Offshore companies are the subject of a persistent misconception. Many assume that the choice to form a business overseas is made to hide illegal activity. Fanned by media reports, there is a sizable portion of the public that believes offshore companies have only one purpose: to conduct criminal activity. The truth is that there are many legal benefits to locating or relocating a business overseas. There are two major benefits worth noting here. The first is a reduction in the tax burden carried by the business. This is not tax evasion, but rather tax avoidance. It is not only legal, but a sound strategy for furthering almost any business interest. The second is asset protection. A business may need to partition or protect certain assets as the result of a complex financing transaction or other legitimate asset structuring plan.
The potential benefits of offshore companies depend largely on the jurisdiction. Tax avoidance is, naturally, dependent on the tax laws of the jurisdiction chosen as well as the nature of the business conducted. If a company chooses the wrong location for an overseas business, it may find itself dealing with the headaches of an inconvenient location without the expected benefits of lower taxes and a beneficial regulatory structure.
While virtually every country could, theoretically, be the home for a venture, there are a few that draw a larger share of offshore businesses. These include
- Cayman Islands,
- St. Kitts and Nevis,
- British Virgin Islands (BVI), and
One thing that is important to remember is that these jurisdictions are only as friendly as their most recent legislation. Any jurisdiction, including the United States, has the power to dramatically alter the landscape for a business by changing the laws that apply. For that reason, some countries have waxed and waned in popularity for people looking to start a business overseas.
It is also the case that some of the benefits of an overseas locale can be diminished by changes to the laws here at home. The U.S. Treasury Department recently passed a new Customer Due Diligence (CDD) rule. The new regulations make it more difficult for business owners to operate discreetly, through the use of shell corporations, if those businesses work with financial institutions. The benefits of a location such as Nevis, which is known for allowing business owners to maintain their privacy, may be somewhat muted by the new CDD rules, depending on the nature of the business involved.
Tax Haven or Business-Friendly Environment?
For a variety of reasons, the United States can be an unfriendly place to run a corporation. The U.S. corporate tax rate is not competitive in the international market. Some American businesses can reduce their tax burdens by taking advantage of tax incentives and tax credits, but others are left to compete with international businesses paying far less.
A business incorporated in the United States faces a corporate tax rate of more than 30%. The same business incorporated in Ireland faces a 12.5% tax rate. Ireland’s rate is among the lowest among the governments participating in the Organisation for Economic Co-operation and Development (OECD). It is not the lowest rate available, however. The Cayman Islands government charges no company or corporation tax and it is not the only jurisdiction to do so. Meanwhile, the rate in the United States is among the highest in the world.
Ireland is not considered a tax haven by the OECD. That distinction is based on four factors laid out by the OECD, including
- little or no tax on relevant income,
- no effective exchange of information,
- a lack of transparency, and
- no substantial activities.
The test basically restricts tax haven status to jurisdictions where corporations exist in name only and record keeping is minimal or nonexistent. Since the OECD established these guidelines, every jurisdiction once considered a tax haven has taken the necessary steps to comply with international guidelines. Some critics still consider certain jurisdictions as tax havens. They believe these countries intentionally serve the interests of illegal enterprises. The commitments made by these countries to comply with OECD guidelines demonstrate that the goal is to attract investment and foster an environment conducive to successful business ventures.
Tax Avoidance at Work
An offshore company can provide tax advantages in numerous ways. One, relatively simple way is to assign intellectual property rights to an offshore business. If a company holds a patent and earns royalties from the use of that patent, it will pay taxes based on the location of ownership. It can pay the relatively high percentage applied in the United States or it can pay the lower percentage applied in many foreign locations.
Patents are a good example, because they derive their value from their existence rather than from labor capital currently being applied. Businesses don’t need workers to capitalize on a patent. This is true for other valuable assets as well. Financial firms are among the most likely to establish subsidiaries offshore. Again, the nature of the business plays a large role in whether or not an offshore business can be beneficial.
Tax Rate and Tax Policy
In addition to a lower corporate tax rate, some countries outside the United States restrict their taxes to income earned within their jurisdiction. The United States is aggressive in seeking tax income for all earnings made by American companies. Foreign earnings will only be taxed in the jurisdiction in which they are earned if a business chooses to incorporate offshore.
