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    The Romance and Risk of Secret Offshore Accounts

    Secret offshore accounts – especially Swiss bank accounts – have a certain cachet, having become synonymous with glamour, financial sophistication, and international intrigue. Following the U.S. Justice Department’s 2009 settlement with the United Bank of Switzerland, increased state and federal enforcement efforts against such accounts might dampen their allure.

    Douglas H. Frazer

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    Wisconsin LawyerWisconsin Lawyer
    Vol. 83, No. 4, April 2010

    Safe The flight of capital is as old as recorded history. Generally it takes two forms. The first, more benign, is an effort to keep property secure – usually from the grasp of the state. The second, less benign, is an effort to keep property – and income from property – secret. The reason, of course, is tax avoidance. The preferred vehicle for tax-related capital flight is the secret offshore account.

    Some Wisconsin taxpayers hold secret offshore accounts. In light of the current enforcement environment, highlighted by the U.S. Justice Department’s settlement with the United Bank of Switzerland (UBS),1 Wisconsin attorneys may have interest in the issue in terms of both policy and practice.

    The Case Against UBS

    On Feb. 17, 2009, the U.S. District Court for the Southern District of Florida unsealed a deferred-prosecution agreement against UBS. Bradley Birkenfeld, an ex-UBS bank officer and a U.S. citizen, had become a cooperating witness. The agreement outlined a course of conduct in which the bank sent to the United States a sales force, equipped with encrypted laptops, to meet with high-net-worth individuals. Through referrals to outside offshore lawyers and promoters, these salespeople assisted U.S. bank customers in setting up layers of offshore corporations, trusts, partnerships, and other entities as conduits. This served to disguise the beneficial ownership of the various accounts by making it seem that the subject assets and income were owned by nonresident aliens or foreign firms.

    The U.S. Department of Justice tax division petitioned the same court to enforce a summons against UBS. The summons – an administrative order to give testimony and documents – directed UBS to disclose an additional 52,000 account relationships with U.S. citizens or resident aliens.

    The parties settled the case. The settlement, and related treaty request, required UBS to turn over the names of approximately 4,450 U.S. account holders.2 The Wisconsin Department of Revenue (DOR) quickly delivered to the Internal Revenue Service a request for the names of Wisconsin account holders consistent with its exchange-of-information agreement.3 Lien priorities between the IRS and the DOR are determined by date of assessment.4 In collection matters, this gives the tax authority that assesses first a decided advantage.

    The financial world took note. Secrecy had defined the Swiss banking industry. In a matter of months, the U.S. tax authorities had moved the (Swiss) cheese.5

    Governments’ Conflicting Policy Concerns

    Governments, at least good governments, have conflicting policy concerns. Governments aspire to raise revenue in a fair and equitable manner, minimize the harm to the economy and the intrusion into the private affairs of their citizens, and create effective and appropriate enforcement mechanisms. Simplified, the four sides of the tax-policy “square” consist of 1) tax rates, 2) the even-handedness of the application of those rates, 3) intrusion into the private affairs of taxpayers, and 4) penalties. Get the elements right, and you have created an economic juggernaut guarded by – and itself guarding – a free and open society. Get it wrong, and you have hardship, tyranny, and rebellion. Wars, including our own war of independence, have been fought over these principles.

    Add to these elements a few wrinkles. The United States is one of the few countries that imposes tax on the worldwide income of its citizens, resident aliens, and domestic corporations, even if the income arises from a transaction or activity originating outside the United States. The United States also taxes nonresident aliens and foreign corporations. With regard to income that is effectively connected to a trade or business conducted within the United States, nonresident aliens and foreign corporations generally are subject to withholding and taxed in the same manner as U.S. taxpayers. With regard to U.S.-source income that is not effectively connected with a trade or business, nonresident aliens and foreign corporations generally are subject to withholding and taxed at a flat
    30-percent rate.

    The global economy has accelerated the speed of capital movement among countries. A country with political stability, low taxes, and financial privacy might attract capital from individuals domiciled in countries with higher taxes. If the laws of the higher-tax country require disclosure of a foreign account, then the law-abiding person may be dissuaded from opening such an account. The greater the tax differential, however, the greater the incentive a taxpayer has to cheat. That is the economic force. The greater the number of cheaters, real or perceived, the greater the incentive a taxpayer has to cheat. That is the social force. The less legitimacy the tax structure enjoys, the greater the incentive a taxpayer has to cheat. That is the political force.

