Monday, November 17, 2008

Bermuda, Britain, and bubble banking

Guest blogger: Prof. Sol Picciotto.

This article assumes a certain level of knowledge about banking and tax. It is nevertheless a most useful addition to TJN’s stable of articles about the role of offshore in the current crisis.

In the (subscription-only) November 10 edition of Tax Notes International, Joann Weiner casts revealing light on the links between credit derivative swaps, which are at the heart of the current financial crisis, and tax avoidance using havens. As has become more widely known since the crisis erupted, credit derivative swaps provide a kind of insurance for holders of credit derivatives (many of them collateralised mortgage-backed debt packages). This enables banks and other holders of such debt to reduce their capital requirements, as much of the risk is assumed by the providers of these swaps, through special purpose vehicles. Much of the article deals with the Primus group, one such provider.

Primus Guaranty is a Bermuda company, tax-exempt in Bermuda because it does not conduct business there. It is a relatively small player in the swap market, listed on the New York Stock Exchange (though it was notified on November 7 that it might lose this listing.) Tax Notes said this:

“Because Primus Guaranty incorporated as an exempt company, it has a straightforward tax burden in Bermuda: zero. Because Bermuda does not withhold on dividends, the shareholders of Primus Guaranty also have a straightforward income tax burden in Bermuda: zero.”

It has an indirect subsidiary, Primus Financial, which sells credit protection to banks and dealers via over-the-counter (OTC) swaps. Financial’s clients have included Kaupthing (exposure $68.2m), Fannie Mae and Freddie Mac ($215m), Lehman Brothers ($80m), and Washington Mutual ($16m). Credit protection is a form of insurance: in exchange for premiums Financial is liable to pay its counterparties the agreed amount on the swap on the occurrence of a credit event, such as bankruptcy or default.

Financial is formed in Delaware, though it claims not to be liable to US taxes. This is because
  1. it claims to be a partnership for US tax purposes, so taxable income and expenses flow through to its owners, who are responsible for any tax liability; however, this would only be the case if Financial is not treated as a publicly traded partnership (PTP); if it were considered a PTP it would not only have to pay US income tax but also a withholding tax of 30% on any payments made to its parent, Primus Bermuda; and

  2. it claims that its only business in the US is to hold investments, and that this activity need not be treated as a US trade or business, as it comes under the provisions of s.864(b) of the US Tax Code, because the income from swaps can be treated as the sale of options. It is able to maintain this interpretation because the IRS has not yet issued a definitive ruling on the tax treatment of swaps, although it issued a consultative notice on the question in 2004, since which time the swap market has ballooned from a value of $5.4 to over $62 trillion. The Treasury stated that it expected to issue guidance on the tax treament of swaps by June 2005, and in the meantime taxpayers were allowed to take any `reasonable’ position on the tax treatment. Hence, Financial chose to treat swaps as options, which evades any US tax liability for itself.
Since Financial considers itself a partnership, the tax liability is passed through to Primus Guaranty, which of course does not pay tax in Bermuda. Guaranty also claims not to be liable to US taxes, because it considers that its activities in selling swaps are investment transactions rather than dealing operations, so it is not conducting trade or business in the US. It does earn fees ($3.5m in 2007) for asset management and advisory services, but presumably these take place outside the US. It set aside only $52k for income taxes in 2007.

Guaranty’s income has averaged some $50m up to 2006. However, its accounts also seem based on strange interpretations. In 2007, as the credit crunch began to bite, it had $614.6m unrealised losses on its $23 billion credit protection portfolio, against capital reserves of $860m. Indeed, its 2007 Annual Report boasted that it had increased its credit protection portfolio from $15.8 billion to $23 billion. However, Weiner points out that Primus prefers to present its accounts on the basis of a concept of `net economic results’, which eliminates unrealised gains/losses on swaps, although its Annual Report also offers a reconciliation using the US GAAP (Generally Accepted Accounting Principles) standard. This shows $12.7m in `net economic earnings’, as opposed to a $563.5m net loss under GAAP. These results were presented under a banner headline proclaiming "A Solid Foundation'.

Not surprisingly, the credit rating agencies have been downgrading the securities which Primus has been guaranteeing, although Financial itself was only placed on credit watch by S&P on 25 September 2008, and by Moody’s shortly after. Weiner and others estimate Primus’s losses due to Kaupthing and Lehman at over $120m. Though the US government’s bailout of Fannie and Freddie saved Primus from taking a hit on them, other defaults are accumulating. However, if the IRS is contemplating a challenge to Primus’s assumptions of zero US tax liability, it would be well advised to do so soon, while the firm is still viable. On the other hand, the potential damage to financial stability of heaping further debts on entities such as Primus will presumably make the Treasury wary of any such action.

Much of this information is available from US sources (indeed it is available on the firm’s website), since Primus is listed in the US and operates through Financial, which is a US entity, though some also emerged following the nationalisation of Kaupthing Bank by the Icelandic government. However, Weiner points out that information about investors in Primus Guaranty would be difficult or impossible even for the IRS to obtain, since Bermuda remains a strong secrecy haven. As an exempt company in Bermuda, not only does Guaranty pay no taxes there, but, Tax Notes said:

“If that weren't enough, Bermuda offers another important advantage. Tax-exempt companies are not required to conduct annual audits as long as directors and shareholders unanimously agree that they are unnecessary.”

But that is not all. As Weiner continues:

“At first glance, Bermuda seems open about its corporate shareholders. It does not allow bearer shares; beneficial owners must be disclosed at the time of incorporation; and the share register is publicly available. Bermudan companies must also provide bank references from financial institutions with whom the beneficial owner has maintained an active bank account for three years.

Because of those features, Bermuda presents itself as a financially transparent jurisdiction that provides effective exchange of information. It justifies its claim by the fact it was one of six low-tax jurisdictions that in 2000 signed an advance commitment letter to cooperate with the OECD, which was then commencing its project to curb harmful tax competition. Bermuda's openness, however, appears more imaginary than real.”

Although the names of shareholders are available on the public companies register, Bermuda allows the use of nominees, so that they can remain secret. Despite having made a "commitment" to the OECD’s harmful tax competition initiative, Bermuda has only two Tax Information Agreements in force, with Australia (concluded in 2007), and the US (dating from 1988); an agreement with the UK signed in December 2007 is not yet in force. Furthermore, Bermuda has not yet signed bilateral agreements with EU states to provide information in connection with the Savings Tax Directive.

Bermuda is of course still a UK Overseas Territory, and in principle this means that the UK government is responsible for its international relations. However, the power to negotiate tax information agreements was delegated in 2003 by the UK to the Bermuda, in common with Anguilla, British Virgin Islands, Cayman Islands, Gibraltar, Montserrat, and the Turks and Caicos Islands. Unsurprisingly, only a handful of TIEAs have been negotiated by any of these territories since then, and only a couple are in force. In any case, as we have pointed out many times, they are of very limited usefulness, since they provide only for information on request, which means that a tax authority must already know something. Bermuda’s lack of any agreements with EU states means that it does not yet have to supply information on interest payments to individuals as required by the savings Directive.

We wonder if Gordon Brown will accompany the proposals for internationally coordinated tax cuts that he is reportedly making at the G20 meeting in Washington with a firm promise to ensure that these UK dependencies provide full transparency for the enforcement of tax as well as financial regulation?

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