February 8, 2008 - Phil Hodgen

International Tax Planning 101 – (5) When invisible isn’t best

This is another in the series of posts that will walk a CEO through the decision of how to make an international tax planning decision.

The first post is here. Introduction.

The second post is here. Consider only real possibilities, not possibilities that are out of bounds because of legal restructions.

The third post is here. Make your life simple when you’re doing business “there,” wherever “there” is.

The fourth post is here. Assume first that you’ll have a simple, “invisible” legal structure unless proven otherwise.

Now we’re going to talk about the “unless proven otherwise.” When is the “invisible” legal strategy NOT the best? Simple answer–when the numbers tell you so.

Recap on invisible

Up to now we’ve said that “invisible” is good. Tax lawyers call companies that are invisible “tax nothings.” They are real companies, protect you from liability and all that stuff. But the IRS treats them as if they don’t exist. It’s pretty easy to do. Take your foreign company, file Form 8832 (PDF) with the IRS, check the right boxes (of course), and your foreign company is a “tax nothing.”

Here’s some tax jargon so you can sound cool at cocktail parties (or blow your CFO’s mind) — this is a “hybrid entity.” This just means that in the foreign country your foreign company is taxed like a corporation but in the United States it isn’t. Well, there you go. Useless trivia. Go crazy with it.

The reason to use this is to get credit in the United States for the foreign taxes paid.

Alternative to invisible

Sometimes, though, the “tax nothing” / “hybrid entity” / blah-blah idea isn’t so good. Here is when.

The default mindset for the Internal Revenue Service is “If you’re American, pay tax on everything you make, everywhere, in the year you earn it.” The alternative to “invisible” is a structure that allows you to postpone paying taxes to Uncle Sam. Let’s call it the “deferral” strategy.

You are a candidate for the deferral strategy if:

Your business is growing outside the United States; and

You can absorb all of your foreign profits and plow them back into foreign operations; and

You won’t need to bring cash back to the United States to fund U. S. operations.

Let’s say you make $10,000,000 of profit outside the United States in a tax-free country. Bring it back to the U. S. using the “invisible” strategy and you pay $3,000,000.

Instead, you set up a “deferral” structure, keep the $10,000,000 in your foreign subsidiary, and use it as working capital to fuel next year’s growth.

What has happened is that the IRS has let you keep–and use–$3,000,000 that would have otherwise gone to taxes. And if you needed $10,000,000 in working capital, you’d have gone to the bank to borrow that money.

The longer you defer the day when U. S. tax is due, the better the deal. The present value of a $3,000,000 payment made 15 years from now is about 78 cents. I exaggerate slightly.

It is possible to earn profits from foreign business operations and not pay U. S. tax on those profits until you bring the profits back to the U. S.

So ask yourself. If you had an extra $3,000,000 in working capital, and you put it to work for 5 years, would that help?

Deferral is the alternative tax strategy to my starting point “invisible” strategy. In the next post I talk about how someone else–not you–is going to generate the numbers (using your revenues, your margins, etc.) to choose “invisible” vs. “deferral.”

Tax and Trusts