When a former colonial territory becomes independent, the tax treaties do not continue automatically. It is doubtful whether e.g. St. Vincent now has a treaty with the United States.
The US imposes a “second dividend tax” and a “second interest tax” where more than 50% of the profits of a foreign company arises from a trade or business in the US. A so-called “second royalty tax” may be imposed on royalties paid by a foreign corporation in respect of use of an asset in the US.
“Treaty shopping” means choosing a jurisdiction with which an investor has no true nexus, in order to obtain the benefit of a tax treaty. The US itself is a favourite jurisdiction for use in this way, but the US is hostile as a matter of policy to treaty shopping, not only because of the loss of tax involved, but because it is inimical to the extension of the treaty network to countries with which the US does not yet have a treaty.
The US treaty with the Netherlands Antilles reduces US rates on interest, dividends and royalties, provided the Antilles company either is a full taxpayer or belongs to a Dutch resident – the latter proviso giving rise to the structure known as the “Dutch sandwich” (where an Antilles company is owned by a Netherlands company in turn owned by another Antilles company).
Both the Antilles and the BVI treaties give exemption from the second dividend and second interest taxes (but not from the “second royalty” tax). Neither protects capital gains; only the Antilles treaty has an interest article.
Of the British jurisdictions, the BVI has been most used; Barbados and Antigua appear to be suitable as a base for US investment. Twenty-five percent of all interest paid from the US to non-residents is paid to the Antilles.
The BVI treaty has been completely renegotiated and awaits the approval of Congress. Negotiations are in progress with the Antilles: as a matter of policy the US seeks to modernise its treaties, to prevent loss of US revenue by treaty shopping and to eliminate the use of foreign jurisdictions by criminals.
Gearing is the manner in which a corporation’s capital requirements are funded as between debt and equity – its debt:equity ratio.
The principal tax feature of the distinction between debt and equity is that in general a corporation can deduct interest paid or credited in respect of debt in determining taxable profits whereas dividends are payable out of profits which have already borne tax and are not deductible in determining those profits. In addition a more favourable withholding tax treatment is usually accorded to interest payments to non-residents – both under domestic law and under treaties. As a consequence, the higher a company’s debt: equity ratio the more likely it is that its parent company in another jurisdiction will be able fully to utilise any available tax credit.
A number of jurisdictions have developed rules and regulations to counter the advantageous tax treatment of debt as compared to equity. Both Canada and the US have debt:equity rules. The Canadian rules adopt a 3:1 debt:equity ratio beyond which interest is not deductible. The Canadian rules can be circumvented in a number of ways and in addition do not apply to Canadian branches of non-resident companies. In the US, the recent Section 385 regulations provide that a corporation’s debt will not be considered excessive if all of the instrument’s terms and conditions, together with the corporation’s financial structure, would be satisfactory to a bank or similar lending institution making ordinary commercial loans. In addition, the excessive debt provisions provide a safe harbour – an outside debt: equity ratio of 10:1 and an inside ratio (excluding liabilities to independent creditors) of 3:1.
In the U.K., interest paid by a resident company to a non-resident related company can in certain circumstances be treated as a distribution and taxed as such. A number of double tax agreements to which the U.K. is a party override this provision.
Leveraged leasing permits an investor to acquire full ownership of an item of equipment without paying its full cost by borrowing on a non-recourse basis from one or more lenders, who agree that repayment can be made exclusively from the rentals produced by the equipment lease and, upon the lessee’s default, the proceeds of sale.
Because an investor can acquire full ownership of an item of equipment without paying its full cost, the ensuing tax benefits are magnified in comparison with the total amount of money put to risk. This enables very high yields to be achieved on an after-tax basis and some part of these can be transferred to the lessee in the form of reduced rentals. This is the single most attractive aspect of leveraged leasing.
The tax aspects of an equipment lease largely depends on whether the lease qualifies as an operating lease or whether it constitutes a financial lease. If the former, then the lessor is usually entitled to the investment and depreciation allowances; if the latter then the lessee is usually entitled to these allowances.
In some countries there is no distinction between an operating lease and a financial lease and only the lessor is entitled to these allowances. In some countries there are no withholding taxes on lease rentals. In others there are, although in many of these countries the rate of withholding is reduced or eliminated pursuant to tax treaties which follow the OECD model and equate lease rentals to royalties. An exception is the US which regards lease rentals as business profits.
The Strathalmond case showed that – for the United Kingdom at least – a tax treaty may give to a resident of a treaty party relief not merely from tax levied by the other treaty party, but relief from tax in the jurisdiction in which he is resident. (This was also seen in the Padmore case). Such relief is not available to US taxpayers, but may be apt to exempt a U.K. resident from capital gains tax on gains of his trustee in Malaysia or Singapore.
