This year Guernsey will face the greatest challenge in the 40 years since it started out as an offshore financial centre. The island has a population of only 65,000 people, but since the 1960s Guernsey has become host to 59 international banks, which hold deposits of almost £70 billion, as well as to mutual funds with a further £70 billion in assets, and to trust assets valued at £100 billion – making the little island in the English Channel one of the world’s leading offshore financial centres.

But the chief reason Guernsey attracted this money – its low-tax regime – is threatened by EU legislation and international competition. “The competition is hotting up,” says Mort Mirghavameddin, managing director at Investec Bank in Guernsey. “Guernsey has been forced to join the international market place.”

The result is that the island is fighting to keep its position as a financial centre by designing new tax breaks for businesses, offering customers new products and marketing itself to customers worldwide. Talmai Morgan, chief executive of Guernsey Finance, says: “We want to make sure that Guernsey does not remain a well kept secret.”

The tax threat that Guernsey is responding to is twofold: first, the island will have to comply with the European Union’s Savings Directive (ESD) when it comes into force in July. This makes it compulsory for savers from EU countries to pay a 15 per cent withholding tax on their savings, or else disclose their savings to their home tax authorities. This means that these savers may no longer gain the full tax benefit they did before from moving their assets to Guernsey. There will, for the time being, still be some value in ‘tax mitigation’, as the experts now call it. But less so than before.

The second tax change is that pressure from the EU’s competition laws has forced Guernsey to make its tax regime the same for onshore as for international businesses. The response in Guernsey, as in other offshore jurisdictions (the Isle of Man, for instance) has been to lower the rate to zero for all. But this means that other new taxes will be needed to make up the tax-revenue shortfall. If these new taxes penalise businesses then they may have to move from Guernsey to less costly jurisdictions, taking their customers with them. Time will tell what effect the tax changes will have.

How big an effect will the ESD have? Certainly, it is a topic that all savers need to consider this year. In Guernsey, many at first feared that it would completely destroy the island’s standing as a financial centre. But now most believe that the effect on customers will be small. Morgan says: “Only 10 per cent of deposits are potentially affected, since only 10 per cent of deposits are from people from EU countries. And of that 10 per cent it may be that a significant proportion will be happy to continue holding their deposits in Guernsey in any case.”

Lisa-Jane Harper, tax manager at Ernst & Young in Guernsey, adds: “For trusts, UK life assurance clients are declaring interest for tax anyway, so there will not be much effect.” As for funds, only the ‘Class A’ funds – those that charge a front-end commission – are expected to be hit by the ESD in Guernsey. But a bigger problem may be that Guernsey loses out because banks are not ready to carry out the extra administrative work that the directive will require. Harper says the cost for the banks and investment and insurance firms will be great. “It has been a headache for all of them. With six and a half months left, there is still time, but there is concern that some will not meet the deadline,” she says.

As to the second threat, the potential consequences of the zero-rating corporate regime, his regime, published in November 2002, was designed to keep tax low for international financial institutions in Guernsey but also to abide by EU tax rules, which say that tax rates must be the same for local and foreign businesses. The upshot is that the statuses of ‘exempt’ and ‘international’ company will be abolished with effect from 1 January 2008, after which these companies will be subject to a 0 per cent or 10 per cent rate and resident companies general rate of income tax will fall from 20 to 0 per cent. A 10 per cent profit tax will be introduced for banks and fiduciaries, insurance managers and fund managers.

Though these low tax rates for businesses are attractive, some observers have said that the sums do not add up. A report from Ernst & Young in 2004 averred that the new tax policy leaves a budget shortfall for the island of £45 million a year. More pointed critics have concluded that other taxes will inevitably have to go up.

Some solutions to the shortfall would hit businesses, such as a tax on companies’ payroll. Peter Symes, managing director at Yorkshire Guernsey, says: “You have to look at the whole picture. We might be paying the zero-10 tax, but also a new payroll tax. Like any business, if we saw that this was not financially viable, we would leave.”

Will islanders have to shoulder the tax burden through personal taxes or VAT? This would be unpopular, to say the least. Guernsey’s Treasury and Resources Department will launch a consultation process on the zero-10 proposals early this year and should report back later in the spring. The most likely outcome is that Guernsey will do whatever it takes to help the business sector thrive. Morgan says: “Because of international issues, we are making changes to safeguard the financial sector, which is Guernsey’s economic motor. We will do what is necessary.”

In the face of these challenges, the financial institutions themselves are fighting back by developing their products – doing what they can to attract new customers now that their traditional status is threatened. Says Symes: “We have just installed a new computer system that means we can provide more products, such as accounts with monthly interest and with bonuses.”

At Investec Bank, which caters more for private banking clients than for the retail market, product development is also vital to competing internationally. “We offer clients more diverse asset classes than many competitors.” The companies, obviously, have been factoring things in.

It is clear that competition is going to get tougher for Guernsey. But that hardly singles it out. The whole offshore world is feeling these changing winds. The island’s regulatory regime has received top marks in international surveys, and most agree that its tax challenges are manageable with a little belt-tightening. Morgan adds that, having been an offshore financial centre for 40 years, Guernsey has an experienced and professional workforce. “In a tough world we are still very positive,” he says.