One of the most common problems facing uninformed entrepreneurs who want to save taxes by starting an offshore company has to do with accounting.
In our consultations, we encounter numerous clients who, without much consideration, have founded a dummy corporation or a shell company and suddenly start to lose all their clients because they cannot deduct taxes from their invoices.
In this article, I will explain why companies that consist of nothing more than an address and a letterbox have problems when issuing invoices and what you need so that your invoices are accepted, recognised and can be deducted.
We will also talk about countries affected by this problem and alternative solutions.
Recognition of offshore invoices
The acceptance of invoices issued from offshore jurisdictions is not a problem on a global scale but depends on each country.
For many of the world’s tax authorities, it does not matter from which country the invoice is issued, provided that the details are valid. And this is the case when it comes to an inspection or a tax audit, something that does not exist in the majority of countries, or is only done when revenue exceeds a million Euros.
In this respect, the English-speaking countries, such as the United Kingdom and the United States, are relatively open-minded. After all, they are the largest tax havens in the world, at least for foreign nationals. Also, many of today’s tax havens used to be colonies of theirs or continue to have close business relationships with them.
Therefore, in the UK or US, you will have no problems with accepting invoices issued by companies in Panama, Hong Kong or the Seychelles, for example (at least as long as the invoice makes sense).
However, this is different in Continental Europe. Particularly in Germany, where you can have serious problems if, during an audit, an invoice from one of the typical offshore countries is found.
If you are not able to prove otherwise, based on evidence, the Treasury in these countries will not recognize the expense and therefore you will not be able to deduct the tax from the invoice.
Despite the large amount of money that you save in taxes by having an offshore company, if you work with European companies or your clients cannot deduct your invoices (or are going to suffer inspections by having you as a supplier); this disadvantage will end up making you lose the majority of your customers.
Why only some commercial clients are problematic
One of the key questions in every Tax Free Today consultation is ‘Who are your clients?’ Are your clients individuals or companies and which countries do they come from?
Apart from the fact that Spanish companies often prefer to only do business with other limited companies for reliability and recognition reasons (and also because of a lack of knowledge of what to do when dealing with foreign companies), one of the most important factors to keep in mind is the risk of not being able to deduct the invoice or of having to withhold money from the supplier.
Although a shell company works perfectly with many business models, its use comes with certain problems if you have to invoice companies (B2B).
If you sell digital products or fitness and nutrition advice, it is normal for you to do business with the end customers. These customers generally don’t need an accepted invoice, since they cannot deduct what they paid.
This is also the case if you sell low-value products. Even if your client was the owner of a Spanish company and buys a digital book from a Panamanian company or a carpet in Dubai, of course on behalf of their company to save VAT and deduct it, they will not have any problems.
After all, the owner can prove that they purchased the product and given the low cost, it is likely that no-one will dispute it.
Something similar occurs with revenue from licences or commissions to third parties. There is often an agreement which clearly states the conditions under which the revenue is distributed. Even if the company receiving the money is in an offshore jurisdiction, there is usually no problem in proving where the commission came from.
It is important to highlight these examples because there is still the belief that the acceptance of these invoices depends solely on the country in which the company issuing the invoice is located.
The truth is that this is not the case, whether you can deduct an invoice primarily depends on how plausible the concept is, i.e. if it can be proven that the service or product was really received.
The country from which the invoice is issued is a clue but it is not a deal breaker.
Of course, if you issue invoices with a Canadian company, which is an OECD member state and a high-taxation country, you will have no problems, even if it is actually a tax-free LP.
The tax agency will not have any problem accepting this type of invoice since it knows that Canadian companies are transparent and public and, therefore, are not suitable for tax evasion.
Another important factor is that a financial official most probably has no idea that a Canadian LP can be used to sell anywhere in the world (except for Canada) without paying taxes. Surely they will assume that this LP also pays high taxes in their country.
Why an invoice’s credibility is fundamental
Ultimately, the determining factor is not the invoice’s country of origin, but its plausibility. And this is where the typical offshore companies based in tax havens usually falter: authorities often doubt their credibility.
In fact, the first idea that comes to every entrepreneur who (innocently) comes across the offshore world for the first time is usually to set-up an offshore company and issue invoices to their company in order to reduce profits and lessen their tax burden.
Of course, this doesn’t work if certain precautions aren’t taken and there are various problems, starting with the CFC rules and continuing with the rules for transactions between related companies.
So, what seemed like a good idea at first becomes a flurry of fines and complications because of the measures against tax evasion. In addition to those already mentioned, there is also the fiscal transparency system and the effective management rule.
Shell companies without offices or any type of real premises end up being treated as a national company for tax purposes, entering into the fiscal transparency system.