Treaties can provide U.K.-resident individuals with a kind of instant non-residence for capital gains tax: for this purpose, the treaties with Canada, Netherlands, Spain, Sweden and New Zealand seem most appropriate.
The use of the “stepping stone” interposed between a source of income in a treaty country and the zero tax ultimate recipient has been discussed at another meeting in relation to interest and royalties. A similar route for business profits may be taken via Australia, Jersey, Luxembourg, New Zealand or Switzerland.
The Cayman Islands developed spectacularly between 1966 and 1973 and its growth has continued since. It has political stability; it has no income tax, and has never had any income tax.
The Companies Law provided for the Exempt Company, which could obtain a government guarantee against tax – a feature which proved popular with the lay public. The Exempt Trust had a similar facility which proved similarly popular.
The system of bank licences has been largely effective in keeping undesirable operations out of the Islands. The political changes in the Bahamas in the early 1970’s caused a good deal of business to move to Cayman.
There was a general increase in offshore activities by multinational companies in the 70’s and the increase in anti-avoidance enactments in high-tax countries made personal tax avoidance a more complicated, and for the Cayman Islands more profitable, business.
The attempt to create a shipping registry was not a success. But the growth of the captive insurance industry has been spectacular. An early example of captive insurance was in the field of medical malpractice.
At the present time, the trend is towards insurance-based schemes for individuals. At the same time, the successful use of havens is becoming more difficult. It will be desirable to shun publicity and keep a low profile.
The need for economic reality is easier to satisfy for the multinational company than for the private client; there may be scope for companies to establish captive banks in tax havens.
The use of tax havens by criminals is undoubtedly bad for the reputation of the havens. People operating in the havens should in their own interest be assiduous in keeping such business out of their jurisdictions.
To obtain the best service from professional advisers, banks and trust companies, the client or his lawyer should bring the people in the haven into the transaction at an early stage.
During the period down to, say, the early 1960’s, tax planning was a much simpler affair than it is now. It has become more difficult, not merely as a result of court decisions and new legislation, but also because – certainly in the United Kingdom – the calibre of the Revenue staff appears to have improved. In the 1960’s, there was a trend towards the use of tax not only for gathering revenue but also for redistributing wealth. The present trend in the United Kingdom has been to reduce the rate of tax on individual effort.
If an avoidance transaction is to be successful in the future, it will require a real commercial element. It will have a smaller chance of success if the same type of transaction is done by many taxpayers – i.e. if it is a marketed scheme.
There seems to be scope for the use of trusts by taxpayers in jurisdictions which do not recognise trusts- especially trusts which contain business assets in many parts of the world.
The last 20 years have seen a number of remarkable developments – high interest rates, political uncertainties, abolition of exchange control of sterling, the use of commodities, mutual funds and other new types of investment, and – perhaps most interestingly – the migration of trusts from one jurisdiction to another.
Control of cash and assets in tax havens presents peculiar difficulties – the bank accounts are numerous, the assets and liabilities located in many and distant places. A client would be well advised to consult with his trustees as to where and how the trust assets should be located and kept. These days, much of the control can be effected by computer and wherever possible this facility should be utilised. Of the many steps which can be taken to protect assets from expropriation, much the best is to ensure that actual control of the assets is in the hands of the right person.
Trustees are bound to take into account all relevant factors before exercising this discretion, but they are not bound to explain their reasons to the beneficiaries. A trustee is not entitled to delegate his decisions to others: he should not authorise a broker or investment banker to operate an account without reference back. A trustee who is negligent has a liability for damages, even though the trust instrument may purport to provide otherwise.
The English Court will recognise a trust made by a settlor domiciled in a civil law country. It appears that the same rule applies in Cayman and the other “Anglo Saxon” jurisdictions. Provisions in trust instruments empowering trustees to change the proper law of the settlement are of doubtful validity. Many problems arise nowadays because the law relating to trusts was settled in an epoch before rapid travel and communications and before modern techniques of investment were developed.
Before a trustee resigns in favour of a new trustee, he has the responsibility to ensure that the person to be appointed is satisfactory.
A trust corporation will not act “blind”: it will need to know all about the client and the business affairs connected with the trust, and to exercise effective control over the trust assets.
A trustee’s liability is not limited. He is bound to provide a discretionary beneficiary with accounts, once the beneficiary has received a payment from the trust.
