Offshore News Digest for Week of December 11, 2006

GLOBAL LIVING & BUSINESS

WHILE AMERICA’S HOUSING MARKET COOLS, PROPERTY ELSEWHERE IS STILL HOT

In many countries, people are showing little sign of losing their appetite for residential property. Although the pace in several of the raciest markets around the world has eased a bit in the last quarter, prices have risen by more than 10% in the past year in eight of the countries in our table. The Economist has been collating these house-price indicators since 2002, allowing us to track the global residential-property boom (see chart).

Although America’s bubble is deflating, other markets are still looking decidedly frothy. Denmark tops our property-inflation table. Elsewhere in Europe, house prices in France, Spain and Ireland are still simmering. In Australia and Britain, where it once seemed that property markets had leveled off, prices have picked up again, rising by 9.5% and 9.6% respectively 11-2006 vs. 11-2005.

The Australian figure disguises marked regional variations. Prices in Sydney rose rapidly in 2003, fell in late 2004 and 2005 and are (just) increasing again. In sizzling Perth prices rose by 46% year over year in the third quarter. In Britain too the pace varies from one area to another. In the year to the third quarter, prices in Northern Ireland rose by a third while those in the north of England rose by less than 1%. But the renewed pep in the national pattern has revived talk of a housing bubble.

In a thoughtful recent study David Miles, of Morgan Stanley, tries to explain the doubling of real British house prices in the past decade. Some of the increase, he says, can be ascribed to rising real incomes. A smaller share can be explained by increases in population. Some can 1/3 and 1/2 is due to increased expectations of house-price inflation. These amplify the effects of other factors. Faster increases in prices foster the belief that future increases will also be stronger, so that higher prices fuel demand rather than dampen it. The need to explain so much of Britain’s house-price inflation by a change in expectations, writes Mr. Miles, “suggests that the current level of house prices may be rather unstable.” Once those expectations come down, real house prices are likely to fall. The trouble, of course, is predicting when.

INDIAN FIRMS ARE MOVING INTO HIGH-VALUE STRATEGIC ADVICE FASTER THAN EXPECTED

Citigroup’s global expansion has complicated its data processing. It had 59 different versions of banking software across 100 countries. So it hired a consultant to strip them all down to a single version. The project will save the company at least the $110 million a year it cost to maintain the old mess. Blackstone Real Estate Group’s LXR Luxury Resorts has amassed 33 properties, along with 681 hotels, under the Extended Stay banner. Again, technological chaos. Within seven months a consulting firm helped Blackstone unite them all, with one system for payroll and reservations, run from one computing center.

The usual providers of this kind of advice are firms such as IBM, Capgemini and Accenture, the well-known shops that sponsor golf tournaments and run ads during the Super Bowl. These firms bid on the aforementioned projects, but they lost. The winners came from Bangalore and Chennai in India. Indian firms, once purely providers of cheap call-center services and payroll processing, are moving up the value ladder. They offer product design, software design, chip engineering and the kind of corporate asset-deploying advice once the sole domain of Western firms like McKinsey and Booz Allen Hamilton. “A lot of consulting deals won by the Indians in the last few years have really shocked the industry,” says Forrester Research analyst Stephanie Moore. “I don’t think companies like EDS or BearingPoint or Deloitte have come to terms with it, and they have no idea what to do about it.”

To be sure, Indian data processing firms still depend for 75% to 85% of their revenue on cheap labor applied to software testing and order processing, but they are adding strategic and innovation consulting services rapidly. The top five Indian players in consulting (Tata, Infosys, Wipro, Satyam and HCL Technologies) have averaged 30% revenue growth this year, while the largest U.S. players have averaged just 4%, according to Datamonitor senior analyst Patrick O’Brien. The Indian firms see consulting work as a way to maintain their competitive edge in the face of wage inflation in India and the rise of Chinese data processing firms. The labor arbitrage is not what it used to be. Wages for project managers in India have increased 23% per year from 2000 to 2004, while salaries for programmers have increased at a 13% pace, according to the McKinsey Global Institute.

Indian firms have moved beyond selling time to selling products born from the expertise built over the last decade of back-office technical work. Western firms are countering the Indians’ move up the value ladder by moving their own operations there or buying up rivals. Accenture, which has 23,000 employees in India, used to play down its offshore operations to clients in the U.S. and Europe. Now it sells their services directly. If you can’t beat ‘em, join ‘em.

FORCE OF CHINA’S IMPACT GROWS IN USA

Smack in the center of the country, more than a thousand miles from the Pacific Ocean, Oklahoma is not a place most people regard as a hotbed of China fever. So when China scholar Peter Gries flew to the University of Oklahoma for a job interview this spring, he was not sure what he would find other than cowboys and oil wells. What he discovered was a state energetically retooling for a globalized economy bearing an ever more distinct “made-in-China” label.

China’s WTO membership sparked far-reaching domestic reforms in the still nominally-communist nation, leading to an economic flowering as well as greater personal freedom for individual Chinese. It has also meant hefty profits for U.S. corporations operating in China, such as GM. But tens of thousands of jobs in textile plants in states such as North Carolina have been wiped out by low-wage Chinese competition even as U.S. consumers enjoy lower-priced clothes, toys and furniture made in Chinese factories. Through massive purchases of U.S. Treasury bonds, the Chinese government effectively finances Americans’ consumption-heavy lifestyles.

Financial waves from China’s rise already have spread beyond traditionally international cities such as New York, Washington and Los Angeles to reshape life in the heartland. Children in Chicago’s public schools study Mandarin. A regional bank in Ohio is scrambling to keep pace with business customers obsessed with the Chinese market. And a struggling iron ore mine in northern Minnesota enjoys new life thanks to China’s ravenous appetite for raw materials. Surging interest in all things Chinese can be seen in the trade delegations from San Bernardino (California) and San Antonio flocking to Beijing as well as the stream of popular books with titles such as China Shakes the World, Chinese Lessons and China, Inc.

U.S. Treasury Secretary Henry Paulson’s trip reflects the relentless political controversy that has accompanied China’s commercial rise. In joining the WTO, China committed itself to follow international trading rules, including lowering tariffs on imported products and lifting requirements for import licenses and quotas. Tariffs have been slashed. But critics in the U.S. business community, and in the new Democratic-led Congress, complain that the Chinese have flouted other commitments, notably on protecting the intellectual property of foreign copyright holders. Pirated movies, music and software remain widely available in China despite repeated vows of government crackdowns. U.S. manufacturers also have grown hoarse griping that the Chinese unfairly subsidize their exports through cut-rate financing from state banks and a currency whose value is kept artificially low.

Paulson’s Beijing foray comes as both China and the U.S. face economic challenges. There are increasing signs the U.S. economy is slowing, and some economists even warn of a possible recession next year. Meanwhile, China, which has grown at an average annual rate of 10% since 1991, is attempting a complicated transition from export-led growth to an economy fueled by domestic consumption. The shift, intended to stabilize an economy flirting with dangerous excesses, would result in larger purchases of foreign-made goods, including from the USA, thus potentially defusing rising protectionist sentiment in Congress.

Gries’s new institute, which conducts policy research and promotes public education about China, is driven by the same broad understanding that motivates Paulson’s high-level diplomatic effort: However remarkable China’s rise has been to date, the Middle Kingdom will only be more consequential tomorrow. In Oklahoma, China’s rising profile includes construction next year of an auto assembly plant in Ardmore, population 34,000. The plant will assemble cars under the MG brand, which was acquired last year by Nanjing Automobile. If Gries has his way, it will not be the last China-related business attracted to Oklahoma.

Paulson’s China obsession misses the big picture.

Sometimes I wish China would just announce an immediate 40% strengthening of the yuan to show the world what would happen. U.S. interest rates would shoot higher as China – and Asian central banks in general – sell devalued Treasuries. Sticker prices at Wal-Mart and Best Buy would skyrocket. China’s economy would grind to a halt, risking social instability in the world’s most-populous nation. Shock waves would sweep through corporate America. A sharply stronger yuan would make household-name U.S. companies cheaper for acquisitive Chinese executives. If you think China is big news in Washington today, just wait until companies in the world’s 4th-biggest economy start bidding for GM, Microsoft, Boeing or Exxon Mobil.

So if the goal is slower global growth and destabilizing what many see as THE market of the future, by all means keep pushing the yuan issue. Or China-obsessed Washington could spend that time and energy getting its own economy in order.

THE YEAR OF THE ELECTION IN LATIN AMERICA

The year of the election in South America ended rather undramatically as Hugo Chavez won his bid for re-election in South America. A year ago, his policies and his anti-U.S. stance were drawing in fans across the continent and indeed across the world. Much had been made of the nationalistic tendencies of South American countries, and Chavez had single handedly seemed to reinvigorate that movement throughout many of his neighboring countries.

Chavez’s movement, however, was overestimated as Peru rejected the socialist party in favor of Alan Garcia, a previous president who was widely criticized for destroying the economy and increasing the amount of violent crime. Colombia, whose president has become of the greatest allies of the U.S. over recent years, re-elected Uribe to another term on the back of free market policies and a strong anti-FARC agenda. Brazil and Chile, who voted towards the left leaning parties, are still moving in a pro-capitalist stance with the election of Bachelet and de Silva. Perhaps the greatest coup for the Chavez movement though was in Nicaragua, where Ortega gained control of the government once again, despite his record of civil war and repossession of private property.

