Should I Stay Or Should I Go…To China?

It is vital that owners work with their tax professionals to determine whether the cost savings outweigh benefits of domestic production.

When business owners think of ways they can save money on their taxes, one of the first ideas that often comes to mind is establishing some sort of “offshore” account. In other words, filtering income through a foreign country to avoid paying taxes. This technique has been so glamorized over the years that many business owners now believe it is a legitimate tax avoidance strategy. In the popular 1993 film The Firm, Gene Hackman plays the role of a high-profile tax attorney who boasts of establishing offshore accounts in the Cayman Islands so that his millionaire client, Sonny Capps, will only pay three percent tax. While these types of techniques may be enticing, most of them are illegal and are classified as tax evasion, as opposed to legitimate tax avoidance techniques.

The use of foreign countries can be beneficial to a business under a different set of circumstances. In recent years, manufacturers have found that by transferring their manufacturing facilities from within the United States to a foreign country (often to China), they can reap significant benefits. While this technique has no direct tax advantages, the overall advantages a business owner can receive are extensive and include the following:

  • Reduced overall production costs,
  • Lower wages,
  • Fewer environmental and workplace regulations,
  • Financial subsidies from the local government and
  • Improved cash flow.

In fact, the transfer of manufacturing operations to China has increased so considerably that China only trails Canada and Mexico in U.S. import volume. Many business owners have experienced the impact of this trend firsthand; however, these experiences have not always been positive.

I recently visited a machine tool manufacturing company in the Midwest that had been extremely successful until recently. Sales had been declining and production had slowed. The cause of this downturn was not due to the owner’s actions; rather, the downturn was caused by forces beyond his control. Many of the company’s competitors had moved their manufacturing facilities to China, thereby allowing them to offer products far below the standard prices. The owner’s hands were tied since he could not offer competitive prices without the risk of losing his business.

However, my team and I were able to streamline the company’s operations and minimize its tax liability so that the company could not only remain in business but operate profitably in future years. One of the techniques used to minimize the amount of tax paid by the company was based on a law recently passed by Congress specifically designed for these types of situations.

In 2004, in an effort to encourage American companies to keep their manufacturing facilities within the United States, thereby increasing U.S. job retention, Congress passed the American Jobs Creation Act. Part of this law, known as the Domestic Production Activities Deduction (Section 199), specifically provides tax incentives for domestic production. It allows businesses to deduct nine percent of the lesser of income from qualified domestic production activities for the taxable year or taxable income for the taxable year. A qualified domestic production activity is defined in the code as any of the following:

  1. The lease, rental, sale or exchange of goods manufactured, produced, grown or extracted by the taxpayer within the United States; any qualified film produced by the taxpayer; or electricity, natural gas or potable water produced by the taxpayer in the United States,
  2. Construction performed in the United States or
  3. Engineering or architectural services performed in the United States for U.S. construction projects.

Clearly, the definition is quite broad and encompasses a number of businesses that typically would not be categorized as “manufacturers.” The Midwestern tool manufacturer fell within this definition though, and by fully utilizing the Section 199 deduction, was able to keep his manufacturing operations here in the United States and remain competitive with those companies who had transferred their manufacturing to China.

This is just one example of how the deduction can be used to increase a company’s after-tax income. Many business owners, and occasionally their accountants, are not aware this deduction exists. Or, if they are aware of the deduction, they assume it is not available to them because they are not involved in typical manufacturing activities.

I recently spent time at an architectural firm in Nevada, and the owners were unaware that the services their company provided qualified them for the deduction. Needless to say, they were pleasantly surprised when they learned their company qualified.

Business owners need to be aware of this deduction and should contact their tax professionals to determine whether or not they qualify, even if the company may not outwardly appear to be involved in domestic production. The costs associated with the avoidance of this deduction are simply too great.

As costs of foreign manufacturing continue to decrease, more and more business owners will be tempted to pick up shop and move their facilities overseas. At the same time, especially given the increasing unemployment rate, added pressure is being placed on Congress to pass laws (similar to Section 199) that will encourage businesses to keep their manufacturing facilities in the United States. A detailed analysis should be performed by all business owners facing this dilemma. It is vital that owners work with their tax professionals to determine whether the cost savings associated with foreign manufacturing outweigh the tax benefits of domestic production.