example, offshore centers now routinely require corporate service providers to establish and track beneficial ownership for companies; this is not generally required under LLC regimes in the U.S. states.

Smaller offshore centers hesitated to sign on to new information exchange systems, because they were concerned that gateways established for money laundering data would lead to the use of such information for other purposes — including tax enforcement. The EU's pitched battle over the savings tax directive leaves no doubt that large countries also recognize that tax information exchange is fundamentally different from exchange of financial information to combat crime.

NOVEL INTERNATIONAL LAW

Tax evasion is a crime. Conduct that encourages, facilitates or ignores tax evasion in another jurisdiction is morally reprehensible. It is not, however, self-evident that condemnation of foreign tax evasion means any jurisdiction is obliged to establish infrastructure to track and exchange data (without recompense) to deal with tax enforcement failures in other countries.

International law supports this view, and imposes no unilateral obligation on a jurisdiction to help another collect taxes. Yet countries do aid each other with extraterritorial enforcement through consensual treaties. Bilateral tax treaties, for example, often include provisions for exchange of information to assist with the enforcement of taxes imposed by the contracting states. But such agreements seldom require a jurisdiction to establish additional rules or infrastructure to enforce the taxes of others. The notion that a country could be obligated to build infrastructure to provide unilateral assistance to help another government enforce taxes — the premise of the OECD Harmful Tax Practices Project — is an entirely novel concept in international law.

In a crucial concession, the OECD accepts that offshore centers are free to operate income-tax-free regimes.6 High-tax OECD systems deserve similar tolerance from offshore centers. This truce would mean, at a minimum, that as long as there is mutual respect for different approaches to taxation, service providers in offshore centers ought not to undermine high-tax OECD regimes by inviting tax evaders to seek refuge in confidential offshore financial structures.

Offshore centers rely on access to foreign markets to maintain local financial services industries much larger than could be supported by domestic demand. Accordingly, while the legal basis for OECD demands for tax information exchange is questionable, it is impractical for an offshore center to unplug from the international legal grid — unless the center is prepared to restrict its local financial sector to its purely domestic, typically tiny market.

Clearly, a negotiated compromise on sovereign cooperation that balances the needs of large and small countries is the reasonable and pragmatic outcome.7 But how to achieve this result?

PROCESS FOR CHANGE

Initiatives on information exchange have been actively promoted by the OECD. (See “Membership Is Key,” page 59.) The OECD has been the leading supranational agency in policy development on this issue, and led the charge with its groundbreaking 1998 study Harmful Tax Competition: An Emerging Global Issue. Until the recent upset in the EU savings tax directive negotiations, the OECD had achieved considerable success in promoting cooperation on tax information exchange from its own members as well as from governments of a number of the offshore financial centers established in such non-member states as the Bahamas and Isle of Man.

The FATF (a sister agency to the OECD housed in its Paris offices) has mounted a campaign with complementary objectives to combat money laundering and terrorist financing. A number of other bodies (including the IMF, the Financial Stability Forum and the United Nations) have pursued similar initiatives to promote transparency in the world's financial system.

These agencies controlling the process for change have overlapping membership, and therefore represent essentially the same sovereign actors operating through different forums. With the exception of the IMF and the UN, the bodies have limited and exclusive membership comprising only the larger countries in the international financial services industry.

Unsurprisingly, the smaller jurisdictions not represented in these agencies are troubled about a game plan for change in which the dominant participants are both players and referees. The OECD exacerbated suspicions in 1998 by its confrontational approach with non-member jurisdictions. The agency immediately demanded higher standards from non-members than those agreed upon by its own members. The OECD also confined discussion on information exchange policy to its members, conceding a right to limited participation only to those non-members who committed to abide by the program's principles. Carrots were in short supply for those without a seat at the table; instead, excommunication from OECD member states' securities and banking markets (characterized as “defensive measures” by the OECD) was threatened for non-members who refused to commit to the OECD's broad and unspecified program for information exchange.

The OECD process has been dogged by its members' dissent on proposals for change, fueling non-member states' worries about a level playing field. Two member countries, Luxembourg and Switzerland, have refused to support OECD reports on the Harmful Tax Practices Project. In addition, although the U.S. federal government has always committed in principle to facilitating information exchange on request, implementing obligations to track beneficial ownership for private corporations is a prerogative within U.S. state jurisdiction and states such as Delaware have been slow to follow the federal lead.