Ortega, at least during his election campaign, promised voters that he was a reformed man. How this will play out is uncertain, but many international investors, especially in the real estate market, have been spooked. International Living, perhaps the most widely read online newsletter involved with international real estate has been touting Nicaragua for years based on its low cost of living, its idealic beaches, and its free markets. Ortega may turn all of this on its head, if he reverts back to the President he was in his previous public life.

Even with Bolivia, Nicaragua, and Venezuela all having chosen communists to lead their country, South America dodged a bullet this year, with the majority of countries electing leaders who see the need for free markets. A year ago, many political analysts were predicting disaster for the continent with as many as 3 or 4 more countries falling into the Chavez movement. With South America having never really escaped nationalism over the past few hundred years, the recent progress of several countries over the last decade had added a great amount of optimism that these people would finally achieve the progress they deserve. 2006 was a pivotal year in this growth, as the South American people gave a vote of confidence for free market reforms, a policy that may usher in an era of prosperity not seen in over a century.

BELIZE TO RESTRUCTURE DEBT AS RATINGS DOWNGRADED TO “SD”

The Government of Belize has announced that it will seek the approval of the Belizean National Assembly for the financial terms of an offer to exchange most categories of Belize’s outstanding external commercial indebtedness for new U.S. Dollar Bonds. If approved by the National Assembly, the exchange offer will be formally launched later this month.

The announcement was made shortly before international ratings agency Standard & Poor’s revised Belize’s foreign currency sovereign credit rating to selective default last week. S&P also revised its long-term foreign currency ratings to “D” on its rated bonds. The government said that the financial terms for which approval is being sought are based on economic data and forecasts that have been published by the IMF as part of Belize’s most recent Article IV Consultation, and take account of the views expressed by creditors during the period of consultations.

Inter-American Development Bank approves loan to help Belize economic reforms.

The IDB has announced the approval of a $25 million fast-disbursing loan to support Belize’s agenda of reforms to restore macroeconomic and financial stability, improve its business climate and bolster investor confidence. The government of Belize said that the IDB loan will assist Belize’s public finances as it takes steps to improve its fiscal position and debt management.

To boost revenues, the government will introduce a new oil tax regime and implement a general sales tax. It will also proceed with an orderly liquidation of the loss-making Development Finance Corporation. The loan was granted for 20 years, with a 5-year grace period and a LIBOR-based interest rate.

“Belize has made progress in addressing serious macroeconomic imbalances by following a homegrown strategy,” the IDB said in a statement. “Its authorities have expressed a firm commitment to maintaining stability through a comprehensive medium-term economic program, where reaching a cooperative agreement with private creditors on restructuring its external debt will be paramount.” The bank noted that fiscal belt-tightening measures already put in place by the government of Belize reduced the fiscal deficit from 8.7% of GDP in 2004 to 3.3% in 2005.

GLOBAL LESSONS

In the past seven weeks, I have circled the globe so many times, my body has lost track of time zones. My recent travels have taken me to Japan, South Africa, the Middle East, Singapore, Hong Kong, China, and Australia. Extensive meetings with business executives, investors, policy makers, and senior government officials in all of these countries cast the global debate in a very different light. Several lessons from these travels strike me as most important.

My recent trips to the Middle East have completely changed my perceptions of this region’s global role. In less than 35 years, the oil-producing states in the Gulf have gone from being exporters to users of capital. IMF estimates put current account surpluses of the Middle East at around $300 billion per year in 2006-07. The region’s newfound penchant for internal absorption suggests this surge in surplus saving could well have profound consequences for the global economy and world financial markets.

My first trip to South Africa was a real eye-opener. Johannesburg and Cape Town had prosperity written all over them, but, sadly, the rest of this country did not. With the national unemployment rate still in excess of 25%, matters of job and income security entered into most of the discussions I had on this leg of my travels. What surprised me the most was the anti-China sentiment I encountered in job-short South Africa.

In Australia, environmental issues came up at literally every meeting. Most concede that their unique drought-affected circumstances have undoubtedly played a key role in bringing this issue to a head. But maybe the point for the rest of us is with concerns over a fragile environment mounting, it does not take much for national sentiment to swing. As I look back on my discussions with global leaders over the past seven weeks, Australia was hardly alone in voicing concerns over climate change. Similar worries were evident in China, elsewhere in Asia, and in Africa. Sadly, America remains on the outside looking in.

It is always risky to paint such a diverse region as Asia with one brush, but there are some common threads that emerge from extensive visits to Japan, China, Singapore, and Hong Kong. First, Asia does not buy the myth perpetrated in the West that a new generation of consumers is taking the region by storm. The need for a pro-consumption rebalancing finds support in developing Asia and is also recognized to be of great importance in Japan, where the consumer has largely been missing in action from an otherwise impressive recovery. Second, Asia is in denial over the possibility of a growth accident in the U.S. That would obviously deal a serious blow to the Chinese export machine – as well as to the Japans, Koreas, and Taiwans that drive Asia’s increasingly China-centric supply chain. Finally, Asia ex Japan is blinded by a very powerful liquidity cycle – the surging flows of low-cost capital that have priced most of the risk out of its stock and bond markets. I remember well the haunting words I heard from a seasoned investor in Hong Kong a few weeks ago, “It hasn’t felt this good since 1997.”

In my multiple spins around the world this fall, I was struck by both the successes and failures of the current strain of globalization. But I was also struck by the persistence of “localization” – nations that remain more caught up in self-interest rather than in the collective benefits of an integrated global economy and world financial markets. It is easy to talk the talk of globalization. It is much harder to walk the walk. That is the lesson that hit me the hardest.

IS THE THE “SKYSCRAPER CURSE” READY TO STRIKE AGAIN?

Hundreds of thousands of Taiwanese have been taking to the streets of Taipei in recent months to oust their president, prompting observers to wonder what gives. Corruption is behind the protests, many will say. Others point to his unsteady handling of relations with China, which considers Taiwan a renegade province. I am wondering if it might make more sense to look at the skyline. Standing out amidst the tangle of skyscrapers is the 1,671 foot (509 meters) Taipei 101, which is currently the world’s tallest building. Its presence, coupled with a worsening political crisis that could trip up the economy, reminds one of the “Skyscraper Curse.”

A bizarre suggestion, perhaps, and certainly an unscientific one. Yet history shows an uncanny correlation between tallest building projects and financial crises. Be it in Kuala Lumpur in 1997, Chicago in 1974, New York in 1930 or the biblical Tower of Babel long ago, mankind’s penchant for architectural overreach is a strangely reliable omen of troubles. A coincidence? Perhaps, yet economists such as Mark Thornton, senior fellow at the Ludwig von Mises Institute, argue that skyscrapers can speak volumes about a nation’s wealth, technological prowess, ambition and, perhaps most importantly, hubris.

For a time in the early 2000s, analyst Andrew Lawrence, then with Deutsche Bank Securities in Hong Kong, published a periodic “Skyscraper Index” for investors. As 2007 approaches, perhaps we need to start producing more building-project barometers. Take Dubai, which is undergoing one of history’s greatest construction booms. After visiting the city recently, economist Claudia Zeisberger of the Asia Pacific Institute of Finance at Insead in Singapore quipped, “All the building going on made me feel like I was experiencing the last days of ancient Rome.”

Perhaps it is just a coincidence, but Dubai is putting the finishing touches on a 2,300-foot building that will top Taipei 101. In China, the 101-story Shanghai World Financial Center will become the most populous nation’s tallest building. And a residential construction project in Chicago will top the Sears Tower, currently North America’s tallest skyscraper. In India, developers are planning to build a 140-story skyscraper in the city of Gurgaon, near New Delhi. In 2008, South Korea will complete the 1,903-foot International Business Center, which the government hopes will solidify Seoul’s place as a global business hub. Massive skyscrapers also are being considered from Australia to Russia to Brazil.

Even though the Federal Reserve, Bank of Japan and European Central Bank have been raising interest rates, markets are still awash in excess cash. Loose monetary policies have fueled investment frenzies in London, Shanghai, Tokyo and elsewhere. Over-investment and financial speculation led to each of the Skyscraper Curse episodes during the 20th century. Coincidence or not, history suggests such projects are often less about technological innovation than economic booms. The desire to have the tallest building correlates suspiciously well with sudden capital inflows that pump up credit creation and confidence.

I guess we will stay tuned to events in Taiwan. Ditto for the architectural one-upmanship afoot in countries hoping to draw attention to their skylines. A crisis is not necessarily in the cards – whether instigated by the smorgasbord of risks out there, the construction trends, or the vagaries of boom-and-bust cycles. Yet a smooth year would mean avoiding the Skyscraper Curse. History suggests that is a tall task.

GAZA STRIPPED: WHATEVER HAPPENED TO ARAFAT’S BILLIONS?

November 11 marked two years since the death of PLO chief Yasir Arafat. His memory is not widely mourned. On a good day in Gaza City, only 40% of the last night’s sewage gets dumped into public beaches along the Mediterranean coast, where gaunt Palestinian kids build sand castles out of thick brown sludge. One and a half million Gazans, mostly children, live overwhelmingly in poverty amid a gutted infrastructure and a dysfunctional democracy. Meanwhile, the First Lady of Palestine, Yasir Arafat’s widow Suha, has been living large in Paris, among other places, at the palatial Hotel Le Bristol. She and her baby daughter left Gaza for France in 2000, during the second intifada and Israel’s reoccupation of Palestinian lands – and reportedly occupied an entire floor of the 5-star hotel, at approximately $16,000 per night.

