Welcome to the World of Taxes! A Philosophical Introduction for New Taxpayers
When I started in the money-management business, in 1969, I inherited a largely European clientele who, it is fair to say, were more knowledgeable and sensitive about taxes than I was.
The reason for this was partly the result of many banks’ and advisers’ preferred technique for acquiring customers, which can be summarized in the title of a popular sales seminar: “Fear Sells, So Sell Fear.” Europe’s history had made that sales approach easy: A succession of wars, invasions, and confiscations had led to a tradition of hiding one’s fortune in a safe place, preferably in another country. More recently, during World War II, many wealthy European families, especially Jewish ones, had found ways to hide some of their assets that might be confiscated by the Nazis in either neutral countries such as Switzerland or faraway ones such as Canada and the United States.
Once the war was over, the business of selling fear helped fuel paranoia over a possible Soviet invasion or other apocalyptic calamities. But then it was discovered that an equally menacing – and more certain – predator was the taxman, present in leading democratic countries eager to finance their welfare-state ambitions. The age-old French adage, “to live happy, live hidden,” thus became the motto of tax advisers everywhere. Fortunes were lured to so-called “tax havens,” countries whose constitutions imposed banking secrecy, thus allowing wealthy families to hide a portion of their riches.
It should be noted that, at the time, not all but many of the schemes offered by tax havens were either legal or tolerated in major countries. One factor that allowed the status quo to survive, even after a number of governments began to frown on tax avoidance, is that until recently there was no cooperation among countries on the subject of taxation. In fact, it might be said that there was fierce competition. All this began to change in 1989, with the creation of the Financial Action Task Force (FATF), an inter-governmental body established on the initiative of the G7 nations and housed at the headquarters of the OECD in Paris.
The FATF’s mission is to generate the necessary political will among its 36 member states to bring about national legislative and regulatory reforms for combating money laundering, terrorist financing, and other related threats to the integrity of the international financial system. Although nowhere is taxation specifically mentioned in its statement of purpose, the FATF initiative has given a tremendous boost to the global exchange of information and cooperation among states on tax matters as well. In very recent years, this has led to a proliferation of multilateral and bilateral tax treaties that have practically eliminated banking secrecy in most countries – at least, those that aim to appear “respectable.”
The Inevitable “Must” Eventually Happens
In the 1970s, French citizens who had accounts in US banks, for example, were not subject to French taxation on these accounts, although they were supposed to disclose them to the French tax authorities. Taxes on the interest earned from these accounts were withheld at the source by the American IRS; and, I was told, a copy of the form reflecting this withholding was routinely dumped into a building somewhere in Pennsylvania. Once a year, a representative of the French tax agency would come in and leave with an armful of withholding notices. Since no crime was being committed, and the statistical odds of an always-unpleasant inquiry were close to zero, no one (to my knowledge) bothered to report these American accounts to the French tax authorities.
However, as soon as IBM introduced its PC, in 1981, and I was able to get an early taste of the potential uses of computers with large databases, it occurred to me that the odds had shifted and bank secrecy was doomed – which is what I started preaching to whomever was willing to listen.
Of course, this was well before the spread of the Internet in the mid-1990s, which made the exchange of massive data easy and instantaneous. With computers’ processing ability having also been immensely increased over the same period, the means were now available for governments to share data on a global scale. At about the same time, the motivation for nations to cooperate by exchanging information was also enhanced and justified by the necessity to fight the narcotics and arms trades and their money-laundering operations.
Given these conditions and events, how could the tax collectors not take their place at the table? What had first been only a possible logical outcome has become a very palpable reality in the last few years.
New Nationalities, New Generations…of Taxpayers
I am writing this paper now because two waves of new investors are just assuming wealth-management responsibilities without any experience of dealing with tax obligations or authorities. The first wave comprises the new generations of wealthy families, who will most likely live in a much more global world than their parents and thus be potentially subject to taxation in several jurisdictions. The second wave includes citizens and residents of countries that recently have joined the modern economy, with many wealth-building opportunities but also new tax obligations looming on the horizon.
