By Michael Luo and Mike Mcintire, New York Times

Published: October 1, 2012

Buried deep in the tax returns released by Mitt Romney’s presidential campaign are references to dozens of offshore holdings with names like Ursa Funding (Luxembourg) S.à.r.l. and Sankaty Credit Opportunities Investors (Offshore) IV, based in the Cayman Islands.

Mr. Romney, responding to opponents’ barbs about his use of overseas tax havens, has offered a narrow defense, saying only that the investments, many made through the private equity firm he founded, Bain Capital, have yielded him “not one dollar of reduction in taxes.”

A review of thousands of pages of financial documents and interviews with tax lawyers found that in some cases, the offshore arrangements enabled his individual retirement account to avoid taxes on its investments and may well have reduced Mr. Romney’s personal income tax bills.

But perhaps a more significant impact of Mr. Romney’s offshore investments has been on the profit side of the ledger — in the way Bain’s tax-avoidance strategies have enhanced his income.

Some of the offshore entities enabled Bain-owned companies to sidestep certain taxes, increasing returns for Mr. Romney and other investors. Others helped Bain attract foreign investors and nonprofit institutions by insulating them from taxes, again augmenting Mr. Romney’s bottom line, since he shared in management fees based on the size of each Bain fund.

The documents — which include confidential Bain prospectuses and foreign regulatory filings, many previously unreported — illustrate how these tax-avoidance strategies are woven into the fabric of Bain’s deal making. While hardly a novel concept and not unique to Bain, the inevitable result is that elite investors like Mr. Romney are able to increase their fortunes in ways unavailable to most taxpayers.

“Private equity fund managers have a responsibility to their investors to maximize their investors’ returns, and part of that responsibility involves minimizing taxes,” said David S. Miller, a tax partner at Cadwalader, Wickersham & Taft.

Many of the details of the Romneys’ wealth — estimated at $250 million — remain hidden, partly because Mr. Romney has released only the last two years of his tax returns. Those returns show an effective tax rate of about 14 percent, because most of the earnings came from investments and are taxed at 15 percent, significantly lower than rates on ordinary income.

In a statement, the Romney campaign said, “Governor and Mrs. Romney have scrupulously followed the tax laws and have paid 100 percent of what they owed.”

Mr. Romney ran Bain for 15 years before leaving to manage the 2002 Salt Lake City Olympics. But he has continued to share in the profits of subsequent Bain funds, thanks to the terms of his retirement agreement.

The sophisticated tax strategies of Bain and other private equity firms begin with the basic architecture of their funds. Though headquartered in Boston, Bain and its credit affiliate, Sankaty Advisors, have set up at least 137 entities in the Caymans, using local lawyers and others who provide an islands address for paperwork purposes.

Contrary to veiled assertions by some of Mr. Romney’s Democratic foes, hiding assets from the Internal Revenue Service is probably not part of their rationale. Some might still assail the arrangements as “tax dodges.” Others, however, would say they are simply efforts to make Bain’s funds more “tax efficient.”

“You can call these loopholes,” Mr. Miller said. “But they’re really just inadvertent consequences of an extremely complicated system.”

To navigate that system, Bain said in a statement, “Like virtually all global asset managers, we use widely accepted, fully legal and recognized structures so that investors may receive predictable tax treatment on investment gains for their constituents.”

The reasons for organizing the funds offshore are varied, each based on a specific tax situation, tax lawyers said.

A variety of Bain funds in the Romneys’ portfolio have controlling stakes in foreign companies. Had those funds been set up in the United States, the Romneys and other American investors would probably have been subject to certain federal taxes for their ownership of “controlled foreign corporations.” Setting up the funds in the Caymans allowed them to avoid those taxes.

“Bermuda and the Caymans are popular choices for U.S.-based funds because they’re both close by and neither imposes local taxes on the fund or its owners,” said Andrew W. Needham, a partner in the tax department at Cravath, Swaine & Moore L.L.P.

Another appeal of offshore funds is that they help private equity attract investment from deep-pocketed big institutions like pension funds and university endowments. While these are generally tax-exempt, they are liable for taxes on “unrelated business taxable income” if they put money in funds that use debt financing to make investments.

Bain and other private equity firms use a variety of mechanisms to help investors avoid those taxes, including setting up offshore “blocker” corporations, a practice that has been criticized in some circles and has prompted legislative efforts to curb it. These offshore corporations become a conduit for money for these institutional investors, as well as foreign investors looking to avoid United States taxes.