A taxpayer needs advice which is not only good but disinterested. He does not want his adviser to have an interest in promoting a scheme or using a particular bank or haven. Schemes can be too blatant, too productive of litigation or too elaborate for the amounts involved. A scheme must be worth doing, even taking into account the risk that the tax in question is not saved.
One should be on one’s guard against sheer bad advice, and on one’s guard too against well-promoted forms of investment which involve heavy commissions, front-end loading and the like. One should require of a tax haven that it is sophisticated and efficient. A firm of professional advisers has to be big enough to know and small enough to care. The ideal adviser is nearby but offshore; he charges a flat fee; he understands the transaction proposed.
The primary purpose of a partnership is to raise finance for an enterprise. If the enterprise is to have predictable tax consequences of a partnership, it is important that the association is a true partnership, i.e. the relevant law and the contract must so provide. In English law, a partnership requires an active enterprise and not a mere passive investment.
The only tax benefit of a UK partnership is a UK tax benefit: it is useful – and useful only – where the enterprise involves a degree of exposure to UK tax. A non-UK investor may have other income in the UK – e.g. rent from UK property. He may benefit from structuring his participation in an enterprise through a partnership which becomes entitled to UK tax relief. The enterprise must be one which is liable to UK tax in the first place, so that the partnership should be managed and controlled in the UK. In practice, this requires at least one UK resident partner in charge of the overall management and control of the business. There are proposals to adopt in the UK a “place of effective management” test of residence; it is therefore wise to ensure from the beginning that this test is also satisfied.
Active trading businesses may generate reliefs for UK tax. An enterprise which requires substantial revenue expenditure in its early years will generate losses, so long as the enterprise is a trade carried on with a view to profit, then losses may be set off against other income taxable in the UK.
Capital allowances or write-offs may create losses. The enterprise must be an active trade, e.g. plying a ship for hire. Mere leasing of the ship would not in general suffice.
Once the reliefs have been used up, such a UK-based enterprise will have a positive liability to UK tax. If the activities of the trade take place outside the UK, it may be possible to sever the link with the UK, and so to avoid recapture of the reliefs, by moving the management and control of the trade outside the United Kingdom, so that the trading activities no longer give rise to a liability to UK tax.
There are restrictions on the availability of UK capital allowances, of which one needs to be aware. As regards individuals, the “sole or main benefit” must not be the obtaining of the allowances; it should be the obtaining of profit. As regards companies, it must be remembered that when a company becomes non-resident, a “cessation” occurs, which causes a recapture of previous allowances. The partnership will be treated as continuing to be resident if at least one corporate partner remains resident in the UK.
A foreign investment for UK investors may be structured through a partnership. One must consider the effect of the structure as regards the country where the business is to be carried on and as regards the tax treaty with that country. The partnership should get tax relief in the UK: it may first be managed and controlled in the UK, and later “emigrated” elsewhere so as to get reliefs in full in the first place and then get the benefit of the 25% reduction given by F.A.1974 s. 23 for individuals once the enterprise becomes profitable.
The use of a limited partnership can give rise to problems: there is some uncertainty whether losses of non-recourse funds qualify for UK tax relief.
It is possible to have a discretionary or contingent partnership: in the UK, income does not become taxable in the hands of the partner until it becomes his beneficially.
Where a partnership has a separate identity – e.g. a Scottish partnership – the income does not belong to the partners until it is distributed, and the partners themselves may therefore not be taxable until then.
Opportunities arise in international tax planning to use US partnerships where the source country has a treaty with the United States which views a partnership as an “entity” rather than an “aggregate” of individual partners.
The Internal Revenue Code generally views a partnership as an “aggregate” of partners rather than as an entity. Therefore, partnerships are not taxpaying entities. They are “reporting” entities, with the tax incidence of their operations falling on the individual partners. The partnership files an annual information return, and it passes through its income, deductions and credits to the partners. These items have the same character and source in the individual partners’ returns as they had on the partnership returns.
However, some of our older treaties do not adhere to the aggregate theory. Some view partnerships as “entities” entitled to treaty protection as a “US enterprise or other entity” without regard to the residence of the partners or the place where the business of the partnership is carried on.
The effect of these older treaties is that US partnerships composed of non-resident foreign persons could avail themselves of these treaties, while not subjecting the partners to tax in either the United States or the source country. This result flows from the fact that a non-resident alien member is subject to tax in the United States only if one of the following jurisdictional contacts exist with respect to the partnership:
a) the partnership income is US source income;
b) the partnership has a business office or other fixed place of business in the US to which certain kinds of foreign source income are deemed effectively connected.
