Offshore Avoidance of U.S. Income Taxation

Offshore Tax Planning

by Timothy Walton
 

This information accurate Summer, 1996 only.

Introduction

No person should pay more taxes than the law requires.1 People who use tax shelters and legal loopholes are not unethical.2 Congress made t hose options available in order to influence people in their use of money.3 This page will examine two loopholes available to the United States taxpayer today. One method of avoiding taxes is to incorporate a business concern in a foreign jurisdiction that does not tax income.4 Another method is to renounce United States citizenship.5 This webpage will compare the two loopholes from the point of view of a U.S. citizen with personal income, examining the dangers and benefits of each method. The situation of a corporation seeking to use a t ax haven is extremely complex and beyond the scope of this page.

I. Foreign Tax Havens

Almost every country in the world has a lower tax rate on some activity than another country's rate on that activity.6 Since countries routinely use their tax laws to influence the use of capital, 7 income tax rates on any given activity vary wildly throughout the world.8 A country which taxes at a high rate for one activity may concur rently provide a low tax on another activity. Only a few countries, however, choose not to tax any income of non-citizens.9 Tax professionals call these countries "tax havens."10 Because the law differs in each of these countries, this paper will consider only one: the Cayman Islands [hereinafter "Cayman"].
Cayman is appropriate for two reasons. One is that Cayman is one of the most popular tax havens.11 The other is that it has similar tax laws to other popular tax havens such as Switze rland and the Bahamas.12 Cayman also has decades of experience as a foreign tax haven.13
Citizens of the United States use Cayman as a tax haven for two purposes: tax evasion and tax avoidance.14 Tax evasion is the illegal hiding of income or assets for the purp ose of deceiving the U.S. Internal Revenue Service [hereinafter IRS].15 Tax avoidance is any legal measure used to lower actual tax liability.16 U.S. taxpayers routinely use Cayman for both reasons.17 The legal method of using the Cayman tax haven is to form a corporation under Cayman law and assign a stream of income to that corporation.18 The corporation, however, must have a legitimate business purpose other than the avoidance of taxes.19 Th e business purpose need not require Cayman as the location, but Cayman must be appropriate for the business purpose.

A. Caymanian Companies For Tax Deferral

Cayman imposes income tax on only those companies doing local business, so it is an ideal place for United States citizens to locate a stream of income.20 United States citizens can incorporate a business (known as a "base company"21) under the law of the Cayman Islands and assign streams of income to the company.22 Property (includ ing the right to a stream of income) used to start a corporation is subject to a one time 35% excise tax.23 Subsequent income is then attributed only to the base company.24 This method of tax avoidance only defers taxation,25 as United States citizens must still pay tax on money when they remove it from a Cayman company. 26 Some taxpayers may be able to enjoy the benefits of the corporation's money while still avoiding taxation through use of "secondary sheltering." 27 This involves recharacterizing the money, such as by having the base company loan money to the U.S. citizen.28
The IRS takes a dim view of this type of tax plan and, unless transactions are conducted at arm's length, may decide the base company is a sham.29 The IRS may then collapse the transac tion, allocating Caymanian income to the U.S. citizen shareholders.30 The IRS may, in the alternative, designate the company a "foreign personal holding company," which eliminates the t ax advantage.31 Caymanian companies owned by U.S. citizens may avoid being classified by the Internal Revenue Service as personal holding companies by forming with many owners, particul arly non-U.S. owners,32 or by showing the Secretary of the Treasury that the purpose of the company was not the avoidance of U.S. income tax. 33 The Secretary's approval must be established every year.34 This can be accomplished by obtaining a private letter ruling. A private letter ruling is a written statemen t from the IRS on the tax effect of the specific facts of the proposed transaction.35 A favorable ruling provides documentation for the taxpayer should a disagreement with the IRS arise later. 36 A taxpayer may request a private letter ruling by writing to the IRS and outlining the specific facts, including a detailed description of the transaction and a statement of b usiness or economic reasons for the transaction, along with arguments in favor of the transaction and an affidavit that the facts are true.37 If the information is too general or the fa cts not unique, the IRS may respond with an information letter, which points out established tax law.38 An information letter does not establish the Secretary's approval of t he business purpose.

