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February 16, 2008 - Phil Hodgen

International Tax Planning 101 – (6) will the deferral strategy work for you

This is the next in a series aimed at helping a non-tax person — a business executive — who is called upon to make a complex tax decision — how to create a legal structure for holding foreign investments or operating a business outside the U. S.

The previous episodes: one, two, three, four, five.

Now we get to choosing between the “invisible” paradigm and the “deferral” paradigm. This is where someone–not you–will crank some numbers. You make a cost/benefit decision.

Tax deferral is bad — if you’re the government

We go back to the old triage methodology I am so fond of. The U. S. government wants money and designs the tax system to extract as much tax as possible as soon as possible. In other words, the casino has stacked the deck against the idea of “pay tax later”. The tax system is designed to tax profits in the year they are earned.

Deferral — real operating business, yes

So if you like the concept of deferral, first see if the IRS lets you use that strategy or whether your business is barred from using it. (Simple concept–income from overseas operations is passive income like interest, dividends, royalties, rent? You’re probably not going to be successful in getting deferral. But if you have a real operating business? You have a decent shot at getting the deferral treatment).

Who’s a good candidates?

Assuming the IRS will let you, the next question is whether you SHOULD–the old cost/benefit question.

We’re going to do a net present value analysis. Numbers. But it’s easy.

Calculate the amount of tax that you theoretically get to defer. Figure your foreign profits for the year. Figure the U. S. tax that would be payable on that. How big a number do you have?

You don’t have to pay tax on that until you bring the profits back to the U. S. How long can you wait until you need the money in the U. S.? Two year? Five years? Never?

Key concept: the deferral strategy works really well when you have lots of foreign profits, and when your foreign operations need lots of working capital to grow. Think of a company with a flat U. S. market and a fast-growing foreign market. That’s a good candidate for the deferral strategy.

Who’s not a good candidate?

The intensely practical question is whether your U. S. operations have such an insatiable appetite for cash that you will be forced to bring the foreign profits back to the U. S. to help fund U. S. operations. Rigorous self-honesty is important. Just ask yourself whether you need the money. If you do, you will not get as much deferral as you need to make this strategy worthwhile.

Doing the math

Totally made-up example.

Figure out what your tax savings will be on foreign operations because you don’t have to pay U. S. tax on the profits. Figure you will wait, say, 5 years before you repatriate the profits.

The amount of tax that you don’t give Uncle Sam now but give Uncle Sam in 5 years is really like an interest-free line of credit from the U. S. government. So in my example, you borrowed $3,000,000 interest free, due and payable in 5 years. How much money can you make on that $3,000,000 of free working capital? Well, if you generate 30% return on assets, it’s worth $900,000 per year.

I go through a much more sophisticated financial model than this, but that’s the idea. Uncle Sam made you a loan. How much money can you make by investing and reinvesting that money before you have to repay Uncle Sam?

The long view

And what if you operate your business so you repay Uncle Sam in 25 years?

Tax and Trusts