The OECD has dismissed these derelictions, noting that most of its member states have accepted the agency's principles for information exchange. But the jurisdictions declining to adopt new standards of transparency — Switzerland, Luxembourg and states within the United States (including Delaware) — are the main OECD competitors in the market for offshore services and account for most of the tax-neutral structures run onshore within OECD states. Thus the OECD's efforts have arguably yielded results that are more apparent than real — while inflaming the fears of non-members.

SAVINGS TAX DIRECTIVE

After intensive and occasionally acrimonious discussions conducted for more than six years, EU member nations finally reached agreement June 3 on the taxation of cross-border payments of interest. The directive will have a major impact on the entire financial services industry throughout the EU and in Switzerland after it becomes effective in 2005. Although the directive applies only to interest paid to individuals, financial institutions will have to monitor all interest payments to know when to apply the directive.

To avoid the migration of banking business to competitors outside its borders, the EU determined to seek the adoption of what it called “equivalent measures” by specific non-member countries, including the United States, Switzerland, Monaco, Liechtenstein, Andorra, San Marino and most of the dependent territories of EU member states.8

The EU negotiations with Switzerland were protracted, with the Swiss refusing to compromise bank secrecy. This public row was watched closely by the offshore centers who already had committed to exchange information based on OECD assurances that the agency would get Switzerland to apply similar standards. Faced with Swiss intransigence and the possible collapse of the savings directive, the EU reluctantly agreed to accept a Swiss offer to impose a withholding tax in lieu of information exchange. Austria, Belgium and Luxembourg, never comfortable with the information exchange plan, then demanded the right to limit their obligations to a comparable withholding tax until Switzerland changes its policy.

The United States has indicated a willingness to engage in information exchange pursuant to bilateral tax treaties, but has rejected a proposed requirement to routinely collect comprehensive information in order to facilitate automatic exchange. Sensing that pressuring the United States on this point would be futile, the EU quietly declared that the U.S. approach constituted “equivalent measures.”

Negotiations with the UK's dependent territories, which also hit some bumps, are not over yet. The constitutional arrangements of these territories differ, but most enjoy effective control over domestic fiscal matters, while their foreign affairs are generally a UK prerogative. Still, a number of the dependent territories were vexed to find that, without first checking with them, the UK promised EU partners that it would secure the territories' consent to the savings tax directive.

The main elements of the directive,9 finally agreed upon June 3, are:

  • The directive is limited to the savings income of EU resident individuals. It is not applicable to trusts or companies, except when these entities are functioning as nominees for individuals.
  • The directive applies only to interest — though not, apparently, interest arising from insurance products and derivative contracts. Redemptions of debt instruments and bond funds are characterized as interest in certain circumstances.
  • Austria, Belgium and Luxembourg are allowed to levy withholding tax in lieu of exchanging information. The rate of withholding tax is 15 percent in 2005, rising to 25 percent in 2007 and 35 percent in 2010. The payor state retains 25 percent of the proceeds collected, remitting 75 percent to the individual's country of residence.
  • Countries outside the EU that participate in the directive effectively have a choice of applying withholding tax or exchanging information. Switzerland will apply withholding tax.
  • Austria, Belgium and Luxembourg are no longer committed to automatic exchange of information after 2010. This requirement is conditional upon the EU securing agreement from Switzerland and the United States (as well as Liechtenstein, San Marino, Monaco and Andorra) to exchange information on request.

The last point suggests the ultimate standard for the EU and OECD will be information exchange on request, rather than automatic. This distinction has important implications for the British Crown dependencies and Overseas Territories to make their own election between the withholding (retention) tax and information exchange. The Crown Dependencies (Guernsey, Jersey and the Isle of Man) have opted for non-resident withholding tax, rather than information exchange. The Caribbean dependent jurisdictions are likely to insist on their right to do likewise.

OECD PROJECT DERAILED

The EU's savings tax directive also has major implications for the OECD Harmful Tax Practices Project. Because of the OECD's assurances that its member states would implement equivalent regulatory measures, 30 non-member so-called “tax havens” (such as the Cayman and Channel islands) pledged to track data and exchange information for tax enforcement purposes.10 Now, though, the OECD faces the embarrassment of having its assurances publicly contradicted by the EU savings directive, which effectively exempts certain OECD states from exchanging tax information until at least 2010, without any promise that matters will change after that date.