Individual retirement accounts, as tax-exempt entities, are subject to the “unrelated business income” tax. But people familiar with Mr. Romney’s investments said his I.R.A., which is managed by an independent trustee and is estimated to be worth between $21 million and $102 million, used offshore blockers to avoid the tax. Mr. Romney’s I.R.A., for instance, has millions invested in several Sankaty funds with onshore and offshore investment vehicles. His I.R.A. would have invested through the offshore funds, they said.

In addition, the largest investment — worth up to $25 million — in Mr. Romney’s I.R.A. is in a fund called BCIP Trust Associates III, a Cayman Islands partnership through which Bain employees invested in the firm’s deals. Documents from a German regulatory authority, detailing the Bain funds’ share of a media holding company in that country, refer to holdings by BCIP Trust’s blockers, indicating it used such entities.

The complexities of tax structuring are apparent in many Bain and Sankaty funds. The 2011 tax return for the blind trust belonging to Mr. Romney’s wife, Ann, released last month, showed holdings, for example, in investment vehicles that control two related funds — Sankaty Credit Opportunities IV, L.P., organized in Delaware, and Sankaty Credit Opportunities (Offshore) IV, L.P., set up in the Caymans.

The confidential offering memorandum for Sankaty Credit Opportunities IV, part of a trove of documents dating to 2004 obtained by The New York Times, is explicit in the purpose of its Caymans counterpart. It states that it is designed to “accommodate qualified non-U.S. investors and U.S. tax-exempt investors,” and explains that the Delaware fund is “expected to incur income that is considered ‘unrelated business taxable income.’ ”

Beyond their tax advantages, however, offshore funds controlled by American money managers can also create new tax problems. Those funds are limited in their ability to make loans without triggering corporate income taxes — an issue for Sankaty funds. Therefore, they usually have a parallel domestic fund that makes the loans, holds them for a period before selling a portion to the offshore fund, a practice known as “season and sell.”

The Sankaty offshore funds feature still another layer of complexity, designed to lower the taxes on profits enjoyed by Bain and Sankaty managing directors, as well as Mr. Romney through his retirement agreement. So-called carried interest, the cut of a fund’s investment gains earned by its managers, enjoys a favorable tax treatment. But under I.R.S. rules, carried interest cannot be derived from a corporation, like the offshore blockers used by Sankaty.

To address that, Sankaty sets up offshore partnerships to work in tandem with the blockers, the documents show. The result is a complex plumbing system. Tax-exempt and foreign investors put their money into blocker corporations to avoid certain taxes. Then the blockers feed their money into the partnerships, which distribute the lightly taxed income to Bain and Sankaty executives.

Most of these and other tax-saving arrangements are embedded in the organizational structure of the funds. It is often hard to drill down on the maneuvers Bain pursued in specific deals. But the 2010 tax returns for Mrs. Romney’s blind trust offer a hint of one, with the mention of Ursa Funding (Luxembourg) S.à.r.l.

In 2006, Bain and another private equity firm, Blackstone Group, bought Michael’s Stores, an arts and crafts chain, for $6 billion, much of it borrowed. The company struggled, however, as its debt skyrocketed with the deal and its sales stagnated.

In early 2009, apparently recognizing an opportunity, Bain and Blackstone set out to purchase some of the stores’ debt at a steep discount. They spent $28.6 million to acquire about $193.6 million in Michael’s debt, going through what was essentially a shell corporation set up in Luxembourg, Ursa Funding, according to financial statements filed in that country and a Bain investor report published by the Web site Gawker.

Two Bain funds, in one of which Mrs. Romney’s trust held up to a $1 million dollar stake, invested about $13.5 million into Ursa, through a Caymans entity. In late 2009 and early 2010, Ursa sold the Michael’s Stores notes for nearly $200 million, giving Bain a hefty profit.

The deal could have saddled Michael’s with a tax on what is known as “cancellation of debt” income, which arises when a company’s debt is repurchased at a discount by the company itself or a related party. Federal withholding on interest payments by Michael’s was another potential issue. But Bain and Blackstone probably ensured Michael’s avoided those taxes by routing the transaction through Ursa, which was “unrelated” to the retailer and situated in a jurisdiction with a tax treaty with the United States that bars withholding taxes on interest. This, in turn, would have bolstered returns for investors like Bain.

The exact amount saved through the Ursa maneuver is difficult to calculate. Around the time the debt was purchased, Michael’s balance sheet made it “insolvent” for tax purposes. Under I.R.S. rules, instead of paying taxes on cancellation of debt income, insolvent companies lose other tax benefits, like the ability to deduct depreciation. By using Ursa to buy the debt, according to documents and tax lawyers, Bain potentially preserved tax benefits worth more than $50 million to Michael’s bottom line.

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