          
          
          
                   The United States Tax Haven Loophole
          
               Few Americans realize this, but the United States
          is considered a tax haven by many foreign investors.
          While U.S. citizens are struggling with federal, state,
          and local tax burdens of 40% or more of their total
          income, foreign investors often can invest in the
          United States tax-free or almost tax-free.
               The country is not a straightforward no-tax haven
          like the Cayman Islands or the Bahamas. Instead, it has
          some complicated tax laws and tax treaties that, when
          taken together and fully understood, provide
          opportunities for the foreign investor to make low-tax
          gains in U.S. investments. Unknown to the average
          American is an elite group of U.S. tax lawyers and
          accountants who refer to themselves as "inbound
          specialists." This means they specialize in structuring
          transactions for foreigners who seek to invest capital
          here.  
               The United States encourages tax-free foreign
          investment because it needs foreign capital to finance
          the economy and the government budget deficit. For
          example, Congress generally imposes a 30% withholding
          tax on all interest payments to foreign residents and
          corporations. Foreign investors let it be known quickly
          that they would take their money elsewhere if the
          withholding tax remained, however, and exceptions to
          the tax now exist.
               The great benefit of the U.S. tax haven for many
          foreigners occurs when the U.S. tax rules are combined
          with those of other countries. The United States taxes
          its citizens and residents on their worldwide income.
          But noncitizens and nonresidents are not taxed on
          income from certain sources within this country. As a
          result, there are a number of foreign individuals who
          invest here in order to take advantage of these non-
          taxable situations. Some of the elite inbound
          specialists insist that a large part of the attendance
          at Wimbledon is made up of attorneys and CPAs who
          receive complimentary tickets from the tennis stars
          whose finances they structure.
               Another fact that few Americans realize is that in
          the right circumstances an American citizen or resident
          can benefit from the same laws that provide tax-free
          income from U.S. investments to these citizens of the
          world. It's not for everyone, but the laws are clear
          and you can exploit them.
               In this chapter, you will learn how you can
          establish an offshore corporation to invest tax-free in
          U.S. securities and other property. You'll also learn
          the consequences of not structuring the arrangement
          properly and the rules Congress set up to deter such
          behavior.

          
          The offshore corporation loophole

               Long ago you could visit a tax haven, have a
          corporation formed, transfer some cash to the
          corporation, and have the corporation invest tax-free
          in the United States. As long as the corporation did
          not have an office here, it was treated as a
          nonresident foreign corporation and could earn most of
          its income tax-free. There would be no tax until
          dividends were taken out of the corporation.
               Part of that scenario still is true today. As long
          as a foreign corporation does not have a U.S. office or
          other contacts with the U.S. that would make it
          "effectively connected" to this country, the
          corporation is a nonresident foreign corporation. It
          can avoid U.S. taxation on certain types of income from
          U.S. sources.
               The difference now is that the U.S. shareholder
          will be taxed like a partner in a partnership. The U.S.
          shareholder who controls a foreign corporation will be
          taxed on his pro rata share of the income of the
          foreign corporation as it is earned, even if the income
          is not paid out in dividends or any other form. This,
          of course, substantially reduces the incentive to
          create the foreign corporation.
               Fortunately, there are two loopholes in the law
          that still allow you to structure tax-free investments
          through offshore corporations.

