The United States Tax Haven Loophole Few Americans realize this, but the United States is considered a tax haven by many foreign investors. While U.S. citizens are struggling with federal, state, and local tax burdens of 40% or more of their total income, foreign investors often can invest in the United States tax-free or almost tax-free. The country is not a straightforward no-tax haven like the Cayman Islands or the Bahamas. Instead, it has some complicated tax laws and tax treaties that, when taken together and fully understood, provide opportunities for the foreign investor to make low-tax gains in U.S. investments. Unknown to the average American is an elite group of U.S. tax lawyers and accountants who refer to themselves as "inbound specialists." This means they specialize in structuring transactions for foreigners who seek to invest capital here. The United States encourages tax-free foreign investment because it needs foreign capital to finance the economy and the government budget deficit. For example, Congress generally imposes a 30% withholding tax on all interest payments to foreign residents and corporations. Foreign investors let it be known quickly that they would take their money elsewhere if the withholding tax remained, however, and exceptions to the tax now exist. The great benefit of the U.S. tax haven for many foreigners occurs when the U.S. tax rules are combined with those of other countries. The United States taxes its citizens and residents on their worldwide income. But noncitizens and nonresidents are not taxed on income from certain sources within this country. As a result, there are a number of foreign individuals who invest here in order to take advantage of these non- taxable situations. Some of the elite inbound specialists insist that a large part of the attendance at Wimbledon is made up of attorneys and CPAs who receive complimentary tickets from the tennis stars whose finances they structure. Another fact that few Americans realize is that in the right circumstances an American citizen or resident can benefit from the same laws that provide tax-free income from U.S. investments to these citizens of the world. It's not for everyone, but the laws are clear and you can exploit them. In this chapter, you will learn how you can establish an offshore corporation to invest tax-free in U.S. securities and other property. You'll also learn the consequences of not structuring the arrangement properly and the rules Congress set up to deter such behavior. The offshore corporation loophole Long ago you could visit a tax haven, have a corporation formed, transfer some cash to the corporation, and have the corporation invest tax-free in the United States. As long as the corporation did not have an office here, it was treated as a nonresident foreign corporation and could earn most of its income tax-free. There would be no tax until dividends were taken out of the corporation. Part of that scenario still is true today. As long as a foreign corporation does not have a U.S. office or other contacts with the U.S. that would make it "effectively connected" to this country, the corporation is a nonresident foreign corporation. It can avoid U.S. taxation on certain types of income from U.S. sources. The difference now is that the U.S. shareholder will be taxed like a partner in a partnership. The U.S. shareholder who controls a foreign corporation will be taxed on his pro rata share of the income of the foreign corporation as it is earned, even if the income is not paid out in dividends or any other form. This, of course, substantially reduces the incentive to create the foreign corporation. Fortunately, there are two loopholes in the law that still allow you to structure tax-free investments through offshore corporations. The "de-control" loophole The U.S. shareholder of an offshore corporation is taxed on the annual income of that corporation if it is a "controlled foreign corporation," or CFC. An offshore corporation is a CFC when more than 50% of its voting power is owned or controlled by "U.S. persons." There are several ways to set up an offshore corporation that is not a CFC...in other words, a corporation that is decontrolled. First, let's look at what will not work. You cannot have your tax haven lawyer take title to over half the corporation's stock, agree to vote it however you wish, and claim that the corporation is decontrolled. Any arrangement such as this might be treated as though you owned all the stock. You will have a CFC. Another scheme that is widely recommended is to set up a string of trusts and corporations that will end up with a trust owning all the stock of the corporation that will actually do the U.S. investing. Though this "daisy chain" arrangement has not actually been tested in the courts, it is likely that the IRS and the courts would simply ignore the chain and conclude that since you formed the initial entity and all the others were formed as part of a plan, you will be considered the owner of the stock. Again, you will have a CFC. The only remotely attractive feature of this arrangement is that it would be very difficult for the IRS to uncover it. But