The Really Big Tax Havens

Today's comment is by Bob Bauman JD, Legal Counsel, Senior Writer and Offshore Expert for The Sovereign Society.

Dear A-Letter Reader,

At financial events, I often define a "tax haven" as a country that welcomes foreign capital and imposes low or no taxes on the foreigners who invest there. I then ask the audience if they know where the leading tax havens are located in the world.

People usually guess Switzerland, the Channel Islands, the Isle of Man, Monaco, Andorra, Liechtenstein, Bermuda or Panama. (Switzerland is not a tax haven per se, because it levies taxes on most investors, although foreigners may obtain refunds under double taxation treaties.)

For those in my audience not "in the know," they are usually surprised when I explain that the world's two largest tax havens are - (drum roll, please) - the United States and the United Kingdom.

Both of these nations have hypocritical governments which continually criticize tax havens. The U.S. and the U.K. like to vilify the many small jurisdictions that are proud to be tax havens. Ironically, the U.S. and the U.K. are tax havens only for foreigners - they offer no comparable tax relief for their own highly taxed citizens.

Poor Old Uncle Sam Needs Money

The U.S. gives virtually tax-free treatment to many hundreds of thousands of foreigners. Uncle Sam likes to reward these foreigners who invest billions annually in American stocks, bonds, real estate and especially U.S. Treasury bonds. Deficit-spending politicians from both parties desperately need the foreign cash float these tax-free investors so generously provide.

In 2005, foreign direct investment in the United States exceeded US$1.5 trillion on a historical cost basis. That huge amount represented 10% of the total market value of all publicly traded American firms.

That huge number has grown since. Total foreign spending to acquire or establish U.S. businesses was over US$100 billion in 2006 alone. And with the ever declining dollar, you can expect many more "fire sale" purchases by foreigners.

We saw this happen earlier this month when Dubai bought a 20% stake in the Nasdaq, and became the single largest owner of America's technology stock exchange.

How America Became the Tax Haven It Is Today

The U.S. government deliberately adopted this generous American tax haven policy in the 1980's. At the time, many leading U.S. financial institutions verged on bankruptcy.

The combination of uncollectible bank loans to the Third World, rampant inflation, savings and loan scandals and a 20% plus prime interest rate had put billion dollar holes in bank's and insurance companies' balance sheets. The political solution was simple and effective: Drop taxes on international capital and watch the money flow in.

Foreigners, (nonresident aliens, as the U.S. government calls them), and foreign corporations these foreigners control are exempt from most U.S. taxes. They're exempt from taxes on certain kinds of interest and on capital gains from owning most types of U.S. securities, bonds or debt obligations.

U.S. corporate dividends paid to foreign persons are subject to withholding taxes. But the tax rate may be low or zero under a treaty between the U.S. and the foreigner's home country. If a non-U.S. person controls an offshore corporation that invests in the U.S., then he or she is not required to file returns with the IRS, unless it does business within the United States.

The IRS likes to insist that offshore investing is laced with tax evasion. They estimated that US$5 trillion in assets worldwide is held "offshore" in tax havens. They also estimated the IRS annually loses a minimum of US$70 billion in tax revenue from individuals investing offshore.

But the IRS and American tax laws welcome the trillions in foreign investment in tax haven USA. They don't seem concerned about the possible tax evasion by foreigners.

The Brits Do It Too

The United Kingdom is also a major tax haven, but with a different twist - the U.K. gives major tax breaks to wealthy foreigners who actually live there. Under British tax law, anyone living in Britain and not born there can choose what is known as "non-domiciled" tax status.

That means scores of billionaires who live there only pay tax on the relatively small amount of money they bring into the U.K. each year. They do not pay U.K. taxes on their much larger worldwide earnings.

This law has made London a tax haven for everyone-- from Russian oil tycoons to thousands of international investment bankers. The country now has 68 billionaires - three times as many as four years ago. Only three of its 10 richest people were born in Britain.

That special U.K. tax law is always under attack. It continually presents a political problem for the new Prime Minister Gordon Brown. The British newspaper, the Guardian, accuses Brown of having a "love affair with the super-rich."

The British trade unions want to end the loophole. For 10 years, Brown regularly promised reform on the "non-dom" tax issue as Chancellor of the Exchequer. But in the end, he did nothing. (That's fine with us. We've never met a tax we liked.)

This Sanctuary for the Super-Rich Will Survive

The International Herald Tribune thinks the non-dom tax exemption for the rich doesn't make sense in a highly taxed country. In the U.K., the top income tax rate is 40%. But we agree with their conclusion that "...it is too late to change it. London and, by extension, the rest of the British economy have become dependent on the mega-rich."

There is no denying the impact the rule has had. According to British Treasury figures, about 112,000 people claimed non-domiciled status in 2005. They reported a total of £9.8 billion (US$19.9 billion), in earnings. But their wealth from overseas income would be much more and they spend a lot of cash in London.

Based on past performance and the politics involved, I predict this U.K. non-dom tax loophole will survive. If we're wrong, there will be a lot of rich people fleeing London for other, more secure tax havens.

The next time you catch some London or Washington political foghorn blasting those terrible tax havens on T.V., send them an email and tell them to look in the mirror. Or tell them to go get lost in the 25,000 pages of the U.S. and/or U.K. tax code. They might just learn something.

