Jack Lew, President Obama’s nominee for treasury secretary, faced questions about his investment in a Cayman Islands-based hedge fund during his confirmation hearings Wednesday. President Obama railed against offshore tax havens in both of his presidential campaigns. But if offshoring is generally legal—and seemingly lucrative—should you try it?
Probably not. You can avoid only specific kinds of taxes using an offshore tax haven, and, for the most part, those taxes are significant only to large groups or very wealthy individuals. Consider, for example, the unrelated-business-income tax. Income from investments inside retirement accounts is generally untaxed until the owner withdraws the profits later in life. However, for complicated historical-legal reasons, if you use retirement funds to borrow money, and then invest that borrowed money in a partnership, you must pay a 35 percent tax on the profits. Hedge funds and pensions circumvent this tax by routing borrowed money through a corporation in an offshore tax haven, which is not the sort of business investment that triggers the 35 percent tax. The trick is known as “round-tripping,” because the money passes through a foreign country on a round trip from the United States. (You may be involved in round-tripping through your own pension fund without knowing it.) It costs money to set up a foreign corporation, though, so this strategy only makes sense for individuals who have vast wealth. If you have enough money in your IRA to consider buying a controlling stake in a business, you probably shouldn’t rely on the Explainer for tax advice.
There are a couple of other scenarios in which you might want to use an offshore tax haven, like if you’re starting a dot-com with friends from other countries. But, for the most part, there are no lawful benefits to opening a savings or investment account in a low-tax or no-tax foreign country. U.S. citizens are required to pay tax to the federal government on foreign investment income, even if the interest, dividends, and appreciation never come home to the United States. Failing to report such income constitutes tax fraud and carries the potential for a 75 percent penalty and a prison sentence. In fact, the federal government requires you to disclose all foreign holdings if they total more than $10,000, even if you have no interest to report on that money. Failure to notify the government of those accounts, using the colorfully named “FBAR” form, carries a penalty of 50 percent of the account value or $100,000, whichever is greater. (The IRS periodically announces amnesties for people willing to come clean about their offshore accounts.) Countries that have served as tax havens, like Switzerland, Panama, and Lichtenstein, are increasingly signing agreements to disclose the existence of these accounts to foreign governments, making it difficult to avoid detection.
If you’re really serious about tax avoidance, you can’t stop at offshoring your savings—you’ll have to offshore yourself. Last year, the federal government predicted that thousands of people would renounce their citizenship by the end of 2012, many of them to avoid paying U.S. tax. There’s still a financial hit, though. When you give up your citizenship, you have to pay a one-time 15 percent tax on all assets. It could still make financial sense: The effective tax rate for U.S. expatriates in some Caribbean islands is under 5 percent. In giving up your passport, you’d be following Facebook co-founder Eduardo Saverin—who relinquished U.S. citizenship before the company’s IPO—and actor Jet Li. Gerard Depardieu became a Russian citizen this year to avoid French taxes.
Got a question about today’s news? Ask the Explainer
Explainer thanks Samuel Brunson of Loyola University of Chicago, James Hines of the University of Michigan Law School, and Daniel Shaviro of the NYU School of Law.
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