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TAX CONCEPTS

FOR OFFSHORE INVESTORS

Enrique Viaña

eviana@ecem-ab.uclm.es

School of Law, University of Castilla-La Mancha (Ciudad Real, Spain)

   

Double taxation

Most governments world wide make more or less extensive use of double taxation. Double taxation often arises from concurrent corporate and personal income taxation. Assume, for instance, that you own Acme Inc., a small company. Assume further that your company annually yields a bottom-line, pre-tax profit of $100,000. Your government levies a 30% corporate tax and a 50% personal income tax. Full double taxation means that the government collects $30,000 from your company’s profit, leaving you with a post-tax profit of $70,000; and, provided that the whole post-tax profit is made payable to you, the shareholder, it collects another $35,000 from your personal income, leaving you with a total post-tax profit of $35,000. You have paid tax totaling $65,000 ($30,000 plus $35,000) on $100,000 of pre-tax earnings! This is what double taxation does. You may well call double taxation for shareholders predatory taxation.

 

Tax credits

Governments sometimes give tax credits. A tax credit is intended to ensure that only personal income is taxed. A tax credit, therefore, completely removes double taxation. In the above example, the government first collects $30,000 from your company’s profit, then gives you as a shareholder a tax credit worth the same amount. Your $30,000 tax credit allows you to pay no more than an additional $20,000 to comply with your obligation as a taxpayer. In the end, you have paid a total of $50,000 ($30,000 plus $20,000) in tax on pre-tax earnings of $100,000. You may consider a full tax credit for shareholders is 'fair' taxation.

 

Tax rebates

Governments frequently give tax rebates. A tax rebate is equivalent to a partial tax credit, and therefore only partially removes double taxation. In the above example, the government first collects $30,000 from your company’s profit, then gives you a tax rebate on your personal income. Assume that the rebate amounts to 10% of your company’s post-tax profit—it might be less, it might be more. Your company’s post-tax profit amounts to $70,000; hence, the rebate amounts to $7,000. You are liable to pay $35,000 personal income tax, but the rebate allows you to pay only $28,000 ($35,000 minus $7,000). In the end, you will have paid a total of $58,000 ($30,000 plus $28,000) in tax on pre-tax earnings of $100,000.

 

Tax evasion

Instead of incorporating in Sylvania, where you stay longer than six months a year, you incorporate in Freedonia, a foreign country. Corporate tax in Freedonia is 2%; personal income tax for non-residents is zero. Believing that the tax authorities in Sylvania will find it difficult to ascertain the amount of your earnings in Freedonia, you choose to pay taxes in a country where you do not live, rather than in your country of residence. In the end, you pay corporate tax of $2,000 and no personal income tax—a total of $2,000 in tax on $100,000 pre-tax earnings! That is tax evasion. Tax evasion is an explicit offence in almost all countries.

 

Tax avoidance

Again, instead of incorporating in Sylvania, where you stay longer than six months a year, you incorporate in Freedonia, a foreign country. Corporate tax in Freedonia is 2%; personal income tax for non-residents is zero. However difficult you think it is for tax collectors in your country to ascertain the amount of your earnings abroad, you choose to pay taxes where you are legally obliged to. Your company therefore pays corporate tax of $2,000 offshore, and you pay personal income tax of $49,000 at home (50% of $98,000, i.e. of $100,000 minus $2,000). In the end, you have paid a total tax amount of $51,000 ($2,000 plus $49,000) on $100,000 pre-tax earnings—an amount close to a full tax credit. That is called tax avoidance.

 

Tax diversion

Assume, as in the above example, that you run a small business yielding $100,000 in pre-tax earnings. The government levies a 30% corporate tax and a 50% tax on personal income, yet grants you a tax rebate amounting to 10% of your post-tax corporate earnings. You would then pay tax totaling $58,000 ($30,000 corporate tax plus $35,000 income tax minus a $7,000 rebate). You think that’s too much money. You close down your facilities and then incorporate offshore so that you exactly replicate the small business abroad. Your business yields, as before, pre-tax earnings of $100,000. The foreign government levies a 2% corporate tax and zero tax on non-residents’ personal income. You pay $2,000 to the foreign government, repatriate the remaining $98,000, and pay your government $49,000. Thus, you pay tax totaling $51,000 ($2,000 corporate tax to the foreign government plus $49,000 personal income tax to your government). You have avoided double taxation to the extent of $7,000 ($8,000 you paid in excess of a full tax credit before minus $1,000 you pay in excess of a full tax credit now). The situation for your government, however, is quite different. The tax authorities in your country calculate that, even though you now run a business that exactly replicates the business you ran before, you are paying them only $49,000 instead of the $58,000 you paid them before. The difference of $9,000 is called tax diversion. Tax worth $2,000 has been diverted abroad (to a foreign government) and tax worth $7,000 has been diverted at home (into your own pocket). Moreover, not only are you currently taking $9,000 away from the government, but also the expectation is that, ceteris paribus, you will take $9,000 away from the government next year and every year thereafter. If you divert $9,000 from your government’s tax revenue every year, the government must surely borrow that amount from the financial markets by means of debt issuance. Assume that the cost of capital for your government (i.e. the interest rate on Treasury bills) is 5%. The discounted value of a perpetual stream of $9,000 a year amounts to $180,000 when the discount rate is 5%. Assume that the two governments are not bound by a treaty to avoid double taxation¾ a reasonable assumption. Your government will be inclined to deem your tax diversion as if you had taken $180,000 away from Treasury, given $40,000 to a foreign government and put the remaining $140,000 into your own pocket. For most governments world wide, tax diversion is a form of tax evasion. One could say that tax avoidance that gives rise to tax diversion is imperfect tax avoidance, and always risks being treated by tax authorities as pure tax evasion.

