Offshore investing is often demonized in the media, which paints a picture of tax-evading investors illegally stashing their money with some shady company located on an obscure Caribbean island. While it's true that there will always be instances of shady deals, the vast majority of offshore investing is perfectly legal. In fact, depending on your situation, offshore investing may offer you many advantages.
Pros and Cons of Offshore Investing
Offshore investing refers to a wide range of investment strategies that capitalize on advantages offered outside of an investor's home country. There is no shortage of money-market, bond and equity assets offered by reputable offshore companies that are fiscally sound, time-tested and, most importantly, legal.
There are several reasons why people invest offshore:
Tax Reduction. Many countries (known as tax havens) offer tax incentives to foreign investors. The favorable tax rates in an offshore country are designed to promote a healthy investment environment that attracts outside wealth. For a tiny country with very few resources and a small population, attracting investors can dramatically increase economic activity.
Simply put, offshore investment occurs when offshore investors form a corporation in a foreign country. The corporation acts as a shell for the investors' accounts, shielding them from the higher tax burden that would be incurred in their home country. Because the corporation does not engage in local operations, little or no tax is imposed on it. Many foreign companies also enjoy tax-exempt status when they invest in U.S. markets. As such, making investments through foreign corporations can hold a distinct advantage over making investments as an individual. (To learn more, see "How International Tax Rates Impact Your Investments.")
Asset Protection. Offshore centers are popular locations for restructuring ownership of assets. Through trusts, foundations or an existing corporation, individual wealth ownership can be transferred. Many individuals who are concerned about lawsuits, foreclosing lenders or creditors collecting on outstanding debts elect to transfer a portion of their assets from their personal estates to an entity that holds it outside of their home country.
By making these on-paper ownership transfers, individuals are no longer susceptible to seizure or other domestic troubles. If the trustor is a U.S. resident, their trustor status allows them to make contributions to their offshore trust free of income tax. However, the trustor of an offshore asset-protection fund will still be taxed on the trust's income (the revenue made from investments under the trust entity), even if that income has not been distributed.
Confidentiality. Many offshore jurisdictions offer the complimentary benefit of secrecy legislation. These countries have enacted laws establishing strict corporate and banking confidentiality. If this confidentiality is breached, there are serious consequences for the offending party. An example of a breach of banking confidentiality is divulging customer identities; disclosing shareholders is a breach of corporate confidentiality in some jurisdictions.
However, this secrecy doesn't mean that offshore investors are criminals with something to hide. It's also important to note that offshore laws will allow identity disclosure in clear instances of drug trafficking, money laundering or other illegal activities. From the point of view of a high-profile investor, however, keeping information, such as the investor's identity, secret while accumulating shares of a public company can offer that investor a significant financial (and legal) advantage. High-profile investors don't like the public at large knowing what stocks they're investing in. Multi-millionaire investors don't want a bunch of little fish buying the same stocks that they have targeted for large-volume share purchases; the small fry run up the prices.
Because nations are not required to accept the laws of a foreign government, offshore jurisdictions are, in most cases, immune to the laws that may apply where the investor resides. U.S. courts can assert jurisdiction over any assets that are located within U.S. borders. Therefore, it is prudent to be sure that the assets an investor is attempting to protect not be held physically in the United States.
Diversification of Investment. In some countries, regulations restrict the international investment opportunities of citizens. Many investors feel that such restriction hinders the establishment of a truly diversified investment portfolio. Offshore accounts are much more flexible, giving investors unlimited access to international markets and to all major exchanges. On top of that, there are many opportunities in developing nations, especially in those that are beginning to privatize sectors formerly under government control. China's willingness to privatize some industries, in particular, has investors drooling over the world's largest consumer market. (For additional information, read "What Is an Emerging Market Economy?")
Tax Laws Are Tightening. In recent years, the U.S. government has become increasingly aware of the tax revenue lost to offshore investing and has created more defined and restrictive laws that close tax loopholes. Investment revenue earned through offshore investment is now a focus of regulators and the tax man alike. According to the U.S. Internal Revenue Service (IRS), U.S. citizens and residents are now taxed on their worldwide income. As a result, investors who use offshore entities to evade U.S. federal income tax on capital gains can be prosecuted for tax evasion. Therefore, although the lower corporate expenses of offshore companies can translate into better gains for investors, the IRS maintains that U.S. taxpayers are not to be allowed to evade taxes by shifting their individual tax liability to some foreign entity.
There are still loopholes, but most are shrinking more and more every year. In 2004, the IRS amended the Internal Revenue Code (IRC) and began to collect taxes from both American corporations that operate out of another country and American citizens and residents who earn money through offshore investments. (For more information on tax laws that affect offshore investors, see the IRS publication International Taxpayer – Expatriation Tax.)
Cost. Offshore accounts are not cheap to set up. Depending on the individual's investment goals and the jurisdiction he or she chooses, an offshore corporation may need to be started, and that may mean steep legal fees, corporate or account registration fees. In some cases, investors are even required to own property (a residence) in the country in which they have an offshore account or operate a holding company. Furthermore, many offshore accounts require minimum investments of between $100,000 and $1 million. Businesses that make money facilitating offshore investment know that their offerings are in high demand by the very wealthy and they charge accordingly.
How Safe Is Offshore Investing?
More than half of the world's assets and investments are held in offshore jurisdictions and many well-recognized companies have investment opportunities in offshore locales. Countries such as the Bahamas, Bermuda, Cayman Islands and Isle of Man are popular and are known to offer fairly secure investment opportunities.
Still, like every investment you make, use common sense and choose a reputable investment firm. It is also a good idea to consult with an experienced and reputable investment advisor, accountant and lawyer who specializes in international investment. If you are looking to protect your assets, or are concerned with estate planning, it would be prudent to find an attorney (or a team of attorneys) specializing in asset protection, wills or business succession. Of course, these professionals come at a cost. In most cases, the benefits of offshore investing are outweighed by the tremendous costs of professional fees, commissions, travel expenses and downside risk. (For more information, see "Investment Scams: Prime Banks.")
The Bottom Line
Offshore investment is beyond the means of most investors and above the risk tolerance of others. Still, despite the many pitfalls, it can still pay off to shift some investment assets from one jurisdiction to another. As with even the most insignificant investment, do your research before parting with your money – unless you're prepared to lose it. (To read more, see "Investing Beyond Your Borders.")