In business, people often talk about offshore ventures and the advantages associated within offshore investment. But what exactly is meant by doing business ‘offshore’ and why do so many businesses and individuals invest money, move assets and incorporate companies in these foreign jurisdictions?
Over the last decade the media and political spotlight has begun to focus heavily on the hoards of cash that U.S. corporations are stockpiling offshore. In 2014, a securities filings review by Bloomberg revealed that U.S. multinationals had stockpiled $2,100,000,000 ($2.10 trillion) in profits overseas to avoid taxes. Tax avoidance is the legal usage of tax regimes to reduce the amount of tax payable. Several loopholes exist both domestically and internationally that hundreds of U.S. corporations take advantage of to great effect.
"U.S. multinationals have stockpiled $2,100,000,000,000 (2.10 trillion) in profits overseas to avoid taxes"
In a world where global trade and investment is expanding at a rapid rate, it is important to understand these issues. Businesses and individuals are looking at how offshore financial centers can benefit them and lawyers are increasingly being asked to advise on the advantages that can be gained from such opportunities.
So what is an offshore financial center?
There is no agreed definition of what constitutes an offshore financial center. Tolleys, a leading global tax guide, has sought to define them as the politically correct term for what used to be known as tax havens. An IRS publication in 1981 famously stated that "a country is a tax haven if it looks like one and if it is considered to be one by those who care". These are not particularly helpful definitions and impart connotations of money laundering and tax evasion. They are also somewhat misleading in the modern day in light of increased regulation in the offshore world as well as extensive mutual assistance treaties and intergovernmental agreements that have enhanced transparency and compelled tax reporting from foreign financial institutions.
Generally speaking, it is accepted that an offshore financial center is a country that satisfies the following criteria.
- Relatively small jurisdiction
- Low or no tax
- Specializes in commercial and corporate services
- Offers those services to non-residents
- Focuses on investment and asset protection
These countries also share common characteristics that have been important factors in their recognition as leading offshore financial centers. They usually have politically stability, a respected legal and judicial system, low regulation and experienced professionals. It is for this reason that several offshore financial centers are British Crown dependancies, British overseas territories or former parts of the British empire.
Where are these financial centers?
The most common offshore financial centers include Bermuda, Cayman Islands, British Virgin Islands, Bahamas, Hong Kong, Singapore, Luxembourg, Switzerland and Panama. Ireland and New Zealand are also becoming more prominent in the offshore market, despite traditionally being regarded as primary jurisdictions. Even the U.S. state of Delaware is regularly seen as an offshore financial center given the disproportionate number of companies that are incorporated in the state.
"The Cayman Islands has no income tax, no corporation tax, no inheritance tax and no capital gains tax."
Each of these jurisdictions is prominent in one or more of the major offshore markets. The Cayman Islands has no income tax, no corporation tax, no inheritance tax and no capital gains tax. It leads the collective investment market thanks to its accommodating mutual funds legislation. It is estimated to house about 75% of the world’s hedge funds and nearly half the industry's projected $1.1 trillion of assets under management. It is also a major player in the captive insurance market. The Bahamas and Panama lead the market in registered vessels while the British Virgin Islands is the registered home to the largest number of offshore companies in the world (roughly 600,000). The British Virgin Islands has approximately 30 registered companies per capita, which is the highest ratio of any country.
Switzerland has more recently focused on tax exemptions and Singapore is rapidly becoming a leader in private banking, hedge funds and wealth management. Bermuda leads the captive insurance market and has established a growing presence in the primary insurance market, an industry not traditionally associated with offshore centers, becoming the third largest in the world. It is also popular for fund management and aircraft registration. Ireland offers a competitive 12.5% corporate tax rate and provides attractive legislation that allows companies incorporated there to obtain an effective tax rate closer to 2% by utilizing its territorial tax regime.
"The British Virgin Islands has approximately 30 registered companies per capita, which is the highest ratio of any country."
