Offshore havens?

By Sharda Prashad
Illustration: Gérard Dubois

When people think of a foreign tax shelter, they imagine an idyllic Caribbean island where anyone can squirrel away dollars, far from the prying eyes of the taxman. It’s not that simple

Clody Kinkade’s company, Offshore Inc. (not real names), wanted to establish a tax shelter in Barbados, but quickly learned that setting up a legal tax shelter is not a simple matter of going to a tropical paradise and registering a company. Offshore spent six months getting the job done, and it took Kinkade, the comptroller, another six months to make the enhancements and improvements needed to get transfer pricing contracts in order and to ensure the company was in compliance with national and international legislation and regulations.

Offshore’s lawyers and accountants spent much of that time reviewing and improving the proposed Barbados limited liability corporation (LLC) by en- suring that Offshore was not violating any rules and creating a structure that would be relatively stable in the event of changing tax rules. (They also spent a lot of time on small details such as ensuring that the people who were to run the Barbados operation had business cards, contact numbers and access to the accounting system in case the structure was audited.) The company decided to move all of its intellectual property to an LLC incorporated in the state of Wyoming, because of less onerous corporate tax laws, and to make the LLC resident in Barbados, because of its low tax rate — 2.5% versus approximately 40% in Canada. Kinkade also spent time looking for reputable representatives in Barbados to set up a trustworthy firm to handle business affairs on a daily basis. His Barbados contingent, the management team, includes a former lawyer and a retired businessperson who look after the day-to-day affairs, intercompany billings and corporate and other regulatory filings. Both, Kinkade says, are “by the book and don’t allow any gray areas.”If Kinkade didn’t care whether the tax shelter was legal, he could have created it much more quickly. Offshore could have established a shell company in Barbados and reported a portion of its income in the island. It could have then claimed that the new company was not a Canadian entity and therefore not subject to Canadian tax. However, that would have been tax avoidance, which was not what Offshore wanted when it created the offshore tax shelter.

 The company’s experience shows that setting up an offshore tax shelter is not as simple as some people may imagine. To be legal and to avoid the attention of the Canada Revenue Agency and avoid any pitfalls, a number of steps need to be followed. And soon new rules will make it more difficult for Canadians to set up offshore tax shelters.

Offshore’s LLC has been up and running nine years, and Kinkade says the initial outlay in effort was worth it: “I would recommend a tax shelter because the tax savings are enormous.” He estimates his organization — which has US$35 million in revenue — saves about US$2 million annually in taxes because of the shelter. “We avoid taxes in Canada that can be between 40% to 45% and additional US taxes, versus Barbados at 2.5%.”

But even after the offshore tax shelter is established, it isn’t easy to maintain, Kinkade warns. “It’s not a quick process and there is a heck of a lot of administration,” he says, estimating that 15% to 20% of Offshore’s finance department’s resources are dedicated to overseeing the structure on a regular basis. The administrative tasks include dealing with the intercompany accounts and ensuring that the mind and management of the LLC reside in Barbados, which means that as the LLC has input on who the product is sold to and how it is developed, the product belongs to the LLC. The offshore has only the right to use it. The LLC, which is a partner with Offshore, approves all Offshore R&D spending. As such, the LLC needs to be aware of all of Offshore’s operations to make informed R&D decisions.

In addition, senior members of Offshore’s staff attend key meetings in Barbados annually to discuss budgets, operational risks, forecasted product sales and to provide updates to the LLC.

Since the shelter was implemented in 1995, the CRA has not questioned it. However, Kinkade says a few years ago the Internal Revenue Service did. “It ultimately gave the blessing that it was proper and not tax evasion,” he says. If his organization had not established the entity in Barbados, Kinkade believes the only other option for the company to minimize taxes would have been to purchase organizations with losses and then apply the losses to his company’s gains. But its policy is to make acquisitions with products that are first or second in the market and therefore enhance its revenue. Kinkade feels this option was less strategic than the offshore structure it has in place now. “It takes a lot of time to invest in the structure,” he says. “But it’s a small price to pay for the savings.”

Christian Girouard, spokesperson for CRA, says it is important to remember that Canadians are taxed on income earned anywhere in the world as if it was all earned in Canada. While tax shelters are not illegal, he says, Canadians and Canadian entities have to report all their income. Problems occur when they don’t.

