In The 1930s, The Bahamas Became A Tax Problem For Treasury

“If you think the Bahamas has ruined your global tax system, you have a pretty terrible global tax system.”

That’s what Steven Dean, a professor at Brooklyn Law School, told Tax Notes contributing editor Robert Goulder last summer during a broader discussion about international tax policy. They were specifically discussing tax haven blacklists and the ways those lists have been racialized over the decades.

When struggling with tax enforcement, rich countries have long tried to shift blame to poor countries. Blacklists have been just one of the tactics used in this effort, albeit one of the more heavy-handed and perhaps unsettling.

“A country with the economic power and diplomatic clout of the United States is never going to be on one of these blacklists ever, really,” Goulder observed in reference to the original OECD blacklist. “It really just smelled like a bunch of big rich countries pushing around small poorer countries, telling them we were going to badger, force, coerce, and shame them into changing their fiscal regime.”

The blacklist blame game is about more than simply wealth and poverty. Tax haven debates, especially in the United States, have always been racialized, both incidentally and deliberately. But the patterns of this racialization have changed over time, shifting in tandem with changes in global power structures.

Which brings us back to the Bahamas. Efforts to blame the island nation for problems with U.S. tax enforcement are hardly new: They date to the 1930s, when wealthy Americans discovered that the Bahamas could be used for more than just liquor smuggling (a revelation of the Prohibition era).

In the 1930s, well-heeled taxpayers developed Bahamas-based strategies to blunt the rising tax rates of Franklin D. Roosevelt’s New Deal.

Notably, the initial legislative effort to curb these practices didn’t devolve into a blame game: American policymakers didn’t seek to strong-arm the Bahamian government into changing its laws or commercial practices. Rather, the United States accepted responsibility for the tax behavior of its own citizens.

Tax Avoidance in 1937

In 1937 Treasury Secretary Henry Morgenthau Jr. sent the White House a memo on tax avoidance practices. Morgenthau had asked his tax experts to compile a list of the most important (or at least egregious) avoidance strategies then in use.

The resulting memo — delivered to the White House in two forms, one naming particular taxpayers and the other scrubbed of identifying details — became the basis for a bombshell message to Congress.

Lawmakers followed up with a series of high-profile hearings over the summer of 1937. While Roosevelt had been persuaded by his more cautious advisers to avoid naming names, witnesses testifying on Capitol Hill were happy to identify the taxpayers involved in particular schemes. And journalists, of course, were happy to amplify all the lurid details.

And there were many lurid details. Treasury officials described egregious examples of tax avoidance, including a range of incorporated yachts, hobby farms, and racehorses. One particular scheme, involving foreign insurance companies established to create spurious interest deductions, actually involved shell companies organized in the Bahamas.

But this Bahamas gambit, which Treasury believed to involve only a half-dozen or so taxpayers, was just a sideshow in the larger circus that the department was staging for lawmakers. And it wasn’t even the most important avoidance strategy involving the Bahamas. A much more prevalent and flexible scheme — and one that drew sustained attention from both Treasury and Congress — was the creation of foreign personal holding companies, many of which were organized in the Bahamas.

Surging Interest

While testifying before the special Joint Committee on Tax Evasion and Avoidance, Treasury officials described an epidemic of tax dodging. In particular, they emphasized the surging popularity of foreign personal holding companies, which taxpayers were creating at a furious pace — one estimate pegged the number of such companies established by U.S. citizens at 585, including 94 in the Bahamas, 202 in Newfoundland, 46 in Panama, and 243 in Prince Edward Island.

Although it wasn’t the most popular jurisdiction, the Bahamas got most of the attention from Treasury experts when they testified at the tax avoidance hearings. In part, this emphasis was attributable to the pace of holding company creation in the islands.

The original Treasury memo sent to the White House had estimated the number of Bahamas companies formed during the previous two years at 64, with an additional 22 in the first two months of 1937; still more had been created in the months since. While not large in absolute terms, these figures represented a drastic increase in the pace of company organization.

