THE BEST PART -- MOST INTERNATIONAL BUSINESS IS TAX FREE! The Use of Tax Havens Tax havens are one of the most important subjects for an international entrepreneur, yet few understand and use them properly. One group discount them as hiding holes for dirty money, which is not a legitimate use for tax havens. Others think they are only for banking money after you have made it. Not true either. Money grows much faster if a tax haven is part of your business planning, and almost any international business has an opportunity to use tax havens. It is the purely domestic business, confined to one country, that cannot benefit from the international fiscal loopholes. Simply stated, a tax haven is any country whose laws, regulations, traditions, and, in some cases, treaty arrangements make it possible for one to reduce his overall tax burden. This general definition, however, covers many types of tax havens, and it is important that you understand their differences. No-Tax Havens. These are countries that have no income, capital gains, or wealth (capital) taxes, and in which you can incorporate and/or form a trust. The governments of these countries do earn some revenue from corporations; "no-tax" means that what you pay is independent of income derived through a company. These states may impose small fees on documents of incorporation, a small charge on the value of corporate shares, annual registration fees, etc. Primary examples are Bermuda, Bahamas, and the Cayman Islands. No-Tax-on-Foreign-Income Havens. These countries do impose income taxes, both on individuals and corporations, but only on locally derived income. They exempt from tax any income earned from foreign sources that involve no local business activities apart from simple "housekeeping" matters. For example, in such a haven there is often no tax on income derived from export of local manufactured goods. The no-tax-on-foreign-income havens break down into two groups. There are those that allow a corporation to do business both internally and externally, taxing only the income coming from internal sources, and those that require a company to decide at the time of incorporation whether it will be one allowed to do local business, with the consequent tax liabilities, or one permitted to do only foreign business and thus be exempt from taxation. Primary examples in these two sub-categories are Panama, Liberia, Jersey, Guernsey, Isle of Man and Gibraltar. Low-Tax Havens. These are countries that impose some taxes on all corporate income, wherever earned. However, most have double-taxation agreements many the high-tax countries that may reduce the withholding tax imposed on income derived from the high-tax countries by local corporations. Cyprus is a primary example. The British Virgin Islands is another, but no longer has a tax treaty with the U.S. Special Tax Havens. These are countries that impose all or most of the usual taxes, but either allow special concessions to special types of companies (such as a total exemption from tax on shipping companies, or movie production companies) or allow very special types of corporate organization, such as the very flexible corporate arrangements offered by Liechtenstein. The Netherlands and Austria are particularly good examples of this. To understand the precise role of tax havens, it is important for you to distinguish two basic sorts of income: (1) return on labor and (2) return on capital. The first kind of return is what you get from your work: salary, wages, fees for professional services, and the like. The second kind of return relates, basically, to the return from your investments: dividends on shares of stock; interest on bank deposits, loans and bonds; rental income; royalties on patents. It is the second kind of income, income from an investment portfolio, that tax havens are useful for. Forming a corporation or trust in a tax haven can make the second form of income totally tax free, or taxed so low that you will hardly notice. Certain types of businesses can be effectively based in a tax haven. If you publish a newsletter, for example, you might be able to set up the entire operation in a totally tax free country such as the Bahamas or the Cayman Islands. If your income comes from copyright royalties, perhaps on the computer program you invented, the Netherlands is famed as a base for sheltering royalty income. Tax havens are a very complex subject, but the hours you spend studying their use will probably pay you more per hour than the hours you spend directly earning an income -- an unfortunate commentary on the confiscatory taxation policies of most governments. For the best detailed information on tax havens, read The Tax Haven Report published by Scope International Ltd., Forestside House, Forestside, Rowlands Castle, Hants. PO9 6EE, Great Britain, who will send you a free catalog. Another source of information is Eden Press, which publishes a series of special reports on different havens and techniques by which Americans can use them. You can obtain their catalog free by writing to them at P. O. Box 8410, Fountain Valley CA 92728. If you want to gain a good understanding of how the government views tax havens, University Microfilms International, through its Books On Demand program, is now making available Tax Havens and Their Uses by United States Taxpayers by Richard Gordon. Frequently referred to as "The Gordon Report," this was a 1981 U.S. Treasury Department study prepared at the request of Congress. It gives considerable detail and examples of the uses of tax havens. It is available from University Microfilms for $67.30 softbound, or $73.30 hardbound. Out of print for over a decade, anyone interested in tax havens who has not studied the work will find much still useful information in it. Copies can be ordered through booksellers, or directly from University Microfilms International, 300 North Zeeb Road, Ann Arbor, Michigan 48106-1346; telephone 800- 521-0600 or 313-761-4700. The UMI catalog number of the book is AU00435, and UMI accepts Visa or MasterCard. In addition to the business use of tax havens, living in a tax haven can have obvious advantages. Moving to Bermuda or the Bahamas is outrageously expensive. But some of the countries we mentioned in the real estate chapter are valuable tax havens, without being notorious or obvious. This is because the general principle of taxation in most Latin American countries is to tax only resident sources of income. So you can make your home in those countries, receive your income from elsewhere (such as your tax haven business corporation), and pay no personal income taxes. Venezuela recently changed its law to provide for worldwide taxation of residents, but this is not likely to be the start of a trend. Guatemala, Uruguay, Costa Rica, Ecuador, Chile, and Mexico all have personal tax haven possibilities in addition to being nice, and inexpensive, places to live. Just stop and think for a moment how much faster your money can grow if you are not paying out an average of 40% to a taxing government somewhere. United States as a tax haven? Incredible as it may seem, the United States is a tax haven for many foreign investors. There is no withholding tax on interest paid by banks (including on bank money market accounts). There is no withholding tax on most corporate bonds (but check carefully, as some older bonds are still subject to tax. There is a withholding tax of 30% on dividends, so investing