Let’s say a U.S. entrepreneur has an idea for a new product that is expected to generate annual pre-tax profit of $1 million. The product will be sold to distributors around the world, with a majority of the products being sold in the U.S. The entrepreneur is trying to decide where she should manufacture the product.
If she sets up a U.S. manufacturing plant, she can set it up as a U.S. “S” corporation. With an S corporation, she can avoid corporate-level tax. The pre-tax profit of $1 million in the S corporation will be taxed directly to her at U.S. Federal rates of up to 39.6%. Thus, her U.S. Federal income tax on the income may be almost $400,000, and she will be left with roughly $600,000 of after-tax cash. For simplicity, this analysis ignores U.S. state income taxes.
As an alternative, the entrepreneur is considering setting up the manufacturing plan in Ireland. The Irish corporate tax rate on manufacturing income is 12.5%. Thus, the Irish corporate tax rate on the pre-tax profit of $1 million will be $125,000. The after-tax corporate earnings will be $875,000.
If the after-tax profits of $875,000 are distributed as a dividend to the entrepreneur, U.S. tax will be imposed on the dividend at rates up to 23.8%. Ireland will also impose a 15% dividend withholding tax on the dividend. The Irish withholding tax of $131,250 (15% x 875,000) can be claimed by the entrepreneur as a credit against her U.S. Federal income tax. Thus, although the entrepreneur will nominally owe U.S. Federal income tax of $208,250 (23.8% x 875,000) on the dividend, after foreign tax credits are taken into consideration the net U.S. tax paid by the entrepreneur will be $77,000 (208,250 – 131,250).
By locating the manufacturing plant in Ireland, the entrepreneur will pay total tax of roughly $333,250 (125,000 corporate tax to Ireland, 131,250 dividend withholding tax to Ireland, and 77,000 dividend tax to the U.S.). The net result is that the entrepreneur is left with $666,750 of after-tax cash in her pocket. She annually saves $66,750 by locating the manufacturing plant in Ireland.
Not only does the current U.S. tax system encourage entrepreneurs to move jobs and investment overseas, but it also shifts the majority of the tax collections on those profits overseas. On $1 million of pre-tax profit, the U.S. government would only collect tax of $77,000 (a 7.7% rate).
[Note that this analysis becomes remarkably more complex if significant intellectual property is involved. We have omitted intellectual property from this example to keep the analysis as simple as possible.]