Tax havens - shelter or shoulder?

• Author: Verzi, Robert A.

Taxpayers frequently wonder whether they can move certain assets to a tax haven country to avoid U.S. income tax on the income and gains. In most cases, this is not possible; U.S. tax rules contain three main weapons to prevent taxpayers from avoiding tax on income earned in a tax haven country.

According to Black's Law Dictionary (Westlaw, 7th ed., 1999), a "tax haven" is "a country that imposes little or no tax on the profits from transactions carried on from that country." Countries that meet this definition include the Cayman Islands, Bermuda, the Bahamas, the British Virgin Islands, Liechtenstein, Belize and the Netherlands Antilles, etc. However, according to the definition, other countries could also be considered tax havens. For instance, Ireland's corporate tax rate is only 12.5% on trading income. When compared with other countries in the European Union or with the U.S., this rate is very low.

Playing by the Rules

There are several reasons why U.S. taxpayers cannot reduce or eliminate U.S. income tax by establishing and funding a corporation in a tax haven.

Example 1: A U.S taxpayer, J, with a substantially appreciated stock portfolio, transfers it to Corp. B, in the Bahamas, to avoid tax on the future income and gains.

The first problem is that the transfer of the stock portfolio triggers U.S. income tax on the transfer. Under Sec. 351, an asset transfer to a controlled corporation in exchange for its stock is generally a nontaxable transaction; the taxpayer recognizes neither gain nor loss on the exchange. Sec. 351 applies whether the controlled corporation is domestic or foreign. However, Sec. 367, an anti-avoidance rule, forces the taxpayer to recognize gain on a transfer to the foreign corporation, with some limited exceptions. Thus, under U.S. tax law, the transfer will trigger U.S. income tax to the extent the fair market value (FMV) of the securities transferred exceed the taxpayer's basis. This could be a significant up-front cost to the taxpayer's overall avoidance plan.

What if J was to transfer securities with a basis equal to their FMVs, or was to transfer cash? The initial cost would be minimized or eliminated. However, as mentioned above, U.S. income tax law provides three main tax regimes to prevent U.S. taxpayers from avoiding income tax on income earned (including capital gain) in a tax haven--the foreign personal holding company (FPHC) rules, subpart F rules and passive foreign investment company (PFIC) roles.

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