In 2003, international auditors reviewed 1,782 individual and corporate cases involving international treaties and re- assessed $900 million in taxes. Of the 1,782 audited cases, Girouard says, 1,004 were large international corporations that represented $761 million in re-assessed taxes. Generally, offshore tax shelters are created by large corporations, so if they get audited, all their holdings, including the offshore ones, are audited. However, the CRA has no numbers on how many firms that have been audited actually have offshore holdings. While the CRA does not audit tax shelters per se, it does audit cases that involve international treaties. These cases would include those with tax shelters.

The CRA has three major approaches for preventing tax avoidance, Girouard says. On the multilateral front, the CRA teams with organizations such as the Organization for Economic and Co-operative Development and the Pacific Association of Tax Administrators to develop strategies and projects to limit the occur-ence of tax avoidance on an international level. The CRA also has a bilateral approach where it shares information about organizations with countries — including those considered tax havens. On the domestic front, Girouard says, the CRA deals with abusers by conducting ongoing audits and assessing risk. For instance, if certain transactions are considered to be based on the motivation for establishing a tax haven instead of a legitimate business reason, the transaction will be examined with greater scrutiny.

Some advisers dissuade clients from the use of tax shelters simply because of this greater scrutiny. For example, Bruce Harris, partner at PricewaterhouseCoopers LLC, says few of his clients use either onshore or offshore tax shelters. “Many clients do not use onshore or offshore tax shelters because tax shelters can push the limits of the law,” he says, “and some clients don’t want to take the tax risk or have problems with the CRA even if there is a chance the shelter could be successful.”

Heather Evans, partner at Deloitte & Touche in Toronto, says it will be more difficult for corporations and individuals to use these structures with the Department of Finance proposing new foreign investment entity (FIE) rules. The pending legislation could replace the “offshore investment fund property rules” in the Income Tax Act. The proposed FIE rules will impact those who invest in foreign corporations, trusts, partnerships, funds and other entities. The new rules were proposed in 1999 and are in their fourth iteration with the latest version issued on October 31, 2003. The legislation will be retroactive generally to January 2003 but has yet to be implemented. (As of January 5, no changes had been implemented.) “The effect of the rules is that there will be few offshore structures that will be able to avoid Canadian tax,” says Evans.

David Wentzell, partner at McMillan Binch LLP, says the new rules are an overlay to the legislation already in place. With the latest iteration of the proposed rulings, there will be three methods of accounting for FIE interests. Evans provides this summary for the three methods of treating an interest in a FIE:

Income imputation (default method) where a taxpayer has a participating interest in a FIE, the interest will be subject to an income imputation inclusion calculated as the designated cost of the participating interest multiplied by the prescribed rate of interest (three-month T-bill rate plus 2%).

Mark-to-market method is elective (except for foreign insurance policies, where it is mandatory) and the election must be made in the first year that the FIE rules apply to the interest. Gains or losses are recognized annually with reference to fluctuations in value and included in income or deducted. This method is only available where the interest has a readily obtainable fair market value.

Accrual method is also elective, but requires extensive financial information that will not be available for most taxpayers and will thus be of limited application. Income earned by the FIE is computed in prescribed form and annual income from the interest is added to a taxpayer’s income for the year.

In the absence of electing mark-to-market or the accrual method, a prescribed interest rate will be applied to the designated cost the taxpayer has established for his or her FIE. The prescribed rate varies, but for the last quarter of 2004 and the first quarter of 2005 it is 5%. Wentzell says the prescribed rate is “quite low at 5%. Many offshore markets give much more than 5%, so it’s a bargain.” Alternatively, the taxpayer can elect to have the FIE interest valued on a mark-to-market basis or have it calculated with the accrual method and have it included in the annual income tax for the year using current income tax rates.

With the introduction of the new rules, it is only natural for a new set of tax planning to evolve that will legitimately fall outside of the rules. “Products might be designed to either capitalize on the exceptions that are written into the rules or [that] specifically fall outside the scope of the rules,” Wentzell says. “For example, cash settled derivative products are spe-cifically excluded and may afford some structuring opportunity. Also excluded are certain listed entities in prescribed countries such as Ireland. Partnerships and controlled foreign affiliates are outside the rules and may provide some planning options.” And, he says, larger rather than smaller investors will use these strategies.

