A growing number of US corporations are switching their parent company domicile to Bermuda, but US politicians are proposing legislation to stem the flow.

Lured by favourable regulations, no corporate income taxes, a stable government, modern business laws and an attractive climate, re/insurers began setting up shop in Bermuda more than 60 years ago. The trend has continued, most recently with more than $13bn in new re/insurance capital flowing to the island following the terrorist attacks of September 11.

Less noticed, however, has been the steady influx of non-insurance US companies that have established paper headquarters on the island. These inversion transactions have drawn the attention of US lawmakers, and measures introduced in Congress to combat the corporate flight to Bermuda could drastically alter the island's secure base for traditional offshore re/insurance transactions.

An inversion transaction typically involves a US corporation forming a subsidiary in a foreign country. After forming the foreign subsidiary, the US corporation makes the foreign subsidiary the parent corporation of the US corporation itself, thereby `inverting' the corporate chain of ownership by having shareholders of the US corporation exchange their shares for shares in the foreign subsidiary.

Once this inversion structure is in place, the new foreign `parent' corporation may have the US corporation (which is now a subsidiary of the foreign parent) transfer its foreign assets and subsidiaries to the foreign parent corporation. When these assets and subsidiaries are moved to the new foreign parent corporation, they are no longer subject to US tax because the US taxing jurisdiction does not tax the foreign operations of a foreign corporation. Consequently, under the inversion structure, the US taxing jurisdiction is limited to the US revenue of the US corporation itself.

As one of the oldest and most successful offshore locations, Bermuda has more than 13,000 international companies registered, but fewer than 400 of these have a physical presence on island. Of the companies with operating offices in Bermuda, about 40% are re/insurance companies. A survey conducted earlier this year by an agency of the Bermuda government found that of the companies that recently located to the island, about 38% said it was because of tax breaks. The foreign-owned companies that said they came to Bermuda for tax reasons contributed 49% of Bermuda's gross domestic product in 2000, the most recent year for which figures are available.

Companies formed as exempt under Bermuda's Companies Act of 1981 enjoy substantial advantages: no capital duty; no restriction on where meetings are held; no requirement for directors to be based in Bermuda; no annual returns or filings; and no exchange controls. There is, however, public disclosure of directors, officers and shareholders, though not of accounts. Identity of the beneficial owners must be disclosed to the authorities prior to incorporation and the granting of tax exempt status. There are no double tax treaties, and there are no income taxes. Further, under the Exempt Undertakings Tax Protection Act 1966, if Bermuda ever does introduce a taxation system, exempt companies will be exempted until 2016.

It is the beneficial tax reduction - which is legal under current US tax laws - that has drawn US non-insurance companies to Bermuda. It has also strongly attracted the attention of US lawmakers. Senator Max Baucus and Senator Charles Grassley this April introduced legislation that would remove most of the tax advantages for US companies that relocate headquarters to Bermuda. In a statement, the senators said they were extremely displeased that corporations "are capitalising on a period of recession and terrorism to maximize their opportunities to escape US taxation on foreign earnings."

The Baucus-Grassley Bill, the `REPO Act' (Reversing the Expatriation of Profits Offshore), divides inversions into two categories (see above) and would severely limit the capacity of newly-formed Bermuda holding companies to reduce taxes on foreign-sourced income. It also provides for increased scrutiny by the Internal Revenue Service (IRS) of some tax transactions. If the bill becomes law, its effective date would be made retroactive to 21 March 2002.

In March, US Representative Richard Neal introduced a bill that seeks to deter US companies from incorporating in Bermuda and other countries by changing the definition of what constitutes a US corporation for tax purposes. Entitled Corporate Patriot Enforcement Act of 2002, the bill would require businesses which decide to invert to a foreign country also to move substantial assets and shareholders to that foreign country. Setting up a post box address in a foreign country would not suffice to avoid US taxes.

In the same month, a similar bill was introduced in the House by Rep. Scott McInnis. Calling the act of reincorporating in Bermuda to avoid US income taxes as "simply un-American!", McInnis' legislation would put in place a two-level test to dissuade companies to redomesticate. The first step checks the level of stock ownership by the same shareholders following the inversion. The second tests the lower level of stock ownership by the same shareholders following the inversion, and sets out a three-part test to distinguish transactions with little substance. The legislation would cover transactions completed on or after 1 January 2002.

