Tax Havens—Shelter or Shoulder?

Taxpayers frequently wonder whether they can move certain assets to a tax haven country to avoid U.S. income tax on the income and gains. In most cases, this is not possible; U.S. tax rules contain three main weapons to prevent taxpayers from avoiding tax on income earned in a tax haven country.

According to Black’s Law Dictionary (Westlaw, 7th ed., 1999), a “tax haven” is “a country that imposes little or no tax on the profits from transactions carried on from that country.” Countries that meet this definition include the Cayman Islands, Bermuda, the Bahamas, the British Virgin Islands, Liechtenstein, Belize and the Netherlands Antilles, etc. However, according to the definition, other countries could also be considered tax havens. For instance, Ireland’s corporate tax rate is only 12.5% on trading income. When compared with other countries in the European Union or with the U.S., this rate is very low.

Playing by the Rules

There are several reasons why U.S. taxpayers cannot reduce or eliminate U.S. income tax by establishing and funding a corporation in a tax haven.

Example 1: A U.S taxpayer, J, with a substantially appreciated stock portfolio, transfers it to Corp. B, in the Bahamas, to avoid tax on the future income and gains.

The first problem is that the transfer of the stock portfolio triggers U.S. income tax on the transfer. Under Sec. 351, an asset transfer to a controlled corporation in exchange for its stock is generally a nontaxable transaction; the taxpayer recognizes neither gain nor loss on the exchange. Sec. 351 applies whether the controlled corporation is domestic or foreign. However, Sec. 367, an anti-avoidance rule, forces the taxpayer to recognize gain on a transfer to the foreign corporation, with some limited exceptions. Thus, under U.S. tax law, the transfer will trigger U.S. income tax to the extent the fair market value (FMV) of the securities transferred exceed the taxpayer’s basis. This could be a significant up-front cost to the taxpayer’s overall avoidance plan.

What if J was to transfer securities with a basis equal to their FMVs, or was to transfer cash? The initial cost would be minimized or eliminated. However, as mentioned above, U.S. income tax law provides three main tax regimes to prevent U.S. taxpayers from avoiding income tax on income earned (including capital gain) in a tax haven—the foreign personal holding company (FPHC) rules, subpart F rules and passive foreign investment company (PFIC) rules.

FPHCs. Secs. 551–558 contain the FPHC rules. Sec. 552 would classify a foreign entity as a FPHC if the entity was controlled (i.e., more than 50% owned) by five or fewer U.S. individuals and the majority (i.e., 50% (60% in the first year)) of its income is FPHC income (as defined in Sec. 553). In general, FPHC income is passive income, such as interest and dividends. If a U.S. taxpayer’s tax-haven-country entity is deemed to be a FPHC, the taxpayer will be subject to U.S. income tax on all of the entity’s income, whether or not such income is actually distributed.

Subpart F. The subpart F rules are in Secs. 951–964. Under subpart F, certain types of income are taxed currently to a foreign corporation’s U.S shareholders who meet an ownership threshold. Under Sec. 951(b), any U.S person who owns at least 10% of such entity meets this threshold. The passive income of the tax-haven corporation (e.g., interest, dividends and capital gains) would be a type of subpart F income. The major difference between the FPHC rules and the subpart F rules is that there is no 50% (or 60%) gross income threshold. The subpart F rules apply at a much lower percentage (generally, more than 5%) of passive income, under Sec. 954(b)(3)(A). If these rules apply, only the subpart F income would be taxable currently as a deemed dividend (whether or not actually distributed).

Example 2: The facts are the same as in Example 1. B is an active business in the Bahamas and earns $5,000 of interest from a bank account located there. Its gross income in the Bahamas is $195,000. Because B’s subpart F income (interest income) is less than 5% of its total gross income ($5,000/$200,000 = 2.5%), none of its interest income will be treated as subpart F income. Because the interest income is not subpart F income, J does not have to include the $5,000 of interest income as a deemed dividend on her U.S. income tax return.

Example 3: The facts are the same as in Example 1, except B is not an active business. Its only income is the $5,000 of interest income.

In Example 3, the interest would be taxed on J’s U.S. income tax return, whether or not B distributes the income. This is why the FPHC and the subpart F rules are often referred to as the “anti-deferral” rules.

In Example 2, J can defer income under the subpart F rules, because the passive income does not exceed the threshold. However, this analysis is not yet complete, because of the PFIC rules.

PFICs. The PFIC rules are in Secs. 1291–1298, and apply to any foreign company that meets an income test or an asset test. The Sec. 1297(a)(1) income test is met if 75% or more of the foreign entity’s income is passive (e.g., interest and dividends). A foreign entity meets the Sec. 1297(a)(2) asset test if 50% or more of its assets generate passive income. The consequences of PFIC treatment are quite severe and include the following:

• If a PFIC distributes a dividend to its U.S. shareholders, an interest charge will be assessed for the tax-deferral period, in addition to U.S. income tax due.

• The interest charge applies if a shareholder sells his or her PFIC stock.

• There is no basis step-up in the shares on the shareholder’s death, for estate tax purposes.

There are many other tax complexities relating to the PFIC regime that are beyond the scope of this item. Needless to say, the PFIC rules are extremely complex.

If J established B after 1997, the PFIC rules will not apply; the subpart F rules override them for such entities; see Sec. 951(f).

Using a Tax-Haven Company

Thus far, the rules above would prevent a U.S taxpayer from achieving a legitimate deferral under the U.S. tax rules. There are, however, instances in which a taxpayer can use a tax-haven entity to defer (but not permanently avoid) U.S. income tax.

Example 4: Corp. X, a U.S. corporation, with valuable intangible assets, creates subsidiary Y, in the Bahamas. X has not been exploiting these intangibles outside the U.S., but decides Y will buy the rights to exploit the intellectual property in this manner.

The price Y paid will usually be determined under the Sec. 482 cost-sharing rules and the transfer-pricing regulations. Because X never exploited the non-U.S. rights, the cost to purchase the intellectual property could be relatively low.

Y, now the owner of the non-U.S. intellectual property rights, earns the income from the sales of these products outside the U.S. The income is not subject to U.S. income tax until Y distributes the income back to X as a dividend. Because the Bahamas does not have a corporate income tax, the income earned is not taxed there, resulting in an effective tax rate of zero. The remaining amount of income that Y retains can be used to expand its business outside the U.S. This tax strategy works best for businesses with rapidly changing technology or for companies that have not previously marketed their products outside the U.S.

Conclusion

The average taxpayer will find it difficult to effectively use tax-haven entities to defer U.S. income taxes. However, if a corporation aspires to sell its products overseas, some planning techniques may permit it to defer U.S. income tax on that business.

From Robert A. Verzi, CPA, Cherry, Bekaert & Holland, LLP, Greenville, SC