    Although it sounds unlawyer-like, we probably should not discount the romantic force, either. The actual or purported existence of secret offshore accounts generally, and Swiss bank accounts specifically, are part of the popular culture. From Goldfinger, to The Day of the Jackal, to Smiley’s People, to The Bourne Identity, Swiss bank accounts have become synonymous with glamour, financial sophistication, and international intrigue.

    Defining ‘Tax Haven’

    Tax haven is a relative term. The term connotes a sovereign jurisdiction that has low taxes, light regulation, and little or no information-exchange obligations with other sovereign jurisdictions. The advantage of placing money in an offshore jurisdiction may depend on the type of tax or whether the taxpayer is a natural person or an entity. Many corporations or other business entities set up offshore financial arrangements for the purpose of minimizing their tax obligations. These arrangements sometimes have interesting and controversial elements. These involve issues of transfer pricing (the assignment of value of economic activity among multicountry operations), tax deferral, and fund repatriation. Some of the strategies are aggressive: legally unsettled but defensible. The common thread is transparency – at least for those inclined to look.

    For individuals, however, tax advantages most often can be gained only by breaking the law. A cadre of professional facilitators, promoters, and arrangers are, for a fee, ready to help.

    Take, for instance, a hypothetical wheeler-dealer by the name of Bert. By day Bert is a podiatrist in Appleton. By night, Bert jets around in a tuxedo among visits with his bankers in the Channel Islands, Switzerland, and Singapore. Granted, the adventure takes place on Bert’s laptop but, as the saying goes, hope springs eternal. When Mrs. Rifkin’s bunion is finally healed, Bert can break away and, in the company of a beautiful girl (like Audrey Tautou with Tom Hanks in The Da Vinci Code), visit his numbered account. If the beautiful girl is unavailable, Bert can console himself with the fact that, good-looking companionship aside, a freier he is not. In Bert’s mind only regular people pay all their taxes. Sophisticated people, like Bert, play the angles. Bert understands that, because of the tax savings, a serious financial advantage can be gained with every dollar stashed offshore.

    Tax havens usually have tax laws that support the camouflage. It’s relatively easy. Tax evasion requires only one broken link in the chain of information exchange.6

    For example, Swiss fiduciary accounts take advantage of Swiss banking-privacy laws without incurring Swiss withholding tax. Fiduciary deposits are deposits made by Swiss banks on behalf of customers in banks in other jurisdictions that impose little or no withholding tax on bank interest. And because deposits pay interest that is from a non-Swiss source, there is no Swiss withholding tax.

    Or consider Swiss custody accounts. These accounts typically hold securities. It is estimated that non-Swiss residents own 59 percent of securities in Swiss custody accounts. For these accounts, no withholding or routine reporting to the tax authorities of investors’ home countries occurs. And the possession of a secret account may be only the first layer.

    Additional layers of secrecy often involve forming offshore shell corporations or trusts and opening accounts in the entity’s name. The laws of the tax haven can help, for example by permitting naming of nominee shareholders, officers, directors, or trustees. Thus, the beneficial owners of the firms – and the money – are obscured.7

    Using one or more of these screens, nominees, or conduits, a beneficial owner can also invest in mutual funds, hedge funds, and insurance companies, many of which also exist offshore.

    Bert, our U.S. investor who is inclined to evade U.S. tax, invests in an offshore hedge fund through a foreign feeder fund. When there is no effectively connected income, the foreign feeder does not have to file a corporate tax return or report to the IRS any payments made to investors. No foreign corporate tax exists because both the hedge fund and the feeder are domiciled in a tax haven. Thus, the collection of tax is dependent on an investor’s voluntary disclosure.

    Douglas H. Frazer

    Douglas H. Frazer, Northwestern 1985, is a shareholder at DeWitt Ross & Stevens in the metro Milwaukee office. He focuses his practice in tax litigation.

    Enforcing U.S. Tax Law

    Enforcement of U.S. tax law in connection to secret accounts is not easy. Here is an example. The United States and many tax-haven jurisdictions have strict anti-money-laundering rules. These laws are designed to block money flows of terrorists, drug dealers, corrupt government or corporate officials, and other such nefarious actors. Anti-money-laundering laws require that financial businesses know the identity of all their customers, including the beneficial owners of corporations or trusts. The exchange of such information would, of course, assist in discovering the run-of-the-mill tax evader.

