A brave new world?

Guest article by Paul Hotchkiss of Hotchkiss Associates Limited

In quiet corners, there are signs of muted celebration regarding the OECD’s recent publication: the Isle of Man is ‘COMPLIANT’.  Yes: capital letters are appropriate!  There are a few who are revelling at the achievement, grasping the moment and thumbing their nose at the naysayers, perhaps thinking they will be silenced by this momentous achievement: after all, we are ahead of most of the major EU countries.  Hurrah! There is no getting away from it: the accolade of a ‘Compliant’ rating (again) is a testament to the hard work of the Government and puts us on a very good footing on the world stage. Some people are saying ‘we told you so’.

Should we be relieved? Are we right to feel a tad smug that we have achieved this rating again?  Certainly yes, but it’s not the end.  In this article, I take a very high level look at the ‘Paradise papers’, recent steps taken by the EU and the OECD, a few challenges to the Island’s economic position and leave you with a few after thoughts. Firstly to paradise…

Paradise papers

Perhaps because of the content, sensationalism and the lack of any real substance, focus on the papers seems to have lost its impetus and slipped off the front pages (although the Papers do get a mention in the recent OECD meeting in Cameroon and the UK Autumn Budget on 22 November 2017).  So why bring it up again now?  Well, it’s relevant to what has happened subsequently.

Looking back, it still seems quite incredible that activities which are legal can have so much scorn thrown on them.  What is odd is that very probably every person in the UK has something to do with an offshore jurisdiction: their pension funds will be invested in offshore funds, IFAs invest customer’s money on offshore life policies, they will unwittingly often work in buildings owned offshore. Nothing wrong with this.  The OECD have rated us as compliant:  should this fact alone not cause the editors and journalists responsible for the ‘Paradise Papers’ to feel a little uneasy?  Maybe that is why the guns of the press have been partly silenced? The objective of the Papers was not clear: in Westminster it was all talk of tax avoidance and in the tabloids it was all about secrecy, hiding and tax dodging: everyone using the expose to further their own ends but shunning balance.

The OECD has shown we are a country at the top of its game in complying with, and adopting, international standards. Admittedly, we can always improve as was highlighted in the recent MoneyVal report but we have a track record of doing so: it’s integral to the way we do things.  More praise for the Government. Oh and we have just ratified (along with Austria) the new international treaty against tax avoidance by multinational companies: what more can we do?  There will always be people who say we need to do more but many of our critics perhaps should look in their own backyards first.

Tax avoidance

In or around the expose, you will have read that there have been calls for direct rule to be imposed by the UK and for a stricter stance on tax avoidance from all political parties.  Let’s not forget the UK already has a plethora of rules and regulations to prevent tax avoidance: the very new ‘enabler’s’ legislation, the requirement to correct, the disclosure of tax avoidance schemes legislation, specific anti-avoidance legislation and the General Anti Abuse Rule, the common reporting standard and tax information exchange agreements.  These already penal rules were bolstered on 22 November 2017 in the Autumn Budget.  There are pages and pages of such measures in law.  It is therefore a little strange why some commentators seem to imply the UK cannot stop tax avoidance: they can and they do. Maybe they are not aware of some practices but in part that knowledge gap will be fixed by trust reporting which is on its way.   One of the difficulties with the concept of tax avoidance is that its meaning is not defined: some practices are allowed and some not: the lines have been blurred. Not everyone will agree with this, of course. Having said that it is unfortunate that the public are blissfully unaware of the weapons the UK has in its armoury to tackle what it believes is tax avoidance.  Were they aware, the focus of their wrath would not be on paradise but on the UK Government for failing to enforce their rules.  Awareness is also absent regarding the extent to which this island embraces change to make sure we adhere to international standards. It is also unfortunate that the press do not seem interested in such matters: it doesn’t sell newspapers, noting it is telling that the achievement of our ‘compliant’ rating has not been widely publicised.  Note: the UK and Germany do not yet have a compliant rating, being judged only ‘largely compliant’…no one is interested.

