OFFSHORE BANKING

An offshore bank is a bank located outside the country of residence of the depositor, typically in a low tax jurisdiction that provides financial and legal advantages. These advantages include:

• greater privacy

• low or no taxation

• easy access to deposits (at least in terms of regulation)

• protection against local political or financial instability

While the term originates from the Channel Islands being "offshore" from the United Kingdom, and most offshore banks are located in island nations, the term is used to refer to such banks regardless of location, including Swiss banks and those of other landlocked nations such as Luxembourg.

Offshore banking emerged due to restrictive regulations governing certain transactions.

Growth of offshore banking was encouraged by certain jurisdictions which saw opportunities to enhance their economic development and job creation capabilities. These were –

• favorable regulatory and tax environment,
• infrastructure supports like telecommunication & transportation as well as development of talent pool,
• expansion of services from booking of loans and deposits units to full fledged banking services like Trade Finance, Wealth Management and Treasury Management

The development of offshore banking will continue though setbacks can occur caused by economic out turns. For instance,

• The development of Hong Kong and Singapore as a financial centre was adversely affected by the 1997 Asian economic crisis
• Some banks reduced or closed down their operations in these locations
• The government of both Hong Kong and Singapore implemented a series of measures to improve the regulatory framework and the infrastructure to improve the attractiveness of their centres
• Singapore identified new growth areas, like wealth management, to be developed
• This in turn attracts more banks to locate operations in these centres and expand existing operations

Offshore banks play a crucial role in the shift of economic power among countries and regions. Offshore banking has often been associated with the underground economy and organized crime, via tax evasion and money laundering; however, legally, offshore banking does not prevent assets from being subject to personal income tax on interest. Except for certain persons who meet fairly complex requirements, the personal income tax of many countries makes no distinction between interest earned in local banks and those earned abroad.

Although offshore banks may decide not to report income to other tax authorities, and have no legal obligation to do so as they are protected by bank secrecy, this does not make the non-declaration of the income by the tax-payer or the evasion of the tax on that income legal. Following September 11, 2001, there have been many calls for more regulation on international finances, these being possible crossroads for major illegal money flows.

Defenders of offshore banking have criticised these attempts at regulation. They claim the process is prompted, not by security and financial concerns, but by the desire of domestic banks and tax agencies to access the money held in offshore accounts. They cite the fact that offshore banking offers a competitive threat to the banking and taxation systems in developed countries, suggesting that Organisation for Economic Co-operation and Development (OECD) countries are trying to stamp out competition.

In the offshore banking business, centres and banks must constantly evolve to remain competitive:

• Centres with poor reputation are less likely to attract business
• Centres must have an available talent pool
• Government policies must be supportive to the continuing development of the centres
• Banks operating in reputable jurisdictions stand a better chance of success provided they
• Have skilled professionals
• Product offering that continues to meet the needs of their clients

Statistics concerning offshore banking

Offshore banking is an important part of the international financial system. Experts believe that as much as half the world's capital flows through offshore centers. Tax havens have 1.2% of the world's population and hold 26% of the world's wealth, including 31% of the net profits of United States multinationals. According to Merrill Lynch and Gemini Consulting's “World Wealth Report” for 2000, one third of the wealth of the world's “high net-worth individuals”—nearly $6 trillion out of $17.5 trillion—may now be held offshore. Some $3 trillion is in deposits in tax haven banks and the rest is in securities held by international business companies (IBCs) and trusts.

The IMF has said that between $600 billion and $1.5 trillion of illicit money is laundered annually, equal to 2% to 5% of global economic output. Today, offshore is where most of the world's drug money is allegedly laundered, estimated at up to $500 billion a year, more than the total income of the world's poorest 20%. Add the proceeds of tax evasion and the figure skyrockets to $1 trillion. Another few hundred billion come from fraud and corruption. "These offshore centers awash in money are the hub of a colossal, underground network of crime, fraud, and corruption" commented Lucy Komisar quoting these statistics. Among offshore banks, Swiss banks hold an estimated 35% of the world's private and institutional funds (or 3 trillion Swiss francs), and the Cayman Islands (1.9 trillion US dollars in deposits) are the fifth largest banking centre globally in terms.