in a money-market fund is not feasible, as their payments are technically classified as a dividend rather than interest. For the same reason you don't want a U.S. based mutual fund that pays out high dividends. A non-dividend paying fund, in which the increase goes solely to a higher share price is fine, because the United States is also a tax haven for foreign investors on capital gains. Because of this, savvy investment managers in the U.S. usually manage foreign accounts separately, because short term trading profits (as well as long term ones) are totally tax free to the foreign account holder, but taxable to an American. Real estate used to be exempt from capital gains tax for foreign investors, but that is no longer the case. After a fantasy scare about "rich Arabs buying up all the farmland" special taxes were placed on foreign property investors. (A later government study found that in fact less than 1% of all farm property was owned by foreign citizens, very few of them Arabs.) The Puerto Rico Loophole Some U.S. taxpayers find tax benefits by establishing residence in Puerto Rico. Since Puerto Rico is a commonwealth of the United States and has a similar tax system, the United States exempts income earned in Puerto Rico if you establish a bona fide residence there. For immigration purposes Puerto Rico is part of the United States. Provided that you are resident in Puerto Rico for the entire calendar year, you file a Puerto Rico tax return instead of a U.S. tax return. Puerto Rico taxes all income on a worldwide basis. You should check out the Puerto Rican tax situation before trying to qualify for this provision. You will be subject to Puerto Rican taxes, and Puerto Rico is not a tax haven. You might, in fact, find the country a tax liability, as its rates are now generally higher than in the U.S. The one particularly interesting exception, however, is that dividends paid from a Puerto Rican company that has a tax holiday (such as the ten year exemption granted to new factories) is free of Puerto Rican tax. One U. S. couple owned a small manufacturing business in Puerto Rico. In the tenth year, they sold the business, but not the corporation, and paid a liquidating dividend from the corporation. Just before the tenth year, they established residence in Puerto Rico, and maintained it for the entire calendar year in which the liquidating dividend was paid. Total exemption from tax on the final payout!. Since the dominant language and culture in Puerto Rico are Spanish, if you are immigrating to the U.S. from a Spanish-speaking country, you may find it preferable to make your base in Puerto Rico instead of the mainland, and have the tax advantages as well. In this case you could be continuously living on tax-free profits from the business. Salary payments would be subject to the Puerto Rican income tax rates, but dividends from the ongoing business would not be. There are some older tax holiday laws on the books in Puerto Rico that are often overlooked. For example, a ten year exemption from tax for companies engaged in export of a locally made or assembled product. This is often a more useful exemption than some of the manufacturing exemptions which give only a partial exemption in urbanized areas. Another way to play a different Puerto Rico tax angle is if you are entering the U.S. to operate your own business, and intend to eventually leave the U.S. A foreign corporation with a branch in Puerto Rico is only taxed on Puerto Rico source income. If you create a Panamanian corporation, open a branch for it in Puerto Rico, and accumulate the profits in the corporation, you can then take the money out of the corporation once you are no longer a U.S. (or Puerto Rican) taxpayer. In this situation you would be taxed on the salary you pay yourself out of the corporation, which you would keep as low as possible, and then let most of the money stay as profits. This angle works particularly well for a consulting or other service business, or for a mail order or publishing business. Since Puerto Rico is within U.S. domestic mail and telephone systems, it can be used as a base for such enterprises very easily. It also works the other way -- the Puerto Rican branch office could be a business engaged in export representation of products to Latin America, since transportation from San Juan, Puerto Rico, to most points in Latin America is very easy with good flight schedules. Some major American corporations have done exactly this -- they created Panamanian sales subsidiaries for their Latin American business, and operate the subsidiaries out of Puerto Rico, from where the sales representatives can easily call on clients throughout the hemisphere. The Men Who Would Be Kings Two people in recent years have become so fed up with taxes that they declared independence. The first was Roy Bates, a former pirate radio station operator in England. He laid claim to an abandoned fort in the English channel, just outside the three mile territorial limit. He declared it to the Principality of Sealand. Subsequent litigation in the British courts established that the fort was indeed outside of the British jurisdiction, and that the British Crown had in fact abandoned it. No country has ever diplomatically recognized his independence, but since the only sovereign with a competing claim, Her Majesty Queen Elizabeth II has been found by one of her own courts not to be the sovereign of Sealand, Roy Bates has achieved his legal independence. The lack of diplomatic recognition is not necessarily a handicap. There are several very real countries with little or no diplomatic recognition. The "homelands" that were granted "independence" by South Africa are recognized only by South Africa. Politicians elsewhere may treat their independence as a joke, but international treaties don't apply to them. The Turkish Republic of Northern Cyprus is recognized only by Turkey. But it is quite obviously there, well populated, and occupying half of the island of Cyprus. Andorra has been an independent state for hundreds of years, has its own passports, and approximately 200 square miles of land (depending upon which way you measure the mountainsides). It does not have diplomatic relations with anyone -- not even the two neighbors, France and Spain, that surround it. It has never been a party to any international treaty -- but it is a very real country, and a very popular tourist destination. Hutt River Province More recently, an enterprising Australian has been trying to make the idea work. Leonard Castley, a Western Australian farmer, seceded from the Commonwealth of Australia in 1970. He then proceeded to crown himself sovereign of his own principality, and stopped paying taxes to Australia. He calls it the Hutt River Principality, and it has become something of a tourist destination, with busloads of Japanese tourists stopping to buy souvenirs. Recently the Hutt River Principality issued the world's first palladium coin, which was minted in the United States, and sold by coin dealers in various countries. In square miles, Hutt River Province Principality dwarfs both Vatican City and Monaco. Like most of Western Australia, however, it is sparsely populated. For most of the year, the population stands at about 30 (most of whom are royal family members); during peak harvest period, it is about twice that. The Hutt River Province Principality issues passports and visas to visitors and mints currency