 

Tax reversion

Assume that you reinvest the amount of tax you have diverted to your pocket ($7,000 a year) at the same rate of return as the total capital invested. Let the rate of return be 6% a year. In the year after you incorporate off-shore, you earn $420 in addition to your $100,000 pre-tax earnings, and this amount yields additional corporate tax of $8.40 (accruing to the foreign government) and additional income tax of $205.80 (accruing to Treasury). This is called tax reversion. You reinvest the remaining $205.80. In year 3, you will have invested $14,205.80 (tax savings worth $7,000 in year 1 plus interest on those savings worth $205.80 plus tax savings worth $7,000 in year 2) in excess of what you would have invested had you not incorporated off-shore. Thus, year 3 pre-tax earnings will amount to $852.35 in excess of the home-incorporation option; additional corporate tax will amount to $17.05 and additional income tax to $417.65. Similarly, in year 4 additional income tax will amount to $635.75, in year 5 to $860.20, and in year 6 to $1,091.30. After year 52, you will have diverted $468,000 away from Treasury and reverted $472,208.85 to it. Undoubtedly, tax collectors will not wait that long. Because of the interest borne by Treasury bills, the outcome of a full reinvestment of the tax flow, annually diverted to your pocket by incorporating off-shore, will be worse than shown by these figures. At an annual rate of 5%, it will take no fewer than 124 years of tax reversion to offset the tax diversion effected by your incorporating abroad plus the capital cost needed to make good the financial gap! That is why you need to offer some positive inducement, in addition to passive tax reversion, to persuade the tax authorities not to target you.

 

Tax creation

Assume, in the example developed so far, that you do not simply replicate abroad the business you ran at home. Assume instead that you de-invest at home to promote a similar offshore business that is, however, a little more profitable. Thus, assume that in the first year after incorporating offshore you earn $110,000; that is, $10,000 in excess of your usual earnings at home. The foreign country’s tax authorities impose a 2% corporate tax, or $2,200, and you repatriate the remaining $107,800. Tax authorities in your country impose a further 50% income tax, or $53,900. This amounts to $4,100 less than before incorporating offshore, or the compound effect of tax diversion worth $9,000 plus opposing tax creation worth $4,900.

 

Perfect tax avoidance

Now assume that in the first year you earn $118,367.35 instead of $100,000. The foreign country’s tax authorities impose a 2% corporate tax, or $2,367.35, and you repatriate the remaining $116,000. Tax authorities in your country impose a 50% income tax, or $58,000, an amount that leaves Treasury neither better nor worse off: tax creation equals tax diversion. You pay a total tax of 52%, six percentage points below the figure you used to pay; but for Treasury, there is no tax loss at all. There is some domestic redistribution of taxes ($30,000) from corporate tax to personal income tax, which cannot affect the overall financial position of Treasury. That is what perfect tax avoidance does. Perfect tax avoidance is simply tax avoidance in which tax creation exactly offsets tax diversion.

 

Tax risk

Those figures are not as impressive as they seem; for instance, if $100,000 represents a 6% return on capital invested, a 7.1% return would be $118,367.35. Undoubtedly, however, perfect tax avoidance is a somewhat ideal solution to the tax problem—something that you can easily find out in theory, but hardly in practice. What perfect tax avoidance presupposes is that you avoid taxes incidentally; that is, in moving from a worse-performing to a better-performing business you happen to avoid taxes. If so, why should the tax authorities care, provided that Treasury’s overall financial position does not worsen?

The same consideration justifies a strategy aiming at tax avoidance, even when this is not perfect. Whenever you close down at home to incorporate offshore, and so do better business than before, this is legitimate behavior from the standpoint of economic efficiency, regardless of whether Treasury’s financial position is made better or worse as a result. If you do better business but your behavior gives rise to net tax diversion (i.e. tax diversion in excess of tax creation), then the problem you will have with the tax authorities is that they will seek to prove that your offshore business has performed less satisfactorily than business at home; that is, they will seek to prove that, if you have earned more money than before, business at home has improved its profits by even more. If proved, this would entitle them to infer that you incorporated offshore not in order to do better business (which allegedly you could have done at home) but in order to evade taxes.

So far, the actual risks that you run when you incorporate off-shore are twofold: on the one hand, economic risk, or the risk that you will not earn as much money as you expected; on the other hand, tax risk, or the risk of being prosecuted for evading taxes. If, for instance, you previously earned $100,000 a year, but you earn $105,000 a year now, you stand a chance of avoiding incrimination. If, however, you now earn only $95,000, the tax authorities will argue that you expected this outcome; for, after paying $1,900 corporate tax off-shore and $46,550 income tax at home, you keep $46,550, or 10.8% more post-tax income than you earned before ($42,000 a year). It therefore looks as if you had planned to earn $5,000 less pre-tax to earn $4,550 more post-tax, imposing the entire loss upon Treasury. Whereas previously it collected from you $58,000, it collects $46,550 now; that is, $11,450 less than before ($1,900 diverted towards a foreign country plus $4,550 diverted into your own pocket plus $5,000 to make good your loss of efficiency). If the tax authorities succeed in suing you for this, you face a serious problem. This risk explains why many businessmen are reluctant to incorporate offshore.

 

Tax feasibility

So far, you have probably understood why incorporating abroad is so hard for national corporations but so common among multinational corporations. The latter prepare thorough briefs to persuade Treasury of the advantages of their international investments. Treasury has learned from experience that multinational corporations’ plans for perfect or quasi-perfect tax avoidance (known as ‘tax-feasibility’ plans) usually pay. You too may benefit from tax-feasibility plans that enable you to incorporate offshore both profitably and safely; but you need to have them drawn up by genuine experts.

 

 

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