To be clear, the UK can stop bad practice and it does.  There are, however, some bits of legislation in UK tax law (and guidance) which encourages places like the Isle of Man to exist, ie a tax neutral environment to, for example, facilitate offshore funds and as places for non-UK residents to invest for a multitude of reasons (not all of which are taxation).  Surely, if the product of such rules are so abhorrent then the UK should remove them?  However, here’s the rub:  the UK wants inward investment, it wants to attract entrepreneurs and for them to bring their money with them.  This is the reason why certain rules exist: e.g. the preferential regime for non-UK domiciliaries and rules which limit taxation for non-residents.   Furthermore, I am sure the UK are fully aware that corporate investors and entrepreneurs are notoriously fickle and like it or not take into consideration the imposition of tax when making decisions to invest, establish businesses or to relocate. Remove these rules and they will not invest or come.

To date in successive Governments they have left many of these laws roughly intact but the Paradise Papers play to the populist view.  The UK, therefore, has a conflict: create rules to provide tax breaks which may not be populist or run the risk of changing such rules and practices which results in driving business away.  They therefore teeter along the edge of the former.

The effect of this conflict is that what happens in the Isle of Man and in other jurisdictions on the one hand causes us to be despised by many and on the other hand, we are encouraged.  The Paradise Papers has shone a light on these mechanisms but these are not our rules.

Whether, with the advent of globalisation, perpetuating such rules is fair is a different question.  But there is a constant and sometimes unseen push and pull between Governments in every jurisdiction in the field of taxation to gain advantage: ‘it’s war out there’.  Despite their protestations, all countries want a slice of the pie, they each want the investment, the businesses and the cash.  They fight for it even if it means penalising jurisdictions or introducing more onshore competitive rules (which are ‘acceptable’, of course) to meet their objectives.  Hypocrisy is of course rife.  Therefore, and somewhat paradoxically, all countries are using domestic laws to gain an advantage but if we do this the  outcome is punishment: to be placed on a blacklist, to make an example of us, with the threat of sanctions if we don’t comply.  Let’s not forget, and to reiterate, it’s not our rules and regulations that represent the problem. Nevertheless we need to deal with the fall out.

The hidden economy

For some, tax was the focus but the Paradise Papers were really more about unveiling another world: a world that the general public rarely see and once seen, many don’t like it. By seeing this are the public at large any the wiser? They are angry but properly explained they might agree that it is the global system that is at fault: we are all involved, like it or not and everyone is to blame. You see no one really knows how this all fits together: the global economy is just too complex to understand never mind to explain.

As a consequence, the Paradise Papers have been subsequently used for the furtherance of a number of agendas: to counter tax avoidance/evasion, to push the public beneficial ownership agenda and transparency.  But just because matters occur out of the public gaze, if they legal and make use of a system of laws in another country, does not make those transactions or how they are carried out incorrect.

The OECD rating proves beyond doubt that we are well on track.  There will be more to do and I am in no doubt the beneficial ownership registration process will evolve.  Mechanisms exist to provide information to the people ‘who matter’ in the fight against terrorism, tax evasion and similar. Whilst some people may be curious about what is ‘offshore’ the reality is that if there are rules being broken the information will flow to the right people and their laws will be engaged to counter any wrongdoing.  This is what laws are for, but if those who matter can get access to the information then one might say ‘what’s the problem?’.  Having knowledge of everyone’s affairs might be said to be the ultimate deterrent but freely available information can also spell danger, eg kidnapping or worse. The difficulty with this is where to draw the line and do people really have a right to privacy, confidentiality and to be left alone?  For some the answer is no.

The result?

The Paradise Papers for all their shortcomings, inaccuracies, sensationalism and lack of substance caused an emotive reaction but moreover resulted in the EU accelerating its blacklisting process and put tax avoidance up the agenda in the UK Autumn Budget.

