Given the timeliness of the subject, we’re interrupting our series on maximizing post-deal proceeds but will resume with our next article.
Approximately 70% of wealth in the U.S. is in the hands of families that own middle market companies. Roughly the same percentage of the U.S. economy is driven by middle market companies. And, these same companies account for about the same percentage of employment.
If one were to segregate U.S. economic growth driven by publicly traded companies and that driven by middle market firms, I’d bet one would find that the larger contribution comes from these family-owned businesses. I don’t have any empirical data on this; it’s just a gut sense.
Just after the Brexit vote in the UK, we had an article in this column about what it might mean for middle market companies. A meaningful percentage of U.S.-based middle market firms have non-U.S. operations, are considering the acquisition of non-U.S. firms, are considering organic expansion into non-U.S. markets, or might be acquired by non-U.S. firms. Because of this, what is happening in the UK with respect to Brexit can have an impact on strategic decisions that U.S.-based middle market businesses make. Hold that thought.
A few months back, we had an article in this column that said Apple’s CEO Tim Cook was absolutely right (and wrong) about U.S. corporate tax policy. The recent decision handed down by the European Commission – which Mr. Cook called “political crap” – bears down on this same issue.
In that article, we noted that the world of corporate income taxation has two “regimes.” The “territorial” regime states that the jurisdiction in which profit is generated is the only jurisdiction that gets to tax that profit. For example, let’s say that a company based in Country A has operations in Country B. Under the territorial regime, only Country B gets to tax the profits generated in Country B. Country A does not.
The “domiciliary” regime states that the jurisdiction of firm’s tax home (think residency) is the only jurisdiction that gets to tax that profit. For example, let’s say that a company based in Country X has operations in Country Y. Under the territorial regime, only Country X gets to tax the profits generated in Country Y. Country Y does not.
The vast majority of countries follow the territorial regime. The OECD advocates the territorial regime.
Of course, the United States follows an oddball path called the “unitary” regime. This method taxes resident firms under the domiciliary regime and taxes non-resident firms under the territorial regime. Why not? It’s more revenue. But, the OECD has been complaining to the U.S. for years that its corporate tax policy is out of step with the rest of the world. The OECD argues that the U.S.’s unitary policy inhibits capital formation (among a range of other ills). We’ll spare the specifics but will say that the OECD is correct.
In our prior article, we commented that Mr. Cook was right. This was a reference to Apple legally maintaining foreign-earned profits offshore. When a U.S.-based company has an operating subsidiary, as opposed to a passive investment entity, the U.S. will only tax the foreign-earned profits of that subsidiary when they are brought back to the U.S. This is a specific provision of the Controlled Foreign Corporation rules in the Internal Revenue Code. Apple is absolutely complying with the law. If this rubs U.S. policymakers the wrong way, amend the Internal Revenue Code. It really is that easy.
Now, it is important to note that because the rest of the world operates in the territorial regime, those foreign-earned profits have been taxed . . . in the jurisdiction in which they were generated. That’s the way the system works. It would be incorrect to argue that any company was dodging taxes or was not paying any tax. These companies ARE paying taxes on these profits . . . in the jurisdiction in which they were generated.
In our prior article, we commented that Mr. Cook was wrong. This was not to say that Mr. Cook was factually wrong. It was to say that Mr. Cook did not go far enough in his criticism of U.S. tax policy. This would be the opinion of the OECD. As we mentioned above, for roughly 20 years, the OECD has attempted to get U.S. policymakers to change corporate income tax policy to the territorial regime . . . without success.
So, now we turn to the recent decision by the European Commission. In that decision, the EU held that the Government of Ireland inappropriately did not tax an Ireland-based subsidiary of Apple. The EU determined what tax Apple’s subsidiary should have paid and added interest and penalties.
Ireland’s Minister of Finance disagrees with the EU decision. A former Commissioner of the Internal Revenue Service disagrees with the EU decision. And, Mr. Cook has described the EU decision as “political crap.” All of them are correct.
It all boils down to this territory regime thing. Where are the profits generated? Under the territorial regime, Ireland would only tax the profit that is generated by operations in Ireland . . . not on that generated outside of Ireland. The fact that Apple’s subsidiary is domiciled in Ireland is irrelevant. That’s the way the system works.
The conversation out there is along the line of Apple paying tax to no jurisdiction. Somehow, Apple is dodging taxes. The conversation seems to pull Apple and other companies into the outrage over certain high-profile persons using offshore accounts. But, as was mentioned above, Apple is paying taxes . . . to jurisdictions in which profits are generated . . . and is in full compliance with the law.
As such, the EU’s decision is incorrect – as a matter of technical application of Ireland’s tax law. As a matter of policy, the EU’s decision is absolutely contrary to the OECD’s policy with respect to the territorial regime for corporate income taxation. So, Mr. Cook’s comment about the EU’s decision being political is spot on.
The vast majority of individuals who understand the issues in play say that the EU’s decision was overreaching. Beyond the technical incorrectness of its decision, tax administration is a “competency” of individual EU member nations and not a power of the EU itself.
In the U.S., the Tenth Amendment of the U.S. Constitution affirms that the individual States still have the power and control over those matters that are properly theirs. Much of the Brexit vote was about the same concept. The UK believes that membership in the EU was relinquishing too much power and control over those that matters the UK felt are properly theirs. Ireland is now feeling some of that same discomfort. This is a big issue.
As has been noted, Apple will appeal the ruling and it will likely take years to reach a final decision. Nonetheless, there are far reaching implications.
For owners and executives of U.S.-based middle market companies with or contemplating having non-U.S. operations, you need to understand how the U.S.’s Controlled Foreign Corporation rules work. You need to understand how the territorial regime of corporate income taxation works. On a country-by-country basis, which regime is in play? And, you need to assess what you would do if the EU (or any other government) hit up your firm in the way that Apple has been hit up. Certainly, Apple has the financial resources to fight what is a technically incorrect ruling and “political crap.” But, do you? And, if you do, what is the cost in terms of time and energy and distraction? It’s best that you think about this now rather than in the heat of battle. You might consider adapting your strategy.
In our next article, we will be resuming our series on maximizing post-deal proceeds.
For a free PDF copy of my book about tax savings when selling your business, please email me at todd@integratedwealth.com.