embossed with an image of the prince. Stamps are sold as collector's items. About 10,000 people around the globe have become citizens of Hutt River, although the passports do not have legal recognition anywhere (yet). The outcome of the legal battle with Australia is still undetermined, and they have not recognized the claims to independence. For further information, contact Prince Leonard of Hutt River, Binnu West, Australia 6532; tel. (61-99) 366-035. These approaches may not work, but we pass them along for inspiration. With creativity you may find your own unique and successful solution, and create your own personal tax haven. Be A PT ... Don't Live Anywhere At All! The majority of Somalis are nomads who have proved themselves gratifyingly resistant to the chaos of civil war and famine. While Western attention has been focused on farmers and devastated city dwellers, the nomads continue to use their mobility -- as they have for centuries -- to avoid much of the hardship. Cities and mechanized agriculture, the results of "civilization," are first to be hurt when the structure of civil order collapses. War has destroyed the largest towns; farmers were quickly cut off from supplies with the onset of hostilities. Nomads, with camel, goat, and sheep herds, are highly mobile and can generally avoid areas where there is fighting. Camels, in particular, are natural survival aids in Somalia. They permit the nomads to scrape a bare subsistence from the arid semi-desert. War and famine have driven up the price of grain, forcing nomads to barter away more of their animals to obtain it. Nevertheless, the incalculable effects of war affect the nomads, though later and less intensely than they impinge on the settled populace. On an international scale there is a survival lesson here for the civilized world as well. Do you want to escape the control over your life and property now held by modern governments? The PT concept could have been called Individual Sovereignty, because PTs look after themselves. We don't want or need authorities dominating every aspect of our existence from cradle to grave. The PT concept is one way to break free. In a nutshell, a PT merely arranges his or her "paperwork" in such a way that all governments consider him a tourist -- a person who is just "passing through." The advantage is that being thought of by government officials as a person who is merely "parked temporarily", a PT is not subjected to taxes, military service, lawsuits, or persecution for partaking in innocent but forbidden pursuits or pleasures. Unlike most citizens or subjects, the PT will not be persecuted for his beliefs or lack of them. PT stands for many things: a PT can be a "prior taxpayer," "perpetual tourist," "practically transparent," "privacy trained," or "permanent traveler" if he or she wants to be. The individual who is a PT can stay in one place most of the time. Or all of the time. PT is a concept, a way of life, a way of perceiving the universe and your place in it. One can be a full-time PT or a part-time PT. Some may not want to break out all at once, or become a PT at all. They just want to be aware of the possibilities, and be prepared to modify their lifestyle in the event of a crisis. Knowledge will make you sort of a PT -- a "possibility thinker" who is "prepared thoroughly" for the future. The PT concept was created by Harry Schultz, the financial consultant and author of a number of books on investing that were best sellers in the 1970s. Today there is a publishing company in Britain specializing in books for the PT -- unique titles on tax havens, obtaining a second citizenship, living in exotic locations, buying a tax free car, and making money internationally. Even if you never buy the books, just reading the catalog is fascinating. The catalog is free, and can be had by writing Scope International Ltd., Forestside House, Forestside, Rowlands Castle, Hants. PO9 6EE, Great Britain. PT is elegant, simple, and requires no accountants, lawyers, offshore corporations, nor other complex arrangements. Since the income of most PTs is immediately doubled, and most frustrations of life with Big Brother are instantly eliminated, the logical question is only: "Can you afford not to become a PT?" The PT, once properly equipped, operates outside of the usual rules, gaining mobility and a full slate of human rights. The value of these rights cannot even be perceived by people who have never experienced them. The message of PT is not, however, to encourage greed, lust, irresponsibility, immorality or any of the other seven deadly sins. The effect of PT being popularized will be to release creative souls from the many burdens of coping with Big Brother. You don't need to found a new country or displace someone else to make yourself a sovereign. The PT need not dominate other people. He or she must only be willing to break out of a parochial way of thinking: the PT must be superior only in that small area located between the ears. We speak of the potential PT now in terms of wealth, talent, intelligence and creativity. Who is this PT in the upper minuscule of the population? It might well be you... The $70,000 -- and More -- Offshore Loophole If you're a typical cash-poor American, you could increase your standard of living dramatically if you could avoid throwing away 40% or more of your income on taxes each year. Thousands of Americans are doing that right now, and many more can. It's one of the clearest provisions in the tax code. As you will learn in this report, the loophole actually is broader, and allows you to earn far more tax-free income, than even most expatriates realize. The loophole is known as the foreign-earned- income-exclusion or the "$70,000 exclusion." It allows for U.S. citizens who live and work outside the U.S. to exclude from gross income up to $70,000 of foreign- earned income. In addition, an employer-provided housing allowance can be excluded from income. There are other tax breaks available: Each member of a married couple working overseas, for example, can exclude salary of up to $70,000. That's a total of $140,000, plus housing allowances. It is important to note that this is not a deduction, credit, or deferral. It is an outright exclusion of the income from gross income. Naturally, to get these benefits you have to meet certain requirements: * You must establish a tax home in a foreign country. * You must pass either the "foreign-residence test" or the "physical-presence test." * You must have earned income. In the rest of this chapter, we'll discuss these tests and give some tips on maximizing tax-free income. Home is where the money is In the IRS view of the world, your tax home is the location of your regular or principal place of business. That is, the tax home is where you work, not where you live. Take a look at what happened recently to one taxpayer who did not check the rules carefully. He is a flight engineer who lives in the Bahamas, but all his flights originate from Kennedy Airport in New York. The Tax Court ruled, not surprisingly, that his tax home is in New York, not in the Bahamas. The flight engineer does not qualify for the $70,000 exclusion. But the definition goes further for the foreign- earned-income exclusion. This is a trap that catches many Americans overseas who think they are earning tax free income. If you work overseas and maintain a place of residence in the United States, your tax home is not outside the