According to the testimony of Treasury Undersecretary Roswell Magill, U.S. taxpayers were using these new companies to minimize taxes with the help of several strategies:

1. assigning income to the foreign personal holding company, thereby avoiding taxation of that income in the United States under the individual income tax;
2. transferring assets to the foreign personal holding company, after which income derived from the assets would be paid to the corporation, reducing the personal tax of the sole stockholder in that company;
3. creating interest deductions when the sole stockholder of the corporation borrowed back its capital or its income;
4. executing abroad — and in the name of the corporation — various profitable deals that had been negotiated within the United States by the sole stockholder;
5. selling personally held securities to the foreign personal holding company, thereby creating a profit that was then used to offset personal realized losses on securities and step up the cost basis of those securities; and
6. assigning royalty income to the foreign personal holding company, thereby avoiding high individual income tax rates in the United States.

Each of these strategies was associated with a particular individual in Treasury’s testimony before Congress. Some of those individuals, moreover, proved to be at least moderately famous, including the founder of the Schick razor company and the actor Charles Laughton.

Not all of them chose to organize their personal holding companies in the Bahamas (Laughton, for instance, established his in the United Kingdom). But some of the most egregious examples took shape there.

Implausible Locale

In discussing Bahamas-based tax avoidance by U.S. citizens, American policymakers indulged a predictable amount of condescension. In recounting the testimony several years later, tax expert Randolph Paul approvingly recalled Magill’s “caustic wit” regarding the implausibility of the Bahamas as a business locale. Magill’s comments don’t seem especially witty to modern ears, but they were certainly caustic.

“The Bahama Islands are not a suitable place for the development of great corporate enterprises,” Magill told lawmakers. “The inhabitants are poverty stricken. There is a small trade in liquor. There are a few hotels for winter tourists. Yet suddenly long lists of impressive sounding corporations, financed by American capital, appear on the directories of the local office buildings.”

Magill then launched into a story about these local office buildings — a story that will seem familiar to anyone who has read more recent coverage of Ugland House in George Town, Cayman Islands. Apparently, Nassau lawyers conceived of the notion that corporate headquarters could be highly consolidated long before anyone in the Caymans had the same thought. As Magill told the story:

“I understand there are two shacks on either side of the street down there — unfortunately I have not been to Nassau — with a long list down the side of these houses of these fine-sounding corporations, which add up to have several hundred million dollars of capital.”

Then, as now, the story was told for dramatic effect. And while the absurdity of such arrangements was undeniable, it was also undeniably played for maximum effect by Treasury officials.

Indeed, they undertook to repeat the story with greater embellishment during the next day of hearings, when Elmer Irey, chief of the intelligence unit at the Bureau of Internal Revenue, added his own colorful details, based on a field investigation by bureau personnel:

“There is a peculiar law in the islands requiring the name of the corporation to be posted on the outside of the building in which it maintains its resident office. The building occupied by Mr. Kenneth Solomon, one of the most prominent attorneys on the islands . . . who has been instrumental in the organization of perhaps 50% of the companies, is literally plastered from foundation to roof with these corporate names. The nameplates are about 30 inches long and 8 inches wide, and the building is so covered with them as to constitute one of the major curiosities of Nassau.”

Irey’s description was lurid enough to prompt the Associated Press to run a photo of the Solomon law office.

Irey also expanded on Magill’s dismissive description of the Bahamian economy, all in an effort to underscore the charge that American corporations organized on the islands must certainly be shams. The use of Bahamian corporations as a tax avoidance method dated to 1935, Irey said.

Prior to that time, the Bahama Islands were not financial centers for any considerable amount of American wealth. The population consists of about 60,000 Negroes, who work for small wages, and several thousand whites, who control the limited business of the island.

