Professor and Mrs. John Robinson
Jupiter 2 Spacecraft
Lost in Space, en route from Alpha Centauri
RE: International tax planning for Lost in Space Enterprises, Inc.
Dear Professor Robinson:
I understand that you and the children are thinking about heading back to Earth in your Jupiter 2 spaceship after a few years of cheesy intergalactic wandering on black and white TV and a 1998 movie remake (sans, in the movie, the aluminum foil costumes and June Lockhart). Now that the plastic action figures from your movie remake are showing up in dollar stores, you’ve decided to use your intergalactic contacts and technology to “launch” a new career as an entrepreneur.
Specifically, you have indicated that you anticipate purchasing equipment and hiring employees for a business that will serve markets in the US, Great Britain and certain EU countries.
You have asked for help in thinking through how to structure your international ventures so as to be able to both confidently plan for, and to minimize, income taxes in the various target countries.
It is a difficult question. Do not be surprised to learn that international taxation is complicated.
It is complicated because it involves squaring the rules of one country’s dense, half coherent tax regimen with the dense, half coherent tax regimen of a second country. And then there are tax treaties, which overlay domestic tax rules, and which mostly apply – but sometimes do not — to cross border business activity.
The first step in navigating this complexity is to select a base of operations.
On this question, the tax-smart approach is to push tax strategies into the background. Concentrate on more core concerns, such as access to markets, suppliers and workforce talent.
Furthermore, if you and your employees are going to be traveling back and forth from Alpha Centauri with any frequency, there is transportation infrastructure to consider. Finally, and not least, there is quality of life. Figure out what works for the health of your business, and for your personal well-being, and then and only then turn to tax strategies.
In Europe and North America, and pretty much anywhere else you are likely to do business, the focus of tax rules is on the source of income, that is, where the most significant activity that led to the income event occurred.
Your plan is to generate the bulk of your revenue from US sales. If your primary base of operations is Alpha Centauri, which has not signed a tax treaty with the US, the key inquiry on US-sourced income has two main parts: first, whether your activities in the US are substantial and continuous enough to be considered a trade or business, and, second, whether the income in question is effectively connected with that deemed US trade or business.
Put more directly, if your activities in the US rise to the level of an active business, all income effectively connected to that active business is taxed, more or less, as if your company were actually resident in the US. (That means, by the way, that repatriating after-tax corporate earnings triggers an additional thirty percent tax on the amount repatriated)
So what if you only plan to ship souvenir tinfoil ray guns directly from Alpha Centauri to US retailers? Is that a US trade or business? The answer is, no.
Is that good? Not really.
Even if your US-sourced income is not effectively connected to a US trade or business, you still have to pay taxes on that revenue — because it is US- sourced. In other words, all that trade or business and effectively connected stuff goes to the size of your US tax bill, not to whether or not you will owe any taxes.
If you have US-sourced income that is not related to a US business operation, you pay taxes at a thirty percent rate. And, worse yet, it’s a tax on revenues, that is, you don’t get to set off the expenses related to the revenue being taxed at thirty percent. Not good.
And what about those royalties you are counting on from Lost in Space reruns? It’s not fun paying taxes at a thirty percent rate on that income either, but that too is the rule.
Is there a better way? Yes.
You need to position this effort so you enjoy the benefits of one or more international tax treaties. Leaving aside the question of why anyone would choose to live on Alpha Centauri (wherever that is) over Paris, London or New York, if you base your operations in a country that has tax treaties with most or all developed countries, your cross-border business is, on the whole, less burdened by tax issues. Indeed, in some instances you actually get to pick the most advantageous rule – the treaty rule or the source country rule – to apply to your case..
There are two major advantages to conducting international business under modern tax treaties. The first is that income derived from an operating business is typically taxed in the source country only if you maintain a permanent establishment in the country where the income is generated.
So, for example, you could ramp up your sales of tinfoil ray guns in the US without subjecting income from those sales to US taxation, provided you don’t run it out of a US permanent establishment. You can even ship to your own US warehouse, as long as you conduct the meaningful parts of the business, such as negotiating sales contracts, from overseas. Absent that treaty rule, the ramped up sales in the US, even if overseen primarily from Alpha Centauri, could get snagged by the US ‘trade or business’ rules.
The second advantage is that the treaty tax rate on passive income, such as dividends, royalties and interest payments, is generally lower than the non-treaty rate.
Last point: You have to set up a real operation – a permanent establishment — in a country here on Earth in order to enjoy the benefits of those treaties. But you can’t satisfy the ‘regular and continuous’ standard for a permanent establishment by merely setting up a shell company, or by parking Jupiter 2 at an airport somewhere and conducting your Earthbound business from it for a requisite number of days. You – meaning your company, not you personally – must be a bona fide resident of the treaty country.
One way to satisfy that requirement is for the company to be fifty-percent or more owned by residents of the treaty country. Another way is to conduct a substantial business operation in that country and to conduct operations in the second, treaty-counterpart country that are the same or similar to the operations conducted in the first country. You can also qualify as a bona fide resident of a treaty country if your stock is traded on a public exchange in that country.
To summarize, there is no great tax dodge to be had in operating a business or businesses across international borders of developed countries. But there is predictability and coherence, as well as some opportunity for tax minimization, to be had by working through the strainer of modern tax treaties.
(Treaty or no treaty, moreover, a taxpayer’s resident country will credit income taxes paid to foreign taxing authorities against taxes owed in the resident country)
Is all this clear so far? Many business owners are lost in their own space when it comes to achieving the optimal mix. The reality is that it is intensely fact specific, you face tough trade-offs at every turn, and the facts and law keep changing. And we haven’t even touched on transfer pricing or the particulars of foreign employees and other cross-border payments for personal services.
You may ask, so what about Apple’s deal in Ireland? And what about uncertainty over Great Britain’s transition out of the European Union?
The kind of sweet tax deal that drew Apple to Ireland is better suited for established, well-capitalized companies. Star Wars you are not. You’re not even Star Trek. Sorry. (To repeat, don’t let the tax tail wag the do-or-die business issues dog)
As for Brexit, when Janet Yellen and Mario Draghi figure that out — and then tell me — I’ll get back to you.
P.S. While your 1998 movie had great special effects, I really missed June Lockhart and the aluminum foil.
Professor and Mrs. John Robinson