Statement of Senator Carl Levin on Introducing the Stop Tax Haven Abuse Act, Part I

America has been knocked flat on its back by the current financial crisis, but the American fighting spirit hasn’t given up. We are battling back. Congress recently passed an $800 billion recovery bill to jumpstart the economy with new jobs and investments. That $800 billion is on top of the $700 billion we set aside earlier to revive the credit markets and recapitalize the financial institutions that got us into this mess. Those steps weren’t easy to take and represent a lot of money going out the door.

That’s why, today, I’m introducing the Stop Tax Haven Abuse Act, [PDF] along with Senators Whitehouse, McCaskill and Bill Nelson, to stop tax cheats who drain our treasury of funds needed to pay for our recovery. The bill’s target is offshore tax abuses that rob the U.S. Treasury of an estimated $100 billion each year, reward tax dodgers using offshore secrecy laws to hide money from Uncle Sam, and offload the tax burden onto the backs of middle income families who play by the rules.

It is time for Congress and this Administration to take a stand against offshore tax evasion. It is unfair; we can’t afford it; and there is a whole lot more we can do to stop it.

The bill we are introducing today is an improved version of the Stop Tax Haven Abuse Act that I introduced in February 2007, with Senator Coleman and then Senator Obama, and that Congressmen Lloyd Doggett and Rahm Emanuel introduced in the House with the support of 47 cosponsors. No action was taken last Congress on either bill, even though evidence has continued to pour in about the extensive and serious nature of offshore tax dodging.

In July 2008, for example, the Senate Permanent Subcommittee on Investigations, which I chair, held two days of hearings and released a report that broke through the wall of secrecy that normally surrounds banks located in tax haven jurisdictions. The Subcommittee presented multiple case histories exposing how two such banks, UBS AG of Switzerland and LGT Bank of Liechtenstein, used an array of secrecy tricks to help U.S. clients hide assets and dodge U.S. taxes.

The hearing showed, for example, that UBS had opened Swiss accounts for an estimated 19,000 U.S. clients with nearly $18 billion in assets, and did not report any of those accounts to the U.S. Internal Revenue Service (IRS). A UBS private banker based in Switzerland pled guilty to conspiring to helping a U.S. billionaire hide $200 million and evade $7.2 million in tax, and provided sworn deposition testimony to the Subcommittee about how UBS Swiss bankers sought and serviced clients right here in the United States. A more senior UBS official asserted his Fifth Amendment rights at the hearing rather than answer questions about UBS conduct.

The Subcommittee investigation also presented seven case histories of U.S. persons who had secretly stashed millions of dollars in accounts at LGT Bank, a private bank owned by the Liechtenstein royal family. These case histories unfolded like spy novels, with secret meetings, hidden funds, shell corporations, and complex offshore transactions spanning the globe from the United States to Liechtenstein, Switzerland, the British Virgin Islands, Australia, and Hong Kong. What the case histories had in common were officials from LGT Bank and its affiliates acting as willing partners to move a lot of money into LGT accounts, while obscuring the ownership and origin of the funds from tax authorities, creditors, and courts.

A former LGT employee, now in hiding for disclosing LGT client information, provided videotaped testimony during the hearing describing a long list of secrecy tricks and deceptive practices used by LGT to conceal client assets. They included using code names for LGT clients; requiring bankers to use outside pay phones to call clients to prevent those calls from being traced back to the bank; establishing offshore shell corporations which clients could use to route money into and out of their LGT accounts without incriminating wire transfers; and creating elaborate offshore structures involving foundations, trusts, and corporations to conceal client ownership of assets. In addition, four U.S. persons asserted their Fifth Amendment rights at the hearing and declined to answer questions about their LGT accounts.

More than 150 U.S. taxpayers are now under investigation by the IRS for having undeclared Liechtenstein accounts. The IRS is not labouring alone. Nearly a dozen countries have investigations underway into possible tax evasion involving Liechtenstein accounts. Germany, for example, is working through a list of 600 to 700 German taxpayers with LGT accounts, including a prominent businessman who allegedly used LGT accounts to evade $1.5 million in taxes.

LGT was invited to the July Subcommittee hearings to defend its actions, but chose not to appear. UBS, to its credit, appeared and announced at the hearings that it would take responsibility for its actions. It apologized for past compliance failures, promised to close all 19,000 Swiss accounts unless the U.S. accountholder agreed to disclose the account to the IRS, and announced it would no longer offer U.S. clients the option of opening Swiss accounts that are not disclosed to the IRS. A few months later, Liechtenstein signed its first tax information exchange agreement with the United States, and LGT announced its intention to change its business model and begin cooperating with foreign tax authorities. The actions taken by UBS and LGT have reverberated around the tax haven world, raising questions about whether the game is finally up and the international community is ready to take action to put an end to offshore secrecy and tax abuses. Some banks, like Credit Suisse, Switzerland’s largest bank after UBS, have decided to follow UBS’ lead and stop offering hidden Swiss bank accounts to U.S. clients. But many other tax haven banks continue their secret ways and continue to engage in practices that facilitate tax evasion.

The United States Government is continuing its efforts to combat offshore secrecy. In November 2008, the U.S. Department of Justice (DOJ) indicted a senior UBS official, then head of the UBS private bank, for conspiring to help other U.S. clients dodge U.S. taxes. Because he has refused to face the charges, he remains a fugitive from justice in Switzerland. In February, DOJ confronted UBS itself, again for conspiring to help U.S. clients dodge U.S. taxes. A criminal information was filed but then deferred, because UBS admitted to the underlying facts, paid a $780 million fine, turned over the names of at least 250 clients with Swiss accounts, and promised to no longer open Swiss accounts for U.S. clients without notifying the IRS. A U.S. criminal prosecution of a major bank is rare; a prosecution of a major bank for helping clients evade U.S. taxes may be unprecedented.

