There has been much publicity lately regarding large multi-national companies and their offshore tax planning strategies, which has led many business owners to wonder how they could employ similar strategies. This article will focus on things small- to medium-sized business owners should know when considering tax planning strategies related to offshore expansion.
Most small- to medium-sized entities (SMEs) have relatively simple tax structures when opening a foreign subsidiary. When expanding into international markets, SMEs with a foreign subsidiary typically treat the entity as a controlled foreign corporation, foreign partnership, or a disregarded entity. This article does not get into the differences between these structures, however it will give you a high level overview as well as reporting requirements.
We often get questions from business owners wondering how they can “see tax rates as low as Apple.” The “Apple” tax structure is somewhat complicated and certainly comes with risk from tax authorities in which Apple does business. Complicated structures come with additional compliance and consulting costs, and for some businesses the tax savings won’t warrant such additional costs.
How does the “Apple” Strategy Work?
Many large multi-national companies, including Apple, Inc.; Facebook, Inc.; Google, Inc., and many others have used structures commonly known as the “Double Irish” or “Double Irish Dutch Sandwich” to reduce their worldwide effective tax rate on royalties derived from exploitation of intellectual property.
Under a typical “Double Irish” structure, a US parent company establishes 2 Irish subsidiaries, IrishCO1 and IrishCO2. IrishCo1 is a first-tier subsidiary that is organized under Irish law but managed and controlled from a jurisdiction with no income tax, such as the British Virgin Islands (BVI). The US tax regulations determine residency based on the country of incorporation, in this case Ireland, however Irish tax regulations determine residency based on control and management. Since IrishCo1 is controlled and managed outside of Ireland, it will be considered an Irish incorporated non-resident (INR). The US parent company will retain all US rights to intellectual property and will license the rights to IrishCo1 to develop and exploit the IP outside the US. IrishCo1 will then sublicense the rights to IrishCo2, which will use the IP to manufacture and sell the products to customers outside the US.
IrishCo2 is wholly-owned by IrishCo1 and is organized, managed, and controlled in Ireland. For Irish tax purposes, IrishCo1 and IrishCo2 will be treated as two separate corporations, one an INR and the other an Irish resident corporation. Ireland will treat royalty payments from IrishCo2 to IrishCo1 as royalties paid by an Irish corporation, therefore IrishCo2 will deduct such payments as an expense for Irish tax purposes, thereby minimizing its Irish tax liability. The net income of IrishCo2 will be taxed at the standard 12.5% Irish tax rate. Since BVI does not have an income tax, the royalty income of IrishCo1 will not be taxed. This creates a scenario where one entity has a tax deduction for income paid to a related party that is not subject to income tax in any jurisdiction. With this structure, Apple has successfully, and legally, shifted profits to a jurisdiction with no income tax.
Doesn’t the US have regulations that prevent this?
Yes, but there is a loophole. For US tax purposes, IrishCo2 will file a “check-the-box” election to be treated as an entity disregarded from its owner, IrishCo1. As a result from a US tax perspective, IrishCo1 and IrishCo2 will be treated as a single Irish corporation and the US will ignore the transactions between IrishCo1 and IrishCo2. By “checking the box,” companies are able to circumvent the burden of the US anti-deferral regime known as Subpart F applicable to controlled foreign corporations (CFC).
A CFC is a foreign entity, treated as a corporation for US tax purposes, and owned more than 50% by a US person. Typically the US does not tax income of a CFC until such income is repatriated to the US as a dividend. However, Subpart F may cause the US parent company to be taxed on certain types of passive or highly mobile income earned by its foreign subsidiaries regardless of whether dividend distributions have been paid.
One of the primary types of Subpart F income is foreign base company income. Foreign base company income includes most forms of passive income, including royalties. However, there is a same-country exception which excludes income from a CFC incorporated in the same country. Under the same country exception it is irrelevant whether the CFC is considered a tax resident under local laws of the country of incorporation.
In our example, both entities are considered to be incorporated in Ireland and the same-country exemption applies. The royalties earned by IrishCO1 (which is not taxed in Ireland) will not be considered Subpart F income because they are paid by a related party organized in the same country. This protects the deferral of income until such time as a dividend is paid.
A variation of the Double Irish Structure includes inserting a Dutch (or other EU) company between IrishCo 1 and IrishCo2. The purpose of this variation is to circumvent withholding tax on the royalty payment that may apply. The Dutch company would also check the box to be disregarded for US tax purposes. IrishCo1 would license the IP to the DutchCo which in turn sublicenses the IP to IrishCo2. Royalty payments from IrishCo2 to DutchCo and from DutchCo to IrishCo1 would not be subject to withholding tax because payments between EU countries are not subject to withholding.
New regulations in Ireland, which went into effect January 1, 2015, will make this structure a bit more difficult, but not impossible (currently) due to Ireland’s extensive treaty network. Many executives enjoy holding annual board meetings in places like the BVI or Cayman Islands. These Caribbean countries do not have treaties with Ireland and are no longer effective in this tax planning strategy. Malta is a country that could be utilized, however the EU is urging Malta to make changes to its current policy which could make this tax structure obsolete.
What obstacles prevent SMEs from implementing a similar tax strategy?
Many SMEs are only exporting goods overseas or purchasing goods from foreign vendors. If a US company sets up an offshore entity for these purposes, the Subpart F regulations would likely require the US parent company to include income earned regardless of whether a dividend was paid to the US company.
