International Tax Planning Comes ThirdSeptember 13, 2013 - Phil HodgenAmerican Business Abroad
Tax planning across borders is complicated. A massive public company has the budget to deal with complex international tax problems. Privately-held businesses must deal with the same tax rules that Apple, Google, and Ford face. But they don’t have the budget to deal with the legal and accounting costs that those highly complex rules will trigger. And more importantly, they cannot afford the opportunity cost—top management will spend too much time wrestling with tax problems, and not enough time running the business.
Let’s call these companies mini-multinationals. Multinational because they do business in more than one country, and mini because they aren’t huge, whatever your definition of “huge” may be. Whether annual revenues are $5 million or $50 million or $750 million, as soon as these businesses start operating abroad the accounting and tax problems facing the CFO will add exponential complexity.
These are the companies we deal with. These companies do not have infinite budgets for tax advisory services. Even more important, these companies have an incredibly thin resource: management time and focus.
We have strong opinions about how these companies should approach international tax planning. We think international tax strategies should be ridiculously simple. We think tax savings should be third—at best—on your “to do” list when you are expanding abroad. We optimize for nimble, adaptable, easily operated, and cheap.
When a U.S. mini-multinational decides to expand operations abroad, some decisions need to be made. Here is the sequence we follow:
- Optimize for simplicity. First, organize the business operations to be as simple as possible. This allows the business to operate with a minimum of distractions, ideally allowing it to concentrate on generating revenue.
- Optimize for reality. Next, dial back the simplicity to acknowledge reality. You will need to add some overhead and complexity to deal with an assortment of practical problems. You are adding overhead and administrative costs here.
- Optimize for tax savings. Finally, look at income taxes. How can you reduce these enough to hit the sweet spot on your cost/benefit analysis?
Optimize for simplicity
What is the absolute bare minimum that you need to make a dollar of profit abroad? The closer you can get to the business model of a street musician, the better. A street musician stands there, making music. People throw money in the guitar case.
Or let’s be a bit more realistic, and describe a situation we see again and again.
Take the extreme example of a mini-multinational: a one-person consulting firm. Perhaps this is a software developer, or perhaps a management consultant. The person might even be a tax lawyer. That person enters and leave a country on a tourist visa, lives in a hotel, gives consulting advice and receives payment, then leaves the country.
You can’t get much simpler than that. This doesn’t scale at all, and it has obvious legal risks. But there is almost no infrastructure and complexity. It is fly-by-night almost by definition, and not recommended.
Still, the general principle holds true: get everything out of the way that interferes with your ability to generate a dollar of revenue. Start with an exaggeratedly overly-simple business structure. You will add complexity, one piece at a time. Consciously and deliberately.
Optimize for reality
Next, optimize for reality. The business model of a street musician or the “under the radar” one-person service company is not practical at scale, even for one person. Even a one-person consultancy needs more infrastructure.
Your brain will pop up a large list of fears: liability protection, the need for a business license, insurance, employment concerns, questions of trust (your employees, your vendors, your partners, your bankers, etc.). List everything you can think of. For each concern, there is a solution. The solutions are largely the same as the solutions you see for purely domestic businesses. The only difference is—you’re implementing them in another country.
As a general rule, you will probably want to set up an entity of some kind wherever you are operating, just to make business operations easier day to day. It is harder (not impossible) to do business in Singapore when you are walking around with the Articles of Incorporation for a Delaware corporation. If you’re planning to stay put for a while, set up a company there.
Again, this is an entirely practical exercise. Every time your brain pops up a “Wait a minute! What about ________?” thought, write this down. As you are wandering the streets of Bangkok trying to get a business going, you’ll encounter problems. Solve the problem with as little additional permanent legal infrastructure as possible. Legal infrastructure requires time, money, and attention to keep healthy. If the infrastructure breaks, you have serious problems.
“Everything should be made as simple as possible, but no simpler.” This quote is attributed to Albert Einstein, possibly incorrectly. In the first step, we overstepped the limits and oversimplified things. Here, by optimizing for reality, we carefully add back enough complexity to solve the known problems, but no more than that.
Optimize for tax
Finally, we optimize for tax savings. This approach is entirely upside down, coming from an international tax law firm. Most people approach us and say “help me minimize income tax” and many are nonplussed when we focus elsewhere first.
There is a reason for putting tax planning third in line. The reason is simple: you only pay tax when you have profits. You only have profits when you have revenue. The CEO’s concentrated attention on gross revenue will pay off far more than attention focused on tax savings. Go for revenue first. You will make more money from generating an extra dollar of revenue than you will from changing your tax rate a few percentage points.
For a mini-multinational, reducing your average tax rate by one percentage point will not add a lot to the bottom line. And if you sacrifice the ability to be nimble, move quickly, and focus everyone’s attention on what is important (hint: getting a customer and collecting money) you will hurt—not help—your bottom line.
“Optimize for tax” means transfer pricing
Create a fraction. The numerator of that fraction is the total income tax paid worldwide. The denominator is your gross profit worldwide. That is your average tax rate.
Tax planning is first all about attempting to reduce that fraction. This is a game of looking at a lot of tax systems from a lot of different countries. Do not optimize for U.S. tax savings. Optimize for worldwide tax savings.
