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New OECD tax agreement improves transparency — but the US doesn’t sign and the US press won’t tell you UPDATED

Last week 31 countries signed a new Organization for Economic Cooperation and Development (OECD) agreement providing for country-by-country corporate information reporting and the automatic exchange of tax info between countries under the Multilateral Competent Authority Agreement (MCAA).

Country-by-country reporting, the brainchild of noted tax reformer Richard Murphy,* is a principle that makes it possible to detect tax avoidance by requiring companies to list their activities in each country (nature of business, number of employees, assets, sales, profit, etc.) and how much tax they pay in each country. A company with few employees yet large profits is probably using abusive transfer pricing to make the profits show up in that country rather than another one, to give one obvious example of how the idea works. In the OECD agreement, the procedure is that beginning in 2016 each company will file a report to every country where it does business, then all the countries receiving such reports will automatically exchange them with each other, meaning each of these countries will then have a full view of how much business Google, for example, does in every jurisdiction. The shortcoming to this is that while governments will have this data, the public will not have it (a fact criticized by the Tax Justice Network) due to alleged concerns about confidentiality. However, the European Commission, including its Luxembourgian president Jean-Claude Juncker, is now talking about requiring publication of the country-by-country data for each EU Member State.

Which highlights an important aspect of this agreement: Many major tax havens, including Luxembourg, Ireland, Liechtenstein, Switzerland, the United Kingdom, the Netherlands, Belgium, and Austria have all signed on. But the United States did not sign it. Surprisingly, you can’t find this out in any U.S. publication, as far as I can tell. I’m a subscriber to the New York Times, and a search for “OECD tax deal” or “OECD tax” for the past week (it was signed six days ago) yields no results. “OECD” yields one result unrelated to the MCAA. Ditto for the Wall Street Journal. Ditto for my premium Nexis subscription: No U.S. stories on the agreement. You’d almost think they’re trying to keep us from finding out. But no, not exactly: The Financial Times was able to get Treasury Secretary Jack Lew himself to comment in its story on the MCAA. He said, “From a US perspective, there are elements of this that don’t require legislation and we’re looking to getting to work right away.”

That’s certainly a clue: Some of the changes do require legislation, and getting that from the Republican Congress is not going to happen. In fact, Republicans have always been willing to step up to keep the United States a tax haven for foreigners, and the Bush Administration went out of its way to undermine previous OECD attacks on tax havens offshore, as Australian political scientist Jason Sharman masterfully showed in his book Havens in a Storm.

Republicans have done such a good job at helping out domestic tax havens that the United States is now “The World’s Favorite New Tax Haven,” according to Bloomberg Businessweek which, in an ironic coincidence, published the story at 12:01AM the day the MCAA was signed (so it didn’t report on the signing either). According to the article, foreigners’ money is pouring out of Swiss banks into the United States, and Rothschild has set up shop in Reno, Nevada.

A little too ironic…

* As regular readers know, Murphy is someone I frequently cite in these pages.

 

UPDATE: @AlexParkerDC from Bloomberg BNA was kind enough to send me to a couple of his posts on the OECD’s Base Erosion and Profit Shifting (BEPS) negotiations. These suggest that the Obama Administration believes it can implement country-by-country reporting through regulation alone, and had already committed to it in the BEPS process. However, the IRS has proposed not to implement country-by-country until 2017, while the new OECD agreement begins with this year’s tax information, as noted above.

Cross-posted from Middle Class Political Economist.

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Apple set to lose billions in EU state aid case

The Financial Times reported on September 30th that the European Commission has decided to open a formal investigation into whether Apple received illegal subsidies (“state aid,” in EU-speak) from Ireland going as far back as 1991. The FT quotes “people involved in the case” as saying that this can cost Apple billions of euros.

What the decision technically does is establish what is known as an “Article 108(2)” investigation, which means that the Commission has concluded from its preliminary investigation that state aid has been granted in violation of the EU’s competition policy rules. It is therefore opening a more comprehensive investigation. It is worth noting that if the Commission opens an Article 108(2) investigation, it almost always decides that illegal state aid was given. The only recent exception I can think of is state aid from Poland to relocate Dell computer manufacturing from Ireland in 2009, and I actually think the Commission should have ruled against that as well, as I discussed in my book Investment Incentives and the Global Competition for Capital.

As I speculated in June, one issue raised by the Commission is Apple’s “nowhere” subsidiaries created under Irish law. Both Apple Operations Europe (AOE) and its subsidiary, Apple Sales International (ASI), are incorporated in Ireland, hence not immediately taxable by the United States until they repatriate their profits to the U.S. However, they are managed from the U.S., which by the provisions of Irish tax law makes them not taxable in Ireland. It is these provisions that are at issue in the case. See, in particular, paragraphs 25-29 of the decision, especially paragraph 29: “According to the information provided by the Irish authorities, the territory of tax residency of AOE and ASI is not identified.” Richard Murphy suggests today that these corporate provisions account for the largest proportion of Apple’s tax risk.