This doesn't mean, however, that the US-based companies that invert to Bermuda can avoid all US taxes. Under the current tax laws, US-based companies that have foreign sourced income must pay taxes on income, or if the tax is paid to a foreign nation, then a credit is taken against US taxes. But by becoming a foreign corporation, the US cannot tax the corporation's foreign sourced income; it can only tax the income generated by the US subsidiary of the Bermuda company. This would not change with redomestication. It is estimated that by using an inversion transaction, a corporation can cut its tax rate from 35% to less than 11%, depending upon the amount of foreign-sourced income and in which country it is earned.

But at present no one knows how much in taxes is lost from inversions to Bermuda or other offshore locations. The IRS said that since tax evasion is usually a secretive operation, accurate estimates are difficult, but concedes it is in the "tens of billions" of dollars annually. To attempt to find out the extent of the problem, the Treasury has announced it will study the trend of US-based companies that are reincorporating overseas as a way of reducing their tax bills.

Among the companies presently redomesticated to Bermuda is the conglomerate Tyco International Ltd, the accounting practices of which have been questioned by ratings agencies and taxation authorities. Last year, it reported it saved $400m in taxes from its inversion to Bermuda.

Other companies inverted to Bermuda include Ingersoll-Rand, which now can save about $40m per year in US taxes. Nabors Industries and Weatherford Industries, two oil drilling services companies in Houston, and Accenture, a consulting firm, have reincorporated in Bermuda, as has Foster Wheeler and Intelstat.

Stanley Works, the maker of hammers and tools, is preparing to set up a new corporate headquarters company in Bermuda. Electrical products maker Cooper Industries Inc said it was going ahead with shifting its incorporation from the US to Bermuda, saying that the reincorporation would increase its cash flow by $55m and reduce its overall annual tax bill to between 20% and 25% from 32%.

Re/insurers have also been active. Everest Reinsurance Holdings Inc formed a new holding company in Bermuda, Everest Re Group Ltd, in 2000. Chairman and CEO Joseph V Taranto commented: "Our new holding company structure will allow us to operate in a financially more efficient manner."

In 1999, White Mountains Insurance Group completed its redomestication from Delaware to Bermuda. White Mountains' President and CEO at the time, Tom Kemp, said: "Redomestication offers a more favourable corporate structure for the formation and growth of non-US-based insurance or reinsurance operations, an enhanced ability to compete with non-US insurance entities, and an enhanced ability to pursue business combinations with non-US entities, including Bermuda companies."

Arch Capital Group Ltd in 2000 changed its legal domicile to Bermuda. It reported income tax expense for the three months ended 31 March 2001 of $3.3m, compared with $12.6m for the period ended 31 March 2000. Leucadia National Corp, a US holding company for insurance, banking and manufacturing units, has said it also is looking to move to Bermuda to slash its tax bills.

Chubb/Hartford follow-on
This latest round of legislation to diminish Bermuda's attractions follows a measure introduced in 2000 which attempted to raise taxes on investment income generated by reserves of US insurers that have been reinsured to their Bermuda parents. Chubb and Hartford teamed up with other US insurers to get Congress to pass the bill, but the initiative failed to attract much interest. A similar bill was introduced last year, but also failed to gain substantial support.

Ironically, back in November Chubb announced it had joined forces with AIG and GS Partners to form Allied World Assurance Holdings Inc, a Bermuda-based writer of worldwide commercial property/casualty re/insurance business.

Rising to her country's defence, Bermuda Premier Jennifer Smith said: "We don't expect other countries to tell us how we should collect our tax, so I am not going to be in a position of commenting on how another country collects their tax."

Smith bristles when Bermuda is called a tax haven. She has pointed out that all companies in Bermuda pay the same taxes, adding that customs duties are among the highest in the world, and "they pay those, just as every one else does."