The OECD has argued that the savings tax directive and its Harmful Tax Practices Project are separate initiatives and should be seen as such. This difference is true at a technical level, as the scope of the savings tax directive is restricted to the cross-border savings of EU resident individuals, and concerns automatic exchange of information (compared to “on request” in the OECD initiative). But the acrimonious EU discussions make plain that it will not be easy to move particular OECD member states on information exchange issues. Austria, Belgium, Luxembourg and Switzerland recognize the potential loss of business that these changes portend. The obvious nexus between the two projects has been generally acknowledged, and the EU negotiations bode ill for success of the OECD project.

It's not just the Europeans who are proving problematic. Eastern financial centers such as Hong Kong and Singapore do not appear on the OECD tax haven list, nor are they members of the OECD. Their international financial services industries must be brought into the OECD project to create a coherent global standard.

The United States poses unique difficulties, as it perceives constitutional constraints in supervising state governments. U.S. limited liability corporations (LLCs) in Delaware and most other U.S. states are not subject to U.S. tax on foreign income — and so are widely used in the offshore world as a substitute for traditional tax-neutral companies. These LLCs do not require disclosure of beneficial ownership or financial information to the state or corporate service provider.11 Accordingly, U.S. state governments would be unable to provide information regarding tax-free LLCs from records maintained in their home jurisdictions in a manner similar to that demanded from offshore centers.12

In order for the OECD's vision of tax information exchange to come true, all countries — and the U.S. states — must make identical, specifically enumerated commitments to change regulations in a functionally equivalent manner, on the same timetable and subject to the same consequences for non-performance. The OECD risked, and has now damaged, its credibility by demanding commitments from outsiders when it lacked similar commitments from key members of its own group. To get back on track, the agency must bring all of its members into line. Even Don Johnston, secretary general of the OECD, admitted in a letter to the European commission — leaked shortly before the initial EU decision on the savings tax directive — “If some OECD countries were to receive more favourable treatment as a result of the EU negotiations, this could lead [the offshore financial centers] to withdraw their commitments.”15

SEIZE THE INITIATIVE

It is tempting for offshore centers to pull back from OECD commitments and await the agency's next move. But this approach would cede the initiative back to the OECD, and raise the certainty of further confrontations. Instead, offshore centers should take the initiative now — and thereby take more control of the process.

Although the OECD is easily criticized, its underlying demand for cooperation is reasonable. Offshore centers should not expect unrestricted access to the banking and securities markets of larger countries without recognizing certain responsibilities in response. Indeed, the offshore centers' assumption of responsibilities is now spurring a metamorphosis in their business mix, positioning them to reap the benefits of a seamless and complete integration into the world financial economy.

Although change is disruptive and provokes consternation, the long-term interests of smaller financial jurisdictions are best served by cooperation with the countries upon whom their business depends. It would be dangerous to discontinue the conversation about information exchange simply because the OECD has faltered.

Negotiations with the OECD since 1998 have persuaded most offshore centers that they do have obligations to engage in some information exchange, even for tax-enforcement purposes. Control over information exchange and the processes adopted for achieving it should now move out of the OECD and into the individual jurisdictions. Thus, offshore centers should make provisions, as a matter of domestic law, for exchange of data in defined circumstances, just as Switzerland does.

Offshore centers also should design the process for this exchange to take their interests into account.14 For example, they should require, as a condition for furnishing information, that those countries seeking it drop provisions in their domestic tax codes that discriminate against tax havens (such as inclusion on blacklists and the like). Standards adopted by the offshore centers should no longer move beyond those adopted in powerful competing financial centers in the larger countries. The smaller centers should instead benchmark and keep pace with emerging global standards — as the larger centers do.

Although the smaller international financial centers usually have been subject to OECD pressure as a group, their concerted action has been surprisingly limited. Offshore centers have had some difficulty taming their competitive instincts — even when shared interests are at stake. Cooperation also has been inhibited by concerns about the range of regulatory quality among the smaller international financial centers. Yet, even though the OECD also represents a wide spectrum (with membership including countries as diverse as France, Turkey, Mexico and New Zealand), it still manages to make progress on a common agenda.

There are some hopeful signs. Prospects for cooperation among the international financial centers have improved with the formation of the International Trade and Investment Organisation, which meets periodically to review matters of mutual concern. Established in March 2001, the ITIO is a group of 16 small and developing economies formed to help develop a unified response to global tax and investment challenges.15 The international Society of Trust and Estate Practitioners, representing industry professionals from financial centers around the world, also has taken important steps in promoting a broad and constructive agenda for change.