What is especially important for this investigation (and the similar ones of Starbucks and Fiat) is that if the Commission finds that state aid was given, it was never notified in advance to the Commission. The state aid laws require that any proposed subsidy be notified in advance and not implemented until approved. Ever since the 1980s, the penalty for giving non-notified, illegal (“not compatible with the common market”) aid is that the aid must be repaid with interest. Since this alleged aid was not notified, and will probably be found to be incompatible with the common market, Apple will be on the hook for aid repayment.

As I reported in June, this would not be the first time the Commission has used the state aid law to force changes to Ireland’s tax system. In 1998, it ruled that Ireland’s 10% corporate income tax for manufacturing was specific enough to be a state aid. Ireland then reduced the corporate income tax to 12.5% for non-manufacturing firms, while raising it to that level for manufacturing (mainly foreign multinational) companies.

If the Commission rules against Ireland and Apple, this will send a signal that the European Union is going to take tax manipulation very seriously with all the tools at its disposal. It would be especially great to see one of the pioneers of arcane tax avoidance strategies taken down a notch. For Ireland, at least there would be a small silver lining from losing this case: Apple’s aid repayment would go to Ireland and help reduce its budget deficit.

Cross-posted from Middle Class Political Economist.

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Illinois’ next governor may make Romney look like a saint

Does the name Bruce Rauner ring a bell? No, me neither. It turns out he’s the Republican nominee for governor in Illinois, which under normal circumstances would mean he’s a nobody. But he’s been leading incumbent Democrat Pat Quinn in polls all summer, and could actually end up as the state’s next governor.

This is a problem, because he is even more out of touch with the middle class than Mitt Romney (Rauner is a private equity near-billionaire) whose idea of transparency is to release the first two pages of his 1040 tax return for 2010-12, and nothing else. Romney at least released his full tax return for each of two years. As Think Progress points out, Rauner is also a big fan of the Cayman Islands as a tax haven, just like Romney. In fact, Rauner is invested in at least five funds there. Also like Romney, Rauner takes full advantage of the “carried interest” tax break that lets him treat his fees, which should be ordinary income taxed at 35%, as capital gains, subject only to a 15% tax rate.

Rauner’s agenda is insistent on the need to spur job growth, but somehow misses the fact that Illinois’ unemployment rate has fallen from 9.2% (seasonally adjusted) in June 2013 to 7.5% in May 2013 (the figure Rauner used) and even more since the agenda was published, to 7.1% in June, the third-largest drop in the country year-over-year. Still a full point worse than the June national unemployment rate, but a lot better than it was.

One place where Rauner is worse than Romney is the minimum wage. Romney, rather surprisingly, supports an increase in the minimum wage, though he did not specify a number. Rauner, in both December and January, called for Illinois to lower its minimum from $8.25 to $7.25, the national rate. After getting a tremendous amount of blowback, he now claims to support an increase.

His agenda says the state “should implement a phased-in minimum wage increase, coupled with workers’ compensation and lawsuit reforms to bring down employer costs.” No mention of what the rate would be, or the period over which it would be phased it. He references an op-ed he wrote in the January 9th Chicago Tribune (now only available through the Nexis subscription service), where he clearly buys into the “job-killer” meme and drops a reference to the futility of a “$20 per hour” minimum wage, for good measure. Somehow I don’t think he really supports an increase.

Not only that, but Rauner proposes turning the Illinois Department of Commerce and Economic Opportunity, the state’s investment promotion agency, into what he calls a “public-private partnership.” He doesn’t say it, but this means there will be less public oversight into the agency’s affairs. As Good Jobs First has shown, such privatized agencies have exhibited high levels of abuse in recent years.

Rauner is a living, breathing example of how we have one tax system for the 1%, and another one for the rest of us. His flip-flop on the minimum wage is as phony as the concern he professes for the middle class. Yet there’s a very good chance he will be the next governor of Illinois.

Cross-posted from Middle Class Political Economist.

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Fun and games with transfer pricing

ProGrowthLiberal in his comments on my last post and in his own post at EconoSpeak highlights the fact that drug-maker AbbVie already makes most of its profits outside the United States, about 87% in fact over 2011-2013 by his calculation. For PGL, then, AbbVie is not the best example of an inversion because the horse is already out of the barn in terms of escaped profits.