Consequently, the distributive share of profits of a non-resident alien member of a US partnership, operating exclusively outside the United States, would not be taxable. For example, such a partnership might purchase or manufacture goods in one foreign country and sell them in another without any US tax incidence to its non-resident foreign partners. Or it might be involved in a foreign licensing arrangement.
If the US partnership were to sell these goods in a country which has such a treaty granting exemption or reduced rates to “US partnerships” such as the current treaty with Australia, New Zealand or Ireland, then the sales income should avoid tax in the source country as well. A royalty arrangement into Switzerland should have the same result.
The non-resident alien partner of the partnership may likewise avoid US tax on the sale or other disposition of his US partnership interest where the business is carried on wholly abroad. Even if the business is carried on within the United States, or the partnership has foreign source income which is deemed effectively connected with a US trade or business, a strong case exists that the partnership interest may be sold free of US tax, provided the sale takes place wholly outside the US. An exception is a sale of a partnership holding US real estate. The Foreign Investment in Real Property Tax Act of 1980 mandates tax by treating the sale of an interest in the partnership as if a proportionate part of the underlying US real property interest had been sold. Where the gain is taxable, it is typically capital gain, but it can be characterised in whole or in part as ordinary income depending on the underlying assets.
Partnerships are resident in the state where they are organised and the certificate of partnership is filed. The residence of the partners is immaterial. Thus, a partnership could be organised in California. However, it would have to maintain its principal office in the state under current statutory law.
California’s taxing rules are typical of other states. A partnership organised in California is a “reporting” and not a “taxpaying” entity, the same as for federal rules. Therefore, a non-resident alien partner would be subject to tax in California only if the partnership regularly carried on business in California, or derived income from California sources.
Partnerships as such, and US partnerships in particular, are not attractive vehicles for non-resident aliens for inbound transactions, i.e. carrying on business in the United States or owning or holding US property. The business of the partnership is attributed to its members and they become fully taxable at graduated rates on their distributive share of US source partnership income. In a multinational business, including business activity in the US, this could raise difficult problems of allocation of income and expense for the partners. Also, privacy cannot be maintained as well as with share ownership of a corporation. Moreover, under established agency principles, the residence of a general partner in the US constitutes the permanent establishment of all other partners and the statutory requirements of maintaining a local office may foreclose individual treaty status of any single partner who might otherwise qualify in his own right as to his distributive share of partnership income. Accordingly, the offshore corporation or domestic corporation is the preferable vehicle on inbound transactions.
Whereas stock in the US corporation is statutorily classified as property situated within the United States for federal estate tax purposes, an interest in a US partnership should not be. The partnership interest, as an intangible property right, should be deemed situated at the partner’s domicile or residence. Thus, the death of a non-resident alien partner should not trigger any US or local death taxes or duties, although the Internal Revenue service may contend otherwise if the partnership conducts US business and has US business property in the United States. Similarly a gift of a partnership interest by a non-resident alien should be free of federal and local gift taxes.
In summary, US partnerships afford tax planning opportunities for certain offshore operations in selected instances where older treaties exist, incorporating the entity theory of partnerships. However, the opportunities are diminishing as the United States systematically renegotiates its treaties to avoid “treaty shopping” by adopting the “aggregate” theory of partnership law to predicate treaty qualification on the residence of the individual partners and/or taxability of the income in the United States.
In Alberta, there is no restriction on the number of limited partners who may be members of a partnership.
Investment in shares presents few tax problems. Withholding tax is at 25% but less under some treaties. Capital gains tax is payable in Canada only if the company is not listed or if the seller has held more than 25% of the shares during the past five years; there are exemptions and partial exemptions under the treaties.
The Foreign Investment Review Act (“FIRA”) requires the non-resident controlling investor in a new Canadian business to obtain government consent: this applies to investments over $250000 but does not apply to exploration.
The investor receiving royalties etc on oil and gas ownership suffers 25% withholding tax – which may be reduced by treaty.
Non-residents may enter into a joint venture with one or more Canadian residents. A joint venture is not treated like a partnership for tax purposes: each joint venturer owns his share of assets directly and pays tax on his own share of the receipts (less his share of the expenses). The drilling of the wells gives each venturer a permanent establishment and a liability to Canadian tax on the business profits, at provincial and at federal level. The calculation of the tax is highly complex.
The foreign investor will not generally himself join with the Canadian operator directly: he will prefer to avoid the bureaucratic difficulties involved; he needs continuous administration on the spot; he will not want unlimited liability for debts created by the activities of the operator.
