Taxes, yay! We all love taxes, right?
Well, I can’t imagine anyone jumping up and down saying “me, me, I love taxes”. But I do feel quite a few people want to have a deeper understanding of how taxes work. This is especially true when doing international business.
First, it is a dynamic and complex specialty. I am not a tax lawyer and my tips and opinions you should verify with your tax professional before implementing.
Ok, done with the disclosure. Read on to learn more about differences between corporate taxes and personal taxes.
What Is Company (Corporate) Tax?
First, let’s define what is tax for a company. The most easy way to envision this is picture a company as your baby. You gave birth to a new life, and this company has a new identity. Thus you need to report to the government about its “health” and its taxes, just like a baby will as he or she grows older.
You as the parent (shareholder and director) will be responsible for its upbringing. You need to now make sure this baby company is filing its paperwork and paying its taxes.
Following along now?
So, where you choose to give birth to this company (register or incorporate) is where you will be reporting taxes for it.
People like Hong Kong because it has a low corporate tax rate of 16.5%, and if you qualify 0% on offshore status. But let’s keep it simple and say 16.5%.
At the end of the year, your company earns $100,000 US dollars. You will need to pay 16.5% taxes on that, or $16,500 US dollars, and the company keeps the rest.
So that takes care of the company (corporate) tax. You also need to make sure you play salary tax on employees, government fees, keep the bookkeeping in order, and do the tax audit. But we’re focused on taxes today.
Now we need to talk about your taxes, as an individual.
What is Personal Tax?
Now we have finished the taxes for the company. But there is you, the “parent” of this baby company. Are you taking money out from this baby company to pay for your living costs? Or will you keep the money in the baby company’s bank account so that the company can grow faster and use that money to invest.
This is something that is tricky and we need to think about. I always like to re-invest money back into the company, but at the same time, we as the “parents” of a company need to make a living.
So, now its time to take money out of the company. And the money we take we need to pay taxes on, as a human being, as an individual.
We can take the money out as a salary or as a dividend.
If you take it out as a salary, you would hire yourself by the company and issue yourself an employment contract to work for the company. You would then need to pay salary tax on that income.
If you take it out as a dividend, it is easier. The main difference with a dividend is that you need to divide out by the percent shares you own. So if the company is 50% yours and 50% another partner, then you need to split the dividend by the percentage breakdown.
So, for example, let’s look at that $100,000 USD profit we mentioned earlier. Say you decide to issue $50,000 USD as a dividend, and keep $50,000 USD in the company for re-investing in growth. That $50,000 USD dividend would have to be an equal split between the owners at $25,000 and $25,000.
So maybe one of the owners doesn’t want to take the dividend, and the other needs the cash to pay his or her bills. Then it might make more sense to hire one of the owners to run the company and to take a salary.
This gets tricky at the personal tax level, let’s go through some things to consider next.
Where Is Your Citizenship?
What passport are you holding? Are you an American? If an American, your life just got more complicated as an international business owner.
Americans can get exempt from taxes up to a certain point if they qualify. But you will always need to file. So you’ll need to report that you have a Hong Kong company. You will need to report that earned income in the company that you will take out as a salary or dividend. Talk to your USA accountant about how you will treat this. There is different tax rules for salary vs dividend.
And if you’re an American residing somewhere else, you may also be subject to paying taxes in that country as well.
Other passport holders, let’s look now at a second criteria.
What Is Your Country of Residence?
Where you are a resident also comes into account when dealing with personal tax. If you’re a German living in Thailand, just because you live there doesn’t make you a resident. Are you on a tourist visa, which governments consider…being a tourist! Or are you on a work permit, which is the assumption that you are working in Thailand and earning an income and paying taxes.
Most places in the world where you have a passport and citizenship (except USA, see FATCA infographic). If you are a bona fide resident of another country, then you are exempt from paying taxes in your home country.
So the dividend or salary you took from your Hong Kong company, you would need to pay taxes in the country you are a resident.
The main point is, you need to pay taxes somewhere in the world. Either your “place of birth” or where you hold your passport and citizenship, or if you can qualify as a resident somewhere else.
Think About It On a Larger Scale – Multi-National Corporations
You are a bit confused. I like to step back and think about it from a big company perspective to give it the complete picture. Let’s say that a massive company has a company in Hong Kong. They have shareholders and directors and it is thousands of different people involved.
Let’s go point by point:
They would have income in their company. Same as you.
Costs, yup. Same as you – marketing, software, payroll, contractors, etc.
Directors – May have a few more than the typical small to medium sized business. This could be the C level executives or the Hong Kong company General Manager.
