Meltdown 101: How do foreign tax havens work?

BY MATTHEW PERRONE
Associated Press

WASHINGTON -- President Barack Obama's proposals to crack down on foreign tax shelters target obscure, complex financial practices that help some of the nation's biggest corporations hold on to billions of dollars.

Here are some questions and answers about tax shelters:

Q: What are foreign tax shelters?

A: Tax shelters are countries with corporate tax rates much lower than those of the United States, which make them popular for U.S. businesses looking to lower their tax bills.

Whereas the U.S. corporate tax rate is 35 percent, Iceland's is 15 percent and Switzerland's is just 8.5 percent. Many countries in the Caribbean don't tax corporations at all. Companies shift profits to subsidiaries in such low-tax countries to avoid paying the Internal Revenue Service.

Q: How do companies use tax shelters to save money?

A: One of the most popular tactics involves setting up multiple overseas subsidiaries to move profits from high-tax countries to low-tax countries. Under so-called ''check the box'' rules, companies can register their subsidiaries as separate units that aren't subject to U.S. tax rules.

In one scenario, a U.S. company could use operations in the Virgin Islands to avoid paying taxes on investments in Sweden. The company does this by setting up three new corporations: a subsidiary in Sweden, a holding company in the Virgin Islands as well as another subsidiary owned by the holding company.

The Virgin Islands subsidiary makes a loan to the Sweden subsidiary for a new facility there. The interest on the loan would be income for the subsidiary in the Virgin Islands and a tax deduction for the Swedish subsidiary.

Q: What happens to money stored in tax havens?

A: In most cases it stays there. Companies can avoid paying taxes on overseas profits indefinitely, as long as they don't bring it back to the U.S.

Q: How would the Obama proposal change the way companies operate overseas?

A: The proposal outlined today would not force companies to return profits from overseas to the U.S., a worst-case scenario for many company executives. Instead Obama would stop companies from deducting expenses in the U.S. that help support their operations overseas. This would have the effect of increasing their tax burden, since companies are generally able to deduct the vast majority of their expenses.