This means that from high taxation countries, like Australia, Canada, France, Portugal, Spain, Germany, Italy and so on you cannot legally stockpile pre-tax money in an offshore company, even if you don’t touch it.
Doing so will be illegal unless you take the trouble to set-up proper premises for the offshore company with registered offices, a director and employees. But even then, you will have to be very careful with linked transactions (i.e. those that occur between related companies).
Prices have to be at normal market rates and you must be able to prove that the service has been provided (which is easier for product sales).
Following this rule, the parent company could bill its subsidiary for certain administrative activities (or vice versa).
Of course, not all entrepreneurs are worried about legality and many establish their offshore company anonymously hoping not to get caught. Then they issue invoices with the company under the concept of consultancy services, a common expense type in many companies and difficult to verify.
In reality, the consultation never happens and the invoice is only issued so as to reduce the other company’s taxable profit. This can succeed, or not, but, of course, carries a certain risk.
The underlying problem: the ineffectiveness of the fight against tax evasion
If a tax evader assembles their corporate structure correctly, the tax authorities will not be able to establish a link between the offshore shell company and the real company from which the evader wants to divert part of the financial profit.
This is something that the laws developed as a result of the latest tax scandals cannot change either. These regulations and laws are simply used to increase fear.
Neither the BEPS initiative, nor the automatic exchange of information nor any other local law has a real solution to tax evasion and, ultimately, the least informed are those that end up being caught.
The irony is that the multiple measures taken ultimately increase the chances that dummy corporations will be used successfully, since politicians, officials and bureaucrats truly believe in the effectiveness of these laws and think that no-one uses such structures anymore.
While it is true that the laws adopted in recent years can be annoying and require certain readjustments in strategy, they have failed to stop those with great knowledge from using shell companies anonymously.
At the moment, the global mechanisms needed to identify financial beneficiaries at company level do not exist.
Even the EU’s transparency register or the bilateral agreements for the exchange of information between countries, just like the dreaded automatic exchange of information (which is harmless when understood correctly) have their legal loopholes.
The only truly dangerous thing is an information leak. This is totally unpredictable, but can be avoided by choosing to work with smaller service providers (and therefore of less interest) instead of with big firms like Mossack Fonseco, in the case of Panama Papers, and Appleby, in the case of Paradise Papers.
For all the reasons mentioned here, the recognition of invoices issued from tax havens poses a big problem for tax authorities since there is a risk that those wanting to avoid taxes have falsified invoices or issued them without providing any service.
Therefore, many tax authorities have chosen not to recognise invoices from offshore companies which lack transparency or they have chosen to implement reverse charge and force domestic companies to retain an amount at source to ensure that they pay taxes if they choose not to claim the withheld money (for which they have to identify themselves).
After all, to prove that an activity has been carried out, the tax evader would probably have to reveal their identity, something which they would prefer not to do, given the illegality of their actions.
In doing so, the domestic tax authorities manage to control at least part of the global tax evasion. There is still not much they can do to stop evasion through business models transferred entirely to shell companies.
Cases in which invoices from companies in tax havens are recognised
For a software developer living in Panama and invoicing through a Panamanian society, in principle, their invoices could also be accepted by the Treasury in Australia, Spain, Germany or whatever country it may be. However, it is likely that the company hiring the software developer will reject the invoice for fear of having trouble with the tax authorities.
If the person behind the company is not hidden and appears registered and has all of their documents in order, in addition to developing a clear occupation that can easily be verified, the recognition of these invoices should not be a problem.
In case of a potential inspection of the company that hired the programmer’s services, the programmer could have provided them with their Panamanian residency certificate and the company registration certificate.
In this way, it would be clear that theirs is not a shell company but rather a real company with offices and employees (and here it doesn’t matter if the offices are their own house and that the company has only one employee).
The tax agency is also going to focus on the concept of the invoice (and how likely it is that the service has been provided), but also on whether the foreign company has a physical location from where they conduct the activity and that there is some type of social security number.
Without a doubt, talking about your company’s history, keeping a list of big clients and/or having a photo on the internet showing the staff and offices, workshops or the establishment will contribute a lot to the company’s credibility.
Ultimately, the key word here is transparency.
Investigating the addresses that appear on invoices is one of the financial officials’ favourite pastimes.
In case of doubts about the legitimacy of an invoice, the first thing they will do is to check if the company’s address is unique or if it is shared by several companies.
This is generally something that can be found out by a simple internet search.
Then, with a simple phone call, they know if the office is real and has someone there or if it only redirects calls.