A spokesperson for the Bermuda International Business Association noted that what has helped give Bermuda a clear competitive advantage over other offshore jurisdictions has been its ability to build a highly competent and advanced infrastructure of support services for the international clients.

Faced with being labelled as a `tax haven' along with less sterling localities such as Liberia, the Marshall Islands, Nauru and Vanuatu by the Organisation for Economic Co-operation & Development (OECD) in 2000, Eugene Cox, Bermuda's Deputy Premier and Finance Minister, said his government "shares the concerns of the OECD about the effects of harmful tax competition." He pledged to eliminate "any aspects of the [tax] regimes for financial and other services that attract business with no substantial domestic activities."

In April 2002, the OECD released its list of countries that were not co-operating in increasing transparency and effective exchange of information. Bermuda was not on the list. The demand for greater transparency has developed quickly in the past few years, according to Karole Dill Barkley, director of Standard & Poor's, New York. "Frankly, I think we are operating in a much more transparent environment now," she said. "There is a lot more information available because of the internet and disclosure rules." Along with this greater openness and disclosure, she observed, has come greater awareness of the various rules and regulations of different countries and how much they vary.

In a positive way, the differences between the various taxation schemes has prompted Senators Baucus and Grassley to attempt to "bring our international tax system in line with our open market trade policies". They believe that reform of the US international tax laws is necessary for US businesses to remain competitive in the global marketplace. "Moreover, those US companies that rejected doing a corporate inversion are left to struggle with the complexity and competitive impediments of our international tax rules," the statement continued. "This is an unjust result for companies that chose to remain in the United States of America."

Reversing the Expatriation of profits Offshore (REPO) Act
The REPO Act addresses two different classes of inversion transactions, the typical pure inversion and the limited inversion.

Pure inversion

A pure inversion happens as follows:

  • a US corporation becomes a subsidiary of a foreign corporation or otherwise transfers substantially all of its properties to a foreign corporation;

  • the shareholders of the US corporation end up with 80% or more of the vote or value of the stock of the foreign corporation immediately; and

  • the foreign corporation, including its subsidiaries, does not have substantial business activities in its country of incorporation.

    Corporations with no significant operating assets, few or no permanent employees, or no significant real property in the foreign country do not meet the substantial business activity test, as outlined in the Act. Under this provision, companies are not considered to be conducting substantial business activity in the country of reincorporation by merely conducting board meetings in the foreign country or by relocating a limited number of executives to the foreign jurisdiction. The purpose of this substantial business activity requirement is to attack inversion structures that use a manila folder in a filing cabinet or a foreign post office box to establish a corporate presence.

    For corporations that engage in a pure inversion transaction, under the REPO Act the new foreign parent corporation would be deemed a domestic corporation for US tax purposes. By dragging the foreign shell corporation back onto US shores, the anticipated benefit of escaping US tax on foreign operations would be completely denied. If the current proposals are enacted, this pure inversion legislation will extend to US partnerships that invert into a foreign corporation.

    Limited inversions

    Limited inversions are similar to pure inversions, except that the shareholders of the US corporation end up with more than 50% and less than 80% of the vote or value of the stock of the foreign corporation. Limited inversions capture inversion transactions that are structured to evade the 80% test of the pure inversion provisions, while at the same time allowing the US shareholders to effectively control the new foreign parent corporation. Limited inversions, which include inverted partnerships, will be treated in the following manner:

  • unlike pure inversions, the foreign parent corporation created by limited inversion transactions will not be treated as a US corporation;

  • the REPO Act would not allow the tax imposed on the untaxed earnings and appreciation in value of foreign properties to be reduced by any corporate tax attribute, credit, or other means. This is intended to strengthen the current law provisions that impose the corporate-level `toll charge' for moving assets out of the US taxing jurisdiction; and

  • limited inversion structures will be monitored to ensure that income cannot be stripped out of the US corporation through transactions with foreign related parties. The REPO Act will require that before any related party deduction is allowed, the US corporation must obtain IRS approval of the terms of their related-party transactions annually for ten years following the inversion. As a further measure to prevent income stripping, the REPO Act will substantially reduce the amount of interest expense that may be deducted by a US corporation for interest payments remitted to a related foreign party after an inversion transaction.