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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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