Uhhhh… you can’t say that!
By: BJ Lawson
If there’s any truth to reincarnation, given the current environment, I’d love to come back as a multinational corporation. While I’d read about the tax minimization strategies of large corporations, it never really hit home until I saw it firsthand.
I recently transitioned from a small technology startup company to a large multinational corporation. As part of my orientation to the new environment, I had a great opportunity to meet folks throughout the organization, and learn about the tremendous corporate resources at our disposal. One of the most memorable conference calls occurred with my introduction to the corporation’s overseas subsidiary. I’d done enough reading to know the purpose for this entity, so when the director on the call asked if I knew what they did, I figured I could show off: “Sure, you’re an intellectual property holding company that upstreams income for tax efficiency.”
(In English, that means that the businesses operating in the United States and other high-tax jurisdictions sell their products as “intellectual property” to this overseas subsidiary. Then, the U.S. operating business pays a handsome royalty to the overseas subsidiary for using/selling their product every year. Thus, the net income of the U.S. operating business is minimized, since the royalty payments to the overseas subsidiary are subtracted from revenue. Since tax is calculated based on net income, the corporation can then deliver more post-tax income to its owners.)
Judging from the prolonged silence on the other end of the phone, I thought something might have been lost in translation. The response, while delayed, was emphatic: “Uhhh… You can’t say that.” You see, the IRS takes a dim view of companies that set up corporate structures just to minimize taxes. (I don’t understand why, though. Why shouldn’t a person or a corporation act in its economic best interest?) So while there is widespread acknowledgment that this technique is being used, the IRS generates work for lots of accountants and lawyers to show conclusively that these sorts of overseas subsidiaries are not just passive intellectual property holding companies. Instead, they need to be operating companies that direct strategy and operations for the business units located in the high-tax jurisdiction.
As you can imagine, there are lots of late-night discussions as to how one might “prove” or “show conclusively” that an offshore company is really calling the shots and not just sitting there generating huge tax savings. You’ve clearly got to hire people over there, and those people have to be busy. They have to create Excel spreadsheets, PowerPoint presentations, have conference calls, and put cover sheets on their TPS reports. It also helps if they travel and interact regularly with their colleagues in the United States as well. Isn’t that a wonderful system?
Over time, I began to realize that I was incorrect with my initial response. This overseas subsidiary did not just collect income, it really did play an active role in operations. But is that a good thing? When you have highly-specialized, nuanced products serving folks in the U.S. market, is it good business sense to have to balance the input from “corporate” half a world away? How does that serve the customer? How does that help make the organization more agile and responsive to challenges in the marketplace?
Hint: it doesn’t. Overall it hurts the company’s competitiveness. But it still enhances the after-tax profitability of the company relative to just earning the income in the high-tax jurisdiction.
Consider this: when a country’s tax system is so punitive that companies who can afford it will create entire divisions overseas, is that country likely to create a lot of new entrepreneurial ventures as well? In the world of Internet-based businesses and global competition, the answer is increasingly no. While there still are certain industries where the advantages in the United States outweigh the high costs, new ventures are increasingly creating jobs and wealth outside of this country.
This data is a bit dated, but it gets the point across. As recently as 2005, we’re squarely in the middle of the pack, and behind China and India. So I’ll ask the question again, when will our government stop strangling the goose that lays the golden eggs of domestic entrepreneurship and job creation?