I see things a little differently on this, but the case is also highly illustrative of a principle we have discussed before, transfer pricing. Let’s take a look at AbbVie’s Form 10-K Annual Report, downloadable here, to see what I mean.

Pre-tax profits ($millions)    2013    2012    2011    3-year total

U.S.                                           -581      625     626     670

Foreign                                    5913    5100    3042     14,055

Total                                        5332    5725    3668     14,725

Source: AbbVie Annual Report, p. 92

I actually calculate the foreign percentage for these three years as 95%, given that AbbVie claims to have lost money in the United States in 2013. In any event, this is a very strange division of the company’s profits given where its sales were made.

Net sales ($billions)    2013    2012    2011

U.S.                                 10.2     10.4     9.7

Foreign                             8.6       7.9     7.7

Total                               18.8     18.4    17.4

Source: AbbVie Annual Report, p. 40. Totals may not sum due to rounding.

As you can see, in each of the three years, over half of the company’s sales were made in United States, but the company reports that only 5% of its profits are in this country. This is pretty funny math, if you like dark humor. Especially since Humira, AbbVie’s biggest-selling drug by far, was developed in the United States. So with the patents in the U.S., and most of the sales in the U.S., the profits have to be in the U.S., right?

In reality, of course they are, but not in the Alice’s Wonderland world of transfer pricing. In this byzantine world, the patent for Humira is almost certainly owned by a subsidiary in Ireland, where royalty payments are tax-free. How else could the company show a loss in the United States in 2013 when 54% of its sales are here? Despite this, the company reports paying about 39% of its worldwide income taxes ($226 million of $580 million worldwide, see p. 92), although we have seen that what companies report in taxes on their 10-K annual report is largely fiction

So what can we do? The answers remain simple, though as politically difficult as ever. First, require companies to publish what they pay, country-by-country. No more hiding behind consolidated accounts. Second, enact unitary taxation, using apportionment formulas to make transfer pricing irrelevant. Third, end the deferral of U.S. corporate income tax on foreign profits. Finally, despite what “everyone,” including the President, says, don’t reduce the corporate income tax rate. We’ve gone long enough with tax policies that exacerbate inequality; there’s no reason to continue down that road when we have the world’s largest economy.

Oh, and my tiny disagreement with ProGrowthLiberal: It seems to me that if a company is already draining giant chunks of its profits abroad, then allowing an inversion ratifies losing a bigger amount of tax money than it would for a company like Walgreen’s that has not moved its profits offshore yet. But I imagine the IRS could still go after AbbVie post-inversion if it wanted to question its pre-inversion transfer prices, so this is a minor point indeed.

Cross-posted from Middle Class Political Economist.

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Unintentional tax humor at Forbes

David Cay Johnston emailed me that there were errors in Forbes contributor Tim Worstall’s recent criticisms of the linked article. Indeed there are, but the biggest one (or at least the funniest one) isn’t the one Johnston pointed me to.

Worstall writes that AbbVie’s pending inversion will not, by itself, reduce the taxes the company owes on its U.S. operations, though it could be a preparatory move to drain profits from the United States. I’ll come back to that point, but Worstall then gives the example of how AbbVie might sell its patents to a foreign subsidiary and pay royalties to that unit, thereby draining U.S.-generated profits to a tax haven subsidiary, for instance Bermuda (though Ireland is more germane in the real world for intellectual property). But then comes the zinger:

However, do note something else that has to happen with that tactic. That Bermudan company must pay full market value for those patents when they are transferred. Meaning that the US part of the company would make a large profit of course: thus accelerating their payment of tax to Uncle Sam. This tax dodging stuff is rather harder than it sometimes looks: if you’re going to place IP offshore you can do that, certainly, but you’ve got to do it before it becomes valuable, not afterwards. [link in original]

“Must pay full market value”? I’m falling off my chair! It’s like Worstall doesn’t think transfer pricing abuse exists. If patent, copyright, and other intellectual property transfers had to be made at full market value, they would never happen. As I explain in the linked post, academic research has shown that transfer pricing abuses, in this case underpricing the intellectual property transferred from the United States to Bermuda (again, really Ireland), are quite common when no arm’s-length market exists for a good. Since companies aren’t going to sell their crown jewels to strangers, how can a tax authority know what will be a fair price for a Microsoft patent going from the U.S., where it was derived, to its Irish subsidiary?

