An offshore company is simply a company that is formed and registered in an IFC and subject to the laws of that jurisdiction. In many respects, companies established in an IFC are similar to companies in any other country. However, there are important differences.
Tax benefits
Tax considerations affect all business and investment
decisions. The tax benefits of using an IFC have been
This does not mean that setting up offshore companies enables foreign companies or individuals to avoid paying tax in their own country – although this can sometimes happen. However, anyone using an offshore company in a no-tax centre does not have to worry about tax rates in the centre itself when making its financial arrangements.
Profits and dividends are not free from tax. If a company establishes an offshore company and receives dividends from the offshore company, those dividends (and possibly the entire profits of the offshore company) will be subject to tax in the company’s own country. Even so, the company has some control over its tax position, because it can decide when it should receive dividends, and when its income from the offshore company becomes subject to tax.
Using offshore companies to manage tax liabilities: examples
There are various other ways in which companies or individuals can use IFCs to reduce or defer tax payments.
Some methods of using IFCs for tax purposes are complex and involve using companies in more than one low-tax or no-tax centre.
One strategy would be for a company to set up a manufacturing operation in a low-cost centre. It could then try to ensure that the profits from this operation are maximised, by transferring as much business as possible to the centre. In this way, its tax liability is reduced. In the past, centres such as the Republic of Ireland have been very successful in promoting a lowtax regime to attract foreign business.
It may be possible to reduce worldwide tax liabilities by setting up an operation in an IFC where the business profits are not taxed, when the same operation would be taxed if set up elsewhere. For example, before the financial crisis that began in 2007, the Cayman Islands was used extensively by US providers of mortgages (home loans) to convert the loans into bonds and sell them back to investors in the US and elsewhere. This ‘securitisation’ of mortgage loans into asset-backed securities would have been taxed if conducted in the US; however, because it was carried out in the Cayman Islands providers were able to avoid paying taxes on such activities.
The tax regimes in IFCs and other countries with no tax or low rates of tax create problems for the tax authorities in countries with higher rates of taxation. The problem quite simply is that if there are other centres in the world where rates of tax are lower, it makes sense for companies to move their business and profits out of the high-tax country to the low-tax country. They could even do this without necessarily having to move many operations out of their own country, because the business and profits could be transferred ‘on paper’ rather than physically.
One measure that an international company could take is to establish an international joint venture or a high-risk operation in a low-tax jurisdiction. The actual business of the joint venture or the high-risk operation could be carried out anywhere in the world, but the profits would be earned by a specially created company in a low- or no-tax centre. If the joint venture or high-risk operation is very profitable, the tax on the profits will be lower than if the company had been established in a higher-tax jurisdiction.
Another method of avoiding tax is the use of transfer pricing between a subsidiary in a high-tax jurisdiction and another subsidiary in a low-tax jurisdiction. If the two subsidiaries trade in goods or services with each other, the prices they charge (the transfer prices) can be set at a level that boosts the profits of the subsidiary in the low-tax centre and reduces the profits of the subsidiary in the high-tax centre by an equal amount. Tax authorities are well aware of the opportunities for avoiding tax through transfer pricing arrangements and try – with limited success – to reduce or eliminate the practice.
Withholding tax
A potential problem for international companies and investors is withholding tax. An offshore company will be expected to make profits or gains that it can transfer to its owners, usually in the form of dividend payments. In many countries, when a domestic company pays dividends to a foreign shareholder, some of the dividend payment is taxed by the government. This tax is called withholding tax. Withholding tax (WHT) is a direct tax that is deducted from income ‘at source’ before it is paid. A company making a payment of interest to its bondholders may be required by local tax law to deduct an amount for tax before the interest is paid to bondholders.
Similarly, when a company pays dividends to its shareholders, local law may require the company to deduct tax before the dividends are paid. This is a mechanism that uses the company as the tax collector so the government does not have to chase or pursue the many bondholders or shareholders (who may or may not reside in the jurisdiction) for the tax due. When tax is deducted at source as withholding tax, it can be offset against the tax payable in the country where the interest or dividends are received, provided that a tax treaty (called a double taxation agreement) exists between the two countries.
