This issue includes an extensive discussion of the rarely discussed problem of transferring intangible assets to a foreign corporation in an attempt to create foreign source (tax deferred) income. We also respond to an assortment of questions from subscribers.

• Beware of I.R.C. Section 367(a)
• IRS Targets 132 Offshore Promoters
• U.S. Proposes Alternative Tax Treatment for Foreign Sales Corporations
• Offshore Banks & Panama Foundations
• Direct Ownership of Stock in a Foreign Corporation
• Questions About Offshore Banking & Investing
• Seminars & Conferences
• About the Authors

Beware of I.R.C. Section 367(a)

The U.S. tax system could be described as a three dimensional maze with instructions in a language only a few really understand. If you don't understand the language, you have no hope of getting through the maze. If you carefully study the sections of the Internal Revenue Code (IRC) that deal with controlled foreign corporations (IRC 951-964), you may easily come to the conclusion that a foreign corporation owned or controlled by U.S. persons can engage in a trade or business outside the U.S. and not be subject to U.S. tax until the profits are repatriated as compensation or as dividends. However, a foreign company not engaged in a trade or business may be treated as a foreign personal holding company (FPHC) or a passive foreign investment company (PFIC) - both of which are subject to current taxes on corporate income.

But if the foreign company can be organized so that it buys from unrelated parties and sells to unrelated parties and if the primary business functions are conducted outside the U.S., although the corporation may be a controlled foreign corporation (CFC), the income is not classified as Subpart F income and no current income taxation results to the shareholders, unless distributions are made. I concluded that this avoided any tax issues until Richard Duke advised me about IRC Section 367(a). This section is described as "Transfers to Foreign Corporations in Reorganizations". While I was aware of this section, I had thought it only affected corporations that were funded with appreciated assets in exchange for corporate stock. My handy Commerce Clearing House tax service introduces this section with the comment,

The rule governing transfers of property outside the United States prevents U.S. persons from deferring taxes on income by using a tax-free exchange to shift appreciated assets overseas to a foreign subsidiary.

Offhand, that doesn't pose a serious problem if the foreign corporation can be funded with high basis (low gain) assets or with cash. If you fund the foreign corporation with appreciated assets, you should be prepared to pay a capital gains tax on those assets.

However, Richard told me that section 367(d) also imposes a "deemed royalty" on the transfer of intangible assets to a foreign corporation.

So I reread Internal Revenue Code section 367(d)(1) which states ...

A transfer by a U.S. person of any intangible property to a foreign corporation in a transfer to a corporation controlled by the transferor (or in a Code Section 361 tax-free reorganization transaction) instead will be treated ... as having sold such (intangible) property in exchange for payments which are contingent upon the productivity, use or disposition of such property.

For this purpose, "intangible property" as defined in IRC Section 936(h)(3)(B) means any ...

The main problem for smaller foreign companies controlled by U.S. persons is that the extremely broad definition of an intangible asset in code section 936(h)(3)(B) can be used by the IRS to assert that virtually any foreign corporation controlled by U.S. persons has some kind of intangible asset that should generate some "deemed royalties" that would be taxable to the U.S. shareholders.

As a practical matter, it's not likely the subject will come up in an audit of a small company unless the income of the foreign corporation is clearly derived from an intangible asset such as a patent or copyright. But, any U.S. person who wants to establish a foreign based company to generate revenue from sales of products or the services of non-owners should at least be prepared for this kind of challenge by making an effort to determine the "arms length value" of any intangible assets that will be used by the foreign company. And, the transfer of an intangible asset to a foreign corporation in exchange for stock ownership in the corporation should be avoided if there is any way to fund the foreign corporation with cash or high basis assets.

It seems to me that anyone who creates a web site to be operated through a foreign corporation and from a foreign web server (computer) physically based in a foreign country needs to be sure that the content of that web site does not include (or sell) any pre-existing copyrighted information, where the information is the property of the owners of the foreign corporation. If the content of the foreign based web site is obtained from non-owners who are compensated for the use of such content by the foreign corporation, then the 367(d) problem should not apply.

The more conservative approach is to value each intangible asset that must be used by the foreign corporation, establish an "arm's length value" and then pay a royalty from the foreign corporation to the U.S. owners of the intangible assets. If you hire a qualified professional appraiser to value those intangibles, then the IRS will be required to show that their values are substantially more reasonable than yours. Or ... if you choose not to do that, you should at least be prepared for the possibility of a challenge by the IRS at some future date.

