Everybody is outraged about offshore investment funds – because nobody understands what they are or what they do

I really must re-tune the alarm clock so that I am not woken in the morning by the BBC trying to drum up a bit of outrage about offshore investments.

Another load of personal data has been stolen from a law firm, and the BBC is trawling through it with prurient glee, trying to find some famous names that it can expose.

What’s in a name?

Their main piece this morning is that the Duchy of Lancaster, the historic estate that provides financial support to the monarchy, has put some money into offshore investment funds.

As the BBC has to admit, this is entirely legal. But what they don’t explain is how there can be anything wrong about it.

We are clearly supposed to think that just because a Caribbean finance centre is involved, something bad is going on. But that trick only works if we don’t understand what is actually happening.

What do offshore investment funds do?

Offshore investment funds do not avoid tax, because the alternative to an offshore fund would not result in any more tax. All the offshore fund does is allows investment management to be simplified and improved.

An investment fund is just a convenient way to manage money. Various investors put their capital into it, which is then professionally managed and invested into various businesses.

The offshore investment fund does not change the tax position. The businesses the fund invests in are taxable wherever they are based. The investors are taxable on the income and gains they receive from the fund wherever they are based in. Indeed one feature of offshore funds is that they often have investors and investments from a variety of different countries, something that is complicated for an onshore fund.

While it is legitimate for the businesses and the investors to be taxed, we don’t want the investment fund to be taxable itself; that would be triple taxation.  The fund is not meant to be a taxable person; it doesn’t benefit itself from the investment income or gains; it is just a mechanism for the investors to invest more efficiently.

But if the investment fund were a UK company, rather than being based in the Caribbean, it would be taxable. Investing through a fund would therefore add a 19% tax charge onto much of the investment income, even though the fund isn’t a real person, it is just a way for the investors to have their capital managed.

No more tax

So the alternative to an offshore fund would not be a UK corporate fund, which would add an additional layer of tax.  If these large investors did not use the offshore investment fund, they would not use a fund at all. Instead they would make their own investments directly and, instead of a fund manager investing it for them, they would have professional advisers telling them where to invest their money.

That would not leave them paying any more UK tax than they do using the offshore fund.  With the investors investing directly, the companies they invest in would still pay tax on their profits and the investors would pay tax on their investment returns, exactly the same as with the offshore investment fund, but because there would be no investment fund, there would be no-one else involved to be taxed.

These large investors such as the Duchy of Lancaster and the very wealthy individuals named in these leaked papers generally have enough investments that they could hire their own professional advisers in this way. If they were prevented from investing in offshore funds (or embarrassed out of it), the result would not be a penny more tax. It would not be worth the extra layer of tax that would result from investing in a UK fund; instead they would invest directly, not using a fund at all.

Everyone would be poorer

But that would be less efficient; it makes much more sense to have collective investment funds where one expert professional team can pool funds from various investors and manage them together.

So the effect of these hyped-up stories will not be that more tax will be paid; it will be less professional management of investments, with more people making their own investments rather than using funds. That means less efficient use of capital and it will be more difficult for businesses to access the investment they need, so ultimately we all become worse off.

And it will not just be less efficient investment for the wealthy or large institutions; it will also make it more expensive for the rest of us to invest.

Many of these offshore funds are also available to smaller retail investors; individuals or small pension funds. Even a lot of investment funds offered by “High Street” financial institutions actually have their funds domiciled in an “offshore tax haven” – either the Caribbean or somewhere like Luxembourg.  At the moment the wealthy and big institutions also invest in these funds, which helps spread the cost and bring the fees down for all of us.

If the offshore funds are closed down, the wealthy investors will stop using collective investment funds; they can afford to hire their own investment advisers and invest directly. But the rest of us can’t, and without being able to join in with the big investors we will be left with less choice of investment funds and higher fees.

Developing countries and technologies

These offshore funds are particularly important for specialist investments, where most investors are not large enough to have their own adviser on every niche area.  Funds investing in developing countries, for example, or in green technology, need expert professionals to handle and arrange the investments, but most investors would only want to risk a small part of their capital in such specific areas and would not have the knowledge to do it themselves, or be able to justify hiring expert advisers in such a limited field.

Only an offshore investment fund can draw in capital from many investors all over the world, creating a large enough pot to employ specialists to manage it, and therefore get vital investment to difficult places where it is really needed.

If we discourage investors from investing in these specialist offshore funds, the result will be less investment into these areas, particularly the developing world, because it will simply be too difficult for the investors to do alone. Which would we prefer – that they invest in developing countries and new technology through an offshore fund, or that they pour even more cash into the already over-heated London property market?

All worse off

So what can be the objection to offshore investment funds?

Not only are they perfectly legal, but also the alternative would be less specialised investment management, less capital available for new technologies and developing countries, and less investment choice and higher fees for ordinary investors who can currently piggy-back on the big investors.

One thing we wouldn’t get, if the wealthy and big institutions stopped investing via offshore funds, would be any more tax. Instead, by making investments less efficient, these campaigns will make us all poorer.

News source: IEA

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