If you are a U.S. person or a tax resident of a high-tax country such as the UK, Canada, Australia, Germany or France, you generally cannot avoid or defer taxation by using offshore corporations. In this article, I’ll explain why. I won’t dive into the specifics of any single tax code. Instead, I’ll break the issue down into the core principles that appear in most tax systems worldwide. Your individual situation will differ in detail, but not in substance.
We’re talking specifically about offshore corporations. Corporation hereby means any incorporated legal entity, not only companies limited by shares. Foundations, cooperatives, associations, companies limited by guarantee are equally subject to these rules.
Partnerships are transparent anyway, so they can’t deliver any tax deferral in the first place. If a certain country taxes partnerships as corporations (e.g. Bulgaria, the U.S. or Germany under check the box-rules), your home country might or might not recognize this tax treatment. If it doesn’t, it will still treat the partnership as transparent for tax purposes. If it does, the rules concerning corporations as described in this article will apply.
Entity recognition rules: The first thing you need to check is if your home country recognizes your offshore corporation as a corporation. Keep in mind that foreign law is by default not binding within your home country, it needs to be explicitly recognized by domestic law and domestic institutions. If your home country does not recognize offshore corporations as legally incorporated, it will most likely treat your offshore corporation as a fully transparent partnership and its assets as your assets. All its profits will be subject to personal income tax in the same tax year they arise.
Corporate residence rules: Now let’s assume that your home country does recognize the incorporation under foreign law as binding, it recognizes your offshore corporation as a legal entity. The next question is where this corporation is a tax resident. Corporations aren’t automatically tax resident where they are registered. Most countries assume that a corporation is tax resident primarily in the country where it is effectively managed (place of effective management), and only secondarily in the country of incorporation or registration.
Also keep in mind that a corporation, just like an individual, might be deemed tax resident by multiple countries at the same time. The country of incorporation might issue a certificate confirming the tax resident status of your corporation. But this doesn’t mean that your home country can’t treat your corporation as a domestic taxpayer. It still can.
Double Taxation Agreements (DTAs) between the country of incorporation and your home country, if any, will usually assign the tax residence of a corporation to the country where it is managed, not to the country where it is registered or incorporated (especially DTAs following the OECD Model Tax Convention).
There might be other rules in some national tax codes regarding the determination of a corporations tax residence, but the place of effective management-rule is the most common one and is mentioned in all three major model tax conventions (OECD, UN, and U.S.).
If a country treats a foreign corporation as tax resident, the corporation will generally need to pay corporate income tax (and other profit-based taxes such as the trade tax in Germany) on its worldwide profits. It will also need to pay dividend tax (or branch profits tax) and comply with withholding rules in your home country. From a tax perspective, there will be no difference whatsoever between an offshore corporation and a domestic corporation if the offshore corporation falls under the corporate residence rules.
Permanent establishment: Alright, let’s assume now you convinced your domestic tax authority that your corporation is not a tax resident in your home country because you don’t manage it from there. Are your profits tax free now?
Generally they’re not. The next thing you need to check is if you have a permanent establishment (PE) under domestic tax law. While the place of effective management only looks at where you take the strategic decisions and fulfill your directors duties, the permanent establishment rules look at the operations. Where do you do your day-to-day tasks, such as sales or fulfillment? Where are your employees? Where are your offices, production sites, equipment, etc.? Where do you have dependent agents, such as contractors or representatives acting on behalf of your company?
A permanent establishment is a fixed place of business. A place where operations are actually performed. Paper and registrations don’t matter here, it’s all about the facts. If your offshore corporation has a permanent establishment in your home country, the profits assigned to this permanent establishment are generally subject to corporate income tax in that same place. Your offshore corporation will need to register as a taxpayer in your home country and file a corporate tax return declaring all profits from operations performed within that country.
If your offshore corporation is a shell company without a fixed place of business in its country of incorporation or any other country, it’s likely that 100 percent of your profits will be assigned to your domestic PE and taxed there. So you don’t save a dime in taxes, you just make filing your tax return a lot more complicated.
Controlled foreign corporation rules: Controlled foreign corporation rules (CFC rules) deal with the fact that certain companies do not need any fixed place of business. They usually aim at holding companies incorporated offshore, receiving royalties, dividends, interest and other income deemed passive (i.e. not connected to any physical business operations).
There’s no universal definition of the term control, it depends on the tax code of your home country. However, controlling more than fifty percent of voting rights within a corporation will result in deemed control everywhere.
