The tactics that multinational companies like Apple, Microsoft and Hewlett-Packard use to avoid paying corporate income taxes might make one wonder why they incorporate in the United States in the first place. Why not Ireland?
Advocates of a territorial-based tax system often point out that taxing United States companies on their worldwide income creates an incentive for new companies to incorporate abroad instead. Many countries tax income earned only within their borders. The United States, by contrast, purports to tax companies on their worldwide income, with credits for any foreign taxes paid.
It’s easy to incorporate as a foreign company even if a company is truly based in the United States. According to the tax code, residency is determined by a company’s place of legal incorporation, not by the location of its headquarters, employees or activities. A company that is incorporated in Delaware or California must pay corporate income tax in the United States, regardless of the size of its operations here.
A company that is legally incorporated abroad â€" say, in Ireland or the Cayman Islands â€" has to pay tax in the United States only on income derived from United States sources. The sourcing rules are notoriously complicated, but they often understate the extent to which a company actually earns money here.
Because corporate residence is, in effect, elective, it is surprising that nearly all new companies with headquarters here elect to incorporate in the United States and pay tax here.
Two new papers by a University of Texas law professor, Susan Morse, help explain why. The first, “Tax Haven Incorporation for U.S.-Headquartered Firms: No Exodus Yet,†with Eric Allen of the University of Southern California, confirms that new companies are not avoiding the United States in favor of tax havens. Among 918 new companies identified as multinationals with headquarters in the United States, just 27 were legally incorporated in tax havens.
Why no exodus yet? In a second paper, Professor Morse takes the perspective of a new company with global ambitions and interviews founders, lawyers and investors in Silicon Valley about how they make the decision about where to incorporate.
The first reason is hiding in plain sight. Because the United States corporate income tax is so leaky, the benefits of avoiding it are smaller than they would appear to be in theory. For technology companies in particular, multinationals based here can obtain low effective tax rates on foreign income. Professor Morse reports estimates of effective tax rates of 3 percent to 6 percent a year on this foreign income.
And, as Apple and others have demonstrated, it is often possible to shift economic income from the United States to tax havens abroad, further reducing tax liability here.
The second reason is that there continue to be significant nontax advantages to incorporating in the United States. Incorporating in Delaware is fast, easy and cheap. Venture capitalists and other investors like the security and predictability of Delaware law, and companies can rely on United States courts to enforce intellectual property rights. Minority investors might be nervous about enforcing their contractual and shareholder rights in a court in Bermuda, British Virgin Islands or Ireland.
We can also learn something by studying the companies that do incorporate abroad. Professor Morse explains that a significant number of these companies are insurance carriers, which benefit from an “extremely favorable†set of tax rules that support incorporating in Bermuda. Insurance premiums collected in the United States and paid to a Bermuda parent are subject neither to income tax nor the usual withholding tax that would apply to such payments. Instead, they are subject to an excise tax of 4 percent or less.
Nontax legal factors, which normally favor the United States, can also sometimes drive companies to legally organize abroad. Commercial shipping companies, passenger cruise lines and online gambling sites are three examples. Other decisions to incorporate abroad appear to be driven by historical links with foreign jurisdictions.
What remains unclear from the research is what would happen if the United States tightened its international tax rules and eliminated deferral of foreign earnings. The nontax factors, or frictions, that encourage incorporation in the United States are substantial but not limitless. I wouldn’t walk across a hot sidewalk in bare feet to pick up a nickel, but I might do it for a $20 bill.
For a time, increasing numbers of British companies were incorporating in Jersey (as in the Channel Islands, not the shore) and moving corporate headquarters to Dublin to avoid high British taxes. In the United States, “anti-inversion†rules make it difficult for existing companies to reincorporate abroad. But no legal rule prevents start-ups from incorporating in Ireland, Bermuda or other havens.
Silicon Valley start-ups, known for being nimble and innovative, are remarkably stodgy when it comes to legal matters. Professor Morse points out that start-up founders rarely have more than a few thousand dollars to spend on legal fees, and it would cost thousands more to set up a parent company in a foreign tax haven. It is only a matter of time, however, before the global legal marketplace makes it easier, faster and cheaper for start-ups to incorporate abroad. Our best hope is that if patching our international tax rules makes incorporating abroad more attractive, founders and venture capitalists continue to focus on the short-term costs of legal innovation instead of the long-term benefits of tax avoidance.
For further readings, see Susan C. Morse, Startup Ltd., Florida Tax Review (forthcoming), and Eric Allen & Susan Morse, Tax Haven Incorporation for U.S.-Headquartered Firms: No Exodus Yet, 66 National Tax Journal (forthcoming).
For further discussion of why nontax business considerations often lead firms to organize as corporations instead of partnerships, see Victor Fleischer, The Rational Exuberance of Structuring Venture Capital Start-Ups, 57 Tax Law Review 137 (2004).
Victor Fleischer is a professor at the University of Colorado Law School, where he teaches partnership tax, tax policy and deals. Twitter: @vicfleischer
