Grand Cayman – George Town from Air (Postcard) (Photo credit: roger4336)

Introduction :    

The Lesson  : You don’t need to be Mitt Romney.

No person should pay more taxes than the law requires.¹ People who use tax shelters and legal loopholes are not unethical.² Congress made t hose options available in order to influence people in their use of money.³ This page will examine two loopholes available to the United States taxpayer today. One method of avoiding taxes is to incorporate a business concern in a foreign jurisdiction that does not tax income.⁴ Another method is to renounce United States citizenship.⁵This webpage will compare the two loopholes from the point of view of a U.S. citizen with personal income, examining the dangers and benefits of each method. The situation of a corporation seeking to use a t ax haven is extremely complex and beyond the scope of this page.

I. Foreign Tax Havens

Almost every country in the world has a lower tax rate on some activity than another country’s rate on that activity.⁶ Since countries routinely use their tax laws to influence the use of capital, ⁷ income tax rates on any given activity vary wildly throughout the world.⁸ A country which taxes at a high rate for one activity may concur rently provide a low tax on another activity. Only a few countries, however, choose not to tax any income of non-citizens.⁹ Tax professionals call these countries “tax havens.”¹⁰ Because the law differs in each of these countries, this paper will consider only one: the Cayman Islands [hereinafter "Cayman"].
Cayman is appropriate for two reasons. One is that Cayman is one of the most popular tax havens.¹¹ The other is that it has similar tax laws to other popular tax havens such as Switze rland and the Bahamas.¹² Cayman also has decades of experience as a foreign tax haven.¹³
Citizens of the United States use Cayman as a tax haven for two purposes: tax evasion and tax avoidance.¹⁴ Tax evasion is the illegal hiding of income or assets for the purp ose of deceiving the U.S. Internal Revenue Service [hereinafter IRS].¹⁵ Tax avoidance is any legal measure used to lower actual tax liability.¹⁶ U.S. taxpayers routinely use Cayman for both reasons.¹⁷ The legal method of using the Cayman tax haven is to form a corporation under Cayman law and assign a stream of income to that corporation.¹⁸ The corporation, however, must have a legitimate business purpose other than the avoidance of taxes.¹⁹ Th e business purpose need not require Cayman as the location, but Cayman must be appropriate for the business purpose.

A. Caymanian Companies For Tax Deferral

Cayman imposes income tax on only those companies doing local business, so it is an ideal place for United States citizens to locate a stream of income.²⁰United States citizens can incorporate a business (known as a “base company”²¹) under the law of the Cayman Islands and assign streams of income to the company.²² Property (includ ing the right to a stream of income) used to start a corporation is subject to a one time 35% excise tax.²³ Subsequent income is then attributed only to the base company.²⁴ This method of tax avoidance only defers taxation,²⁵ as United States citizens must still pay tax on money when they remove it from a Cayman company. ²⁶ Some taxpayers may be able to enjoy the benefits of the corporation’s money while still avoiding taxation through use of “secondary sheltering.” ²⁷ This involves recharacterizing the money, such as by having the base company loan money to the U.S. citizen.²⁸
The IRS takes a dim view of this type of tax plan and, unless transactions are conducted at arm’s length, may decide the base company is a sham.²⁹ The IRS may then collapse the transac tion, allocating Caymanian income to the U.S. citizen shareholders.³⁰ The IRS may, in the alternative, designate the company a “foreign personal holding company,” which eliminates the t ax advantage.³¹ Caymanian companies owned by U.S. citizens may avoid being classified by the Internal Revenue Service as personal holding companies by forming with many owners, particul arly non-U.S. owners,³² or by showing the Secretary of the Treasury that the purpose of the company was not the avoidance of U.S. income tax. ³³ The Secretary’s approval must be established every year.³⁴ This can be accomplished by obtaining a private letter ruling. A private letter ruling is a written statemen t from the IRS on the tax effect of the specific facts of the proposed transaction.³⁵ A favorable ruling provides documentation for the taxpayer should a disagreement with the IRS arise later. ³⁶ A taxpayer may request a private letter ruling by writing to the IRS and outlining the specific facts, including a detailed description of the transaction and a statement of b usiness or economic reasons for the transaction, along with arguments in favor of the transaction and an affidavit that the facts are true.³⁷ If the information is too general or the fa cts not unique, the IRS may respond with an information letter, which points out established tax law.³⁸ An information letter does not establish the Secretary’s approval of t he business purpose.

B. Formation of a Caymanian Company

Cayman will only give guarantees of exemption from taxation to incorporated companies that carry on no Cayman business.³⁹ The guarantee against imposition of income taxes lasts 20 years.⁴⁰ Companies which have been given this guarantee are known as “exempted companies.”⁴¹ Exempted corporations must maintain a local office.⁴² Cayman requires a minimum of three shareholders for incorporation.⁴³ While companies do not have to pay income taxes, they must still file ann ual reports.⁴⁴ Exempted corporations must pay an annual fee of CI$575.⁴⁵ Names of shareholders may be kept confidential.⁴⁶ The corporation may issue bearer shares upon approval by Exchange Control, but Cayman residents may not hold any bearer shares.⁴⁷ There is n o requirement of shareholder meetings.⁴⁸ All companies (except companies which carry on local business in the Cayman Islands) must conduct all business, other than payroll an d local expenses, in currency other than the Cayman dollar.⁴⁹ U.S. citizens must keep records and file all necessary reports when doing transactions with any foreign financial agency.⁵⁰
It is unwise for U.S. owners of foreign businesses to allow other U.S. citizens to buy shares in the corporation after the company is set up.⁵¹ If the U.S. owner needs to liquidate part or all of the ownership, one legal way to sell shares in a foreign corporation is to keep ownership confidential,⁵² offer and sell only outside the United States and only to a non-U.S. person.⁵³ U.S. citizens would be liable for tax on capital gains for shares sold in the Cayman company.⁵⁴
Foreign corporations may still hold assets in domestic banks without the interest being subject to U.S. tax.⁵⁵ This obviously does not shield those assets from discovery by the IRS, bu t the assets may be safer for other reasons.⁵⁶ One reason is the possibility of expropriation of foreign assets by the foreign government in the event of a coup in that jurisdiction.⁵⁷ In addition, assets held in U.S. financial institutions get protection from the Fourth Amendment and the Right to Financial Privacy Act of 1978.⁵⁸ T he legitimate offshore base company, while subject to the discovery of its assets by the IRS, need not fear identification of assets because it is compliance with U.S. law.⁵⁹
Before setting up any foreign business interest, U.S. citizens should consult with an attorney in that jurisdiction who is familiar with its laws.⁶⁰ In addition, consulting with a dome stic tax professional and obtaining a private letter ruling from the IRS would also be advised.⁶¹
As mentioned above, setting up a personal holding company does not reduce the taxes of the U.S. citizen except to the extent the citizen may assign streams of income to the company. ⁶² The expense of setting up and maintaining a corporation in the Caribbean limits the number of U.S. citizens who would realize tax savings. For these very wealthy people, a better alternative might be to renounce< SUP> citizenship in the United States of America.

About Jack A. Bass Business Development Services

Jack A. Bass and Associates

Jack A. Bass and Associates
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