How Big Companies and the Rich Use Tax Havens
Tax havens are also of great use to companies, as well as individuals. In fact, some of the world's largest multinationals such as Pepsi and News International use offshore tax haven structures to minimize the overall amount of tax they pay.
Of course, the big multinationals have teams of highly paid tax advisers whose job it is to ferret out tax-saving opportunities around the globe. Broadly speaking there are two distinct ways they use tax havens to slash a company's overall tax rate.
This overall tax rate (also known as the effective tax rate) is simply the total tax paid by the company divided by its profits.
The first way they reduce their taxes is by 'corporate migration'. The second way is by using tax haven subsidiaries.
Corporate Migration
This is the most straightforward option and at its most simple means that a company transfers its headquarters to an offshore tax haven. This could either be a total transfer of operations, a part transfer of operations or sometimes the transfer would be in name only without the actual operations being moved.
You'll need to be careful when doing this, as many developed countries won't be fooled by a transfer in name only. You would actually need to transfer physical operations, which in itself could lead to a further tax charge.
In practice what you often see is a part transfer of operations with, for example, back-office functions and even some front line services (for example, call centres and customer services functions) being transferred overseas. The tax savings come about because in many tax havens companies do not have to pay taxes on their overseas operations. As always, detailed professional advice is required to ensure that the residence of the company is actually transferred.
Using Tax Haven Subsidiaries
This is really where the teams of tax accountants that the large multinationals have on tap come into their own.
The use of offshore subsidiaries is big business -- Enron, for example had over 600, many just existing in name only.
This is a complex area and the uses of these companies will obviously depend on the jurisdictions involved, types of business and so on. However, as an illustration here are some of the most popular strategies:
Deferring Tax Payments
A number of countries, such as the US, tax resident companies on their worldwide profits but also allow a deferral of tax for any profits generated from overseas operations, provided the profits are reinvested overseas. This therefore allows corporate groups based in these countries to use tax haven subsidiaries to hold overseas trading operations and reduce the overall tax charge.
Income Stripping/Offshore Finance Companies
This idea is developed below but essentially involves a tax haven subsidiary lending money to a tax paying company. The interest charged on the loans is then allowable as a tax deduction for the tax paying company but should be subject to low or no tax in the tax haven company.
Offshore Intellectual Property
Similar to the above, a tax paying company would transfer intellectual property (this is a very wide term and includes patents, copyright, know-how and goodwill) to a tax haven subsidiary. The tax haven company can then charge a licensing fee for the use of the intellectual property.
The income from any overseas subsidiaries that pay the tax haven company for using the intellectual property would then not be taxable in the hands of the tax paying company.
In addition, and in a similar way to income stripping above, the tax haven company can charge the tax paying company and these charges should be tax deductible for the tax paying company (a double benefit arises as there would be both a tax deduction on payment and no tax payable on receipt).
Transfer Pricing
This used to be a major opportunity but some of the larger industrialised countries now have strict transfer-pricing legislation.
Transfer pricing simply means the rate charged for good and services between connected parties, such as between a parent company and subsidiaries.
The aim with any effective transfer pricing strategy would be to arrange the group structure so that tax paying companies are paying management charges or other inter-company service charges to tax haven group companies. Provided the paying company gets a tax deduction for the amount paid, the group would be significantly better off.
This would typically also apply to purchases of stock or parts from overseas or intercompany salaries charged for using overseas staff. The mark-up would enable an increased tax deduction for the company that pays the management charge in the high tax country.
Note that it's essential that the paying company gets a tax deduction for the payments in order for this to be tax effective.
Nowadays companies need to be careful that transfer pricing legislation does not apply to require an arm's length rate to be used. The UK, for example, has some strict transfer-pricing provisions that will effectively only allow a tax deduction in these circumstances for the market value of the services provided. If this applied it would then negate the benefit of the high transfer price.
Restructuring
One of the ways that the larger UK corporate groups look to achieve the benefits of migration is by creating an offshore holding company.
They try to achieve this by interposing a new non-UK holding company between the UK company and its shareholders. The shareholders would then own shares in a non-resident company, which then owns the UK company.
