With the increased demand for transparency and more extensive financial reporting from public and private companies, many C-suite executives have paid closer attention to their companies’ tax functions. While attention has shifted to the tax function’s role as an important tool for maintaining regulatory compliance, its ability to create real, quantifiable value for an organization should not be overlooked.
To be sure, tax strategy is often ancillary to a business’ strategic decision-making process. But if it’s incorporated into the earlier stages of corporate decision-making, tax strategy can become a powerful tool for minimizing a company’s effective tax rate, thereby increasing cash flow and creating more opportunities for business investment.
This adage leads many finance chiefs to conclude that attractive tax planning opportunities should not override a company’s basic economic forecasts because tax strategy and economic reality must first align. That is largely true. While tax incentives can drive core business functions, they should, more often than not, form only part of an organization’s overall business plan.
That truth sometimes obscures a larger issue. More often than not, the tax function is brought into the fold to identify issues and manage implementation only after material decisions have been made. A back-end approach to tax planning indeed works well for many companies. But it can fail to capture full tax optimization, especially as it relates to the kind of international structuring many companies with overseas sales are (or should be) engaging in today.
Finance chiefs are indeed aware of the tax savings and corollary benefits that tax planning can produce on the back end. Added capital and better cash flow can help to streamline operations and permit more responsive investments.
Why, then, should the tax function’s power not be harnessed during the initial strategic decision-making process, when its ability to create value often exceeds what’s possible on the back end? Doing so may later reduce the time and expense needed to streamline a company’s structure as it expands.
As companies seek greater access to foreign markets, finance chiefs are well suited to lead the charge toward introducing tax planning as an important issue to consider alongside traditional early-stage criteria. That said, finance chiefs for companies with existing global structures should also make an effort to explore optimization opportunities, since existing global structures can often be reorganized to optimize tax benefits.
IP Tax Planning for the Global Economy
Intellectual property is generally the most valuable asset held by technology companies and many other businesses across all sectors of the economy. Generally speaking, if sales attributable to IP will be used only in the United States, it’s likely to be more tax efficient for such rights to remain here.
But if a corporation expects to commercialize IP internationally, the company likely should transfer the rights to the IP to a foreign subsidiary. Doing so enables companies to take advantage of lower corporate income tax rates available abroad. And while United States companies generally must pay tax on their worldwide profits at a rate of 35%, taxes on certain income earned abroad can be deferred indefinitely if the income remains overseas.
As IP gained more significance in the global economy, many European countries began to lure companies to their borders not only with lower overall corporate income tax rates, but also with significantly reduced tax rates specifically applicable to income derived from IP. The latter efforts have come to be known collectively as “innovation box” or “patent box” regimes. Google, Apple, Microsoft, and many other well-known technology companies have taken advantage of this strategy.
Companies currently enjoying innovation box benefits must tread carefully in light of recent innovation box regime changes. Broad-based international corporate income tax reform has long been a heated talking point in the United States and in many European countries, but has only recently gained legislative traction.
Final recommendations to member countries were issued in October 2015 as part of the Organization for Economic Cooperation and Development’s (OECD) Base Erosion and Profit Shifting (BEPS) initiative, which generally seeks to align taxation with substance by preventing profits from being shifted away from countries where value is created.
The OECD’s recommendations encourage member countries to condition innovation box benefits on material economic activity occurring within their borders. Many existing innovation box regimes don’t require material economic activity to occur within their borders before taxpayers can claim benefits on IP income sourced to those countries.
Companies currently enjoying innovation box benefits must seriously consider the OECD’s recommendations because they could soon be required to move their research and development or manufacturing activities in order to maintain the status quo.
While not legally binding, the recommendations have already been endorsed by a number of European countries. The United Kingdom announced that its existing innovation box regime will incorporate a modified nexus component, which will use R&D expenditures in the country as a proxy for material economic activity. Luxembourg’s finance minister announced in the country’s 2016 draft state budget the repeal of Luxembourg’s existing innovation box regime. In the United States, legislators are debating the merits of the first-ever domestic innovation box.
Overall, innovation box planning is one among a myriad of tax planning opportunities available to companies with overseas income or those looking to expand to foreign markets. The sooner a company incorporates a thoughtful tax strategy into its structure, the greater the economic benefits of reduced effective tax rates and greater cash flow can be realized.
Mitchell R. Kops is the global head of corporate tax at the law firm Withers Bergman. Jill Kelley is an associate attorney at the firm, specializing in tax matters.