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Archive for February 29th, 2012

International Tax Reform: What Does It All Mean?

Posted in Uncategorized, tagged , , , , , , , , on February 29, 2012 | 3 Comments »

Last week, in our reactions to President Obama’s proposal for corporate tax reform, we took special note of the president’s continued push towards a  ”worldwide” international tax system; one  that greatly expands the reach of the U.S. in taxing non-U.S. sourced income earned by foreign subsidiaries.

Most notably, we highlighted just how dramatically the president’s proposal deviates from those posited by the leading Republican candidates, who favor the “territorial” systems adopted by much of the developed world.

But what do “worldwide” and “territorial” international systems really mean? How do they compare to our current system? And more importantly, how would they change the way the U.S. currently taxes the icnome earned by foreign subsidiaries of domestic corporations?

To illustrate, let’s take a simple fact pattern:

X Co. is a U.S. corporation. X Co. owns 100% of Foreign Co., a foreign corporation that generates no revenue from U.S. sources.

How is Foreign Co.’s income taxed by the U.S. under either:

1) The current “deferral” international tax system?

2) The “territorial” tax system proposed by Mitt Romney and Newt Gingrich?

3) A more expansive “worldwide” tax system as proposed by President Obama.

Current  ”Deferral” Tax System

Under the current system, there is generally no U.S. tax imposed upon the earnings of Foreign Co. until the earnings are repatriated to the U.S through a distribution to X Co. At that point, X Co. will pay U.S. tax on the dividend received from Foreign Co., subject to any tax treaty between X Co. and Foreign Co.’s resident nation.

Upon receiving the dividend, X Co. is permitted to utilize a foreign tax credit to reduce the U.S. tax applied to the dividend, preventing the same income from being taxed twice: once when earned by Foreign Co. and a second time when distributed to X Co.

Pros:

  • The current “foreign tax credit” system ensures that even where Foreign Co. enjoys a lower tax rate in its home nation, tax will ultimately be imposed on the earnings of Foreign Co. at the U.S. corporate rate;
  • U.S. tax is not imposed upon income earned by F Co. until the earnings are repatriated to the U.S.

 Cons:

  •  An administrative nightmare;
  • Encourages X Co. to leave Foreign Co.’s profits offshore to avoid the imposition of U.S. taxes upon repatriation;
  • Gives birth to a wide variety of accounting tricks and sophisticated tax planning measures employed to minimize the U.S. tax burden, which ultimately reduce U.S. tax revenue.

Territorial Tax System

Under a territorial tax system, U.S tax would never be imposed on income earned by Foreign Co. from non-U.S. sources. The U.S. would simply allow Foreign Co.’s home country to tax its earnings. When Foreign Co.’s earnings are subsequently repatriated to X Co., the dividends would not be subject to U.S taxation.  

Pros:

  • Greatly reduces the complexity of international taxation;
  • Eases the administrative burden on multinational corporations;
  • By eliminating the U.S. tax on repatriated foreign earnings, U.S. companies will no longer have to pay to bring overseas income “home,” thus encouraging investment in the U.S.

Cons:

  • Encourages U.S. corporations to shift activities to jurisdictions with lower corporate tax rates, taking jobs and revenue along with them and eroding the U.S. tax base.
  • Transition concerns; What do you do with the foreign income that was previously earned but not yet repatriated to the U.S.?  

A More Expansive Worldwide Tax System

President Obama is proposing a sea change in the way the U.S. taxes international operations; one which embodies the opposite characteristics of the system proposed by his Republican counterparts. The president would eliminate the current laws that permit domestic corporations to defer U.S. tax on Foreign Co.’s earnings until they are repatriated by instituting a worldwide minimum tax. This tax would be imposed on Foreign Co.’s income when earned, regardless of whether it was U.S. sourced or when it is repatriated.

Pros:

  • More tax revenue for us!
  • Does not distort the decision of where to invest.
  • Eliminates incentive to game the system, since the U.S. will tax Foreign Co.’s earnings, wherever they may be.

 Cons:

  • Makes the existing administrative nightmare even worse;
  • I’m not sure if this is a pro or con, but it is the opposite system that much of the developed world is adopting, potentially putting us at a competitive disadvantage.
  • Is sure to be highly opposed by powerful corporations that have successfully shifted much of their earnings overseas under the current regime.

Which system is the best? It’s nearly impossible to say at this point, because under no scenario would the U.S. adopt a pure territorial or worldwide international tax system. Any territorial system would have to adopt elements of a worldwide system to curb abuses, and vice versa. As indicated above, there are advantages and disadvantages to each of the options, and ultimately, the devil will be in the details.

This much is clear, however; the chasm that exists between the proposals fronted by President Obama and the Republican candidates is material and meaningful, and stands to garner more attention as November nears.