once uncovered, the sheer complexity would pretty quickly convince a jury that it was deliberate fraud. Now let's look at the reliable ways to decontrol an offshore corporation. Start with the definition of a "U.S. person." A U.S. person for purposes of the CFC rules is any U.S. citizen or resident who owns 10% or more of an offshore corporation's voting stock. Here we see an easy way to decontrol a corporation: Make sure no U.S. citizen or resident owns 10% or more of the corporation. Suppose you and some associates plan to invest together in the United States. There are at least 11 of you, and you plan to have equal ownership interests in the investing entity. If you divide 100% by 11, you should get 9.09%. You can set up an offshore corporation and it will be decontrolled, because there are no U.S. shareholders involved. No U.S. person owns 10% or more of the voting stock. You can invest in the United States at little or no tax cost the same as a nonresident alien does. The income can compound tax free in the corporation until you decide to take dividends. One trap to be careful of here is the attribution of ownership rules. These rules state that if related taxpayers are the shareholders, they will be considered as owning one another's stock for purposes of the control test. So if the 11 people are family members, the corporation probably will be a CFC. If you own a number of U.S. corporations and try to consider each of them as a separate shareholder, you also will have a CFC. You need at least 11 unrelated U.S. persons to decontrol the corporation. Suppose you have one U.S. person who wants more than 50% of the voting stock. The other U.S. persons will have less than 10% of the voting each. In this case, there is a CFC, because it is more than 50% controlled by U.S. shareholders. But here's a twist. Only the more-than-50% shareholder is taxed on his pro rata share of the corporation's income as it is earned. The other U.S. persons are not "U.S. shareholders," because they each own less than 10% of the voting stock. They are taxed as though it were a decontrolled corporation. Another way to decontrol an offshore corporation is to invest with one or more unrelated foreign partners. If the foreign persons own 50% or more of the voting power, the corporation is decontrolled. It invests in the United States as a nonresident alien, and you are taxed only as you withdraw money from the corporation. Remember that the foreign persons must be the real owners of the stock and not be holding it as your agent in order to avoid the CFC rules. This is particularly popular when the foreign investors are from a country with similar rules. For example, many German investors have made 50-50 deals with American partners to invest in U.S. real estate, and both the German and American can then say to their respective tax authorities that they are not in control. There you have three simple, straightforward ways to decontrol an offshore corporation. The rules are clearly stated in the tax code and the regulations. The favored income loophole Taxes can be avoided even if you have complete control of the offshore corporation and it is classified as a CFC. That is true because only certain types of a CFC's income are taxed pro rata to the U.S. shareholders as they are earned. Only what is known as the "subpart F income" of the CFC passes through to the U.S. shareholders. The rest is treated just as though the corporation were not a CFC. The income can accumulate and compound tax-free in the corporation until it is taken out as dividends. The income that will be taxed pro rata to U.S. shareholders of CFC includes the following: Foreign-personal-holding-company income. This includes all interest, dividends, royalties, and gains on securities, plus rents from related parties. Thus, you can see that most types of investment profits are included in subpart F income. But rent derived from the active conduct of a trade or business is not included unless the rental income is received from a related party. Suppose you own an office building in the Bahamas. You occupy 15% of it for your own business and lease the remainder to unrelated parties. You have a staff to lease and service the building. This would be considered the active conduct of a rental trade or business in a foreign country, and the rental income would not be subpart F income. Or suppose you own an oil-drilling company. When your equipment is idle, it is leased to other oil- drilling companies. The rental from the leases is not considered subpart F income and can be accumulated in an offshore corporation. Foreign-based-company sales income. This is essentially income from the purchase of property from a related person (such as another of your companies) by an unrelated person or the sale on behalf of a related person. Foreign-based-company service income. This is income from consulting services (such as engineering, architectural, or managerial services) performed for a related person. If you perform these services for unrelated persons, the income is not subpart F income and can accumulate tax-free in the offshore corporation. Other subpart F income. There are special