The Cayman Islands and the John Grisham Effect: Yes, Everything Changed

by Isabel Freitas Peres April 29 2010, 01:24

Introduction

            In May 2009 American President Barack Obama spoke of how an address in the Cayman Islands housed 12,000 companies. Alluding to the possibility of illegal activity, he noted that this location was either the biggest building in the world or “the largest tax scam in the world.” This image of Offshore Financial Centers (OFCs) as havens for wrongdoing is generally held throughout the world.   Recent data indicates that the Cayman Islands holds over 670 billion American Dollars in banking assets from international investors.

            Because of such statistics, these small islands are considered a global villain, a haven for illegal capital. According to the OECD Harmful Tax Competition: An Emerging Global Issue (1998 Tax Report) jurisdictions that (a) imposes no or only nominal taxes, (b) lacks policy of effective exchange information, (c) lacks transparency and (d) has no requirement of “substantial activity” is identified as a tax haven. A Background Information Brief released by the OECD (Organisation for Economic Co-operation and Development) in March 2010 acknowledged the implementation of the Cayman’s actions towards transparency and information exchange. Despite this report’s recognition of the Caymans, it touched upon only a few of the measures that have been taken by the Cayman Islands in the last few years. These improvements in the Cayman’s internal structure and the regulatory actions taken by the Cayman Islands have enhanced the islands’ status within the international community. The Cayman’s pejorative title as a “tax haven” is, therefore, incorrect.     

            First, this article will examine the true atmosphere of the Cayman Islands, and how this British territory and the 5th largest banking center in the world is cooperating with the OECD and other jurisdictions by partaking in several Tax Information Exchange Agreements (TIEAs). Second, this article also aims to defend the valuable and important role of international policy distinctions among nations as a pursuit of effectiveness in the financial system worldwide.     

            1. The Hurricane Named Organisation for Economic Co-operation and Development and its implications 

            A taxation system is fundamental to any government’s display of authority and the sovereign’s capability to govern its territory. The rise in number of cross-border economic activities has created new dilemmas for nations, requiring new fiscally oriented legislation, yet such legislation, in turn causes a questioning of a nation’s also, in turn, causing absolute domestic fiscal sovereignty.

            As a result, a cooperative approach to addressing internationalization has emerged. Cross-boarder information exchange and general cooperation between nations has become the new benchmark by which offshore financial centers are evaluated and judged.  The OECD is current the chief organization in the discussion and implementation of tax cooperation amongst developed nations. The OECD has been highly active on the issues of international transparency and facilitating efficient global exchange of information.  The organization believes that these factors are elemental in understan ding how individuals attempt to hide their assets and avoid taxes.  To promote this belief the OECD has developed a tax standard that is contained in the article 26 of the OECD Tax Convention and the 2002 Model Agreement on Exchange of Information on Tax Matters. The standard is used as the international norm for tax co-operation and also is a model for the majority of bilateral tax conventions entered by non-OECD and OECD countries.

           Another tool used by the OECD to draw the political attention to tax matters is the the Global Forum, which is a multilateral framework formed by both OECD member and non-OECD member countries.  This framework publishes annual assessments of the administrative and legal structure for transparency and exchange of information in over 80 countries.

           All members of the Global Forum, including jurisdictions that are not part of the working group, are subjected to the analysis of their systems and the implementation of this policy pertaining to tax related. The TIEAs are model agreements developed jointly by the OECD member countries and delegations of other countries, including offshore centers as the Cayman Islands, to provide for the exchange of information and prevent harmful tax practices.When the Global Forum began, about 22 TIAs were signed in a period of 7 years. Between 2009 and 2010, more than 150 TIEAs were sig ned[9], thereby demonstrating the increased number of jurisdictions willing to exchange tax information with other jurisdictions.   

            2. A Caribbean Giant: the Cayman Islands        

           The Cayman Islands, as a prominent offshore financial jurisdiction, is forced to  confront many challenges. As an offshore financial jurisdiction, the Cayman organizes its legal system primarily to attract foreign investors, operating its framework for the needs of offshore investment. The subjects of this legal framework combine the traditional areas of the law with attractive innovations, especially tax neutrality and innovative instruments for foreign investors.   

