International Taxation Issues

1
Chapter 16

• International Taxation Issues

2
Transfer Pricing and Motorola

• Motorola, one of the worlds largest
  mobile-phone companies, has operations that span
  across the world. As such, it has control over
  transfer prices between its operations in
  different countries. In August of 2004, Motorola
  announced that the Internal Revenue Service was
  seeking an extra 500M in taxes from the company.
  The IRS claims that Motorola set transfer prices
  in order to avoid paying U.S. taxes. They claim
  Motorola should have had an additional 1.4
  billion in U.S. income during the period. As
  such, the IRS might force Motorola to make
  adjustments that would shift profit from other
  countries to the U.S.

3
International Tax Issues

• What kind of revenue is taxable?
• How are expenses determined?
• Should direct or indirect taxes be used?
• How are cultural differences and attitudes toward
  enforcement accounted for?

4
Direct Taxes

• Corporate Income Tax Two Approaches
• Classic System
• Income taxed when received
• Earnings are taxed twice
• Integrated Systems
• Attempt to eliminate double taxation
• Two ways to integrate
• Rate split between income and for profits
  distributed (Germany)
• Imputation tax remitted earnings and dividend
  earnings at the same rate, but shareholders get a
  tax credit (as in EU)
• Corporate income taxes have come down recently

5
OECD and EU Average Corporate Tax Rates
6
Two Methods

• Territorial approach
• Tax income earned in the country where it is
  generated (Hong Kong)

• Worldwide approach
• Tax both domestic and foreign source income
• Some countries alleviate burden with tax credits,
  treaties, and deferral of foreign source income

7
Determination of Expenses

• Expenses are usually a matter of timing
• As useful lives of assets differ, tax burdens
  differ
• Statutory tax rates and effective tax rates
  differ due to
• Determination of expenses
• Tax base
• Broadened with U.S. Tax Reform Act of 1986
• Other OECD countries broadened tax bases in 1980s

8
Withholding Tax

• Income earned by a foreign subsidiary is taxed in
  the foreign country
• Cash returns to the parent are made for
  dividends and the use of patents, trademarks,
  processes, etc.
• Normally a tax is levied on payments by a
  subsidiary to a non resident investor
• Tax varies from country to country
• Depends on existence of tax treaties

9
Indirect Taxes

• Most important source of government revenue in
  some countries (France)
• Examples
• Consumption (sales) taxes
• Value Added Tax (VAT)
• Excise Taxes
• Estate and Gift Taxes
• Employment Taxes
• User Fees

10
Indirect Taxes

• Value Added Tax
• Major source of funding for the EU
• Tax is applied at each stage of production for
  the value added by the firm to goods purchased
  from the outside
• Tax burden ultimately falls on the consumer
• Major method of computation subtractive method
• Tax included in price of goods

11
Computation of VAT
12
Avoidance of Double Taxation of Foreign Source
Income

• Credits and Deductions
• Must be an income tax to be creditable (U.S.)
• Tax credits are only available for taxes directly
  paid by the U.S. corporation

13
Tax Deduction vs. Tax Credit
14
Avoidance of Double Taxation of Foreign Source
Income

• Tax Treaties
• Minimize the effect of double taxation
• Protect each countrys right to collect taxes
• Provide ways to resolve jurisdictional issues
• Tend to reduce or eliminate taxes on dividends,
  interest, and royalty payments
• Model Tax Treaty was approved by the U.S. in 1977
• 1994 U.S. and Canada sign a tax treaty
• Reduces tax rates on payments of dividends,
  interest, and royalties

15
U.S. Taxation of Foreign Source Income

• The Tax Haven Concept
• Tax haven a place where foreigners receive
  income or assets without paying high rates of tax
  upon them
• Mailbox companies have sprung up in
• Liechtenstein, Vanuatu, Netherlands Antilles
• Countries with no income tax include
• Bahamas, Bermuda, Cayman Islands
• Countries with low tax rates (British Virgin
  Islands)
• Countries that exempt income from foreign sources
• Hong Kong, Liberia, Panama
• Countries that allow special privileges

