The Buckets and Pipes Theory of Tax Planning

Singapore Meet-up? 19-24 February 2015

If you want to meet me in Singapore (I leave on the 24th of February to return home) shoot me an email and let’s set something up.

Optimize for Attention

Saturday morning in Singapore I will be talking to about 30 entrepreneurs about tax stuff – a bit for themselves, but mostly about their businesses. And that means talking about cross-border tax strategies. “Can I do what Apple does?” The answer is yes. It’s just not cost-effective until you are operating at scale. For younger companies, the better strategy is to optimize for simplicity. Spend less money on tax brains and pay a bit more in tax. Stay away from the shiny. Simplicity will make your business nimble, and your time and attention will be directed toward what really matters: creating customers. An entrepreneur’s time and attention is worth far more than taxes saved. You don’t get wealthy by paying less tax. You get wealthy by creating customers. Look at Apple. Of course Apple is saving tax with clever international tax strategies. But first, painfully and over a long time, they created customers.

International Tax Planning

International tax planning is fairly simple in concept. No income received by a U.S. taxpayer = no tax payable to the IRS. Your tax-planning strategy is simple: make a profit and leave the money outside the United States. You are rich, but the money is in a pocket that the IRS can’t reach. The IRS cannot reach the income because it was not earned by you. The reason the income was not earned by you? Pesky notions of national sovereignty. Uncle Sam the Farmer can’t wander over to the next farm and milk their cows. The Internal Revenue Code has but one aim: find a way to treat you as if you received that income, then tax you on it. That’s the story of tax law: if Congress is defeated by reality, write up a fictional alt-reality and tax you on that. There are other countries involved, of course. And most of them like to collect tax. This introduces gold-leafed rococo flairs of complexity into the picture. Now you are trying to protect a dollar of profit from the United States and some other country simultaneously. But let’s focus on solving one variable at a time: U.S. tax planning.

Buckets of Money

Look at Apple. Buckets of money outside the United States.¹ Apple generated huge profits outside the United States, and simply does not bring the money back to the mothership. The money stays untaxed by the IRS. The tax debt is deferred to someday in the future. There seem to be three major things that Apple spends money on:

• business operations outside the USA,
• business operations inside the USA, and
• buying back its stock from shareholders.

Two of those three activities will require cash in the United States–working capital for U.S. business operations, and stock buy-backs. If Apple brings in a dollar and pays 30% tax right off the top, that’s expensive working capital. This is why you see Apple sitting on untold billions of cash abroad, and simultaneously borrowing billions of dollars. It can use the borrowed dollars for working capital and stock buy-backs in the United States, leaving the buckets of money abroad to be used for other purposes. The untold billions abroad get reinvested in profitable ventures outside the United States. The tax system creates an incentive for Apple to invest its capital outside the United States. Yes, China is an enormous market. That alone would be good enough for Apple. But it also has an enormous pool of cash it must put to work somewhere. Guess where that money goes? Anywhere but the United States. International tax planning is first about making buckets for deferring U.S. tax payments. This is a present value game. If you can defer the payment date to 10 years from now, what is the present value of that tax liability? Pretty small, no matter what you use as a discount rate.

Pipes

How do you get a dollar of income into a bucket where there is no tax? How do you organize your business so that you can decant a dollar of profit out from underneath the nose of the tax collectors in a high-tax country, and move that dollar into a zero-tax (or low tax) country? International tax planning, after making buckets, is all about making pipes to drain money from one bucket into another. Generically I am going to refer to the strategies as earnings stripping. I use the word “stripping” here as in strip mining. You scrape off profit from a company that operates in a high-tax country by creating tax-deductible business expenses. Your company operating in a high tax country has expenses it pays. These expenses reduce its taxable profit. Less taxable profit = less tax paid. This system works because you are on both sides of the transaction. You are paying a business expense (from a company in a high tax country) to yourself (a company in a low tax country). The dollar of expense reduces your taxes dramatically in the high tax country, but the dollar of income you paid yourself is barely taxed (if at all) in the low tax country. Now you can leave that dollar in the low-tax country company, and make it grow. There are many methods for doing this. Generally, though, the tax deductible business expenses are generated by:

• Services (you have a company in a low tax country that is paid for services rendered to the highly-taxed company);
• Interest (you have a finance company in a low-tax country that lends to your highly-taxed company);
• Product sale (your low-tax company puts a high mark-up on a product and wholesales it to your high-tax company, which barely makes a profit when it retails the product to the end user);
• Royalties (your trademarks, copyrights, patents, etc. are owned by a company in a low-tax country, and your high-tax country company pays royalties to the low-tax country company).

