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August 14, 2006
The First Wives' Club
by Lee A. Sheppard
Article originally published in
Tax Notes International on August 14, 2006

Full Text Published by Tax Analysts®


Your correspondent was once asked by a television interviewer whether there was a "legitimate" reason to have a tax haven bank account. The short answer is no. But there is a generally accepted nontax reason: to hide assets from the ex-wife. Why should that be legitimate? Think about who runs the country — the politicians and their paymasters — and we're talking about a lot of alimony and property settlements.

Which is part of the reason why nothing serious is ever likely to be done about tax haven bank accounts and trusts. The larger reason is that the United States needs the capital that tax and banking havens take in from foreign rich folk who are evading the tax laws and possibly also the capital controls of their home countries. That Americans should use the same havens to hide from the IRS is an unintended and inevitable consequence of a cynical policy to access the rest of the world's capital.

We could do something about tax havens if we really wanted to. We don't really want to. Sen. Carl Levin, D-Mich., suggests that the tax, securities, and money laundering laws presume avoidance when a trust is set up in a haven designated on a Treasury blacklist.

That's nice, and it is hard to disagree with the logic, but it won't get us much farther than we are now. A presumption is just a tool in a factual inquiry that takes place in an audit. To use a hackneyed metaphor, it is closing the barn door after the horse is gone.

More information gathering and more sensible source and residence definitions would work better. Information collection, in particular, would stop a lot of schemes before the fact. Congress is asking second-order questions about what happened, when it should be asking first-order questions about why the tax avoiders have colorable claims for their desired treatment.

First, the Wylys, the poster children for the hearing, are under criminal investigation. That means the government found out about their arrangement, despite apparent efforts to hide it, and some or all of the things they are accused of doing are already illegal.

The underlying transaction they are believed to have carried out does not achieve the desired result. If a U.S. resident sets up a foreign trust over which he has retained power to control all substantial decisions, and an American court has jurisdiction over it, then the trust is considered a U.S. resident trust. (Sections 672(f), 7701(a)(30)(E); reg. section 301.7701-7.) Moreover, when one disclaims ownership of an asset the income from which is taxable in the United States, that could constitute a false statement. (Section 7206.)

The Wylys episode would tend to indicate that new laws might not be necessary. Oh, but it's hard to enforce existing laws. It is especially hard when there is precious little evidence that anyone in the U.S. Treasury is getting out of bed to enforce the existing tax and money laundering laws, as Levin noted. (We would beat up on the Securities and Exchange Commission, too, but those perpetual laggards are too easy a target. How could they not have known that options were backdated?)

It's a helluva thing when the IRS commissioner, who rants about enforcement on a daily basis, confesses to being outgunned by what — a bunch of lawyers who should know better setting up hokey offshore trusts for gullible rich folk?

Yet here was Commissioner Mark Everson blaming globalization and tax law complexity. He even complained about lack of transparency — when the IRS is backpedaling on efforts to get information about putative nonresidents with U.S. investments and bank accounts. Like the subcommittee, Everson mainly dealt with second-order knowledge about offshore shelters, instead of asking what domestic laws and practices enable them in the first place.

Puh-lease. Stop beating up on waitresses for unreported tip income until you have maximized available information gathering powers and have audited every single individual return reporting a seven-figure gross income.

Second, enforcement of existing laws suffers from difficulty of obtaining information, as Levin recognized. Most of the information exchange agreements that the United States signs with other countries, including a lot of tax havens, are not worth the paper they are printed on. Those agreements do not require turnover of any information the signatories are not already collecting. And guess what? Tax havens don't collect beneficial ownership information on anything. And as Everson noted, an agreement is useless without the IRS knowing the identity of the taxpayer.

Information that is not collected in the normal course of tax administration need not be turned over to the treaty partner under any information exchange agreement. But we know how to get information when we really want it. The U.S. information exchange agreement with Canada requires bank account interest paid to nonresident aliens to be reported. (Reg. section 1.6049-8.)

