Article 1 | Geoffrey S. Mitchell

ARTICLE 1

OFFSHORE BUSINESS, OFFSHORE FUNDS AND U.S. TAX AVOIDANCE

Introduction

U.S. Persons are subject to tax on their worldwide income.

Despite being hidden or disguised, the income and assets of U.S. persons are still subject to U.S. tax. Taxpayers should be aware that abusive offshore arrangements will not produce the tax benefits advertised by their promoters and that the IRS is actively examining these types of arrangements. Furthermore, taxpayers and/or the promoters of these offshore arrangements may be subject to civil and/or criminal penalties.

In recent years, a significant increase in offshore activity has been noted among U.S. taxpayers. Numerous schemes have been devised in which the true ownership of income streams and assets is hidden or disguised so as to improperly shield substantial amounts of financial activity from the U.S. tax system.

Such offshore transactions generally involve foreign jurisdictions that offer financial secrecy laws in an effort to attract investment from outside their borders. These jurisdictions are commonly referred to as “tax havens” because, in addition to the financial secrecy they provide, they require little or no taxation of income from sources outside their jurisdiction.

Abusive Promotions

In contrast to their legitimate roles, foreign entities are increasingly being promoted as a means to divert income and conceal assets for taxpayers who have no real operations in a foreign country.

In addition to preferential tax regimes and protection against creditors, most tax havens also offer strict laws against disclosure of banking and business records. Generally, these nations do not have income tax treaties with the United States, and tax evasion is not considered a criminal act subject to Mutual Legal Assistance Treaties. Promoters of many abusive offshore schemes rely on the difficulty of access to records of tax haven banks, attorneys, and trustees. Furthermore, in the absence of government scrutiny, some offshore banks, attorneys, trustees, and other service providers have been known to falsify or fabricate records.

Schemes Watched by the I.R.S.

Offshore Deferred Compensation Arrangements

Many highly compensated professional persons and business owners in the U.S. have been solicited to participate in “offshore deferred compensation plans.” The U.S. taxpayer is encouraged to sever an existing employment relationship and substitute an arrangement in which the nominal employer is a foreign “employee leasing” company. The supposed result of this abusive arrangement is that the taxation of a large portion of the professional’s or business owner’s salary is deferred while he/she gains immediate access to the funds through loans or offshore-based credit cards. An improper deduction for employee leasing expenses is also created on the corporate tax return.

Renunciation of U.S. Citizenship

One method used by taxpayers to avoid U.S. tax has been “expatriation” (the renunciation of one’s U.S. citizenship or resident status and establishment of permanent residence outside the U.S.). However, even when taxpayers become “expatriates” they are still subject to taxation under special rules if the primary purpose for their expatriation was tax avoidance. (IRC § 877)

Fictitious or Overstated Invoicing

Some U.S. taxpayers have entered into schemes in which the taxpayer’s U.S. business is billed by a purportedly unrelated offshore entity for goods or services (e.g., “consulting services”) that are either nonexistent or overvalued.

Factoring of Accounts Receivable

A U.S. taxpayer’s business may discount or “factor” its receivables to a purportedly unrelated foreign business entity. The discount or factoring fee significantly reduces U.S. tax liability, and is moved to an offshore entity where it can either be invested free of U.S. tax or repatriated for the taxpayer’s use and enjoyment.

Abusive Insurance Arrangements

Some promoters have devised arrangements that are characterized as insurance arrangements, giving rise to a deduction for the U.S. taxpayer for “premiums” paid to a purportedly unrelated offshore insurance company. Often these arrangements are merely self-insurance, lacking in real transfer of risk.

Shifting of Income Using Offshore Private Annuities

Some promoters suggest that U.S. taxpayers may avoid or substantially defer tax on income streams or capital gains by exchanging property for an unsecured private annuity. In another abusive scheme an offshore private annuity is used in conjunction with an offshore variable life insurance policy as a devise to “decontrol” a foreign corporation or other entity used in an abusive sequence of transactions. As a result the promoter claims that the foreign corporation or entity is owned by the insurance policy and is not a, controlled foreign corporation, passive foreign investment company, or any entity controlled by a U.S. person whose income could be taxed in the United States to its owner.

Offshore Internet Business

For businesses conducted primarily through the internet, promoters offer “kits” which give the appearance that the business is foreign owned and operated. Transactions may be routed through offshore servers, and business receipts may be collected through offshore bank accounts or credit card merchant accounts. These schemes particularly target businesses that offer delivery of computer software and other digital products such as music, pictures, or video. They may also provide a means of operating offshore gaming activities.

Offshore Wagering

Over the last few years, gambling websites have proliferated on the Internet. Many of these virtual casinos are organized and operated from offshore locations, where the operators feel free from State and Federal interference. The operators of these activities may suggest that players in the U.S. are not subject to tax on their winnings, and may handle collections and disbursements in ways designed to facilitate avoidance of U.S. taxes.

Repatriation of Offshore Funds Using Credit Cards

Credit cards (such as MasterCard and VISA) issued by tax haven domiciled banks are a preferred method used by U.S. taxpayers to anonymously and covertly repatriate offshore funds that may or may not have been previously taxed. American Express cards are used in the same way but differ in that these cards are issued directly by American Express rather than by member

U.S. Tax Returns Require Information on Foreign Activity

Numerous information returns are required with respect to the conduct of certain foreign activities by U.S. citizens, residents, and other entities. Such activities include:

U.S. person creates or transfers assets to a foreign trust
U.S. person receives certain foreign gifts

U.S. person is treated as the “owner” of a foreign trust

U.S. person owns 10% of a controlled foreign corporation or a partnership
U.S. corporation is 25% or more “foreign-owned”
U.S. person transfers assets to a foreign corporation

Types of Offshore Entities of Interest to the IRS

The Abusive Tax Scheme Program is concerned about taxpayers who exploit secrecy laws of offshore jurisdictions in an attempt to conceal assets and income subject to tax by the United States.

