Oh, what a tangled web we weave (Subpart F edition)
Oh what a tangled web we weave, When first we practise to deceive!
Sir Walter Scott, Marmion, Canto vi. Stanza 17
I have been doing cite-checking and editing for a friend’s international tax treatise and as a result I have been living in Subpart F recently.
Two interesting points here.
Subpart F + Subpart G = Subpart F
The first is of interest to tax lawyers only. When we say “Subpart F” we are wrong. The subject matter is actually contained in Subpart F and Subpart G. I never realized this until last night, while perusing a footnote.
Start with a lie . . .
The second point is one brought up by my friend yesterday in conversation. Subpart F achieves its desired result (anti-deferral) through a fiction. The fiction is that we will treat a corporation as a passthrough even though it is not.
As my friend says, the base assumption of Subpart F is a lie. What happens when you start from a lie?
Why are we so amazed that Subpart F has developed over 50 years into a byzantine collection of rococo logical dead-ends, cul-de-sacs, and frankly utter bullshit so convoluted it would be impossible for the Pope to keep up with the theology, let alone mere mortals running businesses and trying to go home to their families before midnight?
My friend’s thought is that the international tax system would be better served by adopting the California model. We’d blow away Subpart F. Section 367? Probably. Lots of other stuff in the Code would be blown away as well.
I can’t help but think about Section 877A here. We start from the fiction of a “make-pretend” sale on the date a person terminates U.S. citizenship or a green card.
This tiny (and seemingly sensible) lie will sprout into a monster. My guess is that in 15 years there will be a metric ton of regulatory debris and administrativia published by the Service, all of which is written with the best of intentions by well-meaning people.
But we’re starting from a lie. The expatriation rules will only get worse. (And for that blinding flash of the obvious I have Steve Toscher to thank. One day a few years ago at a tax conference I was standing between sessions, whining at a Federal official about how badly things were broken. He was standing there. He pulled me aside and said “Trust me. The LAST thing you want is for the government to write a set of rules to fix a messy situation. It only makes it worse.” The topic at hand was the FBAR debacle and the voluntary disclosure program. He was right, of course.)
Apple, $82 Billion of Cash, and Tax Policy
Via Glenn Reynolds I was pointed to a TUAW article that referenced a SeekingAlpha article about Apple, its mythical mountain of cash, and the Law of Unintended Consequences. (That, by the way, is a demonstration of the fabulosity of the interwebs. Hyperlinks and attributions back to the source. The internet is just one person talking to another.)
Back to tax policy and unintended consequences. This stuff is right up my alley because this type of tax planning is What We Do here at the Hodgen Law Group Tax Ranch & Rocket Factory.
Put this blog post under the heading of “Unintended Consequences of International Tax Policy.”
Apple Inc. has a reported $82 billion of cash. That sounds like Apple could buy anything, do anything. It could even spend that money in the United States and (God forbid) create jobs for people.
The author of the Seeking Alpha blog post has read Apple’s financial statements and points out the obvious. A large chunk of that cash — $54 billion, to be precise — is sitting outside the United States and will not return to the United States.
Here’s why. Blame Congress for this.
How Multinational Corporations Pay Income Tax
The default tax treatment for U.S. taxpayers — corporations included — is “All of your income, earned worldwide, is taxed in the year you earn it.” Whether Apple sells an iPhone in China or in Chicago, the profit it earns will be subjected to U.S. income tax in the year that iPhone was sold.
For U.S. corporations doing business outside the United States, however, we can alter the default tax treatment. If the U.S. corporation configures its business operations correctly, a dollar of profit earned outside the United States will only be taxed by the United States when that dollar of profit is brought back to the United States. Earn a dollar of profit abroad and don’t bring it home? No U.S. income tax. Earn a dollar of profit abroad and bring it home? U.S. income tax.
Call this a “deferral strategy.” The U.S. corporation is not exempt from U.S. income tax on its foreign profits. It is just postponing the day that it has to pay tax on those foreign profits to the Internal Revenue Service.
A corporation that follows the deferral strategy ends up with two buckets of income — the U.S. domestic income, which is fully subject to tax, and the foreign income, on which U.S. income tax is deferred until the corporation chooses to bring the income back to the mothership in the United States.
