Matt Blackman , Consultant and Author
Coquitlam, British Columbia
Each year, an increasing number of investors from around the world are flocking to tax havens to establish a business presence in the form of an offshore trust, International Business Corporation or IBC, open an offshore bank account or even start their own bank. In a 1991 Euromoney magazine article, author Anthony Ginsberg estimated that "as much as half the world's stock of money either resides in, or is passing through, tax havens making them an essential catalyst for world trade". Many are lured offshore legitimately but some go offshore for the wrong reasons and do so at great risk. Below are some examples.
Case 1
Mark has worked for the same company for 20 years. He has reached the top of the ladder in his department but the pay is good and he can't afford to quit. He's getting tired of paying taxes and would like to earn extra money. Last year he and his wife Mary started a home based business doing janitorial work for small to medium size companies in the city where they live. Most of the money they receive is either cash or cheque. Mark was surfing the Internet a few months ago and found an ad for offshore services offering to set up a company, including a bank debit card and cheque cashing service for "under $500". The offshore advisor suggested that they could set up an offshore corporation (Clean-It Ltd.) which would own the janitorial service. They could then deposit cheques made payable to Clean-It Inc. and withdraw the money at home using a debit card, which leaves no paper trail at home.
He assured them that the account would be confidential so they wouldn't have to worry about prying income tax inspectors. To add another level of security, the promoter suggested they set up an offshore trust which would own the shares of the janitorial service and be the ultimate home of the income. That way, Mark and Mary don't own anything because the funds would be controlled by an offshore trustee who is sworn to secrecy so no one will be the wiser. The promoter assured them that this way all the money Clean-It Inc. earned would be tax free.
Case 2
Frank owns a company that leases cranes, forklifts and other heavy equipment to construction companies in a number of countries. With the help of an offshore advisor recommended by a friend, Frank 'sold' the leasing company to Equipment Leasing Ltd. (E.L.L.) an offshore company that now buys the equipment and leases it to other companies around the world. Frank retains a small interest in the company and the rest is owned by an offshore trust and an International Business Company (IBC). Furthermore, E.L.L. can sell the equipment after it has been leased a number of times and retain the capital to buy more equipment tax free.
Case 3
Peter is a writer who writes screenplays for well known film companies and is well paid for his labours. His offshore consultant has helped him set up an offshore company that now collects his sizable fees. Peter is paid a smaller fee that he is taxed on at home. His offshore company purchased a villa in the French Riviera that Peter has exclusive use of while in Europe on business.
Case 4
William is an author who writes booklets which he sells on the Internet. His market has grown and he now sells to clients in a number of countries. He realizes that to market world wide, he needs an international presence. The cost and quality of printing dictate that his books be printed in a relatively high tax country which also has very strict avoidance rules so he must be careful not to trigger unnecessary tax liability. He decides to sell the rights to his books to an offshore company in a low tax country that has a number of tax treaties with those countries with which he does business. With careful planning and some able guidance, his books are printed for his company in a high tax country which then pays royalties to the offshore company with only a minimum withholding tax on the royalties. He has even found a way to have some of the income paid to his company at home (a high tax country) tax free!
The question is, in the above four examples, who has gone offshore legitimately and may legally benefit and who has done so illegally and risks a charge of tax evasion?
It's easy to see that Mark and Mary in example one have opened themselves up to a whole heap of trouble. Assuming they live in North America, both Canada and the U.S. have laws with stiff penalties for tax evasion and that is what they are doing. They are sending taxable earnings to their offshore company without declaring it and then bringing it back via a debit card and spending it tax free. If they don't tell anyone and are very careful about what they buy, they may get away with it for a while.
The cheques they receive from their clients are usually under $1,000 and the clients may not know that the funds are going to an offshore company. If the cheques are over $1,000, the risk of being caught goes up because the banks must keep records of all such payments going out of the country for the tax officials.
If Mark and Mary or one of their clients are audited, the risk of detection is high, especially if clients are claiming the janitorial expenses for income tax purposes. Often tax departments will check expenses deducted from one taxpayers' income against income claimed by the recipient. Since Mark and Mary aren't declaring any of the income, it wouldn't take a Sherlock Holmes to catch them at their game.
If they buy real estate, cars, furniture or vacations using their debit card, they also greatly increase the risk of being caught. One of the major weapons used by the US Internal Revenue Service or Revenue Canada is unsupported life style changes. They look at the taxpayers' income and expenditures. Again, it doesn't take a genius to see through a plot if expenditures exceed declared income.
Furthermore, the rules governing trusts in the US and Canada have been substantially tightened in the last two years. A new rule in the US in 1996 requires Mark and Mary to appoint an American trustee to 'oversee' the offshore trust to insure that any tax owing is being paid. Failure to do this will result in stiff penalties and fines. If the trust is earning income not declared as received by it, they risk a 100% tax on the income plus penalties.
Examples two, three and four are a little more complicated.
If Frank legitimately leases heavy equipment to companies around the world and has corporations offshore for reasons other than tax avoidance at home, there are a number of potential benefits.
The tax haven(s) he chooses will determine his tax bill at home. He could set up in a tax haven where his company pays no tax on earnings such as the Cayman Islands, or the Turks and Caicos Islands, but he might be better advised to also use an intermediary company in a country with tax treaties with the countries where he leases his equipment. Rather than lose 25-30% to withholding taxes in the high tax countries where he does business, this amount could be substantially reduced. It will cost him more to set up an intermediary company, but the strategy will reward him with the best of both worlds; complete privacy and liability protection as well as potential tax savings.
There is another consideration.