India:

State Bank of India opened the first Offshore Banking Unit (OBU) in India at the SEEPZ Special Economic Zone, Mumbai on 17th July 2003 - another landmark in the history of India's Financial Sector. The OBU undertakes the following activities:

1. Raise funds in convertible foreign currency as deposits and borrowings from Non Residents sources.

2. Transact in foreign exchange with residents in India who are eligible to enter into or undertake such transactions in terms of various Rules and Regulations as framed under Foreign Exchange Management Act, 1999.

3. Open foreign currency accounts abroad as well as with other OBUs in India

4. Trade in foreign currencies in the overseas market and also with banks in India where both legs of the transactions are denominated in foreign currencies.

5. Provide customised loan and liability products for the benefit of clients

6. Maintain Special Rupee account with an Authorised Dealer in India out of the convertible foreign exchange resources for meeting local expenses

7. Buy Rupees from an Authorised Dealer in India to fund the Special Rupee Account.

Advantages of offshore banking

Offshore banking business continues to evolve as financial institutions strive to meet their clients’ needs:

Technological and IT developments

Globalization of business

Integrated global solutions

Competitive value proposition

More sophisticated

Wider choices

Environment

Clients’ needs

Services

• Offshore banks can sometimes provide access to politically and economically stable jurisdictions. This will be an advantage for residents in areas where there is risk of political turmoil, who fear their assets may be frozen, seized or disappear (corralito for example, during the 2001 Argentine economic crisis). However, developed countries with regulated banking systems offer the same advantages in terms of stability.

• Some offshore banks may operate with a lower cost base and can provide higher interest rates than the legal rate in the home country due to lower overheads and a lack of government intervention. Advocates of offshore banking often characterise government regulation as a form of tax on domestic banks, reducing interest rates on deposits.

• Offshore finance is one of the few industries, along with tourism, in which geographically remote island nations can competitively engage. It can help developing countries source investment and create growth in their economies, and can help redistribute world finance from the developed to the developing world.

• Interest is generally paid by offshore banks without tax being deducted. This is an advantage to individuals who do not pay tax on worldwide income, or who do not pay tax until the tax return is agreed, or who feel that they can illegally evade tax by hiding the interest income.

• Some offshore banks offer banking services that may not be available from domestic banks such as anonymous bank accounts, higher or lower rate loans based on risk and investment opportunities not available elsewhere.

• Offshore banking is often linked to other structures, such as offshore companies, trusts or foundations, which may have specific tax advantages for some individuals.

• Many advocates of offshore banking also assert that the creation of tax and banking competition is an advantage of the industry, arguing with Charles Tiebout that tax competition allows people to choose an appropriate balance of services and taxes. Critics of the industry, however, claim this competition as a disadvantage, arguing that it encourages a "race to the bottom" in which governments in developed countries are pressured to deregulate their own banking systems in an attempt to prevent the offshoring of capital.

Apart from the above, competition among offshore centres and offshore banks have produced positive results like -

• Lower “onshore” tax rates

• Development of new financial products

• Efficient international capital flows

• Financing of the industrial development of South East Asian countries in the 1980’s and 1990’s

• Current financing of China and India’s development

Disadvantages of offshore banking

• Offshore banking has been associated in the past with the underground economy and organized crime, through money laundering. Following September 11, 2001, offshore banks and tax havens, along with clearing houses, have been accused of helping various organized crime gangs, terrorist groups, and other state or non-state actors. However, offshore banking is a legitimate financial exercise undertaken by many expatriate and international workers.

• Offshore jurisdictions are often remote, so physical access and access to information can be difficult. Yet in a world with global telecommunications this is rarely a problem for customers. Accounts can be set up online, by phone or by mail.

• Offshore private banking is usually more accessible to those on higher incomes, because of the costs of establishing and maintaining offshore accounts. However, simple savings accounts can be opened by anyone and maintained with scale fees equivalent to their onshore counterparts. The tax burden in developed countries thus falls disproportionately on middle-income groups. Historically, tax cuts have tended to result in a higher proportion of the tax take being paid by high-income groups, as previously sheltered income is brought back into the mainstream economy [4]. The Laffer curve demonstrates this tendency.

