In simple terms, offshore companies can be extremely effective in avoiding tax if they are used to collect income. But sadly things are not always that simple. Many countries have enacted anti-avoidance legislation designed to reduce or eliminate the effectiveness of such arrangements. Each country has its own specific rules in this area but such legislation can be broadly categorised as follows:
Controlled Foreign Corporation Legislation
Controlled Foreign Corporation (CFC) legislation seeks to tax the profits of a company as though they had been paid out to its owners whether such profits are actually paid out or not. Where an owner holds only a portion of a company then the percentage of the company's profits allocated to him is equal to his percentage of shares.
If, for example, a UK resident owned 50% of an offshore company then he would be liable to declare his interest in the company on his year end tax form and would be taxed as though he had received 50% of the profits of that company, whether he had actually received them or not.
Transfer Pricing Legislation
All arrangements between companies that have any sort of common ownership must be at "arms length", or open market, prices. If this is deemed not to be the case, transfer-pricing legislation enables the local revenue to adjust those prices. For example, if an offshore trading company was set up to buy goods from China and sell those goods to an associated company in the US, then the price at which the goods were sold on must be
the same price as the US company would pay on the open market. If the US company paid a higher than open market price to an associated company in a low tax jurisdiction and thereby shifted profit to that company and reduced its US tax bill then the IRS is entitled to adjust the taxable profit figure to reflect the lower open market price.
General Anti-Avoidance Provisions
Most countries have brought in legislation, or have case law, that simply states that if arrangements are entered into, whose main or primary purpose is to reduce tax; any tax advantage obtained can be removed.
Thus, any arrangements that confer a tax advantage should also have a commercial purpose and be set up, at least in part, for reasons other than tax planning
Anti-Treaty Shopping Provisions
Treaties can be used to reduce withholding tax on dividends, interest and royalties but certain treaties may prevent non-residents of the treaty partner from benefiting. For example, the US withholds tax on royalties paid to non-residents at a rate of 30%. The US/Netherlands treaty reduces the withholding tax on royalties to zero but the treaty contains provisions that make the treaty inapplicable unless the ultimate beneficial owner of the royalty income is a bona fide resident of the Netherlands. A Hong Kong resident wishing to reduce withholding tax in the US could not therefore achieve this by setting up a Netherlands company to receive the income and then pay it on to Hong Kong because the
beneficial owner would be a Hong Kong resident not a resident of the Netherlands. However, there will always be products or structures which are specifically allowed by statute and which give great tax advantage. Likewise there will always be ways in which an operation may be structured so as to prevent it falling foul of anti-avoidance legislation. Simple offshore structures will rarely work.
In most situations a more sophisticated structure will be needed and the on-going administration will have to be handled accurately and with skill if later problems are to be averted.