If Frank's company is set up in a pure tax haven to which he travels and sends money, his chances of an audit are greatly increased, even if he has done nothing wrong. Revenue officials carefully scrutinize any movement to and from well known, high profile tax havens. If they see that an individual has made a number of trips and sent money to such countries, a red flag goes up. If, on the other hand, Frank has a intermediary company in, for example, the Netherlands, which has a number of favourable tax treaties owned by another company in, for example, the Netherlands Antilles, he reduces this risk. Business trips and money sent to (and from) tax treaty countries don't usually elicit the same interest from tax officials.
Peter, the screenwriter, can also benefit from setting up a company in a tax haven as long as he has legitimate reasons for doing so other than for tax avoidance. If he sells his work to a number of different companies in different countries, it could be argued that an international company in a tax haven gives him greater access to business worldwide with fewer restrictions, even if he continues to reside in a high tax country. He could sell the rights to his work to an offshore company for a fee and receive income that is declared at home. He could take the income as a royalty or dividend which are given favourable tax treatment, depending on the countries involved. He, too, may find it beneficial to use an intermediary company in a tax treaty country as well as a tax haven to reduce taxes and give him protection from future creditors at home.
In the above two examples, Frank and Peter must be careful to meet all requirements necessary to reduce taxes payable at home. For maximum tax savings, the companies could be structured so not to qualify as Controlled Foreign Corporations (CFCs). Both the US and Canada have strict laws governing CFCs.
For example, a company qualifies as a CFC in the US if a US person owns 10% or more of the company or 50% or more of the total stock is owned by US shareholders. Even if the company is a CFC, tax on income may be reduced if the income is classified as 'active' as opposed to 'passive'.
William represents a growing number of home based entrepreneurs who's success is tied to the growth of the Internet. They live in high tax countries and have clients around the globe. How many have given any consideration to the tax implication of their new found business income?
If William scores a hit with one publication and sells a million of them for US$9.95, his costs of marketing and distribution on the Internet could be less than ten percent, for a net income of $9,000,000. Considering that the Internet is projected to have in excess of two billion users in three short years, this possibility is not all that far fetched. In Canada his corporate tax bill if earned in one fiscal year could be as high as 45 percent; or 38 percent in the US.
What if William were to sell the rights of his publications to a company in Barbados which would have the books printed and distributed by a company in the US to customers around the world?
Barbados taxes individual and corporate income at 40% so it can't be classified as a 'no tax' tax haven. However, international income is taxed at a rate of 1% to 2.5% in Barbados. A number of favorable tax treaties offer benefits for a Barbados International Business Company (IBC), Offshore Bank Corporation (OBC) or Society with Restricted Liability (SRL) doing business with high tax countries. The withholding tax on royalties paid to a Barbados company by a US corporation is 5% or 10% by a Canadian company.
If William owned a Canadian company that in turn owned the Barbadian company and the latter was classified as a foreign affiliate for Canadian tax purposes generating "active income", the former could receive income from the latter from "exempt surplus" tax free in Canada. (See Canadian Tax Planning Opportunities - Offshore Outlook 12/96).
Many high tax countries (Canada, US, Australia, etc.) have adopted strict anti-avoidance legislation designed to curb the use of tax havens or Offshore Financial Centres (OFCs) for tax avoidance. It is important to note that tax havens were, in effect, created by high tax countries such as the UK and the US in an effort to reduce aid to certain 'have not' Caribbean and other under privileged nations around the world by creating incentives for multinational corporations to invest. These incentives were not intended to encourage individuals to move assets to these nations in an attempt to avoid paying tax, but that has been the net result. However, companies legitimately established that foster world trade and investment in certain "developing" countries derive substantial benefits from such incentives when they know the rules. It is important to remember, according to offshore legal expert Ken Finkelstein, that as long as a person remains resident the US or Canada, they are subject to the tax laws of that country. As such, merely setting up a company in a tax haven will not alleviate nor reduce tax liability for the individual in most cases. The IBC or other type of corporate structure (if classified as a Controlled Foreign Corporation) and the individual will be treated as one person for tax purposes.
OFCs have become an integral part of the tax planning for corporations doing business world wide. High as well as medium net worth individuals are increasingly utilizing offshore corporations to take advantage of investment opportunities unavailable to them at home. The Securities and Exchange Commissions in the US and Canada require all investment companies to provide an exhaustive (and expensive) prospectus before any investment can be offered to it's citizens. Unfortunately, most of the top offshore funds find the process too onerous and expensive to file in many high tax countries and therefore are unable to offer their investment to those citizens. An offshore company, on the other hand, can easily invest in any fund or investment available world-wide.
These passive investments must be disclosed in most high tax countries and capital gains taxes paid, but if the investment is generating over 100% annual return, the net return is still sizable. The Quota Fund, a derivative fund domiciled in the Netherlands Antilles returned 78.8% in 1996 with a five year return of 852%, according to The Micropal Offshore Investment Funds edited by Robert (Woody) Milroy. Wouldn't it be good to know when it comes time to retire, that you have a tidy nest egg awaiting you in your new home on a sunny, tropical Caribbean Island. If you end up becoming a permanent a resident there, the tax savings could pay you a handsome dividend if you don't mind relinquishing your residency at home. (US citizens are taxed on world-wide income, regardless of residency and now derive 'more limited' tax benefits from relinquishing citizenship.)
The decision to utilize OFCs is one that must be given careful consideration but if tax avoidance is the primary motivation, a number of obstacles must be expected by both the individual and corporation. If, on the other hand, your goal is to access new markets, take advantage of business and investment opportunities unavailable at home or to protect assets from future frivolous litigation, an investment in an OFC could reap untold future rewards.