Levin advocates that Treasury report to Congress tax havens that do not cooperate with U.S. enforcement efforts so that Congress can "eliminate U.S. tax benefits for income attributed to those jurisdictions."

For starters, the United States should not allow any passive form of income beneficially owned by a U.S. resident to be considered foreign-source income. It is a matter of having sensible source rules. We do not have sensible source rules. No government seeking to maintain residence-based taxation should define any mobile, passive, investment-type income in the hands of a resident as having a foreign source. Source rules are inherently arbitrary. They can be drafted to minimize abuse potential.

What sanctions does Levin have in mind? Tax havens by and large do not have tax treaties with the United States and can comply with information exchange agreements without providing useful information. What U.S. tax benefits would be denied? Is Levin talking about withholding on passive income paid from the United States to havens, much of which is statutorily exempt from withholding?

Third, the tax laws facilitate shifting income and hiding assets offshore. There is nothing in the Haig-Simons definition of income or the Constitution that says that a trust formed in a foreign country by a U.S. resident must be considered a resident of the country of formation.

Section 7701(a)(31) defines as foreign "any trust other than a trust described in subparagraph (E) of paragraph (30)." It doesn't have to be that way. Foreign status should not be a default category. Trusts should be defined as domestic if they are created by or benefit U.S. residents. The only trusts that should be deemed foreign should be those whose ultimate beneficiaries have been identified to the government and are foreign individuals. Owners of entities in the chain of ownership must be identified so that the ultimate beneficiary can be identified.

Fourth, the IRS is not collecting information on who owns foreign trusts. The IRS is not requiring foreign trusts to have their own identifying numbers. The IRS has the power to collect this information.

There's a line on Schedule B of Form 1040 that asks the individual filer whether he or she has a foreign trust. The creation, transfer to, and receipt of distributions from a foreign trust must be reported. (Section 6048.) Transferors to foreign trusts are treated as owners, and loans from foreign trusts are treated as distributions. (Section 679.) These laws cannot be effectively enforced without information collection.

Remember, even though the trusts are ostensibly offshore, their bank and brokerage accounts are either in the United States or with offshore affiliates of U.S. banks and brokers. Those financial intermediaries, which are regulated, form a link to the needed beneficial ownership information. Yet this link is not being pursued.

Everson barely mentioned information collection by financial intermediaries in his testimony, except to note that the IRS had forgiven noncompliance by securities brokers in a recent amnesty program. The offshore credit card scams the IRS is going after are a mass affluent shelter. The IRS does not appear to be going after the bigger fish.

Oh, but financial intermediaries don't want to collect information. So what? They are regulated. Congress can make them do it. The IRS can condition qualified intermediary status on it. Not asking for information gathering by financial intermediaries is yet another admission that the country is being run for their benefit. At a minimum, the government ought to be asking for identifying numbers for recipients of all outbound payments of investment income, to determine whether the ultimate beneficiary is a U.S. resident.

Fifth, boot the tax and banking havens out of the international clearing system. It can be done. The Palestinian Authority has been effectively booted out of the clearing system by the United States, and it now transacts all of its business in cash. This was accomplished by the U.S. government hinting that it would come down hard on banks that did business with the Palestinian government. The banks, many of them Arab-controlled, got the message.

But somehow Nauru remains in good standing in the clearing system. The United States respects all these little flag-of- convenience countries as real countries. Yet the United States is quite good at bullying powerless little countries when it wants. But the government can't persuade a bunch of little islands utterly dependent on U.S. goodwill to turn over bank information.

What does after-the-fact whinging about offshore tax havens accomplish if Congress is unwilling to act for fear of putting off foreign investors and financial intermediaries? Our legislators look like a bunch of first wives. The difference is that first wives stop being naïve after they have been taken advantage of for a while. Congress cannot say the same for all the little favors it has done for financial intermediaries over the years without attempting to become educated about the consequences.

Lee A. Sheppard is a contributing editor to
Tax Notes International.

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