Offshore Tax Shelters

An offshore tax shelter is a legal mechanism or entity by which income that would normally be earned and taxable in one tax district is only taxable within the domicile of that tax shelter’s registration. In other words, when capital is transferred to another legal jurisdiction and is subject only to that jurisdiction’s taxation system, then income earned from use of that capital is no longer considered taxable in a higher taxed jurisdiction.

Several criteria must apply for offshore tax shelters to be legitimate. For example, if income is earned for purposes other than tax avoidance, it is more likely to be considered legal. This is more the case when the income earned through that tax shelter comes from the country that holds tax sheltered assets. Moreover, this is because income earned in a higher tax zone can still be taxable even if earned from a foreign registered entity.

Some entities attempt to avoid taxable income earned from offshore entities by taking advantage of rules that don’t require taxes from foreign registered entities. For example, a Senate committee report chaired by Senator Carl Levin found that certain hedge funds were avoiding taxes on dividends earned within the U.S. This abusive practice was accomplished by restructuring the transaction so the money would not be taxable under the rules of the new transaction. The transactions were still considered tax evasion because they were believed to not serve the purpose of the transaction, but rather the intent of tax evasion.  

In some cases, tax treaties are signed into law between two countries. The Internal Revenue Service (IRS) states these treaties often do not protect residents or citizens from U.S. Taxes due to a ‘savings clause’. However, also according to the IRS, there are exemptions to the savings clauses of tax treaties. In such case, the saving clause exemptions of a tax treaty can serve an offshore tax shelter by allowing income to be earned within the United States through the tax shelter in so far as tax exemptions apply. Filing of specific tax forms may still be required by the IRS in order to claim the tax exemption.

With our without tax information sharing treaties between countries, tax that is illegally sheltered is still illegally retained income. In other words, tax shelter fraud and misuse of offshore portfolio investment strategy are considered tax evasion and not tax shelters as distinguished by the IRS. For this reason it is necessary to understand the basic tax laws that classify income as either taxable or non-taxable, and the difference between tax shelter fraud and tax shelters.

For most individuals that earn income in an offshore account, that income must still be reported to the IRS. However, if that income is not earned by an individual, but rather an entity that is legally separate from the individual, new rules apply. Even this can be considered tax evasion if that entity is established solely to avoid taxes. In other words, the motive of an offshore tax shelter should not be tax avoidance, but rather tax sheltered income according to  US Legal. When considering offshore tax shelters, consulting with the IRS or contacting a skilled tax professional that is also accurately knowledgeable in the area of offshore tax shelters may be advisable.

1.  (U.S. Senate)
2.      (Internal Revenue Service)
3.    (IRS)
4. (US Legal)