Tax Haven Corporations and Trusts The essence of using tax havens for tax reduction purposes is the creation of legal entities that have these characteristics: (1) They are separate from their creator in a fashion guaranteeing that the income they derive from their assets cannot be considered part of his income. (2) They "reside" in countries where the tax situation is much better than in the investor's home country. (3) An investor can control them and their assets and income as he pleases, without either tax or debt liabilities. Such business entities exemplify the basic idea of separating ownership and control. Once one's portfolio has been vested in such an entity, he no longer has title to it. But since he has title to stock in the company, he has the power to make decisions about the ways its assets are used. There are two basic forms of such entities: the corporation and the trust. We will discuss both in turn, because all the countries that we will later consider as possible tax havens allow at least one form or the other; all of them allow corporations, and some allow trusts. (There are additional kinds of business entities available in Liechtenstein.) At this juncture, it is very important that the nature of corporations and trusts and all the related concepts defined by reference to them be clearly understood. Corporations. Contrary to popular belief, corporations are not necessarily "big" companies, though there are some size characteristics that are relevant to the decision of whether or not to incorporate. Below a certain asset value, incorporation is usually not worthwhile. But first, just what is a corporation? To understand this, it is important to reflect on the way the corporate form of business enterprise first came into being. The initial motivation for forming corporations had nothing to do with taxes; rather, it had to do with debts. If one is, say, a grocer who owns his own store, any loan he takes out to buy stock for his shelves is his personal loan, his personal debt. The security for the loan, the assets that can be taken away from him and sold to cover the loan and repay the debtor, is all the grocer's personal assets, everything he owns. If he fails to repay a loan taken out for business purposes, his debtors can claim his TV set, house, car--everything. This means that if one runs a business as a personal property, he has unlimited debt liability; the business' debts are its owner's debts. Because of this, many persons felt the need to separate business from their personal lives and to defend their personal property from the adverse consequences of business mistakes and failures. The corporation was the answer. Incorporation was, in effect, a declaration like this: "If you give my business a loan, you should know in advance that, in case the business fails to repay you, you have recourse only to what the business owns, not what I personally own." In other words, the formation of a corporation is the creation of a new "legal person" insofar as liabilities are concerned. This legal person can assume its own debts and acquire its own assets. The assets may derive from the individual who establishes the corporation, and he then becomes liable for the debts of the company, but only to the extent of the assets expressly transferred to the corporation or committed to such a transfer. An act of government, the registration of the corporation, makes valid this "legal personification" and defends those with interests in the company from invasions of business debtors into their private lives. At first glance, incorporation seems to be nothing but a legal trick to escape full responsibility for bad decisions. But it has fuller significance and justification when partnerships are concerned. If, say, one is a partner with his neighbor in a small, unincorporated repair shop, both partners are fully liable for the business' debts. If the neighbor runs off with all the company cash, his unfortunate partner would still be liable for all the debts incurred by the business. Suppose one is a passive partner, having lent money to someone to open a shop saying, "I don't want to be a creditor, but a partner. Fifty percent of the profits will be mine after a salary for you is deducted from the profits." Sometime later it is discovered that the active partner has incurred debts beyond the value of the assets of the shop and his own personal property, leaving the passive partner--who had nothing to do with running the business--with the responsibility of covering the remaining debts out of his own pocket. And what about many partners in an enterprise? There seems to be full business justification for becoming a partner with a very small percentage interest in a company, without any active participation in running it but with a percentage of the profit proportional to the original investment. But such an arrangement is quite unfeasible if one has full liability for the company's debts. Who would want to run the risk of having a $100 investment suddenly become a liability of $1 million as a consequence of someone else's blunders? Since it seemed that economic growth required such investment partnerships, and since most people would be reluctant to take part in them if it involved unlimited liability for the partnership's debts, the idea of incorporation became widely accepted. It answered a need. Its essence was that instead of being a partner in the title of a business property (and thus a proportional direct owner of the business assets), one owned stock. Stocks are certificates of partial ownership in a corporation. The corporation is a legal person that owns its own assets and has its own liabilities. Owning the stock of the corporation does not mean owning its assets. The corporation has title to these. The stockholder has title to his stock. The value of the stock may have been printed on it (par value); it might be, say, $20. This means only that this number was printed on the stock certificate, and that if one went through all the certificates ever issued in the name of the company, added up all the figures of par value printed on them, and got a total of $20,000 (the authorized capital of the