In February, BusinessWeek1 ran an article "A Caribbean Tax Holiday for U.S. Businesses" that made mention of the Cayman Islands and which naturally drew my attention. The article featured a number of "small retailers and service providers" that had established companies offshore for the purposes of "minimising their US tax bills by sending credit-card receipts to Panama, Nevis, Aruba, the Cayman Islands and other business-friendly havens".
These were reportedly businesses that have established companies in offshore jurisdictions that levy little or no tax, compared with state tax rates of up to 10 percent in the US and corporate income tax of up to 35 percent. These businesses, according to the article, deposit their credit card receipts in an offshore company to mitigate their tax liabilities. I doubt whether such a strategy has gained much traction in the Cayman Islands, if any, and I don't intend to comment on the viability of such an arrangement.
What is most striking in the article, however, is that offshore jurisdictions, such as the Cayman Islands, are perhaps accurately labelled by BusinessWeek as "business-friendly". This clearly does not connote illegal activity or anything sinister but rather the fostering of an environment that can effectively compete in the global market to attract industry. This perhaps, in and of itself, has given rise to the challenge facing the IRS which estimates that "US$100 billion a year in revenue is escaping the US sales and income taxes in this manner".
The article focused not on big industries or mega corporations but on "mostly small retailers and service providers" trying to mitigate their tax liabilities in a manner that those business owners insist is "entirely lawful and appropriate" and as business owners they are adamant that they "comply with all tax laws". The fact that the IRS has spent "several years .... formally investigating whether the spreading credit-card practice amounts to illegal behaviour", suggests that they might have indeed been successful in structuring their affairs lawfully and appropriately and have withstood the test of scrutiny.
It used to be that inclusive in the fiduciary responsibility of directors was the obligation to mitigate the expenses of that company and ensure maximum profits for the shareholders. In fact, under English common law the principle established in IRC v Duke of Westminster in 1936, still exists. In that case Lord Tomlin commented, "Every man is entitled if he can to order his affairs so as that the tax attaching under the appropriate Acts is less than it otherwise would be. If he succeeds in ordering them so as to secure this result, then, however unappreciative the Commissioners of Inland Revenue or his fellow taxpayers may be of his ingenuity, he cannot be compelled to pay an increased tax2." To legitimately structure a company to ensure that it legally minimises its taxes now however, appears questionable. The disturbing trend of preventing companies from doing so and apparently yielding to payment of higher taxes, defies basic principles of good governance, free competition and capitalism.
The BusinessWeek article went on to state that, "The credit-card investigation is unfolding as the Obama Administration cracks down on a variety of corporate and individual tax-minimisation strategies." Not tax evasion or money laundering but "tax minimisation strategies"!
Such a tactic against large corporations is one thing, but the primary focus of the article was on "mostly small retailers". The very survival of most if not all companies (and particularly smaller businesses) in a recession, might well depend on the ability to be fiscally prudent and the ability to legally mitigate and minimise all liabilities including taxation.
With legitimate and properly structured offshore companies, one can legally mitigate unnecessary payments and liabilities of a business. The Business Week article does however make mention of some concern that there is non-reporting or under-reporting by US citizens in respect of funds derived from offshore entities. Whilst it might well be that there are unscrupulous persons who fail to make adequate tax disclosures to their home countries or fail to disclose repatriated funds, it is unfortunate that more time was not vested by the author of the article in distinguishing the role of legitimate and compliant offshore structures from the illegal activities of such individuals. In perhaps unintentionally blurring the lines between the two, the entire structure of those legitimate and legally compliant offshore companies, falls under undue criticism. Regrettably, this might be the object of the exercise.
Certainly the negative focus on offshore financial jurisdictions such as the Cayman Islands, as opposed to onshore tax havens with no or low taxes, is striking. This is particularly so as many in the Cayman Islands' financial industry are of the view that many of the onshore tax havens play on an unlevel playing field with less due diligence and anti-money laundering legislation than the competing Cayman Islands. Certainly this striking contrast becomes very apparent when comparing the BusinessWeek article to the Guardian.co.uk article, "Is Microsoft a tax dodger", of September 2009.
