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Sharks in Offshore Waters, Part One

No matter where you live, it’s hard to escape the feeling that too many trends are moving in ominous directions. The U.S., besides running suicidal deficits, now wants to make investment income subject to Medicare taxes and convert 401(K)s to annuities, in effect nationalizing them. The Euro Zone is coming apart at the seams, as weaker economies like Greece and Spain find it impossible to live under the same currency regime as Germany. And Latin American countries like Argentina and Venezuela appear to be returning to their banana-republic roots of constitutional crisis, devaluation and expropriation.

So it’s not surprising that capital, wherever it currently lives, is looking for other, safer havens. Here’s how a Miami real estate broker explained it a while back:

“There’s a movement by foreign nationals interested in wealth preservation. A Wall Street fund that wants to buy distressed Florida real estate is typically looking for a 20 percent annual return. The foreign national is looking to just preserve their money and make sure they don’t lose anything, a zero – 5 percent return.”

In other words, geographic diversification is not about making money but about preserving at least some money. We should all be thinking this way. But once you start looking abroad, especially if you’re an individual without a stable of global financial advisers, it becomes clear that offshore investing is a  lot more complicated than clicking on E*trade and buying a thousand shares of Goldcorp. Regulations, languages, and customs differ from place to place, vehicles like asset protection trusts and LLCs may be unfamiliar, and frequently the people you turn to for help are in reality predators who make their living fleecing foreign sheep.

Maybe this will help: Last month I wrote an article for CFA Magazine on the pitfalls of offshore investing. It’s a long piece, so it will appear here in three installments, starting with today’s look at some of the problems with supposedly-straightforward vehicles like trusts and insurance:

The world is a big, scary, and increasingly unstable place. And since investors react to scary and unstable news by diversifying, capital is now pouring across national borders in search of foreign havens. The number of people offering “offshore investing” products and advice is growing apace with predictable results: sharks are enticing inexperienced investors into unwise, unsafe, and occasionally illegal deals. Pitches like the following, which appeared online in October, 2009, abound:

While we were flying back to Munich that night, I sat next to Joel. He’s an American attorney based in the States. And for most of his legal career, he’s done tax planning. He told me he recommends that his clients keep a portion of their assets offshore if possible. And he told me about a completely legal offshore option. With what he called “the last, best tax shelter,” you can

• grow your wealth without paying income tax on the gains,
• choose how your money is invested,
• access your funds without triggering taxable capital gains,
• pass your money on to your heirs, without being subject to estate tax, and
• legally avoid reporting this offshore program to the IRS.

Meanwhile, real estate deals, ranging from Costa Rican resorts that will be carved out of the rain forest sometime in 2012 (as soon as the new highway is built) to Hong Kong luxury condos with sale prices rising by 5 percent a month, are everywhere.

Because much of this activity falls between the regulatory cracks, it’s tailor-made for scam artists, according to Anthony Noto, CFA, president of Shanghai-based Noto Financial Planning. “The offshore finance world needs to be approached with extreme caution,” he says. “Outside the scrutiny of industry watchdogs, products are routinely mis-sold.” A few examples:

SECRET BANK ACCOUNTS AREN’T REALLY SECRET Once upon a time, offshore investing was mainly about avoiding taxes and was premised on the assumptions that (1) tax haven governments would defend bank secrecy against all comers in order to keep the deposits flowing in and (2) these havens had the ability to keep other countries’ tax authorities at bay. This, alas, turned out to be disastrously wrong.

As the recent and much-publicized U.S. assault on Swiss bank UBS has proved, a determined superpower can indeed penetrate even Swiss bank secrecy. But even in cases where U.S. or European tax authorities have not yet won concessions, bank secrecy is problematic. Tax haven bank account information is worth millions on the open market, and all it takes is one rogue employee willing to sell client records to a high-tax government. This recently happened when a clerk at LGT Bank in Liechtenstein sold client account information to tax authorities around the world.

TRUSTS AREN’T “IRON-CLAD” Foreign trusts are marketed by offshore advisers as a simple, nearly foolproof way to protect assets. The idea is to create such an entity in a country that explicitly does not recognize the right of foreign governments to interfere in its financial sector. Design the trust to refuse access even to its owner if the owner is acting under duress, and—voila!—it’s protected from both creditors and tax authorities. This approach is known as the “doctrine of impossibility” because a court—or tax collector—can’t force someone to do something that’s impossible.

The problem, say Jay Adkisson and Chris Riser, California-based attorneys and co-authors of Asset Protection: Concepts and Strategies for Protecting Your Wealth, is that in order for a trust to convincingly refuse its owner’s request for cash, the owner has to have ceded control of the trust to the administrator. That’s a strange thing to do, to put it mildly. It’s also a slap in the face for judges when they attempt to enforce their ruling and are told the money is there but can’t be accessed. So, in a series of recent court cases, judges have countered the doctrine of impossibility with the “doctrine of disbelief,” says Riser. “The court might say, ‘I don’t believe that any normal sane person would take US$10 million and give it to someone in Mauritius and not expect to get it back when they ask for it.’” The judge then tosses the trust owner in jail until he or she coughs up the money.

Writing about one such case, Adkisson and Riser note that “Once again, a court has refused to believe the claims of a settler of an offshore trust that they really have no power to bring the trust assets back to the United States to satisfy creditors—a ruling that was once called ‘impossible’ by some offshore trust pundits, who once upon a time ridiculed the mere suggestion that a U.S. court could make such a ruling. That was the theory, but the metal bars keeping Merry Morris in her cell are all too real. There has yet to be a reported court case where a foreign asset protection trust has worked as a practical matter. Not only have these trusts routinely failed in the courtroom, but courts and legal academics have branded the use of foreign asset protection trusts as a gutter tactic. Remarkably, they continue to be standard planning fare for many planners.”

INSURANCE DOESN’T INSURE A PROFIT One of the most popular of offshore products (in fact, the one that’s alluded to in this article’s opening example) is insurance held in tax havens such as the Isle of Man, Guernsey and Singapore. The idea is that life insurance or a variable annuity is uncontroversial and allows invested funds to grow tax-free.

Both onshore and offshore, insurance companies pay large commissions to advisers selling their investment products — which often translates into high fees for policyholders. “But regulations onshore provide at least some rules and accountability for the advisers selling them,” says Anthony Noto. “Offshore, advisers are usually operating in a regulatory vacuum where they don’t answer to anyone.” The result is an array of fees that can total more than 5% a year, thus wiping out most or all of a policy’s investment gains.

Meanwhile, many policies assume regular contributions for 20 to 30 years and penalize policyholders who don’t keep up the payments. “Most of the people that I come across in these investments have the misconception that they only need to invest for the first 18 to 28 months, and then have complete flexibility,” says Noto. “In reality, the only thing that changes after 18 to 28 months is that the adviser’s commissions are then safe from clawbacks.” One of Noto’s clients, after discovering the true tax and fee structure of a policy he’d bought, “decided to surrender 11,000 euros in contributions rather than be locked into saving like that for another 24 years.” And yet the pitches continue: “In China, the number of ‘independent financial advisers’ chasing after expatriates to sign up for these plans is staggering,” says Noto.

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