           The Cayman Islands, as a tax neutral jurisdiction, attract the attention of not only investors worldwide looking for a safe and less costly investment, but also of onshore taxing authorities. Until April 2009, the Cayman Islands were in the “gray list” of the April Progress Report published by the OECD as a jurisdiction that had committed to the internationally agreed upon tax standard but had not substantially implemented it. In light of the OECD listing criteria, the Cayman Islands and other offshore jurisdictions have become the target of stigmatization for the OECD.  This lead to the OECD discouraging investors from becoming involved with these jurisdictions, thereby causing severe fiscal and economic damages to these small economies, once the OECD actions can be detrimental to islands that do not have a self sufficient economy 

           However, since the introduction of the OECD’s 1998 Report on harmful tax competition, these nations have experienced and faced great losses in the financial sector. Antigua and Barbados for instance, when adopting the OECD guidelines lost 54 of the nation’s seventy-two banks, concomitantly to a decrease in the number of business incorporation in these territories. Consequently, GDP rates decrease and unemployed in the national increased after such measures. Recently, since the Cayman Islands have consented and complied with the OECD demands, several banks have closed, the government threatened to revoke the charters of companies that had not proved considerable domestic activity, and have compelled the financial industry to not guarantee absolute financial secrecy to its clients. Coupled with the consequences of adhering to the OECD recommendations, in August 2009 the Cayman Islands was promoted to the OECD “white list” after signing its twelfth TIEA with New Zealand.  This allowed the Cayman to be  considered as a jurisdiction that substantially implements the international tax standards promoted by the OECD. Nonetheless, it is questionable of to what cost such a title should be given as it jeopardizes the economic stability and continuance of the small offshore jurisdictions. 

            2.1.Cayman Islands Disclosure Mechanisms 

            Confidentiality is an essential principle in the offshore legal structures, as its concept differs from the common law countries. At the same time that confidentiality had been responsible for part of the opportunities created in the offshore jurisdictions, the protection of confidentiality also demoralized the offshore jurisdictions. Nonetheless, confidentiality is not a privilege created by such offshore authorities. As a common law principle, the banking sector has long functioned under the value of confidentiality, largely embodied in the famous 1924 United Kingdom decision, Tournier v. National Provincial Bank. The United States, for instance, has disputed against disclosure in commercial matters, affirming the existence of a “strong and vital interest” in protecting confidentiality in that case.     

           Despite the fact that confidentiality is not exclusively applied and protected in offshore jurisdiction such as the Cayman Islands, onshore jurisdictions have pressured offshore jurisdictions to make its confidentiality protection laws more flexible. The first half of this sentence doesn’t make sense.  Consequently, new anti-money laundering laws and treaties have been developed between the Cayman Islands and onshore jurisdictions, largely piercing the confidentiality standard that has historically existed in OFCs. 

           2.1.1.      Banking Confidentiality 

           With regards to the banking industry, the Cayman Islands Monetary Authority (CIMA) issued in 2008 the Guidance Notes On The Prevention And Detection Of Money Laundering And Terrorist Financing in the Cayman Islands. These standards required the financial institutions to apply a policy of extensive “Know-Your-Customer” (KYC) policies for due diligence investigations of new and existing clients. Financial institutions also have to report suspicious activity and file reports with the Cayman authorities. The KYC rule requires the financial institutions to discover information of potential clients in advance and establish the legitimacy of their investments.

           While draconian on their face, such a rule is less intrusive than those being required by the OECD.  The Cayman Islands has been able to find a middle ground in order to preserve the legitimate confidentiality standards of the Cayman and in this sense the guidance shows Cayman Island’s authorities efforts to frame its regulatory system around international standards of supervision and co-operation with overseas regulatory authorities in the fight against financial crime.