16
U.S. Taxation of Foreign Source Income

• The Tax Haven Concept
• Goal is to shift income from high tax to tax
  haven countries
• Usually accomplished by using a tax haven
  subsidiary as an intermediary
• Income shifting is generally accomplished by
  transfer pricing
• May countries are concerned about minimizing the
  use of tax havens
• OECD plans to impose sanctions on countries
  offering harmful tax competition

17
U.S. Taxation of Foreign Source Income

• Deferral principle income is deferred from U.S.
  taxation until it is received as a dividend
• Exceptions to this principle Subpart F income
  of a Controlled Foreign Corporation (CFC)
• A CFC is a foreign corporation in which U.S.
  shareholders hold more than 50 of the voting
  stock
• U.S. shareholder a person or enterprise that
  holds at least 10 percent of the voting stock of
  the foreign corporation

18
U.S. Taxation of Foreign Source Income

• Revenue Act of 1962 defined Subpart F income as
  passive income
• Subpart F income is divided into eight groups
• Insurance of U.S. risks income from parents is
  taxable to the parent when earned by the CFC
• Foreign-base company personal holding company
  income dividends, interest, royalties and other
  income from holding rights
• Foreign-base company sales income income from
  the sale or purchase of goods produced and
  consumed outside the country where the CFC is
  incorporated
• Foreign-base company services income income
  from contracts utilizing technical, managerial,
  engineering, or other skills

19
U.S. Taxation of Foreign Source Income
20
U.S. Taxation of Foreign Source Income

• Subpart F income is divided into eight groups
• Foreign-base company shipping income income
  from using aircraft or ships for transportation
  outside the country where the CFC is incorporated
• Foreign-base company oil-related income income
  from large oil or natural gas producers in a
  country outside where the CFC is incorporated
• Boycott-related income income from operations
  resulting from countries involved in certain
  international boycotts (such as Arab boycott of
  Israel)
• Foreign bribes brides paid to foreign
  government officials

21
U.S. Taxation of Foreign Source Income

• Implications of Subpart F Income
• For CFCs active income is deferred, but passive
  income must be recognized when earned
• Exception if foreign-based income of a CFC is
  less than 5 of gross income of 1 million, none
  of it is Subpart F income
• Essentially an American phenomenon

22
Tax Effects of Foreign Exchange Gains or Losses

• Gains and losses from foreign currency
  transactions are ordinary and are recognized when
  realized
• Gains or losses cannot be recognized while
  foreign currency balances are being held
• IRS treats foreign currency transactions from the
  two-transactions perspective
• IRS does not recognize gains and losses until
  obligation has been settled

23
Tax Effects of Foreign Exchange Gains or Losses

• U.S. tax law introduced the Qualified Business
  Unit (QBU) a trade or business for which
  separate books are kept
• QBU earnings are divided into two parts
• Earnings distributed back to home office
• Translated at exchange rate on date of transfer
• Earnings retained in foreign office
• Translated at average exchange rate
  (profit-and-loss approach)
• Foreign Exchange Gain Distribution X (AR-ER)
• Total branch profits in parent income includes
  the foreign exchange gain
• Tax credit is computed using ER, the effective
  exchange rate at the time the taxes were paid

24
Taxable Earnings from Foreign Corporations

• Foreign subsidiaries are not taxed until a
  dividend is declared, so the parent company does
  not have to translate statements into
• Controlled Foreign Corporation
• Same rules apply to non-Subpart F income as per a
  non-CFC situation
• Subpart-F income a constructive dividend has
  been declared at year-end, so translation into
  is necessary

25
Tax Incentives

• Two major types
• Incentives to attract foreign investors
• Usually involve tax holidays
• Example Brazilian government provides a 10 year
  holiday to invest in the northeast and Amazon
  regions
• Incentives to encourage exports
• EU many export products are zero rated no VAT
• Firms can offer products at lower prices
• U.S. and U.K. offer reductions in or eliminations
  of property taxes for investments

26
Tax Incentives

• Foreign Sales Corporation Act of 1984 replaced
  the Domestic International Sales Corporation
  (DISC) legislation of 1972
• DISC income was taxed to its shareholders at a
  reduced rate
• The FSC was established in response to criticism
  that the DISC was just a paper shell
• WTO ruled that the FSC incorrectly applied the
  territorial approach only to the export segment
  of foreign source income
• FSCs were phased out by 2001

