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JANUARY 12, 1981 


ROOM 5030 

»UG 1 « 1986 

Tax Havens and 
Their Use By 
United States Taxpayers 
-An Overview 

A report to the 

Commissioner of Internal Revenue 

Assistant Attorney General (Tax Division) 

and the 
Assistant Secretary of the Treasury (Tax Policy) 

Submitted by: 
Richard A. Gordon 
Special Counsel for 
International Taxation 

January 12, 1981 

Publication 1150 (4-81) 

Washington. DC 20224 

January 13, 1980 

Mr. William E. Williams 
Acting Commissioner 
Internal Revenue Service 
Room 3034, 
Washington, D.C. 20224 

Mr. M. Carr Ferguson 
Assistant Attorney General 
Department of Justice 
Room 4143 
Washington, D.C. 20530 

Mr. Donald C. Lubick 

Assistant Secretary (Tax Policy) 

Main Treasury 

Room 3112 

Washington, D.C. 20220 

Dear Sirs: 

You have asked that I review and advise you regarding 

the use of tax havens by United States persons and present 

options to be considered for dealing with problems created 
by that use. 

In response to your request, I am pleased to submit the 
enclosed report which is based on a study and analysis of 
tax haven transactions, United States internal tax laws 
applicable thereto. United States income tax treaties, and 
the attempts of the tax administrators to deal with these 

Richard A. Gordon 
Special Counsel for 

International Taxation 


Department of the Treasury Internal Revenue Service 








Submitted by: 

Richard A. Gordon January 12, 1981 

Special Counsel for 

International Taxation 



Summary of Contents 

Introduction 1 

I. Overview of Findings and Recommendations 3 

II. Tax Havens - In General 14 

III. Statistical Data on Patterns of Use of Tax Havens 32 

IV. united States Taxation of International Transactions 
and the Anti-Avoidance Provisions - An Overview 42 

V. Patterns of Use of Tax Havens.. 59 

VI. Use of Tax Havens to Facilitate Evasion of U.S. Taxes. Ill 

VII. Options for Changes in Substantive Rules 128 

VIII. Treaties with Tax Havens 147 

IX. Information Gathering 180 

X. Administration 217 



Table of Contents 

Introduction. 1 

I. Overview of Findings and Options 3 

II. Tax Havens - In General 14 

A. Characteristics 14 

1 . low Tax 15 

2. Secrecy 15 

3. Relative Importance of Banking 17 

4. Availability of Modern Communications 19 

5. Lack of Currency Controls 19 

6. Self Promotion - Tax Aggression 19 

7. Special Situations - Tax Treaties 20 

B. Background 20 

1. Historical Background 20 

2. Modern Background 21 

3. Present Situation 22 

C. Reasons for Use of Tax Havens 22 

D. Foreign Measures Against Tax Havens 24 

1. Unilateral Approaches 24 

a. Tax Legislation 24 

(i) Provisions similar to subpart F 24 

(ii) Transfer pricing 26 

(iii) Transfers of property abroad 26 

(iv) Provisions relating to deductions 27 

(v) Expatriation 27 

(vi) Special provisions 28 

b. Non-Tax Measures 29 

c. Effectiveness 29 

2. Multilateral Approaches 30 

III. Statistical Data on Patterns of Use of Tax Havens 32 

A. Levels of Use by U.S. Persons Through Tax Haven 
Companies 33 

B. Levels of Use by Foreign Persons 34 

C. Levels of Use by Banks 35 

D. Levels of Use by Tax Evaders 36 

IV. United States Taxation of International Transactions 

and the Anti-Avoidance Provisions - An Overview 42 

A. Policy Objectives 42 

B. Basic Pattern 46 

1. General Rules 46 

2. United States Taxation of Property Held by 

a Foreign Trustee 49 

3. Taxation of Corporations and Their Share- 
holders 50 

- 11 - 

C. Anti-Abuse Measures 51 

1. Accumulated earnings tax 51 

2. Transfer pricing 52 

3. Sections 367 and 1491 52 

4. Personal holding companies 54 

5. Foreign personal holding companies 54 

6. Section 269 55 

7. Foreign investment companies 55 

8. Controlled foreign corporations 56 

9. Dispositions of stock of controlled foreign 
corporations 58 

10. Dispositions of patents to foreign cor- 
porations 58 

V. Patterns of Use of Tax Havens 59 

A. Tax Avoidance v. Tax Evasion 59 

B. Transfers to a Tax Haven Entity 61 

1. Transfer Pricing 62 

2. Transfers of Assets Other than by Transfer 
Pricing 63 

a. Transfers to Tax Haven Corporations — Scope 

of §3 67 63 

b. Transfers Not Reorganizations 66 

C. Transactions Through a Controlled Entity 68 

1. Tax Planning — Minimizing Tax and Maximizing 

the Foreign Tax Credit 69 

2. Holding Companies 72 

3. Sales Activities 74 

4. Services and Construction 79 

5. Transportation 84 

6. Insurance 86 

7. Banking 90 

D. Transactions Through an Entity which is not 
Controlled 91 

E. Principal Patterns of Abusive Tax Haven Use 
Predominently by Promoters and by Individual 
Taxpayers 94 

1. Background 95 

2. Patterns of Use 95 

a. Investment Companies 95 

b. Trading Company 96 

c. Holding Companies 97 

d. Shelters 97 

( i ) Commodities 98 

(ii) Movies 100 

(iii) Foreign situs property 101 

e. Foreign Trusts 101 

f. Double Trusts 104 

g. Generating Deductions 105 

h. Expatriation 106 

- Ill - 

F. Use by Foreign Persons Doing Business in or 

Residing in the U.S 107 

1. Banks 107 

2. Insurance 108 

3. Entertainment Industry 109 

4. Trading and Sales Companies 109 

5. Aliens Resident in the U.S 109 

VI. Use of Tax Havens to Facilitate Evasion of U.S. Taxes.... Ill 

A. Prior Efforts to Investigate Offshore Cases 112 

B. Narcotics Related Cases 116 

C. Patterns of Use of Tax Havens for Evasion 118 

1. Double Trusts 118 

2. Secret Bank Accounts 119 

3. U.S. Taxpayers Using a Foreign Corporation - 
Substance over Form 120 

4. Shelters - Commodity Transactions 121 

5. Income Generated Overseas Deposited in a 
Foreign Bank Account 122 

6. Slush Funds 123 

7. Use of a Foreign Entity to Step-up the Basis 

of U.S. Property 123 

8. Repatriation of Funds 123 

D. Informants and Undercover Operations 124 

E. Analysis 127 

VII. Options for Change in Substantive Rules 128 

A. Options Which Can be Accomplished Administratively. . 128 

1. Burden of Proof 128 

2. Section 482 Regulations 129 

3. Subpart F Regulations 132 

4. Application of §269 and the Accumulated Earnings 
Tax 133 

5. Review Rev. Rul. 54-140 133 

6. Revocation of Acquiescence in CCA, Inc. 134 

7. Captive Insurance Companies 134 

8. Income of Foreign Banks 134 

B. Options Requiring legislation 135 

1. Expansion of Subpart F to Target it on Tax 

Haven Entities 135 

2. Adoption of a Management and Control Test for 
Asserting U.S. Taxing Jurisdiction over Foreign 
Corporations 138 

3. Change in Control Test 139 

4. Service and Construction Income 140 

5. Merger of the Foreign Personal Holding Company 
Provisions into Subpart F 141 

6. Captive Insurance 143 

7. Shipping Income 143 

8. De minimus Exclusion from Foreign Base Company 
Income 143 

9. Commodity Shelters 143 

- IV - 

10. Tax Haven Deductions 144 

11. No Fault Penalty 145 

12. Foreign Trusts 145 

13. Expatriation 146 

14. Residence 146 

VIII. Treaties with Tax Havens 147 

A. Basic Principles 147 

B. Tax Haven Treaty Network 149 

C. Third Country Resident Use of United States Tax 
Treaties with Tax Havens 152 

1. Forms of Third Country Use 152 

a. Foreign borrowing 153 

b. Finance companies 153 

c. Holding companies 154 

d. Active business 156 

e. Real estate Investment 156 

f. Personal service companies — artists and 
athletes 157 

2. Analysis of Third Country Use 157 

D. Use of Treaty Network by Earners of Illegal Income 

or for Evasion of United States Tax 159 

1. Methods of Use 160 

2. Analysis of Illegal Use 161 

E. Administration of Tax Treaty Network 162 

F. Options for Tax Haven Treaties 166 

1. Administrative Options 167 

a. Refund system of withholding 167 

b. Increase audit coverage of treaty issues.. 168 

c. Periodic review of treaties 168 

d. Exchange of information article over- 
riding bank secrecy 168 

e. Improve the quality of routine infor- 
mation received 169 

f. Rulings 169 

g. Coordination with ITC 170 

2. Changes in Treaty Policy 170 

a. Treaty network 170 

b. Source country taxation 171 

c. Anti-holding company or anti-conduit 
approaches 171 

d. Expansion of anti-abuse provisions to 
active business 17 2 

e. Second withholding tax 173 

f. The insurance premium exemption 173 

g. Personal service companies -- artists and 
athletes 174 

3. Legislative Approaches 175 

a. Reduction of the rate of tax on fixed 

or determinable income 175 

b. Anti-treaty abuse rules 176 

c. Branch profits tax 176 

- V 

IX. Information Gathering 180 

A. Reporting 180 

1. IRS Forms 181 

a. Analysis 181 

b. Options 184 

2. Bank Secrecy Act Forms 186 

a. Transactions with financial institutions. .. 186 

b. Transport of currency 188 

c. Foreign bank account 188 

d. TECS 188 

e. Analysis 189 

f . Options 191 

3. Penalties for Failure to File or Adequately 
Complete Forms 192 

a. IRS forms 192 

b. Bank secrecy act forms 192 

c. Options 193 

B. Books and Records — Foreign Transactions — In 
General 193 

1. General Requirements for Maintenance of 
Adequate Books and Records 194 

2. Penalties for Failure to Maintain Adequate 

Books and Records 194 

3. Powers to Compel Production of Books and 
Records 195 

4. Analysis 195 

a. Legal 195 

b. Administrative 196 

c. Tactical 196 

C. Information Gathering Abroad 197 

1. Unilateral Means 198 

a. Public Information 198 

b. Overseas Examination 200 

c. Compulsory Process 201 

( i ) Administrative summons 201 

(ii) Judicial subpoena 204 

(iii) Letters rogatory 205 

d. Tax Court 206 

e. Information Gathering Projects and 
Informants 206 

2. Bilateral and Multilateral Means 206 

a. Tax treaties 207 

b. Mutual assistance treaties 209 

D. Options 210 

1. Unilateral Actions 210 

a. Asserting the taxpayer's burden of proof... 210 

b. Requiring that books and records be 
maintained in the U. S 211 

c. Venue Where a Party Summoned is Outside 

the United States 211 

- VI - 

d. Admissibility of foreign business records. .. 211 

e. IRS review process for mutual assistance. ... 212 
2. Bilateral Approaches 212 

a. Mutual assistance treaties 212 

b. Limited tax treaties 212 

c. Bilateral exchange of information 
agreements 212 

d. Revise exchange of information article 213 

e. Steps to isolate abusive tax havens 213 

X. Administration 217 

A. In General 217 

1. Examination Division 217 

2. Office of International Operations 218 

3. Criminal Investigations 220 

4. Office of the Chief Counsel 221 

B. Analysis 222 

1. Coordination 222 

2. Coverage of Tax Haven Cases - Availability of 
Expertise 225 

3. Providing Technical and Legal Assistance to the 
Field 227 

4. Simultaneous and Industrywide Examinations 228 

5. Chief Counsel 229 

C. Options 229 

1. Improve Coordination with Respect to Tax Haven 
Issues Specifically and International Issues 

in General 229 

2. Increase Coverage of Tax Haven Cases 231 

3. Expand Training of International Examiners to 
Include Noncorporate Issues and Expand Training 

of Agents in the General Program 232 

4. Provide Additional Technical and Legal Expertise 

to the Field 233 

5. Expansion of the Simultaneous Examination Program 
and the Industrywide Exchange of Information 
Programs 233 

6. Chief Counsel 234 




This study was undertaken at the request of the Commissioner 
of Internal Revenue, the Assistant Attorney General (Tax 
Division), and the Assistant Secretary of the Treasury (Tax 
Policy) . 

The purpose of the study was to develop an overview of 
tax havens and the use of tax havens by United States taxpayers. 
The study sought to determine the frequency and nature of 
tax haven transactions, identify specific types of tax haven 
transactions, obtain a description of the United States and 
foreign legal and regulatory environment in which tax haven 
transactions are conducted, describe Internal Revenue Service 
and Justice Department efforts to deal with tax haven related 
transactions, and to identify interagency coordination 

Our findings are based on a review of judicial decisions 
and published literature in the field of international tax 
planning, research into internal IRS documents concerning 
taxpayer activities, interviews with IRS personnel, personnel 
who deal with tax haven issues for other Federal government 
agencies, and lawyers and certified public accountants who 
specialize in international taxation. Our findings are 
also based on a statistical analysis of available data 
concerning international banking. United States direct 
investment abroad, and foreign investment in the United 
States. While we cannot claim that we uncovered all of the 
methods employed to use tax havens, we believe that our 
inquiry was extensive enough to give us an understanding of 
the situation and to enable us to develop options which 
might be useful in improving the administration of the tax 
laws as they apply to tax havens. 

The findings and recommendations of this report are 
directed to six main areas: 

First, identifying tax havens, the policy issues raised 
by them, and the concerns of other countries; 

Second, describing the patterns of use by United States 
and foreign persons and presenting options for curbing that 
use should that be desired; 

Third, describing patterns of use to evade united 
States taxes; 

Fourth, describing the impact of United States income 
tax treaties on tax haven use; 

Fifth, describing the United States information gathering 
capability, the problems caused by limitations on our information 
gathering ability, and presenting options for improving 
United States information gathering; 

Sixth, an analysis of the administration of the tax 
laws and presenting options for improving that administration. 

A number of government professionals contributed substantial 
time and effort to the study. These include, George Bagley, 
Clyde Donald, Vince Gambino, Ross Summers, and Bill Wells of 
the IRS, Jack Feldman, Kenneth Klein, Mike Patton, and 
Alban Salaman of the Office of the Chief Counsel IRS, and 
Ron Cimino and Richard Owens of the Tax Division of the 
Department of Justice. Roy Richards served as the research 
assistant. H. David Rosenbloom, Thomas Horst, and Joel Rabinovitz 
of the Office of the Assistant Secretary of the Treasury 
(Tax Policy) provided useful comment and criticism of the 
report. One of the most important parts of the study was 
the effort to quantify the use of tax havens. The effort 
was directed by Berdj Kenadjian with the help and assistance 
of the IRS Unreported Income Research Group and the IRS 
Statistics Division. The special efforts of Marie Yauss who 
typed and retyped numerous drafts of this report are gratefully 

The study could not have been completed without the 
support of former Commissioner of Internal Revenue, 
Jerome Kurtz. 

The statements of positions on legal issues in this 
report are the positions of the Special Counsel for International 
Taxation and are not necessarily those of the IRS or any 
other agency of the Federal government. 

I. Overview of Findings and Options 

International tax avoidance and evasion, including the 
use of tax havens to avoid or evade United States taxes, have 
been of long-standing concern to the Congress and tax 
administrators. Numerous provisions have been added to the 
tax laws to limit such use, and to limit the erosion of the 
United States tax base. In 1921, the Congress focused on 
foreign subsidiary corporations that were used to "milk" 
United States parent corporations. In the 1930's the Congress 
focused on individuals creating incorporated pocketbooks in 
tax havens and transferring assets to tax havens to avoid 
paying United States tax on the appreciation. In 1962 the 
Congress focused on perceived abuses by multinational 
corporations. In 1970 the Bank Secrecy Act imposed reporting 
requirements on transactions which were believed to be 
particularly susceptible to abuse. In 1976 the Congress 
dealt with the use of foreign trusts. 

The use of tax havens to evade United States tax has 
been of special concern to the Internal Revenue Service. 
Beginning in the mid-1950 's and continuing through the 
1970 's the IRS conducted numerous special projects and 
investigations which sought to identify taxpayers using tax 
havens to avoid United States taxes. Today the IRS devotes 
substantial resources to international transactions through 
general civil and criminal programs and through special 
programs. The use of tax havens to aid in the commission of 
nontax crimes, including narcotics trafficking, has also 
been of special concern to other Federal agencies. 

Foreign governments have also been concerned with the use 
of tax havens to avoid or evade their taxes. Some countries 
have adopted legislative provisions intended to limit the 
use of tax havens by their nationals. Many of these provisions 
are based on United States law. 

Nevertheless, legal and illegal use of tax havens 
appears to be on the increase. The available data and 
interviews with practitioners, IRS personnel, personnel from 
other agencies and representatives of foreign governments 
support the view that taxpayers ranging from large multinational 
companies to small individuals to criminals are making 
extensive use of tax havens. 

The study was limited to transactions involving countries 
having (1) low rates of tax when compared with the United 
States, and (2) a high level of bank or commercial secrecy 
that the country refuses to breach even under an international 
agreement. Several additional characteristics of most tax 
havens include: (a) relative importance of banking and 
similar financial activities to its economy; (b) the availability 

of modern communication facilities; (c) lack of currency 
controls on foreign deposits of foreign currency; (d) self- 
promotion as an offshore financial center. 

Today, many tax havens thrive largely because of the 
presence of foreign banks. The existence of this financial 
business brings an economic advantage to the tax haven in 
terms of jobs and revenue. The resulting highly developed 
and sophisticated banking and communications infrastructure 
in the tax havens also makes it possible to move illegally 
earned income swiftly and efficiently. 

The decision of a country not to tax transactions or to 
attempt to attract offshore financial business is a legitimate 
policy decision. When local laws and practices deny information 
to countries whose tax base is being eroded or whose laws 
have been violated, a situation exists that attracts criminals 
and is abusive to other countries. Most tax havens have 
strict secrecy provisions and will not cooperate with other 
countries seeking to enforce their laws. 

The data support the perception that activity through 
tax haven entities has increased, and that tax haven entities 
are increasingly diverting capital away from entities formed 
in economically advanced countries that have highly developed 
systems of taxation. 

In 1968, according to IRS data, the total assets of 
foreign corporations controlled by United Stated corporations 
and formed in tax havens were $11.7 billion, representing 
12.1 percent of the worldwide assets of United States controlled 
foreign corporations. By 1976 these amounts had risen to 
$55.4 billion and 17.6 percent. 

Commerce Department data, while based on a different 
universe, confirm these trends. Those data show a steady 
growth in direct investment levels in Uhited States-controlled 
tax haven businesses from $4.7 billion in 1968 to $23 billion 
in 1978, a five-fold increase. For the same period, direct 
investment levels in nontax haven business grew from $57.2 
billion to $145.1 billion, an increase of two-and-a-half 

Over the same period. Commerce Department data show 
earnings of tax haven entities increasing from $0.5 billion 
to $4.4 billion -- a nine-fold increase — while earnings of 
nontax haven entities were increasing from $6.0 billion to 
$21.3 billion, or by three and a half times. Ownership by 
Uhited States persons of tax haven subsidiaries has increased 
more than ownership of nontax haven subsidiaries. 

The data tend to confirm that some industries use tax 
haven entities more than other industries. For example, in 
1976 United States-controlled tax haven corporations engaged 
in the transportation business had assets of $9.0 billion, 
which represented 74.2 percent of the assets of united 
States controlled foreign corporations in the transportation 
business. The comparable figures for contract construction 
were $2.2 billion and 41.8 percent. Assets of United States- 
controlled tax haven companies engaged in finance, insurance, 
and real estate, including banking, were $20.9 billion, 
which represented 28.0 percent of the assets of Uhited 
States controlled foreign corporations in that business. In 
1976, $2.4 billion or 23 percent of the assets of United 
States-controlled foreign corporations engaged in providing 
services were held by tax haven corporations. 

Banking activity in tax havens has also grown. Total 
deposits in banks in the tax havens surveyed were $385 
billion in 1978; deposits by nonbanks were $89 billion of 
this amount. Comparable figures for year-end 1968 were $11 
billion and $5 billion, respectively. 

The extent to which tax havens are being used by narcotics 
traffickers and other tax evaders, including those earning 
legal income, could not be quantified reliably. Data concerning 
illegal use of tax havens are often soft or unavailable. 
The report does, however, refer to a methodology that might 
be a first step in making an estimate. Present currency 
flow projects may also help. The perception is that such 
use is large and is growing. 

There is a wide range of use of tax havens by United 
States persons. While many attribute evil motives to any 
such use, this is not the case. Some use is for criminal 
purposes, but much is perfectly legal. In some cases the 
tax consequences of the tax haven transactions reflect clear 
congressional decisions as to the scope of United States 
taxing jurisdiction. 

From a tax planning point of view, tax havens, in and 
of themselves, do not provide a United States tax advantage; 
the United States tax advantage is provided only in combination 
with both the Uhited States system of deferral of taxation 
of earnings of foreign corporations and the United States 
system of consolidated worldwide foreign tax credits. 

Often whether a transaction is tax avoidance or tax 
evasion is difficult to determine, in part because the terms 
are not well defined, and in part because the law governing 
the transactions is imprecise and the information incomplete. 
There also are many grey areas. Tax havens transactions can 
be loosely categorized as follows: 

(1) Transactions that are not tax motivated and may 
have no United States income tax impact. Such use includes 
branch banking that may avoid United States reserve requirements 
but has little impact on United States income tax liability. 

A tax haven subsidiary may be used to avoid currency and 
other controls that may be imposed by countries in which the 
company is carrying on business. It may also be used to 
minimize the risk of expropriation of business assets. A 
foreign person may use a tax haven bank or nominee account 
to shield assets from political oppressors. 

(2) Transactions that are tax motivated, but consistent 
with the letter and the spirit of the law. Examples are 
shipping, banking through subsidiaries, sales by tax haven 
subsidiaries not involving related parties as well as taking 
advantage of certain de minimis exceptions to anti-tax haven 
legislation. While some of these uses create anomalous 
situations, they are legal. For example, a United States 
taxpayer has sheltered over $100 million in passive income 

in a foreign company the income of which is not taxable 
under the anti-avoidance provisions of the Code. 

One of the most common tax motivated but legal uses of 
a tax haven subsidiary is to shift United States source 
income to foreign source income to increase the amount of 
foreign taxes paid by a inited States taxpayer that can be 
credited against, and thus reduce. United States taxes 
otherwise payable by the taxpayer. 

(3) Aggressive tax planning that takes advantage of an 
unintended legal or administrative loophole. Examples are 
the use of captive insurance companies, the use of investment 
companies, some forms of service and construction businesses 
being conducted through tax haven entities, as well as a 
wide range of aggressive transfer pricing situations. 

(4) Tax evasion — an action by which the taxpayer tries 
to escape legal obligations through fraudulent means. 
Fraudulent use includes marketing so-called "double trust" 
schemes involving attempts by United States persons to 
transfer United States assets to tax haven trusts. It also 
includes marketing tax shelters, including certain questionable 
commodity transactions, to United States persons through a 

tax haven in order to hide the fact that the transactions 
that are allegedly creating losses do not take place. One 
tax straddle shelter may have involved as many as 1500 
investors and deductions of as much as $150 million. 

Fraudulent use has also included forming sales companies 
that are structured to appear to deal only with unrelated 
parties but that in fact are dealing with related parties, 
forming corporations to appear to be banks, hiding the fact 
of ownership of tax haven corporations, the use of a Cayman 
Islands corporation by a United States person to hide 
corporate receipts and corporate slush funds. 

Tax havens may be used to commit crimes that violate 
tax as well as other laws. The most serious fraudulent use 
of this kind is by narcotics traffickers to accumulate or 
launder large suras. Often phony shelter schemes violate 
securities as well as tax laws. Shell banks established in 
St. Vincent have been used to defraud Uhited States banks 
and other businesses. 

The provisions of the tax law that apply to international 
transactions in general and to tax haven transactions in 
particular are among the most complex in the Internal Revenue 
Code. The two most important provisions affecting tax haven 
transactions are subpart F, which taxes Uhited States shareholders 
of a United States controlled foreign corporation on certain 
categories of income, and section 482, which authorizes the 
Commissioner to reallocate income among related entities to 
properly reflect their income. Both of these provisions are 
primarily transactional in nature, that is, each separate 
transaction must be analyzed to determine its tax effect. 
Also, the foreign personal holding company provisions and 
the foreign trust provisions may apply. 

The proper administration of subpart F and §482 often 
requires IRS access to detailed books and records which are 
not always available. The complexity coupled with information 
gathering problems makes the law in this area extremely 
difficult to administer. 

Income tax treaties with tax havens are often used by 
residents of nontreaty countries to achieve a reduction in 
United States tax. The United States has a large and 
growing network of income tax treaties mostly with other 
high tax countries, but about 16 treaties are with tax 
havens. Many of the tax haven treaties are the result of 
the extension of the old United States-Lfriited Kingdom treaty 
to former united Kingdom colonies. The treaty with the 
Netherlands Antilles is in force as a result of the extension 
of the united States-Netherlands income tax treaty. United 
States treaties with Luxembourg, the Netherlands and Switzerland 
were independently negoiated. 

There is significant use of tax haven treaties for 
investment in the Uhited States. In 1978, 43 percent of the 
gross income paid to all nonresidents of the United States 
was paid to claimed residents of tax havens. Forty-six 

percent of the gross income paid to residents of all treaty 
countries was paid to claimed residents of tax haven treaty 
countries. Nearly 80 percent of all United States gross 
income paid to residents of tax havens and reported to the 
IRS was paid to corporations. All of this indicates significant 
third-country use of tax haven treaties. 

Third-country residents use tax haven treaties primarily 
to minimize tax on income from United States investments by 
a combination of reduced rates of tax on income paid from 
the united States, the low rate of tax in the tax haven and 
the low rate of tax on distributions to the investor from 
the tax haven. The use of tax haven treaties includes 
forming conduits in the tax haven to lend into the United 
States, the use of holding companies engaging in back-to- 
back licensing and lending transactions, real estate investment 
and finance companies established by United States corporations 
to borrow abroad free of the United States withholding tax. 
There is some evidence of use of tax haven treaties to evade 
united States tax. 

In order to administer the tax laws and to prosecute 
those who evade their tax obligations, the IRS and Federal 
prosecutors must have access to relevant information. The 
ability of the IRS to gather information is severely limited 
where international transactions in general and tax haven 
transactions in particular are involved. With respect to 
legitimate business transactions, information-gathering 
problems include the existence of multiple overlapping 
forms, the sometimes inaccessabil ity of adequate books and 
records of overseas entities, the uncertainty of the extent 
of the United States Government's powers to compel production 
of books and records maintained in tax havens, the ability 
of taxpayers to use the court system to delay the production 
of records and some intentional procrastination and delaying 
tactics by some taxpayers. 

Reports of currency transactions with domestic financial 
institutions have been helpful in developing some criminal 
cases, but more work is needed to improve the quality of the 
information and the dissemination of the information. 
Reports of transportation of currency into and out of the 
united States and reports of interests in foreign bank 
accounts have not been particularly useful to date. 

Substantive laws are not the direct impetus to illegal 
activity, although complicated laws are more susceptible to 
abuse. The problem is getting information to tie the 
united States taxpayer to funds accumulated in or routed 
through a tax haven so that a prosecution for tax evasion is 

possible. lack of meaningful exchange of information is the 
real problem and that lack encourages abuse. The IRS does 
not have available the process of the courts to command the 
production of records that are in the hands of third parties 
in the tax havens. Even if information is obtained, it is 
rarely in a form admissible in United States courts. 

Exchange of information provisions in the existing tax 
treaties with tax havens are simply inadequate because they 
do not override local bank or commercial secrecy laws. In 
any event, the United States does not have treaties with 
most tax havens. The only mutual assistance treaty in force 
to which the United States is a party is with Switzerland, 
and it has not been useful for dealing with tax crimes. 

There also are some administrative problems with the 
international enforcement of the tax laws, such as achieving 
effective coordination among international enforcement 
functions. Further, the volume of transactions with which 
the IRS must deal continues to grow, but the resources 
devoted to auditing international transactions have not kept 
pace with the growth in international trade, and many smaller 
cases, which can be the most abusive, do not receive expert 
attention. The international experts are not trained in the 
kinds of abusive transactions used by individuals such as 
partnerships and trusts. It is difficult for criminal and 
civil agents to get competent, expeditious, technical help 
in the field without going through a formal referral process. 

The Chief Counsel's Office also has the problem of 
diffused technical expertise in the international area. 
Additionally it has no easily accessable central focus of 
international information gathering expertise. 

It can be argued that the basic reason why there continues 
to be so much tax haven activity is the lack of effective 
administration by all nations, coupled with taxpayer awareness 
of that lack. The central issue then becomes whether the 
present legal structure is administerable or whether it 
should be changed regardless of other policy concerns 
because it is not administerable. 

There exists the potential for a serious abuse of the 
LMited States tax system through tax havens. What is needed 
is a coordinated attack on the use of tax havens, including 
better coordination and funding of administrative efforts to 
deal with tax haven problems, and perhaps substantive 
changes in United States law and treaty policy. In order to 
deal with these problems, consideration of the options set 
forth is recommended. While some options can be accomplished 


administratively, others would require legislation or changes 
in existing income tax treaties. We recognize the existence 
of policy considerations in addition to tax considerations. 
The following options are presented purely from a tax 
administration point of view. Some of them would apply to 
international issues in general, because it does not make 
sense to limit them to tax havens. 

The adoption of many of the options set forth in the 
report will require that more resources be devoted to international 
enforcement efforts. Today the IRS does not have the additional 
resources. If decisions are made to adopt options which 
require additional resources, the Congress will have to make 
the resources available. 

The United States alone cannot deal with tax havens. 
The policy must be an international one by the countries 
that are not tax havens to isolate the abusive tax havens. 
The United States should take the lead in encouraging tax 
havens to provide information to enable other countries to 
enforce their laws. For example, the United States could 
terminate tax treaties with abusive tax havens, increase the 
withholding tax on United States source income paid to tax 
havens and take other steps to discourage United States 
business from using tax havens. However, such steps taken 
unilaterally would place United States business at a competitive 
disadvantage as against businesses based in other OECD 
countries. Accordingly, a multilateral approach to deal 
with tax havens is needed. 

The more important options, summarized below, as well 
as others, are presented in more detail in the following 

.Chapter VII - options for administrative and legislative 
changes to deal with technical problems; 

.Chapter VIII - options for changes for tax haven 
treaties ; 

.Chapter IX - options for information gathering; 

.Chapter X - options for administration of the tax 

Options That Can Be Adopted Administratively . The 
following options could be accomplished administratively: 

1. To make clear the obligation of taxpayers to produce 
the books and records of foreign subsidiaries, publish 
regulations requiring that books and records of foreign 


corporations controlled by United States persons be maintained 
in the United States regardless of foreign laws, unless 
those books and records are made readily available to examining 
agents on demand. 

2. To encourage agents to insist that taxpayers meet their 
burden of substantiating deductions, valuations, or pricing, 
give clear directions to the field as to actions to be taken 

by agents to deny deductions or reallocate income where a 
taxpayer has not met the burden of proving the tax consequences 
of a transaction. 

3. To ease the administrative burdens of complicated 

and lengthy audits, study the §482 regulations to determine ,i 

whether clearer more administerable rules are possible. i 


4. To address the problem of unauthorized use of ! 
treaties, change the present system of withholding of tax on j 
payments of fixed and determinable income to foreign persons , 
to a refund system. • 

5. To simplify reporting obligations of taxpayers, and j 
to make the reporting more useful to the IRS, combine into 

one form the existing hodge-podge of international forms I 

that a united States person investing overseas must file. I 

6. To improve coordination with respect to international 
issues in general, and tax haven issues specifically, the 
Assistant Commissioner (Compliance) could study ways of 
improving coordination among the various international 
functions and could consider creating a group to coordinate 
tax haven issues and collect and disseminate tax haven 

7. To enable the IRS to provide expert coverage to tax 
haven cases outside the large case program, expand the IRS 
International Examination program and give the examiners 
additional training in partnerships, trusts, and tax treaties. 

8. To provide better information gathering guidance to 
field agents and to District Counsel trial attorneys, designate 
a person in the National Office of the Chief Counsel as the 
international information gathering expert. 

Legislative Options: 

1. To relieve some of the administrative burdens and to 
give more certainty to transactions involving controlled 
foreign corporations formed in tax havens, expand subpart F 
to add a jurisdictional test that would tax united States 
shareholders of a controlled foreign corporation formed in a 
tax haven on all of its income. 


2. To enable the IRS to deal better with tax haven 
businesses that are in fact run in the United States, add a 
management and control test to the present jurisdictional 
tests for subjecting corporations to Lfriited States tax. 

3. To simplify and rationalize the taxation of tax 

haven income, eliminate some of the overlap among the provisions 
which deal with tax havens by combining the foreign personal 
holding company provisions with subpart F. 

4. To emphasize that the burden of proving the substance 
of tax haven transactions is squarely on the taxpayer, 
provide for the specific disallowance of a tax haven related 
deduction unless the taxpayer establishes by clear and 
convincing evidence that the underlying transactions took 
place, the substance of those transactions, and that the 
amount of the deduction is reasonable. 

5. To discourage taxpayers from taking overly aggres- 
sive positions on the chance that they will not be identified, 
provide for the imposition of a no-fault penalty of a fixed 
percentage of a large deficiency resulting from a tax haven 

Treaty Options : 

1. To deal directly with [Mited States tax treaties 
with tax havens, terminate the existing income tax treaties 
with the Netherlands Antilles and the United Kingdom extensions 
and consider terminating income tax treaties with other tax 
havens, with possible renegotiation. 

2. To prevent future abuse, be selective in negotiating 
income tax treaties with countries with which the United 
States does not have a significant trade or investment 
relationship, and do not enter into full scale income tax 
treaties with known tax havens. As an alternative, selectively 
enter into limited treaties with tax havens that would 
include a nondiscrimination provision and a competent authority 
mechanism and would contain an exchange of information 
provision overriding bank secrecy laws and practices. 

3. To ensure that information necessary to administer 
the tax laws is available, and to insure that information 
necessary to prosecute those who do not comply with those 

laws is available, insist upon a strong exchange of information 
provision in united States income tax treaties that would 
override foreign bank secrecy laws and practices. 


4. To deal with changes in local laws and practices of 
treaty partners, conduct periodic reviews of treaties to 
determine whether they are being abused and whether they are 
serving the function for which they were initially negotiated. 

5. To provide access to information to be used in 
criminal prosecutions, vigorously pursue mutual assistance 
treaties with the more important tax havens. 

6. To encourage abusive tax havens to enter into 
exchange of information agreements with the United States, 
consideration may have to be given to adopting measures to 
discouraging United States business from investing through 
tax havens that do not give information, such as increasing 
taxes on payments to those tax havens. 

7. To limit the potential for abuse of treaties with 
tax havens, and to limit the incentive for treaty partners 
to adopt tax haven practices, incorporate strong provisions 

to limit the use of treaties to residents of a treaty country. 


II. Tax Havens - In General 

In this chapter, an attempt is made to set out the 
principal characteristics of tax havens, to explain some of 
the background, and to present some of the issues raised by 
tax havens from the perspective of the tax haven. The 
concern of countries other than the U.S. and some of the 
steps which they have taken to deal with tax havens is also 
described . 

A. Characteristics 

The term "tax haven" has been loosely defined to include 
any country having a low or zero rate of tax on all or 
certain categories of income, and offering a certain level 
of banking or commercial secrecy. Applied literally, however, 
this definition would sweep in many industrialized countries 
not generally considered tax havens, including the United 
States (the U.S. does not tax interest on bank deposits of 
foreigners) . 

The term "tax haven" may also be defined by a "smell" 
or reputation test: a country is a tax haven if it looks 
like one and if it is considered to be one by those who 
care. Many publications identify jurisdictions as tax 
havens, and the same jurisdictions generally appear on all 
of the lists.— 

Most jurisdictions which are considered tax havens have 
at least some of the characteristics described below. All, 
however, offer low or no taxes on some category of income, 
as well as a high level of confidentiality to banking 
transactions . 

Many countries having tax haven characteristics are 
often bases for minimizing taxation on various types of 
perfectly legal income and activities. These same countries 
provide anonymity sought by persons evading tax laws. 
Accordingly, there is a problem when looking at tax havens 
of combining legitimate and illegitimate activities and 
confusing the former with the latter. Care should be taken 
to avoid this. 

V See, for example, M. Langer, Practical International 

Tax Planning , 278, 279 (2d ed . 1979); B. Spitz, Tax Haven 
Encyclopaedia (1975). 


1 . Low Tax 

Many of the jurisdictions that are considered tax 
havens do impose taxes. All, however, either impose no 
income tax on all or certain categories of income, or impose 
a tax which is low when compared to the tax imposed by the 
countries whose resident taxpayers use them. 

Some jurisdictions do not impose income taxes, or 
impose very low rates of tax. In the Caribbean, the Bahamas, 
Bermuda, the Cayman Islands, and the Turks and Caicos do not 
impose any income or wealth taxes. In some cases the tax 
situation may be part of a policy to attract banking, trust 
or corporation business. In other cases it may exist because 
the country never found the need to impose tax. 

Often, low tax rates are considered an evil. However, 
many tax havens are small less-developed countries whose 
residents are generally poor. In many cases, the small 
population of the country makes an income tax system impractical. 
Instead, the country will establish a license or fee system 
for generating revenue. Instead of imposing an income tax, 
fees can be charged for bank licenses, commercial charters, 
and the like. Administration costs of collecting those 
revenues are kept to a minimum. 

Often jurisdictions, while imposing significant domestic 
taxes, impose low rates on certain income from foreign 
sources, a tax system used by a number of developed high tax 
countries (such as France) as well as by some tax havens. 
Panama is an example. Accordingly, a local corporation can 
be formed and managed in the tax haven with no tax being 
paid to the tax haven on its income from other jur isictions. 

Some tax havens impose low rates of tax on income from 
specific types of business. Some jurisdictions, for example, 
offer special tax regimes to holding companies, making them 
especially useful as financial centers or situs for holding 

Some tax havens combine their tax system with a treaty 
network. This combination can make them a desirable situs 
for forming a holding company to invest in a treaty partner. 

2. Secrecy 

By definition, all of the jurisdictions with which we 
are concerned, afford some level of secrecy or confiden- 
tiality to persons transacting business, particularly with 
banks. This secrecy has its origin in either the common law 
or in statutory law. 


Conunon law secrecy is found in those jurisdictions 
which were or still are British Colonies. It derives from 
the finding of an implied contract between a banker and his 
customer that the banker will treat all of his customer's 
affairs as confidential. If violated, an action for damages 
for breach of contract lies against the banker. 

Many jurisdictions have confirmed or strengthed the 
common law rules by statute, and have added criminal sanc- 
tions for breaching secrecy. In many cases the law was 
strengthened to maintain or improve the particular juris- 
diction's competitive position. For example, in 1976 the 
Cayman Islands, which had strict bank secrecy before, tightened 
its laws by adding more substantial sanctions against persons 
divulging most banking and commercial information.— ^,This 
tightening was a reaction to United States v. Field ,— in 
which the U.S. court directed a Cayman resident to give 
testimony concerning bank information before a U.S. grand 
jury, even though the testimony would violate the bank 
secrecy laws of the Cayman Islands and would subject him to 
limited criminal penalties. 

Some level of secrecy is a characteristic common to 
both tax havens and non-tax havens. Most countries do 
impose some level of protection for banking or commercial 
information. At the same time, however, many countries will 
not protect information from a legitimate inquiry from a 
foreign government, particularly where that inquiry is made 
under a treaty. Tax havens, however, refuse to breach their 
wall of secrecy, even where a serious violation of the laws 
of another country may be involved. The distinction is 
between unreasonably restrictive rules of bank secrecy which 

2/ Langer and Walker, "The Cayman Islands - An Important 

Base for Foreign Companies," U.S. Taxation of International 
Operations, II 8503, Prentice Hall (1978). 

3/ united States v. Field , 532 F. 2d 404 (5th Cir. 1976); 
cert, denied, 429 U.S. 940 (1976). 


may encourage the commitment of international tax and other 
offenses, and those wh^ch pay due regard to the protection 
of individual privacy,-'^ but which also permit legitimate 
inquiry in appropriate cases. 

Secrecy is most troublesome when a violation of U.S. 
criminal laws is under investigation. It also presents 
significant problems to IRS when it attempts to audit legal 
transactions. The secrecy may be used as an excuse by a 
taxpayer not to produce records, or it may present real 
problems preventing IRS access to records. 

3. Relative Importance of Banking 

Banking tends to be more important to the economy of a 
tax haven than it is to the economy of a non-tax haven. 
Most tax havens follow a policy of encouraging offshore 
banking business. This is done by distinguishing between 
resident and nonresident banking activity. Generally, 
nonresident activity will not have reserve requirements, 
will be taxed differently (if at all), and will not be 
subject to foreign exchange or other controls. 

One test of the importance of banking to an economy is 
the relationship of foreign assets of banks in a country to 
that country's foreign trade. When compared to foreign 
trade, foreign assets of deposit banks in tax haven jurisdictions 
were substantially greater than foreign assets of deposit 
banks in non-tax havens. Special statistics developed to 
measure the excessive holdings of foreign assets of tax 
haven banks indicate that these excess assets— are very 
large, and have^been growing at a rapid rate. For all tax 
havens surveyed— excess foreign assets grew from $16.7 

4^/ See Recommendation 833 (1978) on Cooperation Between 
Council of Europe Member States Against International 
Tax Avoidance and Evasion, 1M1 4 and ll(i). 

5^/ Excess assets are those above the worldwide average 
of foreign assets of deposit banks to worldwide 
foreign trade. The amount above what this ratio would 
yield was the excess assets for that jurisdiction. For 
example, 1978 total foreign assets held by deposit banks 
in the Bahamas were $95.2 billion. Based on the world- 
wide average of deposits to world trade, $1.8 billion 
was needed to finance the foreign trade of the Bahamas. 
The difference, $93.4 billion, represents excess inter- 
national assets and is an indication of assets attracted 
because of the tax haven status of the jurisdiction. 

6^/ For this purpose, Bahamas, Bermuda, Cayman Islands, Hong 
Kong, Luxembourg-Belgium (the foreign trade data for the 
two countries could not be separated), Netherlands 
Antilles, Panama, Singapore, and Switzerland. 


billion in 1970 to $272.9 billion in 1978. During the same 
period, excess foreign assets in tax havens, as a percentage 
of foreign assets held worldwide grew from 12.5 percent to 
29.1 percent. When all jurisdictions were compared, only 
13 out of 126 have foreign assets which are excessive relative 
to the world average in 1979. These 13 are the tax haven 
jurisdictions studied and the United Kingdom and France. 
The U.K. is an offshore financial center itself, and its 
data include the tax havens of the Channel Islands and the 
Isle of Man which could not be separated from all other U.K. 
data. France has excess deposits, largely because export 
financing aid is handled through private banks. 

The importance of U.S. banks to the major Caribbean financial 
centers is growing. For example, from 1973 to 1979, total assets 
of U.S. bank branches increased nine times in the Cayman 
Islands, .eight times in the Bahamas, and four times in 

The banking industry has a significant effect on the 
economy of the tax haven. Financial business yields revenues 
in the form of fees and modest taxes on financial institutions. 
The tax haven also benefits from employment of personnel and 
rental of facilities. The Bahamas Central Bank estimated 
that expenditures of banks and offshore branches in the 
Bahamas in 1975 was $32,886,000, including $18,330,000 for 
salaries. Licenses and other fees amounted to $1.5 million, 
and the banks employed 1,890 (1,650 Bahamians) people.— 
Informed sources estimate that by early 1978, the banking 
sector may have employed 2,100 people (1,897 Bahamians), 
paying them salaries in excess of $26 million per annum. An 
additional 10,000 jobs may have been indirectly supported. 

A comparable survey of the Cayman Islands indicates 
that, in 1977, total operating expenditures by Cayman branch 
banks were $10.2 million, of which $5.3 million were for 
salaries. These branches paid $1.6 million in fees and 
employed 433 people, of whom 298 were local citizens.— 

2/ See Hoffman, Caribbean Basin Economic Survey , 

Federal Reserve Bank of Atlanta, May/June/July 1980, 
at 1. 

£/ C.Y. Frances, Central Banking in a Developing Country 
with an Offshore Banking Centre , Central Bank of the 
Bahamas (1978). 

9/ Cayman Islands, Department of Finance and Development. 


4. Availability of Modern Communications 

Many of the countries considered tax havens have excel- 
lent communictions facilities, particularly good telephone, 
cable and telex service linking them to other countries. 
They may also have excellent air service. For example, the 
Cayman Islands has excellent telephone and telex facilities. 
In fact, telephones in the Caymans can be direct dialed from 
the United Kingdom and Canada. There are two daily non-stop 
jet flights between Miami and the Caymans, and direct service 
between Houston and Grand Cayman. 

5. Lack of Currency Controls 

Many tax havens have a dual currency control system, 
which distinguishes between residents and non-residents, and 
between local currency and foreign currency. As a general 
rule, residents are subject to the currency controls; non- 
residents are not. However, non-residents will normally be 
subject to controls with respect to local currency. A 
company, formed in the tax haven, which is beneficially 
owned by non-residents and which conducts most of its business 
outside the tax haven, is generally treated as non-resident 
for exchange control purposes. Accordingly, a foreign 
person can form a tax haven company to do business in other 
jurisdictions. It will not be subject to the tax havens' 
exchange countrols as long as it is dealing in currency of 
other jurisdictions and is not doing business in the tax 

These rules are adapted to facilitate the use of the 
tax haven by a person wishing to establish a tax haven 
corporation to do business in other jurisdictions. 

6. Self Promotion - Tax Aggression 

Most tax havens seek financial business and promote 
themselves as tax havens. Considering the potential advan- 
tages of attracting financial business, this is an understandable 
activity from the point of view of the tax havens. Many of 
these countries view financial business as a relatively 
stable source of revenue and will actively seek it. Barbados, 
for example, recently passed banking legislation intended to 
improve its competitive position as a financial center. 
Many jurisdictions conduct seminars, and their officials 
collaborate in articles extolling the virtues of the particular 
country as a haven. Some tax havens do not hide their 
disdain for the concerns of other countries in this regard. 


7. Special Situations - Tax Treaties 

Most well known tax havens do not have an extensive 
network of tax treaties. There are, however, some exceptions. 
Knowledgeable persons consider the Netherlands to be a tax 
haven, notwithstanding its sophisticated and well administered 
tax system and high tax rates. This is because of its 
network of income tax treaties, its special holding company 
legislation, and administration of its tax laws to facilitate 
the use of Netherlands companies by third country residents. 
The Netherlands Antilles has an income tax treaty with the 
U.S., and special Netherlands legislation, similar in effect 
to a tax treaty, gives the Antilles a tax treaty relationship 
with the Netherlands. 

B. Background 

Tax havens, or something like them, have been used for 
centuries. While some tax havens have evolved through a 
history of laissez-faire economic policies, others, partic- 
ularly those specializing in attracting corporations, have , 
been created as a matter of deliberate government policy. — ' 

1. Historical Background 

People have been looking for ways to avoid taxes for 
many years. Likewise, governments have been using tax 
incentives to attract or maintain business for many years. 

For example, the ancient city of Athens imposed a tax 
on merchants of two percent of the value of exports and imports, 
Merchants would detour twenty miles to avoid these duties. 
The small neighboring islands became safe havens in which to 
hide merchandise to be smuggled into the country at a later 
date. — In the middle ages, the City of London (as well as 
other jurisdictions) exempted Hanseatic traders resident in 
London from all taxes. — ' 

In the fifteenth century, Flanders (now Belgium) was a 
thriving international commercial center. Its government 
imposed few restrictions on domestic or foreign exchange and 

10 / C. Smith, Tax Havens , 1-4 (1959). 

11 / D. Wells, Theory and Practice of Taxation , 91 
(1900), (Wells ). 

12 / C. Doggart, Tax Havens and Their Uses , 1-5 
(1979), (Doggart) . 


freed much trade from duties. English merchants supplied 
the needed raw materials, preferring to sell wool to Belgium 
rather ^^^n to England where they would incur numerous 
duties. — ' 

Holland (which some consider a tax haven today) was a 
tax haven during the sixteenth, seventeenth, and eighteenth 
centuries, applying a minimum of restrictions and duties. 
The commerce attracted made its ports important.—'^ 

International tax avoidance is not new to the U.S. In 
1721, the American colonies shifted their trade to Latin 
America , in order to avoid paying duties imposed by Eng- 
land. — The tax morality which developed from this avoid- 
ance of English duties has been described as follows: "The 
fact that the colonists were constantly evading the naviga- 
tion acts, and made no pretense of paying the duties imposed 
by England must have had a demoralizing effect, and taught 
them , to evade duties imposed by their own lawmakers . . . 

2, Modern Background 

The prototype of the modern tax haven is Switzerland, 
which developed as a "haven" for capital (rather than as a 
"haven" from tax) for those fleeing political and social 
upheavals in Russia, Germany, South America, Spain and the 
Balkans. — 

Today, most major havens are also offshore financial 
centers, that is centers for international borrowing and 
lending in non-local currency. International banking dates 
back to the Renaissance, and modern international banking to 
the early nineteenth century. — Initially, European banks 

13 A. Barton, World History for Workers , 52 (1922). 

14/ Wells , at 74. 

15 / Hill, Early Stages of the United States Tariff Policy , 

16 / Id . at 36. 

17 / Doggart , at 1. 

18 / This portion of the report is based to large extent 
on J. Sterling, Unpublished thesis, John Hopkins 


grew and branched out to finance the burgeoning international 
trade. The Bank of Nova Scotia, Canada's second oldest and 
fourth largest chartered bank, opened its first office in 
the Caribbean in 1889 in Jamaica. — ' 

Offshore financial centers really began to grow in the 
1950's. After World War II, eurocurrency lending (lending 
by a bank in a currency other than that of its country of 
residence) grew rapidly. In the 1950 's a European market 
for dollars outside of the U.S. developed. The uncertain 
world situation, the increased awareness of corporate treasurers 
of the advantages of depositing dollars abroad (higher 
interest), and other factors led to an escalating growth in 
this market. The imposition by the U.S. of the Interest 
Equalization Tax ( lET) in 1963, the increased sophistication 
of American banks, and the increasing credit controls imposed 
by the U.S. helped the market to grow. The web of rules in 
the mid 1960's, including the voluntary Foreign Credit 
Restraint Program (VFCR) in 1965 and the Offices of Foreign 
Direct Investment (OFDI) regulations, which required U.S. 
persons investing abroad to borrow abroad, really launched 
the offshore market. It was this latter provision which 
most increased the offshore market. In 1969, the Federal 
Reserve Board agreed to permit the establishment of shell 
branches abroad so that smaller banks could compete in the 
international financial market. Most of these shell branches 
are in the Bahamas or the Cayman Islands. 

3. Present Situation 

Today, tax havens thrive in large part because of the 
presence of foreign banks. As described above, the existence 
of this financial business clearly brings an economic advantage 
to the haven in terms of jobs and revenue. It may stimulate 
tourism and attract wealthy retirees who spend their money 
in the haven. The financial activities create an infra- 
structure which can be used by criminals to hide money as 
well as by legitimate businesses. 

C. Reasons for Use of Tax Havens 

Before describing the U.S. tax system as it applies to 
tax haven transactions, it is useful to attempt to understand 
why business is done there. Obviously, the low rates of tax 
afforded by tax havens are an inducement. There are, how- 
ever, uses which do not appear to have a significant 
tax impact. These include: 

19 / See The Bank of Nova Scotia Annual Report, 1978. 


(1) confidentiality; 

(2) freedom from currency controls; 

(3) freedom from banking controls, particularly the 
reserve requirements. 

(4) receipt of higher interest rates on bank deposits 
and to borrow at lower interest rates. 

Often the physical location is not important. Obviously, 
if one is running a hotel in the Bahamas one must be in the 
Bahamas, but if one is participating in the Eurodollar 
market one can do it from New York as well as from Nassau. 

Today, most large banks have branch offices in the 
Bahamas and the Cayman Islands. They are there primarily to 
participate in the Eurodollar market free of U.S. control. 
Often they take dollar deposits from foreign persons and 
lend them to their foreign customers, who are often subsidiaries 
of U.S. companies. These transactions could be done in the 
U.S., but the deposits would be subject to reserve requirements 
imposed by the Federal Reserve. Under these requirements, a 
portion of any deposit must be held and cannot be lent out, 
thus that reserved portion cannot produce income. Accordingly, 
it is more profitable to operate overseas where as much of a 
deposit as a bank wishes can be lent or invested. 

A stable tax haven might also be preferable as a cor- 
porate situs if one is conducting an active business in a 
potentially unstable country. For example, a U.S. company 
wishing to engage in the heavy construction industry in a 
less developed unstable country, could do so by forming a 
Bahamian subsidiary, which would then make the investment 
in that unstable country and conduct the operation. Any 
profits and assets which need not be maintained physically 
in that country could be moved out and kept in a branch bank 
in the Bahamas. In this way, the risk of an expropriation 
is minimized. By forming a corporation in a tax haven, 
there is no additional level of tax on the profits, and 
there is little danger of income being blocked by the 
imposition of currency controls. 

Another reason to use a tax haven is anonymity. Bank 
secrecy prevents the country in which a tax has been evaded 
or another crime has been committed from obtaining the 
documentary evidence needed to prosecute the offender. The 
huge volume of financial transactions conducted in a tax 


haven also gives a certain level of confidentiality to 
transactions. Accordingly, a criminal may use a high volume 
financial center tax haven such as the Cayman Islands because 
the Cayman Islands will not divulge bank information, and 
because his transactions are indistinguishable from and can 
be lost among other legitimate transactions. 

D. Foreign Measures Against Tax Havens 

The use of tax havens to avoid or evade taxation is a 
problem which affects almost all developed and developing 
countries. Problems of international evasion are not new. 
In fact, the first tax treaty signed August 12, 1843, was an 
agreement concerninq-.administrative assistance between 
Belgium and France. — ' Attempts to deal with tax havens 
have been undertaken unilaterally, as well as on a bilateral 
and multilateral basis. The concern about tax havens is 
illustrated by a German-French Memorandum-,on Tax Evasion 
and Avoidance on the International Level. — ' 

1. Unilateral Approaches 

The developed countries have taken steps to deal with 
tax havens. Most have been through tax legislation; some 
have involved currency controls. 

a. Tax legislation 

Many of the legislative initiatives of other countries 
are based on U.S. legislation. Provisions similar to subpart 
F (which taxes U.S. shareholders on certain income of con- 
trolled foreign corporations) exist in the tax laws of 
France, Germany, Canada and Japan. 

(i) Provisions similar to subpart F . Under the German 
provision, the passive income of a controlled foreign corporation 
is deemed to accrue to German shareholders if the income is 
subject to a low tax rate, which is defined as a total tax 

20 / Manual for the Negotiation of Bilateral Tax Treaties 
Between Developed and Developing Countries, United 
Nations Publications, ST/ESA/94(1979) , 29. For a 
historical overview of bilateral and multilateral 
efforts to deal with international evasion and avoidance 
see id, at 29-32. 

21 / 14 European Taxation , No. 4, 136 (April 1974). 

The concern with tax havens was made especially clear. 


burden of less than 30 percent. The control requirement is 
satisfied if the German shareholders have more than one-half 
of the control of the foreign corporation. The existence of 
a treaty containing the "affiliation privilege," (which 
treats the income from a foreign subsidiary as tax-exempt in 
the hands of the German parent company if such company holds 
a participation of at least 25 percent in the foreign subsidiary) 
prevents the application of this provision. 

The Canadian provision requires that the Canadian 
shareholder of a controlled foreign affiliate include in 
income "foreign accrual property income" in proportion to 
participation. "Foreign accrual property income" includes 
the affiliate's income from property and businesses other 
than active businesses, as well as capital gain which is 
unrelated to active business activity. The percentage 
ownership required for control, in order to be treated as a 
shareholder, is similar to that under U.S. law. Like the 
U.S. and unlike the other provisions modeled after subpart 
F, there is no requirement that the foreign affiliate be 
located in a low tax country, or that the income of the 
foreign affiliate be subject to a low tax. 