This is relatively straightforward and can be achieved by a share for share exchange provided the share exchange is accepted as being for bona fide commercial purposes. If not then you would be looking at further reorganising to implement the holding company.
You would need to ensure that the holding company was genuinely managed from abroad to ensure it was not UK resident and was exempt from UK corporation tax on overseas income.
The key advantage in having an offshore holding company is that:
• It can receive overseas income streams generally free of UK tax, and
• It can hold shares in CFCs without being subject to the onerous CFC provisions.
In addition, using this type of restructuring avoids a possible exit for the UK company as it would still be controlled from the UK, but the shareholders can obtain the benefits of offshore company tax treatment.
Using Holding Companies
Holding companies are often used as a form of financial funnel. By having a company located in a suitable holding company jurisdiction hold the shares in a variety of companies, it's possible to ensure that the profits are funnelled into a low tax, or tax advantageous environment.
In order to be effective there are a number of prerequisites that a holding company and subsidiary must satisfy, in particular an ability to avoid withholding taxes.
Ability to Avoid Withholding Taxes & CGT
Most developed countries impose some type of withholding tax on dividends, interest or royalties sent overseas by companies.
This usually works a bit like PAYE for employees. When an employee receives salary an amount has already been deducted and paid to the tax authorities by the employer.
In other words, the payer has accounted for tax on behalf of the recipient.
The same applies to withholding taxes. The payer company will complete any required forms and withhold tax from the payment on behalf of the recipient.
The recipient who has suffered the withholding tax will need to look at the domestic tax legislation to identify whether any tax relief can be claimed.
Some countries such as the UK and the US automatically allow a measure of relief for any overseas tax paid when calculating the recipient's local tax liability.
This is where double tax treaties really come in handy. Certain treaties will allow payments between participating states to be made free of withholding tax or at least at reduced rates.
This could therefore allow dividends, interest and royalties to be passed between the holding company and subsidiary companies without any tax being deducted.
Of course, there may be tax on the receipt of the dividend in the holding company, depending on the local tax regime. "Why not then base the holding company in a tax haven to avoid all taxes?" is a question many people ask.
Well, in principle this is sound, the problem is that most tax haven countries do not have any double tax treaties, and where they do they are not the standard OECD treaty giving withholding tax relief. Therefore you would be subject to the full rates of withholding taxes.
The trick therefore is to find a country that has the tax treaty benefits with a favourable domestic tax regime for the holding company.
Another point to bear in mind is capital gains tax (CGT). The holding company will be doing just that -- holding shares in a variety of subsidiary companies.
What if someone comes along and offers to buy one of the subsidiary companies?
The holding company needs to ensure that it's not located in a regime that is going to tax it heavily on the capital gain. Therefore any profits attributable to the holding company when it sells any subsidiaries should be subject to no (or low) taxes.
Another issue mainly for the large multinationals is that the holding company may simply itself be an intermediate company. This is a common structure for multinational groups mainly because the structure of the group can be aligned with the geographical location of the businesses or according to the industries the group operates in. So, for example, Holding Company 1 may hold all the companies trading in Europe, Holding Company 2 may hold all the companies trading in the US, and so on. Alternatively, Holding Company 1 may hold the trading companies involved in the manufacture of widgets, while the other holding companies own shares in trading companies involved in other industries.
You'll therefore see a flow of cash from the trading companies to the holding companies and finally up to the parent company in the form of dividends or by way of other charges (for example, royalties or management charges).
Anyone using such a structure would need to ensure firstly that dividends paid by a holding company to the parent company are either exempt from or subject to low withholding tax in the holding company's jurisdiction. Secondly, low or zero capital gains tax on disposal of the shares by the parent company would be important.
Seeing that one of the main attractions of a holding company is its ability to receive dividend payments with little or no tax deducted and that typical tax haven companies often do not fit this purpose (due to the lack of double tax treaties), which countries are the best place to locate holding companies?