If you find these insane tax rules and regulations to be more than you can cope with, one alternative is to expatriate to a country with a newer and less complex tax structure, or at least to a country that only taxes residents on the income they earn as residents. In varying degrees, nearly every country in the world has a simpler (less comprehensive) tax system than the U.S. (Although one of our subscribers tells me that the French tax system is worse than the U.S.)

A second alternative is to play the "audit lottery" and take your chances on being audited. Even if you are audited, many of the IRS auditors are no better informed on these complex international tax issues than you or your local tax advisors. The really high powered international tax experts with the IRS are generally kept busy with the large multi-national corporations and don't get involved with the smaller foreign companies. Because of the high stakes involved, the IRS has a hard time keeping the really top international tax experts. The large multi-national corporations and the large accounting or law firms are willing to pay far more for the services of such experts. So the "good news" is that most of the best qualified experts in this area of law are on "our side". But bear in mind that if you are audited by an agent who knows these rules, justification for your position must be presented to avoid serious penalties for understating your taxes. Therefore, some advance preparation is still justified.

Being ignorant of these rules may keep you out of jail, but it won't protect you from potential tax assessments, penalties and interest if you are audited by the international division of the IRS.

 The IRS (along with the FBI, CIA and Secret Service) has been watching offshore promoters, beginning some time after January, 1996. In January, 1996, Congress required the IRS to begin training the FBI, CIA and Secret Service on "offshore" matters--trust, corporations, banking, etc. The IRS (and each time I say IRS, this includes the FBI, CIA and the Secret Service) is now focused primarily on 132 offshore promoters. These promoters have many U.S. clients who have evaded the tax laws and are guilty of tax fraud and evasion. And, don't tell me that most of the clients of these promoters are innocent. I know better. I've been in this business too long to believe this.

From the focus on these 132 promoters, this has taken the IRS into the professional network in which these promoters work. The network consists of those who are connected with the promoters: persons who establish structures (trusts, corporations, etc.), establish bank accounts with bearer shares and the banks and other investment managers. With 132 targeted promoters, the network is very, very large. And the amount of taxes to be collected is mind boggling. The IRS will indict the promoters, subpoena the records of the promoters (in other words, their client lists) and then collect huge sums of taxes, penalties and interest from these clients. So, the IRS is aware of "bad" banks and investment managers, the bad professionals, etc. who are in the network of these 132 promoters. No tax returns are being filed by these clients.

The IRS is not interested in U.S. persons who establish a foreign trust or structure and file the required tax returns. The strategy then is to set up a trust or structure that avoids the U. S. litigation system and permits investing in the global arena of investments (otherwise closed to Americans). The focus is on using competent professionals. If you required serious surgery, you would focus on finding a serious and legitimate professional, not some "cute" practitioner who tells everyone that he has found the holy grail of surgery. Serious surgery requires a serious surgeon and those working with him such as the anesthesiologist. The same is true with respect to international planning: the focus is on the professionals: the attorney, the trustee, the investment manager or managers and the trust protector.

The IRS attack on shady promoters and the breakdown of banking privacy (secrecy) offshore has no impact on those who desire to go offshore for legitimate reasons, such as asset protection or access to global investments. The reason that bank privacy is falling apart is due to the lack of tax returns being filed by so many Americans and Europeans. This has nothing to do with Americans who aren't trying to launder money or evade taxes. Banks generally will not divulge your name to anyone so long as you are not a target of the IRS or appear to be engaged in some unlawful activity. The fall of so-called bank secrecy is due to the targeting of money laundering and to a greater extent, tax evasion.

The fact that you dislike and can point out many improper actions of the government is irrelevant if the government catches you in an illegal offshore scheme. Unless you are seriously wealthy, the government is more powerful than you, irrespective of whether their actions are proper or improper. So, comply with the law and avail yourself of the services of serious professionals. As professionals, we agree that the government is often guilty of questionable actions, but we must comply with black and white laws (the gray areas are the areas of planning). If a U. S. person, directly or indirectly, transfers assets out of this country, very black and white laws require the transfer(s) to be reported. No one can legally avoid these very black and white laws.

