How Do Tax Havens Protect Your Money?
Havens aren't tax shelters, and the IRS would rather you not use them
The word “haven” has a nice ring to it, bringing to mind a safe place, somewhere secure. Put it together with an unpleasant issue like taxes, and it’s all good, right? But are tax havens legal? Can you really dodge taxation by secreting your money in such a way?
Yes…and no. The Internal Revenue Service takes a dim view of tax havens, and the U.S. government has taken steps over the years to prevent their use. That hasn’t stopped the likes of Apple, Microsoft, and Alphabet—nee Google—from taking advantage of tax havens, but the whole concept is probably a lot more trouble than it’s worth if you’re not trying to shelter huge sums of money.
Tax Havens vs. Tax Shelters
First, it’s important to understand that a tax haven is not the same as a tax shelter. The IRS is perfectly amenable to letting you take full advantage of tax shelters. The tax code provides several ways for you to do so.
Tax shelters are tax deductions and exclusions you can use to your advantage to accumulate wealth tax-free.
- For example, you can shield up to $250,000 in capital gains as a single taxpayer if you buy a home then sell it for a profit, subject to certain rules.
- You can purchase real estate for investment, then exchange it for a “like-kind” property to defer taxation on your profits.
- You can save money for retirement without paying taxes on the growth if you invest in a Roth IRA. All these tactics are tax shelters.
Tax havens, on the other hand, are places; they’re locations where earnings aren’t taxed, or at a very modest rate if they are taxed.
- Think Switzerland, the Cayman Islands, and Bermuda.
- The British Virgin Islands has no estate or gift tax, no sales tax, and an effective income tax rate of zero.
Tax shelters are perfectly legal ways to shield some income from taxation. Tax havens, on the other hand, are countries where you can put your money to try to avoid taxation.
How Does This Work?
Let’s say you have a business, and it’s kicking off some nice income. The Tax Cuts and Jobs Act recently slashed the U.S. corporate tax rate to 21%, but that's still pretty significant when compared to some other countries.
So, your business forms a subsidiary company in the Cayman Islands. It accomplishes all sales or performs all services through that subsidiary rather than through your parent company, which remains in the U.S. You’ve established tax residency in the Caymans, and you’re holding your assets there.
Now your income is taxed there, as well, at least the portion that’s generated there, not in the U.S. And the effective corporate tax rate in the Caymans is about zero. You’ve just saved yourself 21%, assuming that forming the subsidiary and establishing it in the Caymans didn’t also cost you a small fortune that cut into those savings.
Can Individuals Gain From Tax Havens?
Individuals can use the same premise, establishing small companies with bank accounts in foreign countries, and depositing money in those accounts to escape taxation in America. But the assets would have to be untraceable by the U.S. government. In other words, their route to the tax haven didn’t take them through the U.S. Otherwise, you’d be trying to slide cash out of the country without the IRS noticing.
And that’s not legal.
Yes, the IRS provides for a foreign earned income exclusion that covers some earnings derived from other countries, but you still have to report that foreign income to claim the exclusion on your tax return.
It falls under the umbrella of tax evasion if you don’t, and it’s not easy to pull off given the tax reporting standards in the U.S.
Pretty much anyone who pays you money or even cancels a debt you owe must report the transaction to the IRS on a Form W-2, 1099, or some other informational document, so the IRS knows about it. About the only way to avoid this as an individual is to renounce your U.S. citizenship, but even then, the IRS will meet you at the door on your way out.
The U.S. government imposes an “exit tax” equivalent to a percentage of all your assets, just as though you had sold them. Of course, you can then move to a nation with more favorable tax laws, one that doesn’t tax income earned elsewhere so those assets you left behind in the U.S. might provide you with a tax-free income elsewhere.
Secreting money in a tax haven used to be a lot easier than it is today, and not just because of tax code reporting requirements. By definition, tax havens can only exist if they don’t have to report transactions and holdings to the U.S., and this was the case only through about 2006.
The U.S. passed the Foreign Account Tax Compliance Act in 2010, requiring other countries to report accounts held by U.S. citizens, and it entered into a tax treaty with Switzerland, designed to encourage transparency between the countries regarding foreign accounts held within their borders.
Finally, the death knell for the “don’t ask, don’t tell” practice regarding foreign accounts came in 2016. The International Consortium of Investigative Journalists was behind a colossal leak known as the “Panama Papers,” revealing the offshore holdings of more than 140 public officials and politicians worldwide—and the banks that assisted them. The Panama Papers also disclosed about 214,000 offshore tax haven entities. The information was dug up from 11.5 million files from the databases of the offshore law firm of Mossack Fonseca.
But There’s Another Advantage
Tax havens are obviously a tricky, complicated, borderline legal way for the average American to shield his income from taxation. They’re probably not worth the effort to protect an $80,000 a year salary—or even annual incomes up into six figures. But they do have one other advantage, particularly for high net worth taxpayers.
They offer legal protection in the event you’re ever sued. A fair number of individuals invest in offshore trusts for this reason—not necessarily to dodge Uncle Sam’s collection efforts, but to place their assets out of the reach of judgment holders. And this practice generally is legal, provided that you can prove you didn’t place your assets or income into such a trust in contemplation of a lawsuit.
But if you’re not worried about being sued, and if you don’t have considerable wealth that the IRS would like its share of, you might be better off just taking a closer look at tax shelters instead.