Reinvoicing & Transfer Pricing Schemes

Introduction

IRS Guide to Abusive Offshore Tax Avoidance Schemes An Abusive Scheme Toolkit for External Stakeholders

We get a lot of calls from folks who say "Hey, I'd like your help in forming an offshore corporation which will receive income I am receiving from some source, keep most of the income, and then will pay me a small portion of what is left so that I don't have to pay income taxes on the full amount."

This is the businessman's dream -- to be able to keep from paying income tax, while allowing money to grow tax-free in some sunny Caribbean haven.

But as shown this can amount to tax evasion.

How It Works

A businessman (whom we will call "Client") creates an International Business Company (IBC) in a tax-free haven to which profit is diverted. The intermediary marks-up the price during the transfer (hence "transfer pricing") and then "reinvoices" the Client's domestic corporation at the higher price.

Before Implementation

In the following example, the Client owns a Business which purchases a product for $1. The Client's Business is able to sell the product to the public for $10, thus generating a taxable profit to the Client of $9.

After Implementation

The Client creates an International Business Company (IBC), but does not report the creation of the IBC to the Internal Revenue Service. The IBC purchases the product at $1, but marks-up and reinvoices the Client's Business for the same product at $9. The Client's Business still sells the product to consumers at $10, but the Client only reports $1 in taxable profit to the Internal Revenue Service. The other $8 remains in the IBC and grows-tax free. This is blatant tax-evasion.

Tax Evasion

While these schemes sound very attractive to businessmen, they have been around long enough for a body of law to develop which gives the Internal Revenue Service some of its strongest powers to combat abuses in this area. Now, the IRS essentially has the power to simply disregard the intermediary IBC and tax the Client as if there had been no intermediary, and also assessing severe penalties and interest for the non-payment of tax on this money.

Additionally (claims of sleazy tax practitioners aside) the intermediary IBC is a controlled-foreign corporation, and to not report profits made by it and then made in investments is simply tax evasion.

Offshore corporation providers often promote these schemes, and claim that because of offshore secrecy and confidentiality laws they can never be discovered. However, they are frequently discovered, and in this author's opinion and experience only a scant few succeed. Why? Because it really isn't that difficult for the IRS to figure out these schemes.

IRS Red Flag: Unexplained High Purchase Price -- Let's say Sanyo sells CD players for $15, but you are purchasing the same CD players from a Nevis company for $65. Not too hard to figure out what is going on.

IRS Red Flag: Unnecessary Foreign Transaction -- You are purchasing a product made in Florida and selling it in California. But you are purchasing it from a Panamanian corporation. Not too hard to figure out what is going on.

IRS Red Flag: Brass Plate Company -- The company from whom you are purchasing property doesn't have any real offices, employees, or warehouses. Not too hard to figure out what is going on.

IRS Red Flag: Declining Profits -- Last year you made $10 per unit, but this year only $1 per unit. However, the industry-wide price hasn't changed. Not too hard to figure out what is going on.

IRS Red Flag: Public Complaint -- Now you've divorced and your ex-spouse wants his or her half of the money overseas, in addition to everything else. And so a roadmap of what has happened is provided to the IRS.

These are just a few easy examples known to us. The IRS has dedicated manpower, and has developed a variety of techniques to discover and bust these scams. You're just crazy if you think you can create one of these structures and get away with it for very long.

These schemes are known by a variety of names, in the U.S. they are called "transfer pricing schemes" and offshore they are called "reinvoicing structures". Sometimes they are called "Margolis schemes" because of the late California tax attorney Harry Margolis who created hundreds of these schemes (nearly all of which failed) in the 1980s. See, for example:

• Erhard v. Commissioner of Internal Revenue

• Schulman v. United States

• Goldberg v. United States

[Note: Your author's first federal court trial experience, and first "offshore" experience, was in 1988 as a law clerk assisting a litigation firm in the trial against the estate of the late Mr. Margolis, who had set up one of these schemes using a series of Panamanian corporations.]

Legal Transfer-Pricing Schemes

It is actually possible to create 100% legal transfer pricing schemes, although these schemes benefit from so-called Double Tax Treaties (DTAs), and the goal is the substantial reduction of taxes by taking advantage of different tax rates in different jurisdictions which have tax treaties with the United States. Indeed, there are whole cadres of international tax attorneys who sit around looking for ways to take advantage of DTAs. Even with these, however, we recommend that you get an opinion letter from one of the major accounting firms to protect yourself.

Another method to implement a transfer pricing scheme is to add some value to the product to justify differing the profit abroad. This whole area, however, can be very tricky, and you sure don't want to attempt one of these schemes without a "Transfer Pricing Study" by one of the major accounting firms (and even these studies, which are very expensive, may not protect you).

Captive Insurance

Actually, once businesses get above a certain level they can accomplish this in a 100% legal, fully-discloseable fashion by way of a Captive Insurance Company (UPS, Humana, Harpers, and many other large corporations have formed captives for this purpose). Usually, the business needs to be generating in excess of $1 million in annual net profits before this begins to make sense. Additionally, for a captive insurance company to work there must be full disclosure to the IRS of the company's operations, it insurance contracts, how much third-party insurance it is writing, etc. -- i.e., a captive which "hides" its operations will inherently fail.