Israeli and American intelligence officials say Suha Arafat’s Paris hotel bill would be little more than chump change for the glitzy heiress, whose late husband might just have been the most flagrant embezzler of public funds since Louis XVI. During Arafat’s rule, the U.S., World Bank, E.U., and Arab governments poured $7 billion into the Palestinian Authority to try and help forge a viable Arab-Israeli peace. As much as half that sum is reported to have gone AWOL, with only a small fraction recovered to date. And Suha has proved to be only one of several big-time beneficiaries. “There was never a complete public reckoning of corruption during the Arafat years,” says Ramallah-based Bir Zeit University professor Mudar Kassis, who teaches philosophy and heads the university’s institute of law.

Two years after Arafat’s funeral, an international scavenger hunt continues for the revolutionary leader’s far-flung riches. A motley assortment of investigators ranging from Israel’s security establishment to the Palestinian Islamist group Hamas, which now rules in Ramallah, maintain an ongoing interest in every lost stash. “The only man who knows the whole story is dead,” says a senior Israeli military intelligence official who agreed to answer questions on condition of anonymity. “But the deeper you go into it, the more it stinks.”

Arafat’s money trail leads far beyond the smelly sands of Gaza Beach, to a rainbow coalition of shady figures – Jewish, Christian, and Muslim – and as far west as New York’s Greenwich Village, where the militant chieftain once secretly bought a stake in a trendy bowling alley. You might say the closest the world ever came, in fact, to harmony and peace between all three monotheistic faiths was in the sleazy international campaign to siphon off Palestinian grant aid. It may be too early still to tell the full Where’s Waldo-like tale of where the cash went. But several all-stars of Arafat’s money laundering network have come to light – and the legacy of their greed still has grave repercussions across the Middle East.

Arafat’s lifetime of grubbing for cash on behalf of the Palestinians dates back to his young adulthood in Cairo, where he was born shortly before the American stock market crash of 1929. Few had heard of the Palestinian cause back then, and there were no blue-and-white pushke boxes accepting pocket change for it. But longtime PLO stalwart Nabil Shaath remembers watching, as a 13-year-old, the young revolutionary hit up his father for a cash donation. Shaath told Atlantic Monthly correspondent David Samuels he immediately recognized the future president of Palestine. Arafat’s sister Inam, moreover, recalls the cash-flush teen’s leadership style during the same period. “He formed [the neighborhood kids] into groups and made them march and drill,” she told Arafat’s biographer. “He carried a stick to beat those who did not obey his commands. He also liked making camps in the garden of our house.”

These two remembrances pretty much say it all about Arafat’s lifelong financial strategy and management approach. He leveraged his relationship with authority figures to bankroll his movement, then took that leverage and beat Palestinians over the head with it. He would not, however, go the way of other third-world dictators and settle into luxury living. “He controlled the money,” recalls Eran Lerman, a retired Israeli military intelligence colonel who now heads the American Jewish Committee’s Jerusalem office, “but he hardly ever used it for his own purposes.” Follow the guerrilla leader’s 50-year career, and most eyewitness accounts of the PLO chief at bedtime indicate he went to sleep on a creaky cot. The same may not be said of his close aides and confidantes, many of whom enjoyed opulent lifestyles as a reward for their loyalty to Arafat. “He was a connoisseur of power,” writes David Samuels, “who used the money that he stole to buy influence, to provoke or defuse conspiracies, to pay gunmen, and to collect hangers-on ...”

Over a year after Arafat’s death – when the Islamist terror group Hamas swept the Palestinian Authority elections on an anti-corruption platform – some of these hangers-on tried to fly the coop, with wads of cash tucked under their clothes. More than 30 PLO seniors were caught fleeing town and jailed, according to Hamas sources. Their confiscated moneybags, says the senior Israeli intelligence official, proved an early boon to the nascent Hamas-controlled treasury. But these local cronies were just small potatoes. Incessant infighting among Palestinian elites, so common in patriarchal societies, meant that Arafat would often prefer to pick outsiders – even sworn enemies of the Palestinian people – to handle his most sensitive, high-stakes finance jobs. Consider Arafat’s long-time Lebanese Christian aide and confidante, Pierre Rizk, the former intelligence chief for the Christian “Phalangist” paramilitary during the infamous Sabra and Chatila massacres, who served Arafat for a decade and a half as a confidante and bag man – allegedly pocketing millions. As Arafat lay dying in Paris, Rizk reportedly negotiated with the PLO on behalf of Arafat’s widow Suha for a $20 million cash payment and an ongoing monthly allowance. The outspoken first lady has relocated to Tunis, and not returned to the Palestinian territories since her departure in 2000.

The Arafats’ monied inner circle also found room for some Israelis and Jews. Together with Arafat senior advisor Muhammad Rashid – by birth an Iraqi Kurd – Arafat tapped two ex-Israeli security officials to open doors for PLO money in elite Swiss banks, beginning around 1997. What has become known in the Hebrew press as the “Ginnosar Affair” – named after one of Arafat’s Israeli business partners, ex-spook Yossi Ginnosar – sent shock waves through the Jewish state and Zionist diaspora. It was not just the enormity of the sums – $340 million – these erstwhile enemies were embezzling together while the peace process tanked, but the alleged involvement of some senior members of the American Jewish peace camp in Arafat’s corruption also cast a shadow on their efforts to help broker peace.

Meanwhile in New York City, the shiny black bowling balls of Bowlmor Lanes in Greenwich Village bare rumbling witness to the long, strong arm of Arafat. Flush with cash during the bloody Palestinian intifada of 2000-04, Rashid deputized Palestinian American Zeid Masri to pour $1.3 million of Palestinian Authority largesse into the bowling alley’s parent company, Strike Holdings LLC. SilverHaze Partners LLC, a Virginia-based private equity fund controlled by Masri, fronted the transaction.

After a U.S.-mandated Standard & Poor’s audit of the PA’s investment arm exposed the wacky dealings in 2004, Strike CEO Thomas Shannon took immediate steps to return the funds. “The information was never disclosed to us previously,” he told a reporter. “[H]ad we known the source of these funds, which represent approximately two percent of our company's equity, we would never have accepted them.” How many strikes at Bowlmor Lanes inadvertently fed into Arafat’s coffers, the world may never know. It is a safe bet that none of the proceeds reached Palestinian 13-year-olds on the sludgy shores of Gaza.

TAXES

TAX TRAPS AWAIT UNWARY U.S. INVESTORS OR COMPANIES WHO VENTURE OFFSHORE

There are a number of good reasons for U.S. investors or companies to venture offshore. But the U.S. tax rules relating to various offshore transactions are ambiguous, punitive and vague beyond belief. Penalties for a mere failure to file a form on or before the due date are typically $10,000 for each late form. And these penalties can be imposed by the IRS regardless of whether any profit has been realized and regardless of whether all the offshore transactions have been reported on a U.S. income tax return. More information about the potential penalties that can be imposed may be found here.

For example, say a U.S. corporation owns 100% of a small foreign corporation and requests an automatic extension of time to file its corporate Form 1120 until September 15th, which also extends the time required to file the Form 5471 for the foreign subsidiary. Due to some unanticipated computer problems, the company files its Form 1120 a few days late. Since the company has a loss, there is no penalty for a late filing of the corporate income tax form. However, there is a potential penalty of $10,000 for a late filing of the Form 5471 for the foreign subsidiary – even though that subsidiary also has no profit. Taxpayers can request a waiver of such penalties for reasonable cause, but the waiver is entirely at the discretion of the IRS. A failure to file a timely return for a foreign trust can cost the taxpayer 35% of the assets in the trust. [Ed: Not all foreign trusts incur filing requirements. See Appendix 1 of Introduction to International Asset Protection.]

Problems associated with foreign mutual funds, known in the tax law as passive foreign investment companies (PFIC) can lead to obscene results, wherein the tax and penalties can exceed the total income and/or gains from the PFIC. The reason is because gains from such funds are allocated to all of the years the fund has been owned. Then a tax is computed for each year based on the highest rate in the tax tables – without regard to the marginal tax bracket of the taxpayer. To add insult to injury, a non-deductible interest charge is added to the amount of tax and compounded on a daily basis. Because gains can not be reduced by losses, the tax and interest can easily exceed the total net gain from the investment. For more information on the U.S. tax treatment of U.S. investors in foreign mutual funds, see this page.

The U.S. tax system imposes a tax on the worldwide income of any U.S. citizen, permanent resident or any entity formed in the U.S. The U.S. system also taxes the U.S. owners of any foreign entities such as foreign trusts, foreign corporations, and various foreign investments. When income is earned or realized in a foreign country that imposes an income tax, the U.S. tax system permits taxpayers to claim a credit against their U.S. tax for the taxes paid to the foreign country. But there are numerous restrictions and limitations on the foreign tax credit that are being changed nearly every year by the tax writing committees in the Congress. An example of a limitation is that a U.S. corporation can claim a credit for foreign taxes paid by a foreign subsidiary. But if a foreign corporation is owned by an individual (or a partnership), the credit is not permitted. Another example is that if a value added tax is imposed on the profits earned in a foreign country, the VAT is not allowed as a credit against the U.S. taxes on the same income. Why? Because the VAT is not deemed to be an income tax.

