TWN Info Service on Finance and Development (May16/02)
10 May 2016
Third World Network

Flows to offshore financial hubs remain sizeable
Published in SUNS #8236 dated 9  May 2016

Geneva, 4 May (Kanaga Raja) - Investment flows to offshore financial hubs, including to offshore financial centres (OFCs) and special purpose entities (SPEs), while registering a decline, nevertheless remain significant, the UN Conference on Trade and Development (UNCTAD) has said.

In its latest Global Investment Trends Monitor (No. 23 of 3 May 2016), UNCTAD also said that the volatility of investment flows through these hubs rose significantly in 2015.

It found that financial flows through SPEs surged in volume during 2015, and the magnitude of quarterly flows through SPEs, in terms of absolute value, rose sharply compared with 2014, reaching the levels registered in 2012-2013.

UNCTAD however said that pronounced volatility, with flows swinging from large-scale net investment to net divestment, tempered the annual result, which dipped to US$221 billion.

"Investment flows to offshore financial centres continued to retreat from its recent high of US$132 billion in 2013, but remained roughly in line with the flows of previous years."

Investment to these jurisdictions, which hit an estimated US$72 billion in 2015, had risen in recent years by the growing flows from multinational enterprises (MNEs) located in developing and transition economies, sometimes in the form of investment round-tripping.

"The proportion of investment income booked in low tax, often offshore, jurisdictions is high - and possibly growing. The disconnect between the locations of income generation and productive investment results in substantial fiscal losses, and is therefore a key concern for policymakers," said UNCTAD.

According to the UNCTAD report, offshore financial hubs offer low tax rates or beneficial fiscal treatment of cross-border financial transactions, extensive bilateral investment and double taxation treaty networks, and access to international financial markets, which make them attractive to companies large and small.

"Flows through these hubs are frequently associated with intra-firm financial operations - including the raising of capital in international markets - as well as holding activities, including of intangible assets such as brands and patents."

According to UNCTAD, investment flows to SPEs, which represent the majority of offshore investment flows, registered significant volatility in 2015. Financial flows through SPEs nonetheless surged in volume during much of the year.

"Pronounced volatility, with flows swinging from large-scale net investment during the first quarter to a huge net divestment during the last quarter, tempered the annual 2015 results."

The primary recipient of SPE-related investment flows in 2015 was Luxembourg. Flows to SPEs located in Luxembourg were associated with funds financing investments in the United States. This was especially apparent in the first quarter of the year, when SPE inflows rose to US$129 billion.

SPE outflows in the same quarter reached US$155 billion, which in turn was reflected in data from the United States, where inward FDI from Luxembourg topped US$153 billion (77% of total inflows).

"After surging for three quarters, more than tripling their 2014 levels for the same period, SPE inflows turned negative in the last three months of the year, recording a net divestment of roughly US$115 billion, as SPEs in the country paid down intra-company loans to the tune of US$207 billion."

According to the report, after registering a sharp decline in 2014, SPE-related inflows in the Netherlands initially showed signs of a rebound in 2015, rising from US$2 billion in the first quarter to US$148 billion in the third quarter (their highest quarterly level since 2007 Q3).

As in Luxembourg, these flows retreated sharply in the fourth quarter, with a net divestment of equity capital and reinvested earnings of roughly US$200 billion.

UNCTAD said that an analysis of the geographical breakdown of total investment flows suggests that this trend was driven by investors from Luxembourg and the United Kingdom.

Reflecting the pass-through nature of these flows, outward investment flows by SPEs also tumbled in the fourth quarter, led by dramatic declines in overall investments targeting Luxembourg and the United Kingdom.

"The tight interrelation between SPE flows in Luxembourg and the Netherlands highlights the existence of dense and complex networks of these entities in both countries, with capital flowing rapidly among them in response to financing needs and tax planning considerations."

The report noted that recent policy changes may be responsible for the most recent decline in investment flows to SPEs.

The Netherlands, for instance, adopted new substance requirements for group financing and licensing companies; these requirements also allowed for the automatic exchange of information about entities with little or no substance in the country with tax treaty partners and other EU countries.

In Luxembourg, the authorities enacted a number of changes in their tax framework, including greater substance requirements, a revision of transfer pricing rules, and a reform of the process and substance of tax rulings.

"Due to the volatile nature of offshore financial flows, the actual impact of these policy changes will become clearer over the next few years," said UNCTAD.