In investment matters I have often made the point that there is a plethora of ready-made technical answers, but that the right questions (lifestyle choices, values, and priorities) are rarely asked. In my experience, the same applies to tax planning. I should stress that I am in no way an expert in taxation matters and I therefore do not dispense tax advice. But, since I have witnessed many instances where families were faced with tax-related decisions, I consider myself an informed generalist; as such, I have some personal observations (again, as opposed to advice) to offer newcomers to the world of tax planning.
There is no more hiding. You must pay taxes somewhere.
In a world where the taxman is not only increasingly sophisticated, but also better informed and connected to colleagues worldwide, aiming for zero or minimal tax has become a fantasy that could eventually prove costly. There already are many cooperation agreements that demand that a country provide information on accounts housed by its financial institutions when specifically (and narrowly) requested by another country’s tax authorities. Now, however, the world is moving toward automatic exchange of information among nations, without the need for specific demands. This means that the geographic location of an account may be important if you like the climate for vacations, but it will soon make very little difference in terms of privacy. [Note that some countries that previously did not consider tax evasion a crime and, on the contrary, considered the breach of banking secrecy to be one, have now reluctantly signed these same information-exchange agreements.]
Given a choice of where you pay taxes, legally and politically strong countries are most favorable.
Some people change their residencies, or even nationalities, in order to pay taxes in a specific country. I do not think taxes should be one’s primary criterion in choosing one’s residence. When there are more compelling reasons, however, considering taxes makes sense to the extent that, when you become a taxpayer in a country, that country will naturally protect you against the potential rapacity of other countries. There are bilateral treaties to that effect, and a country will normally tend to protect a loyal taxpayer.
I’ve also observed that countries that operate under Common Law, which is largely built upon jurisprudence (past court decisions), are preferable to those that operate under Statutory Law (written laws, usually enacted by a legislative body). Again, without being a tax expert, I perceive common-law countries as more likely to be fair and less likely to change rules retroactively than statutory-law nations, where arbitrary changes obviously could play havoc with tax-planning efforts.
I was reinforced in this sentiment by recent developments in France. Some years ago the French Treasury attempted to impose its wealth tax on two French beneficiaries of an American trust. The Treasury lost a court case when the judge ruled that, since the trust was irrevocable and discretionary (distributions to the beneficiaries were entirely at the discretion of the trustees), the assets did not belong to the beneficiaries unless distributed. Until then, there should be no wealth to tax. This decision was based on a broad body of international jurisprudence. So, rather than appeal the court’s decision, the Treasury wrote and pushed through the National Assembly a new law that, among other things, denied the tax treatment that had heretofore been applied to trusts.
Taxation criteria can vary by country. For example, citizens and permanent residents (green-card holders) of the United States are generally liable for US taxes on their worldwide income. In Britain, however, nationality is not a criterion, and residents may not be taxable on their assets abroad if they are not domiciled in Britain (domicile is where one intends to eventually return or to die). This statute periodically comes under criticism as a social privilege of the wealthy. Other countries that are not now levying taxes on assets abroad, like Belgium, nevertheless require a reporting of these assets – can taxation be far off?
I have also observed that it is risky to place assets in countries where radical political change is a possibility. Even if they claim constitutional protection against foreign taxes now, changes in local tax laws may still follow changes in political regimes.
Be neither contemptuous nor too “cute.”
Taxation is a hugely complicated matter because tax authorities constantly invent new rules to keep up with tax experts who invent new loopholes to bypass existing rules. As a game, this is quite stimulating intellectually. And, in fact, early in my career I tried to concoct such a scheme, which I presented to an old tax adviser for several families. His advice still resonates:
“Never underestimate the adverse party, and particularly the taxman. They are smart, well trained, and have huge resources at their disposal.” And he added, “Your scheme is too cute. A smart agent who likes a challenge will treat this as a bull would a red flag waved in its face. Keep it simple.”
As in all money matters, the popularity of a tax scheme usually is a bad omen.
The nature of investments is that the more popular they are, the higher their price goes, which by definition lowers future returns. A similar curse afflicts tax-advantaged products and schemes.
