An introduction to offshore banking

Offshore banking can be explained as the carrying on of banking and financial activities in an environment which is essentially free of fiscal and exchange controls i.e. tax havens or low tax areas, commonly referred to as offshore finance centres. These conditions normally would also include favourable banking regulations or banking laws considerably less stringent than those in most domestic jurisdictions.

Offshore banks are used for a variety of purposes.

Frequently they may be formed as a subsidiary of a domestic or international bank to:
Accept deposits outside the controlled environment. This is an increasingly popular activity, particularly for foreign currency deposits.
Book transactions which do not fall within the domestic jurisdiction such as large internationally syndicated loans particularly where the participating banks are located in various jurisdictions.
Make loans which are tax effective to their clients.
Avoid onerous debt-equity ratios and lending restrictions applicable in the more severely regulated jurisdictions in which they operate.
Provide their clients with banking secrecy.

Many other offshore banks are created by corporate groups to handle external borrowing or to consolidate intra-group finance or banking transactions. Corporations involved in international trade may use an offshore bank as a foreign or multi-currency management centre. Eurocurrency market underwriting are often raised through captive offshore banks or finance companies.

The activities of international finance companies also fall within the category of offshore banking. These activities may include external loan raising, provision of confirming finance to clients and group entities, discounting or factoring of intra-group and other debts, and tax effective intra-group loans.

The leasing of equipment through an offshore based captive finance company is another useful offshore banking concept. This activity may be for the purpose of providing vendor lease finance to group customers or to fund group asset acquisitions.

BENEFITS OF OFFSHORE BANKING

The benefits of offshore banking can accrue to the banking institution and its clients. Freedom from taxation and exchange controls are important reasons for the formation of an offshore bank and usually these will be of significant advantage and mutual benefit to both the offshore bank and its client.

A tax free or low tax environment will not only allow the offshore bank to generate a better bottom-line but will also provide it with a stable operating base by avoiding the vagaries or contingencies of onshore fiscal policies. The earnings of the offshore bank from currency management, participation in syndicated loans, money market and securities dealings and deposit-taking activities can be protected from the high rates of income taxes applicable in domestic banks or financial institutions which may well be subject to interest withholding taxes imposed by the domestic fiscal authority. However, these can usually be minimised by careful forward planning.

The absence of exchange controls will obviously enable the offshore bank to move funds with a greater degree of freedom and flexibility than from within an exchange controlled area. The offshore bank should benefit from this enhanced flexibility by being able to conclude transactions promptly, particularly in volatile market conditions.

The banking institution which offers offshore banking facilities to its clients should be able to increase its deposit base at a greater rate that its wholly domestic competitors, its clients will benefit by receiving their interest income free of any withholding tax and the lower tax base of the offshore bank should enable it to be more competitive with its interest rates. If the client is also able to structure his own assets through an offshore trust or investment holding company then his interest income may also be free from tax in his domestic jurisdiction and his deposits not subject to onshore exchange controls. The availability of banking secrecy in the offshore banking environment may be a further benefit to the client.

Corporate groups which establish offshore banks benefit in a variety of ways, including the tax advantages outlined above. In general, the corporate group will aim to maximise interest deductions against profits in high-tax areas whilst protecting group interest income from tax by accumulation in an offshore environment The offshore bank is therefore a most effective means of deploying accumulated group funds. Eurobond issues and foreign currency loans are often raised through the medium of an offshore bank to maximise the overall tax effect by enabling the corporate group to disperse the funds as appropriate within the group. Fee income from intra-group confirming finance, discounts from debt factoring and interest derived from leasing or hire purchase transactions can be protected from the high tax rates applicable in the onshore jurisdictions.

By conducting its banking ordinance activities through an offshore bank the corporate group will be able to carry out these operations essentially without interference from domestic regulatory authorities. The absence of banking laws requiring minimum debt-equity ratios, high capitalisation, and arm's length rules as imposed by most onshore central monetary authorities, will undoubtedly be of benefit to the corporate group.

The use of an offshore bank as the currency management centre of a corporate group will provide a flexible and fiscally effective means of controlling foreign exchange exposure. Group exchange gains or losses, whether realised or unrealised, can be consolidated into one entity with resultant cost and administration benefits Overall foreign exchange risk can be reduced and hedging or borrowing costs minimised. Exchange gains, fees, discounts, and interest income can be treated on a group basis in the most tax effective way. Centralisation of the currency management function allows more direct involvement by the group treasurer and the offshore environment permits him greater flexibility.