In addition, DOJ served UBS with a John Doe summons seeking the names of the other 19,000 U.S. clients with Swiss accounts hidden from the IRS. UBS said at the Subcommittee hearing in July that it was ready to cooperate, but virtually none of the information requested by the John Doe summons has been turned over, primarily because the Swiss Government has taken the position that turning over this client account information would violate Swiss secrecy laws. In the deferred prosecution agreement, UBS agreed to contest the summons in court, but if it lost, to turn over the information to the United States or risk resumption of the criminal prosecution against the bank. DOJ has asked the U.S. court that approved the summons to enforce it, and a trial to resolve the issue is now scheduled for July 2009, one year after the initial request for the information. The fact that the United States is having such a difficult time getting the client names, despite catching UBS red-handed and obtaining its admission of wrongdoing, shows how tough the offshore tax evasion problem is.

It is worth noting that Switzerland is refusing to allow UBS to provide the names of potential U.S. tax cheats, while at the same time attempting to claim it is not a tax haven and it is not a secrecy jurisdiction. It is also worth noting that top Swiss government officials have now formed a “strategic delegation” charged with defending Swiss bank secrecy against efforts by the United States, European Union, and other countries to change Swiss practices.

Right now, tax haven governments and tax haven banks often dress up their secrecy laws and banking practices with phrases like “financial privacy” and “wealth management.” Some enter into tax treaties and tax information exchange agreements with the United States, while setting up procedures that deny or delay providing information essential for effective tax enforcement. They also use their secrecy laws and practices to hide, not only the wrongdoing of the taxpayers, but also the actions of the tax haven participants who aid and abet the wrongdoing.

Secrecy breeds tax evasion. Tax evasion eats at the fabric of society, not only by starving health care, education, and other needed government services of resources, but also by undermining trust – making honest folks feel like they are being taken advantage of when they pay their fair share. We can fight back against offshore secrecy jurisdictions and offshore tax abuses if we summon the political will. Our bill offers powerful new tools to tear down the tax haven secrecy walls in favour of transparency, cooperation, and tax compliance. To tear down those secrecy walls, protect honest taxpayers, and obtain the revenues essential for critical needs, I hope my colleagues will act during this Congress to enact our legislation to shut down the $100 billion in offshore tax abuses.

The Stop Tax Haven Abuse Act is the product of years of work. My Subcommittee, through reports and hearings, has exposed numerous abusive practices involving offshore tax havens as well as home-grown abusive tax shelters. In the 109th Congress, we confronted these twin threats to our treasury by introducing S. 1565, the Tax Shelter and Tax Haven Reform Act. In the 110th Congress, we introduced an improved version of that legislation, S. 681, reflecting not only the Subcommittee’s additional investigative work but also innovative ideas to end the use of tax havens and to stop unethical tax advisers from aiding and abetting U.S. tax evasion.

Today’s bill is very similar to S. 681, but with three new additions. A new Section 103 addresses the tax dodging that occurs when a business incorporates in a tax haven, pretending to be a foreign corporation for U.S. tax purposes, while, in reality, being managed and controlled from the United States. A new Section 108 seeks to put an end to financial gimmicks being used by offshore hedge funds and others to dodge payment of U.S. taxes on U.S. stock dividends. A new Section 109 expands reporting requirements for U.S. persons who benefit from a passive foreign investment corporation. These new sections offer powerful new tools to combat offshore tax abuse.

I will now describe some of the tax abuses that need to be addressed and explain what our bill would do to stop them. First, I will look at the offshore tax problem and then at some of our home-grown abusive tax shelters.

Tax Haven Abuses

A tax haven is a foreign jurisdiction that maintains corporate, bank, and tax secrecy laws and industry practices that make it very difficult for other countries to find out whether their citizens are using the tax haven to cheat on their taxes. In effect, tax havens sell secrecy to attract clients to their shores. They peddle secrecy the way other countries advertise high quality services. That secrecy is used to cloak tax evasion and other misconduct, and it is that offshore secrecy that is targeted in our bill.

The Tax Justice Network, an international non-profit organization dedicated to fighting tax evasion, has estimated that wealthy individuals worldwide have stashed $11.5 trillion of their assets in offshore tax havens. The IMF has estimated that, in 2000 alone, $1.7 trillion in investments were sent through offshore tax havens. A series of 2007 Tax Notes articles estimated that over $1.5 trillion in hidden assets were located in just four tax havens, Guernsey, Jersey, Isle of Man, and Switzerland, characterizing those assets as beneficially owned by nonresident individuals likely avoiding tax in their home jurisdictions. At one Subcommittee hearing, a former owner of an offshore bank in the Cayman Islands testified that he believed 100 percent of his former bank clients were engaged in tax evasion. He said that almost all were from the United States and had taken elaborate measures to avoid IRS detection of their money transfers. He also expressed confidence that the offshore government that licensed his bank would vigorously defend client secrecy in order to continue attracting business.

In connection with a hearing held in August 2006, the Subcommittee released a staff report with six case studies describing how U.S. individuals use offshore tax havens to evade U.S. taxes. In one case, two brothers from Texas, Sam and Charles Wyly, established 58 offshore trusts and corporations, and operated them for more than 13 years without alerting U.S. authorities. To move funds abroad, the brothers transferred over $190 million in stock option compensation they had received from U.S. publicly traded companies to the offshore corporations. They claimed that they did not have to pay tax on this compensation, because, in exchange, the offshore corporations provided them with private annuities which would not begin to make payments to them until years later. In the meantime, the brothers directed the offshore corporations to cash in the stock options and start investing the money. The brothers failed to disclose these offshore stock transactions to the SEC despite their position as directors and major shareholders in the relevant companies.