However, some IFCs offer a tax regime in which there is no withholding tax on interest or dividend payments by companies. So when a company in an IFC pays a dividend, there is no withholding tax and the problem of withholding tax does not exist for the company’s investors.
For example, suppose that a company in Country A sets up a new company in Country B, and the new company subsequently pays dividends. The dividends will be subject to withholding tax in Country B. This tax will be paid to the authorities in Country B, and the company in Country A will receive the dividends minus the tax. If there is a double tax treaty between Country A and Country B, the company in Country A will then be able to claim back the withholding tax as a reduction in the amount of tax payable to the authorities in Country A. So the company in Country A avoids paying tax twice on the dividends it receives, but the withholding tax affects the timing of its cash flows. It loses the withholding tax as soon as the dividend is paid.
In contrast, suppose that the company in Country A sets up an offshore company in IFC C, which is a notax centre, and the offshore company pays dividends. There will be no withholding tax. The company in Country A will simply be liable for tax in Country A at the appropriate time on the dividends it has received. This system is much simpler and it allows the company in Country A to defer the payment of tax.
Double taxation agreements
Double taxation agreements are tax treaties between two countries. Many countries have double taxation agreements with each other. These are tax treaties that specify the rules for the payment of tax on profits, interest, royalties and other income earned in one country but payable to a person in the other country. Double taxation agreements are intended to ensure that income is not taxed twice, once in each country. They also specify the rates of tax for items such as withholding tax on dividends.
The general purpose of a double taxation agreement is to prevent residents of either country from being taxed in full on their income by the tax authorities in each country. However, they are negotiated individually and the detailed content varies between treaties. Most IFCs (both low-tax and no-tax centres) have double taxation agreements with some other countries and these can sometimes provide taxefficient opportunities for investment. Arrangements for saving tax can often involve using companies in more than one IFC. As stated earlier, a tax expert should be consulted for advice on potential tax benefits.
Inward investment and double taxation agreements
As well as offering opportunities for moving assets or business offshore, IFCs can also be used for ‘inward investment’. In some cases it may be possible for an international company to use a specific IFC when it wants to do business in a country that has a favourable tax treaty with the centre. By channelling business through the IFC, an international company could benefit from the low-tax features of a double taxation agreement to reduce the tax payable on its profits.
For example, IFCs might be used to arrange for foreign investment into China. Under this type of arrangement, a foreign investor (such as an international company) might set up a company in an IFC and through this company set up another company in China.
The foreign investor therefore acquires an investment in China through a company in an IFC.
Tax is important in this type of arrangement because dividends payments by the company in China to the offshore company will be subject to tax. Some of the dividends will be withheld (as withholding tax) by the Chinese tax authorities. Tax rules will also apply to any other payments by the company in China to the offshore company, such as payments of interest or royalties.
Some countries have double taxation agreements with some offshore and onshore centres. China has agreements for example with Barbados, Dubai, Labuan, Luxembourg, Mauritius, The Netherlands, The Seychelles and Malta.
The existence of these double taxation agreements can allow foreign investors to organise their tax affairs more efficiently by investing in countries such as China by setting up companies offshore and making the investment through the offshore company.
Regulation of companies and other business structures
Companies in any country are subject to the requirements of local company law. An advantage of offshore companies is that such regulations are much less restrictive than in many other countries.
On the other hand, IFCs have a sufficiently welldeveloped legal and regulatory system to provide adequate protection for company shareholders, which reduces the legal and political risk of investing in such centres.
Advantages offered by an IFC are likely to include:
- No requirements for companies to disclose in a public document or record the names of its directors or shareholders
- No requirement to keep accounts
- No requirement for the company to have a director or shareholder who is a resident of the IFC
- No requirement for the company’s directors or shareholders to hold any meetings in the IFC
- No requirements for a minimum amount of share capital. A company can be set up with share capital of just $1 (or the local currency equivalent).
Typical uses of an offshore company for business
Offshore companies can be established for a number of different reasons:
Trading
Offshore companies can be used for trading internationally. There are several benefits in trading through an offshore company (ie a company set up in an IFC).
