The Changing Environment

This article originally appeared in Offshore Funds

Today. To read the magazine in it's entirety please click

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It is timely to look at the current tax and regulatory

initiatives and consider their impact on offshore funds and their

domiciles.

This is currently a very fluid issue. The volume of information

available is vast. We have tried to focus on core considerations

with the objective of identifying the most likely outcome as it

relates to offshore funds and their domiciles.

Why Use An Offshore Fund?

Most successful hedge fund managers attract, and compete for,

international as well as domestic investors. Typically, hedge fund

investors are not retail investors but institutional investors such

as sovereign wealth funds, pension plans, insurance companies,

university endowments and high net worth investors. Whilst many

investors are located in the US or the EU, an increasing number are

located in South America, the Middle East and Asia.

In considering where to domicile its fund to collect up its

international investors, the manager's primary concern is that

it will be acceptable to these potential investors. As such, the

manager must consider the location of the investors, including any

relevant offering restrictions, the countries in which the fund

will invest, the effect of any tax or exchange controls on cash

flows through the fund, the confidence, familiarity and preference

of the investors and trading counterparties in dealing with the

selected domicile, the regulatory position and the quality of the

local service providers.

The international investors will want to invest in a tax neutral

investment fund. They do not want to invest in a hedge fund based

in a jurisdiction where the hedge fund would itself be subject to

tax or exchange controls.

The hedge fund, although domiciled in an offshore financial

centre (OFC), will still be required to comply with the laws on

market manipulation, insider dealing, late trading and short

selling in the jurisdictions in which it trades. Additionally, the

fund itself will pay tax in jurisdictions where it invests and the

investors will be liable to tax in their home jurisdictions in

respect of any distributions received.

How Will the Environment Evolve?

Tax Initiatives

These initiatives are very politically charged and driven by the

obvious concerns in the US and the EU of the potential leakage of

taxable revenues. This issue has received greater prominence

recently due to the global recession and the fiscal deficits which

have led to actual or threatened increases in tax rates and tax

revenue policies.

OECD

The current initiatives are not new. The Organisation for

Economic Co-operation and Development (OECD) began working on its

harmful tax practices project back in 1996. In an OECD 1998 report,

four key factors were identified as the basis for classifying a

country as a tax haven:

no or nominal tax on the relevant income (it was accepted that

this criteria alone was not sufficient to classify a country as a

tax haven);

no effective exchange of information in respect of taxpayers

benefiting from the low tax jurisdiction;

lack of transparency in the operation of the legislative, legal

or administrative provisions; and

the absence of a requirement that the activity be substantial

is important since it suggests that a jurisdiction may be

attempting to attract investment or transactions that are purely

tax driven.

Subsequent work was done to develop the international standards

for transparency and effective exchange of information in tax

matters culminating in the development of the 2002 Model Agreement

on Exchange of Information on Tax Matters. This model has been used

for more than 80 Tax Information Exchange Agreements (TIEAs). This

model is now also endorsed by and reflected in the UN Model Tax

Convention.

In 2008, the OECD made it known that in June 2009, it would be

publishing a "green list" of jurisdictions making good

progress. Then the G-20 process leading up to the recent London

G-20 summit intervened and the whole issue became subject to

extraordinary political pressures.

On 2 April 2009 immediately following the G-20 meeting, the OECD

published its latest findings on OFCs. In its report the OECD

created three tiers of jurisdictions based on the degree to which

each jurisdiction has implemented the agreed international tax

standards for information exchange and co-operation. The three

tiers are:

White - those jurisdictions that have

substantially implemented the internationally agreed tax

standards;

Grey - those jurisdictions that have committed

to the internationally agreed tax standards, but have not yet

substantially implemented then; and

Black - those jurisdictions that have not

committed to the internationally agreed tax standards.

Categorisation as White required an OFC to have entered into at

least 12 bilateral TIEAs.

The core Ogier jurisdictions of BVI, Cayman, Guernsey and Jersey

all fared well: Guernsey and Jersey are listed in the White

category and BVI and Cayman in the Grey category - but the fact

that both BVI and Cayman have significant additional initiatives in

hand should see them re-classified in the White category within a

short period of time.

The G-20 declaration made on 2 April 2009 confirmed that action

will be taken against those jurisdictions which do not meet

international standards in relation to tax transparency. The

counter-measures outlined included:

increased disclosure requirements on the part of taxpayers and

financial institutions to report transactions involving

non-co-operative jurisdictions;

withholding taxes in respect of a wide variety of

payments;

denying deductions in respect of expense payments to payees

resident in a non-co-operative jurisdiction;

reviewing tax treaty policy;

asking international institutions and regional development

banks to review their investment policies; and

giving extra weight to the principles of tax transparency and

information exchange when designing bilateral aid programs.

European Union

The EU contains 27 separate states with a diverse range of

social models and political perspectives. Some states are more

focused on international financial business than others and it is

difficult to build a coherent EU view on tax initiatives by

analysing statements from individual member states. However, the UK

is the mother country to all the pre-eminent common law OFCs and so

it is instructive to analyse its attitude to OFCs in the context of

the current international initiatives.

The UK has launched two reviews. The first, the "Turner

Report", was a review of the financial crisis commissioned by

the Financial Services Authority and is complete. The Turner Report

made it clear that OFCs were not to blame for the financial crisis

nor were they a major contributor to it. The second review, being a

review of British OFCs (the "Foot Review"), was

commissioned by the UK government. The Foot Review will not produce

its final report until the end of 2009, but the likely result is a

continued push for OFCs to meet international standards of

financial regulation, anti-money laundering and the sharing of

financial and tax information.

It should not be overlooked that as a result of the

implementation of the EU Savings Directive, the EU has had the

benefit of a reporting or tax collection agreement with all the

leading OFCs (including BVI, Cayman, Guernsey and Jersey). As a

result there is reporting and accounting to EU member states of

savings income earned by EU nationals outside of their home state.

In the evolving environment we may see the scope of the EU Savings

Directive expanded to include more...