Panama Papers: The Secret State of Delaware

Cayman
North West Point in Grand Cayman, Cayman Islands. An offshore dream. David Rogers/Getty

When conjuring up a picture of a tax haven, one generally imagines a faraway, zero-tax, Caribbean land like the Cayman Islands or Bermuda.

President Obama has criticized offshore jurisdictions like these and citing the Panama Papers at the White House, in Washington, earlier this week, he urged leaders around the world to tighten laws and crack down on the "huge problem" of global tax avoidance.

But under 100 miles from where Obama accused lawyers and accountants of "wiggling out" of responsibilities that ordinary citizens are having to abide by, lies Delaware, a small Eastern U.S. state where there are more corporate entities—public and private—than people. The ratio stood at 945,326 to 897,934, at the last count.

Delaware, through its developed legal system and laws protecting shareholder rights, is geared toward the large complex public corporation.

And while it is impossible to know exactly how much underreported income is hidden in the state's shell companies, the First State's ability to attract the formation of anonymous companies suggests that it could rival the amount of income hidden in more well-known offshore tax havens.

So what is so attractive about Delaware?

The state's "business-friendly climate" and dedicated corporate court system (the Chancery Court) combined with an enormous network of corporate lawyers and legislation that favors management over shareholders, makes it a tax avoider's dream.

A loophole in Delaware's tax code is responsible for the loss of billions of dollars in revenue in other U.S. states, and its lack of incorporation transparency makes it a magnet for people looking to create anonymous shell companies, which individuals and corporations can use to evade an inestimable amount in federal and foreign taxes.

The Internal Revenue Service estimated a total tax gap of about $450 billion, with $376 billion of it due to filers underreporting income, in 2006.

In fact, in 2009, the Tax Justice Network named the United States as No. 1 on its Financial Secrecy Index, ahead of Luxembourg and Switzerland. It cited Delaware as one of the reasons.

"Our analysis reveals that the United States is the jurisdiction of greatest concern, having made few concessions and posing serious threats to emerging transparency initiatives," the report says. "Rising from sixth to third place in our index, the U.S. is one of the few whose secrecy score worsened after 2013."

Another part of the appeal is the ease and rapidity with which a business entity can be formed there. Business entities can be set up in a number of hours and, once they are, Delaware law is committed to protect the rights of boards of directors and shareholders.

Last year, 133,297 businesses were set up in the state, making nearly half of all public corporations in the United States incorporated in Delaware.

The faraway, exotic lands of the Caymans are, still, alluring for many reasons. There, businesses can operate in relative secrecy, attract more foreign customers, avoid regulation and enjoy a low tax rate.

In one respect, however, Delaware is even better than the Caymans. At some point, American companies have to bring back their foreign profits from the Caymans and pay federal taxes.

But in Delaware, the state tax savings through the Delaware loophole are permanent.