Shell companies, offshore accounts, beneficial ownership, bearer shares, nominees. Tax havens.
Once upon a time, these were concepts rarely discussed outside boardrooms and academia.
Today, they are well and truly part of the public conversation, following the extensive media coverage of recent events such as the Panama Papers data leak.
More so than ever, I have found the topic of tax havens popping up in conversations with curious clients, colleagues, family and friends. Most have read how the mega-wealthy, huge corporations and criminal networks can use them to hide assets and avoid tax. Yet, what I’ve often found they are really interested in understanding, is the juncture between small business and tax havens.
A typical conversation goes something like this:
To this I say “Of course you can set up a company in a tax haven. But, if you want to save tax, you need to be prepared to make some significant lifestyle changes.”
“Why do I need to make significant lifestyle changes?” they say. “Isn’t it just a matter of incorporating a company in a tax haven and having that company run the business?”
“Well… where do you want to live?”
They say “Australia”
“And where would your staff be based?”
“Well”, I say, “perhaps we have a slight roadblock to the tax haven plan.”
Let me explain.
Today's tax havens are not tropical islands
When asked to name a tax haven, most people rattle off the usual list of tropical islands like Bermuda, the Bahamas and the British Virgin Islands, and European enclaves like Andorra, Monaco and the Channel Islands.
Companies incorporated in these countries play an important role in the financial affairs of multinational corporations, managed funds and wealthy investors, but generally only as investment holding vehicles. This includes holding intellectual property, shares in other companies and financial instruments such as bonds, loans and insurance policies.
In the context of a small business looking to minimise taxes, companies incorporated in these types of tax havens are for the most part, useless.
Generally speaking, the profits of small businesses are generated through operations rather than investments. The owners also tend to be heavily involved in the day-to-day operations of the business. This presents a problem, as while these traditional tax havens may have no taxes, they often lack the fundamental characteristics required to support an operational business, including:
- proximity to customers;
- depth of local talent or visa framework essential to recruiting a skilled workforce;
- “liveability”, including a vibrant social and cultural setting; and
- infrastructure and amenities to support business operations.
Are there any alternatives?
If you know where to look, it is possible to identify certain countries that combine the benefits of a tax haven (including low taxes, flexible foreign ownership rules, no CFC regime, no restrictions on capital flows), with the socioeconomic characteristics required to support an operational small business.
These countries are not isolated tropical islands. They are hidden in plain sight.
Think Singapore, Hong Kong, Dubai, Ireland and under certain circumstances, even the UK.
With low-taxes, a solid trading reputation and network of tax treaties, these countries can provide the right kind of small business with the ideal environment to achieve business success on the global stage.
However, before rushing to incorporate a company in one of these countries, let’s take a moment to refresh our understanding of how company profits are taxed. This is fundamental to understanding how tax havens actually operate to reduce taxes.
Company profits are taxed at two levels
Level 1: Company levelAs a general rule, companies pay tax based on their worldwide income at the prevailing corporate tax rate in the country in which they are tax resident. Exceptions to this include countries that do not tax foreign sourced income, such as Hong Kong and Singapore, and countries that do not tax income at all, such as the UAE (Dubai, with some minor exceptions) and Bermuda.
Where a company has international operations, each of the countries in which it operates (but is not tax resident), can seek to tax a portion of the company’s income that is deemed attributable to the company’s operations in that country. This is known as ‘source’ country taxation.
Speaking in general terms, this means that if a company is incorporated in a tax haven but does most of its business in a high-tax jurisdiction, it is likely that most of the company’s income would be sourced in the high-tax jurisdiction and subject to tax there at the corporate tax rate.
This could negate much (if not all) of the expected tax savings from setting up a company in a tax haven in the first place.
For example, if a company incorporated in Bermuda has business operations in Australia, depending on the nature and scope of the company’s Australian operations, the Bermudan company could be subject to source country tax in Australia. Despite the tax rate in Bermuda being 0%, the Australian sourced portion of the company’s income (less related expenses) would remain subject to tax at the Australian corporate tax rate of 30%.