Offshore centers should continue to try to work together so they can influence, even direct, the agenda for tax information exchange. They also must cooperate with the larger countries. International talks should focus on well-regulated tax-neutral platforms — rather than the perceived recalcitrance of ungrateful small countries benefiting, but not contributing, to the policing of the global economy.

The process and new rules must be designed to:

  • establish a level playing field;
  • discuss and decide policy in a universal forum that includes all affected parties;
  • acknowledge competing considerations, such as reasonable financial privacy; and
  • create regulatory approaches proportionate to the risks and benefits associated with the activity being regulated.

Although the recent EU fireworks are unfortunate, the OECD is to be commended for stimulating the debate on global financial transparency. Offshore centers should use this pause in the OECD project to seize the initiative, recognizing that greater cooperation and information exchange are inevitable in an increasingly integrated world. These jurisdictions have proven to be nimble players in adapting to change. They are now well-positioned to exercise that strength.

Endnotes

  1. In “Towards World Tax Cooperation,” OECD Observer (June 27, 2000), Jeffrey Owens, OECD head of fiscal affairs, reviewed the OECD's demands for transparency in the Harmful Tax Competition initiative and stated: “And let me [emphasize] that the same standards will apply to all [OECD] member countries and non-member countries.”

  2. Services provided on tax-neutral platforms include the following:

    • establishment and administration of mutual fund companies and trusts;
    • investment management;
    • banking facilities;
    • structured debt and special-purpose vehicles to support capital markets transactions;
    • structures for the management of political and personal risk;
    • special-purpose vehicles for securitizations;
    • insurance and reinsurance products;
    • international employee stock option plans;
    • deferred compensation and pension plans;
    • international tax and estate planning; and
    • shipping and aircraft financing structures.
  3. See “International Trade in Offshore Business Services: Can Developing Countries Compete?” by Rajiv Biswas in International Tax Competition, Globalisation and Fiscal Sovereignty, edited by Rajiv Biswas (Commonwealth Secretariat, 2002), p. 112.

  4. As the Financial Stability Forum's Report of the Working Group on Offshore Centres notes at p. 8, the growth of London as the largest offshore banking center has been linked directly to regulations imposed on the U.S. banking sector: capital controls implemented through the Interest Equalisation Tax of 1964, the Foreign Credit and Exchange Act of 1965, cash reserve requirements on deposits imposed in 1977 and a ceiling on time deposits in 1979. By establishing foreign branches to which these regulations did not apply, U.S. banks were able to operate in more cost-attractive environments.

  5. See the comparative tables for standards of regulation in OECD and non-OECD international financial centers in Towards a Level Playing Field: Regulating Corporate Vehicles in Cross-Border Transactions, a review conducted by Stikeman Elliott, 2002 (see in particular Appendices C-E). www.itio.org/NewTLPF-II_What_is.htm

  6. Towards Global Tax Co-operation, June 26, 2000.

  7. For a wide-ranging and thoughtful consideration of the rationale and need for greater government access to taxpayer data in a globalizing world see “Going, Going, Gone… Global: A Canadian Perspective on International Tax Administration Issues in the Exchange of Information Age,” by Sarah K. McCracken, Canadian Tax Journal, 2002, Volume 50, No. 6, p. 1869.

  8. Apparently in error, the draft proposal on the Taxation of Savings Income published on July 18, 2001 referred to the Caribbean territories of the UK, and so failed to impose an obligation to secure the consent of Bermuda.

  9. See the two-part piece entitled “The E.U. Savings Directive and its Impact on the Banking Industry” by P. Gerrits, M. Grob, S. Jarrett, M.J. Michaels and P. Marcovici of Baker & McKenzie, Amsterdam, Zurich and Geneva, Tax Planning International (July and August 2003) for an informative review of the structure and operation of the directive.

  10. Six of the so-called “tax havens” committed to tax information exchange in the Spring of 2000. Most of the remaining offshore centers classed by the OECD as tax havens committed over the period from mid-February to mid-April 2002. The later commitments were conditional on the establishment of a level playing field for the regulation of financial services. The accords concluded between the OECD and the putative tax havens also set out plans for the tracking and exchange of financial and beneficial ownership information with elements as follows:

    1. Criminal information exchange: All committing offshore centers agreed to adopt administrative procedures for the exchange of financial data by 2004, to be achieved through negotiated tax information agreements with OECD member countries. Exchange of information will generally take place pursuant to specific request only and subject to protections against unauthorized disclosure or use of the information.

