Advanced Taxation – A339
Spring Term 2002
Research Project

Zelda has a friend, Cy Burr-Naughten, who studied accounting at State University – until he flunked out because he was spending so much time playing and programming computer games. After he married, Cy learned that he could not make enough money selling "cheats" and "fixes" for computer games, so he searched around for something more lucrative. With Zelda's help, Cy is putting together a business plan. In the process, Cy and Zelda came across some tax-related questions. They have requested your assistance. In your initial discussions with them, you have established the following facts and information:

Cy was one of the first 100 persons to virtually immigrate to Cybertown™. There, and at similar locales, Cy made many contacts with persons from around the globe. Some of those contacts have carried over into the "real" world. Cy corresponds and has business contacts with persons from Europe, North and South America, the Far East, India, Australia, Africa, and a number of islands. Some of those persons have expressed an interest in Cy's proposed business, as customers, or investors, or both.

Cy's business idea has two parts. One part is to establish an electronic databank for persons interested in online gaming and virtual communities. Cy calls this part the "Virtual Genie Bank"™ ("VGB"). VGB would store and distribute computer programs and data, concentrating on game and virtual world demos, avatars, virtual factories, houses, furniture, character sketches, scenes, maps, and similar things. Customers with credit cards will be able to download selected files. The fee for any one file will be relatively small (most less than $2.50). But Cy's marketing projections indicate that thousands of files will be downloaded each week. If the actual results reach 15% of projections, VGB will be a financial success.

The second part of Cy's business idea is to provide consulting services, principally to game and virtual-community developers and programmers. Cy calls this part "Spectral Actuation Group"™ ("SAG"). Cy has made, and continues to make, meticulous notes concerning what is good and bad about innumerable game and virtual-community sites. With his programming knowledge, the information he has accumulated, and information to be gathered at the VGB, Cy will be in a good position to provide valuable expertise to anyone wishing to create or operate virtual scenes and worlds. Interestingly, one of the persons most enthusiastic about SAG is "General Rob" [his or her virtual identity]. In the real world, General Rob is responsible for all military training in a globally significant country (not in North America). In contrast to VGB's download prices, SAG's consulting services would not be inexpensive. In addition, SAG's operating expenses will be very low. The physical equipment necessary for VGB's operations will accommodate most of SAG's needs. As SAG's business grows, it may be necessary to set up equipment and systems independent of SAG's. By the time that need will arise, SAG will have more than enough income to cover the costs. Cy's projections indicate that after one year the average cost of SAG's services will be between 10% and 15% of gross income.

Both VGB and SAG will operate on the Internet or its successors. The data for both will be stored solely on computers. The only non-Internet requirements for VGB will be storing, indexing, etc., the database files. That can be done on or from any computer with an Internet connection. SAG may have greater real-world requirements, but still not many. Cy, obviously, will need an office area, but he has been using a very large basement room for many years, so the office need not be expensive or elaborate. The physical space needed for computers is not great, and is becoming smaller almost daily. Cy's business plan does not require that the computers be purchased. It is common to lease storage space and programs on computers owned by others.

Because the principal requirement for Cy's proposed business is high-speed Internet connection, the computers can be located anywhere in the world with adequate Internet services. Currently, that is about half the world, including all the "developed" and most of the "developing" countries. Additionally, there is no requirement that the computers be physically near Cy or his employees, or that they be all in one location. To increase download speeds, if nothing else, VGB will own or lease computers in at least six locations in different parts of the world. The programs and data at all locations can be manipulated from a distance. For example, a person could easily update databases in Japan, Finland, Argentina and Fiji from a computer in Singapore.

As most people know, the cost of identical goods or services can vary widely from market to market. The rental value of 100 square feet of office space in Los Angeles is much greater than the cost of the same amount of space in Warsaw, Indiana. The cost of services (wages) also varies substantially. Because VGB and SAG do not require specific geographic locations, Cy can establish business locations wherever adequate communications infrastructure exists and the costs are lowest.

Like all competent business persons, Zelda and Cy know that businesses must pay taxes. Also like other competent business persons, Cy would like to pay the least possible tax, particularly on his business income. Cy, being a life-long U.S. citizen and resident, objects less to paying state and federal income taxes in the U.S. than he objects to paying taxes to other countries. Cy intends to permanently reside in the U.S. He expects to travel to other countries on occasion, but hopes that those trips will be for pleasure, not business. He is much more accustomed to Cybertown's "jump gate" than an airplane seat. Cy also expects that some of his investors will be residents of other countries, i.e. "nonresident aliens" for U.S. income tax purposes. He also expects that investors, U.S. and foreign, will want some equity ownership in exchange for her or his investment. Based on the above facts, Cy and Zelda have asked your advice on the following questions:

1. What arrangements should be made for computer operations in non-U.S. countries so that the greatest portion of income from those operations will be considered income earned in the U.S. Or, to put it differently, so that the smallest portion will be considered income earned in the country where the computers are physically located?

2. Assume Cy wants (a) to keep the greatest amount of control (and income) possible, and (b) to be relatively flexible with respect to transferring equity interests to investors. For U.S. tax purposes, what form of business would be best for his U.S.-based operations?

3. Make the same assumptions as in #2. For U.S. tax purposes, what form of business operation would be best for his foreign-based operations:

If the foreign country requires that at least 51% of domestic business organizations be owned by that country's citizens.

If the foreign country allows domestic business organizations be 100% owned by foreigners.

4. Draft a U.S.-income-tax-related question that you think Cy and Zelda should ask. Obtain specific approval from the instructor before researching this question – it cannot be a simple question with an obvious answer (Zelda already knows the answers to those questions).

NOTES:

A. The questions cannot be adequately answered solely by referring to one portion of the text, such as the portions giving an overview of the tax attributes of various business organization types. At a minimum, make differing assumptions about the income stream from operations locations and determine which organization(s) will provide the desired results under those assumptions. Determining the results will, of course, require careful examination of the I.R.C. and other authorities.

B. The different portions of Cy's proposed operations may be, if appropriate, organized differently. It may, or may not, be advantageous to organize legally independent operations, or subsidiary-parent operations, or some combination. If more than one is appropriate, the organizations need not be the same type. For example, a partnership can own corporations, or be a member of another partnership or an LLC.

C. It might be a good idea to at least skim through the text chapter on "International Taxation" near the beginning of work on this project.