Cayman Island Companies – Split the baby! President Obama’s Tax Proposal

Cayman Island Companies – Split the baby! President Obama’s Tax Proposal

Further related to President Obama’s Corporate Tax Proposal of May 4, 2009:
(See: http://media.npr.org/documents/2009/may/whitehouse_taxhavens.pdf)

May I suggest there are two types of Offshore Holding Companies – in the Cayman Islands, Bermuda, the Netherlands, and others, but let’s stay with the Cayman Islands for this Blog.

The President has repeatedly pointed out:

“In the Cayman Islands, one address alone houses 18,857 corporations, very few of which have a physical presence in the islands.”

I’m sure that is accurate.  But let’s break it down.

“Bad” Cayman Company

The Cayman Islands does not share tax information on income of its resident individuals, corporations or trusts with the I.R.S. or any other tax authority.

Therefore, individuals and companies use the laws of the Cayman Islands to establish corporations and trusts to exploit these so-called “privacy” rules.  They open a bank account or make other types of investments and do not report the income from these investments to their home-country tax authority.

This is often clear tax evasion. No one, including the most aggressive (legal) tax advisors, favors or encourages this arrangement, as it is unfair to all U.S. taxpayers for some to hide their income.

We fully encourage the I.R.S. to find the people involved in such transactions and enforce the tax laws with collection action and, where appropriate, criminal prosecution.

There is no reasonable argument to encourage “Bad” Cayman Companies.

“Good” Cayman Company

But, there are good, legal uses of a Cayman Island Company.

For example, assume a U.S. parent company is doing business in Germany.  The U.S. company incorporates a German subsidiary. (Local laws in Germany force the U.S. parent company to do so, trust me on this.)  The German subsidiary earns a profit and is ready to pay a dividend.  The German subsidiary has already paid +30% German corporate income tax on the German-based profits.

Let say the U.S. parent company wants to build a new factory in France.  Again, trust me, the U.S. company will be forced to establish a French subsidiary that will own the new factory, sales, marketing, finance, admin, and other activities required to run a business in France.

Can the German subsidiary just give its profits to the French subsidiary to use to build the factory?  NO!  U.S. tax law says that transaction is a taxable dividend payment, first, to the U.S. parent company and, second, a contribution of funds from the U.S. parent company to the French subsidiary.  This is known in the tax world a “round-tripping” and has bad tax consequences.

Let’s analyze what happens with round-tripping.

The U.S. parent company is taxed on the dividend from Germany.  Up to a 35% U.S. tax is imposed (less a credit for a share of the German tax paid on the same income — it gets complex.  IRC Sec. 902).

Simplistically, if the German tax rate is about 30% and the U.S. rate is 35%, the difference of 5% (it is actually more due to withholding taxes paid to Germany and allocations under U.S. tax law [Reg. 1.861-8] ) is lost money, just for the right to send the money back out to France to build the factory.

Therefore, the better answer is to create a Cayman Island holding company and move (referring to the subsidiaries only by their country) Germany and France to become subsidiaries of Cayman.  A dividend from Germany to Cayman (of “active” business income – not investment income earned in Germany) escapes U.S. taxation as no cash arrives in the U.S. parent company bank account.

Cayman now contributes the dividend cash from Germany to France which then builds the factory.  The round-trip is through tax-free Cayman and not the U.S. The corporate tax rate in Cayman on the dividend is zero.

It is still not a complete free-lunch due to withholding taxes imposed by Germany on payments to Cayman.  That’s why the Netherlands is used, because the withholding tax under the tax treaty between the Netherlands and Germany on a dividends paid to the Netherlands from Germany is less….but let’s stick with Cayman for now.

Warning:  Don’t go off and move existing subsidiaries under Cayman without good tax advice. Large U.S. taxable events can result.

The reason this so-called “deferral” structure has evolve is, as the Wall Street Journal wrote on May 6th:  “The current tax-deferral system is a clumsy attempt to deal with the fact that most countries don’t tax their companies’ overseas profits. A Germany firm doing business in Ireland, say, pays no German income tax on its Irish profits but it does pay Ireland’s corporate income tax at its 12.5% rate.  The U.S. company competing with the German business in Ireland by contrast, pays Ireland the same 12.5% on its profits – and it then pays Uncle Sam up to 35% minus a credit for what it paid the Irish.”

The German company in the WSJ example NEVER faces additional tax on the Irish income, no matter what it does with the related cash dividend.

On the other hand, the U.S. company faces incremental U.S. tax if that cash ever touches a U.S. bank account of the U.S. parent company or U.S. related parties…or is deemed, under the tax law, to have round-tripped through the U.S. parent company, as in my earlier example.  What a legal mess.

So, the long-held deal Congress made was to avoid the U.S. tax as long as the money was never “repatriated” to the U.S. parent company, and, further never distributed as a dividend to the shareholders of the U.S. parent company.  Fair Deal!

Hence, intermediary tax-haven holding companies are used to move cash around outside the U.S. to allow multi-national businesses to build, expand and compete outside the U.S. Just what a good tax policy should encourage, aye!

GOOD Cayman, Bermuda, Netherland holding companies, etc. are just a tool to do what Congress intended and is in the best interest of U.S. based multi-nationals, and, may I say, the U.S. voters they employ.

Capital, intellectual property and human resources are movable.  A pseudo patriotic view that “these companies can’t just up and leave” if deferral structures become illegal or severally limited, is naïve.  Just arrange a visit to any Silicon Valley Board of Directors meeting to see what I mean.

The I.R.S. would find itself in endless court battles regarding outbound transfers of technology…assuming they have the resources and expertise to even identify and develop the issues.

When the “crown jewels” of a company, in terms of intellectual property, can be transmitted anywhere in the world with a few clicks of a mouse, I submit that deferral structures are – as Martha Stewart would say — “a good thing.”

The GOOD CAYMANs should be encouraged!

So, please Mr. President, split the baby.  Go get the bad Caymans and encourage the Good Caymans.

I can always be reached for comments or questions at (510) 797-8661 x237.