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April 21, 2011 - Phil Hodgen

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.

Question

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.

Taxation

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.

Hilarity ensued.

American Business Abroad