The management of subsidiaries, or shell companies as they are often referred to, is well illustrated by Ugland House, a five-story office building in the Cayman Islands that is the registered office for 18,857 companies. Like many other offshore jurisdictions, the Cayman Islands levies no income taxes on companies incorporated in the country. Simply by registering subsidiaries in the Cayman Islands, U.S. companies can take advantage of the Cayman Islands' tax regime and pay no tax on their foreign earned income. They may also be able to utilize accounting loopholes so that portions of U.S. earned income can be recorded as being earned in the Caymans.
Can U.S. businesses legally avoid or reduce their taxes by setting up companies offshore?
The U.S. worldwide system of corporate taxation requires multinational corporations to pay taxes twice, first to the foreign country in which they do business and then to the IRS once they repatriate their profits. U.S. businesses are required to pay the 35% federal corporate tax rate on their income no matter where it is earned - domestically or abroad.
Corporations operating in foreign countries pay income taxes to the country in which those profits were earned. For example, if a subsidiary of a U.S. company earns $100 million in profits in Singapore, it pays the Singapore corporate income tax rate of 17% (or $17 million) on those profits. When those profits are brought back to the U.S., an additional tax equal to the difference between the U.S. tax rate of 35% and the Singapore corporate rate of 17% ($18 million in this case) is collected by the IRS. Between the two nations, the U.S. company will have paid a total of $35 million, or 35%, in taxes on its foreign profits. If a U.S. company that was incorporated in the Cayman Islands earned $100 million, it would not pay any corporate tax to the Cayman Government, as there is no corporation tax in the jurisdiction. The company would however be liable for the full 35% federal corporate tax when it brings the funds into the U.S.
U.S. companies can delay paying U.S. tax on their foreign profits choosing instead to pay the additional tax when the profits are eventually repatriated. If the business does not need to bring the profits of its foreign business back in to the U.S., it is able to defer its tax liability until such time that is chooses to repatriate the money and can instead utilize the funds offshore, paying no or nominal tax to a foreign government. Large companies can reinvest the money to expand their global business and some are said to have used sophisticated methods of exploiting tax code to invest the money held by offshore subsidiaries in U.S. assets and securities.
General Electric leads the long list of U.S. corporations that store cash offshore, currently holding $119 billion overseas. However, in terms of recent performance, it was Microsoft and Apple that stacked up the most foreign profits offshore in 2014. The eight largest tech companies, including Microsoft Corp., Apple Inc., Google Inc., and IBM Corp. account for more than a fifth of the $2.1 trillion currently being stockpiled offshore by U.S. corporations. Last year alone saw the eight largest tech giants amass $69 billion in offshore profits.
Bloomberg has reported that Apple generated $23.3 billion in offshore profit during 2014, the vast majority of which is held by Irish subsidiaries. That amounts to the entire annual budget for both the Department of Transportation and the Social Security Administration. Microsoft generated even more foreign profit, raking in $29 billion, all of which is stockpiled offshore.
Last year President Obama proposed applying a 14% mandatory tax on the stockpiled profits and a 19% minimum tax on foreign earnings going forward. The one-time tax would generate $268 billion over six years, which Obama wants to use for infrastructure. Obama’s plan hasn’t advanced in Congress, amid Republican objections, and it appears that the current tax loopholes are here to stay, at least for the short-term future.
"General Electric currently leads the long list of U.S. corporations that store cash offshore, currently holding $119 billion overseas."
As most small and medium sized businesses rely on the profits of foreign earned income, they do not have the luxury of keeping the profits offshore. Such an arrangement also prevents companies from using the funds to pay dividends to its shareholders.
Despite not being able to reduce their tax liability per se, large U.S. multinationals regularly structure their businesses so that they may take advantage of offshore tax regimes, allowing them to avoid U.S. tax and reinvest the funds to further global business expansion. It would seem that the U.S. corporations with offshore stockpiles are waiting for a government incentive to repatriate their cash, as was the case in 2004 when a law was passed that gave companies a voluntary repatriation holiday with a 5.25% tax rate. President Obama and top Republicans on the tax-writing committee have stated there would not be a repeat of the 2004 law, but it would not be surprising to see some form of incentive to be tendered to attract large multinationals to bring home some of the $2.1 trillion currently sitting offshore.
