Though both go hand in hand to help high-net-worth individuals (HNWIs), and others, legally decrease their income tax burdens, there is an important difference between tax havens and tax shelters. Tax havens are locations around the globe known for having lax or nonexistent tax laws that allow individuals or companies to vastly reduce their tax liabilities by holding their assets offshore. Tax shelters are simply investment accounts, securities, investment and tax-planning strategies that minimize tax liability within your own country's tax system.
Tax Havens: The Basics
A tax haven is simply a locale, whether a country, state or territory, that has less-than-stringent tax laws. In some cases, these places either have no income tax at all or they charge very reduced tax rates. The use of tax havens is so prevalent in the global economy that you would be hard pressed to find a multinational corporation that does not take advantage of the benefits of tax havens in some way.
However, these bastions of tax-free profits are not only for large companies. In general, tax havens also provide offshore banking services to nonresident companies and individuals. In addition to having easy access to offshore bank accounts and trusts, foreigners can easily form an international business corporation (IBC) or offshore corporation. Often, these business entities are guaranteed tax exemption for a set period of time. In Dominica, for example, both business types are entitled to 20 years of tax-exemption beginning on the day of incorporation.
Offshore financial products offer a level of security and anonymity that many find appealing. Even if an HNWI wants to protect personal wealth rather than corporate profits, tax havens make it easy to create a shell corporation that then owns his personal assets and shields his identity. For example, assume a wealthy person owns a large piece of property but does not want it connected to him personally. He can create a tax-haven-based offshore company under a different name and transfer ownership of the property to that company. When ownership documentation for the property is reviewed for any reason, only the name of the shell company is listed. Because of the strict privacy laws enforced by most tax havens, any attempt to ascertain the owner of the shell company will likely be unsuccessful.
Though the use of tax havens is technically legal, it is widely frowned upon by the Internal Revenue Service (IRS), and revelations of offshore banking activity are viewed poorly by the public.
Common Tax Havens
There are a number of tax havens around the world that have become increasingly popular with wealthy individuals and successful businesses looking to shield their incomes from taxation. Two of the most widely known tax havens are the Cayman Islands and Bermuda. In addition to being tropical paradises, both offer full protection for corporate profits. Neither country has a corporate tax rate, meaning companies with subsidiaries based in these tax havens can safely hold their assets tax-free, rather than paying the 35% corporate tax in the United States.
The Hollywood stereotype of the Swiss bank account is still largely accurate, as many wealthy individuals flock to Switzerland to shield their income from taxation and their identities from the prying eyes of the world. Luxembourg is a less well-known tax haven but one that Apple, Inc. uses actively, directing all its iTunes sales through a Luxembourg-based subsidiary in exchange for the promise of tax breaks on this significant revenue stream.
The British Virgin Islands (BVI) are considered a pure tax haven because the only income generated by offshore banking activities comes from annual fees paid directly to the government. The BVI have no corporate, capital gains, sales, gift, inheritance or estate taxes. The effective income tax rate is zero. However, many countries are beginning to crack down on the use of this tax haven and have signed tax-information exchange treaties with the tiny island nation, meaning the anonymity of account holders is less secure.
Tax Shelters: The Basics
While tax havens often seem shrouded in mystery, or accessible only to the rich and famous, tax shelters are commonly used by taxpayers of every stripe. A tax shelter is simply a method of legally reducing your tax burden through the use of specific investment types or strategies. While tax shelters are often temporary, requiring the payment of income tax at some point in the future, they can be very useful tools for those looking to limit their tax liability during their earning years when tax rates are generally the highest.
Tax-sheltering investment products are those that offer deferred taxation on your investment. Instead of paying income tax on your contributions in the year the dollars are earned, they are included in your taxable income for the year in which they are withdrawn, usually many years later. Many people are in a lower tax bracket after retirement, so making salary contributions to a tax-deferred account can help lower their current tax liability while enabling them to pay a lower tax rate after retirement.
Individuals and businesses can also utilize tax-sheltering investment techniques that combine specific types of investment vehicles with investment timing to minimize tax liability. For example, under the U.S. tax code, gains from investments held longer than one year are taxed at the capital gains rate rather than as ordinary income. Because the difference between these two tax rates can be as much as 20%, many people choose to employ a buy-and-hold investment strategy to avoid paying the higher tax rate on short-term gains.
Common Tax Shelters
Common tax shelters include retirement savings plans, such as traditional 401(k) and IRA accounts. In both cases, contributions are made with pretax dollars and account holders simply pay income tax on funds upon withdrawal. Because the IRS regulations restrict withdrawals before a certain age, these funds are often subject to a lower income tax rate at withdrawal because the account owner has retired and his income is reduced.
Mutual funds that invest in government or municipal bonds are also common tax shelters. Though you still pay income tax on your initial investment when those dollars are earned, the interest generated by these debt securities is exempt from federal income taxes, so your investment generates annual income tax-free.
Tax-sheltering investment strategies can be used in many scenarios. Using 401(k) or IRA funds to invest in stocks or mutual funds temporarily shields your gains from taxation until withdrawal after retirement. In addition, many mutual funds are managed with the goal of tax efficiency. These funds avoid issuing dividend or short-term capital gains distributions because this type of income increases the current tax liability of its shareholders. Instead, these funds hold assets for longer periods and make a smaller number of long-term capital gains distributions that are subject to shareholders' capital gains tax rate.