          
          The "de-control" loophole

               The U.S. shareholder of an offshore corporation is
          taxed on the annual income of that corporation if it is
          a "controlled foreign corporation," or CFC. An offshore
          corporation is a CFC when more than 50% of its voting
          power is owned or controlled by "U.S. persons." There
          are several ways to set up an offshore corporation that
          is not a CFC...in other words, a corporation that is
          decontrolled.
               First, let's look at what will not work. You
          cannot have your tax haven lawyer take title to over
          half the corporation's stock, agree to vote it however
          you wish, and claim that the corporation is
          decontrolled. Any arrangement such as this might be
          treated as though you owned all the stock. You will
          have a CFC.
               Another scheme that is widely recommended is to
          set up a string of trusts and corporations that will
          end up with a trust owning all the stock of the
          corporation that will actually do the U.S. investing.
          Though this "daisy chain" arrangement has not actually
          been tested in the courts, it is likely that the IRS
          and the courts would simply ignore the chain and
          conclude that since you formed the initial entity and
          all the others were formed as part of a plan, you will
          be considered the owner of the stock. Again, you will
          have a CFC. The only remotely attractive feature of
          this arrangement is that it would be very difficult for
          the IRS to uncover it.  But once uncovered, the sheer
          complexity would pretty quickly convince a jury that it
          was deliberate fraud.
               Now let's look at the reliable ways to decontrol
          an offshore corporation.
               Start with the definition of a "U.S. person." A
          U.S. person for purposes of the CFC rules is any U.S.
          citizen or resident who owns 10% or more of an offshore
          corporation's voting stock. Here we see an easy way to
          decontrol a corporation: Make sure no U.S. citizen or
          resident owns 10% or more of the corporation.
               Suppose you and some associates plan to invest
          together in the United States. There are at least 11 of
          you, and you plan to have equal ownership interests in
          the investing entity. If you divide 100% by 11, you
          should get 9.09%. You can set up an offshore
          corporation and it will be decontrolled, because there
          are no U.S. shareholders involved. No U.S. person owns
          10% or more of the voting stock. You can invest in the
          United States at little or no tax cost the same as a
          nonresident alien does. The income can compound tax
          free in the corporation until you decide to take
          dividends.
               One trap to be careful of here is the attribution
          of ownership rules. These rules state that if related
          taxpayers are the shareholders, they will be considered
          as owning one another's stock for purposes of the
          control test. So if the 11 people are family members,
          the corporation probably will be a CFC. If you own a
          number of U.S. corporations and try to consider each of
          them as a separate shareholder, you also will have a
          CFC. You need at least 11 unrelated U.S. persons to
          decontrol the corporation.
               Suppose you have one U.S. person who wants more
          than 50% of the voting stock. The other U.S. persons
          will have less than 10% of the voting each. In this
          case, there is a CFC, because it is more than 50%
          controlled by U.S. shareholders. But here's a twist.
          Only the more-than-50% shareholder is taxed on his pro
          rata share of the corporation's income as it is earned.
          The other U.S. persons are not "U.S. shareholders,"
          because they each own less than 10% of the voting
          stock. They are taxed as though it were a decontrolled
          corporation.
               Another way to decontrol an offshore corporation
          is to invest with one or more unrelated foreign
          partners. If the foreign persons own 50% or more of the
          voting power, the corporation is decontrolled. It
          invests in the United States as a nonresident alien,
          and you are taxed only as you withdraw money from the
          corporation. Remember that the foreign persons must be
          the real owners of the stock and not be holding it as
          your agent in order to avoid the CFC rules.  This is
          particularly popular when the foreign investors are
          from a country with similar rules.  For example, many
          German investors have made 50-50 deals with American
          partners to invest in U.S. real estate, and both the
          German and American can then say to their respective
          tax authorities that they are not in control.  
               There you have three simple, straightforward ways
          to decontrol an offshore corporation. The rules are
          clearly stated in the tax code and the regulations.