In general this means that if you have the possibility of booking a dollar of taxable profit in one country or another, you are going to have it land in the country with the lower tax rate. The insider jargon for this strategy is “transfer pricing”. These are the games played by Apple and Google that appear in the popular press from time to time, triggering much clutching of pearls by horrified onlookers.
“Optimize for tax” means deferral
Second, international tax planning is about postponing the day you must actually take money out of the bank and give it to the government for income tax due. The insider jargon amongst tax professionals for these strategies is “deferral”.
The U.S. tax system attempts to impose tax on income in the year it is earned. If you can figure out how to postpone the date that you have to pay income tax on that income, you create an economic benefit for yourself.
You have $4,000 of profit from your foreign business operations. Your U.S. income tax rate is 25%, so you will pay income tax of $1,000 if the profit is subject to tax in the United States this year. Assume further that your foreign business operations were in Dubai, where there is no income tax.
You create a strategy so you legally are not required to include your $4,000 of foreign-source profit on your U.S. income tax return this year. Instead, you will have to report the income of $4,000 and pay the IRS the income tax of $1,000 in twelve months— on next year’s tax return.
Instead of giving the IRS $1,000, you put it in the bank, where it earns a princely 1% interest rate. Next year you have $1,010 in the bank. You pay the tax of $1,000, and have $10 of interest income left over. You pay income tax of 25% on the interest income, you have $7.50 left over, after tax.
By postponing the payment of U.S. income tax by one year, you have made yourself $7.50 wealthier.
Now let’s get realistic.
Your multinational business has $4,000,000 of profit generated from its foreign operations. The U.S. income tax rate is 25%. If the profit is taxable in the United States your business will pay $1,000,000 income tax.
You once again find a strategy to defer the time for payment of income tax for one year. Instead of parking the $1,000,000 in a bank account for a year, you use it as working capital in your foreign business operations.
Your multinational’s profit margin is 40%. This means that if you use the $1,000,000 to buy inventory and then sell it, you will end up with $1,400,000: you recovered your costs and earned $400,000 of profit. That’s exactly what you do. One year later the business has $1,400,000.
You pay the $1,000,000 to the IRS that was deferred for one year. And you pay $100,000 in income tax on the $400,000 of profit.
The payoff for deferring the payment of tax by one year is $300,000 of after-tax profit.
That’s not peanuts.
Ingredients for a Successful Deferral Strategy
This example reveals the dynamics of the deferral strategy. In order to make it work, you need the following:
- A lot of taxable profit from foreign operations. (A lot of profit means a lot of U.S. tax liability that you can defer).
- The ability to reinvest the deferred tax and generate a high rate of return. (Parking cash at 1% does not make sense, but using the money as working capital in your business does).
- No need for capital in the United States for a long time. (You only defer the U.S. income tax liability if you leave the money outside the United States).
- Your U.S. income tax rate is high. (If your tax rate is low, you might as well pay the tax, then be free of the artificial restrictions imposed by your tax deferral strategy).
- Your foreign taxes are low. (If you are paying tax on a dollar of foreign profit to another country, the money is gone; there is no deferral).
The Price of Tax Optimization
This just gives you a sense of the size of the economic benefit from doing international tax planning. But that’s half of the question. You are buying tax rate reduction and tax deferral. What does it cost you?
Some costs are quantifiable; some are not:
- The legal and accounting costs of creating, implementing, and maintaining the tax strategy;
- The expected value of penalties incurred because you screwed up some paperwork somewhere (and you will screw things up because thing get really complicated);
- The in-house administrative cost of running your business through this new structure (you will need more employees); and
- A loss of nimbleness and simplicity, which slows down business operations and creates distraction to management.
Much more subtle is the change in that planning will affect your strategic business decisions. Using the tax deferral strategy is a commitment to long term growth outside the United States. Bringing earnings back to the United States means a tax hit, so you are better off leaving foreign operating profits outside the United States permanently, and reinvesting them in your foreign business operations.
How Do You Begin?
So how does a mini-multinational begin?
- Optimize for simplicity. Send your scouts abroad and create the business plan. As soon as you have decided to start up operations abroad, bring in your CFO and tax accountants in the United States. Pretend you are opening up a new line of business in the United States, and pretend you are using a limited liability company wholly owned by the parent corporation of your business.
- Optimize for reality. Get a lawyer and an accountant where you are going to be operating. They will tell you the baseline legal and tax requirements for that country. Ideally you will have hired someone local who can tell you about the practical things that will make running the business easier. Do what sounds sensible.
- Optimize for tax. From the foreign tax advice you get, make sure your CFO and tax accountants can flow the income through to the U.S. parent corporation, and that any foreign income tax can be easily taken as a foreign tax credit on the parent corporation’s U.S. income tax return. In a perfect world this means you will be able to make a “check the box” election for the foreign entity you form. See Form 8832. This makes that foreign entity behave (for U.S. tax purposes) just like a domestic limited liability company—it is disregarded for U.S. tax.
- Be ready for the jump. Develop a business model that will help you see when foreign operating profits becoming large enough (and the costs for achieving them small enough) so that it is economically to your advantage to shift from a flow-through tax strategy to a deferral strategy. Know—and plan for—the threshold and when you know you should restructure.
That’s the big picture. Good luck with your new foreign business plans, and remember to keep things simple.