The Japanese anti-haven law basically provides that 
Japanese income tax shall be imposed currently upon the pro 
rata share of the undistributed income of so-called "specified 
foreign subsidiaries" attributable to Japanese resident or 
corporate shareholders owning, directly or indirectly, 10 
percent of the total shares of the foreign subsidiary. Under 
the statute, a "specified foreign subsidiary" is defined 
as a foreign corporation or other legal entity more than 50 
percent of the issued shares of which are owned, directly or 
indirectly, by Japanese residents or by corporations which 
have a Japanese resident shareholder who owns or belongs to 
a family shareholding group owning, directly or indirectly, 
10 percent or more of the total shares issued by the foreign 
subsidiary, and which is incorporated in a low tax country. 
Determination of the latter is to be made by the Minister of 
Finance on a case-by-case basis. 

An exemption from the Japanese statute is provided if 
the foreign subsidiary: is not a mere holding company; has 
a physical facility in its country of residence necessary 
for its business activities; has local management and control; 
engages in its business activity, principally with unrelated 
parties or in its country of residence, depending upon the 
type of activity; has not received greater than five percent 
of its gross revenues in the form of dividends from other 
"specified foreign subsidiaries." The Japanese provision, 
unlike the U.S. sul- ■>art F provision, does not define particular 


types of activities as "tainted," but instead treats certain 
companies, namely those incorporated in low tax countries, 
as "tainted." However, the activities of the "specified 
foreign subsidiary" are crucial to the determination as to 
whether an exemption is to be applied. 

The French provision provides that where an enterprise 
liable for corporate tax owns, directly or indirectly, at 
least 25 percent of the shares of a corporation based in a 
country with a privileged tax regime, the French enterprise 
will be taxed on the profits (whether or not distributed) of 
the foreign company in proportion to its rights in the 
foreign company. The standard used in determining whether 
a country has a privileged tax regime is whether that 
country's tax on income and profits is notably less than 
the French tax. The provision will not apply if the enter- 
prise satisfies the tax authorities that the foreign country 
is actually engaged in industrial or commercial activities 
predominantly with unrelated parties. 

(ii) Transfer pricing . Most developed countries have 
adopted transfer pricing rules giving their tax administrators 
the authority to reallocate income or scrutinize transactions 
between related parties and disallow costs which are determined 
not to be arm's length. These provisions apply generally, 
and are not focused particularly on tax haven transactions. 

(iii) Transfers of property abroad . The United Kingdom 
taxes a United Kingdom resident who has the power to enjoy 
the income of a foreign person (including a foreign corporation 
or trust) . The income is treated as income of the resident. 
For it to be taxed, it must have arisen from assets transferred 
out of the United Kingdom. The provision also treats as 
income of a U.K. resident any capital sum (including amounts 
categorized as a loan) that a U.K. resident is entitled to 
receive with respect to the property transferred, to the 
extent of income generated by the transferred property. 
Therefore, if property is transferred abroad by a U.K. 
resident to a foreign trust and the U.K. resident receives 
money in the form of a loan from the foreign trust, the 
amount received by the U.K. resident will be taxed to him to 
the extent of any income of the trust. This provision 
should be compared to § 679 of the Internal Revenue Code, 
which treats a U.S. person who transfers property to a 
foreign trust as the owner of the portion of the trust 
attributable to such property, if for such year there is a 
U.S. beneficiary of any portion of the trust. 


The Netherlands has neither a specific provision aimed 
at tax haven abuse, nor anything comparable to subpart F. 
However, the transfer of property by Dutch citizens to a 
foreign corporation which accumulates portfolio income is 
treated as a sham transaction by the Dutch authorities. The 
effect is that the foreign corporation would be treated as a 
Dutch corporation or merely as a collection of Dutch individuals. 

(iv) Provisions relating to deductions . Specific tax 
provisions denying deductions with respect to activities 
carried on in low tax countries exist under French and 
Belgian law. The French tax code provides that interest, 
royalties, or consideration for services paid by a person 
domiciled or established in a foreign country which has a 
privileged tax regime are deductible for tax purposes, only 
if taxpayers prove that the expenses incurred correspond to 
actual operations, and are not abnormal or exaggerated. The 
definition of privileged tax regime, for purposes of this 
provision, is a country in which the tax on profits or 
income is noticeably less than taxes in France. Belgian law 
contains an almost identical provision. Under both provisions, 
the burden of proof as to the deductibility of the payments 
made to the foreign entity shifts to the taxpayer. This is 
contrary to many other French tax statutes. 

The purpose of the French and Belgian provisions, 
limiting or denying payments with respect to low tax countries 
is to prevent the taxpayer from deducting payments made to 
persons in countries with a privileged tax regime for facilities 
or overvalued services rendered, since the taxpayer must 
prove that such operation is a normal one. The French tax 
authorities have found the provision quite effective. 
However, it deals with merely one part of the tax haven 
problem. In the normal situation, the aim is to avoid tax 
on the income generated by the transferred property, rather 
than to obtain a deduction for facilities provided or services 
rendered by the foreign entity. 

(v) Expatriation . Under German law, a provision 
similar to §877 of the Internal Revenue Code applies to 
German citizens or former German citizens who transfer their 
residence from Germany to a low tax country and who, for 
five out of the last 10 years, were German citizens or 
subject to German tax as residents. If such individual 


retains a significant economic interest in the Federal 
Republic of Germany or West Berlin after transferring residence 
abroad, and if the transfer is to a low tax country (a 
country imposing less than 2/3 of the tax imposed by Germany), 
then such individual is subject to extended tax liability as 
a nonresident (which involves taxation of German source 
income but without certain exemptions available to a nonresident 
who did not emigrate). 

The United Kingdom, under the Capital Transfer Tax Act, 
imposes a tax on the transfer of property situated in the 
united Kingdom. The provision applies to a domiciliary, 
even if he is no longer resident in the United Kingdom. The 
provision was enacted to prevent a domiciliary from trans- 
ferring domicile and thereby avoiding all tax on non-U. K. 
assets. If, however, the individual is not living in the 
U.K., there is a practical problem of obtaining information 
to enforce the provision, and of collecting the tax unless 
assets are still in the U.K. 

Under Canadian rules, an individual who expatriates 
from Canada is subject to a tax on the appreciation of his 
property on the date he expatriates. The tax is imposed on 
an amount equal to the value of the property less its basis. 

(vi) Special provisions . France has a specific provision 
aimed at preventing artists incorporating themselves in low 
tax countries and performing services in France. Under the 
provision, if proceeds are received by a corporation ("artist 
corporation") or other legal entity which has its seat of 
management outside of France in consideration for services 
rendered by persons domiciled in France, the proceeds are 
taxed to the persons domiciled in France if: (1) such 
persons participate, directly or indirectly, in the management, 
control, or capital of the foreign legal entity; (2) if the 
persons domiciled in France do not prove that the foreign 
legal entities are engaged in an industrial or commercial 
activity other than the rendering of services; or (3) in any 
case in which the foreign legal entities have their seats of 
management in a country which is not linked to France by an 
income tax treaty or has a privileged tax regime. There- 
fore, if a corporation has its seat of management in a tax 
haven country and receives payments for services rendered in 
France by a domiciliary of France, the income received from 
the rendering of the services is taxed to the individual 
domiciled in France. 


b. Non-Tax Measures 

Control of tax haven abuse has not been limited to tax 
legislation. Australia dealt with tax haven activities 
through foreign exchange controls. Under Australian law, a 
transfer of funds overseas requires bank clearance. Under 
the Banking Act, the reserve bank is required to refer to 
the Australian Commissioner of Taxation any applications 
made to the bank for authority to deal in any jurisdiction 
listed as a tax haven. The Taxation Department has the 
authority to issue a certificate, and may refuse to issue 
the certificate if the taxpayer does not satisfy the 
Commissioner that the actions proposed in connection with 
the application will not involve the avoidance or evasion 
of Australian tax. The foreign exchange controls through 
the banking system and the requirement of a tax certificate 
for transfers to tax haven countries are the principal 
methods used by Australia in controlling tax haven abuses. 

There is no provision in Australian law comparable to 
subpart F; foreign trusts are not regulated, since transfers 
are regulated; and there are no provisions restricting 
deductions with respect to activities carried on in tax 
haven countries. The Australian Government believes that 
such provisions are unnecessary, because the foreign exchange 
controls and the requirement that a tax certificate be 
obtained insure that only bona fide activities in tax haven 
countries would be permitted in the first place. However, 
notwithstanding the controls, circumvention is possible if 
a transfer were made to a non-tax haven country followed 
by a transfer to a tax haven country. 

France also has exchange controls which regulate the 
transfer of property outside of France, but the controls are 
general in nature and are not specifically directed at tax 
haven abuses. 

c . Effectiveness 

The effectiveness of legislation against tax haven 
abuse varies from country to country. Australian tax authorities 
believe that foreign exchange controls and the elimination 
of certain Australian territories as tax havens has been 
very effective in combating tax haven abuse. However, it 
was not clear that this has completely solved the problem. 
For example, money could still be invested in a non-tax 
haven country and then transferred to a tax haven. 


The German experience with tax haven legislation adopted 
in 1972 has been positive. Prior to its enactment, the German 
tax authorities had to rely on general principles of tax law. 
This gave rise to a great deal of litigation and mixed 
success in courts. The litigation difficulties resulted in 
a reluctance of German tax authorities to pursue cases of 
tax haven abuse. With the enactment of the 1972 legislation, 
the tax administration has actively pursued cases of tax 
haven abuse. They have noted an increased willingness of 
taxpayers to settle rather than litigate, and also have 
noted a decline in use of holding companies in tax havens. 
Despite the effectiveness of the legislation, there remains 
a significant problem of illegal transfers and the use of 
the secrecy laws of tax havens to conceal the transfer of 

The French and Japanese provisions modeled after sub- 
part F are new, and it is too early to ascertain their 
effectiveness. As discussed previously, France has a 
provision which shifts the burden of proof to the taxpayer 
with respect to deductions taken relating to activities in 
tax haven countries. France has found this provision an 
effective tool to prevent French taxpayers from deducting 
payments made to persons in countries with a privileged tax 
regime for facilities or overvalued services. 

Even though the recent tax haven legislation enacted 
in Western Europe and Japan gives the tax administrations 
the legal tools necessary to fight tax haven abuse, problems 
remain due to the circumventing of the provisions by illegal 
and fictitious transfers and the use of secrecy laws existing 
in tax havens to frustrate tax authorities. 

2. Multilateral Approaches 

In the past decade, the growing concern with inter- 
national tax evasion and avoidance in general, and tax 
havens in particular, has led to various efforts. 

The only multilateral convention dealing specifically 
with international tax evasion and avoidance is the Con- 
vention on Administrative Assistance in Tax Matters Concluded 
by Denmark, Finland, Iceland, Norway and Sweden. This 
convention was signed on November 9, 1972, and supplemented 
in 1973 and 1976. 


In 1975, the European Economic Community adopted a 
resolution on measures to be taken to combat international 
tax evasion and avoidance. The Council of the Community, 
on December 19, 1977, adopted a directive concerning mutual 
assistance on direct tax matters. 

In April of 1978 the Parliamentary Assembly of the 
Council of Europe adopted a recommendation on cooperation 
between Council of Europe member states against international 
tax avoidance and evasion. — ' This recommendation recognized 
an increase in international tax avoidance and evasion, and 
a lack of efficient cooperation between European tax adminis- 
trations. The Parliamentary Assembly recommended that the 
European countries conclude a European multilateral agreement 
on combating international tax evasion and avoidance, including 
an exchange of information. It also urged member governments 
(which include Switzerland) "to abolish unduly strict rules 
on bank secrecy, wherever necessary, with a view to facili- 
tating investigations in cases of tax evasion or concealing 
income arising from other criminal activities, while paying 
due regard to the protection of individual privacy." The 
Council also recommended that member countries refrain from 
enacting holding company legislation and take actions to make 
it more difficult for multinational companies to use tax 

The Assembly of the Council of Europe held a colloquy 
on international tax avoidance and evasion from March 5 to 
7, 1980, in an attempt to define international tax evasion 
and avoidance issues, which might be handled multilaterally , 
and to define approaches to the problems. The colloquy 
focused on the relative advantages and difficulties of 
bilateral as opposed to multilateral cooperation. 

The OECD also has addressed the problem of tax avoidance 
and evasion. The OECD Council adopted, on September 21, 
1977, a recommendation calling upon member governments to 
strengthen their powers to detect and prevent international 
tax avoidance and evasion, and to develop exchanges of 
information between tax administrators. A working party 
of the OECD Committee on Fiscal Affairs is presently con- 
sidering this problem. 

22/ Recommendation 833 (1978) 


III. Statistical Data on Patterns of Use of Tax Havens 

The data relating to the volume of tax haven use are 
summarized in this chapter. The data are not all inclusive. 
For each of the categories the available data for the most 
important tax havens for that category were included. 

A. Levels of Use by U.S. Persons Through Tax Haven Companies 

Data on direct investment in tax havens are summarized 
below. The data are taken from forms filed by U.S. share- 
holders of controlled foreign corporations and from surveys 
conducted by the Commerce Department. There are large gaps 
in data on the direct investment of U.S. persons which are 
not corporations. Accordingly, levels of investment through 
tax havens is probably understated. 

Use of tax havens by U.S. persons is large and appar- 
ently growing. The available data, and interviews with 
practitioners and IRS personnel, have shown that taxpayers 
ranging from large multinational companies to small individuals 
are making extensive use of tax havens. 

Direct investments in particular are growing much 
faster than similar activity in the non-havens. Commerce 
Department data reflected in Table 1 show that in 1968 U.S. 
direct investment levels in tax haven corporations was $4.7 
billion, which represented 7.6 percent of total U.S. direct 
investment in U.S. controlled foreign enterprises. In 1978, 
U.S. direct investment in tax haven enterprises was $23.0 
billion, representing 13.7 percent of total U.S. direct 
investment in U.S. controlled foreign enterprises. Between 
1968 and 1978, the data show an increase of almost five 
times in U.S. direct investment in business formed in tax 
havens and about a two and a half times increase in investment 
in non-tax haven businesses. 

Commerce Department data in Table 1 show that the 
earnings of U.S. controlled businesses formed in tax havens 
increased from $0.5 billion in 1968 to $4.4 billion in 1978, 
an increase of nine times. During the same period, earnings 
of U.S. controlled businesses formed in non-tax havens 
increased three and a half times from $6.0 billion to $21.3 

These trends are more pronounced in some of the better 
known tax havens. For example, direct investment levels in 
foreign businesses formed in the Bahamas increased from less 
than $0.4 billion in 1968 to $1.8 billion in 1976, approximately 
a five fold increase. Over the same period, however, earnings 
of those businesses increased seventeen times, from $44 million 


to $746 million. In Bermuda, direct investments increased 
from $0.2 billion in 1968 to $7.2 billion in 1978, a 37 fold 
increase, while earnings increased from $25 million to $959 
million, or 38 times. Most of the increases in Bermuda 
occurred between 1972 and 1978, which partially reflect the 
growth in captive insurance business. 

IRS data in Table 2 are limited to figures reported on 
the Form 2952 filed by corporate U.S. shareholders of con- 
trolled foreign corporations, , These data show a similar 
trend between 1968 and 1976.— There is also evidence that 
tax haven jurisdictions are increasingly diverting U.S. 
capital away from economically advanced countries that have 
highly developed systems of business taxation. In 1968 U.S. 
controlled foreign corporations formed in tax havens had 
assets of $11.7 billion, which represented 12.1 percent of 
the assets of all U.S. controlled foreign corporations. In 
1976, such corporations had assets of $55.4 billion, which 
represented 17.6 percent of the assets of all U.S. controlled 
foreign corporations. IRS data show an almost five fold 
increase in the assets of U.S. controlled corporations 
formed in tax havens, and a three fold increase in the 
assets of non-tax haven corporations. 

IRS data in Table 2 show the industrial composition of 
controlled foreign corporations formed in the tax havens. 
The data indicate that the composition in tax havens differs 
from the composition in non-tax havens. For example, assets 
of manufacturing companies as a percent of assets of all 
companies formed in the tax havens was 13.7 percent in 1976. 
In non-tax havens, it was 54.8 percent. In tax havens, the 
combined total of assets in finance, insurance and real 
estate, wholesale trade, transportation (essentially shipping), 
construction and services — typical tax haven industries — was 
81.2 percent of total assets. For companies formed in non- 
tax havens, for the same year, it was 37.8 percent. 

1/ 1976 is the last year for which IRS data are available. 


Another indication of relative tax haven use is the 
pattern of growth in U.S. ownership of foreign corporations. 
Data for the period 1970-1974, and 1974-1979 are taken from 
Table 3. These data show that for the period 1970 to 1974 
the number of wholly or almost wholly owned tax haven sub- 
sidiaries decreased by 2.9 percent, while the comparable 
number of non-tax haven subsidiaries increased by 7.6 percent. 
For the period 1974 to 1979 this trend reversed. The number 
of wholly or almost wholly owned tax haven subsidiaries 
increased by 42.7 percent, and the number of wholly owned 
non-tax haven subsidiaries increased by 26.4 percent. 

The available figures for U.S. investment in other 
foreign corporations have always shown a great pro-tax haven 
bias. For the period 1970-1974, the number of tax haven 
corporations in which U.S. persons owned an interest of 5 to 
50 percent increased 164.8 percent, while the increase in 
non-tax havens was 57.8 percent. From 1974 to 1979 the 
increases were 36.4 percent in the havens and 17.1 percent 
elsewhere. Patterns of growth in foreign corporations where 
the U.S. interest is from over 50 to 94 percent, reflect a 
similar pro-tax haven bias. 

There are other indications of significant and increasing 
usage of tax haven corporations to conduct business outside 
of tax havens. In 1979 U.S. persons owned five percent or 
more of the stock of 10,400 tax haven corporations and 
52,000 corporations formed in non-tax havens. The relative 
importance of those figures is more meaningful when looked 
at in terms of ratios of corporations to population. In 
1979, there were 55.1 such corporations formed in tax havens 
per 100,000 population, and only 1.2 corporations per 100,000 
population in non-tax havens. These represent increases 
from 32.9 in tax havens in 1970 and from 0.9 in non-tax 

The growth in ownership of Western Hemisphere tax 
haven companies is even greater. In 1979 there were 108.1 
foreign subsidiaries of U.S. persons per 100,000 population, 
about 40 more than in 1970. In non-tax haven areas of the 
Western Hemisphere the growth was negligible, from 2.0 per 
100,000 of population in 1970 to 2.1 in 1979. 

B. Levels of Use by Foreign Persons 

Foreign investment in the U.S. through tax havens is 
more difficult to measure. The indirect measures from IRS 
data on non-resident alien gross income paid by U.S. payors, 
and incomplete data from the Commerce Department on direct 
investments in the U.S., indicate that the level of inward 


investment from the tax havens is very high. In 1978, U.S. 
gross dividends, interest and other income payments to 
recipients in the havens increased $1.9 billion. These 
sums as a percentage of total such payments to all non- 
resident aliens were 42 percent. In 1978, payments to 
Switzerland alone were about $1.2 billion, which was 26 
percent of payments to all non-resident aliens. Payments to 
the Netherlands Antilles was another $0.2 billion, which 
accounts for an additional four percent of the total. 
Thus, there is at least an indication of third country use 
of tax havens for investment in the U.S. 

A large portion of foreign capital invested in the U.S. 
from the tax havens is flowing through business organi- 
zations. In 1978, nearly 80 percent of all U.S. gross 
income paid to the havens and reported to the IRS on Forms 
1042S went to foreign corporations. 

The use of income tax treaties with tax havens, and the 
relevant data, are discussed in Chapter VIII. 

C. Levels of Use by Banks 

The presence of international banking facilities is 
essential to tax haven use. Initially, in most instances, 
assets which are to be invested abroad through a tax haven 
would move through the international banking system. The 
international deposits by non-banks held in banks resident 
in tax havens is a major use of tax havens to hold assets. 
Accordingly, this study attempted to measure levels of 
banking activity in the tax havens. 

The estimates were developed from national source data 
in the tax havens, where available, as well as from Federal 
Reserve data. In the few cases where complete national 
source data were not available estimates were made. 

Data for this discussion are taken from Table 4. These 
data show that total deposits in banks resident in the tax 
havens surveyed were $385 billion dollars at year end 1978. 
This figure includes deposits by other banks as well as 
deposits from non-banks. Deposits by non-banks were $89 
billion at year end 1978. Comparable figures for year end 
1968 were $11 billion and $5 billion respectively. The data 
show a sustained very rapid growth throughout this period. 
This growth occurs both before and after the rapid escalation 
in the price of petroleum. 

The growth appears to be even more rapid in the case of 
deposits -in banks resident in the Western Hempishere tax 
havens,- particularly in the case of deposits by non-banks. 

2/ Primarily the Bahamas, the Cayman Islands, and Panama. 


At year end 1978 total deposits in these banks (by both 
banks and non-banks) were $160 billion, and total deposits 
by non-banks were $32 billion. Most deposits in banks 
resident in Western Hemisphere tax havens are in branches or 
subsidiaries of U.S. banks. The Western Hemisphere data are 
particularly relevant to the U.S. Since to a great extent, 
the data reflect U.S. use of tax haven banking facilities. 
This is because of the conveniences of using Western Hemisphere 
tax havens, including the fact that they are in or near the 
same time zones as the major money center banks in the U.S. 

D. Levels of Use by Tax Evaders 

In the course of this study members of the Unreported 
Income Research Group of the Internal Revenue Service attempted 
to estimate the levels of use of tax havens to further non- 
compliance with U.S. tax laws. Because of the lack of 
available information, it was not possible to develop reliable 
estimates. Currency flow projects now underway hopefully 
will develop data that, when combined with other information, 
including data developed for this study, will throw some 
light on illegal use of tax havens. 

While the study did not estimate the use of tax havens 
to hide evasion money, it did develop a methodology which, 
given a firm commitment of resources over a few years, 
might be extended to estimate noncompliance as a residual 
derived from total tax haven funds. If this approach were 
used, it would first be necessary to estimate total foreign 
assets in tax havens, including nondeposit assets. (The 
methodology developed for this study resulted in reliable 
estimates mainly relating to international deposits held in 
or through tax havens. ) Then, it would be necessary to 
subtract: (1) funds invested in the tax havens which do not 
belong to U.S. persons, and (2) funds invested in tax havens 
which are legally earned and reported to tax authorities. 

Another problem with estimating the use of tax havens 
by tax evaders is that funds may be "laundered" by being 
deposited in a tax haven bank and immediately withdrawn. 
The volume of these kinds of transactions is almost impossible 
to measure because neither data nor adequate methods to 
estimate such flows are available. 

The study team did estimate important aspects of tax 
haven use, but because of significant data gaps, could not 
develop a total estimate. Firm evidence was found that 
total tax haven deposit assets were at least $118 billion at 
the end of 1978. The findings on Swiss banking data give 
some insight into the use of tax havens to achieve anonymity. 
Swiss banks maintain three types of accounts: regular 
deposit accounts, fiduciary accounts, and security-advisory 
accounts. Fiduciary accounts consist almost entirely of 


deposits by non-residents of Switzerland which are deposited 
in banks outside of Switzerland. The deposits are generally 
in the name of the Swiss bank, but for the account and the 
risk of the depositor. The Swiss banks charge a fee of 
between 1/8 and 1/2 percent of the amount of the deposit for 
this service. Because this deposit in non-Swiss banks could 
be made directly, it can be assumed that a significant portion 
of deposits in these accounts belong to persons seeking 
secrecy. It is reported that as of the end of 1978 deposits 
in fiduciary accounts totaled $29.3 billion. 

The security-advisory accounts are essentially trust 
accounts which are expensive to maintain. The proceeds of 

these accounts are not usually deposited in other banks, but > 

are used to invest in other financial or fixed assets. J 

There are^no data for these accounts, although based on i 

estimates— and information provided by some knowledgeable i 

sources, it may be estimated that total assets may range 

between $60 and $140 billion. These accounts may hold ^ 

bearer shares, and are recognized as an important factor in , 

the Eurobond market. In any event, such figures could be » 

used at least to estimate the levels of haven use to buy |J 

anonymity. ' 

3/ M.S. Mendelsohn, Money on the Move , 221 (1980). , 


















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Table 2 
Assets of U.S. -Controlled Foreign Corporations in 
Tax-Haven and Other Areas. 1968 and 1976 

Total Assets* in 

Tax Havens — 

Other Areas 


All Areas — 

(Amounts in Billion $s^ 


Ml Industries 




Contract construction 












Wholesale trade 




Finance, insurance and 

real estate 










Holding and other in- 
vestment companies- 















)ther industries 





Wl Industries 




Contract construction 












Wholesale trade 




Finance, insurance and 

real estate 










Holding and other in- 
vestment companies- 
















Other industries 




Assets in havens 
as a percent of 
assets in all 

















- Tax-haven areas covered are the Bahamas, Bermuda, Costa Rica, Netherlands Antilles, 
Other British West Indies (other than Cayman Islands^ Panama, Bahrain (for 1976 
only), Hong Kong, Liberia, Liechtenstein, Luxembourg, Singapore, and Switzerland. 


- Sum of two components may not add up to the totals because of rounding. 

- Excludes bank holding companies which are included in Other. 

Source: U.S. Department of the Treasury, Internal Revenue Service, Statistics of Income — 
1968-1972, International Income and Taxes, U.S. Corporations and Their Controlled 
Foreign Corporations , Washington, D.C., U.S. Government Printing Office, 1979 and 
unpublished tabulations on Controlled Foreign Corporations (from Form 2952) of U.S. 
corporations with assets of $250,000,000 or more (giants) for 1968, 1972 and 1976. 

^These were estimated for 1976 since the actual data tabulated from Forms 2952 covered only 
the assets of CFCs controlled by the giants. To include also the assets of CFCs of smaller 
U.S. corporations, the data on giants were stepped up based on observed ratios between total 
CFCs and CFCs of giant U.S. corporations for 1968 and 1972. These ratios were projected 
forward to 1976 by industry. (The step-up ratio for all industries for 1976 was 1.128 in 
tax-haven areas and 1.118 in other areas. 


Table 3 

Patterns of Growth in U.S. -Owned Foreign Corporations 
by Area and Percent of U.S. Ownership, 1970-1979 

(In Percents) 
























Bermuda , 
British Islands 













Costa Rica 






















Western Hemisphere 

Tax-Haven areas 














Hong Kong 



































Other tax-haven 








Total tax-haven 
















CFCs stands for Controlled Foreign Corporations, where more than 50 percent 
of all the voting stock is owned by U.S. shareholders. 

To be considered U.S. -owned, there must be at least five percent ownership. 

British Islands consist of British Antilles, British Virgin Islands, Cayman 

Islands, Montesserat, Anguila, Nevis, St. Christopher (also known as St. Kitts), 

Antigua, Dominica, St. Lucia and St. Vincent. 

Source: U.S. Treasury Department, Internal Revenue Service, unpublished tabulations 
from Form 959. 













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IV. United States Taxation of International Transactions 
and the Anti-Avoidance Provisions - An Overview 

The Congress has never sought to eliminate tax haven 
operations by U.S. taxpayers. Instead, from time to time, 
the Congress has identified abuses and legislated to eliminate 
them. The result is a patchwork of anti-avoidance provisions, 
some intended to deal particularly with tax havens, although 
of general application, and some intended to deal with more 
general abuse situations, but which might also be used by 
the IRS to deal with tax haven transactions. 

When dealing with illicit use of tax havens, the substantive 
tax rules are rarely the problem (although lack of clarity 
often encourages illicit use). Rather, gaps in United States 
evidence-gathering ability hinder attempts to prosecute 

The discussion below seeks to place tax havens within 
the context of the U.S. system of taxing international 
transactions. When the system is analyzed, it becomes clear 
that without appropriate anti-abuse provisions, the U.S. tax 
system contains provisions which would encourage the use of 
low tax jurisdictions by U.S. persons, and that where anti- 
avoidance provisions are not effective, U.S. persons have 
positively responded to this encouragement. It is also 
clear that tax havens, in and of themselves, do not provide 
a U.S. tax advantage; the U.S. tax advantage is provided 
only in combination with both the U.S. system of deferral of 
taxation of corporate earnings and the U.S. system of consolidated 
worldwide foreign tax credits. 

It cannot be emphasized too strongly that tax haven 
problems cannot be completely divorced from the taxation of 
international transactions in general, or from non-tax 
policy concerns. Accordingly, some of the materials address 
more general problems. 

A. Policy Objectives 

Stated United States tax policy is decidedly against 
tax haven use. However, in practice that policy becomes 
ambivalent. It reflects an unresolved conflict between the 
following policy objectives: 

(1) Maintaining the competitive position of U.S. 
businesses investing abroad or exporting; 

(2) Maintaining tax equity as between investment in 
the U.S. and investment abroad; 

(3) The need to provide fair rules for taxing foreign 
investment ; 


(4) Administrative efficiency; 

(5) Foreign policy considerations; 

(6) Promotion of investment in the U.S. 

The result has been policy ambiguities and compromises 
in legislation which have failed to resolve these conflicts, 
and which have left U.S. law without a clear focus with 
respect to tax havens. Concern for administrative feasibility 
has been practically non-existent. 

The development of U. S. taxation of foreign transactions 
shows a consistent tension between these objectives. For 
example, Congress introduced .the foreign tax credit as part 
of the Revenue Act of 1918.— They did so not only to 
provide a "just" system, but "a very wise one," without 
which "we would discourage men from going out after commerce 
business in different countries or residing for such purposes 
in different countries if we continue to maintain this 
double taxation."— 

Nowhere is this tension more apparent than when it is 
focused on tax havens. Nowhere is the failure to resolve 
the policy issues more obvious. Congress over the years, 
while maintaining deferral of tax on the earnings of foreign 
corporations controlled by U.S. persons, has at the same 
time passed numerous anti-avoidance provisions generally 
intended to solve perceived tax haven-related problems. All 
have had numerous exceptions, have been complex and difficult 
to administer, and all have had gaps (many intended, some 
not) . 

The tension between the policies and the ultimate 
attempt to deal with tax avoidance through tax havens, came 
to a head in connection with the legislative deliberations 
which resulted in the Revenue Act of 1962 and subpart F of 
the Code.-/ 


Revenue Act of 1918, §§222(a) and 238(a). 

-/ 56 Cong. Rec . 677-78 (1918) 
-/ §§ 951-964. 


President Kennedy in his State of the Union Message had 
recommended that the tax deferral accorded foreign corporate 
subsidiaries of U.S. corporations be terminated in all 
cases. His emphasis, however, was on haven practices. He 
stated that, 

"The undesirability of continuing deferral is 
underscored where deferral has served as the shelter 
for escape through the unjustifiable use of tax havens 
such as Switzerland. Recently more and more enter- 
prises organized abroad by American firms have 
arranged their corporate structures aided by artificial 
arrangements between parent and subsidiary regarding 
intercompany pricing, the transfer of patent licensing 
rights, the shifting of management fees, and similar 
practices which maximize the accumulation of profits 
in the tax haven--so as to exploit the multiplicity 
of foreign tax systems and international agreements 
in order to reduce sharply or eliminate completely 
their tax liabilities both at home and abroad."—^ 

The President's recommendation was, 

"elimination of the tax haven device anywhere in the 
world, even in the underdeveloped countries, through 
the elimination of tax deferral privileges for those 
forms of activities such as trading, licensing, insurance, 
and others, that typically seek out tax haven methods 
of operation. There is no valid reason to permit 
their remaining untaxed regardless of the country in 
which they are located."— 

The Congress, however, refused to go as far as the 
President recommended. Rather, it singled out tax haven 
devices, but did not end deferral for operating companies 
not considered to be using tax haven devices. The reasons 
for the transaction approach reflected the policy of maintaining 
the competitive position of U. S. business overseas. They 
stated that their bill: 

4/ ... 

— ' President's Recommendations on Tax Revision; Hearings 

Before the House Ways and Means Committee , 87th Cong., 

1st Sess. 8 (1961). 

-/ Id. at 9. 


". . . does not eliminate tax deferral in the case of 
operating businesses owned by Americans which are 
located in economically developed countries of the 
world. Testimony in hearings before your committee 
suggested that the location of investments in these 
countries is an important factor in stimulating American 
exports to the same areas. Moreover, it appeared that 
to impose the U. S. tax currently on the U.S. shareholders 
of American-owned businesses operating abroad would 
place such firms at a disadvantage with other firms , 
located within the same areas not subject to U.S. tax."— '^ 

In fact, subpart F as finally enacted was a limited 

response to President Kennedy's initial proposal. Only the ) 

most obvious tax haven issues identified at the time were J 

addressed. « 

The evidence submitted during the 1961 and 1962 delibera- [j 

tions demonstrated a significant use and rapid growth of tax ^ 

havens by U.S. multi-nationally based corporations.— A . 

memorandum and letter submitted by the Treasury described E 

the various types of operations and the recurrent severe , r 

administrative problems in dealing with the operations.—''^ ^ 


Nevertheless, in reality, subpart F was not drafted in g 

terms of companies formed in tax havens. Rather, it focused n 

on defined activities conducted abroad which were generally 
considered tax haven devices. While the Congress repeatedly 
referred to the provision as an anti-tax haven provision, in ( 

fact, it can apply in developed countries as well as in tax k 

havens. It is transactional, not jurisdictional. The j 

Congress also provided significant exceptions from the 

application of subpart F for certain businesses. In 1975 

and again in 1976, significant changes in some of the exclusionary t 
rules were made. 




H. Rep. No. 1447, 87th Cong., 2nd Sess. 57-58 (1962), 
1962-3 C.B. 405, 461-462 ( H. Rep. No. 1447). 

President's Recommendations on Tax Revision; Hearings 
Before The House Ways and Means Committee , 87th Cong., 
1st Sess. 3522 (1961). In 1978, President Carter also 
recommended elimination of tax deferral in the case of 
foreign corporations owned by U.S. persons. However, the 
Congress did not adopt this proposal. See President' s 
1978 Tax Reduction and Reform Proposals: Hearings Before 
The House Committee on Ways and Means , 95th Cong. , 2d Sess, 
19 (1978). 

Proposed Amendments to the Revenue Act of 1954; Hearings 
on H. R. 10650 Before The Senate Committee on Finance , 
87th Cong., 2d Sess. 228 (1962). 


In addition to legislative provisions the U. S. has in 
force a network of income tax treaties, including some with 
tax havens. These treaties also reflect a tension between 
similiar inconsistent policy objectives and, in addition, a 
policy to encourage foreign investment in the U.S. 

While treaties are discussed in a later chapter, it is 
worth noting at this point that their existence has clearly 
attracted taxpayers to tax havens. In fact, in at least one 
case (the Netherlands Antilles), the treaty may have created 
a tax haven. 

B. Basic Pattern 

The general rules applicable to international trade and 
investment apply to income from tax havens as they do to 
income earned in any foreign jurisdiction. While certain 
provisions were added to the Code to deal with tax avoidance 
related to tax havens, there is no provision which on its 
face deals specifically and exclusively with tax havens per 

1. General Rules 

The U.S. taxes U.S. citizens^ residents and corpora- 
tions on their worldwide income.—'^ The U.S. taxes non- 
resident alien individuals and foreign corporations on their 
U.S. source income which is not effectively connected with 
the conduct of a trade or business in the U.S. They are 
also taxed on their income which is effectively connected 
with the conduct of a trade or business in the U.S. whether 
or not that income is U.S. source or foreign source.—'^ 

Income which is effectively connected with the conduct 
of a trade or business in the U.S. is subjected to tax at 
the normal graduated rates on a net basis.— ^ Deductions 
are allowed in computing effectively connected taxable 
income, but "only if and to the extent that they are connected 
with income which is effectively connected . . . . "_/ 
Deductions and credits are allowed only if the taxpayer 
files a true and accurate return.—^ 


-' See § 1 and § 11. 

—^ §§871, 881, and 882. 

—^ §§ 871(b)(1) and 882(a)(1). 

—^ §§ 873(a) and 882(c)(1). 

— ' §§ 874(a) and 883(c)(2); Brittingham v. Commiss ioner, 
66 T.C. 373 (1976). 


United States source non-ef f ectively connected interest, 
dividends, rents, salaries, wages, premiums, annuities, and 
other fixed or determinable income received by a non-resident 
alien or foreign corporation are subject, to tax at a rate of 
30 percent of the gross amount received. — ' The net U.S. 
source capital gains of a nonresident alien present in the 
U.S. for at least 183 days during a taxable year are taxed 
at the 30 percent rate. — ' The 30 percent rate on these 
various income items may be lowered by treaty. 

Until 1980, a non-resident alien or foreign corporation 
could elect to treat all income from U.S. real property 
(including gains from its disposition, rents or royalties 
from natural deposits, and certain gains from the disposition 

of timber) as effectively connected income, and thus have it 
taxed on a net basis. — ' Once made, an election could not 
be revoked without the consent of the IRS. — ' 

The 30 percent flat rate of tax on non-resident aliens 
not engaged in trade or business in the U.S. is imposed on 
payments from U.S. sources. United States source payments 
are defined in § 861 to include interest paid by a U.S. 
person and dividends paid by a domestic corporation, with 
certain exceptions for payments from persons most of whose 
income is from foreign sources. U.S. source payments also 
include certain interest and dividends paid by a foreign 
corporation which earned more than 50 percent of its income 
from a U.S. business. — ' This gross tax on fixed or determinable 
income is often reduced or eliminated in the case of payments 
to residents of countries with which the U.S. has an income 
tax treaty. — ' 

The 30 percent (or lower treaty rate) tax imposed on 
U.S. source non-ef fectively connected income~paid to foreign 
persons is collected by means of withholding. — The person 


§§ 871 (a) and 881 (a). 
§ 871(a)(2). 

— / §§ 871(d)(1) and 882(d)(1). 


§§ 871(d) (2) and 882(d) (2) . 

— / §§ 861(a)(1)(C) and 861(a)(2)(B) 


Treaties are discussed in Chapter IX. 


— ' §§ 1441 (individuals) and 1442 (corporations). 


required to withhold is specifically liable for the tax but 
is indemnified under the Code against any claims for the 
withholding tax other than claims by the U.S. — ' Statutory 
exceptions from withholding are provided, including one for 
income effectively connected with the conduct of a trade or 
business within the U.S. — ' 

Under the regulations, the obligation to withhold in 
the case of dividends depends upon the recipient's address. 
In the case of interest and royalties, it depends on a 
certification by the taxpayer. Thus, withholding on a 
dividend payment is required if the shareholder's address is 
outside of the U.S., but not if the address is inside the 
U.S. — ' An exemption from withholding can be claimed on the 
basis of U.S. citizenship or residence. — 

Certain exemptions from the gross tax are provided. 
Bank account interest is defined as foreign source interest 
and, therefore, is exempt. — ' Likewise, interest and dividends 
paid by a U.S. corporation which earns less than 20% of its 
gross income from U. S^^sources is defined as foreign source 
income and is exempt. — Exemptions are also provided for 
certain original issue discount and for income of a foreign 
government from investments in U.S. securities. Our treaties 
also provide for exemption from tax in certain cases. 

Worldwide taxation can result in double taxation of 
foreign source income. The U.S. seeks to mitigate this 
double taxation by permitting a dollar-for-dollar credit 
against U.S. tax imposed on foreign source income. The 
limitation to foreign source income is computed on a world- 
wide consolidated basis. Here all income taxes paid to all 
foreign countries are combined to offset U.S. taxes on all 
foreign income. A credit is also provided non-resident 
aliens and foreign corporations, but only for certain foreign 
taxes imposed on foreign effectively connected income. — 

21/ § 1461. 

— / § 1441(c) (1). 

— / Treas. Reg. § 1 . 1441-3 (b) ( 3 ) . 

— / Treas. Reg. § 1.1441-5(a) and (b). 

— / § 861(a) (1) (A) and (c). 

— / § 861(a)(1)(B) and (a)(2)(A), 

21/ § 906. 


2. United States Taxation of Property Held by a Foreign Trustee 

For tax purposes, foreign trusts in general are treated 
as non-resident alien individuals. To qualify as a foreign 
trust, the entity must be both a "foreign trust," as defined 
in § 7701(a)(31) and Treas. Reg. § 301 . 7701-4^ and considered 
to be a non-resident or foreign situs entity. — ' 

Because it is taxed as a nonresident alien, a foreign 
trust which has U.S. source income not effectively connected 
with its conduct as a U.S. trade or business, would be taxed 
at the flat 30 percent rate on certain passive income and 
gains. Also, interest on amounts deposited with U.S. banks 
that is received by the foreign trust is not considered U.S. 
source income and, therefore, not taxed to the trust. If 
such interest, however, is "effectively connected" with the 
conduct of a U.S. trade or business, it may still be taxable. 


A foreign trust which is engaged in a U.S. trade or 
business is taxable at the normal graduated rates on all 
income effectively connected with the conduct of that trade 
of business, whether such amounts are sourced within or 
without the U.S.—' Prior to 1980 legislation, a foreign 
trust, as a non-resident alien, could make the special 
election under § 871(d) in the case of "real property income" 
as defined in § 871(d)(1). 

A foreign trust which is not a grantor trust can be 
used to defer U.S. tax on income from property, even when 
held for the benefit of a U.S. person. In 1962, the Congress 
first dealt with tax avoidance by the use of foreign trusts. 
The beneficiaries of foreign trusts created by U.S. persons 
were subjected to an unlimited throw-back rule at the time 
of the ultimate distribution of accumulated income. 

In 1976, the Congress passed legislation intended to 
eliminate the deferral privilege accorded foreign trusts 
created by U.S. persons for the benefit of U.S. beneficiaries. 
Ifrider that legislation, a U.S. person who directly or indirectly 
transfers property to a foreign trust is treated as the 

—^ See Rev. Rul. 60-181, 1960-1 C.B. 257; B.W. Jones Trust 
V. Commissioner, 46 B.T. A. 531 (1942), af f 'd, 132 F.2d. 

914 (4th Cir. 1943) . 
— / §§ 861(a)(1)(A) and 861(c). 
— / § 871(b). 


owner for the taxable year of that portion of the trust 
attributable to the property transferred, if for the year- , 
there is a U.S. beneficiary for any portion of the trust.—' 
Therefore, the U.S. grantor is taxed on the income. 

3. Taxation of Corporations and Their Shareholders 

The U.S. taxes corporations and their shareholders 
under the so-called "classical" system of corporation taxation, 
a system under which a corporation and its shareholders are 
separately taxed. In general, corporate earnings are taxed 
to the corporation and not to its shareholders, and a share- 
holder is taxed only on dividends received. 

The same system governs the taxation of foreign corpora- 
tions and U.S. persons who are shareholders of foreign 
corporations. In general, the earnings of the foreign 
corporation are not taxed until the shareholder receives a 
dividend from the corporation. Also, the general jurisdictional 
rules described above apply to a foreign corporation with 
U.S. shareholders, even if those shareholders control the 
corporation. Accordingly, a foreign corporation controlled 
by U.S. persons is taxed only on its income from U.S. sources 
and on its foreign effectively connected income. 

A shareholder of a corporation may also be taxed when 
he sells or exchanges his stock of the corporation, or when 
he transfers property to it or receives property from it. 
The Code, however, contains numerous provisions providing 
for nonrecognition of gain in such cases. 

A corporation can be easily utilized to the tax advantage 
of its shareholders. In the domestic context, the advantage 
can generally occur because of the differential in rates of 
tax between corporations and individuals. In the foreign 
context that differential may be much larger, and if a tax 
haven is used, the rate of tax imposed on the corporate 
earnings may be zero. 

Absent the anti-avoidance provisions in the law, cor- 
porations can easily be manipulated by U.S. shareholders 
engaged in foreign transactions. In the simplest case, a 
U.S. person could, in a transaction which qualifies for non- 
recognition treatment, transfer income producing assets 
(such as stock or bonds) to a foreign corporation organized 

— / § 679(a)(1). 


in a zero tax jurisdiction. The income earned by the foreign 
corporation would not be taxed by the U.S. or by the zero 
tax jurisdiction. The assets remain under the control of 
the U.S. person, but the income would not be taxed until 
repatriated. The shareholder would be taxed on the sale of 
the stock, but at favorable capital gains rates. If the 
shareholder holds the stock until he dies, it is subject to 
U.S. estate tax but passes to his heirs free of income tax 
at its value as of the date of his death. His heirs could 
then liquidate the foreign corporation free of income tax 
(because of the step-up in basis by reason of the shareholder's 
death) and return the property to the U.S. to start again. 
Or, they could maintain their ownership in the foreign 
corporation and shelter the income. 

Another manipulation could occur if a parent cor- 
poration selling goods overseas forms a foreign corporation 
in a tax haven to make those sales. The parent would then 
sell the goods to the subsidiary at a small or zero profit, 
and the subsidiary would sell them to the ultimate customer 
at a substantial mark-up. The profit on the sale would not 
be taxed by the U.S. and could accumulate free of tax in a 
tax haven. 

In order to curtail what it, from time to time, cate- 
gorized as abuses, the Congress has periodically adjusted 
the system of taxation and the non-recognition provisions of 
the Code. Because of the resulting anti-abuse provisions, 
the simple manipulations just described are not possible. 

C. Anti-Abuse Measures 

Since the adoption of the income tax in 1913, Congress 
has incorporated into the tax laws numerous provisions in- 
tended to correct perceived deficiencies. Some were intended 
to mitigate double taxation, while others were intended to 
deal with abuse. There follows a summary of the anti-abuse 
measures. While most are technically applicable to foreign 
corporations, those that have not been specifically tailored 
to foreign corporations tend not to be useful to curb tax 
haven abuse. 

1. Accumulated earnings tax . The accumulated earnings 
tax was the earliest anti-abuse measure. — ^ As originally 
adopted, if a corporation were formed or fraudulently availed 
of to accumulate income, then each shareholder's ratable 

—' Revenue Act of 1913. 


share of the corporation's income would be taxed to him. 
The provision was amended in 1921 to impose a penalty tax on 
a corporation when it unreasonably accumulated earnings for 
purposes of avoiding income tax of the shareholders by 
permitting the earnings and profits of the corporation to 
accumulate instead of being distributed. The operative test 
is accumulation beyond the reasonably anticipated needs of^ , 
the business. The 1921 structure continues in use today.— '^ 
The tax clearly applies to the U.S. source-, income of a 
foreign as well as a domestic corporation. — 

2. Transfer pricing . In 1921, the Congress gave the 
Commissioner the authority to "consolidate accounts for 
related trades or businesses" for the purpose of "making an 
accurate distribution or apportionment of gains, profits, 
income, deductions, or^capital between or among such related 
trades or businesses." — ' The provision was replaced in 
1928 by the predecessor of § 482, which provided for the 
allocation of gross income or deductions between or among 
related trades or businesses. 

In 1968, in response to Congressional proding during 
the Revenue Act of 1962, the IRS published revised detailed 
regulations setting forth the standards it will apply in 
shifting income among related entities to prevent tax avoidance. 

Today, §482 is one of the most important anti-avoidance 
provisions in the law, and is, along with subpart F, the 
central focus of IRS international enforcement efforts. In 
1979 the tax value of § 482 adjustments proposed by international 
examiners was $500 million, which represented 36 percent of 
the tax value of all adjustments proposed by the international 
examiners . 

3. Sections 367 and 1491 . In 1932, the Congress, 
recognizirig that the various Code provisions permitting 
nonrecognition treatment for gains realized in certain 
exchanges and reorganizations involving foreign corporations 
constituted "serious loophole [s] for the avoidance of taxes,"— '''^ 
enacted the predecessor to § 367. That section and its 
successors have uniformly provided that a taxpayer seeking 
nonrecognition treatment for gains realized on certain 
foreign transfers must show to the "satisfaction" of the 


§§ 531-537. 

§ 532(a) . 

Revenue Act of 1921, § 240(d). 

H.R. Rep. No. 708, 72d Cong., 1st Sess., 20 (1932), 
1939-1 C.B. (Part 2) 457, 471. 


Commissioner, that the transaction does not have as one of 

its principal purposes the avoidance of Federal income 

taxes. Nonrecogni tion treatment requires a ruling issued 
under that provision. 

Today's version of § 367 distinguishes between trans- 
fers from the United States and all other transfers. For 
transfers from the United States, non-recognition treatment 
is not available unless, pursuant to a request filed not 
later than 183 days after the beginning of a transfer, it is 
established to the satisfaction of the Commissioner that the 
exchange does not have as one of its principal purposes the 
avoidance of Federal income taxes. For all other transfers 
(foreign to foreign and foreign to U.S.) a ruling is not 
required, but the rules governing the tax consequences are 
provided in regulations which can deny non-recognition to 
the extent necessary to prevent tax avoidance. — ' 

Also, in 1932 the Congress dealt with a second aspect 
of the transfer problem and enacted the predecessor to § 
1491. That section imposed an excise tax upon the transfer 
of stock or securities by a U.S. person to a foreign corporation 
as paid-in surplus or as a contribution to capital, or to a 
foreign estate, trust, or partnership. The tax was measured 
by the difference between the fair market value_Qf the 
property at the time of transfer and its basis. — ' The 
difference is reduced by the amount of any gain recognized 
by the transferor on the transfer. Section 1491 was amended 
in 1976 to apply to transfers of any property and to increase 
the excise tax to 35 percent from 27 1/2 percent. The 
excise tax does not apply to a transfer described in § 367 
or a transfer for which an election has been made under § 
1057. — ' In lieu of the payment under § 1491, the taxpayer 
may elect under §1057 to treat a transfer described in § 
1491 as a taxable sale or exchange, and to recognize gain 
equal to the excess of the .fair market value of the property 
over its adjusted basis. — ' 


=-^' See Revenue Act of 1932, § 112(k); Revenue Act of 1934, 

§ 112(i); Revenue Act of 1936, § 112(i); Revenue Act 

of 1938, § 112(i); 1939 I.R.C. § 112(i). 

—^ H.R. Rep. No. 708, 72d Cong., 1st Sess. , (1932), 1939-1 C.B. 
(Part 2) 457, 494. 

— / § 1492. 

i°/ § 1057. 


4. Personal holding companies . The undistributed 
personal holding company income of a personal holding company 
is subject to a penalty tax of 70 percent. This provision, 
added to the law in 1934 and extensively revised in 1937 and 
1964, was intended to thwart the creation of so-called 
incorporated pocketbooks and the transfer of services to 
corporations organized by the provider of those services. 

The Congress, in adopting this provision, acknowledged that 
the accumulated earnings tax was not working to prevent some 
significant abuses in the area. 

A corporation is a personal holding company if at least 
60 percent of its adjusted ordinary gross income is personal 
holding company income (passive investment income and certain 
personal services income), and more than 50 percent in value 
of its stock is owned by five or fewer individuals. The tax 
is imposed on the corporation (not the shareholders), and 
provision is made for relief from the tax to the extent a 
"deficiency dividend" is paid. 

A foreign corporation can be a personal holding com- 
pany. However, if all of its outstanding stock during the 
last half of the year is owned by nonresident aliens, then 
it is not a personal holding company. 

5. Foreign personal holding companies . In 1937, the 
Congress, in response to a request of President Roosevelt 
and the Report of the Joint Committee on Tax Evasion and 
Avoidance of the Congress of the United States — ' , again 
acted against incorporated pocketbooks. This time, it 
focused on those incorporated abroad by U.S. persons. The 
result was the foreign personal holding company provisions. 
It is of interest that Congress focused on corporations 
domiciled in countries such as the Bahamas and Panama, which 
had little or no corporate income tax (at least on foreign 
source income) and which are today considered to be tax 
havens . 

The U.S. shareholders of a foreign personal holding 
company are taxed on their proportionate share of the cor- 
poration's undistributed foreign personal holding company 
income. A foreign corporation is a foreign personal holding 
company if at least 60 percent of the corporation's gross 
income for the year is foreign personal holding company 

— / H.R. Doc. No. 337, 75th Cong., 1st Bess. (1937). 


income, and if more than 50 percent in value of the corporation's 
outstanding stock is owned (directly or indirectly) by not 
more than five individuals who are citizens or residents of 
the U.S. 

Foreign personal holding company income includes passive 
income such as dividends, interest, royalties, and annuities, 
gains from sale of stocks, securities, and future transactions 
in certain commodities, income from an estate or trust or 
the sale of an interest therein, income from certain personal 
service contracts, compensation for the use of corporate 
property by 25 percent shareholders, and rents, unless they 
constitute 50 percent or more of the gross income of the 

The foreign personal holding company provisions take 
precedence over the personal holding company provisions, 
thus, a foreign corporation which meets both tests is 
treated as a foreign personal holding company. — ' Generally, 
they take precedence over the subpart F provisions. — ' 

6. Section 269 > , In 1943, the Congress enacted the 
predecessor of §269 — ' , which grants to the Secretary the 
power to disallow a tax benefit if the principal purpose of 
the acquisition of control of a corporation, or of the 
acquisition by a corporation from another corporation of 
property with a carryover basis, is evasion or avoidance of 
Federal income tax by securing the tax benefit. This provision 
applies to foreign corporations as well as domestic corporations. 

7. Foreign investment companies . Despite the provisions j 
described above, activities perceived as abusive continued. C 
One of those activities was the establishment of foreign 
investment companies which sold shares widely among U.S. C 
individuals. * 

In connection with the 1962 Act, Congress attacked the f 

problem of the foreign investment company which avoided 
being a personal holding or foreign personal holding company 
because it avoided the shareholder test by selling shares 
widely to U.S. persons. These companies, often organized in 
jurisdictions which did not tax their income, could invest 
in securities or other passive assets and accumulate income 



§ 542(c)(5). 


— / § 951(d). 

— / 1939 I.R.C. § 129. 


The Revenue Act of 1962 adopted §§ 1246 and 1247 as an 
alternative means of attacking these companies. Under § 
1246 a U.S. shareholder realizes ordinary income on the sale 
or redemption of his stock in a foreign investment company, 
to the extent of his ratable share of its earnings accumulated 
by the company after 1962 and during the time the share- 
holder held the stock. 

Under § 1247, a foreign investment company could, prior 
to 1963, elect to have its U.S. shareholders taxed substan- 
tially like the shareholders in a domestic regulated invest- 
ment company. This meant that the shareholders had to 
receive a distribution of 90 percent of the company's ordinary 
income, and any capital gains realized by the company were 
taxed to the shareholders. 

8. Controlled foreign corporations . In 1962 Congress 
enacted subpart F which taxes U.S. shareholders of con- 
trolled foreign corporations on their proportionate share of 
certain categories of undistributed profits from tax haven 
activities and certain other activities of the foreign 
corporation. A controlled foreign corporation is defined as 
a foreign corporation in which more than 50 percent of the 
voting power in the corporation is owned by U.S. shareholders. 
A U.S. shareholder is a United States person who owns directly 
or indirectly 10 percent or more of the voting stock of a 
foreign corporation. In contrast, the ownership test for 
foreign personal holding company status is ownership by five 
or fewer individuals of more than 50 percent in value of the 
stock of the foreign corporation. There is no minimum 
ownership threshhold for a shareholder's interest to be 
taken into account for foreign personal holding company 

The categories of income subject to current taxation 
under subpart F are foreign personal holding company income, 
sales income from property purchased from, or sold to, a 
related person if the property is manufactured and sold for 
use, consumption or disposition outside the country of the 
corporation's incorporation, service income from services 
also performed outside the country of the corporation's 
incorporation, for or on behalf of any related person, and 
certain shipping income. The Code refers to these types of 
income as "foreign base company income." Basically, this 
provision is designed to prevent tax avoidance by the diversion 
of sales or other types of income to a related foreign 
corporation which is incorporated in a country which imposes 
little or no tax on this income when it is received by that 


corporation since it arose in connection with an activity 
taking place outside of that country. In addition, the Code 
provides for the current taxation of the income derived by a 
controlled foreign corporation from the insurance of U.S. 
risks. Foreign base company income, income from the insurance 
of U.S. risks, and certain other income are collectively 
referred to as subpart F income. The Code also provides 
under subpart F that earnings of controlled foreign corporations 
are to be taxed currently to U.S. shareholders if they are 
invested in U.S. property. 

