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Comment: Making a virtue out of necessity

Guernsey, Jersey and the Isle of Man have announced that they plan to work together to review their fiscal arrangements after it was made clear to the three crown dependencies by the UK government that their ‘zero-10’ corporate tax strategies are considered to breach the spirit, if not the letter, of the European Union’s Code of Conduct on Business Taxation.

The three territories aim to develop new corporate tax regimes “broadly similar to each other that remain competitive, yet also within international standards.” The unspoken message is that the days of zero corporate tax rates are over.

The EU Code of Conduct, which does not have legal force but is a statement of political intent, was drawn up some 12 years ago and published in December 1997 as part of a campaign to discourage tax measures on the part of member states and their dependent territories deemed to constitute harmful tax competition.

Particularly in the firing line, as far as offshore financial centres that fell within the EU’s ambit were concerned, were tax benefits reserved for non-residents and tax incentives for activities that were isolated from the domestic economy and therefore had no impact on the national tax base – notably tax-exempt status for international companies.

In the first years of this decade, the crown dependencies decided to respond and remove the different treatment of domestic and international companies by creating a single standard zero rate of corporate taxation for all companies, local and international (there were in most cases exceptions for specific types of company, such as banks and utilities, that would pay a 10 per cent rate).

This apparently elegant solution left the offshore financial centres able to offer an attractive tax regime while satisfying the EU’s insistence on a level playing field for corporate taxation. But now, the crown dependencies acknowledge, the goalposts have been moved – what matters is not just that local and international companies be treated equally but that a zero standard corporate tax rate looks like a predatory move aimed at stealing business from onshore jurisdictions that cant afford not to tax corporate profits.

The territories “recognise that the recent and unprecedented changes in the world economy have led to shifts in perceptions and attitudes across the globe [that] mean that other EU member states are now unlikely to accept the stance of the UK that our fiscal regimes are code compliant”.

In times past, the crown dependencies and other offshore centres might have been tempted to tell the EU where to stick its Code of Conduct on Business Taxation. But today international financial jurisdictions are on the back foot, desperately trying to convince the countries where their business originates that they are committed to helping the onshore world curb tax evasion and that they will not encourage artificial tax avoidance schemes.

In the case of most leading offshore jurisdictions, there is a particularly pressing reason to stay on the right side of the EU – its planned Directive on Alternative Investment Fund Managers. With offshore centres potentially facing the need to demonstrate that they offer equivalent levels of regulation if they are to be allowed to compete with EU-domiciled funds, non-one is going to pick a fight with the union on regulatory and fiscal matters.

Some people might say this is a classic case of the EU bullying smaller territories by threatening to close key financial services markets. But the crown dependencies recognise that this is a fight they cannot win and that right now they have no alternative but to fall into line with the EU’s view of what is fair or unfair in tax matters.

Besides which, they have an excellent pragmatic reason for reintroducing meaningful taxation of corporate income. The viability of the zero-10 approach was always contingent upon the financial sector generating sufficient taxable activity in other areas such as personal income and goods and services, as well as licensing and regulatory fees, to compensate for the loss of revenue from corporate taxation.

The Isle of Man figured that its collection of VAT would make up the difference; Jersey introduced a goods and services charge; and Guernsey waited to see if its contingency fund would bridge the gap until growing revenue from other sources come on stream. But all their calculations have been thrown out by the financial crisis that began two years ago and the drying up of new business in key areas such as funds.

The Cayman Islands’ desperate efforts over the past couple of months to borrow money to pay government employees are merely the most dramatic evidence of the fiscal quandary now facing offshore centres. It’s clear that other jurisdictions will have to find new revenue sources to avoid finding themselves in the same position, being forced to go cap in hand to an unsympathetic UK Treasury.

With no sign that revenues generated by financial services will return to their pre-crisis levels in the foreseeable future, all jurisdictions are being forced into an urgent rethink of their public finances. So being forced by the EU to start levying a significant level of corporate income tax could quietly be helpful to the crown dependencies and their competitors, as long as the entire offshore world is in the same position.

Who will benefit from this development? First in line are onshore EU financial centres such as Luxembourg and Malta, whose corporate tax levels will be more competitive with their offshore rivals at a time when the regulatory benefits of being within the EU are set to become more compelling.

For the past decade Ireland has competed with the offshore world with its own flat corporate tax rate of 12.5 per cent, but in the current environment this is placing an increasingly heavy fiscal burden on individual taxpayers. Might the government in Dublin not be secretly hoping that the country’s tax regime, which is unloved by many of its fellow EU member states, also be deemed out of kilter with the spirit of the code of conduct?

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