EU Blacklisting

To put this in context the EU were always going to draw up a new blacklist of jurisdictions which, to them, operated harmful tax practices. Almost a year ago, the EU (through Ecofin) set out a series of draft criteria which they were to propose countries complied with to come off the list.  In the early days the UK managed to water down the criteria relating to the no or low taxation. Ecofin (having revised the Code of Conduct on Business Taxation) accelerated their blacklisting process.

So, what is the deal in relation to the blacklisting?  Various comments leaked out in the press in early November. The decision regarding blacklisting of up to 53 countries will, by the time this article has been published, have been made: there will have been an Ecofin meeting on 5/6 December 2017 in Brussels. In the Financial Times and in some newspapers it has already been reported that these countries will have been required to give a political commitment and provide a specific plan to comply.  Failure to comply will result in sanctions and these will be decided at the same Ecofin meeting.  It has also been speculated that some countries thought that they may not be able to comply.  Comply with what I hear you ask?  Presumably to comply with the New Code of Conduct criteria in full.  In one article in the Jersey Evening Post under the heading ‘Island could fail on one test’ it said ‘However, one of the criteria (2.2) will require further consideration, because of the opportunity it gives to interpret what is meant by the requirement that offshore structures in the jurisdictions being screened have “real economic activity” or “substance”. This is not helped by the fact that currently there is no international standard on these matters.’

This economic substance test is linked to the zero rate of taxation. This again has been speculated on and perhaps gives a clue as to what might be coming down the line. But what is economic substance?  This is difficult to define and that is part of the problem: it depends on the type of business. Broadly it means in order to preserve taxing rights in a particular country an entity must have sufficient resources (both employees and otherwise) to retain the rights to levy tax there.  There is a phrase used in VAT legislation which may be helpful “sufficient human and technical resources permanently present” which relates to making and receiving supplies – and it would be useful to think of substance in these terms. But, not all entities need so-called substance to operate: an investment holding company or a nominee can operate through its board, companies being incubated will outsource services.  It’s going to be tough to define sensibly and could take years.

Can we afford to be blacklisted?

As an Island we cannot afford to be blacklisted: it would affect most businesses in some shape of form. We can protest but it is unclear where it would get us. Of course all 28 EU member states must agree to the blacklisting and so far some have been less than keen eg UK, Luxembourg, Malta, Ireland…funny that!  So we will wait and see.  But it does seem ironic is that the EU does seem to operate some double standards: it is acceptable to allow countries like Portugal to have a zero rate applying to Portuguese holding companies or Malta to have its imputation system of taxation but treat our regimes past and present (all of which have passed the EU muster in the past) as not being quite compliant.  The move is perhaps much more political. It all does seem a little unfair but of course the Code Group criteria have been reset so I suppose the past doesn’t matter.

As you are aware, this all happened in early November hot on the heels of the Paradise Papers: next came the OECD. The following was stated in the OECD’s recent Statement of Outcomes published as a result of the 10th meeting of the OECD Global Tax Forum on Transparency in Cameroon on 15-17 November:

“Some members expressed concern that the ongoing EU listing process, which includes criteria related to tax transparency, is occurring outside of the framework of the Global Forum. While acknowledging that the EU criteria on transparency rely on the work of the Global Forum, the links to transparency aspects within the fair taxation criteria lack clarity. Several members expressed the need for a platform to support further clarification of the criteria to ensure their objective and consistent understanding and application on the basis of the principle of level playing field. It was agreed that it is desirable to discuss the issues further in an informal voluntary group comprising of the Global Forum and Inclusive Framework members working together with the EU Code of Conduct Group and drawing on the work of the Global Forum and of the Forum on Harmful Tax Practices. To that end, the Secretariat was requested to liaise with the EU Code of Conduct Group to discuss the modalities and timing of the joint work.”

