Lifting the veil on round-tripping, a pervasive method of offshore tax evasion

Bermuda. Bahamas, Cayman Islands. Dream vacation spots? Maybe. Places to evade United States income taxes? Definitely.

But nobody—not even the Internal Revenue Service—has been able to venture much more than a guess at the volume of tax evasion occurring via offshore tax havens.

“Systematic evidence of illegal activities is hard to come by,” says Jacob Thornock, an assistant professor of accounting at the University of Washington Foster School of Business. “So tax evasion has been nearly impossible to measure.”

Until now. A new study by Thornock sheds first light on a form of illegal tax evasion called “round-tripping,” in which Americans disguise their investments in US securities by routing them via shell corporations based in offshore havens.

Thornock and co-authors Michelle Hanlon of MIT and Edward Maydew of the University of North Carolina investigated the effects of varying levels of risk and reward from round-tripping via 11 known tax havens. They find that an increase in the risk of getting caught—in the form of tightening international tax exchange agreements—results in decreased volumes of round-trip investment. And an increase in potential reward—in the form of rising US tax rates—results in a two- to three-fold increase in round-trip investment.

With this analysis, the authors were able to estimate that between $34 billion and $109 billion is invested annually through round-tripping.

Round-tripping

Offshore tax havens are famous—or infamous—for hosting many legal ways to avoid paying US taxes. But Thornock stresses there’s a big difference between tax avoidance and tax evasion. The latter is a criminal offense.

Round-tripping is considered to be one of the most successful methods of circumventing the IRS illegally.

Here’s how it works. Say you’re a resident of the US who wishes to invest in US equity and debt markets without having to pay income tax on your earnings. So you simply establish a corporation in one of a handful of tax havens—from the Caymans to Switzerland to Singapore. You route money to your new corporation which is then invested in stocks and bonds on the NYSE or NASDAQ. Though the earnings on these investments flow back to you, they appear to the IRS to be the earnings of your foreign corporation, which owes no taxes to the US. And, fortunately, your corporation is headquartered in a country that just happens to collect no income tax either.

The investment income accumulates tax-free. “The IRS sees the transaction, but it looks like it’s coming from a foreign corporation, not a US citizen,” Thornock says.

Measuring the immeasurable

Tax evasion, like other illegal activities, is difficult to observe. What’s more, the majority of the $1.2 trillion invested annually from the 11 largest offshore tax havens is done so using tactics that are perfectly legal in the US.

But how large a piece of that $1.2 trillion pie is illegal? Thornock and his colleagues created a novel way to isolate the strategy and estimate its occurrence: examine the effect of shifting costs and benefits—risks and rewards—that should be specific only to investors seeking to evade taxes illegally.

They first analyzed foreign investments following changes to Tax Information Exchange Agreements between the US and many of these tax havens. After agreements were strengthened, increasing the risk of being caught, they observed the volume of tax evasion decreased.

Then they studied the outcome of changes in the US tax rates on both ordinary income and capital gains. They found that a rate increase of 1 percent yielded an increase in the volume of tax evasion between 2 and 3 percent. “The higher the tax rate, the more you stand to save by evading it,” Thornock explains.

“And these costs and benefits should only apply to a tax evader,” he adds. “Changes to the US tax rates or exchange agreements should have no influence on the actions of legal investors and citizens of these nations at all.”

Understanding the problem

The study, Thornock admits, does not attempt to provide solutions to the problem of round-tripping. But there is significant value in simply being able to quantify the problem for the first time.

“We can’t hand the IRS a magic bullet to solve this form of tax evasion,” he says. “But we can hand them a radar gun to help them evaluate how much people are speeding.”

The tax collectors and policy makers are interested. By invitation, the authors have presented the paper to the IRS and to the senior staff of the US Senate Committee on Homeland Security.

Thornock asserts that the heyday of tax evasion may be over—or at least dwindling—as banking transparency, enforcement, and international cooperation have steadily increased over the past decades. Policy makers will have to judge whether the problem is worth the costs of strengthening enforcement.

“Will we ever eliminate tax evasion? No way. It’s like any crime,” says Thornock. “But with increased enforcement and transparency, it’s way more difficult to be a tax evader today than it was 30 years ago.”

Taking the Long Way Home: Offshore Investments in U.S. Equity and Debt Markets and U.S. Tax Evasion” is forthcoming in the Journal of Finance.