Efficient Capital Flows

Published by Cayman Financial Review – April 2013

Economists, of which I confess to be one, always create models based on a number of assumptions to explain behaviours of the markets. So far so good right?   But the problem is more often than not these assumptions are beyond the realm of the possible, and due to a failure to create better models, we end up accepting the only available models and forget the assumptions on which it was built.

Most financial models for valuating investments or whole markets in different countries assume capital flow is not restricted in any way, and its movement seeking a better combination of risk and reward is effective and efficient. Unfortunately, that is not the world in which we live.

Countries impose all kinds of restrictions and inefficiencies; in some cases, those are quite explicit where citizens of a country are subject to explicit limitations to invest their money abroad or are subject to exorbitant costs to do so. For those living in countries with no restrictions like the US or Cayman, it sounds incredible the government can limit what you can choose to do with your own money, but countries of very different sizes and histories still impose these restrictions, including some as big as China.

In many cases these restrictions are imposed as temporary measures during a crisis; however, the long-term effects of these decisions may be underestimated. Some countries, like Argentina where I was born, have changed these rules over the years on many occasions.

The problem is that capital has at least some memory, and when the restrictions are lifted, capital is likely to exit or not return due to the fear of new limitations being imposed in the future.

A much less severe restriction is that imposed by tax treatment of foreign investment, whether it is that of a resident outside the country or that of a non-resident in the country. In many cases, the tax rate imposed differs based on the residence or nationality of the investor; and quite often, countries offer preferential tax treatment for investments of its residents within their borders.

The challenge with these practices is that capital is no longer allocated purely on the basis of the quality of the investment (expected return/risk combination) but affected by a number of other factors that effectively influence the available capital and relative valuation of different investments.

Additionally, as countries seem to be constantly changing, these rules, the added uncertainty of the tax treatment, and capital movement restriction adds another risk that in many cases stops projects. In other words, the constant discussions about new taxes and changes in tax regulation do not only impose a direct break on economic growth but also an indirect one by the risk of further changes being imposed in the future.

Is Cayman looking even more like a paradise by now?

Jurisdictions that are frequently attacked as conduits to tax avoidance (or even worse evasion) provide a key tool to the global economy to minimise these problems and manage them in an efficient manner; unfortunately, we still have a lot of work to do to communicate this. Let me try to explain.

Among all these constant changes and tax treatments, issues become even more complicated when investors from different parts of the world want to invest together – whether through a hedge fund, investment fund or into a direct investment project.

The nationalities of the investors may affect the treatment of the project, and the tax treatment of one country to its citizens may end up affecting the tax treatment of other investors indirectly.

While many countries have double tax treaties by which a person investing in country A and residing in country B can deduct the tax paid in country A from his tax bill in country B, managing these tax deductions and refunds is complicated, expensive and can become unmanageable when several jurisdictions are involved.

Not only that, but in certain cases it might be impossible to avoid the double taxation, especially in cases where investors from jurisdictions that tax on a nationality basis are co-investing with or investing in jurisdictions that tax on a residency basis.

Tax free?

Jurisdictions like Cayman are constantly misrepresented as tax free jurisdictions. If you live in these beautiful Islands you probably know this is not the case. If you don’t and ever decide to come, don’t be shocked when you pay the taxi from the airport or by the cost of a drink.

Life in Cayman does not come cheap and that mainly is because of the Cayman Islands government, as any government around the world needs to collect revenue to operate. In Cayman’s case most of that revenue is collected through import duty and other consumption based taxes.

Cayman, as other jurisdictions, offers an efficient way to manage collective international investments in an efficient manner by offering a tax neutral structure (no added layer of tax) that allows the investment, as well as the investors, to pay the tax they should pay without the complications of tax treaties, deductions and refunds.

Cayman provides a little bit of oil to the world economic growth machine; unfortunately, the machine has not been sounding very well lately. This much-needed oil may not prove enough to facilitate capital flows and reactivate economic growth, and the machine may need major service or some real re-building.

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