           2.1.2.      Tax Information Exchange Agreement (TIEA)

           The TIEA is not an automatic disclosure of information. Requests may be denied when not in conformity with the TIEA, i.e. when all means available were not pursued to obtain the information in the U.S., and where disclosure would be contrary to public policy. The TIEA agreement signed between Cayman Islands and the United States allows to the IRS to overcome the Cayman confidentiality laws in order to track financial criminals, but not as a method of tax enforcement. When the U.S. submits a letter of request to the Cayman Islands, it must: (a) come from U.S. body having an adjudicative function; (b) establish a need for the evidence in the U.S. proceedings, such as the nature of proceedings for which the evidence is needed, why evidence is needed, and the precise issue for which evidence will be used; and (c) not attempt to phish for information. Among other requirements, the U.S. must establish the need for the evidence, must know the nature of the information requested, and the identity of the parties; and (d) not attempt to acquire information for tax enforcement purposes. 

           2.1.3.      European Union (E.U.) Savings Tax Directive 

           The Cayman Islands implemented measures equivalent to the E.U. Savings Tax Directive through bi-lateral agreements with E.U. member states in 2005. The Cayman Islands agreed to exchange information on the accounts of E.U. residents that earn interest. Paying agents in the Cayman Islands must report to the Cayman Islands Competent Authority information about interest payments to a beneficial owner who is a resident in an E.U. member state. The Competent Authority forwards the information to the E.U. member state where the beneficial owner lives 

           2.1.4.      Mutual Legal Assistance Treaty 

           The Cayman Islands and the United States signed a Mutual Legal Assistance Treaty (MLAT) in 1986. Under the MLAT, proceeds of criminal conduct recovered are either restored to the victims in fraud cases or shared equitably between government agencies.  

           Also, the MLAT covers exchange of information concerning criminal offenses common to the Cayman Islands and the United States, including insider trading and racketeering.  

            2.1.5.      The United States Reporting Requirements of Offshore Bank Accounts 

            In 1970, Congress enacted the Bank Secrecy Act (“BSA”), codified in Title 31. The Act specifies that a person who maintains a relationship with a foreign financial agency keep records and file reports.

           Specifically, a “U.S. person” with a financial interest or signature authority over a foreign bank account with a balance of more than $10,000 during the calendar must file a Report of Foreign Bank and Financial Accounts (FBAR). A “U.S. person” is a citizen or resident of the United States, a domestic partnership, a domestic corporation, or a domestic estate or trust. The investigation and enforcement of the civil penalties related to FBAR reporting is delegated to the IRS. The Cayman Islands has implemented and changed its regulation in order to comply with the new changes on confidentiality laws, especially by signing TIEAs with various countries. Not only has Cayman been signing agreements with other jurisdictions, but the Cayman Islands also has the necessary resources to support the laws and possible investigations or process that might take place in the Islands.

           2.1.6.      The Cayman Islands Financial Reporting Authority 

           The Cayman Islands Financial Reporting Authority (CAYFIN) is responsible for deterring money laundering and preventing terrorist financing from developing in the Cayman. It’s a Financial Intelligence Unit (FIU) that receives and analyses financial information concerning the proceeds of money laundering and criminal conduct in the Islands pursuant to the provisions of the Proceeds of Crime Law (2008).

           According to the CAYFIN, reports of suspicious financial activity, money laundering and other reports of irregularities related to the finance market increased by about 30% between July 2008 and June 2009. Such reports to CAYFIN come from inside and outside the Cayman Islands, as many transactions turn out to be lecal bank transactions, yet are still examined by the authorities.  

           3. The Positive Aspects of Jurisdictional Tax Diversity

           The determination of tax policy by national governments is likely based upon the needs and the agenda of each national jurisdiction. When different jurisdictions adopt different rules, despite the fact that those rules generate different consequences in each country, they have also a significant impact on the public policy debate. The tax competition is part of this debate. Globalization has contributed to the increase of tax competition in a manner that the OECD seeks to restrain. Because of the mobility of capital and labor over borders, the nations that adopt a better policy attract qualified professionals and investments from other nations.

