One of the (many) ways by which rich, sophisticated taxpayers who are also ultra-greedy have managed to avoid paying their fair share of taxes is to move money offshore through trusts and "companies" set up in various no-tax/lo-tax, hi-sun jurisdictions like the Cayman Islands, British Virgin Islands, Cook Islands, Singapore, etc. I suppose for many years this scheme served multiple objectives--it stashed the cash beyond the reach of the US government, it provided a nice place to visit the cash, and it had the cachet of belonging to the exclusive jet set behind it.
That's becoming less so as the US continues to pursue tax cheats with unreported offshore accounts. The dam started bursting with the revelation of the way Swiss bankers groveled at their American clients' feet, from smuggling diamonds into the country in toothpaste tubes to secreting gold in deep, hidden vaults to setting up sham companies in the Phillipines or other countries. Over the last half decade, more people have participated in voluntary disclosure and more have been identified for more serious penalty programs (including criminal prosecution). Each voluntary disclosure included full information about those who facilitated the offshoring--bankers' names, other involved lawyers, accountants, and bankers, other entities. That groundswell of information facilitated identification of even more tax cheats, and those identifications yielded a new trove of relational data--those who had assisted them. That finally seemed to begin to put some teeth into enforcement efforts and some gnashing of teeth into the lives of the otherwise obliviously happy tax evaders.
But various commentators (including my colleague at Wayne Law, Professor Michael McIntyre) have been concerned that the offshore gambit can't be cleaned up until countries begin more automatic sharing of the tax information they have without requiring the requesting country to have already identified the accountholder well enough to ask for information specifically about that person. If they can ask specifically, of course, it means they have already been found, which makes for a catch-22 that has made pursuing secret bank account holders an overly arduous task.
That makes the IRS's announcement today of a new coordinated effort among the U.S., U.K, and Australia heartening news. They have agreed to share information about trusts and companies holding assets in tax havens like the British Virgin Islands, the Cayman Islands, and Singapore. See IRS news release IR-2013-48 (May 9, 2013). With the cache of information each country has gleaned from the recent efforts, coordination will allow them all to benefit from each one's effort. That should accelerate the effort to catch the tax cheats.
It seems that billionaires think they are entitled to it all and think they should be able to run their speculative games without paying much of anything at all in taxes to the government they depend on. And none of this is good for the economy or good for the taxpayers not in "the 1%".
Case in point--John Paulson, the notorious hedge fund manager who got a CDO built to his desires with a bunch of iffy subprime mortgages and then took the short side of the bet, making a fortune off the bet against subprimes in the mortgage crashes underlying the 2007-8 Great Recession. See, e.g., Zuckerman, Trader Made Billions on Subprime, Wall St. J. (Jan. 15, 2008).
What has Paulson done? He established a new "reinsurance company" in Bermuda in April, that turned around in June and put the money invested in it back into Paulson's hedge funds in New York, as a portfolio of insurance "reserves" to be held to pay off insurance risks that go bad. The result is tax deferment for Paulson and other executives of his hedge fund along with recharacterization of ordinary compensation income as preferentially taxed capital gains.
For a discussion of the hedge fund reinsurer gambit, see , e.g., any of the following. The story at Bloomberg has reinvigorated media attention to this issue.
Barile notes that these hedge funds are using reinsurance premiums and investing in a very aggressive way, compared to traditional reinsurers". This aggressive position produces a downside if there are low investment returns, especially if there are catastrophes for which they have to pay claims when their investment strategies have produced losses. He says that "it remains to be seen" whether hedge-fund reinsurers are in it for the long haul, since they have a shorter time frame on making greater returns on their money.
Looking at this as a global concern, Baker ultimately suggests that the Basle Capital Accord rules should be extended to hedge fund reinsurer operations, "Another area in which the BIS should take a leadership position," he says, "is the role in which reinsurance firms play in hedge fund operations. The tax implications of hedge funds using reinsurance firms in their funds for tax advantages points to the need for more government regulation of this activity."
