By Sonali Basak From Bloomberg

It’s not the warm waters that have attracted so many corporations to places like Bermuda, the British Virgin Islands and the Cayman Islands. It’s how these havens help keep profits from tax collectors. To prevent U.S. companies from shifting earnings offshore, Republicans in the U.S. House of Representatives are weighing a 20 percent tax on payments made to offshore affiliates. This could hit the advantages that make the locations so attractive to people and companies looking to protect their money from the Internal Revenue Service.

1. Why’s so much of this in the Caribbean?

A single number: zero. That’s the tax rate for corporations and capital gains in Bermuda, the Cayman Islands and BVI. And the locales have created friendly rules to help foreign firms set up shop. Bermuda in the past few years has given partnerships the same rights as companies, helping boost the number of asset managers registered there. Partnerships can “pay dividends, distribute capital, open and maintain bank accounts and acquire assets and net liabilities in any currency,” a Deloitte LLP report says. They also have court systems that are able to process disputes among investors.

2. How is this used to avoid taxes?

An ongoing series of stories from a project known as the Paradise Papersdetails how multinational corporations and hedge funds can keep more of their money by shifting profits to low-tax jurisdictions. Many hedge funds do this by setting up reinsurers in no-tax locales. Money goes into a reinsurer, which then invests it in the hedge fund. That way, any profits go to the reinsurer, which doesn’t owe taxes on them. The money can grow for years tax-free. When the investors sell their stake in the reinsurer, they owe only capital-gains tax.

3. What’s a reinsurer?

It’s a company that insures an insurer. It’s a legitimate industry, but after so many hedge funds piled in, the IRS and a number of U.S. senators tried toclamp down on the use of reinsurers to avoid taxes. In 2015, one proposedbill would have disallowed a company from qualifying as an insurer for tax purposes if its insurance liabilities were less than 10 percent of assets. Ahead of that bill, a report on Bermuda-based insurers by the U.S. Congress Joint Committee on Taxation found that PaCRe Ltd., a reinsurer set up by John Paulson, had a ratio of about 1 percent in 2012. PaCRe was shuttered in 2016 but plenty of reinsurers remain in the Caribbean, like hedge fund manager Dan Loeb’s Third Point Reinsurance Ltd, based in Bermuda, and David Einhorn’s Greenlight Capital Re Ltd, in the Cayman Islands.

4. Why not just base the hedge fund in a tax-free country?

Because it would have to pay IRS penalties on what the agency calls “passive foreign investment companies” — which are designed to discourage people from avoiding U.S. taxes. But the IRS considers insurance companies “active” businesses. To qualify as active, firms can’t have a pool of capital far greater than what they need to back the insurance they sell. The IRS has never specified what that ratio should be.

5. How much money is avoiding taxes this way?

No one knows for sure. But in 2016, while introducing another bill meant to curtail offshore reinsurance tax breaks, Senator Mark Warner, a Democrat from Virginia, said that the amount of reinsurance sent offshore went from $4 billion in 1996 to nearly $42 billion in 2014.

6. This is legal?

Yes. Bermuda, Cayman and BVI are U.K. overseas territories grounded in U.K. common law. While the islands don’t have precisely the same laws as the European Union or U.K., they’ve made it easy for business to function in multiple places. For example, Bermuda has been recognized by the European Commission to have equivalent regulatory standards for insurance companies. This decision prompted insurer XL Group Plc torelocate there from Dublin, Ireland. Chinese companies have also flocked to the regions, with nearly half of Hong Kong-listed companies incorporated in Cayman, according to law firm Walkers Global. For those companies, being based offshore can make it cheaper and easier to list on the Hong Kong exchange, and also to go private.

7. Can the U.S. really go after these funds?

It might try. A bill under consideration in the House of Representatives would levy a new 20 percent excise tax on payments from U.S. companies to offshore subsidiaries. The tax could apply to intellectual-property royalties that technology and pharmaceutical firms make to their overseas affiliates; U.S. companies’ imports of generic drugs, cars and other products from their affiliates; and the cost of reinsurance that global insurers buy from foreign affiliates. Opposition to such a tax is building in Washington.

The Reference Shelf

• A Bloomberg report on how insurance has become the hot new way to avoid taxes, and another from 2016: “Dan Loeb’s Hedge Fund Is Biggest Winner in Dan Loeb’s Reinsurer.”’
• From Bloomberg Businessweek, why hedge funds turned to reinsurance companies.
• A 2014 report by the U.S. Congress Joint Committee on Taxation on hedge fund reinsurance.
• The Paradise Papers report on how the Mercer family used offshore vehicles to avoid taxes.
• QuickTake explainers on the U.S. tax-cut debate and on profit shifting.

— With assistance by Brandon Kochkodin, and Hannah Levitt

IMAGES: Photographer: Mike Coppola/Getty Images

For more on this story go to: https://www.bloomberg.com/news/articles/2017-11-07/how-reinsurers-help-hedge-funds-shelter-taxes-quicktake-q-a