In 1976, subpart F income was expanded to include 
boycott generated income, and illegal bribes or other payments 
paid by or on behalf of the controlled foreign corporation 

directly or indirectly to a government official. Neither of \ 

these later items necessarily involves tax havens. ; 

Subpart F contains certain exclusions from foreign base I 

company income. Income from the use of ships in foreign I 

commerce is excluded to the^extent that the income is rein- [ 

vested in shipping assets. — ^ Foreign base company income 

also does not include any income received by a controlled i 

foreign corporation, if it is established to the satisfaction ' 

of the Commissioner that neither the creation or organization ! 

of the controlled foreign corporation receiving the income ( 

nor the effecting of the transaction giving rise to the > 

income through the controlled foreign corporation has as one ^ 

of its significant purposes the substantial reduction of j 

income taxes. !; 


There is also the 10-70 rule: if foreign base company ^ 

income is less than 10 percent of a controlled foreign f 

corporation's gross income, then none of its income is •■ 

foreign base company income, and if more than 70 percent of i 

its gross income is foreign base company income, then its t 

entire gross income is treated as foreign base company i. 

income. If the percentage is between 10 percent and 70 i 

percent, then the actual amount of foreign base company *■ 
income is treated as such. 


— As originally enacted, shipping income was excluded 

without regard to reinvestment. 


Income derived from the insurance of U.S. risks is 
subpart F income, if the controlled foreign corporation 
receives premiums in respect of insurance or reinsurance in 
excess of five percent of the total premiums and other 
considerations it received during its taxable year. For 
purposes of applying the insurance of U.S. risks rules, a 
controlled foreign corporation in certain cases includes one 
of which more than 25 percent of the total combined voting 
power of all classes of voting stock is owned by U.S. shareholders. 

9. Dispositions of stock of controlled foreign corporations . 
The Revenue Act of 1962 also introduced § 1248 to the Code. 

That section requires a U.S. shareholder who disposes of his 
shares in a controlled foreign corporation to report any 
gains on the disposition as a dividend, to the extent of the 
earnings and profits of the foreign corporation accumulated 
after 1962. Accordingly, this rule can be beneficial because 
foreign taxes paid or accrued by the corporation may be 
credited against U.S. taxes of a domestic corporation. 

10. Dispositions of patents to foreign corporations . 
The Revenue Act of 1962 also adopted § 1249, which requires 
that gain from the sale or exchange of patents, copyrights, 
secret formulae or processes, or similar property rights to 

a foreign corporation by a person controlling that corporation, 
is to be treated as ordinary income rather than capital 
gain. The House-passed bill had included, as a category of 
subpart F income, income from patents, copyrights, and 
similar property developed in the U.S. or acquired from 
related U.S. persons. The income to be included was royalty 
income, and a constructive royalty if the foreign corporation 
used the property itself. — ' The Senate rejected the House 

approach because of difficulties it 
constructive income. — 

foresaw in determining 

— / H. Rep. No. 1447, 61, 1962-3 C.B. 402, 465. 


— ' S. Rep. No. 1881 87th Cong., 2d Sess. 109-111 (1962) 

(S. Rep. No. 1881), 1962-3 C.B. 703, 815. 


V. Patterns of Use of Tax Havens 

The figures in Chapter III, and our interviews indicate 
that tax havens are being used by U.S. persons investing 
overseas, and by foreign persons investing in the U.S. Not 
all of this use is tax motivated. Much, however, is. Some 
of the transactions are clearly legitimate, being within the 
letter and the spirit of the law. Other transactions are 
fraudulent, although proving the necessary willfulness to 
establish a criminal case may not be possible. An overriding 
problem is that the complexity of the law, the difficulties 
in information gathering, and administrative problems within 
the IRS often make it difficult to distinguish between the 

This chapter begins with a brief discussion of the ;; 

distinction between tax avoidance and tax evasion. It then « 

describes how assets can be transferred to tax havens in the ; 

context of the Code provisions which seek to insure that the ! 

transfers themselves are not abusive. This chapter then 

describes the activities which are being carried on in tax 

havens within the context of United States tax laws which i 

apply to those transactions. * 


The transactions described begin with corporations and f 

multinationals. They illustrate how existing rules are ', 

utilized in a legal way. The descriptions also point out " 
how, in some instances, unscrupulous taxpayers arrange their 

affairs so that they appear legal, but are in fact fraudulent. 2 

More abusive transactions are also described. In Chapter VI, J 
transactions which have been investigated as frauds are 

discussed. In Chapter VII, options for administrative and I 

legislative changes are presented. These might help rationalize i 

the taxation of tax haven transactions, and make the rules easier T 

to administer. k 

A. Tax Avoidance v. Tax Evasion Q 

Many consider tax haven transactions evil per se 
simply because there is a tax haven involved. Others look 
at the tax system as something to be manipulated, viewing 
tax havens as a piece in that game. They see little wrong 
in using a tax haven transaction to avoid taxes that they 
know are due, provided that transaction is reported. Others 
will use the complexities of the law to hide income or 
create deductions. In truth, often the question of whether 
a tax haven transaction is legitimate or illegitimate, 
whether it is tax avoidance or tax evasion, is in the eyes 
of the beholder. 


Whether or not a tax haven transaction is tax avoidance 
or tax evasion or something else depends in part on how you 
define those terms. In fact, the terms have probably never 
been adequately defined. The term "avoidance" is partic- 
ularly imprecise. Furthermore, "avoidance" has certain 
connotations which in themselves seem to import evil doing 
although not quite to the extent that evasion does. The 
problems with distinguishing in this area and in using these 
terms have been described as follows: 

The term tax avoidance itself has 
unfortunate connotations; it is con- 
sidered as referring to an attitude 
of unethical and, indeed, unlawful 
behavior, although it is actually a 
neutral term. In the pejorative sense 
the term tax evasion should be used, 
which indicates an action by which 
a taxpayer tries to escape his legal 
obligations by fraudulent means. The 
confusion arises from the fact that 
sometimes taxes are avoided — by the 
use of perfectly legal measures -- 
against the purpose and spirit of 
the law. Where this is the case, 
the taxpayer involved is abusing the 
law and he is blamed for it, although, 
no penal measures can be taken 
against him.— 

Rather than attempt to define the terms with any pre- 
decision, we have identified four categories of use, ranging 
from completely legal (from a tax point of view) to fraud: 

(1) Non-tax motivated use, transactions involving tax 
havens where no U.S. tax impact results. An example is a 
U.S. branch bank in a tax haven which is fully taxable by 
the United States and where the source of income is not 


J. van Hoorn Jr., "The Uses and Abuses of Tax Havens", 
Tax Havens and Measures Against Tax Evasion and Avoid- 
ance in the EEC , Associated Business Programs (London, 


(2) A transaction which has a tax effect, but which is 
completely within the letter and the spirit of the law. An 
example is the formation of a subsidiary in a tax haven to 
conduct a shipping business or the formation of a subsidiary 
in a tax haven to conduct a banking business, where all of 
the necessary functions are performed by the tax haven 
entity in the tax haven. 

(3) Aggressive tax planning that takes advantage of an 
unintended legal or administrative loophole. An example of 
this might be establishing a service business in a tax haven 
to provide services for a branch of that business located in 
a third country. A further example might be the use by a 
multinational corporation of artificially high transfer 
pricing to shift income into a tax haven. Often, the parties 
know full well that, if the transaction is thoroughly audited, 
a significant adjustment will probably be made. They rely 

on difficulties in information gathering and on complications 
to possibly avoid payment of, or at least to postpone payment 
of, some tax. 

(4) Tax evasion; an action by which the taxpayer tries 
to escape his legal obligations by fraudulent means. This 
might involve simply failing to report income, or trying to 
create excess deductions. This category can also be broken 
down into two subcategories: (a) evasion of tax on income 
which is legally earned, such as slush funds; (b) evasion of 
tax on income which arises from an illegal activity, such as 
trafficking in narcotics. 

In this chapter, patterns of use of tax havens are 
described. At times, the transactions are so complicated 
and the information gathering problems so difficult that it 
may not be possible to distinguish between the various 
categories. The lines become murky because the law is murky 
and the information is incomplete. 

B. Transfers to a Tax Haven Fntity 

United States persons doing business abroad continue 
to use tax havens in traditional ways. They will form a 
corporate entity in a tax haven and use it to carry out 
their foreign operations. The use of a tax haven company 
has significant advantages. From a U.S. tax point of view, 
it may give the benefit of deferral or enable a U.S. parent 
corporation to absorb excess foreign tax credits. It may 
also decrease the overall foreign tax burden of a taxpayer 
or affiliated group of corporations, and may allow a company 
to do business overseas free of currency or other controls. 
Generally, in order to use a tax haven entity, property must 
be transferred to it. 


1. Transfer Pricing 

United States taxpayers may attempt to shift assets and 
income to low or no tax countries from high tax countries 
through transfer pricing. Where this shifting is at arm's 
length and within the guidelines set by the IRS and the 
courts, it is perfectly legitimate. There often are honest 
disagreements as to what is an appropriate charge or price. 
This happens very often because taxpayers find the §482 
regulations difficult to deal with. If the price is too 
high, the IRS can allocate the income. Transactions generally 
not permissible under IRS regulations and for which an 
allocation may therefore be appropriate can take numerous 
forms, as follows: 

a. Payment of interest from the U.S. or another high 
tax country to a tax haven affiliate at above market rates. 

b. Payment of royalties from the U.S. or other high 
tax country to a tax haven affiliate at higher than fair 
market value rates. 

c. Sale of property by an entity located in a high tax 
country to an affiliate in a tax haven at a low price, 
followed by a sale by the tax haven entity at a high price. 

d. Transfer of income producing assets, such as stocks, 
bonds or other securities, or patent rights, from a U.S. 
person or from any affiliate of a U.S. person in a high tax 
country to an affiliate in a tax haven at a low cost. 

e. Payment of management, service or other fees to a 
related entity which has not in fact performed services; or 
payment for services performed but at a price above fair 
market value. 

f. Leasing of tangible property to a tax haven entity 
for less than fair market value. 

g. Transfer of components for less than market value, 
to a tax haven affiliate for assembly, followed by a sale of 
the finished product at a high price. 

In many cases, in addition to shifting assets to the 
tax haven entity, the transactions will result in deductions 
for the high tax country entity which is income shifting. 
For example, the payment of interest by a U.S. corporation 


to a foreign affiliate results not only in the shifting of 
the interest to the tax haven, but in a deduction for interest 
expense to the tt.s. company. Likewise, if a U.S. company 
develops technology, deducts the development expenses, and 
then transfers the technology to the tax haven affiliate 
for sublicensing or for use in its trade or business without 
adequate compensation, not only is income-producing property 
transferred to the tax haven entity, but the U.S. affiliate 
has been able to take deductions for expenses without having 
to realize the income that accrues from the expenses. 

A somewhat related problem is the failure of a U.S. 
company to properly allocate to a tax haven affiliate expenses 
it incurs for that affiliate. For example, a U.S. company 
may provide managerial services for a tax haven affiliate, 
and fail to charge for them. In addition, it may fail to 
allocate expenses which it incurs and which are, in reality, 
for the tax haven affiliate. A greater foreign tax credit 
may be available because of this failure to properly allocate 

2. Transfers of Assets Other than by Transfer Pricing 

Another method for transferring property to a tax haven 
entity is by a tax free reorganization or other exchange. 
In the case of transfers from the U.S., the general non- 
recognition provisions of the Code operate only if the 
transferor receives a ruling from the IRS that the exchange 
did not have as one of its principal purposes the avoidance 
of Federal income taxes.— 

a. Transfers to Tax Haven Corporations--Scope of §367. 

Section 367 was originally intended to prevent taxpayers 
from permanently circumventing the tax^ordinarily payable on 
the disposition of appreciated assets.— When created, the 
tax avoidance concept was thus of limited scope. 

-/ § 367. 

-^ See H.R. Rep. No. 708, 72d Cong., 1st Sess. 20 (1932); 
and S. Rep. No. 665, 72d Cong., 1st Sess. 26-27 (1932). 

To illustrate the loophole they sought to close, the 
House and Senate gave this example in their report: 

A, an American citizen, owns 100,000 shares of 
stock in corporation X, a domestic corporation, which 
originally cost him $1,000,000 but now has a market 
value of $10,000,000. Instead of selling the stock 


The IRS, however, expanded this scope by looking to 
other consequences of asset transferral. In addition to the 
complete avoidance of tax on realized appreciation from 
investment assets, the IRS considered the potential for 
temporary deferral of tax and also the deferral of tax on 
other income produced by the transferred asset, e.g. , interest 
and dividends, in determining whether a tax avoidance purpose 
was present. Application of the tax avoidance concept was 
thus enlarged to include both the nature of the transferred 
assets and the nature of their subsequent use. 

The breadth of this inquiry was reduced by the IRS in 
1968, in response to the 1962 enactment of subpart F.-^ 
The IRS announced, in Revenue Procedure 68-23,-^ that its 

outright, A organizes a corporation under the laws of 
Canada to which he transfers the 100,000 shares of 
stock in exchange for the entire capital stock of the 
Canadian company. This transaction is a nontaxable 
exchange. The Canadian corporation sells the stock of 
corporation X for $10,000,000 in cash. The latter 
transaction is exempt from tax under the Canadian law 
and is not taxable as United States income under the 
present law. The Canadian corporation organizes 
corporation Y under the laws of the United States and 
transfers the $10,000,000 cash received upon the sale 
of corporation X's stock in exchange for the entire 
capital stock of Y. The Canadian corporation then 
distributes the stock of Y to A in connection with a 
reorganization. By this series of transactions, A has 
had the stock of X converted into cash and has it in 
complete control. 

When this provision was adopted, Canada was considered 
to be a tax haven. 


- See J. Sitrick, "Section 367 and Tax Avoidance: An 

Analysis of the Section 367 Guidelines" 25 Tax L. Rev. 
429 (1970). 

Mr. Sitrick, formerly of the Office of Tax Legislative 
Counsel (International), states that 

. . . while the importance of section 367 was 
reduced considerably by reason of the 1962 legislation, 
the section retains importance in transactions with 
which the provisions of subpart F were not intended to 
deal directly. [25 Tax L. Rev, at 442.] 

-/ 1968-1 C.B. 821. 


concern would be limited to the nature of the assets transferred, 
i.e., to their inherent potential for income and gain.— 

The IRS also announced in Revenue Procedure 68-23, at 
§3.02(1), that when the transferred assets are " be 
devoted by the transferee foreign corporation to the active 
conduct, in any foreign country, of a trade or business... 
[the transaction will ordinarily receive favorable consideration] 
Although apparently in conflict with the new policy to leave 
consideration of post-transfer use to subpart F, adoption of 
this "active business" criterion was not intended to provide 
a means for determining whether tax avoidance would flow 
from the post-transfer activity itself. Rather, it was 
included to test the avoidance potential of the individual 
asset, the thought being that property used in an active 
trade or business would not be transferred with a principal 
view to the realization of its appreciation_or enjoyment of 
its income outside the taxing jurisdiction.— Therefore, 
the active business requirement dpes not impinge on the 
deferral permitted by subpart F.— 

In 1976, the Congress amended § 367 to remove the pre- 
transaction filing requirement .in all cases, and the ruling 
requirement in certain cases.— None of the statutory ■■» , 
changes significantly clarified the meaning of tax avoidance. — '^ 

-'^ See Rev. Proc. 68-23, §§ 3. 02 ( 1 ) ( a ) -( d ) (describing 
certain "tainted" assets), § 3.01(2), and § 3.03(l)(a) 

-^ See also § 3 . 02( 1 ) (a) ( iv) of Rev. Proc. 68-23. 

— Section 367 clearance will not be granted if property 
transferred to a foreign corporation will be used to 
conduct a trade or business in the United States. To 
this extent, the subsequent use test retains vitality 
under § 367. 

-' Tax Reform Act of 1976, § 1042. 


H.R. Rep. No. 94-658, 94th Cong., 1st Sess. 239-40 (1976), 
1976-3 C.B. (Vol. 2) 931-2; and S. Rep. No. 94-938, 
94th Cong., 2d Sess. 261-2 (1976), 1976-3 C.B. (Vol. 3) 


As presently construed, § 367 is of limited utility in 
tax haven related tax administration. While it does prevent 
the transfer of certain assets with income-producing potential, 
it will not prevent the transfer of an active business which 
may then be conducted free of subpart F. For example, a tax 
free transfer can be used to enable a U.S. manufacturer to 
take advantage of a tax exemption granted by one country to 
attract manufacturing and the low rates of tax afforded by a 
tax haven on passive investment income. 

Section 367 can be used only to deny non-recognition 
for a transfer to a corporate entity, and therefore its 
impact is limited to permitting a tax (often a capital gain 
tax) on appreciation. In many cases it is unclear that 
anything of value has been transferred. For example, an 
engineering company which is to perform services in the 
Middle East may be able to form a subsidiary corporation in 
a tax haven without a §367 ruling. Arguably, under Revenue 
Ruling 79-288, — ^ no ruling would be required if, before the 
transfer, the parent had no rights under the tax haven's law 
to use, and protect from unauthorized use, the parent's 
name. However, a ruling may be required for the transfer of 
the active business or for the transfer of goodwill. 

b. Transfers Not Reorganizations 

Section 367 does not affect a transfer to a trust, a 
partnership, or a corporation where the reorganization 
provisions are not applicable in any case. Instead, the § 
1491 excise tax might apply. 

Like § 367, § 1491 was intended to prevent taxpayers 
from transferring appreciated property to foreign entities 
to avoid United States tax on the gain. Today, § 1491 is 
broad, covering almost all transfers to almost all foreign 
entities. There are, however, exceptions which can be 
abused. Further, like § 367, the IRS does not interpret § 
1491 as taking into account post-transfer use of the assets 
transferred in determining whether it operates. Therefore, 
if the transfer fits one of the exceptions, the § 1491 
excise tax does not apply. 

Legislative exceptions to the § 1491 tax are provided 
(1) for transfers to a tax exempt organization, (2) if the 
transfer is not in pursuance of a plan having as one of its 
principal purposes the avoidance of Federal income taxes, 
(3) if § 367 applies to the transfer, or (41 ,if an election 
to recognize gain on the transfer is made. — ' 

— / 1979-2 C.B. 139. 
— / § 1492. 


Attempts have been made to avoid or evade §1491 by the 
following transactions: 

1. A transfer of unappreciated or slightly appre- 
ciated property, or a transfer of slightly appreciated 
property with respect to which a § 1057 election has been 

2. A transfer to a friendly foreign foundation which 
is a tax exempt organization. 

3. A transfer of ordinary income property (subject to 
the excise tax, but at a lower rate of tax than the ordinary 

rates) . ^ 

4. A transfer at death by operation of law rather than ^ 
by devise. « 

5. A transfer through a conduit, such as a shell U.S. 
corporation which has no assets with which to pay the § 1491 
tax, or through a friendly non-resident alien to a trust for 
the benefit of the U.S. transferor or his family. 

Some of these transactions are fraudulent. The use of 
a foreign intermediary to pass property to a foreign trust, 
for example, is a willful attempt to evade or defeat tax. 
The willful failure to file the required return (Form 926) 
is punishable under § 7203. The same is true of the transfer 
to a friendly foreign foundation where the real intent is 
that the property will be used for the benefit of the transferor 
or his family. 

To the extent that the transactions described above are 
permitted by the Code, they reflect Congressional policy 
determinations. For example, the fact that § 1491 is 
avoided by a § 1057 election or the realization of a small 
amount of income reflects a Congressional policy of protecting 
the U.S. tax on the gain inherent in the property. Not 
subjecting to U.S. tax the income earned from the property 
after transfer is a deferral issue, and occurs because of 
Congressional policy decisions as to the scope of the trust 
rules or other anti-avoidance rules. 



Similarly, § 1491 will not apply to a transfer to a 
foreign trust by a non-resident alien who then becomes a 
United States resident. Section 1491 can also be avoided by 
a United States expatriate transferring property after 
renouncing citizenship. Both gaps could be closed by legislation 
subjecting at least some transfers to §1491. Once again, 
however, any problems are caused by Congressional decisions 
as to the scope of the United States taxing jurisdiction. 

C. Transactions Through a Controlled Entity 

Today, major corporations conduct varied activities in 
tax havens. During consideration of the 1962 Revenue Act, 
the IRS described certain categories of tax avoidance devices 
used by U.S. taxpayers doing business overseas. Some appear 
to be used today and in some cases their use has grown; 
others have been substantially eliminated. Corporations 
continue to divert income to foreign subsidiaries which 
engage in no real activity abroad. They continue to organize 
foreign subsidiaries to carry on the same type of business 
activity previously conducted by the domestic parent and to 
divert income through improper pricing arrangements and 
through the transfer of valuable income producing assets, 
both tangible and intangible, to tax haven entities. Diversion 
of income through improper expensing also continues. Foreign 
transportation and reinsurance still continue to a significant 

Patterns of use by industry groups is apparent. For 
example, the petroleum industry makes significant use of 
tax havens. It uses them by forming companies in tax havens 
to carry out the traditional functions of shipping and 
refining and selling petroleum, and for newer activities 
including transshipping. 

The insurance industry also continues to make extensive 
use of tax havens. Foreign insurance companies doing business 
in the United States often have a Bermuda or Cayman subsidiary 
through which they reinsure risks written in the United 
States. Many United States multinational companies have 
captive insurance subsidiaries located in Bermuda. 

The construction industry and other service industries 
are making increasing use of tax havens. The growth in 
these industries appears to have been the fastest of any 
industry group. 


Tax havens are an overwhelming factor in the shipping 
industry. Many United States companies own shipping companies 
formed in tax havens (most often Liberia or Panama). 

Commercial banks have extensive operations in tax 
havens, operating there mostly through branches, although 
some U.S. banks have subsidiaries in tax havens. As the 
data in our tax haven levels estimate show, this use has 

deal of 

grown enormously in the past .few years, with a great 
the growth in the Bahamas. — ' 

The heavy equipment industry also tends to utilize 
sales companies in tax havens. In a few cases manufacturing 
or assembly operations have been conducted in tax havens. 
Most manufacturing and assembly operations, however, are 
conducted in low cost areas offering tax incentives to 
attract industry, such as Taiwan, Korea, the Phillippines, 
Ireland, and Puerto Rico, which were generally not addressed 
in this study. At times, a tax haven corporation is formed 
to make the investment in the manufacturing tax haven. 

1. Tax Planning — Minimizing Tax and Maximizing the 
Foreign Tax Credit 

United States taxpayers use tax havens in legal tax 
planning for one of three purposes or a combination of 
them: (1) to minimize United States tax on a transaction or 
on investment income; (2) to increase foreign source income 
free of foreign tax to enable the taxpayer to credit more 
foreign income taxes; and (3) to minimize foreign taxes 
which might otherwise be imposed on a transaction. 

Tax haven entities can be used to minimize taxes. If 
the goal is to avoid U.S. tax on the income from a transaction, 
the transaction would have to be structured to avoid the 
application of subpart F and the foreign personal holding 
company rules. It would also have to comply with the §482 
pricing regulations. Prior to 1976, foreign trusts could be 
used for this purpose, but this use has been substantially 
curtailed, although not totally eliminated. Avoiding or 
deferring U.S. tax on the income might be accomplished by, 
for example, keeping within the de minimis exception from 
subpart F, or by conducting transactions which subpart F 
does not tax. 

— ^ See Chapter III, supra. See New York Times, Friday, 
March 24, 1977, at Al. 


In some tax haven transactions may result in U.S. tax 
liability under subpart F or the foreign personal holding 
company provisions. In other cases, the IRS may shift 
income to or from the tax haven entity under the intercompany 
pricing rules and accordingly minimize the tax avoidance 
potential of the haven entity. In some cases, however, 
unless the income is treated as U.S. source income, taxing 
the tax haven entity's income to the U.S. parent under 
subpart F has no real U.S. tax effect, because the U.S. 
parent is in an excess foreign tax credit position and 
foreign taxes imposed on non-tax haven income will in any 
event offset any U.S. tax which may be imposed on the subpart 
F income. In fact, at times, a planning goal is achieved if 
income can be shifted from the United States to a tax haven 
so as to absorb excess credits from taxes paid to high tax 
countries. Some practitioners believe that most large 
multinational companies are at or near an excess credit 
position, and that any changes to tax more tax haven income 
will affect small companies, not the larger ones. Nevertheless, 
the larger companies are using tax havens to significant 

A U.S. taxpayer can credit foreign taxes on a dollar-for- 
dollar basis against its U.S. tax imposed on foreign source 
income. The limitation is computed on a worldwide basis so 
that taxes paid to high tax countries can offset U.S. taxes 
on income earned in low tax countries such as tax havens. 
The foreign tax credit is available up to the U.S. tax rate. 
If the foreign taxes paid or accrued in a taxable year 
exceed the U.S. rate, the excess can be carried back or 
carried forward for a limited number of years. If they 
cannot be used within that period, they are lost. 

Assume, for example, that U.S. corporation X has taxable 
income of $10 million, $5 million from U.S. sources and $5 
million from Country A. Country A imposes a tax of 50 
percent, or $2.5 million in this case. X's U.S. tax before 


credit is $4.6 million (46% of $10 million). X's foreign 

tax credit limitation is $2.3 million ($5,000,000 ^ $10,000,000 

X $4,600,000) which leaves X with a $200,000 excess credit. 

Its worldwide tax burden is $4.8 million. If this same 

pattern recurs annually so that X will not be able to use 

the excess credits in other years, then X has an additional 

cost of $200,000 per year. 

Assume, however, that X can structure its transactions 
to convert $1.0 million of its U.S. source income to foreign 
source income in a tax haven which does not tax that income. 
For example, X could form a Bahamian company and sell through 
it to generate foreign base company sales income, or it 
could transfer working capital to be invested by the Bahamian 
company. In either case, X would be taxed under subpart F 
on the income of the Bahamian company. Thus, X is still 
taxed by the U.S. on $10 million and its U.S. tax before 
credit is still $4.6 million. However, X's foreign tax 
credit limitation is now $2.76 million ($6,000,000 ^ $10,000,000 
X $4,600,000). X can therefore credit its entire Country A 
tax of $2.5 million bringing its worldwide tax burden down 
to $4. 6 million. 

If the above transactions are not conducted at arms 
length the income might be reallocated to the U.S. under 
§482. Also, the IRS may have an argument for disregarding 
the tax haven company under §269. If, however, the transactions 
cannot be restructured a tax advantage has been gained. 

The same worldwide tax reduction can be accomplished by 
reducing foreign taxes, which is at times easier than minimizing 
united States taxes. Often foreign laws are not as well 
developed as United States laws and foreign tax administrators 
may not be as sophisticated as United States tax administrators, 
or have the resources which are available to the United 
States. If foreign taxes can be minimized so that they do 
not exceed the inited States foreign tax credit limitation, 
a cost of doing business has been reduced. Thus, an alternative 
approach in the above example would be to try to shift 
income from Country A to the tax haven. 


2. Holding Companies 

One of the most significant uses of a tax haven corporation 
is as a holding company. Holding companies are used to 
control other companies through stock ownership, as investment 
vehicles, or to collect income such as dividends, loan 
interest, and royalties or licencing fees. The company will 
either distribute the funds to the parent or it will reinvest 
the funds, in some cases lending them to affiliates. 

Generally, the company will be established in a tax 
haven which imposes little or no income tax on the earnings 
of the company, and which imposes no withholding tax on the 
distributions and payments it will make. If possible, a tax 
haven with a widespread treaty network will be used so that 
payments to the holding company will incur relatively low 
rates of tax in the source country. A country with a special 
tax regime for holding companies might be chosen. Thus, 
many holding companies are established in Switzerland, 
Luxemborg, Liechtenstein, or the Netherlands (which becomes 
a tax haven by reason of its treaty network). 

The holding company is formed in the tax haven, and 
assets are transferred for nominal consideration or in a tax 
free reorganization transaction. The company then either 
collects dividends, in the case of stock, or in the case of 
patents, relinquishes these rights to other foreign corporations 
and receives royalties. 

Initially, the Congress addressed holding company abuse 
by individuals and sought to eliminate that f^i^se by the 
foreign personal holding company provisions. — ' Widely held 
companies, however, were free to obtain the benefits of 
deferral by the formation of a holding company in a tax 
haven. In 1962, the Congress sought to prohibit corporate 
holding companies by including, as a category of-,subpart F 
income, foreign personal holding company income. — In 
doing so, they recognized "the need to maintain active 
American business operations abroad on an equal competitive 
footing with other operating businesses in the same countries", 
but saw "no need to maintain the deferral of U. S. tax where 
the investments are portfolio types of investments or where , , , 
the company is merely partially receiving investment income." — 


§§ 551-558. 

1^/ § 954(a)(1) 


H. Rep. No. 1447, 87th Cong., 2d Sess. 62 (1962); S. Rep. 
No. 1881, 87th Cong., 2d Sess. 82 (1962). 


For subpart F purposes, foreign personal holding 
company income is defined as that term is defined for ,-. . 
purposes of the foreign personal holding company provisions, — ' 
but with numerous modifications, generally intended to 
exclude actual business income and income received from a 
related company in the same country as the receiving company. 

There is still significant use of tax haven holding and 
investment companies. In 1976, controlled foreign cor- 
porations formed in tax havens and classified as holding 
companies and other investment companies reported assets of 
$8.3 billion. This figure represents more than half of the 
worldwide assets of such companies. 

The foreign personal holding company provisions may be 
circumvented by transferring the income producing assets to 
an active business rather than to a holding company. Under 
subpart F, if the foreign base company income of a con- 
trolled foreign corporation is less than 10 percent of gross 
income, no part of the gross income for the taxable year is 
treated as foreign base company income. Accordingly, if a 
substantial non-base company income producing business is 
being conducted, passive income can be sheltered, provided 
the passive income is less than 10 percent of the gross 
income of the controlled foreign corporation. The amount 
sheltered can be large. For example, if a foreign subsidiary 
has gross income of $10 million, none of which is base 
company income, over $1 million in passive income could be 
shifted to it and sheltered. In fact, there are base 
companies with over $1 billion in gross non-base company 
income. Such a company could shelter more than $100 million 
in passive income. 

A holding company can also be used to advantage to 
change U.S. source income into foreign source income to 
absorb excess foreign tax credits. For example, X, a U.S. 
multinational corporation, has cash invested in CD's in a 
U.S. bank. The income is U.S. source income taxable in the 
U.S. The interest income could be turned into foreign 
source income simply by placing the cash in a foreign bank. 
However, there is a separate foreign tax credit limitation 
for bank interest income to prevent just such planning. 
Instead, X contributes the cash to Y, its tax haven holding 
company. Y deposits the cash in a foreign bank. The 
interest Y receives on the deposit is foreign personal 

il/ § 553. 


holding company income taxable to X under subpart F, but as 
a dividend not subject to the separate limitation for interest. 
Uhited States source interest income has been converted into 
foreign source income against which foreign taxes may be 
credited. This transaction is perfectly legal, and is done 

Some persons have attempted to avoid paying U.S. tax on 
the personal holding company type income of their foreign 
corporation, circumventing the personal holding company 
income provisions by claiming that the income of the foreign 
corporation is derived from the active conduct of a banking 
or financing business, one of the exclusions from foreign 
personal holding company income. — ' In many cases the 
schemes are fraudulent. In others, however, the issue is 
not so clear because the form of establishing a bank and 
engaging in the banking business is followed. 

For example, in an attempt to create a colorable claim 
of entitlement to this exclusion, an individual or a company 
organizes a bank or finance company in a friendly tax haven 
jurisdiction, such as St. Vincent, that has little or no 
control over its local banks. The bank may engage in various 
activities. For example, it m^y lend funds to related 
parties and receive the income free of tax. It may also 
engage in some limited banking activity, such as selling 
CD's to foreigners, and then relending the proceeds for use 
in its controlling shareholders business or for use by 
others. If the taxpayer is successful in avoiding audit, 
or, in the unlikely event that he is sustained in the 
argument that his foreign corporation is engaged in the 
banking business, the personal holding company type income 
can be accumulated in the tax haven free of tax. St. Vincent 
shell banks have allegedly been used to defraud banks and 
other businesses in the United States.—' 

3. Sales Activities 

A tax haven corporation may be used as a sales company. 
The sales company may buy from or sell to affiliates or may 
engage in sales only with unrelated persons. Transactions 
with affiliates will frequently be priced to minimize the 
tax liability of the affiliated group. Generally, this 
means that the sales will be structured to maximize the 
profit of the tax haven affiliate. 

— / §954{c)(3)(B). 


— ' See New York Times, Tuesday, Oct. 21, 1980, D-5. 


Prior to the Revenue Act of 1962, U.S. companies had 
established a significant number of sales companies in tax 
havens. The Congress sought to limit this use by including 
in the U.S. shareholder's income "foreign base company 
sales income". — ' Foreign base company sales income is the 
income of a controlled foreign corporation derived from (1) 
the selling of property purchased from a related person, or 
(2) the buying of personal property for sale to a related 
person, if the property is produced outside the country 
under the laws of which the controlled foreign corporation 
is created or organized and the property is sold for use 
outside of that country. — ' Commission income from those 
sales is also included. 

The crucial element in foreign base company sales *J 

income is a purchase from or a sale to a party related to \ 

the controlled foreign corporation. If the transactions are 5 

with unrelated parties, there is no foreign base company * 

income. 2 

under this provision, income earned by a Bahamian «i 

corporation from the sale to unrelated Italian customers of 2 

goods purchased from a German affiliate would be foreign il 

base company sales income. Income earned by the Bahamian 2 

corporation from the sale to unrelated Italian customers of » 

goods purchased from an unrelated German supplier would not £ 

be foreign base company sales income. d 


Despite subpart F, some sales activity continues in tax J 

havens. Attempts may be made to circumvent subpart F. A - 

U.S. company can arguably avoid the foreign base company ^ 

sales income provisions by licensing an unrelated foreign J 

company to manufacture goods, and having a tax haven subsidiary 1 

purchase those goods for sale to customers in a third country. / 

The 10 percent de minimis exception can be used to ;J 

shelter enormous amounts of income. Foreign tax haven ^ 

corporations wholly owned by a U.S. corporation have had 
gross income of more than $1.0 billion from purchasing and 
selling from and to unrelated persons. The companies also 
earned shipping income and had passive investment income. 
There was no subpart F income because the sales activity was 
with unrelated parties, the transportation income was exempt, 
and the passive income was sheltered by the 10 percent de 
minimis exception. 

— / § 954(a)(2). 
— / § 954(d)(1). 


In the petroleum industry, trading companies have been 
formed by the major integrated companies, and also by small 
oil companies commonly known as oil resellers, which do not 
have production of their own. The majors will often use the 
trading companies for dealing with unrelated parties. If 
the trading company is actually engaged in this business, 
the activity is specifically outside the scope of subpart F. 
In many cases, however, all of the decisions regarding the 
purchases and sales by the trading company are made in the 
United States. In some cases, the business functions of the 
parent are duplicated by the foreign subsidiary. There may 
be two buying and selling organizations, one engaging in 
domestic business and the other in foreign with respect to 
the same oil. It is difficult to determine who is really 
doing what for whom. Similar patterns may exist in the 
grain industry. 

While trading companies are legitimate tax planning 
tools, fraudulent arrangements may be structured to look 
like trading companies. Often, information gathering problems, 
including lack of access to tax haven records, make it 
difficult to prove criminal fraud. Transactions are, at 
times, arranged with friendly third parties to avoid purchases 
and sales with a related party. For example, oil company X 
forms subsidiary corporation Y in a tax haven. Y is to 
engage only in the buying and selling of foreign oil. 
Usually, Y buys foreign oil from an unrelated party and 
sells that oil to an unrelated third party. It is believed, 
however, that at times swapping arrangements are entered 
into under which Y buys from an unrelated party and sells to 
an unrelated friend at a high price. The friend then sells 
to X, the U.S. parent, at its cost or at cost plus a small 
profit. In reality, Y has sold oil to X at a price which is 
too high. If the facts were known, the IRS could reallocate 
the income to X under § 482, and Y would have subpart F 
income. Because of the frequency of transactions, the 
fungibility of oil, and the lack of adequate records, it is 
difficult for the IRS to establish the substance of the 

Trading companies were involved in the so called "daisy 
chain" scheme that was used to attempt to avoid the Depart- 
ment of Energy price control regulations. In one case, a 
U.S. company bought domestic oil and sold it to a tax haven 
corporation, which the U.S. company claimed was not an 
affiliate. The oil was sold through a number of different 
companies, and then the same oil was purchased by the U.S. 
corporation's foreign subsidiary, which sold it to other 
parties and then back into the United States. The initial 


sale by the U.S. company to the tax haven company was at a 
low controlled price. The oil was eventually sold back into 
the United States at the higher world price. The substantial 
markup was left in the offshore companies. The persons who 
control the U.S. company also control the tax haven company, 
but evidence which can be introduced in a court is not 

The foreign base company sales income provisions may 
be avoided by structuring an entity as an assembly operation 
rather than as a sales company. Foreign base company sales 
income does not include income from the sale of property 
manufactured, produced, grown or constructed by the controlled 
foreign corporation in whole or in part from property which 
it purchased. — ^ Property is considered manufactured, 
produced, grown or constructed by the subsidiary if it is 
substantially transformed prior to sale or if the property 
purchased is used as a component of the property sold. — ' 
The substantial transformation test is subjective. The 
component test in the regulations can be met through a cost 
test or a subjective test. Purchased property is used as a 
component if the operations conducted by the selling corporation 
in connection with the property purchased and sold are 
substantial in nature and^ace manufacturing, production or 
construction of property. — ' In addition, the operations 
of the selling corporation, in connection with the use of 
the purchased property as a component part of the personal 
property which is sold, is considered the manufacture of a 
product if, in connection with the property, conversion 
costs of the corporatioRc-are 20 percent or more of the total 
cost of the goods sold. — 

1.954-3(a) (4). 

1.954-3(a) (4) (ii) and (iii). 

1.954-3(a) (4) (iii) . 

For an example of the application of the manufacturing 
exception see, Dave Fischbein Mfg. Co. v. Commissioner , 
59 T.C. 338 (1972), acq . 1973-2 C.B. 2, in which a bag 
assembly operation was conducted by a Belgian corporation 
wholly owned by a U.S. corporation. The Belgian company 
bought components from its U.S. affiliates, and some 
minor parts locally, assembled them in Belgium, and then 
sold them worldwide. The court simply disagreed with 
the contention of the IRS that the activities were not 














•^1 r^ 


A U.S. company can, therefore, form a subsidiary in a 
tax haven, sell components to the subsidiary which assembles 
them, and take the position that no foreign base company 
sales income is earned on the sale of the property which 
includes the components. The 20 percent safe harbor is 
relatively easy to meet. In addition, the subjective tests 
in the regulations are difficult for the IRS to deal with 
because of problems of access to books and records, personnel, 
and the manufacturing plant itself. 

The assembly operations may be subject to scrutiny 
under the intercompany pricing rules. The IRS may reallocate 
income from_sales between the haven subsidiary and its 
affiliates. — ' In addition, allocations might be made on 
the grounds that an affiliate is performing services for the 
tax haven subsidiary — ' or that an affiliate has licensed 
intangibles (such as a_trademark) to the subsidiary without 
adequate compensation. — ^ There are, however, information 
gathering problems in applying these rules. 

Also included in foreign base company sales income is 
income of a branch of a controlled foreign corporation 
operating outside of the country in which the controlled 
foreign corporation is incorporated, if the use of the 
branch has substantially the same tax effect as if the 
branch were a wholly owned subsidiary corporation of the 
controlled foreign corporation. — ' The regulations assume a 
substantially similar tax effect if the branch is taxed at a 
somewhat lower rate than it would have-been in the country 
where the subsidiary is incorporated. — ' Under this rule, 
if a tax haven company is organized in Panama, and has a 
selling branch in a low tax country, the branch rule will 
operate, because Panama imposes a corporation tax on business 

— / § 482; Treas. Reg. § 1 . 482-2 (e )( 1 )( ii ) . 

— / Treas. Reg. § 1.482-2(b). 

— / Treas. Reg. § 1.482-2(d). 

— / § 954(d)(2). 

— / Treas. Reg. § 1. 954-3 (b) (1 ) . 


income from Panamanian sources. If, however, the base 
company is formed in the Cayman Islands (which has a zero 
rate of tax) it can establish a branch^in a second country 
and not be subject to the branch rule.— ^ 

A pattern of doing business has developed to take 
advantage of the branch rule and the 10 percent foreign base 
company de minimis rule. A U.S. company wishing to take 
advantage of a tax holiday offered by a country which is 
trying to attract manufacturing plants, forms a subsidiary 
in a tax haven with which the United States has a tax treaty 
and transfers to it the requisite capital and technology. 
The tax haven company constructs the manufacturing plant in 
the tax holiday country and its production is exported and sold 
to unrelated persons. Assuming the initial transfer qualifies 
under § 351, a favorable § 367 ruling would ordinarily be 
issued because the property will be used in the active 
conduct of a trade or business.— ^ The manufacturing profits 
are not taxed to the U.S. parent because they are not foreign 
base company income. The sales profits are not foreign base 
company sales income because of the local manufacturing 
test. In addition, the earnings can be reinvested in the 
tax haven substantially free of tax if the income from those 
earnings is less than 10 percent of the foreign corporation's 
gross income. The tax haven entity is used because while 
the tax holiday country does not tax the export manufacturing 
profits it would tax the passive income earned on retained 
earnings at a high rate. The tax haven may tax these earnings 
but at a very low rate of tax. The retained earnings of the 
tax haven company might also be reinvested in active business 
assets free of tax. The tax effect is the avoidance of the 
tax holiday country tax, not necessarily U.S. tax. 

4. Services and Construction 

The service and construction industries have increased 
.their use of tax haven entities enormously. The data demon- 
strate rapid growth in assets invested through tax haven 
entities in both of these industries. The growth greatly 
exceeds the growth in other industries, despite subpart F's 
application to services and the existence of detailed § 482 
allocation regulations applying to services. 


— ' Of course, if the second country is a high tax country, 

then to the extent that the branch is subject to tax in 

that second country there is no overall tax avoidance. 

However, by careful planning, some second country 

tax can often be avoided. 

— / See Rev. Proc. 68-23, 1968-1 C.B. 821, 823. 


For 1976, earnings of controlled foreign corporations 
formed in the tax havens are estimated at $330 million in 
the service industries and over $500 million in construc- 
tion. These companies are estimated to have assets of $2.4 
billion and $2.2 billion respectively. In 1976, controlled 
foreign corporations formed in the tax havens held 23 percent 
of the worldwide assets of service companies and 42 percent 
in construction. These figures represent an increase from 11 
percent and 26 percent respectively, from 1968. 

Subpart F income includes foreign base company services 
income. Foreign base company services income is defined as 
income from the performance of technical, managerial, engin- 
eering, architectural or like services outside of the country 
of incorporation of the controlled foreign corporation, if 
such services are performed for, or on behalf of, a related 
person. — ^ Services which are performed for, or on behalf 
of, a related person include (i) direct or indirect compensation 
paid to a controlled foreign corporation by a related person 
for performing services, (ii) performance of services by a 
controlled foreign corporation which a related person is 
obligated to perform, (iii) performance of services with 
respect to property sold by a related person where the 
performance of services constitutes a condition of sale, and 
(iv) substantial assistance contributing to the performance 
of the services by the controlled .foreign corporation furnished 
by a related person or persons. — ' A related party provides 
substantial assistance to a controlled foreign corporation 
if the assistance furnished provides the controlled foreign 
corporation with the "skills" which are a principal element 
in producing the income from the performance of the services 
or the cost to the controlled foreign corporation of the 
assistance is 50 percent or more of the total cost to the 
foreign corporation of performing the services; assistance 
is not taken into account unless it assists thej-subsidiary 
"directly" in the performance of the services. — ' 

Despite these provisions, little income tax has been 
collected from the service or construction industries in 
havens. According to IRS 'statistics, includable income of 
controlled foreign corporations in the services industry was 

— / § 954(b) (3). 

— / Treas. Reg. § 1 . 954-4 (b )( 1 ) . 

— / Treas. Reg. § 1 . 954-4 (b) ( 2 ) ( i i ) (b ) and (e) 


approximately $5.7 million in 1975 and in the construction 
industry was approximately $2.6 million. 

The foreign base company services income concept was 
drafted with manuf acturinq-related services in mind. Congress 
stated that "as in the case of sales income, the purpose 
here is to deny tax deferral where a service subsidiary is 
separated from manufacturing or similar activities of a 
related corporation and organized in another country primarily 
to obtain a lower rate of tax for the service income." — ' 
Today, the services which appear to be making the greatest 
use of tax havens are independent construction, natural 
resource exploration, and high technology services, which 
are not related to manufacturing. A portion of a business 
which is conducted in the U.S. can simply be excised from 
the U.S. business and transplanted to a tax haven. The 
services are not being performed for a related party, but 
rather are being performed for unrelated parties. The income 
is being accumulated free of tax. 

The problems with the service rules are generally due 
to the approach taken by the Congress, which, in effect, 
mandates regulations requiring difficult line drawing. It 
is unclear what facts and circumstances are necessary for 
the IRS to assert that substantial assistance has been 
rendered to the foreign subsidiary. The regulations do not 
establish guidelines, other than two examples which are not 
particularly helpful. One example indicates that if a 
contract for the provision of services is supervised by 
employees of the U.S. parent corporation who are temporarily 
on loan to the subsidiary, then substantial assistance is 
rendered to the subsidiary by the related person, and the 
income from the^oerformance of the contract is foreign base 
company income. — If, however, the contract is supervised 
by permanent employees of the subsidiary, and the U.S. 
parent only provides clerical assistance, then such assistance 
is not substantial and income from the contract is not 

— / S. Rep. No. 1881, at 84, 1962-3 C.B. 703, 790. 
— / Treas. Reg. § 1 . 954-4 (b) ( 3 ) example (2). 


foreign base company services income. — ' The example also 

indicates that if permanent employees of a controlled foreign 

corporation oversee a contract with no substantial assistance 

rendered by a related person, then no foreign base company 

services income arises from the performance of the contract.—' 

The determination of whether an employee is permanent 
or temporary presents a very difficult factual issue. By char- 
acterizing employees as permanent employees of a controlled 
foreign corporation, a U.S. shareholder can take the position 
that the transactions in question do not produce foreign 
base company services income. 

The factual issue of what constitutes substantial 
assistance has arisen in connection with a number of services, 
including offshore drilling. In a prototype case, a U.S. 
parent establishes a foreign subsidiary in a tax haven to 
conduct offshore drilling operations outside of the subsidiary's 
country of incorporation. The officers of the parent may 
negotiate the drilling contracts and then enter into an 
agreement with third parties as officers of the subsidiary. 
The parent corporation is not liable on the contracts and 
does not guarantee performance of the contracts. The parent 
may lease the equipment necessary to conduct the drilling 
operations at the safe harbor arms-length charge under the 
§ 482 regulations. The day-to-day drilling operations are 
managed and performed by on-site employees of the foreign 
subsidiary, who are characterized as permanent employees. 
The joint officers of the parent and the subsidiary perform 
various managerial services for the subsidiary. In many 
cases, there will be little or no tax imposed on the service 
income by the country in which the services are performed. 

Arguably, the parent renders minimal rather than substantial 
assistance to the foreign subsidiary, and therefore income 
from the drilling operations is not foreign base company 
services income. On the other hand, it may be argued that 
the income received by the subsidiary is foreign base 
company services income because the assistance rendered by 
the parent in the form of overall direction of the subsidiary 
drilling contracts is substantial. The issue is difficult 
to resolve, particularly since important facts may be known 
to employees of the foreign subsidiary who cannot be compelled 
to testify. 

— ' Treas. Reg. § 1 . 954-4 (b ) ( 3 ) example (3). 
—' Treas. Reg. § 1. 954-4 (b) ( 3 ) example (3). 


A construction company will also often use a subsidiary 
formed in a tax haven to conduct its construction projects 
abroad. A construction project generally will consist of 
three phases: (1) a prospectus phase during which the plans 
for the project are outlined; (2) a planning phase during 
which actual detailed plans will be drafted; and (3) a 
construction phase during which a construction manager is 
placed on the construction site to supervise the project. 

The initial prospectus will often be prepared and 
promoted by a U.S. company. If the company is successful in 
obtaining the contract, the contract will be signed by 
officers of the offshore subsidiary of the U.S. company, who 
may also be officers of the U.S. parent. Supervision of the 
construction will be conducted by the offshore company 
through an on-site manager who is an employee of that company, 
but who at one time may have been an employee of the U.S. 
parent. He may have obtained all of his knowledge and 
skills from the U.S. parent. 

As with the drilling rig situation, it may be difficult 
to establish that the services were performed for or on 
behalf of a related person. Once the company develops 
substance overseas, so that fewer of its managerial services 
are being performed by the U.S. parent, it becomes more 
difficult for the IRS to make the substantial assistance 

The Commissioner may be able to allocate some of the 
services income from the services to the U.S. parent under 
§ 482. The regulations under § 482 provide that where a 
member of a controlled group of entities performs managerial 
or technical services "for the benefit of, or on behalf of, 
another member of the group" without charge, an allocation 
may be made -to reflect an arms-length charge for those 
services. — ' The test of whether the services were performed 
for the benefit of or on behalf of the parent is, as with 
the subpart F tests, a very difficult subjective test for 
the IRS to apply. 

Agents believe that a few of these cases are in fact 
abusive. An example of such a situation might be the nego- 
tiation and agreement of a construction contract by the U.S. 
parent but, at the last minute, having the contract signed 

— / Treas. Reg. § 1.482-2(b). 


by an officer of the tax haven subsidiary. This contract is 
valuable and in some cases there has therefore been a transfer 
of assets and gain should have been reported or the profits 
from the activity should have been reported. Failure by a 
sophisticated, well-advised taxpayer to report may be fraud, 
but it would be difficult to establish. 

Some companies have been able to accumulate significant 
income overseas by leasing equipment to a tax haven subsidiary 
to be used in the service business. By manipulating the § 
482 rental safe harbor rule and the fair market value of the 
equipment, significant income can be accumulated in the tax 
haven company. This income can be used to create substance 
in the tax haven company, which makes the arrangement .between 
the two companies even more difficult to challenge.—^ 

5. Transportation 

U.S. companies are engaged in the transportation industry 
in tax havens (primarily shipping) to a significant degree. 
As of December 31, 1977, 687 foreign flag vessels were owned, 
by U.S. companies or foreign affiliates of U.S. companies. — ' 
Four hundred eighty-eight of these were tankers. Three 
hundred eighty-five vessels were registered in Liberia, and 
88 were registered in Panama. In 1976, approximately 74 
percent of the assets of controlled foreign corporations 
engaged in the transportation business were held by companies 
formed in tax havens. — ' This represents a substantial 
increase over 1968 when 50.6 percent of assets were in 
companies formed in tax havens. Most of this use is completely 
legal. While there can be significant tax savings, the 
structures are within the spirit and letter of the law. 

Two aspects of U.S. law encourage the use of tax haven 
subsidiaries for carrying on the transportation business: 

(1) the reciprocal exemption from U.S. income tax of foreign 
flag ships which engage in traffic to and from the U.S.; and 

(2) the deferral of tax on the income of foreign corporations 
controlled by U.S. shareholders, whether or not they are 
engaged in activities involving the U.S. In addition, U.S. 
source rules operate to minimize .U.-S. tax even when the 
vessels are shipping to the U.S. — ' 


— See safe harbor rental rule in Treas. Reg. § 1.482-2(c). 


U.S. Department of Commerce, Maritime Administration, 
Foreign Flag Merchant Ships owned by U.S. Parent Companies , 
April 1979. 


—^' See table 2 in Chapter III. 


— ' See § 863, and Treas. Reg. § 1.863-4. 


Earnings derived from the operation of a ship documented 
under the laws of a foreign country which grants an equiva- 
lent exemption to citizens or corporations of the United 
States are exempt from U.S. tax.— ^ To qualify for the 
exemption, the foreign country granting the exemption must 
be the country of registration of the vessel.—' 

Under a provision adopted by the Tax Reduction Act of 
1975, syl^part F income includes foreign base company shipping 
income; — this is income derived from or in connection with 
the use of any vessel in foreign commerce and income derived 
from or in connection with the performance of services 
directly related to the use of any such vessel or from the 
sale, exchange or other disposition of the vessel. Prior to 
1975, shipping income was excluded from subpart F. Amounts 
reinvested in the shipping business are still excluded. 
Amounts of previously excluded shipping income which are 
withdrawn from investment in the shipping business are 
included as subpart F income in the year of withdrawal. 
Accordingly, a company can continue to reinvest its earnings 
in the prescribed categories of assets, and not realize 
subpart F income. 

We have been advised that while it was anticipated that 
most companies would be able to qualify for the exclusion 
through reinvestment, in fact, because of the glut of oil 
tankers, some companies may be forced to report subpart F 
shipping income for lack of reinvestment opportunities 
within the next few years. Moreover, this provision may be 
irrelevant to major petroleum companies because they are in 
an excess credit position. 

A relatively new development in the petroleum industry 
is the transshipment of oil, which originated in 1972 when 
the use of super tankers became necessary. The super tankers 
load their cargo in the producing countries and transport it 
to the Caribbean where the oil is unloaded and stored by a 
related corporation, or by an independent transshipping 
company. When needed, the oil is loaded on smaller vessels 
which bring it to the United States. A terminalling charge 
of $.13 to $.17 per barrel has been paid by the refiner to 
the transshipper for the removal and storage of the oil. 

— / §§ 872(b)(1) and 883(a)(1). 

— / Rev. Rul. 75-459, 1975-2 C.B. 289. 
47/ § 954(f). 


However, some transshippers have charged as much as $.30 a 
barrel, and the Department of Energy has apparently permitted 
$.27 a barrel. In the usual case, the oil will remain in 
the terminal for no more than 30 days. The terminalling 
company is an offshore tax haven company. Because this is a 
relatively new phenomenon, the full extent of use is not 
known, but it is generally assumed to be significant. It is 
known that most oil imported from the Persian Gulf is transshipped, 
One tax benefit can be deferral of the tax on the profit 
from the transshipping. If the transshipper is an affiliate, 
overcharging can mean a shifting of income from the U.S. to 
the tax haven affiliate. 

6. Insurance 

No deduction is allowed for self insurance. To circumvent 
this rule, many companies find it advantageous to form a 
wholly owned insurance subsidiary known as a "captive insurance 
company" to insure risks of the parent or its affiliates. 
If the company is considered an insurance company for tax 
purposes, and if it assumes the full risk (does not reinsure), 
it can invest the entire premium and realize income most of 
which would be free of tax. — ' 

In the prototype case, the U.S. company forms a Bermuda 
company to engage in the insurance business. The captive 
must have a minimum paid-in capital of $120,000. The captive 
enters into an insurance contract with its parent, pursuant 
to which it will insure risks of its U.S. parent or of 
foreign subsidiaries of the U.S. parent. In most cases the 
captive enters into a reinsurance contract with an unrelated 
insurance company. Under this contract, the unrelated 
insurance company assumes the risk which had been assumed by 
the captive. The captive invests the premium, and then, at 
the end of the insurance period, pays over the reinsurance 
premium, retaining a small percentage of it. In addition, 
it retains the profit realized on the invested premiums. 
This investment income is earned because, while the insurance 
premiums are paid in advance by the insured, the reinsurance 
premiums are not paid by the captive until the end of the 
coverage period. 


Most captives are formed in a tax haven. Some have 
been formed in the United States in Colorado, which 
has a captive insurance company law relieving captives 
of many of the reserve and other requirements normally 
imposed on insurance companies. A Colorado captive 
is subject to Federal income tax, but at the favorable 
insurance company effective rates. 


In addition to significant tax advantages, a captive 
also provides business advantages. It can underwrite 
insurance which is not available in the commercial insurance 
market, or i^gavailable only at a high premium or with large 
deductibles. — ''^ It can be established in jurisdictions 
which free it from many State controls. Bermuda has been 
the foremost situs for captives, although the Cayman Islands 
is attempting to attract captive business, as are other 
havens. — ' 

The earnings of a captive insurance company are potentially 
subject to tax under subpart F, but only to the extent those 
earnings are from the insurance of U.S. risks. Subpart F 
income^includes income derived from the insurance of U.S. ^^ . 
risks, — '^ which includes U.S. property and U.S. residents.—^ 
If the premiums for insuring U.S. risk do not exceed five 
percent of total premium of the foreign company, then the 
subpart F provisions do not apply. — ' For purposes of the 
subpart F insurance provisions, a foreign corporation is a 
controlled foreign corporation if more than 25 percent of 
the total combined voting power of all classes of stock of 
the corporation is owned directly or indirectly by U.S. 
shareholders on any day of the taxable year. — However, 
the 25 percent rule, rather than the normal 50 percent rule 
for controlled foreign corporations, applies only if the 
gross amount of premiums or other consideration in respect 
of the reinsurance or the issuing of insurance on U.S. risks 
exceeds 75 percent of the gross .amount of all premiums or 
other consideration received. — ' 

Subpart F has not been useful in dealing with captives. 
First, there is a U.S. tax advantage to being taxed as an 
insurance company, and the subpart F income of the company 
would be computed by applying the insurance company rules. 
Accordingly, a U.S. company may choose to form a captive 
even if its income will be taxed. 