He describes the basic problem as follows: "wealthy individuals invest in private placement offerings of offshore reinsurance companies. These companies, many headquartered in Bermuda, buy insurance policies written by name-brand insurers...and "may then invest its stock issue returns in a hedge fund. ...[That reinsurer] pays no taxes on the trading profits until it sells the fund shares and then the reinsurer is taxed at a lower capital gains tax. The tax savings are passed on to the individual investor.
He goes on to say that "The problem ... is that insurers are exempt from registering as investment companies....These reinsurers do not have to make annual distribution of profits as mutual funds do and they are not taxed by the Internal Revenue Service as investment vehicles. ...In short, the activity ... is a method for wealthy investors to reduce their tax burden as a result of a tax loophole. Since these insurance companies are mixing insurance business with investment business, they need more supervision.
This is especially true when hedge funds are involved. "[H]edge funds work with reinsurers to reduce tax liabilities for their wealthy clients. ...U.S. hedge fund managers and investors form a tax-advantaged reinsurance company offshore in...Bermuda, which has no corporate income tax. The Bermuda-based reinsurer sends investment assets to the hedge fund to invest. Investors return to the United States with shares of the reinsurer and pay no taxes until the company goes public. At that time, investors [and managers] sell their shares in the reinsurer company and are taxed at a lower capital gains rate.
These schemes are worrisome from both tax and insurer regulatory perspectives. "Aside from the tax loophole problem, the real issue in these cases is the added underwriting risk incurred in the process. ... [Hedge funds acting as reinsurance companies] have insufficient insurance expertise.... Much of this activity has stemmed from financial engineering and deal making of the 1990s. ... [W]ithout the bailout of LTCM [Long-term Capital Management hedge fund] by national bank regulatory authorities, many banks and reinsurers might have collapsed as well."
So why do it and how does the hedge fund reinsurer gambit work? Remember that these hedge fund execs get a ridiculous amount in compensation in the form of a "fee" (usually 2% of assets under management) and a "carry" (usually 20% of the profits). (The fee and carry are often represented as 2 and 20, but can be much higher for some firms with status, rising to as much as 5 and 50.) Without more, hedge fund managers don't get as much benefit from the claimed treatment of a "profits" partner as private equity fund managers do. Though the managers claim classification as "profits" partners whose taxation is based on their share of the partnership's gains and ordinary income and not as payments of (ordinary) compensation, hedges mainly yield ordinary income so don't act directly as "converter" entities. Private equity fund managers also claim they are "profits" partners whose income should not be classed as compensation but as pass-through shares of the partnership items: in their case, most of the private equity fund's gains will be deferred anyway (for several years at least until the partnership sells the leveraged company) and they claim those deferred gains should be characterized as pass-throughs characterized by the partnership rather than being characterized as ordinary compensation income to them.
So for hedge fund managers, gaining deferment (of what is clearly in substance their compensation as managers) can achieve minimal current tax. If the money is cycled through an offshore corporation that pays no taxes, that's even better because it gets preferential rates as well. The deferrment is achieved by waiting to sell the stock, and the sale of the stock is reported as a capital gain. Thus what is really current compensation income is recharacterized, through the reinsurer "conduit" scam, as a deferred capital gain. So hedge fund and private equity managers ultimately both claim to get the best of all possible worlds--their wages from work are not currently taxed as wages at ordinary income rates, they pay no payroll taxes on their compensation, and their compensation is deferred and taxed at preferential capital gains rates.
This is so obviously unfair to the vast majority of ordinary taxpayers who pay taxes on their compensation income even before the end of the tax year through the withholding mechanism that Congress should step in with legislation. It seems hard to justify a "profits" interest in a partnership at all: it has been created by the "Wall Street Rule" that gains credence because big-money people claim it is correct. As usual, tax administration eventually mostly went along with it (Rev. Proc. 93-27) and a few court cases (Diamond, Hale) mostly treat the notion of a profits partner who pays no taxes on his compensation as reasonable. Congress could easily legislate away the profits interest and define partner in a partnership for tax purposes as someone who has made a genuine at-risk equity contribution of cash or property to the partnership. There really should be no such thing as a services partner with a "profits" interest who hasn't contributed up front for a capital interest. And all compensation shares to what are currently treated as profits partners could be treated as ordinary income --i.e., compensation currently subject to the income tax and to payroll (Social Security/Medicare) taxation.