But the very issues that dog the Cayman Islands as a low tax jurisdiction might eventually haunt some onshore jurisdictions, including the United States.
The Guardian.co.uk 3covered a brewing controversy over Microsoft's offices. Although located in the United States, Microsoft's offices are set up in Reno, Nevada, a state that has no corporate income tax, for the purposes of licensing the company's software and from which its software licensing revenue is reported. This setup appears very much like the smaller businesses under the focus of the IRS for having their offices located in the Caribbean as reported in the BusinessWeek article. In setting up its offices in Nevada, Microsoft has avoided paying business and occupation tax that would otherwise be required on software reproduction in Washington State, allowing the company to minimise its tax liabilities legally. In the report there is an interesting editorial note in the Guardian.co.uk where mention is made of Microsoft's "...tax, er, avoidance*..." and at the end of the article it explains that "*Tax evasion is illegal, tax avoidance isn't."
Whilst there is no clear indication of a major investigation against Microsoft or any of these larger companies that have opted to establish offices in Nevada or Delaware to legally minimise their taxes, it has drawn the attention and ire of some US citizens. In fact blogs have been dedicated to protest and petition that corporations such as Microsoft have "avoided" paying their "full" taxes and should be forced to pay some 1.4 billion in back taxes, interest and penalties (keep in mind the Guardian's own definition of avoidance versus evasion). After all, it is argued, given the fact that Washington has a 2.4 billion dollar shortfall, obtaining this money from such corporations would be a panacea. In fact the blog has been successful enough to receive a response from the Government's Department of Revenue, only not the response that they had hoped for but rather one defending the Department of Revenue's "inaction against Microsoft".
The blog and the postings thereto, make for interesting reading. It transcends the legality of the transactions in question, and addresses the wider issues of low or no tax jurisdictions versus fair and legal competition against higher tax jurisdictions. Not unlike my own views as a resident of the Cayman Islands, a resident of Nevada responded that they "...agree ....that in light of Washington State's attitude and business killing tax structure, Microsoft should move the entire company to Nevada". But more to the point someone made the interesting comment that dared to echo the nagging underlying issue of directors' fiduciary responsibilities to their company: "Microsoft is a public company owned by a lot of shareholders. I expect them to be as profitable as possible. If that means shopping around to avoid taxes, all the more power to them. You keep pushing taxes on these companies and they'll leave and take their ball with them. Just look at Boeing. Instead of bitching about Microsoft looking for tax breaks, why don't you post an article detailing how much money Microsoft actually 'puts' into the WA economy and WA state coffers. Instead of taxing these companies out of state, how about cutting back on the spending for a few years like most households in this state are doing".
No one appears immune from what can only best be described as harassment or bullying tactics, where there appears to be no legitimate or legal means of compelling payment under a higher tax regime. No one, including Microsoft or Meg Whitman the Republican Gubernatorial candidate in California, is immune.
The California Accountability Project, an independent group, set out its cause for concern in a statement released in February4 that Ms. Whitman's charitable foundation, invested US$4 million in offshore hedge funds, including the Cayman Islands (keep in mind that almost 80 percent of the worlds hedge funds are incorporated in the Cayman Islands). And according to them this begs the question "Is Meg Whitman still shifting her millions into offshore tax havens to avoid having to pay her fair share?.....California's voters expect and deserve to know if Whitman is continuing to engage in tax avoidance schemes". Again we are reminded of the Guardian's distinction between avoidance and evasion.
Relevant to this, and what aids in putting this all into perspective, is the recent intriguing role of the US Treasury Secretary, Timothy Geithner in the American International Group ("AIG") bailout scandal (Geithner was then head of the Federal Reserve Bank of New York ("Fed.")). As it turns out, AIG's lawyers were preparing a filing to explain how it eliminated one of its portfolios of derivatives (credit-default swaps) through a company created with the Fed called "Maiden Lane III." Maiden Lane III bought up the debts from AIG, making the financial institutions AIG owed under swaps, whole, and taking the liabilities off the balance sheets of AIG. AIG was then able to tear up those swaps bought by Maiden Lane III.