           The presence of a close OFC with an efficient financial sector is likely to have a large competitive implication for the onshore banking sector. In light of this competition, it is not surprising that all the major developed nations have decreased their individual income tax rate in recent years. Among the nations that are members of the OECD, the average top income tax rate used to be nearly 68% in 1980. Due to tax competition among nations to attract capital mainly, the top tax rate today is 42%.  Worldwide reductions on corporate tax rate have also been significant over the past three decades. For instance, the United States, following a major corporate tax cut in Britain from 52 per cent to 35 per cent, reduced its federal rate from 46 per cent to 34 per cent in 1986. Another wave of tax reductions has followed mostly in the European Union and in other countries, and most recently Ireland cut its corporate tax from 50 per cent to 12.5 per cent. Such restructuring in tax policies has resulted in an average corporate tax that ranges in about 27 per cent today, instead of 48 per cent some decades ago. 

           The OECD economists have already agreed to the fact the tax competition does play an important role in a pro-growth global economy. In this sense, low tax financial centers such as the Cayman Islands have been useful in encouraging politicians in other countries to reduce tax rates, as well as reduce the double taxation of income of investors. Without tax competition, the adequate incentives would not exist to lead governments to reduce its taxation rates. The level of total taxation, without incentives of offshore jurisdictions as the Cayman Islands, would certainly be higher.      

            Conclusion

            The Cayman Islands has been tracing a clear path in the global economy: it is reaffirming it’s role as a major financial jurisdiction and concurrently following international disclosure requirements and regulations. The numbers and efforts cited in this article proves the compliance of the Cayman Islands are in lock step with the principles and new requirements of the international community. 

            Despite the fact that the Cayman Islands face challenges with respect to its financial situation today, it is likely considering the lessons with respect to the history of  other OFCs. Curacao, for example, was once considered one of the world’s largest offshore financial centers yet around the 1970s, the relationship between the Antilles and the U.S. became difficult.  As the tax treaty between the two countries was abused, and citizens engaged in  treaty shopping” There was a decreas in U.S. Revenue. The U.S. authorities therefore terminated the treaty in July 1987, as Antilles’ governmental authority would not offer concessions to satisfy the U.S. treasurey on preventing on shore revenue evasion.   In contrast to Cuarcao , the Cayman Islands has reformed and modernized its regulation while still preserving their right to maintain their tax policy.