This use of reinsurers by hedge funds is itself a tax dodge that has been around a decade or so. In 2007, the Senate Finance Committee held a hearing on Offshore Tax Issues: Reinsurance and Hedge Funds (S. Hrg. 110-875, Sept. 26, 2007) (179 pages). In his introduction, Baucus described insurance tax avoidance schemes as follows:
Insurance companies make a living by doing two things: they assess premiums based on the prediction of the likelihood of events against which they insure—that is called underwriting—and they also make money by investing the premiums that they collect until they have to pay out claims. If they are good at those two jobs, they make a profit.
Customers buy insurance from insurance companies to guard against the risk of fire, disaster, or some other calamity. In exchange for paying premiums, the customers shift some of their risk to the insurance companies. Insurance companies also buy insurance. Property and casualty insurance companies pay premiums to reinsurance companies in exchange for shifting some of their risk to the reinsurance company. Sometimes the reinsurance company is also the parent company of the property and casualty insurance company. In that case, the property and casualty insurance company shifts risk to their parent reinsurance company at something less than an arm’s length transaction.
Here is where the tax avoidance comes in. Some parent insurance companies set their headquarters in low-tax jurisdictions, like Bermuda. Subsidiary property and casualty insurance companies shift risk to the Bermuda parent. Because of Bermuda’s low tax burden, the Bermuda parent can get a greater after-tax return on their investment activities. As a result, subsidiary property and casualty insurance companies can charge lower premiums for their insurance. They get a competitive advantage over insurance companies doing business in jurisdictions that tax investments.
The second setting that we will examine today involves hedge funds. Foundations and other nonprofits are some of the largest investors in the world. The law requires a nonprofit investor that invests directly in hedge fund partnerships to pay the unrealized business income tax, otherwise known as UBIT. The policy behind the law is that tax-exempt entities should not be able to have an unfair advantage over taxpaying entities doing the same thing. To avoid UBIT, nonprofit investors sometimes invest in hedge funds through offshore entities incorporated in lowor no-tax jurisdictions, such as the Cayman Islands or Bermuda. These offshore entities are called blockers.
The third setting we will examine today is the compensation of hedge fund managers. Hedge fund managers receive fees from offshore blocker corporations used by nonprofits and foreign investors.Some hedge fund managers elect to defer their income, and deferring income means you pay taxes later, which is the same as a significanttax savings.
The IRS has already noted that offshore arrangements using reinsurers for hedge fund managers may be shams that are subject to challenge on audit. See Notice 2003-34 (indicating that "Treasury and the Internal Revenue Service have become aware of arrangements, described below, that are being used by taxpayers to defer recognition of ordinary income or to characterize ordinary income as a capital gain. The arrangements involve an investment in a purported insurance company that is organized offshore which invests in hedge funds or investments in which hedge funds typically invest.") Although the notice says that these purported insurers may be challenged as not insurers because they are not using their capital and efforts "primarily in earning income from the issuance of insurance", and although it states that such arrangements will be subject to close scrutiny that could result in the application of the PFIC rules (leading to current taxation), it has apparently not bothered to challenge any of the big hedge funds' reinsurer companies.
Again, why would they be subject to challenge? On the basis that they are not real reinsurers, since the low amount of reinsurance that many provide is the less risky part of the business and provides a buffer to the very high reserves that they retain, sometimes invested solely in a single promoter's hedge funds. And if they are not insurers, they are at the least "passive foreign investment companies" (PFICs) on which shareholders are subject to current taxation on profits. (Or perhaps the IRS might go further and recharacterize the arrangement as a sham , causing the hedge fund executive to have current ordinary compensation income.) In other words, there is good cause to think that for many of these, the tax haven corporation is acting as an offshore tax-avoidance pocketbook for the hedge fund executive, and not really as an insurer.
By the way, if you think these hedge fund managers who are making multi-millions and billions from managing other people's assets and hardly paying any U.S. taxes on those huge compensation payments are incredibly smart people who add to the economy's well-being and therefore merit that kind of out-sized pay or because of the returns they bring to people that then invest them in needed projects in the good ole US of A, you need to rethink that. Hedge funds typically pay out very poor returns, when all the expenses and profits to managers are taken into account.