One trust that will continue to avoid Canadian tax under the new rules is the Immigrant Trust. In the case of the Immigrant Trust, up to 60 months after an immigrant arrives in Canada, he or she will be able to invest funds offshore without having to pay taxes on them. (The Income Tax Act has long encouraged anyone coming to Canada to take advantage of this trust.) Evans says anyone coming here  with significant investment assets could set up an offshore trust if they intend to be in Canada less than five years. She has found that Europeans prefer investments in the Channel Islands whereas others, including Canadians, prefer investments in Carib- bean countries because of their geographic proximity and familiarity.

Granny trusts could see changes with the new rules. Under a Granny Trust, if a foreigner sets up an offshore trust for a Canadian beneficiary, it will be exempt from Canadian taxes. However, beneficiaries of the Granny Trust may be exposed to Canadian tax under the new FIE rules.

According to Evans, other offshore trusts had to have a Canadian resident contributor and a Canadian resident beneficiary to be subject to Canadian tax in the past; these trusts now need only have a Canadian resident contributor. “These anti-avoidance provisions will have a chilling effect on the industry,” she says.

Individuals and organizations using offshore shelters for tax planning are on the decline, Evans says, and there has been a minor increase in those using offshore shelters for investments (hedge funds). There’s no tax play with such investments as you pay tax at the national rate, but they are more interesting options.

This is something Evans attributes to the greater number of international investment opportunities. Cameron McIntosh, president of Calgary’s Overseas Tax Consultants, suggests offshore shelters to clients, especially to his high-income clients, primarily for asset protection, not to avoid taxes. One of the advantages of using offshore shelters for asset protection is that creditors cannot attack money held offshore through nondisclosure arrangements. McIntosh recommends these shelters for those in highly litigious positions such as doctors and lawyers. He says most clients do not understand the costs associated with offshore shelters, such as maintaining the structure and legal expenses. And you need to have significant amounts of money to justify the cost of creating and maintaining one. “A lot of people have a false impression and think you should put $200,000 offshore,” says McIntosh. “You need about $1 million.”

According to McIntosh, currently the most popular places for an offshore shelter are the Bahamas, Belize, the Channel Islands and the Isle of Man. Other choices include the Cayman Islands, Barbados and Turks and Caicos. McIntosh’s personal fav-ourite is the Bahamas, because its laws are entrenched in that type of business. Many laws are modelled after the British system, which has more stability and credibility.

Wendy Warren of the Bahamas Financial Services Board says there is “no information that indicates that the Bahamas is uniquely attractive for Canadians who want offshore tax protection.” Its attraction as an international financial centre is due to several factors, says Warren, including providing a tax neutral platform (no direct taxes are imposed on anyone — Bahamian or foreign national); a pro-business government; and a long-standing respect for personal privacy. These factors are shared by other so-called tax havens.

Canadians who do invest in the Baha- mas should be aware that the Bahamas (as well as other tax havens) has entered into Mutual Legal Assistance Treaties with Canada. “The treaty with Canada provides for mutual legal assistance in all matters relating to the investigation, prosecution and suppression of offences,” Warren says. This means the Bahamas will take witness testimony; locate and identify persons, objects and sites; execute requests for searches and seizures; service documents and provide documents and records.

While some Canadians might be deterred from investing offshore because of this open information exchange, others might be hesitant because of fly-by-night operators who bamboozle foreigners. The nontax issue concerning investing offshore is whether rogue traders will take off with the money and leave individuals and/or corporations with valueless accounts. “It’s fair to say there are actors on the scene that are less reputable than others,” Wentzell says. When setting up an offshore investment, it’s always a concern of regulators that many markets are unregulated or loosely regulated, although even in tax haven jurisdictions there is increased scru- tiny and more regulations.

Warren says anyone considering offshore transactions begin by speaking to advisers familiar with the investment and legal frameworks in the country where they are planning to invest and in the country in which they live. The investor should also ensure the institution being considered for investment is licensed by national or international regulators.

“There is no shortage of quality islands that are bona fide,” says Wentzell. “I would do a comprehensive due diligence to scope out what it is.”

Once you’ve completed your due diligence with your advisers, you’re well on your way to deciding if a tax shelter is for you. Kinkade admits he wasn’t a tax specialist yet managed to learn most of the intricacies of tax shelters on the job with the help of his lawyers and auditors.

Offshore tax shelters won’t work for everyone yet can have tremendous benefits. The issue is finding a structure that is legal and has these benefits. However, with new FIE rules, this combination will become even more difficult.

Sharda Prashad, CA, is a Toronto-based writer