International tax planning is a game of using these tools to move profit to a low tax country. The governments of the world are united in their resolve to defeat your use of these tools.

Buckets and Pipes For Not-Apple

Even if your business is not Apple-sized, all of these ideas will work for you. But it is a question of cost. Money cost and attention cost. Hiring a tax lawyer to help you gets only marginally more expensive as you scale up from $1,000 of tax savings to $1,000,000 in tax savings. Since overhead is constant but tax savings scale up, you do not want to do complicated stuff too early. Why spend $1 on legal fees to generate $1.05 of tax savings? Buckets and pipes are complicated, and require constant attention. This is money expensive. There is another much larger problem. Until the company can afford to hire people to abstract away all of the thinking from the entrepreneur’s daily thought, it will be too expensive – opportunity cost expensive. At Apple-scale everything it is possible to hire sufficient talent to handle the tax stuff so that the people who are doing the most important thing – creating customers – are not distracted. The marketing plan not executed because you were busy meeting with lawyers and accountants. The new idea you did not have because you were so fatigued and distracted. These are the true costs. In fairness, there are many other things that can distract an executive or entrepreneur and derail a company. But tax planning is shiny and appealing. And it seems to have a payoff – extra dollars in the bank. Ah, but those dollars can be expensive. It’s like a friend of mine said once about a business. “Yeah, that’s the goose that lays the golden egg. But you have to keep feeding it diamonds.” (He passed on the deal, of course.)

Keep It Simple

You need opening assumptions for everything you do. “Until proven otherwise, I think X is the best idea.” Then you go out and try to prove X is a bad idea. In tech jargon, you do A/B testing. Kids these days and their slang. In Ye Olden Tymes we had control groups. And statistical analysis. So I take the anti-clever approach at the beginning of every tax planning job I take on. Let water run downhill. Let the sun rise in the east and set in the west. Make worldwide income taxable in the U.S. You will need a company everywhere you do business, and that will generate a baseline level of necessary accounting work and tax paperwork requirements. But otherwise, concede the force of gravity and have profits taxed fully. But strive for operational simplicity–lower accounting fees, lower legal fees. Simplicity tends to deliver a not-bad result, especially for operations in high-tax countries. Whether you pay tax in the U.K. or the U.S. doesn’t really matter because the tax rates are roughly equivalent. Simplicity also means fewer things to break. That avoids calamitous penalties. Penalties in the international arena tend to default to $10,000 and up. It’s easy to create huge problems fast. I’ve seen it. A U.S. company with four foreign subsidiaries. They are late filing Form 5471 for each of these companies. The first time, they get a hall pass from the IRS. The second time, no hall pass. 4 x $10,000 = $40,000 penalty. At Apple scale, a $10,000 penalty doesn’t mean much. At entrepreneur scale, it’s a lot. Use flow-through entities (companies that are not taxpayers, but rather just pass along the income to their owners–like partnerships do). Be modest in your use of earnings stripping techniques. Above all, spend money on the boring stuff: bulletproof bookkeeping and accounting, done in real time. Evoking the Coase Theorem, I like to see bookkeeping, accounting, tax return preparation, and tax planning all done in one place.² Or at least all of these functions should be understood and managed by two brains simultaneously (you don’t want a single point of failure if an employee quits). The executive or entrepreneur’s brain should not be one of them. As you scale, there will be plenty of opportunities to reduce tax by adding buckets and pipes. Just don’t get too clever too fast.

Until Next Time

This one doesn’t need a disclaimer because there is no legal imperative in it. “Go forth and do X!” Not here. Just an admonishment to hunker down and do first things first. Hit the reply button and talk to me. I’d love to hear from you. /Phil