U.S. In other words, to qualify for the foreign-earned-income exclusion you have to establish both your principal place of business and your residence outside the United States. This trap catches a number of construction and oil workers. These workers generally work on a construction site or oil platform for three to six months. They get a few weeks or months off. Many of them make the mistake of leaving their family and personal possessions at their U.S. home and visiting this home during their vacations. They can't use the offshore loophole because they never establish a tax home outside the United States. They maintained a place of residence in the United States. You need to sell or rent your U.S. home and establish a primary residence outside the United States. After establishing your tax home, you must pass one of two additional tests. Counting the days The more straightforward test is the physical presence test. To pass the test, you must be outside of the United States for 330 days out of any 12 consecutive months. The days, of course, do not have to be consecutive. That sounds very simple, but there are a number of smaller rules that can complicate it. Few people begin their foreign assignments on Jan. 1 and end them on Dec. 31. Thus for most people, the first and last 12 months of their overseas stay will occupy two tax years. This requires them to prorate their income and the $70,000 exclusion for those tax years. In addition, to count a day as one spent outside of the United States, you must be out of the United States for the entire day. There are exceptions for traveling days and days spent flying over the United States if the flight did not originate there. The IRS has a number of rules on counting days. If you are going to travel back and forth between the United States and foreign countries and if you want to try to pass this test, you'll have to learn the rules and count days very carefully. An easier way? The subjective test, known as the foreign- residence test, is probably easier for most taxpayers to pass. You must establish yourself as a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire taxable year, and you must intend to stay there indefinitely. If you do not pass this test, you are considered by the IRS a transient, or sojourner, instead of a foreign resident, and will not qualify as a foreign resident. According to the tax law, your residence is a state of mind. It is where you intend to be domiciled indefinitely. To determine your state of mind, the IRS looks at the degree of your attachment to the country in question. A number of factors, none of them decisive or significantly more important than the others, are examined. The bottom line is that you establish yourself as a member of a foreign community. The factors include the following: Sleeping quarters: A transient is more likely to sleep in a hotel; a resident likely owns housing or signs at least a year-long lease. Personal belongings: The more you take to the foreign country, the more you seem to be establishing a foreign residence. Leaving most of your personal belongings in temporary storage in the United States indicates an intention to keep that country as your residence. U.S. property: Owning a U.S. residence that you leave vacant is a sign of an intention not to establish a foreign residence. But selling or renting your U.S. residence indicates an intention to establish a foreign residence. Local documents: It is helpful to obtain a foreign driverþs license and foreign voter registration when possible. But maintaining your U.S. license and voter registration won't kill your chances. Local involvement: You should show involvement in local social and community activities to the same extent you were involved in such activities in the United States It is also helpful to let U.S. club memberships lapse while you are overseas, or to join similar clubs overseas. If you want to keep U. S. memberships in clubs that are hard to rejoin, see if you can convert them to a non-resident membership for the duration. (You may save on dues as well.) Foreign taxes: Foreign countries tax on the basis of residence. If you claim exemption from local taxes because you are not resident in that country, the IRS will conclude that you are a U.S. resident and do not qualify for the foreign-earned-income exclusion under the foreign-residence test. Thus some people prefer to qualify under the physical-presence test rather than under the foreign residence test. With the physical- presence test, you might be able to claim that you are not a resident of the foreign country and thereby exempt from their taxes. At the same time, you can claim exemption from U.S. taxes. Bank accounts: This does not seem to greatly affect residence status. But if your case seems to be borderline, it is a good idea to open at least a local checking account even if a U.S. account is maintained. Many U.S. expatriates maintain U.S. accounts because it is easier to have their U.S. employers deposit paychecks directly in the U.S. account. Permanent address: You will occasionally complete documents, such as passport applications, that ask for a permanent address. It is best to list a foreign address or some address of convenience, such as a friend's or relative's, from which your mail can be forwarded. Once your foreign residence is established, you must show that it is for an indefinite duration. If you have plans to return to the United States after a definite time has passed, you are not a foreign resident. In deciding whether or not the foreign residence is indefinite, the IRS generally looks at your employment contract. (Note that it is permissible to have a vague intention to return to the U.S. someday. But if you have in mind a definite limit to your foreign stay, you will have problems establishing that you are a foreign resident.) Generally, if your employment contract lasts for one year or less, that is an indication that you have a definite intent to return to the United States after a short period of time. You would not be able to qualify as a foreign resident. But if the contract is indefinite, open-ended, can be renewed, or is likely to lead to a new job, you probably can qualify as a foreign resident. It is best to have a contract that does not pertain to a definite project. If there is no written contract, the IRS will examine the nature of the job, the employer's personnel manual, and any other facts that indicate the intentions of you and your employer. After establishing the residence, you can make occasional trips to the United States for business or vacations without losing your foreign-residence status. Just be certain that the trips are temporary, and that you do not disturb any of the factors that qualify you as a foreign resident. Which income to exclude Once you have qualified for the offshore loophole, you must identify the kind of income that qualifies. Not all income qualifies for the exclusion -- only foreign-earned income. Foreign-earned income is income paid for services you have performed in a foreign country. This includes salaries, professional fees, tips, and similar compensation. Interest, dividends, and capital gains do not qualify. Self-employed people must adhere to some additional rules. Professionals who do not make material use of capital in performing their services can qualify all of their net income for the loophole. But when both personal services and capital are used to generate