— ' See O'Brien and Tung, "Captive Off-Shore Insurance 

Companies," 31 N.Y.U. Inst, on Fed. Tax. , 665, 719 (1973). 

— See "A Survey of Offshore Captives," Tax Haven and Shelter 
Report, 4 (August 1978). 

^/ § 952(a)(1). 

— / § 953(a)(1). 


^^' § 953(a). 

— / § 957(b). 

ii/ Id. 


Second, the insurance company rules are considerably 
narrower than the foreign base company income provisions, 
and therefore apply in fewer cases. The provision is 
limited to income from insuring U.S. risks. — ' The foreign \ 

risks of affiliates, therefore, may be insured without 
generating subpart F income. The foreign personal holding 
company rules generallyj-do not apply to the passive income 
of the foreign insurer, — ' and certain amounts relating to 
reserves for foreign risks can be invested in U.S. property 
without being taxed to the U. S. ^.shareholders as an increase 
in investment in U.S. property. — ' Arguably, however, insuring 
the foreign risks of affiliates will generate foreign base 
company services income. 

The IRS has sought to deal with captives outside of 
subpart F. It has ruled that a premium paid by a domestic 
corporation and its affiliates to a captive insurance company, 
either directly or through an intermediary independent 
insurance company which reinsures with the parent's captive, 
is not deductible because there is no economic shifting or 
distribution of risk of loss with respect to any of the risk 
carried or retained by the wholly owned foreign subsidiary. 
To the extent that an unrelated insurer retains the risk, or 
to the extent that the risk is shifted to an unceLated 
insurance company, the premiums are deductible. — ' IRS has 
also ruled that the so-called "insurance premiums" paid by 
domestic subsidiaries of a U.S. parent were to be considered 
distributions of dividends to the parent, and then as a 
contribution to capital of the foreign subsidiary by the 
parent. Also, the ruling held that the companies were not 
insurance companies for tax purposes. This view was upheld 
by the Tax Court in Carnation Company v. Commissioner. — ' 



§ 953(a) 

— / § 954(c)(3)(B); see § 954(c)(3)(C), which excludes from 
subpart F investment yields on an amount equal to one- 
third of the premiums earned on certain insurance contracts, 
provided they are not attributable to risks of related 

i^/ § 956(b) (2) (E). 


Rev. Rul. 77-316, 1977-2 C.B. 53. 

71 T.C. 400 (1978), appeals pending (9th Cir. 1978). 


Under the IRS view, therefore, the deduction of premiums 
paid to a captive would be denied, and, in the case of 
premium payments for insurance by foreign subsidiaries to 
the captive, there would be a constructive dividend to the 
parent which would be taxable income, followed by a contribution 
to the capital of the foreign captive. The foreign captive 
would not have subpart F income because it would not be 
engaged in the insurance business. Because the amounts are 
contributions to capital rather than premium income, the 
foreign corporation does not have any gross income from the 
purported insurance transactions, hence it does not have any 
foreign source income for purposes of the foreign tax credit 
limitation. — ' 

The IRS has ruled, however, that where the company is 
not a wholly owned captive, but rather is owned by a group 
of taxpayers, premiums will be deductible. — ' 

Despite IRS attention to this area, the data show that 
significant captive insurance business continues. In some 
cases the captive insurance companies are beginning to 
write small amounts of insurance for unrelated third parties. 
In one case a captive has reached the point where 70 percent 
of the risk insured by it is risk of unrelated parties. By 
insuring some unrelated risk, it is intended that the company 
will be deemed an insurer and the premium paid by the domestic 
parent will be deductible. Because income from insurance of 
foreign (even if related) risk is not subpart F income, it 
can be expected that captives will continue to grow if 
taxpayers can avoid the holding of Carnation . Captives have 
also begun to underwrite open market business by participating 
in "pools" in order tp-improve their chances of being considered 
an insurance company. — ' Because the premiums from the related 
and unrelated income are not fragmented for tax purposes, sub- 
stantial amounts of income arguably can be shifted to a captive 
if it writes some unrelated risk. 

— See Carnation Company , Id. 



Rev. Rul. 78-338, 1978-2 C.B. 107, holding that a foreign 
insurance company owned and organized by 31 domestic 
companies was a viable insurance company. 

"A Survey of Offshore DDcation for Captives", Tax Haven 
and Shelter Report, 4 (August, 1978). 


Another method of attempting to circumvent the Carnation 
case, and the IRS position, is the use of a so-called "rent- 
a-captive". Under this scheme, the taxpayer enters into an 
insurance contract with an unrelated U.S. commercial insurer 
that in turn enters into a reinsurance agreement with a 
tax haven company and cedes most of the premium to it. 
Payments of the reinsurance premiums are made at the time 
the taxpayer pays the premium so that the cash balances are 
held by the tax haven company. The taxpayer then purchases 
nonvoting preferred stock in the tax haven company. The 
shares have a value equal to a fixed percentage of the 
premium of the primary policy. After a period of years, the 
taxpayer gets a return of the capital paid for the preferred 
shares plus investment income on the capital and loss reserves. 
The taxpayer can borrow an amount equal to its capital and 
pay interest to its preferred account. 

The promoters take the position that the premiums are 
deductible, and that the income of the tax haven company 
will accumulate free of tax, because the company's share 
dispersal will be such that it will not be a controlled 
foreign corporation. In addition, they claim that there 
will be adequate risk shifting if properly structured so 
that the premiums will be deductible. Finally, they point 
out that large multinational corporations can benefit because 
the income realized when the preferred shares are redeemed 
will be considered foreign source income which will increase 
allowable foreign tax credits. 

7. Banking 

united States banks continue to conduct significant 
business through offshore financial centers. Generally, the 
business is conducted in branch form and the income generated 
is taxed currently by the U.S., subject to the availability 
of the foreign tax credit as limited by the overall foreign 
tax credit limitation. In some cases, however, U.S. banks 
establish holding companies and other subsidiary corporations 
in the havens to conduct trust or other businesses. A few 
of the large U.S. banks have a presence in most, if not all, 
of the tax havens. 

The use of tax havens by banks is large and growing. 
Many major banks now have trust companies in the havens. 
These companies are not subject to U.S. tax under subpart F. 
Wholly owned subsidiaries of U.S. banks in the Bahamas, 
Cayman Islands, Netherlands Antilles, Panama, Hong Kong, 
Luxembourg, Singapore, and Switzerland had combined surplus 
and undivided profits of over $500 million at the end of 
1979. The total earnings of subsidiaries of large banks in 
these tax havens were $96 million in 1976. 


D. Transactions Through An Entity VThich Is Not Controlled 

The anti-avoidance provisions which apply to foreign 
transactions generally require that the foreign entity being 
scrutinized be controlled by a U.S. person. Without control, 
many of the reports by which transactions with potential 
U.S. tax consequences are identified arguably do not have to 
be filed, and the powers to compel production of records are 

The subpart F or foreign personal holding company 
provisions apply to a foreign entity only if that entity is 
controlled by U.S. persons. Income is attributed to U.S. 
persons under subpart F only if-the foreign corporation is a 
controlled foreign corporation. — A foreign corporation is 
a controlled foreign corporation if more than 50 percent of 
the total combined voting power of all classes of its voting ,^. 
stock is owned, or is considered as owned, by U.S. shareholders. — ' 
A U.S. shareholder is a U.S. person who owns 10 percent or 
more of the voting stock of the foreign corporation. — ' 
There is no equity or value test for purposes of determining 
whether or not a corporation is a controlled foreign corporation. 

The regulations make clear that arrangements to shift 
nominal voting power to non-U. S. shareholders, when actual 
control is retained, will be disregarded. — ' The IRS has 
successfully defended this regulation in court. All of the 
litigated cases involved domestic corporations attempting to 
"decontrol" their foreign subsidiaries through the issuance 
of voting preferred stock to non-U. S. shareholders. — ' 

Nevertheless, if real decontrol can be achieved, subpart 
F does not apply. A foreign corporation can be structured 
so that U.S. persons own one-half or less of its voting 
stock, but more than one half of the equity in the corporation 


§ 951(a) . 

^/ § 957(a). 


§ 951(b) . 

Treas. Reg. § 1.957-1. 

Garlock, Inc. v. Commissioner , 489 F. 2d 197 (2d Cir. 
1973), cert, denied , 417 U.S. 911 (1974); Kraus v. 
Commissioner , 490 F. 2d 598 (2d Cir. 1974), aff 'g . 59 
T.C. 681 (1973); Koehring Co. v. United States , 583 F. 
2d 313 (7th Cir. 1978). But see , CCA Inc. v. Commissioner , 
64 T.C. 137 (1974), acq. 1976-2 C.B. 1. 


through, for example, the use of voting preferred stock. 
Because there is no value test, the corporation (assuming 
that actual control cannot be proved) is not a controlled 
foreign corporation. 

Moreover , a 
as owning 10 per 
power of the for 
corporation may 
shareholders, ea 
stock, and it wi 
subject to tax u 
a foreign person 
test under those 
individual share 
a foreign corpor 

U.S. share 
cent or mor 
eign corpor 
be formed w 
ch owning n 
11 not be a 
nder subpar 
al holding 

provis ions 
holders of 
ation's out 

holder must own or 
e of the total comb 
ation. Accordingly 
ith its stock owned 
ine percent of the 

controlled foreign 
t F. In addition, 
company because the 

is ownership by fi 
more than 50 percen 
standing stock. 

be considered 
ined voting 
, a foreign 

by 11 U.S. 
corporation ' s 

it will not be 

ve or fewer 
t in value of 

Methods have developed for maintaining actual voting 
control, while achieving technical decontrol for subpart F 
purposes. One such method is the issuance of "stapled", 
"paired", or "back-to-back" stock. A domestic parent corporation 
forms a tax haven subsidiary and then distributes ratably to 
its shareholders its stock of the foreign subsidiary. The 
shares of the two companies are tied together so that they 
can be transferred only as a unit. The IRS has ruled, in 
the domestic context, that the result is a brother/ sister 
relationship between the two corporations, rather than a 
parent/subsidiary relationship, and that the distribution of 
the subsidiary's stock is a distribution of property includable 
in income as a dividend distribution to the parent shareholders. 
The result of the published IRS positions is that controlled 
foreign corporation status is avoided. 

The distribution may be treated as a dividend to the 
shareholders of the U.S. company. If, however, the sub- 
sidiary is not valuable at the time its stock is distributed, 
decontrol may be achieved at little cost. In addition, the 
distribution may qualify as a tax free reorganization. 

In one case a U.S. company spun off to its shareholders 
the stock of its wholly owned tax haven subsidiary. Within 
a few years, the gross income of the tax haven company grew 
to well over $100 million. 



Rev. Rul. 54-140, 1954-1 C.B. 116. See also Rev. Rul . 
80-213, 1980-28 I.R.B. 7. Stapled stock may also be 
used to avoid the boycott provisions of § 999 of the 
Code, and with a DISC to avoid taxation of DISC income 
at the corporate parent level. 


Another method for attempting to avoid the subpart F 
provisions is to do business through a controlled foreign 
corporation which is a partner in a foreign partnership. 
The foreign base company sales income and the foreign base 
company services income rules apply to transactions with 
related persons. The term related person does not include a . 
partnership controlled by a controlled foreign corporation.— ^ 
Accordingly, a U.S. person could arguably form a controlled 
foreign corporation which in turn would enter into a partnership 
with ^n unrelated person and enter into base company type 
transactions through the partnership. Even if the other 
person had a relatively small interest in the partnership 
(for example, 10 percent), the related party status, and 
thus subpart F, would be avoided. — ' 

Promoters have sold decontrol through fraudulent schemes 
which attempt to avoid all reporting requirements and thus 
IRS scrutiny. For example, the May 1980 issue of the Journal 
of T axation describes a scheme in which a Panamanian corporation 
establishes a British Virgin Islands (BVI) trust for the 
benefit of the Mexican Red Cross, contributing to the trust 
a nominal sum of money. The trust then organizes a Hong 
Kong company. Ninety-six percent of the stock is issued to 
the trust and four percent is issued to the U.S. person who is 
the investor. The BVI trust then has the U.S. person assume 
management and control over the Hong Kong company. 

The promoters apparently take the position that the 
Hong Kong company is neither a controlled foreign corporation 
nor a foreign personal holding company, because control is 
in the BVI trust which is a foreign trust created by a 
foreign grantor and having a foreign beneficiary (the Mexican 
Red Cross). Further, the promoters take the position that 
the U.S. investor does not have to file a Form 959 because 
the U.S. person acquired less than five percent of the stock 
of the foreign corporation. Under this theory, no other 
return would have to be filed. The Mexican Red Cross never 
gets anything because the company never pays dividends. 
Instead, its profits are "lent" to the U.S. investor. 


See § 954(d) (3). 

— / See MCA Inc. v. United States , 46 AFTR 2d 80-5337 (D. C. 
CD. Cal. 1980), holding that a partnership consisting 
of a controlled foreign corporation and an employee 
trust was a corporation related to the controlled foreign 
corporation. Lack of separate interests among the 
partners caused the alleged partnerships to be treated 
as corporations. See Toan, "Foreign Base Company 
Services Income," Subpart F - Foreign Subsidiaries and 
Their Tax Consequences , Feinschreiber , ed. , 132 (1979). 


In another scheme, the 50 percent threshhold has been 
combined with improper transfer pricing in a fraudulent 
scheme to syphon patent royalties into a tax haven holding 
company. For example, U.S. company X wants to license a 
patent from unrelated foreign licensor Y. It is anticipated 
that the royalties will be $100 per year. X's after tax 
cost would be $54 ($100 less $46 tax). Instead, X and Y 
form tax haven corporation Z in a treaty country. Y licenses 
the patent to Z which sublicenses to X for $200 per year. X 
deducts the $200. While X's cost is $200, its after tax 
cost is $8 ($200 less $92 less $100 in the tax haven corporation) 
Further, the $100 X owns in the tax haven corporation can 
earn investment income free of U.S. and local tax. X will 
not have subpart F income because it does not own more than 
50 percent of the stock of Z. The scheme is fraudulent, but 
cloaked in legitimacy. The participation of the unrelated 
licensor may make it difficult for the IRS to establish 
improper transfer pricing. 

The application of the §482 rules may also be avoided 
through decontrol. In order for §482 to be applied, the 
organizations dealing with one another must be owned or 
controlled, directly or indirectly, by the same interests. 
The regulations define the relationship broadly, stating 
that "the term control includes any kind of de facto control, 
direct or indirect, whether leqally enforceable, and however 
exercisable or exercised...." — ' Nevertheless, control 
still must be found in order for a § 482 allocation to be 
possible. Therefore, in cases where decontrol is achieved, 
arguably not only do subpart F and the foreign personal 
holding company provisions no longer apply, but allocations 
can no longer be made under § 482. 

E. Principal Patterns of Abusive Tax Haven Use Predominently 
by Promoters and by Individual Taxpayers 

Individuals use tax havens in many of the same ways and 
for many of the same reasons as do multi-national companies. 
Thus, many of the structures described above are used by 
individuals. Promoters, including tax practitioners, have 
also been advising individuals to use tax havens to abuse 
the tax structure. Some of these uses are highlighted 

1. Background 

The earliest anti-avoidance legislation, the predecessors 
of §§ 367, 1491 and the foreign personal holding company and 
personal holding company provisions, were intended to deal 
with abusive tax avoidance by individuals. In a letter to 


— ' Treas. Reg. § 1. 482-1 ( a ) ( 3 ) . 


President Roosevelt, Secretary of the Treasury Morgenthau 
cited numerous instances of the abusive use by individuals 
of holding companies in the Bahamas, Panama, and Canada 
(then a haven). The uses included creation of artificial 
deductions by means of loans made to individuals by their 
personal holding company, removing assets (three million 
dollars in one case) to a Bahamian company, with the individual 
shareholder then filing returns in successive years from 
such diverse places as New Brunswick, Maine, British Columbia, 
Jamaica, and expatriation by a retired army officer who 
immediately established Bahamian corporations to hold and 
sell his securities. — ' 

Many of the most flagrant abuses of holding companies 
seem to have been curtailed. Significant use of tax havens 
by individuals, however, is still possible and much of it 
does not comport with Congressional intent. There appears 
to be a growing use of tax havens for small transactions. 

2. Patterns of Use 

Described below are some of the abusive schemes we have 
seen by which individuals have attempted to use tax havens 
to avoid U.S. tax. 

a. Investment Companies 

A promoter forms P, a Bermuda company, which in turn 
forms a Bermuda subsidiary (S) to engage in speculative 
trading in commodity futures and forward contracts. All of 
the stock of P is held by U.S. persons. All trading is to 
be done by S. S receives a ruling from Bermuda authorities 
that it is exempt from current and future Bermuda taxes. 
The promoter takes the position that neither P nor S will 
incur U.S. tax because: they are foreign corporations; will 
not conduct business in the U.S.; will not have any U.S. 
source income; P's share dispersal among U.S. persons will 
be such as to avoid controlled foreign corporation or foreign 
personal holding company status; and capital gain on the 
disposition of P's shares will be afforded by avoiding 
§ 1246, because the company did not register under the 
Investment Company Act of 1940 and was not engaged in trading 
or dealing in securities. 

73 / 

-^' See report of the Joint Committee on Tax Evasion and 

Avoidance of the Congress of the United States, 75th 

Cong., 1st Sess., No. 337 (1937) at 1. 


The Congress adopted §1246 in 1962 in an effort to 
limit what it considered an abuse which had arisen by persons 
forming investment companies in tax havens with shares being 
sold to U.S. persons. Prior to 1962, the company was not 
taxed, and the U.S. shareholders were taxed at the favorable 
capital gain rates when the shares were sold or redeemed. 
Section 1246, however, applies only to a company which 
trades in securities. Arguably, commodities futures contracts 
are not securities, and thus §1246 does not apply. In 
addition, the company would not^be a personal holding company 
because of its share dispersal. — ' In any event, personal 
holding company- income does not include income from trading 
in commodities. — ' Furthermore, if the commodity transactions 
are executed in the U.S. through a U.S. broker, S will not 
be engaged in trade or business in the U.S. and the short- 
term capital gain realized on the sales will not be taxed in 
the U.S. because it is not fixed or determinable income. 

S might be subject to the accumulated earnings tax on 
its U.S. source income if its earnings are accumulated 
beyond the reasonable needs of the business. In an attempt 
to avoid this result, S will distribute dividends to P. P 
will not be subject to the accumulated earnings tax because 
it does not have U.S. source income. However, § 269 might 
apply to enable the IRS to disregard S, in which case P 
would have to distribute the income to its U.S. shareholders 
or pay the accumulated earnings tax. 

b. Trading Company 

A promoter forms a company in the Grand Cayman Islands, 
citing the company's tax-free status there. The promoter 
purchases 50 percent of the shares in the company, and the 
other 50 percent are sold to 20 unrelated U.S. individuals. 
Each person who purchases shares signs a contract obligating 
himself to pay up to $10,000 over a period of 18 months. 
The agreement provides that the profits will be split fifty- 
fifty between the shareholders and the corporation during 
the 18-month period. Afterwards, all of the profits will 
belong to the corporation, with the shareholders receiving 
distributions. The promoters take the position that there 
is no U.S. tax because the company is not a controlled 

— / § 542(a)(2). 
— / See § 543. 


foreign corporation or a foreign personal holding company, 
because it does not meet the "more than" fifty percent 
ownership test. The promoters also take the position that 
the $10,000 payment is a deductible reimbursement for expenses, 
and not an investment in assets. 

c. Holding Companies 

Foreign companies have been used in an attempt to shelter 
royalty or similar income. In one case a U.S. person purchased 
the movie rights to a series of books. A Swiss corporation 
was formed, with a U.S. individual receiving 50 percent of 
the stock and a U.S. distributor receiving 50 percent of the 
stock. The individual transferred the movie rights to the 
Swiss corporation. The Swiss corporation then gave the 
distribution rights to the film to the U.S. distributor. 
Royalties are paid to the Swiss company, which claims that 
activities of the corporation are conducted by the Swiss 
company in Switzerland. Under the U.S. -Swiss treaty, the 
royalties are exempt from tax by the U.S. The company has 
accumulated millions of dollars and has paid only limited 
dividends. The U.S. individual shareholder has borrowed 
millions from the company, and has paid only interest. Most 
of the company's retained earnings are invested in the U.S. 
in CD's, or are invested in the Eurobond market. The company 
claims that it is engaged in an active business and that 
it does not have subpart F income. In fact the shareholders 
should be taxed on the loans to them under § 956. 

d. Shelters 

Abusive tax shelters present the IRS with one of its 
most serious compliance problems. The IRS has identified 
approximately 25,000 different shelter promotions in recent 
years. These involve roughly 190,000 returns and perhaps as 
much as five billion dollars in potential adjustments. 

A recent, and apparently growing, phenomenon is the 
interjection of an offshore jurisdiction into the shelter 
scheme. A tax haven may be used in an attempt to hide the 
fact that a transaction upon which a deduction is based 
never took place, to hide the promoter's profit, or to hide 
the list of investors. Also, losses may be transferred to 
an investor's account in a tax haven and the ownership 
relationship with the account hidden. Tax haven shelter 
activity appears to have increased markedly over the past 
few years; and, in a few cases, previously domestic shelter 
schemes have moved off-shore in later years. 


(i) Commodities . We have identified a number of cases 
where offshore entities or locations were used to faciliate 
alleged commodity transactions. Generally, these are so 
called "tax spreads" which seek to give the investor a tax 
advantage by generating large ordinary losses in year one, 
and then long-term capital gain in year two. The benefit to 
the taxpayer is the difference between the tax saved on the 
ordinary loss and the tax paid on the capital gain. A 
Treasury Bill-GNMA straddle is entered into to produce 
ordinary loss on the T-Bill leg and long term capital gain 
on the GNMA leg. The purpose is to convert ordinary income 
in one year into long term capital gain in the immediately 
succeeding year. The taxpayer liquidates his loss by 
covering the short sale on the T-Bill leg. The taxpayer 
then borrows money to cover the loss from a broker located 
in the Bahamas, and locks in the gain by entering into a 
contract to deliver the GNMA's at the current price in 
twelve months. At the end of the twelve month period, the 
taxpayer delivers the GNMA's and realizes long terra capital 
gain. There is evidence that the transactions may never 
have taken place. In one case, a revenue agent estimates 
that there may be as many as 1,500 investors and deductions 
of as much as $150 million. 

Another scheme has been marketed over a four year 
period to at least 500 taxpayers. The IRS has identified 
40 income tax returns for two taxable years which were 
involved with this tax shelter on which losses were deducted 
in excess of $4,000,000. 

Salesmen for the taxpayer will approach wealthy individuals 
and advise them that they have a perfectly legitimate tax 
shelter device which will allow the investor to double his 
money in one year. It is explained that the marketing 
organization will set up for the taxpayer a foreign trust 
which will be located in a tax haven jurisdiction. The 
foreign trust will be a grantor trust which will have the 
taxpayer as its sole beneficiary. The trust will be formed 
ostensibly for the purpose of investing in gold and silver 
with the idea of making a profit. 

The investor puts up $20,000 in cash which constitutes 
the corpus of the trust. The trust subsequently becomes a 
limited partner in a limited partnership formed in Liechtenstein 
or another tax haven. The limited partnership is a foreign 
partnership not doing business in the United States which 
would not be subject to United States income tax. The 
stated business of the partnership is investing in gold or 
silver with the intent of making a profit. 


Next, three simultaneous contracts are entered into. 
In the first contract, the partnership borrows from a foreign 
bank $1,200,000 payable one year from the date of the loan 
with interest at the rate of 10% per annum, so that the 
interest during the first year would be $120,000. The 
general partner is supposed to pay the interest. The trust 
as a limited partner would enter into an agreement stating 
that the trust would be responsible for the payment of the 
interest in the event of default. Next, the partnership 
purchases gold or silver valued at $1,200,000 which is 
pledged as collateral for the $1,200,000 bank loan. Finally, 
the partnership enters into a contract to sell the gold or 
silver one year from the date of the contract at a profit 
of 10% or $1,320,000. 

The taxpayer is advised that as a result of these 
transactions during the first year the partnership pays 
interest in the amount of $120,000, has no income, and thus 
has a loss in the amount of $120,000 which would flow through 
the trust to the individual investor. Assuming the taxpayer 
is in the 50 percent tax bracket, the $120,000 deduction 
would be worth $60,000 in tax savings to the taxpayer. 
Thus, for an investment of $20,000, the taxpayer has recouped 
his initial $20,000 plus he has received a profit of $40,000 
payable by the United States Government. He has thus managed 
to double his money with no risk. 

During the second taxable year, the trust should have 
capital gain of $120,000 with no offsetting deductions. 
Thus, the ordinary loss has been converted into capital 
gain. However, the taxpayer may enter into a similar arrangement 
during the second taxable year. The trust will have neither 
gain nor loss because the $120,000 gain resulting from the 
first series of transactions will be offset by an interest 
deduction of $120,000 resulting from the second set of 
transactions. Thus, by entering into similar arrangements 
each year on the anniversary date of the contracts, the 
taxpayer may postpone indefinitely the recognition of gain. 

In point of fact, none of these transactions takes 
place, although the taxpayer-investor is lead to believe 
this is a legitimate tax shelter which can be used to offset 
income taxes. 

In reality, the promoter of this tax shelter utilizes 
the services of foreign attorneys, accountants, nominee 
corporations and foreign banks for the purposes of creating 
documentation of transactions which are not consummated. 
Thus, the investor will be furnished with letters and a 
contract from foreign attorneys which purportedly establish 


the validity of the gold or silver transaction as well as 

the bank loans and interest payments. These documents will 

then be provided to the IRS upon audit to substantiate the 
taxpayer's claimed deductions. 

The promoter uses the services of a nominee tax haven 
corporation which receives the investor's original $20,000 
investment. This money is deposited in a bank located in a 
tax haven jurisdiction in an account under the name of the 
nominee corporation. Subsequently, the taxpayer arranges 
through the use of a United States corporation to "borrow" 
money from the bank in which has been deposited the investor's 
original $20,000. The promoter, in turn, borrows this money 
which he uses for personal living expenses. 

A similar straddle was arranged through a domestic 
trust. In order to avoid partnership reporting, a domestic 
trust was formed for the benefit of the investor. The domestic 
trust then becomes a beneficiary of a Bahamian trust. The 
Bahamian trust realizes the brokerage losses, which are 
distributed back to the domestic trust and in turn to the 
U.S. taxpayers. 

Offshore commodity schemes to defraud the consumer 
rather than the IRS have also been marketed. Commodity 
brokers may establish accounts in a tax haven and structure 
commodity trading losses through those accounts. The broker 
will deny ownership of the accounts. In some cases, such an 
account has been used to defraud the investor. For example, 
a Cayman company sells silver options to investors. If the 
investor decides to exercise the option, he is told that the 
silver has been lost or that the company is insolvent. The 
investor has lost his investment. 

Both the Securities and Exchange Commission and the 
Commodities Futures Trading Corporation are investigating 
offshore commodity schemes. 

(ii) Movies . A U.S. promoter forms a corporation in 
Liechtenstein which purchases a low grade movie. The movie 
is then sold to a U.S. partnership for up to fifty times 
the purchase price. The consideration paid by the partnership 
might be 10 or 15 percent of the inflated sales price in 
cash and a nonrecourse note for the remainder. The cash 
remains in the Liechtenstein corporation and the note is 
never paid. The investors receive a statement from the 
promoter showing the payment of interest and other fees for 
a particular year, and take deductions accordingly. 


(iii) Foreign situs property . A number of cases have 
been identified in which the property which is the shelter 
investment is located in a foreign country which may or may 
not be a tax haven. Even where the property is not in a 
tax haven, the investment vehicle (partnership or trust) or 
the promoter may have a tax haven address. One case involved 
the sale of an interest in a South African mine. Each 
investor paid a 20 percent "advanced" royalty in cash and 
signed a non-recourse note guaranteed by a Cayman insurance 
company for the balance. The investors deduct the start-up 
costs, and the promoting entity (which it is alleged is 
owned by U.S. persons) retains the advanced payment. Revenue 
agents involved estimated that they had identified $30 
million in deductions through this shelter, and that investors 
may have taken as much as $150 million in deductions. 

Other cases involving South and Central American gold 
mines were identified. The shelter vehicles had in fact 
purchased mining claims but their valuations were too high. 
In the case of one promotion, we have identified a number of 
returns with deductions for "mining development costs" of as 
much as $175,000. It would be difficult for the IRS to 
refute the valuation, if that were necessary, because of the 
lack of availability of expert witnesses. 

e. Foreign Trusts 

Foreign trusts have been an important vehicle for tax- 
free investment by U.S. persons, in or through tax havens. 
Prior to 1962 a trust afforded the deferral advantages of a 
foreign corporation, and in addition could accumulate passive 
income without foreign personal holding company consequences. 
In 1962, Congress subjected beneficiaries of foreign trusts 
created by U.S. persons to an unlimited throv/-back rule at 
the time of the ultimate distribution of accumulated income. 
The distributed income itself was taxed whether it represented 
gross income from sources within or without the United 
States. Unless distributed, however, the income could be 
accumulated tax free in a tax haven. 

In 1976, Congress dealt more directly with foreign 
trusts by removing the deferral privilege for foreign trusts 
created by a U.S. person if the foreign trust had or acquired 
United States beneficiaries. Today, a U.S. person who 
directly or indirectly transfers property to a foreign trust 
is treated as the owner for the taxable year of the portion 
of the trust attributable to the property transferred, if 
for the year, there is a U.S. beneficiary of any portion of 
the trust.— '^ The provisions apply to both direct and 

— / § 679(a)(1). 


indirect transfers, and include transfers by gift, sale, 
exchange or otherwise. An exception is provided for transfers 
by reason of the death of the transferor. In addition, an 
exception is provided for any sale or exchange of property 
at its fair market value in a transaction in which all of 
the gain to the transferor is realized at the time of the 
transfer and is recognized either at that time or is returned 
as is provided in § 453. 

Generally, a trust has a U.S. beneficiary unless the 
trust instrument provides that no part of the income or corpus 
may be paid or accumulated for the benefit of the U.S. 
person. Attribution rules are provided under which a foreign 
corporation is treated as a U.S. beneficiary if more than 50 
percent of the total combined voting power of all classes of 
stock is owned, or is considered owned, by U.S. shareholders 
under § 958. A foreign partnership is treated as a U.S. 
beneficiary if any U.S. person is a partner of the partnership 
directly or indirectly. A foreign trust or estate is considered 
a U.S. beneficiary if the foreign trust or estate has a U.S. 

The Tax Reform Act of 1976, while significantly curtailing 
the ability of U.S. persons to use foreign trusts, did not 
eliminate them. Some practitioners believe that foreign 
trusts may still be used to a U.S. tax advantage, either by 
structuring transactions to avoid § 679 or by the using 
rules of § 679 to achieve certain tax advantages. Most are 
abusive, and in any event distributions of property from a 
foreign trust would incur the onerous interest charge on 
accumulation distributions imposed by §668. 

A foreign trust may be used to avoid the corporate 
anti-abuse provisions in some cases. For example, if a 
foreign trust is not a § 679 trust, then a sale by the trust 
of stock of a controlled foreign corporation will not be 
subject to the ordinary income rules of § 1248, because 
§ 1248 applies to a U.S. person who sells or exchanges stock 
in a foreign corporation. Likewise, gain on the sale of 
collapsible corporation stock (which should be taxable as 
ordinary income) would be deferred until the proceeds are 
distributed to the beneficiaries. Some claim that the stock 
can be transferred to the trust by a long-term installment 
sale thus qualifying for the sale or exchange exception. 


Section 679 does not apply to any transfer by reason of 
the death of the transferor, nor does it apply to an inter 
vivos trust after the death of the transferor. Therefore, a 
foreign trust can still be used as an estate planning tool. 
Distributions would, however, be taxed to the beneficiaries, 
and the interest charge imposed by § 668 would apply to 
those distributions. In the alternative, an inter vivos 
trust can be created, and property transferred to it. A 
U.S. grantor can transfer non-income producing property with 
appreciation potential to the trust. The transferor is 
subject to tax on the income from the property but, because 
the property is non-income producing he will pay no tax. 
Further, if the property generates losses, the grantor will 
receive the benefit of those losses during his lifetime. 
After his death, the property can be sold and the assets 
invested in income producing property, with the income 
accumulating for the benefit of the beneficiary. While 
distribution will incur tax and an interest charge, some 
beneficiaries attempt to take the income out in the form of 
"loans" which are not taxed unless they are detected. 

Section 679 does not apply to a sale or exchange of 
property at its fair market value in a transaction in which 
all of the gain to the transferor is realized at the time of 
the transfer and is recognized either at such time or is 
returned as provided in § 453. Accordingly, a U.S. person 
can purchase property, wait for it to appreciate slightly 
(to qualify for the "gain realized exception"), and then 
sell it to a tax haven trust which he created. He will 
realize gain but take back a long-term installment note at 
stated interest, thereby according current reporting of that 

Some practitioners seem to be taking the position that 
§ 679 is avoided if a ,§ 1057 election is made for a transfer 
to a foreign trust. — ' A combination of these exception 
provisions might then be used in conjunction with a foreign 
trust to accelerate the recognition of gain without disposing 
of property, by transferring appreciated inventory to a 
foreign trust, making a § 1057 election (thereby recog- 
nizing gain), and then, when the inventory is needed back, 
liquidating the trust. The gain could be used to offset 
expiring net operating loss carryovers. The inventory would 
come back at a stepped-up basis, so that sales of the inven- 
tory would not generate income (unless the inventory had 
further appreciated). 

— / § 679(a)(2)(B) 


A foreign trust can be used to generate losses for the 
benefit of the grantor (this can also be done with a domestic 
trust). One scheme which has been described is for a U.S. 
grantor to transfer property to a foreign trust for the 
benefit of foreign beneficiaries. In the years when there 
are significant losses, a beneficiary can establish residence 
in the U.S., thereby flowing the losses through to a U.S. 
resident. If it appears that the trust will earn income for 
a year, the beneficiary can return to his own country. It 
is unlikely that such a scheme really happens often. 

Section 679 applies only to transfers by U.S. persons. 
A nonresident alien emigrating to the U.S. may, prior to 
assuming resident status, make a transfer to a foreign trust 
with a U.S. beneficiary, and not be subject to § 679 when he 
becomes a U.S. resident. Similarly, a nonresident alien 
individual spouse who intends to make a § 6013 (g) or (h) 
election to be treated as a U.S. resident could make the 
transfer in a„year before the first year to which the election 
is to apply. — ' If a foreign trust does not have U.S. 
beneficiaries in the year of a transfer by a foreign person, 
and if the foreign beneficiaries become U.S. beneficiaries 
at the same time the transferor becomes a U.S. person, 
neither § 679 (a) (1) nor § 679 (b) (concerning trusts 
acquiring U.S. beneficiaries) applies. Consequently, the 
§ 679 rules are avoided and income can be accumulated abroad 
free of tax for the benefit of a person who is not a U.S. 
resident. However, any distribution will incur the §668 
interest charge. 

f . Double Trusts 

A number of persons have been promoting a fraudulent 
scheme known as so-called "double trusts" or "triple trusts" 
as a method for avoiding U.S. income taxation. Over 200 
returns which appear to involve these trusts have been 

Under one such scheme the taxpayer agrees with a promoter 
to enter into a "double trust" arrangement. After payment 
of a large fee to the promoter, the promoter arranges for a 
foreign person to create a trust in a tax haven. The foreign 
creator appoints the taxpayer as trustee and the taxpayer 
transfers assets to the trust. The assets may range from 
real estate to an active business. The foreign person then 
creates a second trust in the same tax haven and names the 


— ^ Sections 6013(g) and (h) permit certain nonresident 

alien individuals married to U.S. citizens or residents 

to make an election to be treated as U.S. residents. 


first trust as trustee of the second trust. The beneficiary 
of the second trust may be a friendly foreign "Credit Union". 
The trustee is given broad powers to deal with trust property. 

The first trust will earn the income and the trustee 
will distribute it to the second trust. The second trust 
will, from time to time, make distributions in the form of 
gifts or loans to the taxpayer or his family. If the assets 
of the first trust include an active business in the U.S., 
the trusts should, and many of them do, file an income tax 
return. Many of these returns eliminate taxable income by 
reporting the payment of a "contingent royalty", presumably 
to the second trust. Some of the returns identified indicate 
that the offshore entity is purchasing supplies and selling 
them to the Uhited States party at an inflated price. The 
profit is being accumulated in the tax haven, or is being 
returned to the taxpayer as a gift or a loan. 

Section 679 will apply to these trusts if the U.S. 
person (or any U.S. person) is a beneficiary. The indirect 
transfer rule may apply to the second trust if the "expenditures" 
are fraudulent, as may be the case. In the case of the 
transfer of business assets, §679 clearly applies. The 
ultimate beneficial interest, which may be shown by the 
receipt of a "gift" or "loan", is owned by a U.S. person. 
If U.S. persons are not the ultimate beneficiaries, then § ^g, 
679 does not apply, but § 1491 should apply to the transfer. — ^ 

The double trust problem is a compliance problem — proof 
of the existence of the foreign trusts, the U.S. beneficiaries, 
the fraudulent nature of deductions, etc. , must be obtained. 
Once obtained, § 679, 1491, or the grantor trust rules 
should apply. Identification of returns (if any) involving 
double trusts is an important step. 

g. Generating Deductions 

Tax haven entities have been used to generate 
deductions other than shelter deductions. An example of a 
scheme is contained in an article about recent IRS successes 
in the Tax Court. The cases involved transactions planned 
by Harry Margolis, a west coast attorney. According to the 
Wall Street Journal, an investor would arrange to "borrow" 
$50,000 from an entity called Anglo Dutch Capital Co., which 
the government alleged existed only on paper. Then the 
investor would invest the loan proceeds in Del Ceiro Associates, 
another entity the article alleges was controlled by Mr. Margolis. 
With $5,000 in real cash, the taxpayer would prepay a year's 

— / See Rev. Rul 80-74, 1980-1 C.B. 137. 


interest on the loan he supposedly got from Anglo Dutch. 
But, according to the Journal, the "investment" in Del Ceiro 
would turn sour, and the client would take a total deduction 
of $55,000 for his loss plus the interest he paid on his 
loan. The Tax Court has found this case and others like it 
to be shams. 

There are over 800 additional cases docketed against 
clients of Mr. Margolis. If each case had to be tried 
separately, it would take years to resolve them. 

h. Expatriation 

U.S. persons can leave the U.S. and renounce their 
citizenship in order to avoid paying U.S. taxes. For example, 
if a U.S. person owns appreciated property, he may move to a 
low tax haven such as the British Virgin Islands or Bermuda, 
establish residence and renounce his U.S. citizenship, and 
then obtain a British passport which enables him to move 
around the world. In some cases, the U.S. person may even 
expatriate to a country such as Canada, which gives an 
immigrant a basis in his assets equal to their fair market 
value as of the date residence is established. 

United States tax law limits the advantage of expatriation 
for tax purposes, by retaining .jurisdiction to tax the 
expatriate in limited cases. — ^ Under the Code, the expatriate 
would be taxed on his U.S. source income and his foreign 
source effectively connected income. For purposes of this 
provision, income from U.S. real estate, stock or securities 
of a U.S. corporation, and debt of a U.S. person, would be 
considered U.S. source income taxable to the expatriate. 
This provision applies only to income earned within ten 
years of the date of expatriation. No tax is imposed on 
foreign source income, including income from the disposition 
of appreciated foreign assets. 

In addition to permitting expatriation to avoid U.S. 
tax on foreign assets, the U.S. law is difficult to administer. 
Once the U.S. person has removed himself from U.S. jurisdiction, 
various schemes can be used to dispose of U.S. assets in a 
manner which makes it difficult to detect. 

In one case a U.S. person, allegedly to avoid U.S. 
capital gains tax on over $20 million in appreciation, 
expatriated and almost immediately sold his appreciated 
stock in a foreign corporation. 

10/ § 877. 


F. Use by Foreign Persons Doing Business in or Residing 
in the U.S. 

Foreign persons investing in the U.S. or doing business 
in the U.S. make extensive use of tax havens. The most 
widely publicized use is that of the Netherlands Antilles 
for investment in U.S. real estate. Much has been written 
on this subject, and it has been extensively studied by 
various branches of the Federal Government. It is discussed 
in Chapter VIII dealing with treaties. Legislation enacted 
in December 1980 will subject foreign persons to tax on 
their gain from the sale of United States real property. Often, 
foreign investors' use of tax havens is connected with 
treaty shopping, which is also discussed in Chapter VIII. 

1 . Banks 

Foreign banks may use tax havens as investment vehicles 
or otherwise in connection with U.S. business. 

Foreign banks conduct business in the United States 
through branches, agencies, and subsidiaries (a branch takes 
deposits, but only in the form of large denomination CD's; 
an agency does not accept these deposits). In many cases 
foreign banks first came to the U.S. to finance imports to 
this country and to finance sales of raw materials to their 
home countries. Today, many function as full service 
commercial banks, and some U.S. subsidiaries of foreign 
banks are among the largest commercial banks. 

It appears that most large foreign banks have subsidiaries 
or branches in tax havens. While their investments are not 
necessarily funneled through tax havens in all cases, havens 
nevertheless play an important role in their tax planning. 
In a few recent instances, foreign persons have formed a tax 
haven corporation to acquire significant interests in major 
U.S. banks. 

For example, dollars may be loaned to U.S. customers or 
to foreign customers. In either case, the loans may be 
"booked" at Nassau or the Cayman Islands, and the interest 
paid to the home office. The bank often takes the position 
that there is no U.S. business income from this type of 
transaction, and that any interest paid is free of tax 
because of a tax treaty. The reason is that a foreign 
corporation engaged in a trade or business within the U.S. 
is taxable at normal rates on its income which is effectively 
connected with the conduct of a trade or business within the 
U.S.— ^ Income from a security (which would include a note) 

— / § 882(a). 


which is from U.S. sources, and derived by a foreign corporation 
in the banking business, is treated as effectively connected 
income QQly if the securities are "attributable" to the U.S. 
office. — loans which are "booked" abroad are not attributable 
to a U.S. office, and therefore , the interest from the loans 
is not effectively connected. — 

under the IRS regulations, it would appear that U.S. 
source interest on loans booked overseas is not effectively 
connected with the conduct of a trade or business in the 
U.S., and therefore the interest is not taxable on a net 
basis by the U.S. If the U.S. has a tax treaty with the 
home country of the bank, and the interest is paid to the 
home country, then the treaty rate of tax (often zero) will 
apply. Accordingly, there is no U.S. tax on the transaction. 

However, in the case of foreign source interest, the 
IRS position is that active participation by the U.S. office 
is sufficient to make the income effectively connected. — ' 

The problems with the foreign source interest rules are 
largely administrative. Lack of cooperation in supplying 
books and records, and in permitting tax haven employees to 
be interviewed, makes it difficult for the IRS to determine 
whether the haven company or the U.S. office negotiated the 
loan. In addition, the "booking" rule in the effectively 
connected regulations makes it easy for a bank to choose the 
tax treatment of its U.S. source loan transactions. 

2. Insurance 

Foreign insurance companies do business in the U.S. 
through branches or through U.S. subsidiary corporations. 
The trend seems to be toward incorporating the branches. 
The IRS Office of International Operations appears to have 
no tax haven problems with foreign insurance companies, 
although the companies do reinsure a part of their domestic 
risk through tax havens (most often Bermuda, but in some 
cases the Caymans). 


Treas. Reg. § 1. 864-4 (c) ( 5) ( ii ) . 

—^ Treas. Reg. § 1. 864-4 (c) ( 5) { iii ) ( 2) . 
— ^ Rev. Rul. 75-253, 1975-1 C.B. 203. 


3. Entertainment Industry 

Foreign entertainers appear to make extensive use of 
tax havens in structuring their U.S. and foreign business. 
An entertainer or a group of entertainers may establish a 
corporation in a tax haven with which the U.S. has a treaty 
(most often the Netherlands Antilles or Switzerland), and 
enter into a long term employment contract with that corporation. 
The corporation then contracts with a U.S. promoter to 
arrange tours for the entertainers. The proceeds from the 
tour are paid to the tax haven company, and that company 
then pays the entertainer an annual salary. 

The corporation also contracts with a U.S. distributor 
for the distribution of records. Profits from the sale of 
the records are paid by the U.S. distributor to the tax 
haven company, and the company takes the position that the 
amounts are royalties and that the treaty benefits apply. 
In the case of the Swiss and Netherland Antilles treaties, 
this means that the amounts are not taxed by the U.S. This 
issue is discussed in Chapter VIII, relating to treaties. 

4. Trading and Sales Companies 

A foreign corporation may invest in the U.S. through a 
tax haven. The treaty shopping issues of this form of 
investment are discussed in Chapter VIII. 

In some cases, a foreign corporation selling into the 
U.S. through a U.S. subsidiary will establish a second 
subsidiary in a tax haven. The U.S. subsidiary will sell to 
or purchase from the tax haven subsidiary, often at prices 
which are not arms length. These transactions should be 
subject to a § 482 adjustment. In some cases, however, the 
IRS is not aware of the ownership of the tax haven entity, 
and therefore an appropriate § 482 adjustment is not made. 

This is a problem of administrative detection, which can 
probably best be dealt with by good solid auditing. In 
addition, a schedule might be prepared to be attached to the 
Form 1120 filed by a U.S. subsidiary of a foreign corporation. 
The schedule would request information necessary to enable 
the revenue agent to consider a § 482 adjustment. 

5. Aliens Resident in the U.S. 

It is generally believed that there are a large number 
of aliens living in the U.S. who claim to be nonresidents, 
but who in fact spend substantial amounts of time here and 
for all practical purposes might be considered residents. 


Many of these persons own expensive apartments and have no 
other permanent abode. An alien may enter this country as 
a tourist, advise Immigration that he will be here for from 
60 to 90 days, and then, within the 60 to 90 day period, 
leave to travel or to visit his offshore bank. He then 
returns and gives Immigration the same story. 

The alien will often transfer his assets to a holding 
company or a trust located in a tax haven. His money will 
be invested in U.S. bank accounts, the Eurobond market, or 
in other financial assets. The assets may also be invested 
in U.S. real estate. Because the alien claims to be a 
nonresident alien and does not consider any of his income as 
being from U.S. sources, he does not report any of this 
income on U.S. returns. 

Aliens are able to avoid tax, and the IRS is unable to 
deal with them because of: a lack of reporting; a lack of 
information concerning payments to the aliens; a lack of 
coherent information disseminated to the IRS; and the absence 
of a clear definition of the term "residence." 

There is little that can be done about the lack of 
reporting of income or obtaining information on receipts of 
income, unless a readily administerable definition of residence 
is developed and information concerning the comings and 
goings of aliens is made available to the IRS. 

Under U.S. law, a non-resident alien not engaged in 
trade or business within the U.S. is taxed only on his U.S. 
source income, but a resident alien is taxed on his worldwide 
income. Accordingly, while the determination of resident 
status can have an enormous impact, thergj-is no precise 
definition of the term. The regulations — ' define a resident 
as one "actually present in the United States who is not a 
mere transient or sojourner." The length of his stay and 
its nature are factors to be considered. No definite rule 
is provided. The IRS has, however, ruled that presence igf:/ 
the U.S. for one year creates a presumption of residence. — ' 

— '^ Treas. Reg. §1.871-2(b). 

— / Rev. Rul. 69-611, 1969-2 C.B. 150. 


VI. Use of Tax Havens To Facilitate 
Evasion of U.S. Taxes 

The use of tax havens by earners of illegal income 
(particularly narcotics trafficers) has generated signi- 
ficant publicity over the years. The extent of this type of 
use, and the extent of use for tax evasion purposes in general, 
is not definitively known. The statistical study undertaken 
in connection with the Tax Haven Study has not given us an 
estimate of the level of this use although the study does 
show enormous and growing levels of financial activity and 
accumulation of funds in tax havens.—^ 

Our study has been able to conclude that there are a 
large number of transactions involving illegally earned 
income and legally earned income which is diverted to or 
passed through havens for purposes of tax evasion. We 
identified approximately 250 criminal cases (either currently 
active or closed within approximately the past three years) 
involving offshore transactions. This number of cases 
is an indication of a significant level of use. 

Many of the cases identified were closed without prosecu- 
tion, often because the evidence was not available to estab- 
lish a key element in a case. Almost every case involved 
either an offshore entity such as a trust or corporation or 
a foreign bank account. 

A fair statement of the problems in dealing with this 
type of activity is that of Assistant Attorney General (Tax 
Division) Ferguson in his statement to the Oversight Com- 
mittee of the Ways and Means Committee:— 

"As you might expect, evasion 
of United States taxes through sham 
business transactions involving foreign 
entities is difficult to detect, hard 
to recognize when found, and, where 
foreign witnesses and documents are 
crucial, sometimes impossible to prove 
in court. Even the most transparent 

1/ See Chapter III, infra, 

2J The Use of Offshore Tax Havens for the Purposes of 

Evading Income Taxes; Hearings Before the House Sub- 
committee on Oversight of the Committee on Ways and 
Means, 96th Cong., 1st Sess. 18 (1979). 


transactions are likely to have 
sufficient documentation to satisfy 
a surface inquiry by an auditor and 
enough complexity to discourage a 
deeper look. Furthermore, being 
dependent on form and multiplicity 
of steps, such transactions will 
utilize entities in tax haven juris- 
dictions offering business and banking 
secrecy to conceal their lack of 
substance. " 

A. Prior Efforts To Investigate Offshore Cases 

Over the past two decades, Revenue Agents and Special 
Agents have conducted a number of investigations involving 
tax havens. 

During 1957 and 1958, special agents in the Manhattan 
District attempted to establish the identity of persons 
making large deposits of currency in New York banks for 
subsequent transfer to secret (numbered or coded) Swiss bank 
accounts. During one three month period, a New York bank 
filed 81 currency forms reflecting deposits of $1.1 million 
under 77 different names and addresses. These deposits were 
transferred to coded accounts in specified Swiss banks. 
Investigation by eight Special Agents revealed that all 77 
names and addresses given to the bank by the depositors were 
fictitious; the depositors could not be located. 

Follow-up investigations of other currency deposit 
forms did locate depositors who had transferred funds to 
numbered Swiss bank accounts. The reasons for maintenance 
of the accounts ranged from engaging in complicated inter- 
national commercial transactions to political refugee situ- 
ations. Although it was suspected that some of these trans- 
actions involved tax evasion or other violations of U.S. 
law — including narcotics, securities law, and smuggling--the 
inability to secure information on the accounts from Switzer- 
land contributed to the lack of success in developing any 
cases for prosecution. 

The investigations served to increase concerns of law 
enforcement authorities about the potential for using secret 
foreign bank accounts for illegal purposes, and suggested a 
need for tighter regulation or better reporting of inter- 
national currency transfers. Accordingly, during the summer 

3/ Forms TCR-1 (predecessor of Form 4789). 


of 1960, a conference was held in the National Office of IRS 
to develop means for controlling illicit international money 
flows. None of the ideas put forth at the conference was 
implemented, in part because they required legislation. It 
was felt that the lack of proof that secret foreign bank 
accounts were in fact being used for tax evasion purposes 
made prospects poor for legislation to require improved 
reporting on international currency transfers. 

From 1966 through early 1967, IRS agents worked with 
the U.S. District Attorney for New York City, who was then 
conducting a grand jury investigation of the use of foreign 
banks by suspected "underworld" figures. IRS agents assisted 
in examining bank records and correspondence of taxpayers 
who opened and funded Swiss accounts by making deposits in 
U.S. branches of Swiss banks. In early 1967, a task force 
was formed to coordinate Examination, Criminal Investigation 
and Office of International Operations activities regarding 
secret foreign bank accounts. Although these efforts improved 
IRS knowledge of the use of secret foreign bank accounts, 
audits of 130 taxpayers identified via grand jury investi- 
gation were disappointing in terms of taxes collected, due 
to lack of adequate documentation and perhaps also due to 
the inexperience of audit personnel in dealing with cases 
where pertinent records were beyond the reach of U.S. law. 

As an outgrowth of these efforts, a project known as 
"Swiss Mail Watch" and later as the "Foreign Bank Account 
Project", was initiated to identify U.S. taxpayers receiving 
mail from Swiss banks. From January 8 to May 2, 1968, with 
the assistance of the postal authorities, IRS monitored mail 
received in a New York post office. Swiss bank mail was 
identified by the postage meter numbers used by the Swiss 
banks, and the outside of envelopes mailed by the Swiss 
banks to individuals and firms in the U.S. was photocopied. 
From this monitoring, a list of 8,500 taxpayers was prepared, 
from which 168 taxpayers were selected for audit by 16 
agents in two districts. The audits resulted in the assess- 
ment of about $2 million in taxes and penalties, less than a 
third of which was attributable to the foreign bank accounts. 
The audits indicated that only about a fifth of the tax- 
payers used their Swiss accounts as a depository for unreported 
income or to avoid the interest equalization tax, and that 
the unreported income in such cases was not substantial. 
Because of the inability to obtain corroborating testimony 
and documentation from the Swiss banks, no prosecutions 


Subsequently, two more mail watches were initiated, one 
(during the period January 2 through February 2, 1969, and 
the last from December 27, 1970 through February 4, 1971. 
The 1969 mail watch identified about 21,500 taxpayers who I 

appeared to have Swiss bank accounts, and the 1971 mail | 

watch identified another 20,000 to 25,000 taxpayers who | 

appeared to have such accounts. However, no IRS audit was i 

initiated as a result of these later mail watches. 

The Foreign Bank Accounts Project was discontinued for \ 

a combination of reasons. A mutual assistance treaty was 
being negotiated with Switzerland which, it was hoped, would ' 
permit Swiss banks to provide bank account information about 
Americans suspected of crimes. It was believed that use of I 

the mail watch data would jeopardize the treaty negotiations. 
In addition, a Senate Subcommittee on Constitutional Rights 
was raising questions about the propriety of developing com- 
puterized files of suspected tax violators. Finally, some 
officials believed that the audit results, and failure to 
develop prosecution cases, were disappointing in terms of 
resources expended; staff costs were estimated at 2,318 
staff days, at a salary of $260,000. They also believed 
that this technique did not offer a long-term solution to 
the foreign bank account problem. The issue was also being 
addressed by the House and Senate Banking and Currency 
Committees; the result was the enactment of the Bank Secrecy 
Act— on October 26, 1970, which became effective upon publication 
of implementing regulations in July 1972. 

Other investigative efforts were initiated during the 
1960s and early 1970s. One was an investigation (sometimes 
referred to as the "Bahamas Project" ) of a West Coast attorney 
who appeared to be promoting the use of tax havens to evade 
the taxes of well-to-do clients. A lengthy examination 
resulted in criminal prosecution, and a trial that lasted 
six months. The attorney was acquitted, but hundreds of 
civil tax cases, involving over $100 million in taxes, 
resulted against his clients. Most of these civil cases 
are still pending in the Tax Court. 

In another effort, a special agent from the IRS Reno 
District established liaison with a police department official 
of Grand Cayman Island, who subsequently furnished limited 
information concerning bank accounts of U.S. citizens. This 
effort, called "Project Pirate," was terminated in 1975. 

4/ P.L. 91-508. 


Records do not indicate that any successful audits or crim- 
inal prosecutions resulted from this information. In 1976, 
the Caymans strengthened their bank secrecy laws, making it 
a crime for any person to reveal information about bank 
accounts in the Cayman Islands. 

The above investigative efforts were examined in con- 
siderable detail in several Congressional hearings. These 
hearings gave principal attention, however, to an effort 
termed "Operation Tradewinds," and to an offshoot termed 
"Project Haven." 

