United States as a tax haven

Transcription

Man: Let's say that I run a country or I run a company, I should say, that is based inside of the United States. So this right over here is my company. Maybe I have some smokestacks of some kind. So that is my company and it makes a million dollars in pretax profits. 1 million dollars and this is before tax, so pretax profits. Let's say that the country that I'm in and the way that I have drawn it, this is the United States. Let's say at the time that I make those pretax profits, the corporate tax rate is 35%. So it's pretty straightforward to think about how much taxes I would have to pay. I would pay 35% on this 1 million dollars or essentially I would pay $350,000 in taxes. I would have $650,000 left in profit. Now what I want to think about. Let's say my company wants to get a little bit more creative about how it might save on taxes. So what it does is it realizes that there is an island not too far off the US coast and there are actually several of them that has a substantially lower tax rate and I'm just picking it arbitrary but let's say it has a 5% corporate tax rate. So how can this company, which is physically, or for the most part based in this country, somehow benefit from this lower tax rate that is happening offshore? Well what they'll typically do is set up another subsidiary, one that this company owns and controls, but it is set up in this little island nation. So let's set it up right over here. So that's the other company. And what it'll do is it will tend to oftentimes it will give it some intellectual property, maybe patents, trademarks, things like that. So it gets all of the intellectual property of the parent company. Then what it can say is, and this is owned by the parent entity, so I'll draw a little dotted line here. It's owned and controlled by this country, this company that is based in the US. And what they'll say is, "Look we don't have a "million dollar pretax profit anymore "because we essentially licensed the use "of this intellectual property," whether it's trademarks, copyrights, patents, "We've got to pay this entity right over here some amount of money "to use that intellectual property." So let's say that they say that we're going to pay them I don't know, $800,000. This is essentially transfer pricing. In theory there should be a way of deciding what is the fair rate for that intellectual property but oftentimes that intellectual property is fairly unique so it's hard to determine a market rate which really just leads this company to decide it for itself. Let's go into that reality, where instead of this reality, this company, before it had a million in pretax profits, but now it's paying $800,000 in royalties and licensing to this entity right over here. So out of that 1 million you have $800,000 going offshore. So the real pretax profit for this company now based on accounting for it this way, based on paying this subsidiary that is offshore for use of the intellectual property, the company now has 200K in pretax profits. That was before the licensing, now this is after the licensing. This is the new pretax number. So the US it would only pay 35% of the $200,000. Instead of paying $350,000 in taxes, it would now pay, so it's no longer $350,000 in taxes. 35% of 200K is 70K in taxes. The US, I guess you could say parent company, would show a profit of 200K minus the 70K of $130,000. I would call it net profit, or we could say posttax profit. Then this character right over here, let's say it has very minimal cost. Let's say it has no cost for simplification. It would have some to do some paperwork. All of this would essentially be profit. Maybe have a few thousand dollars in cost but we'll ignore that for now. So all of this would be its pretax profit. It would have to pay 5% of it. 5% in taxes to this country right over here. So 5% of $800,000 is $40,000. So it would pay $40,000 in taxes to the government of this island right over here. Then it would be left with the remainder $760,000, so it would have $760,000. I guess you could call that it's net profit after paying taxes. So you can see here the company saved substantially on taxes. It paid $70,000 in the US and $40,000 abroad. So it paid a total of $110,000 in taxes versus the $350,000 it would have had to pay if it was based purely in the United States. You might say, "Hey this is a great thing. "Why even have a $800,000 transfer price, "why not do a million?" Obviously if you do it a little bit too ridiculously it will get more and more scrutiny, so there is some balancing influence there. Obviously if there is a market for this intellectual property or that type of intellectual property, or if you are licensing to other people, that might dictate what this is. You might say, "Well why not do this night and day?" Well the question is, you now have this profit and it might be in the form of cash. We go into other videos in more depth when it might not be. But you have essentially this profit. You won't be able to get it back into the United States without paying a tax on it. So if you want to get it back in the United States, that's actually the check. The reason why we do tax, repatriation of funds, is so that companies can't do this night and day. Essentially transfer profits abroad and then bring the cash back in. In order to close this loophole, that's why the repatriation of these funds are actually taxed. I want you to think about, and it obviously depends on what the transfer prices are and things like that, but essentially what this tax rate would have to be in order for a company to come out neutral. There are other ways of getting around it and I'll do other videos later, of ways that this cash could be put to use and it still is not actually taxed.