The Rise and Fall of Curaçao's Offshore Financial Sector
SEPTEMBER 23, 2009 by ANDREW P. MORRISS
A longer examination, with footnotes, of Curaçao’s rise and fall, “Change, Dependency, and Regime Plasticity in Offshore Financial Intermediation: The Saga of the Netherlands Antilles,” by Craig M. Boise and Andrew P. Morriss, is forthcoming in the Texas International Law Journal and is available on SSRN.
In the late 1970s virtually every major U.S. corporation had a subsidiary in the Dutch Caribbean island of Curaçao, which was used to obtain cheap capital from the vast Eurodollar bond market. By 1982 the Eurobond market reached $48.9 billion, compared to the U.S. corporate bond market’s $33.5 billion, and more than half was likely issued through Curaçao-based subsidiaries of U.S. firms. Many early hedge funds (including George Soros’s) were also domiciled there.
A few years later Curaçao’s offshore finance business collapsed almost overnight. How did an obscure Dutch possession in the Caribbean come to be so important to the U.S. economy and why did its finance business collapse so quickly? As the United States and European Union ramp up their war on offshore finance, a look back at the history of Curaçao provides a cautionary tale about the conflict between onshore tax authorities and offshore financial centers (OFCs).
The discovery of oil in Venezuela launched an economic boom in Curaçao beginning at the start of the 1920s. Venezuelan political instability made the Anglo-Dutch oil company Royal Dutch Shell unwilling to refine oil there, and so the company built a major refinery in Curaçao. Along with prosperity, the refinery brought accountants, lawyers, and other professionals to the Dutch islands, a crucial ingredient for the development of the OFC. Even more came after Nazi Germany invaded the Netherlands and Dutch multinationals shifted their legal domiciles there. An entrepreneur, Anton Smeets, created the Curaçao International Trust Company (CITCO) to manage overseas Dutch firms for their owners.
While most of the multinationals returned to the Netherlands after the war, the companies had learned how to operate in Curaçao, and Smeets seized the opportunity to persuade them to locate subsidiaries there by convincing the Antillean government to create a special low-tax regime with rates of 2.4–3.0 percent for foreign companies legally resident in Curaçao but not physically doing business there. Curaçao OFC was born.
The Dutch islands were able to seize the opportunity Smeets provided because the restructuring of the Kingdom of the Netherlands after the war left them considerable autonomy over their domestic affairs. In an unsuccessful attempt to persuade Indonesia to remain part of the kingdom, the Dutch offered their non-European possessions equal status within a federal structure. Indonesia left anyway, but the remaining territories saw considerable advantages to remaining. However, the five smaller Dutch islands (Aruba, Bonaire, Saba, Sint Eustatius, and Sint Maarten) resisted being lumped together with Curaçao in a single entity, fearing the larger island would dominate the shared government and grab most of the development assistance expected from the Dutch. A compromise brought the six together into a federal unit (the Netherlands Antilles) within the larger kingdom and solved that problem, but left the islands without enough politicians to effectively run three levels of government. To solve the staffing problem, kingdom institutions were scaled back, with the Dutch Parliament and cabinet serving as the Kingdom Parliament and cabinet when augmented by overseas members.
The refinery-driven economy slowed after the war as automation began to reduce labor needs and Venezuelan demands for a share of the refining business prompted Royal Dutch Shell to shift capacity to the mainland. This provided Smeets with a ready audience for his proposals for economic development through financial services. The island’s relationship with the Dutch gave it the remaining two things it needed to attract international businesses. First, since they could appeal to the highly regarded Dutch courts in The Hague, investors did not need to fear that local prejudice would influence cases. Second, the Netherlands’ postwar tax treaty with the United States allowed for a routine extension to Dutch overseas territories, making the Antilles attractive for U.S. firms. With these elements in place, Curaçao began to attract offshore business despite the twin handicaps of an unfamiliar (to Americans) civil law legal system and the requirement of Dutch-language legal documents.
The Growth of the Finance Subsidiaries
In the 1960s the combination of social spending and Vietnam war financing strained U.S. capital markets. The Treasury pressed U.S. multinationals to raise funds outside the United States to finance their foreign operations, encouraging firms to tap into the growing market of dollars deposited in non-U.S. banks. Rising U.S. interest rates in the 1960s led companies to seek Eurobond issues to fund their domestic operations as well. A major obstacle was the 30 percent “withholding tax” the United States imposed on interest payments to foreigners. Since corporate bonds were typically issued on a net basis, a U.S. issuer would have to “gross up” the interest payments to make up for the tax, raising the cost of borrowing and eliminating the advantage of borrowing from the Eurocurrency markets.
The U.S.-Antilles tax treaty exempted interest payments to Antillean entities from this tax. Thus if a U.S. firm established a subsidiary in the Antilles, the subsidiary could sell Eurobonds in the London market and relend the money to its American parent. Interest payments to the subsidiary by the parent would be exempt from the tax under the treaty, and the Antilles imposed no tax on the subsidiary’s payments to the third-country bondholder.
As Americans and foreigners alike became accustomed to the use of Antillean entities, creative entrepreneurs began to find new uses for them. Moreover, like most civil-law jurisdictions the Antilles permitted the use of anonymous bearer shares, making the ownership of Antillean entities an effective means of concealing the identity of the owner. For foreign investors nervous about domestic reaction to their ownership of U.S. assets, particularly Middle Eastern investors worried about a backlash from the Arab oil embargo in the early 1970s, this provided additional security for foreigners’ investments in the United States.