    2. Civil tax information exchange: All committing jurisdictions agreed to provide for administrative exchange of ”civil” tax data by 2006. Once again, this would be achieved through agreements negotiated with OECD member countries and limited to circumstances in which there is a specific request. The term “civil” was generally undefined in the commitments.

    3. Access to ownership and financial data: Committing jurisdictions generally agreed to ensure that information on the beneficial ownership of companies, partnerships, other legal entities and similar information for trusts would be available to local authorities and available for international exchange. Most commitments will effectively permit jurisdictions to satisfy this commitment by ensuring that local service providers have information available for their governments on request.

    4. Filing and audit of financial data: All accords made some reference to the filing and auditing of data, though significant variations existed between the commitments on these points. The OECD showed considerable flexibility on these points in its “Global Forum” meeting in Cayman in October 2002 with the committed non-member jurisdictions, now referred to by the OECD as “participating partners.”

  11. See the reference to the U.S. General Accounting Office Report, Suspicious Banking Activities: Possible Money Laundering by U.S. Corporations Formed for Russian Entities.

  12. “Crackdown on Tax Cheats Could Backfire on the EU,” International Herald Tribune (Jan. 23, 2003) p. 1.

  13. For an insightful review of negotiating strategies for offshore centers, see “Issues Low Tax Regimes Should Raise When Negotiating with the OECD,” by Bruce Zagaris, Tax Notes International 523 (Jan. 29, 2001).

  14. ITIO currently comprises Anguilla, Antigua and Barbuda, Bahamas, Barbados, Belize, British Virgin Islands, Cayman Islands, Cook Islands, Isle of Man, Malaysia, Panama, St. Kitts and Nevis, St. Lucia, St. Vincent and the Grenadines, Turks and Caicos and Vanuatu.

  15. ITIO and STEP worked together in commissioning Towards A Level Play-ing Field: Regulating Corporate Vehi-cles in Cross-Border Transactions.

MEMBERSHIP IS KEY

Major developed countries enjoy cross-membership in the world's supranational organizations — giving them greater control over talks about the new, global system for tax information exchange

G7 G7 OECD FATF FSF Percentage Of Total Votes in IMF
Canada X1 X X X 2.95
France X X X X 4.97
Germany X X X X 6.02
Italy X X X X 3.27
Japan X X X X 6.16
United Kingdom X X X X 4.97
United States X X X X 17.16
OECD
Australia X X X 1.51
Austria X X 0.88
Belgium X X 2.14
Czech Republic X 0.39
Denmark X X 0.77
Finland X X 0.59
Greece X X 0.39
Hungary X 0.49
Iceland X X 0.07
Ireland X X 0.4
Korea X 0.77
Luxembourg X X 0.14
Mexico X X 1.2
Netherlands X X X 2.39
New Zealand X X 0.42
Norway X X 0.78
Poland X 0.64
Portugal X X 0.41
Slovak Republic X 0.18
Spain X X 1.42
Sweden X X 1.12
Switzerland X X 1.61
Turkey X X 0.46
NON-OECD-MEMBER JURISDICTIONS
Andorra
Anguilla
Antigua and Barbuda 0.02
Aruba
The Bahamas 0.07
Bahrain 0.07
Barbados 0.04
Belize 0.02
Bermuda
British Virgin Islands
Cayman Islands
Cook Islands
Costa Rica 0.09
Cyprus 0.08
Dominica 0.02
Gibraltar
Grenada 0.02
Guernsey
Hong Kong SAR X X
Isle of Man
Jersey
Labuan (Malaysia)
Lebanon 0.11
Liberia 0.04
Liechtenstein
Macau SAR
Maldives 0.02
Malta 0.06
Marshall Islands 0.01
Mauritius 0.06
Monaco
Montserrat
Nauru
Netherlands Antilles
Niue
Panama 0.11
St Kitts & Nevis 0.02
St Lucia 0.02
St Vincent & the Grenadines 0.02
Samoa 0.02
San Marino 0.02
Seychelles 0.02
Singapore X X 0.41
Tonga 0.01
Turks & Caicos
U.S. Virgin Islands
Vanuatu 0.02
Endnotes:
1. X indicates membership.