The Subcommittee was able to trace more than $600 million in stock option proceeds that the brothers invested in various ventures they controlled, including two hedge funds, an energy company, and an offshore insurance firm. They also used the offshore funds to purchase real estate, jewelry, and artwork for themselves and their family members, claiming they could use these offshore dollars to advance their personal and business interests without having to pay any taxes on the offshore income. The Wylys were able to carry on these tax maneuvers in large part because all of their activities were shrouded in offshore secrecy.

In another of the case histories, six U.S. taxpayers relied on phantom stock trades between two offshore shell companies to generate fake stock losses which were then used to shelter billions in income. This offshore tax shelter scheme, known as the POINT Strategy, was devised by Quellos, a U.S. securities firm headquartered in Seattle; coordinated with a European financial firm known as Euram Advisers; and blessed by opinion letters issued by two prominent U.S. law firms, Cravath Swaine and Bryan Cave. The two offshore shell companies at the center of the strategy, known as Jackstones and Barneville, supposedly created a stock portfolio worth $9.6 billion. However, no cash or stock transfers ever took place. Moreover, the shell companies that conducted these phantom trades were so shrouded in offshore secrecy that no one would admit to knowing who owns them. One U.S. taxpayer used the scheme to shelter about $1.5 billion from U.S. taxes. Another sought to shelter about $145 million. Both have since agreed to settle with the IRS.

The persons examined by the Subcommittee are far from the only U.S. taxpayers engaging in these types of offshore tax abuses. Two experts, Joseph Guttentag and Professor Reuven Avi-Yonah, have estimated that U.S. individuals are using offshore tax schemes to avoid payment of $40 to $70 billion in taxes each year.

Corporations are also using tax havens to avoid payment of U.S. taxes. Data released by the Commerce Department indicates that, as of 2001, almost half of all foreign profits of U.S. corporations were in tax havens. A study released by the journal Tax Notes in September 2004 found that American companies were able to shift $149 billion of profits to 18 tax haven countries in 2002, up 68 percent from $88 billion in 1999. Professor Kimberly Clausing has estimated that corporate offshore abuses utilizing transfer pricing schemes resulted in $60 billion in lost U.S. tax revenues in 2004, and other experts have estimated similar amounts.

Corporate use of tax haven jurisdictions is also widespread. In January 2009, Senator Dorgan and I released a report by the Government Accounting Office (GAO) which shows that out of the 100 largest U.S. publicly traded corporations, 83 have subsidiaries in tax havens. Of the 100 largest federal contractors, 63 have tax haven subsidiaries. Using data from their corporate filings with the Securities and Exchange Commission, GAO listed the number of tax haven subsidiaries for each of these corporations. GAO determined, for example, that Morgan Stanley has 273 tax haven subsidiaries, while Citigroup has 427, with 90 in the Cayman Islands alone. News Corp. has 152, while Procter and Gamble has 83, Pfizer has 80, Oracle has 77, and Marathon Oil has 76. My Subcommittee is currently engaged in an effort to understand why so many of these corporations have so many tax haven affiliates. To do that we are going to have to battle secrecy laws in 50 different jurisdictions.

Here’s just one simplified example of the gimmicks being used by corporations to transfer taxable income from the United States to tax havens to escape taxation. Suppose a profitable U.S. corporation establishes a shell corporation in a tax haven. The shell corporation has no office or employees, just a mailbox address. The U.S. parent transfers a valuable patent to the shell corporation. Then, the U.S. parent and all of its subsidiaries begin to pay a hefty fee to the shell corporation for use of the patent, reducing its U.S. income through deducting the patent fees and thus shifting taxable income out of the United States to the shell corporation. The shell corporation declares a portion of the fees as profit, but pays no U.S. tax since it is a tax haven resident. The icing on the cake is that the shell corporation can then “lend” the income it has accumulated from the fees back to the U.S. parent for its use. The parent, in turn, pays “interest” on the “loans” to the shell corporation, shifting still more taxable income out of the United States to the tax haven. This example highlights just a few of the tax haven ploys being used by some U.S. corporations to escape paying their fair share of taxes here at home.

Our Subcommittee’s 2008 investigation into tax haven banks and our 2006 investigation into offshore abuses also highlight the extent to which offshore secrecy rules make it possible for taxpayers to participate in illicit activity with little fear of getting caught. Through a series of case studies, the Subcommittee has shown how U.S. taxpayers, with the help of offshore financial institutions, service providers, legal counsel, and tax professionals, set up financial accounts and entities in secrecy jurisdictions to hide assets and dodge taxes. The case studies showed how some U.S. persons created complex offshore structures to hide their ownership of offshore bank accounts. Others formed offshore entities which they claimed were independent but, in fact, exercised control over them through compliant offshore trustees, officers, directors, and corporate administrators. Because of offshore secrecy laws and practices, offshore businesses could and did take steps to protect their U.S. clients’ identities and financial information from U.S. tax and regulatory authorities, making it extremely difficult, if not impossible, for U.S. law enforcement authorities to get the information needed to enforce U.S. tax laws.

The extent of the offshore tax abuses documented by years of Subcommittee reports and hearings demonstrates the importance of obtaining new tools to combat offshore secrecy and restore the ability of U.S. tax enforcement to pursue offshore tax cheats. I’d now like to describe the key measures in the Stop Tax Havens Act providing those new enforcement tools. They include new legal presumptions to overcome offshore secrecy barriers, special measures to combat persons who impede U.S. tax enforcement, treatment of offshore corporations as domestic corporations when controlled by U.S. persons, elimination of the offshore dividend tax loophole, greater disclosure of offshore transactions, and more.

