Hi, it’s Phil Hodgen. Merry Christmas. (And no, I am not writing this on Christmas Day.)
This is the biweekly Friday Edition, chock-full of international tax goodness. You signed up for this newsletter, but if you want to stop getting it, no problem — just click the Unsubscribe link at the bottom of the email.
Next International Tax Lunch
January 8, 2016 — our regular monthly International Tax Lunch series returns after the Christmas break. Noon, Pacific time. In person or dial in.
I will be doing one hour on the foreign earned income exclusion and how to prepare Form 2555. Yes, even the housing allowance stuff.
If you are in Southern California, why not come by and hang out with us. Ask questions. We will buy you lunch.
Go to hodgen.com/lists and sign up for the International Tax Lunch list. You will get announcements, instructions on how to dial into the conference call or come to the event in person, and even get the handouts.
A Hidden Tide
After you watch the tax press roll by for a few months, you start to wonder if there is a hidden trend.
First. Lots and lots of tax and information sharing agreements exist, and more are being signed every month. Here’s where my brain went. (References are toWorldwide Tax Daily for those of you who have Lexis accounts.)
- Income Tax Treaty Signed Between Saudi Arabia and Gabon. 2015 WTD 243-12. This agreement is not terribly important by itself, but I give it to you as being representative of an astonishing stream of activity happening out there in the world of diplomacy. If you watch the international tax news, as I do, you will see more and more tax and information sharing agreements between countries.
- U.S. in Treaty Negotiations With Luxembourg. 2015 WTD 243-8. An IRS attorney divulged at a recent tax conference that the two countries were working on a treaty. Hits a little closer to home than Saudi Arabia and Gabon, right?
- U.S. TIEA Protocols With Isle of Man, Jersey in Force. 2015 WTD 242-11. More information sharing.
Next. It is politically popular to chase “them”, especially when “they” have more money than you do. (Information sharing agreements help you do that.) Again, note that the transparency is a one-way street. The government wants to know more about you.
- Brazilian Senate Approves Voluntary Disclosure Program. 2015 WTD 242-7. We see yet another country mimic the IRS methodology for pursuing taxpayers who might have done something that they shouldn’t oughtta have done, if you know what I mean. Indonesia is another country that I know about personally — I do a lot of business there — that is launching a similar program. Expect more countries to squeeze their citizens for hidden assets and unreported income.
Finally. Cross-border (and domestic, because it is easier) information sharing will be automated.
- Swiss Upper House Approves Automatic Exchange of Tax Information. 2015 WTD 240-2. And this, my friends, is the beginning of the end game. Sovereign tax systems will present APIs to each other in order spit data across borders. Expect this to become the norm. Why? Because it is possible.
Prediction. Financial data is all visible to the government, and tax collection is automatic. Because it is possible.
- The Death of Bank Products Has Been Greatly Under-Exaggerated. You know the joke about drills, right? People don’t buy drills because they want drills. They buy drills because they want holes. The author’s point here is that people do not have credit cards because they want pieces of pieces of plastic. They grudgingly carry pieces of plastic because they want to buy a thing.
The same logic is true about tax administration. Transparency (translation: your government knows everything about you, but not vice versa) and the digitization of everything means a hidden tide is flowing:
- Tax Returns Become Digitized, Then Disappear. My wife has a clothing business. The sales tax returns have gone from paper (a pain in the neck) to online (not too hard). Soon it won’t be hard for the authorities to see sales and grab the sales tax revenue at source. The same is true for income tax returns. Our office prepares paper income tax returns that are inches thick. Why?
- Tax Policies Morph. The sometimes alarming Red Team Rules tell us (Rule 16) that “Target dictates the weapon and the weapon dictates the movement”. The resources you have dictate what you can do. As the IRS gains data (“Transparency!”) and reduces internal friction (all things become digital), the methods of extracting tax from you will change. Me, I expect the VAT to arrive in a few years, because it can.
- Complexity Remains Constant. If life were a perfect vacuum, I would expect tax rates to go down and collection of income at source to be the norm. The government can collect the same revenue with less effort that way. But two things stand in the way: government spending expands to fully overspend all available resources, and tax policies are an inherently political tool serving political (not economic) ends. So the overall tax system will remain the same muddled bucket of complexity and confusion. The complexity will just get pushed to different places.
This leads me to a couple of guiding principles:
- Choose Uncertainty. If you want to thrive, go where the complexity and confusion is greatest. E.g., being an entrepreneur is more confusing than working a corporate 40 hour/week job. If the government can’t get a decent handle on a particular aspect of human behavior, there is probably something intensely interesting, lucrative, and fun going on there.
- You are Insecure; Be Ready. As the government acquires more information about you (“Transparency!”) you lose control over your destiny. As data pools increase in size and value, the probability of breach approaches 1. Government-controlled data pools are no exception. When all data resided on paper, grabbing your tax information was expensive. When everything about you sits in a database, breaching your privacy costs zero. Prepare for this.
There was a lot of chatter in the tax press in the last couple of weeks about corporate inversions. The trigger du jour for all of this discussion was the Pfizer-Allergan merger of juggernaut pharma manufacturers.
There is nothing that actually happened — the chatter is just a bunch of people displaying their political affiliations and moral imperatives while coolly and professionally talking about tax esoterica. “Something Must Be Done” etc.
Nopes. It’s not politics, patriotism, or morality. It’s just economics.
Corporate inversions are the business equivalent of human expatriations. A U.S. corporation, through some complex legal maneuvers, reincarnates itself as a corporation based in a foreign country. It continues to do business exactly as before, except it pays less income tax worldwide.
