Panama Papers: Is there ever a good reason for setting up a shell company?

A leak of documents from the law firm of Mossack Fonseca in Panama City, Panama, has touched off new awareness of the use of offshore accounts by the wealthy. Sometimes there are valid reasons for such accounts, experts say.
A leak of documents from the law firm of Mossack Fonseca in Panama City, Panama, has touched off new awareness of the use of offshore accounts by the wealthy. Sometimes there are valid reasons for such accounts, experts say. AP

One of Miami tax lawyer Michael Kosnitzky’s former clients had a more urgent reason for hiding his wealth than merely evading taxes.

The wealthy Peruvian was trying to avoid being murdered.

His finger had been severed and a relative kidnapped to force him to pay a hefty ransom. He moved to South Florida and hired Kosnitzky in an attempt to protect his money, his family and himself.

“That’s why wealthy Latin Americans come to Miami,” Kosnitzky, who also practices law in New York and Los Angeles, told McClatchy. “They feel safe walking around Bal Harbour and Aventura and Dadeland and South Beach and Lincoln Road. In a lot of these countries, they need their own security force. It sometimes looks like they have their own army.”

The rich, as novelist F. Scott Fitzgerald put it, are different from you and me. In between buying yachts or collecting art, they spend a lot of time engaged in complex financial transactions sometimes tied to companies that exist only on paper.

But that doesn’t mean shell companies can’t have valid purposes. Lawyers who’ve prosecuted people for using dummy companies to hide money and attorneys who’ve represented them agree that there are perfectly understandable reasons for a shell company to exist. The explosive Panama Papers leak has revealed at least 214,000 such entities, mostly tied to individuals.

“There are legal vehicles for setting up anonymous companies both onshore and offshore, and there are certainly many legitimate reasons for doing that,” said Polly Greenberg, a former Manhattan-based state prosecutor of white-collar crime who currently serves as a regulatory and compliance adviser at Duff & Phelps in New York.

“A lot of people may think they’re morally wrong because they don’t like the fact that wealthy people can use them to avoid paying taxes,” Greenberg said. “That doesn’t make them illegal or even wrong.”

Among the legal reasons: large American companies that move jobs and profits offshore, partly to decrease their taxes. The practice has drawn particularly sharp criticism from Republican presidential front-runner Donald Trump, the New York City businessman, and Democratic presidential candidate Bernie Sanders of Vermont, both of whom have vowed to change laws that allow multinational corporations to shift operations overseas.

“What multinational corporations are doing when they set up a Cayman Islands or a Bermuda company is tax avoidance, which is legal,” said Victor Fleischer, a tax law professor at the University of San Diego. “If not endorsed by the U.S. government, it’s certainly not necessarily viewed badly. The purpose of these companies is not to hide assets or keep the government from having information. It’s merely to take advantage of the legal rules.”

Such offshore companies are bad public policy, however, said Gabriel Zucman, an economist at the University of California in Berkeley and an expert on hidden wealth.

“The current tax system makes it very easy for big U.S. companies to pay little taxes,” said Zucman, who published a book last year on hidden wealth. “So much of what’s going on in terms of using tax havens is legal. That doesn’t mean that it’s right or good for society.”

Other legitimate reasons for setting up an offshore entity include financing actual foreign operations and investing in foreign capital markets, Fleischer said. For individuals, an illegitimate reason, he added, would be to hide assets from a spouse just prior to a divorce.

Shell companies date back almost a century in the United States. That’s when progressive taxation — imposing progressively higher tax rates on greater incomes — was introduced in response to massive accumulations of wealth during the Roaring Twenties.

Over the subsequent decades, the imposition of heavier taxes led some wealthy Americans to seek shelters for their money in a perennial cat-and-mouse game with the Internal Revenue Service that made “Swiss bank accounts” a synonym for questionable activity and prompted the creation of countless shell companies.

But not all shell companies are offshore. During the Enron scandal of the early 2000s, Americans learned that a major Houston-based energy conglomerate was little more than a series of interconnected phony firms whose value had been wildly inflated by Enron accountants.

Despite stricter income-reporting requirements in the United States than in many foreign countries, Delaware, Nevada and other states are notorious for hosting anonymous firms with hard-to-trace owners.

Legal or not, shell companies and similar fiscal structures are ripe for abuse.

“Nearly every securities fraud investigation we did,” said Greenberg, the former federal prosecutor, “had shell companies involved somewhere, somehow.”

Cindy Schipani, an expert on corporate governance at the University of Michigan, agrees that an offshore account is not in itself necessarily a sign of wrongdoing, “provided all income from those accounts is accurately disclosed, the relevant taxes are paid and all regulations are followed.”

But she acknowledged that “they tend to be tainted in public opinion because some companies and individuals have abused the accounts to hide income and often correspondingly fail to pay the appropriate taxes.”

In an attempt to crack down on the use of shell companies for outright tax evasion, Congress enacted and President Barack Obama signed into law the 2010 Foreign Account Tax Compliance Act. That law requires Americans to report significant assets held outside the United States to the Financial Crimes Enforcement Network, a section of the Treasury Department, and it also requires foreign banks and investment firms to report American-owned accounts to the U.S. government.

Interestingly enough, despite the size of the U.S. economy, Americans are thought to make less frequent use of offshore accounts than individuals or companies from Latin America, Africa, Russia and beyond. “It’s much less of a problem here in the United States today,” said Fleischer, the University of San Diego professor.

Data assembled by Zucman show that only 4 percent of all wealth in the United States is held offshore, compared with 57 percent in Persian Gulf countries and 52 percent in Russia.

Yet in sheer dollar amounts, because the American economy is so big, the cost of offshore operations and other tax-avoidance schemes to the U.S. government is staggering – perhaps $165 billion a year, Zucman estimates.

Beyond the government, Zucman said, everyday Americans suffer as well.

“The taxes that are avoided by Facebook and Google and similar companies at the end of the day have to be compensated by higher taxes on the middle class,” he said. “Tax havens are one of the main reasons why income disparities are growing. If it’s easy for very wealthy individuals and big companies to evade taxes, that becomes a powerful force pushing in the direction of more income inequality.”

CORRECTION: An earlier version of this story incorrectly described Polly Greenberg as former federal prosecutor. She is a former state prosecutor. It also misreported the estimated amount of tax revenue the U.S. government fails to collect because of offshoring. It is $165 billion.

James Rosen: 202-383-0014; Twitter: @jamesmartinrose