Operation Tradewinds was an information gathering 
effort by IPS agents in the Jacksonville, Florida District 
to obtain information from Bahamian bank employees about the 
identity of U.S. taxpayers using Bahamian trusts and bank 
accounts. Information was obtained from informants passing 
on the information through Americans acting as intermediaries 
to IRS agents. 

Operation Tradewinds produced considerable useful 
information, resulting in audit deficiencies recommended in 
45 cases, and several criminal prosecutions, before the 
operation was suspended in January 1975. It also developed 
the information which gave rise to Project Haven. 

Project Haven was initiated in 1972 in connection with 
an investigation of a narcotics trafficker, who it was 
learned had dealings with a Bahamian bank. A confidential 
informant was used to obtain Bahamian bank documents regarding 
this individual; in the process the informant learned that 
the Bahamian bank was receiving and disbursing funds on 
behalf of U.S. citizens whose identities were not revealed 
to the correspondent U.S. banks in Miami, New York, and 

The confidential informant, having developed a social 
relationship with a Bahamian bank official, learned that the 
bank official was planning to travel to the U.S. in January 
1973, with a stop-off in Miami. At the banker's request, 
the informant arranged a date for the banker. While dining 
out, the banker left his briefcase in his date's apartment. 
She had previously given the informant a key to the apart- 
ment. The informant entered the apartment, removed the 
briefcase, had it opened by a locksmith, and made the docu- 
ments therein available to IRS agents for photocopying. 
After photocopying, the documents were replaced and the 
briefcase returned to the apartment, all without the banker's 


The documents identified over 300 U.S. citizens and 
firms having accounts with that Bahamian bank. A large 
number of civil and criminal investigations were initiated 
on the basis of this information. The criminal cases (about 
6 dozen in all) were initially investigated by several grand 
juries, and were finally consolidated in 1975 under one 
grand jury in the Southern Judicial District of Florida. 
One of the criminal cases reached the Supreme Court,— which 
ruled that the defendent lacked standing to object to admiss- 
ibility of evidence obtained by the "briefcase caper," since 
the defendant's (as distinguished from the banker's) con- 
stitutional rights were not violated. 

B. Narcotics Related Cases 

Much of the concern with tax havens centers on their 
use by narcotics traffickers. Over the past few years there 
have been numerous Congressional hearings directed at 
problems involving the use of havens by narcotics traffickers. 
The press has, from time to time, reported on alleged use. 

Tax havens are ideally suited to the purposes of the 
narcotics trafficker. The trafficker's goal, once he has 
sold his product, is to cleanse his money or to hide it so 
that he can put it to use without it being attributed to him 
as unreported income. A tax haven facilitates achievement 
of this goal by providing a veil of secrecy over parts of 
the transaction, so that the taxpayer cannot be definitely 
tied to the flow of funds. Furthermore, the tax haven's 
infrastructure, which often includes modern banking and com- 
munications facilities, serves to facilitate rapid movement 
of funds. 

The problem can be illustrated by a simple case. A 
narcotics trafficker arranges for a carrier to carry $50,000 
cash in a suitcase to the Cayman Islands, where it is deposited 
in a small private bank. The small bank then transfers the 
money to an account at the branch of a large money center 
bank. The U.S. narcotics trafficker then borrows $50,000 
from a Canadian bank. Both the U.S. trafficker and the 
Canadian bank claim the loan is simply a signature loan to 
the individual. In fact, the loan is effectively secured by 
the Cayman deposit. The IRS, however, is unable to establish 
the connection and therefore cannot prosecute. The IRS may 
be able to identify the money leaving the U.S. by use of 

5/ united States v. Payner , 46 AFTR 2d 80-5174 (1980) 
rev'g 590 F. 2d 206 (6th Cir. 1979). 


currency transaction reports and records of wire transfers. 
It may see the money entering the U.S. The veil of secrecy 
prevents tying the two together. While Canada might give 
the U.S. information pursuant to a treaty request, the 
information may not be sufficient to tie the taxpayer to the 
Cayman account. To a great extent, it is the highly developed 
and sophisticated banking and communications infrastructure 
in the tax haven which makes it possible to move the money 
swiftly and efficiently. 

In general, there does not appear to be much that is 
new or exceptionally sophisticated in the methods used by 
narcotics traffickers to move their money. For example, in 
a standard pattern a courier deposits cash in a U.S. bank 
and the money is then wired to a haven bank account. From 
there it can be moved with relative ease. 

Many narcotics cases do not involve offshore trans- 
actions at all. In addition, in some cases foreign juris- 
dictions which are not tax havens are utilized. For example, 
Mexico and Canada have been used because of their proximity 
to the U.S. and perhaps because of their lack of taint. A 
transaction with the Cayman Islands is suspect; a trans- 
action with Canada is not. Our current investigations 
indicate, however, that many narcotics transactions do 
involve offshore activity. The Florida Cash Flow Project 
has uncovered some. 

It would appear that the most effective methods for 
dealing with narcotics traffickers have been intensive well 
coordinated inter-agency grand jury investigations. These 
investigations have the advantage of enabling one person 
(the Assistant U.S. Attorney) to provide direction and 
coordination. They also enable agents from various agencies 
to work more closely together with a common goal. Further- 
more, a joint investigation brings together a number of 
different disciplines and expertise. Finally, it enables 
the IRS to avoid some of the coordination problems caused by 
the disclosure rules of § 6103.— 

Other successful methods of uncovering large scale 
narcotics operations have involved the use of informants or 
undercover operators to launder money through financial 

6^/ See , for example, "Narcotics Agents Track Big Cash 
Transactions to Trap Dope Dealers", The Wall Street 
Journal, November 26, 1980, A-1. 


Caution must be exercised in applying resources in the 
narcotics area. The CID agent is a highly trained financial 
investigator who is capable of dealing with sophisticated 
cases. Too much pressure to apply resources without identi- 
fying adequate and proper cases could lead to a waste of 
these valuable people by having them recommending term- 
ination assessments against low level drug dealers. This 
kind of problem was encountered in the early 1970's, and in 
the opinion of some resulted in some overreaching. The use 
of termination and jeopardy assessments at one time or 
another became disproportionate. 

C. Patterns of Use of Tax Havens for Evasion 

A brief description of the general categories of trans- 
actions which we identified follows. In many of these 
cases, the only reason prosecution was possible was because 
an informant was available. 

1. Double Trusts 

The IRS has under investigation a number of promoters 
of so-called double trusts or family estate trust schemes. 
There are at least two grand juries and numerous civil 
investigations. The schemes seem to be concentrated in the 
western part of the country. 

The schemes, while differing somewhat from promoter to 
promoter, generally involve having an unrelated party set up 
a trust in a haven. The first trust then sets up a second 
trust which it designates as the beneficiary of the first 
trust. Some promoters also use a third trust. The U.S. 
taxpayer may appoint himself as the trustee of the first 
trust, and then appoint the first trust the trustee of the 
second trust, and so on. The U.S. person transfers his 
assets or his right to earn income, or both, to the first 
trust in exchange for certificates of ownership. The income 
then flows to the second trust, which may make "gifts" or 
"loans" to the U.S. taxpayer. 

Some of the returns indicate that the offshore entity 
is purchasing supplies and selling them to the U.S. party at 
an inflated price. The profit is being accumulated in the 
haven, or is being returned to the taxpayer as gifts or 

There is no way of knowing how many persons having an 
interest in these trusts have dropped out of the tax return 
filing population. 


2. Secret Bank Accounts 

Generally, these cases involve unreported income being 
diverted to a bank account located in a tax haven. Many of 
the taxpayers under investigation are alleged narcotics 
traffickers. The money is most often diverted from the U.S. 
by physically removing it from the country or by wire trans- 
fers. If money is diverted by wire transfer it must first be 
deposited in a U.S. bank. A currency transaction report may 
have to be filed by the bank. However, the depositor may give 
a fictitious name, or may simply leave the country before 
a report can be investigated. 

In one case, the taxpayer was the sole shareholder of a 
corporation which acted as a sales agent for a major foreign 
corporation. The taxpayer's corporation received commissions 
for the sales activities performed, which were properly 
recorded on the books of the corporation. However, the 
corporation received additional commission payments from the 
foreign corporation which were not accounted for on its 
books and records. Pursuant to a direction by the share- 
holder, these additional commissions were wired by the 
foreign corporation to a numbered bank account in Switzerland 
maintained by the taxpayer. The special agent examined the 
records of the foreign corporation, which indicated that the 
wire transfer had been made, and also interviewed foreign 
corporate officials who stated that the taxpayer had directed 
them to transfer the funds into the numbered Swiss bank 
account. However, the foreign corporate officials subsequently 
refused to cooperate, and prosecution of this case had to be 
declined by District Counsel due to the lack of available 
witnesses and documentary evidence subject to the compulsory 
jurisdiction of the United States courts. 

In another case recently prosecuted by the United 
States Attorney's office, the United States was able to 
successfully prove that corporate receipts had been diverted 
to a foreign bank account. In this case, a United States 
corporation purchased machinery and equipment from a Puerto 
Rican corporation. The purchase agreement and the payments 
made were properly reflected both on the books of the cor- 
poration and on the corporation's tax return. However, 
additional agreements had been entered into, in connection 
with the purchase of the machinery and equipment, which were 
not reflected on the corporate books and records or on the 
tax returns. These agreements provided that if the machinery 
and equipment sold to the U.S. corporation were not delivered 
by a certain date, then the Puerto Rican corporation would 
be liable for lease payments at a stated rental per month. 
When the Puerto Rican corporation failed to deliver the 
equipment and machinery on the specified date, it became 
liable for the rental payments which were subsequently paid. 


In receiving payment, the U.S. corporate officials 
arranged it so that the proceeds from the payment were used 
to purchase certificates of deposit in a nominee name in 
Puerto Rico. Subsequently, the proceeds from these certificates 
of deposit were deposited in a bank account in the Cayman 
Islands, in the name of a Cayman corporation whose stock was 
held by nominees. The amount in the Cayman bank account was 
eventually divided up among the corporate officials, in 
proportion to their stock ownership. 

The corporate offical who masterminded the scheme, an 
attorney familiar with the methods used by the IRS to 
prosecute tax crimes, advised the other participants that 
the money from the bank account should only be spent in such 
a way so that it left no trace, in order to avoid the IRS' 
making a net worth and expenditures case against the shareholders. 

Successful prosecution in this case was made possible 
by an informant, an uninvolved corporate employee, who 
furnished the IRS with information of the details of this 
scheme, as well as with copies of bank statements for the 
Cayman Islands bank account and with an agreement drawn up 
by a Cayman Islands attorney reflecting the fact that the 
nominal shareholders of the Cayman corporation were merely 
acting as nominees for the corporate officals. Other corporate 
officials also testified at the trial under grants of pro- 
secutorial immunity. 

Also involved in this case was the use of a corporate 
jet to ferry cash secretly out of the country. In this 
scheme, the corporation sold component parts of heavy con- 
struction equipment for cash, without reporting the sales of 
the components on the books and records of the corporation. 
The pilot of the corporate jet would then meet someone at a 
U.S. airport who would hand him a brief case. The pilot 
was instructed to fly to the Cayman Islands and to give the 
brief case to an attorney. The brief case contained cash 
representing the unreported sales proceeds, and was deposited 
by the Cayman Islands attorney in the secret bank account 
mentioned above. 

3. U.S. Taxpayers Using a Foreign Corporation - Substance 
Over Form 

In some cases, taxpayers form corporations in tax 
havens, ownership is not denied, and the required returns 
are filed. Cases may, for example, involve sales subsidiaries. 
In at least one case, a large company had formed and used a 
captive insurance company. Most of the recommendations for 
prosecution were declined either by Chief Counsel or the Tax 


Other cases appear fraudulent but necessary evidence 
cannot be obtained. In a recent routine civil examination 
of a return, it was discovered that substantial amounts had 
been deducted as business expenses relating to rental property 
which was not owned by the taxpayer. Upon further examination, 
it was discovered that the rental property was owned by a 
trust with the trustee being a bank located in a Caribbean 
tax haven. The taxpayer was listed as the United States 
agent for the trust. It was also determined that the taxpayer 
was listed as the agent for the bank, which was the sole 
shareholder of several corporations doing business in the 
United States with which the taxpayer had formerly been 
associated. Because information was received that the 
taxpayer had unreported consulting fees, as well as unreported 
capital gain income, the case was referred to Criminal 
Investigation for investigation. 

During the investigation, it was determined that returns 
had been filed by all of the corporations and trusts, and 
reflected the items of income and expense involved. No 
evidence was produced to substantiate the allegations of 
unreported consulting fees or unreported capital gain income. 
However, since the taxpayer refused to cooperate, and because 
of commercial secrecy laws in the Bahamas, no information 
could be obtained concerning the trusts or the corporations 
and their relationship to the taxpayer. In addition, no 
financial records of any of these organizations could be 
examined to determine if unreported income of the taxpayer 
was being diverted to these entities. Accordingly, because 
of the lack of evidence to substantiate allegations of 
unreported income, and because, at most, the case involved a 
question of substance over form. District Counsel and Crim- 
inal Investigation agreed that the investigation should be 

4. Shelters - Commodity Transactions 

We have identified a number of cases where offshore 
entities or locations were used to faciliate alleged com- 
modity transactions. Generally, these are so called "tax 
spreads" which seek to give the investor a tax advantage by 
generating large ordinary losses in year one, and then long- 
term capital gain in year two. The benefit to the taxpayer 
is the difference between the tax saved on the ordinary loss 
and the tax paid on the capital gain. A tax haven entity may 
be used in these schemes to conceal the fact that transactions 
never take place, or to conceal the promoter's profit. Some of 
these transactions were discussed in Chapter V, supra. , and 
an option for dealing with these schemes on a technical 
basis is presented in Chapter VII, infra . 


5. Income Generated Overseas Deposited in a Foreign Bank Account 

A taxpayer who was an employee of a large United 
States multinational tire and rubber manufacturer, through 
the use of a nominee bank account in Switzerland, was able 
to receive large amounts of kickbacks, from sellers of raw 
materials to his employer corporation, which were deposited 
in the Swiss bank account and which were not reported for 
federal income tax purposes. 

The taxpayer approached a seller of natural rubber and 
suggested that the seller have one of its subsidiary companies 
increase the sales price paid by the employer company for 
rubber purchased from the subsidiary. The increased sales 
price would then be partially kicked back to a subsidiary of 
the employer corporation, with the difference between the 
amount of first kickback and the increased purchase price 
being transferred to a Swiss bank account. 

In order to avoid having the Swiss bank account traced 
to him, the taxpayer persuaded an officer of the foreign 
selling corporation to set up the bank account in the officer's 
name. The foreign corporate official made arrangements with 
the Swiss bank so that the taxpayer had full authority over 
the account. The initial deposit to this account was $25,000. 

In addition to this arrangement, the taxpayer also 
arranged to have kickbacks paid by another corporation which 
sold raw materials to his corporation. This second kickback 
scheme was falsely recorded on the books and records of the 
selling corporation. Records of this corporation indicated 
that the amounts which were kicked back represented consulting 
fees paid to the first foreign corporate official mentioned 
above. Checks were made in the name of the foreign corporate 
offical and were deposited to the Swiss bank account which 
bore his name. Subsequently, the taxpayer or an agent of 
his withdrew these amounts from the Swiss bank account. The 
amount of kickbacks which were deposited and withdrawn based 
upon this scheme amounted to $220,000. 

The foreign corporate offical was unaware of this 
scheme with the second selling corporation. In point of 
fact, he was not a consultant to the selling corporation nor 
had he received any of the monies in question, all of which 
had been withdrawn for the use of the taxpayer. This case 
resulted in a successful criminal prosecution. The taxpayer 
was sentenced to three years imprisonment. 


6 . Slush Funds 

Most of these cases were identified in the mid 1970's. 
They generally involved large companies which were facili- 
tating the payment of bribes or kickbacks to persons in 
foreign countries, who assisted in the sales of products by 
the U.S. company. Usually, the slush fund money was generated 
by increasing the contract price and having the excess paid 
into a foreign account. In most cases the funds used for 
the bribes were generated overseas. Other cases involved 
payments to sales agents in a foreign country, with the 
commissions being funneled to foreign government officials. 

Most of these cases appear to have been developed from 
data provided by the company to the Securities and Exchange 
Commission as part of a voluntary disclosure program. The 
IRS initiated approximately 200 criminal investigations. 
Only about four of these cases resulted in a conviction or 
a plea of guilty. 

7. Use of a Foreign Entity To Step-up the Basis of U.S. 

A number of cases have been identified where a foreign 
entity was apparently used by a U.S. taxpayer to step-up his 
basis in property and thus obtain higher depreciation 
deductions on his U.S. tax return. In one case, a shelter 
promoter allegedly established a Cayman Islands company. 
The promoter then purchased slum property and sold it to the 
Cayman entity at a low price. The Cayman entity sold the 
property to a U.S. limited partnership at a greatly inflated 
price in exchange for cash and notes. The limited partner- 
ship then marketed interests in the slum property. 

8 . Repatriation of Funds 

One problem that the tax evader faces is obtaining the 
use of funds which he has failed to report as income. 
Various schemes are resorted to so that the taxpayer can 
justify his use of the funds. 

In one case, agents of an alleged narcotics dealer 
placed $2.5 million in the Panamanian account of a Panamanian 
corporation. The Panamanian company had a U.S. subsidiary 
which it capitalized by cash contributions. The U.S. company 
had made major investments in the U.S. The taxpayer was a 
salaried employee of the U.S. company. 


Perhaps the most common form of repatriation of evasion 
money is a loan from a foreign entity to the taxpayer. In 
one case IRS was able to track deposits into a Canadian 
bank which had a branch in the Cayman Islands. The loans 
were fully documented, but the authenticity of the documentation 
was questionable. There was no proof which would be admissible 
in court of the connection between the Cayman deposits and 
the Canadian loans. Without evidence from the Cayman Islands, 
we cannot refute the authenticity of the loans. In another 
case, the taxpayer's lawyer told the IRS agent that any net 
worth figures that they developed could be explained through 
fully documented loans. The agent was told that the loan 
papers would be produced when the allegations were made. 

Another pattern is for a tax haven entity to make payments 
to third parties on behalf of the taxpayer. Still another 
method of using the funds is to make indirect payments for 
the benefit of children or relatives of the taxpayer. This 
is often done through a trust disbursing the funds. In one 
case a closely held U.S. company owned a valuable asset. 
The asset was sold to a Cayman Island trust which had as its 
beneficiary the children of the shareholders of the U.S. 
company. The corporation then licensed the asset back from 
the trust and paid substantial license fees to the trust. 
It was alleged by the taxpayer that an unrelted party controlled 
the trust. This could not be refuted because of the unavailability 
of witnesses and records from the Cayman Islands. 

D. Informants and Undercover Operations 

Informants are a useful means of developing leads in 
havens. Often, they are the only vehicle with which to 
breach the wall of secrecy. Even if an informant cannot 
supply documentary evidence, leads developed from information 
supplied by an informant may often provide the missing 
pieces in an investigation. In the case of a narcotics 
related investigation or an organized crime case, an informant 
may be the only lead with which to develop a case worthy of 

IRS special agents are advised that informants are 
often necessary in order to complete an investigation and 
acquire .essential evidence. This can include "undercover 
work".— Since 1977 CID has held regional and district 

7/ See IRM 9372.1. 


seminars on developing, handling, and paying informants. In 
order to place new emphasis on the need to develop informants, 
CID has prepared a new film which, after some testing, will 
be disseminated nationally. This film presents the latest 
techniques for identifying informants, extracting information 
from them, controlling informants, and making payments to 
informants. It also highlights the pitfalls which must be 
watched for in dealing with informants. 

The IRS is authorized to pay rewards for information 
leading to the detection and punishment of any person guilty 
of violating the tax law.- The payments are generally 
limited to 10 percent of the additional taxo^penalties, and 
fines collected because of the information.— 

In addition, the IRS can pay informants for specific 
information or to lay the-qroundwork for the later pro- 
curement of information. — ' The instructions to the special 
agents also provide for "confidential expenditures" for the 
purchasing of information. — ' They also make clear that it 
is the policy of the IRS to maintain the confidentiality of 
the identity of informants and that superiors, while they 
have a right to know who an informant is, will generally not ,„ , 
inquire as to his identity unless the knowledge is necessary. — ' 

Since 1977 the IRS has developed an increased number of 
cases by the use of informants. The number of cases initiated 
because of information furnished by informants has grown 
from 25 in 1977 to 72 in 1979, and the number of cases 
opened because of information supplied by informants has 
grown from 64 in 1977 to 187 in 1979. Because of procedures 
developed to protect the identity of informants, the extent 
of the use of informants to investigate offshore cases 
cannot be disclosed. However, there are no restrictions on 

8/ § 7623. 

9/ Treas. Reg. §301.7623-1 (c). 

10/ See IRM 9772. 

n/ See IRM 93 72.2. 

12/ IRM 9373.1. 


the development of offshore informants, at least if they are 
controlled in the U.S. In fact, the recent training film 
dealing with developing informants, while not specifically 
discussing developing offshore informants, does use as a 
example a case involving laundering of money through an 
offshore jurisdiction. 

The IRS has also been involved in undercover operations, 
both alone and in conjunction with other agencies. Where 
necessary, the IRS has made funds available to use in those 

In one case reported in the Dallas Morning News , Miami 
Herald , and the Cayman Compus , the IRS cooperated with the 
Drug Enforcement Administration (DEA) in laundering $50,000 
of IRS money through a Cayman Island bank. According to the 
press reports, DEA agents posed as drug dealers and approached 
a Dallas businessman who told them that he could supply them 
with cocaine and hashish and could advise them of a "fool 
proof scheme to legitimize the illegal profits and make them 
tax exempt at the same time". The businessman introduced 
the agents to a Dallas attorney who formed a U.S. company 
for them, took them to the Cayman Islands to a phony loan 
company, deposited their $50,000 in a bank and then withdrew 
$46,222, keeping a six percent service charge and a small 
Cayman Islands tax. A check in the amount of $46,222 was 
drawn on the phony loan company and made payable to the 
U.S. company. The attorney then brought the check back into 
the united States. Once back in the United States, according 
to the newspapers, the attorney made out phony records to 
show that the amount of the check was a loan to the U.S. 
company from the Cayman company at six percent interest. 
According to the paper, the undercover agents were told to 
pay themselves liberal salaries, expense reimbursements, and 
annual bonuses, and to drive company owned cars and deduct 
the loan interest from their federal income taxes. 

The DEA and IRS agents then followed the businessman to 
Miami where he was eventually arrested and "charged with 
smuggling currency and with possession of cocaine with 
intent to distribute." The attorney was also arrested and 
charged with smuggling currency out of the country. According 
to an article which appeared on December 20, 1977, in the 
Cayman Compus the phony loan company was under the manage- 
ment of a Cayman company. 


E. Analysis 

The IRS and the Department of Justice encounter sig- 
nificant problems when trying to investigate or prosecute 
cases involving tax haven transactions. 

It is difficult, if not impossible, to obtain admissible 
evidence connecting the U.S. taxpayer with an income item in 
such cases. For example, in the Canadian loan case described 
above, there is circumstantial evidence which might tie the 
taxpayer to the money. However, there is no admissible 
evidence directly tying the taxpayer to the funds. Often, 
ownership of an entity cannot be proven. For example, in a 
number of the schemes described above, there are transactions 
which go through an offshore entity which appears to be • 

accumulating a significant amount of money. While the money J 

may accumulate for the benefit of a U.S. person or be used ' 

by him in some way, there is no available evidence to connect j 

him with ownership of the entity. General information j 

gathering problems and options for dealing with them are 

discussed in Chapter IX. J 


There are also administrative problems. The level of j 

coordination of offshore cases is unclear. In at least one \ 

case, promoters of a scheme were being independently investi- J 

gated in two separate districts. Problems of coordination j 

are discussed in Chapter X. < 


Another problem is the identification of cases for \ 
investigation. Many offshore cases are technically difficult 
from a legal perspective, and the facts are difficult to ' . J 

sort out. A number of cases which were thoroughly investi- ' 

gated, after the expenditure of signficant time and money, ^ 
turned out to involve lawful business arrangements, although ' i 

legal issues such as pricing or allocation of expenses may \ 

be present. This problem, and the possibility of providing i 

legal assistance to the agents during the course of an 4 
investigation, are addressed in Chapter X. 

Options are presented in Chapter VII for technical changes, 
both administrative and legislative, which might help ration- 
alize the taxation of tax haven transactions and accordingly 
might limit some fraudulent use. 


VII. Options for Change in Substantive Rules 

Many of the transactions described in Chapter V are 
perfectly legitimate and reflect Congressional policies as to 
Uhited States taxing jurisdiction. In many cases, decisions 
to change those policies should not be made without thorough 
economic analysis; such analysis is beyond the scope of this 
report. Nevertheless, there are both administrative and 
legislative changes which can be made which might help to 
curtail some of the tax haven use and ease the government's 
administrative burdens in this area. Options dealing with 
tax haven income tax treaties, with information gathering 
problems, and with internal IRS structure are dealt with in 
Chapters VIII, IX and X, respectively. 

The transactions described in Chapter VI are fraudulent, 
and, in general, will not be prevented by changes in substantial 
rules. However, better administrative efforts and more rational 
tax rules might discourage some fraudulent use, and might make 
fraudulent use easier to detect. 

A. Options Which Can be Accomplished Administratively 

While it may be advisable to make some legislative 
changes, decisions to change the Code should be made only 
after thorough analysis. Additional rules generally bring 
more complexity, and may make the process more difficult 
for both taxpayers and tax administrators. The options 
discussed below could be pursued without changes in legislation. 

1. Burden of Proof 

Many of the cases described above involve a U.S. person 
taking a deduction for an amount paid to a tax haven (e.g. , 
shelter transactions). Agents often spend significant time 
attempting to determine whether the taxpayer has in fact 
incurred an expense, or whether an offshore piece of property 
is correctly valued. The same problem occurs in pricing 
cases where taxpayers fail to establish that the price which 
they charge is the proper price, or with allocation of 
deduction issues where foreign taxpayers refuse to produce home 
office books adequate to establish the proper allocation of 
home office expenses to the U.S. 

The burden of proof to establish the tax consequences 
of a transaction is on the taxpayer. IRS agents should be 
given clear direction that they should deny deductions where 
a taxpayer has not established entitlement to the deduction, 
or where valuations or proper pricing have not been established. 
A series of rulings advising taxpayers that the IRS will 
take this position should be published. An initial step in 
this direction was taken in Rev. Rul. 80-324.— 

1/ 1980-48 I.R.B. 20. 


2. Section 482 Regulations 

Consideration should be given to establishing a regu- 
lations project to analyze the §482 regulations, with a view 
toward amending them to ease some of the administrative 
burdens placed on taxpayers and the IRS, and to achieve 
greater certainty in pricing international transactions. 

Section 482 is one of the most important provisions 
available to the IRS to deal with tax haven transactions. 
The regulations take the position that transactions between 
related parties are to be conducted at arm's length. If 
they are not, and taxable incomes are thereby understated, 

the IRS can make allocations to determine the2t.rue taxable , 

income of each member of an affiliated group.— The regulations ' 

set forth rules for determining taxable income in five • 

specific situations.— In each, the method to be used is a j 

price which would have been charged an unrelated person. In 
a transaction involving a sale of goods, for example, this 
is referred to as the "comparable uncontrolled price".— 

Taxpayers and IRS agents have had difficulty in dealing | 

with the §482 regulations, in part because of the dependence } 

upon comparable uncontrolled prices, which often are difficult i 

to find, and in part because of the subjective judgments * 

which need to be made. Some believe that in a number of I 

cases IRS agents disregard the ordering rules in the regula- ' 

tions for determining the method to be used, and instead go ) 

to some more general method sooner than they should.— The ) 
Internal Revenue Manual directs the agents to perform a 

"functional analysis" to determine the relative values of , 

the respective functions performed by the two related entities ! 

involved in a transaction.— j 

2/ Treas. Reg. §1.482-2 (e) (2). 

3/ Treas. Reg. §1.482-2. 

4/ Treas. Reg. §1.482-2 (e) (2). 

5/ See, J. Burns, "How IRS Applies the Inter-Company 
Pricing Rules of Section 482: A Corporate Survey", 
52 J. of Tax. 308 (May 1980). 

6/ IRM 4233, Text 623. 


The inconsistency between the two approaches, and the 
problems caused both taxpayers and the IRS, can be seen by 
contrasting the approach taken by the courts in the Du Pont 


approach taken by the courts in 
U.S. Steel case.— In Du Pont tl 

case— ^ and the U.S. Steel case.— In Du Pont the court 
seemed to be saying that the IRS failure to use a pricing 
approach set forth in the regulations was permissible, but 
the taxpayer was obligated to prove its case under the 
regulations.-/ In U.S. Steel the court seemed to be saying 
that the regulations as drafted required the IRS to use 
comparables, when they exist, even if they are not precisely 
comparable. — ^ These cases, and the cited articles, point 
out significant problems which deserve attention. In both 
cases, tax havens were involved. 

While the §482 provisions are extremely important 
in dealing with tax haven problems, and while the cases 
cited above involved tax havens, it is beyond the scope of 
this report to recommend particular solutions, because these 
regulations present major issues involving all international 
transactions, most of which occur with countries which are 
not tax havens. Instead, a major study should be undertaken 
to identify problems and recommend solutions. Any such 
study should involve the outside business community, which 
will be greatly affected by changes in the §482 regulations. 
The General Accounting Office has completed a study of the 
administration of §482; its report should be published in 
early 1981. Also, the IRS National Office Examination 
Division is in the midst of a two year study of the adminis- 
tration of §482. In any event, the issues need to be debated 
and resolved. 

2/ E.I. Du Pont de Nemours and Company , 608 F. 2nd 44 5 
(Ct. Cls. 1979). 

^/ Uiited States Steel Corp. v. Commissioner , 617 F.2d 
942 (2nd Cir. 1980). 

9/ See , Fuller, "Problems in Applying the §482 Inter- 
Company Pricing Regulations, Accentuated by Dupont 
Case", 52 J. of Tax. 10 (January, 1980). 

10 / See , Decelles and Raedel, "Use of Comparability 
Test in Inter-Company Pricing Strengthed by U.S. 
Steel Case", 52 J. of Tax. 102 (August, 1980). 


In the course of any such study certain approaches 
might be considered. iFqc example, a profit splitting approach 
has been recommended. — ' under this approach the IRS would 
look to functions performed by each of the related entities 
involved in a transaction and would attempt to split the 
profits between them. In effect, this was in part the 
approach which the court in the Du Pont case seemed to accept. 
Whether such an approach is feasible, and if so, whether it 
should be an alternative to an arm's length standard or 
should be applied only if an arm's length price cannot be 
found is something that needs to be considered. A disadvantage 
to this approach is the need to make subjective judgements 
and to apply significant audit time in performing a functional 
analysis. The IRS has particular problems today doing this, 
especially where a taxpayer refuses to cooperate. ; 


In addition, some commentators suggesting a profit | 

splitting approach assume that intercompany pricing really J 
involves which country gets to tax which portion of the 

profits from a transaction, and that accordingly profit • 

splitting is the issue. Where a tax haven is involved, \ 

however, this may not be the case, instead the issue may be J 

whether the profits are taxed at all. It may be decided I 

that a profit splitting approach is not adequate where a tax j 

haven is involved and that special rules should apply to tax \ 

haven transactions. i 

Another problem with adopting new §482 rules which | 

depart radically from the present rules is that the OECD has j 

recently published a report which describes generally accepted ' 

practices to determine transfer prices. — ' The practices • 

set forth are very similiar to the present §482 regulations. \ 

The hope was that the report would encourage geater uniformity ) 

among OECD countries in transfer pricing, and accordingly ] 

would reduce conflicts. Changes in the regulations would i 

retard this process. 3 

Another approach is a unitary or formula system, which 
is used by a few of the states. However, such a system would 
completely violate the separate accounting concept under 
which many multinational companies operate. It is contrary 
to the way most other OECD countries approach transfer 
pricing, and contrary to the taxation by the U.S. of other 
transfer payments such as those imposed on fixed or determinable 

11/ See , for example. Fuller , supra at 11. 

12 / OECD, Transfer Pricing and Multinational Enterprises, 
Re por t of the OECD Committee on Fiscal Affairs (1979) 


A sense has developed that foreign multinational 
coinpanies are competing against U.S. businesses in the U.S. 
and using tax havens to do this. They are often at a competitive 
advantage because the §482 regulations were not drafted with 
foreign investors in mind. We have seen cases where it is 
even unclear that a U.S. company owned by a foreign person 
is dealing with a related party in a tax haven, because it 
is often difficult to develop the facts to indicate affiliation. 

Obviously, if a decision is made to revise the §482 
regulations, the goal would be to develop workable rules 
which would enable a true and accurate allocation of income 
to be made. 

Problems with income from the performance of services 
might also be dealt with through changes in the §482 regu- 
lations, even if a complete revision were not undertaken. 
Many of the service income cases involve a potential §482 
adjustment, but the subjective judgments which must be made 
under the regulations are difficult and time consuming. Also, 
the treatment of the transfer of intangibles in the service 
business context is not clearly addressed. 

It may well be that the service income situation can be 
best remedied by statutory enactment. However, in addition 
to, or as an alternative to, legislative changes, a regulations 
project could be established to determine whether the §482 
regulations could be revised to develop clearer standards, 
particularly for allocating income attributable to "know 
how" and other intangibles used by a tax haven subsidiary 
performing services abroad. 

3. Subpart F Regulations 

The subpart F regulations should be reviewed with a 
view toward eliminating, where possible, the need for subjective 
judgments. The subpart F regulations, as in the case of the 
§482 regulations, often require that subjective judgments be 
made to determine whether a transaction falls v;ithin the 
ambit of subpart F. This is particularly true of the regulations 
which interpret the foreign base company service income 
provisions. For example, the regulations require that in 
order for foreiqn base company service income to be generated, 
substantial assistance contributing to performance of services 
by a controlled foreign corporation must be furnished by a 
related person or persons. The determination of whether 
substantial assistance is furnished is based on a mathematical 
formula, or on a facts and circumstances test. The facts 
and circumstances test, which it appears that revenue agents 
most often have to rely on, is unclear, and few guidelines 
are given in the regulations. It would be useful to at 
least provide additional guidelines as to when substantial 
assistance is deemed to occur. 


4. Application of §269 and the Accumulated Earnings Tax 

The IRS should determine the extent to which §269 and 
the accumulated earnings tax can be applied to tax haven 
transactions, and should publish a series of rulings showing 
cases in which §269 or the accumulated earnings tax will be 
applied to tax haven transactions. 

The foreign taxation area is extremely difficult to 
administer. The audit of some of the more abusive transactions, 
or transactions which threaten the U.S. tax base, might 
require that a new approach be tried. One of these would be 
to apply §269 more vigorously. The extent to which §269 
would apply in the foreign area has not been adequately 

explored. For example, in Chapter V there is described a » 

promotion involving an offshore commodity company which has • 

an offshore parent, the stock of which is owned by U.S. i 

persons. The subsidiary distributes its earnings to its j 

parent in order to avoid the accumulated earnings tax. This j 

transaction might be attacked by applying §269 to disregard , 

the subsidiary. Then, unless the parent distributed its ' 

income to its shareholders, the accumulated earnings tax I 

would apply to the U.S. source income of the parent. Other ) 

instances abound where these provisions might be applied. } 

Arguably, both provisions are ideally suited to deal j 

with tax haven transactions. Section 269 on its face is . 

intended to apply where the principal purpose of an acquisi- I 

tion is avoidance of U.S. tax. By definition, tax haven I 

entities are often formed for just such a purpose. « 


5. Rev iew R ev. Rul. 54-140 ) 

11/ 1 

Revenue Ruling 54-140— ^ held, in effect, that a distri- ' 

bution of stock in a subsidiary corporation v/as a dividend, ] 

and established a brother-sister relationship between the « 

two corporations. This result has been applied in the case 

of pairing of stock in Rev. Rul. 80-213. — ' Accordingly, 

abusive decontrol of foreign corporations can take place. (See 

discussion at chapter V. D. re "paired" or "stapled" stock.) 

— / 1954-1 C.B. 116. 
— / 1980-28 I.R.B. 7. 


The IRS should reevaluate its position in Rev. Rul. 54- 
116. Although the IRS has stated its position, the cases 
are not clear— ^, and the result of the ruling in the 
foreign area has been some avoidance of U.S. anti-abuse 

6. Revocation of Acquiescence in CCA, Inc. 

The IRS should consider revoking its acquiescence in 
CCA, Inc. V. Commissioner — , in which the Tax Court held 
that a foreign corporation, fifty percent of the voting 
rights of which were held by U.S. shareholders and fifty 
percent of the voting rights of which were held by non-U.S. 
shareholders, was not a controlled foreign corporation. It 
is questionable whether the powers held by the foreign 
persons in this case were significantly different than the 
powers of the foreign shareholders in the cases that the IRS 
won in this area. Considering the potential for abuse, the 
acquiescence should be revoked. 

7. Captive Insurance Companies 

The IRS has published a ruling and won a Tax Court case 
on this issue. Nevertheless, there is significant activity. 
Taxpayers are attempting to have their captives write small 
amounts of unrelated risk to avoid "captive" status. 

The IRS might consider publishing a ruling stating that 
a captive can be fragmented for purposes of determining 
whether premiums are deductible. Under this approach, there 
would be no shifting or spreading of risk, and hence premiums 
would not be deductible, if the premiums paid to the captive 
by affiliates exceeded a certain percentage of gross premiums 
received by the captive during a year. 

8. Income of Foreign Banks 

As described in Chapter V, foreign banks doing business 
in the U.S. can avoid U.S. tax by booking loans at a tax 
haven branch. 

— / See DeCoppet v. Helvering, 108 F. 2d 787 (2d Cir. 

1940), Wilkinson v. Commissioner , 29 T.C. 421 (1957), 
nonacq. 1960-1 C.B. 7. Cf. Spreckels-Rosekrans Investment 
Co. V. Lewis , 146 F. 2d 982 (9th Cir. 1945). 

— / 64 T.C. 137 (1975), acq. 1976-2 C.B. 1. 


The problem can be viewed as a regulatory problem, as 
a treaty problem, or as an audit problem. The regulations 
could be amended to provide that income from a loan negotiated 
in the U.S. will be effectively connected regardless of 
where booked. In the alternative, the Code could be amended 
to give the taxpayer an irrevocable election to treat the 
income as effectively connected or not. If the taxpayer 
treats the income as not effectively connected with a U.S. 
business, it would also have to waive any treaty benefit 
otherwise applicable to the interest payment. The audit 
problem is one of access to books and records. This could 
in part be solved by restructuring transactions in cases where 
taxpayers do not supply the necessary records, and putting 
the banks to their burden of proof. 


B. Options Requiring Legislation | 


The study has shown a significant and growing level of 
tax haven use. Transactions which are attempts to evade 
U.S. taxes, including transactions to hide narcotics earnings, 

appear to be important elements, although legal use is i 

probably much greater. The legal use, particularly use by [ 

multinational corporations, includes many transactions which | 

involve drains on what would otherwise be U.S. source income. ■ 

The IRS has great difficulty in administering the current ( 

rules. The levels of use and the potential for eroding the I 

U.S. tax base, as well as the administrative problems caused , 

by current law, are significant enough to warrant considera- i 
tion of changes in the way in which the U.S. taxes tax haven 

income. ' 


1. Expansion of Subpart F to Target it on Tax Haven Entities { 

Subpart F could be amended by adding a provision which 1 

would tax all of the tax haven income of a controlled foreign . 

corporation. This could be accomplished by providing that 3 

subpart F income would include the income of a controlled J 

foreign corporation formed in a tax haven, resident in a tax 
haven, or managed and controlled in a tax haven. In the 
alternative, the provision could be drafted to treat as 
subpart F income that income of a controlled foreign corporation 
which is not taxed above some minimal level by the country 
where the corporation is formed. 

The addition of a targeted approach would be an improve- 
ment over the present system from an administrative point of 
view. It would provide a clearer focus than the current 
lav/ and would eliminate many of difficult technical issues 
encountered in tax haven transactions, and accordingly might 
discourage some abusive tax haven use. 


A targeted approach would require that the term "tax 
haven" be defined. The Secretary of the Treasury could be 
authorized to designate the countries considered tax havens. 
In general, a tax haven might be defined as any country in 
which the tax burden on all income or on particular categories 
of income is substantially lower than the U.S. tax rate on 
that income. Countries designated as tax havens would thus 
include countries (1) with low tax rates on all income; (2) 
with low tax rates on income from foreign sources; (3) with 
low tax rates on income from specific types of business; or 
(4) which grant low rates of taxation to companies engaged 
in "offshore business". A country with a low tax rate would 
generally be one which imposes a rate of tax which is one 
half or less than one half of the U.S. coryorrate tax rate. 
While targeting jurisdictions can present some difficult 
problems, Japan, France, and Australia have done so. 

Some flexibility could be given to the Secretary by 
making the standards "guidelines," rather than fixed objective 
classification rules. Thus, the Secretary could take into 
account such factors as the existence of a tax treaty between 
the U.S. and the other country in determining whether or not 
to classify the country as a tax haven. The availability or 
nonavailability of commercial or bank information, however, 
should not be a factor, as this system would focus more on 
legal use than on determinations as to whether a country is 
an abusive tax haven. 

An exclusion from U.S. taxation could be provided for 
income earned by a corporation: (1) that has a physical 
facility in its country of residence which is necessary for 
its business activities in that country; (2) that is managed 
and controlled locally, and which is engaged in its principal 
business activity, principally with unrelated parties, in 
the country of residence; and (3) that does not receive 
greater than a fixed percentage of its gross revenues in the 
form of holding company type income (say five percent). 

While this option could subject some high taxed non-tax 
haven income to U.S. tax, a foreign tax credit would be 
available to offset any U.S. tax imposed on that income. 

This option does not address the so called "runaway 
plants", which are manufacturing operations established by 
U.S. companies in countries offering tax incentives to 
attract labor intensive investment. Those cases present 
issues not addressed by this report. 


As an alternative to amending subpart F to add a new 
category of subpart F income as described above, subpart F 
could be changed by narrowing its scope so that it would be 
targeted exclusively on tax havens. A problem with this 
approach is that non-tax havens can, at times, be used in 
ways similar to tax havens. Thus, it might be wiser to 
expand subpart F rather than simply to replace it with a 
narrower provision. 

If a decision is made to target subpart F, the issue 
must be addressed of whether to permit taxes paid high tax 
countries to offset U.S. tax on tax haven income. Under 
present rules, the foreign tax credit limitation prevents 
U.S. taxpayers from crediting foreign taxes against U.S. 

taxes imposed on U.S. source income. The limitation is i 

generally computed on an overall worldwide basis, with I 

separate "baskets", however, for certain kinds of income, I 

including oil-related income and certain interest income. 
Excess credits from one country can be used to offset U.S. 
tax imposed on income from another country. At times, 

taxpayers attempt to convert U.S. source income to subpart F ' 

income (which changes its source to foreign) in order to i 

absorb excess tax credits. This leaves some continued j 

incentive to use tax havens. If subpart F is amended to j 

include a provision targeted at tax havens, without any [ 

change in the foreign tax credit limitation, the same j 

planning opportunities would be available. i 

One alternative is to adopt a per-country limitation on . 

the foreign tax credit, under which taxes paid to each 

country are in separate baskets. This method has been used ] 

before, and at one time was an optional alternative to the ' 

overall limitation. It is, however, difficult to administer. ' 

Transfer pricing and allocation of deductions between all j 

foreign affiliates, not only between the U.S. and foreign j 

affiliates, would have to be scrutinized. i 


An alternative would be to create two baskets for 
foreign taxes, a high tax basket and a low tax basket. 
Taxes paid to all high tax countries would be averaged 
together, and taxes paid to all low tax countries would be 
averaged together. Therefore, the excess credits from high 
tax countries would not offset U.S. tax on tax haven income. 
While some administrative problems would exist because of 
the need to allocate income and deductions between the two 
baskets, the problems would be fewer than those involved 
with a per-country limitation. 


2. Adoption of a Management and Control Test for Asserting 
united States Taxing Jurisdiction Over Foreign Corporations 

Consideration should be given to expanding U.S. taxing 
jurisdiction over corporations to include foreign corporations 
which are managed and controlled in the United States. 
Today, the United States asserts worldwide taxing jurisdiction 
over a domestic corporation, which is defined as a corporation 
created or organized in the United States. — ' A foreign 
corporation is taxed only on its U.S. source income and 
foreign source income which is effectively connected with a 
U.S. business. 

Often, tax haven corporations conduct substantial 
business overseas but are in reality managed in the United 
States. That is, all significant policy decisions, as well 
as some day-to-day management decisions, are made by employees 
of the U.S. parent corporation. Significant administrative 
support may also be provided. In some cases, the tax haven 
corporation has, at most, a few clerical support employees 
located in the tax haven. 

In some cases, existing law would permit the United 
States to tax at least a portion of the earnings of the 
foreign corporation. For example, at times the IRS may 
argue that the foreign corporation is doing business in the 
United States. In other cases, it may be possible for the 
IRS to apply §482 to allocate income from the tax haven 
corporation to the U.S. Neither of these approaches is 
completely adequate. Prevailing in the trade or business 
argument only subjects the corporation's U.S. source income 
and its foreign source effectively connected income to United 
States tax, whereas U.S. source income would generally be 
taxed by the United States in any event. Section 482 can be 
extremely difficult to apply from an administrative point of 
view. Developing the necessary facts can be time consuming, 
particularly when the foreign corporation is located in a 
tax haven which restricts access to books and records. 

The management and control test for asserting taxing 
jurisdiction over a corporation is used in many countries, 
including the United Kingdom and its former colonies. This 

— / §7701 (a)(4); Treas. Reg. §301.7701-5. 


test does have limitations as the sole test of taxing 
jurisdiction because of the subjective judgments which 
often must be made. As an addition to the present rule, 
however, it would provide the IRS with an additional means 
of scrutinizing many tax haven operations. At times it 
would be easier to apply than § 482. 

Canada applies a dual test (having adopted the incor- 
poration test as an addition to the management and control 
test), and has found it useful in dealing with international 
taxation problems. 

3. Change in Control Test 

A number of cases involve attempts to decontrol tax j 

haven corporations to avoid subpart F and U.S. reporting I 

obligations. While case law supports the view that actual i 

control, even without actual stock ownership control, leads 
to controlled status, it can be very difficult for the IRS 
to establish the fact of control, particularly where the 
corporation and the other owners are in a tax haven. At 
times, side agreements are suspected but their existence is 
difficult, if not impossible, to prove. There are other 
control problems, including pairing of stock, which could 
become significant if action is not taken. Furthermore, the 
10 percent threshhold requirement for U.S. shareholder 
status permits distortions and unequitable treatment of 
taxpayers in some cases. 

Consideration might be given to reducing the percentage 
ownership test for controlled foreign corporations status to 
a 50 percent test, and to adding a value test as an alter- 
native test, as well as to reducing to one percent the level 
of stock ownershippfor determining when a U.S. person is a 
U.S. shareholder. — ' Adoption of these rules would permit 
U.S. taxation of the growing number of 50/50 joint ventures, 
and would eliminate avoidance of U.S. tax through the pairing 
of stock. It would also provide some equity as between U.S. 
persons who own 10 percent of the stock and those who do 
not. Consideration might also be given to dropping the 
controlled threshhold down to 25 percent, as was done in the 
case of U.S. insurance of U.S. risks for subpart F purposes, 
and as the French have done in their tax haven legislation. 
A drop in the threshhold could apply only to corporations 
formed in tax havens. 


The Senate version of the Tax Reduction Act of 1975 
contained a provision which would have redefined the 
term "U.S. shareholder" to include a U.S. person holding 
a one percent or greater interest in a foreign corporation. 
See H. Rep. No. 94-120, 94th Cong., 1st Sess. 69-70 
1975-1 C.B. 631. 


At the very least, the "paired" or "stapled" stock 
problems should be addressed. One option is to amend the 
Code to treat stock of a corporation which is paired with 
stock of a second corporation as owned by the second 
corporation. Such a provision would also curtail avoidance 
of the anti-boycott and DISC provisions through pairing. 

4. Service and Construction Income 

The service and construction industries are significant 
users of tax havens, and present the IRS with unique problems. 
Many of the problems appear to involve the transfer of a 
U.S. business to an offshore subsidiary, and include the 
transfer of know-how or goodwill from the U.S. parent to the 
tax haven affiliate. There also seem to be significant 
situations involving, for example, the negotiation of contracts 
in the U.S., their signature by officers of the foreign 
affiliate who may also be officers or employees of the U.S. 
parent follow by the transfer of know-how without any com- 
pensation. Many of these cases might result in subpart F 
income or §482 allocations to the parent if identified and 
fully developed by the IRS. Considering the limitations of 
resources, however, identifying these cases and fully de- 
veloping them is extremely difficult. Moreover, the foreign 
subsidiaries are routinely established in tax havens having 
commercial secrecy, which present the IRS with additional 
books and records problems. 

A narrow approach to dealing solely with services 
income would be to add a branch rule to the foreign base 
company services income provisions. A branch rule {which is 
contained in the subpart F sales provisions) could provide 
that foreign base company services income would include the 
income attributable to the carrying on of service activities 
of a branch of the controlled foreign corporation, by treating 
the income as derived by a wholly owned subsidiary of the 
controlled foreign corporation. Thus, if a tax haven company 
is performing services in a third country through a branch, 
and the direction for or support of those services is provided 
by the tax haven company's home office, or by employees of 
that office, the income would be foreign base company services 
income. An alternative approach, and one which would be far 
simpler to administer, would be to treat all income from the 
performance of services outside of the country of incor- 
poration of the controlled foreign corporation as subpart F 


Two serious issues which must be addressed in the service 
and construction cases are whether the tax treatment of 
these businesses should be left alone for competitive reasons 
and whether we can afford to continue to export this kind 
of technology without exacting a U.S. tax. 

5. Merger of the Foreign Personal Holding Company Provisions 
into Subpart F 

Consideration should be given to eliminating the foreign 
personal holding company provisions and incorporating their 
substance into subpart F. 

Today, foreign personal holding company income may be 
taxed under either the foreign personal holding company 
provisions — or under subpart F. If both provisions apply 
to a particular foreign corporation, then the foreign 
personal holding company provisions will apply and not 
subpart F. — ' Accordingly, it may^be possible to avoid the 
investment in U.S. property rules — of subpart F by causing 
a foreign corporation to be a foreign personal holding company 
and to earn a small amount of foreign personal holding 
company income in a year in , which a significant investment 
in U.S. property is made. — 

1^/ §§551 through 558. 
20/ §951(d). 
21/ §956. 

22/ See Estate of iDvett, 1980-1 USTC 9432; contra. Estate 
of Whitlock V. Commissioner, 494 F. 2d 1297 (10th Cir. 
1974), rev'g 59 T.C. 501 (1972), cert, denied, 419 U.S, 
839 (1974), reh'g denied 419 U.S. 1041 (1974). 

Further, the foreign personal holding company attribu- | 

tion rules have never been rationalized. The provisions i 

contain technical problems. For example, the foreign personal j 

holding company attribution rules provide for attribution of . 
stock ownership between siblings. In addition, they require 

attribution from a foreign individual to a U.S. individual. J 

Accordingly, the acquisition by a U.S. person of a small ' 
amount of stock of a foreign corporation, in which his 

sister (who is a foreign resident) owns 50 percent of the j 

stock, could make that corporation a foreign personal holding j 

company and subject that person to tax. Attribution occurs J 

even without actual ownership of stock by the individual. < 
A U.S. person may thus have a technical obligation to file a 


return with respect to the foreign company, even though he 
owns no stock and may not be able to get any of the details 
needed to complete a return. The IRS has lost a case on 
this issue. — ' 

Moreover, the foreign personal holding company pro- 
visions do not contain proper anti-double counting rules 
similar to those in §959. 

Finally, it appears that few foreign personal holding 
company returns are audited. If foreign personal holding 
company issues are raised, they generally will be addressed 
by agents who are not trained in those issues. Because 
international examiners concentrate on large cases, they 
have not developed practical audit experience in the foreign 
personal holding company area. 

The structure of taxing foreign corporations controlled 
by U.S. persons would be simplified by repealing the foreign 
personal holding company provisions, and incorporating their 
substance into subpart F. Some technical changes, including 
a change in the subpart F stock ownership test, might be 

In the alternative, §951 (d) could be amended to over- 
ride the Lovett case. This could be accomplished by pro- 
viding that a U.S. shareholder who is subject to tax under 
§551(b) on income of a controlled foreign corporation for 
his taxable year, which is also a controlled foreign 
corporation, will be required to include in gross income, 
for that taxable year, any amount with respect to that 
controlled foreign corporation invested in U.S. property, 
to the extent of its earnings and profits, but the amount so 
included will be reduced by the amount included under §551. 
The foreign personal holding company attribution rules could 
be amended to incorporate the §958 rules. 

These changes would at least eliminate the loophole 
created by the lovett case, and would rationalize the foreign 
personal holding company provisions somewhat. They would, 
however, still maintain two parallel and possibly overlapping 
systems with all of the attendant administrative problems. 

23 / See Estate of Nettie S. Miller v. Commissioner, 43 T. C. 
760 (1965), non acq. 1966-2 C.B. 8. 


6. Captive Insurance 

Despite IRS rulings and a successful court case, captive 
insurance companies continue to proliferate in the tax 
havens. In f^g^/ aggressive planning is attempting to avoid 
the case law. — One legislative approach might be to amend 
subpart F to extend its coverage to include the premiums 
received by a controlled foreign corporation for insuring 
foreign risks of related persons. This approach would be 
consistent with the base company concept found in the foreign 
base company sales and services income provisions. Another 
approach might be to clarify the application of the foreign 
base company services income provisions to insurance of 
risks of related parties. 

7. Shipping Income 

The use of tax havens to shelter income from shipping , 

has been considered by the Congress. As originally provided, I 

shipping income was excluded from subpart F. In 1975, | 
subpart F was amended to include shipping income, but earnings 

reinvested in the shipping business were excluded. The IRS i 

has had little audit experience with these provisions to j 

date, but they are technically complex and may require some i 

on-site audits, which as a practical matter may be impossible j 

to do. For administrative reasons, consideration might be • 

given to taxing shipping income directly. I 

8. De minimis Exclusion from Foreign Base Company Income 

The de minimis exclusion from foreign base company ^ 

income could be amended to add an alternative dollar limitation. • 

Today, if foreign base company income of a controlled j 

foreign corporation is less than 10 percent of its gross ' 

income, none of its gross income is taxable as foreign base j 

company income. By using this exception, larger companies , 

can shelter significant amounts of passive income. — This • 

shelter could be removed by adding an alternative dollar 
limitation, so that the exception would not apply if the 
controlled foreign corporation's foreign base company income 
exceeds a fixed dollar amount. 

9. Commodity Shelters 

One solution to the use of tax havens as situs for 
alleged commodity shelter transactions would be to deal 
directly on a technical basis with tax straddles. The Code 

24 / See discussion at Chapter V. C.6. 
25/ See discussion at Chapter v. C.2. 


could be amended by adopting a provision which would (1) 
postpone recognition of losses from certain straddle positions 
during the period in which the taxpayer holds offsetting 
positions plus the following 30 days, and (2) suspend the 
running of the holding periods (of the assets comprising the 
offsetting positions) during the balance, plus the following 
30 days. In addition, §1221(5) (denying capital asset 
treatment to certain government obligations) could be repealed. 

Tax straddles are a significant and growing problem. 
They are motivated solely by tax considerations, and offer 
no opportunity for meaningful economic return. As explained 
in Chapter V, a tax haven situs is often used as the alleged 
situs for the transaction in order to obfuscate the audit 
trail. Significant amounts of audit time, as well as crowded 
court calendars, can make it difficult to deal with these 
cases under current law. Tax straddles are an even more 
significant problem domestically. 

Most often the straddle shelters are used to defer 
income by producing paper losses in one year while deferring 
the offsetting gains to a later year. They may also be used 
in an attempt to convert short term gain into long term gain 
or capital losses into ordinary losses. These straddles 
have been structured primarily in commodities, including 
metals, and in government securities. 

The above proposal would deal directly with the problem 
by denying the benefits of the tax straddle. While it could 
be developed solely in terms of tax haven transactions, the 
scope of the problem would require that any legislation 
considered should also cover domestic tax straddle transactions. 