If there are doubts about the legitimacy of the business premises (all offshore providers offer a commercial address with mail forwarding and a local telephone number from which calls are answered), the Treasury can send their inspectors on holiday to this place (which is something that is actually done, tax havens are usually also very attractive for holidaymakers) and once there they pay a visit to the alleged office.
Before resorting to this, they usually use social media or even Google Street View to verify the existence of business premises.
Criteria for the acceptance of the invoice
Ultimately, many EU countries apply the “substance over means” principle, as, in order to avoid problems, there has to be a real premise from where the business is run.
This can greatly increase the costs of starting a company abroad, in particular for those that are unsure and think that they can start and run a shell company in Ireland or Cyprus simply because they are countries in the EU.
The fact is that, in many EU countries, you are required to have business premises to be able to request a European tax identification number. And the intra-European identification number, in turn, indicates that the company is reputable and aware of its obligations and keeps accounts that can be submitted and verified in case of doubt.
This is the reason why companies in the United Arab Emirates’ free zones can issue invoices that are recognised in any country, something which dummy corporations in the same jurisdiction are unable to do.
In order to start a company in the free zone, you have to have an office there, even if it is just a folding desk. This is what allows us here at Tax Free Today to issue invoices (although rarely requested) that are tax-deductible.
The second deciding factor when recognising an invoice is the social security number, something that the tax authorities also review.
After all, the legitimacy of the companies is not only based on having permanent premises available, but also on having employees that pay income tax and social security contributions.
Even if there are no employees, at the very least the managing partner should be contributing to social security with their wage. If this were not the case, this would probably raise suspicions and, in case of other clues, would reinforce doubts about the legitimacy of the invoice.
Example of a company in Delaware vs. in Canada
In recent years, U.S. corporations have become increasingly popular in the state of Delaware.
It is a very popular location for both new companies and large corporations, for its corporate and securities law, and for not having taxes at the state level (these companies only pay federal taxes).
At the same time, Delaware is the only state in the USA where corporations are potentially exempt from taxes. For this, the company must not have offices or employees; it can be nothing more than a shell company with income and clients from outside the US.
Because of its large amount of legitimate businesses, Delaware has long been problem-free when it comes to the acceptance of invoices, even those from shell companies.
Therefore, in spite of certain restrictions, the LLCs in Delaware have remained popular since 2017. It is still practically impossible to separate dummy corporations from real domestic companies if all you do is focus on the invoice.
However, for this very reason, the tax authorities are focusing more and more on this type of invoice, at least on whether it is for a large amount and has somehow attracted attention during tax audits, even more so if it is an LLC in Delaware.
So, if a social security number, a local tax identification number or local business premises cannot be found, the invoice may not be accepted.
As shown, the invoice’s country of origin is only used as a clue, but in an audit, the determining factors are as follows:
- the existence of a Social Security number
- the existence of physical premises suitable for the operation
- a transparent register that shows who is behind the company
- a local company bank account (you often need to make a physical appearance in order to open a bank account)
Unlike what happens with LPs in the US, LPs in Canada (although technically shell companies) do not have any problem with invoicing other companies.
In addition to the protection provided by the lack of knowledge about the fiscal possibilities of this type of company, another reason why there are no problems with the recognition of this type of invoice is the existence of a public commercial register in Canada, which clearly identifies the partners.
Although with Canadian LPs you can also hire fiduciary services or use offshore companies when registering the company, as soon as you hire services (financial or otherwise) from local providers, the beneficiary of the company will be revealed.
Of course, Canada will not cause problems for any state wanting to investigate the owners of any of the companies registered in their jurisdiction.
All of this, unlike what happens with LPs and corporations in Delaware, makes Canadian LPs useless for tax evasion.
In order to be able to benefit from a Canadian LP, the partner, whether a natural person or not, would have to reside in a country without taxes.
Why the criteria for the acceptance of invoices is unrealistic in the modern world
It is worth considering whether the above criteria of having a business establishment and a social security number still makes sense in a world with thousands of profitable online business models managed by digital nomads who travel all over with just a laptop.
Even though they are not legally subject to taxes, it is often difficult to keep an office, or at the very least it is inconvenient and an unnecessary additional financial effort. Especially if you are starting as a freelancer, the expenses usually exceed the profits.
Just like you need housing to open a bank account or for any formality as a natural person, your business needs an office for any proceeding as a company.
This is not something that is going to change in the near future, since where there are no existing rental contracts or a property; there is also no type of control.
Of course, there is nothing that the Western governments, countries with high taxation, fear more than a lack of control over flexible entrepreneurs without physical ties who are willing to leave the country they are in if they are not being treated well.
This does not mean that if you are starting out and do not have enough money to make founding a company in current conditions worthwhile you have to stay in your country of origin for your invoices to be recognized.
