IN A SKIT from the New York Financial Writers Association "Financial Follies," the performers sang, "It is little wonder why we smile/We found an offshore domicile/We like the sunshine on our backs/And it's perfect for escaping tax/We're all moving to Bermuda/Ride a moped and a scooter/It's a nice vacation/And we like the tax evasion."
A number of U.S. companies have reincorporated in recent years to take advantage of lower corporate income taxes. In some cases, they've paid no taxes at all. While it's good for the corporate bottom line, if you're a shareholder, you end up paying! Here's how it works, what to watch out for, and how to prevent the problem.
A U.S. firm changes its legal address to a foreign, offshore tax haven. This is perfectly legitimate. In technical legal babble, it's called a "corporate inversion." Such corporations typically select Bermuda, and hold their board meetings in a nation with a favorable tax treaty, usually Barbados. It's an easy thing to do.
Becoming a "foreign corporation"
What's the result? Not only do these companies avoid American and foreign taxes, but they strengthen their shield from shareholder litigation. Technically, by reincorporating abroad, these companies switch from being a "U.S. corporation"--which is taxable on its worldwide income--to a "foreign corporation" that is taxable only on its U.S.-connected income.
We're not done yet. Things keep getting better. They don't really have to move. They just have to change their legal address. They can keep their actual, physical headquarters in the U.S.
This works great for the company. Lower, or zero, taxes means it has a competitive advantage over others who have to pay. In February and April, 2002, The New York Times reported that major accounting firms, notably Ernst & Young, were urging companies to acquire offshore addresses to avoid taxes on profits. In recent years, several dozen, including Nabors Industries, Ingersoll-Rand, and Cooper Industries, have changed their legal addresses.
If you are a shareholder, though, tax law requires that you pay a tax! It's treated as if you have sold your old shares and replaced them with shares in the new, offshore company. You are liable for taxes on any appreciation over your cost. You haven't received any cash, but you are taxed as if you have. In "tax-babble," the process is called "marked to market," and the cashless income is called "phantom income. …