B. Formation of a Caymanian Company

Cayman will only give guarantees of exemption from taxation to incorporated companies that carry on no Cayman business.39 The guarantee against imposition of income taxes lasts 20 years.40 Companies which have been given this guarantee are known as "exempted companies."41 Exempted corporations must maintain a local office.42 Cayman requires a minimum of three shareholders for incorporation.43 While companies do not have to pay income taxes, they must still file ann ual reports.44 Exempted corporations must pay an annual fee of CI$575.45 Names of shareholders may be kept confidential.46 The corporation may issue bearer shares upon approval by Exchange Control, but Cayman residents may not hold any bearer shares.47 There is n o requirement of shareholder meetings.48 All companies (except companies which carry on local business in the Cayman Islands) must conduct all business, other than payroll an d local expenses, in currency other than the Cayman dollar.49 U.S. citizens must keep records and file all necessary reports when doing transactions with any foreign financial agency.50
It is unwise for U.S. owners of foreign businesses to allow other U.S. citizens to buy shares in the corporation after the company is set up.51 If the U.S. owner needs to liquidate part or all of the ownership, one legal way to sell shares in a foreign corporation is to keep ownership confidential,52 offer and sell only outside the United States and only to a non-U.S. person.53 U.S. citizens would be liable for tax on capital gains for shares sold in the Cayman company.54
Foreign corporations may still hold assets in domestic banks without the interest being subject to U.S. tax.55 This obviously does not shield those assets from discovery by the IRS, bu t the assets may be safer for other reasons.56 One reason is the possibility of expropriation of foreign assets by the foreign government in the event of a coup in that jurisdiction.57 In addition, assets held in U.S. financial institutions get protection from the Fourth Amendment and the Right to Financial Privacy Act of 1978.58 T he legitimate offshore base company, while subject to the discovery of its assets by the IRS, need not fear identification of assets because it is compliance with U.S. law.59
Before setting up any foreign business interest, U.S. citizens should consult with an attorney in that jurisdiction who is familiar with its laws.60 In addition, consulting with a dome stic tax professional and obtaining a private letter ruling from the IRS would also be advised.61
As mentioned above, setting up a personal holding company does not reduce the taxes of the U.S. citizen except to the extent the citizen may assign streams of income to the company. 62 The expense of setting up and maintaining a corporation in the Caribbean limits the number of U.S. citizens who would realize tax savings. For these very wealthy people, a better alternative might be to renounce< SUP> citizenship in the United States of America.

II. Renunciation of United States Citizenship

In recent years, a number of very rich people have renounced their United States citizenship and moved abroad.63 The reason for this is simple: it saves them enormous amounts of money in U.S. inc ome taxes.64 This is an extreme reaction to government taxation of income, and tax professionals hesitate to recommend it.65 The Treasury Department estimates that only persons with more than $5 million in assets would find this advantageous.66
Some recent millionaires that have renounced their citizenship and moved overseas include Mark Harris Getty and Christopher Ronald Getty, grandsons of John Paul Getty,67 Kenneth Dart, president of Dart containers Corp.,68 Michael Dingman, chairman of Abex,69 J. Mark Mobius, 70 Richard Minns,71 John Dorrance III, heir to the Campbell Soup fortune,72 John Templeton, 73 and Joseph Bogdanovich, vice chairman of H.R. Heinz Co.74 These high profile expatriations have prompted Congress to introduce bills to eliminate this particular loophole 75 and thus the extensive grumbling by editorial writers.76 The Joint Committee on Taxation, in a study of the "problem" of expatriation, howev er, decided that eliminating the loophole would exacerbate what is, ultimately, a minor problem.77

A. Benefits

The major advantage to renunciation of one's U.S. citizenship is that the United States will only tax the U.S.-sourced income of a person who is neither a citizen nor a resident.78 Interest incom e on a non-resident alien's money on deposit in domestic banks is not taxed at all.79 People that renounce citizenship in the United States need no longer pay rates of 55% on estate taxes, 55% on gift taxes, or 39.6% for income taxes.80
Persons who renounce U.S. citizenship may set up foreign trusts with U.S. citizens as beneficiaries.81 A trust is an arrangement where a property right is held by one person (the trust ee) for the benefit of another person (the beneficiary).82 A foreign trust is considered a "nonresident alien individual" under the U.S. Internal Revenue Code. 83 Neither the foreign trust nor the trustee is required to file a U.S. tax return.84 The assets held in trust also escape probate on the estate of the grantor. 85 A trust may be created either orally or in writing.86 An expatriate's trusts may hold assets in the U.S. or another jurisdiction. 87 Each foreign trust should own a private investment company which may then open an investment account in the U.S.88 Setting up a foreign trust allows the expatriate to avoid U.S. estate tax on U.S. securities.89

B. Dangers

The largest flaw in using expatriation as a tax avoidance measure is that it is necessary to leave the United States.90 Simply renouncing citizenship is not enough because resident aliens are sub ject to U.S. income taxes.91 To avoid classification as a resident, one can spend no more than 120 days per year in the United States.92 Also, if the IRS can prove that the person moved purely for tax reasons, it will continue to tax a person for up to ten years after the move.93 Returning to the United States within ten years allo ws the IRS to retroactively tax the income earned in that decade.94
Another problem with renunciation is that in order to travel internationally, one must have a passport specifying country of citizenship.95 People generally obtain citizenship in anothe r country before renouncing U.S.. citizenship.96 There are some Caribbean countries that will sell citizenship for between $30,000 and $50,000.97 It is also possible to obtain Canadian citizenship after three years of residency.98 Canada does not tax nonresidents, so once a U.S. expatriate has obtained citizenship, the new Canadian citizen may choose to reside anywhere in the world without being subject to Canadian taxation.99
Though it is not usually a concern for wealthy expatriates, renouncing U.S. citizenship results in the loss of Medicare benefits (although not Social Security).100

