Offshore financial centres play a key role in global wealth management and international commerce

The definition of Offshore Financial Centre and which jurisdictions are classified as such is not universally accepted. For the sake of simplicity, we will use the term to mean a jurisdiction that provides financial services to non-residents in a volume that is significant considering the size of their economy. Almost all countries provide some of these services to non-residents; what is considered an OFC will depend on what we define a “significant volume” to be.

What makes these jurisdictions attractive is varied and also evolves over time. However, the key features revolve around one or more of the following: they provide preferential tax treatment to non-residents, their legal and regulatory framework is flexible and considered safe, they provide privacy to those engaging in that jurisdiction, and they have significant local expertise in providing financial, trust and corporate services. As we will see later, although no country is safe from criminal financial activity, reputable offshore centres have strict regulations and are subject to thorough international scrutiny.

There are about $10 trillion of financial assets, such as cash, bonds, and other instruments, held at OFCs. This represents a small fraction of global financial assets given that there are over $140 trillion held in the US alone. However, offshore centres offer a sophisticated ecosystem that provides asset protection, innovative financial services, and tax neutrality, while at the same time, contrary to what many believe, increases tax and wealth transparency.

Asset protection reduces risk

The most popular offshore jurisdictions have become trusted financial centres, in part, as a result of a long tradition of rule of law, sound regulation, and neutrality. By definition, the economy of offshore centres is heavily dependent on financial services. Therefore, their regulators go to great lengths in ensuring that the reputation of the jurisdiction is preserved and, thus, that the law and contracts are enforced.

For example, people or companies can transfer assets into a legal structure set up in an OFC, such as a trust. This legal arrangement will be administered by a third party regulated in the OFC as per the instructions provided by the parties. Given the strong legal and regulatory protections offered by the jurisdiction and the neutrality of the 3rd party, parties can be assured that their assets are protected.

This reduces the risk of doing business in riskier or lesser understood countries or with less trusted counterparties. It also provides individuals and companies with protection for their own assets, making long term planning possible. Risk can be expensive to manage and lead to rejecting commercial or investment opportunities that would provide economic development, particularly in countries that need it the most.

Flexibility and competition leads to innovation

The overwhelming majority of financial services are provided onshore and are tightly regulated to ensure economic stability and protection of its users. Offshore financial services are not typically accessible to the general public and are used by individuals or institutions that are financially sophisticated or have access to sophisticated advice, such as multinational corporations, high net worth individuals, and sovereign or pension funds.

Given who has access and the comparative small size of the market, offshore centres allow for innovation in financial services while at the same time minimizing the risk for the economy and people. The flexible regulatory environment, continuous competition between centres, and concentration of financially savvy individuals, creates the perfect environment for new ideas to develop. 

A great example of the support to innovation that OFCs provide is the significant virtual assets activity that we see in these jurisdictions. According to the 4th Annual Global Crypto Hedge Fund Report 2022, Cayman Islands and British Virgin Islands hold the top 2 positions in market share of crypto hedge funds, accounting for 50% and 13% of the market respectively.

Tax neutrality makes economic decisions more efficient

Offshore jurisdictions will typically offer legal structures for investment purposes that do not levy any taxes (known as tax neutral structures). When using these vehicles, taxes are paid by the investor based only on where the investor resides. Otherwise, taxes would be paid depending on the tax rates and agreements between the jurisdictions where the structure and investor are domiciled. 

Tax neutrality simplifies investor tax planning and ensures that investment decisions are based on the economic attractiveness of the opportunity rather than tax arbitrage. Capital is therefore allocated in a more efficient manner, thus leading to more prosperity. 

Most countries recognize the importance of having a tax policy that does not influence economic decisions, apart from the exceptions of certain industries that want to be explicitly incentivized (such as green energy) or disincentivized (for example, tobacco). This is the reason why many onshore jurisdictions with significant fund activity, such as France and the United States, have introduced the ability to set up tax neutral funds to their own regulatory frameworks.

Transparency is a non-negotiable for OFCs

The IMF, FATF and OECD have introduced common reporting standards, national risk assessments, country guidelines, and country greylists and blacklists to protect the international financial system from criminal activity and unfair tax treatment. 

Offshore centres have therefore issued local regulation and equipped their supervisory authorities to comply with these international standards and avoid being greylisted or blacklisted. Examples of the regulatory requirements imposed on trust and corporate service providers are direct oversight from the financial services regulator, strict customer due diligence policies, reporting of changes to ownership and control of legal entities, etc..

OFCs tend to be smaller countries that are easier to scrutinize and cannot use political pressure to avoid being penalized by international organizations and major governments. When a jurisdiction is greylisted or blacklisted, it makes it difficult and costly for foreign companies and individuals to do business there. This typically has a devastating effect on their economy as they are highly dependent on international capital given how small their local markets are. 

Conclusion: A sophisticated competitive ecosystem that boots economic activity globally

Offshore centres are vital to the global financial ecosystem, serving as sophisticated hubs for asset and wealth management. These markets provide a flexible and secure regulatory environment that facilitates and increases the efficiency of economic activity.

There are risks and downsides of uncontrolled offshore financial activity. However, in their current form and with their decades of expertise in complex financial services, offshore jurisdictions offer innovation while adhering to the most rigorous international standards.