Is the United States a Tax Haven for Foreigners?
For many years, foreigners have enjoyed the freedom to form LLCs in the United States, whether as a means to access the U.S. banking system, to gain anonymity or asset protection benefits for their investment holdings, or possibly to avoid taxation of investment income in other jurisdictions. Foreigners are subject to punitive withholding tax rates on U.S.-sourced fixed, determinable, annual, and periodic income items such as interest and dividends. However, capital gains (aside from gains on U.S. real estate) are normally not subject to tax in the United States. Accordingly, a foreigner seeking to avoid tax in his or her home jurisdiction might take advantage of a Wyoming or Delaware LLC to hold an investment portfolio of, say, small cap stocks that occasionally realized capital gains but do not usually pay dividends.
Increasingly, OECD member countries have been critical of the U.S. approach to sharing tax data with other countries. While most Western countries have signed onto OECD-backed initiatives for the sharing of tax enforcement data, the United States has opted to follow its own approach: FATCA. This has put the U.S. government at odds with its Western partners, but the Treasury Department has sagely pointed out the limits under which it can share taxpayer data under U.S. law. For this reason, it is assumed that many foreigners actively exploit this mismatch in enforcement by using the United States as a tax haven.
Proposed Regulations to the Rescue
Perhaps in order to combat the perception that the U.S. is developing into a modern-day tax haven, the Treasury Department published proposed regulations on May 5, 2016, concerning foreign-owned single-member LLCs organized in the United States. The regulations were subsequently published in the Federal Register on May 10, 2016.
In its background report to the proposed regulations, the Treasury Department observes that, under the check-the-box regime of Treas. Regs. § 301.7701-1 through -3, a domestic single-member LLC owned by a foreigner is treated as a disregarded entity, the same as if the sole member were a domestic taxpayer. If the LLC does not have a tax-reporting obligation or otherwise require an EIN (e.g., it does not have employees), the U.S. government has no immediate method to ascertain the ownership and activity of the LLC, much less a basis for sharing this information with another country’s tax authorities. As the report notes:
These difficulties have been noted in reviews of the U.S. legal system by international organizations, including the Financial Action Task Force and the Global Forum on Transparency and Exchange of Information for Tax Purposes, which is affiliated with the Organisation for Economic Cooperation and Development.
The proposed regulations offer to amend Treas. Regs. § 301.7701-2(c) to treat a domestic disregarded entity that is wholly owned by a foreigner as a domestic corporation separate from its owner for the limited purposes of the reporting and record maintenance requirements (including the associated procedural compliance requirements) under IRC § 6038A. The report clarifies that the proposed regulations do not seek to change the fundamental tax treatment of the single-member LLC as a disregarded entity. Rather, the effect would be “to provide the IRS with improved access to information that it needs to satisfy its obligations under U.S. tax treaties, tax information exchange agreements and similar international agreements, as well as to strengthen the enforcement of U.S. tax laws.”
Impact of IRC § 6038A
The proposed regulations would treat a domestic single-member LLC, in which the sole member is a foreigner, as a domestic corporation for the specific purposes of IRC § 6038A. This means that the LLC would be regarded as a “reporting corporation” within the meaning of IRC § 6038A. Thus, the LLC would be required to file IRS Form 5472 and disclose transactions occurring between the LLC and its foreign member or other foreign related parties, just as if those transactions took place between a domestic corporation and the foreign member or other related parties. The LLC would also be required to maintain records sufficient to establish the accuracy of the information return and the correct U.S. tax treatment of such transactions.
Importantly, to comply with the reporting requirements of IRC § 6038A, the LLC would be required to obtain an EIN by filing a Form SS-4 that includes responsible party information. This may actually be a benefit to those foreigners who historically relied on obtaining ITINs in order to open a bank account or investment account for their single-member domestic LLC.
Reportable Transactions
The proposed regulations expand the scope of reportable transactions under IRC § 6038A to include any transaction described in Treas. Regs. § 1.482-1(i)(7), treating the LLC as a separate taxpayer for this purpose. The term “transaction” is defined in Treas. Regs. § 1.482-1(i)(7) to include any sale, assignment, lease, license, loan, advance, contribution, or other transfer of any interest in or a right to use any property or money, as well as the performance of any services for the benefit of, or on behalf of, another taxpayer. The Treasury Department explains the impact of this particular change by indicating that contributions and distributions between the LLC and its sole member would now be considered reportable transactions. Likewise, a transaction between the LLC and its sole member (or another single-member LLC owned by the same member) would be considered a reportable transaction.
The impact of this particular change will be of concern to multinational business operations that engage in the U.S. marketplace through one or more single-member LLC subsidiaries. The impact of this change will be to expand the scope of reporting – and audit scrutiny – to include transactions that previously did not exist for tax purposes. Moreover, the audit scrutiny can be expected to include § 482 transfer pricing analysis.
