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By
Marshall J. Langer, London, UK
I have been involved in the offshore world since the early 1950s, a period of more than 50 years. It was a comparatively simple world in the early days. There were corporations, partnerships, trusts and the exotic Liechtenstein entities – the anstalt and the stiftung – used almost exclusively by wealthy Europeans. There were no CFC (controlled foreign corporation) rules. Tax treaties were still in their infancy. There were not many tax treaties, and there were almost no meaningful restrictions on using them. There were a few places like the Bahamas, Bermuda, Liechtenstein, Luxembourg, Panama and Switzerland serving the offshore market.
It was acceptable to call these places tax havens. Many now call them offshore financial centres. I still generally call them tax havens because the biggest ones are onshore, not offshore. Some of the countries whose politicians complain the most about tax havens are in fact themselves significant tax havens.
No one is surprised when I tell them that the most important tax haven in the world is an island. They are surprised, however, when I tell them that the name of that island is Manhattan. Moreover, the second most important tax haven in the world is located on an island; it is a city called London in the UK. However, there is one big problem - the US is a tax haven only for foreigners who invest in the US. Most of its best tax haven attributes don’t work for you if you are either a US citizen or US resident. And, Britain is a tax haven for many of those who move there from abroad, but not for those whose domicile of origin is in the UK.
US Tax Haven Attributes
A US citizen or resident receiving interest from a bank deposit must pay federal income tax of up to 35% on that income. In most cases, he/she also pays state income taxes on that income, increasing the rate to 40% or more. The amount of interest paid to him/her is reported to the IRS annually by every bank in the US.
A nonresident alien individual or foreign corporation pays no US income tax on US bank deposit interest. Except for residents of Canada, the amount of interest paid is not reported to the IRS, so the amount of that interest is obviously not being reported to other countries under US tax treaties or TIEAs. Interest on US bank deposits held by foreign persons has been effectively exempt from US income tax since 1921. The bank deposit itself is also exempt from the US federal death tax. Even though the account is not taxable, each deposit in an insured US bank is insured up to USD100,000 by America’s Federal Deposit Insurance Corporation.
Although the US wants every country to give it tax information, US law does not permit the IRS to give any tax information to a foreign country unless that country has either a tax treaty or a TIEA with the US. The European Savings Tax Directive was not supposed to take effect until Switzerland, the US and several other places agreed to participate. Switzerland and the others have done so, but the US has not (yet) finalised proposed rules under which it would obtain such information and furnish it to EU countries. Rules enabling it to do so were proposed during the final days of President Bill Clinton’s Administration. They have languished under the George W. Bush Administration for fear that a large part of an estimated USD3.5 trillion dollars of foreign-held US bank deposits would flee the US if the rules were put into effect. That position may be reversed if Hillary Clinton or some other Democrat becomes president in January 2009.
The US has some other significant tax haven attributes that have been conveniently ignored by the OECD in its reports on allegedly harmful tax competition by countries it deems to be tax havens:
• Since 1984, portfolio interest paid to a foreign person is paid free of US income tax. Interest paid to a foreign person on government bonds, notes, and treasury bills, and on many corporate bonds, is free of income tax but may be subject to some reporting requirements. All such interest is fully taxable when paid to a US citizen or resident.
• Long-term capital gains derived by a US citizen or resident are currently taxed at a reduced 15% rate. Short-term capital gains (on assets held less than a year) are fully taxed at rates up to 35%. Guess what? All capital gains, other than those derived from the sale of US real estate (or a US real estate holding company) are tax-free when paid to a foreign person. I was consulted a few years ago about a case in which a foreign individual earned more than USD100 million in a single year on day-trading profits on US securities that were treated as tax-free capital gains.
• The US still imposes federal death and gift taxes at rates up to 45% on all transfers of property at death or by lifetime gift made by a US citizen or resident. Although these taxes theoretically also apply to transfers of US property by a nonresident alien, such transfers are exempt if the alien individual uses a foreign holding company to own his US property.
Britain’s Tax Haven Attributes
Paraphrasing the late George Orwell, under British tax law all residents are equal but some are more equal than others. Residents of Britain who are considered to be domiciled in some part of the UK are fully taxed on their worldwide income. However, residents of Britain who are treated as non-domiciled residents currently still enjoy a privileged status under which they are not taxed on their income from abroad unless it is remitted (brought back) to Britain. These non-domiciled rules have survived for over 200 years but Britain’s new chancellor of the exchequer has just announced significant changes to these rules that are scheduled to take effect in 2008.
British taxes were confiscatory during the 1970s under an earlier Labour government, quickly reaching a maximum rate of 83% on earned income from working and 98% on unearned income from items such as dividends and interest. They are still high (about 40%) for the natives but not for most outsiders who move to Britain and live there on a remittance basis, paying tax only on local income, if any, and remitted foreign income. Many people have lived in London for years on remitted capital (not income) and have never had to pay a single pound of British income taxes. Until now, many of them didn’t even have to file any tax returns. They do, of course, pay lots of VAT. Banks in places such as the Channel Islands and the Isle of Man expertly help their clients to maintain separate accounts for income and capital and assist them in converting certain types of income into capital that can be remitted to the UK without tax.