Presumptions Related to Offshore Secrecy Jurisdictions

The 2006 Subcommittee staff report provided six case histories detailing how U.S. taxpayers are using offshore tax havens to avoid payment of the taxes they owe. These case histories examined an Internet based company that helped persons obtain offshore entities and accounts; U.S. promoters that designed complex offshore structures to hide client assets, even providing clients with a how-to manual for going offshore; U.S. taxpayers who diverted business income offshore through phony loans and invoices; a one-time tax dodge that deducted phantom offshore stock losses from real U.S. stock income to shelter that income from U.S. taxes; and the 13-year offshore empire built by Sam and Charles Wyly. Each of these case histories presented the same fact pattern in which the U.S. taxpayer, through lawyers, banks, or other representatives, set up offshore trusts, corporations, or other entities which had all the trappings of independence but, in fact, were controlled by the U.S. taxpayer whose directives were implemented by compliant offshore personnel acting as the trustees, officers, directors or nominee owners of the offshore entities.

In the case of the Wylys, the brothers and their representatives communicated Wyly directives to a so-called trust protector who then relayed the directives to the offshore trustees. In the 13 years examined by the Subcommittee, the offshore trustees never once rejected a Wyly request and never once initiated an action without Wyly approval. They simply did what they were told. A U.S. taxpayer in another case history told the Subcommittee that the offshore personnel who nominally owned and controlled his offshore entities, in fact, always followed his directions, describing himself as the “puppet master” in charge of his offshore holdings.

When the Subcommittee discussed these case histories with financial administrators from the Isle of Man, the regulators explained that none of the offshore personnel were engaged in any wrongdoing, because their laws permit foreign clients to transmit detailed, daily instructions to offshore service providers on how to handle offshore assets, so long as it is the offshore trustee or corporate officer who gives the final order to buy or sell the assets. They explained that, under their law, an offshore entity is considered legally independent from the person directing its activities so long as that person follows the form of transmitting “requests” to the offshore personnel who retain the formal right to make the decisions, even though the offshore personnel always do as they are asked.

The Subcommittee case histories illustrate what the tax literature and law enforcement experience have shown for years: that the business model followed in all offshore secrecy jurisdictions is for compliant trustees, corporate administrators, and financial institutions to provide a veneer of independence while ensuring that their U.S. clients retain complete and unfettered control over “their” offshore assets. That’s the standard operating procedure offshore. Offshore service providers pretend to own or control the offshore trusts, corporations, and accounts they help establish, but what they really do is whatever their clients tell them to do. In truth, the independence of offshore entities is a legal fiction, and it is past time to pull back the curtain on the reality hiding behind the legal formalities.

The reality behind these offshore practices makes a mockery of U.S. laws that normally view trusts and corporations as independent entities. They invite game-playing and tax evasion. To combat these offshore abuses, our bill takes them head on in a number of ways.

Section 101 – Rebuttable Evidentiary Presumptions and Initial List of Offshore Secrecy Jurisdictions

The first section of our bill, Section 101, tackles this issue by creating several rebuttable evidentiary presumptions that would strip the veneer of independence from the U.S. person involved with offshore entities, transactions, and accounts, unless that U.S. person presents clear and convincing evidence to the contrary. These presumptions would apply only in civil judicial or administrative tax or securities enforcement proceedings examining transactions, entities, or accounts in offshore secrecy jurisdictions. These presumptions would put the burden of producing evidence from the offshore secrecy jurisdiction on the taxpayer who chose to do business there, and who has access to the information, rather than on the federal government which has little or no practical ability to get the information. The creation of these presumptions implements a bipartisan recommendation in the August 2006 Subcommittee staff report on tax haven abuses.

The bill would establish three evidentiary presumptions that could be used in a civil tax enforcement proceeding: (1) a presumption that a U.S. taxpayer who “formed, transferred assets to, was a beneficiary of, or received money or property” from an offshore entity, such as a trust or corporation, is in control of that entity; (2) a presumption that funds or other property received from offshore are taxable income, and that funds or other property transferred offshore have not yet been taxed; and (3) a presumption that a financial account controlled by a U.S. taxpayer in a foreign country contains enough money -- $10,000 -- to trigger an existing statutory reporting threshold and allow the IRS to assert the minimum penalty for nondisclosure of the account by the taxpayer.

In addition, the bill would establish two evidentiary presumptions applicable to civil proceedings to enforce U.S. securities laws. One would specify that if a director, officer, or major shareholder of a U.S. publicly traded corporation were associated with an offshore entity, that person would be presumed to control that offshore entity. The second provides that securities nominally owned by an offshore entity are presumed to be beneficially owned by any U.S. person who controlled the offshore entity. These presumptions are rebuttable, which means that the U.S. person who is the subject of the proceeding could provide clear and convincing evidence to show that the presumptions were factually inaccurate. To rebut the presumptions, a taxpayer could establish, for example, that an offshore corporation really was controlled by an independent third party, or that money sent from an offshore account really represented a nontaxable gift instead of taxable income. If the taxpayer wished to introduce evidence from a foreign person, such as an offshore banker, corporate officer, or trust administrator, to establish those facts, that foreign person would have to actually appear in the U.S. proceeding in a manner that would permit cross examination in order for the taxpayer to rebut the presumption. A simple affidavit from an offshore resident who refused to submit to cross examination in the United States would be insufficient.

There are several limitations on these presumptions to ensure their operation is fair and reasonable. First, the evidentiary rules in criminal cases would not be affected by this bill which would apply only to civil proceedings. Second, because the presumptions apply only in enforcement “proceedings,” they would not directly affect, for example, a person’s reporting obligations on a tax return or SEC filing. The presumptions would come into play only if the IRS or SEC were to challenge a matter in a formal proceeding. Third, the bill does not apply the presumptions to situations where either the U.S. person or the offshore entity is a publicly traded company, because in those situations, even if a transaction were abusive, IRS and SEC officials are generally able to obtain access to necessary information. Fourth, the bill recognizes that certain classes of offshore transactions, such as corporate reorganizations, may not present a potential for abuse, and accordingly authorizes Treasury and the Securities and Exchange Commission to issue regulations or guidance identifying such classes of transactions, to which the presumptions would then not apply.