DO I HAVE TO PAY U.S. TAXES ON INCOME FROM OMAN? (YES)

Question: I work in the Middle East and I am paid by the joint venture from the Middle east. The joint venture is half American and half Oman. Do I have to pay taxes?

Reply: You did not ask whether you were referring to taxes in Oman or in the U.S. However, if you were not a U.S. citizen or permanent resident, you would not have any reason to ask the question. According to a quick Google search, Oman does not impose a personal income tax. If it did, it is very likely that all of your income would be subject to tax by Oman. Since you are apparently a U.S. citizen (or permanent resident), the U.S. tax law says you are subject to U.S. taxes on your world wide income, regardless of where you live or where you work.

However, if you meet certain residence tests outside the U.S., you might be eligible for the “foreign earned income exclusion”. That section of the tax law (IRC 911) provides for an exclusion from U.S. taxes for up to $84,200 (for 2006). There are two residency tests to qualify for this exclusion. One is that you must live and work outside the U.S. for at least 330 days out of 12 consecutive months. The other is that you must have made a permanent change in your residence to a foreign country. There have been some attempts by some members of Congress to repeal this tax break for U.S. persons working abroad, but repeal will meet strong opposition from U.S. corporations who need U.S. workers to work outside the U.S. The repeal is also oppossed by the American Institute of CPAs.

THINK TAX-BACKWARD TO AVOID THE AMT

Taxpayers, walk away from the gift wrap and pick up your pencils. You have less than three weeks to strategize your way out of the alternative minimum tax for 2006. The AMT has become a universally unpopular symbol of policy gone awry. Initiated in 1969 as a way to catch high-income Americans who were dodging all income taxes, it has morphed into an almost-incomprehensible parallel tax system that disproportionately affects middle-income taxpayers who have many kids or live in high-tax states. Because its brackets are not automatically indexed for inflation (unlike the regular income structure), it catches more taxpayers every year as their incomes rise to AMT levels. “This year it will affect 3.6 million taxpayers, at an average of about $6,000 per return,” says a director of tax services at an accounting and tax business in Pennsylvania.

It is tough to understand, but ignore it at your own peril. If the AMT snags snags you, the very actions you take to cut your taxes (such as making extra mortgage payments in mid-December) could come back to bite you. Here is what you need to do, right now:

1. Get a basic idea of how the AMT works.
2. Drill down and guesstimate whether you are going to be subject to the AMT.
3. If you expect to be AMT’d, think backward. Put off that year-end home equity or tax payment until January. Defer your miscellaneous expenses, like investment interest or job-hunting expenses. Bring extra income, such as bonuses, into this year. Your mission is to keep “preference items” low enough to kick you out of AMT contention, at least for one more year.
4. Watch Washington. Both Democrats and Republicans say they want to “fix” the AMT problem, but they will have problems offsetting any lost tax revenues. It is likely that the best they will do is continue to adjust it annually. That buys them continued attention from tax-focused lobbyists, and it buys them higher revenues that they can count in the out-years, even if they are just going to adjust them away too. So if you are just falling under the AMT radar, you might continue to escape it, one year at a time.

LEFT-RIGHT COALITION SEEKS REVIVAL OF U.S. TAX REFORM DEBATE

An alliance between Sens. Ron Wyden (D-Oregon), Larry Craig (R-Idaho) and 15 organizations spanning the U.S. political spectrum have pledged to work together toward a Congressional debate over federal tax reform. The coalition's campaign is centered around the principles outlined in its “Cleanse the Code” statement, which contains three broad principles: (1) Simplification, Transparency, and Certainty, (2) Opportunity for All Americans to Get Ahead, and (3) Fiscal Responsibility.

“Although we may disagree on the merits of a particular tax reform proposal (and each may have additional core standards for reform), we do agree that major reform – much as we saw in 1986 – is needed,” the joint statement noted. The signatories ranged from the Progressive Policy Institute to the American Conservative Union, from the National Taxpayers Union to Citizens for Tax Justice, from the Taxpayers for Common Sense to the Center on Budget and Policy Priorities. “Most taxpayers should be able to calculate their taxes on a single form or no form at all, and in most cases by themselves, with a few hours or less of preparation,” the statement continued.

EU TAX RULING A MIXED BLESSING FOR UK-BASED CORPORATIONS

A ruling by the European Court of Justice has left the UK government open to potentially billions of pounds in tax repayments to companies, but has also added yet more complexity to the UK’s already burdensome corporate tax system, according to accounting firm KPMG. The EJC ruling on the FII (franked investment income) case covered two key issues: (1) The legality of advance corporate tax payments made prior to the tax’s abolition in 1999, and (2) the tax treatment of foreign sourced dividend income from subsidiaries of UK parent companies located in other EU member states.

The ECJ’s decision on the tax treatment of resident and non-resident dividend pavements is a mixed blessing, says KPMG. While the court accepted in principle that foreign sourced dividends should not suffer more UK tax than UK-sourced dividends, it went on to hold that existing measures to compensate for this discriminatory treatment by way of tax credits to relieve double taxation on foreign sourced dividends were adequate. The Court has referred the matter back to the UK courts to determine whether the UK rules operate to achieve this parity. “It is disappointing that the ECJ has stopped short of ruling that the UK should apply the same rules to both UK and foreign sourced dividends,” Bridges noted. “Achieving equality of treatment via a credit system may, on the face of it, sound reasonable but it is not straightforward. ... The ECJ’s ruling today fails to fully appreciate the fact that not all profits in the UK are taxed at the corporate tax rate of 30%. For example those deriving from share sales are completely exempt.”

NEW ZEALAND TO REVIEW TAX ON OFFSHORE INCOME

A review of international tax rules aims to improve the competitiveness of New Zealand companies operating in export markets overseas, Finance Minister Michael Cullen and Revenue Minister Peter Dunne announced. “Active income from the offshore operations of New Zealand companies may be exempted from domestic income tax to help them compete internationally,” the Ministers explained. The possible change was outlined in a discussion document released this week that seeks feedback on options for a major revamp of New Zealand’s international tax rules.

The Ministers continued, “We are looking at a radical shift in our approach to taxing offshore income from our companies operating overseas, one that distinguishes between active income, such as manufacturing and industrial activity, and passive income, such as royalties and interest. Under such a distinction, offshore active income would be exempt from New Zealand tax, rather than taxed as it is earned, as happens now.

“The current rules may encourage New Zealand companies to relocate their headquarters to some countries where their offshore income is treated more favourably. Reducing the tax burden will improve their competitiveness and help to ensure New Zealand retains more activity.”

ST. KITTS AND NEVIS RAISES TAXES

Presenting the St. Kitts and Nevis budget for 2007 this week, Prime Minister and Minister of Finance, Dr. Denzil Douglas, said that despite the shutting down of the federation’s once important sugar production sector, 2006 would see growth in the economy of 4.6%. The tourism and construction sectors were continuing to underpin the economy, he said, as they had done in 2005. All service sectors however had shown growth, including communications, banking and insurance.

Citing increased social costs as a result of the shut-down, Dr. Douglas announced a range of tax increases, including a 5% levy on domestic telephone calls in St. Kitts and Nevis, from January 1, 2007. There will also be a 15% excise duty on alcohol and tobacco products, and an increase in the existing Social Services Levy from 8% to 10% on salaries in excess of EC$8,000 monthly. The Prime Minister claimed that liberalization of the telecommunications sector has driven down prices, so that, overall, costs would not increase. Income tax legislation will also be amended to require companies to pay taxes at the same time as filing their tax returns, vs. the three months in which to pay they currently have. Commenting on the new excise duties, he said, “[O]ur health system incurs tremendous cost in respect of diseases associated with the consumption of alcohol and tobaccos. It is only fair that the users of these products be asked to bear a portion of this cost.”

ASSET PROTECTION / LEGAL STRUCTURES

AVOIDING FORCED HEIRSHIP IN CIVIL LAW COUNTRIES USING TRUSTS AND LLC’S

Forced heirship rules in many civil law countries are an ongoing source of family problems which have frustrated proper estate planning and divided families into warring camps for generations. While there are a number of very good solutions for this problem, one of the most popular is the use of a foreign trust structure to hold the assets indefinitely without ever triggering heirship rules since a trust can be perpetual.

A trust is a common law vehicle that was first used during the Crusades. Though it has many variations of form and exists in many jurisdictions, trust law is universally considered to be well-settled – stable and predictable. Were this the only consideration, a trust could be created in any one of dozens of jurisdictions. However, because of increasing concerns with issue of money-laundering, tax-evasion and terrorism, the choice of a jurisdiction becomes increasingly important. As such, creating such a structure in a jurisdiction that is neither generally considered to be tax haven nor on international black lists has its virtues.

With these concerns in mind, a New Zealand Trust structure which owns subsidiary Delaware-U.S. limited liability companies, is such a solution. Neither the U.S. nor New Zealand are considered to be tax-havens, though they both offer considerable tax and asset protection advantages for those who are not citizens or residents. Properly organized, a NZ Trust is entirely tax-free for non-residents of New Zealand. Furthermore, a tax-free private NZ trustee company can be established to operate the NZ Trust.

However, since civil law jurisdictions generally do not recognize trusts, the NZ Trust cannot actually own the assets. Instead a different vehicle, wholly-owned by the NZ Trust, will legally hold title the assets. The perfect vehicle for this is the Delaware LLC. A properly set up Delaware LLC which does no U.S.-based business will not only be tax-free, but will not be required to even file a U.S. tax return, even if it has a tax ID number. Such a structure might look like this.

