Over the past decade we have seen much criticism concerning international tax havens for engaging in harmful tax practices. It is no wonder that the Organization for Economic Co-operation and Development (OECD) most powerful member, the United States, is still receiving sharp criticism from domestic and foreign critics alike because it may in fact be the world’s largest “offshore” tax haven.
Critical to understanding the US role as a tax haven is an appreciation that its tax-free benefits are, as with many traditional tax havens, reserved for its foreign (i.e., nonresident alien and foreign company) investors.
The United States has established incentives to international investors and has in return reaped the benefits of foreign nonresident investment since the early 1920s. While not all forms of investment are tax-free, for example, most real estate investments, US source business income, etc., the following US investments by nonresident aliens may enjoy zero income and capital gains tax:
- Investment and trading of shares in companies trading on any US stock exchange. (Subject to withholding tax, but may be significantly reduced by one of the numerous double tax treaties the US has entered into with other jurisdictions). For example, the US Netherlands Antilles Treaty.
- Deposits in US Banks.
- US Corporate and Treasury Bonds. (Not subject to withholding tax).
- Interest on Notes.
Why is it that these benefits to nonresident alien investors are not widely publicized (and not known to most US persons)? The reason is twofold. Firstly, the US, as a developed high tax jurisdiction, could not possibly offer the same incentives to its own taxpayers and so the loss of tax revenue precludes the inclusion US persons. Ironically, if the general population of US taxpayers was made aware of this arrangement the likely outcome would not be favorable to the US economy. Outright dissention might lead to legislation to curb or eliminate such incentives to foreign investment which in turn would precipitate an outflow of foreign investment capital from the US. The effect would be devastating as direct foreign investment in the US is estimated to be in excess of $390 billion. Secondly, the United States as a G7 member of the OECD would find itself in the difficult position of publicly condemning the past blacklisted tax havens while promoting their very own tax haven – a “do as I say, not as I do” approach. Notwithstanding, a change in this policy is, however, not likely to occur any time soon.
The OECD, and others has tried to classify tax havens and determine which policies constitute “harmful tax practices”. Let’s take a look at how the United States would fair within the OECD definitions.
The report defines a tax haven that conducts harmful tax competition as:
- Any nation that imposes nominal or no tax on income.
The United States imposes zero income and capital gains tax on the investments listed above where the income is not effectively connected with a US trade or business or otherwise exempt. (See IR Code s.871(i)).
Therefore the US imposes nominal or no tax on income.
- Any nation offering preferential treatment to certain types of income at no or low tax rates.
The United States offers foreign investors preferential treatment on certain investments. The tax rate on those investments is zero.
Therefore the US offers preferential treatment to certain types of income at no or low tax rates.
- Any nation that offers or is perceived to offer non-residents the ability to escape taxes in their country of residence.
Nonresident foreign investors of the particular investments described in this article are required to complete and file IRS form W-8BEN with the US bank or investment firm as a prerequisite to opening an account. Further, this report must be reviewed and, if necessary, revised every three years. Notwithstanding, IRC sections 6049(b)(2)(c) and (b)(5)(B)(iv) provide for an exemption from reporting of the nonresident’s interest by the banking and financial institution. This means that the institution makes no informational report to the Internal Revenue Service. Thus no report on the investor’s activity is submitted to his home jurisdiction.
This creates an absolute ability for investors to awfully reduce (or lawfully avoid) taxes in their country of residence – should they choose to do so.
- Practices which prevent the effective exchange of relevant information with other governments on taxpayers benefiting from a low or no tax rate.
The United States does not generally collect information on foreign nonresident investors for the particular types of investments described in this article. By not obtaining this information, the US might be said to be preventing the exchange of relevant information. It should be noted, however, that currently no US double tax treaties or model treaty (e.g., OECD), requires collection and exchange of such information beyond the scope of its domestic law. In consideration of the IRC section 6049, etc., being US domestic law, the US is, legally speaking, not in violation of this prong, however, it is arguable that its failure collect and disseminate information readily available establishes, in spirit, a practice of prevention. [The author does not advocate this argument.]
Questionable Practices of Lack of Transparency and the use of Bearer Shares.
While this article focuses primarily on the individual foreign nonresident investor use of the United States as a tax haven, there are many tax planning strategies available using US corporations or Limited Liability Companies to decrease or eliminate tax altogether. With this in mind, let’s consider the issue of transparency or the lack thereof. One of the OECD’s chief criticisms of tax havens is the use of companies issuing bearer shares. Interestingly, a number of US states permit the establishment of companies with nominee directors and permit issuance of bearer bonds. While generally something to avoid without competent advice, this practice, in theory, shields the true owner(s) from being exposed from liability BUT does not do away with one’s lawful reporting obligations in in the US and in most other tax jurisdictions.