That’s the picture that Seeking Alpha points out for Apple Inc. It has two buckets of cash:
- $28 billion of cash it generated from selling stuff in the United States, on which U.S. income tax has presumably been paid; and
- $54 billion of cash it generated from selling stuff outside the United States, on which foreign income tax has (probably) been paid but U.S. income tax has not (yet) been paid.
Why Tax Deferral is Good
Why would U.S. corporations do such a thing? The short answer is to blurt out the words “present value” and your nimble brain can connect the dots.
The better way to explain this is with an example.
Pretend that Apple has a subsidiary corporation in China. They sell iPhones in China and generate $1,000,000 of profit.
- Scenario Number 1. If they bring the $1,000,000 back to the United States, that $1,000,000 of income on Apple’s income tax return will be taxed (let’s pretend) at 35%, leaving Apple with $650,000 in after-tax cash. Apple now has $650,000 in the bank. It is going to use that money to build more iPhones to sell. Pretend that each iPhone costs $130 to build–that is Apple’s cost to manufacture an iPhone. (I’m making up numbers here, folks. They’re all fakey-fake for the purpose of this example.) That means Apple can build 5,000 iPhones to sell using the profits it generated from the first batch of iPhones it sold.
- Scenario Number 2. If Apple Inc. leaves the money outside the United States, the IRS does not take 35%. That means Apple has $1,000,000 in the bank to use to build more iPhones to sell. At $130/unit for cost of manufacture, Apple can build (Phil runs to his calculator . . . let’s see . . . $1,000,000 divided by $130 = . . . ) 7,692 iPhones.
If you can build more iPhones, you can sell more iPhones. If you can sell more iPhones, you can make more profit. So we like Scenario Number 2.
Tax Deferral Drives Business Expansion
If you’re going to pick Scenario Number 2 and the deferral strategy, you can’t bring your foreign profits back to the United States. If the foreign profits are transferred to back to the Mothership in Cupertino, they get taxed.
What happens is that a multinational corporation starts to accumulate cash. Self-evidently you can accumulate more cash quicker if you’re not paying tax than if you are. So cash in the bank grows faster outside the United States than inside the United States.
The multinational corporation uses that cash as working capital. Since it has more working capital outside the United States, it has more fuel to generate sales growth which can only occur outside the United States. The multinational corporation has an incentive to focus on foreign markets because its return on investment is higher. Over time, this leads to faster growth outside the United States and the U.S. market becomes a smaller and smaller slice of the multinational corporation’s overall sales.
That’s tax policy at work. U.S. tax policy makes it expensive for a U.S. corporation to repatriate its earnings. That means that it has less working capital in the United States. That, in turn, means it can’t spend as much money in the United States to generate more sales, grow its business, hire people, etc.
There’s another self-evident point. There are more people outside the United States than there are inside the United States.
So from Apple’s perspective, they have a LOT of working capital outside the United States and a LOT of potential customers outside the United States. Hmmm. I wonder what is going through Tim Cook’s mind.
Now do you start to see why there are so many articles about China quickly becoming Apple’s biggest market? It’s not just that there are so many people there who want iPhones. It is because Apple has a big bucket of cash that they must reinvest to fuel further expansion outside the United States. Apple must plow its foreign profits back into making more products to sell outside the United States.
Tax Repatriation Holidays and Some History
Periodically Congress wakes up and sees the problem. Laws are proposed to provide a temporary tax loophole for U.S. corporations to bring their foreign profits back to the United States. Here’s recent example.
The better solution would be a wholesale re-architecture of the Internal Revenue Code. That’s a topic for another blog post sometime.
I would just point out, however, that the current Internal Revenue Code we have has its intellectual underpinnings in brains that hearken back to the Civil War. Our current version of the Internal Revenue Code is the 1986 Code. It is largely a creature of the Internal Revenue Code of 1954. The Chairman of the House Ways & Means Committee from 1933 until 1953 (except for a two year stretch) was Robert L. Doughton. He was born in 1863 and his father was a Captain in the Confederate Army.
Imagine what international commerce looked like to someone born in 1863. When Robert Doughton was working on tax laws in the 1930s, 1940s, and 1950s, all of which culminated in the 1954 Code, what did his world look like? His childhood knew of steam ships. The telegraph. Horses as transportation. From brains like these grew our current international tax rules.
