H. Jacob Lager

Archive for May, 2012|Monthly archive page

The top four tax rumors about the Facebook IPO: Busted!

In Business entities, Business entity, Offshore Accounts, Tax rumors on May 23, 2012 at 6:50 am

Facebook tax

I love it when current events make my job easy.

To wit: the recent Facebook IPO, Ed Saverin’s expatriation, and Sen. Chuck Schumer’s legislative reaction thereto.

In case you live entirely off the grid, chances are you’ve heard about a little company called Facebook that went public this past Friday, making a lot of people instant millionaires, and a few people billionaires.  One of those people, Ed Saverin reportedly ceded his US citizenship recently to avoid paying US taxes on his recent windfall.  In response, Sen. Schumer (D-NY) introduced a rather drastic piece of legislation that would ban Saverin from ever setting foot on US soil again!

So, with that in mind, I give you, the top four tax rumors about the Facebook IPO:  Busted! (Consider this the tax version of Snopes.com).

1.   Ed Saverin has sneakily avoided US taxes.

Status: False

By expatriating, Saverin has incurred what’s known as the “exit tax.” He will be treated as having sold all his US assets on the day of his expatriation, which will cause Saverin to owe a 15% a capital gains tax for 2012 on the appreciation of his Facebook shares.  Although his exact stake in Facebook is unknown, Saverin himself has issued statements indicating that his exit tax bill will exceed several hundred million dollars.

So why is Schumer so upset?

2.  Ed Saverin is paying less taxes than he would have without leaving the US.

Status: True

The date of Saverin’s exit is key.  By leaving prior to the IPO, Saverin effectively “sold” his Facebook shares at a value that is far less certain (and likely less rich) than it’s opening $38/share value.

Saverin’s early exit also opens the door for some valuation discounting.  At the time of his expatriation, Saverin owned a non-controlling minority position in a company that was not publicly traded.  Also, as famously depicted in The Social Network, Saverin had long ago been pushed out of any management role at the company.

“So that means that it is highly likely that Saverin applied one or more significant discounts to the value of his shares due to the lack of any open market for his shares and  the lack of company control that his minority stake would impart a willing buyer,” notes Barbara Barschak, CPA a partner with the Los Angeles firm of Katz Cassidy.

So, if we assume Saverin’s shares had a book value of $20/share at the time of his exit, a 40 percent discount would further reduce his per share value to $12.   Compared to today’s $34 trading value, Saverin would be paying $1.80 of capital gains tax on each share instead of $5.10.  That’s 35.3 percent of what he would pay today.

But wait!  There’s more!

3.  Ed Saverin is avoiding future US taxes.

Status: True

In general, proceeds from the sale of intangible property is sourced to the seller’s tax residence.  This means that when Saverin does decide to sell his shares, the resulting proceeds will be subject to the prevailing capital gain tax rate of Singapore.

If Singapore had a capital gains tax.  It does not.

When you consider the likelihood of higher US capital gains rates in the future (at the very least, we know Saverin would be subject to next year’s extra 3.8% Medicare tax on high earners), expatriating this year ends up saving Saverin even more money.

“Good for him, but bad for the US,” says Barschak.

4.  Ed Saverin will never be allowed to return to the US.

Status:  Highly Unlikely.

Because expatriation is perfectly legal, there is very little the federal government can do to thwart Saverin’s savings.  The IRS could dispute Saverin’s per share value or his applied discounts, but those are just factual disputes.  The concepts underlying Saverin’s tax savings are legal and somewhat vanilla.  At the end of the day he will realize a significant tax savings from this move,

So  what’s a lawmaker filled with righteous fury to do?

Why, ban Saverin from ever visiting the US again, of course!  That’s what Senators Chuck Schumer and Robert Casey (D-Pa) have proposed for any US citizen who expatriates to avoid taxes.

In the unlikely event this legislation actually becomes law, such a retroactive application would be vulnerable to constitutional attack as a targeted bill of attainder.  So why would a US Senator waste his time pushing such a bill?

Oh, right.  Election year.