So what are the benefits of incorporating, registering or investing in an offshore financial center?
With tax reduction being a benefit that can only truly be enjoyed by corporations with substantial foreign profits, why would businesses or individuals look to set up a company, fund or trust offshore?
Asset Protection - Wealthy individuals who live in politically unstable countries utilize offshore companies or set up foreign trusts to hold family wealth to avoid potential expropriation in the country in which they live. Trusts are also widely used by many, including U.S. citizens, to prevent their assets from being seized by creditors or becoming subject to lawsuits. Given that U.S. courts can assert jurisdiction over assets located within the U.S., it is wise to ensure that any assets an investor is looking to protect by utilizing offshore laws are not physically held within U.S borders.
Avoidance of forced heirship provisions - Many countries from France to Saudi Arabia (and the U.S. State of Louisiana) continue to employ forced heirship provisions in their succession law, limiting the testator's freedom to distribute assets upon death. By placing assets into an offshore corporation, and then having probate of the shares determined by the laws of the offshore jurisdiction (usually in accordance with a specific will or codicil sworn for that purpose), the testator can sometimes avoid such restrictions.
Collective Investment Vehicles - Mutual funds, hedge funds and private equity funds are formed offshore to facilitate international distribution. By being domiciled in a low tax jurisdiction, investors from around the world only have to consider the tax implications of their own domicile or residency. This makes the management and distribution of these funds significantly easier and more cost effective.
"High-profile investors do not want rivals or the public knowing what stocks they're investing in."
Confidentiality - Most offshore financial centers give the benefit of secrecy legislation or a form of conditional relationship law. These laws provide investors and shareholders with the privacy protection afforded under strict corporate and banking confidentiality. Breaching these laws can have serious consequences for the offending party. Disclosing information in relation to an account holder is a breach of banking confidentiality and disclosing information about shareholders is a breach of corporate confidentiality. It is often wrongly perceived that those corporations and individuals who rely on these banking secrecy and confidentiality laws are criminals seeking to hide their actions. But the reality is that many high-profile investors can gain a substantial economic advantage keeping their identity secret while accumulating shares of a public company. High-profile investors do not want rivals or the public knowing what stocks they're investing in. If they did, they could lose a significant commercial advantage as smaller investors buy the same stocks that they have targeted for large volume share purchases, which drives up the price. Despite the strict enforcement of these confidentiality laws, where there is clear evidence of drug trafficking, money laundering or other illegal activities, the regulators and judicial systems will not serve to protect offending parties.
Diversification of Investment – Regulators in some countries, including the U.S., restrict the investment methods and opportunities of citizens, much to the frustration of investors who are seeking to diversify their investments and manage them in such a way that allows them to take advantage of market conditions without regulatory interference. Funds and accounts registered offshore are much more flexible, in many cases allowing investors unlimited access to international markets and to all major exchanges. There are no restrictions on investment objectives or trading strategies. Importantly, investors are free to take advantage of opportunities in developing nations, particularly those that are privatizing industries previously run by the state. China's decision to privatize some sectors has investors lining up to invest in the world's largest consumer market. Africa is also attracting substantial foreign investment in its private sectors (technology, retail and business services) and its former state-run industries.
In conclusion, as global trade and investment increases, there is a greater need to understand the services, key legislation and opportunities available in offshore financial centers. The offshore world does not necessarily present the direct tax reductions with which they are often associated (at least not for U.S. citizens and U.S. corporation), but they do offer significant benefits. Most notably, more and more U.S. corporations are engaging in offshore corporate restructuring to increase net profit margins and develop their global operations, while growing numbers of investors are turning to offshore registered funds to benefit from the greater opportunities available in global markets, free from the burdensome U.S. regulatory framework and protected by confidentiality laws.
Content prepared by Richard Parry. © Richard Parry, 2015
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