Offshore companies can be used to establish a trading partnership with a company in a different country. An advantage of setting up trading agreements through an offshore company is that the IFC provides a ‘neutral ground’ for doing business with foreign companies.
For example, a company in China and a company in Argentina might agree to establish a joint venture, by setting up a company in an IFC in which each has a shareholding. The joint venture would be subject to the laws of the IFC, which means that neither partner in the joint venture would have the benefit of better knowledge of the local laws or business customs. You could plausibly at some stage in your relations be at an enormous disadvantage commercially if, say, the CEO of the company with which you had formed a joint venture, happened to have relations who were eminent government figures.
It might be easier for an offshore trading company to arrange for trading transactions to be subject to international law. Many countries subscribe to the UN Convention on Contracts for the International Sale of Goods (CISG), and contracts for international trade in goods can be made subject to the terms of the UN Convention. In the event of a dispute between the two parties, the matter can be referred for resolution to the court system of a country specified in the contract, and the court will apply the UN Convention in reaching its decision.
A company can establish an importing company in an IFC. The importing company will buy goods from foreign suppliers and arrange for them to be delivered direct to one or more locations in other countries. The importing company will make a profit on the difference between the price at which it buys the goods and the price at which it resells them, but it does not handle the goods itself. The profits of the importing company accumulate in the IFC, and can be reinvested tax free, until the profits are eventually paid out to the company’s owner. Similarly a company could establish an exporting company in an IFC for selling its goods to buyers in other countries. The exporting company does not handle the exported goods, which are delivered direct to the end-customer. However, it makes a profit on the difference between the price at which it buys the goods and the price at which it resells them, and its profits accumulate in the IFC.
A company that uses an importing or exporting subsidiary in an IFC is subject to the tax rules of its own country relating to the internal transfer pricing between itself and the offshore company. This is because tax authorities recognise that tax can be avoided or deferred by means of transfer prices, and so have developed rules to prevent abuse.
The use of offshore companies for inward investment has been mentioned earlier. An international company might establish a company in an IFC that is treated as a ‘resident’ of the IFC for tax purposes. This company might then be used to invest in another country, such as China, with which the IFC has an attractive double taxation agreement.
IFCs can also be used to make ‘round trip investments’.
This involves a company in a particular country setting up a subsidiary in an IFC, and the subsidiary then investing in the company’s own country. This arrangement can ‘move profits’ offshore and in doing so improve the company’s tax arrangements.
Companies or individuals do not need to use just one offshore company or one IFC. For example, a company wishing to transfer ownership of its assets to an offshore subsidiary can transfer different assets to different offshore companies. In doing so, their business risk or investment risk might be reduced.
Offshore holding companies
A company might be established in an IFC to act as a holding company. A holding company is a company that holds (owns) a controlling interest in the shares of other companies.
An international company trading through a number of different subsidiary companies might decide that its affairs will be organised more efficiently if it establishes a 100%-owned company in an IFC and transfers the shares of the international trading companies to the holding company.
The trading activities of the subsidiaries may be financed through the holding company. Interest payments to the holding company would be allowable for tax in the subsidiary’s own country, but the offshore holding company should not pay tax on its interest income in the IFC. This can provide opportunities for tax-efficient management of finance.
Property owning (asset holding)
A company could establish an offshore company to be the legal owner of a particular item of property, such as real estate in another country. For example, a company in China might establish an offshore company to take ownership of real estate in the United States. The offshore company would benefit from any increase in the value of the property and would also receive any income that the property is able to provide.
When a company disposes of a large asset, it couldbe subject to tax on any capital gain that it might make on the sale. However, companies in IFCs are generally not subject to tax on capital gains. Tax on any capital gain can therefore be deferred until dividends on the capital gain are paid out to the company’s owners.
Intellectual property rights
An offshore company could be set up to take possession of intellectual property rights, such as patent rights, or the copyright to music or literature. The company would then receive income from the royalties on those rights, or could grant licences to companies in other countries to use the rights.
For example, a company with intellectual property rights based in a high-tax country, or a country where intellectual property rights are not well protected by law, could transfer its rights to a company established in an IFC. It would then pay the offshore company for the use of the intellectual assets in any other country, and the profits from the rights would accumulate offshore.