So it seems the EU have, in their haste to get the blacklist out, departed from the Global Forum’s approach and the recommendation is they work together.  This is good news: at least a genuine level playing field will hopefully prevail, which one assumes will not be marred by political interference. This is good news and makes sense: we need an internationally agreed framework otherwise it leaves the possibility of loopholes.

Back to our compliant rating…

The OECD

The OECD granted the coveted ‘COMPLIANT’ rating (sorry did I use capitals again?) in relation to the Island’s position in August 2016: so it’s recent: let’s not forget that.  It’s worth a look at the statistics.

At the end of the first round of peer reviews:

“119 jurisdictions have been rated, with 18% of them that have achieved a rating of “Compliant” (22), while the majority (75%) needed to make some progress and were rated “Largely Compliant” (77) or “Provisionally Largely Compliant” (13). The remaining 7% were recommended to address serious issues and rated as “Partially Compliant” (5), “Provisionally Partially Compliant” (1) or “Non-Compliant” (1)”

The IOM has ALWAYS been, and is one of only 3 jurisdictions to have remained compliant (even after the first round of reviews) although this fact is not easily apparent from the published tables. Some countries have been knocked off the coveted pedestal of compliant second time around, so we are doing well.  This is (conveniently?) forgotten by those who criticise the Island.   In percentage terms, we are really up there: not only being in the first wave of jurisdictions undertaking first exchanges with the OECD (so-called ‘early adopters’) but now achieving and maintaining the highest rating.  We are in the top 20% and it can’t be argued that this is not too shabby.

However, let us not forget those muted celebrations referred to at the beginning of this article: it’s not all about transparency and whilst our compliant rating is part of the picture: there is more. One of the main objectives of the OECD is the BEPS project and this is where the EU, and specifically the Code of Conduct and the OECD’s BEPS project, are not too far apart.  There is a global desire to make sure profits are taxed in the countries with which they are most closely aligned ie broadly where those profits are generated.  As referred to above, this it seems is what the EU commitment is all about but the brakes have in part been put on by the OECD.

That’s the backdrop.

What does this mean for the Island?

To summarise: we have a complaint rating from the OECD, the EU want to blacklist unless we comply with the Code of conduct and this seems to point to the need for substance.  We can’t talk about substance without putting this in context.

What are our economic pressures?

The possible continued reliance on reserves

As an Island nation, we have money in the bank (our reserves): more than most countries.  But in recent years, we have placed increasing reliance on reserves to support the economy ie to plug the gap between revenue and expenses.  Will this trend continue or reverse?  No one seems to really know publically: therefore, one can only speculate. It seems to me that the trend will only reverse if we become much more economically active. This means growing existing businesses, attracting new ones and new industries and more importantly collecting revenues from those businesses and their employees (eg currently income tax, NI, VAT etc.).

The need to increase working population

To become more economically active, we need businesses to come and grow and we also need to grow the working population dramatically in order to plug the gap.  This has been said many times before and as many as 15,000 new workers has been mentioned: I have no idea what this figure is based upon.  Of course, increasing working population seems key but it raises its own problems in terms of infrastructure (schools/hospitals etc) and begs the question: is the Island attractive enough as a general economy to bring the workers here?

The Island has recently relaxed work permits: this is helpful and clearly in some sectors was necessary and has worked.   But is this really a preventative which causes people to not choose the Island to live and work?  Clearly the work permit process can get in the way but we also need to look at other factors:

  • the Island is an expensive place to live: goods and services are generally more expensive here that the UK;
  • it is expensive to travel to and from the Island; and
  • (assuming that many employees come from the UK) for ‘average’ salaries there is not much difference in take home pay between the UK and IOM and the margins only become life changing when higher salary levels are reached.

