November 2017 (167) – THE OFFSHORE NIGHTMARE

If you are an entrepreneur or a professional adviser to an entrepreneur, you will not want to miss the IBSA annual conference which will be with us in a couple of weeks on November 16th at the Landmark hotel London (click here). Every entrepreneur is concerned with knowing how to raise finance for his or her business, how to protect valuable intellectual property created and ensure no-one else’s IP is a concern, options of tax residence and optimum business structuring, and planning for issues such as divorce or inheritance. Based on a case study, the talented panel of speakers will explore these and many other issues. IFS newsletter readers are invited to attend at a special rate of £600 plus VAT which represents a 20% reduction of the standard fee and which will include a post conference networking reception. When registering with Eventbrite, please state “The Offshore Nightmare” to obtain the discounted price.

The overriding theme of the conference is commerciality. Nowadays, unless a structure demonstrates a clear business purpose for its existence, no amount of clever planning will remove it from the sword of Damocles in the form of a tax investigation. This is the topic that I am exploring in this month’s article “The Offshore Nightmare”, which in fact I wrote nearly 20 years ago. Entrepreneurial clients have always been the lifeblood of IFS’ practice, and have provided me with practical illustrations of why planning their business ventures at the outset is an invaluable asset for their future sanity. Mr Washington in the article below rues the day he took advice from Bodgit & Scarper.

With kind regards

Roy Saunders


How many times has a Special Office Tax Inspector gleefully exclaimed “Oh what a tangled web we weave …” whilst the tax practitioner defensively declares “Well, the best laid plans of mice and men …”. At IFS Consultants, we are not mice afraid to assist clients imaginatively in creating sound commercial structures which have tax mitigation as one of their objectives, but our forty five years of experience purely in international tax planning have demonstrated time and again that arachnidan structures are best studied by anthropologists than tax planners. This comic strip is designed to highlight some of the problems that can be encountered with a very common ‘offshore’ structure involving a Trust, a holding company and a tax haven company. The fictional characters are exactly that but I wonder whether readers recognise anybody!

The ‘offshore’ structure

George Washington had for a long time been known as a maverick inventor within the food and beverage industry and had after many years invented the unique ‘onion glasses’ so that there will “no longer be tears before mealtimes”. He had sought the advice from ‘Bodgit & Scarper’ as to how he could best exploit this invention with as little tax exposure as possible.

The Washington Family Settlement was formed in 1994 on the advice of Arthur Bodgit, the settlor being Mrs Golightly who is an elderly spinster friend of the Washington family who now resides in Monaco. Although Mr Washington is not named as the settlor, he did arrange with the trustees, B&S Trustees Ltd of Jersey, for the rights to the patent for the onion glasses to be registered in the name of a British Virgin Islands company, Dry Eyes Inc. However, in order to allow Mr Washington some degree of control over the trustees’ actions, Mr Washington was named as the Protector and has also presented to the trustees a Letter of Wishes to be acted on in the event of his death.

Having successfully exploited the Dry Eyes Onion Glasses at home, Mr Washington sought advice as to a suitable corporate structure for overseas sales. Eventually, he accepted that the Trustees would transfer the shares of Dry Eyes Inc to a Netherlands Antilles company which would then further transfer the shares to a Dutch company. The Dutch company would then form subsidiaries in various high tax jurisdictions which would be licensed by the BVI company Dry Eyes Inc to sell the glasses subject to a substantial royalty payment which would reduce taxable profits. Thus the Washington Family Trust would own Dry Eyes Corporation NV of the Antilles which in turn would own Dry Eyes Holdings BV in Holland. The Dutch company would own Dry Eyes Inc of the BVI owning the rights, as well as subsidiaries in several European countries and the US.

Mr Washington has now sought the assistance of Maurice Brightman at IFS to comment on the structure in place.

The Trust

MB “The first thing to consider here Mr Washington is the fact that the trust was formed in 1994 and as such, if you are considered the settlor, any capital gains which arise in the trust or any underlying subsidiary, say from the sale of the shares in the BVI company, will be liable to tax in the beneficiaries hands. I suspect that Bodgit did not inform you of this?”

GW “Quite right Mr Brightman, but you see, I’m not the settlor, Mrs Golightly is” George said with a satisfied smile.

