Tax havens and tax shelters aren’t the same thing. Andeven though a haven sounds like a good place to secure your money, the IRS would prefer that you don´t use them. Here we will help you learn everything about tax havens.
The word haven reminds us of a plesent, safe place, but are tax havens legal? Can you really avoid taxation by hiding your money in such a way? The answer is very tricky. The U.S. government has taken steps over the years to prevent their use and the Internal Revenue Service takes a dim view of tax havens.
That hasn’t stopped companies such as Microsoft or Apple from taking advantage of tax havens, but, if you’re not trying to shelter very big sums of money, the whole process is probably a lot more trouble than what it’s really worth.
Tax Havens or Tax Shelters
First, it’s important to understand that a tax haven and a tax shelter are different things. The IRS is willing to let you take full advantage of tax shelters. These are tax deductions and exclusions you can use to your advantage to accumulate wealth tax-free and the tax code provides several ways for you to do so:
• For instance, you can save money for retirement without paying taxes on the growth if you invest in a Roth IRA
• 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, taking into account some rules.
• You can purchase investments, sell them, then reinvest in a similar asset to postpone taxation on your profits, among other examples.
On the other hand, tax havens, are places. They are locations where earnings are taxed at a very modest rate or are not taxed at all:
• Examples of this are Switzerland, the Cayman Islands and Bermuda.
• The British Virgin Islands have no estate or gift tax, no sales tax, and an effective income tax rate of zero.
While tax shelters are legal ways to shield some income from taxation, tax havens, are countries where you can put your money to try to dodge taxation.
Understanding how it works
The Tax Cuts and Jobs Act recently slashed the U.S. corporate tax rate to 21 percent, but that's still quite a lot when compared to some other countries. So if your business is starting to generate a higher income, this option may seem attractive.
The fist step is for your business to form a banch company in Bermuda, for instance. It accomplishes all sales or performs all services through that subsidiary rather than through your head company, which remains in the U.S. You’ve established tax residency in Bermuda, and you’re holding your assets there.
Now your income is also taxed there, at least the portion that’s not generated in the U.S. And the effective corporate tax rate in Bermuda is almost zero. You’ve just saved yourself 21 percent, You must, of course take into account the costs of seting up a subsidiary company.
Do Individuals Gain From Tax Havens?
Individuals can also establish small companies with bank accounts in foreign countries, and deposit money in those accounts to avoid taxation in America, as long as the assets are not traceable by the U.S. government. Otherwise you’d be trying to slide cash out of the country without the IRS noticing. And that’s ilegal.
The IRS provides for a foreign earned income exclusion that covers some earnings derived from other countries, but it is necessary to report that foreign income to claim the exclusion on your tax return. It is regarded as tax evasion if you don’t, and it’s not easy to achieve, given the tax reporting standards in the U.S.
Only through about 2006 it was easy to secret money in these locations for they didn’t have to report transactions and holdings to the U.S. This is what defines tax havens, and that changed when the U.S. passed the Foreign Account Tax Compliance Act in 2010, requiring other countries to report accounts held by U.S. citizens. It also entered into a tax treaty with Switzerland, designed to encourage transparency between both countries regarding foreign accounts held within their borders.
The death sentance for the “Don’t ask, don’t tell” practice regarding foreign accounts finally came in 2016. The International Consortium of Investigative Journalists was behind an enormous leak known as the “Panama Papers,” revealing the offshore holdings of more than 140 public officials and politicians- and the Banks that assisted them- around the world.
One Last Advantage
Tax havens are obviously a tricky, complicated, borderline legal way for the average American to protect his income from taxation. They’re probably not worth the effort to protect his salary, but they do have one other advantage, particularly for high net worth taxpayers.
An important amount of individuals invest in offshore trusts because they offer legal protection in the event you're ever sued—not necessarily to avoid taxes. They place their assets out of the reach of judgment holders and this practice 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 being sued isn’t a concern, and if you don’t have considerable wealth, you might be better off just taking a better look at tax shelters and their benefits.