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If you had a bank account in the Cayman Islands, why would you pay taxes on it?

Michael Froman, President Obama’s nominee to be the next US trade representative, found himself in political hot water today because of investments in the Cayman Islands, a tax haven that President Obama has criticized. Similar investments by Treasury Secretary Jack Lew put a wrinkle in his confirmation process, too.

Both men, whose investments were part of their compensation for work at Citigroup, say they have reported all their earnings to the IRS and paid the appropriate taxes. Which raises the question: If you’re not dodging taxes, why the heck would you put your investment vehicle in the Caymans? The answer may have less to do with avoiding their taxes and more to do with helping Citi’s clients avoid theirs.

It’s likely that the tax dodgers weren’t Froman or Lew, but non-US investors in the same funds who were trying to avoid paying taxes. If foreign investors put their money in a US hedge or private equity fund, their earnings are considered “effectively connected income,” which requires them to file tax forms. While they might not have to pay US taxes, the compliance is extra work and, more importantly, that financial data could be shared with their home country, which might tax the income itself.

But if Citi registers the fund in the Cayman Islands, it isn’t required to file any paperwork with the IRS, even though it is managed from the US. That way, the US government won’t know that foreign investors are receiving any income. (The same applies to any US investors investing through an anonymous offshore corporation.) Skirting disclosure means more money for the fund, and more fees for Citi, according Rebecca Wilkins, chief counsel at Citizens for Tax Justice. In 2008, Citi had 427 subsidiaries in tax havens, including 90 in the Cayman Islands.

“What I think is going on is this fund is attracting a whole bunch of capital, it must include foreign investors,” says Jennifer Blouin, an accounting professor at the Wharton School of Business. “The US employees who are responsible for the success of this fund get a cut as part of their compensation package, and it just happens to be a Caymans fund. As a US citizen, they have to report it.”

That explanation gibes with Froman and Lew’s jobs at Citi: Froman managed investments in foreign infrastructure and worked as the head of emerging markets strategy, while Lew managed a variety of investment funds, including those in the Caymans, as the COO of the banks’ alternative investments group.

This doesn’t undercut critics of Obama who argue that hiring the two men while shaming tax evaders is hypocritical. But at least it makes more sense.

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