Any profits remaining after-tax could either be retained within the company and reinvested, or distributed to shareholders by way of dividend.
Where the profits are retained within the company, no further tax would apply. However, where the company pays a dividend, these profits can be subject to tax again at the shareholder level.
Level 2: Shareholder / individual levelIn the context of small businesses, it is generally individuals (i.e. natural persons) who are the ultimate beneficial owners of the shares in the company operating the business. These shares could be owned either directly, or indirectly through a number of interposed holding entities.
Where their shares are owned directly, the individual would receive a dividend from the company in direct proportion to their shareholding. Where their shares are owned indirectly, this dividend may need to be distributed through a number of different entities before it reaches the individual. Either way, in the hands of the individual, the dividend income would be taxable at individual rates in the country in which they are tax resident (less any credits or exemptions).
For example, in Australia, dividends from Australian resident companies are taxed under an imputation system, which allows Australian resident individual taxpayers to claim a credit (franking credit) against their personal tax payable for the tax already paid by the company paying the dividend (i.e. the tax at Level 1).
Where the individual’s marginal tax rate is less than the corporate tax rate, they would receive a cash refund of the differential. Where the individual’s marginal tax rate is more than the corporate tax rate, they would be required to pay additional tax to make up the differential. This is commonly referred to as ‘top up tax’.
Other countries tax dividends under a classical system, where the dividend is taxed again at the individual level, without any credit for tax paid by the company at Level 1. This is the case in the USA (subject to a reduced rate of individual tax for qualifying dividends).
Some countries exempt dividends from tax at the individual level altogether. For example, dividends received by a Hong Kong resident individual are tax-exempt, meaning there is no Level 2 tax.
The key point here is that by retaining profits within a company rather than distributing them to shareholders, Level 2 tax can be deferred indefinitely.
The two levels of tax payable on company profits are best explained by way of example.
Happy Panda Co - masters of the memeHappy Panda Co Ltd (Panda Co) is a company incorporated in Hong Kong. Panda Co operates a profitable business developing internet memes for viral content publishers such as Buzzfeed and Lad Bible.
Panda Co has one class of shares on offer, owned one third each by three brothers – Ben, Simon and Tim.
Simon and Tim live in Hong Kong and work out of the Panda Co head office located in Hong Kong. They are in charge of day to day business operations, managing a team of creatives who develop the memes.
Ben lives with his family in Sydney, Australia and works full time as the sales and business development manager for Panda Co. This involves liaising with prospective customers from around the world and managing existing publisher accounts.
For the purposes of this example, assume that the work Ben does in Australia would amount to Panda Co being subject to tax in Australia on a portion of its income, on the basis that it is ‘sourced’ in Australia. Also assume that Panda Co is not considered an Australian tax resident company.
This means that Panda Co’s income and expenses would need to be apportioned between the company’s operations in Australia and its operations in Hong Kong. The profits attributable to Panda Co’s Australian operations would be taxed to the company at 30%, while the profits attributable to its Hong Kong head office would be taxed at the Hong Kong corporate tax rate of 16.5%.
In Hong Kong, Panda Co’s Australian sourced profits would be considered foreign income and exempt from tax (in practice this can't be assumed - an analysis of 'source' for Hong Kong tax purposes would be required in order to support the company's foreign income exemption claim).
Assuming Panda Co made a US $2 million profit in a given year, apportioned 75% Hong Kong / 25% Australia, the company would be taxed as follows:
$397,500 is the Level 1 tax payable by Panda Co.
Note: this 75% / 25% apportionment across the two tax jurisdictions is arbitrary for the purposes of this example.
In a real-life scenario, profits sourced in Australia would need to be calculated with reference to transfer pricing arm’s length principles. This is, broadly, the profit that an independent third party would have made by charging Panda Co for the services being provided by Ben while he is located in Australia.
Once the Level 1 tax of $397,500 has been accounted for, the profits remaining in Panda Co would be $1,602,500.
The three brothers could choose to keep these profits in Panda Co and re-invest them in the business without any further tax liability, or, they could choose to pay a dividend to themselves from the company.
