Tax havens and their use by the rich, famous, or by large corporations are often the subject of controversy in the media, particularly since the beginning of the current economic and financial crisis. Because of their opacity, they are frequently blamed to host criminal activities and tax evasion.
However, is it possible to use tax havens in a totally legal way?
The answer is yes, but it will be only interesting in very specific cases. Of course, it is possible to form and own an offshore company without breaking the law, by reporting all their profits in one’s personal tax return in the country of residence. The problem is that, in many cases, the tax treatment of these profits wouldn’t be favourable at all, because of certain “anti-circumvention” measures that exist for many countries and, which try to make tax haven investments unattractive. The most well known are the so-called “CFC (controlled foreign corporations) rules” which treat offshore companies as transparent or “disregarded” entities. What does this mean? Basically, that any profit obtained by the company is attributed directly to the owner, regardless of whether or not dividends are distributed or capital is repatriated to the country of residence. Under these circumstances, incorporating an offshore company would not provide any tax advantage and be may be quite useless. Of course, unless it is formed for non-tax-related reasons such as such as privacy, asset protection or portfolio risk reduction through global investment.
So then, who can take advantage of tax havens without incurring a tax evasion? Generally, four distinct groups:
- The first would consist of natural or legal persons residing in a country with a territorial taxation system. Such states tax their citizens only for those profits obtained within its own territory, while all foreign source income being tax exempted. This kind of system can be found in countries like Hong Kong, Singapore, Panama and Uruguay, to name a few.
- The second group are the residents in countries that have not yet developed proper anti-circumvention rules in their legislation. This allows owners of offshore companies to defer tax payments, and be taxed solely on those profits that they decide to repatriate to their home countries. Most industrialized nations have “CFC rules” in their legislation, but there are still a number of developing nations that either has no such rules, or they are in very early stage of implementation. As part of this group, we could mention certain countries in Africa, Central America or Asia.
- The third group would be made up from individuals who have taken up residence in countries that offer tax advantages to those who reside more or less permanently within their territory, but conduct their business in other parts of the world. Here we could mention certain residency by investment or so-called economic citizenship programmes” as the ones existing in countries such as Malta, Dominica, St. Kitts & Nevis and so on. A well known example is also the UK “non-dom” status.
- In the fourth and last group, we would have those investors who are not affected by “CFC rules” as they are considered not to have enough voting power or control over an offshore company to decide about profit or dividend distribution. Generally, anti-circumvention legislation only applies to persons or entities that control 50% or more of the share of an offshore company, either directly or through other related persons. It doesn’t apply to minority shareholders, because otherwise they would be forced to pay taxes on profits which even may not have been distributed yet. This minority shareholder exemption can be enjoyed by virtually any offshore company that has three or more shareholder having less than 50% voting power each. In that case the owners will only pay taxes on those profits distributed as a dividend, being able to indefinitely defer taxation for all income which is kept inside the company as retained earnings. Those funds may also be re-invested in the same or other tax-free offshore jurisdictions. This is one of the exceptions to the application of CFC rules which allows many multinationals, having a large number of shareholders, to use tax heavens extensively for aggressive tax planning.
All this shows that, despite the generalization of “CFC rules,” there are still a large number of companies or individuals who can benefit from tax havens in a perfectly legal way.