Richard

U.S. Proposes Alternative Tax Treatment for Foreign Sales Corporations

The World Trade Organization (WTO) has concluded that the foreign sales corporation (FSC) tax "incentive" is an illegal trade subsidy in accord with the agreement of the member nations -- which includes the U.S. They have ruled that the U.S. must end its tax subsidy by October of this year.

Their initiation of this action after many years of ignoring the FSC tax rules was precipitated by complaints from the Economic Union (EU). In an article by Elliott Brown in Offshore Finance USA, (July/August, 2000) the U.S. has responded with a proposal to replace the FSC tax subsidy with "special tax rates on income from foreign sales, rentals, and leases by certain manufacturers, (who are) subject to U.S. taxes and meet certain other specific requirements." According to Brown, "The response of EU officials to the proposal was predictably cool."

It seems to us that the U.S. could easily compensate the current foreign sales corporations for the loss of the FSC tax break by reducing the top tax rates on all U.S. corporations by about 5 percentage points. The FSCs would not be any worse off and all domestic companies would get a tax break.

But then the EU and WTO would probably counter that we are engaged in "harmful tax competition". The phrase itself is an oxymoron -- an inherent contradiction that seems to be lost on the moron advocates of the high tax welfare states. Competition is inherently beneficial to the customer/consumer and to the economy of a country even though it may not be beneficial for specific producers of goods and services. Competition is only "harmful" to those who can't or won't compete with those who offer better services and/or lower prices. Now the bureaucrat minions of the high tax countries are whining that competition from low tax countries is "harmful". Harmful to whom? Certainly not to their citizens or residents. The "harm" is only to the self-serving politicians and the bureaucrats who want to retain their cushy and overpriced jobs in countries where the residents are regarded as little more than fodder for the fat and lazy politicians and bureaucrats.

Vern Jacobs

Normally, I don't have or take the time to engage in extended correspondence with people who send me questions by email, but this one sort of caught my "hot button" and prompted me to reply. I'm reprinting the exchange because it's a variation of a question that both Richard and I have received many times.

QUESTION: What do you think of Panamanian foundations? (Name withheld)

REPLY: Richard Duke has discussed that in previous issues of Offshore Tax Strategies. Basically, if a U.S. person establishes a foreign foundation, the foundation must be classified, for tax purposes as a trust, a corporation, a partnership, or a disregarded entity. This classification is determined under U.S. regulations, not on its legal status under the foreign law. The only exception to these classifications is a true non-profit charitable entity.

RESPONSE: It is interesting that you write that because these foundations are being marketed for thousands or tens of thousands of dollars. The airline sky mall catalog" has ads for forming offshore banks and " rabbi trusts" by a man in Vancouver for about $40,000 and someone in Panama who says they have 14,000 clients who do these foundations which they claim are 100% legal . Both them and others claim you do not understand the law of the USA. (Emphasis added).

REPLY: Of course they say we don't understand the law. Our advice is costing them serious money because potential prospects are not buying their package deal after they talk to us. However, these promoters don't live in the U.S. and are not subject to the U.S. laws so they can say whatever they want.

RESPONSE: Are there correct legal structures that you can set up that will also do what they say theirs do and if so what does it cost? If what they do doesn't work and the IRS is after their clients, why is it not public? If they are U.S. citizens, they are still subject to U.S. law.

REPLY: Many of the more aggressive promoters do not reside in the U.S. These illegal schemes have proliferated due to only a few attacks by the internal revenue service against promoters, thus far. However, the most prominent U.S. promoters are on an IRS hit list as discussed above by Richard. The IRS may not be able to get the client lists of the promoters who live offshore unless it's an "accident" -- like the Mathewson case involving a Cayman Islands banker. Briefly, Mathewson was a U.S. person who had established a bank in the Cayman Islands that apparently catered to tax evaders and money launderers. He was nabbed (while in the U.S.) on money laundering charges and he agreed to give the U.S. Treasury Department a list of his 1,500 bank customers (mostly U.S. persons) in exchange for a more lenient sentence. Thus, the IRS accidentally got his records and are auditing his customers. The IRS will probably have more difficulty finding a way to get the client records of former U.S. citizens who are now promoting illegal tax schemes from outside the U.S. but it won't be for any lack of effort.