Let’s be a bit more precise. What would it take for Apple to buy all of Microsoft’s patents? In return for whatever lump sum Apple paid, it would need the equivalent back in terms of the present value of all Microsoft’s future royalty payments. But if Microsoft sold its patents to its Irish subsidiary at that price, Worstall would be right that there would be no tax benefit. And it’s not like it’s cost-free to organize such a transaction. Not only would Microsoft incur the costs of drawing up the contract and so forth, but nowadays companies are taking reputational hits as a result of their tax shenanigans: Ask Starbucks, Google, and Amazon. So if the transaction created no true savings, yet hurt a company’s reputation, we know that it wouldn’t make the transaction. The fact that multinationals are flocking to sell their intellectual property to Irish subsidiaries where the royalties are tax free tells us that the transfer price is not the “full market value” Worstall claims.

Moreover, contra Worstall, it isn’t a question of transferring the intellectual property before it’s valuable. If you’re a multinational drug company, you can make estimates of FDA approval, how much you think a drug will earn, and so forth. And you’ve got inside information! To take the simplest possible example, let’s say AbbVie has two drugs it thinks are each 50% likely to generate revenues with a present value of $500 million each. If you believe Worstall, it will sell one of the patents to its Bermudan subsidiary for only $250 million. But it will sell its other patent for another $250 million, so the supposed cost will still be $500 million and the subsidiary will expect to earn revenues equal to a present value of $500 million off whichever drug turns out to be successful. It’s inescapable that there is no point for a multinational company to sell the patent to its subsidiary at a fair price. There would be no tax benefit, and we wouldn’t be seeing Microsoft with $76.4 billion offshore or Apple with $54.4 billion offshore in 2013. Or a total of $1.95 trillion for 307 companies. Heck, even AbbVie has $21 billion permanently reinvested offshore, according to its 2013 Annual Report (downloadable here), p. 93. “Full market value,” indeed.

Finally, a note on Johnston’s and Worstall’s main dispute. Worstall argued that an inversion does not reduce the tax that a U.S. subsidiary would owe to the United States, noting that you can drain profits (except, as we saw, he doesn’t really believe you can drain profits) from the American subsidiary as long as you have a tax haven subsidiary, i.e., you don’t need inversion for that.

From a very narrow point of view, this is correct. But what Worstall overlooks is that, for the U.S., worldwide taxation substitutes for a general anti-avoidance rule making avoidance itself illegal, which is the approach most other industrialized countries take. Inversions make it impossible to police avoidance, so they indeed threaten tax collections from U.S. subsidiaries. But one might argue that deferral has almost completely neutered the benefit from worldwide taxation already. The bottom line is that the United States needs an end to deferrals at least until it adopts strong anti-avoidance rules, at which point it would only then be possible to discuss ending worldwide taxation.

But all of that will be for naught if we allow ourselves to be seduced by silly claims about how transfer prices have to be the same as “full market value.”

Cross-posted from Middle Class Political Economist.

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Corporate “inversions” shift the tax burden to us

Corporate “inversions” are back in the news again, as multinational corporations try every “creative” way they can to get out of paying their fair share of taxes for being located in the United States. With inversions, the idea is to pretend to be a foreign company even though it is physically located and the majority of its shareholders are in the U.S.

“What’s that?” you say. At its base, what happens with an inversion is that a U.S. corporation claims that its head office is really in Ireland, the Cayman Islands, Jersey, etc. Originally, all you had to do was say that your headquarters was abroad. Literally.

Now, the rules require you to have at least 20% foreign ownership to make this claim, but companies as diverse as Pfizer, AbbVie, and Walgreen’s are set to run rings around this low hurdle. The basic idea is that you take over a smaller foreign company and pay for it partly with your own company’s stock to give the shareholders of the foreign takeover target at least a 20% ownership stake in your company.

Thus, with pharmaceutical company AbbVie’s takeover of the Irish company Shire (legally incorporated in the even worse tax haven Jersey), Shire’s shareholders will own about 25% of the new company, thereby qualifying to take advantage of the inversion rules. It expects that its effective tax rate will decline from 22.6% in 2013 to 13% in 2016. Yet nothing will actually change in the new company: it will still be headquartered in Chicago, and the overwhelming majority of shareholders will be American.

As David Cay Johnston points out, even some staunch business advocates like Fortune magazine are calling this tax dodge “positively un-American.” Further, as he notes, Walgreen’s wants to still benefit from filling Medicare and Medicaid prescriptions even if it ceases to pay much in U.S. corporate income tax. In other words, it will get all the benefits of being in the U.S., including lucrative government contracts, without paying for the costs of government.

As I told The Fiscal Times, if companies like these get their tax burden reduced, there are only three possible reactions that can occur: someone else (i.e., you and me) will pay more taxes; the government must run a higher deficit; or government programs must be cut. Of course, there is a limitless number of combinations of these three changes that can result, but one or more of them has to happen.

