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Will US Corporate Taxation Drive Startups to Incorporate Abroad?

The recent revelations that corporate giants such as Apple, Microsoft and Hewlett-Packard have been successful at using certain federal tax regulations to pay extremely low corporate income taxes have brought up a number of questions about the impact of U.S. tax policy on multi-national businesses.

Many countries only tax corporations on the income they earn within their own boundaries, while the U.S. -- at least in theory -- levies corporate income taxes on all profits earned by U.S.-based corporations with credits for any foreign taxes paid abroad. Federal tax law sharply limits the ability of corporations to reincorporate abroad, but there is nothing to stop startups -- even those physically located here -- from legally incorporating abroad.

Incorporation in countries such as Ireland, Bermuda and the British Virgin Islands can offer significant corporate tax advantages, but there are also some distinct non-tax advantages of incorporating in the U.S. So, are new American startups beginning to incorporate in tax-haven countries?

Apparently not, according to an analysis by a University of Texas law professor. After identifying 918 new multinational startups with U.S. headquarters, she found only 27 that had been legally incorporated in tax haven countries.

Why aren’t they? The law professor interviewed founders of companies that did choose to incorporate in tax havens and those that did not. Those who chose to go the traditional route cited several reasons:

  • The U.S. corporate income tax is far lower than its nominal rate. With an effective tax rate of 3 to 6 percent of income earned abroad, the tax advantage is often not enough to overcome non-tax factors. For example, incorporation in Delaware is simple and cheap, while foreign incorporation requires additional legal work, which can be costly. 
  • Foreign incorporation often requires shareholder and contract disputes to be handled through that country’s courts, which many investors won’t accept.
  • Inertia may be an important factor, but that could change if the U.S. tightens certain rules and ends up making foreign incorporation much more attractive.

In the U.S., companies that choose foreign incorporation are often in specific industries with negative non-tax legal disabilities, such as Internet gambling companies and cruise ship companies. Insurance companies have found that incorporating in Bermuda exempts most premiums, even those paid by U.S. companies, from virtually all income taxation.

For now, startups continue to focus their energies on innovation, including legal innovation intended to limit U.S. taxation. When and if it becomes less expensive and onerous to incorporate abroad than it is to do so in the U.S., however, that may change quickly.

Source: The New York Times’ DealBook, “Despite Tax Rules, Companies Stick With U.S.,” Victor Fleischer, June 6, 2013

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