    But such exchanges of information do not routinely happen. First, no U.S. Treasury anti-money-laundering regulations currently exist for hedge funds. Second, anti-money-laundering information exchange mostly involves the confirmation rather than the discovery of tax evasion. Absent a reasonable suspicion arising from an independent source that a person has an illegal account or account relationship, the holder of the information usually does not disclose it. In other words, it is a case-by-case matter. The U.S. authorities must have a specific taxpayer under investigation. The U.S. authorities must develop their own leads. And that may be only the first procedural roadblock. The offshore financial business often can set up its own bureaucratic roadblocks. Then, there may be additional legal requirements to fulfill – including appeal rights given to the account holder.

    A second roadblock is definitional. In the United States, tax fraud or evasion is criminal. Switzerland and other tax havens maintain a peculiar and highly artificial distinction between tax fraud and tax evasion. In Switzerland, tax fraud is criminal. It involves an affirmative act of deception, like falsifying a document. Tax evasion, however, is not criminal. It involves the intentional effort to evade or defeat the payment of tax by failing to report the existence of an account. It is incorrect to say that tax evasion is legal in Switzerland. Rather, the Swiss treat tax evasion like speeding, as a civil matter instead of a criminal offense.

    Article 26 of the 1996 United States-Swiss Tax Treaty provides for the exchange of information as is necessary “for the prevention of tax fraud or the like.” Thus, so long as a bank customer has not lied to Swiss bank officials, Swiss financial privacy law historically has protected that customer.

    With the UBS settlement, it appeared that Switzerland’s interpretation of “tax fraud and the like” had become more elastic because it explicitly included a “scheme of lies” or submission of incorrect and false documents.8 The problem with this view is that the protocol to the still-in-effect 1996 treaty contained the same language.9 Thus, apart from the new Aug. 19, 2009, agreement containing the understanding that the existing Swiss law could be read to permit UBS to hand over the account information, had anything really changed? The short answer was no. On Jan. 21, 2010, the Swiss Federal Administrative Court held that “tax fraud and the like” could not, contrary to the Aug. 19, 2009 agreement, include the mere failure of an account holder to file a U.S. form W-9. The determination barred the handover of UBS client data and has, for now, effectively torpedoed the UBS settlement.

    In the meantime, various western countries and international bodies, including the Organization of European Economic Development (OECD), have leaned on Switzerland, Liechtenstein, Luxembourg, Singapore, and 34 other “gray-list” countries. These gray-list countries, tax havens all, have agreed to improve transparency standards by adopting Article 26 of the OECD’s model tax convention.10 The changes are intended as a work-around to the tax fraud/tax evasion distinction. The changes will allow the tax authorities of signatory nations to provide foreign authorities with actionable information on local accounts even if the request does not relate to a local (that is, tax-evasion-related) matter. The request for information will still need to be clear, specific, relevant, and consistent with the new internationally agreed-on standard. This standard allows the responding jurisdiction to reject requests that are frivolous or spurious in nature or are fishing expeditions. Again, unless the requesting authority has independently developed a case, it is not going to be able to rely on information-exchange agreements to identify the evader.

    Advising Clients

    Probably the most sensible advice attorneys can give to clients is to voluntarily disclose. On March 26, 2009, the IRS announced a voluntary offshore-disclosure program. The program offered the chance to avoid criminal prosecution and reduce tax, penalties, and interest that could be owed. Before the Oct. 15, 2009, deadline, approximately 14,700 taxpayers initiated disclosure under this program.11 The DOR announced a similar program with a contact deadline of Jan. 15, 2010. (Although an exact number is not available, the DOR reports that “many dozens” of Wisconsin taxpayers have initiated disclosure.)

    Although the deadline for each program has passed, taxpayers still, presumably, have the opportunity, through the tax authorities’ regular voluntary-disclosure programs, to avoid criminal prosecution and secure reduced penalties.12 In view of the fluid nature of information exchange, the issue of the timeliness of the disclosure is likely to arise. Thus, taxpayers inclined to self report should not delay.

    Conclusion

    Stepped-up enforcement will catch some and deter others. But, as the saying goes, what is taxed needs to be surveyed. Even with advanced technology and beefed-up information exchange, there is an awful lot out there to survey. A semisophisticated evader-to-be still has plenty of opportunity to evade and a low probability of being caught. It is probably a mistake to conclude that the UBS case portends the end of secret offshore accounts. If the war on secret offshore accounts is anything like the war on drugs, the UBS enforcement initiative may just be an exercise in gently squeezing a balloon.

