The murky world of offshore tax havens

How to create an offshore shell company
How to create an offshore shell company

Offshore holdings. Shell companies. Secret accounts.

These are some of the tools allegedly used by elected leaders, officials and celebrities to hide money, according to reports published by a coalition of news organizations that have opened a window into the shadowy world of offshore investment.

The news reports are based on more than 11 million documents from a single law firm in Panama. The leaked files go back decades and reference 12 current or former world leaders, as well as 128 other politicians and public officials.

Full coverage: Rich and powerful respond to claims they hid billions offshore

Offshore investment is among the murkiest sectors of the financial world. That's by design -- keeping money offshore can help shield money from tax authorities, obscure its origin and conceal the genuine owners.

Why an offshore account?

There are many legitimate reasons for opening an offshore banks account. Wealthy people do it to better manage their investment portfolios or protect their assets. Offshore accounts can also help the rich pay less tax -- legally.

However, offshore accounts are also the lynchpin in many illegal tax avoidance schemes. Owners go to great lengths to conceal the existence of these accounts from their home governments, and they are often helped by lax disclosure rules in offshore tax havens.

Investors caught trying to hide their accounts can face steep penalties.

What's a shell company?

Shell companies look like real companies on paper, but they don't actually do much. They don't make any products, and they typically don't have an office or employees. Shell companies have some legitimate uses in business, but they can also be used to help obscure the ownership of assets or avoid taxes.

It's pretty easy to set one up. For Americans, usually all that's required is a few hours and a couple hundred dollars.

Company officials need to disclose the business to the proper tax authorities, however. Staying on the right side of tax authorities will also require lots of time spent filling out disclosure and tax forms.

Bad actors, meanwhile, can layer shell companies on top of each other, through various jurisdictions, in order to conceal their ownership or launder money.

Where are the top tax havens?

The law firm at the center of the offshore revelations, Mossack Fonseca, is based in Panama. But according to the International Consortium of Investigative Journalists, it has incorporated tens of thousands of companies in Seychelles, an Indian Ocean archipelago often described as a tax haven.

Mossack Fonseca said in a statement that it had done nothing wrong.

"The facts are these: while we may have been the victim of a data breach, nothing we've seen in this illegally obtained cache of documents suggests we've done anything illegal," the firm said.

Tax havens attract investors by having lower tax rates and special exemptions. They also often have lax reporting requirements, making them ideal for questionable activity.

Bermuda, the Cayman Islands and the British Virgin Islands are three of the biggest tax havens for U.S. companies, according to a report last year from the left-leaning Citizens for Tax Justice and the U.S. Public Interest Research Group.

Related: Report IDs world's top tax havens

According to the report, U.S.-controlled companies in these locations reported $155 billion in profits in 2010, the most recent available data. By comparison, the gross domestic product of those countries that year totaled $10 billion.

Bermuda stood out -- booking about $94 billion in profits, dwarfing its gross domestic product of $6 billion.

Tax cheats, beware!

The Panama Papers reports should not be read as a how-to guide. Individuals caught messing around with offshore bank accounts and shell companies in order to avoid taxes or hide dirty money can face massive penalties.

The U.S., for example, is working to implement a new law called the Foreign Account Tax Compliance Act.

Under FATCA, the U.S. Treasury has struck agreements with more than 100 countries that require those countries' banks to report back to the IRS on any accounts held by U.S. taxpayers.

If the IRS finds that you willfully failed to disclose overseas accounts, you could owe a penalty of 50% of your total balance or $100,000, whichever is greater, for every year you failed to file a special form.

European regulators are also working to crack down on offshore tax evasion.

-- Ivana Kottasova, Alanna Petroff and Jeanne Sahadi contributed reporting.

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