The Paradise Papers have created another media frenzy around “offshore investing”. This week Tim Bennett demystifies a contentious concept.

What is offshore investing?

Few financial markets topics attract as much regular press attention as the existence of offshore jurisdictions. So, what are they and do they deserve all of the criticism?

A definition

In simple terms, an offshore asset is one that is held in a legal jurisdiction that is not that of an investor. These assets can include anything from bank accounts, bonds and shares to tangible property such as houses and aircraft. One of the more contentious issues that arises is then how and where any income generated by such assets, whether interest, dividends or in some cases royalties, is taxed, if indeed it is taxed at all. We will return to this issue shortly.

“Offshore” tax havens

Much of the regular media attention focuses on certain specific jurisdictions that are famous for offering low rates of tax compared to the home countries of the individuals that use them. Here is a list of some of best-known tax havens;

Are investments in these places legal?

The legality of offshore investing turns largely on one key distinction – if the objective is to avoid tax, that is reduce an individual’s tax bill within the law, then there is no legality issue. However, if the objective is to evade tax, which is reducing the bills by concealing and/or not declaring assets and income then it becomes illegal. Naturally if the original assets themselves have been procured through a crime, such as money laundering, then any income subsequently generated with be deemed “proceeds of crime”.

Other motives

Contrary to what the media would have you believe sometimes, there are quite a few reasons why an investor might use an offshore jurisdiction that have little, or nothing, to do with tax. For example an investor concerned about the security of assets they hold in their home country might register them offshore to protect them. Equally some very wealthy investors like the relative privacy that offshore investing can offer. Others benefit from a greater ability to diversify their holdings via an offshore centre than they may get otherwise.

Even when tax is the driver, the motive might be simply administrative, as is the case with one of the most widely used offshore structures relating to double taxation.

Double the tax, double the admin

Consider an arrangement whereby a New York fund manager sets up a fund in the Cayman Islands in order to target UK investors. It all sounds a bit shady, however the rather dull truth may be that the Cayman Islands vehicle avoids double taxation both on the fee income generated in the US for the manager and any distributions paid to the UK investor. No-one is trying to evade tax but all parties are hoping to only pay it once and not have to worry about processing a double hit followed by a reclaim for excess tax later.

Offshore investing has been criticised as the preserve of the wealthy elite, however, the truth is that many pension funds benefit from the sort of structure described above. Many investors are therefore indirectly offshore beneficiaries even if they don’t realise it.

It’s not always straightforward

When it comes to offshore arrangements, investors have to weigh up three potential downsides;

·         The rules are being tightened all the time, which makes falling foul of them easier

·         Offshore structures can be expensive to set up

·         The PR damage from getting it wrong can be considerable

The critics

Part of the reason the rules are being tightened is that in some cases there have undoubtedly been abuses of offshore tax havens. Politically they are also under attack for conferring unfair advantages on the wealthy, facilitating the avoidance of tax that could be funding public services and even lowering the global tax take by putting pressure on “onshore” jurisdictions to compete. So, as consultancy Price WaterhouseCoopers puts it;

In short, if offshore jurisdictions want to continue to attract the investment that they do, individuals and firms need to be more transparent about why they are used and the benefits. Otherwise there is a risk that the baby (legitimate administrative objectives achieved via offshore structures) will be thrown out with the bathwater as a drive to stamp out any abuse of tax haven status gradually marginalises the whole industry.