27
Tax Dimensions of Expatriates

• Finding of survey by Business International
• U.S. is the only country from the sample that
  taxes expatriates on worldwide income
• U.S. does provide some relief through the Foreign
  Earned Income Exclusion
• Foreign country must be their tax home
• Must have foreign income
• Citizen of another country or present for entire
  tax year or 330 days out of any 12 consecutive
  months

28
Intracorporate Transfer Pricing

• Transfer pricing the pricing of goods and
  services between all combinations of parents and
  subsidiaries
• Transfer pricing is often used to take advantage
  of tax havens
• Factors influencing transfer pricing decisions
  (Tang survey, 1992)
• Corporate profitability
• Differential tax rates
• Restrictions on repatriation of profits or
  dividends
• Competitive position of foreign subsidiaries

29
Intracorporate Transfer Pricing

• The Corporate Shell Game Newsweek
• Newsweek magazine gave an overly simplistic,
  hypothetical example of a U.S. company that
  manufactured goods through its German subsidiary
  and sold them to its Irish subsidiary, which in
  turn sold the goods back to the U.S. parent
  company. The goods were manufactured at a cost of
  80 by the German subsidiary and sold for the
  same amount to the Irish subsidiary. Even though
  the tax rate in Germany is 45 percent, there is
  no tax on the transaction. The Irish subsidiary
  then sells the goods to the U.S. parent for 150,
  earning a profit of 70. Because the tax rate in
  Ireland is only 4 percent for that transaction,
  the Irish subsidiary pays only 2.80 in tax. The
  U.S. parent then sells the goods for 150,
  earning no profit and paying no tax, even though
  the U.S. tax rate is 35 percent. Thus, the U.S.
  company ends up paying only 2.80 in income
  taxes, and this amount is paid in Ireland.

30
Intracorporate Transfer Pricing

• Transfer pricing has become increasingly
  important with the increase in MNEs
• Ernst and Young Transfer Pricing 2003 Global
  Survey Results
• 86 of MNE parent companies and 93 of
  subsidiaries identified transfer pricing as the
  most important international tax issue they deal
  with
• If companies must make an adjustment, 1 in 3 with
  be threatened with a penalty and 1 in 7 will pay
  a penalty
• 40 of adjustments result in double taxation
• Sales of goods are the most audited, while audits
  of services and intangibles are increasing

31
Intracorporate Transfer Pricing

• U.S. Rules
• Section 482 of IRS code governs transfer pricing
• IRS may reallocate income, deductions, credits,
  and allowances if it feels tax evasion is
  occurring
• Transactions must be at arms length
• IRS is concerned with five areas
• Loans and Advances
• Performance of services
• Use of tangible property
• Use of intangible property
• Sale of tangible property

32
Intracorporate Transfer Pricing

• Methods for Determining Arms Length Prices
• For tangible property there are six methods
• Comparable uncontrollable price method market
  price determines transfer price
• Resale price method used if comparable
  uncontrollable price method cannot be used
• Comparable profits method less common
• Cost-plus method costs of manufacturing plus a
  normal profit margin
• Profits split method less common
• Other methods less common

33
Tax Planning in the International Environment

• Choice of Methods of Serving Foreign Markets
• Exports of goods and services and technology
• Should the firm service products for the parent
  country or abroad?
• Consider the benefits of a sales office abroad
• If licensing technology, be aware of withholding
  taxes and relevant tax treaties
• Branch operations
• Good to open a branch office at first to offset
  home country income with foreign losses
• Branch remittances are not usually subject to
  withholding taxes

34
Tax Planning in the International Environment

• Choice of Methods of Serving Foreign Markets
• Foreign Subsidiaries
• Income is sheltered from taxation in home country
  until a dividend is remitted (except for passive
  income of a CFC)
• Cannot recognize losses by the subsidiary in the
  parent company
• More valuable after start-up years

35
Tax Planning in the International Environment

• Factors on Location of Foreign Operations
• Tax Incentives
• Can reduce cash outflow of an investment project
• Tax Rates
• Tax Treaties
• Example Withholding tax between U.S. and U.K.
  is 15, but both countries have 5 withholding
  agreement with the Netherlands
• An arrangement could be made to send dividends
  from the U.K. to Holland, then to the U.S., and
  the 15 tax would be partially avoided
• Tax planning decisions should not crowd out
  management control and other essential issues