company), the proportion of the ownership in the corporation represented by one share would be one thousandth. Par value is not necessarily what would be paid for the stock. In principle, a buyer could pay a "percentage" of, say, 10 percent of par. This would mean that he could pay $2 and owe the company $18. If everybody bought stock at the same percentage, this would mean that the corporation would start off with a paid-up capital of $2,000, 10 percent of its authorized capital. If tomorrow our example company got into heavy debt and declared bankruptcy, the liquidator, whether a private individual or the government, would inspect the company books and find that it has $2,000 of paid-up capital and that the stockholders owe the company $18,000. The stockholders' debt is the company's asset, and it has to be called in to pay off the corporation's debts. But the debtors cannot make claims against the stockholders beyond the amount they owe the company. Some stock has no par value. In such cases, each certificate represents a part of the total ownership of the corporation equal to that represented by any other. Even so, legal requirements for a minimum of authorized capital and, usually, paid-up capital apply everywhere. Clearly, such minima are necessary; nobody would give a loan to a corporation if there were no clue to at least its authorized capital. A stockholder's percentage of ownership in a corporation equals the number of shares he holds divided by the total issued. The corporation may have a fixed authorized capital or, in some countries, a variable one. Say it can vary between $10,000 and $50,000. It may start, then, with 100 shares of $100 par value each. Each such share would then equal one percent control of the company. But then the company could expand its capital base by selling new shares up to the limit of $50,000. A $100 share would then represent only 0.2 percent control. Another important distinction concerning shares of corporate stock is that between registered and bearer shares. A registered share has the name of its current owner printed on the certificate and in the official corporation record (the shareholders ledger). The record of registered shares is open to official inspection, and the owners of such stock are easily identified. A registered share thus has obvious drawbacks when privacy is important. A bearer share belongs to whoever physically holds it; there is no name on it, and its sale is not logged anywhere. The sale of registered shares is always recorded and, depending on the corporation, may require the agreement of other shareholders. Bearer shares can be bought and sold in complete privacy without any third-party interference. Bearer shares are not allowed in some tax havens. A major problem with bearer shares is that they can be stolen, and the owner has no means of proving ownership. In addition, unlike registered shares, which can be purchased at a percentage, bearer shares usually must be paid for in full. It is possible to have the "best of both worlds" by buying registered shares at a percentage and having them registered in the name of a proxy. This reduces the capital requirements while at the same time providing privacy and security. A private contract can be arranged with the proxy that binds him to follow the real owner's instructions in all his actions as a stockholder. A proxy can be a real individual or an institution. Corporation A can hold stock in Corporation B, serving as a holding company. Holding companies are very popular because they can, if they are tax haven corporations, release their owners from registered ownership; they can be used to absorb and reinvest returns on the shares they hold without tax liabilities; and they can be established in many countries with very low local tax liabilities, even if there are heavy local taxes on other types of corporations. This leads us to the issue of control of corporations in general, which is an important one. A corporation is a legal person; while being, in essence, a documentary fiction, it must simulate somehow the faculties and capacities of a real person. It must have the ability to evaluate its past actions and its present circumstances, to reach policy decisions in light of this information, to implement them in specific everyday decisions, and to commit itself contractually. A real person does all these things. A corporation must have a legal anatomy that allows it to simulate the psychological anatomy of a real person. This dictates the traditional structure and nature of a corporation. The basic existence of a corporation usually derives from two documents, the articles of incorporation and the articles of association (by-laws). The articles of incorporation are prepared by the lawyer who represents the corporation. They must include certain information about the newly born pseudoperson: (1) Its name (including an indication of its status as a corporation such as "Inc." [incorporated], "Ltd." [limited], "Co." [company], or whatever else local conventions associate with corporate status). The name must not be the same as that of an already existing corporation and must not be misleading according to local conventions. Some countries, for instance, forbid companies to use their national names as part of a corporate name. (2) Its registered address. This is required to make possible communication with the corporation. (3) Its objects and aims. Usually these are stated broadly, but they must be so stated as not to allow any reason for suspicion that the corporation is formed to promote illegal or immoral aims. (4) Its capitalization. There is country-to-country variability concerning this requirement. It usually pertains to authorized capital, the paid-up capital, the nature of shares (par value, no par value, number, registered, bearer, premium, no premium). This stipulation is usually required to be backed up by some officially acceptable proof (such as a bank account record) that the minimum paid-up capital requirements have been met by cash or by assets whose provable value adds up to the minimum. (5) A statement that the company is a limited liability organization. Apart from these general