An even more fundamental limitation on the presumptions is that they would apply only to transactions, accounts, or entities in offshore jurisdictions with secrecy laws or practices that unreasonably restrict the ability of the U.S. government to get needed information and which do not have effective information exchange programs with U.S. law enforcement. The bill requires the Secretary of the Treasury to identify those offshore secrecy jurisdictions, based upon the practical experience of the IRS in obtaining needed information from the relevant country.

To provide a starting point for Treasury, the bill presents an initial list of 34 offshore secrecy jurisdictions. This list is taken from actual IRS court filings in court proceedings in which the IRS sought permission to obtain information about U.S. taxpayers active in the named jurisdictions. The bill thus identifies the same jurisdictions that the IRS has already named publicly as probable locations for U.S. tax evasion. Federal courts all over the country have consistently found, when presented with the IRS list and supporting evidence, that the IRS had a reasonable basis for concluding that U.S. taxpayers with financial accounts in those countries presented a risk of tax noncompliance. In every case, the courts allowed the IRS to collect information about accounts and transactions in the listed offshore jurisdictions.

The bill also provides Treasury with the authority to add or remove jurisdictions from the initial list so that the list can change over time and reflect the actual record of experience of the United States in its dealings with specific jurisdictions around the world. The bill provides two tests for Treasury to use in determining whether a jurisdiction should be identified as an “offshore secrecy jurisdiction” triggering the evidentiary presumptions: (1) whether the jurisdiction’s secrecy laws and practices unreasonably restrict U.S. access to information, and (2) whether the jurisdiction maintains a tax information exchange process with the United States that is effective in practice.

If offshore jurisdictions make a decision to enact secrecy laws and support industry practices furthering corporate, financial, and tax secrecy, that’s their business. But when U.S. taxpayers start using those offshore secrecy laws and practices to evade U.S. taxes to the tune of $100 billion per year, that’s our business. We have a right to enforce our tax laws and to expect that other countries will not help U.S. tax cheats achieve their ends.

The aim of the presumptions created by the bill is to eliminate the unfair advantage provided by offshore secrecy laws that for too long have enabled U.S. persons to conceal their misconduct offshore and game U.S. law enforcement. These presumptions would allow U.S. law enforcement to establish what we all know from experience is normally the case in an offshore jurisdiction – that a U.S. person associated with an offshore entity controls that entity; that money and property sent to or from an offshore entity involves taxable income; and that an offshore account that wasn’t disclosed to U.S. authorities should have been. U.S. law enforcement can establish these facts presumptively, without having to pierce the secrecy veil. At the same time, U.S. persons who chose to transact their affairs through an offshore secrecy jurisdiction are given the opportunity to lift the veil of secrecy and demonstrate that the presumptions are factually wrong.

We believe these evidentiary presumptions will provide U.S. tax and securities law enforcement with powerful new tools to shut down tax haven abuses.

Section 102 - Special Measures Where U.S. Tax Enforcement is Impeded

Section 102 of the bill is another innovative approach to combating tax haven abuses. This section would build upon existing Treasury authority to apply an array of sanctions to counter specific foreign money laundering threats by extending that same authority to counter specific foreign tax administration threats.

In 2001, the Patriot Act gave Treasury the authority under 31 U.S.C. 5318A to require domestic financial institutions and agencies to take special measures with respect to foreign jurisdictions, financial institutions, or transactions found to be of “primary money laundering concern.” Once Treasury designates a foreign jurisdiction or financial institution to be of primary money laundering concern, Section 5318A allows Treasury to impose a range of requirements on U.S. financial institutions in their dealings with the designated entity -- from requiring U.S. financial institutions, for example, to provide greater information than normal about transactions involving the designated entity, to prohibiting U.S. financial institutions from opening accounts for that foreign entity.

This Patriot Act authority has been used sparingly, but to telling effect. In some instances Treasury has employed special measures against an entire country, such as Burma, to stop its financial institutions from laundering funds through the U.S. financial system. More often, Treasury has used the authority surgically, against a single problem financial institution, to stop laundered funds from entering the United States. The provision has clearly succeeded in giving Treasury a powerful tool to protect the U.S. financial system from money laundering abuses.

The bill would authorize Treasury to use that same tool to require U.S. financial institutions to take the same special measures against foreign jurisdictions or financial institutions found by Treasury to be “impeding U.S. tax enforcement.” Treasury could, for example, in consultation with the IRS, Secretary of State, and the Attorney General, require U.S. financial institutions that have correspondent accounts for a designated foreign bank to produce information on all of that foreign bank’s customers. Alternatively, Treasury could prohibit U.S. financial institutions from opening accounts for a designated foreign bank, thereby cutting off that foreign bank’s access to the U.S. financial system. These types of sanctions could be as effective in ending the worst tax haven abuses as they have been in curbing money laundering.

In addition to extending Treasury’s ability to impose special measures against foreign entities impeding U.S. tax enforcement, the bill would add one new measure to the list of possible sanctions that could be applied to foreign entities: it would allow Treasury to instruct U.S. financial institutions not to authorize or accept credit card transactions involving a designated foreign jurisdiction or financial institution. Denying tax haven banks the ability to issue credit cards for use in the United States, for example, would be a powerful new way to stop U.S. tax cheats from obtaining access to funds hidden offshore.