OFFSHORE BANKING LOCATIONS

The principal criteria in determining the location of an offshore bank are:

Legislation

All countries have legislation which regulates the carrying on of banking activities within their respective jurisdictions and in some cases also extends their authority to the external activities of domestic based banks. Locations which are suitable for offshore banking normally limit their primary regulations to control banking operations within the domestic sphere and provide a more relaxed set of banking rules for activities conducted with non-residents. Many offshore banking centres have a dual licensing system with full licences for domestic banking operations and restricted licences for offshore banks which conduct their banking activities with non-resident entities.

The banking legislation of a suitable offshore banking centre should permit:

Low capitalisation without statutory minimum capital and reserve requirements
Loan raising without mandatory debt-equity ratios
Unrestricted lending activities
Complete foreign ownership of offshore banks
Cash management without minimum liquidity rules
Administration free from excessive reporting obligations
Non-disclosure of client activities

Obviously some of these benefits will not be required by all offshore banks, particularly those, which are owned by international banking groups.

The corporate legislation or the offshore banking centre is also an important factor and should complement the banking laws. Preferably the corporate law should be consistent with that adopted in jurisdictions in which the banking or corporate group operates. Special factors, such as anonymity of ownership, corporate secrecy provisions, transfer of corporate domicile and minimal reporting requirements may be attractive for some offshore banks.

Taxation

In order to obtain the benefits previously outlined the offshore bank requires an operating environment which is tax free, has a low tax rate or provides concessional rates of tax to an offshore bank. Normally the former is preferred. The need for specific tax factors will vary with the requirements of the offshore bank. In some instances it may be desirable to utilise double tax treaties. However, in many circumstances they will be of no benefit and their exchange of information provisions may be detrimental to the activities of the offshore bank.

An offshore banking centre which does not impose interest withholding taxes will normally be preferred by clients of the offshore bank and will also be attractive to the offshore bank as interest withholding taxes are often part of its funding costs. The absence of a dividend withholding tax will also be an important consideration for the shareholders of the offshore bank.

Taxes other than income taxes must also be considered. Stamp duty on loan or mortgage documents, receipt taxes and stamp duty on securities transfers can be significant cost factors where appropriate. Capital registration fees and business or banking licence fees should be kept to a minimum.

Exchange controls

The flexible banking policies available under suitable offshore banking legislation will be severely restricted unless they are complemented by free movement of moneys. The offshore bank must be able to move its funds freely through the international banking network and the offshore banking centre should provide direct access to that network.

Other criteria

Various other factors should be considered in selecting a location suitable for offshore banking. These include:

Political and economic stability
Availability of banking and professional expertise
Access to telecommunications

OPERATIONAL ASPECTS OF OFFSHORE BANKING

Formation

The procedures for incorporation of an offshore bank vary in each location. However, most of the more suitable jurisdictions the incorporation of an offshore bank is effected by the usual English law registration system. An application for a permit to incorporate must be lodged together with an application for an offshore bank or financial institution licence. Licence applications must be accompanied by the information specified in the offshore bank guidelines. If the application satisfies the guidelines then a licence will be issued promptly. Normally the application is a confidential document and may be subject to the secrecy provisions of the relevant corporate legislation.

Banking activities

Subject to the terms of its licence the offshore bank will be able to undertake any form of banking activity but the most common offshore banking operations include:

Deposit taking
Syndicated loans or Eurocurrency under writings
Corporate loan raising
Intra-group lending
Foreign currency management
Provision of confirming finance
Lease finance
Debt factoring

Management

The management and administration of the offshore bank should not be conducted in the domestic jurisdictions of the corporate group and care must be taken to ensure that offshore deposit-taking activities do not breach domestic banking laws. If too many of the management activities of the offshore bank are effected in the domestic locations the offshore bank may be deemed to be carrying on business there through a branch, with adverse consequences under both tax and banking legislation. The management functions should therefore be carried out by the offshore bank.

The offshore bank can either employ its own permanent staff and base them in the offshore location or in another suitable management location. Alternatively it can engage the services of a local trust company or professional management firm who would work closely with the management of the corporate group.

Most offshore banks choose the latter alternative which keeps management on an arm's length basis. It should also be remembered that the appointment of local management in the offshore location will avoid potential complications with tax and banking authorities in the domestic jurisdictions.

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