International law on intellectual property is not well established, but creating an offshore company to own the rights might provide a company with a way of managing its worldwide rights that is more effective than managing the rights through a domestic company. For example, it might be possible by means of an offshore company to reduce the total amount of withholding tax on licence or royalty payments where withholding tax rates are high.
Shipping
Some IFCs specialise in the registration of ships, by operating a shipping registry and allowing foreign shipowners to register. A foreign company could establish a company in the IFC to take ownership of a ship, which is then registered in that IFC. (At sea, the ship will ‘fly the flag’ of the IFC.)
The foreign company that becomes the owner of a ship through an offshore company does not pay any tax in the IFC on the profits of the shipping company, dividends paid by the shipping company or profits on the eventual sale of the ship.
An attraction of this type of arrangement to a foreign shipowner is therefore tax neutrality, but there are the extra advantages of both confidentiality and also of using a centre that specialises in shipping registrations and has many local firms with expertise in this area. Registering a ship in the owner’s own country could be much more complex, and might be subject to higher direct or indirect taxation.
Countries such as Panama and Liberia have long-established reputations as centres for the registration of ships of all sizes and types under a ‘flag of convenience’. Other IFCs, for example the British Virgin Islands, offer similar facilities.
Introduction to a stock market
Many companies have ambitions to grow their business and to do this they often need to raise additional finance from external sources. Animportant source of new finance could be a domestic stock market, where individual and institutional investors can subscribe for new shares that a company issues. In many developing countries, the national stock market is used mainly by local investors rather than international investors. A company seeking large increases in capital could also want to attract funding from large and wellestablished international investors such as US and UK investment funds. One way of doing this is to issue new shares on a foreign stock market, for example in London, New York or Paris.
In some situations, a company wishing to gain a listing on an established stock market can use an IFC to make the process easier to accomplish. A notable example is the use of a centre in the Channel Islands (Jersey or Guernsey) to obtain admission to the Alternative Investment Market (AIM) in the UK or possibly even the main stock market in London or Euronext in Paris. In 2007 there were over 50 Chinese companies listed on AIM in the UK.
AIM is a stock market in the UK for relatively new or small public companies, and gaining admission to AIM largely depends on two factors. First, the company that applies for admission to the market must meet certain standards. Second, the company must be sufficiently attractive to investors so that some are willing to buy its shares – either from existing shareholders or by subscribing to a new share issue.
A non-UK company could therefore establish a company in the Channel Islands and at a suitable time apply for this offshore company to gain admission to AIM.
Special Purpose Acquisition Company (SPAC)
A Special Purpose Acquisition Company (SPAC) is used in some financial markets, notably the US, as a means of raising international capital for investing in another country. A SPAC is a company that initially has no business and no assets. It might be established in an IFC.It then raises money on a stock market in the US or elsewhere, for the purpose of acquiring or merging with existing trading companies in one or more other target countries. Investors are invited to put money into investing in the target country, although there has not yet been any decision about what those acquisitions or mergers will be.
Special purpose entities for issuing bonds
Some international companies may set up a company known as a special purpose entity (SPE) for the purpose of issuing bonds and raising debt finance. The purpose of issuing bonds this way, through an SPE in an IFC, is that regulations are less strict and the bond issue can be arranged much more quickly than in a larger onshore centre.
Captive insurance
A large group of companies can establish a captive insurance company. This is a specialised subsidiary that provides insurance to other subsidiaries in the group, so that the group owns and operates its own ‘in-house’ insurance business. Captive insurance companies might be used by groups of companies which have a very large, and therefore very costly, requirement for risk insurance.
Captive insurance companies are used for several reasons:
- By providing insurance cover to subsidiaries through its own insurance company, the group is able to earn the profits that would otherwise be paid in insurance premiums to an external insurance company.
- Captive insurance companies offer greater flexibility in deciding how to insure risks. If the costs of insurance premiums in the open market are low, a captive insurance company can obtain insurance (or ‘reinsurance’) by purchasing it in the market. On the other hand, if the costs of insurance premiums in the open market are high, the captive company can choose to provide insurance at its own risk.
