Tax Reform Explanation for the Start Up Nation
The US has endorsed Jerusalem, but their tax reform did not forget Tel Aviv and its startups. Although the new tax reform takes affect primarily in 2018, there are provisions that will already affect your 2017 filings. Here's a summary of how the US is using its tax reform to attract tech companies, what that means for your existing entity and what you should consider when establishing future startups.
Incentives for Businesses and Hi-Tech
Similar to Israel, the U.S. goal is to be a haven overall for business, especially hi-tech companies. The new law incorporates many incentives to that end. First and foremost, the overall corporate federal tax rate for a U.S. corporation has dropped to 21% as of January 1, 2018, significantly below the previous rate of 35% (and somewhat lower than the Israeli rate of 23%, unless the U.S. corporation also has state tax to pay. In this case, figure an additional 5% in the U.S.)
Furthermore, the U.S. would like hi-tech companies to retain their IP in the U.S. For example, if the IP is located in the U.S., then the income generated from outside the U.S. can be taxed at a rate as low as 13.125%. That’s better than the typical tax a Tel Aviv start up would pay, even if it were eligible for Approved Enterprise rates. Lastly, if the U.S. company’s foreign subsidiaries generate a profit (even a transfer pricing profit), those profits are no longer subject to U.S. dividend taxes.
Advantages of Creating a U.S. Parent Company
These changes, among others, make having a U.S. parent company a very viable option from a tax perspective. What’s more, many VC’s prefer to hold shares directly in a U.S. company. This also satisfies a common business need that our clients often voice: they want a U.S. company that will be the front for their customers, both for the U.S. and for the rest of the world. And now, by having the U.S. company as both the sales entity and the owner of the IP, it also eliminates the need for the U.S. entity to rent or lease the IP product from their Israeli company.
In short, when contemplating about where to open the parent vs. subsidiary, it seems that starting in 2018, the deck has shifted overall. For an existing U.S. company with an Israeli parent, you will need to review the specifics of the business model as well as the current valuation of your IP in order to analyze whether a reorganization would be worthwhile. There are many ramifications to restructuring, yet it is still possible and in many instances still beneficial, especially if it can bring an added value, such as attracting appropriate investors.
Flip Side: Taxes to Pay
But (you knew that was coming), here’s the flip side. If you currently have the structure of a U.S. parent company with an Israeli subsidiary, you may be subject already in your 2017 filing to a one-time transfer tax. This is targeted to bring the accumulated profits offshore, in this case, in the Israeli subsidiary back to the U.S. If the Israeli company has losses, then this will not affect your tax bill. However, if the subsidiary has been generating profits, even via a cost-plus arrangement, then the company will be forced to recognize this deemed repatriation. To ease the pain, there are lower tax rates on this income, an 8-year payment plan and foreign tax credits are available, but nonetheless, you will need to perform a thorough calculation, albeit still possibly ending up with a tax bill.
Another aspect of the reform which will affect tech companies is that any new losses generated from Jan 1, 2018 will only be allowed to offset up to 80% of future taxable income. This can result in any given year that the company will generate a profit, that it will be required to pay income tax on 20% of the net income, even if the accumulated losses are significantly higher than those profits.
Another interesting point is that the U.S. wants to retain all jobs and IP development in the U.S. Consequently, as of 2022, if a U.S. company pays R&D costs to a foreign entity, it will not be allowed a deduction for such expenses. Rather, it will be forced to capitalize those expenses over 15 years. The typical cost plus arrangement for R&D expenses will likely fall directly under this category. However, 2022 is still some time away and there could be many new developments over the next four years. Most likely, there will be unique ways to structure your intercompany agreements and expense some or most of these costs in an efficient way.
The Bottom Line
In summary, this article is intended to direct your focus to what seem to be the most relevant structuring issues for the typical startup. But by no means does this cover the breadth and depth of this historical reform. We look forward to keeping you posted on other aspects of the tax reform which relate to the Israeli startup scene.