Another major slice of the U.S. international tax law came into place in 1960. What was the world like then? People in Congress in 1960 would have been born in the early (20th) Century. What biases and understanding did they bring to the table about America’s place in international commerce?
Life moves fast. You Don’t Live in the World You Were Born Into. But to a surprisingly large extent, Apple Inc.’s current business strategies are driven by tax policies from the brain of a man born in 1863 to a Confederate Army veteran. Funny, that.
Credit where credit is due. Brian Dooley is the one who first introduced me into the history lesson I have described here. He does it far more eloquently than I do.
List of international tax forms (first draft)
I am going to be giving a one-hour high speed presentation at the 2011 Tax Update and Planning Conference sponsored by the California Society of CPAs. It will be presented in Universal City, San Francisco, and on the web.
My hour is intended to give practitioners a checklist approach to the various tax and reporting forms they might need to know about in the international context. For someone who deals primarily with domestic stuff, the international world is a mystery. I want to dispel that mystery a bit.
First draft of a list
Here, from my course materials for my Tax Planning and Compliance for Multinational Families course is where I am in gathering a comprehensive list of all of the tax forms that are specific to international tax practice.
I need help
Help! Do you know of any other forms out there that I might have missed?
Another point — what would be a good way to organize these? By taxpayer type (individual, trust, estate, corporation, etc.)? By inbound/outbound? By reverse height according to eye color? What is useful?
- Form W-7 — (Application for Individual Taxpayer Identification Number)
- W-8 — Certificate of Foreign Status
- W-8EXP — Certificate of Foreign Government or Other Foreign Organization for United States Tax
- W-8BEN — Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding
- W-8ECI — Certificate of Foreign Person’s Claim for Exemption From Withholding on Income Effectively Connected With the Conduct of a Trade or Business in the United States
- W-8IMY — Certificate of Foreign Intermediary, Foreign Partnership, or Certain U.S. Branches for United States Tax Withholding
- Form 706 — United States Estate (and Generation-Skipping Transfer) Tax Return
- Form 706-A — United States Additional Estate Tax Return
- Form 706-GS(D) — Generation-Skipping Transfer Tax Return for Distributions
- Form 706-GS(D-1):Notification of Distribution from a Generation-Skipping Trust
- Form 706-CE — Certificate of Payment of Foreign Death Tax
- Form 706-GS(T) — Generation-Skipping Transfer Tax Return for Terminations
- Form 706-NA — United States Estate (and Generation Skipping Transfer) Tax Return
- Form 706-QDT — U.S. Estate Tax Return for Qualified Domestic Trusts
- Form 720 — Quarterly Federal Excise Tax Return
- Form 1001 — Ownership, Exemption, or Reduced Rate Certificate
- Form 1040NR — U.S. Non-Resident Alien Income Tax Return
- Form 1040NR-EZ — U.S. Income Tax Return for Certain Nonresident Aliens with No Dependents
- Form 1042 — Annual Withholding Tax Return for U.S. Source Income of Foreign Persons
- Form 1042-S — Foreign Person’s U.S. Source Income Subject to Withholding
- Form 1078 — Certificate of Alien Claiming Residence in the United States
- Form 1120-F — U.S. Income Return of a Foreign Corporation
- Form 5472 — Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business
- Form 8288 — U.S. Withholding Tax Return for Dispositions by Foreign Persons of U.S. Real Property Interests
- Form 8288-B — Application for Withholding Certificate for Dispositions by Foreign Persons of U.S. Real Property Interests
- Form 8300 — Report of Cash Payments Over $10,000 Received in a Trade or Business
- Form 8709 — Exemption from Withholding on Investment Income of Foreign Governments and International Organizations
- TD F 90-22.1 — Report of Foreign Bank and Financial Accounts
- TD F 90-22.47 — Suspicious Activity Report
- TD F 90-22.53 — Designation of Exempt Person
U.S. Direct Investment Abroad
These forms are found at the United States Department of Commerce website for the Bureau of Economic Analysis: http://bea.gov/surveys/diasurv.htm
- BE-10A — Benchmark Survey of U.S. Direct Investment Abroad
- BE-11A — Annual Survey of U.S. Direct Investment Abroad — Report for U.S. Reporter
- BE-11B(LF) — Annual Survey of U.S. Direct Investment Abroad — Report for Majority Owned Foreign Affiliate
- BE-11B(SF) — Annual Survey of U.S. Direct Investment Abroad — Report for Majority Owned Foreign Affiliate
- BE-11C — Annual Survey of U.S. Direct Investment Abroad — Report for Minority Owned Foreign Affiliates
- BE-11 — Annual Survey of U.S. Direct Investment Abroad — Claim for Not Filing
- BE-577 — Direct Transactions of U.S. Reporter with Foreign Affiliate
Foreign Direct Investment in the United States
These forms can be found at the United States Department of Commerce website for the Bureau of Economic Analysis: http://bea.gov/surveys/fdiusurv.htm
- BE-12(LF) — Benchmark Survey of Foreign Direct Investment in the U.S.
