Tax planning with "tax havens" is not unlike other planning scenarios. Objectives or goals are defined, information is gathered, alternatives are researched, and a decision is made based on the information available. In order to implement any tax savings plan, taxpayers need to make a decision on a strategy, comply with the legalities of such a strategy, and properly reflect the strategy in their accounting and tax records.
There is nothing within the tax law prohibiting a taxpayer from planning his/her activities to minimize the burden of taxation. The imposition of a tax is an obligation enforced by the government; it is not a voluntary contribution by the taxpayer. The taxpayer who is capable of planning a tax transaction with the least tax consequences should be rewarded with a lower tax bill, as long as the substance of the transaction is within the boundaries of the law, regardless of the transaction's form. The avoidance of tax is therefore the result of using acceptable, viable alternatives.
Setting aside what some believe are ethical considerations, the utilization of tax havens has its place in legitimate tax planning. However, planners need to keep in mind that tax evasion, on the other side of the spectrum, is tainted by the taxpayer's (or his/her practitioner's) willful intent to disregard established tax law and is not a legitimate component of a "tax plan."
Income Tax Planning Considerations
Historically, taxpayers have utilized tax havens or Offshore Financial Centers (OFCs) to minimize their overall tax liability. Although the definition of a "tax haven" may vary from nation to nation, a common factor is that the foreign jurisdiction imposes an income tax that is lower than the tax imposed by the taxpayer's home country. According to Professors Walter and Dorothy Diamond in their treatise Tax Havens of the World, the "absence of income taxes or low taxation was the primary reason for selecting an OFC a decade ago." The Diamonds cite 30 key factors/considerations in deciding the optimal OFC, and emphasize that that "all of the advantages and drawbacks of a specific country must be analyzed with extreme care in order to be certain that the location chosen satisfies the company's particular needs." In the wake of 9/11, many Americans have altered their focus from tax haven to "safe haven" in choosing the optimal country in which to establish their business and investment ties. Although tax considerations are still significant, there are many non-tax benefits that can be achieved from the use of tax-haven related strategies. Critical non-tax factors in choosing a tax haven include:
* guarantees against expropriation or nationalization,
* confidentiality of financial and commercial information,
* investment concessions,
* interest rates and inflation,
* avoidance of currency restrictions, and
* political and economic stability.
Although there are other considerations, taxpayers need to determine if the country's financial structure includes residents skilled in financial transactions (i.e., bankers, lawyers, and accountants) and a modern communications system. In addition, taxpayers need to ascertain if the haven has a treaty network, providing reduced tax rates on income tax by its treaty partners. Tax havens enjoying treaty networks often provide an attractive combination in the formation of a multi-national tax strategy. As a general rule, this combination offers increased flexibility in tax planning with tax havens by reducing tax rates through treaty shopping.
The United States taxes its citizens and residents on their worldwide income. Consequently, where the income is earned--domestically or internationally--is irrelevant. The authority to tax is determined by the residency or citizenship of the taxpayer. However, the characterization of whether income is domestic or foreign is significant in determining the timing of when a particular item of income is subject to tax.
As a general rule, the United States does not tax foreign business profits earned through a foreign subsidiary until the subsidiary repatriates those earnings through payment of a dividend to the U.S. resident. This "tax deferral policy" levels the worldwide "tax playing field" by allowing U.S. companies to compete globally on a tax parity with their foreign competitors. While promoting competitiveness abroad, this deferral also creates an opportunity for avoiding U.S. taxes on
inventory trading profits and other income that can easily be shifted to a foreign-based company.
Taxpayers contemplating the use of tax havens need to be aware of anti-avoidance provisions that may circumvent their tax strategy. For example, many foreign countries such as the Cayman Islands, Hong Kong, the Republic of Ireland, Puerto Rico, and Singapore, offer tax holidays or tax incentives (i.e., low tax rates) to attract foreign investment. Barring anti-avoidance provisions, a U.S. multinational could shift income to a foreign-based company in these low-tax countries by selling merchandise to the foreign company at an artificially low price. The foreign-based company could then resell the merchandise at a higher (market) price to a marketing affiliate of the U.S. multinational located in another country for resale to the ultimate foreign customer. This strategy shifts the spread (i.e., the profit) between the two transfer prices from the countries in which the manufacturing and marketing occur to the tax haven jurisdiction.
In the United States, the Internal Revenue Service (IRS) can utilize Internal Revenue Code (IRC) Section 482 to attack such tax avoidance strategies. Under Section 482, the IRS has the power to allocate income among domestic and foreign affiliates whenever an allocation is necessary to "clearly reflect the income" of each party to a transaction. However, the "arm's length" standard of IRC Section 482 has proven difficult to administer, primarily due to a lack of information regarding comparable uncontrolled transactions. As a result of the Section's administrative complexities and problems related to enforcement, Congress enacted Subpart F (IRC Sections 951-964) in 1962, which automatically denies deferral to certain types of tainted income earned through a foreign corporation.
Estate and Asset Protection Planning
Tax havens are often utilized for estate and asset protection planning. The purpose of an asset protection plan utilizing OFCs is to protect and shield wealth from the claims of creditors, discourage lawsuits, reduce or supplement liability insurance, and avoid or supplement prenuptial agreements. In essence, the offshore Asset Protection Trust (APT) serves to insulate assets from the dangers associated with lawsuits and business risks. The APT is also designed to minimize or avoid estate taxes and probate, and often serves as a tool to pass property to heirs. However, a properly structured asset protection plan is effective only if planning is done in advance of any claim or pending claim.
In evaluating the cost of any tax or asset protection plan utilizing offshore trusts, offshore financial centers, and various other alternative plans, the professional and/or client should match the level of protection desired with the appropriate planning mechanism. As with any decision-making process, a cost/benefit analysis must be performed. For example, an offshore trust is a consideration only if a client has significant liquid assets or a net worth exceeding a million dollars. If less wealth is at risk, alternative tax and asset protection planning strategies should be considered.
Tax havens are an integral component of many tax and asset protection strategies. In addition to selecting a particular tax haven for purposes such as low taxation, a host of other factors may prove far more essential: confidentiality, banking, currency control, communications, and treaty networks. Before selecting a particular tax haven, taxpayers need to cautiously examine the economic and political stability of the nation, its geographic accessibility to worldwide markets, the availability of labor, the risk of nationalization of assets, and government cooperation.
Thomas M. Brinker, Jr., JD, MS, CPA
Thomas M. Brinker, JD, MS, CPA, is Associate Professor of Accounting at Arcadia University in Glenside, PA. He can be reached at 215-572-4039.…