requirements, local laws differ. In some cases, names of persons associated with the corporation must also be mentioned, with their addresses: shareholders, ultimate-beneficiary share-owners (in the cases where shares are held by proxies), directors, officers. Other countries may require a specification of the span of time the corporation is supposed to exist before liquidation. Sometimes the articles of association are required to be a part of the articles of incorporation. The articles of incorporation are usually approved and confirmed by a government official, the "Registrar of Companies" or something comparable. Most often, but not always, an announcement of the formation of a new corporation is required to be published in some official government gazette. The articles of association usually must also be submitted to the government registrar. These articles represent the basic terms of a corporation's structure and direction. There are variations from country to country on the requirements. In some places the local law is rigid and detailed; in others it indicates broad outlines and certain specific restrictions. Thus the law may require that each corporation have a board of directors and that at least one director reside in the country where incorporation takes place. However, the law may leave the number of directors open. This, of course, is a mere illustration. Some uniform features of corporations, following from the essential nature of a corporation as a fictitious person that simulates a real person, are: Stockholders' Meeting. This is the "ultimate authority" of the corporation. There is usually a requirement that it meet annually, and sometimes there is a requirement that it have a quorum of a certain percentage of the shares outstanding. In this meeting all stockholders are allowed to participate and, usually, to vote, with one vote per share. Sometimes, however, there are nonvoting shares, sold as such. The annual meeting has to discuss and approve certain things by majority decision: (1) The business actions of the corporation in the preceding year as represented by its declared annual accounts of both profit and loss and its assets and liabilities. The correctness of these documents usually has to be certified by a separate body of auditors or accountants. Disapproval of such reports by the majority of the stockholders is similar to a parliamentary no confidence vote. It is an expression of dissatisfaction with the management of the company. (2) Policy decisions on future business actions. Trends of possible company developments have to be approved, as well as the manner in which the net profit of the company (after deduction of both expenses and taxes) is to be divided. What dividend will the shareholders receive? How much will go for investment in company growth? How much will be kept in bank reserves? (3) Personnel decisions. Should the president, secretary, and treasurer be retained or replaced? Should the auditors continue to be the same? Are the directors satisfactory? (4) Constitutional issues. Should the articles of association be modified within the limit of the law? Should the quorum requirements be changed? The annual meeting is chaired by an elected chairman. His position is a distinct one in the company structure. Board of Directors. While the annual meeting constitutes the "parliament" of the corporation, the articles of association also specify requirements for the "cabinet," the board of directors. How many directors? How are they appointed? How are they replaced? How many times do they meet? And so on. In general, the board is supposed to make decisions on the issues that are too specific for the general meeting to discuss but which are beyond the day to-day responsibility of the company management. Corporate officers. Another cabinetlike institution, sometimes part of the board of directors, is the group of corporate officers--the president, the secretary, the treasurer, etc. These individuals usually have the right to represent the company to third parties, to negotiate and make commitments in its name. This means they can put it into debt, and stipulations may be made as to whether they can do this separately or only in common. The local law may specify an annual minimum of officers' and directors' meetings, even sometimes demanding a specific location for them; it may stipulate whether the directors have to be at the meetings in person or whether they can be represented by proxies. The law may also (and usually does) require a corporation to keep records of proceedings and decisions in such meetings, a book of minutes that, in some places, must be open to public and/or official inspection. Auditors. The last body usually required is the auditors, who are required to inspect the company's bookkeeping and verify the correctness of annual accounts. These are not usually employees or directors of the corporation but an outside firm. The legal structure of a corporation is distinct, of course, from its operational structure. It may have branches, divisions, departments, etc., headed by managers or executives who may or may not be members of the board of directors and may act separately or collectively as the articles of association may specify explicitly or as the directors or officers dictate. Now, this looks a formidable structure, and one may wonder if having so many employees may not cost more than the taxes to be minimized through incorporation. But all this vast structure need not be more than a tissue of technicalities if incorporation is accomplished in a tax haven. If the local law requires three initial incorporators, these can be supplied, for a reasonable fee, by the local law firm that handles the incorporation. These proxies can then either turn over their shares to the "real incorporator" after incorporation or continue to act on his behalf under a private contract. Similarly, the general meeting of stockholders can in some cases be no more than a meeting with the single majority stockholder in front of the bathroom mirror, with minutes duly recorded, of course. If this is not good enough for the local law, a real local annual stockholders' meeting can be