- BE-12 Bank — Benchmark Survey of Foreign Direct Investment in the U.S.
- BE-12(SF) — Benchmark Survey of Foreign Direct Investment in the U.S.
- BE-12(X) — Benchmark Survey of Foreign Direct Investment in the U.S. — Claim for Exemption from Filing BE-12(LF), BE-12(SF), or BE-12Bank
- Initial Report on a Foreign Person’s Direct or Indirect Acquisition, Establishment, or Purchase of the Operating Assets of a U.S. Business Enterprise, Including Real Estate
- Report by a U.S. Person Who Assists or Intervenes in the Acquisition of a U.S. Business Enterprise by, or Who Enters Into a Joint Venture With, a Foreign Person
These forms are found at the United States Department of Commerce website for the Bureau of Economic Analysis: http://bea.gov/surveys/fdiusurv.htm
- BE-605 — Transactions of a U.S. Affiliate, Except a U.S. Banking Affiliate, with Foreign Parent
- BE-605 (Bank) — Transactions of a U.S. Affiliate, Except a U.S. Banking Affiliate, with Foreign Parent & Bank, Transactions of U.S. Banking Affiliate with Foreign Parent
- BE-15(LF) — Annual Survey of Foreign Direct Investment in the U.S.
- BE-15(SF) — Annual Survey of Foreign Direct Investment in the U.S.
- BE-15 Supplement C — Annual Survey of Foreign Direct Investment in the U.S. — Claim for Exemption from Filing a BE-15(LF) or BE-15(SF)
- BE-22 — Annual Survey of Selected Services Transactions with Unaffiliated Foreign Persons
- Ocean Freight Revenues and Foreign Expenses of U.S. Carriers, Foreign Airline Operators’ Revenues and Expenses in the U.S.
- U.S. Airline Operators’ Foreign Revenues and Expenses
- Annual Survey of Construction, Engineering, Architectural, and Mining Services Provided by U.S. Firms to Unaffiliated Foreign Persons
- Annual Survey of Reinsurance and Other Insurance Transactions by U.S. Insurance Companies with Foreign Persons
- BE-93 — Annual Survey of Royalties, License Fees, and Other Receipts and Payments for Intangible Rights Between U.S. and Unaffiliated Foreign Persons
- BE-120 — Benchmark Survey of Selected Services Transactions with Unaffiliated Foreign Persons
- 16 CFR 803—Appendix: Notification and Report Form for Certain Mergers and Acquisitions (this is the “Hart, Scott, Rodino Notification”)
Foreign startup, US venture capital, and taxation
I like Hacker News. Let’s just say that I spend too much time there. Shout-out to Ronnie Roller and his iHackernews site, because mostly I look at HN on my iPhone. I lurk mostly, and comment infrequently. It’s recreational for me. I am username = philiphodgen there, FWIW.
I got an email overnight from a HN community member asking me a question and I thought it would be worth sharing the question (suitably disguised) and my answer.
Warning to my correspondent: the answer here on the blog is far better because the email I sent you was done in the early morning on my iPhone. That’s not conducive to clear thinking and clean prose. :-) Now I’m sitting in front of an iMac and writing inside MarsEdit.
The question from my correspondent:
Does a mobile software startup with Asian R&D operations and a US sales force targeting the US market require a US holding company to attract US VC funds or is a [Country] holding company acceptable? The company’s resources are split between US and Asia. Thanks.
