An Inquiry Into The Legitimacy Of Offshore Tax Planning; Substance Over Form and World Wide Taxation

When planning and constructing a transaction, merely complying with the technical provisions of the code is insufficient.  For example, the tax code allows a specific deduction for interest (26. U.S.C. 163).   But the debt used in a transaction claiming the deduction must comply with certain factors in order for the transactional instrument to be recognized at law.  All tax code sections contain this added layer of depth with which each element of the transaction must comply.  This is the lesson learned from the myriad tax shelters promoted by large accounting firms in the 1990s that followed the letter of the law to a "T" but had no corporate substance (see this Senate report (from the 108th Congress) on the US tax shelter industry).  

All of the transactions listed in this report (BOSS, son of BOSS, OPIS, BLIPs and many others) began with an extremely technical analysis of a particular code provision -- or even a much smaller sub-section of the code.  A structure was then built around this particular analysis and sold to clients.  The inherent problem with this methodology is it completely ignores the particular client's situation and moreover assumes a uniformity of structure and need between potential clients that does not exist.  The proper way to construct a transaction is the exact opposite: begin with an analysis of a client's overall situation and stated goals then develop a solution which complements that situation.  While it sounds cliche' (and perhaps a bit like a legal inside joke) the individual facts and circumstances of each circumstance really are unique and should be considered in their respective entirely to craft a unique solution to each situation.

When looking at the legislative intent (or substance) of the tax code, one fact stands out very clearly, rising to the stature black letter law: the US' tax code intends to tax US citizens on their world wide income.  This is derived from two sources, the first of which is a plain reading of 26 U.S.C. 61 which states, "gross income means all income from whatever source derived, including (but not limited to) the following items."  The accompanying Treasury Regulations use the exact same phrase: "Gross income means all income from whatever source derived, unless excluded by law."  And finally, Treasury Regulation 1.1-1(b) states, "In general, all citizens of the United States, wherever resident, and all resident alien individuals are liable to the income taxes imposed by the Code whether the income is received from sources within or without the United States."

Regarding foreign earned business income, earnings from various foreign corporations is included in the income of certain US shareholders under the controlled foreign corporation statute (sections 951-965 of the tax code).  These rules were added to the tax code in the early 1960s as a way to prevent the then growing practice of forming a corporation offshore and then transferring family wealth to the newly formed foreign corporation.  The assumption in this section of the code is that certain offshore structures are prima facie evidence of tax evasion.  Offshore partnership income is assumed to flow through to US taxpayers via general partnership law tax principles and the code sections listed in the previous paragraph clearly and indisputably apply to personally earned income.  Certain income from offshore trusts are also included in US taxpayer's income under specific grantor trust rules.  Finally, the US tax code uses a foreign tax credit system, offsetting US taxes with foreign taxes paid.    

The legislative intent could not be clearer: the code defines income in the broadest terms possible, and then specifically excludes various categories of income, all contained in Chapter 1, Subchapter B of the tax code.  The locus of the earning activity is not relevant; it is included unless specifically excluded.  Put more directly, the substance of the tax code when read in its entirely is that all income earned by US citizens is taxable by the US.  Moving offshore for the sole purpose of avoiding US taxation runs counter to legislative intent and the substance of the tax code when read holistically.  And complying with the technical requirements of code -- especially in small section level pieces -- is insufficient legal grounds for a transaction to be recognized at law.