Most U.S. international tax professionals who really know the international tax law don't work in the consumer market. They work for huge international corporations. There are only a few international tax professionals in the consumer and small business market who know that these schemes are not compliant with the tax law. However, we have little financial incentive to spend huge amounts to advertise in the airline magazines (or offshore publications) in order to convince people they can't legally do something they want to do. People who are selling a promise of huge tax savings for a big fee can always afford to spend more to promote their packages than the professionals who are asked whether these deals are legal. It's a little bit like the hucksters who are selling a phony cure for cancer versus the medical professionals who can only offer sympathy.

I do not know of any structures that will legally do what they say theirs will do, or they would be using them and so would we. There are legal ways to arrange an offshore trust, an offshore corporation or to own an offshore bank. We have discussed many of them in previous issues of this newsletter. There is nothing inherently wrong with a Panama foundation if it's used in a manner consistent with the U.S. tax laws. Owning an offshore bank isn't illegal, but using it to avoid U.S. taxes is illegal unless it meets the IRS requirements for a bone fide bank that can conduct business in the country where the bank is chartered.

Some persons enter into improper structures hoping they will not be audited or caught by the IRS or other governmental agencies. Others take the position that most civilized countries do not consider tax evasion to be a crime. Discussions of other countries' laws or philosophies may be interesting, but it is useless if the IRS has brought a case of tax fraud and/or tax evasion against you. Our primary objection is toward promoters who prey upon persons who are desperately looking for some magic elixir to reduce their U.S. taxes. We object to these promoters because they are causing their clients to commit potential criminal and/or civil fraud or, at the least, become subject to serious and substantial tax penalties that are associated with offshore transactions and structuring.

QUESTION: If a United States citizen owns shares in a privately held Costa Rican or Panamanian Corporation, is there any IRS tax reporting requirement? Since it is a corporation, the shareholder should have no tax consequences. Do you agree? [ Scott ]

REPLY: If a foreign corporation is not controlled by U.S. shareholders, then direct ownership would not require any reporting unless the corporation were a passive foreign investment company. Basically, the tax consequences would be the same as ownership of shares in a U.S. corporation. If a U.S. person owns more than 5% of the foreign corporation and transfers any appreciated assets in exchange for stock in that corporation, they may be required to file Form 926. These are general explanations and are not intended to be comprehensive. For a detailed answer to your question, you would need to study the instructions for Form 5471 and Form 926. Also, the answers might be different for those who are officers or directors of a foreign corporation and if you receive any dividends or compensation from the corporation or capital gains from selling any stock of the corporation. Further details on the tax treatment of foreign corporations owned by U.S. persons are available in our 45 page special report, Controlled Foreign Corporation Tax Guide -- which is available on our paid subscribers' web site or in printed form for $57.00. The printed copy of the report includes a copy of the related tax forms and instructions.

Vern Jacobs

"I have recently heard several things about offshore banking and investing and would like to know if you can answer any of my questions."

QUESTION 1: I was told that as Americans we do not have direct access to the world's top performing mutual funds. The reason I was given is that these funds are just not willing to jump through the SEC's hoops, which would increase the cost to the investor. If they are not under the SEC's control then are they regulated in any way?

Seminars & Conferences

J. Richard Duke:

. Argon Limited Seminar, Barbados, August 8-9, 2000.

· Jyske Bank's Investment Seminars 2000, Zurich, Switzerland, September 27-October 1, 2000.

· Banque SCS Alliance Conference, Higher Net-worth Individuals, November 11-12, 2000, Nassau, Bahamas.

· Prime Global Asset Protection Summit, November 13, 2000, Boca Raton, Florida and New York, New York, November 15, 2000.

Vernon K. Jacobs

· Prime Global Asset Protection Summit, November 13, 2000, Boca Raton, Florida and New York, New York, November 15, 2000.

Yours truly,

Vern Jacobs and Richard Duke

© Copyright, 2000. All rights reserved. Research Press, Inc. (913) 362-9667

Vernon K. Jacobs is a CPA who provides tax preparation and consulting services for U.S. persons with foreign entities or non U.S. persons with U.S. tax obligations. Phone/fax (913) 362-9667. His web site is http://www.rpifs.com/vkjcpa/

J. Richard Duke is an attorney practicing mainly in the area of international tax law. He is also a professor of international tax law. His email address is richard@assetlaw.com. His phone is (205) 823-3900 and his

fax is (205) 823-2630. His web site address is http://www.assetlaw.com