The tax advantages to a U.S. startup of incorporating offshore typically outweigh the additional administrative and compliance costs in the long run for many successful businesses. The tax advantage is due to the fact that many countries have lower corporate tax rates than the United States, and, unlike the United States, they generally do not tax the income earned outside their jurisdiction.
The conventional wisdom
To understand the long-term tax advantages of incorporating offshore, one should consider the evolution of a typical U.S. multinational formed 40 or 50 years ago and its global tax situation today. Many of these business began as S corporations or partnerships. Later, they became taxable corporations (so called “C corporations”) when they went public. Then, as they expanded overseas, they set up foreign subsidiaries owned by their U.S. parent. Although each of these steps seemed reasonable at the time, companies that have followed this path find themselves at a disadvantage when competing globally.
The U.S. tax system disadvantages U.S. companies in the global marketplace
Foreign corporate tax rates have dropped over the last 20 years when compared with the U.S. corporate tax rate. For example, the U.S. statutory corporate tax rate today (combined federal and state) is about 39%. In a recent report, the Congressional Research Service stated that the average statutory corporate tax rate of the OECD countries (excluding the United States) is only 25.5%. (The U.S. effective corporate tax rate is somewhat lower than the statutory rate, however, due to tax incentives including accelerated depreciation and the R&E tax credit.)
Tax is a significant cost of doing business, and this tax rate differential has proven to be a significant competitive burden for U.S. multinationals. In order to lower their overall effective tax rate, U.S. companies have implemented foreign corporate structures that locate foreign profit in low-tax jurisdictions. These foreign corporate structures have some major disadvantages, however:
- The lock-out effect: U.S. companies have accumulated significant amounts of cash in low-tax jurisdictions that they cannot distribute to the United States without paying a substantial U.S. income tax. The United States, unlike other developed countries, ultimately taxes all the profits that U.S. companies earn – even those earned in overseas subsidiaries. This stranded cash, which for some companies is billions of dollars, has been labeled the “lockout effect.”
- The BEPS initiative: The G20 countries are now engaged in a concerted effort to revise their tax laws and transfer pricing rules to counter many aspects of this type of tax planning. This effort is known as the BEPS (Base Erosion and Profit Shifting) initiative, and it will almost certainly raise the effective tax rate of many U.S. (and other) multinationals in the future.
- Adverse publicity: This type of planning can draw adverse media attention to a company. For example, Apple, Google, and Starbucks, among others, all have experienced unwanted media coverage over their corporate tax strategies.
The benefits of incorporating offshore
There are two principal benefits of incorporating a start-up offshore and operating through a U.S. branch (or forming a foreign holding company with a U.S. subsidiary). The extent of the benefit depends upon the jurisdiction and the characteristics of the business.
- No U.S. corporate-level tax on foreign earnings: The principal benefit of incorporating offshore is to avoid the U.S. corporate-level tax on income earned in overseas subsidiaries. Most other countries do not tax the overseas income of their multinationals. They tax only the income earned within their jurisdiction. This is called a territorial corporate tax system. With a foreign parent company, income earned outside the United States by a foreign parent (or one of its foreign subsidiaries) will not be subject to the relatively high U.S. corporate income tax. This income also will bear no other foreign corporate income tax — other than in the jurisdiction in which it is earned.
- The opportunity to locate parts of the business in lower tax jurisdictions: Having a foreign parent with foreign subsidiaries allows considerable flexibility in allocating assets, risks and functions of the group to foreign companies in lower tax jurisdictions. Consider the tax rates today in some well-known European jurisdictions: the Dutch corporate income tax rate is 25%, the United Kingdom’s main corporate tax rate is 21%; and the Irish corporate tax rate is 12 ½% for “trading income.” For many start-ups, their intellectual property is their most valuable asset. The United Kingdom, the Netherlands, Belgium and Luxembourg, among other countries, have special tax regimes to encourage R&D. The tax rate on eligible income generally is in the range of 5% – 6%.
Congress has blocked the exits
Is it feasible for the founders of a start-up to defer incorporating offshore by forming a U.S. business entity today and contributing their shares to a foreign holding company at a future date? Congress effectively blocked this path with legislation enacted in 2004. Today, when a foreign corporation acquires substantially all of a U.S. corporation (or partnership) and the owners of the U.S. corporation (or partnership) become the owners of at least 80% of the foreign corporation, that foreign corporation is treated as a U.S. corporation for all purposes of the Internal Revenue Code and U.S. income tax treaties, unless the business has very substantial activities in the foreign jurisdiction. The transaction, in effect, is ignored. Thus, in order to be effective for tax purposes, the foreign corporation usually must be formed at the inception of the business.
Incorporating a start-up offshore brings its own set of U.S. tax issues that must be addressed. The issues include:
- The foreign corporation may be a “controlled foreign corporation” for U.S. tax purposes, depending upon how concentrated its share ownership is in U.S. hands. For this reason, while the U.S. founding group owns all or most of the foreign corporation, there likely will be additional U.S. tax filings required. Also, additional tax planning may be necessary because of the U.S. subpart F rules. After a foreign company goes public, however, this should not an issue.
- Transfers of appreciated assets by the U.S. founders to a foreign corporation may result in the recognition of taxable gain by those founders. Also, special tax rules apply to the transfer of intangible assets such as patents, copyrights, etc. to a foreign corporation by U.S. persons.
- Incorporating offshore does not avoid U.S. income tax on income attributable to activities carried on in the United States, which typically will be substantial. The foreign corporation, if it has a U.S. branch (or a U.S. subsidiary, if the mutlinational carries on U.S. operations through such a subsidiary) will have to file a U.S. income tax return and pay tax on the income generated by these U.S. activities at regular U.S. corporate tax rates.
Whether incorporating a startup offshore is worth the cost and effort depends upon the characteristics of the business and the founders’ objectives. If the founders’ vision is, in the long run, to go public and operate globally, then incorporating offshore is a tax-efficient route that should be seriously considered. Just how compelling is incorporating offshore for a budding global enterprise? Some years ago, in testimony before Congress, the VP of Tax, Licensing and Customs of Intel Corporation at the time said that if Intel were to be formed today he would strongly recommend that the parent company not be formed in the United States.
The information contained herein is of a general nature and is based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.