income, no more than 30% of net profits will be considered eligible for the exclusion. Note that for self-employed individuals and for partners, the net income is the amount that is applied toward the exclusion limit, not the gross income. Other types of income that do not qualify for the loophole include the following: employer-provided meals and lodging on the business premises, pension and annuity payments, income paid to employees of the U.S. government or its agencies, non-qualified deferred compensation, disallowed moving expense reimbursements, income received two years or more after you earn it. But some of these paymentsþsuch as employer-provided meals and lodging on the business premisesþare tax-free under regular U.S. tax rules and retain that status. This is one way you can earn more than $70,000 tax- free. The $70,000 limit on the offshore loophole applies to individual taxpayers. So if you are married, you and your spouse potentially can exclude up to $140,000 of foreign-earned income. But you cannot share each other's limit. For example, if one of you earns $80,000 and the other earns $30,000, you exclude only $100,000 on the return ($70,000 plus $30,000). Don't close the loophole Too many U.S. expatriates inadvertently close the offshore loophole. There are several ways of doing this. One way is not to realize that the provision has requirements that must be met. Many Americans assume that since they are living overseas, everything they do is free from U.S. tax. That's not so. You've seen some examples of that in this chapter already, and there are other regulations for taxpayers in different situations. Special situations include not being overseas for the full year and receiving advance or deferred payments of income, bonuses, and other special income items. It is well worth your while to discuss the matter with a tax attorney or accountant who understands the offshore loophole. Go over your situation and your plans in detail before leaving the United States. That way, you'll be sure to qualify for and make maximum use of this loophole. Another way people close this loophole is by not filing tax returns. To get the exemption, you must file a tax return and claim the exemption on Form 2555. The IRS has had success in recent years contending that anyone who does not file the return loses the loophole, even if he meets all the requirements. Be sure you file the return and properly claim the loophole. The loophole exempts your foreign-earned income from tax, but it does not exempt you from the filing requirement. Recent tax laws, plus some heavy criticism from the General Accounting Office, have caused the IRS to increase its monitoring of U.S. citizens overseas. The IRS now reviews passport applications and renewals to ensure that you not receive or renew a passport unless your tax returns are filed and paid up. The IRS is also looking for expatriate Americans and informing them of their tax obligations. It is estimated that about two-thirds of expatriate Americans are not filing any U.S. tax returns, and the IRS aims to change that. Be sure to file your tax returns. Tax credit option Instead of excluding income from taxes, you can take a deduction for foreign taxes paid on the income. But the foreign tax credit can get complicated, and in almost all cases, you'll find that it makes more sense to exclude income than it does to take the credit. But if your foreign-earned income exceeds the $70,000 limit, look into taking the credit for taxes paid on the income that exceeds the exclusion amount. Beware those other taxes The disappointing part of the $70,000 exclusion is that it applies only to federal income taxes. The Social Security tax might still apply to salaried employees, and the self-employment tax might still apply to self-employed individuals. The self-employed, for example, still figure their net self-employment income on Schedule C. The net income up to $70,000 still is excluded from gross income. But it also is used on Schedule SE to compute the self-employment tax. For salaried workers with U.S.-based employers, the employer is supposed to withhold Social Security taxes. Possible exemptions are discussed later. Expanding the loophole -- exempt more than $70,000 The $70,000 offshore loophole is generous, but savvy taxpayers know how to make it even more generous. In many situations, you can exclude or deduct foreign housing costs. You have an option here. You can deduct your housing costs to the extent that they exceed a base amount. Or if your employer reimburses you for the excess, the reimbursement can be excluded from income. To get the write-off or exclusion, you must meet the same tests as for the foreign-earned income exclusion. That means either establishing a foreign residence or meeting the physical-presence, test as well as establishing a foreign tax home. The all-important base housing amount is 16% of the salary of a federal government employee with the grade of GS-14, Level 1. You use the salary that was effective on Jan. 1 of the year you became eligible for the housing loophole. If you are not eligible for the loophole for the entire year, the base amount must be prorated, just as the income exclusion is prorated in that situation. When your employer pays or reimburses you for qualified housing expenses, you can exclude from income the amount of the employer's payments that exceed the base housing amount. The employer's payments that qualify can be made in any of the following forms: part of your salary; reimbursements for housing, the education of your dependents, or tax equalization, or employer-provided meals and lodging that are not excluded from income under the regular tax rules. Any of these kinds of expenditures also qualify for the exclusion if they are made directly to a third party instead of to you. If you and your employer agree that a part of the payments received is for housing, but you have no firm agreement as to how much is for salary and how much is for housing, you still get to use the housing exclusion. The excludable amount is your actual housing costs minus the base housing amount. The exclusion cannot exceed either your foreign- earned income or the employer-provided payments for housing expenses. In addition, the exclusion for housing expenses is applied before the foreign-earned- income exclusion. The effect of this is to make it harder to excluded housing expenses against non-earned income, such as dividends and interest. Suppose you are self-employed, or suppose your employer does not provide payment or reimbursement for housing expenses. In these cases, instead of excluding the amount from income, you can take a deduction for the excess housing expenses if you meet the same eligibility rules as for the exclusion. The deduction is computed the same way as the exclusion. You subtract the base amount from your total qualified housing expenses, and then you subtract any employer- provided payments for housing expenses. Whatever is left over is your deduction. The deduction cannot be more than the difference between your foreign-earned income and the combination of the foreign-earned-income limitation ($70,000) and any exclusion you take for housing expenses. In other words, your foreign-earned income must be above the exclusion limit of $70,000 in order for you to take the deduction. If you cannot deduct the expenses, you might be able to deduct some of them the following year if your