The Rising Tax-Electivity of U.S. Corporate Residence

The Rising Tax-Electivity of U.S. Corporate Residence

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In 1975, Bill Gates moved to New Mexico and founded Microsoft there. This may have been a mistake. William Woods, while head of the Bermuda Stock Exchange, claimed that Gates “would be fabulously more wealthy if he had started Microsoft in Bermuda . . . [H]is ignorance about tax cost him a fortune.” As the author of the article quoting Woods, adds, “Mr. Gates has not done badly even so, but he knows better now. The new company that he recently cofounded is now incorporated in Bermuda.” Notwithstanding any boosterism or hyperbole that one might detect in this statement, Woods had an undeniable point. Gates' new company, as a foreign corporation for U.S. federal income tax purposes, is taxable in the United States only on what the U.S. rules classify as domestic source income. Microsoft, by contrast, as a U.S. corporation and thus, under the rules, a resident taxpayer just like any individual who is an U.S. citizen, potentially is taxable in the United States on all of its worldwide income. This may be inconvenient for a company like Microsoft, not just because it earns vast profits abroad, but also because its resident status impedes tax planning that otherwise might have been available to minimize its domestic source income, as defined by the U.S. rules. Once a company is incorporated in the United States, however, escaping its status as a U.S. resident is difficult. It may require genuinely being purchased by new owners, such as a private equity fund or else a distinct foreign company with its own shareholders and managers. “Real” expatriations of this kind do happen, and U.S. international tax law effectively encourages them by making them a magic bullet for eliminating domestic resident status, but the associated ownership disruption may go well beyond what a large, successful company such as Microsoft is willing to contemplate just for the tax benefits. Bill Gates is not the only entrepreneur to learn in recent years that up-front U.S. incorporation of a contemplated multinational enterprise may neither be wise from a tax standpoint nor necessary from a business standpoint. Increasingly, Americans forming new companies with global business potential, as well as foreigners who want to reach investors in U.S. capital markets, have found that they do not need to pay the tax price of incorporating at home. Foreign incorporation—often in jurisdictions such as Bermuda and the Cayman Islands that lack significant domestic income tax systems—has become more common, and I have heard U.S. tax lawyers joke that recommending (or even not objecting to) U.S. incorporation of an intended global business verges on being malpractice per se. Increasingly, moreover, other countries—not just those like Bermuda and the Cayman Islands that cater to foreign investors, but even major industrial powers like England, France, Germany, and Japan--do not comparably attempt to tax resident companies on their worldwide business income. Instead, they have primarily territorial tax systems (also known as exemption systems), in which resident companies' foreign source active business income generally is exempt from domestic taxation. This effectively increases the relative tax price of U.S. incorporation for a projected global business. The fact that U.S. incorporation of new global businesses is moving towards being just an undesirable election—whereas terminating U.S. residence for existing companies is far more difficult—is at once well-known in the international tax policy literature, and yet, to a surprising degree, ignored. Each half of the picture has an important implication. Rising electivity for new companies is potentially a game-changer. The long and frequently vociferous debate about whether the United States should seek to strengthen its worldwide taxation of resident companies, or instead follow the rest of the world by moving towards exemption, would become a historical curio over time if there were no significant nontax reasons for incorporating in the United States. A mere election to pay more tax, by gratuitously subjecting oneself to the U.S. worldwide system (such as it is), would make too little sense even to matter-though, by the same token, this would rebut claims by exemption's proponents that this system was actually harming the U.S. economy. Moreover, while electivity is likely to remain incomplete, the underlying factors thus limiting electivity need analysis, as they help determine the actual consequences of a worldwide residence-based tax.

Source Publication

ITP@20 [1996-2016]

Source Editors/Authors

H. David Rosenbloom, Igor Alexandre Felipe de Macêdo, Amanda Kazacos, Francisco Lisboa Moreira, Carlo U. Olivar

Publication Date

2016

The Rising Tax-Electivity of U.S. Corporate Residence

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