Section 103 – Deny Tax Benefits for Foreign Corporations Managed and Controlled in the United States

In July 2008, the Senate Finance Committee held a hearing detailing findings made by GAO when it went to the Cayman Islands to look at the infamous Ugland House, a five-story building that is the official address for over 18,800 registered companies. GAO’s review seems to indicate that the Cayman Islands has more registered businesses than residents, with a mutual fund or hedge fund for every five residents, and two registered companies for every resident.

GAO also determined that about half of the alleged Ugland House tenants — around 9,000 entities — have a billing address in the United States and were not actual occupants of the building. In fact, GAO determined that none of the nearly 19,000 companies registered at the Ugland House was an actual occupant. GAO found that the only true occupant of the building is a Cayman law firm, Maples and Calder. According to the GAO:

“Very few Ugland House registered entities have a significant physical presence in the Cayman Islands or carry out business in the Cayman Islands. According to Maples and Calder partners, the persons establishing these entities are typically referred to Maples by counsel from outside the Cayman Islands, fund managers, and investment banks. As of March 2008 the Cayman Islands Registrar reported that 18,857 entities were registered at the Ugland House address. Approximately 96 percent of these entities were classified as exempted entities under Cayman Islands law, and were thus generally prohibited from carrying out domestic business within the Cayman Islands.”

Section 103 of the bill is a new addition to the Stop Tax Haven Abuse Act designed to address the Ugland House problem. It focuses on the situation where a corporation is incorporated in a tax haven as a mere shell operation with little or no physical presence or employees in the jurisdiction. The shell entity pretends it is operating in the tax haven, even though its key personnel and decisionmakers are in the United States. The objective of this set up is to enable the owners of the shell entity to take advantage of all of the benefits provided by U.S. legal, educational, financial, and commercial systems, and at the same time avoid paying U.S. taxes.

My Subcommittee has seen numerous companies exploit this situation, declaring themselves to be foreign corporations, even though they really operate out of the United States. For example, thousands of hedge funds whose financial experts live in Connecticut, New York, Texas, or California play this game to escape taxes and avoid regulation. In an October 2008 Subcommittee hearing, three sizeable hedge funds, Angelo Gordon, Highbridge Capital, and Maverick Capital, admitted that, although all they claimed to be based in the Cayman Islands, none had an office or a single full time employee in that jurisdiction. Instead, their offices and key decisionmakers were located and did business right here in the United States.

Section 103 will put an end to such corporate fictions and offshore tax dodging. It states that if a corporation is publicly traded or has aggregate gross assets of $50 million or more, and its management and control occurs primarily in the United States, that corporation will be treated as a U.S. domestic corporation for income tax purposes.

To implement this provision, Treasury is directed to issue regulations to guide the determination of when management and control occur primarily in the United States, looking at whether “substantially all of the executive officers and senior management of the corporation who exercise day-to-day responsibility for making decisions involving strategic, financial, and operational policies of the corporation are located primarily within the United States.”

This new section relies on the same principles regarding the true location of ownership and control of a company that underlie the corporate inversion rules adopted in the American Jobs Creation Act of 2005. Those inversion rules, however, do not address the fact that some entities directly incorporate in foreign countries and manage their businesses activities from the United States. Section 103 seeks to level the playing field and ensure that entities which incorporate directly in another country are subject to a similar management and control test. Section 103 is also similar in concept to the substantial presence test in the income tax treaty between the United States and the Netherlands, which looks to the primary place of management and control to determine corporate residency.

Section 103 also provides an exception for foreign corporations with U.S. parents. This exception from the $50 million gross assets test recognizes that, within a multinational operation, strategic, financial, and operational decisions are often made from a global or regional headquarters location and then implemented by affiliated foreign corporations. Where such decisions are undertaken by a parent corporation that is actively engaged in a U.S. trade or business and is organized in the United States -- and is, therefore, already a domestic corporation -- the bill generally will not override existing U.S. taxation of international operations. At the same time, this exception makes it clear that the mere existence of a U.S. parent corporation is not sufficient to shield a foreign corporation from also being treated as a domestic corporation under this section. The section also creates an exception for private companies that once met the section’s test for treatment as a domestic corporation but, during a later tax year, fell below the $50 million gross assets test, do not expect to exceed that threshold again, and are granted a waiver by the Treasury Secretary.

Section 103 is intended to stop, in particular, the outrageous tax dodging that now goes on by too many hedge funds and investment management businesses that structure themselves to appear to be foreign entities, even though their key decisionmakers – the folks who exercise control of the company, its assets, and investment decisions – live and work right here in the United States. Too many hedge funds establish a structure of offshore entities, often including master and feeder funds, that make it appear as if the hedge fund’s assets and investment decisions are offshore, when, in fact, the funds are being managed and controlled by investment experts located in the United States. It is unacceptable that such companies utilize U.S. offices, personnel, laws, and markets to make their money, but then stiff Uncle Sam and offload their tax burden onto competitors who play by the rules.

To put an end to this charade, Section 103 specifically directs Treasury regulations to specify that, when corporate assets are being managed primarily on behalf of investors and the investment decisions are being made in the United States, the management and control of that corporation shall be treated as occurring primarily in the United States, and that corporation shall be subject to U.S. taxes in the same manner as any other U.S. corporation.

If enacted into law, Section 103, the Ugland House provision, would put an end to the unfair situation where some U.S.-based companies pay their fair share of taxes, while others who set up a shell corporation in a tax haven are able to defer or escape taxation, despite the fact that their foreign status is nothing more than a paper fiction.