Shareholders – Quite a few, could be a publicly traded company. It may be 100% owned by a company in another country.
Like anywhere, this multi-national company has income and expenses. The company can try to adjust that in various countries where they have their different entities setup. This is transfer pricing. It can also transfer price by invoicing other companies in its network.
At the end of the day, they will need to report their yearly books to the Hong Kong Inland Revenue Department. The company will pay taxes based on how much it earned in the Hong Kong company.
How about the directors and shareholders of this large company? Most likely the shareholders don’t expect to live off the dividends of the company. Instead want to keep the earnings in the company to reinvest in growing the company even bigger. These shareholders are most likely hands off. They want to see their investment make a long term return on investment. The directors, let’s say there is a CEO and a COO, will get a salary and bonus. The shareholder’s board of directors approve the salary for the directors. Lots of times there may be stock options and bonus of cash payments based on performance of this executive team.
But in a large company, the owners do not live and depend on the dividends coming out of the business.
So, just like you – the company is to make money. But it is more clear that in a larger company there is a clear separation of shareholders and directors. Yet, smaller businesses the shareholders are the same as the directors. The directors need to earn a living and also optimize their taxes.
But how does one pay this dividend and/or salary to the director is a **Personal** tax event, not the same as corporate tax event.
Worth Noting – Do All Shareholders & Directors Agree on the Payout Structure?
Since we’re on this topic it’s worth sharing. Many times people get into business partnerships and they didn’t first discuss the money! How much of the money remains in the company versus how much will the company pay out as a dividend (or salary) to the shareholders.
**Discussing this with your business partners before the company is set up is critical**. This is a critical element. When you have this discussion you will find out if all other business owners in this venture are on the same page as you.
Based on my own experience, I have been in business ventures where my partners needed to take the cash out of the business ASAP. They needed this income to pay the bills. Whereas I was more focused on reinvesting this profit back into the business to grow it.
This difference in viewpoint and goals caused a lot of tension, as one may imagine. Each side has a fair argument. My partners in the deal said that if they don’t see the money coming out of the business they’ll lose focus. They want to benefit them in the short term to help focus on building this company. I much prefer the other side of doubling down the profits to quadrupling the investment of profits.
Which do you prefer? This should definitely be a topic you discuss with your partners as soon as possible. You should cover it in your shareholder’s agreement. Or at least noted as a mutual understanding document somewhere – a piece of paper or back of an envelope on the plane ride!
Big Companies – Keeping Their Corporate Profits Overseas
It is always a hot topic in American news. Massive comglomorates who make tons of money “offshore” or in international markets. These companies keep this millions (or billions) of dollars earned in these foreign companies. Then rather than sending the cash back up to the US company, the invest it overseas to delay the American taxs.
Again, we’re separating our personal taxes from company taxes. Remember, it is like a separate person. So Apple is earning tons of money in China on iPhones and other products. The company earns this cash from sales in China, but their headquarters is in California wants the tax money. The US government would love for them to wire transfer those billions to their USA bank account. This would then create a huge bump in revenue in their USA company, which translates to tax liabilities.
How This Applies To A Small Business Owners
Don’t have businesses setup around the globe? So you don’t have the leisure to decide where to report your billions of dollars of earnings, poor you! And poor me! There are things you can learn from this though. If your company makes money, it doesn’t mean you as the shareholder or the director are making money – at least in the short term. If your company is reinvesting the profit and not sending you the cash, you can wait. At least for that tax year – then you will not be liable for those taxes – as an individual.
Make sense? Again, it is critical that you separate your personal tax from your company tax situation. Company may earn a profit this year. But if it doesn’t send the money to the shareholders, or pay out as salary to the directors, then those individuals won’t be paying personal taxes on it that year.
Hope this helps. The laws and the places in the world where you are a resident or citizen may make this a different situation. So please ask a licensed accountant in your country where you file your taxes as an individual.
Focus On Building Your Business – Not Tax Shelters
I want to end today’s guide with a reminder. A lot of tax specialists always stress that the business exists to get customers and earn profit. It is not about spending all your time trying to avoid taxes.
Think of Google or Apple. They started in garages in California with a few people. I can’t imagine Larry Page or Steve Jobs sitting in their garage discussing how to setup offshore corporations. They’re not focused to avoid paying taxes on the small or non-existent revenue they were making.
That was all setup later, but expensive CPAs and corporate lawyers.
So if you’re reading this and at the early stage of your business, please save your brainpower. Put that energy on building your product and getting customers.
If you’re already past the early and middle stages of your business and want to get more advanced, sure, let’s talk!
How was this guide, please let us know by sharing your comments or questions below!