Denmark
Denmark is a highly attractive location for holding companies. Being part of the EU, it's subject to the EU's Parent-Subsidiary directive. This means that where a Danish holding company controls at least 25% of the shares of another EU subsidiary, any dividends paid by the subsidiary to the Danish holding company will not have withholding tax deducted.
As a back-up, Denmark also has lots of double tax treaties (approximately 60) to reduce the rates of withholding tax on dividends received by Danish holding companies from non-EU countries, or where the EU directive doesn't apply. Avoiding withholding taxes is just one aspect. Of crucial importance is the tax treatment in Denmark itself. The Danish corporate income tax rate is 25% but there is special legislation that exempts dividends received by a Danish holding company, provided various conditions are satisfied. Where this applies there's no tax in Denmark, even if tax has not been paid by the subsidiary that paid the dividend.
This makes Denmark unusual in the EU as the other key holding company jurisdictions (Austria, Belgium, France, Germany, Luxembourg, The Netherlands and the UK) only exempt the dividend income if the foreign subsidiary has already paid tax.
In terms of capital gains tax on the sale of shares by the holding company, the standard CGT rate in Denmark can be up to 25%. However, again the domestic legislation contains an exemption which can ensure that no CGT is charged on the gains that a holding company makes when it disposes of an overseas subsidiary.
Therefore, Denmark offers a highly attractive regime for locating a holding company and is often considered the benchmark offshore holding company jurisdiction.
In terms of tax on dividend income, the combination of Denmark's double tax treaty network and its holding company regime means that it offers some serious advantages and there are currently approximately 35 countries which can route their dividends through Denmark without paying any withholding taxes. This combined with the CGT exemption means it is one of the top holding company destinations.
Belgium
Belgium is another popular location for holding companies. The principal advantage is on the capital gains tax front. Where a Belgian holding company disposes of shares in a subsidiary, the gain it realises can be completely exempt from Belgian CGT. This is similar to the position of Danish holding companies, however in actual fact it's even more beneficial. This is because the Danish holding companies are subject to more restrictions that do not apply to Belgian companies (for example, the holding company would need to hold the shares for at least three years).
United Kingdom
The UK is often overlooked as a holding country location, although it does offer some excellent opportunities. For a start the UK has more double tax treaties than all of its main competitors. Given the quality and extent of the treaty network, it is often said to be the best country for extracting overseas dividends at the lowest tax cost.
The UK will also allow the shareholder to claim a tax credit for any 'underlying tax'. This is the tax the company has already paid before paying the dividend (for example, the company's corporation tax charge). In order to claim credit for underlying tax, the shareholder must own at least 10% of the shares in the company.
This therefore means that where the underlying foreign corporate tax rate is 24% or more (for 2012/13), this credit will normally mean total relief from UK corporation tax. So it's therefore effectively the same as an exemption in these circumstances. Also bear in mind that the UK has lower rates of corporation tax than most other industrial nations.
There have, however, been provisions introduced to simplify this system in 2009. In essence overseas dividends received by a UK company could qualify for a complete tax exemption.
The UK is also pretty unusual in that it doesn't impose any withholding tax on dividends distributed by UK companies to UK non-resident shareholders. So non-resident shareholders can usually extract funds from a UK company free of UK income tax.
There are also capital gains tax benefits to UK holding companies. Where they are part of a trading group, new substantial shareholding legislation should apply to exempt any gain arising in full.
Finally, it's also very cheap to set up and run a UK holding company.
Using Holding Companies to Own Tax Haven Subsidiaries
If you're looking to establish overseas companies in nil-tax jurisdictions, it's also important to consider whether the holding company jurisdiction has any special provisions that apply to dividends from tax-haven jurisdictions. Some of the preferred jurisdictions in this case are:
Malaysia
When considering Malaysia you would usually use a Malaysian holding company that is 100% owned by an offshore Labuan company.
The scope of Malaysian taxes is limited by the principle of territoriality. This means that any income earned outside Malaysia is exempt from Malaysian taxes even though it is paid to a Malaysian company. Therefore, dividend income from an overseas subsidiary would be excluded from Malaysian taxes.
