Multiple taxation
In an effort to maximize revenues and to exert control over the private sector, most governments use a variety of taxes. For example, assume that you own a company, XYZ Widgets, Inc. At the end of the year you've made $50,000 profit. You decide to keep $25,000 in the company to grow it and distribute $25,000 to yourself so that you can use it to purchase a modest automobile. But before you can distribute the profits, the company is taxed at the current corporate rate... say twenty-five percent. So you actually only have $37,500 available for dividends. If you stick to your plan and leave $25,000 in the company, you only have $12,500 to purchase the car. So you decide to leave just $12,500 in the company and take out $25,000 to purchase the car.
Now your government counts that $25,000 as part of your income and taxes it at the highest marginal rate that your total income is subject to... perhaps twenty-five percent as well. So now you have only $18,750 left to purchase that car with. Perhaps you' ll settle for a used one instead. Oh, but you need to pay the sales tax on the car. That's 7 1/2%, so you'll have to settle for one that costs only $17,440. So from your company's $50,000 profit you've managed to actually keep only $29,440. The government has walked away with more than forty percent of your profits. And if you live in the United States, you may have to pay state and city income taxes as well. Traditionally populations have revolted when taxation exceeded ten percent. It is notable that that is no longer the case.
Some governments will have tax policies that are less onerous for small businessmen. In such cases double taxation is either at a lower level or may be totally avoidable through the use of special types of companies (e.g. S Corporations for U.S. citizens and LLC's more generally).
Tax credits
Tax credits are used to control your actions and those of your business. Credits are given for all sorts of reason - to persuade you to export to certain countries, to reward you for producing certain products or simply to reward you for being a generous donor to someone's political campaign. A tax credit comes off the actual tax you would pay. If your company was liable for $50,000 in taxes and you followed your government's export guidelines you might find that you were required to pay only $25,000. Of course, this type of subsidy by the government is generally in violation of international treaties but that doesn't seem to prevent governments from providing them.
Tax evasion
Suppose that instead of incorporating in say, Canada, where you stay longer than six months a year, you incorporate in Slabovia, a foreign country. Corporate tax in Slabovia is 2%; personal income tax for non-residents is zero. Believing that the tax authorities in Canada will find it difficult to ascertain the amount of your earnings in Slobovia, you choose to pay taxes in Slobovia even though you don't live there. As a result, your company pays $1,000 on its $50,000 in income and you pay no personal income tax. That is tax evasion. Tax evasion is an explicit offence in almost all countries. Not smart.
Tax avoidance
Again, instead of incorporating in Canada, where you stay longer than six months a year, you incorporate in Slobovia, a foreign country. Corporate tax in Slabovia is one percent; personal income tax for non-residents is zero. However difficult you think it is for tax collectors in your country to ascertain the amount of your earnings abroad, you choose to pay taxes where you are legally obliged to. Your company therefore pays corporate tax of $1,000 offshore, and you pay personal income tax of $6,250 at home (25% of $25,000 of the distribution that you gave to yourself). Your total taxes have been only $6,250 and you've retained $24,000 in your company to grow it in the future Now you are acting legally and wisely.
Tax diversion
Assume, as in the above example, that you run a small business yielding $50,000 in pre-tax earnings. The government levies a 25% corporate tax and a 25% tax on personal income, and grants you a tax rebate amounting to 10% of your post-tax corporate earnings. You would then pay tax totaling $18,250 ($12,500 corporate tax plus $6,250 income tax). You'd rather keep your money so you close down your business and replicate it abroad. Your business yields, as before, pre-tax earnings of $50,000. The foreign government levies a 1% corporate tax and zero tax on non-residents’ personal income. You pay $1,000 to the foreign government, repatriate the remaining $49,000 as salary, and pay your government $12,250. Thus, you pay tax totaling $13,250 ($1,000 corporate tax to the foreign government plus $12,250 personal income tax to your government). You have avoided unnecessary taxation to the extent of $8,625).
The situation for your government, however, is quite different. The tax authorities in your country calculate that, even though you now run a business that exactly replicates the business you ran before, you are paying them only $18,250 instead of the $21,875 you paid them before. The difference is called tax diversion. Tax worth $1,000 has been diverted abroad (to a foreign government) and tax worth $8,625 has been diverted at home (into your own pocket). Moreover, not only are you currently taking $8,625 away from the government, but also the expectation is that, ceteris paribus, you will take $8,625 away from the government next year and every year thereafter. For most governments world wide, tax diversion is a form of tax evasion. One could say that tax avoidance that gives rise to tax diversion is imperfect tax avoidance, and always risks being treated by tax authorities as pure tax evasion.
