Wherein we see using a U.S. corporation is better than a tax haven corporationApril 15, 2016 - Phil HodgenFriday Edition
Hi from Phil. Welcome to the Friday Edition, where we talk about international tax. You can stop receiving this email by clicking the unsubscribe link at the bottom of the email.
International tax planning is about tax deferral. Avoid the phrase “tax savings” because you will confuse yourself. You’re not saving tax. You are postponing the payment date.
Do not automatically assume that if you achieve tax deferral you have accomplished something good. The Lord giveth, and the Lord taketh away. The IRS has countermeasures.
I give an example where using a tax haven corporation can give you a bigger tax bill than using a U.S. corporation.
You will not know whether Clever Tax Lawyer Tricks™ are a good idea or not until you build a spreadsheet or two. Math For the Win.
Let’s look at a situation where a U.S. person is starting a business. The idea will be to build the business, then sell.
The business will have customers all over the world, and could be based anywhere in the world. But – key assumption – the owners of the business are U.S. taxpayers.
Before becoming enamored with complicated holding structures in tax havens, transfer pricing, and other fun stuff, let’s see if it even makes sense to do this stuff at all.
Two Objectives of Tax Planning
There are two objectives for tax planning:
- Make income be not taxed at all; or
- Make some income be taxed later.
Banish the phrase “save tax” from your vocabulary. Know exactly what you are talking about when you are talking about tax planning. Think of tax planning as either tax-free income (because there is a rule making it tax-free) or tax-deferred income (because you know it will be taxed, but you will pay tax in the future instead of when you earn the tax).
International Tax Planning Is About Tax Deferral
The objective of international tax planning for U.S. companies and individuals isdeferral. Pay tax to the United States Treasury later rather than now.
Tax-free income? Yes, there are a few people whose tax planning involves “put money in a faraway place and don’t tell the IRS.” That works really well until it doesn’t. And then it fails spectacularly. Don’t do that.
For normal business operations, there is no such thing as “tax-free income”. Even countries that give tax holidays (“Set up your factory here and don’t pay any tax for 20 years!”) do not give you tax-free income, because Uncle Sam also has a claim on that income, and let me tell you… Uncle Sam does not give tax holidays. As a general principle, Uncle Sam wants you to pay income tax in the same year you earn the income.
Tax-deferred income is what you want.
You want tax deferral because of the time value of money. If you owe $100 of tax, and you can pay it now or later, you should pay it later.
- If you pay $100 of tax now, your net worth drops by $100.
- If you pay $100 of tax next year, you can put the money in the bank and earn a princely 1.5% interest on the money. At the end of next year you have $101.50 in the bank. You then send the $100 to the IRS for the tax, and you have $1.50 left over.
Time made you richer.
You may mock my example. Who cares about $1.50? No one. But what if your tax bill is $10,000,000, and instead of putting your money in the bank at 1.5% interest you use it as working capital to generate 40% net profit on new sales? Now your $10,000,000 tax deferral earns you $4,000,000 of profit in a year.
How It’s Done
You create a corporation and put $1,000 cash into it as the starting capital. You write software, and then the software is sold to customers all over the world.
- If your corporation is in the United States, it pays income tax on its profits. Your corporation earns $10,000 of profit and pays $1,500 of tax. There is $8,500 of after-tax profit.
- If your corporation is in a tax-free country, it pays no income tax. At the end of the year it has $10,000 in after-tax profit.
Let’s stay with this ultra-simple example for now. One corporation, either in the USA or in a tax-free country. Let’s follow the example all the way through to the end – when someone comes along and buys the business.
And let’s keep it ultra-ultra simple. The cash after tax is not used as working capital. It is just stashed in the bank, then the business is sold at the end of the first year.
Let’s Sell the Company
At the end of the year, your corporation has a customer base, some software, and cash in the bank. Let’s say someone comes along and buys the stock of your corporation for $50,000.
Consider first the tax result if you set up your software corporation in the United States. You sold the stock of the U.S. corporation for $50,000. You invested $1,000 in creating this corporation, so you have $49,000 of capital gain.
Keep it simple. Let’s say that the tax rate is 23.8% (for long term capital gain, with the ObamaCare tax of 3.8% on top of that).
You pay $11,662 of tax.
Now compare that to the result if you used a foreign corporation. You sold the stock of the foreign corporation for $50,000. It had made $10,000 of profits, and it held on to the $10,000 – it did not pay you a dividend of that money. Call that money accumulated earnings.
Of the $49,000 of capital gain you received, $10,000 is taxed as if it is a dividend; let’s assume the tax rate is 39.6%.1 The remaining $39,000 is taxed normally, as long term capital gain.
The total tax you pay when selling your business will be:
- $10,000 x 39.6% = $3,960
- $39,000 x 23.8% = $9,282
- $13,242 of tax
Using a corporation in a tax-free country cost you an extra $1,580 in tax when you sold your business.
And yes, I know. This is a ridiculous example. The purchase price for a U.S. corporation will not be the same as the purchase price of a foreign corporation, for 1,000 different reasons. There are other reasons why the comparison might not apply to you. But the basic truth applies: some of your capital gain will be taxed at ordinary income tax rates if you sell stock of a Controlled Foreign Corporation.
Tax Geek Time
The countermeasure used is Internal Revenue Code Section 1248. Sale of stock of a Controlled Foreign Corporation (which your foreign corporation would be, because it is 100% owned by a U.S. person, namely you) is taxed like a regular stock sale (as capital gain). With one exception: some of the money you received from selling your stock in a Controlled Foreign Corporation is taxed at dividend rates (ordinary income) – up to the amount of accumulated earnings.
And of course:
- Section 1248 itself is riddled with exceptions, and
- I have vastly and ridiculously over-simplified how Section 1248 works,
so in fact in many cases it DOES make sense to use a corporation in a tax-free country.
What I Do
To test the limits of Clever Tax Lawyer Tricks™ here’s what I do. I create simplified financial projections.
- Pick a time horizon (let’s say five years) and pretend the company operates according to plan for those five years, then is sold.
- Do tax projections for a U.S. corporation (with and without dividend payments), a tax-haven corporation (again, with and without dividend payments), possibly a foreign corporation in a country that has a tax treaty with the USA, and a partnership.
What do the numbers look like? Math is good.
That’s the start of the analysis. Often this is the knockout punch that tells us the answer. In other situations, we move to the next step in designing the corporate structure. (Hint: future growth of the business is likely to be outside the USA).
Disclaimer (aka What You Do)
Insert a standard customized disclaimer here. Complex. Weird. Conflicting rules. (Rufus Rhoades was in my office today telling me about a new Temporary Regulation that is one sentence long and completely unintelligible. Haha. That’s tax law for you.) Hire someone to give you good advice but FFS K.I.S.S. Pls.
See you in a couple of weeks. Meanwhile, I’m going back to the spreadsheets. The more I am doing them, the more I am dissuaded from using an IP-Box or any one of a host of ideas for a start-up. Simple and pass-through is the likely answer in this case, completely contrary to the early discussions and ideas we were throwing around at the start of the brainstorming. “Shiny!” “Clever!” Nope, just nope.
- A dividend from a foreign corporation in a zero-tax country will not usually be taxed as qualified dividend income (at the capital gain tax rate). One of the requirements for being taxed that way is that there is a treaty between the USA and that country. The USA doesn’t do tax treaties with tax havens. ↩