MB “Well, let’s look at the facts. Mrs Golightly did indeed pay the £100 settled sum for the Trust’s initial funds, but you allowed very valuable rights to vest in a subsidiary company of the Trust, so creating the opportunity for the Trust to make significant profits. You would therefore be regarded as the ‘deemed’ settlor. I expect Mr Bodgit didn’t explain this to you ”.

GW “No he didn’t”, as a worried expression crossed George’s face.

MB “Moreover, the tax authorities may assess you on the value of the rights transferred to Dry Eyes Inc, since there is no doubt that you made a disposal for capital gains tax purposes. Can I get you a stiff drink Mr Washington?”

On hearing this news Mr Washington lets out a gasp and turns a shade of grey Maurice had never seen before, letting out expletives that are best left unprinted. Mr Washington accepts the offer and decides to have a whiskey and water; after all it is late morning already.

GW “Carry on Maurice” Mr Washington prompts after letting the first mouthful of whiskey warm his throat, “I’m sure this is not the only bad news you have for me this afternoon.”

MB “Well, assuming that you are the deemed settlor, and because you have not been specifically excluded as a beneficiary of the trust, the entire income of the trust is taxed in your hands on an arising basis. Moreover, this extends to income of an underlying company, such as Dry Eyes Inc, even though the income left in the other subsidiaries may be protected under relevant double tax treaty arrangements. The anti-avoidance provisions, which are designed to stop taxpayers like you from avoiding tax through the creation of offshore trusts, have caught you. I also see that you have been named as a Protector to the trust which is fine, but I recall you told me that you have been sending instructions to the trustees for the last 3 years and they have been complying with these instructions without comment. This is interesting because there has been quite a lot of case law recently which tends to suggest that an over-zealous Protector could indeed assume the responsibilities shouldered by trustees, and in fact become a “quasi trustee”. Thus the management of the trust could be said to be taking place where you are resident, bringing the trust under the remit of domestic tax law.”

GW “Is there anything else you want to scare me with now or is that it for the Trust”, said Mr Washington now in a very disgruntled mood.

MB “Probably if I look more closely at the trust deed, which appears amazingly short at three pages, but now let’s move on to the BVI company”

The BVI company

Maurice then takes a sip of iced water and looks through some notes he made before meeting Mr Washington.

MB “This company seems to have been formed properly, however I see that Mr Rossi and Mr Bianco are the two directors, and they are resident in Lugano, Switzerland. Are you familiar with the tax concept of management and control?”

Mr Washington looks blankly at Maurice, indication enough that this basic rule is unfamiliar to Mr Washington and enough reason for Maurice to continue.

MB “Management and control is the test for a company’s residence, and although a company may well be incorporated in the British Virgin Islands, if the day-to-day management of the company is exercised by directors who are resident in Switzerland, the Swiss authorities may consider that Dry Eyes Inc is de facto a Swiss company. As such, they would be more than within their rights were they to assess the BVI company for Swiss taxation.”

GW “But I thought Switzerland was an offshore centre” Mr Washington exclaimed with a look of bemusement spreading across his face.

MB “Technically the word offshore applies to all non-domestic companies, but I know what you mean. The Swiss have for many years offered various incentives for companies and individuals alike, however it is not a no-tax jurisdiction. If on the other hand say Jersey directors are used, and board meetings are held and the decisions of the company are made in Jersey, then this company would be run properly as an ‘offshore’ company in your understanding.”

GW “Well that’s all right then, I’ll kick the Swiss directors off the Board and appoint Jersey directors – can you recommend any?”

MB “It’s not quite as simple as that. I understand that Dry Eyes Inc has a bank account in Switzerland and that you have sole authority to sign on the account. Moreover, I would guess without too much difficulty that the Swiss directors listen rather obediently to your suggestions as to contracts they need to enter into for the licensing arrangements,” asked Maurice tactfully.

GW “Well, who else knows the business”, asked George.

MB “Precisely,” and after allowing the notion to sink in during the pause, continued, “I have no problems with you being a director of Dry Eyes Inc since you clearly are the business provider, but as long as the other directors perform clear functions of management and that you are present for the board meetings in Jersey where all decisions affecting the company are taken, then the company should be considered to be resident ‘offshore’. However, if you are seen to be exercising control in your country of residence, then you might just as well have formed the company as a domestic company and paid full domestic taxation”

GW “Oh dear, I assume that what you have just said also applies to the Dutch company.”