Of course, every detail must be properly handled in order to ensure that the entire structure functions as the client intends, without triggering any adverse tax or heirship issues.

THE LLC CHAMELEON

The IRS classifies every non-trust company as either a partnership, corporation, or disregarded entity. This applies to both domestic U.S. LLCs and foreign LLCs. While there are default rules for the classification of both foreign and domestic LLCs, one has the option in both cases of selecting a different classification simply by checking the box on IRS form 8832.

Under the default rules, a domestic LLC is considered a partnership if it has two or more members and a disregarded entity if it only has one member. Under those same rules a foreign LLC is considered (1) a partnership if it has two or more members and at least one of the members does not have limited liability, (2) a corporation (in tax law language, it is actually called an “association”) if it has two or more members all of which have limited liability, and (3) a disregarded entity if it has a single member who does not have limited liability. Again, that can be changed by checking the box on the form 8832. Thus, any LLC – foreign or domestic – can choose to be considered either a corporation or partnership for tax purposes. And if it only has one member, even if that member is another legal entity, it can choose to be considered a disregarded entity for tax purposes.

One could have a Delaware LLC owned by a foreign company that could be a disregarded entity for U.S. tax purposes. Such an LLC could still have a U.S. tax number, bank accounts, and even brokerage accounts. If it were indeed owned by a foreign company, under the rules governing the use of IRS form W-8 BEN, the beneficial owner of the LLC would be the foreign company. So long as that Delaware LLC had no U.S. income except bank interest and capital gains, it would not be required to file any U.S. tax return nor be liable for US taxes. Indeed, it could operate businesses throughout the world, and so long as they were not effectively connected with the U.S. there would be no tax or tax return due.

The LLC act of the Republic of the Marshall Islands is almost word for word copied from the Delaware act, which means the two can be made to fit perfectly together. In this example, the U.S. LLC and the Marshall Islands LLC could mirror each other in every respect except that the U.S. LLC could be treated as a disregarded entity for U.S. tax purposes, while the Marshall Islands LLC could be treated as a foreign corporation for U.S. tax purposes. As such, the Marshall Islands LLC would be the beneficial owner of the U.S. LLC. Which would legally shield the identities of the owner of the Marshall Islands LLC.

One could go further and set up a Delaware series LLC owned a by a mirror image Marshall Islands series LLC, in which case the Marshall Islands LLC would own a the Delaware LLC, and each series within the Marshall Islands LLC would own the complementary series within the Delaware LLC. This provides major asset protection alongside tax simplification, or in the case of foreign persons, major tax efficiency.

THE FOREIGN DEFERRED PRIVATE ANNUITY

One of the most powerfulk estate planning tools available to the modern international financial planning practitioner is the FDPA. An FDPA is a contract between an individual (the “Annuitant”) and a foreign entity that is neither an insurance company nor in the business of selling annuities (the “Company”). The Annuitant transfers cash or other property to the Company in exchange for the Company’s contractual promise to make payments to the Annuitant for a specific number of years, usually for the remainder of the Annuitant’s life.

Contributed assets may be “Appreciated Property” and the recognition of any taxable gain (capital gains or ordinary income) inherent in the asset may be deferred even though the assets may be “cashed in” and the funds invested elsewhere. The annuity payments may be deferred until the Annuitant turns 70. So that the Annuitant can defer paying taxes on the exchange for many years, and then pay them on a pro-rata basis as annuity payments are received over the course of many more years.

The foreign company which issued the FDPA may invest anywhere in the world, including the U.S., and has investment advantages that are not offered to U.S. investors. For example, there are various tax provisions only available to foreign persons that the U.S. has enacted to encourage investment in the U.S. and the use of U.S. banks and savings institutions. As a result, the FDPA Company may invest tax-free in U.S. stocks and financial accounts. The Company may sell appreciated stocks utilizing an FDPA with no tax recognition and reinvest the funds back in the U.S. on a private and tax-free basis. The FDPA offers a wide range of benefits that no other single business and estate planning device can match.

Similar to the taxation of installment sales, an FDPA permits the Annuitant to defer gain – and taxes on gains – on the sale of any type of property by spreading it ratably over the life expectancy of the Annuitant and, in the case of an FDPA subject to a term, over a stated term rather than reporting the entire amount of the gain in the year of sale. However, the Tax Reform Act of 1986 made installment sales much more difficult, and in many cases impossible. For example, installment sales are not allowed for certain assets, such as publicly traded stock. In contrast, an FFDPA permits the Annuitant to receive a tax deferral on any appreciated asset. Appreciated assets may be transferred to the Annuity Company and converted into investment funds without payment of any income tax on capital gains or ordinary income.

An FDPA also allows the removal of the transferred property from the Annuitant’s gross estate without triggering any U.S. gift tax. Upon the death of the Annuitant, the transferred property as well as any future appreciation in such property will not be included in the decedent’s gross estate. If the annuity is an FDPA based on a single life, as opposed to two lives, the annuity payments are also excluded from the Annuitant’s gross estate for estate tax purposes. With appropriate estate planning, appreciated foreign investments may be passed to heirs without estate tax consequences.

Furthermore, since property that is properly transferred in an FDPA transaction is no longer considered owned by the Annuitant, the transferred property is beyond the reach of creditors and lawsuit or bankruptcy judgments. As long as the present value of the annuity is equal to the fair market value of the property transferred for the annuity, the transfer will not be overturned under the fraudulent conveyance laws. An FDPA holds property away from U.S. jurisdiction, thus providing asset protection against future creditors, ex-spouses, and governments. The FDPA can usually be used to allow a client to exchange these assets while avoiding disqualification for federal or state assistance for medical or institutional costs. Generally, the transferred assets will not be included in the annuitant’s estate for Medicare purposes.

Since property in an FDPA can be used to earn greater investment returns. There is no reporting of the interim growth or U.S. tax payable at any time on FDPA investments. Since taxes may be paid at some time in the future, when and if the Annuity is activated and funds flow back to the U.S., this investing is best called tax-advantaged. Well planned, investments may result in tax-free returns. Foreign investments can grow tax-free and in privacy. An FDPA may invest anywhere in the world without the oversight of the U.S. Government. In contrast, U.S. Persons are not allowed to invest internationally unless the investment has been approved by the SEC. A high percentage of the most successful mutual fund and bank investments are outside North America and not available to U.S. Persons.

An FDPA can be structured to operate an international business venture, with indefinite life, and yet the business profits are not taxed in the U.S. unless they are “effectively connected” to business activity there. An FDPA can generate a fixed income for life while still retaining control of the asset or business within the family. By transferring property to a family member utilizing an FDPA, the Annuitant is able to shift management of the property to descendants rather than waiting to bequeath it subject to the possible burden of estate taxes. The annuity could be be structured so that the fixed payments provide a minimum threshold income while allowing for reinvested profits from the investments to increase the annuity’s value and payments.

The FDPA is NOT a loophole! The IRS originally determined that certain transactions would be treated as private annuities in 1969. Since that time, while the IRS has attempted to reduce the opportunities to abuse private annuities it has never suggested eliminating private annuities as a whole. U.S. tax law changes are very rarely made retroactive, so any future changes will likely not affect pre-existing FDPAs. Furthermore, there is nothing in the transaction that should cause an audit flag, but if there is an audit, it should be remembered that the transaction is 100% legal. Lastly, unlike the 401(k) program there are no limitations on the amount of assets transferred to the FDPA Company in exchange for the Annuity without causing a taxable event. This makes the FDPA an excellent choice for establishing what can be considered and treated as a private pension plan or retirement account.

If the FDPA is issued in conjunction with a legally non-controlled foreign company structure, the FDPA’s benefits noted heretofore are additionally enhanced, because the Annuitant will participate in the management of the foreign company structure that acquires the FDPA and owns the assets. The Annuitant will then be able to pass his ownership interest and management rights in that structure to his heirs on a virtually tax-free basis. The heirs can choose to continue the structure and enjoy the asset protection, tax reduction, estate planning and investment benefits it provides, OR, after waiting one year, can liquidate it and repatriate the assets as long-term capital gains income.

Note that since the FDPA is not secured, you could lose everything invested in it if you deal with the wrong people. The usual caveats apply, and then some.

A, B, C, OFFSHORE, AND SHELL BANKS, AND THE DIFFERENCES THEREOF

In the world of international finance you will hear a number of confusing terms to describe various kinds of banks. A shell bank is one which has no substantial presence, staff, or independent existence. These banks are often nothing more than a banking license lodged at an attorney’s office with the nameplate on the door from which they have also come to be called, brass plate banks. Under the Patriot Act, these banks are de facto presumed to be criminal operations. The most famous purveyor of these banks was Jerome Schneider, who has since been convicted of various felonies.

The major difference between an offshore bank on one hand, and an A, B, or C bank is that the former is generally regulated by a government finance Ministry – and as such is not a real bank, nor directly tied into the worldwide banking system – while the latter are real banks with various kinds of licenses. An A bank is a standard commercial bank, the kind with which you probably deal in your hometown. In some countries this is called a universal bank, because its banking license allows it to do almost everything.