What can we do about this? One obvious answer to to raise the bar for foreign ownership to at least 50%+ to call a company foreign. Even more comprehensive, as reported by Citizens for Tax Justice, would be to continue to consider a company “American” for tax purposes as long as it had “substantial operations” in the United States and was managed from the United States. Furthermore, the Obama Administration has proposed limiting the amount of deductions American companies can take for interest paid on loans “from” their foreign subsidiaries, thereby preventing what is often called “profit stripping.” Another idea, from Senator Bernie Sanders, would be to bar such companies from government contracts.

The whole concept of “inversions” no doubt sounds very arcane to the average person. But one of the bills to rein them in is estimated to raise $20 billion in tax revenue over the next 10 years. The stakes are substantial, so we need to take a minute to wrap our head around it if we want to head off yet another way in which the tax burden is shifted to the middle class.

Cross-posted from Middle Class Political Economist.

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Apple, Starbucks, Others Under EU Tax Investigation

No sooner do I comment on the difference between tax planning and tax avoidance than Richard Murphy points out that several multinational corporations are having their tax deals looked at for potential violations of the European Union’s state aid rules. As The Guardian and The Wall Street Journal report, there are three cases currently under investigation by the European Commission, but more investigations may be opened in the near future.

First is Apple in Ireland. What a surprise! It has a subsidiary it claims is taxable nowhere, incorporated in Ireland but managed from California, which under Irish law makes the subsidiary not subject to Irish tax. Of course, since it is incorporated in Ireland, Apple can defer its U.S. taxation on the unit’s profits until it repatriates them, if it ever does so. Two issues are relevant here: Did Ireland’s creation of this class of entity provide firms with state fiscal aid? Second, did Ireland negotiate a special deal with Apple giving the company a tax rate far below Ireland’s already low 12.5% corporate income tax rate, as Apple CEO Tim Cook testified last year before the U.S. Senate, under oath. In fact, according to the New York Times, the company paid ” as little as one-twentieth of 1 percent in taxes on billions of dollars in income.” One source quoted by the Times said the company saved $7.7 billion in taxes in 2011.

If the tax saving in Ireland is deemed to be state aid, the Commission would have to determine two things: Was it notified to the Commission, as required by the state aid rules? (No, or we wouldn’t be having this investigation in the first place.) Is the aid compatible with the common market, and thus allowable? My guess is that the Commission expects to find that fiscal aid to Apple and others (see below) distorts competition, and hence is not compatible with the common market.

It is worth remembering that Ireland has a 12.5% corporate income tax rate, rather than the 10% rate it had for decades, precisely because in 1998 the Commission found that the 10% rate was state aid and was not compatible with the common market (Competing for Capital, p. 95). So the use of the state aid rules to attack arcane tax provisions is nothing new for the Commission.

The second case is Starbucks and possible fiscal aid from the Netherlands. I have already reported on how the company happily tells investors how profitable its British subsidiary is, but books a loss in the United Kingdom and had no tax liability for 14 years. As discussed then, the issue ultimately revolves around transfer pricing between the “loss-making” U.K. affiliate and the Dutch subsidiary which holds Starbucks’ intellectual property and collects 6% of revenue as royalties, plus transfer pricing into Switzerland. Theoretically, the case could also expand to the Swiss transfer pricing as Switzerland is also subject to state aid rules as part of its free trade agreement with the European Union.

Finally, the Commission is investigating whether Fiat receive state aid from Luxembourg, again as part of its tax treatment there.

All three of these cases demonstrate what I emphasized in my last post, namely that tax avoidance increases tax risk, whereas tax planning does not. It also underscores a point I made in Competing for Capital that the Commission can be quite creative in finding ways to attack fiscal provisions under the state aid rules. It’s good to see that the Commission is actively attacking corporate tax avoidance; it would be great to see equal creativity and perseverance on this side of the Atlantic.

Cross-posted from Middle Class Political Economist.

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Four easy fixes for corporate taxation

Everyone “knows” that the corporate income tax is a mess. Ask any company. They pay too much in corporate income tax, face rates higher than in any other OECD country, and are just following the law when they use tax havens to keep profits eternally deferred from taxation and to perform general sleight-of-hand.

 

Don’t believe a word of it. While some economists believe we shouldn’t tax corporations at all, the corporate income tax (CIT) is a necessary backstop to the personal income tax (PIT). With no CIT or a rate lower than the PIT, individuals have an incentive to incorporate their economic activities so they aren’t taxed on them, or are taxed less. Needless to say, this is something an average wage or salary worker would not have the ability to do. This is another area where we have one tax law for the 1%, and different rules for the rest of us.