Section 104 - Extension of Time for Offshore Audits

Section 104 of the bill addresses a key problem faced by the IRS in cases involving offshore jurisdictions – completing audits in a timely fashion when the evidence needed is located in a jurisdiction with secrecy laws. Currently, in the absence of fraud or some other exception, the IRS has three years from the date a tax return is filed to complete an audit and assess any additional tax. Because offshore secrecy laws slow down, and sometimes impede, efforts by the United States to obtain offshore financial and beneficial ownership information, the bill gives the IRS an extra three years to complete an audit and assess a tax on transactions involving an offshore secrecy jurisdiction. Of course, in the event that a case turns out to involve actual fraud, this provision of the bill is not intended to limit the rule giving the IRS unlimited time to assess tax in such cases.

Section 105 - Increased Disclosure of Offshore Accounts and Entities

Offshore tax abuses thrive in secrecy. Section 105 attempts to pierce that secrecy by creating two new disclosure mechanisms requiring third parties to report on offshore transactions undertaken by U.S. persons.

The first disclosure mechanism focuses on U.S. financial institutions that open a U.S. account in the name of an offshore entity, such as an offshore trust or corporation, and learn from an anti-money laundering due diligence review, that a U.S. person is the beneficial owner behind that offshore entity. In the Wyly case history examined by the Subcommittee, for example, three major U.S. financial institutions opened dozens of accounts for offshore trusts and corporations which they knew were associated with the Wyly family.

Under current anti-money laundering law, all U.S. financial institutions are supposed to know who is behind an account opened in the name of, for example, an offshore shell corporation or trust. They are supposed to obtain this information to safeguard the U.S. financial system against misuse by terrorists, money launderers, and other criminals.

Under current tax law, a bank or securities broker that opens an account for a U.S. person is also required to give the IRS a 1099 form reporting any capital gains or other reportable income earned on the account. However, the bank or securities broker need not file a 1099 form if the account is owned by a foreign entity not subject to U.S. tax law. Problems arise when an account is opened in the name of an offshore entity that is nominally not subject to tax, but which the bank or broker knows, from its anti-money laundering review, is owned or controlled by a U.S. person who is subject to tax. The U.S. person should be filing a tax return with the IRS reporting the income of the “controlled foreign corporation.” However, since he or she knows it is difficult for the IRS to connect an offshore accountholder to a particular taxpayer, he or she may feel safe in not reporting that income. That complacency might change, however, if the U.S. person knew that the bank or broker who opened the account and learned of the connection had a legal obligation to report any account income to the IRS.

Under current law, the way the regulations are written and typically interpreted, the bank or broker can treat an account opened in the name of a foreign corporation as an account that is held by an independent entity that is separate from the U.S. person, even if it knows that the foreign corporation is merely holding title to the account for the U.S. person, who exercises complete authority over the corporation and benefits from any income earned on the account. Many banks and brokers contend that the current regulations impose no duty on them to file a 1099 or other form disclosing that type of account to the IRS.

The bill would strengthen current law by expressly requiring a bank or broker that knows, as a result of its anti-money laundering due diligence or otherwise, that a U.S. person is the beneficial owner of a foreign entity that opened an account, to disclose that account to the IRS by filing a 1099 or equivalent form reporting the account income. This reporting obligation would not require banks or brokers to gather any new information – financial institutions are already required to perform anti-money laundering due diligence for accounts opened by offshore shell entities. The bill would instead require U.S. financial institutions to act on what they already know by filing the relevant form with the IRS.

This section would require such reports to the IRS from two sets of financial institutions. The first set are financial institutions which are located and do business in the United States, supply 1099 and other forms to the IRS, and open U.S. accounts for foreign entities which the financial institution knows are beneficially owned by U.S. persons. The second set are foreign financial institutions which are located and do business outside of the United States, but are voluntary participants in the Qualified Intermediary Program, and have agreed to provide information to the IRS about certain accounts. Under this section, if a foreign financial institution has an account under the QI Program, and the accountholder is a non-U.S. entity that is controlled or beneficially owned by a U.S. person, then that foreign financial institution would have to report to the IRS any U.S. securities or other reportable assets or income in that account.

The second disclosure mechanism created by Section 105 targets U.S. financial institutions that open foreign bank accounts or set up offshore corporations, trusts, or other entities for their U.S. clients. Our investigations have shown that it is common for private bankers and brokers in the United States to provide these services to their wealthy clients, so that the clients do not even need to leave home to set up an offshore structure. The offshore entities can then open both offshore and U.S. accounts and supposedly be treated as foreign account holders for tax purposes.

A Subcommittee investigation learned, for example, that Citibank Private Bank routinely offered to its clients private banking services which included establishing one or more offshore shell corporations – which it called Private Investment Corporations or PICs – in jurisdictions like the Cayman Islands. The paperwork to form the PIC was typically completed by a Citibank affiliate located in the jurisdiction, such as Cititrust, which is a Cayman trust company. Cititrust could then help the PIC open offshore accounts, while Citibank could help the PIC open U.S. accounts.

Section 105 would require any U.S. financial institution that directly or indirectly opens a foreign account or establishes a foreign corporation or other entity for a U.S. customer to report that action to the IRS. The bill authorizes the regulators of banks and securities firms, as well as the IRS, to enforce this filing requirement. Existing tax law already requires U.S. taxpayers that take such actions to report them to the IRS, but many fail to do so, secure in the knowledge that offshore secrecy laws limit the ability of the IRS to find out about the establishment of new offshore accounts and entities. That’s why our bill turns to a third party – the financial institution – to disclose the information. Placing this third party reporting requirement on the private banks and brokers will make it more difficult for U.S. clients to hide their offshore transactions.

Section 106 - Closing Foreign Trust Loopholes

Section 106 of our bill strengthens the ability of the IRS to stop offshore trust abuses by making narrow but important changes to the Revenue Code provisions dealing with taxation of foreign trusts. The rules on foreign trust taxation have been significantly strengthened over the past 30 years to the point where they now appear adequate to prevent or punish many of the more serious abuses. However, the Subcommittee’s 2006 investigation found a few loopholes that are still being exploited by tax cheats and that need to be shut down.