10. Tax Haven Deductions 

Another more general approach to tax haven related 
shelters, and to the overall problem of phoney tax haven 
related deductions, would be to amend the Code to specifically 
disallow a deduction for amounts paid or accrued to a tax 
haven person or entity, unless the taxpayer establishes by 
clear and convincing evidence that the underlying trans- 
action occurred and that the amount of the deduction is 
reasonable. While this in essence is the current law, a 
clear rule targeted at tax havens would help to speed up the 
administration of the law. A similar rule, requiring a 
taxpayer to produce documentary evidence as to the value of 
offshore property, would also be useful. This would require 
that the taxpayer give to the IRS written material which IRS 
engineers can evaluate without having to visit the property. 


Additional reporting of tax haven transactions would 
also be helpful. A major problem today is identifying haven 
transactions so that they can be audited. Consideration 
should be given to reporting of any transaction with a 
foreign person, as well as any investment in foreign property. 
In addition to the existing criminal and civil penalties for 
non-filing which would apply in this case, the penalty for 
failure to provide the information could include denying any 
deductions relating to the unreported foreign transaction. 

11. No Fault Penalty 

Consideration should be given to adopting a no fault 
penalty on the order of 50 percent of a substantial tax 
haven related tax deficiency. 

Today, taxpayers often enter into questionable tax 1 

haven transactions, taking the calculated risk that they ' 

will not be identified. Even if the taxpayer is identified, j 

a number of years can pass before the tax plus interest is j 

actually paid. During this time the taxpayer has the use of ' 

the money, the effect being a loan from the Treasury. ' 

A no fault penalty would place the taxpayer under some 
risk and would go a long way toward curbing abusive shelter 
and other deduction generating transactions. 

12. Foreign Trusts 

Most non-fraudulent use of foreign trusts by U.S. . 

persons appears to have been eliminated. However, some 

schemes have developed to take advantage of perceived loopholes. \ 

For example, the sale or exchange exception from §679 is ' 

allegedly being abused. To curb this abuse, the exception ' 

could be eliminated. In the alternative, the provision ! 

could be eliminated only in the case of transactions with a j 

trust which has as a party in interest a person related ' 

to the transferor. The sale or exchange exception is often i 

met, by a long-term installment sale. This scheme could be 
eliminated either by eliminating the sale or exchange exception 
or by providing that an installment sale will not be considered 
a sale or exchange to a foreign trust if the note runs for 
more than a set period of years, such as five years. 

The use of foreign trusts by foreiqn persons who later 
become U.S. residents could be minimized by providing that a 
tranferor will be taxed on the income from property transferred 
to a foreign trust if the transfer takes place within a 
fixed period of time before the transferor becomes a U.S. 
resident. This is a jurisdictional problem and any change 
requires a major policy decision as to the point at which 
the U.S. should assert taxing jurisdiction. 


The foreign trust rules do not apply to a transfer by 
reason of the death of the transferor. To limit the estate 
planning opportunities exceptions for testamentary transfers 
could be removed. The income would have to be taxed to the 
beneficiaries, however. Technical changes, such as elimi- 
nating §679 from the scope of a §1057 election, and changing 
the definition of a U.S. beneficiary so that a foreign 
corporation is considered a U.S. beneficiary if more than 10 
percent of its stock is owned directly or indirectly by 
foreign persons, could be made. 

13. Expatriation 

U.S. persons who seek to expatriate often expatriate to 
a tax haven. The current rules covering expatriates are 
complicated and at times difficult to administer. They 
could be improved and made easier to administer by sub- 
jecting the expatriate to tax on the difference between the 
fair market value of his property at the date of expatriation 
and his basis in the property. In this way the tax, including 
the tax on foreign property, would be paid upon expatriation 
and the expatriate could then be treated as any other non- 
resident alien person. Canada has a similar system. A 
similar rule could be adopted for the departure of resident 
aliens, although such a change would represent a greater 
deviation from present policy than the change suggested for 

14. Residence 

A clear objective rule for determining when an alien 
becomes a U.S. resident might be adopted. Today, the rules 
as to when an alien becomes a resident are subjective and 
are difficult to administer. It might be better to adopt 
a clear rule for determining residence, for example, 183 
days in the U.S. during a year. While such a rule is sub- 
ject to manipulation, so is the present rule, and certainty 
might be preferable. 


VIII. Treaties With Tax Havens 

Tax treaties modify domestic tax law to reduce tax 
otherwise imposed on foreign investment in the treaty countries. 
Treaties with tax havens are often used by residents of non- 
treaty countries to achieve a reduction in United States taxes. 
Although most of this use is not fraudulent, some is abusive 
and inconsistent with present United States tax policy. The 
low rates of tax coupled with the anonymity afforded by tax 
havens do, however, give rise to some fraudulent use. 

United States taxpayers, particularly multinational 
corporations, may also use the United States treaty network 
and tax havens to advantage. The most widely known use is 
that of Netherlands Antilles finance subsidiaries to achieve 
zero rates of tax on interest paid on foreign borrowings. 
Often, the advantages which can be achieved through tax 
haven treaties can also be achieved through treaties with 
non-tax havens. 

A. Basic Principles 

Tax treaties are often referred to as conventions to 
eliminate double taxation and avoid fiscal evasion. Double 
taxation can arise in the case of a United States taxpayer, 
because the income earned by him may be taxed by both the 
United States and, if earned in another country, by that 
country as well. The United States unilaterally attempts to 
mitigate this double taxation by permitting a tax credit for 
income taxes paid to foreign countries. However, because of 
differences in source rules between the United States and 
the other country, and because of problems of defining when 
a foreign tax is an income tax for purposes of the United States 
foreign tax credit, there may still be some cases of significant 
double taxation.— 

1/ It can be argued that the real impact of treaties > 

is to eliminate excess taxation. The unilateral relief 
afforded by the United States probably works well in most 
cases. However, rates of tax in the other country may 
exceed United States rates, particularly when withholding 
taxes on distributions are taken into account. Reduction 
of these taxes leads to elimination of excess taxation 
rather than double taxation. 


Under United States law, passive income paid to foreigners 
not doing business in the United States is taxed„at a rate 
of 30 percent of the gross amount of the income.— United 
States income tax treaties reduce this rate of tax in the 
case of payments to residents of a treaty country. The 
United States position, as reflected in the United States 
Model Income Tax Treaty, is that the rate of tax on dividends 
should be reduced to five percent in the case of direct 
investment (ownership of 10 percent or more of the stock of 
the payor corporation) and to 1 5 percent in the case of 
portfolio investment. Interest and royalties should be 
exempt from tax at source. The OECD Model contains similar 
rules for dividends and royalties, but permits a 10 percent 
tax on interest at source. 

While treaty benefits are theoretically intended to 
inure to residents of each of the treaty countries, third 
country residents often seek to take advantage of them. At 
times, this use by third country residents may coincide with 
perceived United States interests; at other times, however, 
this use may be abusive. The treaties therefore generally 
contain some provisions designed to limit the benefits of 
the treaty to residents of either of the two contracting 
countries. However, "resident" is broadly defined as any 
person who under the laws of a country is liable for tax by 
reason of his domicile, residence, citizenship, place of 
management, place of incorporation, or other criterion of a 
similar nature. Persons taxable in a country only on 
income from sources in that country , or on capital situated 
in that country are not residents.— Interest and royalties 
are covered at source only if both "derived and beneficially 
owned by" a resident of the other country. 

The United States Model and some of the treaties in 
force contain an anti-holding company provision which denies 
the reduced rate of tax on dividends, interest, and royalties 
(1) if the recipient corporation is a resident of the other 
country which is at least 25 percent owned, directly or 
indirectly, by individual residents of a country other than 
the country of residence of the corporation, and (2) if 
special tax measures apply in the country of residence which 

2/ §§871 and 881. 

3/ Article 4, U.S. and OECD Models. 


reduce, substantially below the generally applicable corporate 
tax rates, that country's tax imposed on dividends, interest, 
and royalty income from sources outside that country.-'^ 

Variations on the Model article are found in other 
treaties. In the proposed Cyprus treaty, denial of reduc- 
tion of tax at source is applicable if either (1) the tax 
burden in the country of residence of the corporation on the 
income is substantially less than the tax generally applied 
in that country on corporate profits, or (2) 25 percent or 
more of the stock of the recipient corporation is owned by 
individuals not resident in that country. 

B. Tax Haven Treaty Network 

The United States has over thirty income tax treaties 
in force. Most are with developed countries which are 
significant trading partners. However, the United States does 
have treaties in force with at least 15 jurisdictions generally 
considered to be tax havens to some degree. In addition, 
the United States has an income tax treaty with the Netherlands, 
generally considered a tax haven by reason of its treaty 
network and its special holding company legislation. For 
purposes of this chapter, the Netherlands will be considered 
to be a tax haven. 

Most tax haven treaties are in force as a result of the 
extension of the old 1945 United States-United Kingdom 
Income Tax Treaty to the former United Kingdom colonies. 
That treaty provided for its extension to overseas territories 
of the United Kingdom. The United Kingdom requested that 
extension, and the Senate gave advice and consent to ratification 
of the extensions in 1958. The extensions became fully 
effective in 1959. I 


Likewise, the treaty with the Netherlands Antilles is 
in force as a result of the extension of the United States- 
Netherlands Income Tax Treaty of 1948, as amended. The 
treaty provided for extension to overseas territories of the 
Netherlands. This extension was effective to the Netherlands 
Antilles in 1955. The Netherlands Antilles adjusted its 
internal law to take advantage of the treaty by providing 

4/ Article 4, United States and OECD Models. Similar 
provisions are contained in United States treaties 
with Finland, Iceland, Korea, Luxembourg, Norway, Trinidad 
and Tobago, and the United Kingdom. A limited 
anti-avoidance provision applicable only to direct 
investment dividends is contained in the Netherlands 
Antilles treaty. 


for special tax regimes for certain local holding companies. 
Generally, such companies were taxed at rates ranging between 
2.4 and 3.0 percent. This made the Netherlands Antilles an 
attractive vehicle to residents of third countries who 
wanted to invest in the united States. A 1963 protocol, 
effective in 1967, reduced or eliminated some of the benefits 
of the Antilles treaty which were formerly available, but 
other benefits remained. 

The United States also has tax haven treaties which 
were directly negotiated with Luxembourg, the Netherlands, 
and Switzerland. The Luxembourg treaty was signed in 1962 
and came into force in 1964. The Swiss treaty was signed in 
1951 and entered into force in that year. The treaty with 
the Netherlands was originally entered into in 1948, and has 
|! been amended from time to time, most recently by a 1965 
t' protocol which became fully effective in 1967. The United 
[' States has recently signed an income tax treaty with Cyprus, 
j a recognized tax haven.— 

There does not seem to have been much, if any, consid- 
eration of either potential abuse in the negotiation of the 
existing tax haven treaties, or of whether to permit extension 
of treaties to the territories of our treaty partners. 
Currently, efforts are under way to deal with the problems 
created by the Swiss and Netherlands treaties, as well as 
the Netherlands Antilles and British Virgin Islands treaties. 
In addition, abuse of treaties was addressed in the Cyprus 
treaty, which contains a number of anti-avoidance provisions. 

The data in tables 1 and 2, to this chapter, indicate 
that there is significant use of treaty countries in general, 
and tax haven treaties in particular for investment in the 
United States. Much of this use must be by nonresidents of 
the treaty country, because the volume of investment does 
not bear any relationship to the indigenous populations of 
those countries. In 1978, $3.9 billion out of a total of 
$4.5 billion, or 89 percent, of gross income paid to nonresidents 
of the United States was paid to treaty countries. Of that 
amount, $1.8 billion out of the total $4.5 billion of gross 
income paid to nonresidents of the United States went to 
treaty countries which are also tax havens. In that same 
year, $309 million or 31 percent of the interest paid to 
nonresidents went to tax haven treaty countries, and $1.4 

5^/ M. Langer , Practical International Tax Planning , 278, 279 
(2d ed. 1979) B. Spitz, Tax Havens Encyclopaedia , (1975). 


billion or 48 percent 
haven treaty countries 
Switzerland is clearly 
one-third of the divid 
of the United States, 
interest, went to Swit 
Netherlands Antilles a 
passive income from th 
of the Netherlands rec 
the dividends, and 3.6 
paid to nonresidents, 
with a population of o 
the total United State 
13 percent of the inte 
dividends. These thre 
approximately 40 perce 
more than 48 percent o 
interest. None of the 
gross terms, although 
British Virgin Islands 
million in 1975 to $8 
the gross payment in 1 

of the dividends paid went to tax 
On a country by country basis, 

the most widely used. In 1978, over 
ends ($985 million) paid to nonresidents 
and 14 percent ($135 million) of the 
zerland. The Netherlands and the 
Iso received significant amounts of 
e United States. In 1978, residents 
eived 12 percent ($331.7 million) of 

percent ($35.5 million) of the interest 

Residents of the Antilles, a country 
nly 230,000, received four percent of 
s payments to foreigners, comprised of 
rest and almost two percent of the 
e countries together accounted for 
nt of all payments made to foreigners; 
f the dividends and 30 percent of the 

other tax havens is significant in 
total payments to "residents" of the 

have grown from approximately $1 
million in 1978, with about two-thirds of 
978 consisting of dividends. 

It is interesting to note that the number of British 
Virgin Island companies in which United States persons have 
an interest grew from 53 in 1970 to 678 in 1979. The number 
of BVI companies in which United States persons own more 
than 95 percent of the stock increased over the same period 
from 40 to 316. 

Despite the obvious abuse of the treaties, a large and 
growing network of treaties, and an aggressive treaty nego- 
tiation program, existing treaties are not reviewed on any 
systematic regular basis, and the United States has shown 
little inclination to terminate them. Consequently, treaties 
which perhaps can be abused or which no longer serve a 
legitimate economic purpose are still in effect. Further, 
the United States has been slow to take action to deal with 
changes in the domestic laws of its treaty partners. 

Barbados amended its tax laws some years ago to provide 
for favorable tax treatment for international business 
companies.—'^ The United Kingdom quickly dealt with the 
problem by insisting that the United Kingdom-Barbados Income 
Tax Treaty be revised to exclude international business 

6/ Barbados International Companies Act of 1965 (No. 50 of 
1965, as amended by No. 60 of 1977). 


companies.— The United States has never taken steps to 

deal with Barbados. Another of our treaty partners, St. 

Vincent, has become a center for "captive banks," that have 

been used to perpetrate some significant frauds upon United 

States banks and that allegedly have been used„by aggressive 

tax planners in an attempt to avoid subpart F.— The efforts 

of the British Virgin Islands to adapt its law to the United 

States-British Virgin Islands Income Tax Treaty are set out 

in a detailed article in the Tax Law Review.—^ 

C. Third Country Resident Use of United States Tax Treaties 
with Tax Havens 

Most of the transactions described below are permitted 

by the literal language of the Code and the treaties. These 

transactions are permissible because of a conflict between 
two inconsistent policy objectives: 

(1) Encouraging foreign investment in the United States 
and the free flow of international trade and capital; 

(2) Not treating foreign investment in the United States 
differently from investment by United States persons, 
and not providing incentives to foreign investment by 
united States companies. 

Any attempt to tax some of the transactions must also 
attempt to reconcile this conflict. In addition, foreign 
policy considerations as well as international trade policy 
considerations must be taken into account. 

1. Forms of Third Country Use 

Each of the following hypothetical transactions is 
based on a number of actual cases that either have been 
described to us or have been the subject of a ruling or a 
court case. Many of these transactions are permitted by the 
treaty language. Some reflect policy decisions of the 

Ij See Article XXIII U. K. -Barbados Income Tax Convention. 

See M. Edwards-Ker, The International Tax Treaties Service , 
Article 4, page 46. 

V See Chapter V. C.2. 

9^/ Vogel, Bernstein, and Nitsche, "Inward Investment in 
Securities and Direct Operations Through the British 
Virgin Islands: How Serious a Rival to the Netherlands 
Antilles Island of Paradise?", 34 Tax L. Rev. 321 (1979). 


treaty negotiators. The tax consequences of some transactions 
would be changed if detected, however, detection is difficult, 
often depending upon the cooperation of the treaty partner. 

a. Foreign borrowing . A borrowing by a United States 
person is arranged through a treaty jurisdiction to take 
advantage of the reduced rate of tax (zero in most cases) on 
interest. There are two patterns of borrowing: (1) a 
conduit which a United States borrower or foreign lender 
forms as an entity in a treaty country for the specific 
purpose of funneling a specific loan through it; (2) a 
finance company situation in which a United States company 
forms a subsidiary in a treaty country and the subsidiary 
then sells its obligations to the public overseas. 

An abusive example of the conduit case is described in 
Aiken Industries, Inc. — ' A United States corporation 
borrowed money from its Bahamian parent and issued a promissory 
note to the parent. A Honduran company was then formed and 
the parent transferred the United States corporation's note 
to the Honduran company in exchange for its demand notes 
bearing the same rate of interest as the United States corporation's 
note. The United States corporation claimed exemption from 
its withholding obligation under the then effective IMited 
States-Honduras income tax convention, which exempted interest 
received by a Honduran corporation from a united States 
corporation from United States withholding tax. Although 
not stated in the case, presumably interest payments by the 
Honduran company to its Bahamian parent were not taxed by 

The court held that the exemption did not apply because 
the treaty language exempted interest from United States 
sources "received by" a Honduran corporation. Under the 
facts presented the interest was not received by a Honduran 
corporation. The Tax Court interpreted the words "received 
by" to mean something more than merely obtaining physical 
possession of the funds coupled with an obligation to pass 
it on to a third party. 

b. Finance companies . Without a treaty, a United States 
company which borrows abroad must withhold the statutory 30 
percent tax imposed on the interest paid with respect to the 
debt. The cost of this tax is born, at least in part, by 

the united States borrower in the form of an increased 
interest payment to cover the United States tax on the 
interest. In an attempt to avoid imposition of this tax, 
many borrowers, particularly multinational companies, 
establish a subsidiary in the Netherlands Antilles. The 
subsidiary then borrows overseas (usually in the eurodollar 
market), and relends the borrowed funds to the parent. The 

10/ 56 T.C. 925 (1971). 


position taken by the borrower is that the interest paid by 
the parent to the subsidiary is deductible for United States 
tax purposes and is exempt from Lfriited States withholding 
tax. The payment of interest by the subsidiary to the 
foreign lender is also exempt. The Antilles company would 
be taxable by the Antilles on the interest it receives, but 
the interest it pays out to the ultimate lenders is deductible. 
Accordingly, the only tax on the interest payment is the 
Antilles tax on the difference between the interest received 
and the interest paid out, usually a small amount. That 
tax might be a creditable tax for United States purposes. 
The Antilles will not impose a withholding tax on the interest 
paid by the Antilles company. (Similar results, sometimes 
through different arrangements, might be achieved under 
other treaties, e.g. ,, British Virgin Islands, Luxembourg, 
and the Netherlands. )— ^ 

c. Holding companies . Another use of tax haven treaties 
involves establishing a holding company in a tax haven with 
which the United States has a treaty and then arranging to 
have the income received from the United States paid out in 
a deductible form. One use of a holding company is for so- 
called back-to-back or pass through royalties. A foreign 
person licensing a patent for use in the United States is 
subject to a United States tax of 30 percent of any royalty 
received. This tax can be reduced (in some cases to zero) 
by forming a Netherlands corporation and licensing the 
patent to that corporation. The Dutch corporation would 
then license the patent to the United States licensee. The 
royalty would be paid to the Dutch company, which will, in 
turn, pay it to the owner of the patent in a deductible 
form either as a royalty or as interest. 

Article IX of the United States-Netherlands income tax 
treaty exempts from United States tax "royalties paid to a 
resident or corporation of one of the contracting states . . . 
Accordingly, taxpayers take the position that the payment of 
the patent royalty to the Netherlands company will not incur 
any United States tax. The Netherlands company can deduct 
the royalty (or interest) paid to its shareholder and the 
Netherlands does not impose a tax on a royalty payment. 
Thus, the royalties will be paid out to the Netherlands 

11 / See , however, Lederman , "The Offshore Finance 

Subsidiary: An Analysis of the Current Benefits and 
Problems," J. of Tax . 86, (1979), discussing various 
possible approaches which the IRS could consider 
to deal with finance companies. See , Joint Committee 
on Taxation Pamphlet, Description of H. S. 7 553 
Relating to Exemptions from U.S. tax for Interest 
Paid to Foreign Persons (June 18, 1980). 


company free of United States tax, the Netherlands company 
will incur little or no tax, and the patent owner will pay 
no tax (assuming, of course, that he is resident in a country 
which does not tax the income, or he has the royalties paid 
to a nominee in a second zero tax jurisdiction). 

The Netherlands treaty does not have any anti-treaty 
shopping provision applicable to this structure. Even if 
the treaty contained a provision similar to Article 16 of 
the United States Model, the abuse would not be prevented 
because, in order for Article 16 to apply to deny treaty 
benefits, the income of the Netherlands company must be 
subject to a special rate of tax by the Netherlands. Instead 
of subjecting the corporation to a special rate of tax, the 
regular corporate rates may be applicable, but because the 
payment by the Netherlands company is deductible by it, and 
because it almost equals the royalty received, there would 
be little or no tax due. 

The payment of the royalty from the Netherlands company 
to the ultimate owner is United States source income subject 
to the 30 percent LTnited States tax, because the royalty is 
paid for the use of patents in the U.S. — ' A taxpayer might 
attempt to avoid this result by having the Netherlands 
company pay the royalties in another deductible form such as 

Direct investment in the United States can also be 
structured through a holding company. For example, a foreign 
company can establish a Netherlands holding company which in 
turn forms a wholly owned subsidiary in the United States. 
Under the treaty with the Netherlands, dividends paid by the 
United States subsidiary (assuming it conducts an active 
business) may be taxed by the United States at the rate, of 
five percent rather than the 30 percent statutory rate. — ' 
With proper planning, the Netherlands corporate tax may not 
be imposed. Furthermore, if the Dutch company is a subsidiary 
of an Antilles company, the Dutch company can then pay 
dividends to the Antilles free of tax. The same result is 
available by having a corporation resident in the British 
Virgin Islands own all of the stock of the United States 
corporation . 

12 / §861(a)(4). See Rev. Rul. 80-362, 1980-52 I.R.B. 14. 

13 / Article VII, United States-Netherlands Income Tax 


d. Active business . A foreign person can engage in an 
active United States business by forming a company in an 
appropriate tax haven treaty country and having that company 
conduct the business. Some treaties waive the tax imposed 
on dividends and interest paid by a foreign corporation 
which earns most of its income in the United States. — ' 
Article XII of the United States-Netherlands Income Tax 
treaty as extended to the Antilles (the United States-Antilles 
treaty), for example, provides that dividends and interest 
paid by an Antilles corporation are exempt from United 
States tax except where the recipient is a IMited States 
person. The Antilles does not impose a tax on dividends 

paid by an Antilles company. Accordingly, if an Antilles 
company earns most of its income in the Lftiited States no tax 
would be paid on its dividend distributions (or payments of 
interest by it). A resident of a non-treaty country can, 
therefore, establish a corporation in the Antilles to 
directly engage in an active business in the United States, 
and avoid the 30 percent tax on dividends which would otherwise 
be imposed. The same result can be achieved under the 
Netherlands treaty by structuring the investment so that the 
stock of , the Netherlands company is held by an Antilles 
company. — 

e. Real estate investment . Another form of tax haven 
treaty investment in the United States is the use of a 
company formed in the treaty country to invest in United 
States real estate. The tax advantage of using a tax haven 
for real estate investment has been limited by recently 
enacted legislation. This legislation will override existing 
treaties, but not until 1985. A non-resident alien individual 
or foreign person not engaged in trade or business in the 
United States is taxable on the gross amount of rents from 
real property at the 30 percent or lower treaty rate. 

Before the new legislation is effective for treaty countries, 
gain from the sale of the property is not taxed. The 
investor could elect to tax the income on a "net basis" 
rather than a gross basis. The election applied to gain 
from the sale of the property, as well as to rental income 
from it. The election could not be revoked except with 
consent of the IRS. Under the United States-Antilles treaty, 
however, an individual or corporation resident in the 
Antilles could make an annual election to have the 

lA/ See §861(a) (1) (D) and §861 ( a ) ( 2 ) (B) providing 

that dividends and interest paid by corporations are 
united States source income. 

15 / The second withholding tax is also waived in United 

States treaties with Finland, Iceland, Korea, Luxembourg, 
Norway, Trinidad and Tobago, and the United Kingdom. 


income from United States real estate taxed on a net basis. 
Accordingly, a foreign investor who purchased real estate 
through an Antilles company would usually make the net 
election in the years he holds the property in order to be 
able to use the deductions generated by it. Then, in the 
year he wishes to sell, he could simply not elect to be 
taxed on a net basis and avoid Uhited States capital gain 
taxes on any gain realized on the sale. Furthermore, amounts 
could be paid on the property free of United States tax to 
the Antilles company or by the Antilles company to other 
foreign persons. The use of an Antilles company by non- 
residents of the Antilles to take advantage of this provision 
had become standard practice. 

f. Personal service companies — artists and athletes . The 
provider of an entertainment service enters into an employ- 
ment contract with a company formed in a tax haven. The 
contract generally provides that the artist will work exclusively 
for that company which will have the sole right to contract 
his services. In addition, the company has the right to the 
proceeds from the sale of artistic works, such as phono- 
graph records. The entertainer receives a fixed salary from 
the company. The company then enters into a contract with a 
promoter who arranges a United States tour for the entertainer. 
The entertainer takes the position that the income from the 
tour is income of the company. The company does not have a 
fixed place of business in the United States and therefore 
there is no United States tax. The entertainer's salary may 
not be taxed because of the operation of a treaty. Further, 
the proceeds from the sale of the phonograph records will be 
paid to the tax haven company, and the zero treaty rate of 
tax on royalties will be claimed. In some cases, the IRS may 
argue that the entertainer has a permanent establishment in 
the United States, that the profits from the sale of the 
record are effectively connected with it, and that they are 
therefore subject to United States tax. 

Under Article 17 of the new United States-Uhited Kingdom 
treaty and under the United States Model, the income from 
the performance of the services would be subject to United 
States tax. However, in most cases the expenses related to 
a tour are high and thus taxable income is low. The real 
purpose of the tours is often to promote records, and the 
income from the sales of records can be high. The payments, 
however, may be exempt from tax as royalties. They will not 
be taxed in the tax haven. 

2. Analysis of Third Country Use 

The problem created by treaties are third country use, 
or treaty shopping, and administration of the treaties. 


Successful treaty shopping generally consists of three 
elements: (1) a reduction of source country taxation; (2) a 
low or zero effective rate of tax in the payee treaty country; 
and (3) a low or zero rate of tax on payments from the 
payee treaty country to the taxpayer. Many of these elements 
exist with respect to non-tax haven treaties as well as tax 
haven treaties. For example, some non-tax haven countries 
with which we have treaties do not impose a withholding tax 
on payments of interest or dividends, and accordingly can 
be used as the Netherlands or the Antilles is used. 

The first element is provided by the treaty reduction 
of United States tax on United States source fixed or determinable 
income, by the limitation on business income subject to tax, 
and by certain exemptions from tax for capital gains and 
transportation income. 

The second element is provided by a tax haven which may 
impose a low rate of tax on income of "residents", or which 
may provide a special tax regime for holding companies. It 
is also provided by a back-to-back pattern in which the 
amounts received by the company in the treaty country are paid 
out in a deductible form. 

The third element is provided by tax havens, by some 
non-tax havens which do not tax distributions, and by 
treaties between the payee country and third countries. It 
is also provided by United States treaties which eliminate 
the second withholding tax imposed by the United States. 

The above cases, as well as IRS data, indicate significant 
third country use of United States treaties. The data 
indicate that our treaties are a substantial funnel for 
foreign investment in the United States, particularly through 
tax haven countries with whom we have treaties. 

The tax burden on a third country treaty user can be 
less than that on a non-user, a United States investor or a 
resident of the treaty country. This is because in most 
cases the United States investor will pay a United States tax 
on his return on investment, and the true resident of a 
treaty country will pay tax to his home country, while in 
the case of a third country user who is avoiding his home 
country tax or whose home country does not impose a tax, no 
tax will be paid. 

Accordingly, our tax haven treaties probably do place United 
States businesses in a competitive position to attract 
foreign capital. As the above transactions demonstrate, 
however, this incentive is often accomplished at the expense 
of simplicity and overall equity, by economic structures and 


business transactions which cannot be justified on business 
grounds. In addition, a substantial part of the investment 
through tax haven treaties may not be incremental at all. 
It may merely be shifted to the most favorable structure 
from a tax planning point of view. 

In relying on treaties with tax havens to encourage 
foreign investment in the United States we also encourage 
the use of transactions which have little or no economic 
substance. This, in turn, has a negative effect on the 
taxpayer's respect for the system. For example, a Netherlands 
holding company that licenses patents to United States 
persons, or a Barbados international business corporation 
which invests in U.S. securities, have little business 
purpose other than utilization of the treaties (and perhaps 
avoiding local exchange controls). While the United States 
arguably benefits in some way by the investment, it does so 
at the cost of allowing taxpayers to play fast and loose 
with the system, with adverse consequences for overall tax 

The first inquiry therefore is whether, in fact, we 
wish to curtail some or all of the above described transactions. 
Such a decision requires basic policy analysis and decisions 
which are beyond the scope of this report. However, it 
should be pointed out that much of what we say we are doing 
through treaty policy, that is, encouraging inward invest- 
ment, could be done unilaterally through the Code. What 
would be lost would be the reciprocal benefits which we can 
negotiate; what would be gained would be a clearer, more 
rational tax system. Also, the existence of treaty shopping 
potential discounts the value of high withholding taxes as a 
bargaining chip in treaty negotiations. As long as the 
treaty shopping potential exists, there is less pressure on 
other treaty countries whose residents invest in the United 
States through treaty countries to negotiate with the United 

D. Use of Treaty Network by Earners of Illegal Income or 
for Evasion of Lftiited States Tax 

It is not possible to determine the extent of use of 
the United States treaty network by earners of illegal 
income, or by persons who have moved money from the United 
States for tax evasion purposes. There is, however, evidence 
of such use. 

Treaty oriented tax evasion includes: (a) recycling 
funds earned (legally or illegally) in the U.S. or abroad 
back into the United States through a treaty country after 
it has first been laundered in a non-treaty tax haven jurisdiction; 
(b) fraudulent use by United States persons to remove income 
from the United States at reduced rates of tax by masquerading 
as foreign taxpayers; and (c) fraudulent use by foreigners 
to obtain benefits of treaty rates. 


1 . Methods of Use 

A United States person who has earned illegal income 
from, for example, narcotics trafficking, might carry that 
income in cash to the Cayman Islands. In the Caymans, the 
money would be placed in a trust account with a small private 
bank. Those funds could then be used to capitalize an 
Antilles bearer share company. The Antilles company could 
in turn invest in United States real estate, taking advantage 
of the treaty benefits. Because of the exchange of information 
provision in the Antilles treaty, it is unlikely that the 
money would be carried directly to the Antilles. However, 
the Antilles government cannot determine who the true owner 
of an Antilles bearer share company is, nor could it determine 
the true owner of any other Antilles company if its shares 
are held by a nominee located in a second tax haven jurisdiction. 

Fraudulent use of treaties by Unite-3 States persons to 
remove passive income from the United States could be accomplished 
by forming a corporation in a non-treaty country, having 
that corporation in turn establish a second corporation in a 
treaty country, and then running passive income (such as 
royalties) from the United States to the treaty country and 
through it to the second country. Under the treaty, the 
payment would be taxed at a reduced rate by the United 
States. Because the second company may be in a haven or a 
commercial secrecy jurisdiction, the true owners remain 
anonymous . 

This latter case has allegedly arisen under the Antilles 
treaty. Under that treaty, an Antilles corporation owned by 
a Dutch corporation is entitled to receive royalties free of 
United States tax. The United States payee can pay the 
royalties, without withholding, jjf certification of Dutch 
ownership by the Antilles government is provided by the 
Antilles company. (Certification is indicated on a "VS-4" 
certificate.) The Antilles government does little checking 
to see who owns the Netherlands company. They also do not 
check, in all cases, to see whether the Antilles company is 
filing a tax return. Because the VS-4 is good for three 
years, three years can go by before anybody realizes that 
the Antilles company is not paying tax. By that time„ 
whatever fraud was planned may have been completed. — ' 

16 / Where the Antilles entity is not owned by a Dutch 

resident, certification of entitlement to treaty bene- 
fits is given by a VS-3 which is good for only one year. 
Similar problems have apparently arisen for payments 
covered by a VS-3. 


Another fraudulent use of treaties by foreigners has 
allegedly arisen under the Antilles treaty. That treaty 
provides for a zero rate of tax on interest payments from 
the United States to an Antilles resident who does not take 
advantage of the special low rate of tax accorded Antilles 
investment companies. A third country resident wishing to 
lend funds into the United States can establish an Antilles 
company, capitalize it, and have the company lend the money 
into the United States. The interest payments from the United 
States to the Antilles company are free of United States tax. 
If, however, the interest is paid to the controlling shareholders 
of the Antilles company, the Antilles company may not be 
permitted to deduct that interest. Accordingly, the regular 
corporate rate (30 percent) will be applied to the interest 
received . 

To avoid this tax, and the necessity of establishing an 
Antilles company, a foreigner can deposit, in an Antilles 
bank, an amount equal to the amount of the loan he wishes to 
make. The Antilles bank then lends the proceeds to the United 
States person. The Antilles bank will receive interest from 
the United States person, subject to the zero rate of tax 
under the treaty. The interest, and eventually the principal, 
are then remitted to the nonresident, with the bank retaining 
a small fee. 

Under this scheme, the bank would insist upon security 
for the loan, which would be documents signed by the foreign 
person. This scheme is fraudulent because, if the IRS agent 
knew all of the facts (the existence of some kind of security 
agreement between the nonresident and the bank), the loan 
would clearly be considered a direct loan by the foreign 
person to the United States person, which does not qualify 
under the treaty because the foreign person is not a resident 
of the Antilles. 

At times, back-to-back arrangements might also be 
considered fraudulent. For example, the use of a Dutch 
holding company to sublicense patents into the United States 
would be tax fraud if the recipient of royalties paid by the 
Dutch company did not pay the United States tax on those 
royalties known to be subject to United States tax. 

2. Analysis of Illegal Use 

As in any other case of tax fraud, the problems in 
dealing with fraudulent use of treaties are of detection, 
investigative techniques, and the ability to gather evidence 
which can be used in a criminal prosecution. The schemes 
described above depend, to a large extent, on the anonymity 


afforded by a tax haven country. For example, the use of an 
Antilles bearer share company makes it difficult to identify 
the true owners of the company. Likewise, bank secrecy 
policies make it difficult to identify the relationship of a 
bank depositor and a bank loan. Layering of entities in 
treaty and non-treaty countries makes detection even more 
difficult. As in many other areas, complexity plus information 
gathering difficulties makes it hard to identify the improper 
or fraudulent transactions. 

E. Administration of Tax Treaty Network 

Treaty issues involving foreign investment in the United 
States and treaty issues involving foreign persons doing 
business in the United States are generally under the jurisdiction 
of the IRS Office of International Operations (010). Treaty 
issues involving United States investment overseas are under 
the jurisdiction of the Examination Division, and are most 
often addressed by agents in its International Examination 

Procedural treaty matters such as exchanges of information 
and competent authority cases are generally handled by 010. 
Certain exchanges of information pursuant to the simultaneous 
examination program, and spontaneous exchanges of information, 
are handled by the Examination Division. Tax treaties are 
negotiated by the Office of the Assistant Secretary of the 
Treasury for Tax Policy, specifically the Office of International 
Tax Affairs. That Office also gives policy guidance in the 
interpretation of the treaties. 

Tax haven treaty issues most often involve the question 
of whether a payment of passive income to a tax haven qualifies 
for an exemption or reduced rate of tax under a treaty. One 
of the most important administrative tools available to the 
IRS is the withholding of tax on payments to foreigners. — ' 
Present regulations require withholding of the statutory 30 
percent tax on United States source, gcoss income when the 
income is paid to a foreign person. — ^ An "address" system 
is used for dividend income under which withholding is 
at the reduced treaty rate, if the address of the dividend 
recipient is in a treaty country. With respect to other 
income, a self-certification system is in effect under which 

\1_/ §§1441 and 1442. 

18/ Treas. Reg. §1.1441-1. 


the recipient of the income can claim a treaty reduction or 
exemption by filing a Form 1001 with the withholding agent. 
Once claimed, an exemption is valid for three years. Under 
this system, a foreign trustee or an officer of a corporation 
resident in a treaty country can file the Form 1001 and 
achieve the treaty reduction. The withholding agent is 
under no obligation to look behind the claim and the IRS is 
not notified of the claim before payments are made. Accordingly, 
there is no practical opportunity for the IRS to determine 
qualification for exemption before a payment is made. 

For example, a Dutch company licenses a patent to a 
United States manufacturer. The Dutch company supplies the 
manufacturer with a Form 1001 claiming the benefits of the 
United States-Netherlands income tax convention, which 
provides that industrial royalties paid to a Dutch resident 
are exempt from the 30 percent Uhited States tax. The IRS 
may, however, wish to independently determine whether the 
Dutch company is entitled to the exemption. For example, 
the IRS may wish to determine whether the Dutch company is, 
in reality, an agent of a resident of a third country, or if 
the Dutch company itself is paying out the royalties to a 
resident of a non-treaty country, in which case the royalties 
are United States source income and subject to tax by the 
United States. To make these determinations, the IRS would 
want the records of the Dutch company to determine whether 
it is the effective owner of the patent. IRS may wish to 
know the owners of the company, and it may wish to know 
whether the Dutch company is making payments (such as interest) 
in lieu of royalty payments. Much of this information could 
be obtained under the exchange of information provision of 
the treaty, but this takes time. In addition, the information 
sought might be protected by the secrecy laws of the treaty 
partners. If some of the information is not available, then 
it may be necessary to audit the books of the company or 
talk to its personnel. All of this is time consuming, and 
some tax havens might not permit it. Furthermore, by the 
time the IRS can gather the necessary facts, all of the 
income may have been paid out; the tax may have become un- 

Effective administration of tax treaties and the anti- 
abuse provisions contained in them are limited for at least 
three reasons. First, because effective administration 
depends upon the full and willing cooperation of the treaty 
partner's tax administration. This involves a commitment of 
their resources and the availability of the necessary 


The anti-abuse provisions of the treaty operate when a 
nonresident of a treaty country seeks to take improper 
advantage of the treaty, usually through a holding company 
or a trust or nominee account in the treaty country. Information 
as to ownership of an entity and the residence of the owner 
is in the hands of persons within the jurisdiction of the 
treaty partner. Therefore, any application of the anti- 
abuse rules requires an inquiry by the tax administrators 
of the treaty partner into the residence of the owners of 
the entity. The IRS can do very little to adequately administer 
these provisions without the full cooperation of the treaty 

For example, the holding company anti-abuse rules in 
the proposed Cyprus treaty apply to deny certain benefits if 
a Cyprus company is owned "directly or indirectly" by non- 
residents of Cyprus. The only way the IRS can tell whether 
a Cyprus company is owned by non-residents is by being able 
to look behind any required documentation. If the stock is 
owned by a Cypriot individual, the only way to determine if 
he is the true owner, rather than a nominee, is to investigate 
him, which may involve interviewing him. The IRS does not 
have the resources to conduct this kind of examination on a 
wide scale, nor can we expect our treaty partners to permit 

It is not clear that most of our present or prospective 
tax haven treaty partners have the resources or expertise to 
make the inquiries on a regular basis. Many promote themselves 
as tax havens, and it may not be in the best interest of the 
tax haven to vigorously administer the anti-abuse provisions. 

Second, proper administration of the treaties depends, 
to a great extent, on a meaningful exchange of information, 
which in turn depends upon the scope of the information 
which can be provided under the exchange of information 
article. The articles in the existing tax haven treaties do 
not override local commercial secrecy laws or customs. They 
also do not obligate our tax haven treaty partner to obtain 
any more for the United States then they obtain for themselves. 
Accordingly, the IRS cannot always expect to get the information 
needed to determine whether third country residents are 
improperly using the treaties. In the existing Model treaty, 
the exchange of information article does follow the OECD 
article, and we can anticipate negotiation problems if we 
deviate from it. Nevertheless, the article does contain 
gaps when dealing with a jurisdiction which has commercial 


Third, administration at a level which can prevent 
abuse of the treaty would require a much greater committment 
of resources than are presently available. The IRS has 
limited resources which it can devote to administering tax 
treaties. In 1979 only about 75 Form 1042's (the form which 
must be filed by a United States person making a payment to 
a foreign person) were audited. Despite a growing treaty 
network, the Congress has not made available additional 
resources necessary to administer the treaties. The IRS 
simply is not in a position to audit tax haven holding or 
insurance companies claiming treaty benefits to determine if 
they are eligible for those benefits. 

Furthermore, there are practical limitations. Effective 
administration of anti-abuse provisions most likely involves 
auditing tax haven entitites. This infringes on the sovereignty 
of the tax haven. It is unlikely that a tax haven would 
permit any large scale activity of this kind. 

IRS rulings policy has not always kept up with developments 
in the use of tax haven treaties. IRS rulings show an 
inconsistent policy toward treaty shopping, which reflects 
equally inconsistent Treasury and Congressional policies. 

The IRS has attempted to deal with some of the most 
obvious abuse cases while at the same time permit ing_some 
treaty shopping. For example. Revenue Ruling 79-65 — held 
that dividends paid by a United States subsidiary to its 
Netherlands Antilles parent company were not eligible for 
the five percent withholding rate provided by the United States- 
Antilles treaty, because the United States subsidiary had 
not provided the information, when requested by the IRS, to 
establish that the relationship between it and its Antilles 
parent was not "arranged or maintained" primarily to secure 
the five percent rate. The sole shareholder of the Antilles 
company was an individual who was not a United States person, 
or a citizen or resident of the Netherlands, the Antilles, 
or any other country having a treaty with the United States. 

While the ruling denies the five percent rate, it does 
so under the "arranged or maintained" language in the treaty 
(which is not in the United States Model and is found only 
in a few of our older treaties), and indicates that the dividend 
may qualify for the 15 percent rate allowed under the treaty 
if the recipient is a resident of or a corporation of the 
Antilles. Even the 15 percent rate places a pr^gium on 
treaty shopping. See also Revenue Ruling 75-23 — ''^ and 

19/ 1979-1 C.B. 458. 
20/ 1975-1 C.B. 290. 


Revenue Ruling 75-118 — ' which indicate approval of the use 

of the Antilles and the Netherlands, respectively, by persons 

who are not resident in either country. 

The United Kingdom treaty extensions (the BVI , etc.) 
provide for a 15 percent rate of United States tax on dividends 
derived from a United States corporation by a resident of a 
former United Kingdom territory who is subject to tax by 
that former territory on the dividend. The rate is five percent 
if the corporate parent controls 95 percent of the voting 
power of the payor, and if the passive income limitation is 
met. The reduction to five percent does not apply "if the 
relationship of the two corporations has been arranged or is 
maintained primarily with the intention of securing such a 
reduced rate." — ^ The dividend article contains a provision 
permitting either party to terminate the article under 
notice to the other party. 

The "arranged or maintained" language in the context of 
the United Kingdom extensions has not been interpreted. 
There are no published IRS positions, and the issues do not 
seem to have been raised on audit. 

Another problem in tax treaty administration is the 
lack of adequate coordination between Treasury's Office of 
International Tax Counsel (ITC) and IRS, and lack of coor- 
dination with the Tax Division of the Department of Justice 
(Tax Division) on exchange of information problems. Today, 
coordination appears to be on an ad hoc basis. Only if ITC 
has a problem, do they coordinate. As a result, it is 
possible that inadequate attention is given to tax administration 
concerns in formulating treaty policy. 

F. Options for Tax Haven Treaties 

Tax haven treaties present special problems because the 
combination of low rates of tax imposed by the other country 
and the reduction in United States tax rates by reason of 
the treaty attracts third country residents to use the 
treaty to invest in the United States. Accordingly, when 
attempting to deal with tax haven treaty problems, we are 
attempting to limit treaty shopping. This could be done by 
administrative, legislative, or treaty policy changes. The 
best approach, of course, is not to have treaties with tax 
havens. Other factors, however, often make that goal unattainable, 

21/ 1975-1 C.B. 390. 

2 2 / Article VI United States-United Kingdom Income Tax 

Convention of July 25, 1946, as extended to the United 
Kingdom territories. 


1. Administrative Options 

Many of the investment patterns described above are 
permitted by the literal language of the treaties. There 
are, however, some which are not, and administrative actions 
might be taken which might help in dealing with some of the 

Consideration should be given to the following options 
for curtailing tax haven treaty abuse. 

a. Refund system of withholding . The present system 
of withholding could be changed to a refund system. Many of 
the schemes involve the use of a treaty to obtain a reduced 
rate of tax at source. In order to qualify, all that the 
foreign taxpayer need do is submit a form or letter to the 
withholding agent once every three years. 

Under a full refund system, withholding would be at 
the statutory rate, and the reduced rates accorded by the 
treaties would be available only upon application for a 
refund by the affected foreign investor. The application 
would include a certification from the treaty partner that 
the investor is entitled to the benefits of the treaty. The 
United States certifies for Belgium, France, Luxembourg, and 
the United Kingdom. A refund system would at least force 
the foreign investor to submit a claim with the government, 
which could in itself curtail some of the more abusive use. 
It would also give the IRS a better opportunity to identify 
cases for audit. 

A refund system, however, can be expensive to administer. 
Moreover, those who can afford competent tax advice can 
often get around it. It can be argued that what is created 
is really just a loan to the united States Government without 
any meaningful reduction in abuse. 

As an alternative, a "certification system" could be 
adopted under which withholding would be at the statutory 
rate, unless the investor submitted a certification from the 
treaty partner that he was entitled to the reduced treaty 
rate. A combination of the two is also possible. Under 
this system, withholding would be at the statutory rate for 
the first year in which a payment is made. The investor 
would then file for a refund and include a certification of 
eligibility from the treaty partner. Thereafter (or for a 
fixed period of years), withholding would be at the reduced 
treaty rate. 


b. Increase audit coverage of treaty issues . Consideration 
should be given to expanding the audit coverage of foreign 
investors claiming treaty benefits. One possibility is to 

use the tables which list the tax haven payees who receive 
income (the 1042 tables) in an attempt to identify quality 
cases . 

Clearer directions could be given to examining agents 
in the finance company area, and better training in the 
treaty area could be provided. There is an ambivalence in 
the law and in IRS rulings policy which in the past has 
been reflected in agents generally not auditing many finance 
company cases. Some agents appear to avoid finance 
subsidiary issues on the theory that they had subpart F 
income in any event. This analysis shows a need for better 
understanding of the treaty issues involved. The IRS 
should develop a clear policy toward finance subsidiaries, 
and make that policy known to the examining agents. 

c. Periodic review of treaties . Treasury should 
consider subjecting treaties to a regular periodic review. 
Jurisdictions that have treaties in effect that are abused, 
or are not in the best interest of the United States, would 
be notified of termination. Priority renegotiation would 
then be instituted. In this way, the pressure to renegotiate 
would be placed on the treaty partner. Congress might pass 
legislation requiring that results of this review be made 
available to the public and subject to Congressional scrutiny. 

In order to facilitate this option, a change could be 
made in the termination clauses of the treaties. Under most 
of the existing treaties, notice of termination must be 
given at least 6 months before the termination date. The 
treaty then terminates as of the first day of January next 
following the expiration of the 6 month period. Accordingly, 
the Treasury would have at most one year to negotiate a 
treaty and have it approved by the Senate. This is not 
enough time. This problem could be solved by making it 
clear that the notice of termination can be effective the 
first of a designated January which is at least 6 months in 
the future. Thus, more than one year could be allowed for 
renegotiation, but with a fixed termination date. 

Adoption of this option would require that additional 
resources be made available to the Treasury. 

d. Exchange of information article overriding bank 
secrecy . The exchange of information article in U.S. tax 
treaties with tax havens could be strengthened to override 
local bank and commercial secrecy. This issue and a possible 
approach is discussed in Chapter IX. 


e . Improve the quality of routine information received . 
Attempts should be made to improve the quality of the 
information which we get from our tax haven treaty partners. 
In many cases, the information which we receive from our 
treaty partners is not in usable form. Often, details 
necessary to identify a United States taxpayer receiving 
income are not available. This makes it difficult to identify 
United States persons who may be receiving income from a tax 
haven and not reporting it. Furthermore, the IRS does not 
get information which is useful in dealing with treaty 
shopping. Moreover, the exchange of information articles in 
the treaties do not override bank secrecy, which means that 
important information is often not available. 

f. Rulings . IRS rulings policy has at times appeared 
ambivalent with respect to the use of tax haven treaties by 
treaty shoppers. At times taxpayers get the impression that 
the IRS condones such use. To dispel this impression, the 
IRS could attempt to challenge the back-to-back royalty 
situation, by taking the position that amounts paid by a 
corporation in a treaty country are United States source 
income and are not exempted by the language of the treaty. 
For example, as described above, patents may be licenses 
into the United States through a company established in the 
Netherlands. The United States-Netherlands treaty provides 
that royalties paid to a corporation of one of the contracting 
countries are exempt from tax by the other contracting 

country. Accordingly, royalties paid by the United States licensee 
to the Netherlands company are exempt. The IRS could argue, 
however, that royalties paid by the Netherlands company to a 
third country national are royalties for the use of a patent 
in the-United States and accordingly are United States source 
income—''^, and that the Netherlands company is a withholding 
agent required to withhold the United States tax of 30 
percent of the gross amount paid. While it would be difficult 
for the IRS to enforce the withholding obligation of the 
Dutch company, the payments to the Dutch company could be 
attached . 

The IRS could also publish a ruling stating that any 
United States investment through a former United Kingdom territory 
will be closely scrutinized, with a view toward determining 
whether the "arranged or maintained" language is applicable 
to deny the five percent rate. A procedure could be adopted 
under which the reduced rate will not be granted, unless a 
prior ruling is obtained that the arrangement between a United 
States corporation and a corporation resident in the treaty 
partner has not been and will not be aranged primarily with 
the intention of securing the reduced rate. 

23/ See §861(a) (4) . 


g. Coordination with ITC . ITC should consider coord- 
inating with IRS and the Tax Division on a more regular 
basis when formulating treaty policy. This would enable ITC 
to be better aware of the administrative and law enforcement 
problems faced by the administrators who will have to deal 
with the treaties. It might also give tax administration 
considerations more weight in formulating treaty policy. 
Efforts to improve coordination -within the IRS would make 
coordination with ITC easier. — ^ 

2. Changes in Treaty Policy 

The options set forth below are intended to apply to 
treaties with tax havens, and are intended to help limit the 
use of tax haven treaties by third country residents. It is 
this use of treaties by third country residents which creates 
whatever problems are caused by treaties. 

a. Treaty network . The most direct attack on tax 
haven treaty problems would be not to have treaties with tax 
havens. Solely from a tax administration perspective, the 
United States should not have standard treaties with tax 

The United States should consider terminating its 
existing tax haven treaties, particularly those with the 
Netherlands Antilles and the former United Kingdom territories. 
The United Kingdom extensions are an affront to sound tax 
administration, existing only to be abused. The Antilles 
treaty has also been regularly abused. The IRS has not had 
much success in enforcing the anti-abuse rules. 

It is recognized that for non-tax considerations, it may 
be necessary to enter into tax treaties with tax havens. 
Such treaties should be as limited as possible, and should 
focus on the specific policy objectives for negotiating the 
treaty. They should contain a strong exchange of infor- „j. , 
mation provision which overrides secrecy laws and practices. — ' 

In order to prevent some of the smaller Western Hemis- 
phere jurisdictions (and perhaps jurisdictions in other 
areas) from becoming aggressive tax havens, we might con- 
sider entering into limited income tax treaties with them. 
These treaties could provide for competent autority procedures 
to deal with transfer pricing and allocation problems. They 

24 / See discussion in Chapter X, supra. 

2 5 / See Chapter IX for suggested model exchange of information 


could contain a non-discrimination provision. They should 
also contain a strong exchange of information provision, 
similar to that discussed in Chapter IX. They might also 
obligate the LMited States to provide technical assistance 
for tax administration. Further, the termination Article should 
contain a provision providing that either party can terminate 
the treaty, if either determines that the other party is not 
able to administer the anti-abuse provisions of the treaty 
or is not meeting its obligations under the treaty. 

b. Source country taxation . Present treaty policy, 
which is consistent with the OECD approach, is to give 
primacy to tax to the country of residence of the earner of 
income, except in the case of business income and income 
from real property. Even in the case of business income, 

the treaty approach is more restrictive of the source country's 
jurisdiction than is the Internal Revenue Code. This policy 
should be reconsidered with respect to tax havens or juris- 
dictions which have the potential to become tax havens. 

One solution to the tax haven treaty shopping problem, 
which is reflected generally in the approach of the developing 
countries — ' , would be to adopt a policy of giving the 
source country the primary right to tax income. The reductions 
in tax on the gross amount of passive income (dividends, 
interest and royalties) would be limited, some significant 
United States tax on the investments would be preserved, and 
the incentive to shop for the best possible return would be 
limited. Further, the categories of income considered to be 
business profits could be restricted, and more categories 
could be subjected to gross tax. 

c. Anti-holding company or anti-conduit approaches. 
Article 16 of the united States Model and similar provisions 
in a number of existing treaties attempt to limit the use 

of the treaties by third country residents through an investment 
or holding company. There are also other anti-abuse provisions 
contained in the treaties. These provisions do not appear 
to be effective in preventing treaty abuse. 

One or more of the following approaches could be adopted 
to deal with tax haven treaty shopping, the goal being to 
eliminate third country use of these treaties. In general, 
treaties with countries that are or that have particular 
potential to become tax havens should contain as many useful 
anti-avoidance provisions as possible. 

26 / Manual for the Negotiation of Bilateral Tax Treaties 
Between Developed and Developing Countries , United 
Nations Publication ST/ESA/94 (1979), discussion of 
interest guidelines at 66-73. 


(i) Article 16 of the Model could be expanded to con- 
form to the proposed Cyprus treaty — ' , to deny reduced rates 
of tax in the case of payments to a company (1) that is 
owned 25 percent or more by non-residents of the treaty 
partner, or (2) whose income is subject to tax in the other 
state at a rate substantially less than the normally applicable 
corporate rate. In dealing with potential tax havens, this 
approach would be an improvement over the existing provision. 
It does, however, contain the same administrative difficulties. 

(ii) Article 16 could be expanded to deny treaty benefits 
to a company if more than a stated percentage of its gross 
income is passive income. A payment to a holding company 
would not be eligible for reduced withholding taxes, regard- 
less of the ownership or tax burden borne by that company in 
the home country. In the alternative, the passive income 
test could be combined with the ownership test in (i) above, 
or with the ownership and reduced rates of tax test. The 
reduced rates of tax would be denied to a company which 
receives a substantial amount of passive income, and which 
is subject to a reduced rate of tax in the home country, 
even though it is owned exclusively by residents of the 
treaty country. 

(iii) The holding company test could be abandoned in 
favor of a more direct approach. For example, the reduced 
rate of tax on interest could be denied with respect to a 
debt obligation that is created or assigned mainly for the 
purpose of taking advantage of the reduced rate of tax, and 
not for bona fide commercial reasons. A similar provision 
for royalties could be included, under which the reduced 
rate of tax would not be available if the right or property 
giving rise to the royalty was created or assigned mainly 
for the purpose of taking advantage of the reduced rate of 
tax, and not for bona fide commercial reasons. — ' 

d . Expansion of anti-abuse provisions to active business . 
The Article 16 approach could be expanded to cover all 
treaty rules. Article 16, and most anti-treaty shopping 
provisions, apply to dividends, interest and royalties. 
They do not apply to a corporation established by a third 

27/ Article 26. 