          
          The favored income loophole

               Taxes can be avoided even if you have complete
          control of the offshore corporation and it is
          classified as a CFC. That is true because only certain
          types of a CFC's income are taxed pro rata to the U.S.
          shareholders as they are earned. Only what is known as
          the "subpart F income" of the CFC passes through to the
          U.S. shareholders. The rest is treated just as though
          the corporation were not a CFC. The income can
          accumulate and compound tax-free in the corporation
          until it is taken out as dividends.
               The income that will be taxed pro rata to U.S.
          shareholders of CFC includes the following:
               Foreign-personal-holding-company income. This
          includes all interest, dividends, royalties, and gains
          on securities, plus rents from related parties. Thus,
          you can see that most types of investment profits are
          included in subpart F income. But rent derived from the
          active conduct of a trade or business is not included
          unless the rental income is received from a related
          party.
               Suppose you own an office building in the Bahamas.
          You occupy 15% of it for your own business and lease
          the remainder to unrelated parties. You have a staff to
          lease and service the building. This would be
          considered the active conduct of a rental trade or
          business in a foreign country, and the rental income
          would not be subpart F income.
               Or suppose you own an oil-drilling company. When
          your equipment is idle, it is leased to other oil-
          drilling companies. The rental from the leases is not
          considered subpart F income and can be accumulated in
          an offshore corporation.
               Foreign-based-company sales income. This is
          essentially income from the purchase of property from a
          related person (such as another of your companies) by
          an unrelated person or the sale on behalf of a related
          person. 
               Foreign-based-company service income. This is
          income from consulting services (such as engineering,
          architectural, or managerial services) performed for a
          related person. If you perform these services for
          unrelated persons, the income is not subpart F income
          and can accumulate tax-free in the offshore
          corporation.
               Other subpart F income. There are special rules
          for banking, insurance, shipping, and oil service
          income. If you have these types of income earned
          overseas, your operation probably can be structured to
          avoid the subpart F rules. Consult an international tax
          adviser to see if it can be done.
               As you can see, loopholes abound in the definition
          of subpart F income. But it seems that most types of
          investment income are included in that definition, and
          the route to tax avoidance from these types of income
          is to form a decontrolled corporation. That is largely
          true, at least, but there is one other loophole in the
          definition of subpart F income that you might want to
          consider first.
               One way to avoid having the shareholders taxed on
          the subpart F income of the offshore corporation is to
          take advantage of the de minimis rule. The rule says
          that if the sum of the foreign-based-company service
          income plus the gross insurance income does not exceed
          5% of the CFC's total income or $1 million, whichever
          is smaller, none of the income is foreign-based-company
          income or insurance income.  
               For example, suppose that your offshore
          corporation buys some condominiums in the Cayman
          Islands. You rent these condominiums to tourists who
          are unrelated to any of the corporation's owners.
          Rental income from unrelated persons is not subpart F
          income, so this income will not be passed through pro
          rata to the U.S. shareholders. In addition, if the
          rental income is at least 95% of the offshore
          corporations total income, it will keep the subpart F
          income from being passed through to the U.S.
          shareholders under the de minimis rule.  
               If you have manufacturing or personal consulting
          services that can be moved offshore, you might be able
          to use non-subpart F income from these operations to
          shelter investments in the United States. In addition,
          the manufacturing and consulting income probably will
          not be subpart F income and will also be sheltered in
          the offshore corporation.
               But be careful. There is a sort of reverse de
          minimis rule. If the subpart F income of the
          corporation is more than 70% of the total income, all
          income is treated as subpart F income. In that case,
          income that normally would escape the subpart F rules
          would be included under those rules.
               The subpart F rules have plenty of loopholes, even
          if you have a controlled foreign corporation. But
          remember that the rules are very complicated and have
          numerous qualifications and exceptions that cannot be
          mentioned here. If you think that one or more of these
          loopholes might apply to you, consult an experienced
          U.S. international tax adviser before going forward
          with a tax plan.

          
          The investment company trap

               To plug some of the offshore corporation
          loopholes, the Tax Reform Act of 1986 established the
          passive-foreign-investment-company (PFIC) rules. These
          rules are more difficult to get around than those
          already discussed.
               A PFIC is any foreign corporation that either has
          75% or more of its gross income as passive income or
          has at least 50% of the value of its assets producing
          passive income or held for the production of passive
          income. Passive income is interest, dividends, capital
          gains, royalties, and some other types of income.
               Unlike the case with a CFC, there is no control
          requirement for the PFIC. If the offshore corporation
          is owned only 1% by U.S. persons and has the minimum
          amount of passive income, it is a PFIC.
               The penalty for owning PFIC shares is fairly
          severe. It is discussed in more detail in the chapter
          on offshore mutual funds. Briefly, you have two
          choices. One is to pay a penalty tax when you either
          sell the shares or take an excess distribution. The
          penalty tax assumes that the undistributed income and
          gains of the PFIC were distributed annually. You pay
          the tax plus interest based on the number of years you
          held the shares without paying the taxes. 
               The other option is for the PFIC to elect to be a
          "qualified electing corporation." That means you report
          your pro rata shares of the PFIC's income and gains
          annually, just as you would with a U.S.-based mutual
          fund. In other words, you lose the benefit of tax
          deferral.
               You can avoid the PFIC trap by reducing the
          percentage of the offshore corporation's income that is
          passive. For example, the corporation can own foreign
          real estate and rent it to unrelated parties. Such
          income is not passive. If the activity is significant
          enough, the corporation falls out of the PFIC
          definition.
               Another option is to combine the investment
          activities of the offshore corporation with an
          operating offshore business. If you have manufacturing
          or consulting operations overseas, these can be used to
          avoid the PFIC penalty.
               Another potential trap in the tax law is the
          foreign-personal-holding-company rules, which are
          different from the PFIC rules. In most cases, however,
          if you avoid the CFC rules or have a decontrolled
          offshore corporation, you also avoid the foreign-
          personal-holding-company rules.

