Tax Exempts - The Paradise Papers

Tax Exempts - The Paradise Papers

Taxes are flavor of the month. The Tax Cuts and Jobs Act (House Bill) was released last week; the Senate is about a week behind with its own bill. The press and professional advisors are producing article after article to figure out what it all means.






The lobbyists are outraged – of course – and are busy at work on behalf of their clients. Amid all this, the Süddeutsche Zeitung in co-operation with the International Consortium of Investigative Journalists has released the Paradise Papers. The New York Times has covered this in depth.


The New York Times is an excellent newspaper. Sometimes it loses a step, though, when it comes to taxes. The recent article by Stephanie Saul is an example.


The article is another in the series of articles concerning the Paradise Papers. The Paradise Papers, an even larger trove of leaked documents than the Panama Papers, released in 2015, cover in massive (13.4mn documents) detail the activities of individuals and corporations using offshore entities in tax planning. The information originates, in large part from the law firm Appleby.


Some of the activities described are questionable and need further investigation by affected tax authorities. The one that Saul focuses on is not objectionable. The ostensible problem is that US tax-exempt investors such as endowments and pension funds are investing in offshore entities and avoiding tax. This much is true. It is not, however, a problem and there should be no objection.


Tax-exempt foundations are supposed to be passive investors of funds designed to meet tax-exempt needs such as education or the provision of pensions. What they are not supposed to do is participate in active commercial businesses. The concern is that they would have an unfair competitive advantage if, for example, they started making ice-cream and selling it for a profit. To discourage this behaviour, Congress imposes a tax on the unrelated business income of tax-exempt organizations (UBI or UBIT).

 





The structure Saul targets is the one where tax-exempts invest in US hedge or private equity funds though offshore blocker corporations in a low-tax jurisdiction such as The Cayman Islands. The result of this structure is that tax-exempts can invest in such funds without suffering UBIT. Leverage employed by the partnership creates a similar UBIT problem.


Because these funds are structured typically as partnerships, investors in them are attributed with the activities of the partnership itself. A recent article discussed one aspect of this of concern to foreign investors who, if they invest in a hedge fund that originates loans, will be deemed to be participating in the business of lending. This would cause them to have effectively connected income and oblige them to file a US tax return.


Tax-exempts investing directly in a US hedge fund or private equity vehicle would be considered, for similar reasons to be involved in the business of those partnerships and, therefore, to have UBIT.


If, however, they invest through a corporation, they will be blocked from such attribution – hence the term ‘blocker corporation’. The problem with corporations is that they impose a second level of tax. This is a friction suffered by all corporate investors, but one that is particularly frustrating for a tax-exempt investor. If the blocker corporation is situated in a low-tax jurisdiction, this friction is reduced or eliminated.







Blocker corporations of this kind are usually referred to as passive foreign investment corporations (PFICs). The IRS is alert to the opportunities that exist for offshore tax deferral in PFICs and so imposes obstacles and penalties on PFIC investment. One way of avoiding the penalties is to declare the income and recognize it currently. Investors may make an election to do so. Such an election turns the PFIC into a qualified electing fund (QEF) and the penalty is avoided. The cost, of course, is that the income distributed is subject to taxation – or not, if the investor is exempt from tax in the US. Another way to avoid PFIC penalties is simply to receive distributions currently.


PFICs, therefore, are the investment vehicle of choice for US tax-exempt investors wishing to allocate investment dollars to hedge funds and private equity (alternative investments). While it is fair to describe the structure as one that is entered into for the avoidance of tax, the tax being avoided is one that might more properly be described as tax that should not be payable by tax-exempt investors but would – somewhat unfairly – be paid without such structuring.


The question of whether it would be fair for a tax-exempt investor to pay UBIT in these circumstances is clearly one of policy. The policy should be informed by the rationale for any investor, including tax-exempts, for investing is the asset class, broadly described as alternative investments, represented by hedge funds and private equity – anything, in fact, other than stocks, bonds or cash. It is not the purpose of this article to make the business case for alternative investments, but simply to note that alternative investments now represent a $7 trillion sector worldwide. As an asset class suitable for tax-exempts, it was pioneered by endowments run by Harvard and Yale as a means of generating absolute returns uncorrelated to other asset classes. By now, it is mainstream.


There are no doubt many abuses that lie in the 13.4 million documents that comprise the Paradise Papers. Tax-exempt investors investing through offshore blockers is not one of them.

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  • Joshua Buckley

    They had to do an investigation to tell us the elites are corrupt..... We already knew that ;)

  • Letícia Miller

    Hope that it's not like the Panama Papers that never really went anywhere. Excellent read as usual !!

  • Gary Cooper

    Nothing new. You can put your money anywhere you want as long as it's declared.

  • Colin Henderson

    Rich people keep getting richer and the poor continue to get poorer. Us with current accounts get 0.25% interest and pay tax on it, we have no money for shell companies. Thanks for sharing this with us.

  • Jenna Ab

    Make rich corporations pay back taxes on what they earn, maybe world governments can finally balance the budget on their respective countries. LET us make PARADISE feel like HELL for them

  • Jeff Smith

    The UK has the lowest tax out of the EU and USA, but there are people who aren't satisfied, let that sink in.......

  • Amy Lowis

    Why there is so much surprise and disappointment in the comments section surrounding the 'paradise papers'? There is no harm in tax dodging if you are doing it legally.

  • Kirill Kondrachov

    Nothing is illegal for putting your money offshore. This is what happens when you have ridiculously high taxes. The top 3% pay 90% of all income tax. The bottom 56% don't pay any, but intact claim some sort of benefit.

  • Tony Gomez

    Money is cancer and the source of almost every problem in the world.

  • Christian Evans

    Poor rich people. They think they are treated so unfairly.

  • Peter

    Capitalism is becoming a parody of itself. The way I feel is, if you want to keep your money overseas and not pay your taxes, you can move there too. This is so telling of the state of the world. The super rich gets everything they want. They own everything. They own the system itself. Money isn't the root of all evil, it's people.

  • Laura G

    Love your article. To all the haters, did the Paradise Papers reveal anything we didn't already know?

  • Jack Stephens

    Helped so much. Thank you!

  • Gary Churchill

    Great content as always Neil !

  • Chris B

    I really appreciate your honesty and keeping it real with us because I’m tired of paying a lot.

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Neil Winward

Taxation Guru

Neil is the CEO of Sevara Capital Advisors. He is passionate about solving tax, accounting and regulatory problems for institutions that have invested billions of dollars of capital in multiple jurisdictions. His company provides solutions for banks, insurance companies and hedge funds to tackle their problems related to tax returns, financial statements, accounting and internal finance matters. Neil holds a master’s degree in Law from the University of Cambridge. 

   

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