Some different types of entities and schemes being used in Abusive Offshore Tax Schemes include:

Foreign trusts
Foreign corporations
Foreign (offshore) partnerships, LLCs and LLPs
International Business Companies (IBCs)
Offshore private annuities
Private banking (U.S. and offshore)
Personal investment companies
Captive insurance companies
Offshore bank accounts and credit cards
Related-party loans

Abusive schemes usually create structures that make it appear a nonresident alien or foreign entity is the owner of assets and income, when in fact and substance, true ownership remains with a U.S. taxpayer.

Taxpayers may utilize a variety of devices to conceal transfers of money or other property to a foreign entity, where the income it generates may be hidden. The simplest method of diverting income is sending skimmed income to an offshore account or entity. Other methods used to transfer money or other property offshore include the use of payments disguised as deductible expenses (for example, rents or purchases) that are paid to entities controlled by the taxpayer and generally located in a tax haven jurisdiction.

Taxpayers may fabricate sales of property to a foreign entity that they control, perhaps in exchange for a note of which they do not expect repayment. This gets title to the property – and its future earnings – offshore. In some cases, taxpayers may purchase nonexistent equipment from a tax haven corporation controlled by a related entity. Taxpayers then often improperly claim depreciation on payments really made to themselves.

Once money or title to property is moved offshore, the taxpayer can continue to manage it with ease using sophisticated means of communication and funds transfers. Some tax haven banks, trust companies, attorneys, and accountants operate virtual factories making false documents to create paper trails to confound auditors. A taxpayer or his foreign representative can easily create front corporations inside or outside the United States to carry out the taxpayer’s instructions. For example, one Cayman banker explained how his bank could credit checks made payable to U.S. dummy corporations to a customer’s offshore account. These dummy corporations are set up for that purpose so that the checks would clear through the offshore bank’s correspondent account at a U.S. bank with no evidence the funds were credited elsewhere.

Representations of foreign entities may be entirely fictitious. An example involved the Bank of Credit and Commerce International (BCCI), which recorded many large transactions with its Bahamas branch. In fact, BCCI had no charter in the Bahamas and no presence there. The Bahamas Branch was merely a “cyber bank”, a separate set of books kept on a BCCI computer in Miami.

Methods Of Repatriating Funds Watched by the IRS:

Credit cards which simply draw on the U.S. taxpayer’s offshore account
Loans from mystery offshore lenders
Loans from domestic lenders in amounts beyond the taxpayer’s apparent borrowing power (may be secured by offsetting deposits of offshore funds)
Use of property titled to offshore entities at zero or below-market rental
Bogus transactions designed simply to transfer funds to or from offshore entities, such as sales of property to offshore entities in jurisdictions where it is unlikely the property will actually be used or sold
Gifts
Scholarships for taxpayer’s children
Payable Through” accounts

Promoters Schemes

Promoters of such schemes may offer comprehensive management services that include bookkeeping and return preparation. Or, the promoter may simply create initial documents that create a “paper shield” behind which the taxpayer/client can control everything.

Certain promoters are candid with their clients, acknowledging the scheme depends on fictitious arrangements designed to mislead the IRS. Others unscrupulously sell their clients on the idea that the arrangement legally permits avoidance of tax liability. Such promoters may point to case law and show the client how their arrangement avoids the pitfalls of previous schemes.

Keep in mind the promoter does not have to convince the IRS; just convince the client long enough to make the sale. Once a taxpayer has entered into an abusive scheme, it may be difficult to get out of it. Consequently, the taxpayer may rely heavily on the promoter for advice, and even representation, when confronted with an IRS examination.

The growth of Internet promotions has led increasing numbers of middle-income taxpayers into such arrangements. Even though the dollar amounts involved are usually smaller, the growth in numbers of taxpayers represents a serious compliance problem.

Tax Havens

Abusive offshore transactions generally involve foreign jurisdictions that offer financial secrecy laws in an effort to attract investment from outside their borders. These jurisdictions are commonly referred to as “tax havens” because, in addition to the financial secrecy they provide, they impose little or no tax on income from sources outside their jurisdiction.

It is difficult to quantify the amount of assets being held offshore or the rate at which the industry is growing. But it has been estimated that some $5 trillion in assets worldwide is held “offshore” in tax havens. Presumably, transfers from the U.S. represent a large share of this wealth. One authority has estimated the annual revenue loss to the U.S. at a minimum of $70 billion.

Tax haven service providers and their clients know their actions are veiled from tax authorities by banking and commercial secrecy laws and by lack of tax treaties or tax information exchange agreements. They create paper entities to disguise the real parties to the transactions, and many are willing to create false documents to disguise the real nature of transactions.

At least 40 countries aggressively market themselves as tax havens. Some have gone so far as to offer asylum or immunity to criminals who invest sufficient funds. They permit the formation of companies without any proof of identity of the owners, perhaps even by remote computer connection. Generally, though, such extremes are found in emerging nations where the stability and security of the financial, legal, and political systems is questionable.

The largest concentrations of assets are attracted to the stable, secure environments of the established tax havens – those that have existed a number of years, and enjoy the diplomatic protection of former colonial powers.