Note that transfers between the Malaysian and Labuan companies would be free of taxes, including withholding taxes.
Any dividends payable to a UK or US shareholder would then be from the Labuan company and would be free of withholding taxes.
Any future disposal of the shares in the subsidiaries by the Malaysian company would again be free of capital gains tax.
Therefore the Malaysian holding company option provides a method of avoiding corporation tax and outgoing withholding taxes.
If the subsidiary jurisdictions did levy withholding taxes (ie they weren't located in nil-tax havens) you'd then need to review any tax treaties. The treaties between Malaysia and the subsidiaries are of crucial importance, however it is fair to say that they are at a disadvantage compared with the European holding companies as they are not entitled to the benefits of the EU parent/subsidiary directive, which can eliminate withholding taxes on dividends between EU companies.
Switzerland
Swiss companies can be taxed on their income at both federal and canton level. There are, however, specific tax reliefs for Swiss holding companies. Effectively this is a holding company that doesn't conduct business in Switzerland and the deeds of the company specifically state it is a holding company. The net effect of being classed as a holding company is that there is no cantonal tax, and the federal income tax is 8.5%.
There is, however, a participation exemption that applies where the holding company owns more than 20% of the shares in the subsidiary. In this case, dividend income received from the subsidiary is effectively received free of income tax. So importantly, the Swiss holding company should also be effectively tax free for dividend receipts and as there are no controlled foreign companies' regulations, the fact that dividends are received from tax havens would not affect this.
The downside is that the standard Swiss withholding tax rate is 35%. However it does have some treaties, which can reduce this to 5%-15%.
In terms of dividends received by the Swiss company from subsidiaries, you would have to look to the available double-tax treaties. Most treaties apply a 15% treaty rate. However Switzerland has signed an EU agreement so that dividends paid by subsidiary companies to a Swiss holding company are not liable for taxation in the subsidiary country subject to various conditions. This puts Switzerland in the favourable position of being able to receive dividends from EU states free of withholding taxes.
Cyprus
The general rule is that taxable profits of all Cyprus companies are now taxed at the rate of 10%. However Cyprus also has a special regime for holding companies.
Dividend income from an overseas subsidiary to a Cypriot holding company is exempt from corporation tax provided the holding company owns at least 1% of the share capital of the subsidiary.
Note that this exemption will not apply if the company paying the dividend engages in more than 50% of its activities in producing investment income and the foreign tax burden on the income of the company paying the dividends is substantially lower than that in Cyprus.
In this case, the Cyprus company would be taxed at a rate of 15%.
However, provided the overseas subsidiaries are trading, the fact that dividends are from a tax haven would not result in a Cypriot tax charge.
There is no withholding tax on the payment of dividends from Cyprus to a UK or US shareholder and any gain on the sale of the shares would be exempt from corporation tax.
Therefore of key importance are the withholding taxes on the payments to the holding company.
Cyprus has fewer treaties than other jurisdictions such as Denmark or Switzerland but the provisions can be beneficial. Dividends from countries such as Bulgaria, Greece, Ireland, Malta and Russia are subject to reduced withholding taxes.
In addition, as it is party to the EU parent/subsidiary directive, dividends from EU companies should be free of withholding taxes.
So like Switzerland, Cyprus is effective in that it exempts dividends from tax in Cyprus, has no CGT on disposal, and does not impose a withholding tax on outgoing dividends. In terms of incoming dividends it is very efficient as a holding company for Eastern European companies given the number and nature of treaties with these countries. It would, for example, be an effective intermediary holding company for shares in a Russian company. Dividends could pass with reduced withholding taxes to the Cyprus company and then onwards to the ultimate holding company.
Madeira
Madeira has a special regime for holding companies. In terms of domestic taxation, on the receipt of dividends from EU subsidiaries there would be a 100% tax reduction providing an effective tax rate of 0%. Dividends from non-EU subsidiary companies would also not be taxed. As a party to the EU parent/subsidiary directive any dividends would be received from EU companies free of withholding taxes, and non-EU jurisdictions would be dependent on the terms of relevant double-tax treaties. For example, the Bulgarian treaty provides for 10%/15% withholding taxes on dividends while the agreement with Germany provides for a fixed 15%.