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The Tax Free Tour; a look at the offshore tax haven system

We’ve all talked and read about the idea and practice of offshore accounting to reduce taxation. Here is an article produced by a show called Backlight.  Backlight appears to be a news journal show in the idea of Frontline by a Dutch public broadcasting organization known as VPRO.

This episode is titled: The Tax FreeTour.  To date it has only just over 22 thousand hits.  Considering the effect offshoring plays in everyone’s life, I think more people need to see it.   It is about 1 hour long taking a look at the places of tax havens and the structures to get there. I found it very interesting and highly encourage you to watch the entire episode.  I have not seen another presentation as complete as this on the issue of off shore tax havens and the system.
They interview international experts including one who worked for KPMG: Richard Murphy, accountant. He notes you need 3 things, banks, accountants and lawyers to have a tax haven and thinks accounts have gotten off easy.  A past chief economist for the McKenzie Consultancy James S. Henry who quantified the amount of capital parked in the off shore industry, $21 to $32 trillion year end 2010.  Business Intelligence Investigator William Brittian Catlin who’s job is to sort out the offshore links for investors. Ava Joly, former French Judge, currently EU Parliamentarian investigating $1 trillion in lost EU tax revenue.
I did not realize, but these big corporations have special deals with nations such as the Netherlands regarding their taxation that they are not allowed to talk about. How convenient.  The Netherlands has the most tax treaties in the world. Walmart has 6 entities there all with completely different unrelated names, yet does no physical business related to their core activity of retail sales in the Netherlands. Trust companies are the structures involved as they hold the mail boxes. $11 Trillion is routed through the Netherlands every year. Up to 20 times the Dutch GDP.  0.14% of the world’s population controls about 95% of the offshore money.

Do watch the entire show to get the full appreciation. There is so much more in it than what I highlight here. If your time is short then: To get a quick overview of the game, watch starting at 9:35 through 14:48 of the show and 32:24 to 33:00. To know about the people watch 20:00 to 22:54. To understand tax free zone use watch 25:40 to 26:50 and 27:19 to 28:00.

Here are four cuts from the show. The first two are to let people know what our Senate Banking committee hearings would look and sound like if there were more than just Elizabeth Warren.

These two get at the effects on our ability to govern our self.

These two get at the effects on our ability to govern our self.

My thought after watching The Tax Free Tour? What we are experiencing here in the US when companies go shopping and pit one part of the nation, state or town against another is the same model including the government responses that is the off shore industry. Globalization is the scaling up of home developed systems that have proven successful in reducing taxation via government rule changes ultimately maximizing profit with no regard toward anything beyond the need of the one’s money. The “one” being an entity or an individual. Globalization means more than just out sourcing manufacturing. Globalization is the expansion to the globe of money management systems developed over time designed to segregate the rich in the major aspect of their lives from the rest of the people of the world; the wealthy’s connection with the rest of humanity via national identity.  The systems are designed to assure the wealthy are guiltless in the presence of harm. Kind of a plausible deniability?

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Hedge Fund Tax Avoidance Schemes–using (purported) offshore reinsurers

by Linda Beale

Hedge Fund Tax Avoidance Schemes–using (purported) offshore reinsurers

It seems that billionaires think they are entitled to it all and think they should be able to run their speculative games without paying much of anything at all in taxes to the government they depend on. And none of this is good for the economy or good for the taxpayers not in “the 1%”.

Case in point–John Paulson, the notorious hedge fund manager who got a CDO built to his desires with a bunch of iffy subprime mortgages and then took the short side of the bet, making a fortune off the bet against subprimes in the mortgage crashes underlying the 2007-8 Great Recession.  See, e.g., Zuckerman, Trader Made Billions on Subprime, Wall St. J. (Jan. 15, 2008).

What has Paulson done?  He established a new “reinsurance company” in Bermuda in April, that turned around in June and put the money invested in it  back into Paulson’s hedge funds in New York, as a portfolio of insurance “reserves” to be held to pay off insurance risks that go bad.   The result is tax deferment for Paulson and other executives of his hedge fund along with re-characterization of ordinary compensation income as preferentially taxed capital gains.

For a discussion of the hedge fund reinsurer gambit, see , e.g., any of the following.  The story at Bloomberg has reinvigorated media attention to this issue.

Barile notes that these hedge funds are using reinsurance premiums and investing in a very aggressive way, compared to traditional reinsurers”.  This aggressive position produces a downside if there are low investment returns, especially if there are catastrophes for which they have to pay claims when their investment strategies have produced losses.  He says that “it remains to be seen” whether hedge-fund reinsurers are in it for the long haul, since they have a shorter time frame on making greater returns on their money.