arranged by the corporate legal representative in the haven, with proxies provided for moderate fees. The same sort of arrangements can be made to cover all requirements for local corporate officers and the like. The "ultimate owner" can run the company as he pleases, with all the legally formidable structure and rituals carried out by proxies. Returning to the essential aspects of corporations, it should be remembered that the corporate legal form came into being for business purposes, not tax purposes. Corporations were invented to encourage capital investment in the form of ownership with limited debt liability. Since corporations are legal persons, government approval is required to form them, and corporation laws, quite similar all over the world but with important place-to-place variations, have been enacted, establishing government control over the formation and operation of corporations. Moreover, since corporations, as legally acknowledged persons, make possible all kinds of sophisticated fraud, governments encourage their formation. This claim may seem strange, but nonetheless it is true. The existence of corporations enhances government's role of "defender of the innocent" against the "robber barons." Very complex corporation laws, requiring publication of annual corporate accounts and records, independent accounting, forbidding deals of "no less than arm's length" between two corporations with the same or virtually the same ownership of certain kinds, and so on, are justified by reference to the opportunities for corporate mischief. On the other hand, corporations require special tax treatment, to avoid killing the goose that lays the golden egg. They cannot be taxed progressively, as individuals are, because the "justification" for progressive taxation of individuals does not apply. If an individual has a very large income, he is "too rich," and the soak-the-rich mentality of modern welfare statism makes progressive taxation popular. But even a huge corporation with large gross profits can be owned by thousands of "little men." Progressive corporate taxation would wipe out the little guys' profits--hardly a politically popular consequence--and would discourage investment in corporations. Consequently, with but two exceptions, corporate income taxes everywhere are assessed at flat rates, in most cases 40-50 percent of net profits. The exceptions are, of all places, Switzerland and Liechtenstein. In these two nations, corporate-tax brackets are determined by the ratio between profit and authorized capital. For example, $100,000 made on an authorized capital of $1 million, a 10 percent yield, would be taxed at a higher rate than the same dollar profit on an authorized capital of $10 million, a one percent yield. The fact that corporate taxes are flat-rate taxes means that incorporation can be used to reduce tax burdens by alienating personal sources of income to a corporation. This may be a good idea, and it is a major reason for incorporation in a tax haven that has no or very low corporate taxes. In sum, here is what a tax haven corporation can do for a shrewd investor: It can alienate returns on investments from personal income, and thus save them from crippling home country tax rates. Even if the investments are in a high tax country, a tax haven corporation can reduce the total tax on them, sometimes, with a proper setup, to as low as 5 percent. The profits can then be reinvested to grow in whole dollars. If these fast-growing savings are repatriated to the investor's home country as dividends or as capital gains on the liquidation of the corporation, the investor will have to pay his country's taxes. Shrewd investors live off the income from their work and keep reinvesting the tax haven profits abroad, to be tapped later upon retirement or to be passed on to heirs. Concerning the matter of inheritance, if the money is returned to the investor's home country while the investor is still alive, there will be a tax penalty in the form of high income or capital gains taxes and, at the investor's death, estate taxes and probate duties. If the tax haven company survives the investor, its stock is part of his estate and is subject to estate taxes and probate in his country. In both cases, if the tax haven investment is principally intended to benefit heirs, a tax haven trust is called for. Trusts. Like corporations, trusts were originally spawned by non-tax considerations. A careful father, suspicious of his frivolous and careless son, yet still affectionately concerned for his future, would decide not to bequeath the whole of his accumulated wealth directly to his son. Rather, he would set up a trust, a contract (the trust deed, or instrument) between himself (the trustor) and a trustee. The trustee would be somebody who could be counted on to responsibly manage and disburse the trust assets; he could be a personal friend, the family lawyer, or a professional trust company. The trustee would agree to manage the trust fund, or assets, which are thereby alienated from the founder's property and become a legally distinct entity, like a corporation, with its own assets and liabilities. The trustee would invest the assets according to his own discretion within the limits of the provisions of the trust deed. He would then, after a period specified in the trust deed and in conformance with pertinent legal requirements, start paying the trust beneficiary (the son) a regular sum as specified in the trust deed. This payout might be subject to certain conditions laid down by the trustor: the son gets the money only if, say, he is married before he turns thirty, or only if he refrains from drinking cherry brandy, or what have you. The money distributed to the beneficiary would include both the return on the investment of the trust principal, the original sum constituting the assets of the trust, as well as, gradually, portions of the principal itself. The trust would be legally required to terminate at some point, when all funds, principal, and return on principal, have been distributed to the beneficiary, less, of course, management expenses incurred by the trustee. As you can see, a trust serves a role similar