How Can You Use the Offshore Holding Company?
It's all very well learning how multinationals benefit from offshore holding companies. But if you're looking at establishing an international business, how can you take advantage of these opportunities?
Some of the possibilities are as follows:
Offshore Finance Company
A common use of the offshore company is as a provider or funds.
If you're looking at establishing a business to trade in the EU or USA for example, you could use an offshore holding company that would provide funds to subsidiaries in various countries so that the subsidiaries obtain the benefit of tax deductions on interest paid.
This is effectively a way of creating a tax deduction that may not otherwise be available. Note you would need to be careful to ensure that any loan was correctly drafted (for example, using suitable loan agreements) and the interest rate is calculated on an arm's length basis.
Example
You've designed a new widget and will be selling it around the world. As well as establishing suitable trading companies onshore, you could take advantage of an offshore holding company to fund the initial set up.
The holding company would obtain the funds (either from a bank or investors) and would lend the funds to the trading subsidiaries. They would then use the funds for the purpose of their trade (for example, the manufacture and sale of new widgets).
Ideally the holding company would be situated offshore in an area where there is no corporation tax and this would allow it to roll up funds tax free. The trading companies should also be entitled to a tax deduction for the interest paid to the holding company, provided this is structured correctly.
This is a win-win scenario as there is a tax deduction, with no corresponding taxable receipt.
Interest payments from group companies may be subject to withholding tax, but these taxes differ from the usual corporation taxes. Many large companies establish their own offshore companies for the purpose of mixing dividends of subsidiaries and deriving maximum advantage from tax credits. This 'pooling' or 'mixing' of income is a complex area and is something that in house tax departments of multinationals look at in considerable detail.
Offshore Patent Holding
If you've designed a new process or product you could consider using an offshore company. The offshore company could purchase the right to use your patent and sublicense it.
The offshore company can then enter into agreements with licensees around the world who may then manufacture or otherwise use your patent allowing a tax-free roll up of funds in the offshore company. Royalties paid out of a high-tax country often attract withholding taxes at source but in many cases using a holding company may allow a reduction in the rate of tax withheld at source.
Note that the offshore company should acquire the patent as soon as possible to ensure that little value is attributed to it. If possible it should be assigned/sold while still pending, as a gain may well arise on the transfer to the company. If the patent holder is based in a high tax jurisdiction this could represent a substantial gain arising, particularly if the transfer to the overseas company is deemed to be at market value (which would be the case in most high-tax jurisdictions).
Minimizing Risk
This is based on the 'don't place all your eggs in one basket' principle. As some countries suffer from both political and economic instability you may like to follow the example of many large multinationals that move the base of operations and ownership of assets offshore. If you're looking for a sound environment, with excellent political stability, some of the Caribbean jurisdictions may not be top choice. Places like Luxembourg or Bermuda are the favoured jurisdictions.
Avoidance of CGT and Withholding Taxes
As you've seen above, one of the main uses of offshore holding companies is to extract profits free of withholding taxes and CGT. You may be considering investing or trading in a country with which your home country does not have a double tax treaty.
In this case, you may decide to use a holding company in a jurisdiction that does have a suitable double tax treaty. For example, Cyprus has an extensive double tax treaty network with many Eastern European countries and countries of the former Soviet Union, and the use of Cypriot companies for inward investment into these countries is often advised.
You have to be careful as some double tax treaties, in particular US treaties, now have 'limitation of benefits' articles which can restrict treaty benefits (see Chapter 10 on double tax treaties).
About the Author
The Author of this article is our site Editor, Lee Hadnum. Lee is a rarity among tax advisers having both legal and chartered accountant qualifications. After qualifying a prize winner in the Institute of Chartered Accountants exams, he also went on to become a chartered tax adviser (CTA).
He worked in Ernst & Youngs Entrepreneurial Services department for a number of years before setting up his own tax planning practice. He is now a full time tax author.
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