[1] Press Release, The White House, Remarks by the President on International Tax Policy Reform (May 4, 2009),available at http://www.whitehouse.gov/the_press_office/Remarks-By-The-President-On-International-Tax-Policy-Reform.
[2] [2] Taylor Morgan Hoffman, The Future of Offshore Tax Havens, 2 CHI. J. Int’l L. 511, 513 (2001). The author indicates that only the markets of Tokyo, Hong Kong, New York and London have larger capital markets than the Cayman Islands.
[3] Alexander Townsend, Jr., The Global Schoolyard Bully: the Organisation for Economic Co-operation and Development’s Coercive Efforts to Control Tax Competition, 25 Fordham Int'l L.J. 215 (2001)
[4]Id. 
[5] OECD Background Information Brief, dated 25 March 2010. Available at http://www.oecd.org/document/42/0,3343,en_2649_33767_44392746_1_1_1_37427,00.html
[6] Id.
[7] Id
[8] Organisation for Economic Cooperation and Development TIEAs, available at http://www.oecd.org/document/7/0,3343,en_2649_33767_38312839_1_1_1_1,00.html  (last visited April 14, 2010)
[9] Id.
[10] Rose-Marie Antoine, The Legitimacy of the Offshore Financial Sector – A Legal Perspective, in REGULATORY COMPETITION &OFFSHORE FINANCIAL CENTERS (Andrew P. Morriss, ed. forthcoming) 
[11] Natasha Lance Rogoff, Heaven or Havoc, FRONTLINE, Feb. 19, 2004, available athttp://www.pbs.org/wgbh/pages/frontline/shows/tax/schemes/cayman.html
[12]Progress Report on the Jurisdictions Surveyed by the OECD Global Forum in Implementing the Internationally Agreed Tax Standard, April 2, 2009. Available at http://www.oecd.org/dataoecd/38/14/42497950.pdf
[13] Richard A. Johnson, Why Harmful Tax Practices Will Continue After Developing Nations Pay: a Critique of the OECDs Initiatives Against Harmful Tax Competition, 26 B.C. Third World L.J. 351, 359 (2006). Besides the agricultural dependence in the past, the external factors of distant trading relationship, volatility of the climate, frequent political turmoil have also contributed to the high levels of poverty and debt in these islands
[14] Id.
[15] Id. The impact of the OECD compliance to the nation of St. Dominica was similar and because of its lost it was forced to change its national budget and increase domestic taxes affecting the population in the island. 
[16] WILLIAM BRITTAIN-CATLIN, OFFSHORE: THE DARK SIDE OF THE GLOBAL ECONOMY (2005)
[17] Cayman Islands Government News Release, OECD Recognizes Cayman Islands International Tax Cooperation Regime, 14 August, 2009. Available at http://www.tia.gov.ky/pdf/IM_OECD_Recog_CI_Tax_Regime.pdf
[18] Rose-Marie Antoine, The Legitimacy of the Offshore Financial Sector – A Legal Perspective, in REGULATORY COMPETITION &OFFSHORE FINANCIAL CENTERS (Andrew P. Morriss, ed. forthcoming). The author understands confidentiality in offshore jurisdictions as a hybrid concept and it encompasses strict and extremely broad-based statutory duties of confidentiality.
[19] Case: Tournier v. Nat’l Provincial Bank [1924] 1 K.B. 461 (C.A.) (U.K.).
[20] Guidance Notes On The Prevention And Detection Of Money Laundering And Terrorist Financing In The Cayman Islands, December 2008. Available at http://www.cimoney.com.ky/regulatory_framework/reg_frame_ra.aspx?id=1738&ekmensel=e2f22c9a_16_92_1738_3
[21] Supra note 13
[22] Agreement between the government of the United States of America and the Government of the United Kingdom of Great Britain and Northern Ireland, including the Government of Cayman Islands for the Exchange of Information relating to Taxes (2001), available at http://www.oecd.org/dataoecd/20/17/35514531.pdf?contentId=35514532
[23] Treaty Relating to Mutual Legal Assistance Between the U.S. and the United Kingdom concerning the CaymanIslands (subsequently expanded to cover Anguilla, the British Virgin Islands, Montserrat and the Turks and CaicosIslands), signed 7/3/86; entered into force March 19, 1990, 100th Cong., 1st Sess., Treaty Doc. 100-8, Exec. Rpt.100-26; Exec. Rpt. 101-8; 26 ILM 536, March 1987
[24] Currency and Foreign Transactions Reporting Act, Pub. L. No. 91-508, tits. I-II (1970).
[25] 31 U.S.C. § 5314 (2004)
[26] Regulation of the Financial Reporting Authority of the Cayman Islands . This internal organ in the Cayman is under the guidance of the Anti-Money Laundering Steering Group that consists of the Attorney General, the Financial Secretary, Commissioner of Police, Collector of Customs, Managing Director of Cayman Islands Monetary Authority (CIMA) and the Solicitor General. Available at http://www.fra.gov.ky/
[27] Brent Fuller, Financial Reporting Authority – Suspicious Activities Reports Up to 30%, Cayman Financial Review, January 5, 2010, available at http://www.compasscayman.com/cfr/2010/01/05/Financial-Reporting-Authority-%E2%80%93-suspicious-activity-reports-up-30-per-cent/
[28] Id.
[29] Supra note 3.
[30]Andrew K. Rose and Mark M. Spiegel, Offshore financial Centers: Parasites or Symbionts? NBER Working Paper No. W12044, available at http://ssrn.com/abstract=885641  
[31] Daniel Mitchell, The Positive Global Role of Jurisdictional Competition and International Financial Centres, July 7, 2009
[32] Id.
[33] Id.
[34] Id.
[35] Id.
[36] OECD statement about the ability to choose the location of economic activity offsets shortcomings in government budgeting processes, limiting a tendency to spend and tax excessively, available at http://www.oecd.org/dataoecd/50/17/2088806.pdf
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