When New Labour was elected in 1997, Gordon Brown (now prime minister) became chancellor of the exchequer. While in Opposition during earlier years, Mr. Brown as shadow chancellor had strongly criticised some aspects of the UK residence and domicile rules. In 1994, he had issued a document entitled Tackling Abuses – Tackling Unemployment, which stated (in part):
“Taxation of non-residents, non-domiciles and those with off-shore accounts should be overhauled in line with the recommendations of the Inland Revenue. It is not fair that a wealthy few be allowed to work or live in the UK without making a fair contribution through taxation…In Britain it is easy for a few, even if they live or work here to avoid substantial amounts of tax through claiming to be non-resident or non-domiciled…”
The system Mr. Brown criticised was not a new one put in to attract wealthy individuals to Britain. It has been a part of UK tax law since income tax was first introduced in Britain by William Pitt in 1799. Until the First World War, all residents of Britain enjoyed such treatment. The revenue needs of that conflict resulted in a change that has since required those British residents who are domiciled in Britain to pay income tax on their worldwide income. Until October 2007, attempts to make non-domiciled residents similarly taxable on their worldwide income were beaten back by carefully devised lobbying efforts. The UK Inland Revenue (now HMRC) published a green paper in 1988 that proposed significant changes but, following complaints by wealthy Greek ship-owners who threatened to move large businesses out of Britain, the Conservative government, then led by Margaret Thatcher, and the Labour opposition, both agreed not to change the system. The current New Labour government discussed possible changes to these rules both before coming to power and since but until October they made no changes. Some of the largest contributors to New Labour have been individuals who benefit substantially from the existing rules.
The New UK Rules
The proposed new UK non-domiciled rules announced in October’s pre-budget announcement are supposed to take effect for UK tax years beginning in April 2008. Those of us who have already been non-domiciled UK residents for more than seven years will now have three choices. We can pay full UK tax on worldwide income. We can continue using the remittance basis of taxation by paying an additional tax charge of GBP30,000 per year. This, of course, will require those who have not heretofore had to file tax returns to begin doing so. We can, of course, also leave the UK and many will do so. Some of the super-wealthy may stay for a while but they run the risk that the initial tax charge is the camel’s nose under the tent. The cost of remaining resident in Britain may rise substantially in future years. US Supreme Court Justice Oliver Wendell Holmes Jr. once said “Taxes are what we pay for civilized society.” The price of civilization is going up for non-domiciled UK residents. Many of them may now seek to obtain a Swiss forfait instead.
Looking Back at the Early Days
Shortly after becoming a lawyer in 1951, I began teaching a course on Latin American Tax Systems at the University of Miami Law School. Many Latin American countries then had a territorial tax system – few do today. Although most of my daily law practice in the early days involved domestic transactions, I travelled extensively in the Caribbean and in Central and South America. In 1956, I taught for two weeks as a Visiting Law Professor at the University of Havana (Cuba). Some then considered Cuba to be a tax haven; no one would treat it as such today.
Harvard Law School’s International Program in Taxation published a book in 1957 called Tax Factors in Basing International Business Abroad. The book noted that although the US taxed US corporations on their worldwide income, it did not then tax US corporations carrying on their foreign operations through holding companies organised in third countries that did not tax foreign-source income. The book disliked the term “tax havens” so it called these “base company” operations. It suggested 13 countries as suitable places for these base company operations. Seven of these – the Bahamas, Bermuda, Liechtenstein, Luxembourg, the Netherlands Antilles, Panama and Switzerland – are still considered offshore centres today. None of the other six would be useful today; they were Canada, Haiti, Liberia, Tangier, Uruguay and Venezuela.
In those days, Canada did not tax the foreign-source income of nonresident companies incorporated in Canada but managed and controlled elsewhere. Canada amended its laws in the late 1960s, and it now taxes all companies incorporated in Canada regardless of where they are resident.
No one in their right mind would even think of using Haiti today.
Liberia was for many years an important base for forming companies and registering ships. It lost that status during a series of civil wars. I remember being dismayed upon receiving a company maintenance bill from Monrovia for a client a decade or so ago; the rather large postage stamp on the cover showed a colour picture of some poor unfortunate souls being shot by soldiers on a Liberian beach.
Tangier lost any possible usefulness as a company base shortly after it was reintegrated into Morocco in 1956, at about the time the Harvard book was being published. Most of its 5,000 nonresident-owned companies have since faded away.
Uruguay was considered the “Switzerland of the Americas” when I visited there in 1954. It subsequently lost that status because of economic chaos and political instability from which it has recently begun to recover.
Venezuela had a territorial tax system and a strong oil-based economy for many years, but no one would use it as a base today. It now taxes worldwide income and has over 20 tax treaties, but its currency has deteriorated and many of its formerly wealthy citizens have fled the country.
Part 2 of this column will appear in the next issue.
Please send your comments to marshall@mjlanger.com with a copy to editorial@offshoreinvestment.com.
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