rules for banking, insurance, shipping, and oil service income. If you have these types of income earned overseas, your operation probably can be structured to avoid the subpart F rules. Consult an international tax adviser to see if it can be done. As you can see, loopholes abound in the definition of subpart F income. But it seems that most types of investment income are included in that definition, and the route to tax avoidance from these types of income is to form a decontrolled corporation. That is largely true, at least, but there is one other loophole in the definition of subpart F income that you might want to consider first. One way to avoid having the shareholders taxed on the subpart F income of the offshore corporation is to take advantage of the de minimis rule. The rule says that if the sum of the foreign-based-company service income plus the gross insurance income does not exceed 5% of the CFC's total income or $1 million, whichever is smaller, none of the income is foreign-based-company income or insurance income. For example, suppose that your offshore corporation buys some condominiums in the Cayman Islands. You rent these condominiums to tourists who are unrelated to any of the corporation's owners. Rental income from unrelated persons is not subpart F income, so this income will not be passed through pro rata to the U.S. shareholders. In addition, if the rental income is at least 95% of the offshore corporationžs total income, it will keep the subpart F income from being passed through to the U.S. shareholders under the de minimis rule. If you have manufacturing or personal consulting services that can be moved offshore, you might be able to use non-subpart F income from these operations to shelter investments in the United States. In addition, the manufacturing and consulting income probably will not be subpart F income and will also be sheltered in the offshore corporation. But be careful. There is a sort of reverse de minimis rule. If the subpart F income of the corporation is more than 70% of the total income, all income is treated as subpart F income. In that case, income that normally would escape the subpart F rules would be included under those rules. The subpart F rules have plenty of loopholes, even if you have a controlled foreign corporation. But remember that the rules are very complicated and have numerous qualifications and exceptions that cannot be mentioned here. If you think that one or more of these loopholes might apply to you, consult an experienced U.S. international tax adviser before going forward with a tax plan. The investment company trap To plug some of the offshore corporation loopholes, the Tax Reform Act of 1986 established the passive-foreign-investment-company (PFIC) rules. These rules are more difficult to get around than those already discussed. A PFIC is any foreign corporation that either has 75% or more of its gross income as passive income or has at least 50% of the value of its assets producing passive income or held for the production of passive income. Passive income is interest, dividends, capital gains, royalties, and some other types of income. Unlike the case with a CFC, there is no control requirement for the PFIC. If the offshore corporation is owned only 1% by U.S. persons and has the minimum amount of passive income, it is a PFIC. The penalty for owning PFIC shares is fairly severe. It is discussed in more detail in the chapter on offshore mutual funds. Briefly, you have two choices. One is to pay a penalty tax when you either sell the shares or take an excess distribution. The penalty tax assumes that the undistributed income and gains of the PFIC were distributed annually. You pay the tax plus interest based on the number of years you held the shares without paying the taxes. The other option is for the PFIC to elect to be a "qualified electing corporation." That means you report your pro rata shares of the PFIC's income and gains annually, just as you would with a U.S.-based mutual fund. In other words, you lose the benefit of tax deferral. You can avoid the PFIC trap by reducing the percentage of the offshore corporation's income that is passive. For example, the corporation can own foreign real estate and rent it to unrelated parties. Such income is not passive. If the activity is significant enough, the corporation falls out of the PFIC definition. Another option is to combine the investment activities of the offshore corporation with an operating offshore business. If you have manufacturing or consulting operations overseas, these can be used to avoid the PFIC penalty. Another potential trap in the tax law is the foreign-personal-holding-company rules, which are different from the PFIC rules. In most cases, however, if you avoid the CFC rules or have a decontrolled offshore corporation, you also avoid the foreign- personal-holding-company rules. Investment loopholes in the United States Once an offshore corporation is established to take advantage of the loopholes described above, that corporation can invest in the United States. The key to tax-free or almost tax-free investing is to ensure that the offshore corporation is