During the Prohibition era in the United States, a great deal of liquor was shipped from these islands to this country. However, since the repeal of Prohibition and prior to 1935, the business of the islands has consisted almost entirely in gathering sponges, fishing, and catering to tourists.

Again, this assessment of the Bahamian economy was not inaccurate. And its description of the island’s social structure and racial dynamics was also reasonable (if conveyed in the racial language common to 1930s America).

But the Treasury and Bureau of Internal Revenue presentations both relied on condescension and ridicule to make a point, and to attract press attention. It was grandstanding in the traditional sense of American politics — conducted at the expense of another nation.

No Blame Shifting

Notably, however, neither Magill nor Irey sought to blame the Bahamas for its booming business in facilitating tax avoidance by U.S. citizens. Irey, in fact, chose to quote from a contemporary editorial published in The Nassau Guardian that questioned whether the Bahamas had any ethical responsibility to curb this behavior.

“The question of tax evasion in the United States has now been definitely brought into the open by President Roosevelt,” the newspaper observed.

The Bahamas now found itself in a position similar to the one it faced during Prohibition. Nothing in the law had prevented Bahamians from selling alcohol to Americans outside U.S. waters in the 1920s. A decade later, nothing prevented Bahamians from selling tax avoidance schemes to Americans as long as companies were organized according to Bahamian law.

“Of course in the former case our customers were law breakers while now we are only dealing with evaders of the law,” the paper acknowledged. “But the moral difference could hardly be located with a microscope.”

Irey went on to actually endorse this view explicitly, insisting that Bahamians had no responsibility to shut down the avoidance techniques made possible by personal holding companies organized in the islands.

“The editor then went on to discuss whether the Bahama Islands had any additional responsibility on account of this condition,” Irey told lawmakers. “He came to the following very sensible conclusion: ‘In the last analysis the whole problem is for the United States to make its laws proof against evasion or nearer to that ideal than they have yet been able to come and that is evidently the next move being planned by the present administration.’”

“In other words, the Bahama Islands quite justifiably feel that if the United States chooses to permit this kind of tax avoidance, it is not their moral responsibility,” Irey told lawmakers.

This conclusion was striking. Treasury’s willingness to absolve the Bahamas of responsibility for facilitating tax avoidance stands in marked contrast to more recent efforts, in which stigmatizing tax havens as bad actors has become almost the norm.

Explaining this shift is complicated — and speculative. But in all likelihood, the willingness of U.S. policymakers to accept responsibility for curbing the problems associated with foreign personal holding companies stemmed from two factors.

First, New Deal officials were committed to a broad and vigorous attack on tax avoidance. Roosevelt himself was determined that Congress pass comprehensive legislation shutting down numerous avoidance techniques.

In such a context, shifting blame and responsibility to a foreign government would have missed the point: FDR wanted credit for spearheading an antiavoidance campaign, and he wanted Congress — not the Bahamas — to act on his recommendations.

Second, U.S. policymakers may have been willing to accept responsibility for fixing their own tax problems because of the way they viewed the Bahamas. As noted above, Treasury officials were quick to ridicule Bahamians for their perceived backward, underdeveloped economy. But they were more respectful of Bahamian political institutions.

This respect probably derived from the islands’ position as a dependency of Great Britain. With a governor general appointed by the Crown, the Bahamas enjoyed some of the status accorded to Britain itself.

This political status, moreover, seems to have been implicitly racialized; U.S. political discussion of the Bahamian economy tended to emphasize, either directly or indirectly, the poverty of its working-class Black majority. By contrast, discussion of its political status tended to be more respectful, perhaps reflecting the whiteness of its ruling class.

When all was said and done, the Revenue Act of 1937 included curbs on foreign personal holding companies — not just those organized in the Bahamas, but around the world. In retrospect, however, the episode is most striking for the willingness of U.S. officials to take responsibility for the problems plaguing their own tax system. And their unwillingness to stigmatize “tax haven” jurisdictions as somehow lawless or ethically compromised.