International tax planning is the main ingredient for success in a tech startup. Planning, launching, and developing a global tech startup is stressful, but exciting. We are now addressing the founders who are really intended to take their companies global (not just enjoy a smoothie). Such founders have to find out where VAT goes when they work with Google Play and where it goes when they work with App Store, and as well deal with lots of other major and minor issues, including the following:
- What to do with IP rights and where to keep an IP-Box?
- There are 195 (or even more) countries in the world. Why does everyone opt for Delaware, USA, instead of the Democratic Republic of Congo? By the way, in some African countries, international investors are allowed not to pay any taxes for 10 years.
- Speaking of which, what’s up with taxes? How to manage taxes? And why am I thinking of a cost-sharing agreement right now?
- What is a super holding and why is it actually super?
From the moment a business idea has been invented in a garage and seed funding has been raised, startuppers make millions of on-the-spot decisions. However, they don’t think of strategic consequences of such decisions. The truth is, they don’t have to.
Still, one day, you will have to ask yourself or your lawyer: “How do I structure my business and which jurisdiction do I choose to set up a holding company?” Since you have designs on building a global company, most of your lawyer’s intellectual efforts should be focused on international tax planning.
Once you have chosen a jurisdiction, you have to decide how to pay taxes in a number of jurisdictions all over the world, since this issue will obviously arise before tax reporting deadlines. No pressure! However, if you don’t decide on the complex tax planning from the very beginning, you may suffer serious tax consequences that may put at risk the launch of your business.
In the first instance, you have to deal with three major issues: a) Which form of business do I use? b) Where to carry out core business activities? That is, how to structure a company? Which jurisdiction to choose for a head office (from tax perspective)? c) How to avoid double tax efficiently, or how to avoid paying tax at the rate of 50-100% (it is called a membership in the “100% club”.
By the way, efficient international tax planning offers the businesses another benefit, which is not very obvious: a competitive advantage, as compared to competitors who are not experts in international tax planning strategies. In other words, early and efficient tax planning will obviously give you a lot of benefits.
How to structure a business?
Most of Ukrainian companies started as Ukrainian residents. As their businesses continued to grow, they began to incorporate companies in other jurisdictions. Founders or CEOs may choose between two major options for international corporate structuring: corporations or flow-through entities (also referred to as fiscally-transparent entities), where investors/owners are taxed on revenues, taking into account their shares in the revenue, not the entity itself.
It’s a long-established worldwide tradition to incorporate companies in jurisdictions with appropriate product markets, investors, and adequate tax regulations. In some cases, industry specifics should be taken into account as well.
When launching a startup, you can choose any form of business
In some jurisdictions, corporations may receive partial corporate income tax refund. For example, in Malta, for commercial activities, tax refund rate is 6/7. Let us say, a certain Maltese company has received 100 000 EUR as a result of its commercial activities and paid 35% of corporate tax, i.e. 35 000 EUR. A foreign entity is a shareholder who owns 100% of a company. The Maltese company distributes dividends to its non-resident shareholder, who is entitled to apply for tax refund at the rate of 6/7. Therefore, the amount of tax refund (which will be refunded to a shareholder by the Maltese tax authority) equals 30 000 EUR. In this case, corporate tax burden in Malta equals 5%. On the other hand, high corporate tax rate may be significantly reduced for a company incorporated as a flow-through entity.
Where to conduct business operations?
There are three main options for setting up a company: the USA, the EU, or a jurisdiction with low tax rates. When tech startups enter the global marketplace, they often underestimate the influence of international tax structures or other financial operations on them (and their investors as well) in the course of their business activities. That’s why startups should be aware of risks and take measures that will help avoid double taxation and reduce their total tax rates.
Jurisdictions play the most important role in business tax structuring. For instance, the Internet that provides endless opportunities for business operations. If you are engaged in e-commerce, it is quite possible that your business will go global. This means that you will be able to issue software licenses in other countries, sell products in foreign jurisdictions or outsource your brilliant IP works to India, Israel or even Ukraine.
Therefore, entrepreneurs should understand the main aspects of international tax law that defines the countries that have the right to withhold tax not only from a company’s future revenue, but as well from its owners and employees. Entrepreneurs should know what activities will be defined as tax presence on any continent. In addition, entrepreneurs should know where they can get tax incentives, tax holidays, and be able to reduce their tax base.
Residency and territory
Every jurisdiction defines tax procedures for residents and in-state business operations. Taxes are as a rule deducted based on the following principles: citizenship; residency; source of revenue.
Citizenship-based system is easy. It depends on an individual’s citizenship or on a place where a company has been incorporated. Countries applying this system may tax you on your worldwide income.
Territorial (residence-based) system depends on where people, property, or a company’s head office is located. That is, tax is withheld under the laws of a jurisdiction where a company’s head office is based. In jurisdictions with territorial tax system, only non-resident’s local income is taxed, as well as dividends, interests, royalty, etc. Income earned by residents outside of a country is not taxed.
Countries may follow the source-based taxation principle, according to which they tax businesses operating in a certain jurisdiction (for instance, Ukrainian web-designer’s client base is in the USA). If a country taxes a company based on its source of income, only income generated in this country will be taken into account when defining a taxable base for income tax purposes.
As for Ukraine, residents and non-residents are taxed on their income earned in Ukraine.
