Corporate Accounting & Taxation
It’s important to keep in mind, as one navigates the shoals of international tax planning, just what the hazards are.
We have tax codes throughout the world to thank for the development of the offshore financial world. Without their assistance, the Cayman Islands would probably be a set of desert islands and no one would ever have heard of Vanuatu. One of the main purposes of this workk is to reduce or eliminate taxes. The countries we have been talking about here are called “tax havens” after all.
Tax planning is the essence of offshore financial operations. Most of the players of the international money game are overseas because of taxes. They share with all the peoples of the world a desire to pay less taxes.
In principle, international tax planning is quite simple; the details are what drive one mad. International tax planning is based on the fact that the revenue laws of any state are largely restricted to its domestic economy. The tax authorities have a hard time crossing borders but people and wealth can do so easily.
A person can make three basic changes in his tax situation through offshore tax jurisdictions. He can change his residence, the geographic source of his income, of the form of the tax planning entities that he uses. A tax haven is a country that imposes no taxes on the income of companies and other entities so long as they do no local business beyond spending money. A treaty-haven jurisdiction is a country that has a tax treaty in force with the United States or other high-tax nations.
What one wants to do is to accumulate different forms of income through different companies and trusts in various jurisdictions in such a way that the total tax bill is minimised. Once the plan is in place, it might operate something like this:
Income arises in the United States but it belongs to a corporation that is physically located in another country which has a tax treaty with the United Stated. The income passes to that company with little or no withholding tax because the terms of the tax treaty between the US and the other country – a treaty haven in this case) – require a lesser rate of withholding. If income is paid to a person of company in a jurisdiction with to tax treaty with the US, then the person paying the income must withhold 30 percent for United States taxes. Now that the money is sitting in the treaty-haven company, it is transferred to another entity – say a trust – in a tax haven jurisdiction, where it is allowed to accumulate.
This tax plan would best be served by finding a tax-treaty jurisdiction that does not tax US source income at all, so that the whole transaction could be carried out free of taxation. In practice, this is not possible because the United States tries to avoid having tax treaties in force with jurisdictions that do not levy taxes themselves. Most tax treaties were written to reduce the problems of the same income being taxed by two countries.
In the past, US tax treaties with Britain and The Netherlands were extended to those countries current and former colonies in the Caribbean. Some of those places such as the Netherlands Antilles and the British Virgin Islands have low tax rates and do not tax various sorts of foreign activities, so it was possible to substantially reduce the total tax bill by using those treaty jurisdictions. In recent years, as part of the IRS crackdown on international tax planning, several of these tax treaties have been thrown out, including the ones with the Netherlands Antilles and the British Virgin Islands. New treaties are being negotiated in both cases.
There are still many possibilities open, however; there are countries with low tax rates for certain types of income. Loopholes can be found in any tax law if one looks hard enough. Simply find a low tax rate applied to a certain sort of income in one of the many countries with a tax treaty with the United States and then structure the income stream to produce that sort of income in that country. Once it is moved through the tax treaty country, it can be transferred anywhere.
This area of the law can be as complicated as one wants to make it. In fact, a complex series of transactions may work better than a simple one because the simple loopholes have probably been plugged long ago. The multinational investor and his tax expert must work this out carefully. In the course of a single plan, one may use all of the techniques covered in this book and some that we漹e never heard of.
* A Brief Lesson In Tax Law
It is important to keep in mind, as one navigates the shoals of international tax planning, just what the hazards are. Following is a brief lesson in tax law. Our purpose is not to torture the reader but merely to define the terms we will be using later in this chapter in specific examples.