Offshore companies also can be useful for protecting assets. Many foreign jurisdictions have rules that are beneficial to business owners, rather than creditors. While no reliable jurisdiction will protect assets conveyed fraudulently (for the purpose of escaping existing or anticipated creditors), assets transferred for legitimate business purposes may receive more protection in foreign jurisdictions than they do at home.
The law in the United States is heavily weighted toward creditors. Even the most debtor-friendly states allow creditors to pursue assets conveyed two years prior. Some foreign jurisdictions allow for much shorter look-back periods. Assets put in place a year or even six months prior are not accessible to creditors. In addition, a creditor seeking to initiate a legal action against a company will consider the potential outcome. If the creditor can’t find offshore assets or believes it will be more difficult to access them, they may be discouraged from pursuing the matter at all. Businesses looking for liability protection should consider the greater security afforded to them by foreign jurisdictions.
Drawbacks of Offshore Formation
The benefits of forming overseas are only half the story. If the corporate tax rate was the only factor involved, no one would choose to start a business in the United States. The specific circumstances of the business dictate just how much benefit can be derived from forming overseas. For many businesses, there are no tax advantages to being offshore.
Perhaps the primary disadvantage of an offshore strategy is the uncertainty that comes with it. The U.S. Internal Revenue Service regularly makes changes that can be difficult to reconcile with offshore investment. The benefits of using an offshore company for a particular type of transaction can evaporate with a tweak to the tax code or an opinion on how the current code will be applied. The owners of offshore businesses must have tax professionals up to the task of monitoring these changes as they apply to their particular business.
In addition to the uncertainty introduced by U.S. regulators, offshore companies are at the mercy of lawmakers in their chosen jurisdictions. The stability and predictability of these jurisdictions may vary. Some countries, such as the Cayman Islands, have a long-standing history of providing favorable business conditions. Business owners should consider their risk tolerance before choosing an offshore jurisdiction in which to form.
Fees and Other Expenses
It is natural to wonder why a country would choose to offer itself as a tax-free home for overseas businesses. How does a country benefit from companies that primarily or exclusively do business outside its borders? The answer may lie in fees and regulations that require companies to pay locals to perform otherwise unnecessary services. It is important to understand the costs involved in establishing an offshore entity before moving forward.
Legal fees must also be considered when evaluating offshore formations. Finding a local law firm with the skill and knowledge to guide principals through the process of establishing an overseas business is vital. The legal rights afforded to business owners can disappear if mistakes are made in the formation and governance process.
Many popular offshore business destinations tailor their services for very high income investors. They cater their services exclusively to VIPs. There may be a minimum investment amount that strains the resources of a new business owner. The fees may come as a shock to many businesses. Offshore investment in some cases is a luxury item for which a business should expect to pay luxury prices.
There are aspects of running a business abroad that do not fit neatly into the categories of pro or con. The impact of offshore formation on a business’s reputation is one of those aspects. Some companies value their brand reputation as among their most treasured assets. Other companies have no brand to speak of and can successfully achieve their goals in near total anonymity. The nature of the business dictates whether brand is something worth considering.
If brand reputation is important to a business, the owners need to consider the impact their offshore company will have on their clients. Forming in a jurisdiction like Ireland or the Cayman Islands could lend gravitas to a fledgling business. It could also raise questions about the dependability or even legality of the enterprise. Many Americans are familiar with the practice of forming in a different state, typically Delaware, rather than the state where most of the business is conducted. They may be less familiar with the legitimate reasons businesses choose to form in a place like Belize. If brand management is an issue for a business, it should weigh the impact of an overseas formation on its reputation.
Should a Business Consider Offshore Formation?
Businesses should at least consider the benefits of forming offshore. Not every business can profit from an international formation, but enough can that it is worth some investigation. Under the right circumstances, a business can minimize its tax liability, protect its assets from creditors, maintain high levels of confidentiality, and ease some of the regulatory burden of owning and operating a business.
Whether these benefits outweigh the drawbacks depends on the following considerations:
- type of business the principals are looking to build,
- tolerance for risk,
- types of transactions in which the business will engage,
- tax treatment those transactions will receive, and
- value placed on privacy, security, dependability, and convenience.
Although there are many considerations, exploring the potential benefits of forming overseas is certainly a wise investment and may lead to a much more profitable and protected company.