(Tax) Cat and (Corporate) Mouse

June 22nd, 2010

Creative corporate tax strategy is nothing new. As Congress passes laws and the tax code changes, so does the strategy of how firms choose to declare their revenues and losses and financial flows overall. Many times, in efforts to avoid intended taxes on their profits, corporations will create and use a foreign-based shell company in a tax haven or secrecy jurisdiction. Doing this allows the company to siphon funds away from the eyes of the U.S. government to a company that it fully or partially owns, in a destination like the Cayman Islands, and then later to filter the funds back in, or repatriate them, to the United States through various methods that avoid taxation.

A recent article by Lucy Komisar in The American Interest demonstrated such a method ofshifting funds offshore then back to the U.S. Komisar lays out the mechanics: ICE Holding Co. L.P. was established in the Caymans in 2008.  Soon after, The Clearing Corporation (TCC) – whose owners include Goldman Sachs, Citigroup, JPMorgan Chase, BofA, Merrill Lynch and Morgan Stanley – merged with this newly formed ICE Holding Co. L.P. in the Caymans. Effectively, these major trading firms became owners in an offshore clearinghouse.  Clearing houses provide clearing and settlement services for firms trading financial products, and when these institutions are located offshore, they are not subject to SEC reporting and monitoring and pay little or no taxes. Adding this offshore twist to the mix changes how and under what conditions financial flows and profits from those firms may be taxed in the United States. When these banks trade derivatives – which are contracts derived from the value of some other thing – between their offshore company and their domestic firm, through a series of loopholes, they effectively either 1) bring the money back into the U.S. minimally or completely untaxed or 2) continue to use the money offshore to increase profits.

Both the taxation and tax avoidance schemes are complex. Komisar elucidates the particular process of evasion through the trading of derivatives on a firm’s own account, or proprietary trading, using a scheme structured by a complex web of interrelated firms – Intercontinental Exchange Inc. (ICE), ICE US Holding Co. L.P., ICE US Holding Co. GP L.L.C., and ICE Trust U.S. I highlight here two points that are implicit in the article, but warrant explicit attention, because they underlie the entire problem with the complexities and crises caused by offshore entities run by U.S. banks. The only reason ICE US Holding Co. L.P. (which has merged with the clearing house formerly based in the U.S.) is in the Caymans is to avoid reporting requirements as well as U.S. corporate tax law, both of which undermine the U.S. and global financial system in different ways.

The only difference between a clearinghouse in the Caymans and one in the U.S. is that the one in the Caymans does not have to abide by U.S. laws. Many banks argue that if money is offshore, the United States and its private sector banking institutions are not responsible for what happens; that if illegal activity occurs and many shareholders are swindled that the burden is not on the firm or the U.S. government to fix it. That is simply not true. Just because once-domestic money owned by a U.S. firm has made its way to an offshore account that is still owned by the US firm, doesn’t mean that the U.S. economy or domestic firm will not feel the hit when volatility occurs in the risky derivatives markets. No large institution can walk away from its international obligations despite the legal technicalities.

So, while ICE Holding Co. L.P in the Caymans will stand to lose big if its financial bets don’t pan out, its purpose is only to be a shell/filter for funds from U.S. domestic and other global banks. With a related entity in the Caymans, U.S. banking firms can continue to trade derivatives in the form of Credit Default Swaps (CDS) with what is still essentially domestic money to be lost. The ICE shell will hurt the domestic banks in the end, despite the fact that the revenue is passed through the filter of being “foreign money” from the Caymans. If things go poorly again, domestic banks will absorb much of the impact of the financial shock…again, and the conditions for requiring a large scale government bailout could be the same as before.

Kosimar states that the ICE member banks account for about 90 percent of the CDS market. If the bulk of this clearing now takes place abroad, but has the ability to affect financial stability at home, there is clearly a problem. The major banks filtering funds through this offshore holding company are reaping the benefits of a more stable and more regulated environment in the U.S. (relatively, compared to most other countries in the world) while simultaneously depriving that structure of the revenue it needs to sustain and improve itself. Now, not only does the firm avoid corporate taxes and place a larger burden of tax collection on you, the private citizen, but it facilitates and perpetuates the toxic model of convoluted and opaque financial transactions, especially in trading high-risk instruments.

ICE US Holding L.P. is one tangible example of how the efforts to benefit a few corporate elite contribute many times over to creating vulnerabilities that destabilize the financial system as a whole. The persistent effort to avoid corporate taxes comes at the extremely high cost of stability to financial markets.

Had the proposed Merkley-Levin amendment banning proprietary trading passed in the U.S. Senate, it would have made illegal the process of trading with the firm’s own money into a holding company the firm already part owns. It would have closed a loophole that the banks literally capitalized on and which helped, in part, to facilitate the financial crises. Anything that perpetuates opacity in markets for high-risk financial instruments contributes to instability in the system as a whole. In reality though, closing the loophole is just another play in the game of (tax) cat and (corporate) mouse. The real fix is more transparency; if transparency increases, developing new methods to hide funds becomes more difficult.

Note 1: A separate piece of the argument is whether or not taxing the margin (posted collateral) is logical (and in the spirit of the pre-2008 section 956 of the U.S. tax code). Taxing the margin of the proprietary trade rather than the revenue of the trade creates a disincentive for larger margin posts which create more stability and accountability. As I understand it, before the 2008 US financial downturn, banks were not expected to be burden-sharing shareholders in the clearinghouses they were using. Now that they are –whether informally or in the future possibly legally –partners in the clearinghouse, their margin posts, newly, fall under section 956 and are taxable; so what were not considered taxable corporate funds became taxable after the banks restructured their chains of control to include what is considered proprietary trading to related offshore entities – in anticipation of new laws and regulations on banks. That being said, the law is the law, and because many of these partner financial entities are located in the Caymans, it allows any U.S. partner bank to circumvent the law. According to the Komisar article, income to the IRS would be considerable if taxes on the margins of those prop trades were to be collected. What is also clear is that a company incorporated in the Caymans does not have a single financial reporting requirement to the country in which it is incorporated. This underpins the crippling opacity and convoluted financial schemes that make oversight and/or regulation by the U.S. so difficult.

Note 2: Komisar in the American Interest article states that the Caymans offshore structure is legal and approved by the New York Federal Reserve Bank, the New York Banking Department, and also that the parent ICE Holding company reported the company in the Caymans to the Securities and Exchange Commission (SEC). Given the fact that separate agencies and boards within the US government know, in a decentralized manner, the structure of and relationship between these entities, it becomes glaringly clear that there is a great opportunity to better aggregate information. This is part of what proponents of banking regulatory reform have been advocating. Just because different U.S. agencies and officials okayed different aspects of the ICE ownership/partnership chain without knowing how they are all related, it does not mean that the government as a whole soundly endorses the structure. Many banks use this as an argument in defense of their actions – “We filed with the various segregated boards and agencies and haven’t been found to be doing anything illegal, what more do you want?”…Yet another play in (Tax) Cat and (Corporate) Mouse.

Written by Karly Curcio

Follow @FinTrCo