foreign-earned income exceeds the limit. Consult your tax advisor to see if you qualify. A few limits The exclusion or deduction for housing expenses applies only to reasonable housing expenses. The IRS gives no clear-cut definition of reasonable. Most tax advisors say that if your foreign housing is of the same standard that you were used to in the United States, it should be considered reasonable. The following types of expenses qualify for this loophole: * Rent * Fair rental value of employer-provided housing * Utilities, except telephones * Insurance on real and personal property * Occupancy taxes that are not normally deductible under U.S. tax law * Non refundable lease fees * Rent for furniture and accessories * Repairs * Parking fees The following types of expenses do not qualify for this loophole: * Capital expenditures, such the costs of purchasing, constructing, or improving a home * Purchase cost of furniture and accessories * Domestic labor * Mortgage-principal payments * Depreciation * Interest and taxes that normally are deductible * Deductible moving expenses * Pay-television subscriptions The second overseas home loophole A few taxpayers are able to exclude or deduct the expenses of two homes outside the United States. To do this, you must show that the location of your tax home, or principal residence, is subject to adverse living conditions. That is, the living conditions must be "dangerous, unhealthful, or otherwise adverse." If the location of your tax home is in a state of war or civil insurrection, you are living in adverse conditions. A different kind of adverse condition is when the employer's business premises are a drilling rig, construction project, or similar operation; the taxpayer lives there; and it is not feasible for the taxpayer's family to reside there. In this case, a second overseas home can be established for the family, and the expenses qualify for the exclusion. If you think you might qualify for one of these exclusions, consult a tax advisor. There have been numerous regulations, cases, and rulings in regard to these matters. The tax advisor should be able to make sure you meet the requirements for maximum tax benefits. Like the foreign-earned-income exclusion, the allowance for housing expenses is determined separately for spouses. The Social Security offshore loophole Not many people know this but the U.S. has agreements that exempt overseas workers from either the U.S. Social Security tax or that of the adopted nation. Most developed countries have some form of social security tax. The problem for many U.S. expatriates in the past was that many foreign social security taxes are far broader and have far higher rates than does the U.S. Social Security tax. In some countries, it is equivalent to our income tax, with rates above 30%. The agreements, known as totalization agreements, dictate that U.S. citizens who are temporarily working overseas are subject only to the U.S. Social Security tax and are exempt from the host country's tax. The United States has signed such agreements with 12 countries so far: Belgium, Canada, France, Germany, Italy, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, and the United Kingdom. A much larger number of countries will exempt you from paying the local social security tax, without a treaty, provided you present both proof that your employment is temporary, and that you are covered by U.S. social security. To be exempt from the host country's tax, you must qualify as a "detached worker." A detached worker is one whose assignment in the host country is expected to last five years or less. The wording differs somewhat in each treaty, so be sure to have that checked out before accepting a foreign assignment. If you are not a detached worker, you are exempt from U.S. Social Security tax and are subject to the host country's tax. The treaties also work for self-employed individuals. Many U.S. employers who send their employees overseas do not even know about these treaties; this ignorance prevents employees from minimizing taxes on their foreign assignments. To qualify for the exemption, you must obtain a certificate from the U.S. Social Security Administration before the foreign assignment. You can apply for a certificate and get other information about these agreements by contacting the Social Security Administration, Office of International Policy, P.O. Box 17741, Baltimore, MD 21235. Pamphlets about agreements with individual countries are available from the same address. The State and Local Tax Loophole The United States government taxes all its citizens, wherever they live in the world. Most foreign countries tax only their residents or domiciliaries. If a British citizen moves to the Cayman Islands and establishes residence there, he is not subject to British taxes. States in the United States tax the way foreign countries doþbased on residence. Therefore, when you establish a residence outside the United States, you avoid its state and local income taxes. For residents of high-tax states, this is not a minor consideration. Around one-third of some people's U.S. tax bill is made up of state and local taxes. Take this into account when deciding whether or not to take advantage of the offshore loophole. But states have a broader definition of residence. Some states require you to sever all contacts in order to cease residency. The Foreign Tax Loophole U.S. taxes are only part of the picture. Unless you move to a no-tax haven, you must examine the tax code of the host country to determine your tax obligations there. Again, most countries tax on the basis of residence or domicile. The rules vary from country to country, but usually someone who has established a place of abode in a country for more than six months is a resident or domicile. This often means that you can be considered a resident of two countries at the same time and can be subject to taxes in both countries. Or you can be considered a resident of no country. Different degrees of residence are taxed differently. For example, the United Kingdom uses the terms "domiciled" and "ordinarily resident", along with "resident." Someone who is domiciled in the United Kingdom is taxed in the United Kingdom on all worldwide income. Someone who is ordinarily resident or resident, but not domiciled, might be taxed only on the income derived from U.K. sources. The rule is similar in Ireland, and a lot of countries whose tax laws derived from the United Kingdom. We cannot survey the rules of all countries, though some are profiled in this report, but you should be aware of this potential problem and consider it before deciding to take advantage of the offshore loophole. You might find ways to eliminate taxes from both the United States and the foreign country in question, or you might find ways to drastically limit the overall tax bite. Another consideration is the double-tax convention, or tax treaty. The United States has tax treaties with about two dozen major countries. The intent of the treaties is to ensure that individuals and businesses are not fully taxed by two countries on the same income. But in many cases, the treaty can offer a more substantial advantage than that by reducing the total tax bill from what it would have been had only one country-in absence of a treaty-had taxed the income. Your tax advisor should check any treaty before you make a decision about the offshore loophole. The Home Sale Loophole If you want to