If your offshore corporation is classified as a CFC by your domestic tax authority, you need to include its profits (or your share of its profits) on your personal income tax return in the year they arise. In some countries they are taxed as a deemed dividend, however, most countries tax them at the full personal income tax rate. That’s because the corporation itself hasn’t paid any tax, so a deemed dividend would still be advantageous for you. It’s more likely that you will need to pay ordinary income tax, depending on the tax code of your home country.
While generally tailored to holding corporations, some countries also have CFC rules for operating companies with active income (e.g. the U.S. in IRC § 951A or Germany in § 9 StAbwG, § 7 AStG).
Grantor trust rules: If a foreign trustee controls a corporation on your behalf, either as a nominee shareholder, a nominee director or both, the control will be attributed to you. The same is true to the yields of other assets you transfer to a foreign trustee. These yields need to appear on your personal income tax return in the year they arise.
Grantor trust rules might also apply to foreign foundations. If no controlling domestic taxpayer can be identified under CFC rules, but the grantor (settlor) is a domestic taxpayer, many tax authorities will default to attributing the foundations income to the grantor.
Transfer pricing rules and exit taxation: Transfer pricing rules concern cross-border transactions between related parties. These transactions are relevant from a tax perspective in three scenarios.
First, you might want to shift profits from your domestic company to an offshore company by paying interest, royalties, or service fees. You claim these payments as deductible business expenses at home, while they are paid to a tax-free offshore entity you control (directly or indirectly, this doesn’t make a difference). To prevent you from (excessively) shifting profits, your tax authority will look at these transactions and if there’s any real economic reason behind them. If there’s no real value exchange, it will not allow the deduction. If there is a real value exchange, but the prices are unreasonable (e.g. you’re paying more for a loan or a license than you would ever pay to a third party), it will reassess the value of the transaction, effectively limiting your deduction.
The tax planning schemes of major corporations are built around these profit shifting methods. They involve countries where the transfer pricing rules themselves are less strict than the OECD standard like, for example, Ireland. Within the European Union, profit shifting is particularly easy due to the parent-subsidiary-directive. However, implementing such structures compliantly requires a good amount of administrative overhead and risk tolerance – see the changes in Irish tax law in 2015 that reduced the effectiveness of the famous “Double Irish with a Dutch Sandwich”-structure significantly.
Second, you might want to transfer your existing business or assets of your business to an offshore corporation to continue operations at a lower tax rate than previously. Such a transfer of assets is deemed a sale for tax purposes, and the hypothetical price is calculated according to transfer pricing rules. This means that your tax authority will value the transfer as if you sold the assets to a competitor. You will need to pay tax on any profit arising from this hypothetical sale.
Third, you might want to move your personal tax residence abroad to lower your personal income tax rate. Some countries (such as Germany) levy an exit tax in such cases. On the day of departure, they will calculate the market value of all domestic and foreign corporations you own. Then you need to pay income tax as if you sold all these shares to a third party, at a price calculated under specific transfer pricing principles.
In short: the idea behind transfer pricing rules is to limit profit shifting and asset transfers between related parties. The value of such transactions is reassessed as if they took place between independent parties (“dealing at arms length”).
Withholding taxes: Withholding taxes (WHT) are taxes levied at the source. Most countries levy WHT on dividends, royalties and interest paid to foreign recipients. Some countries also levy them on service fees and other transactions. Since they are levied at the source from another taxpayer in the source country, you can’t claim any deductions, tax credits or allowances.
Taxpayers in high-tax countries can normally claim significant reductions of WHT, oftentimes to zero, under the DTAs of their home country. Tax havens such as the British Virgin Islands or the Seychelles do not tend to have many favorable DTAs. Corporations that are tax residents in such countries, therefore, can’t claim treaty benefits and effectively pay the full WHT rate.
Since effective taxation under WHT is oftentimes higher than simply paying regular corporate income tax or personal income tax (due to missing deductions and allowances), this is another reason why the use of offshore corporation might prove less worthwhile than you initially think.
WHT is largely eliminated for corporations within the European Union under the parent-subsidiary-directive. This explains the popularity of Cyprus and Malta for incorporating holding companies. Cyprus and Malta do not levy WHT on dividends.
Conclusion: The only effective and legal way to save taxes using offshore companies is by moving your personal tax residence to a tax haven. But even if you do so you will still need to comply with permanent establishment rules, transfer pricing rules, and you will pay withholding taxes. A lot of withholding taxes.
The best tax hack is maximizing the market value of your company. Gains in market value are not taxed until you sell the company. Tripling the market value will cost you as much time, money and effort as saving 30 percent in taxes. Oftentimes less.
If that’s your plan, you know where to find me.
See you.