A B bank is very similar to an offshore bank in that both are restricted from dealing with the residents of the country in which they are chartered. However, a B bank is a real bank, regulated by the central bank, and as such part of the worldwide banking system. A C bank is further restricted so that it can only do business with those persons or entities named within the charter. As such, it is the banking equivalent of a captive insurance company. In some places there are offshore banks that operate under similar restrictions and they are usually known as restricted offshore banks.

As noted, the Patriot Act places a huge onus on shell banks. This was extended by Attorney General John Ashcroft to include offshore banks generally. Because of this, the utility of offshore banks has decreased considerably. The real Holy Grail for offshore business is a domestic commercial (i.e., A) bank, which is friendly to nonresident accounts.

WHEN IS A DOLLAR NOT A DOLLAR?

Panama has a currency arrangement unlike any other in the world. The official currency of Panama is the Balboa. The Balboa has always been pegged at 1:1 to the U.S. dollar. Further, no Balboa currency has ever been printed. Balboa-denominated coins are minted in exactly the same size, shape and value as the U.S. penny, nickel, dime, quarter and half- dollar. In practice, this means that the U.S. dollar changes hands in Panama as the local currency. In practice, Panama has always been “dollarized” like the British Virgin Islands, the Turks & Caicos Islands, and more recently, El Salvador and Ecuador. Nevertheless, legally, Panama’s currency is still the elusive Balboa.

Why does this matter? Because bank accounts in many Panamanian banks can be held in U.S. dollars or Balboas. Dollars and Balboas can be exchanged freely at no fee and without any discount. This anomaly allows one to safely hold their dollar reserves in Balboas. Unlike dollar accounts, Balboas cannot be summarily seized or frozen by U.S. officials in an end-run around Panama’s bank privacy laws. This is a technicality worth exploiting!

The amazing thing is that nobody seems to realize this until you point it out to them. They have been so busy promoting their dollarized status that they have overlooked this hugely important point. Now comes the hard part – finding a Panamanian banker who 1) understands this, and 2) will do it for you.

PRIVACY

BUSH “PRIVACY BOARD” A FARCE

The first public meeting of a Bush administration “civil liberties protection panel” had a surreal quality to it, as the 5-member board refused to answer any questions from the press, and stonewalled privacy advocates and academics on key questions about domestic spying. The Privacy and Civil Liberties Oversight Board was created by Congress in 2004 on the recommendation of the 9-11 Commission, but is part of the White House, which handpicked all the members. Though mandated by law in late 2004, the board was not sworn in until March 2006, due to inaction on the part of the White House and Congress.

The three-hour meeting, held at Georgetown University, quickly established that the panel would be something less than a fierce watchdog of civil liberties. Instead, members all but said they view their job as helping Americans learn to relax and love warrantless surveillance. “The question is, how much can the board share with the public about the protections incorporated in both the development and implementation of those policies?” said Alan Raul, a Washington D.C. lawyer who serves as vice chairman. “On the public side, I believe the board can help advance national security and the rights of American by helping explain how the government safeguards U.S. personal information.”

Board members were briefed on the government’s NSA-run warrantless wiretapping program last week, and said they were impressed by how the program handled information collected from American citizens’ private phone calls and email. But the ACLU’s Caroline Fredrickson was quick to ridicule the board’s response to the administration’s anti-terrorism policies, charging that the panel’s private meetings to date largely consisted of phone calls with government insiders and agencies. Lisa Graves, the deputy director of the Center for National Security Studies, asked the board two simple questions: (1) Did they know how many Americans had been eavesdropped on by the warrantless wiretapping program, and, (2) if so, how many? Raul acknowledged in a roundabout way that the data existed, but said it was too sensitive to release. Graves then asked if the board had pushed to have that data made public, as the Justice Department is required to do with typical spy wiretaps. Raul declined to say.

Graves tried to push the issue of whether the board was going to be public or private, but chairwoman Carol Dinkins politely cut her off and ended the question-and-answer session. Board member Lanny Davis, who had introduced himself by saying he grew up in a household where the ACLU was considered a “heroic organization”, explained that, “Congress put us in the office of the president, we didn’t.Had Congress wanted us to be an incensement agency, it would have made us independent.”

Fred Cate, a cybersecurity professor at Indiana University, stressed that anti-terrorism programs that collect and sift through data on Americans – such as the no-fly list and the recently announced Automated Targeting Center that has been computing terrorism quotients for those flying in and out of the country for more than five years – need to have a robust way for people to contest the scores and underlying data. “Redress seems to be the foundation of any system,” Cate said. “The only certainty in this entire field is that there will be false positives.”

MORE CHEER FOR THE HOLIDAY TRAVEL SEASON

This holiday travel season, Santa Claus is not the only one who is checking to see whether you have been naughty or nice. For the last four years, the U.S. government has been snooping by computer into people’s travel records and assigning them a risk score for being terrorists or criminals. Of all the government’s violations of civil liberties since 9/11, the DHS’s Automated Targeting System (ATS) is probably one of the worst in terms of numbers of people affected.

Invariably, some of the traveling public that I chat with in airport security lines will say that if you have done nothing wrong, you have nothing to fear from the government’s intrusive measures. That dubious line of reasoning, however, makes the Herculean assumption that government usually gets things right. Also, after examining where you are from, your motor vehicle records, how you paid for your airline ticket, and even your seating preference and the type of meal you ordered, and then assigning a risk factor to you, the government allows everyone to see this rating but you. Unlike privately held credit scores, you have no means to challenge any inaccuracies or the rationale for the government giving you a certain risk factor. Yet there is more bad news. The risk assessment is then shared with state, local, and foreign governments, Congress, the courts, and private contractors, and can be used to deny employment in shipping and travel, licenses, security clearances, and government contracts. The government intends to keep these assessments on file for 40 years.

One could easily assume that the next step is to give “high risk” people more hassles at airport security checkpoints. So if you get too many parking or speeding tickets could you end up on the terrorist watch list? If you eat too many vegetarian meals, could you be banned from flying?

Of course, as usual, government officials have refused to say whether the program has caught any terrorists. Given the fact that terrorism is rare – another thing missed by those air travelers who are champions of intrusive security – probably not. All of this leads to the question of whether we should have a greater fear of the terrorists or the government’s overreaction to the threat. Many powerful vested interests that build security and data mining systems peddle their wares to government security agencies that care little about the sacred liberties that make this nation unique. Like any bureaucracy, the security organizations use crises to gain more authority, bigger budgets, and the latest technological tools—consequences for the country and individual liberty be damned.

The U.S. government executive branch’s coercive power is supposed to be checked by Congress, the courts, an unfettered media, state and local governments, and the Bill of Rights. Unfortunately, in the age of the imperial presidency many of these checks and balances are breaking down. The presidency is now so powerful that the chief executive apparently can simply violate laws by asserting that he is commander-in-chief – as President Bush did when he flagrantly ignored the law prohibiting surveillance without a warrant. The ATS system is yet another example of executive power encroaching on the privacy of individuals. Given current trends, during future holiday seasons, perhaps the government will assign ordinary people permanent ratings on their risk for committing murder, rape, burglary, armed assault, child molestation, speeding, and jay walking. Santa Claus could certainly use a comprehensive system like this to determine who is naughty or nice. In the meantime, the government’s “war on terror” is the gift that just keeps on giving (more power to the security bureaucracies).

GOVERNMENT NUDIE SHOWS, STARRING YOU

In its tireless efforts to molest passengers, the Transportation Security Administration (TSA) is photographing them at Phoenix Sky Harbor International Airport. Naked. The TSA is about the baddest, bawdiest bureaucracy ever to curse a country, but geez, even they must have needed help on this one. I figure they went to Larry Flynt at Hustler for advice. Only a pornographer of his unsavory talents could have dreamed up such wickedness. Tell Americans that merely groping us is no longer enough protection from the terrorists thronging our airports. Now we must pose for dirty pictures, too.

And so the TSA has installed “backscatter X-ray” equipment in Phoenix. These contraptions penetrate clothing to show the flesh beneath. Victims do not strip. The rays do it for them. Screeners leering at the monitor see only our birthday suits – and, of course, the guns and knives so many of us tape to our thighs. The TSA claims its debauchery at Sky Harbor is only a test. But because “the machines have the potential to speed up the security process,” they are “likely future replacements for the metal detectors now in use” at other airports. That is all the excuse the TSA wants to plant the gizmos everywhere. A nationwide peepshow! Wanna bet Flynt is the star of the agency’s Christmas party this year?

The TSA certainly dreams big. It is already scheming to move its smutty technology beyond airports. Consumer Affairs reports that “Backscatter machines ... are also being considered for big-city train and subway stations.” Like a dirty old man who cannot decide when to pounce, the TSA has dithered about dosing us with backscatter X-rays for years. But a media as sympathetic as it is gullible reports that the bureaucrats “struggl[ed] with privacy issues.” Sure. USAToday assures us that “the machines will be used only on travelers who require extra screening beyond a metal detector.” You poor slobs who are hauled aside for “secondary screening,” whose belongings are rifled while a uniformed goon violates your body ... it is your own fault! You can either be sexually assaulted or photographed naked. It is your “choice”! Thank you, Leviathan.