28 / See Articles 12 and 13 of the Netherlands-United Kingdom 
Income Tax Treaty, as amended by protocol entering 
into force on October 19, 1977. 


country resident to conduct an active business in the United 
States. Accordingly, a third country resident wishing to 
conduct an active business in the United States can form a 
resident corporation in a treaty country, and take advantage 
of the benefits accorded by the permanent establishment 
rules and any other benefits given by the convention. This 
use of treaties could be curtailed by extending the anti- 
holding company rules to all activity carried on by a corporation 
owned by third-country residents. 

e. Second withholding tax . The second withholding tax 
should not be waived when the treaty partner does not impose 
a tax on payments out. The waiver of the United States tax 
imposed upon payment of dividends and interest by a foreign 
corporation is an important element in successful treaty 
shopping. This waiver permits the income to be paid from 
the treaty country to the owner of the income free of tax. 
By insisting on retaining the second withholding tax, this 
element is removed. See 3.c. below for a legislative suggestion 
dealing with replacing the second withholding tax with a 
branch profits tax. 

f. The insurance premium exemption . The United States 
imposes an excise tax on insurance or reinsurance premiums 
paid to foreign insurers. — ' The rate is four percent of 
the premium, or one percent in the case of reinsurance. The 
United States-United Kingdom treaty gives up the tax on 
payments of or reinsurance premiums to a United Kingdom 
enterprise . — 

The exemption has allegedly been abused, and some of 
the premiums may be flowing through insurance companies 
resident in a treaty partner (particularly in the United Kingdom) 
to insurance companies or reinsurers located in tax havens 
such as Bermuda. In some cases, the tax haven company may 
be owned by the United States company, but this relationship 
is hidden. Further, if the foreign company is not paying a 
significant rate of tax in its real country of residence, it 
has a competitive advantage over United States insurers. 
While, in theory, a tax is due when the treaty country 
insurer lays off the risk to a foreign company, in fact, any 
procedures to collect such a tax would be unenforceable. 

29/ §4371. 

30/ Article 7 (6A) . 


(i) The broad exemption from the excise tax imposed on 
insurance or reinsurance premiums paid to foreign insurance 
companies could be eliminated. 

(ii) The IRS could adopt, generally, the position taken 
in the French protocol, under which the exemption is applicable 
only "to the extent that the foreign insurer does not reinsure 
such risks with a person not entitled to .exemption from such 
tax under this or another convention." — ' This approach has 
the administrative problems of any anti-treaty abuse pro- 
vision: dependence upon our treaty partner to enforce a 
provision it may be unable to enforce or which it may have 
no interest in enforcing. An additional administrative 
problem is that, generally, pools of risk, not single risks, 
are reinsured. This makes any anti-abuse provision difficult 
to administer, even with a fully cooperative treaty partner. 
The taxpayer could be put to his burden of proof that the 
premiums were not passed through, if problems are suspected. 

g. Personal service companies — artists and athletes . 
The United States Model contains an article which deals with 
the so-called lend-a-star problem, by permitting the country 
in which services are performed by an artist or an athlete 
to tax the income from performance of the services where the 
income in respect of the service accrued to another. — ' The 
model provision is based on Article 17 of the L&iited Kingdom 

As explained above, the provision does not deal clearly 
with amounts paid for works created by the artist. The real 
problem with taxing the income from record sales, for example, 
is defining what that income is, i.e., income from the 
performance of services or royalties. If the income is 
service income then arguably it should be taxed where the .,_ . 
services are performed, which is where the record is recorded. — ' 
If the compensation is royalty income the result may be 
different. This conflict could be handled in the treaties 
by further defining what the income is and how it will be 
taxed. In the alternative, it could be dealt with by amending 
the Code to establish clear source rules. 

— Art. 1(a) united States-France Income Tax Convention. 


— ' United States Model, Art. 17. 


=-^' See Ingram v. Bowers , 47 F. 2d 925 (S.D.N.Y. 1931); 

aff'd, 57 F. 2d 65 (2d Cir. 1932). 


An alternative is to treat the compensation from the 
use of any copyright of literary or artistic work as business 
profits, and attributable to a permanent establishment or 
fixed place of business in the country where entertainment 
activities are performed, if the royalties are earned 
within a fixed period of time after the artist has performed 
in the United States. Under this system, the amounts from 
the sale of the records would be taxed on a net basis when 
paid to the tax haven company. Another alternative is to 
clearly define the income as royalties, and not have a zero 
rate of tax on royalties, at least in tax haven treaties. 

3 . Legislative Approaches 

The best approach to dealing with treaty problems is to 
handle them through the negotiation process. Some of the 
problems can, in part, be dealt with through administrative 
changes. There are, however, some legislative options which 
should be considered for dealing with tax haven oriented 
treaty problems. As with any other treaty legislation 
directed at tax havens, a decision would have to be made 
whether any legislative approaches would apply generally, or 
would apply solely to tax haven transactions. 

a. Reduction of the rate of tax on fixed or determinable 
income. One possible approach is to reduce the 30 percent 
tax which the United States currently imposes on fixed or 
determinable income paid to foreigners. Many claim that our 
current rates are high. For example, when imposed on interest 
paid to a bank, they can exceed the net income of that bank. 
Treaties are the mechanism by which we bring our rates down 
to a more reasonable level. In lieu of the treaty approach, 
we could rationalize our rates of tax legislatively. If the 
rates are set at a rate which is higher than current treaty 
rates, the legislation could override the treaties, or, in 
the alternative, the legislation could provide a maximum 
rate with the treaties continuing to take precedence. 
Legislation to eliminate the tax on portfolio interest has 
been proposed, but to date the Congress has failed to act on 
that proposal. 

As an anti-haven measure, the present 30 percent 
statutory rate could be continued for payments to designated 
tax havens, or an even higher rate could be imposed. 


b. Anti-treaty abuse rule . Another possibility is to 
place an anti-treaty abuse provision in the Code. The Code 
could be amended to deny treaty benefits to a foreign person 
who is not a contemplated beneficiary of treaty benefits, or 
if a substantial part of the treaty relief benefits persons 
not entitled to the benefits of a convention. This provision 
would give the IRS the authority to deny treaty benefits in 
abusive cases which might come within the literal language 

of the treaties, but which were not anticipated by the 
treaty negotiators. The provisions could be drafted by 
simply referring to a person who is not a contemplated 
beneficiary, leaving the IRS with broad authority to develop 
guidelines. An objective standard could be included to deny 
treaty benefits in the case of payments to a foreign entity 
if (1) more than a fixed percentage of income for which the 
treaty benefit is claimed is paid to a person not entitled 
to the benefits of the treaty, (2) the income is not reported 
as taxable income to the treaty partner, or (3) the debt to 
equity ratio of the recipient company exceeds a designated 
level . 

In the alternative, or in addition, an anti-holding 
company provision similar to that contained in the United 
States Model or the more extensive provision contained in 
the proposed Cyprus treaty could be added to the Code. Such 
a provision might be applicable only with respect to designated 
tax havens. 

c. Branch profits tax . The second withholding tax 
problem may also be handled through legislation. As dis- 
cussed above, some countries, particularly tax havens, do 
not impose a tax on payments from their domestic corporations 
to non-residents of the tax haven. The United States, 
however, imposes a tax on dividends and interest of foreign 
corporations which earn a certain percentage of their income 
in the United States. Some treaties waive this second 
withholding tax, and even when not waived it can be difficult 
to collect because the withholding agent is the foreign 
corporation. An alternative, used by numerous countries, is 
to impose a branch profits tax on the income of a United 
States branch of a foreign corporation. Under this approach, 
a tax equal to the withholding tax imposed on fixed and 
determinable United States source income would be imposed on 
the branch when it remits income to its foreign office. 

This removes the collection problem and is a somewhat more 
rational system. This tax could be waived in appropriate 
treaties, but not in treaties with tax havens. 


Table 1 

U.S. Gross Income Pild to Nonresident Aliens 

and Foreign Corporations in Tax Havens and Other Jurisdictions 

Within and Without the U.S. Treaty Network, by Type of Income, 1978 

(In Thousamls of Dollars) 







All countries, total 





Treaty countries, total 





Tax haven treaty 

countries, total 




















British Virgin I 











Falkland Islands 

























Netherlands Antilles 





St. Chrlstopher- 






St. Lucia 





St. Vincent 















Non-tax haven trea 


countries, total 



































Finland , 














Germany, Federal 

Republic of 







































-^^Includes Norfolk Island and Papua New Guinea. 

— Includes French Guiana, Guadeloupe, Martinique and Reunion. 


U.S. Gross Income Paid fo Nonresident. Aliens 
and Foreign Corporations in Tax Haven and Other Jurisdictions 
Within and Without the U.S. Treaty Network, by Type of Income, 1978 

(In Thousands of Dollars) 

New Zealand- 

Sierra Leone 
South Africa 

Trinidad and Tobago 
United Kingdom 

Non-treaty countries, total 

Tax haven countries 
Non-tax haven countries 
















































































— Includes Cook Islands and Nlue. 

*Le8S than $500. 

Note: Detail may not add to totals due to rounding. 

Source: Statistics Division, Internal Revenue Service, unpublished tabulations on 
"Nonresident Alien Income and Tax Withheld as Reported on Forms 1042s" for 
Calendar Year 1978. 


Table 2 

U.S. Gross Income Paid to Nonresident Aliens 
and Foreign Corporations in Tax Haven Countries 
Within and Without the U.S. Treaty Network, 1978 

(Amounts in Million Dollars) 


Percent of 
all countries 

Treaty countries, total 



Tax havens 



Nontreaty countries, total 



Tax havens 



All countries, total 



Sura of components may not add to totals due to rounding. 

Source: Statistics Division, Internal Revenue Service, unpublished tab- 
ulations on "Nonresident Alien Income and Tax Withheld as Re- 
ported on Forms 1042s" for Calendar Year 1978. 

IX. Information Gathering 

The Secretary of the Treasury has broad authority to 
require taxpayers to file tax returns, and to keep records 
necessary to determine tax liability.— The Secretary is 
empowered to examine any books, papers, records, or other 
data that may be relevant, or material to verify the correctness 
of any return or to compute any tax liability.— The Secretary's 
powers, which are delegated to the IRS, and the IRS' ability 
to enforce them are essential to effective administration of 
the Internal Revenue Code. In the international sector, 
these powers frequently are insufficient for the task. 

International transactions in general, and tax haven- 
related transactions in particular, present special problems 
to the tax administrator. To begin with, U.S. tax laws 
governing international transactions are among the most 
complex in the Internal Revenue Code. In addition, the 
acquisition of information necessary to verify a return or 
establish tax liability where such transactions are involved 
is always difficult, often impossible. Investigative efforts 
are logistically complicated by distance or language differences. 
Such efforts are procedurally complicated by internal laws 
and practices of other sovereigns. The ultimate stumbling 
block is political--the U.S. investigative need often clashes 
with a foreign interest. When a tax haven is involved, 
conflicts with foreign laws and practices result in more 
than merely complex and time-consuming procedures. 

A, Reporting 

The foundation of the U.S. self-assessment system is 
the reporting of income and income-producing transactions by 
taxpayers. Reliance on taxpayer-supplied information applies 
to international as well as domestic transactions. In both 
areas, that reliance gives rise to the following questions: 
(1) What information should be reported? (2) Is IRS asking 
for it? (3) Is IRS asking for it in a manner that does not 
place an undue burden on the taxpayer? (4) Is IRS obtaining 
what it is asking for? (5) Is IRS using the information it 

1/ §6001. 
2/ §7602(1). 


1. IRS Forms 

The primary source of taxpayer -suppl led information is 
the IRS forms filed by taxpayers. Some forms are used to 
compute tax liability. Others report data or the occurence 
of certain transactions which do not necessarily reflect the 
reporter's tax liability. The IRS forms required of a U.S. 
taxpayer to report international transactions are as follows: 

Form 959 (acquisition or disposition of an interest 
in a foreign corporation); 

Forms 926 and 3520 (transfer of property to a 
foreign entity) ; 

Forms 958 and 2952 (transactions of a controlled 
foreign corporation); 

Form 3520-A (income of a foreign trust in which 
the taxpayer has an interest) ; 

Forms 957, 958, and 3646 (receipt of income from a 
foreign corporation); 

Forms 1042 and 1042S (payment of certain fixed or 
determinable income to a foreign person); 

Forms 1120NR (corporation) and 1040NR (individual) 
(receipt of U.S. income or foreign effectively connected 
income by a resident or non-resident foreign corporation, 
and a nonresident alien individual, respectively). 

The time and place for filing these forms vary. The 
time is often controlled by the event to be reported (e.g.. 
Form 959). Some are filed with the taxpayer's return (e.g.. 
Form 2952), others are filed separately but at the same 
service center where the taxpayer files his return (e.g.. 
Form 926), while still others are filed at the Philadelphia 
Service Center (e.g.. Form 957). 

a. Analysis 

Problems associated with reporting include: (1) inadequacy 
of the information requested from taxpayers, (2) poor quality 
of information supplied by taxpayers, (3) overlap among 
forms requesting information, (4) ambiguity in filing require- 
ments for these forms, and (5) IRS processing difficulties. 

With respect to the first problem, there are several 
significant reporting gaps. 


A U.S. person doing business overseas is not required 
to report the nature of his transactions. Thus, loans from 
foreign entities, a primary method of repatriating funds 
laundered through tax havens, need not be reported. As a 
result, the IRS is unable to identify returns where audit 
would be appropriate. 

In addition, there is a gap in the Form 959 filing 
requirements. Today, a Form 959 must be filed by certain 
U.S. persons with respect to an acquisition of stock in a 
foreign corporation if the acquisition results in a U.S. 
person owning five percent , or more of the value of the 
stock of the corporation.— Stock owned .directly or indirectly 
by a person will be taken into account.— The regulations 
provide for attribution of stock owned by a foreign corporation 
or a foreign partnership to its shareholders or partners.—^ 
They do not provide for attribution from a foreign trust. 

Accordingly, under the regulations, if a foreign trust 
for the benefit of a U.S. person acquires stock in a foreign 
corporation, the fact of that acquisition does not have to 
be reported. If the foreign trust which acquires the stock 
is a grantor trust with a U.S. grantor or is a §679 trust, 
then the grantor or U.S. person taxable under §679 as the 
owner of the property would have to file, because that 
person is considered to be the owner of the stock. This 
rule is not explicitly set forth in the regulations. 

A fiduciary of a foreign trust that has U.S. source 
income or that is engaged in a trade or business in the U.S. 
must file a Form 1040NR. However, the form does not require 
that the fiduciary identify the principal of the trust, 
specify whether the trust entity has a U.S. business, or 
clarify his relationship to the entity (i.e., trustee, 
nominee). As a result, information which the IRS might use 
to classify a return is not readily available. 

A U.S. beneficiary of a foreign trust which was established 
by a foreign person does not have to report his interest in 
the trust. As a result, it can be difficult for the IRS to 
identify income paid to such a person from the trust. 

3/ §6046. 

V §6046(c). 

5/ Treas. Reg. §1. 6046-1 ( i ) (1 ) . 


A U.S. partnership is required to report its income and 
deduction items on Form 1065, as well as each partner's 
distributive share of the partnership income and expenses on 
Schedule K of the form. The partnership advises each partner 
of his distributive share on Schedule K-1, which the partner 
then reports on his return. A foreign partnership has a 
duty to file Form 1065 only if it is engaged in a trade or 
business in the U.S. A U.S. partner in a foreign partnership 
not so engaged in business in the U.S. is required to report 
his distributive share of the income and deductible items of 
that partnership. However, because the partnership does not 
file a Form 1065, the IRS is without details regarding the 
nature of partnership income and deductions. As a result, 
it is difficult to identify partners of foreign partnerships 
for audit. 

A U.S. subsidiary of a foreign parent is required, as a 
U.S. corporation, to file a Form il20. It need not submit 
information concerning its foreign affiliates. Thus the 
U.S. subsidiary may engage in transactions with foreign 
affiliates v/ithout the IRS being aware of the relationship. 
As a result, the IRS may not scrutinize the arms-length 
nature of such transactions. 

With respect to the second problem, any number of 
factors (e.g., placement of questions on forms, clarity of 
questions, lack of follow-up by the IRS where responses are 
inadequate) come into play, all of which are correctible. 

With respect to the third problem, overlap among the 
forms certainly exists. Although Form 3646 is used to 
compute tax liability (income attributable to certain U.S. 
shareholders), and Form 2952 is an information return, both 
require much the same information. Lilcewise, Form 957 and 
958 often overlap and may overlap with Forms 2952 and 3646 
if the foreign corporation is both a foreign personal holding 
company and a controlled foreign corporation. Form 959 may 
also require information similar to that required on these 
other forms. To the extent that overlaping does not serve a 
useful tax administration purpose, it places an unnecessary 
burden on taxpayers. 

With respect to the fourth problem, the multiplicity of 
forms, and ambiguity in designating "who should file what", 
creates confusion. Not only is it difficult for individuals 
to know precisely what form they are supposed to be filing, 
it also appears that the IRS also has difficulty in determining 
the manner in which to deal with these forms, as discussed 


With respect to the fifth problem, some required IRS 
forms that are filed never get into the regular audit stream 
and, consequently, are rarely audited. Until recently, some 
required information returns (e.g., foreign trust forms) were 
neither associated with relevant individual or corporate 
income tax returns nor otherwise used.— '^ For example, Forms 

957 (United States Information Return by an Officer, Director, 
or U.S. Shareholder of a Foreign Personal Holding Company) 
and 958 (U.S. Annual Information Return by an Officer or 
Director of a Foreign Personal Holding Company) are filed 
with the Philadelphia Service Center, but not forwarded to 
the district offices. Thus they are rarely audited or 
associated with the U.S. taxpayer's return. In fact, during 
extensive field visits with international examiners, only 

one examiner was found who had audited a foreign personal 
holding company return. 

The IRS has taken steps to associate Forms 3520 and 
3520-A with the relevant income tax returns. The Philadelphia 
Service Center now posts the fact that a related 3520 or 
3520-A has been filed in the taxpayer's computerized tax 
file (module) in Martinsburg, West Virginia. The existence 
of a related 3520 or 3520-A will be noted on the return. 
Whether this will prove to be of value has yet to be deter- 
mined, since very few Forms 3520 and 3520-A are filed. 

b. Options 

For taxpayer-supplied information to remain a solid 
foundation of the U.S. self-assessment system where inter- 
national transactions are involved, change is required. 
The above analysis suggests a number of possibilities, both 
legislative and administrative. 

(i) One possibility is to streamline and improve 
existing forms by combining them into fewer forms. If no 
other action with respect to IRS forms is taken, the IRS 
should reevaluate all existing forms for reporting foreign- 
related items and, to the extent possible, combine them into 
a single clear and concise form. For example. Forms 957 and 

958 covering foreign personal holding companies, and Forms 2952 
and 3646 covering controlled foreign corporations, can be 
combined into a single form. The IRS has already prepared 
draft Form 5741 to replace the above-mentioned forms and 

%_/ GAO report, "Better Use of Currency and Foreign Accounts 
Report by Treasury and IRS Needed for Law Enforcement 
Purposes" (April 6, 1979). 


Form 958 as well. Prior to disseminating the draft form, it 
needs to be updated to reflect changes made to subpart F by 
the Tax Reduction Act of 1975, the Tax Reform Act of 1976, 
and the Revenue Act of 1978. In addition, it might be 
expanded to include the information currently combined on 
Form 959. At least two legislative changes are necessary. 
The filing date for Form 959 must be changed to require 
filing within a fixed period of time after the taxable year 
in which the reportable event took place, instead of within 
90 days after the event. Also, §6035 must be amended so 
that returns relating to a foreign personal holding company 
can be filed on an annual basis with the return of the U.S. 

(ii) As an alternative to option (i), the IRS could 
create a new all-encompassing IRS "international" form. 
IRS could devise one form to be filed by any taxpayer engaged 
in any international transaction or having any interest in a 
foreign account or entity. Taxpayers could be clearly and 
directly advised of the obligation to complete this form by 
a reference on Form 1040. 

(iii) Consideration should be given to imposing 
additional reporting requirements, such as, for example, 
the following: 

(a) Requiring an individual engaged in any international 
transaction to submit a balance sheet identifying assets 

held overseas. The requirement could be limited to individuals 
with total positive income above a certain level. 

(b) Requiring an individual engaged in any international 
transaction with a foreign entity to report that transaction 
(e.g., where a loan is obtained from a foreign entity, 
whether or not the taxpayer has an interest in or association 
with that entity). An exemption for transactions under a 
minimum amount (e.g., $1,000) might be appropriate. 

(c) Requiring a U.S. partner in a foreign partnership 
to report the income, deductions, and assets of the partner- 
ship in a form similar to that used by U.S. shareholders of 
a controlled foreign corporation. Where the partnership has 
more than one U.S. partner, permit one to report on behalf 
of the others, provided that each U.S. partner refers to 
ownership of the partnership interest on his individual 

(d) Amending Treasury Regulation §1 . 6046-1 ( i )( 1 ) to 
provide that for purposes of determining liability for 
filing a Form 959 stock owned directly or indirectly by a 


foreign trust will be considered as being owned proportionately 
by its beneficiaries or grantors. It should be made clear 
that a grantor or transferor to a foreign trust who is 
otherwise considered to be the owner of the stock of the 
foreign corporation will continue to have the obligation to 
file a Form 959 with respect to the acquisition of stock of 
a foreign corporation. 

(e) Placing an additional block on Form in40NR to be 
checked by a fiduciary of any foreign trust engaged in a 
trade or business in the United States. Further, the fiduciary 
should be required to clearly state the capacity in which he 

is acting as a fiduciary, and to list any U.S. beneficiaries 
of the entity. 

(f) Deleting the "ordinary course of a trade or busi- 
ness" exemption referred to in question 12 of Form 2952 
(Information Return with Respect to Controlled Foreign Cor- 
porations). This would provide additional information on 
transactions between brother-sister corporations when a U.S. 
person is the parent of both. 

(iv) IRS should encourage better taxpayer information 
reporting. The IRS should work with the Tax Executive 
Institute, the American Institute of Certified Public Accountants, 
and other interested groups to develop methods for improving 
the quality of reports now filed. 

2. Rank Secrecy Act Forms 

In 1970 Congress, recognizing the ". . . serious and 
widespread use of foreign financial facilities located in 
secrecy jurisdictions for the purpose of violating American 
law"— enacted the Bank Secrecy Act of 1970— which authorized 
the Secretary of the Treasury to require reporting of (1) 
transactions v;ith domestic financial institutions, (2) 
transport of currency into and out of the United States, and 
(3) relationships with foreign financial institutions. 
Congress intended to enable law enforcement agencies to 
secure information which might provide leads to earners of 
illegal income. In fact, the Act does provide IRS with a 
secondary source of taxpayer-supplied information concerning 
assets which may or may not have tax consequences. 

a. Transactions with financial institutions 

A financial institution covered by the Act is required 
to report each deposit, withdrawal, exchange of currency, 
payment, or any transfer by, through, or to such financial 

7/ H. Rep. No. 91-975, 91st Cong., 2d Sess., 1(1970) 
8/ Bank Secrecy Act, 31 C.F.R. §103. 22(a) (1970). 


institution, on Treasury Form 4789 (Currency Transaction 
Report, or "CTR" ) , ifgit involves a transaction in currency 
of more than $10, 000. -^ Exceptions are provided.—^ Prior 
to July, 1980, transfers or transactions with or originated 
by financial institutions or foreign banks were not required 
to be reported; nor were transfers between banks and certain 
established customers maintaining a fixed deposit relationship 
with the bank, provided the bank determined that the amounts 
involved were commensurate with the customary conduct of the 
customer's business. 

In July, 1980, Treasury published new regulations — ' 
which expand the scope of reporting to (1) require the 
reporting of large currency transactions by securities 
dealers, foreign banks, and miscellaneous financial institutions, 
such as dealers in foreign exchange, persons in the business 
of transferring funds for others, and money-order issuers; 
(2) require more complete identification of a person dealing 
in large amounts of currency; and, (3) restrict the ability 
of financial institutions to exempt customers from the 
reporting requirements. 

Transactions with an established customer maintaining a 
deposit relationship have always been exempt from the 
reporting requirement. The recent amendment limits this 
exemption to certain domestic businesses and requires that 
the location and nature of the business be identified in a 
report of exempt customers which must be furnished to Treasury. 
These changes were made necessary when it became clear that 
certain banks were abusing the existing exemption rules, 
exempting foreign nationals, boat dealers and others whose 
only common trait was that they frequently deposited large 
amounts of cash. 

A CTR must be filed within 15 days of the qualifying 
transaction with the Ogden, Utah, Service Center. The 
financial institution must retain a copy of the report for 
five years. The original is processed in the Ogden Service 
Center. Information on the form is entered into the Treasury 
Enforcement Communications System (TECS). The fact that a 
CTR has been filed is recorded in several IRS taxpayer 
files, so that if a return is audited, the auditor can use 
TECS to retrieve the CTR information. The existence of a 
CTR is also noted in the IRS' "non-filer check." 

9/ 31 C.F.R. §103. 
10/ Id. 

11 / 45 Fed. Reg. 37, 818 (1980) (to be codified in 
31 C.F.R. §103) . 

b. Transport of carrency 

Each person who transports, mails, ships, or causes to 
be physically transported, mailed, or shipped, more than 
$5,000 in currency or any other bearer instrument into or 
out of the United States, must report the transaction on 
Treasury Form 4790 (Report of the International Transportation 
of Currency or other Monetary Instruments, or "CMIR"). The 
form must be filed with the U.S. Customs Service at the time 
of entry into or departure, mailing, or shipping from the 
Lfriited States. A recipient of currency must file the form 
with the Commissioner of Customs within 30 days of receipt. 
The information contained on the form is entered into TECS, 
and is thereby made available to IRS agents through that system. 

Form 4790 is rarely used by the IRS. The identifying 
information on the form is generally incomplete, and most 
filers appear to be non-resident aliens. 

c. Foreign bank account 

In accordance with the authority granted by Title II of 
the Bank Secrecy Act, the IRS requires a taxpayer who files 
Form 1040 to answer the question whether ". . .at any time 
during the taxable year, [that person] had an interest in or 
signature authority over a bank, securities, or other financial 
account in a foreign country." If the answer is "yes" and 
the amount involved is over $1,000 at anytime during the 
year, the taxpayer is required to report that account by 
filing Treasury Form 90-22.1 with the Treasury Department 
on or before June 30 of the following year. Form 90-22.1, 
formerly IRS Form 4683, was removed from IRS jurisdiction in 
October, 1977, to give freer access to the .information 
contained on the form to other agencies. — ^ 

Upon receipt. Treasury enters onto TECS the name, 
social security number, and reference to a microfiche where 
a copy of the form can be located. An IRS agent then can have 
access to the information contained on the form. 

d. TECS 

The Treasury Department operates a computerized infor- 
mation storage and retrieval system which makes information 
available to Federal Government personnel in carrying out 
law enforcement functions. The system is the Treasury 

12/ See §6103. 


Enforcement Communication System (TECS). TECS is controlled 
by Customs, which places the information into the system. 
Information from CTRs , CMIRs, and the Foreign Bank Account 
reporting forms is entered on TECS. IRS civil and criminal 
investigating agents then have access to the information 
through TECS. 

e. Analysis 

In April, 1979, GAO released its study captioned "Better 
Use of Currency and Foreign Account Reports by Treasury and 
IRS Needed for Law Enforcement Purposes", highlighting areas 
in which return information was poorly utilized. Current 
processing of CTRs and foreign bank account forms reflects 
an attempt to adopt GAO suggestions. Additional processing 
changes are planned and will be implemented. For example, 
IRS will begin corresponding with reporting financial 
institutions when incomplete CTRs are received. 

The IRS has become more aggressive in this area. A 
recent notice to all agents reminds them that they are 
required "to pursue, in all field and office examinations, 
the Foreign Accounts and Foreign Trust questions appearing 
on tax returns." Examiners have also been directed to 
verify whether the taxpayer filed correctly any required 
foreign trust, bank account, or currency reports. A forthcoming 
Manual Supplement will make it mandatory for the agent to 
attempt to determine the correctness of the answer to the 
bank account question, and will re-emphasize the directive 
to pursue the above mentioned forms. 

The GAO study did not analyze the effectiveness of the 
various forms; their utility for tax administration purposes 
is still uncertain. Form 4789 probably has the greatest 
potential, because it is prepared and filed by an impartial 
third party (the financial institution). Just how useful 
this form can become may depend upon Treasury's success in 
securing better quality reporting from financial institutions. 
The information received is still of poor quality, and in 
many cases the CTRs are incomplete. It has, however, already 
proved useful. For example, CID has found cases of CTRs 
filed for transactions by persons for whom there is no 
record of income tax returns being filed. CTRs have provided 
leads for investigations, and have resulted in referrals to 
the IRS civil tax auditors for civil investigation. CTR 
portraits have lead to the discovery that banks in a particular 
state were generally not filing CTRs. 

Skepticism exists as to whether Form 4790 can be useful. 
The information secured is of poor quality, probably because 
it is filled out by the transporter under hurried conditions, 
i.e., at the airport. The limited authority of Customs to 


The usefulness of the foreign bank account question has 
yet to be established. There have been few criminal pros- 
secutions for failure to answer the question, and civil 
penalties are generally not imposed. However, taxpayers 
have been prosecuted and, in at least two instances, convicted 
for answering the question falsely. In addition, a false 
response can be used in the prosecution's case as evidence 
of willfulness, even though the taxpayer is not specifically 
charged with answering the question falsely. 

Most taxpayers do not answer the foreign bank account 
question. Placement of the question on the Form 1040 does 
appear to affect the response rate. For tax year 1970, when 
the question was at the top of page 2 of Form 1040, 66 
percent of the returns filed contained no answer. In 1971 
and 1972, when the question was on the bottom of page 1 of 
Form 1040 just above the signature line, returns containing 
no ansv;er were 4 percent and 6 percent respectively. In 
1973 and 1974 when the question was moved to the bottom of 
page 2 of Form 1040, the "no-response" rose to 62 percent 
and 64 percent respectively. Since 1976 when the question 
was moved to Schedule B, the "no-response" rate has ranged 
from 20 to 33 percent. It should be noted that TCMP data 
for 1973 suggest that only 300,000 taxpayers had foreign 
bank accounts. Preliminary TCMP data for 1976 suggests that 
perhaps 345,000 taxpayers had foreign bank accounts. This 
is a relatively small number of accounts when compared to 
the Form 1040 filing population of over 52,000,000. However, 
there was more than a four-fold increase in the number of 
audit adjustments due to transactions involving foreign bank 
accounts, from 7,005 adjustments in 1973, to 31,810 in 1976. 

It may be that those taxpayers who do not file a Schedule 
B, but do have a foreign bank account, also do not file a 
Form 90-22.1. Even if Schedule B is filed with "yes" checked 
for the foreign bank account question, there is no routine 
verification made that the taxpayer filed the Form 90-22.1 with 
Treasury (the form is not to be filed with IRS). 


The reporting requirement is not comprehensive. Reporting 
is required only if the taxpayer has a financial interest in 
or signature authority over an account in a foreign country. 
It does not cover a U.S. account with a foreign nominee 
acting for a U.S. person, or control over other foreign 
assets. Nor does it cover an account held by a corporation, 
trust or partnership unless the individual has more than a 
50 percent interest in the entity. This may exclude accounts 
owned by a foreign corporation in which a husband and wife 
each own 50 percent of the stock. 

The IRS seems to have made substantial progress in 
utilizing information currently on TECS. It would seem, 
however, that TECS could be put to additional uses in tax 
administration, and aid in coordinating investigations involving 
two or more agencies, as well as in coordinating IRS investi- 
gations. Actions along these lines are being taken. 

f . Options 

The Rank Secrecy Act reports have proved useful at 
times. Their utility increases as more experience is gained. 
Some options to be considered for further improvement are 
presented below. 

(i) Recent amendments to the Treasury Regulation 
regarding Form 4789 should improve the quality of the infor- 
mation provided; the IRS is taking positive steps to improve 
processing of that information. More work, however, is re- 
quired. With respect to tax haven cases, some attempt to 
verify addresses should be undertaken. Other recent recommendations, 
such as increased use of CTR printouts with additional 
information on those printouts, should be pursued. Furthermore, 
additional attempts should be made to obtain the assistance 
of the Controller of the Currency in improving reporting. 

(ii) More work is required with respect to Form 4790. 
To improve the quality of information on that form, legislative 
changes may be required. Initially, Congress should amend 
the Bank Secrecy Act to make it illegal to attempt to export 
or import currency and to give Customs greater authority to 
conduct border searches with respect to currency trans- 
portation. H.R. 5961, introduced during 1980, contained 
amendments which would have accomplished this. 

(iii) With respect to the bank account question, the 
following suggestions should be considered. 


(a) Consideration should be given to improving the 
existing placement of the question on the income tax return. 
It could, for example, either be returned to page one of 
Form 1040 or, at a minimum, placed on side A rather than 
side B of Schedule A-B. 

(b) The information presently requested could be 
supplemented by requiring a taxpayer to report beneficial 
ownership of assets acquired or managed by a foreign inter- 
mediary (e.g., ownership of U.S. assets managed by a foreign 
nominee) . 

(c) IRS could encourage better taxpayer information 
reporting by, for example, sending a follow-up to taxpayers 
who fail to respond to the question. This follow-up could 
be limited to those who both failed to check either box and 
have a total positive income of over a certain amount (e.g., 
$50,000). In addition, tax return preparers' penalties might 
be imposed for failing to answer the question on returns they 

3. Penalties for Failure to File or Adequately Complete 

a. IRS forms 

The Internal Revenue Code provides civil penalties for 
failure to file or for filing inaccurate income tax forms 
and returns. Criminal penalties are provided for willful 
failure to file and for tax evasion. Most civil penalties 
are not viewed as severe, and we are not certain how aggressively 
they are enforced. For example, §6038 of the Code requires 
a U.S. person who controls a foreign corporation to file 
Form 2952. Section 6038(b) provides that the penalty for 
failure to file is reduction of the foreign tax credit. 
Despite complaints by IRS agents that taxpayers do not 
properly complete the form, this penalty is rarely, if ever, 
imposed. In part, this may be because the penalty itself is 
mechanically complicated. Or, the IRS may have determined 
that this particular penalty is too severe. Some agents 
have stated that they hesitate even to recommend imposition 
of the penalty, because it makes the taxpayer more antagonistic 
and, if imposed, will be abated anyway. 

b. Bank secrecy act forms 

Willful violations of the Bank Secrecy Act may con- 
stitute either a felony or a misdemeanor. Fines of up to 
$500,000 and imprisonment for up to five years are provided 
in cases of long-term patterns of substantial violation, and 


violations committeri in furtherance of certain other Federal 
crimes. It is also a felony for any person to make a false 
or fraudulent statement in any required report. Any currency 
or monetary instruments being transported without the required 
report having been filed, or as to which the report omits 
material facts or contains misstatements, may be seized and 
forfeited to the United States. The Act also provides for 
assessing a civil penalty, which may range from $1,000 up to 
the amount of currency or monetary instruments seized, less 
any amount forfeited. 

c. Options 

Civil penalties are essential to the enforcement of 
filing requirements. As a general proposition, such penalties 
should be significant in amount so as to be meaningful, 
sufficiently easy to impose so as to be readily available, 
and flexible in application so as to be useful toward the 
goal of securing taxpayer compliance. The IRS might re- 
examine existing penalty provisions and procedures related 
thereto, with an eye toward the following: 

(i) Seeking legislative changes where the penalties 
are inadequate. For example, where a taxpayer fails to file 
a properly completed Form 2952, reduction of the foreign tax 
credit may be an appropriate secondary penalty to be applied 
in flagrant cases. Where a taxpayer required to furnish 
information under §6039(a) of the Code fails to do so in a 
timely and complete manner, §6038(b) could be amended to 
provide a minimum mandatory penalty (e.g., $25,000). The 
IRS should also have the option to reduce the foreign tax 
credit in gross cases. 

(ii) Providing clearer direction to the field regarding 
the imposition of penalties. Field personnel must be made 
aware that voluntary compliance is promoted through the 
exercise of good judgment in assessing penalties. A policy 
of imposing penalties in all cases of poorly completed IRS 
forms serves only to increase tensions with taxpayers and 
clog the administrative and judicial systems. On the other 
hand, failure to impose the penalty when merited has a 
detrimental impact on voluntary compliance. 

R. Books and Records — Foreign Transactions — In General 

Many of the tax and information returns previously 
discussed give IRS the basic information with which to begin 
investigations involving international (or domestic) transactions. 
Thereafter, a meaningful audit or investigation of a taxpayer's 


return may require access to books and records of the taxpayer 

or third parties, irrespective of whether such books and 

records were used in preparation of the return being scrutinized. 

1. General Requirements for Maintenance of Adequate Books 
and Records 

Every person who is liable for any income or excise tax 
must keep such records, render such statements, make such 
returns, and comply with such rules and .regulations as the 
Secretary of the Treasury prescribes. — ' The Secretary has 
promulgated regulations which require a taxpayer to maintain 
books and records adequate to establish his tax, liability or 
other matters required to be shown on a return. — ' These 
records must be kept at a convenient location and must be 
accessible to IRS employees. — ' Similar recordkeeping 
requirements are specifically directed to a U.S. shareholder 
of a controlled foreign corporation "as necessary to carry 
out the provisions of subparts F and G. " — ' The Secretary, 
by regulation, permits such records to be maintained in a 
foreign country, but requires, their production within a 
reasonable time after demand. — ' The records required to be 
produced are, in general, those necessary to verify the 
amounts reported under subpart F or G. — ' 

2. Penalties for Failure to Maintain Adequate Rooks and 

The Internal Revenue Code authorizes a civil penalty of 
five percent of any underpayment due to nealigence or inten- 
tional disregard of rules and regulations. — ' This penalty 
can be imposed for failure to maintain books and records 
adequate to establish items of income and deduction. — ' 

\^/ §6001. 

14 / Treas. Reg. §6001-l(a). 

15^/ Treas. Reg. §31 . 6001-1 (e ) . 

16^/ §964(c) (1) . 

17 / Treas. Reg. §1.964-3(a). 

1^/ Treas. Reg. §1.964-3(b). 

1^/ §6653{a). 

20 / R. Simkins Estate , 37 T.C.M. 1388, DEC 35, 368 (M) T.C. 
Memo 1978-338, affd., D.C. Cir. (Apr. 28, 1980), unpub- 
lished opinion. 


3. Powers to Compel Production of Books and Records 

While the Internal Revenue Code gives the IRS the right 
of access to taxpayer books and records, taxpayers do not 
always willingly cooperate. To deal with these situations, 
the IRS is given broad authority to compel the production of 
books and records (and testimony) believed to be relevant. 

Section 7602 of the Code provides that the IRS may 
examine any books, papers, records, or other data which may 
be relevant or material to determine tax liability, and may 
summon or command the person liable for the tax or an officer 
of the taxpayer to produce the above and to give testimony 
under oath as may be relevant or material to computation of 
the tax liability. Section 7602 further authorizes the IRS 
to command production of books and records in the hands of a 
third-party recordkeeper. A summons may be enforced by a 
United States district court. ^^^ Failure to, comply with a 
summons can result in a contempt citation. — ' 

4. Analysis 

Although the IRS is statutorily granted broad access to 
relevant information, significant legal and practical problems 
restrict that access. 

a. Legal 

A taxpayer may assert legal defenses against an IRS 
demand for books and records. If the taxpayer believes that 
an investigation may lead to a criminal charge, he may 
exercise his Constitutional privilege against self-incrim- 
ination. If the books and records are in the hands of an 
agent, the taxpayer may assert that they are protected by 
the attorney-client privilege. The limits of these defenses 
are fairly well established by case law. A taxpayer may 
claim that the material summoned is irrelevant to his tax 
liability, or that production of the material would be 
unduly burdensome. A taxpayer may stay compliance of the 
summons and intervene in a summons enforcement proceeding to 
contest the production of books and records in the hands of 
third-party recordkeepers. — 

2_1/ §7604{b) . 
22/ Id^ 
23/ §7609. 


A few taxpayers have apparently taken the position that 
production of books and records of their foreign subsidiary 
is not required unless a subpart F issue is raised. — ' 
Thus, if the issue raised by the agent deals with §482, 
these taxpayers argue that they are not required to produce 
the records. Section 6001 does not specifically refer to 
books and records of a foreign affiliate. 

b. Administrative 

The IRS is often subject to administrative constraints, 
self-imposed and otherwise. Perceived time pressures often 
encourage the closing of cases at the agent level before 
access has been gained to all accountable books. Limited 
resources produce a similar result. 

c. Tactical 

Taxpayers aware of IRS administrative constraints often 
employ delaying tactics. Legal claims may be asserted for 
dilatory purposes only. Because a taxpayer can stay com- 
pliance with a third party summons without reason, such is 
often the practice. Intervention does toll the statute of 
limitations, but only from the time a Government petition in 
response to a stay of compliance is filed with the district 
court. Significant time lags occur between IRS receipt of a 
stay of compliance and filing of a petition in response. 
The IRS and Justice internal review processes are partially 
responsible. Also, there are significant delays after a 
proceeding is brought in a district court. 

Taxpayers may employ more devious delaying tactics. 
In some cases, deadlines agreed to between IRS agents and 
taxpayers pass without receipt of requested and promised 
information. In some cases this is due to taxpayer administrative 
difficulties in complying with a request, but in others it 
appears due to malice or benign neglect on the part of the 
taxpayer, who believes that procrastination will cause the 
IRS to lose interest in the case or to propose only poorly 
developed adjustments. A survey of all International Examiners 
in conjunction with this study identified a significant 
number of cases where the agent believed, and appeared to 
have reason to believe, that a taxpayer unnecessarily delayed 
the production of requested material. A number of cases 
appeared clearly abusive. 

24 / In which case production is required under §964(c). 


On the other hand, it was not our impression that most 
taxpayers procrastinated. As industry groups have pointed 
out, it is both time consuming and expensive for a company 
to delay the conclusion of an examination. There is also 
the problem of imprecise requests for information from IRS 
agents. Industry groups have alleged that, in some instances, 
requests for information are "nothing more than fishing 
expeditions." Overly broad requests, such as requests for 
"all sales invoices of a particular foreign subsidiary" or 
"all communications between the foreign subsidiary and the 
parent company", have been cited. There is a great deal of 
reluctance to respond to such broad based inquiries, particularly 
when the materials are in a foreign country and in a foreign 

Furthermore, in some cases cited by International 
Examiners as abusive delays, a criminal investigation had 
been commenced. It is unrealistic to expect that the subject 
of a criminal investigation will cooperate in an investigation 
which could lead to a criminal prosecution. 

C. Information Gathering Abroad 

Except in the case of a United States shareholder of 
a controlled foreign corporation, the Internal Revenue Code 
does not specifically require that books and records relevant 
to tax liability , of a U.S. taxpayer be maintained in the 
United States. — ' Of course, the Code cannot mandate maintenance 
of books and records of third parties who are not U.S. 
taxpayers, citizens, or residents. When information necessary 
for an audit or investigation is unavailable in this country, 
it must be sought abroad. 

Information may be sought abroad unilaterally or through 
bilateral or multilateral conventions to which the United 
States is a party. In either case, success in obtaining 
information is dependent on a number of factors. Initially, 
the IRS must be aware that the information does or may 
exist. While the tax and information returns previously 
discussed may be useful, a taxpayer seeking to avoid or 
evade tax, or to hide assets, may either fail to file the 
relevant return or file a false return. A second major 
factor is gaining access to the information; this depends to 
a great degree on resolving conflicts between U.S. and 

25/ §964{c). 


foreign law and on the willingness of the foreign juris- 
diction to cooperate. An additional factor, of primary 
importance in criminal cases, is that the information must 
be secured in a form admissible in a United States court of 

1. Unilateral Means 

The United States does not have income tax treaties or 
other exchange of information agreements with most tax havens. 
Those in force often do not override local secrecy laws and 
practices. Therefore, unilateral means to gain access to 
information must be used. 

a. Public Information 

The extent to which useful public information is available 
depends upon the country involved. In some jurisdictions 
public information concerning commercial or corporate affairs 
is extensive, while in others such information is extremely 
limited. In jurisdictions maintaining extensive public 
records, an "impartial observer" seeking, for example, 
information concerning the business and financial affairs of 
a foreign corporation, might expect to find a copy of a 
corporate charter, corporate financial statements, a statement 
of corporate business affairs, corporate earnings statements, 
and perhaps even the identify of the corporate board of 
directors or similar body, and principal officers and shareholders, 
However, even where useful information is publicly available, 
some jurisdictions view access to it in the course of an 
official IRS examination as a breach of sovereignty which 
requires permission of the foreign government before information 
gathering may commence. As part of this study, the Office 
of International Operations (OIO) compiled a description of 
publicly available information in over 30 tax haven juris- 

Even where public records are available and the local 
government does not unduly restrict IRS activities in obtaining 
them, the legal use of nominees or bearer shares which 
conceal the identity of persons involved with the corporation 
will close off investigative leads. OIO advises that use of 
nominees is common in tax haven countries such as the Bahamas, 
the Cayman Islands, and Panama. 

An example of a tax haven country maintaining extensive 
public records is Switzerland. Switzerland requires that 
corporations publish extensive corporate and finanacial 
data. Under Swiss law, every business enterprise is required 
to file certain basic information in the register of commerce 


located in the Canton where its principal place of business 
is situated. Information required to be filed includes: a 
copy of the statute (charter) of the enterprise, including 
its name, purpose and address of registered seat; the names 
and nationalities of directors or managers; the names of the 
founder or partners, and the extent of their contributions, 
liabilities and preferential rights; the amount of authorized 
and paid-in share capital; the names and powers of persons 
authorized to sign on behalf of the enterprise; and the way 
in which official notices are to be published. Changes with 
respect to any of the required information must also be 

Notwithstanding the extensive amount of information 
required to be made public, the identity of owners of a 
Swiss entity can easily be hidden. It is common practice 
for those wishing to conceal their business affairs to use 
either nominees or bearer shares to do so. In addition, 
holding companies may appoint the office of a local bank, a 
lawyer, or a chartered accountant as their local office in 
order to further conceal corporate affairs. 

Information gathering in Switzerland is severely re- 
stricted by both Swiss law and Swiss Government policy. 
Swiss approval must be obtained before any information 
gathering is conducted in Switzerland. Several articles of 
the Swiss Penal Code, the violation of which would subject 
an IRS agent to imprisonment, apply to unauthorized information 
gathering in Switzerland, even for an official IRS investigation. 

In contrast to Switzerland, the Cayman Islands government 
prohibits extensive public records with respect to corporations. 
The Confidential Relationships (Preservation) Law prohibits 
the disclosure of any corporate information other than the 
name of the corporation, date of incorporation, and registered 
office for the corporation. The registered office is usually 
the office of a law firm or trust company, which also is 
prohibited by the law from disclosing information. No 
commercial register is maintained on the Cayman Islands, and 
disclosure of court records is prohibited to the extent that 
they involve matters covered by the confidentiality laws. A 
limited procedure for obtaining some information subject to 
the confidentiality laws is available, in the case of crimes 
occuring within the United States involving financial transactions 
in the Cayman Islands. 

Even this limited exception does not apply in the case 
of tax crimes. Moreover, any information gathered in the 
Cayman Islands, including public information, is subject to 
clearance by the United States Consul and permission of the 
Cayman Government. 


Even in those instances where useful public information 
can be obtained, practical problems may arise which render 
such information useless for tax purposes. For example, in 
conducting a net worth investigation of a taxpayer, a special 
agent may discover that the taxpayer is secreting money into 
the Cayman Islands to purchase real estate there. Although 
the Cayman Islands maintains public records of real estate 
transactions, this information is not indexed in an alphabetical 
file. To obtain land records, it is necessary to know the 
legal description of the property. In those cases where such 
information is not available, and where the taxpayer refuses 
to cooperate or exercises his right against self-incrimination, 
it is impossible to confirm ownership absent an independent 

b. Overseas Examination 

If, during an audit or investigation, it becomes necessary 
to examine the taxpayer's books and records located outside 
the territorial jurisdiction of the United States, the IRS 
may request the taxpayer's permission to conduct an overseas 
audit or on-site examination. In criminal cases taxpayers 
obviously will not cooperate. If permission is granted, the 
IRS may have one of its overseas Revenue Service Representatives 
(RSRs) perform the task. In the alternative, the agent 
assigned to the case in the United States may be authorized 
to travel abroad. Either alternative has drawbacks. Travel 
funds and time involved in sending a U.S. based agent abroad 
can be substantial. Use of an RSR can limit the cost, and 
the RSRs have been very helpful in obtaining specific 
information. The RSR may not, however, have the background 
in the matter to know when to follow up on specific requests. 

In many instances an on-site examination may not be the 
most efficient use of resources. For example, if the IRS is 
trying to corroborate a deduction, the records might be more 
appropriately produced here or the deduction denied. 

Where an on-site examination appears desirable, the IRS 
is generally required to secure .permission of the local 
government before proceeding. — ' Governmental permission is 
likewise generally needed prior to interviewing a person in 
a foreign country relative to an IRS investigation. The 
necessity for obtaining both taxpayer and local government 
permission to make an on-site examination severely limits 
its utility. The IRS has experienced situations in which an 
on-site audit was successful in one year, and permission was 
then denied in the next year, either by the taxpayer or the 
local government. 

26/ See infra at C.l.a. of this Chapter re Switzerland. 


c. Compulsory Process 

If the taxpayer is unwilling to permit an on-site 
examination of books and records located outside the United 
States, or if the books and records are those of a third 
party, the IRS may resort to compulsory process. This can 
take the form of an administrative summons, a judicial 
subpoena, or, when requesting that a foreign juridiction 
exercise its compulsory process for the benefit of the IRS, 
letters rogatory. 

(i) Administrative summons . The IRS has been successful 
in obtaining access to books and records, physically located 
in a foreign jurisdiction, through the issuance of an adminis- 
trative summons, at least where those documents are under 
the custody or control of an entity or person controlled by 
a U.S. person. In addition to the defenses (discussed in 
P. 4. a. of this chapter) which a taxpayer or third party i 
record keeper has to the production of books and records in 
response to an administrative summons, the defense often 
encountered here is that a foreign law or rule of law imposing 
civil or criminal liability prohibits the taxpayer or third 
party from producing the documents requested. By definition, 
this will generally be the case where the documents to be 
produced are located in a tax haven jurisdiction. 

As a general proposition, the courts of this country 
will not require a person to perform an act in this country 
which would violate foreign law. — ''^ Some courts have balanced 
the IRS interest in obtaining the documents or testimony 
requested against the foreiqnp'50v^J^'^rnent ' s interests in 
maintaining its rule of law. — ^ Thus, cases are decided on 
an ad hoc basis, the outcome depending on the unique facts 
involved in each (e.g., the type of foreign law involved, 
the identity of the person being requested to produce). 
Some relevant factors are illustrated by the following 
hypothetical examples, based, in part, on actual cases. 

In an investigation of a United States-based multinational 
corporation, a special agent believes that a Swiss bank 
account, maintained by a wholly owned subsidiary of the U.S. 
parent, was used by the foreign subsidiary to make an illegal 

27 / United States v. First National City Rank , 396 F. 2d 
897 (2d Cir. 1968) . 

28 / In re Westinghouse Electric Corporation Uranium 

Contracts Litigation , 563 F. 2d 992 (10th Cir. 1977) ; 
Restatement (Second) of the Foreign Relations Law of 
the United States, §§39 and 40 (1965). 


payment to a foreign official to effectuate a sales agreement 
between the U.S. parent and the foreign official's government. 
The agent further believes the payment was incorrectly 
characterized and deducted on the corporate tax return. The 
agent has served an administrative summons on the U.S. 
parent commanding production of the subsidiary's records of 
the Swiss Bank account, including copies of deposited items 
to the account and checks written on the account. Upon 
advice of counsel, the U.S. parent refuses to produce these 
records on the basis that (a) the records are located in 
Switzerland and hence not subject to the summons power, and 
(b) the production of these records would violate the Swiss 
bank secrecy law. 

Standing alone, the fact that records are located 
overseas will not deprive a United States district court of 
jurisdiction to compel their produc tioDQin proceedings to 
enforce an IRS administrative summons. — ' Similarly, the 
argument that the U.S. parent could not produce the records 
since it does not have control over them would be unavailing 
because the U.S. parent is the sole shareholder of the Swiss 
subsidiary and, in that capacity, would be able to exercise 
its authority as shareholder to force the subsidiary to have 
the records produced. — ' 

A different question is presented with respect to the 
violation of the Swiss Bank Secrecy law. While it is generally 
true that the United States courts will hesitate to require 
a person to do an act in this country which would violate 
foreign law, under the facts of this example a violation of 
the Swiss bank secrecy law is not involved. ^- Under that law 
the customer is "the master of the secret." — ' In the 
summons enforcement proceeding, the court would require the 
U.S. parent to exercise its control with respect to the 
requested records. — ' 

29 / Societe Internationalee Pour Participations Industries 
V. Rogers , 357 U.S. 197 (1958). 

30 / Societe, supra ; First National City Bank v. Internal 
Revenue Service , 271 F. 2d 616, 618 (2d Cir. 1959), 
cert, denied , 361 U.S. 948 (1960). 

31 / Trade Development Bank v. Continental Insurance Capital , 
469 F. 2d 35, 41 at n. 3 (2d Cir. 1972). 

32 / Securities and Exchange Commission v. Minas de Artemisa , 
S.A. , 159 F. 2d 215 (9th Cir. 1945). 


In another case, a revenue agent is examining the 
income tax return of a nonresident alien, a foreign entertainer 
who has earned substantial sums of money, on a concert tour 
in the United States, which the entertainer claims are 
exempt from U.S. income taxes by reason of an income tax 
treaty. To determine the entertainer's U.S. tax liability, 
the revenue agent must see several employment and royalty 
agreements between the entertainer and a Grand Cayman Islands 
corporation, copies of which are in the physical possession 
of the Grand Caymans branch of a large international accounting 
firm whose headquarters are in New York. The revenue agent 
served an administrative summons on the head office of the 
accounting firm in New York to obtain copies of these agreements. 
Upon advice of counsel, the accounting firm refuses to turn 
over the records, citing as its reason that production of 
the records would violate the criminal laws of the Cayman 

Based on the authorities discussed above, the accounting 
firm would be required, at a minimum, to exercise good faith 
efforts to obtain the consent of the entertainer to produce 
the agreements. Failing in that, it is unclear whether the 
accounting firm would still be required to produce the records.—^ 

In another case, a special agent has under investigation 
a taxpayer who is a sole shareholder of a corporation in the 
manufacturing business. The special agent believes that the 
taxpayer has omitted substantial amounts of income from the 
corporate tax return, by deducting payments to a Bahamian 
corporation for goods allegedly used in the manufacturing 
process. The special agent believes that, in reality, the 
Bahamian corporation is owned by the taxpayer, and that the 
payments made to it are not for items purchased but are merely 
a diversion of corporate receipts to a numbered bank account 
in the Bahamas owned and maintained by the taxpayer. A check 
of the public records in the Bahamas indicates that the 
Bahamian corporation is incorporated and has its office at the 
offices of an attorney in the Bahamas. In response to a 
summons issued to him, the taxpayer has refused to answer any 
of the special agent's questions regarding this transaction, 
citing his right against self-incrimination under the Fifth 

33 / Application of Chase Manhattan Bank , 297 F. 2d 611 (2d 
Cir . 1962); Lfriited States v. Fir st~National City Bank , 
396 F. 2d 897 (2d Cir. 1962); United States v. Field , 
532 F. 2d 404 (5th Cir. 1976); cert, denied , 429 U.S. 
940 (197 6); Arthur Andersen Company v. Finesilver , 546 
F. 2d 338 (10th Cir. 1976), cert, denied , 429 U.S. 1096 


Under the facts of this example, the agent will be unable 
to gain access to either the bank or corporate records needed 
to complete the investigation, since there is no person subject 
to the personal jurisdiction of the United States courts who 
can be forced to produce these records. Thus, absent evidence 
of other violations by this taxpayer, or evidence provided by 
an independent source, this case cannot be forwarded for 
prosecution. However, in the event that a person became subject 
to the jurisdiction of the United States courts to be required 
to testify, the taxpayer would be unable at trial to block such 
testimony based upon the assertion of the bank secrecy law of 
the Bahamas. — 

Use of process has other limitations. If a United States 
citizen is outside the United States, an administrative 
summons apparently can be directed to him. However, IRS may 
not be able to enforce that summons, since the law neglects 
to specifically confer venue except when a person "resides -^z 
or may be found" in a judicial district of the United States. — ' 
A summons cannot be served on a foreign person not present 
in the United States. Accordingly, as indicated in the last 
example, an administrative summons cannot be used to compel 
the testimony of a Cayman bank official not present in the 
United States. 