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Tax Season Lesson #6: Proper Treatment of Organizational and Start Up Costs

Posted in Uncategorized, tagged , , , , , , on February 29, 2012 | 3 Comments »

Willie Moore (Moore) spent his 9-5 as a system support analyst for the city of Houston. On the side, Moore started a used car dealership, and for the first year the dealership was in existence, he attached a Schedule C to his tax return reflecting no revenue and $35,000 in expenses.  

The IRS disallowed the $35,000 loss incurred by the dealership, and the Tax Court upheld the disallowance. The court did so despite acknowledging that most of the expenses were legitimate, substantiated costs necessary to get the dealership off the ground.  

So then, why were the expenses disallowed?

Because in general, when a taxpayer incurs expenses in forming a Schedule C business or separate corporation (together, “a business,”)  those costs create an asset with a life longer than one year, i.e., the business. And as a basic tenet of tax law, those types of expenses must be capitalized. Making matters worse, because a business does not have a readily determinable lifespan, barring a statutory exception, these initial expenses would not be eligible for amortization.

And though Congress granted a reprieve with the enactment of Code Sections 248 (dealing with organizational costs) and 195 (dealing with start-up costs.) — which allow a new business to elect to expense or amortize costs that would otherwise go unamortized – each of these sibling sections contains a triggering date that signals the appropriate time to deduct the expense or begin the amortization. Attempt to deduct these costs prior to that triggering date — as Willie Moore did — and you face disallowance at the hands of the IRS.

Organizational Costs

Think of organizational costs as the expenses that give birth to a new business, such as legal services to draft corporate charters, by-laws, and articles of incorporation, accounting and consulting services incurred to choose the entity type, and expenses of initial meetings of directors and shareholders.

As discussed above, absent I.R.C. § 248, these expenses would be required to be capitalized and would not be eligible for amortization, as they create an asset with an indefinite life. Under I.R.C. § 248, however, up to $5,000 of organizational costs can be deducted in the year the taxpayer begins business. This deduction is reduced for every dollar the total organizational expenditures exceed $50,000, and any remaining expenses are amortized over a 15-year period beginning with the month in which the taxpayer begins business.[i]

As emphasized above, organizational costs cannot be deducted or amortized until the taxpayer “begins business;” a date that is separate and distinct from that on which the taxpayer comes into existence. For example, while a corporation comes into existence on its date of incorporation, it doesn’t “begin business” until it starts the operations for which it was organized. The regulations provide that in general, the acquisition of operating assets which are necessary to the type of business contemplated should constitute the beginning of business.

Start-Up Costs

Start-up costs, on the other hand, are the next expenses incurred as part of the business life cycle; they are incurred after a business is born, but before it begins its “active trade or business.” As with organizational costs, these expenses are considered to be part and parcel with creating the business, and thus would not be deductible or amortizable in the absence of I.R.C. § 195.

Typical start-up costs upon the creation of a new business include initial advertising and marketing costs, salaries and benefits prior to starting production or generating revenue, initial accounting and legal fees beyond those incurred as part of the organizational process, and rent and utilities in the pre-opening phase.

Given those examples, perhaps its best to simply default to treating all expenses incurred by a corporation prior to starting an “active trade or business” as falling within the gambit of Section 195.[ii]  

Like organizational costs, upon election a corporation my deduct up to $5,000 of start-up costs (phased out for each dollar total start-up costs exceed $50,000), and amortize the remaining costs over 15 years beginning with the first year in which the taxpayer beings an “active trade or business.”[iii]  .

Also similar to organizational costs, the real crux of applying I.R.C. § 195 is determining on what date to begin deducting or amortizing the expenses. The regulations offer little help in clarifying when an “active trade or business” begins,  and thus the determination of when to begin amortizing start-up costs has been frequently litigated.

In general, the courts have established that it is reasonable to mark the taxpayer’s start of its active trade or business in part based on the nature of its business. For example, the courts have held that for a manufacturing business, an active trade or business begins when the taxpayer acquires all necessary assets and places them in service, even if no income has been generated.[iv] To the contrary, the courts take a more stringent view of retail businesses; holding that an active trade or business begins only when the doors are open and revenues are flowing.[v]

What Can We Learn?

Willie Moore was deinied a $35,000 loss on his start-up car dealership not because the expenses incurred were fabricated or unsubstantiated, but rather because they were incurred prior to the date the dealership began its active trade or business, and thus were not yet eligible for deduction or amortization pursuant to Section 195. In denying the expenses, the Tax Court issued a reminder to all taxpayers that just because you’ve “started your business,” it doesn’t mean you’ve started your business. 

[i] No affirmative election is made; the taxpayer is deemed to have made the election by deducting/amortizing the organizational costs in the year business begins.

[ii] Except for interest, state taxes, and R&D expenses, which are excluded from I.R.C. § 195 by statute.

[iii] Also similar to I.R.C. § 248, the election to deduct/amortize is deemed to be made by the taxpayer by treating the costs accordingly on the first tax return on which the “active trade or business” begins.

[iv] Richmond Television v. U.S. 345 F.2d 901 (4th. Cir. 1965).

[v] Kennedy v. Commissioner, T.C. Memo 1973-15

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