Similar to the seasonal hurricanes that threaten otherwise tranquil island nations, a legislative storm has once again appeared in Congress that is targeting investment funds domiciled in tax neutral countries such as Bermuda and the Cayman Islands. On July 12, 2011, an updated version of the “Stop Tax Haven Abuse Act” was introduced in the Senate by Sen. Levin (D-Mich), with seven co-sponsors, and on July 27, 2011, substantially identical legislation was introduced in the House of Representatives by Rep. Doggett (D-Tex), with 56 co-sponsors.
The 2011 version of this tax haven legislation retains a provision which would treat as a domestic corporation subject to U.S. income tax any foreign corporation that has aggregate gross assets of at least $50 million if the corporation’s executive officers and senior management exercising day-to-day responsibilities are based primarily in the United States. The legislation specifically provides that the management and control of a corporation will be treated as occurring primarily within the United States if the assets of the corporation consist primarily of assets being managed on behalf of investors and decisions about how to invest the assets are made in the United States.
The provisions of the Stop Tax Haven Abuse Act would apply to foreign corporations for taxable years beginning on or after the date which is two years after the date of enactment of the legislation. Other than this two-year window, there is no transition rule for existing foreign corporations.
Most offshore investment funds are classified as corporations for U.S. tax purposes so as to avoid having their foreign investors be partners in partnerships that invest in U.S. securities. Accordingly, if enacted in its current form, the Stop Tax Haven Abuse Act would adversely affect most offshore investment vehicles typically used in financing structures (e.g., blocker corporations) or by hedge funds, real estate funds, CLOs, or other investment funds that have gross assets of at least $50 million and are managed by U.S. managers.
This offshore fund tax haven legislation traces its roots to a bill originally proposed in 2005, then re-proposed in 2007 and again in 2009. In 2007, then Senator Barack Obama was a co-sponsor of the legislation.
The 2009 version of the Stop Tax Haven Abuse Act introduced as a “strengthening measure” the concept of taxing offshore investment funds with U.S. managers as though they were domestic corporations. At the time the 2009 legislation was introduced in Congress, Treasury Secretary Geithner and the Obama Administration publicly announced their support of the bill.
“... a legislative storm has once again appeared in Congress that is targeting investment funds domiciled in tax neutral countries such as Bermuda and the Cayman Islands.”
Although certain provisions of the 2009 Stop Tax Haven Abuse Act were enacted into law as part of other legislation, the proposed taxation of U.S.-managed offshore funds as domestic corporations did not survive. However, the 2011 version of the legislation coincides with the highly publicized efforts of the Internal Revenue Service to locate and stop offshore tax evasion and the voluntary program for taxpayers to disclose the existence of overseas assets to the federal government. The legislation is seen as building upon the Foreign Account Tax Compliance Act adopted in 2010 that would impose a 30% U.S. withholding tax on payments by U.S. borrowers to certain foreign persons unless information sharing agreements are entered into with the Treasury Department. The legislation also contains a provision that would authorize the use of “special measures” against foreign jurisdictions and financial institutions that impede U.S. tax enforcement.
Unlike perhaps in prior years, it is difficult to dismiss the prospects for passage of the current tax haven legislation, including the provision calling for the U.S. taxation of offshore funds, because it is being presented to Congress at a time when Congress is struggling with a desperate need for deficit reduction combined with a total aversion to any tax increase on U.S. taxpayers. The proponents of the Stop Tax Haven Abuse Act have taken advantage of the current predicament. On August 1, 2011, Rep. Doggett reportedly stated that the “legislation to stop the abusive use of offshore tax havens could restore billions in revenue at a time when federal coffers are stretched to the limit.”1 Similarly, on July 12, 2011, Sen. Levin reportedly stated that “the Stop Tax Haven Abuse Act could gain momentum in a Congress focused on deficit reduction [which] could take the bill over the finish line after earlier versions of the measure did not gain traction.”2
The principal sponsors of the legislation publicly emphasize that passage of the legislation could recapture at least $100 billion of revenue lost each year through what they believe are inappropriate uses of offshore tax havens. The appeal of stopping offshore tax evasion, coupled with the recapture of substantial lost tax revenues, is likely to draw support from all political parties. Particularly given the magnitude of that claimed revenue loss in the current political environment, the Stop Tax Haven Abuse Act of 2011 has the potential to become a powerful legislative storm threatening the tax-free status of offshore investment funds.
It will be important for U.S.-based investment management companies to monitor the progress of the Stop Tax Haven Abuse Act of 2011 in Congress. As is generally the case with international tax legislation of this type, there are changes in organizational structure or in operations that U.S. managers of offshore funds may want to consider that could mitigate the potential adverse effects of the legislation. After all, when a serious storm is predicted, preparedness is of extreme importance!