Given this, what incentive is there to relocate in financial terms? The recent Earnings Survey (part of which compares earnings between the UK and the IOM) shows salaries on average are 6.4% higher on the Island than the UK.  This is all good.  However, this belies the fact that the median is 0.3% below the UK.  You can probably tell I am not an economist, but these figures seems to highlight the pull in wages towards the higher earners who are in the more profitable sectors. Some industries have a thirst for more and more employees. This is great news and what the island needs but if island resident employees who are already in employment naturally jump on the employment merry-go-round chasing higher and higher salaries, where do the businesses losing staff get replacements from?  We have a finite (and shrinking) population. The impact of this pull is to push the cost of employment up as companies are having to increase wages to avoid losing staff to better funded competitors. Without new entrants into the market this is unsustainable: in a service based economy with more and more disruptive technologies there is a limit to the price consumers will pay for services. This means profits are squeezed and businesses will slowly become uncompetitive and bear in mind much of the competition is international.  Let’s put some of this in context.

If an employee earns £50,000 in the UK, they will be better off by about £2,000 by moving to the Isle of Man.  I am sure you will all agree an annual £2,000 differential is not likely to cover the cost of living difference. Sure, the employing company can get relocation allowance but the process needs to be thought about so far in advance to get approval it makes it impractical for smaller businesses to obtain.  Therefore, such salaries may not encourage people to relocate. This is another example of competitive taxation at work.  Competitor countries want to retain their workforces and tax rates are used to achieve this.  Think about it: we need to attract 15,000 people (allegedly) and they all need to contribute annually to boost the economy: where are they going to come from? It is clear we are going to have to make relocation more attractive.

VAT sharing

There was a lot of talk in the paradise papers about VAT and Lewis Hamilton (he even got a mention in the UK Autumn Budget 2017). In reality, all this seems to have done is to shine a light on the VAT sharing agreement and the rhetoric coming out of Westminster is that the UK are supporting our economy through this mechanism.  It is easily forgotten (or conveniently overlooked) that we do collect a lot of VAT and contribute to the pie (in which the UK shares).  Whether we contribute enough based on the agreed model is a different matter but as usual the focus of the press is on the UK supporting us and not what we contribute.  The VAT agreement itself is, I understand, up for renegotiation.  My understanding is that the last round of negotiations resulted in an estimated readjustment of the VAT share for a three-year period and this next round will look at the previous three years and adjust to actual which may result in a payment to or from the UK. I could be wrong.  Assuming this is correct once any differences are paid we will have achieved balance: that’s fair and within the terms of the agreement.  If the agreement is continued, it may of course do so on a different basis and possibly result in a different split.  From an economic perspective, it is not ideal having this constant seesaw effect when planning for the future.

There are a whole bunch of other factors and this article is already too long!

To summarise, if it looks like we need to move at some point to a substance-based model (whatever that is).  This, more than likely, requires more employees, which need to be home grown or encouraged to relocate, they will need jobs which requires existing businesses to grow and more businesses to come (encouraging business to move is a lot harder: remember other countries try to keep them captive using tax).  This in part points towards taking a close look at our system of taxation to create an environment for growth coupled with non-tax incentives, such as expanding the grant system.  From a taxation perspective, we need to look to our competitor jurisdictions to see how they design their tax systems and devise tangible tax incentives: this may cost us and such measures may not always be populist.

But (there is always a ‘but’) can we afford such measures based on our current economic model? Numbers of employees are increasing (and so is tax take) but is it fast enough bearing in mind these new pressures and can our infrastructure keep up anyway?

In my view, we need to go back to basics and navel gaze: what does our offering (including our tax system) need to look like for a sustainable future, taking into account disruptive technologies and the very real need to balance between economic need, what our competition are doing and the need to attract and retain business. Tax plays a huge part in this: currently this is where most of money comes from. We have a tax system but is it the right one? That comes down to that balance: countering the competition’s offerings, the needs of business and the needs of the economy.  Some other countries’ tax systems are way ahead, largely because they don’t necessarily have the spectre of the EU watching over them.  If we rid ourselves of this, we can bring about faster change.