However, as use of Antillean entities grew, so too did opposition within Treasury and law enforcement agencies. Treasury discovered that the tax treaty with the Antilles was becoming what it termed a “treaty with the world,” as individuals from countries without tax treaties with the United States created Antillean companies to conduct business here. A newfound concern with “treaty abuse” became a major policy matter at Treasury, although the Antilles insisted that this “abuse” was just a relabeling of long-standing practices consistent with international law. Most important, Treasury found many countries uninterested in negotiating tax treaties with the United States, as their citizens could avoid the 30 percent withholding tax simply by routing their U.S. investments through the Antilles. By undermining Treasury’s biggest carrot, the Antilles treaty hampered efforts to persuade countries to sign on to information-sharing agreements with the United States. In addition, Treasury worried that Americans were opting for Antillean vehicles to hold U.S. investments, illegally but undetectably evading U.S. income taxes via the anonymous bearer shares. Law enforcement authorities had similar concerns about money laundering.
By the end of the 1970s the Treasury (which handled U.S. tax treaties) was determined to do something about the Antilles. In 1982, it canceled the tax treaty with the British Virgin Islands; this was intended to send a signal to the world that the United States was serious about closing what it saw as “loopholes” in treaties. This and other measures persuaded the Antilles to open negotiations, and for a time it appeared that a new agreement would be reached. Ultimately this proved impossible, as American demands for information on ownership of Antillean entities and limitation of benefits to entities formed by Antillean residents could not be accommodated without destroying the Antilles’ business model and changing fundamental international legal principles about corporate citizenship. Unable to conclude a new treaty, Treasury announced cancellation of the tax treaty in July 1987, effective six months later.
Curaçao’s financial sector never recovered from this blow. As a result of the loss of revenue, the Antilles became more dependent on Dutch subsidies, and internal disputes among the six islands led to an ongoing reorganization of their relationship with the Netherlands. Aruba pulled out of the Antilles, but not the kingdom, in the 1980s; Curaçao and Sint Maarten are scheduled to assume similar status in the near future; and the remaining three islands will become overseas municipalities within the Netherlands. The result was the loss of a major funding source, increased emigration to the Netherlands, and greater dependence on Dutch subsidies. Almost half the Antillean population now lives in the Netherlands, including a significant number of young people. In addition, Dutch money has come with strings, and the Netherlands is more involved in Antillean government today than in the past, reducing Antillean sovereignty in practice if not in theory.
Lessons from the Antilles
Curaçao’s rise and fall has three lessons for the rest of the world. First, the fragility of even a robust financial services industry is a cautionary tale in an era when government regulators are assuming unprecedented powers over financial institutions. Curaçao lost a thriving financial sector in an instant because of policy changes in the United States. Once gone, it has proven remarkably difficult to get back.
Second, the Antillean finance industry illustrates how international financial transactions benefit both parties. The Antilles obtained economic development and government revenue; the United States lowered its firms’ cost of borrowing, making them more competitive.
Third, Curaçao lost its leading position because it was not sufficiently flexible to adapt to changed circumstances. The dominant OFCs today–Barbados, Bermuda, the Cayman Islands, the British Channel Islands, Hong Kong, Singapore–have prospered because they have adapted to the changing international climate by inventing new products and services. The creation of captive-insurance laws in Bermuda, Cayman, and Guernsey, for example, brought those jurisdictions considerable business by providing business structures initially unavailable elsewhere. Curaçao had a chance to seize the lead in a number of areas–George Soros located his hedge funds there and a number of others followed–but the island did little to provide specialized services or laws for the nascent funds industry, which is now largely in Cayman.
Curaçao’s government was unable to respond to new opportunities as quickly for several reasons. The government paid less attention to the financial sector than its rivals’ governments did, in part because of internal divisions over access to Dutch subsidies. Moreover, the Netherlands is itself a financial center, and the Dutch-controlled kingdom government has been less responsive than the governments of independent jurisdictions (like Barbados) or U.K. overseas territories (like Cayman). As a result, the Netherlands has a more favorable tax arrangement with its fellow EU member Malta than it does with the Antilles. Finally, government business in the Antilles is conducted in Dutch, requiring everything from corporate documents to statutes to be translated. This introduces uncertainty, cost, and delay. This is a significant handicap in an era when some Caribbean OFCs are now allowing the filing of corporate documents in Chinese.
The United States and many European nations are putting new pressures on OFCs through measures like the Stop Tax Haven Abuse Act in the United States and the European Union’s Savings Directive. These measures risk harming both sides. Today’s OFCs depend on the international financial services industry, but the United States and Europe also benefit from these jurisdictions. For example, a heavy-handed regulatory approach is likely to increase costs for the many U.S. nonprofit hospitals that use the Cayman Islands for their insurance needs, divert investment capital from the United States by making it harder to organize investment funds in tax-neutral jurisdictions, and raise the cost of everything from air travel to televisions by harming the structured finance and shipping registry businesses that enable firms to cut costs. Perhaps the most important lesson for onshore governments has something to do with avoiding cutting off of one’s nose to spite one’s face.