Why Islamic finance and offshore financial centres go hand-in-hand

In early 2016 popular opinion on the utility and function of offshore centres (OFCs) or, to use the more inflammatory term, tax havens, must be close to an all-time low. The general view, stirred up by cash-strapped governments and the media, is that the vast majority of the world’s wealth is hidden away in secret island jurisdictions, controlled by shady businessmen and inaccessible to the common man. 

OFCs face a constant battle to justify their existence to the general population, as few non finance professionals understand their value and contribution to the world’s economic systems. In contrast, knowledgeable and sophisticated clients continue to use jurisdictions such as the British Virgin Islands and the Cayman Islands for incorporating their financing entities, as the use of such jurisdictions facilitates and lowers the transaction and regulatory costs of cross-border lending, enabling a wider access to funding. 

Islamic banks in particular have recognised the benefit of arranging their financing activities through such jurisdictions. Tax-mitigation and privacy are significant factors, but are not the main drivers behind selection of jurisdiction for Islamic investors and institutions. If they were, we would not see so much business coming out of the Gulf, as the local tax regimes tend to be favourable for local business. So why do we see so many BVI and Cayman-incorporated SPVs in Shariah financings? 

Benefits of using OFCs
There are many reasons to use an OFC in a Shariah-based structure, the most important being reliability, efficiency and flexibility. Business friendly OFCs benefit from having a stable political foundation, a strong regulatory framework and a legal system based on English law; ultimate recourse is to the Privy Council, which provides comfort that any disputes will be determined fairly. These jurisdictions are also committed to adhering to international standards of transparency, investor protection and anti-money laundering (AML); for example, the BVI proactively participates in international measures relating to AML regulations, information exchange, mutual co-operation and transparency. It has entered into bilateral tax information exchange agreements with 27 countries as well as an inter-governmental agreement with the USA to comply with the requirements of FATCA. Finance and legal professionals are knowledgeable and responsive, companies can be set up very quickly and economically and there are few restrictions on company structures and activities. Crucially, foreign ownership and directorship are permitted.

The use of a neutral (not just tax-neutral) OFC in cross-border financing structures is also very much in keeping with the Shariah principles of fairness, equity and risk-sharing. If the relevant entities are incorporated offshore, then disputes as to governing law and differences in interpretation are less likely and lender and client are on a more equal-footing. An offshore vehicle is also less at risk from issues arising from political unrest and fluctuating commodity prices; the use of an OFC can provide comfort and certainty to lenders, thus enabling a developing country or a country experiencing other difficulties to attract investment where otherwise it might not be possible. Security interests can be taken over shares in an offshore SPV or monies in an offshore account in cases where the laws in the sponsor’s jurisdiction do not permit this or are otherwise not lender-friendly. 

OFCs have the ability to pass legislation to benefit the business community relatively quickly. Onshore financial centres are unwieldy in comparison, requiring a much longer and more complicated process to amend existing laws and respond to market forces. The BVI is constantly reviewing and updating its companies law and recent changes to legislation have been implemented which will, among other things, streamline and provide certainty in lending transactions:

  • The enforcement of share security has been simplified so that registered agents must effect a transfer of ownership of shares in a BVI company when validly instructed to do so by the board, irrespective of the wishes of their "client of record";
  • A BVI company may go into voluntary liquidation even if there is a security interest registered against it, but the liquidator will have a duty to apply the BVI company's assets towards payment of the secured creditor;
  • Consent of secured creditors will be required when a BVI company wishes to continue out of the BVI;
  • Transaction completions have been simplified by the express authorisation to add pre-signed pages to the final form of deeds; and
  • Changes to a BVI company's privately-maintained register of charges must be made within 14 days of the change.

The future
The "traditional" OFCs are former British dependencies but such has been their success in attracting nonresident business that many other countries have passed legislation to enable them to compete and keep investment closer to home. Key onshore Islamic jurisdictions such as Malaysia and the GCC have replicated the OFC model by establishing "offshore" free-zones where doing business is simpler, less expensive and with fewer restrictions. This trend began with the establishment of the Dubai International Financial Centre, with Qatar and Abu Dhabi following suit with the Qatar Financial Centre and the Global Marketplace Abu Dhabi. Malaysia has responded with the formation of the Labuan International Business and Financial Centre.

The UAE (Dubai in particular) and Qatar have benefited enormously from foreign investment and immigration, thanks to the foresight of their governments in opening up these special economic zones. But despite the emergence of such free-zones, traditional OFCs should continue to flourish, as some of their advantages cannot be duplicated. They will ensure that they maintain their market-leading position by developing and innovating, as they have done many times in the past.

This article was originally published in Islamic Finance News.