U.S. multinationals are good at finding ways around the U.S. system’s “pay tax on all of your profits, no matter where you earned it, every year”. You need only look at Apple and Google for examples.
But life becomes a lot easier — and you pay less tax — when the corporation ceases to be a U.S. corporation.
The government started its fight against corporate expatriation in 2004, by enacting Section 7874 into the Internal Revenue Code. Through it all, inversions have continued.
It’s not surprising. A sane corporate executive will ask “What is the cost of inversion?” and “What is the benefit of inversion?” Over any considerable period of time, the benefits of taking a corporation offshore will outweigh the cost.
The government’s anti-inversion strategies are designed to make inversions more expensive. The benefit side of the equation, however, is untouched. And I suspect that any decent present value calculation will demonstrate this.
- Expect to hear about the evils of corporate inversions in the 2016 election rhetoric. Heh.
- Expect the government to continue to make corporate expatriation more difficult and more expensive. Yet corporations will continue to move abroad, and those that don’t will continue to hoard capital abroad rather than bring it home and pay tax.
- (This one will be hard to see because you’re looking for something that isn’t there, but it is real because I tell startups to do it right now). Expect new businesses to start as foreign-based companies rather than U.S. based companies, because if you’re a foreign corporation you don’t need to expatriate — you are already safe. So over time, expect entrepreneurs to be more and more willing to build their companies abroad, to the long-term detriment of the U.S. economy.
Big Money Coming to U.S. Real Estate
The Protecting Americans from Tax Hikes (PATH) Act of 2015 (passed into law on December 17, 2015) opened a giant door for foreign investment in U.S. real estate through publicly traded REITs.
(Side note: do politicians think we are morons? What is with the ridiculous acronyms that they keep bolting onto Frankenstein legislation? “”PATH””? OMFG srsly no. And do they think we are so stupid as to imagine that they sit around in Congress figuring out how to protect us from Tax Hikes? I have a few un-PC things to say here but I won’t.)
There’s this tax law called “FIRPTA”, which dates from 1980. Whenever a “U.S. Real Property Interest” is sold by a foreign person, capital gain tax must be paid. If you have a corporation that owns a lot of real estate (like a REIT), then the sale of that stock is treated as the sale of a U.S. Real Property Interest, and capital gain tax must be paid.
If you are a nonresident investor, trying to decide between buying Apple stock or some publicly traded REIT, what do you choose? You can take your capital gain on Apple stock and not pay U.S. capital gain tax, or you can take your capital gain on the REIT shares and pay U.S. capital gain tax.
Previously, there was an exception for small shareholders in publicly traded REITS: if you owned less than 5% of the REIT, you did not have to pay the capital gain tax on sale of the shares. In the new law, that threshold is now 10%. Suddenly, big money can pour into REIT shares and enjoy more favorable tax treatment.
A second point. U.S. pension plans can buy REIT stock and sell it and not pay capital gains tax on the gain. The tax system allows them to do so because they are investing for workers’ pensions, and eventually (when the pension payouts are made) the money will be taxed.
Foreign pension plans did not (up to now) have that tax-free benefit if they bought REIT shares. Now they do. More money coming to U.S. real estate.
More foreign institutional money will pour into U.S. real estate investments. Prices for large properties (those favored by REITs especially) will go up. Cap rates go down.
FIRPTA Withholding is Now 15%
Since 1980, when a nonresident investor in U.S. real estate sold out, the buyer has been required to withhold 10% of the purchase price as a withholding tax, and give it to the IRS. The nonresident seller would file a tax return, and that 10% withholding tax would be applied to whatever the actual tax liability was for the sale. In that way, the withholding worked exactly like the tax withheld from your paycheck every two weeks.
The new law changes the withholding rate to 15%. See Section 324 of the PATH Act.
- This will make it harder for some nonresident investors to sell. If 15% of the sales price is getting scraped off the top for withholding tax, and another 5% – 7% is going out to broker’s commissions and closing cost, this means a highly-leveraged property cannot be sold. There isn’t enough cash to pay off the mortgage, pay the tax, and pay the closing costs.
- We will be doing a LOT more work for withholding reduction certificates, seeking permission from the IRS to reduce withholding to a sane level. (Hint: go look at IRS Form 8288-B). More pointless expense for sellers, more pointless paperwork processing for the IRS. (Eventually this will be digitized away, of course.)
Last week I was driving back to Pasadena from some meetings in Beverly Hills. For kicks I took Sunset Boulevard all the way home. Somewhere in Silverlake, in wall-to-wall Friday afternoon rush hour traffic, a storefront caught my eye.
It was dusk, and the light shining through the large windows was bright and warm. I glanced over. Leather goods. Nice-looking stuff, I thought. Luckily there was a parking spot at 4:30 pm on the street, right out front. I went in.
The store is Killspencer, at 2522 West Sunset Boulevard, Los Angeles CA 90026. They manufacture everything right there in the store. Walk in and the whole space smells of leather. Wonderful. Their products are exquisite, and the workmanship immaculate.
I might have bought something. Just sayin’.
Oh, who cares. This email is going out on Christmas and by the time you read this my wife will have opened the box.
Tell Me About Something Interesting
Tell me about a cool, indie store or product you know about. Tell me about things where humans do interesting stuff. It could be anywhere on the planet — I like getting on planes!
Until Next Time
Merry Christmas and Happy New Year. Talk to you in a couple of weeks.