In Depth February 11, 2010, 5:00PM EST

A Caribbean Tax Holiday for U.S. Businesses

The IRS is investigating how $100 billion a year in credit-card receipts are escaping U.S. sales and income taxes in locales like Aruba and St. Kitts

By Jessica Silver-Greenberg

Browse Issues

Browse the BusinessWeek Archive

Story Tools

http://images.businessweek.com/mz/10/08/370/1008_mz_46offshore.jpg

Illustration by Matt Dorfman

(This story has been updated to correct the location of payment-processing company, First Data.)

Greg Hennessy designs software in New York, where his $2 million-a-year company, SWAT, is based. His customer credit-card payments go to a bank in Panama, where his business is incorporated. As a result, he pays taxes at Panama's bargain-basement rates, far lower than what he'd owe in the U.S. "So far," he says, "it's been excellent."

Red Ball, a company in Phoenix, runs Web sites selling collectibles, software, and assorted other goods. It routes its nearly $15 million in card revenue to the tropical island of Nevis, where Red Ball is incorporated. Gregg Larry, who heads the company, says: "Sure, we get to pay less income tax, but it's not about tax evasion."

These two tiny companies illustrate a growing trend. At a time when the Obama Administration is preparing for a bitter battle with big multinationals over closing arcane tax loopholes, legions of mostly small retailers and service providers are minimizing their U.S. tax bills by sending credit-card receipts to Panama, Nevis, Aruba, the Cayman Islands, and other business-friendly havens. The IRS estimates that $100 billion a year in revenue is escaping U.S. sales and income taxes in this manner.

For several years the tax agency has been formally investigating whether the spreading credit-card practice amounts to illegal behavior. Daniel Reeves, the IRS special agent leading the probe, said in April in an affidavit filed in federal court in Denver that "a number of U.S. taxpayers may be under-reporting income, evading taxes, and breaking the law" by sending card receipts offshore. Reeves declined to talk to Bloomberg BusinessWeek, and the IRS won't provide specifics about the continuing probe.

Companies that route card revenue offshore say what they do is entirely lawful and appropriate. They typically note that they do not have to charge their customers any American sales tax because they have incorporated overseas. The companies say that they notify the IRS of this arrangement. They also maintain that eventually they pay income tax on any money they bring back to the U.S. Tax experts say that if businesses take all of these steps, they are indeed operating within the law.

The IRS suspects that a lot of the offshore credit-card activity isn't, in fact, reported and that repatriated funds frequently escape income taxation. Some executives in the business of processing card payments in the U.S. agree. "You can report a foreign bank account all day long, and that doesn't mean that you are accurately reporting the amount of money stashed there," says Todd Fuller, senior vice-president of Jetpay Merchant Services, a domestic U.S. card processor that competes against companies that arrange for offshore deposits.

Many Caribbean locales levy little or no sales tax, compared with state tax rates of up to 10% in the U.S. Similarly, many Caribbean jurisdictions impose corporate income tax rates far below the standard U.S. rate of 35%.

Hennessy, the software designer, says that while he benefits from this discrepancy, he nevertheless follows the rules. "I comply with all tax laws," he says. "I prefer to have my bank account in Panama, where it's safer than in the U.S., at least from frivolous lawsuits." Red Ball's Larry said he got fed up with paying high processing fees at home: "I just got sick of it." It's cheaper to send receipts to Nevis, he adds.

The credit-card investigation is unfolding as the Obama Administration cracks down on a variety of corporate and individual tax-minimization strategies. In the best known case, the U.S. government has pressured the Swiss banking giant UBS (UBS) to turn over the names of 4,450 American clients who the IRS suspects are using offshore bank accounts to shield personal wealth from income tax. UBS avoided criminal prosecution in the U.S. by agreeing to pay a settlement of $780 million and admitting it helped foster tax evasion.