The Dutch BV

MB “Unfortunately yes, that is correct Mr Washington”, Maurice sighs knowing that he is the bearer of bad tidings, a position he would rather not be in. “The Dutch company was set up as a holding company to own the overseas subsidiaries, which in itself is good advice given the excellent double tax treaties Holland has concluded and the Dutch tax advantages for holding companies. However, again the fundamental principles do not seem to have been explained to you by Bodgit. Whilst one of the directors is resident in Holland, the other two, yourself and your wife, are resident in the UK, and I can find no records of any board meetings having been held in Holland during the past two years. Even if you had a majority of non-resident directors, unless they were really involved in the management of Dry Eyes Holdings BV, the UK Revenue would presume that you and your wife controlled the Dutch company.”

GW “But what sort of management can people do in my own company which would have any credibility”, asked George.

MB “Well, a suitably qualified accountant can control the finances of the company and its underlying subsidiaries, taking some of the financial control off your shoulders including dealing with group auditors. Similarly, a lawyer can prepare the contractual arrangements which govern the relationship between Dry Eyes group companies. Local administrative personnel in Holland can liaise with foreign tax authorities to ensure that royalties are received by Dry Eyes Inc with the minimum of withholding tax, and they can also assist with local employee problems when the group expands, such as ensuring proper contracts of employment comply with local legislation. And so on, and so on.”

Maurice was feeling jaded now and was looking forward to a relaxing swim at the club just five minutes from the office. He was thinking the floatation tank might be even better. However he hadn’t concluded his consultation yet.

MB “Oh, and incidentally, although I am sure Mr Bodgit chose a Dutch holding company because dividends and capital gains from subsidiaries can be received tax free under the participation exemption, you ought to know that they won’t”, added Maurice pausing for maximum effect, “since Dry Eyes Inc is a BVI company which is not subject to tax on its profits, which is one of the three fundamental requirements for subsidiaries of Dutch companies to come within the participation exemption”.

The US Problem

Mr Washington had on the advice of Bodgit established a small warehousing facility in New Jersey, which was used in the first instance simply to house boxes of the onion glasses before distribution to the various American wholesalers who had been interested in the new idea.

MB “Can you tell me the reasons, if any, why the BVI company opened the warehouse in New Jersey before you formed the US subsidiary, Mr Washington?”

GW “Well, I took the advice of Bodgit who told me that under US law, a warehouse would not amount to a permanent establishment, whatever one of those is, and as such I would not be liable to US tax. The US company could then act as a sort of promotional company only with the sales to the wholesalers being done direct from the BVI company. Seemed like good advice to me at the time”

MB “Hmm. I’m not too sure about that. The first problem you are faced with is that the BVI company does not benefit from a double tax treaty with the US. This means that a permanent establishment does not have to exist for the US authorities to assess a foreign company which is trading in the US, which you are clearly doing. It is true that under the terms of a double tax treaty, it is quite often possible for a foreign company to have a warehouse or showroom without it amounting to a taxable presence, and this is in order to attract foreign business. Therefore I would have understood it more if the Dutch company had opened the warehouse in New Jersey, although the new US/Dutch treaty now prevents the treaty from applying at all to Dutch companies such as yours. But I will not dwell on that.”

“The main problem is that the US corporation will be attributed with the profits earned by Dry Eyes Inc on its sales to US wholesalers under the “force of attraction” principle. You cannot artificially separate the source of profits merely by using separate corporate entities.”

“And of course, the perennial problem of ‘transfer pricing’ has not even been discussed with you. I understand that Dry Eyes Inc is buying the onion glasses from a third party manufacturer and selling them to group subsidiaries, presumably at a profit. If so, this profit of the BVI company could be attacked under the transfer pricing rules as it reduces the income subject to tax in the high tax subsidiaries.”

GW “But surely that’s the idea isn’t it?”

MB “Not as far as the tax authorities are concerned. And incidentally, transfer pricing also affects the amount of royalties you are extracting from group companies, interest charges you are levying on inter-company loans, management fees and all other related party payments”.

GW “There doesn’t seem much point in having set up the whole operation, which incidentally has cost me a huge amount in administration fees, if I can’t avoid the taxman. I might just as well have operated from the outset as a UK company throughout the world”.

MB “Quite. I am afraid that besides my modest fee for this consultation, you do have significant tax assessments to look forward to. And the fact that you may be susceptible to double taxation on the same income should not be overlooked, so perhaps I can help by arranging a meeting with the tax authorities and discuss a voluntary settlement”.

The above comic strip was written by Roy Saunders in January 1998