In the good old days of income taxation, it was possible to transfer income-producing assets to a foreign corporation or trust and let the income accumulate tax free in some tax haven. When one wanted to bring the money back to the high tax jurisdiction, one dissolved the corporation or had the trust make a distribution to its beneficiaries and be liable only for capital gains. While the offshore entity existed, one was free to borrow money from it and deduct interest paid on the loans, thus expatriating more money. These foreign corporations or trusts were considered beyond the jurisdiction of the US tax code. Congress did not look kindly upon such transactions however, and beginning in 1932, gradually tightened up the law. The IRS did its part by writing pages and pages of complex, inconsistent, and incoherent regulations dealing with foreign entities controlled by Americans.
The United States, by the way, is unique among the major civilised nations because it taxes the income of its citizens earned anywhere in the world. Most countries collect taxes only on income earned within their borders. Foreign entities that do not do business in the United States and are not controlled by US persons are not subject to US taxes. If a US person is found to have some controlling interest in a foreign entity, however, he may find himself with taxable income even though the entity has no other US contacts.
US taxpayers heading overseas for tax savings represent two different approaches. One group of taxpayers intends to violate US tax laws (tax evasion) by using the secrecy available in the tax havens and the logistical difficulties of overseas tax investigations to hide parts of their tax and income transactions. These are transactions that the IRS could set aside if it knew all the facts but these taxpayers hope that the agency will never discover the whole truth.
The other group of taxpayers wants to remain within the law. They don’t mind getting into an argument with the IRS but they want to remain within the realm of arguable legality. They hope to use the varying laws of different countries and loopholes in the complex Revenue Code to minimise their taxes (tax avoidance).
It is often very difficult for an individual to determine whether a particular transaction is tax avoidance or tax evasion. The terms are not at all well defined and the law governing new transaction forms is variable and imprecise. When the IRS encounters unfamiliar transaction, it attempts to rule on these actions under existing laws – created with different circumstances in mind. The result is confusion with this year’s tax shelter becoming next year’s unlawful abuse. Plus there are the many grey areas.
Transactions that are not tax motivated and may have no US income tax impact. For example, a US bank may open a tax haven branch to avoid US reserve requirements. Another company may use a tax haven subsidiary to avoid currency controls or other regulations imposed by a country that it does business with. A tax haven may be used to minimise the risks of expropriation that accompany business activities in much of the Third World. A foreign person may use a tax haven bank or a nominee account to shield his assets from his political enemies.
Transactions that are tax motivated but consistent with the letter and spirit of the law. Some examples of these transactions are flag-of-convenience shipping, (which avoids high registration fees), banking through subsidiaries, (which postpones taxes on the profits from loans to foreign entities), transactions between subsidiaries of unrelated companies that are designed to avoid sales tax, and certain transactions that take advantage of minor loopholes in the laws aimed at tax haven use. While some of these may create anomalous situations, they’re legal.
One of the most common tax motivated uses of a tax haven subsidiary is to change US source income into foreign source income. This increases the amount of foreign taxes paid by a US taxpayer that can be credited against, and thus reduce, US taxes paid by the taxpayer.
Aggressive tax planning that takes advantage of an unintended legal or administrative loophole. Examples include captive insurance companies, investment companies, some service and construction businesses being conducted through tax haven entities, and pricing of transactions. One instance of this might be the establishment of a service business in a tax haven to provide services for another branch of the same business located in a third country. A further example might be the use by a multinational corporation of artificially high transfer pricing to shift income into a tax haven. Often, the parties are aware that if the transaction were thoroughly audited, a significant adjustment would probably be made. They rely on the difficulties involved in overseas information gathering and on the complexity of the transactions to avoid payment of the taxes.
Tax evasion is an action by which the taxpayer tries to escape legal obligations by fraudulent means. This might involve simply failing to report income or trying to create excess deductions. This category can also be broken down into two subcategories: (A) Evasion of tax on income that is legally earned; and, (B) Evasion of tax on income that arises from an illegal activity such as trafficking in narcotics. An example of tax fraud would be the formation of sales companies that appear to deal only with unrelated parties, but in fact deal with related parties, hiding the fact that one owns a particular tax haven corporation. These tax haven corporations are also used to hide corporate receipts or slush funds.
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