Obviously, loopholes in the tax codes, usually the result of lobbying efforts by special interests, are often overlooked by tax-enforcing agencies – until the lost revenue becomes too costly. Then you can be sure that the loopholes will be closed, sooner or later. And when they are, many taxpayers will have to live with past decisions that cannot always be reversed retroactively.
Possibly even more perverse are tax breaks resulting from governmental policy decisions: tax shelters to attract capital to specific industries or to disadvantaged regions, for example. These are often well intentioned; but, when successful, they usually attract too much capital to a relatively limited number of legitimate investment opportunities. In my observation, they wind up being either marginally or not at all profitable.
Too many investors thus gain an immediate tax savings, only to miss true moneymaking opportunities.
Tax avoidance or interest-free loan from the government?
Just as I was looking for a conclusion to this paper, the Financial Times published an article entitled “The $62 Billion Secret of Warren Buffett’s Success” (3/4/2015). Besides the spectacular long-term investment record of his company, Berkshire Hathaway, Buffett is well known for his seemingly contradictory attitude toward taxes.
On the one hand, he has been a vocal advocate of higher taxes on the rich – like himself. On the other hand, as he said to Fortune magazine in 2014, “I will do anything that is basically covered by the law to reduce Berkshire’s tax rate.”
It is not as if Berkshire avoided taxes altogether. In fact, based on the Financial Times article, its effective tax rate has been around 30 percent for the last three years, not too far from the standard US corporate tax rate of 35 percent. What Buffett has been particularly good at, however, is postponing the payment of taxes that will eventually become due. For example, he has avoided selling divisions or subsidiaries, preferring instead to swap them for other assets or companies. Taxes on such swaps would only become due when the assets acquired in the exchange are ultimately sold. In Buffett’s case, this can be very far into the future, since his investment credo is, “The best time to sell a stock is never.”
Using this and other legal loopholes in the US tax code, Buffett has been a master in postponing the payment of taxes due. For example, according to the Financial Times, Berkshire paid $4.9 billion in taxes in 2014 out of the $7.9 billion it will eventually have to disburse for that year. The use of the money between the time when a tax becomes owed and when it must be paid amounts to what Buffett has described as an “interest-free loan” from the government.
Finally, despite his political views, Mr. Buffett is not eager to pay unnecessary taxes himself. As the largest individual shareholder in Berkshire Hathaway, he prefers his company not to pay a dividend: When he (or his shareholders) needs money or income, he prefers to sell some shares, thus incurring tax only at the lower rate for long-term capital gains.
In spite of all this, Buffett’s tax attitudes and practices are not necessarily as contradictory as they seem. It is true, for example, that Berkshire Hathaway’s energy subsidiaries have been avid users of tax credits and subsidies for investment in wind and solar energy, and Buffett has publically stated that the only reason they build wind farms is that they get tax credits for doing so: “They don’t make sense without the tax credit.”
But I doubt that, as one of the most successful investors in history, Buffett would have invested billions of dollars in businesses representing 6-7 percent of the US renewable energy market just for the tax credits. In fact, the more likely reason is that, past the initial investment, renewables will likely be steady generators of long-term cash flows, consistent with Berkshire’s concept of value. And when you calculate long-term returns, the amount of the starting investment is crucial: If it is reduced by tax credits and subsidies, your potential long-term return is proportionally enhanced.
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The purpose of this paper has not been to argue against tax awareness or tax planning. On the contrary, a strong case exists to seek and implement the optimal tax packages once other, more crucial, decisions have been made. But, since tax matters often tend to create a sort of paranoia that leads us to make tax decisions before we have decided on more fundamental choices, let’s try to remember that the cart does not go before the horse, but behind it.
François Sicart
Disclosure: This article reflects the views of the author as of the date or dates cited and may change at any time. The information should not be construed as investment advice. No representation is made concerning the accuracy of cited data, nor is there any guarantee that any projection, forecast or opinion will be realized.
This article is not intended to provide tax advice. Please consult with a legal professional or an accountant for such advice.