    Still, the problem of secret offshore accounts might suggest its own solution – both for the federal government and for Wisconsin. It is generally agreed that lower tax rates lead to lower levels of tax evasion. As Daniel J. Mitchell at the Cato Institute has argued, tax competition among jurisdictions is a positive force.13 It puts downward pressure on tax rates. It encourages efficiencies in capital formation and capital flow. If capital flight and tax evasion are prevalent in a high-tax jurisdiction, it may be a signal to that jurisdiction that more attractive tax policies are in order.

    On the other hand, no law is perfect. The United States is entitled to enforce its laws. If Switzerland and countries like it want to enjoy the benefits of belonging to the world financial community, they may have to share the burden and responsibilities that such participation requires. These may include the adoption of financial safeguards and the acceptance of accountability concerning the movement of capital.

    But accountability, transparency, and cooperation should not be ends in themselves. In a free society, exchange of personal information should require a system of checks and balances. Information exchange that is too easy can, and will, lead to fishing expeditions, abrogation of financial privacy, the debasement of fundamental liberties, and, ultimately, tyranny. Given our tradition of civil liberties and constitutional protections, the United States should think long and hard before entering into a bilateral treaty or international protocol that permits financial dragnets for unreported offshore accounts.

    The problem of tax fraud or evasion, like the abuse of power, is not a problem that we can fix. It is, however, a problem we can better manage. The federal and Wisconsin efforts appear to be working. Taxpayers are voluntarily coming forward. This is an outcome we should applaud. It is, however, only one piece of the puzzle. It would be a shame if, in the afterglow of the UBS enforcement initiative, the federal and state tax authorities did not use this moment as an opportunity to reexamine the other sides of the tax policy square. Taxpayers like Bert actually may have some legitimate gripes. But the proper avenue for redress is not through secret offshore accounts. It is, unromantically, with Congress and our elected officials in Madison.

    Endnotes

    1Agreement between the United States of America and the Swiss Confederation, Aug. 19, 2009.

    2Settlement Agreement, United States v. UBS AG, Case No. 09-20423 (S.D. Fla. Aug. 19, 2009).

    3Email communication with Audit Bureau Director Vicki L. Gibbons on Sept. 8, 2009; Wisconsin Department of Revenue announcement (Nov. 3, 2009).

    4Wisconsin Dep’t of Revenue v. Bar Coat Blacktop Inc., 640 F. Supp. 407, 414 (W.D. Wis. 1986).

    5Spencer Johnson, Who Moved My Cheese? An Amazing Way to Deal with Change in Your Work and Your Life (Putnam 1998) (parable describing change in one’s work and life and four typical reactions to change).

    6See generally Martin A. Sullivan & Lee A. Sheppard, “The Offshore Project,” Tax Analyst (2007-08).

    7A beneficial owner refers to the true owner of an entity, asset, or transaction, as opposed to any stated ownership provided in documents or oral representations. The beneficial owner is the one that receives or has the right to receive proceeds or other advantages as a result of the ownership. It is common practice in offshore financial secrecy schemes to interpose entities, individuals, or both as stated owners. The beneficial or true owner is contractually acknowledged in side agreements or statements or by other means.

    8The annex to the UBS Settlement Treaty Request refers to the tax treaty, various protocols to the treaty, an appendix, and unilateral and bilateral side agreements. The wording is convoluted. The information-exchange requirement contains many limitations. The existence of “tax fraud and the like,” as described in the annex, appears to depend on 1) a facts-and-circumstances analysis and 2) information contained in the bank’s records. Despite these shortcomings, the treaty request and annex likely represent a step forward – and may have precedential value. A joint declaration attached to the treaty request makes clear that on a pattern of facts and circumstances similar to the UBS case, the United States can make, and the Swiss will process, information requests with respect to Swiss banks other than UBS.

    9U.S.-Swiss Treaty Protocol, § 10 (Oct. 2, 1996).

    10Overview of the OECD’s Work on Countering International Tax Evasion, OECD Centre for Tax Policy and Administration (Jan. 11, 2010).

    11Lynnley Browning, 14,700 Disclosed Offshore Accounts, N.Y. Times (Nov. 17, 2009).

    12For the IRS program, the requirements and procedure are set forth in Internal Revenue Manual 9.5.11.9 (Dec. 2, 2009). For the DOR program, see Wisconsin Voluntary Disclosure Program, updated Dec. 11, 2009, at www.revenue.wi.gov/pubs/voldis.html.

    13Daniel Mitchell, In Defense of Tax Havens, Forbes Magazine (May 6, 2009).   




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