As is the case with many things in life, size does matter, in this case, the invoice amount. You can make invoices from an LLC in Wyoming, for example, or even go without an invoice (if your client agrees).
Of course, the higher the invoice amount or the more frequent your invoices to the same client are, the greater the likelihood of raising suspicion and being investigated.
What small businesses can do
In many countries, there are regulations which automatically accept small invoices.
For example, in Germany, micro-invoices up to a total of €250 are recognised, provided that they comply with a few basic conditions.
In these micro-invoices, you do not have to include the tax identification number (NIF), only a consecutive invoice number, the date, the purpose of the invoice, the issuing person’s and the recipient’s addresses, as well as the total amount and information about how the payment will be made.
In theory, it is also possible to work at first as a freelancer without fiscal residency or a company and collect your earnings in a private bank account.
Even if the total of the invoice issued to a German company exceeds €250, this does not have to be a problem. As long as it can be proven that a service was provided and, in case of doubt, the person can be clearly identified, there shouldn’t be a problem even if the amounts are high (but this totally depends on the countries you are working with).
And then, of course, you also have the option of using the services of companies that bill in your name.
As you can see, although you are starting as a freelancer without a company, you are not required to work solely for companies in tax havens. However, once you have reached a certain income level, you will have no choice but to start a company and even have a small office to be able to prove that there is a real tie to the jurisdiction in which your company is based.
Each country has its own rules and works differently
If, for example, you want to start a business in Hong Kong because there you can register a PayPal account for businesses, you will be surprised to discover that in order to register an account with PayPal, you not only need a company bank account (which is already rather complicated) but also physical premises.
Of course, the territoriality principle in Hong Kong could be triggered, meaning that your company would stop being treated as “offshore” and become subject to the 16.5% domestic corporation tax rate.
When we start an offshore company we have to carefully consider what we need.
On the one hand, we are free from taxes and have less bureaucracy and security in the face of court injunctions and corporate responsibility.
But on the other, certain countries do not recognise our invoices and we have difficulties in using services (particularly financial) of certain providers.
We have had to help many clients in our consultations because they have offshore companies whose invoices were not recognised or who lost a large amount of money because of the fees charged when receiving credit card payments or who were desperate due to the slow speed and high costs of transactions from offshore banks (in some of them they paid €50 for a simple transfer).
You not only have to take into account the tax situation but also all the infrastructure that you need for your business model to work.
It is often preferable to choose a European country with few taxes and an office and cheap workers (like in Bulgaria) instead of choosing a shell company that is tax-free but has a lot of hidden costs.
Even so, offshore companies will never disappear because there are still enough business models that work even with anonymous shell companies.
Whether it involves trade, a membership/subscription, the sale of digital products or rights and royalties, commissions or the management of personal assets; in the end, the only problem is the acceptance of your invoices by companies, especially if large sums to high-taxation countries are involved. But even then, there are alternative solutions as we will see below.
Alternatives so that your invoices are recognised
Apart from choosing to create corporate substance (physical office and employees) or to start the company in a jurisdiction with a good reputation, you have two further solutions: you can start your own collection subsidiary or hire an agency to invoice in your place.
In short: the first solution involves creating a company in addition to your offshore company. This new company would be a subsidiary of the original and would be responsible for billing.
You must sign a profit transfer agreement with the offshore parent company so that you can transfer money without problems.
This is a common practice for Cypriot or English companies, among others, as it is legal there to transfer a good part of the profits before taxes.
These two countries do not care if the invoices come from shell companies, as long as there is at least a small part of the profit to tax (also that the cash output is justified by the agreement). After all, a company should make a profit.
Even so, especially if turnover is not very high, it is much easier to hire the services of a billing agency.
The agency must consist of a company located in a country with a good reputation (England or Ireland, for example) with acceptable offices, employees with social security, an intra-community tax identification number and a local company bank account, among other things.
This agency is responsible for invoicing the necessary companies and then transferring the money to the offshore contractor company, after taking a small fee.
Tax Free Today, in partnership with a billing agency, offers this service to offshore companies. The service can only be retained by offshore companies that issue several invoices of at least €1,000 per year.
However, if you are going to bill less, as we have seen this is not usually a problem.
The commission amounts to 5.25% of the invoice total, in addition to a small fixed amount when signing the contract (a one-time payment only). If you are interested, you can contact me directly at firstname.lastname@example.org.
Even though there are many aspects to consider when talking about the acceptance of invoices from offshore or shell companies, there is a solution for everything.
There is no list that tells us which countries’ invoices are recognised (or not), it always depends on each specific case and I hope I have been able to explain how it works in this article. In any case, if you need more help with your individual case, you can always request an individual consultation.