to that of a will, with these additional advantages: (1) It can be separate from one's will and thereby maintain the secrecy of certain heirs who it would be socially inconvenient to acknowledge in a publicly read will. (2) It allows for the separation of some assets from one's property for inheritance purposes before death, and these assets are thereby immune to further business liabilities incurred by the trustor. This way, especially if the trust is irrevocable (the trustor being debarred under the trust deed from canceling it and reabsorbing the trust assets) and the trustor or his wife is not a beneficiary, money can be guaranteed to the trustor's loved ones without threat of loss through bankruptcy or other reverses. His creditors would have no access to the trust assets, since they would be separated from his estate. (3) It allows for competent professional management of the trust assets. (4) It allows the trustor to determine what aspects of the beneficiary's life he wants to encourage (or discourage) by allocating benefits for certain specified purposes. This contrasts with a will, which determines transfer of ownership, but which can establish no control over what is done with the transferred assets after the transfer is made. (5) It allows avoidance of laws that limit the right to decide how a legacy will be divided. The major disadvantages of a trust are, of course, irrevocability and the chance of trustee abuse of trust assets. The latter can be avoided by careful formulation of the trust deed and careful trustee selection. In the case of professional trust companies, any temptation to abuse trustee powers is strongly moderated by the need to maintain a good professional reputation. A minor disadvantage is that legal tradition generally requires that a trust have a fixed, or "upward-bounded," perpetuity period, at the end of which the trust assets must be completely disbursed to beneficiaries. The perpetuity period is variously defined in different countries. It is important to understand that trusts are quite different from corporations. Usually, they need not be publicly recorded. A legal contract, combined with proper separation of the trust fund from the trustor's assets, establishes the trust. The contract, moreover, is peculiar in that (1) those who have rights to sue on the basis of it (the beneficiaries, who are entitled to sue the trustee if he violates the provisions of the trust deed in a manner that harms them) are not parties to the contract, (2) one party to the contract, the trustor, is usually debarred by law from any official right to intervene in the management of the trust, and (3) the trustee, who has full power to manage and distribute trust assets, cannot have any personal interest in the trust. This peculiar legal structure, with the infinite possibilities for variation it allows, is a historical development in the common law tradition. Common law is peculiar in that it arose from a tradition of concrete cases, established in courts by reference to precedent rather than to statute law. It applies in the United Kingdom and its former colonies, including the United States and all Commonwealth countries. Only common law countries permit true trusts. There exists another legal tradition, dating back to old Rome, revitalized and modernized by Napoleon in his Code Napoleon and accepted throughout continental Europe and in the new states that are former colonies of France, Germany, and others. This is the civil law tradition. It accepts as the basis for legal reasoning legal principles derived from explicit legislation. Precedent has a very limited role. While some civil law countries have enacted trust laws allowing the simulation of common law trusts within a civil law framework, it is generally advisable not to use such a simulacrum. It is only the rich common law tradition that guarantees beneficiaries their rights under the provisions of a trust. An artificial trust law is unlikely to capture many of the undreamt of possibilities specific cases may pose, and a judge deprived of the support of the vast common law tradition may decide in a very arbitrary manner sanctioned by the schematic, underdeveloped, officially legislated law. There are many common law tax havens in which to settle a trust, so there is no need to consider the civil law havens for this purpose. (Liechtenstein, as we will discuss later, is an important exception to this general rule.) But what do trusts have to do with taxes? To begin with, money given to a trust when the trustor is alive (a living trust) may be subject to a gift tax, but not to heavy estate taxes and probate duties. Thus, a living trust is superior to a testamentary trust, one that is established in a will, because the latter can be established only with funds already decimated by taxes and probate. Moreover, trust income is not usually taxable to the trustor. Nor is it taxable to the trustee, who derives no benefits from its growth (except his fees and expenses, which are tax deductible expenses of the trust). The beneficiaries, of course, cannot be taxed until they start receiving benefits. The trust itself is subject to a tax on its income. But a tax haven trust is not subject to this tax, and so can serve to reinvest its income tax-free, growing rapidly through whole-dollar investment. Thus, a tax haven trust can do for one's heirs what a tax haven corporation can do for oneself. Tax haven trusts can be used in conjunction with haven corporations. Instead of owning a holding company that, in turn, holds stock and other investments, one can be a beneficiary of a trust established by a foreign holding company to hold its own stock. This and other double-tier structures are of huge importance when home-country tax provisions come into play. Remember that trusts, unlike corporations, are almost never publicly advertised entities. No official confirmation of their creation has to be published anywhere. No audited accounts need reach anybody except the trustor and/or his beneficiaries. Such privacy allows one to decide, on the basis of whatever considerations he chooses to take into account, what information should be broadcast publicly.