And what happens to our pictures when the TSA’s done with them? Has Larry cut a deal with the Feds that will save him modeling fees? Au contraire. The TSA’s website alleges that the photos are deliberately blurred in a high-tech version of the fig leaf and that they are “erased from the screen” as soon as the prey clears security. Furthermore, “the capability of printing, storing or transmitting the image is not available to the Transportation Security Officer.” This from the liars who insisted that Rigoberto Alpizar hollered about a bomb before air marshals killed him last year, contradicting other passengers’ testimony. They are pedophiles and thieves. The Administration that created their agency has lied about WMD’s, eavesdropping on us, torturing POW’s, and just about everything else for the last six years. I trust the TSA’s denials that screeners can “print, store or transmit” blurred pictures of naked passengers about as much as I would Larry’s claims that he reads Playboy for the articles.

LAW

FEDS PROMISE LENIENCE FOR COMPANIES THAT CONFESS TO OVERSEAS CORRUPTION. YEAH, SURE

Over five years, beginning in 1999, employees in Asia working for a Portland, Oregon company called Schnitzer Steel Industries gave $205,000 in cash and gifts to managers of government-owned businesses in China in the hope of making them customers. The company became aware of the practice in 2004, stopped it on its own and then behaved exactly how U.S. authorities would have wanted. It voluntarily disclosed the matter to federal prosecutors, began an internal investigation and promptly shared the results. It disciplined wrongdoers, replaced senior management and implemented what authorities called “a robust compliance program.”

With this kind of decisive action, Schnitzer should have gotten off easy. Federal prosecutors and S.E.C. lawyers have for years promised leniency to companies that voluntarily disclose potential violations of the Foreign Corrupt Practices Act, a law that prohibits bribery of government officials overseas. And authorities involved with the Schnitzer case even hailed it as “an excellent example of how voluntary disclosure followed by extraordinary cooperation with the Department [of Justice] results in a real, tangible benefit to the company.”

Yet the benefit was hard to discern. Authorities also alleged the company made $1.7 million in “corrupt” payments to managers of privately owned companies in South Korea and China without properly disclosing them. In October the DoJ announced the company’s South Korean subsidiary had pleaded guilty to conspiracy and bribery and would pay a $7.5 million fine. The parent company would pay another $7.7 million and install a government-approved compliance monitor that would bill the company for its time yet report back to the government on its findings. Former Schnitzer executives could also face charges, and the company says it may incur further expenses.

Cases like this are prompting corporate defense lawyers to question the strategy of voluntary confessions. No one is condoning bribery, but companies are finding that by turning themselves in they are opening themselves up to years of negative publicity, fines, criminal investigations, indictments and highly intrusive compliance monitors that have billed companies for as many as 40,000 hours, at rates up to $700 an hour.

The FCPA was first enacted in 1977 but for 25 years got only spotty enforcement. That changed in the wake of corporate scandals, Sarbanes-Oxley and foreign treaties that made it easier for U.S. prosecutors to extract information from abroad. In the last five years law enforcement has brought more actions than in the previous two decades. Most of the investigations were begun after companies themselves disclosed potential problems.

Alexandra Wrage, president of Trace International, a nonprofit that helps companies comply with the FCPA, and others say it is now dawning on companies that disclosure is merely the beginning of a tortuous and expensive process. Some companies get hit with shareholder suits. Others can be penalized by the World Bank or foreign governments, or lose out on federal contracts. Most are also required to hire expensive compliance monitors, who have every incentive to find more wrongdoing, thus pleasing their ultimate client – the federal government – and getting more lucrative work in the future. Typically companies must comply with all of a monitor’s recommendations, with virtually no recourse.

Prosecutors acknowledge the difficult bind companies face. At an American Bar Association conference in Washington, D.C. in October Alice S. Fisher, head of DoJ’s criminal division, said she was aware of concerns that there was not enough certainty in the process. Yet she still encouraged companies to come forward. “It may not mean that you or your client will get a complete pass,” she said, “but you’ll get a real, tangible benefit.” Unless we decide you don’t.

U.S. HAS WORLD’S LARGEST PRISON POPULATION AND HIGHEST INCARCERATION RATE

Tough sentencing laws, record numbers of drug offenders and high crime rates have contributed to the U.S. having the largest prison population and the highest rate of incarceration in the world, according to criminal justice experts. A U.S. Justice Department report released on November 30 showed that a record 7 million people – or one in every 32 American adults – were behind bars, on probation or on parole at the end of last year. Of the total, 2.2 million were in prison or jail.

According to the International Center for Prison Studies at King’s College in London, more people are behind bars in the U.S. than in any other country. China ranks second with 1.5 million prisoners, followed by Russia with 870,000. The U.S. incarceration rate of 737 per 100,000 people in the highest, followed by 611 in Russia and 547 for St. Kitts and Nevis. In contrast, the incarceration rates in many Western industrial nations range around 100 per 100,000 people.

Groups advocating reform of U.S. sentencing laws seized on the latest U.S. prison population figures showing admissions of inmates have been rising even faster than the numbers of prisoners who have been released. “The United States has 5 percent of the world’s population and 25 percent of the world’s incarcerated population. We rank first in the world in locking up our fellow citizens,” said Ethan Nadelmann of the Drug Policy Alliance, which supports alternatives in the war on drugs. “We now imprison more people for drug law violations than all of western Europe, with a much larger population, incarcerates for all offenses.” Ryan King, a policy analyst at The Sentencing Project, a group advocating sentencing reform, said the United States has a more punitive criminal justice system than other countries.

AMERICA’S INJUSTICE SYSTEM IS CRIMINAL

The Christmas season is a time to remember the unfortunate. Among the most unfortunate people are those who have been wrongly convicted and imprisoned. The U.S. has a large number of wrongfully convicted. There are many reasons for this. One is that the U.S. has the largest percentage of its citizens imprisoned of all countries in the world, including China. One of every 32 U.S. adults is behind bars, on probation or on parole. The U.S. has 5% of the world’s population and 25% of the world’s prisoners. The American incarceration rate is seven times higher than that of European countries. Either America is the land of criminals, or something is seriously wrong with the criminal justice (sic) system in “the land of the free.” Given a wrongful conviction rate, the larger the percentage of citizens in jails, the greater the number of wrongfully convicted.

In the U.S. the wrongful conviction rate is extremely high. One reason is that hardly any of the convicted have had a jury trial. No peers have heard the evidence against them and found them guilty. In the U.S. criminal justice (sic) system, more than 95% of all felony cases are settled with a plea bargain. Before jumping to the conclusion that an innocent person would not admit guilt, be aware of how the process works. Any defendant who stands trial faces more severe penalties if found guilty than if he agrees to a plea bargain. Prosecutors do not like trials because they are time consuming and a lot of work. To discourage trials, prosecutors offer defendants reduced charges and lighter sentences than would result from a jury conviction. In the event a defendant insists upon his innocence, prosecutors pile on charges until the defendant’s lawyer and family convince the defendant that a jury is likely to give the prosecutor a conviction on at least one of the many charges and that the penalty will be greater than a negotiated plea.

The criminal justice (sic) system today consists of a process whereby a defendant is coerced into admitting to a crime in order to escape more severe punishment for maintaining his innocence. Many of the crimes for which people are imprisoned never occurred. They are made up crimes created by the process of negotiation to close a case. This takes most of the work out of the system and, thereby, suits police, prosecutors, and judges to a tee. Police do not have to be careful about evidence, because they know that no more than one case out of 20 will ever be tested in the courtroom. By coercing pleas, prosecutors can prosecute every case and boast of extremely high conviction rates. When prosecutors had to decide which cases to prosecute, they had to examine the evidence and to investigate the defendant’s side of the story. No more. The evidence seldom comes into play. In place of a determination of innocence or guilt, prosecutors negotiate with lawyers the crimes to which a defendant will enter a plea.

Prosecutors have lost sight of innocence and guilt. What we have today is a conveyor belt that convicts almost everyone who is charged. Every defense attorney knows that today prosecutors can purchase testimony against a defendant by paying a “witness” with money, dropped charges, or reduced time to testify against the defendant. Many prosecutors become highly annoyed at any disruption of the plea bargain conviction process. A defendant that incurs the prosecutor’s ire is certain to be framed on far more serious charges than a negotiated plea.

Going to trial is no guarantee that an innocent person will be acquitted. Prosecutors routinely withhold exculpatory evidence and suborn perjury. Generally, jurors trust prosecutors and are unaware of their inventory of dirty tricks. Few jurors can tell the difference between bogus evidence and real evidence. Prosecutors who are meticulous about their cases and fair to defendants – and there are still a few – show poor results compared to the high convictions attained by prosecutors who run plea bargain mills and frame-up factories. Today’s criminal justice (sic) system is results orientated, not justice orientated. In the past judges could give light sentences to people they believed had been wrongfully convicted. But “law and order conservatives” have taken sentencing discretion away from judges. Today prosecutors hold all the cards.

Prosecutors are like President Bush. They absolutely refuse to admit that they ever make a mistake and have to be forced to disgorge their innocent victims. Nothing makes a prosecutor more angry than to have to give back a wrongfully convicted person’s life. Lt. William Strong and Christophe Gaynor are two of the hundreds of thousands of wrongfully convicted Americans whose lives have been ruined by an irresponsible and corrupt criminal justice (sic) system. Virginia’s governor could pardon Strong and Gaynor. But feminists and “child advocates” would scream and yell, as would prosecutors and “law and order conservatives”. Nothing matters to these groups but their own single-issue, and justice is not part of it. In America justice cannot be done unless a governor is prepared to sacrifice his own political career in the interest of justice. What kind of people are we when we exercise no oversight over a criminal justice (sic) system that destroys the lives of innocent people with lies?

