Understanding Regulatory Arbitrage

I remember when I first heard "regulatory arbitrage." I knew about arbitrage but I never thought that this expression can be also used in compliance. Taking advantage of the different taxation rules and regulations of various countries sounded like an abstract idea, but in reality, it is a commonly used loophole. Even today, online businesses can easily shift their operation abroad, in order to reduce their tax burdens, often leaving larger (and more stable) economies struggling with how to maintain fairness.

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Opportunity Wrapped in Complexity

Regulatory arbitrage is similar to traditional arbitrage but focuses on using gaps between legal and regulatory rules across different nations. Companies can choose to operate from locations which provide favorable regulations, cutting their taxes and costs. Regulatory arbitrage became prominent after the 1929 stock market crash when many U.S. businesses expanded internationally, setting up offshore branches. Initially aiming for global growth, these branches quickly noticed the benefits of countries like the Cayman Islands, Hong Kong, and Singapore, where tax rates were much lower than in the U.S.

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With the rise of the internet, businesses became borderless, needing only a server and an internet connection to trade globally. Entrepreneurs suddenly had the freedom to pick any location that best suited their needs. As tax rules tightened and costs grew in larger nations during the 1960s and 1970s, smaller countries attracted foreign investments with lower taxes. Setting up a company in a low-tax location, with the help of skilled accounting firms that understood the rules, gave companies a big financial advantage. As invoices started arriving from places like the British Virgin Islands (BVI), it was clear this strategy was working.

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The British Virgin Islands

To put things in perspective, the BVI, with a population of just over 31,000 in 2021, was home to over 375,000 active businesses. The inflow of foreign investment led to economic growth and development in these smaller nations, improving property values, salaries, and infrastructure. However, it also placed a heavier tax burden on local companies in larger countries that couldn't move, forcing them to shoulder the impact of those who moved operations overseas.

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The global community recognized that unchecked regulatory arbitrage could undermine their tax systems, leading to increased scrutiny and collaboration. Initiatives like the Organization for Economic Co-operation and Development's (OECD) Base Erosion and Profit Shifting (BEPS) project sought to create a level playing field and transparency. It became evident that the borderless, tax-free days couldn't last forever.

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Setting Up a Company in Cyprus

One country that excelled in attracting foreign investments was Cyprus. For decades, Cyprus has been known for its friendly tax environment, particularly in Europe. In the past, it provided exemptions on profits from trading securities, bonds, or other investments. This attracted brokerage firms and individual traders, making Cyprus a lively financial hub. Even today, Cyprus offers one of Europe's best tax systems, with a corporate tax rate of just 12.5% and relatively low setup and management costs.

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Years ago, companies could easily set up without local Cypriot directors, but as regulations became stricter, these structures couldn't hold up. Now, businesses must prove that their management is conducted in Cyprus to benefit from its tax rules. A local director and office is usually needed to show that the business is genuinely operated from Cyprus, not just as a tax avoidance scheme. If a company based in Cyprus can't prove local management and control, it risks being accused of tax evasion.

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A local director can ensure that decisions are made within Cyprus and that the low taxes are a side benefit, not a deliberate strategy. The challenge lies in striking a balance between maintaining a real presence and taking advantage of the island's financial perks.

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Banking Challenges in Offshore Setups

Setting up an overseas company with favorable tax conditions might be legal, but banks may not be eager to work with such companies. Even if a business operates within the law, banks are often cautious about the risks of these entities. Their concerns aren't just about the legal aspects—they also consider ethical and reputational factors assisting with the potential tax avoidance.

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Banks must be careful about regulatory arbitrage, especially if a company has chosen a location with lower taxes or more lenient rules. In these cases, banks may be suspicious that the business is using legal tax avoidance as a cover for unethical practices. They want to avoid supporting tax evasion or questionable activities, which could harm their reputation.

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So, companies must consider more than just the legal side of setting up offshore. They should ensure that their chosen bank aligns with their business model and meets their needs. It's a delicate balance between finding a favorable location and securing a bank that isn't afraid of some risk. The cautious approach comes from years of international pressure to prevent money laundering and unethical practices.

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A Global Regulatory Environment in Transition

As businesses worldwide continue to navigate the rules around compliance and tax planning, it's clear that the international community is moving toward stricter regulation. Companies must now ensure their operations can withstand scrutiny and align with ethical standards.

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Today's regulatory environment requires a deeper understanding of global taxation trends and banking risk tolerance. While favorable jurisdictions remain, businesses should prepare for an increasingly challenging environment, where the right steps combine strategic planning with careful compliance.

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In this changing financial world, a company's success depends not just on knowing tax laws but also on securing strong banking and payment planning, to source and maintain the relevant finacncial partners who grasp the balance between legality, ethics, and reputation.

How can PSP Angels help

PSP Angels Group is an independent payment consulting firm.

We understand the payment market and have a huge network of different banks and financial providers, so we can give?our?clients an accurate picture of all the different payment and banking options.

We know the payments market’s ever-changing risk appetite and licensing requirements, as well as what fees are currently offered. We help?our?clients make informative decisions about the possible options, prices and risks.

Within?our personalized payment consulting services, we set up an overall payment plan, help to move funds between countries, reduce real banking and payment risks, re-negotiate current fees to match the lower market rates, optimize tax and cash flow, and assist with the overall payment/banking setup.

Helping?our?clients to take their business globally, we explain what country uses which types of payment options and we also refer them to local payment providers for safer and cheaper banking and financial products. We have several partners who offer payment solutions, alternative payment methods, mobile payments, wallets, open banking, vouchers, crypto payments, chargeback and fraud tools, cashiers, and correspondent banks, based on individual circumstances and needs.

Our Cyprus?branch offers?various?fiduciary, accounting, taxation and audit services, where we assist companies not only during their operation, but also from incorporation, including company setup, licensing (office and personal setups, executive and non-executive directors, AML officers, lawyers, software providers, correspondent banks etc.)

Our Malta?branch offers?banking and payment consulting, aimed specifically for the iGaming and Gambling industry.

Via?our new Greek?branch, we now offer in mergers and acquisitions of financial licensed companies such as brokerages, crypto exchanges, banks, E-money institutions, small payment institutions, money service businesses insurance, and remittance companies, etc. globally

We also specialize in payment and financial evaluations on different projects to assist.

In 2023 PSP Angels won the Payment Consultants of the Year 2023 award by Acquisition International Magazine https://www.acquisition-international.com/winners/psp-angels-2/