Roughly speaking, if the typical fund manager worked for free, and if the investment firms didn’t charge, these masters of the universe would still have underperformed a balanced index since 2003, by roughly 2.5 per cent per year. Andrew Hallam, Think you're smarter than a hedge fund manager?, The Globe and Mail (Feb. 19, 2013) (emphasis added).
Michigan's Levin says the next big thing for the government to focus on, now that the offshore accounting schemes of individual taxpayers have gotten its full attention, should be the corporate transfer pricing game.
What happens in transfer pricing? Corporations in the US, for example, may develop a new drug and take out a patent on that drug. If the patent is used in the US and the drug is manufactured here, the corporation will owe US income tax on its profits. That tax is at a 35% statutory rate, but corporations don't usually end up paying anything near the statutory rate on their economic profits--their effective rates are considerably lower, with many of the large US corporations paying no federal income tax whatsoever, from a combination of accelerated depreciation, loss deduction carryovers, and other "tax expenditures" that act to reduce their taxes (such as the many items in the Code that reduce taxes on Big Oil companies that extract natural resources--at great cost to our environment and coastal beauty, as it turns out).
One of the things multinational corporations do to lower their taxes even further is to shift income offshore. Perhaps they have a reinsurance subsidiary, so they pay reinsurance premiums to that subsidiary and shift their actual insurance offshore. Frequently, the companies that profits are shifted to have almost no employees. They mail be just a mailbox conduit in the Netherlands or the Cayman Islands, where thousands of corporations are "located" in a single four-story building. The tax code has a provision that is intended to empower the IRS to fight such manipulation of income. It's called the "transfer pricing" provision in section 482, which says that items of deduction, income, credit are supposed to "clearly reflect income"--meaning that taxable income should be related to economic income, except for provisions clearly intended to provide a special benefit (such as subsidies for corporations that Congress has built into the code, like accelerated depreciation and bonus depreciation).
But policing transfer pricing is not easy. It involves detailed facts and circumstances, takes inordinate time, and must ultimately be tried before courts that have been packed by GOP presidents with business-friendly judges, most of whom over the last thirty years have also enjoyed "educational" seminars in Chicago school-style economics funded by the Olin Foundation and sponsored by George Mason law school with the intent of influencing judges' decision-making in favor of the now-discredited "free market" thinking of Milton Friedman.
Accordingly, a number of tax and business experts have suggested that Congress should scrap the fact-intensive analysis required under current transfer pricing theory for a formulaic approach that would allot a percentage of a company's profits to the US based on the number of employees, facilities and revenues in the US compared to elsewhere. That sounds like a good idea to me--less audit time required, more objective, and less easily manipulated for the benefit of the corporate taxpayer. As those who've read much of my scholarly work will recognize, I have long argued that the ability of a taxpayer to manipulate the income reported to the IRS Is problematic, raising questions of fairness and efficiency and administrability, all of which are important for tax policy considerations.
Bloomberg.com has an article today on the transfer pricing issue, written by a former Wall Street Journal reporter who knows the beat well. I commend it to you for a view of the problem faced by the Congress and IRS as any attempt to crack down on transfer pricing scams gets underway. It describes the "double Irish". And I have to admit, this was a ruse known widely to Wall Street law firms when I was there in the late 1990s and early 2000s. Have a company in Ireland, have it paid by a company in the Netherlands (which is just a conduit--no real company) in order to get the inter -EU protection from withholding, have that Netherlands company paid by a company in one of the Island tax havens (Caymans, Bermuda). Behold! Lots of income leaves the US tax rolls, and doesn't get taxed anywhere else. See Drucker, Companies Dodge $60 Billion in Taxes Even Tea Party Condemns, Bloomberg.com, May 13, 2010.
The Tax Court has issued a notice about an email scam addressed to those who have cases before it. As the New York Times reported this morning, hackers and attackers are getting more and more sophisticated. Not surprisingly, it is harder to tell "good" email messages from "bad" ones.
Here's the content of the notice. DON'T click on the links!