Where a dividend is paid, the three shareholders would each be subject to tax on their 1/3 share of the dividend, at individual tax rates in the country in which they are tax resident.
Assuming Panda Co paid all $1,602,500 as a dividend, Ben would be subject to tax on his share of the dividend at individual marginal rates in Australia, while Simon and Tim would not be subject to tax at all, as dividends are exempt from tax in Hong Kong.
This is the Level 2 tax payable by the individual shareholders in Panda Co.
As you can see, simply living in Australia can create quite the tax liability. After tax, Ben is only left with $302,478. Compare this to his brothers, who each get to keep their entire share of $534,167.
Poor Ben might be feeling a little short changed.
Tax deferral - a potentially overstated benefit for small business
If Panda Co had not paid the dividend and instead retained the funds in Hong Kong, Ben’s hefty tax liability could have been deferred indefinitely.
It is this ability to defer tax indefinitely by retaining funds offshore that presents a key advantage of using companies incorporated in tax havens or low-tax jurisdictions. This is especially the case for multinational companies with access to a range of funding sources that can afford to retain excess funds offshore indefinitely. Apple reportedly has $181 billion held offshore that has not been subjected to US tax.
Unlike Apple, small business owners often have just one operating company that remains the primary source of funding available for them to support their lifestyle. In order for them to access that funding, their choices are to:
- pay themselves a salary from the company; or
- pay a dividend from the company (many countries have restrictions upon owners borrowing from a company to fund personal expenses).
As soon as either of these payments are made, tax would be payable at the individual level (i.e. Level 2) and any deferral benefit would expire.
Simply incorporating in a tax haven does nothing to minimise tax
As demonstrated by Ben’s situation in the Panda Co example, we can identify two significant roadblocks preventing business owners from actually saving any tax by attempting to operate their global businesses through a company in a low or no tax jurisdiction.
Regardless of where the company is incorporated, if it has business operations in a high-tax jurisdiction such as Australia, there is a high likelihood that some or all of the company’s profits would be sourced in the high-tax jurisdiction and subject to tax there.
As long as an individual remains tax resident in a high-tax jurisdiction, deferral of personal (i.e. Level 2) tax would be the only benefit of locating business operations in a low tax jurisdiction. Level 2 tax at individual marginal rates would eventually apply when the company’s profits are repatriated.
With these two roadblocks identified, is there anything that the owners of Panda Co could do, to operate their business more tax-efficiently?
Have Ben move to Hong Kong
Had Ben moved to Hong Kong prior to starting Panda Co, both the company and Ben himself would have avoided paying any Australian tax on their income. This would result in a combined tax saving of close to $300,000.
Comparing the two outcomes:
As demonstrated in Figure 4, having Ben move to Hong Kong would result in a combined tax saving of $299,189, with Ben himself saving $231,689 and Panda Co saving $67,500.
What about if Ben moved to Hong Kong after Panda Co had already been established?
If Ben were to move to Hong Kong on a permanent basis after Panda Co had already been established, the tax outcome would be the same as in Option 2 described above, from when Ben moves to Hong Kong, going forward.
There is however, one major caveat to Ben moving to Hong Kong after Panda Co has been established. Capital gains tax (CGT) Event I1.
CGT Event I1
When an individual ceases to be an Australian tax resident (generally when they move overseas permanently), they cease to be taxable in Australia on the future disposal of any CGT assets that they owned while they were a resident (other than real property which is always subject to CGT in Australia regardless of the owner’s tax residence).
CGT Event I1 happens at the time an individual ceases to be an Australian tax resident and requires them to either:
Calculate the capital gain or loss for each CGT asset that they own, based upon the market value of each asset at the date upon which they ceased to be an Australian tax resident (generally the day they left Australia) and pay capital gains tax accordingly; or
Remain taxable in Australia on any future capital gain when they eventually dispose of each of their CGT assets.
In this way, CGT Event I1 is designed to prevent Australian tax residents from moving overseas while owning assets that have increased significantly in value, then disposing of them once they have ceased residency and escaping Australian tax on the disposal altogether.