VCs and self-inflicted brain damage
There are two things hiding in this question. The first is the question of attracting VC money.
That’s a simple thing to handle. ”When Mama’s happy, everybody’s happy.” Except for the exceptionally well-informed VC, they’re going to see brain damage if you ask them to buy into a company organized and operating outside the United States.
The purpose of putting money into a deal is to (eventually) get money out of the deal. Understanding how to do that is difficult even when you are living in California and investing in a start-up in California. So imagine what happens when you add variables to the investment decision:
- You (the VC) can’t jump in a car and go meet with the founders to see how things are going. This is not fatal, but all else equal, you’d rather be able to keep tabs on your deals, right?
- You (the VC) don’t intuitively understand the corporate laws of the other country so you don’t know exactly what you’re buying into when you get shares of a foreign corporation. And you don’t have a trusted, experienced lawyer that you know to give you advice, so you have to shop for someone new. More expense, more delay, more uncertainty.
- You (the VC) don’t exactly know how to handle cashing out in the future, assuming the start-up flourishes. The doorways to a successful start-up exit are pretty well marked in the USA. The doorways probably look pretty similar in other countries, but there is some nagging uncertainty in your (the VC’s brain).
There are probably a bunch of other things. Banking. Accounting. Etc. Tax, FFS. The U.S. tax authorities cheerfully bang you with $10,000 penalties because you forgot to file a form saying you are a shareholder in a foreign corporation, so all of a sudden the tax return preparation job for the VC becomes much riskier and therefore expensive.
As one of my investor clients (not an American, and trying to decide whether he should invest in a U.S. deal or not) once said to me,
“Why should I fly 10,000 km to lose money when I can lose money at home?”
It’s a fair point.
The second thing hiding in this question is the question of taxation. How will this mobile software venture be taxed? Look at this from two perspectives:
- How and where will the business profits be taxed? and
- If there is a successful exit for this start-up (a publicly traded company comes running with fistfuls of $100 bills) how and where will that be taxed?
The question of setting up a multi-national business in order to minimize taxation on business operations and net profit is exceedingly complex. Spock and three-dimensional chess and all that stuff.
I’ll leave that alone, except to say that as soon as you have humans working inside the United States (in my correspondent’s example, he expects to have a US sales force), you have a sufficiently strong connection to the USA so that it can exert its taxing power over you. Your best hope at that point is to limit how much of the overall worldwide business profit will be taxed in the United States. You don’t want to be based in Country X, make sales to customers in Country Y, and have the USA tax your profits when no part of the business transaction touched the USA.
The question of cashing out ultimately becomes one of “who owns what?” and “what is being sold?” If PublicCo buys out Start-up’s stock, that causes one type of result. If PublicCo buys all of Start-up’s assets (all of the IP, for instance), that leads to a different type of result. Again, three dimensional chess and all that stuff.
However, on the “cashing out” question there is a default starting point for me. If my correspondent paid me money to work on this I would start on the assumption that all of the IP that is developed should be owned from inception by a non-U.S. company. To the extent that the IP is exploited in the USA, it will be done by a limited license granted by the non-U.S. company. I would then find reasons to deviate from that starting assumption.
The reasons for this are best left to some other blog post. But as a general idea: IP that is owned by a U.S. person (corporation or human) and transferred to a foreign person (corporation or human) will generally be treated as a sale, even if it is not a sale. There is a toll charge to get ownership of IP out of the United States. There is no equivalent toll charge for IP transferred from a foreign owner to a U.S. owner.
In other words, for companies that own IP, the United States is a roach motel. You can come in, but you can’t get out, without a giant tax cost.
Toll charge on IP
I’ll give you an example. I worked on a deal for an online company that started from nothing and built a big, profitable company. They decided to restructure and reincorporate outside the United States for various and good business reasons.
At that point one of the assets of the company was the domain name. (Duh). The domain name would go–along with all of the other assets of the California corporation–to the new foreign corporation. Same shareholders as before, same business operations, same engineers sitting in the same place doing the same stuff. When we were going to do this deal the domain name appraised at a value of $6,000,000.
The transfer of the domain name from the California corporation to the foreign corporation would have been treated as a sale. The difference between what you pay for a domain name ($10) and what you sell it for ($6,000,000) is taxable income.