III. Criminal Behavior

While avoiding taxation is legal, evading it is not.101 One popular misconception about tax havens is that it is possible to simply leave a lot of money in a bank and the government will not ta x the interest the deposits earn.102 The United States government does tax foreign interest income.103 Schedule B of the 1040 Form dem ands acknowledgment of all resources held in foreign banks.104 Taxpayers may legally avoid iteration of money held abroad only if the combined total amounts to less than $10,000. 105 If interest combines with principal to bring the amount on deposit above that limit, however, then the taxpayer has a duty to disclose the deposits.106 Cayman banks are unlikely to cooperate with the IRS,107 but the penalty for active fraud is severe.108
The statute of limitations provides some protection for errors when filing tax return, but not in cases of fraud.109 The statute tolls three years from due date or actual file date, whichever is later.110 There is no statute of limitations for failure to file a return or for taking active steps in perpetuation of a fraud.111
Assuming the Internal Revenue Service has no proof of fraud, the taxpayer may keep undeclared income from years past, but runs the risk that in any given year the IRS will discover the underreporting. it is the taxpayer's responsib ility to keep records and file all necessary documents.112 This risk becomes far too great for the taxpayer with several hundred million dollars worth of assets.113 Such a taxpayer would be better served by renouncing citizenship. The risk is also too great for any taxpayer with less than $100,000 in income per year, for the amount that taxpayer could hide would amount to less than the penalties incurred if the scheme were discovered.114

IV. Policy

The United States Tax Code is a long and complex set of rules. Congress passed many of the rules to influence the use of money in the United States.115 Some were also passed to establish limits on the jurisdiction of U.S. taxation.116 The actual consequences of those rules were not always immediately obvious to the Legislators creating them. 117 Thus, some tax loopholes were intended and some were not.118 The fact that Congress has repeatedly attempted to close the foreign base company loophole indicates that it was un intended.119 Congress constantly tinkers with the Code in an attempt to close unintended loopholes and create new ones for influential constituents. The expatriation loopho le is unlikely to remain in its present form for much longer.120
Taxpayers who take advantage of unintended loopholes run the risk that the Internal Revenue Service will close the loophole through judicial process. Facing the IRS in court could result in penalties and interest on back taxes. The cautious taxpayer that applies for a private letter ruling allows the IRS to close the loophole before it can be used, but avoids some of the risk of using an unintended loophole.121
The line between tax avoidance and tax evasion can sometimes be very fuzzy.122 For example, a technically legal corporation may frustrate an IRS attempt to re-allocate its income by t aking illegal advantage of Cayman secrecy laws.123 Some active tax cheats also attempt to frustrate the IRS by employing a multi-tiered corporate structure. 124 This is done by forming a corporation that then forms and owns another corporation, thereby moving the U.S. citizen further from the assets. This does not necessarily change the ownership of the assets, 125 but it makes it more difficult for the IRS to prove the fraud.
The United States has an inherent interest in keeping capital located domestically.126 Access to adequate capital is necessary for increased revenue (and ultimately the taxation) of o ngoing businesses. Congress recognized this when it exempted foreign capital from taxation.127 Perhaps if the United States lowered the tax rates on higher income levels, there would not be so many people trying to avoid taxation through complicated business structures and repatriation. Studies show that the temptation to cheat on taxes rises faster than the tax rate. 128 A flat tax rate with no deductions or credits ( and subsequently no loopholes) could solve that problem both by eliminating some incentive to cheat and by increasing the difficulty of cheating. 129
One problem with eliminating deductions and credits, however, is that Congress would lose a lot of its power to control the use of capital.130 Capitalism allows some people to become more wealthy and financially secure than their neighbors. The Internal Revenue Code levels the playing field somewhat by redistributing the resources of those with more to some of those with less. The governme nt has a responsibility to all of its citizens. Another problem with the flat tax is that it could reduce government revenue. The United States faces severe economic problems.

Conclusion

Taxpayers should use all legal methods for lessening the bite of income taxes. Available methods of doing so, including the renouncement of U.S. citizenship or establishment of a foreign company, may entail a significant amount of expense and effort. Remaining within the letter of the law, however, allows the taxpayer and her attorney to sleep well at night.

Spring, 1996

Cayman Law

Disclaimer

1996 Timothy J. Walton
All Rights Reserved