qualify as a foreign resident, selling or renting your home is recommended. But selling the home is not always required, and many expatriates retain their U.S. homes because they plan to return someday. Expatriates who sell their homes after returning, however, could have some problems. Take a look at one IRS ruling: A taxpayer purchased a house in Washington, D.C., in 1969 and used it as a personal residence. He was transferred out of the United States in 1982 and had someone house-sit until he returned to the United States in 1986. He sold the home in 1987 and moved to New York City. He planned to exclude from gross income $125,000 of the gain on the sale, since he was over age 55. But there was a problem. The tax law requires that you own the home and use it as your principal residence for at least three out of the five years that immediately precede the sale. Since the taxpayer was out of the country for most of that period, the house did not qualify as the principal residence, and he could not exclude the gain (Letter Ruling 8825021). He could have avoided the problem by staying in the D.C. home for at least another two years, or he could have deferred the gain by purchasing a new home in New York City. He chose to rent an apartment. He could have sold the home before leaving the country, deferred the gain by rolling the sale proceeds into a home in the foreign country, and then tried to qualify gain on the sale of that home for the $125,000 exclusion when his foreign assignment ended. But he did not properly plan for his foreign assignment, and he lost the tax benefit. A similar problem occurs when people sell their U.S. homes before taking an overseas assignment. To defer the gain, you normally need to buy a new home within two years. Civilians have 4 years if overseas and military members have 4 years (stateside or overseas). This replacement period is suspended while military members are stationed outside the United States. Note however, that the replacement period, plus any period of suspension, cannot last more than 8 years after the sale of the home. So if you are gone more than four years and do not purchase a foreign residence, the gain is not deferred. You can defer gain by purchasing a foreign residence, since there is no requirement that the replacement residence be located in the United States. Deduct The Cost of Taking a Spouse on a Business Trip Not everyone can do this, but it is possible. Your spouse's presence must have a bona-fide business purpose. If your employer requires you to bring your spouse, the cost is deductible. Generally, the IRS also allows the deduction if your spouse's presence is required to socialize with your business associates and their spouses. If the spouse works for the business, the expenses will be deductible if the main reason for his or her presence is to learn new techniques relevant to his or her regular business duties. Sometimes the presence of an executive's spouse serves a bona-fide business purpose. The spouse's expenses can be deductible when the spouse's duties are to help the executive establish a close, friendly business relationship with customers; to tour manufacturing plants and make appropriate complimentary remarks about them; and to entertain customers and their spouses. (Warwick, 236 F. Supp. 761) Roy Disney could deduct the cost of taking his wife on a foreign trip because his wife's presence enhanced the family-entertainment image of Walt Disney Productions. In one case a wife's expenses were deductible because the husband had an acute medical problem, the wife was trained to deal with the problem, and the wife would not have been taken on the trip but for these factors. (Quinn, 77-1 USTC 9369). Swiss Annuities As An International Pension Plan Upon hearing the word "annuity" the majority of investors have a knee-jerk reaction, and negative visions of insurance salesmen float through their heads. Most of us have something of a lifetime negativity towards insurance companies and insurance products anyway, but experience over the years has shown that there are times when they can play an important role in financial planning. Most people have an overconfidence in their own money management ability, combined with a worry about how a spouse will manage the money in case of death. This is certainly a role that annuities can fill very well, because they provide a guaranteed income to cover family needs no matter what happens. No worries about the spouse marrying a "gold digger" or getting taken by an investment scam. But often the spouse with inherited money is the frugal one -- because that spouse knows that the inherited money is all there is to live on. The money- earning spouse may well be the one taking unnecessary risks with the family capital -- either directly through poor business or investment decisions, or indirectly through business activities that lead to a lawsuit. In these circumstances an annuity bought before the venture can have a wonderful insulating effect -- the ultimate security blanket against entrepreneurial failure. Somebody with $500,000 to invest in a risky venture might find a better result in putting a portion of the money in an annuity, and then making the high risk investment with the remainder. If the venture does bring the expected high rewards, everything is great, but if not, there is a bottom below which the entrepreneur will not fall. In these circumstances an annuity that matches monthly expenses (including the mortgage) can make a huge difference to the family. There is a similar philosophy in investment management -- often the 5% of a portfolio that is devoted to speculation, perhaps commodities futures, makes more than the other 95% of the portfolio. But the security of that other 95% is what allows the prudent speculation that might be a 100% loss. With the basic nest egg covered, one can then afford to pursue an occasional really big gamble that might achieve super results. For an international entrepreneur, a Swiss annuity can be particularly important, because it often can be a substitute for a U.S. individual retirement account or Keogh plan. If you have arranged affairs to avoid paying U.S. taxes, then you can't make contributions to a qualified U.S. pension plan. The Swiss annuity provides an admirable substitute. Once the basic decision is made to consider an annuity, it can be used as a tool for international diversification as well. This provides capital preservation by not being totally linked to one currency. It is important not to think only in terms of U.S. dollar investments. Annuity need not mean a poorly performing junk bond fund run by an unrated insurance company. There are some excellent products in the marketplace, often little known because it is the worst products (with accordingly high commissions) that tend to get promoted by high-pressure insurance salesmen on the telephone or in "free" investment seminars advertised in the local paper. According to Swiss law, insurance policies -- including annuity contracts -- cannot be seized by creditors. They also cannot be included in a Swiss bankruptcy procedure. Even if an American court expressly orders the seizure of a Swiss annuity account or its inclusion in a bankruptcy estate, the account will not be seized by Swiss authorities, provided that it has been structured the right way. There are two requirements: A policyholder who buys an annuity from a Swiss insurance company must designate