Tax reversion
Assume that you reinvest the amount of tax you have diverted to your pocket ($8,625 a year) at the same rate of return as the total capital invested. Let the rate of return be 6% a year. In the year after you incorporate off-shore, you earn $431.25 in addition to your $50,000 pre-tax earnings, and this amount yields additional corporate tax of $4.31 (accruing to the foreign government) and additional income tax of $107.81 (accruing to your government's Treasury). This is called tax reversion.
Tax creation
Assume, in the example developed so far, that you do not simply replicate abroad the business you ran at home. Assume instead that you de-invest at home to promote a similar offshore business that is, however, a little more profitable. Perhaps you make use of offshore labour to reduce your costs. Thus, assume that in the first year after incorporating offshore you earn $60,000; that is, $10,000 in excess of your usual earnings at home. The foreign country’s tax authorities impose a 2% corporate tax, or $1,200, and you repatriate the remaining $58,800. Tax authorities in your country impose a further 25% income tax, or $14,700. This amounts to $7,175 less than before incorporating offshore plus offsetting tax creation worth $2,500.
Perfect tax avoidance
Now assume that in the first year you earn sufficient income so that when you repatriate the income the total taxes taken by your country equal those it would have made before you started your company in the tax-advantaged jurisdiction. Your country has lost nothing. Perfect tax avoidance is simply tax avoidance in which tax creation exactly offsets tax diversion.
Tax risk
Perfect tax avoidance is a somewhat ideal solution to the tax problem—something that you can easily find out in theory, but hardly in practice. What perfect tax avoidance presupposes is that you avoid taxes incidentally; that is, in moving from a worse-performing to a better-performing business you happen to avoid taxes. If so, why should the tax authorities care, provided that Treasury’s overall financial position does not worsen?
The same consideration justifies a strategy aiming at tax avoidance, even when this is not perfect. Whenever you close down at home to incorporate offshore, and so do better business than before, this is legitimate behavior from the standpoint of economic efficiency, regardless of whether Treasury’s financial position is made better or worse as a result. If you do better business but your behavior gives rise to net tax diversion (i.e. tax diversion in excess of tax creation), then the problem you will have with the tax authorities is that they will seek to prove that your offshore business has performed less satisfactorily than business at home; that is, they will seek to prove that, if you have earned more money than before, business at home has improved its profits by even more. If proved, this would entitle them to infer that you incorporated offshore not in order to do better business (which allegedly you could have done at home) but in order to evade taxes.
So far, the actual risks that you run when you incorporate off-shore are twofold: on the one hand, economic risk, or the risk that you will not earn as much money as you expected; on the other hand, tax risk, or the risk of being prosecuted for evading taxes. If, for instance, you previously earned $50,000 a year, but you earn $55,000 a year now, you stand a chance of avoiding incrimination. If, however, you now earn only $45,000, the tax authorities will argue that you expected this outcome; for, your actual net after taxes will still be higher than before, even though your business is making less.. If the tax authorities succeed in suing you for this, you face a serious problem. This risk explains why many businessmen are reluctant to incorporate offshore.
Tax feasibility
So far, you have probably understood why incorporating abroad is so hard for national corporations but so common among multinational corporations. The latter prepare thorough briefs to persuade Treasury of the advantages of their international investments. Treasury has learned from experience that multinational corporations’ plans for perfect or quasi-perfect tax avoidance (known as ‘tax-feasibility’ plans) usually pay. You too may benefit from tax-feasibility plans that enable you to incorporate offshore both profitably and safely; but you need to have them drawn up by genuine experts.
If you are in the position of starting a new business that does not replicate anything that you have done before in your home country, then you are in the ideal situation for incorporating abroad for no taxes are being diverted. For example, you have been a successful landscape artist but you decide to go into business purchasing kaolin in China and reselling it throughout the world. An offshore business could be an ideal tool for you.
Whatever you do, check with your lawyer and your accountant first. No two situations are identical and mistakes can be very costly.
