We answer these and other questions below.
a. Definition of “tax haven”
There is no precise definition of what a “tax haven” is, but it typically is a state, country, or territory that has low (or no) tax, and is often characterized by a lack of transparency. The Organization for Economic Co-operation and Development (OECD) identified four factors when it tried to define a tax haven. It asks whether the state, region, or territory: (i) contains low or no tax; (ii) fails to have an effective exchange of information; (iii) lacks transparency; and (iv) whether it requires there to be substantial activity—but whether it is simply attracting people to park their assets there for tax reasons.
See Organization for Economic Development and Cooperation, Harmful Tax Competition: An Emerging Global Issue, 1998, p. 23 (https://www.oecd.org/tax/transparency/44430243.pdf).
b. Identified tax havens
Most of the identified tax havens tend to be concentrated in certain regions—like the Caribbean, the West Indies, or Europe. There are about 50 such regions, they include (but not limited to): Aruba, Bahamas, Barbados, the British Virgin Islands, Cayman Islands, St. Lucia; the U.S.Virgin Islands, Costa Rica, Panama, Hong Kong, Liechtenstein, Cook Islands, etc.
The United States system of income tax is such that U.S. taxpayers are taxed on their “worldwide” income—income from all sources. That is not necessarily so with many other countries. These other countries impose income tax on income that is “sourced” to that country. Therefore, U.S. taxpayers frequently transfer funds to offshore accounts (like an offshore hedge fund, for example, which are organized outside the United States), where it will be managed in a tax haven, subject to low or no income tax. These taxpayers are further incentivized by the bank secrecy laws that may exist in that state, country, or territory. These taxpayers, often successfully and often unsuccessfully, avoid income tax on a fair amount of their foreign investment income.
The Cayman Islands is presently one of the favored jurisdictions for hedge funds to be registered in. In 2008, the Cayman authorities reported that over 10,000 hedge funds were registered there. Bermuda is also favored—it is reported to have a growing number of hedge funds. Bermuda, like any good tax haven, has no or minimal tax and offers bank secrecy. However, the regulations on Bermuda hedge funds are increasing—yet, despite this increase, one’s account information is often thought to be beyond the reach of many jurisdictions. In this respect it differs from the Cayman Islands or the British Virgin Islands which have certain bilateral tax information agreements in place.
c. Bermuda and other tax havens—are they beyond the reach of the IRS? Pending legislation threatens many tax havens.
Although Bermuda (and other places) are thought by many to be beyond the reach of other jurisdictions (like the United States), things are not always that clear. Current proposed legislation would put a swift death to many legal structures in tax havens, including foreign hedge funds managed and controlled in the United States.
When a hedge fund files its articles of organization in a tax haven (like Bermuda) it is a non-resident for U.S. income tax purposes. These hedge funds often invest in U.S. stocks, as well as foreign stocks (and other investments). Moreover, many of these so-called “offshore hedge funds” are actually managed and controlled within the United States.
d. Stop Tax Haven Abuse Act
This has spurred some to pressure Congress to modify the definition of a “domestic” hedge fund to include any and all those that are managed/controlled within the United States. Presently, under Section 7701(a)(4), a “domestic” corporation or partnership is one that is created or organized in the United States or under the law of the United States or of any State unless, in the case of a partnership, the Secretary provides otherwise by regulations. Section 7701(a)(5) provides “foreign” corporation or partnership is one that is not domestic. There is proposed legislation that would expand this definition. See the text of “Stop Tax Haven Abuse Act”: https://beta.congress.gov/bill/113th-congress/senate-bill/1533/text
The effect of Stop Tax Haven Abuse Act is to make foreign hedge funds organized under the laws of Bermuda (and other jurisdiction)—but which are managed and controlled in the United States—have U.S. sourced income, subject to U.S. taxation. In other words, it would make them U.S. domestic corporations for income tax purposes. It would also entail, as a practical matter, that in order for a hedge fund to remain “foreign” the day-to-day operations, staff, major decisions, and the like must be made at the situs of the tax haven.