As mentioned earlier, foreign base company income is the most typical type of Subpart F income. In addition to passive income, foreign base company income can include income from the following sources of a CFC:
- Income derived from the purchase of personal property (such as inventory) from a related person and its sale to any person where the property is manufactured outside the CFCs country or organization and the property is sold for use outside the country of organization
- Income derived in connection with the performance of services, which are performed for or on behalf of any related person and are performed outside the CFC’s country of organization.
In other words, a US company could not set up a foreign entity to purchase goods and sell them to a company (including the US parent) outside the foreign company’s country of organization at a mark-up and defer tax on the income inside the CFC. Additionally, a US company cannot set up a foreign entity to perform services for the US company and defer tax on the income inside the CFC.
What types of international tax strategies can an SME implement?
Intellectual Property – Development Stages
If you have a company in the process of developing intellectual property, it is possible you could take advantage of tax strategy similar to those discussed above. Before moving forward with any tax strategy, it is important to analyze the tax benefit versus the administrative and compliance costs such an endeavor will entail. Items to consider include:
- How much income from the exploitation of IP in foreign markets is expected?
- Will the US company need the cash flow derived from foreign sales to efficiently operate the US company?
If most of your income is derived from the US market or the US entity is expected to need the cash flow from foreign sales to operate the business, it probably would not make sense to consider moving the IP offshore. Remember, in the examples above, the US entity retained the rights to IP for sales in the US. Income earned from the exploitation of IP in US markets will be taxed in the US.
Intellectual Property – Developed
If you have already developed intangible property, moving the IP offshore will be a taxable event. A US company can transfer some or all of its IP to a foreign subsidiary for cash or a note receivable. In this case an arm’s length price must be paid for the IP and the payment in consideration for the IP must be commensurate with the income attributable to the intangible. The US would not longer maintain the rights to the IP and therefore would not be able to expense additional R&D costs. In addition, if the US entity takes advantage of the Research & Experimentation tax credit, such credit may not longer be available. There are many complex regulations which must be navigated to ensure correct compliance. These complexities are outside the scope of this article.
A US parent company could also elect to transfer IP to a foreign subsidiary for stock. This would also be a taxable event as typically the US parent would be deemed to have sold the IP in exchange for annual payments. The deemed annual payments must satisfy the commensurate with income standard. Such payments would be included in the US parent’s income over the life of the IP.
A US parent company could also enter into a cost-sharing arrangement with a foreign subsidiary. Such an arrangement is typically accompanied with a buy-in for existing IP that is owned by the US company. Cost-sharing arrangements must comply with detailed regulations in the tax code, however, if the intent is to exploit the IP in foreign markets, this may be an option worth exploring.
Each of the above options comes with an immediate tax cost but has the potential to defer income from US taxation in the future. Careful analysis and projections are recommended to determine whether the present value of the current tax cost is less than the present value of future tax deferral.
Certain US manufacturers exporting their product outside the US may be able to implement an IC-DISC strategy and reduce their US tax burden. Proper planning is required to ensure the IC-DISC has been established correctly and to ensure the tax benefits are maximized each year. See our previous article on IC-DISC for more information.
Set Proper Transfer Pricing Policies
If a US company is conducting business in international jurisdictions, the US entity should ensure transfer pricing between to the US and foreign entity is at arm’s length. Transfer pricing policies are often overlooked with regard to how they can be utilized to manage effective worldwide tax planning opportunities. Every company’s situation is different, but we find this is the most often overlooked tax planning opportunity. If the US has foreign subsidiaries and either the US entity or the foreign entities have net operating losses, it is possible the transfer pricing policy is not efficient from a tax planning perspective. Transfer pricing policies can be in compliance with tax regulations while still providing effective tax planning opportunities.
What Else Should A SME Consider before Offshore Expansion?
Changes Are Coming
The Organization for Economic Co-operation and Development (OECD) nations are currently undergoing what is known in the international tax community as the BEPS project (Base Erosion Profit Shifting). BEPS is a technical term referring to tax planning strategies that exploit gaps and mismatches in tax rules to artificially shift profits to low or no-tax jurisdictions where there is little or no overall economic activity, resulting in little or no overall corporate income tax being paid.
The project is essentially a bunch of working groups, composed of officials from the world’s largest economies, that are tasked with the job of trying to figure out how the international tax landscape for corporations should change. The group is expected to issue 15 action plans before the end of 2015 intending to:
- Address the use of certain abusive tax strategies by multinational enterprises
- Eliminate double nontaxation
- Address profit shifting to areas with little or no economic activity
In September 2014, 7 of the 15 Actions were delivered in draft form and included:
- Address tax challenges of the digital economy
- Neutralize hybrid mismatch arrangements
- Counter harmful tax practices
- Prevent abuse of tax treaties
- Address transfer pricing issues in the key area of intangibles
- Improved transfer pricing documentation and a template for country by country reporting
- Develop a multilateral instrument to amend bilateral tax treaties
The outcome of this project is expected to require country by country reporting for each jurisdiction in which a company has a tax filing requirement. This reporting is expected to include information, which will help tax authorities identify where income is earned with little economic activity and is expected to give rise to increased transfer pricing audits. It is possible the BEPS project will make some tax strategies obsolete once the outcomes are implemented.
Implementing an international tax strategy takes careful planning and consideration. Navigating the rules and regulations surrounding this topic can be quite complex. It is recommended you consult with a US tax advisor as well as an advisor in the country you are considering expansion.