OPINION & ANALYSIS

BOOMERANG EFFECT

One of the things U.S. troops are learning in Iraq is how people with little training and few resources can fight a state. Most American troops will see this within the framework of counterinsurgency. But a minority will apply their new-found knowledge in a very different way. After they return to the U.S. and leave the military, they will take what they learned in Iraq back to the inner cities, to the ethnic groups, gangs, and other alternate loyalties they left when they joined the service. There, they will put their new knowledge to work, in wars with each other and wars against the American state. It will not be long before we see police squad cars getting hit with IEDs and other techniques employed by Iraqi insurgents, right here in the streets of American cities.

I know this thought – not to speak of the reality when it happens – will be shocking to some readers. To anyone who really understands Fourth Generation war, it should not be. 4GW does not merely work on the will of a state’s political leaders. It pulls an opposing state apart at the moral level. We saw this phenomenon in the effect the defeat in Afghanistan had on the Soviet Union. Just as that defeat led to the disintegration of the USSR, so defeat in the current Afghan war will bring the disintegration of NATO. We are seeing 4GW pull Israel apart today. We will see the same thing here, powerfully I think, as a result of our defeat in Iraq. It will manifest itself in many ways, and one of those ways will be the progression of inner-city and gang crime into something close to warfare, including war against the state.

Police will not be surprised by this prediction. I have talked with cops about Fourth Generation war, and they “get it” much better than do American soldiers and Marines. Many have told me that they already recognize elements of war in what they are encountering, especially in inner cities. Cops have been killed while just sitting in their cruisers, because they represent the authority of the state. How big a step is it for those cruisers to get hit with IEDs instead of pistol shots?

The Bush administration, as usual, has it exactly backwards. The danger is not that the “terrorists” we are fighting in Iraq will come here if we pull out there. Rather, American involvement in 4GW in Iraq will create “terrorism” here from among the people we have sent to fight the war there. Of course only a small minority of returning troops will go this route. But something else they will have learned from the Iraqi insurgents, along with how to make and deploy IEDs, is that it takes very few people to create and sustain an insurgency.

The boomerang effect is a central element of 4GW. When a state involves itself in 4GW over there, it lays a basis for 4GW at home. That is true even if it wins over there, and all the more true if it loses, as states usually do. The toxic fallout from America’s 4GW defeats in Iraq and Afghanistan will be far greater than most people expect, and it will fall most heavily on America’s police.

WORST. MEETING. EVER!

Applying government ideas to private business.

In my role as a business consultant, I am often asked to provide solutions to highly complex problems. Recently, a large, politically well-connected agricultural business paid me a fortune to provide them with a 5-year plan on how to best allocate their assets, capital and human resources in order to maximize profitability. The complexity of the business challenges involved were overwhelming, and I almost despaired of being able to provide them with a solution. The night before my big presentation, however, I suddenly remembered a central lesson I had learned in my political science classes. Armed with inspiration, I scribbled down a complete and total 6-step solution, slept well, and presented my answer at the Board of Directors meeting the next morning.

This is what I showed them:

1. Find some people.
2. Arm them.
3. Help them disarm everyone else.
4. Give them enormous amounts of money.
5. Give them your wish list.
6. Wait for the solution!

I finished my presentation and turned to my audience, flushed with triumph. But for some reason, my solution was not greeted with cheers and accolades. Instead, I saw nothing but baffled and angry faces.

“What the hell was that?” demanded the Chairman of the Board.

“I’m sorry,” I frowned. “I’m totally confused. Are there any Republicans or Democrats in the room?” ... “Well of course, but...” ... “And do you vote? Do you all vote?” ... “Sure, but ...”

“Well,” I asked, “do you have something against democracy then?”

Of course not, they all cried, but what does any of that have to do with this presentation?

“Well,” I said, “that is the beauty of it! If you are a Republican or a Democrat, you already agree that this ‘six-step’ solution is the perfect answer to incredibly complex problems like educating children, providing health care, alleviating poverty and eliminating drug use – and tons of other problems far more complex than the one you want me to solve! So – given that you already approve of this ‘six-step’ program for the most complicated and challenging social problems, surely it should be perfectly applicable to your much less complicated business issue! Heck, it might even be overkill!”

This did not go over very well at all, which was rather surprising to me. I had to interrupt their angry words. “What on earth are you upset about?” I demanded. “Do you disapprove of public education? Does public education use something other than this ‘six-step’ program? Why on earth are you angry? You have already approved this plan!”

More anger, more hostility – and then, most strangely, the Chairman suddenly demanded that I give them a full refund! I could not believe it! I asked if everyone had decided that they no longer were Democrats or Republicans. Strenuous denials all around! I held up my hand. “Excuse me. Excuse me! What do you do when the government fails to give you what you want? Do you demand a refund? If not, then why should I give you one?” They ended up throwing me out on the street, shook their fists in my face, and promised to sue me if I did not give them back every penny they had paid me.

I got up and dusted myself off, shaking my head in utter confusion. When I offer them a political solution, they scowl and yell at me – but they cheer and vote for a politician! I offer them the exact same solution that the government does, and they express loyalty to the government and threaten me! They throw me out into the street – and then meekly send their children to government schools. And jails. And wars. People are very, very confusing.

NEVER CALL RETREAT?

“When a battle is lost, the strength of the army is broken – its moral even more than its physical strength. A second battle without the help of new and more favorable factors would mean outright defeat, perhaps even absolute destruction. That is a military axiom. It is in the nature of things that a retreat should be continued until the balance of power is reestablished.” ~~ Carl von Clausewitz, On War

Clausewitz was writing of war when he first penned these words in the late 1820s, and of the distinct campaigns that constitute a war. Years earlier, he had learned his martial lessons while fighting the likes of Napoleon. So when writing of retreat, Clausewitz was also writing about the evidence that he had gathered by participating in the battles of the Napoleonic Wars. Clausewitz observed firsthand the retreats of his own Prussian forces in the face of French advances. And then later on, he observed French retreats while himself advancing against the opponent, in the company of his Russian employers.

Let us apply Clausewitz’s form of thinking to an even larger scale. What is to become of a nation that has overinvested itself in empire? What happens when it dawns upon the leadership of a nation, let alone if this notion becomes fixed in the collective mind of its people or its enemies, that the world of yesterday has passed? What are the manifestations of the decline of a great nation? Joseph Tainter has written a fine book on this very subject, called The Collapse of Complex Societies.

The U.S. is, and has been for many decades, sustaining itself and its empire on borrowed money and imported, and depleting, oil supplies. At what point will the self-destructive fiscal and monetary policies end? When will the energy policies swing toward recognizing the looming decline in available oil supply, at almost any price? What kind of systemic shock will it take? Yes, the war in Iraq is one manifestation of a nation that has mislearned its own history and has extended itself too far in an effort to do too much. But as Bill Bonner likes to say, “Every empire finds a way to destroy itself.” And there are many ways to do so, notes Bill, with one of the easiest ways being “to invade Mesopotamia and conquer Baghdad.”

Clausewitz wrote about strategy, about setting goals and achieving them. And he wrote about achieving victory and avoiding defeat. Clausewitz because he mastered the strategic concept of war, and did so in the context of a modern intellectual era that immediately predated the oil age. From the perspective of Clausewitz, strategy was strategy, war was war, fighting was fighting, and the results were apparent to the interested observer. There is a basic accuracy to his observations of Clausewitz. When he discussed the strength of an army, and in particular its “physical” and “moral” strength, he made a powerful point. Applying this analogy to current times, are U.S. forces lacking in “physical strength” in their efforts in Iraq? I do not think so. The army provided a quick victory in the opening phases. It was the endgame that failed, but that is another discussion for another time. But the leadership is where, or so it appears, the “moral” strength behind the effort in Iraq has been spent.

The war in Iraq is just not working, for whatever reason. You know it, I know it, the soldiers who email me know it, the Iraqis appear to know it, and most other people in the rest of the world seem to know it. So it seems to me that we have to get back to what Clausewitz wrote. That is, to continue the fight “without the help of new and more favorable factors would mean outright defeat, perhaps even absolute destruction.” How to avoid “absolute destruction”? In the view of Clausewitz, “It is in the nature of things that a retreat should be continued until the balance of power is reestablished.”

What is this “balance of power” that needs to be reestablished? It is very important not to think of it solely in the propensity to employ a military approach to the nation’s foreign policies. The war in Iraq has damaged the U.S. in many ways, both economic and political, but national debt and depletion of energy resources have the potential to destroy the nation. Thus, even more important over the long term than whatever happens in Iraq in the next six months (unless, of course, you or a member of your family happen to be serving in Iraq) is for the U.S. to get its monetary and energy policies straightened out. This will require the U.S. to retreat from its horrific, consumption-biased economic and energy policies and follies of the past 50 years or so and move toward economic and energy policies that focus on domestic investment in capital projects.

The U.S., as a nation, is a reflection of an immense amount of policy hubris and false illusion. This has been so in war, in peace, in its economy, and in its narcissistic conception of so-called “American Exceptionalism”. (If we as a nation ever were exceptional, we are not anymore.) The misunderstanding of the nation’s history has thus deluded, if not blinded, many leaders and much of the population to the longer-term consequences. And as one bad policy compounds another, the necessary reassessment never seems to occur. Never call retreat? Sometimes, retreat is the wisest of choices.