The bill would make several changes to close these loopholes. First, our investigation showed that U.S. taxpayers exercising control over a supposedly independent foreign trust commonly used the services of a liaison, called a trust “protector” or “enforcer,” to convey their directives to the supposedly independent offshore trustees. A trust protector is typically authorized to replace a foreign trustee at will and to advise the trustees on a wide range of trust matters, including the handling of trust assets and the naming of trust beneficiaries. In cases examined by the Subcommittee, the trust protector was often a friend, business associate, or employee of the U.S. person exercising control over the foreign trust. Section 105 provides that, for tax purposes, any powers held by a trust protector shall be attributed to the trust grantor.

A second problem addressed by our bill involves U.S. taxpayers who establish foreign trusts for the benefit of their families in an effort to escape U.S. tax on the accumulation of trust income. Foreign trusts can accumulate income tax free for many years. Previous amendments to the foreign trust rules have addressed the taxation problem by basically disregarding such trusts and taxing the trust income to the grantors as it is earned. However, as currently written, this taxation rule applies only to years in which the foreign trust has a named “U.S. beneficiary.” In response, to avoid the reach of the rule, some taxpayers have begun structuring their foreign trusts so that they operate with no named U.S. beneficiaries.

For example, the Subcommittee’s investigation into the Wyly trusts discovered that the foreign trust agreements had only two named beneficiaries, both of which were foreign charities, but also gave the offshore trustees “discretion” to name beneficiaries in the future. The offshore trustees had been informed in a letter of wishes from the Wyly brothers that the trust assets were to go to their children after death. The trustees also knew that the trust protector selected by the Wylys had the power to replace them if they did not comply with the Wylys’ instructions. In addition, during the life of the Wyly brothers, and in accordance with instructions supplied by the trust protector, the offshore trustees authorized millions of dollars in trust income to be invested in Wyly business ventures and spent on real estate, jewelry, artwork, and other goods and services used by the Wylys and their families. The Wylys plainly thought they had found a legal loophole that would let them enjoy and direct the foreign trust assets without any obligation to pay taxes on the money they used.

To stop such foreign trust abuses, the bill would make it impossible to pretend that this type of foreign trust has no U.S. beneficiaries. The bill would shut down the loophole by providing that: (1) any U.S. person actually benefiting from a foreign trust is treated as a trust beneficiary, even if they are not named in the trust instrument; (2) future or contingent U.S. beneficiaries are treated the same as current beneficiaries; and (3) loans of foreign trust assets or property such as real estate, jewelry and artwork (in addition to loans of cash or securities already covered by current law) are treated as trust distributions for tax purposes.

Section 107- Legal Opinion Protection from Penalties

Section 107 of the bill takes aim at legal opinions that are used to try to immunize taxpayers against penalties for tax shelter transactions with offshore elements. The Subcommittee investigations have found that tax practitioners sometimes tell potential clients that they can invest in an offshore tax scheme without fear of penalty, because they will be given a legal opinion that will shield the taxpayer from any imposition of the 20 percent accuracy related penalties in the tax code. Current law does, in fact, allow taxpayers to escape these penalties if they can produce a legal opinion letter stating that the tax arrangement in question is “more likely than not” to survive challenge by the IRS. The problem with such opinions where part of the transaction occurs in an offshore secrecy jurisdiction is that critical assumptions of the opinions are often based on offshore events, transactions and facts that are hidden and cannot be easily ascertained by the IRS. Legal opinions based on such assumptions should be understood by any reasonable person to be inherently unreliable.

The bill therefore provides that, for any transaction involving an offshore secrecy jurisdiction, the taxpayer would need to have some other basis, independent of the legal opinion, to show that there was reasonable cause to claim the tax benefit. The “more likely than not” opinion would no longer be sufficient in and of itself to shield a taxpayer from all penalties if an offshore secrecy jurisdiction is involved. This provision, which is based upon a suggestion made by IRS Commissioner Mark Everson at our August 2006 hearing, is intended to force taxpayers to think twice about entering into an offshore scheme and to stop thinking that an opinion by a lawyer is all they need to escape any penalty for nonpayment of taxes owed. By making this change, we would also provide an incentive for taxpayers to understand and document the complete facts of the offshore aspects of a transaction before claiming favorable tax treatment.

To ensure that this section does not impede legitimate business arrangements in offshore secrecy jurisdictions, the bill authorizes the Treasury Secretary to issue regulations exempting two types of legal opinions from the application of this section. First, the Treasury Secretary could exempt all legal opinions that have a confidence level substantially above the more-likely-than-not level, such as opinions which express confidence that a proposed tax arrangement “should” withstand an IRS challenge. “More-likely-than-not” opinion letters are normally viewed as expressing confidence that a tax arrangement has at least a 50 percent change of surviving IRS review, while a “should” opinion is normally viewed as expressing a confidence level of 70 to 75 percent. This first exemption is intended to ensure that legal opinions on arrangements that are highly likely to survive IRS review would continue to shield taxpayers from the 20 percent penalty.

Second, the Treasury Secretary could exempt legal opinions addressing classes of transactions, such as corporate reorganizations, that do not present the potential for abuse. These exemptions would ensure that taxpayers who obtain legal opinions for these classes of transactions would also be protected from tax code penalties.

Finally, in drafting such regulations, it is intended that the Secretary of the Treasury take into account the function of the “more likely than not” standard in the context of corporations that are independently audited and subject to accounting rules requiring disclosure of uncertain tax positions. It is intended that the regulations issued under this bill provision be coordinated with the objectives of those accounting rules to ensure consistent guidance for detecting and stopping abusive transactions without disrupting the financial accounting of legitimate transactions.

(Continued: Part II)