BOB BAUMAN, Legal Counsel

P.S. Unfortunately, these obscure little tax rewards hidden in the 25,000 pages of American and British tax code don't apply to U.K. or U.S. citizens. But if you're looking for legal tax avoidance, you can visit other places where you're the foreigner - and reap the foreigner's tax benefits. Click here for some ideas on where to look.

Where 55,000 Forbidden Investments Are Hiding

Offshore mutual funds are the crème de la crème of offshore investments. They're exciting. They're lucrative. But they're also so-called "forbidden" offshore investments because you need to know exactly how to invest so you can profit from them as an American.

But it's worth the extra legwork, when you can invest in over 55,000 offshore mutual funds available worldwide.

Luxembourg remains the largest hub for these products. After the United States, Luxembourg is the world's second-largest mutual fund domicile. This country offers tax-free funds called Sicavs.

But unlike North American mutual funds, offshore funds sold primarily in Europe (Luxembourg, Ireland, Switzerland, Scandinavia) are available in euro, sterling, Swiss francs, the Norwegian krone and of course, the U.S. dollar.

Plus, retail investors can access a whole range of traditional and non-traditional funds like hedge funds, private equity funds, British investment trusts and managed futures funds without being accredited or forking over a few hundred thousand dollars.

The entire gamut of offshore funds is far more profitable. Plus, offshore funds are probably safer on a risk-adjusted basis because multiple asset classes are available to retail clients.

For example, in the United States and Canada, you have to be a high net-worth investor to buy alternative investment products. Some smaller investors can access these products through structured vehicles offered by some of the big banks, but the fees are colossal and performance isn't worth the effort. So to really get in on the ground floor with some of the best hedge funds, you need millions.

That's not the case overseas. One of the world's largest multi-manager hedge fund companies since 1983 continues to offer a terrific selection of top-flight money-managers from their Irish umbrella. And they're starting at just US$25,000. The same complex also offers products denominated in dollars, euro, sterling and Swiss francs.

Going offshore certainly has its benefits from an investment perspective. But there's also several important caveats investors must realize prior to investing their hard-earned dollars or euro.

This November, I'll give you the best investment ideas for 2008 and beyond at our Offshore Advantage Academy. But I'll also explain how to avoid offshore taxation pitfalls so you can invest successfully and tax-effectively for long-term profits.

ERIC ROSEMAN, Investment Director

P.S. From November 7-10, The Sovereign Society will host its second annual Offshore Advantage Academy on Paradise Island, The Bahamas. I'll be this year's Investment Professor deliberating on offshore mutual funds, bonds, stocks, commodities, hedge funds, British investment trusts and currencies. I'll also delve into international taxation of foreign investments, including dividend withholding and potentially onerous U.S. tax consequences for Americans and Canadians buying offshore mutual funds and how to successfully defer the taxes on non-U.S.-based funds. Last I heard, seats were going fast, so click here to R.S.V.P. right now before we sell out.

Bonus Wealth

Thanks Bernanke, But We're
Not Out of the Woods Yet

Bloomberg greeted investors this morning, with a headline saying that the Japanese yen appreciated overnight against the other currencies. This is just more evidence that the carry-trade is unwinding, because "credit market losses are spreading."

News out of the U.K. indicates that the run on the bank at Northern Rock Plc left the British deposit protection plan (the rough British equivalent of U.S. FDIC insurance) short of cash to bailout the bank.

According to Bloomberg, "Northern Rock customers withdrew an estimated £2 billion" in deposits from the troubled mortgage lender in recent weeks.

Trouble is, "the U.K. Financial Services Compensation Scheme holds £4.4 million (US$8.9 million), while a similar U.S. fund has US$49 billion. The plan may have to increase insurance fees from participating banks."

Meanwhile in Canada, investors are running from the Canadian commercial paper markets. They're freezing-up about US$40 billion worth of CP rollovers. Seventeen funds run by Canadian finance companies "couldn't raise money to pay back lenders, according to ratings company DBRS Ltd" because investors feared the fallout from the sub-prime contagion.

Beginning in July, "growing defaults in U.S. home loans caused the cost of borrowing to increase for all but the most creditworthy companies. Rates on asset-backed commercial paper soared, rising to six-year highs in the U.S." according to Bloomberg.

Even the International Monetary Fund, which has repeatedly raised its estimates for global growth (most recently to 5.2% this year), has warned that "instability stemming from credit-market turmoil in the U.S. is 'likely to be protracted,' according to the Bloomberg.

Today, the National Association of Realtors should report another slump in existing home sales. This is expected to drop another 5% in the most recent month, while consumer confidence is expected to slump in September.

The ongoing housing recession is likely to get much worse in coming months. An estimated US$600 billion in adjustable-rate mortgages ratchet up to higher monthly payments.

This will pressure home prices further, as more homeowners throw in the towel and sell at fire-sale prices - dragging down Americans' wealth even more.

And for those homeowners who manage to hang in there with higher mortgage payments, discretionary spending on other "stuff" will most certainly slow.

Bottom line: Fed rate cut or no - we're not out of the woods just yet.

MIKE BURNICK, Senior Editor & Global Markets Analyst