Investment flows to Caribbean offshore financial centres continued to decline from their 2013 record levels, when a single large cross-border M&A caused them to surge markedly. Compared with that year, inflows in these economies were down 42% to an estimated average of US$75 billion in 2014-2015.

Nevertheless, said UNCTAD, this is in line with their 2008-2012 period average of US$75 billion, due to the high level of flows to two major OFCs.

The report said that while MNEs from developed economies, in particular from the United States, traditionally dominated flows to these jurisdictions, in recent years rising investment flows from developing and transition economies have played an important role.

Between 2010 and 2014, Hong Kong-China, the Russian Federation, China and Brazil accounted for 65% of investment flows to the largest Caribbean financial centres, the British Virgin Islands and the Cayman Islands.

UNCTAD said that a key concern for policymakers globally is the potential for a substantial disconnect between productive investments and income generation by MNEs with implications for sustainable development in their economies. "The significant share of MNEs' total FDI income booked in low tax, often offshore, jurisdictions remain therefore problematic."

It said that ratios of income attributed to foreign affiliates of outward investing countries to the gross domestic product (GDP) of the economy where those affiliates are resident reveal profits that are out of line with economic fundamentals.

For example, MNEs from a sample of 26 developed countries registered more profits in Bermuda (US$43.7 billion) than in China (US$36.4 billion) in 2014. Unsurprisingly, the share of their profits relative to the size of Bermuda's economy is an impressive 779.4% of GDP, compared to less than 1% of GDP in a number of countries.

Elevated FDI income to GDP ratios can also be observed in other countries. For example, the FDI income of foreign affiliates (as reported by their home countries) in the Netherlands, Luxembourg, Ireland and Singapore relative to their GDPs all exceed the weighted world average by a substantial margin.

According to UNCTAD, high FDI income to GDP ratios reflects the emergence of holding companies as major aggregators of MNEs' foreign profits.

In the case of Bermuda, the outsized profits of foreign affiliates in the country largely reflect income attributed to investors from the United States.

Taking a longer term view, data from the United States highlights a significant shift in the sources of overall FDI income since the global economic and financial crisis. Prior to the crisis, most FDI income was generated from entities other than holding companies, the latter accounting for an average 40% of total quarterly income between 2003 and 2008.

In the aftermath of the crisis, however, the share of FDI income attributed to holding companies has steadily risen to a quarterly average of 52% in 2015.

"The growing importance of holding companies is due to a number of factors, including the greater reliance on regional centres to coordinate activities in host countries, but their frequent location in jurisdictions with low tax rates or favourable fiscal regimes suggests that tax motivations play a key role," said UNCTAD.

The six countries that each accounted for 5% or more of the United States' outward FDI stock in holding companies in 2014 - Bermuda, Ireland, Luxembourg, Netherlands, United Kingdom, United Kingdom Islands (Caribbean) - generated an average 40% of FDI outward income between 2005 and 2008.

In 2015, said UNCTAD, this share had risen to a quarterly average of 59%, an increase of nearly 20 percentage points in the span of less than a decade.


The UNCTAD report said efforts to stem offshore financial flows have been underway both at the national and international levels.

Revelations that firms large and small have been using offshore financial centres and jurisdictions to evade or avoid taxes have provided additional impetus to policy reforms in these areas. More efforts are indeed necessary, and the persistence of investment flows routed through offshore finance centres, as well as the level of profits booked in these jurisdictions, highlight the pressing need to create greater coherence among tax and investment policies at the global level.

"A lack of coordination between these two crucial policy areas will limit positive spillovers from one to the other, limiting potential gains in tax compliance as well as productive investment," said UNCTAD.

The international investment and tax policy regimes are closely inter-related, it noted, adding that both have the same ultimate objective: promoting and facilitating cross-border investment.

They have a similar architecture, made up of a "spaghetti bowl" of mostly bilateral agreements. The two systems face similar challenges, such as, for example, strengthening their sustainable development dimension and maintaining their legitimacy. They interact, with potential consequences in both directions; and both are the object of reform efforts.

"These reforms must maintain the effectiveness of both policy regimes to sustain confidence in, and support for, both. The policy imperative is to continue facilitating cross-border productive investment and taking action against tax avoidance to support domestic resource mobilization for the pursuit of sustainable development."

UNCTAD said ensuring that international tax and investment policies are mutually reinforcing is fundamental to building and maintaining an enabling environment for investment, maximizing the chances of securing financing for development targets, and supporting the integration of developing countries in the global economy.