Elimination of double taxation and membership in the “100% club”
Imagine the World Quidditch Cup, where all referees use different rules. In this case, it would be almost impossible to avoid conflicts. International tax law is very similar to this game. Conflicts between the countries with different tax rules arise every day, which can lead to double taxation, penalties, and can even be fatal for a company (or for a taxpayer). Actually, without proper tax planning, tax may be levied in multiple jurisdictions at the same time, which can result in the total tax rate equal to more than 50% of the revenue. Therefore, understanding of basic tax rules in this or that jurisdiction allows avoiding double taxation.
Sometimes, you may find yourself in tough situations, including the following:
- A number of countries impose tax on a certain company. That is, two countries claim that a certain company is their resident subject to tax treatment.
- A number of countries impose tax on a certain business operation. What do we get here? Two countries claim that a certain entity gained income from a certain business operation in both countries, and therefore, this income should be taxed in both countries.
- 50/50. In this case, a country claims that it has the right to tax a company, since a company is a resident company, while the other country claims that it is entitled to tax transactions executed in this country.
Avoiding tax traps
While most taxpayers want to minimize double taxation risks, most countries want to increase their profit by imposing certain taxes. However, international tax system is not the Wild West. Most governments aim their efforts at avoiding, or at least, relieving double taxation in order to support the development of global commerce.
With the assistance from international organizations, such as the Organization for Economic Co-operation and Development (OECD), businesses and governments make significant efforts to prevent international conflicts and ensure equitable distribution of an international tax cake.
Methods used by governments
These methods may help startups get double taxation relief on an international level.
Some jurisdictions do not tax foreign income of their citizens, non-residents, and companies.
Other jurisdictions offer tax credits for taxpayers who pay taxes abroad (credit method), i.e. jurisdictions reduce the taxable base for a company by the amount of tax paid abroad on this income.
In addition, some jurisdictions use the exemption method, which means that a country of the owner’s permanent residence (or a place of business) or a temporary place of business exempts tax on company’s foreign revenue from an income tax base established before tax deduction.
Methods used according to international tax agreements
Usually, reduced tax rates for some types of income are provided for by international agreements. However, to seek for this tax reduction, you have to make sure that reduced or zero tax rates may actually be available for you. These agreements should set forth at least the following:
- What is residence and physical presence
- How is a source of income defined in this or that jurisdictions?
- Establish the priority right of a country to tax the revenue generated within this country according to the territory-based taxation principle, leaving the space for countries that follow the citizenship-based taxation principle.
Risks associated with tax evasion
Let us say, a startup is doing very well and it is planning on entering foreign markets as soon as possible. For this purpose, a startup needs to incorporate a company. Its owner has chosen a jurisdiction with low tax rates for incorporation. Here is when the first risk arises in connection with a company ownership. To own an offshore company, the resident of Ukraine is required to obtain a license from the National Bank of Ukraine that allows to invest abroad. In addition, tech startups can face tax evasion changes in Ukraine, since the mere fact that you own an offshore company puts you in the so-called risk zone.
Risks are everywhere. For example, a company may be charged with tax evasion, provided that a part of a holding company’s revenue from a legal source abroad has been generated through the revenue from passive investments in a jurisdiction with low tax rates. In addition, there are risks associated with transfer pricing, when a company’s total revenue has been generated through triangle sales, where a part of operations is carried out between related companies (controlled operations). This means that such triangle operations may be used to change a company’s total revenue base through manipulations or by failing to comply with the arm’s length principle in such controlled operations. Eventually, if IP rights have been transferred not at the market price established according to applicable regulations, tax authorities may define this operation as a deed of gift.
Some aspects of transferring IP rights abroad
It should be taken into account that before you transfer IP rights to any jurisdiction, you should check and double check every detail. For example, in the USA, under the anti-tax evasion rules established by the Internal Revenue Service (IRS), you may not assign intangible assets, such as intellectual property. That is, you may not assign intangible assets to foreign companies you control. Such transferring of IP rights is defined as sale at the fair market price in exchange for royalty throughout the validity term of intangible assets. Fair market price is defined based on the revenue earned from such intangible assets. Therefore, you should be very careful.
Do not step over the line. Efficient tax planning is your key to Narnia
Taking into account the numerous components of international tax planning, it is obvious that while dealing with tax planning and looking to reduce total tax rates, global start-ups should not step over the line and run into danger of being charged with tax evasion. Instead, they should use the benefits of tax credit or tax deferral methods in order to manage their tax obligations legally and fairly.
To cut the long story short, rules and restrictions applied to foreign tax credit and tax exemption methods are complicated and all too often unavailable mechanisms. Skills and experience are the essential components for technological start-ups launching their business ideas on the global market. In addition, skills and experience may help avoid the membership in the “100% club”. Obviously, the tax credit method, if available and properly used, may significantly reduce tax obligation for companies doing business abroad. However, there are numerous difficulties one may come across. If worst comes to worst, you may run the risk of paying double tax or 50% of your revenue in taxes, and consequently, become a member of 100% club.
One of the main tasks for entrepreneurs is to stay away from anything that could be identified as tax evasion. However, at the same time, entrepreneurs should use the advantages of existing tax regimes (for example, elimination of double taxation, tax deferment for non-repatriable currency earnings, etc.).
Tech startups, their founders, owners, investors and entrepreneurs prowling the Internet and e-commerce, businesses developing copyrightable works, or simply dudes who are ambitious enough to do business abroad, will sooner or later have to deal with tax structuring and choosing jurisdictions. Therefore, it’s better to manage international tax structuring right from the very start of your company. Certainly, you can later rebuild your business structure, but restructuring is a time-consuming, complicated, and quite expensive procedure that rarely turns out to be efficient.