• Offshore bank accounts are sometimes touted as the solution to every legal, financial and asset protection strategy but this is often much more exaggerated than the reality.

Regulation of offshore banks

Offshore banks have come nder hard international scrutiny with regard to their –

• Business practices

• Contribution to international efforts such as fights against money laundering and terrorism financing

• Their role in international financial stability

• Compliance with other international standards set by G10, OECD, etc institutions

In the 21st century, regulation of offshore banking is allegedly improving, although critics maintain it remains largely insufficient. The quality of the regulation is monitored by supra-national bodies such as the International Monetary Fund (IMF). Banks are generally required to maintain capital adequacy in accordance with international standards. They must report at least quarterly to the regulator on the current state of the business.

Since the late 1990s, especially following September 11, 2001, there have been a number of initiatives to increase the transparency of offshore banking, although critics such as the Association for the Taxation of Financial Transactions for the Aid of Citizens (ATTAC) non-governmental organization (NGO) maintain that they have been insufficient. A few examples of these are:

• The tightening of anti-money laundering regulations in many countries including most popular offshore banking locations means that bankers are required, by good faith, to report suspicion of money laundering to the local police authority, regardless of banking secrecy rules. There is more international co-operation between police authorities.

• In the US the Internal Revenue Service (IRS) introduced Qualifying Intermediary requirements, which mean that the names of the recipients of US-source investment income are passed to the IRS.

• Following 9/11 the US introduced the USA PATRIOT Act, which authorises the US authorities to seize the assets of a bank, where it is believed that the bank holds assets for a suspected criminal. Similar measures have been introduced in some other countries.

• The European Union has introduced sharing of information between certain jurisdictions, and enforced this in respect of certain controlled centres, such as the UK Offshore Islands, so that tax information is able to be shared in respect of interest.

European Savings Tax Directive: In their efforts to stamp down on cross border interest payments EU governments agreed to the introduction of the Savings Tax Directive in the form of the European Union withholding tax in July 2005. A complex measure, it forced EU resident savers depositing money in any country other than the one they are resident in to choose between forfeiting tax at the point of payment, or allowing notification by the offshore banks to tax authorities in their country of residence. This tax affects any cross border interest payment to an individual resident in the EU.

Furthermore the rate of tax deducted at source will rise in 2008 and again in 2011, making disclosure increasingly attractive. Savers' choice of action is complex; tax authorities are not prevented from enquiring into accounts previously held by savers which were not then disclosed.

Recent Steps

But no government has ever taken any serious steps to clamp down on this anti-social economic offence till date. It is only after the unanimous decision in G-20 summit of London in early April, 2009 that the member countries appear to have resolved, either willingly or under political and economic pressures, to take specific steps to demolish tax heavens in some foreign countries. The Organisation for Economic Cooperation and Development (OECD) has strongly supported the move saying that a crackdown on tax heavens and cross border tax evasion will help developing countries to raise more revenues to pay for much-needed schools, roads and hospitals.

The USA has resolved to put a shutter on the country’s loopholes in tax laws and has proposed to outlaw three offshore tax-avoidance techniques, the use of which has given a specific company the scope of saving tax worth $190 billion in one decade. The Obama government will limit tax concessions like expense deductions for American companies, deferring of tax on foreign profits and halting abusive foreign tax credit. The burden of proof will be on individuals when assets are allegedly hidden in offshore bank accounts.

India should be equally determined to take such stringent measures to unearth thousands of crores of rupees in the form of such hidden assets in foreign banks. In response to a public interest litigation and query made by the Supreme Court of India, the Centre has indicated that many Indians might have parked their huge sums of illicit money in the LGT bank of Lichenstein in Germany. The German authorities have recently given a list of account holders of that bank to India. India’s income tax department has raised a demand of Rs 71,848 crore against only one such wrong-doer among hundreds on the basis of seized documents and materials.