I am sure all of us want a stable economy with degree of certainty with a competitive and fair taxation system.  This is the 4th occasion the EU has looked at our tax system and on the three earlier occasions we have complied with the EU’s demands and lived to fight another day. Whilst the preliminary sabre rattling usually quietens down this time I think the mood is different: partly fuelled by the Paradise Papers but mainly by Brexit and the ambitions of the OECD.  Of course we can sit tight and wait and see.  This is a good tactic: it gives us time to think: but think we must. Is it not time to decide our own destiny, from a tax point of view, before changes are foisted upon us? In my humble opinion, the time is right. In the game, we have all the cards: we know the needs of the economy and we know the direction of travel being encouraged by the EU and OECD.  The question is what do we do?

How can we encourage businesses to move or to set up here?

There are a number of possibilities.  Firstly, we need to really understand what encourages and what prevents businesses from relocating.  Granted business and their owners may never have heard of the Island or its advantages so that is one thing and we are all trying to raise awareness continuously as are DED (now Department for Enterprise). But is that enough?  I am not sure we sufficiently understand the needs of our targets: we may not even know who they are. We also need to understand what our competition are doing to retain business or pull it away from us.  I have met a lot of businesses who are excited about the Island, but when we started talking tax (apart from the usual glazing of eyes) there is often dawning that moving the business and relocating staff is not as easy as they first thought: it can cost.  Let’s be clear it can difficult to move business here.  You can’t pack it in a van and drive it over on the boat.  Why? Remember the fiscal war I was talking about earlier?  Countries try to keep hold of businesses and people and can sometimes penalise those who try to leave.  We therefore need to engage in the battle: choose the right targets, understand them and change our legislation, regulation (and anything else we can think of!) to attract and make the process simpler.

Chose local

This is just an afterthought.  We can achieve a lot by changing our thinking here and even providing incentives. When we pay local businesses, generally some or all of the money stays in our economy.  It is sometimes inaccessible to Government because it is locking in companies but it is here nonetheless. Local businesses can expand, employ more people who pay tax and NI (if they can get them) and distributions are taxed.  All good.  When we pay off-island companies eg service providers, we get very little back. Many other small jurisdictions take a more protectionist approach than we do: why shouldn’t we?  So often we hear of non-Island businesses winning tenders: this simply results in an outflow of business so another country profits. Of course everyone wants and needs choice but why not try and encourage those off-island businesses to set up here by with incentives. Specifically target support and service industries? Not the usual mainstream businesses but their support infrastructure.  I am sure if we all could get together and see how much money is spent on the same or similar companies in say the UK by each of us independently, we would find a number of businesses are used time and time again.  We could identify them and target them.  Easier said than done but worth a go.

Also UK businesses are here all the time touting for work: most of the time it can be undertaken locally. The ‘choose local’ campaign is not all about buying local produce it should be about all services. I could imagine an advert: Island wants XYZ type of business to establish to help serve the gaming sector: incentives offered, please contact…

Where does this leave us?

We are being attacked on all sides, often for the wrong reasons, we have an economy to run and need to maintain a competitive edge. Refusing to bow to international pressure is a choice but the firepower being slowly deployed against us is substantial and is likely to accelerate change in the way we do business and think.

There are many positives: (a) we are fleet of foot and can legislate quickly, (b) access to, and the relationship business has with, government, despite being decried in the Paradise Papers, is a good thing and many countries would like to have the same symbiotic relationship between business and Government and to top it off (c) we are willing to, continuously demonstrate we wish to, be good global citizens as demonstrated by the OECD rating.

But (there is always a ‘but’) if we are to meet possible future requirements to create and maintain substance levels (once defined and if needed) we need to  think long and hard about our tax system, our economic need, what the competition are doing and understand the impact on our existing industries and markets.  Only then can we modify our laws to engage in the battle.

This in my view should be way up there in terms of priority.