By Kevin Dowling, CPA, Richard A. Eisner & Company LLP

Offshore investing in U.S. markets has become a mainstay of the U.S. financial markets. Offshore financial centers such as the Cayman Islands, Bermuda, and the Netherlands Antilles, for example, have become renowned for their capabilities as a base for funds that deal regularly with U.S. markets.

Below is a brief introduction to the Cayman Islands and some of the ways individuals have used offshore investments to their advantage.

What Are the Cayman Islands?

The Cayman Islands are located about 475 miles south of Miami in the Caribbean. They are a British Crown Colony; the British government handles the islands' external relations and defense and appoints government officials. The islands have a local executive branch that is drawn from the majority party in the legislative assembly representing the islands' population.

The population of the Caymans is about 35,000, approximately 40% of whom are from outside the islands, with substantial representation from Canada, the U.S., and the U.K. Internationals primarily staff the nearly 100 banks, 29 law firms, and numerous financial services enterprises that have established representation in the islands. The islands have become a key player in the world's financial market: Currently, the islands are home to the fifth largest financial center in the world.

There are no direct taxes imposed within the Caymans on individuals or companies; government income derives primarily through the collection of import duties and fees and through the Caymans' extensive tourism business. Foreign ownership of real estate is permitted.

Privacy is held at a premium within the Caymans. The government enacted the Confidential Relationships (Preservations) law, which prohibits the unauthorized dissemination of any business information. Failure to comply with the law is a criminal offense and carries with it fines and/or imprisonment if information is improperly disclosed.

U.S. Investors

The reasons why U.S. individuals or entities may opt for offshore investing are varied. Some individuals may wish to establish a mechanism for protecting their assets by transferring them pursuant to an orderly estate plan or structuring asset protection trusts.

One wealthy individual, for example, entered a new venture which greatly increased his wealth, but also increased his risk of encountering potentially expensive law suits. He sought to transfer his assets to a separate entity in the Caymans. By taking these steps, he was then able to increase the level of protection for those assets from any adverse developments from his new venture. Other U.S. individuals and institutional investors may find it easier to use offshore investment funds to invest in securities of companies not listed or registered in the U.S. For this reason, most major investment companies have offshore funds which are offered to U.S. residents.

Some U.S. investors take advantage of offshore investment centers simply to avoid U.S. taxation on business ventures not specifically related to activities in the U.S. For example, after establishing a healthy business in the U.S., an American importer of products manufactured in the People's Republic of China was ready to expand distribution to the European market. By setting up his own company in the Caymans, he established an intermediary between China and Europe and, in the process, deferred taxation on the services which he provided for his European venture.

Foreign investors have been able to participate in the largest capital market in the world, that of the U.S., while enjoying significant Federal tax advantages.

Foreign Investors

The IRC has long provided that a nonresident alien individual trading stocks or securities for his or her own account is not engaged in a "trade or business within the United States." This is true even if the individual has employees or other agents present in the United States, and gives them discretionary authority in affecting the transactions. For this purpose, "trading" means a degree of buying and selling activity sufficiently frequent to cause a United States citizen or resident to be engaged in a trade or business. Mere investing (as opposed to active trading) has never been considered to be a trade or business under the Internal Revenue Code, and thus never needed a special statutory exemption from U.S. taxation.

The significance of this provision was that neither long-term nor short-term capital gains on such stocks or securities were taxed to the nonresident alien, although he or she would be subject to tax at the rate of 30% (unless reduced or even eliminated by a tax treaty) on dividends and certain types of interest from U. S. sources. A nonresident alien was not eligible for this benefit if he or she was a dealer in securities. Thus foreign investors could gain access to U.S. markets with the added bonus of no capital gains tax.

Foreign investors can also invest indirectly by participating in a fund. They can enjoy all of the advantages that a domestic investor has (namely, diversification of portfolio and professional fund management). Such funds are frequently organized in the Cayman Islands. The investor gets the benefits of a U.S. fund manager, operating in real time in the U.S. market. Moreover, foreign investors in Cayman Island funds would have the twin assurances of confidentiality concerning their investments and protection against litigation or confiscation.

Cayman Advantages

The Caymans' proximity to the U.S. is one reason it is such a popular offshore investment site among U.S. fund managers. It is ideal for the offshore location to have fund administration within the same time zone, driven by managers who speak the same language, and follow roughly the same accounting rules and equivalent legal rules. The conservative Cayman Islands society also provides a stable and safe tax haven with no local taxes. This respected infrastructure is an especially attractive aspect.

Among foreigners, some use the resources in the Cayman Islands in a creative way for asset protection. For example, a wealthy Brazilian who was in the market to buy a home in Brazil established a company in the Caymans; the company actually bought the house. The individual, in effect, leased the house from this newly-formed Caymanian entity, thus allowing him not only to deduct the rent from his tax return, but also to avoid taxes on the Cayman-based entity's accruing profits because it was a legitimate business transaction outside of the country.

Foreign investors may also wish to expatriate money from their own country for reasons of asset protection, estate planning, protection from their own currency's inflation and shifts, etc. This reverts to the stability of the islands and the confidentiality of keeping money there. *

This article first appeared in Trends and Developments, a publication of Richard A. Eisner & Co. LLP

Editors:
Milton Miller, CPA
Consultant

William Bregman, CPA\PFS

Contributing Editors:
Alan J. Straus, CPA
Own Account