Looking at this as a global concern, Baker ultimately suggests that the Basle Capital Accord rules should be extended to hedge fund reinsurer operations,  “Another area in which the BIS should take a leadership position,” he says, “is the role in which reinsurance firms play in hedge fund operations.  The tax implications of hedge funds using reinsurance firms in their funds for tax advantages points to the need for more government regulation of this activity.”

He describes the basic problem as follows:  “wealthy individuals invest in private placement offerings of offshore reinsurance companies.  These companies, many headquartered in Bermuda, buy insurance policies written by name-brand insurers…and “may then invest its stock issue returns in a hedge fund.  …[That reinsurer] pays no taxes on the trading profits until it sells the fund shares and then the reinsurer is taxed at a lower capital gains tax.  The tax savings are passed on to the individual investor.

He goes on to say that “The problem … is that insurers are exempt from registering as investment companies….These reinsurers do not have to make annual distribution of profits as mutual funds do and they are not taxed by the Internal Revenue Service as investment vehicles.  …In short, the activity … is a method for wealthy investors to reduce their tax burden as a result of a tax loophole.  Since these insurance companies are mixing insurance business with investment business, they need more supervision.

This is especially true when hedge funds are involved.  “[H]edge funds work with reinsurers to reduce tax liabilities for their wealthy clients.  …U.S. hedge fund managers and investors form a tax-advantaged reinsurance company offshore in…Bermuda, which has no corporate income tax.  The Bermuda-based reinsurer sends investment assets to the hedge fund to invest.  Investors return to the United States with shares of the reinsurer and pay no taxes until the company goes public.  At that time, investors [and managers] sell their shares in the reinsurer company and are taxed at a lower capital gains rate.
These schemes are worrisome from both tax and insurer regulatory perspectives.  “Aside from the tax loophole problem, the real issue in these cases is the added underwriting risk incurred in the process. … [Hedge funds acting as reinsurance companies] have insufficient insurance expertise…. Much of this activity has stemmed from financial engineering and deal making of the 1990s. … [W]ithout the bailout of LTCM [Long-term Capital Management hedge fund] by national bank regulatory authorities, many banks and reinsurers might have collapsed as well.”

So why do it and how does the hedge fund reinsurer gambit work?  Remember that these hedge fund execs get a ridiculous amount in compensation in the form of a “fee” (usually 2% of assets under management) and a “carry” (usually 20% of the profits).  (The fee and carry are often represented as 2 and 20, but can be much higher for some firms with status, rising to as much as 5 and 50.)  Without more, hedge fund managers don’t get as much benefit from the claimed treatment of a “profits” partner as private equity fund managers do.  Though the managers claim classification as “profits” partners whose taxation is based on their share of the partnership’s gains and ordinary income and not as payments of (ordinary) compensation, hedges mainly yield ordinary income so don’t act directly as “converter” entities.   Private equity fund managers also claim they are “profits” partners whose income should not be classed as compensation but as pass-through shares of the  partnership items:  in their case, most of the private equity fund’s gains will be deferred anyway (for several years at least until the partnership sells the leveraged company) and they claim those deferred gains should be characterized as pass-throughs characterized by the partnership rather than being characterized as ordinary compensation income to them.  

So for hedge fund managers,  gaining deferment (of what is clearly in substance their compensation as managers) can achieve  minimal current tax.  If the money is cycled through an offshore corporation that pays no taxes, that’s even better because it gets preferential rates as well.  The deferment is achieved by waiting to sell the stock, and the sale of the stock is reported as a capital gain.  Thus what is really current compensation income is re-characterized, through the reinsurer “conduit” scam, as a deferred capital gain.   So hedge fund and private equity managers ultimately both claim to get the best of all possible worlds–their wages from work are not currently taxed as wages at ordinary income rates, they pay no payroll taxes on their compensation, and their compensation is deferred and taxed at preferential capital gains rates.

This is so obviously unfair to the vast majority of ordinary taxpayers who pay taxes on their compensation income even before the end of the tax year through the withholding mechanism that Congress should step in with legislation.   It seems hard to justify a “profits” interest in a partnership at all: it has been created by the “Wall Street Rule” that gains credence because big-money people claim it is correct.  As usual, tax administration eventually mostly went along with it (Rev. Proc. 93-27) and a few court cases (Diamond, Hale) mostly treat the notion of a profits partner who pays no taxes on his compensation as reasonable.  Congress could easily legislate away the profits interest and define partner in a partnership for tax purposes as someone who has made a genuine at-risk equity contribution of cash or property to the partnership. There really should be no such thing as a services partner with a “profits” interest who hasn’t contributed up front for a capital interest.  And all compensation shares to what are currently treated as profits partners could be treated as ordinary income –i.e., compensation currently subject to the income tax and to payroll (Social Security/Medicare) taxation.

