International Tax Loopholes – The Playing Field Is Not Level

 A recent Bloomberg article reported that the offshore cash hoard of U.S. multinational companies had risen by $206 billion last year as the companies continued to avoid U.S. taxation (see article here http://www.bloomberg.com/news/2014-03-12/cash-abroad-rises-206-billion-as-apple-to-ibm-avoid-tax.html).  Personally, I find it amazing that the popular press and its American readership see prudent corporate tax planning as some sort of illicit tax dodge.  Nevertheless, the thing that surprised me the most was that many of my clients read the article and called or wrote me asking why they too are not utilizing the same “loophole” that Apple and General Electric are gaming.  My surprise was not that these honest business people wanted to engage in the same activity being portrayed in the press as scandalous (after all, everyone loves a loophole), I was surprised that they didn’t understand why the law worked for Apple but not for them.

The simple truth is, as my mother would say over and over again to me and my siblings when we were young, “life is not fair.”  If you are a large U.S. based multinational manufacturing, technology, pharmaceutical or financial company, you can isolate profits in low-tax, offshore jurisdictions.  Those profits will not be currently taxed in the U.S.  You are free to use the profits to grow your businesses outside the U.S. but you can’t send the money back to the U.S. (not even as a loan) or use the cash to benefit the U.S. business without incurring current tax in the U.S.  However, if you are a domestic hedge fund manager (or just a U.S. citizen with a large amount of investable assets), you are not afforded the same tax deferral opportunities.  You see, investment income and investment management fees, are not the right “type” of income for deferral.

In 1962, as the U.S. economy really started to become global in nature, the Kennedy administration decided they needed to take action to curb the erosion of the U.S. tax base.  Prior to that time the U.S. operated on a more territorial tax system where only domestic profits were taxed in the U.S.  Corporate subsidiaries operating outside the U.S. did not subject their profits to U.S. taxation unless and until such profits were repatriated.  Following World War II, U.S. corporations became much more open to the idea of operating on a global basis and with that jurisdictional expansion came prudent tax planning.  U.S. corporations isolated non-U.S. profits in corporate subsidiaries set up in low or no tax jurisdictions.  By 1960 the issue had grown large enough to cause a noticeable erosion of the U.S. tax base.  The Kennedy administration proposed a groundbreaking change – global taxation.  American people and companies would be taxed on income earned anywhere in the world.  As you might expect, those with lobbying dollars at hand put them to work.  The paid for compromise is now known as Subpart F. 

Under Subpart F, “legitimate business” profits earned by corporate subsidiaries outside the U.S. are not currently taxed in the U.S. and continue to be treated much like they were pre-1962.  All other income, also known as “Subpart F income”, earned by corporate subsidiaries is taxed currently in the U.S., even if the income is foreign source and even if the cash is not repatriated to the U.S.

Now, fast forward to 2014, U.S. multinational companies have amassed $1.95 trillion of profits outside the U.S.  Most of this has been very lightly taxed in other jurisdictions if at all.  Just 22 of the U.S. based companies account for $984 billion of that money.

If a hedge fund manager tries to put $100 million or so in a Cayman corporation and invest as usual, the resulting income is Subpart F income.  Subpart F income flows up through the company’s shares and is taxed at the shareholder level currently (if owned by a U.S. person), even if no cash is distributed.  Thus, there is no tax deferral opportunity.  This was the compromise with the Kennedy administration in 1962.  Rather than tax all global income of U.S. based companies, the U.S. would tax all income other than legitimate business profits earned outside the U.S.  Investment income is not deemed legitimate business profits.  Rather, investment income is deemed Subpart F income and is taxed currently in the U.S.  The short story is, Apple and Google can do it but you can’t.  Too bad, life is not fair.

Does that mean all is lost and you should just pay full 39.6% federal tax on all income and call it a day?  No!  There are still many tax planning ideas that can help the hedge fund manager and the high net worth individual alike.  Moreover, many of the tax strategies pioneered by companies like Apple and Google can often be used by many taxpayers for some portion of their income. 

If you would like to know more about these or other tax planning ideas please contact your local WithumSmith+Brown advisor.

Tony Tuths

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5 replies

    • Thanks for the comments. I do agree with you, as I stated in my blog, there are many ways to reduce one’s U.S. tax liability. It’s true that PFIC’s don’t file U.S. tax returns, however they do issue annual PFIC statements to their U.S. shareholders (assuming the U.S. shareholder wants to make a QEF election). Moreover, the U.S. shareholder must file IRS Form 8621 (and, depending on the facts, also IRS Forms 926, 5471, and 8938 – not to mention FinCEN Form 114), so the IRS is well aware of the U.S. person’s offshore assets – nothing should be hidden. I can’t speak to Mitt Romney’s tax reporting position, he hasn’t retained me yet. Thanks

      • Compared to the approx. 400,000 BVI PFIC registered done by British system that really offer nothing “safe” or tax effective, to the U.S. Investor, you have to wonder why an American would choose such poorly structured “set-ups” (with no compliance – just tax evasive secrecy). BVI and Cayman are going the way of UBS in time. Only the new York Wall street gang who also have the money as well as the tax lawyers are the beneficiaries now… As the US justice department will be undefeated in their dismantling of these havens. Who you incorporate can save you a lot of grief. http://tomazz1.wordpress.com/2014/04/13/offshore-company-formations-banking-bahamas/

  1. The IRS offered over $800 Billion in (dividend) deductions to US companies that had CFCs in Cayman, Bermuda & Switzerland, but few of them bit.. They would let these offshore companies repatriate their profits with a tax rate of just 5.25% overall.

    Some 843 corporations, a relatively small number of corporations given that roughly 9,700 corporations had CFCs in 2004, took advantage of the deduction. But these corporations repatriated almost $362 billion. OF that, $312 billion qualified for the deduction, creating a total deduction of $265 billion.

    The newly added Internal Revenue Code section 965 outlines the provisions for this deduction,

    The IRS wrote: “Firms can be expected to park considerable shares of their earnings and profits in the Netherlands, Switzerland, Bermuda, Ireland, Luxembourg, and the Cayman Islands, as these countries are known for their favorable tax policies”

    The link below is an IRS link and the IRS gathered the information and a special tax law was written into the tax code.

    Scroll down to the charts and view the dollar amounts of the companies involved. http://www.irs.gov/pub/irs-soi/08codivdeductbul.pdf

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