considered a foreign corporation not engaged in a U.S. trade or business under U.S. tax law. There are detailed regulations that give numerous rules and examples. The important points are that generally there cannot be a U.S. office or agent in the United States, books and records must be maintained outside this country, and management and control must not be located here. Directors' and shareholders' meetings should be held outside the country, and the corporation cannot have a business here. It is vital that a U.S tax adviser structure your arrangement to comply with the law and give you a complete list of dos and don'ts. Once your offshore corporation secures its status as a nonresident alien, you can get these benefits in many situations: * No U.S. taxes on bank-deposit interest * No U.S. tax on capital gains earned on U.S. stocks and bonds. There will, however, be some tax on dividends from U.S. stocks. In cases in which a tax might be incurred, such as on dividends, this often can be reduced or avoided by locating the offshore corporation in a country that has a favorable tax treaty with the United States. The Treasury Department has renegotiated a number of the tax treaties, but there still are some under which the U.S. withholding tax rate on dividends is significantly reduced. The advantages foreign investors have over U.S. ones were most apparent in the junk bond crisis and the problems it created for some insurance companies and savings and loan associations. If you followed the news stories closely, you saw that only foreign corporations or partnerships were submitting the best bids for the portfolios of junk bonds that these institutions were trying to sell. The primary reason for that is the tax advantages the foreign investors would enjoy. Any U.S. buyer of the bonds would have to pay taxes on any interest and capital gains they earned. The foreign investors face no U.S. taxes and, if they are based in a tax haven like Hong Kong, no domestic taxes either. This allows them to make bids 10% or more above those of U.S. competitors. Investing in U.S. real estate used to be an easy way to tax-free income and gains for nonresident aliens. But the rules were changed in 1980, and the profits no longer will be tax-free. Still, investment in U.S. real estate through a decontrolled offshore corporation can result in lower tax on profits if the transaction is structured properly. This is a complicated and rapidly changing area, but the general approach is to set up an offshore company in a country that has a favorable tax treaty with the United States. (The Netherlands is the historical favorite.) The offshore company then creates a U.S. corporation, which buys the real estate. Sometimes, it makes sense to have one U.S. company own the real estate while another is set up to manage the property and collect management fees. The IRS periodically issues revenue rulings to attack schemes that it has heard are being used. To get any of these results, you need up-to-date advice from an experienced U.S. tax adviser. Summary There are a number of ways that U.S. citizens and other residents can take advantage of one or more offshore corporations to invest tax-free or at low tax cost in the United States. But taking advantage of these loopholes requires careful and thorough planning with the help of someone who is knowledgeable in the U.S. tax aspects of these transactions. This chapter is able to touch on only the highlights, and you should be aware that the law in this area changes rapidly. When considering an offshore investment opportunity, you should look at both the ownership structure (decontrolled corporation, CFC, etc.) and the type of income to be earned (subpart F, non-subpart F). U.S. citizens who are evaluating an offshore tax- planning opportunity should be wary of several types of schemes. These include ones involving daisy chains of foreign corporations and trusts all of which ultimately are controlled by the same person, foreign lawyers and agents who will act as "accommodators" to establish foreign control of an entity, and plans emphasizing the secrecy involved and how difficult it will be for the IRS to uncover the transactions. Another element to be cautious of is the "thinly capitalized" corporation. This is a corporation that has few assets. The IRS and the courts often will simply ignore such a corporation when determining the tax effects of a transaction or series of transactions. Holding companies have their purposes, but dummy or sham corporations with no legal or business purpose tend to be ignored. Many Americans could take advantage of the offshore corporation loophole if they were aware of the opportunities available. This chapter has given you an outline of the rules involved and identify the types of transactions that could be profitably and legally conducted through an offshore corporation with a very low tax bite. If your situation was identified here, seek out an international tax expert to examine your situation further. For help in forming foreign corporations and obtaining proper tax advice, see the "A Source of Help" section at the end of the Offshore Trust Loophole chapter.