Flowchart: All Your Business Entity Selection Questions Answered On One Page

In Business entities, Business entity, Business tax rate, Business tax rates on May 14, 2012 at 9:27 am

Business entity selection is an issue at comes up in every deal I encounter.  For tax purposes, the correct type of business entity for a given client cam be ascertained by how they answer the following questions:

Am I the sole owner?

Am I willing to pay a state/franchise tax for limited liability?

Am I taking on any debt?

Am I taking on any preferred investors?

Am I willing to deal with a second level of taxation?

Compare your answers to this flowchart to see where you end up.

Business entity selection, business entities

If you have even more questions regarding business entity selection, please contact me.  We can cover your specific needs and help start the best business entity for your situation.

Administrative Appeals to D. C.: Check Your Work. Update!!

In Transfer pricing on May 8, 2012 at 8:45 am

Remember in high school, when you knew the answer to a complicated math question but still got dinged on your exam because you didn’t show your work?

That’s pretty much what happened earlier this month when the D.C. Office of Administrative Hearings granted summary judgment in favor of Microsoft Corp. Inc., who had challenged a corporate franchise tax assessment based on a shorthand third-party transfer pricing analysis.

I’ll be the first to admit that transfer pricing is a pretty complex area of tax law.  Embodied in Code Section 482 and its voluminous related regulations is the concept that taxpayers engaging in transactions with controlled or affiliated entities must price those transactions according to an “arm’s length” standard.  In short, a related party transaction must be “consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances.”  Treas. Reg. § 1.482-1(b)(1).  Transfer pricing analysis has particular importance in international taxation since it would be theoretically very easy to move money to a low-tax jurisdiction by simply doing business with a controlled entity formed in that jurisdiction.  Section 482’s regime is meant to address that potential abuse.

In this case, the District of Columbia assessed approximately $12.75 million in tax against Microsoft for its 2006 fiscal year based on a contracted transfer pricing analysis performed by Chainbridge Software Inc.  Chainbridge analyzed Microsoft’s profit-to-cost ratio and compared it with other profit-to-cost ratios to measure Microsoft’s controlled transactions against the arm’s-length standard.  However, Microsoft pointed out that Chainbridge’s analysis failed in a number of ways:

  1. Chainbridge failed to isolate Microsoft’s controlled transactions from its third party dealings.  Under the Section 482 regulations, the comparable profits method requires an examination of only controlled transactions;
  2. Chainbridge improperly aggregated all of Microsoft’s transactions, even though the transfer pricing regulations require a taxpayer’s transactions to be separated based on type and business line; and
  3. Perhaps most importantly, Chainbridge did not perform an actual audit of Microsoft’s books and records.  Instead, it built its analysis on Microsoft’s D.C. tax returns and publicly available information.  Chainbridge did not scrutinize any particular intercompany transaction or type of transaction and instead, it simply reviewed Microsoft’s total sales and other income, cost of goods sold, and total deductions to determine Microsoft’s net-profit-to-sales ratio.

In short, Chainbridge was a little lazy.  Creative, perhaps, but lazy.  In fact, D.C. essentially lampshaded its own shortcomings by arguing that Microsoft’s business structure was so complex that complete aggregation was the only way it could be analyzed.

While acknowledging that Microsoft has at least 100 affiliated businesses and has had thousands of inter-company transactions, the D.C. Office of Administrative Hearings dismissed this argument, noting that “the fact that Microsoft has 100 or even 2,000 affiliates does not address the question of why there was no effort to isolate the controlled transactions.”  In the end, the administrative panel found that Chainbridge’s analysis was “useless in determining whether Microsoft’s controlled transactions were conducted in accordance with the arm’s-length standard” and its findings were “arbitrary, capricious, and unreasonable.”

This case’s resolution should provide some healthy ammunition for any other multi-jurisdictional entity facing a similar broad application of transfer pricing concepts.  Foreign, state, and municipal entities who contract out their transfer pricing audits to private entities will need to keep this result in mind.  Indeed, any such sovereign should seriously investigate the vendor’s methods before agreeing to pay for these services.

Because you’ve got to check your work.

UPDATE:  And due to demand, you can now read the final order in its entirety.

Photo courtesy of  Svadilfari