(ii) Judicial subpoena . Where IRS has determined that 
a particular matter should be pursued criminally, it may 
seek authorization to place the investigation in the hands 
of a grand jury. A grand jury investigation has the advantage 
of the subpoena power, which is much faster than an administrative 
summons in compelling the production of books and records 
relevant to an investigation. Moreover, when IRS personnel 
are assigned to assist the grand jury, they are able to 
coordinate closely with law enforcement personnel from^other 
agencies, a practice otherwise restricted by statute. — ^ On 
the negative side, the procedures which the IRS must follow 
to obtain grand jury authorization have been cumbersome and 
time-consuming. At one time, approval of a request through 
both IRS and the Department of Justice, which approval is 
required by law, could take six months, even if the request 

34/ United States v. Frank , 494 F. 2d 145 {2d Cir. 1974). 

35 / §§ 7402(b) and 7604(a). See United States v. Harkins , 
581 F. 2d 431, 438 at n. 11 (5th Cir. 1978). 

36/ See §6103. 


was generated outsid^^of the IRS. Steps have been taken to 
reduce this time lag — ' and, while it is too early to tell 
whether they will be effective, there are indications of 

Grand jury proceedings are secret and an IRS employee 
privy to information obtained by the grand jury may not 
disclose it. Thus, information gathered by the grand jury 
may not be used to determine civil tax liabilities, absent a 
court order granted pursuant to Rule 6(e), Federal Rules of 
Criminal Procedure, unless the information becomes part of 
the public record. Information independently developed by 
the IRS is not so restricted and may be used for civil tax 
purposes. Should the IRS desire to secure grand jury material 
for civil tax purposes, a request for a Rule 6{e) order can 
be made only by a Justice Department attorney, not by an IRS 
(Chief Counsel) attorney. The IRS interest in civil enforcement 
can come into conflict with the Justice Department's overriding 
interest in the criminal justice system. 

The ability of a subpoena to secure books and records 
physically located in a foreign jurisdiction is roughly 
equivalent to that of the administrative summons. The same 
legal principles apply. Unlike the summons, a subpoena 
directed to a U.S. citizen situated abroad is clearly enforcable 
in the United States district court from which it issues. 

(iii) Letters rogatory . Where evidence located in a 
foreign jurisdiction is neither in the custody of nor controlled 
by a person subject to the jurisdiction of the United States 
court, the IRS may seek to obtain it through letters rogatory. 
In this case, letters rogatory represent the request of the 
United States court (in a civil or criminal matter) for the 
assistance of a foreign tribunal in obtaining evidence. The 
requested assistance can range from the effecting of service 
of process to the taking of testimony or the securing of 
books and records. The procedure is available only in a 
judicial proceeding. 

Letters rogatory have been used infrequently in tax 
cases (civil or criminal). The decision to grant assistance 
is completely within the discretion of the foreign tribunal. 
Should that tribunal decide to execute the request, the 
"turn around" time is tremendous — anywhere from three 
months to a year. 

37/ See IRM 9267.2. 


d. Tax Court 

The United States Tax Court, at the trial stage, has 
the authority to require a foreign petitioner to produce 
books, records, documents or other evidence deemed necessary 
to the proceeding. — If the petitioner fails or refuses to 
comply after a reasonable time for compliance, the Tax 
Court, upon motion, may strike the pleadings or parts thereof, 
dismiss the proceeding or any part^thereof , or render judgment 
by default against the petitioner. — ' 

These Tax Court powers are limited to those cases in 
which the petitioner is a nonresident alien individual, 
foreign trust or estate, or foreign corporation. Such 
sanctions are not otherwise available and, therefore, cannot 
be used to penalize, for example, a U.S. shareholder of a 
controlled foreign corporation which fails to produce the 
necessary corporate records. 

e. Information Gathering Projects and Informants 

The IRS has conducted information gathering projects. 
Some were intended to develop institutional knowledge about 
tax haven activities. Others were intended to identify tax 
offenders or evaders. In criminal cases, informants have 
proved valuable at times. These subjects are discussed in 
Chapter VI. 

2. Bilateral or Multilateral Means 

Because unilateral means for obtaining information are 
limited by the willingness of foreign governments to cooperate 
on a case-by-case basis, and by the lack of established 
channels for obtaining assistance, the United States has 
entered into various bilateral and multilateral agreements 
with other countries which provide both an agreement for 
cooperation and a procedural framework for obtaining information 
pursuant thereto. Unfortunately, with the exception of tax 
treaties, these agreements have been of little use in tax adminis- 

3J^/ §7456{b) 
39/ Id. 


a. Tax treaties 

Tax treaties, in addition to dealing with double taxation 
issues, are intended to prevent fiscal evasion. — ' United 
States treaties in force contain an article obligating this 
country and its treaty partner to exchange information on 
matters related to tax administration. The United States 
Model Income Tax Convention and the OECD Model Income Tax 
Convention "exchange of information" articles provide for 
exchanges of information necessary to carry out the provisions 
of the convention or of, the domestic laws of the respective 
contracting countries. — 

Poth models contain identical limitations. The parties 
need not go beyond the internal laws or administrative 
practices of either party to obtain information for the 
requesting country. (The OECD commentary states that a 
country is obligated to make special investigations if 
similar investigations would be made for its own purposes.) 
Both parties must treat information received as confidential, 
to be used only in tax proceedings concerning taxes covered 
by the convention. A party may disseminate information only 
to those involved in the collection of taxes or the enforcement 
of tax laws. 

The U.S. model is broader in scope than the OFCD model. 
The U.S. model requires that information be provided in an 
authenticated form. However, a country is required to 
produce this quality of information only if permitted under 
its laws and practices. It also provides for collection of 
taxes if necessary to ensure that the tax benefits of the 
convention do not inure to persons not entitled to the 
relief provided. It further applies to taxes not covered by 
the convention. 

The United States has interpreted most of its treaties 
as permitting three methods of providing information: 

First, a routine or automatic transmittal of information, 
consisting generally of lists of names of U.S. resident tax- 
payers receiving passive income from sources within the 
treaty partner, and notifications of changes in foreign law. 

40 / The substantive provisions of income tax treaties are 
discussed in Chapter VIII. 

41/ Article 26, U.S. Model Income Tax Convention; Article 
26, OECD Model Income Tax Convention. 


Second, requests for specific information, which generally 
are requests of the U.S. competent authority for information. 
Specific requests for information also result from simultaneous 
examinations of a single taxpayer coordinated with certain 
treaty partners. One criterion in selecting a taxpayer for 
simultaneous examination is the use of tax havens in its 

Third, spontaneous exchange of information at the 
discretion of the transmitting country. This exchange 
occurs when an examining agent in one country discovers 
information during a tax examination which suggests or 
establishes noncompliance with the tax laws of a treaty 
partner. This information may be provided without a specific 

The utility of tax treaties is presently limited. The 
United States does not have tax treaties with the most 
important tax haven countries (e.g., Bahamas, Bermuda, 
Cayman Islands, Lichtenstein, Panama). Where the United 
States does have treaties, serious technical deficiencies 
with the exchange of information provisions restrict the 
value thereof. The tax haven treaty partner is obligated 
only to give such information as is obtainable under local 
law. Thus, if the jurisdiction has a bank secrecy law, bank 
account information will not be obtainable; if the jurisdiction 
has a commercial secrecy law, corporate ownership and business 
information will not be obtainable and, perhaps, even interviews 
with residents of the jurisdiction will be prohibited. In 
many tax haven jurisdictions, access to such information is 
not only limited to foreign jurisdictions, but also to the 
government of the jurisdiction itself. 

A second deficiency with the exchange of information 
provision is that under a literal reading a requested country 
may not be obligated to perform actions which the requesting 
country could not perform under its laws. Thus, once the 
IRS has referred a matter to the Department of Justice for 
possible criminal prosecution, the United States cannot 
be certain that a treaty partner will secure information by 
administrative process to be provided pursuant to the exchange 
information provision, because the United States can no 
longer use an administrative summons internally. This is, 
admittedly, a literal reading of the treaty provision; 
however, it is one that has been adopted in some cases. A 
strict reciprocity approach contrasts sharply with the 
United States position in mutual assistance treaty negotiations, 
wherein this country has attempted to move away from direct 


Even where secrecy laws are not a factor, the attitude 
of the treaty partner can make a significant difference. 
Some countries (e.g., Canada) are more cooperative in preventing 
international tax evasion and avoidance and, accordingly, 
take an expansive view of the exchange of information provisions. 
Other countries (e.g., Switzerland) take a very restrictive 
view of the scope of the exchange of information provisions. 
Attitude may or may not affect the quality of information 
received from a treaty partner. In any event, it is often 
of poor quality. For example, IRS receives routine information 
from many treaty partners which fails to identify the par- 
ticular taxpayer involved or the year in which the significant 
transaction took place. The United States does not have 
leverage available to encourage a treaty partner to provide 
quality information. Information is rarely produced in a 
form which will allow it to be introduced in court. 

IRS internal policies and procedures may have further 
restricted treaty effectiveness. With respect to procedure, 
those requests which are made pursuant to treaty take a 
substantial amount of time, upwards of a year from the 
agent's preparation of a routine request until the time he 
gets the information requested. The IRS internal review 
process may have been partially at fault. Prior to September, 
1980, a request generated by an agent was reviewed by his 
group manager, reviewed through the regional level, and sent 
to the competent authority, the Assistant Commissiner (Compliance), 
where it is forwarded to 010 for formal processing. The procedure 
has been streamlined so that the final field review is now 
at the district, rather than regional, level. The request 
then goes directly to 010 with copies to appropriate managers. 
Information received is sent by 010 directly to the district. 
If problems develop, supplemental information must also 
follow this same path. The request must then be prepared 
and delivered to the competent authority of the requested 
country. Thereafter, IRS is dependent upon the good will of 
the treaty partner to get the information within a reasonable 
period of time. 

b. Mutual assistance treaties 

The United States has onl^/One mutual assistance treaty 
in force — with Switzerland. — ^ A second, with Turkey, is 
awaiting ratification by the Turkish government. The 
united States has initialed treaties with Columbia and the 
Netherlands, and is currently negotiating similar treaties 
with a number of other governments. None of those negotiations 
is with an important tax haven country. Some agreement with 

42/ 2 U.S.T. 2019, TIAS 8302 (1976). 


the Commonwealth of the Bahama Islands may soon be possible. 
At one time, the Bahamian government indicated its willingness 
to discuss a mutual assistance treaty. In December, 1980, a 
Uhited States delegation went to the Bahamas on a fact- 
finding mission, one purpose of which was to further explore 
the possibility of negotiating such a treaty. 

The usefulness of mutual assistance treaties with 
respect to tax matters will depend on the scope of each 
treaty. Experience with the Swiss treaty has not been 
encouraging. First, the Swiss treaty is limited to criminal 
matters. Second, it is applicable to "tax crimes" only if 
the subject of the investigation is an organized crime 
figure, the evidence available to the United States is 
insufficient to prosecute the individual in connection with 
his organized criminal activity, and the requested assistance 
will substantially facilitate the successful prosecution and 
imprisonment of that individual. Third, under Swiss imple- 
menting legislation, the subject of the investigation can 
contest the taking of authenticated testimony. If contested, 
production of the testimony could be delayed for at least 
one year. Understandably, the Swiss treaty has not been 
useful in tax cases; the standards are too difficult to 

Treaties negotiated or under negotiation since the 
Swiss treaty are much broader in scope. Fiscal crimes in 
general, and tax offenses in particular, are specifically 
covered. Moreover, the United States negotiators have taken 
the position, with a great deal of success, that criminal 
tax offenses ought to be treated in a manner similar to any 
other criminal offenses. 

D. Options 

Where books and records are not in the United States, 
the IRS and the law enforcement community have special 
problems. Some options to be considered to improve access 
to books and records are presented below: 

1. Unilateral Actions 

The United States could change its regulations and laws 
to make more information available, and to make it easier to 
introduce evidence obtained. Some suggestions follow. 

a. Asserting the taxpayer's burden of proof. In 
civil cases, the burden of establishing the tax consequences 
of a transaction is on the taxpayer. As discussed in Chapter 
VII. A. 1., this burden should be vigorously relied upon in 
appropriate cases. 


b. Requiring that books and records be maintained 

in the U.sT Consideration should be given to requiring that 
books and records relevant to tax liability in the United 
States be maintained within the territorial jurisdiction of 
this country, in appropriate cases. The regulations under 
§6001 could be amended to make clear the requirement that 
revelant books and records of foreign subsidiaries of U.S. 
persons must be made available to the IRS. The regulation 
could provide that if the requested records are not produced 
within some stated period of time (e.g., 90 days) the 
taxpayer would thereafter be required to maintain the records 
in the United States. In addition, records of a controlled 
foreign corporation formed in or doing business in a tax 
haven could be required to be kept in the United States, 
unless the U.S. shareholder and the controlled foreign 
corporation agree, in writing, to comply with the stated 
time rule and provide any necessary waivers of foreign law 
rights to withhold the records. 

Similar record keeping requirements could be provided 
for U.S. persons who have control over a foreign trust or an 
interest in a foreign partnership. A regulations project 
dealing with these issues has been established. 

c. Venue where a party summoned is outside the United 
States . Section 7604 could be amended to establish venue in 
a particular U.S. district (e.g., the District of Columbia) 
in those situations where the party summoned is subject to 
the summons jurisdiction of the IRS but resides or may be 
found outside the territorial jurisdiction of the United 

d. Admissibility of foreign business records. Once 
access to books and records in a tax haven is secured, the 
materials must be obtained in a form admissible in court. 
Moreover, an authenticating witness is often required. 
Because, in dealing with foreign jurisdictions, either or 
both requirements often cannot be met, consideration should 
be given to amending Rules 803 and 902 of the Federal Rules 

of Evidence to provide that extrinsic evidence of authenticity 
as a condition precedent to admissibility is not required 
with respect to a foreign business record if (1) the record 
was obtained pursuant to a treaty of the United States, (2) 
authenticity of the record is attested to by the custodian, 
and (3) advance notice is given to the opposing party to 
provide a reasonable opportunity to investigate the authen- 
ticity of the document. Requiring the above procedures to 
be followed (including use of the treaty mechanism) should 
insure that documents will have a high degree of reliability. 


e. IRS review process for mutual assistance . The IRS 
review process for exchange of information requests has been 
streamlineti. It should be monitored to see that delays are 
not occurring. If they are, consideration might be given to 
further streamlining so that a group manager will have 
final field review. Problems of regional or district coordi- 
nation could still be handled by providing copies of 
correspondence to an appropriate official. 

2. Bilateral Approaches 

Tax haven problems, by definition, involve a second 
sovereign jurisdiction, and, also by definition, conflict 
between the laws of that jurisdiction and the U.S. The best 
way to overcome these problems, particularly where a possible 
crime is under investigation, is to enter into bilateral agree- 
ments with the tax haven. 

a. Mutual assistance treaties. The U.S. should consider 
expanding its effort to enter into mutual assistance treaties 
under which the U.S. and its treaty partner agree to provide 
assistance in criminal investigations. Every effort should 

be made to cover fiscal crimes in general, and tax offenses 
in particular. Tax offenses should be treated as any other 
criminal offense. The persons responsible for negotiating 
these treaties should coordinate with IRS, Treasury, and Tax 
Division in deciding which countries should receive priority. 

b. Limited tax treaties . Mutual assistance treaties 
apply only to criminal matters. In addition to mutual 
assistance treaties the United States might attempt to 
negotiate limited tax treaties with tax haven jurisdictions, 
along the lines suggested in Chapter VIII. They would 
include an exchange of information article overriding bank 
and commercial secrecy laws. See draft Model Exchange of 
Information and Administrative Assistance, Paragraph 2, at 
Appendix A to this chapter. The exchange of information 
article would cover both civil and criminal tax information. 

c. Bilateral exchange of information agreements . 
Congress could empower the President to enter into bilateral 
executive agreements with foreign jurisdictions for the 
exchange of tax information. Arguably, the Internal Revenue 
Code disclosure of information provision contained in §6103(k)(4) 
would permit such agreements, in spirit if not literally. 
Technical amendment to the disclosure provision is recommended 
for the sake of clarity. In addition, the summons provisions 

of the Code should be amended to permit the United States to 
assist a foreign jurisdiction which is a party to such an 


d. Revise exchange of information article . The Treasury 
Department should consider amending the model exchange of 
information provision to better comport with the realities 

of international evidence gathering among countries with 
disparate internal legal systems. A contracting country should 
be obligated to use its best efforts within the framework of 
its internal system to supply information pursuant to a 
treaty request. The model, by considering mutuality of 
legal systems among treaty partners, inhibits this. The 
model should require a requested country to use whatever 
procedures it has, even if the requesting country does not 
have or cannot use similar procedures. A draft model article 
is attached as Appendix A to this chapter. 

e. Steps to isolate abusive tax havens . While most 
tax havens deny any interest in attracting tainted money, 
the United States receives little or no cooperation in 
penetrating bank and commercial secrecy laws for tax administration 
purposes. As described in various portions of this report, 

this unwillingness to cooperate creates significant, and at 
times insurmountable, problems for United States tax adminis- 
trators, as well as members of the law enforcement community. 
At some point the United States may determine that tax 
havens are a sufficiently serious problem to require drastic 
steps directed towards gaining access to such information, 
either through a tax convention or an executive agreement. 
One such step might be to adopt legislation specifically 
aimed at tax havens which do not provide information necessary 
to enable the United States to administer its tax laws, as well 
as its other relevant laws. Any country which refused to 
provide information necessary to prove the substance of a 
transaction in a United States court of law would be designated 
a tax haven. Any such legislation would, of course, have to 
contain appropriate relief provisions to permit U.S. taxpayers 
to rearrange their affairs without adverse tax consequences. 
United States taxpayers would be denied tax benefit of any 
transactions with a country so designated. The purpose 
would be to discourage U.S. business activity in the tax 

(i) The tax imposed on amounts paid from the United 
States to a foreign individual or corporation in a designated 
tax haven would be increased from 30 perent to 50 percent. 
This rate would be applied to interest on deposits in U.S. 

(ii) The proceeds of a loan from a designated tax 
haven to a U.S. person would be taxable to the recipient as 
ordinary income, unless that person could prove to the 
satisfaction of the Commissioner, that the loan is bona fide, 
and that the borrower does not have an interest in the 


(iii) For purposes of §902, a foreign corporation 
organized in a designated tax haven would not be deemed to 
have paid any foreign taxes. In addition, the income from a 
designated foreign tax haven would be considered U.S. source 
income, so that it would not increase the numerator of the 
foreign tax credit limitation. This would effectively 
prohibit excess credits from other countries to offset U.S. 
taxes otherwise imposed on income from designated tax havens, 
and would discourage U.S. business from establishing sub- 
sidiaries in tax havens. 

(iv) No deduction would be allowed for an expense or a 
loss arising out of a transaction entered into, with, or by 
an entity located in a designated tax haven, unless the 
taxpayer could establish by clear and convincing evidence, 
including records in the hands of third parties, that the 
transaction had in fact taken place and did not involve a 
related party. Inability to produce third party records 
because of local law would preclude the deduction or other 
tax effect claimed by the taxpayer. 

(v) United States airlines might be prohibited from 
flying to a designated tax haven, and direct flights from 
the United States to or from the haven would be prohibited. 

(vi) U.S. banks might be prohibited from conducting 
business in a designated tax haven. In the alternative, 
they may either be prohibited from making wire transfers 
from the United States to a designated tax haven, or from 
designated tax havens to the United States, or they may be 
required to report all wire transfers between a designated 
tax haven and the United States. 

The following inducements might also be provided to 
encourage tax havens to provide information: 

(i) An exception from the foreign convention rules of 

(ii) Technical tax administrative assistance to smaller 
tax havens and potential tax havens willing to enter into 
limited tax treaties, exchange of information agreements, or 
mutual assistance treaties covering fiscal crimes, with the 
United States. Any treaty would have to contain a meaning- 
ful exchange of information article which overrides present 
or later-enacted secrecy laws. 

Chapter IX - Appendix A 

Article 26 

1. The competent author ites of the Contracting States 
shall exchange such information as is necessary for carrying 
out the provisions of this Convention or of the domestic 
laws of the Contracting States concerning taxes covered by 
the Convention insofar as the taxation thereunder is not 
contrary to the convention. The exchange of information is 
not restricted by Article 1 (Personal Scope). Any infor- 
mation received by a Contracting State shall be treated as 
secret in the same manner as information obtained under the 
domestic laws of that State and shall be disclosed only to 
persons or authorities (including courts and administrative 
bodies) involved in the assessment or collection of, the 
enforcement or prosecution in respect of, or the deter- 
mination of appeals in relation to, the taxes covered by the 
Convention. Such persons or authorities shall use the 
information only for such purposes. They may disclose the 
information in public court proceedings or in judicial 
decisions . 

2. The provisions of paragraph 1 shall be construed so 
as to impose on a Contracting State the obligation to estab- 
lish laws and administrative practices which permit disclosure 
to its own competent authority of such information as is 
necessary for the carrying out of the provisions of this 
Convention or of the domestic laws of the Contracting States 
concerning taxes covered by this Convention. The provisions 
of paragraph 1 shall not be construed so as to impose on a 
Contracting State the obligation: 

(a) to carry out administrative measures at variance 
with its laws and administrative practices; 

(b) to supply information which is obtainable under 
the laws or administrative practice of neither Contracting 

(c) to supply information which would disclose any 
trade, business, industrial, commercial or professional 
secret or trade process, or information, the disclosure of 
which would be contrary to public policy. 

3. The competent authority shall promptly comply with 
a request for information, or, when appropriate, shall 
transmit it to the authority having jurisdiction to do so. 
The competent judicial officials and other officials of the 
Cotracting State requested to provide information shall do 
everything in their power to execute the request. 


4. If information is requested by a Contracting State 
in accordance with this Article, the other Contracting State 
shall obain the information to which the request relates in 
the same manner and to the same extent as if the tax of the 
first-mentioned State were the tax of that other State and 
were being imposed by that other State. If specifically 
requested by the competent authority of a Contracting State, 
the competent authority of the other Contracting State shall 
provide information under the Article in the form of deposi- 
tions of witnesses and authenticated copies of unedited 
original documents (including books, papers, statements, 
records, accounts, or writings), to the same extent such 
depositions and documents can be obtained under the laws and 
administrative practices of such other State with respect to 
its own taxes. 

5. Each of the Contracting States shall endeavor to 
collect on behalf of the other Contracting State such amounts 
as may be necessary to ensure that relief granted by the 
present Convention from taxation imposed by such other 
Contracting State does not enure to the benefit of persons 
not entitled thereto. 

6. Paragraph 5 of this Article shall not impose upon 
either of the Contracting States the obligation to carry out 
administrative measures which are of a different nature from 
those used in the collection of its own tax, or which would 
be contrary to its sovereignty, security, or public policy. 

7. For the purpose of this Article, this Convention 
shall apply to taxes of every kind imposed by a Contracting 


X. Administration 

International issues in general, and tax haven related 
issues in particular, are diffused throughout IRS functions 
and programs. In addition, responsibility for these issues 
shifts, at the litigation stage, either to the Office of the 
Chief Counsel or to the Tax Division of the Justice Department. 
Moreover, other agencies may be investigating a taxpayer 
with respect to the nontax aspects of a case. This is 
particularly likely to occur in narcotics related investigations 
and in tax shelter investigations. 

A. In General 

The IRS annually processes over 95 million income tax 
returns, sends out more than 27 million computer notices 
and conducts over two million examinations of tax returns. It 
is a highly decentralized organization. In the last fiscal 
year the IRS employed an average of approximately 87,000 
people. Approximately 5,000 of these people work in the 
National Office in Washington, D. C. The remainder are 
spread throughout seven regions and 58 districts in more 
than 850 offices across the country and in 15 posts abroad. 

The National Office provides policy direction and 
program guidance and has principal responsibility for 
allocating available resources among IRS programs and among 
the regions. The regional offices, under the direction of 
the Regional Commissioners, perform supervisory oversight 
functions with respect to the districts and service centers 
within their respective regions. The District and Service 
Center Directors are responsible for the conduct of the 
IRS's various programs, including the audit of returns 
having international and tax haven issues and the investigation 
of criminal cases. 

Legal assistance to the IRS is provided by the Office 
of the Chief Counsel. The office is divided into Regional 
and District Counsel Offices. In addition, the Tax Division 
of the Department of Justice litigates tax cases, other than 
in the U.S. Tax Court. 

The two principal IRS functions that establish policy 
and overall direction with respect to enforcement of the tax 
laws as they relate to tax havens are the Examination Division, 
and the Criminal Investigation Division (CID). The principal 
IRS function with day-to-day involvement in the foreign 
area, in support of programs developed at the policy level 
is the Office of International Operations (010). A brief 
description of each of these functions follows. 


1. Examination Division 

The National Office Examination Division provides 
policy direction and program guidance for the examination of 
returns. The General Program Branch has program responsibility 
for a wide range of returns, while the Special Programs 
Branch develops programs for handling special cases, including 
international issues. Generally, field agents of the Examination 
Division audit U.S. persons doing business abroad and 
foreign subsidiaries of U.S. corporations. 

The Examination Division programs that may cover tax 
haven issues include the general program, the fraud program, 
the coordinated examination program (which handles large 
cases and includes an industrywide program), the tax shelter/ 
partnership program, the illegal tax protesters program, the 
unreported income program and the drug and narcotics program. 
The International Enforcement Program (lEP) provides specialists 
to assist examination agents with the international aspects 
of a case. 

The lEP was part of 010 and was removed from 010 in a 
reorganization in the 1960 's. This program is deployed on a 
key district concept. Presently, there are approximately 
200 international agents in 11 key districts and 17 groups. 
The international examiners are specialized agents who 
assist revenue agents in the General Program when a referral 
is submitted. Most of the international examiners are 
assigned to the examination of large multinational corporations. 
International examiners generally do not work on tax haven 
cases concerning individuals, trusts, partnerships or small 

The lEP includes a simultaneous examination program, 
which coordinates joint audits of multinational companies 
with certain of our treaty partners. One criterion for 
selecting a taxpayer for simultaneous examination is involvement 
of a tax haven. There is also an industrywide program 
that gathers and exchanges information on particular industries. 

2. Office of International Operations 

010 was established in 1955 as a division under the 
Baltimore District. On May 1, 1956, it was transferred to 
the Office of Assistant Commissioner (Operations), now 
Office of Assistant Commissioner (Compliance). Over the 
years some organizational changes have been made to better 
enable 010 to deal better with international tax matters 
under its jurisdiction. 


010 is a district type office that, because of its 
unique jurisdictional base and structure, is organized 
within the Office of the Assistant Commissioner (Compliance). 
As in a district office, 010 has an Examination Division, 
Collection Division, Criminal Investigation Division and 
Taxpayer Service Division. In addition to these functions, 
there are the Foreign Programs, and Tax Treaty and Technical 
Services Divisions. 

010 examination agents audit returns of U.S. citizens 
residing abroad, foreign taxpayers (individual and corporate) 
having U.S. source income and returns filed by persons 
required to withhold tax on income paid to foreign persons. 
It conducts coordinated examinations of large foreign corporations 
and, on request from the field, it conducts support examinations 
of overseas subsidiaries of U.S. -based multinational corporations. 
It also examines estate and gift tax returns of both nonresident 
U.S. citizens and aliens. Groups of field agents specialize 
in foreign entertainers, athletes, banks and insurance 

010 operates as a service organization for all 58 
districts in securing information from foreign countries to 
the extent that the districts bring these matters to the 
attention of 010. The Foreign Programs Division assists in 
the performance of functions under tax treaties, principally 
involving specific requests under the exchange of information 
provisions. The Division also coordinates and controls 
foreign travel of IRS employees and generally assists 
employees in the execution of assigned duties performed 

The IRS has 15 foreign posts organized under the Foreign 
Programs Division, including a post in the Bahamas. The 
foreign activities of 010 are carried out by Revenue Service 
Representatives (RSR's) located at the foreign posts. They 
perform examination and collection functions directly and 
also pursuant to collateral requests from other IRS offices. 
On request of a district, they may obtain information in 
connection with a district criminal investigation. They 
hold conferences abroad for the Appeals Office, and assist 
in settling administratively with foreign counterparts any 
international tax disputes that arise under Competent Authority 
provisions of tax treaties. 

The Tax Treaty and Technical Services Division accumu- 
lates and analyzes information concerning foreign tax laws 
and U.S. tax treaties. It also has responsibility for the 
preparation and negotiation of Competent Authority cases. 


3. Criminal Investigations 

The Criminal Investigation Division (CID) generally 
deals with fraud investigations of U.S. residents and citizens, 
including citizens residing abroad and nonresident aliens 
that are subject to U.S. filing requirements. The National 
Office CID assists field CID offices in special inquiries 
and assists in securing available information from foreign 
countries and U.S. possessions relating to tax matters under 
joint investigation. 

The Criminal Investigation Division oversees 2,800 
special agents that enforce the criminal statutes applicable 
to the tax laws. Special agents receive specialized professional 
training at the Federal Law Enforcement Training Center 
operated by the Department of Treasury. The special agents 
investigate criminal violations of the tax laws in joint 
investigations with revenue agents. They also participate 
in joint investigations with other agencies, often in a 
grand jury. The tax crimes investigated include bribes, 
kickbacks, laundered money and hidden deposits. 

Special agents are located in each of the 58 IRS dis- 
trict offices throughout the country. Within each district, 
a Criminal Investigation Division is responsible for investigations 
within its area. 010 also has a Criminal Investigation 
Division which may investigate alleged criminal violations 
by taxpayers under 010 jurisdiction. Seven Assistant Regional 
Commissioners (Criminal Investigation) work functionally 
with the Office of the Director of CID in the National 

The criminal narcotics effort of the IRS is undertaken 
by CID and is coordinated in the National Office in the 
Special Enforcement Program by the High Level Drug Dealers 
Project, which focuses on major drug traffickers. The IRS 
has investigated some 1,200 cases since the inception of the 
project in July of 1976 and currently has under active 
investigation over 400 alleged drug traffickers. The IRS is 
also currently participating in 14 strike forces, in connection 
with which it is investigating some 270 organized crime 

Few of these cases (less than 10) involve narcotics. 
IRS management intends to increase the narcotics-related 
effort. In fiscal year 1981, it is estimated that 15 percent 
of CID's direct investigation time will be devoted to narcotics- 
related investigations. 


In order to develop high quality narcotics cases 
efforts are being made to improve coordination with the 
Department of Justice, particularly the Controlled Substances 
Unit under the direction of the U.S. Attorneys, and the cash 
flow projects. Further efforts at better coordination with the 
Drug Enforcement Administration (DEA) are proceeding and 
investigations of leads supplied by the DEA are being stepped- 
up. It is too early to determine how many of these will 
result in prosecutions that involve the use of offshore tax 

The IRS is also increasing its efforts to identify 
potential criminal investigation tacgets. Additional work 
is being done to increase the utilization of the currency 
transaction reports (Form 4790) in cooperation with the 
Customs Service. The IRS has also placed one full-time 
agent at the El Paso Intelligence Center (EPIC) run by DEA. 
EPIC is a computerized data base with numerous participating 
federal and state agencies of which DEA is the leading 
agency. EPIC is used for the detection, interdiction and 
investigation of narcotics trafficking and financing. It is 
hoped that placing an agent there will help the IRS to 
identify high level drug traffickers and those helping them 
to conduct their finances. 

4. Office of the Chief Counsel 

The Office of the Chief Counsel is organized in regions 
and districts parallel to the IRS field structure. In the 
National Office there are various divisions, including a 
Criminal Tax Division, a General Litigation Division, a Tax 
Litigation Division, an Interpretative Division, a legislation 
and Regulations Division and a Disclosure Division. Much 
of the attorney time is spent in preparing, reviewing and 
assisting in the development of substantive and procedural 
guidance, including tax regulations, revenue rulings and 
decisions to litigate. 

There are also seven Regional Counsel and 45 District 
Counsel. Most of the attorneys in the District Counsel 
offices are engaged in tax court litigation; others advise 
Justice attorneys on various matters, including summons 
enforcement. One of the District Counsel offices services 


B. Analysis 

The international examiners and the 010 agents are the 
IRS's international tax audit experts. Therefore, the 
manner in which they are trained and deployed can impact on 
all international audit areas, including tax havens. The 
agents in the General Program are not prohibited from exam- 
ining international issues, and, in fact, there appears to 
be significant international activity in the general pro- 

1 . Coordination 

One of the most significant problems in international 
enforcement lies in achieving effective coordination between 
functions. The volume of international transactions with 
which the IRS must deal continues to grow. Issues become 
continuously more complex. Despite the continued efforts of 
management to maintain close liason and coordination in the 
international area, there are delays and failures of communication. 
These problems impact particularly on the ability to deal 
with tax haven transactions, where the law and the schemes 
change rapidly and where it is important that up-to-date 
information be disseminated to the field. 

Because IRS is a diverse decentralized organization, inter- 
national tax matters, as any others, arise in many of the 
functions. Within the Office of the Assistant Commissioner 
(Compliance), international issues arise in both the international 
program and the general program of the Examination Division, 
in 010, in CID, and in Collection. There is an international 
group in Technical. In the Chief Counsel's office, international 
issues are addressed by the Legislation and Regulations 
Division, by the Interpretative Division, and by the Tax 
Litigation Division, as well as by District Counsel attorneys 
in the course of litigation. Furthermore, the Department of 
Justice Tax Division deals with international issues in its 
consideration of civil and criminal cases. 

The central problem is that there is no one person below 
the Assistant Commissioner level with whom one can discuss 
international compliance problems. For example, if it is 
necessary to gather information concerning civil inter- 
national activities, both 010 and the Examination Division 
must be contacted. 


The lack of centralized control also makes it difficult 
to be certain that tax haven cases are being properly controlled. 
For example, it is possible for 010 to refer matters to the 
field without clearance from the Examination Division. 
Accordingly, cases which lEP is trying to coordinate can 
inadvertantly be sent to the field. 

This also creates problems of dissemination of information 
to the field. For example, general information that is 
gathered by lEP and disseminated to its agents is not necessarily 
given to 010 and CID agents. The converse is also true. 

In addition, there appears to be some problem in coor- 
dination between Treasury's Office of International Tax 
Counsel and IRS. There is some feeling that IRS is con- 
sulted only on an ad hoc basis, making coordination between 
the overall needs of international tax administration and 
current treaty policy difficult. In part, this may result 
because of the difficulty of finding the proper person with 
whom to coordinate in IRS. 

Another problem of coordination that was raised numerous 
times during our discussions with field agents is a perceived 
lack of communication between the field and 010. The feeling 
was expressed that the problems arose particularly where a 
tax haven was involved. Some agents believe that their 
requests were not always handled as quickly as the field 
agents would have liked and that, at times, information 
that may have been available was not developed and sent to 
the field. The same problem was raised by attorneys in the 
Tax Division. 

In part, the problem may be a failure of communication. 
CID agents. Examination agents, and Justice attorneys do not 
fully understand the problems faced by RSRs in gathering 
requested information. In part, the problem may lie in the 
procedures for referrals from the field to 010. This procedure 
has recently been streamlined and an option for further 
streamlining is presented in Chapter IX. 

Questions have been raised as to the adequacy of coordi- 
nation between the IRS and other federal agencies concerned 
with offshore transactions. There seems to be a high level 
of coordination with respect to individual requests involv- 
ing specific active cases. We are uncertain whether there 
is adequate coordination at higher levels on other than an 
ad hoc basis. There does not appear to be much coordination 
in the way of exchange of information on offshore issues. 


Most coordination takes place at the case investigation 
level. The Examination Division, which handles civil cases, 
has a central coordinator or liaison with responsibility for 
funneling field agents' requests for information to other 
agencies. Often, there is a liaison person at the requested 
agency with whom the IRS liaison can speak. There is no 
central IRS liaison for requests from other agencies. The 
other agency writes to the director of the IRS district 
that has audit jurisdiction over their target. The request 
is then routed through that district's disclosure office to 
determine whether it can be honored. There is no centralized 
file of such requests. 

Liaison with the Commodity Futures Trading Corporation 
(CFTC) is handled separately. Commodity shelters, partic- 
ularly so-called "tax straddles," have become a major problem, 
and are of particular concern to the IRS and the CFTC. The 
IRS has established a shelter coordinator to monitor IRS 
shelter activity, including commodity shelters. Liaison 
with the CFTC is maintained directly by that coordinator. 
This liaison includes funneling IRS field requests to the 
CFTC as well as arranging for some joint training with the 
CFTC. A procedure has been established under which the 
CFTC will advise IRS when it has completed an investigation, 
thus IRS can conduct a tax investigation if warranted. The 
CFTC, however, has rarely become involved in offshore transactions, 
because it does not have jurisdiction unless the offshore 
transactions are being conducted through a domestic broker. 

CID has a liaison person in the National Office who 
funnels requests from the field to other agencies. In CID, 
however, much of the routine coordination occurs at the 
field level. National office liaison is available to those 
agencies that prefer to deal with the National Office. Most 
agencies apparently prefer to deal directly with the field 
and come to the National Office only if there is a liaison 
problem. The general feeling is that the liaison works well 
within the bounds set by the disclosure rules. 

There are special coordination procedures with the Drug 
Enforcement Administration (DEA) with respect to narcotics 
investigations. CID has a separate DEA liaison person. 
Most of the contact is at the local level where it can be 
focused on ongoing investigations. The National Office 
generally attempts to facilitate local level contacts and to 
arrange for new methods of cooperation, should that be nec- 
essary. In addition, approximately 32 percent of the currently 
active narcotics cases are before grand juries, coordinated 
by the Assistant U.S. Attorney conducting the grand jury. 
Most of these grand juries involve multiagency investigations. 


With respect to ongoing investigations of major drug 
dealers and other major financial crimes, interagency coordination 
can best be achieved through the grand jury. There the 
U.S. Attorney can provide direction and coordinate the 
efforts of the various agencies involved. It also overcomes 
some of the coordination problems caused by the disclosure 
rules of §6103. 

At the beginning of this study some agents in the IRS 
and other agencies expressed the opinion that it took too 
long for IRS to approve participation in a grand jury investigation. 
Steps have been taken to speed up the review process for 
grand jury clearance, and most agents we talked with were 
hopeful that the problem had been minimized. 

There is also an interagency narcotics-oriented group 
that meets to discuss general offshore problems and to 
share expertise involving offshore cases. 

There appears to be little routine regular coordination 

at the managerial level, either in the civil cases involving 

the Examination Division or in the criminal cases involving 

2. Coverage of Tax Haven Cases - Availability of Expertise 

Another significant problem is the lack of expert 
coverage of smaller tax haven cases. During 1980, the Tax 
Haven Study Group sent a questionnaire to 6,085 General 
Program agents. Two thousand five hundred responded that 
they had closed a case involving a foreign transaction 
during the preceding 12 months. A second questionnaire 
prepared in an attempt to get more detailed information on 
certain specific international transactions indicated that a 
significant number of these cases involved a tax haven. 
This survey of the General Program indicated that agents are 
raising international issues, but the survey did not attempt 
to evaluate the merit, quality or development of these 
issues. Nevertheless, we did note that General Program 
agents, particularly those who handled smaller cases, did 
not always seem to understand the international issues in 
general, and the special problems of tax havens in particular. 
Often, the agents did not distinguish between the lEP and 


International Enforcement Agents deal primarily with 
large cases. In many districts, the international enforce- 
ment program does not have the resources to handle a significantly 
increased work load, which would likely result if more referrals 
from the General Program were made. Furthermore, because 
they have not had the opportunity to work the cases, agents 
in the International Program did not appear to be knowledgeable 
about tax haven-type entities commonly used by individuals, 
such as trusts and partnerships. As a result, tax haven 
issues often do not get adequate coverage. 

In fact, the Internal Revenue Manual sets forth man- 
datory requirements for selecting for audit, domestic cor- , , 
porate returns having stated international characteristics.— 
However, there are no mandatory requirements for selecting 
domestic individual, partnership, and fiduciary returns 
indicating foreign business„transactions or interest in 
foreign financial accounts.—'^ Thus, the tendency would be 
for corporate rather than individual returns to be scrutinized. 

During discussions with field personnel it has been 
stated that there is a reluctance to examine tax returns 
with international tax issues, and tax haven issues in 
particular, because of the difficulty of obtaining information, 
and because such cases were perceived as taking more time 
than domestic cases. This perception may have been due to a 
lack of understanding of the issues. 

It is obvious that practitioners are aware of, and take 
advantage of, both the lack of coverage and the lack of 
coordination. It would appear that at least some tax 
planning using tax havens for smaller taxpayers results in 
transactions that are not receiving expert coverage; some of 
these are the most abusive transactions. 

The staff resources devoted to international issues, and 
tax haven issues in particular, have not kept pace with the 
growth in international business. As indicated in Chapter 
III, data show that U.S. direct investment levels in foreign 
corporations almost tripled from 1968 to 1978, and that 
earnings increased four times. During the same period the 
number of international examiners only doubled, from 94 to 
192. As of the end of 1980, there were 209 international 
examiners. A concomitant problem is that overall audit coverage 
has not increased since 1971, and in fact has declined since 
1976. In 1976 2.59 percent of relevant returns were audited, 

1/ IRM 4171. 22. 
2/ IRM 4171.21(1). 


while in fiscal year 1980 only 2.12 percent were audited. 
If current budget requests are not supplemented, it is 
projected that coverage may drop to 1.86 percent in 1981. 
This means that the IRS will not be able to do its job in 
the tax haven area. More coverage is necessary and additional 
resources are needed to provide that coverage. 

3. Providing Technical and Legal Assistance to the Field 

Adequate technical expertise is not available to the 
field on a routine basis. In the course of an audit, an 
agent can request technical assistance from the Assistant 
Commissioner (Technical). This, however, is a formal procedure 
that can require significant time. Accordingly, the 
tendency is not to use it in many cases. The process is not 
available to a CID agent and was never intended to be. 
Furthermore, there is no central repository of knowledge on 
tax haven problems. Accordingly, new developments in the 
tax havens themselves, or in the use of tax havens by U.S. 
persons, are not brought to the attention of agents or 
others who can deal with them. Part of the problem is 
coordination, which was addressed above. 

Tax shelter cases that come to the attention of Technical 's 
tax shelter group are an exception. If needed, a ruling can 
be prepared and issued on an expedited basis. 

In CID, unless there is a local agent who has gained 
some expertise on offshore cases, there is no ready source 
of knowledge about tax haven problems to whom a special agent 
can turn for guidance. 

Examination and CID agents have only limited access to 
research tools and current publications. The IRS National 
Office Library did not even have some of the more regularly 
used tax haven publications. 010 has a library, but, as a 
practical matter, it cannot be used by district agents on a 
regular basis. 

A related problem is the lack of expert legal assist- 
ance to CID during the course of a criminal investigation. 
Tax haven cases are often more complex and difficult to 
develop than domestic cases. The law involving foreign 
transactions and reporting requirements is among the most 
complex in the Internal Revenue Code. Moreover, criminal 
cases often involve violations of nontax statutes, which 
can present complicated legal issues. 


CID agents are well trained and experienced financial 
investigators. They are not necessarily experts in the 
technicalities of the tax law. Accordingly, considering the 
complex legal issues that arise in the course of a tax 
haven investigation, it would be useful if CID agents could 
get legal assistance during an investigation. 

It does not appear that special agents have a significant 
level of legal assistance available to them during an investigation. 
As a general rule, a lawyer is involved only after the 
investigation is completed, and then only in the course of 
review of a prosecution recommendation by the District 
Counsel, Department of Justice's Tax Division, or the U.S. 
Attorney. As a result, some cases are declined during the 
review process because of a legal flaw that might have been 
corrected had an attorney assisted during an investigation. 
Alternative approaches could have been recommended, or the 
case dropped before significant resources were expended. 

IRS does have a procedure that permits CID to pre-refer 
cases to District Counsel during an investigation. However, 
it is rarely used. There are a number of reasons for this. 
With respect to tax havens, a primary reason is that CID agents 
believe district counsel attorneys rarely have the expertise 
to help with the complicated international and criminal issues. 

4. Simultaneous and Industrywide Examinations 

The Simultaneous Examination Program has become an 
important focus of the lEP. Basically, the program is a 
coordinated exchange of information between the U.S. and one 
of its treaty partners with respect to designated taxpayers. 
The selection criteria and procedures for each country with 
which we have a program are set forth in a manual supplement. 
One of the stated objectives of the program is to improve 
procedures for exchanging information to be used in examinations 
of multinational companies which have intragroup transactions 
that may involve tax havens. 

The chief advantage of the program is that it allows 
each country to see a transaction from both sides. For 
example, if a foreign company is exporting goods from France 
to a tax haven and then selling from the tax haven to the 
U.S., the IRS, under the simultaneous program, can get from 
France information regarding the sales price. Without the 
simultaneous program, it is often difficult to get this 
kind of information in a timely manner. The program does 
appear to have limits. The tax years under audit must be 
the same in each country, and as a practical matter, the 


taxpayer must have significant international transactions of 
interest to both countries. The program, by its nature, is 
most useful for cases involving larger companies or cases 
involving many taxpayers (such as a tax shelter case). The 
program can only be used with treaty partners, and IRS will 
probably not be able to arrange programs with all of them. 

5. Chief Counsel 

International expertise in the Chief Counsel's Office 
is diffused among a number of divisions and is not avail- 
able to the field on a routine basis. While there is special- 
ized international expertise in the National Office, there 
is little in the Regional and District Counsel offices. 
Field agents often complain that they cannot get expert 
legal assistance in tax haven cases. There is no formal 
coordination between the international functions in the 
various Chief Counsel divisions. 

Some of the most difficult tax haven issues involve 
international information gathering. However, there is little 
international information gathering expertise in Chief Counsel 
offices. Today, the Chief Counsel experts are in 010 District 
Counsel. Its primary function is to service 010, which 
takes up most of its time. In addition, it provides assistance 
to the field upon request. However, they do not get many requests 
and we have found that many field personnel are not aware of 
the existence of this expertise. The Office does not have the 
resources to promote itself. 

C. Options 

Described below are numerous options that might be 
considered for changes in IRS administrative practices and 
training to better deal with tax haven related problems. As 
with other areas addressed in this report, it is often 
difficult to separate tax haven issues from other international 
issues. Accordingly, some of the options presented below 
should be considered for international issues in general. 

1. Improve Coordination With Respect to Tax Haven Issues 
Specifically and International Issues in General 

Improved coordination with respect to tax haven transactions 
is needed within the IRS and in the Office of the Assistant 
Commissioner (Compliance) in particular. In fact, better 
coordination of international issues in general appears 
warranted. Furthermore, more focused attention on tax 
havens is needed. 


The decentralization of the IRS makes coordination 
particularly difficult. With respect to tax havens, there 
is a threshold problem that there is no centralized group to 
gather information. Consideration should be given to creating 
a unit in the National Office that would coordinate Exami- 
nation and 010 programs involving tax havens, keep abreast 
of current tax haven planning and information, and most 
importantly, disseminate this information to field personnel. 
The information dissemination function and coordination 
function should also include CID. This group could make 
materials available to Examination and CID, provide a certain 
level of expertise to the field, and keep apprised of developments 
in the area. Members of the group could attend seminars and 
prepare reports that would be made available to the agents. 
Materials gathered at seminars could likewise be disseminated 
to the field. Further, the group could coordinate with 
programs, such as the tax shelter program, which include 
cases that involve significant tax haven issues. The group 
might also coordinate with other agencies concerned with tax 

Creating such a group would, however, further fragment 
the international area. The Assistant Commissioner (Compliance) 
should study ways in which coordination among the various 
compliance functions dealing with tax haven issues can be 
improved. The goal should be to have one person in the 
Assistant Commissioner's office who would be aware of the 
international issues in Compliance, and who would be familiar 
with tax treaties and the foreign information gathering 
activities of the IRS. This person might have personnel who 
would concentrate on monitoring important international 
issues, gathering information, and providing guidance and 
assistance to the field. Providing a central focus would 
also improve coordination with other Assistant Commissioners,—^ 
Chief Counsel and Treasury's Office of International Tax 

Consideration should be given to appointing an offshore 
coordinator in CID. This person could disseminate tax haven 
information to the field, and could act as a liaison with 
other groups within IRS, Chief Counsel and other government 
agencies with respect to tax haven matters. 

2/ The Assistant Commissioner (Compliance), for example, is 
the Competent Authority for treaty interpretation, but 
the Assistant Commissioner (Technical) must concur in 


010 might also explore means of improving communications 
with the field and Justice's Tax Division. Any study by the 
Assistant Commissioner to determine ways in which coordination 
can be improved might also focus on means for improving 
coordination between the overseas information gathering 
functions of the IRS and the field. Seeking broad experience, 
as well as foreign language skills in appropriate cases, 
might be useful. 

As described above, while there appears to be adequate 
coordination with respect to individual cases and gathering 
information in individual cases, we see inadequate coordi- 
nation with respect to tax haven issues at a more strategic 
level. It was our sense from visiting and discussing 
problems with personnel in other agencies that it would be 
useful to arrange for some meetings at a managerial level to 
determine what kind of information sharing could be done. 
In some respects this is happening with the ad hoc group on 
narcotics. However, a high level group, focusing on more 
than narcotics, might be worthwhile. 

2. Increase Coverage of Tax Haven Cases 

It is clear that the use of tax havens by U.S. taxpayers 
is significant and is growing. There are large numbers of 
cases with tax haven issues under audit in the general 
program. Very few agents in the general program, however, 
have the expertise to deal with complicated and unique tax 
haven cases. The lEP contains Examination's international 
experts, but they focus primarily on large cases. As a conse- 
quence, the failure to take on smaller cases has prevented 
the development of a body of expertise in the international 
trust, partnership and shelter area in the field. As a result, 
some tax haven cases are not being adequately developed 
because most regular agents do not have the training or 
experience to deal with them. Accordingly, taxpayers can 
abuse the system with a good chance of success. 

The lEP could be expanded to enable it to give more 
assistance in smaller cases, including those of individuals 
engaged in shelter or trust transactions involving tax 
havens. Increased coverage would require that additional 
agents be assigned to the international program. A decision 
must be made by managment as to whether such an expansion 
is justified if it is at the expense of audit coverage 
elsewhere. Additional agents should be specifically allocated 
to auditing individuals and smaller companies. This would 
help to insure that smaller international cases receive 
adequate attention. 


If the lEP is expanded, consideration should be given 
to mandatory requirements for selecting or referring for 
audit or assistance individual, partnership and fiduciary 
returns indicating international transactions involving tax 
havens. Because some of the more elusive schemes involve non- 
filers or returns which appear to lack audit potential, it will 
often be necessary to identify the schemes and the promoters 
in order to identify the tax returns. 

3. Expand Training of International Examiners to Include 
Noncorporate Issues and Expand Training of Agents in 
the General Program 

Because the International Examiners generally handle 
large cases involving multinational corporations, they get 
little exposure to trust or partnership issues. Their 
training does not cover these issues. If it were decided 
to expand the lEP as suggested above, then training should 
include partnerships and trusts. 

At times, it appears that agents are not thoroughly 
familiar with the problems faced by taxpayers in complying 
with requests for information. Misunderstandings and unnec- 
essary confrontation can result. In addition, today most 
training is done by the IRS's own agents who, because they 
are dealing with prior years' tax returns, may not be completely 
aware of the most recent developments. 

To correct this situation, arrangements could be made 
to hold short training sessions conducted by outside persons. 
Outside experts could give agents valuable insight into the 
methods businesses follows in operating. For example, the 
Federal Bureau of Investigation has a program under which 
financial experts from the Wharton School of Business teach 
courses in international banking. They have found this 
extremely useful in helping their agents to deal with bank 
fraud cases. 

Tax haven awareness training, as well as some general inter- 
national training, should be given to agents in the general 
program. Today, many agents in the regular program are not 
aware of tax haven problems. They do not realize, for 
example, that transactions involving the Turks and Caicos 
Islands or Belize are potentially questionable. General 
training does not make them aware of these kinds of issues, 
nor does it make them familiar with foreign trusts, foreign 
bank accounts or other foreign transactions. 


It would appear that the level of international activ- 
ities in the general program is high enough that some aware- 
ness training, as well as some basic training, could be 
provided. We would suggest that any awareness training and 
general international training describe the lEP and 010, and 
the referral procedures to each. We found significant 
confusion among agents as to the distinction between the two 

Furthermore, training could give some guidance on 
dealing with dilatory tactics of taxpayers. Some taxpayers 
employ delaying tactics when dealing with an IRS agent, 
particularly where tax haven issues are involved. It is not 
clear how widespread this problem is, but it clearly exists. 
In many cases agents are not prepared to deal with these 
tactics. Agents should be schooled in the basic principle 
that if the taxpayer fails to corroborate a deduction, the 
deduction can be denied without the IRS having to go through 
unreasonable attempts to obtain records. Techniques for 
setting up §482 adjustments and for denying deemed paid 
credits where adequate information is not made available 
could also be taught. 

4. Provide Additional Technical and Legal Expertise to 
the Field 

There is clearly a need to provide the field with 
additional technical expertise. Establishing a tax haven 
coordinator or group within Compliance might help as might 
appointing an offshore expert in CID. 

Another option that should be considered is to make 
legal assistance available to agents, particularly CID 
agents, during the course of an investigation. While adoption 
of this option would require expenditure of resources, this 
guidance might replace District Counsel post-investigation 
review in offshore cases, and thus save the attorney time 
expended in performing that review. In addition, it would 
enable District Counsel attorneys to gain much needed experience 
in both international and criminal issues. 

5. Expansion of the Simultaneous Examination Program 
and the Industrywide Exchange of Information Programs 

The Simultaneous Examination Program has already proved 
useful in dealing with tax haven related cases. It has the 
potential to be one of the most useful programs for auditing 
tax haven cases. At the same time, however, it also has the 
potential to be costly from the point of view of National Office 
management time. The industrywide program appears to be 


developing useful knowledge concerning the tax haven operation 
of a few industries. Consideration should be given to 
expanding these programs, both by adding additional treaty 
partners, and by increasing the number of cases under simultaneous 
examination. This expansion must be coupled, however, with 
careful monitoring to insure that the program does not grow 
beyond a useful level, that the best cases are being identified, 
and that the U.S. is getting its share of the benefits. 

6. Chief Counsel 

Consideration should be given to designating a National 
Office attorney as the international evidence gathering 
expert for Chief Counsel. 

As described in Chapter IX, international information 
gathering is complicated, time consuming and presents 
unique legal issues. The necessary expertise can only be 
acquired by seeing a large number of problems. A person who 
is the focal point for all Chief Counsel information gathering 
problems would eventually develop that expertise. 

This expertise could best be developed and made avail- 
able to the field by designating one National Office Chief 
Counsel lawyer as the internal information gathering expert. 
This person's primary function would be to give guidance to 
field personnel with international information gathering 
problems. He could visit district offices in order to make 
them aware of the availability of his services. In the 
alternative, this function could be left in 010 District 
Counsel, but with additional resources so that they could 
devote more time to educating other district counsel and the 
field as to the availability of their expertise and to 
following up on cases to further develop the expertise. 

An advantage to keeping the function in 010 District 
Counsel is that a number of attorneys, including a career- 
oriented District Counsel, would gain expertise. There is 
less chance that the expertise would be lost if one attorney 
left an office. On the other hand, a National Office person 
would be able to focus more clearly on providing a service 
to the field, because that would be his sole function. The 
010 District Counsel office also services 010 and the same 
focus is accordingly not as easy to develop. 

The Justice Department has, in its Criminal Division, 
an Office of International Affairs that provides such 
expertise to that department. Their Tax Division has recently 
designated one of its attorneys as its international infor- 
mation gathering expert. A Chief Counsel expert could 
develop contacts in that and other Federal offices concerned 
with similar problems. 


Further, consideration should be given to designating 
one attorney in each of certain key districts as the inter- 
national expert for the region or for a number of districts. 
An international expert could assist agents in Examination 
and CID when they are faced with difficult technical issues 
or with international information gathering problems. These 
attorneys might also be available to advise or assist Chief 
Counsel attorneys litigating complicated international