CHAPTER 3 USING AN OFFSHORE TAX ENTITY IN THE DEAL
| Jurisdiction | United States |
(Apr 1999)
USING AN OFFSHORE TAX ENTITY IN THE DEAL
Steiner, Darling, Hutchinson & Wilson LLP
Denver, Colorado, USA
Table of Contents
1 INTRODUCTION
1.1 WHAT IS AN OFFSHORE ENTITY?
1.1.1 Pure Tax Havens
1.1.2 Low-Tax Jurisdictions
1.1.3 Preferential Tax Regimes
1.2 OVERVIEW OF CONSIDERATIONS IN USING AN OFFSHORE JURISDICTION
1.2.1. Tax Considerations
1.2.1.1 Residence Country
1.2.1.2 Source Country
1.2.1.3 Tax-Haven Country
1.2.2 Nontax Considerations
2. RESIDENCE COUNTRY TAXATION
2.1 NATURE OF TAX SYSTEMS
2.2 DEALING WITH FOREIGN INCOME
2.2.1 Exemption Method
2.2.2 Credit Method
2.2.3 Reporting
2.3 DEALING WITH FOREIGN SUBSIDIARIES
2.3.1 Deferral Principle
2.3.2 Limitations on Deferral
2.3.3 Anti-Deferral Regimes
2.3.3.1 Bad Country Rules
2.3.3.2 Bad Income Rules
2.4 EU CODE OF CONDUCT ON HARMFUL TAX COMPETITION
2.5 OECD INITIATIVE ON TAX HAVENS
2.6 SUMMARY AND COMMENT
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3. SOURCE COUNTRY TAXATION
3.1 SOURCE COUNTRY ENTITIES
3.2 FOREIGN LEGAL ENTITIES
3.2.1 Doing Business
3.2.2 Permanent Establishments
3.3 WITHHOLDING/BRANCH TAXES
3.4 TAX TREATIES
3.4.1 Permanent Establishment Limitations
3.4.2 Reduction of Withholding Rates
3.4.3 Treaty Shopping
3.5 EARNINGS STRIPPING
3.6 SUMMARY AND COMMENT
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USING AN OFFSHORE TAX
ENTITY IN THE DEAL
John R. Wilson1
1. INTRODUCTION
Offshore entities have long been an important element in international tax planning, including the structuring of cross-border resource investments. Ideally, such entities can be used to reduce the overall tax burden on the resource venture, both in the country where the resources are located (hereinafter the "source country") and in the investor's home country (hereinafter the "residence country"). Offshore entities also may facilitate joint venture investments by investors from different countries (and different tax systems) by providing a neutral investment vehicle.
Using offshore entities in a tax-efficient manner, however, requires a careful balancing of the often-conflicting tax rules of several jurisdictions. Relevant rules include the outbound tax rules of the residence country, the inbound tax rules of the source country and the tax rules of any intermediate countries in the structure. Moreover, the use of offshore entities is subject to increasing scrutiny by taxing authorities worldwide.
1.1 WHAT IS AN OFFSHORE ENTITY?
"Offshore entities," or "tax-haven entities," are generally those entities formed in various low- or no-tax jurisdictions commonly known as "tax havens,"2 the most notable of which are certain self-governing island colonies and dependencies of the United Kingdom. A tax-haven entity generally pays no tax in its country of formation, or is able to obtain favorable local tax treatment on certain types of foreign income.
The world is full of tax havens, and the world of tax havens is constantly changing.3
1.1.1 Pure Tax Havens
"Pure" tax-haven companies formed in jurisdictions such as Bermuda or the Isle of Man are not subject to any local income taxation. Such companies instead pay an annual
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corporate fee as a condition of maintaining their company status and tax exemption. Pure tax-haven companies generally are not entitled to any relief under tax treaties, because other countries generally will not negotiate tax treaties with tax-haven jurisdictions.4
Pure tax havens include many Caribbean jurisdictions (Anguilla, Antigua, Bahamas, Bermuda, British Virgin Islands, Cayman Islands, Grenada, Nevis and Turks & Caicos) and well-established European offshore centers (Jersey, Guernsey and the Isle of Man).5 Gibraltar and Malta are two other European tax-haven destinations.
1.1.2 Low-Tax Jurisdictions
Companies formed in other jurisdictions may be subject to a fairly modest rate of local tax and yet still be considered tax-haven companies because the modest local tax burden is offset by special tax relationships, e.g., such companies may be able to use particular tax treaties to facilitate tax-advantaged investments in certain source countries. Thus, these companies may be useful in international tax planning.