No Small Corporation/De Minimus Exception
The proposed regulations provide that the exceptions to the record maintenance requirements in Treas. Regs. § 1.6038A-1(h) and (i) for small corporations and de minimis transactions will not apply to foreign-owned single-member domestic LLCs that are disregarded entities. This will significantly increase the reporting burden for foreigners who choose to maintain a single-member LLC as a disregarded entity in the United States.
Additional Changes on the Horizon
As if the proposed regulations were not enough, the Treasury Department’s announcement indicates that it is considering modifications to corporate, partnership, and other tax or information returns to require the filer of these returns to identify all the foreign and domestic disregarded entities it owns.
Our Analysis
Planning Alternatives
By not altering the fundamental outcomes of the check-the-box rules, the Proposed Regulations simultaneously discourage the use of domestically-organized LLCs while encouraging the use of foreign-organized LLCs. Consider this: If a foreigner establishes an LLC in Wyoming, the Proposed Regulations trigger tax reporting under IRC § 6038A. Alternatively, if that same foreigner establishes a Belize LLC and then registers the LLC as a foreign LLC authorized to do business in Wyoming, now the Belize LLC has relatively unfettered access to the U.S. marketplace (including banking and brokerage services) without triggering IRC § 6038A because the Belize LLC remains a foreign LLC under the check-the-box rules, albeit the Belize LLC member has to file a check-the-box election affirmatively selecting disregarded entity status.
Foreign businesses that continue to engage in the U.S. market will in all likelihood continue to use domestic LLC subsidiaries to contain their operations and will simply have to incur the increasing reporting burden. However, foreign individuals may be better off considering the use of a trust rather than a domestic single-member LLC. Properly structured, a Wyoming international qualified spendthrift trust can have foreign trust status, thereby alleviating both the trustee and the foreign individual settlor from any U.S. tax reporting, even though one of the trustees may be based in Wyoming and operating a Wyoming investment account on behalf of the trust.
Where is the Missing $150 Billion?
The FATCA and OECD initiatives have effectively killed off “poor man’s tax evasion” by eliminating bank secrecy as a means to avoid reporting taxable income. However, the trade-off has been an exponential increase in the reporting burden of those taxpayers who dare to wander outside the United States to engage in business and personal wealth planning. That effort is now coming full circle, with the Treasury Department threatening to damage inbound international business and wealth planning through an avalanche of tax reporting obligations.
Tax scholars will recall that FATCA was enacted after former Senator Carl Levin published a report claiming that the U.S. was missing out on $150 billion each year in tax revenue lost to offshore schemes. His wild claims were built in part on dubious research performed by Joseph Guttentag and Michigan Law Professor Reuven Avi-Yonah, who themselves claimed $50-70 billion in tax revenue was going out the door every year due to bank secrecy and tax evasion. This bogus number was repeated by many media outlets as if it were fact, even though the math made absolutely no sense at the time that Guttentag and Avi-Yonah published their research. After all, $150 billion in lost tax revenue really means $450 billion in pre-tax dollars being hidden from the U.S. government, a rate of malfeasance that simply would have been unrealistic for the U.S. economy back when FATCA was enacted.
Since FATCA was enacted, exactly how much money has the U.S. government collected? Would you believe less than $250 million per year?!? And what about the cost of compliance with FATCA? Try in excess of $200 billion per year if you do not include manual administration costs! The overall cost when including individual taxpayers appears to be in the neighborhood of $1-2 trillion per year.
Not only is FATCA a colossal revenue failure, but there is absolutely no accountability for the failure of its architects and those who were screaming at the time that the sky was falling. Professor Avi-Yonah has never taken responsibility for the shortcomings of his research. This guy should have a big fat asterisk attached to his resume; his research was utterly wrong, was criticized at the time as a likely fiction, and raises a genuine question over the integrity of his academic work.
Long-Term Prospects
We are agnostic when it comes to the politics of the matter. Rather, we ask whether the extreme increase in the cost of compliance – as contrasted with the minimal added revenues realized – among the OECD-member countries over the past seven years has damaged global commerce and economic growth. Tax fairness is an admirable goal, but so is good government and tax efficiency. One OECD initiative would prevent a member country from lowering its taxes by too much lest the citizens of other member countries take notice and complain that their taxes are too high (or, stated slightly differently, that they are paying too much for government). Regulation for the sake of regulation is not a very high-minded goal for any society, and it leads us to ask whether an organization such as the OECD – whose mission was to help Europe rebuild after World War II – has fulfilled its purpose when it begins to wander into tax policy and push laws that underserve the public interest.
After 70 years, perhaps the OECD has become an anachronistic expenditure worthy of elimination. This would save taxpayers at least $80 million per year, which is pretty handsome in relation to the $250 million per year collected under FATCA.
You can read an online copy of the proposed regulations here.