If the investor is a limited partner, FIRA consent need not be required for his participation; the limited partnership enters into the joint venture agreement with the operator.
The limited partnership and the operator each file tax returns in Canada. The partnership is treated as distributing its profits, and the partners must file tax returns accordingly. A foreign company partner will be liable to the 15% branch profits tax.
Limited partnership interests are not easily realise: sometimes the partnerships may buy in the interests, sometimes the interests may be exchanged for shares in the operating company but the terms are generally unfavourable to the partner. Consequently, investors often prefer to make their investment through a listed company which becomes the joint venturer. On sale of his shares, he would not be subject to tax in Canada on any capital gain.
When advising a client resident in his own jurisdiction on investment in another, the practitioner requires the “hard” information about his own jurisdiction, i.e. a complete knowledge of the domestic tax effect of the chosen method of investment, and should aim to have the “soft”information about the other jurisdiction, i.e. about the methods of investment likely to be tax-efficient there, so as to formulate proposals which may be put to an expert in that other jurisdiction.
Liability to capital taxes – wealth taxes, gift taxes, and estate taxes or other taxes on death in the jurisdiction of the investment – generally indicate investment by a corporation rather than an individual. In general, tax on rent may be substantially reduced by “back-to”back” financing through a local bank. Profit on disposal of the property is not always taxable, but where it is may be exempt under an appropriate treaty.
The Foreign Investment in Real Property Tax Act 1980 imposes a general tax on capital gains arising from “real estate interest” – a concept very broadly defined, and extends e.g. to stock in a Real Property Holding Corporation (i.e. a US company whose assets at any time in the previous 5 years have consisted as to 50% or more of US real estate interests). Until the end of 1984 available exemptions under treaties remain available, but not thereafter. It is still possible therefore until 1984 for a Dutch company to sell stock in a US Real Property Holding Corporation without giving rise to a tax liability.
The statute imposes extensive reporting requirements and contains substantial penalties for failure to do so. Information must be given about every substantial investor in a Real Property Holding Corporation (other than a listed corporation) unless the IRS can otherwise be satisfied that all tax will be paid.
A foreign corporation may elect to be taxed as a US corporation, if the relevant treaty has anti-discrimination provisions. Possibly a non-resident alien may become a US resident, exchange his US property for foreign property and then cease to be resident. Perhaps the property profit may be taken out by way of interest on borrowing. By adding non-property assets to a Real Property Holding Corporation, a company can take itself out of that category. An investor may marry his profit with a loss corporation, or merge his corporation with another with other kinds of assets, or go public.
It is still desirable for an individual to own US real estate through a foreign corporation, so as to avoid estate tax.
Life Assurance In most countries, holders of life policies are accorded favourable tax treatment, in recognition of the fact that the income and gains of the life fund are subject to tax. When a policy holder switches his policy from one fund to another within a segregated life fund, some allowance requires to be made for the tax potentially payable by the fund.
The advantage of the offshore life company is that the life fund is not taxed. It can offer a policyholder an investment free of exchange control and often one more flexible than he can obtain in his home jurisdiction.
Single-premium policies in the hands of UK residents give rise to tax on maturity or surrender, but if the policyholder has no other income in the year of maturity or surrender, the rate of tax can be very low. The benefits of an offshore policy rise sharply where high rates of return can be achieved.
Pure endowment policies in the hands of different generations of the same family may effectively reduce the assets passing on the death of the older members of the family.
Life assurance seems a promising field for the development of international tax planning techniques.
Captive Insurance Much development has already occurred in this field. Part of the attraction of the captive company is its ability to cover risks which the market would not accept or for which the market – whose rates are based on average experience and not on the particular history of the insured – would charge more highly.
Premiums to a captive may be deductible for tax and may operate to take funds across exchange barriers. To be profitable, a captive requires good risk management, together with sound investment – especially of premium funds awaiting claims. Its income is derived from conventional underwriting and investment sources, and also from ceding commission paid by re-insurance companies. This commission is normally paid as an “introductory commission” to cover marketing expenses. Since a captive has no such expenses, the commission becomes a major profit source.
The mechanisms of the world insurance industry lend themselves to the transfer of funds from high tax jurisdictions to low tax jurisdictions, both by way of premiums paid to offshore captives, and by way of re-insurance premiums paid by onshore captives or general insurance companies to offshore re-insurance companies. Payment of claims can also be routed so that a claim may be paid in a different jurisdiction from that where the event giving rise to the claim occurred.
The location of a captive insurance company is determined by reference to several criteria:
b) Legal and Exchange Control requirements
c) Fiscal treatment
d) The intended source of its business