It’s common for U.S. companies to use offshore subsidiaries and here we’ll talk about how it works, the strategies involved, and the steps the U.S. government is taking to counter this practice.
Why do American companies need offshore subsidiaries?
Companies establish subsidiaries in low-tax countries to achieve the following goals:
- Reduce tax obligations: Income earned in low-tax jurisdictions may be untaxed or taxed at rates much lower than in the U.S.
- Streamline international operations: Offshore subsidiaries make it easier to expand into foreign markets and manage finances and assets internationally.
- Protect assets and increase confidentiality: These structures separate assets from the main business often to safeguard capital from potential lawsuits.
Examples of popular offshore strategies
American companies use various offshore strategies to optimize taxes. Here are a few examples:
Double Irish with a Dutch Sandwich
This structure involves transferring intellectual property (IP) through Irish and Dutch subsidiaries to lower the U.S. tax base. Here’s how it works:
- Transferring IP rights to Ireland: A company establishes a subsidiary in Ireland and assigns IP rights to it.
- Dutch intermediary: The Irish subsidiary sets up an intermediary in the Netherlands to receive royalties thus avoiding withholding taxes on interest and licensing fees.
- Revenue routing: A second Irish subsidiary (registered as a resident in a tax haven such as Bermuda, for instance) collects revenue and royalties from end-users and then funnels income back through the Dutch entity into a tax-free jurisdiction.
This scheme allowed major corporations to reduce taxable profits, keeping most of their earnings in tax havens. Companies such as Apple and Google actively used the “Double Irish with a Dutch Sandwich” until the U.S. and European authorities imposed restrictions.
Major U.S. banks and holding companies with offshore subsidiaries
Banks use offshore subsidiaries for multiple purposes to reduce their taxable base, minimize profit tax, and optimize capital expenditures. Here’s how they usually structure these setups for maximum benefit:
Creating offshore structures for passive income
Banks often use offshore subsidiaries to manage income generated from interest, dividends, or securities transactions. Here’s how it works:
- Establishing a subsidiary in a low-tax jurisdiction: Banks register companies in countries where tax rates on passive income, such as interest and dividends, are low or non-existent (e.g., the British Virgin Islands or Cayman Islands).
- Transferring assets offshore: Assets such as securities, bonds, or deposits are transferred to the offshore subsidiary, allowing it to earn income on these assets and retain it in the low-tax jurisdiction.
The advantage here is that profits held in offshore accounts remain untaxed in the U.S. until repatriated (returned to the U.S. parent company).
Using transfer pricing for intercompany services
Another essential mechanism is transfer pricing that regulates service pricing between the parent company and its subsidiaries.
- Intra-company billing: The parent company (U.S.-based bank) can pay the offshore subsidiary for consulting, administrative, and other services. For example, the offshore structure may act as an internal financial center providing specialized services to the parent company.
- Reducing U.S. taxable income: The cost of these services is deducted as an expense by the parent company in the U.S., which decreases its taxable income. Since the offshore subsidiary is in a low-tax area, the income from these “internal” services is taxed minimally.
Transfer pricing allows funds to be shifted as expenses and reinvested offshore, keeping profits in a low-tax environment.
Using offshore structures for derivatives trading and risk hedging
Banks actively use derivative financial instruments (e.g., futures, options, and swaps) and risk-hedging strategies that allow them to manage assets flexibly and generate profit while minimizing taxes:
- Setting up subsidiaries for derivatives trading: Offshore subsidiaries handle trading in derivatives, earning profits in low-tax jurisdictions. When derivatives yield income, for instance, through favorable rates or price changes on assets, that income accumulates offshore.
- Risk hedging through offshore companies: Complex hedging structures “insure” core operations in the U.S., which allows banks to secure compensation or profits offshore from operations that, under adverse conditions, would otherwise be taxable in the U.S.
Synthetic loans and capital operations
Synthetic loans, a combination of derivatives and loan obligations, can also be managed through offshore subsidiaries:
- Issuing bonds through offshore entities: Banks often issue bonds via offshore companies. Bonds issued in offshore zones aren’t taxed in the U.S. and this allows banks to attract capital without additional tax obligations.
- Synthetic loans: For instance, a U.S.-based bank may loan funds to an offshore subsidiary that then reinvests those funds into stocks or bonds. The profit from these investments remains offshore and it is untaxed until the funds are repatriated to the U.S.
Examples of banks using offshore entities
Some American banks, such as JPMorgan Chase and Bank of America, have subsidiaries registered in tax havens such as the Cayman Islands and Bermuda. Specifically:
- JPMorgan Chase: Has around 700 offshore subsidiaries, most in tax havens. They use offshore entities for risk hedging, asset management, and synthetic capital operations.
- Bank of America: Has over 300 offshore subsidiaries, using them for derivatives operations and structuring assets with minimal tax exposure.
Legality of these strategies and U.S. countermeasures
If you are wondering if using offshore entities is legal in the U.S., the answer is YES. Establishing and using offshore subsidiaries isn’t illegal in itself. Many companies adhere to regulations and carefully document their structures and operations. However, since the 2010s, the U.S. has ramped up its fight against aggressive tax optimization. Key measures include the following ones:
- Controlled Foreign Corporation (CFC) tax rules: Under CFC regulations, American companies must declare and pay taxes on their offshore subsidiaries’ profits if those subsidiaries generate passive income, such as dividends and royalties.
- Foreign Account Tax Compliance Act (FATCA): Passed in 2010, FATCA requires foreign banks and financial institutions to report information on accounts held by American taxpayers. This allows the IRS to track funds on foreign accounts and prevent tax evasion with the help of offshore instruments.
- Repatriation Tax: The 2017 Tax Cuts and Jobs Act requires companies to repatriate (bring back) and pay taxes on undistributed profits held in offshore subsidiaries.
The U.S. authorities are also implementing measures to eliminate profit-shifting schemes:
- Restrictions on transactions with low-tax jurisdictions: Companies are required to report transfer-pricing practices and the U.S. tax service monitors compliance with market standards in transactions between parent and subsidiary companies.
- Sanctions and agreements with offshore jurisdictions: Under FATCA and other international initiatives, offshore jurisdictions now share more data with the U.S. on companies and their transactions. Some offshore countries have agreed to revise their tax laws and close loopholes used by American corporations.
Conclusion
Using offshore subsidiaries is a legal practice but up to a point. As long as companies comply with CFC and FATCA rules, their offshore structures remain within legal boundaries. At the same time, the U.S. Government continues to tighten control, close tax loopholes, and enhance the transparency of international financial operations to minimize revenue losses.