his or her spouse or descendants, or a third party (if done so irrevocably) as beneficiaries. Also, to avoid suspicion of making a fraudulent conveyance to avoid a specific judgment, under Swiss law, the person must have purchased the policy or designated the beneficiaries not less than six months before any bankruptcy decree or collection process. The policyholder can also protect the policy by converting a designation of spouse or children into an irrevocable designation when he becomes aware of the fact that his creditors will seize his assets and that a court might compel him to repatriate the funds in the insurance policy. If he is subsequently ordered to revoke the designation of the beneficiary and to liquidate the policy he will not be able to do so as the insurance company will not accept his instructions because of the irrevocable designation of the beneficiaries. Article 81 of the Swiss insurance law provides that if a policyholder has made a revocable designation of spouse or children as beneficiaries, they automatically become policyholders and acquire all rights if the policyholder is declared bankrupt. In such a case the original policyholder therefore automatically loses control over the policy and also his right to demand the liquidation of the policy and the repatriation of funds. A court therefore cannot compel the policyholder to liquidate the policy or otherwise repatriate his funds. If the spouse or children notify the insurance company of the bankruptcy, the insurance company will note that in its records. Even if the original policyholder sends instructions because a court has ordered him to do so, the insurance company will ignore those instructions. It is important that the company be notified promptly of the bankruptcy, so that they do not inadvertently follow the original policyholder's instructions because they weren't told of the bankruptcy. If the policyholder has designated his spouse or his children as beneficiaries of the annuity, the insurance policy is protected from his creditors regardless of whether the designation is revocable or irrevocable. The policyholder may therefore designate his spouse or children as beneficiaries on a revocable basis and revoke this designation before the policy expires if at such time there is no threat from any creditors. These laws are part of fundamental Swiss law. They were not created to make Switzerland an asset protection haven. There is a current fad of various offshore islands passing special legislation allowing the creation of asset protection trusts for foreigners. Since they are not part of the fundamental legal structure of the country concerned, local legislators really don't care if they work or not -- the fees have already been collected. And since most of these trusts are simply used as a convenient legal title to assets that are left in the U.S., such as brokerage accounts, houses, or office buildings, it is very easy for an American court to simply call the trust a sham to defraud creditors and ignore its legal title -- seizing the assets that are within the physical jurisdiction of the court. Such flimsy structures, providing only a thin legal screen to the title to local property, are quite different from real assets being solely under the control of a rock-solid insurance company in a major industrialized country. A defendant trying to convince a local court that his local brokerage account is really owned by a trust represented by a brass-plate under a palm tree on a faraway island is not likely to be successful -- more likely the court will simply seize the asset. But with the Swiss annuity, the insurance policy is not being protected by the Swiss courts and government because of any especial concern for the foreign investor, but because the principle of protection of insurance policies is a fundamental part of Swiss law -- for the protection of the Swiss themselves. Insurance is for the family, not something to be taken by creditors or other claimants. No Swiss lawyer would even waste his time bringing such a case. Swiss annuities help the international entrepreneur to minimize the risk, by diversifying some of his assets into a secure investment. They are heavily regulated to avoid any potential funding problem. They denominate accounts in the strong Swiss franc, compared to the weakening dollar. And the annuity payout is guaranteed. Swiss annuities are exempt from the famous 35% withholding tax imposed by Switzerland on bank account interest received by foreigners. Annuities do not have to be reported to Swiss or foreign tax authorities. A U.S. purchaser of an annuity is required to pay a 1% U.S. federal excise tax on the purchase of any policy from a foreign company. This is much like the sales tax rule that says that if a person shops in a different state, with a lower sales tax than their home state, when they get home they are required to mail a check to their home state's sales tax department for the difference in sales tax rates. The U.S. federal excise tax form (IRS Form 720) does not ask for details of the policy bought or who it was bought from -- it merely asks for a calculation of 1% tax of any foreign policies purchased. This is a one time tax at the time of purchase; it is not an ongoing tax. It is the responsibility of the U.S. taxpayer, to report the Swiss annuity or other foreign insurance policy. Swiss insurance companies do not report anything to any government agency, Swiss or American -- not the initial purchase of the policy, nor the payments into it, nor interest and dividends earned. A Swiss franc annuity is not a "foreign bank account," subject to the reporting requirements on the IRS Form 1040 or the special U.S. Treasury form for reporting foreign accounts. Transfers of funds by check or wire are not reportable under U.S. law by individuals -- the reporting requirements apply only to cash and "cash equivalents" -- such as money orders, cashier's checks, and travellers' checks. Swiss annuities can be placed in a U.S. tax- sheltered pension plans, such as IRA, Keogh, or corporate plans, or such a plan can be rolled over into a Swiss-annuity. Investment in Swiss annuities is on a "no load" basis, front-end or back-end. The investments can be canceled at any time, without a loss of principal, and with all principal, interest and dividends payable if canceled after one year. (If canceled in the first year, there is a small penalty of about 500 Swiss francs, plus loss of interest.) Although called an annuity, these plans act more like a savings account than a deferred annuity. But it is operated under an insurance company's umbrella, so that it conforms to the IRS' definition of an annuity, and as such, compounds tax-free until it is liquidated or converted into an income annuity later on. The only way for North Americans to get information on Swiss annuities is to send a letter to a Swiss insurance broker. This is because very few transactions can be concluded directly by foreigners either with a Swiss insurance company or with regular Swiss insurance agents. So far one firm specializes in dealing with English speaking investors, and everybody in the firm speaks excellent English. They are also familiar with U.S. laws affecting the purchase of Swiss annuities. Contact: Mr. Jurg Lattmann, JML Swiss Investment Counsellors, Dept. 212, Germaniastrasse 55, 8033 Zurich, Switzerland; telephone (41-1) 363-2510; fax: (41-1) 361-4074, attn: Dept. 212.