However, there were $10 billion worth of swaps that could not be purchased due to the nature of those particular swaps. AIG was unable to rid itself of them. The Fed instructed AIG to delete any reference to these toxic assets when disclosure of them was required under federal law.
There is strong speculation that this "editing" was to ensure that there would be no questions raised as to the 100 cents on the dollar being paid by the Fed to AIG for their toxic assets amongst other issues.
An article in the New York Times5 on these revelations raised a number of intriguing facts. To start, the entity that bought the derivatives, Maiden Lane III, set up by the Fed with AIG for the purposes of payment of the bailout money, was setup in Delaware! Delaware is also a low tax haven that competes effectively in the same market as the rest of the offshore jurisdictions and has as many companies registered as most of its competing offshore jurisdictions (perhaps put together).
It would appear that the US Government is also of the view that there is a necessary role for the use of a company incorporated in a low tax jurisdiction in a legitimate transaction (for the purposes of this discussion, I will use the term "legitimate" loosely here).
The general counsel for the Fed tried to defend the failure to make all of the necessary disclosures under the federal securities laws, notwithstanding that the tax payers paid 100 cents on the dollar for soured investments. Mr. Geithner tried to distance himself from the decision, notwithstanding that he was the head of the Fed at the time (it would be the second time Mr. Geithner pleaded ignorance of the relevant tax details. The first being for non-payment of his own taxes, causing the Obama Administration some embarrassment on Mr. Geithner's appointment as US Treasurer, and which he quickly remedied with full payment).
The full details as to why the Fed set up a company with AIG in Delaware is even more intriguing. Their reasons seem to go beyond just tax avoidance. The speculation as to why they did so and the shroud of secrecy that has enveloped the details of Maiden Lane III is all unflattering to the Fed6.
The irony of this is brought home by the proposals from the US Government to overhaul the financial regulation of the securitisation market back in September 2009 in response to the mortgage crisis, but before this scandal broke. The proposals include "increased market transparency" amongst a slew of other regulatory changes.
Yet it is not clear if any of the proposals for change would have caught the deliberate decision by the Fed not to make adequate disclosures under existing laws in an effort to prevent businesses that were "too big to fail" from failing.
The failings in this particular transaction though, might have little to do with AIG or Maiden Lane III or where Maiden Lane III was incorporated. The onus of being forthright and making full disclosures as required under the law remains the crux of the matter. It distinguishes the legality and legitimacy of the transaction from the deliberate failings of individuals to be compliant with the law.
It will be interesting to see how the matter unfolds in Congress, or not, as the case may be.
The silver lining for those of us in the offshore industry is that the US Government has adequately demonstrated that there is a legitimate role for the incorporation of companies in low tax jurisdictions in the commercial market. It might be though, that given the US Government's own reluctance to touch Microsoft in Nevada, and its own propensity to utilise Delaware, that its scrutiny depends solely on where that low tax jurisdiction is located. Perhaps if it's a small island outside of the US, it's fair game, and the sledgehammer approach from the podium of the White House is an option.
Mr. Geithner taught us a few lessons worth passing on to our clients: in addition to the legitimate need and role of well regulated low tax jurisdictions in the global market, Mr. Geithner's actions also pointed out the need to encourage the client to make all necessary disclosures in their respective jurisdictions where one is required to do so under the law. But, dare I say it, yes; to encourage the client to take good counsel and then pay his or her relevant taxes as is legally required (after all you never know when someone might tap you on the shoulder to become the US Treasurer)!
Sophia Harris is the Managing Partner of Solomon Harris Attorneys-at-Law in the Cayman Islands. For further information relating to this article, please contact the author.
1.February 11, 2010.
2. IRC v Duke of Westminster  19 TC 490.
3. By Charles Arthur, September 23, 2009.
4. The California Majority Report, February 24, 2010.
5. Fed Advice to AIG Scrutinised, January 8, 2010.
6. The Huffington Post, February 18, 2010.
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