Ethics and governance in the European Financial centers

In only one week Jean Guill, new director CSSF, killed the credibility of the Luxembourg regulator.

The process started on Monday in the framework of an interview with Reuters. Guill said that the Luxembourg financial watchdog could not have detected Madoff's fraud and that it never had any reason to suspect such a crime. The watchdog had been aware that Luxalpha and other funds' assets were managed by Madoff. It did not oppose the contracts the custodian banks signed with investors limiting their responsibility as custodian. "People did not invest with Mr Madoff because they thought he was a thief, but precisely because he had a very good reputation. People thought that explained why he could give good results," Guill said.

I had commented that on my blog to underline that the Luxembourg regulator seems very naïve as Jean Guill implicitly admits that Luxembourg regulation opened the drift with Madoff

I guess Luxembourg professionals read my blog.

On Thursday Jean Guill rectified what was communicated on Monday. « Non, la CSSF n'avait aucune connaissance de l'implication de Bernard Madoff dans Luxalpha et les autres fonds. De surcroît, il n'est pas d'usage que la CSSF reçoive le bulletin de souscription d'un fonds. Et donc ne pouvait pas s'y opposer. » (free translation: No, the CSSF was not informed any of Bernard Madoff’s involvement in Luxalpha and the other funds. In addition, it is not use which the CSSF receives the application form of funds. An therefore it could oppose).

I contacted Reuters to tighten up the ship and they confirmed by mail that they stand by their version and have nothing to add to what they published.

The process ended on Friday with an interview available on the ABBL (the Luxembourg Bankers’ Association) website: he states that “the new management team of the CSSF sees no need for a “revolution” in the CSSF’s style or supervision. We will continue to exercise our duties with meticulous care and to adopt a prudent approach, as was the case in the past.”

He does not call for a true independence of the regulator in this small jurisdictions were there are many conflicts of interest and where professionals admit that the regulator is practically closely monitored by the financial sector.

This is exactly what means “"The relationship between the Luxembourg Commission de Surveillance du Secteur Financier Luxembourg ( CSSF ) and the Financial centre it supervises has always been described, and rightly so, as being heavily influenced by a true common interest approach. (...) The Luxembourg Investment Fund Industry has regularly had a very close and direct say on the evolution of the Luxembourg prudential regulatory environment governing the collective Investment Industry. (...) This influence has been exerted directly and indirectly by the lobbying initiatives taken on the level of the different professional associations, be it ALFI or ABBL , but also and more importantly, trough a direct association with the Luxembourg Supervisory Authorities by means of a number of standing committees" (Source: Rafik Fischer, Vice Chairman, ALFI, in 2005)

Additionnaly he does not explicitly call for the relevant change suggested in March by the Commission on the Financial crisis in its report. The report stated « le rôle de la CSSF, défini à l’époque comme celui non seulement d’un contrôleur du secteur financier mais encore d’un promoteur de la place doit être revu afin d’éviter tout équivoque sur sa mission essentielle qui est celle de la surveillance prudentielle » (free translation: “the role of the CSSF, defined at the time as both a controller of the financial sector and as a promoter of the financial center, must be re-examined in order to avoid any ambiguity on its essential mission which is that of the prudential monitoring”)

The so-called regulated financial center is being rammed by its actors themselves because of a terrific communication, whether it is the one of the CSSF or the one of LFF, and because they have created an insulated culture that systematically excludes any information that could contradict its reigning picture of reality.

Jane G. Gravelle, Senior Specialist in Economic Policy, recently published a report that was prepared for Members and Committees of Congress.

The findings are the following:

The federal government loses both individual and corporate income tax revenue from the shifting of profits and income into low-tax countries, often referred to as tax havens. The revenue losses from this tax avoidance and evasion are difficult to estimate, but some have suggested that the annual cost of offshore tax abuses may be around $100 billion per year. International tax avoidance can arise from large multinational corporations who shift profits into low-tax foreign subsidiaries or wealthy individual investors who set up secret bank accounts in tax haven countries.

Recent actions by the Organization for Economic Cooperation and Development (OECD) and the G-20 industrialized nations have targeted tax haven countries, focusing primarily on evasion issues. There are also a number of legislative proposals that address these issues including the Stop Tax Haven Abuse Act (S. 506, H.R. 1265); draft proposals by the Senate Finance Committee; two other related bills, S. 386 and S. 569; and a proposal by President Obama.

Multinational firms can artificially shift profits from high-tax to low-tax jurisdictions using a variety of techniques, such as shifting debt to high-tax jurisdictions. Since tax on the income of foreign subsidiaries (except for certain passive income) is deferred until repatriated, this income can avoid current U.S. taxes and perhaps do so indefinitely. The taxation of passive income (called Subpart F income) has been reduced, perhaps significantly, through the use of “hybrid entities” that are treated differently in different jurisdictions. The use of hybrid entities was greatly expanding by a new regulation (termed “check-the-box”) introduced in the late 1990s thathad unintended consequences for foreign firms. In addition, earnings from income that is taxed can often be shielded by foreign tax credits on other income. On average very little tax is paid on the foreign source income of U.S. firms. Ample evidence of a significant amount of profit shifting  exists, but the revenue cost estimates vary from about $10 billion to $60 billion per year.

Individuals can evade taxes on passive income, such as interest, dividends, and capital gains, by not reporting income earned abroad. In addition, since interest paid to foreign recipients is not taxed, individuals can also evade taxes on U.S. source income by setting up shell corporations and trusts in foreign haven countries to channel funds. There is no general third party reporting of income as is the case for ordinary passive income earned domestically; the IRS relies on qualified intermediaries (QIs)who certify nationality without revealing the beneficial owners. Estimates of the cost of individual evasion have ranged from $40 billion to $70 billion.

Most provisions to address profit shifting by multinational firms would involve changing the tax law: repealing or limiting deferral, limiting the ability of the foreign tax credit to offset income, addressing check-the-box, or even formula apportionment. President Obama’s proposals include a proposal to disallow overall deductions and foreign tax credits for deferred income and restrictions on the use of hybrid entities. Provisions to address individual evasion includeincreased information reporting, and provisions to increase enforcement, such as shifting the burden of proof to the taxpayer, increased penalties, and increased resources. Individual tax evasion is the main target of the proposed Stop Tax Haven Abuse Act and the Senate Finance Committee proposals; some revisions are also included in President Obama’s plan.

I was impressed by the figure page 17: U.S. Foreign Company Profits Relative to GDP, Larger Countries (GDP At Least $10 billion) on Tax Haven Lists and the Netherlands. In the case of Luxembourg, these profits are 18.2% of output. Shares are also very large in Cyprus (9.8%) and Ireland (7.6%).

Download report

Saturday's Globe and Mail has reported that the United States appears to have forced open a crack in the fortress-like protections the Swiss government grants clients of its country's banks, a victory that could upend the business of dodging domestic levies through international tax havens.

UBS would escape fine but would provide 5000 names.

If the Swiss can be broken, anyone can be broken," said Reuven Avi-Yonah, a University of Michigan professor who has advised the U.S. Treasury on international tax law. "Other tax havens don't have the diplomatic clout of Switzerland."

Raymond Baker, director of the Global Financial Integrity, an organization that works to end illegal international money transfers, said it's critical that U.S. officials push for greater information sharing so tax evasion and other financial crimes can be investigated.

"What happens with the UBS case will be noted around the world, but what will set a true precedent for tax havens around the world is what we do next," Baker said (Source : AP).