How startups can avoid international tax fall-out during hypergrowth
As more startups expand internationally, and look abroad for expansion opportunities earlier in their life cycle, the tax function has shot up the boardroom priority list to mitigate against hefty revenue losses and risk of non-compliance with local tax guidelines.
Startups have a particularly unique experience when it comes to staying on top of international tax regulation. Shareholders are usually comprised of founders, co-founders, angel investors or VCs - hence a higher degree of transparency and compliance is required.
Many startups also decide to set up subsidiaries in foreign countries to source cheaper distributed talent, and many are providers of global solutions, which may require maintaining an overseas presence. As a result, startups open themselves up to a whole host of international tax bureaucracy they must abide by.
Expanding internationally means startups need to manage both international tax matters as well as local foreign tax matters. Greater scrutiny on international groups’ tax arrangements comes off the back of a global outcry over multinationals moving profits to low-tax jurisdictions or to entities with carry-forward losses, to minimise their bills - also known as transfer pricing. With increased transparency in modern tax administration, inappropriate profit shifting between related affiliates and failure to document transfer pricing arrangements accurately are sought out by tax authorities regularly.
With HMRC currently consulting on the requirement for large multinationals operating in the UK to produce a master file on transfer pricing agreements, cross-border tax complexity is only set to increase and impact smaller taxpayers as well. Without a lofty piggy bank to dip into, tight budgets mean that startups simply cannot afford to not adopt efficient and creative ways to reduce tax compliance costs.
Funding could be harder to secure if tax house not in order
As a startup, investment is in your life blood. However, successfully winning venture capital funding depends on a variety of factors - including startups' level of tax compliance.
In today’s economy, there are a large portion of venture capital firms that won’t fund startups if they are having significant tax compliance issues on a regular basis. As startups have an ultimate goal towards an exit - IPO or to be acquired by a large corporate - maintaining compliance during the years prior to this is crucial to execute this goal and maximise value.
When expanding internationally, startups need to take into account a number of international tax issues:
- Which type of foreign entity they should establish (e.g., in the US a corporation, LLC, S corporation).
- Setting a supply chain and transfer pricing policy with respect to their intercompany transactions.
- Managing both legal and economic ownership of technology intellectual property, including location of R&D leaders and defining the responsibilities of their R&D’s centres.
- Classifying the nature of their intercompany transaction to avoid withholding tax. Depending on the relevant tax treaty, royalties for use of technology may be subject to withholding tax while resale of software (including SaaS) may not.
- Filing annual tax returns in the foreign country, but also maintaining updated transfer pricing reports.
Companies commonly charge tax incorrectly if they’re unfamiliar with the tax regulations in the industry and country they’re operating in. For example, trading in the U.S. can cause significant difficulties for businesses in the indirect tax area due to the sheer number of tax jurisdictions that exist.
There are over 13,000 sales and use tax jurisdictions in the U.S. — many overlap significantly and have different tax rates. In a single U.S. transaction, a company might have to calculate and apply tax rates from state, county, and city regulations. This can be complicated and time consuming to manage.
Although it’s indirectly related, charging the incorrect tax can affect venture capital prospects. Additionally, charging incorrect tax can lead to significant legal and financial penalties, which can discourage investors. One of the key factors VC firms look for in a startup is an existing customer base that’s satisfied by the service the startup provides. If taxes are charged incorrectly, the customer experience can be damaged from sudden price shifts.
Many startups also struggle with changes to their tax liability, particularly if they’ve recently expanded their business. Operating in a new country (or even a new city) might mean applying a new set of tax rates, implementing a new method of registering for tax, or remitting tax to a new authority.
U.S. nexus laws are a great example of how complex liability can be. If you have a physical presence in a state, or if you sell more than a certain value of goods there, you’ll establish nexus and have to remit sales tax to the relevant authority. Although it might sound simple, the specific nexus rules for each state can become very complicated for businesses new to the U.S.
Venture capital funding and understanding liability can be closely connected, because venture capital may be given to support a startup’s expansion. If tax liability mistakes jeopardise that expansion, there will also be a negative impact on the agreement made with the VC firm.
What type of startup is most susceptible to non-compliance?
IP Advances in digital technology have made it easier for startups to go global earlier in their growth than ever before. Strides in technology have meant that many startups are able to offer global solutions to a range of markets, whilst employing international employees, and acquiring diverse shareholders and exit strategies. These characteristics all mean that startups face a whole host of intercompany transactional hurdles to jump in order to stay compliant with international tax regulation.
Digital startups in particular commonly make mistakes when it comes to the taxation of their goods, as digital tax law is inconsistent across different territories and changes often.
For example, digital tax law varies considerably between different U.S. states, and EU rules on digital services VAT differ depending on if the buyer is a business or a consumer. A business that primarily sells digital goods (e.g. a software company) must thoroughly research how their goods and services will be taxed in a region before they start trading into that region.
As Saas companies continue to work to overtake on-premise software, modern venture capital firms tend to invest most often in technology and software businesses due to capital-efficiency. As such, they are likely to be more aware of compliance mistakes that specifically affect software startups.
Automating processes to mitigate fall-out
Winning venture capital funding can help startups grow at a significant rate, but it’s essential that the business is in the best position to win funding first. Auditing tax compliance processes should be a central part of these preparations, to clearly identify and fix any compliance mistakes.
When profits have been shifted to low-tax jurisdictions for business purposes - transfer pricing - partnering with the right technology third-party is essential. They can provide startups with a smart automated transfer pricing documentation tool and real-time counsel on changing OECD and local tax guidelines, helping startups maintain their compliance as they expand their international footprint.
Using automation allows non-experts to also generate transfer pricing reports, freeing startups to use their compliance budget on tax planning and growth-focused consulting rather than just meeting compliance obligations.
Avalara Transfer Pricing for Accountants aims to simplify the process by enabling accounting firms without specialised in-house teams or expertise to prepare fully compliant transfer-pricing reports for clients that meet both U.S. regulations and OECD guidelines.
The solution uses predetermined benchmarks of covered transactions paired with an online self-guided questionnaire. Once an accountant identifies their client's intercompany transactions in the covered transactions, and the predetermined benchmark fits their client's results for the relevant fiscal year, they need only complete the questionnaire. Following Avalara's review, a complete transfer pricing report is then ready to download.
Startups’ sensitivity to tax compliance shouldn’t put them off international expansion and planning for hypergrowth with VC backing. Business leaders simply must be adequately prepared to not fall foul to local tax guidelines. Start-ups are solving a plethora of problems every day, and tax is one of those complicated areas where leaning on others goes a long way - lightening this administrative burden and accelerating growth.