Money: Secret Foreign Bank Accounts

In these days when American taxpayers are becoming both more rebellious and more sophisticated, you now and then hear wonderful stories of a beautiful green paradise in Europe where the snow is white and tight-lipped bankers will tell IRS agents to go jump off an Alp. If you would like to curl up with a good compendium of these moral tales, you might try T.R. Fehrenbach's THE SWISS BANKS (McGraw-Hill, 1966).

While much of the fame of the numbered Swiss account is deserved, there are some problems. For one thing, a secret account transaction is never closed for tax purposes, i.e., there is no statute of limitations in tax fraud cases. For another, even if a businessman can handle his secret account with no difficulty, he cannot count on his heirs being as adept. His widow may find handling the account beyond her capabilities, either technically or emotionally; she may find herself plagued by fear and worries rather than enjoying the security her husband intended. To cite just one other problem, the IRS practice of paying rewards for informers would put a dangerous power in the hands of a disgruntled employee or vindictive wife.

To avoid these problems, the individual should understand exactly what he wants. Most potential users of Swiss accounts are not as interested in secrecy as they are in tax savings. By seeking to save taxes by relying on secrecy, the investor runs the risk of serious penalties upon exposure. Most Americans are unaware that there are legitimate "tax havens" which do not rely upon secrecy.

Tax havens such as Switzerland and Liechtenstein are structured along the continental civil law tradition and depend on secrecy and the confidential relationship between banker and client or lawyer and client. In addition to secret accounts, there are holding companies with nominee officers whose shares are in bearer form and whose ownership is hidden behind the confidential relationship between the nominee-officers, usually local attorneys, and the true parties in interest whose identity is desired to be kept secret.

The use of this latter device could be illustrated by the situation in which ownership of a business, say an international newsletter, is sold to a dummy Swiss firm for a modest cash consideration. The former owner continues on a salary. The sales price and salary are taxable to the former owner. The profits from the operation of the business accrue to the company in Switzerland. Because little of the business income is Swiss-based, there is little Swiss tax due. Since the company is now based in Switzerland, the former taxing jurisdiction of the owner is left nothing to tax except his modest salary. Ownership of the Swiss company is hidden by the fact that all its shares are in bearer form (i.e., the owner's name is not a matter of official record) and are very likely deposited in the name of some attorney in yet another jurisdiction, say Liechtenstein. Ownership of these shares may in fact be in the original owner who has gone through this rigmarole in order to avoid taxes on the profits of his business.

As imaginative as such a scheme may be, it doesn't hold water, tax-wise. The only reason it works is because the true ownership of the Swiss corporation is hidden behind several layers of bank secrecy and attorney-client privilege. Otherwise, the 'grantor trust', 'controlled foreign corporation', and/or 'sham transaction' rules, to mention just a few of the IRS's options, would shoot the transaction down easily. The British taxing authorities are at least as resourceful.

In contrast to the continental tradition, nations of the English common law tradition have a refinement of property ownership known as the trust. When property is given in trust, the former owner parts with ownership and control of the property to the trustee. The rights and obligations of ownership, including the incidence of taxation, now fall on the trustee. The trustee owns full legal title, subject to the obligation to pay over all or part of the property or income to certain persons, called the beneficiaries, under certain conditions defined in the terms of the trust or created by law. The law of trusts was created in England centuries ago as a means of avoiding feudal obligations and has a substantial body of experience and practice behind it. Liechtenstein has recently adopted a trust law, but its lawyers and courts have so little experience with it that its functioning must for now be a matter of speculation.

In the case of tax haven jurisdictions based on the English common law tradition, such as Bermuda or the Cayman Islands, tax planning centers on the use of foreign trusts.

Under this practice, a citizen in a high tax jurisdiction, such as US or UK, transfers cash or other assets to a trustee, perhaps a bank or a company organized to administer trusts, under certain terms. These terms usually provide that income will be accumulated for a period of years and paid under certain conditions to particular persons or classes of persons, such as children or heirs. The trustee is domiciled in a low-tax jurisdiction, such as the Caymans, and can accumulate trust income tax free. When the funds are eventually paid out they will be taxable to the recipient but under conditions resulting in a significant tax savings due to the long deferral of taxes and the generally lower tax bracket of the recipient. The recipient may, in fact, go further and plan to be domiciled in a low-tax jurisdiction at the time the trust income is paid to him.

None of this involves secrecy of any form. All matters are open and legal and neither the donor nor his heirs need lose sleep for fear of the unexpected arrival of the tax agent.

Such transactions, being legal, are somewhat more involved and expensive than simply putting the money in a numbered account and not telling anyone. The trust must be for at least a ten year period and numerous other U.S. laws respecting the use of trusts to avoid taxation must be followed. The transfer of funds to a foreign trust must be reported on a special form within 90 days of the transfer. If securities are transferred, there is a 27½% tax on their appreciation. Since the donor must part with all strings on the assets, he will not be able to regain the funds until the trust terminates should he suddenly find himself in need of the property.

All of these factors will involve planning and some legal expenses. Banks and trust companies will charge for their services, though these charges are generally quite modest. On the other hand, considerable taxes, both on income and estates, can be avoided with as much safety as you can normally expect in tax planning. As the author of an article on tax havens in the English journal THE BANKER observed:

Businessmen, bankers and tax planners will always be tempted to utilize the secret numbered account as a method of evading death duties and income taxes. Yet the only line of defence and protection is secrecy. Once this is pierced, there is nothing to fall back upon. While the adverse consequences resulting from the discovery of secret accounts used for purposes of tax evasion will vary from country to country the potential for both serious personal and financial loss is great. In the area of legitimate tax planning and particularly with the use of the foreign trustee, to the creative mind there are almost unlimited opportunities for tax control and tax deferral. It is in my view regrettable that so many taxpayers should have resorted to the numbered account scheme when careful sophisticated planning is available to minimize the pain of the tax collector's bite.

One should probably point out that the author of the above quotation is an officer of a Cayman trust company and therefore biased in favor of his own product. Nonetheless, his points are well made. There is no point in breaking laws unnecessarily.

Davis Keeler's Money column alternates monthly in REASON with John J. Pierce's Science Fiction column.