- Controlling a captive insurance company means that processing insurance claims is usually much quicker and easier.
It might be preferable to establish a captive insurance company in an IFC:
- for tax reasons, and also
- because the costs of operating a captive insurance company in an IFC are often much lower than in an onshore centre, where the costs of expert employees or advisors can be very much higher.
Note on cell companies
Smaller companies wishing to establish a captive insurance company might be able to do so by joining with other companies to create a ‘protected cell company’. This is an ‘umbrella company’ consisting of a number of different cells. Each cell is separate from the others, so that assets and liabilities (such as insurance claims) of one cell cannot be transferred to another. The ‘umbrella’ company looks after the insurance requirements of all the individual cells.
For example, ten smaller companies might join to create a protected cell company with ten cells, for the purpose of operating a captive insurance company.
Professional services
A company or limited liability partnership can be established in an IFC for the purpose of providing specialised or professional services to clients in other countries. The individuals providing the professional services could be qualified engineers, architects or lawyers who are willing to provide their services to clients in other countries.
The advantage of organising this type of company or partnership through an IFC is that the clients pay fees to the IFC, where the money can then be reinvested in a tax-free environment. Payments to the individuals who provide the professional services can be organised and timed in a way that minimises the income tax payable to their own domestic tax authorities.
Banking Some IFCs specialise in the registration and licencing of banking companies, subject to local banking law. A foreign bank may be allowed to register in an IFC as a foreign bank, and obtain a licence.
- Large multinational companies could obtain a banking licence for their centralised treasury department which manages the money and investments of the group through its offshore banking operation in a tax-free environment. Treasury operations include managing cash for a global company, raising capital for the group as a whole, providing finance to individual subsidiaries within the group and managing financial risk.
- Many individuals use banks in IFCs. Such centres emphasise the benefits of privacy and asset protection, but consistently deny allegations that individuals use offshore banks as a means of avoiding tax in their own country.
International efforts to prevent money-laundering have led to changes in banking regulations in some IFCs, especially those that were suspected of tolerating the handling of ‘dirty’ or ‘criminal’ money by their banks. In many IFCs there are now banking laws that require banks to carry out checks on the identity of any new customer (‘know your customer’ checks) before allowing that individual to open an account.
Investment: offshore mutual funds
Investment companies and mutual funds are organisations that specialise in investing in shares of other companies, bonds and other investments.
- Some large financial institutions might set up an investment company or a mutual trust in an IFC.
- Individuals can invest their money offshore by buying shares in the investment company or mutual trust.
Investment companies
An investment company is similar to other companies, except that the purpose of its business is to make profits from investing in other companies, financial assets and possibly other assets (such as real estate). IFCs can be used to establish investment companies.
For example, in the past many hedge funds operating in the United States have been established in centres such as the Cayman Islands. The ‘holding company’ operation is in the IFC, but the management of the fund’s assets is sub-contracted to a firm in the country where the investments originate and are traded, such as the United States.
There are investment institutions in some IFCs that specialise in particular types of investment. For example, Singapore has some investment companies called real estate investment companies (REITs): these issue shares to investors and specialise in using their funds to invest in real estate assets.
Shareholders therefore invest indirectly in real estate by purchasing shares in a REIT.
Mutual funds
Mutual funds are not companies but are a different type of investment institution. They take money frominvestors and put the money into a specified type of investment, for example North American equities, corporate bonds, money markets and so on.
In return investors receive shares in the fund, which they can sell back to the fund managers at any time. Investors in a mutual fund receive a return from their investment in the form of either income or a growth in the market value of their investment. Returns for investors in a mutual fund depend on the performance of the investments in which the fund has invested.
As new investors buy shares in the fund and existing investors sell their shares, the amount of money invested in a fund is continually increasing or falling: there is no limit to how big the fund may become, but also no restriction on investors withdrawing their investment at any time by selling their shares.
An attraction of offshore mutual funds to an investor can be the tax laws of the IFC, which enable the investor to manage his investments more efficiently. The advantage of offshore investment is that returns are not subject to tax until the money is paid back to the investor, when it then becomes taxable in the investor’s own country.