          
          Investment loopholes in the United States

               Once an offshore corporation is established to
          take advantage of the loopholes described above, that
          corporation can invest in the United States.  
               The key to tax-free or almost tax-free investing
          is to ensure that the offshore corporation is
          considered a foreign corporation not engaged in a U.S.
          trade or business under U.S. tax law. There are
          detailed regulations that give numerous rules and
          examples. The important points are that generally there
          cannot be a U.S. office or agent in the United States,
          books and records must be maintained outside this
          country, and management and control must not be located
          here. Directors' and shareholders' meetings should be
          held outside the country, and the corporation cannot
          have a business here. It is vital that a U.S tax
          adviser structure your arrangement to comply with the
          law and give you a complete list of dos and don'ts.
               Once your offshore corporation secures its status
          as a nonresident alien, you can get these benefits in
          many situations:
               * No U.S. taxes on bank-deposit interest
               * No U.S. tax on capital gains earned on U.S.
          stocks and bonds. There will, however, be some tax on 
          dividends from U.S. stocks.
               In cases in which a tax might be incurred, such as
          on dividends, this often can be reduced or avoided by
          locating the offshore corporation in a country that has
          a favorable tax treaty with the United States. The
          Treasury Department has renegotiated a number of the
          tax treaties, but there still are some under which the
          U.S. withholding tax rate on dividends is significantly
          reduced.
               The advantages foreign investors have over U.S.
          ones were most apparent in the junk bond crisis and the
          problems it created for some insurance companies and
          savings and loan associations. If you followed the news
          stories closely, you saw that only foreign corporations
          or partnerships were submitting the best bids for the
          portfolios of junk bonds that these institutions were
          trying to sell. The primary reason for that is the tax
          advantages the foreign investors would enjoy. Any U.S.
          buyer of the bonds would have to pay taxes on any
          interest and capital gains they earned. The foreign
          investors face no U.S. taxes and, if they are based in
          a tax haven like Hong Kong, no domestic taxes either.
          This allows them to make bids 10% or more above  those
          of U.S. competitors.
               Investing in U.S. real estate used to be an easy
          way to tax-free income and gains for nonresident
          aliens. But the rules were changed in 1980, and the
          profits no longer will be tax-free. Still, investment
          in U.S. real estate through a decontrolled offshore
          corporation can result in lower tax on profits if the
          transaction is structured properly. This is a
          complicated and rapidly changing area, but the general
          approach is to set up an offshore company in a country
          that has a favorable tax treaty with the United States.
          (The Netherlands is the historical favorite.) The
          offshore company then creates a U.S. corporation, which
          buys the real estate. Sometimes, it makes sense to have
          one U.S. company own the real estate while another is
          set up to manage the property and collect management
          fees.  
               The IRS periodically issues revenue rulings to
          attack schemes that it has heard are being used. To get
          any of these results, you need up-to-date advice from
          an experienced U.S. tax adviser.
          

          Summary

               There are a number of ways that U.S. citizens and
          other residents can take advantage of one or more
          offshore corporations to invest tax-free or at low tax
          cost in the United States. But taking advantage of
          these loopholes requires careful and thorough planning
          with the help of someone who is knowledgeable in the
          U.S. tax aspects of these transactions. This chapter is
          able to touch on only the highlights, and you should be
          aware that the law in this area changes rapidly. When
          considering an offshore investment opportunity, you
          should look at both the ownership structure
          (decontrolled corporation, CFC, etc.) and the type of
          income to be earned (subpart F, non-subpart F).
               U.S. citizens who are evaluating an offshore tax-
          planning opportunity should be wary of several types of
          schemes. These include ones involving daisy chains of
          foreign corporations and trusts all of which ultimately
          are controlled by the same person, foreign lawyers and
          agents who will act as "accommodators" to establish
          foreign control of an entity, and plans emphasizing the
          secrecy involved and how difficult it will be for the
          IRS to uncover the transactions.
               Another element to be cautious of is the "thinly
          capitalized" corporation. This is a corporation that
          has few assets. The IRS and the courts often will
          simply ignore such a corporation when determining the
          tax effects of a transaction or series of transactions.
          Holding companies have their purposes, but dummy or
          sham corporations with no legal or business purpose
          tend to be ignored.
               Many Americans could take advantage of the
          offshore corporation loophole if they were aware of the
          opportunities available. This chapter has given you an
          outline of the rules involved and identify the types of
          transactions that could be profitably and legally
          conducted through an offshore corporation with a very
          low tax bite. If your situation was identified here,
          seek out an international tax expert to examine your
          situation further.
          
          
          
               For help in forming foreign corporations and obtaining
          proper tax advice, see the "A Source of Help" section at
          the end of the Offshore Trust Loophole chapter.