This use of reinsurers by hedge funds is itself a tax dodge that has been around a decade or so.  In 2007, the Senate Finance Committee held a hearing on Offshore Tax Issues: Reinsurance and Hedge Funds (S. Hrg. 110-875, Sept. 26, 2007) (179 pages).  In his introduction, Baucus described insurance tax avoidance schemes as follows:

Insurance companies make a living by doing two things: they assess premiums based on the prediction of the likelihood of events against which they insure—that is called underwriting—and they also make money by investing the premiums that they collect until they have to pay out claims. If they are good at those two jobs, they  make a profit.

Customers buy insurance from insurance companies to guard against the risk of fire, disaster, or some other calamity. In exchange for paying premiums, the customers shift some of their risk to the insurance companies. Insurance companies also buy insurance. Property and casualty insurance companies pay premiums to reinsurance companies in exchange for shifting some of their risk to the reinsurance company. Sometimes the reinsurance company is also the parent company of the property and casualty insurance company. In that case, the property and casualty insurance company shifts risk to their parent reinsurance company at something less than an arm’s length transaction.

Here is where the tax avoidance comes in. Some parent insurance companies set their headquarters in low-tax jurisdictions, like Bermuda. Subsidiary property and casualty insurance companies shift risk to the Bermuda parent. Because of Bermuda’s low tax burden, the Bermuda parent can get a greater after-tax return on their investment activities. As a result, subsidiary property and casualty insurance companies can charge lower premiums for their insurance. They get a competitive advantage over insurance companies doing business in jurisdictions that tax investments.

The second setting that we will examine today involves hedge funds. Foundations and other nonprofits are some of the largest investors in the world. The law requires a nonprofit investor that invests directly in hedge fund partnerships to pay the unrealized business income tax, otherwise known as UBIT. The policy behind the law is that tax-exempt entities should not be able to have an unfair advantage over taxpaying entities doing the same thing. To avoid UBIT, nonprofit investors sometimes invest in hedge funds through offshore entities incorporated in low or no-tax jurisdictions, such as the Cayman Islands or Bermuda. These offshore entities are called blockers.

The third setting we will examine today is the compensation of hedge fund managers. Hedge fund managers receive fees from offshore blocker corporations used by nonprofits and foreign investors.Some hedge fund managers elect to defer their income, and deferring income means you pay taxes later, which is the same as a significanttax savings.

The IRS has already noted that offshore arrangements using reinsurers for hedge fund managers may be shams that are subject to challenge on audit.  See Notice 2003-34 (indicating that “Treasury and the Internal Revenue Service have become aware of arrangements, described below, that are being used by taxpayers to defer recognition of ordinary income or to characterize ordinary income as a capital gain.  The arrangements involve an investment in a purported insurance company that is organized offshore which invests in hedge funds or investments in which hedge funds typically invest.”)  Although the notice says that these purported insurers may be challenged as not insurers because they are not using their capital and efforts “primarily in earning income from the issuance of insurance”, and although it states that such arrangements will be subject to close scrutiny that could result in the application of the PFIC rules (leading to current taxation), it has apparently not bothered to challenge any of the big hedge funds’ reinsurer companies.

Again, why would they be subject to challenge?  On the basis that they are not real reinsurers, since the low amount of reinsurance that many provide is the less risky part of the business and provides a buffer to the very high reserves that they retain, sometimes invested solely in a single promoter’s hedge funds.  And if they are not insurers, they are at the least “passive foreign investment companies” (PFICs) on which shareholders are subject to current taxation on profits.  (Or perhaps the IRS might go further and re-characterize the arrangement as a sham , causing the hedge fund executive to have current ordinary compensation income.)    In other words, there is good cause to think that for many of these, the tax haven corporation is acting as an offshore tax-avoidance pocketbook for the hedge fund executive, and not really as an insurer.
By the way, if you think these hedge fund managers who are making multi-millions and billions from managing other people’s assets and hardly paying any U.S. taxes on those huge compensation payments are incredibly smart people who add to the economy’s well-being and therefore merit that kind of out-sized pay or because of the returns they bring to people that then invest them in needed projects in the good ole US of A, you need to rethink that. Hedge funds typically pay out very poor returns, when all the expenses and profits to managers are taken into account.

Roughly speaking, if the typical fund manager worked for free, and if the investment firms didn’t charge, these masters of the universe would still have underperformed a balanced index since 2003, by roughly 2.5 per cent per year. Andrew Hallam, Think you’re smarter than a hedge fund manager?, The Globe and Mail (Feb. 19, 2013) (emphasis added).

cross posted with ataxingmatter

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