In practice, option 1 provides for a more favourable tax outcome if the individual’s CGT assets are expected to appreciate in value over time, as any appreciation in value after the cessation of tax residency would not be subject to CGT in Australia. As of 8 May 2012, non-residents are no longer eligible to claim the 50% CGT discount, which makes the case for choosing option 1 even more compelling.
Referring back to Ben’s case, CGT Event I1 would happen in relation to his shares in Panda Co if he were to move to Hong Kong after the company had been started. Therefore, he would be required to choose one of the above options.
Assuming that Panda Co’s business growth prospects are strong and Ben’s shares are expected to increase in value over time, Option 1 should provide Ben with a better overall tax outcome. This being said, Option 1 may not actually be a viable option for him due to the size of the upfront tax payment required.
If Ben were to elect to pay tax based on Option 1, he would need to find funding of $925,447 just to pay his personal tax liability. Without actually having sold his shares, this may prove difficult for him.
If Ben were unable to choose Option 1, he would continue to be taxable on his shares in Panda Co in Australia under Option 2, which could prove costly should Panda Co eventually be sold for a significant profit.
It is worth mentioning that the above example assumes Ben would not meet the eligibility criteria to access the small business CGT concessions to further reduce or eliminate his capital gain. While a detailed discussion of these is outside the scope of this post, suffice to say, if available, accessing the concessions could provide a significantly better tax outcome for Ben.
Setup an Australian consulting company
Where Ben is committed to remaining in Australia and continuing to work remotely on the Panda Co business, he could setup an Australian private company through which to provide consulting services to Panda Co.
Using this company to charge a consulting fee to Panda Co for Ben’s services would mean that any Australian sourced income generated by Ben’s presence in Australia would be derived by Ben’s Australian company, rather than Panda Co, eliminating Panda Co’s Australian tax presence.
Referring back to the calculations in Figure 2, eliminating Panda Co’s Australian presence would result in a tax saving to the company of $150,000.
There is one disadvantage to this strategy - Ben would need to pay tax upfront on the entire amount of the consulting fee paid by Panda Co to his company, at individual marginal tax rates in Australia (versus only being taxed when Panda Co pays a dividend). This is due to the operation of the personal services rules, which prevent individuals from consulting through companies (rather than in their own name) and paying tax at the 30% company tax rate, rather than their marginal tax rate (which could be higher).
Exactly how much would be taxable to Ben upfront depends on the amount of the consulting fee required to be charged by Ben’s company to Panda Co. This fee would need to be determined with reference to the transfer pricing arm’s length principle, being what would have been charged by an independent party entering into a comparable transaction with Panda Co.
For the purposes of equalising the entitlements of the three shareholders to the residual profits in Panda Co, the shareholders could resolve to allow Simon & Tim to borrow from the company on interest free terms, an amount equivalent to the consulting fee charged by Ben’s company. Another potential alternative could be to issue a new class of shares in Panda Co to Simon & Tim that carry with them separate rights to dividends.
Regardless of whether you are starting up a new business with global aspirations, or expanding a successful local business into international markets, try not to begin your journey obsessing over tax. The days of paper profits accumulating in faraway tax havens are well and truly numbered.
Technology is creating a business environment where full disclosure is the new norm - whether it is enforced by governments through initiatives such as automatic exchange of information, or whether it is enforced by the community itself through whistleblowing and data leaks.
Today's small businesses should plan to be taxed in the country where their economic activity actually takes place. In fact, the best international tax planning a small business owner can do begins with a pen and paper.
Write down where your customers are located, where talented staff can be recruited and most importantly of all, write down the things you need to live a fulfilling and enjoyable lifestyle. Only once these facts have been established should tax rates and tax havens become a relevant concern. And remember to look beyond the obvious.
Today’s tax havens are hidden in plain sight.
It is important to remember that everyones situation is different. The information contained in this post should not be relied upon as specific professional advice. Please contact us to obtain specific advice in relation to your particular situation.
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