NOTICE: The United States Tax Court has received many telephone calls regarding an e-mail which purports to originate from the Court being sent by a member of the Tax Court's practitioner bar.This message is an example of "Spear Phishing", which is an e-mail spoofing attempt that targets a specific organization.The Tax Court is not disseminating any e-mail notice to anyone who currently has a case before this Court. If you receive an e-mail with a subject line that includes the text, "Notice of Deficiency #" followed by a series of numbers or "US Tax Petition", along with a malformed docket number following the format #000-000, and a sender address ofnoreply@ustaxcourt.org , complaints@ustaxcourt.org, or notice@ustaxcourt.org, please ignore/ delete the e-mail and do not click any link within the e-mail message.
This is a different kind of tax scam. Not the case where a wealthy taxpayer sells a business and wants to avoid tax on a $70 million capital gain so hires a well-known accounting firm to devise a complex transaction using various financial derivatives to generate an artificial loss to offset the real gain. Not the outright fraud of the shim-sham man who counseled hundreds that the federal income tax applied only to foreigners.
Instead, this involves buying influence and power over Congress. It turns out that Jack Abramoof didn't always want it to be clear whose money was going to whom for what. So the corrupt lobbyist did what most crooks do--he "laundered" the money. What is interesting here is just who did the laundering. In effect, some tax exempt organizations served as a hidden part of Abramoff's lobbying empire. See this AP story on Prob Links Norquist, Abramoff.
Remember Grover Norquist, who consulted with Mr. Bush back in 2003 about the best way to cut taxes for the rich? Norquist runs Americans for Tax Reform, a group that has aggressively lobbied for estate tax repeal, privatization of Social Security, and consumption-type taxes that exempt capital income from taxation. Norquist hosts get-togethers in Washington where people of privilege can rub shoulders with high officials in the Bush Administration. See this item on DailyKos from the National Journal.
Norquist is also an old buddy of Abramoff, from college days, so Norquist's group also served as a conduit for money flowing from Abramoff clients to finance fake grassroots campaigns--Abramoff just needed to remind himself to "Call Ralph re Grover doing pass through." (That'd be Ralph Reed, the purportedly upstanding leader of the Christian Coalition and now a politico in his own behalf.) See Susan Schmidt and James Grimaldi, NonProfit Groups Funneled Money for Abramoff, Washington Post, June 25, 2006, at A1 (reporting on the Senate Indian Affairs Committee report on tribal lobbying).
Abramoff also cautioned Norquist to be discreet, since they wouldn't want to appear to be "buy[ing] the taxpayer movement." Id. The article notes that Norquist claimed that his group and Abramoff's gambling clients just happened to share the same anti-tax views and that ATR wasn't concealing the source of funds.
The Senate hearings on the lobbying activity are available at this Indian Affairs Committee site. The 373-page report, "Gimme Five--Investigation of Tribal Lobbying Affairs" (June 22, 2006), is available in pdf form here. The report concludes that various tax-exempt organizations were engaging in activities outside their purpose, helping to channel funds to hide their source and/or to evade taxes, and serving as "extensions" of lobbying organizations. Yet the committee concludes that no further legislation is needed and settles for recommending some "best practice" measures.
I suspect lobbying needs to be more strongly regulated. How about publicising the time, place and names of lobbyinsts who meet with any government official? And organizations like ATR that have funneled money from one pocket to another should be denied tax exemption. These activities of serving as a conduit go to the core of the purpose of tax exemption--it was not intended to facilitate the Abramoff-Norquist type of influence-peddling.
Thanks to Paul Caron at TaxProf and Jim Maule at Mauled Again, more people are becoming aware of the "phishing" scams that appear to be emails from the IRS informing the recipient that a tax refund awaits. If you get such an email, do not be fooled--the IRS does not send out emails to notify unsuspecting recipients that they have a refund. The phisher hopes the recipient will respond with information that the phisher can use. There is, of course, no real refund awaiting the recipient's action.
If you receive such an email, let the IRS know so that it can track down the culprits. And pass along the information below on the scams to friends, neighbors and countrymen and women, so that the phishers will find no takers!
Paul Caron shows a copy of the official-looking phishing notice he received, at this link.
Jim Maule has a good description of the scam and the right response to it, at this link.
If you receive an IRS phishing notice, you can report it to the IRS by
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