My children watched me prepare my 2012 tax return and had some questions. The concept of taxes is a bit alien to 10 year olds, but they were taken aback about the rates of tax and asked, “Can something be done to reduce the amount of tax?” I let them know the question is a common one, and there are always opportunities to mitigate taxes, typically on the front end of transactions and activities and not after the fact.
The changes enacted just after the New Year may allow for some opportunities. Qualified dividends still receive the benefit of the preferential long-term capital gain tax rates rather than ordinary income tax rates. The Medicare tax on investment income has added some additional tax cost and complexity for many taxpayers. The recent changes in tax law once again will require careful consideration of the tax consequences of different investment decisions. However, this doesn’t apply only to the recent changes but to taxes in general.
Many business investment decisions are based on the rates of taxation (income, property, VAT, etc.) of doing business with respect to a particular jurisdiction. Many businesses evaluate where in the U.S. to conduct business activities and where to locate manufacturing facilities and other operations. State and local tax incentives often impact this decision. Taxes impact cash flow and cash flow impacts business profits and shareholder value. Investment decisions, whether purchasing a stock, or investing in a municipal bond, or structuring an entity as a C corporation or an S corporation, all involve tax implications that should be considered.
Many of us can relate to the considerations for the use of S corporations or limited liability companies by individual investors. The utilization of these entities allows for one level of taxation on the business profits generated by the S corporation or LLC. In addition, as we discussed two months ago, the use of a Domestic International Sales Corporation, or DISC, can reduce the effective rate of taxation on export profits of a business to as low as the qualified dividend tax rate rather than the ordinary income tax rate on a business’s export-related profits.
Tax efficiency is a common discussion among many companies. In 2012, two large hospitality groups announced plans to convert to real estate investment trust, or REIT, structures for the hotel real estate segment of their businesses. This follows a trend of a number of companies with significant real estate assets making a REIT conversion. In the REIT conversion situations, the use of the REIT allows for one level of tax if the income of the REIT is distributed to the REIT shareholders. The tax liability (similar to S corporations and LLCs) is generally borne at the shareholder level rather than the corporate level. In fact, several large timber products companies have reorganized as REITs in recent years, which takes advantage of the provision in the tax code that treats sales of standing timber as capital gains and thus passes out the REIT distributions as qualified dividends that are taxed at the long-term capital gains tax rate rather than ordinary tax rates.
Foreign investors with U.S. activities take advantage of the ability to use debt and receive interest payments at favorable tax rates of withholding tax under double tax treaties with the major trading partners. In most tax treaties, the withholding rate is zero for interest payments to qualified residents of the treaty country.
Foreign investors also use debt and interest to repatriate earnings from their U.S. subsidiaries. The ability to receive U.S. interest deductions at the relatively high U.S. corporate tax rate allows many foreign investors to obtain benefits from the tax rate arbitrage on the interest payment. For example, the U.K. just announced it is dropping its corporate rate to 20 percent in 2015. Any interest paid by a U.S. subsidiary of a U.K. parent receives a tax benefit in the U.S. at approximately 40 percent (federal and state combined marginal tax rate), and the U.K. parent pays tax in the U.K. on the same payment at 20 percent. Thus, a nearly 20 percent rate arbitrage on the interest payment. This tax savings can be enhanced further with some more sophisticated tax planning.
The recent changes in the U.K. and other foreign trading partners have assisted in the debate in Washington on corporate tax rates. The U.S. corporate tax rate is high in comparison to Canada (26 percent), the U.K. (moving to 20 percent), Ireland (12.5 percent) and other trading partners. Many U.S. companies also utilize tax strategies to reduce foreign taxes. There have been news reports about the use structures referred to as “Double Irish” and “Dutch Sandwich.” Some of the tax authorities in Europe have taken issue with the impact these strategies have on their local income tax receipts.
In addition to corporate tax rate reductions, most of our trading partners have adopted tax regimes that provide an exemption for foreign profits repatriated to the U.S. if generated from active business operations in other countries. Germany, France, the U.K., Canada and Japan all have some an exemption system that exempts 95 percent or 100 percent of foreign profits from additional tax when the profits are repatriated back to the home country. The U.S. doesn’t provide such an exemption but rather taxes the profits distributed at the full U.S. tax rate and allows for a foreign tax credit for any foreign taxes paid on the profits. In addition, the U.S. has a complex foreign tax credit mechanism that doesn’t always allow for a full credit of any foreign taxes paid on the foreign profits. This is why we see the news reports of multinational companies accumulating significant amounts of cash in their foreign subsidiaries. There would be a significant U.S. tax cost to repatriate the profits back to the U.S.
Some U.S. companies have become creative in the strategies that are employed to access the cash in the foreign subsidiaries and use it in the U.S. The Wall Street Journal reported recently on the dueling loan strategy employed by several U.S. multinational companies to access the cash that is sitting in their foreign subsidiaries. A series of short-term loans are arranged to maneuver through some U.S. tax rules to avoid current U.S. taxation on the use of the foreign cash on temporary basis.
As the budget and sequester debates continue in Washington, Congress and the Obama administration have their own thoughts on tax policy and tax reform. The recent changes in tax rates for 2013 and beyond may, and likely will, impact business investment decisions. As Washington considers tax reform, it hopefully appreciates how taxes impact business decisions and economic activity. And when the reform is complete, new planning opportunities will likely result.
William Roth is a tax partner with the local office of BDO USA LLP. The views expressed are those of the author. The comments are not to be considered specific tax or accounting advice.