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:
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.
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.
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.
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.
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.
This example reveals the dynamics of the deferral strategy. In order to make it work, you need the following:
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:
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.
So how does a mini-multinational begin?
That’s the big picture. Good luck with your new foreign business plans, and remember to keep things simple.