Examples of such low-tax jurisdictions include Barbados, Cyprus and the Netherlands Antilles. Barbados offers low-tax "international business companies" and is party to a number of tax treaties. Because of the Canada/Barbados treaty, Barbados can be particularly useful in Canadian outbound structures.6 Cyprus offshore companies are subject to a 4.25 percent tax rate and, owing to Cyprus's treaty network, are principally used for investments in Russia and other Eastern European countries. The tax advantages of the Netherlands Antilles follow from its special tax relationship with the Netherlands.7
1.1.3 Preferential Tax Regimes
Other "tax-haven" companies may be formed in countries that are not tax havens (or even low-tax jurisdictions) in the classic sense of the term but that offer preferential tax treatment of certain income (e.g., no tax on dividends from foreign subsidiaries).
A classic example of a preferential tax regime is the Dutch "participation exemption," which allows Dutch companies to avoid Dutch tax on dividends and capital gains with
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respect to holdings in foreign subsidiaries.8 Dutch companies also benefit from the extensive Dutch treaty network, permitting the reduction of withholding taxes on payments from a source country entity to the Dutch company. Luxembourg and Switzerland offer other possibilities for tax-efficient holding and finance companies. Ireland allows the formation of a "nonresident company," which, although incorporated under Irish law, is managed elsewhere and thus is exempt from Irish taxation of non-Irish income.9 A recent variant of a nonresident company is the U.S. "limited liability company," or "LLC," which generally is treated as a partnership (transparent entity) for U.S. tax purposes.10 If the LLC itself does not engage in U.S. activities, and its members are foreign persons, no U.S. tax will be imposed on the LLC or its owners, even though the owners thereby obtain the nontax advantages of a U.S. entity with limited liability.
1.2 OVERVIEW OF CONSIDERATIONS IN USING AN OFFSHORE ENTITY
In determining whether an offshore entity makes sense for an international resources project, both tax and nontax issues must be considered. There is no single best tax haven for all projects. Each investor's particular tax situation in its residence country may be affected by using an offshore entity, depending upon the residence country's rules for taxing foreign income. Further, using a tax-haven entity may give rise to tax issues in the source country, depending upon the source country's internal tax rules and the possible effect of tax treaties. Finally, nontax issues arising from the use of a tax-haven entity must be considered.
1.2.1 Tax Considerations
1.2.1.1 Residence Country
Residence countries use different approaches to tax foreign income earned by their tax residents. Some countries use an exemption method, while others use a credit method. Many use a mixture of the two. Irrespective of the particular method employed, a principal issue in the taxation of foreign income is whether profits earned by an offshore entity (viewed as a foreign corporation in the residence country's tax system) will be presently taxed or will qualify for exemption or deferral.
Most residence countries have well-developed rules concerning the taxation of foreign income that attempt to provide relief from double taxation. Residence
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countries also seek to prevent "tax evasion" through offshore transactions and to define the limits of "tax avoidance" in the international context. Tax evasion and tax avoidance both implicate tax havens, but have very different meanings. Tax evasion, which is generally criminal in nature, largely consists of not reporting income or activities to the residence country (e.g., not reporting interest from an offshore bank account). Tax avoidance, on the other hand, consists of using the tax laws (including the rules governing the taxation of offshore entities) in a legal way to a taxpayer's advantage.
1.2.1.2 Source Country
Taxation issues also arise in the source country. The resource project likely will be owned either by a source country entity (owned, directly or indirectly, by the offshore entity) or by the offshore entity itself. As a practical matter, given the nature of a resource project, there undoubtedly will be some source country taxation.11 Thus, the question becomes how to limit source country taxation and repatriate profits in the most tax-efficient manner. The choice of legal entity and the means of financing the project may be important in this regard.
Taxes other than income taxes also may be a concern in the source country, including employment and value-added taxes.
1.2.1.3 Tax-Haven Country
By design, taxation issues are not of great significance in the tax-haven country itself. This assumes, of course, that the tax-haven company conducts its operations so as to qualify for the desired tax exemption or other favorable tax treatment. In some jurisdictions, such as the Netherlands, it is possible to consult with the local tax authorities and obtain assurance (in the form of a ruling) as to the desired tax treatment.
1.2.2 Nontax Considerations
Nontax considerations, such as political stability, infrastructure and location, can be important in assessing the desirability of an offshore jurisdiction.12 These concerns are heightened if the tax-haven entity will be used as a joint venture vehicle (i.e., if potentially adverse interests will hold interests in the entity). In this case, the parties need
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