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Chapter 16
International Taxation Issues
Transfer Pricing and Motorola
Motorola, one of the world’s 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.
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?
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
OECD and EU Average Corporate Tax Rates
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
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
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
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
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
Computation of VAT
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
Tax Deduction vs. Tax Credit
Avoidance of Double Taxation of Foreign Source Income
Tax Treaties Minimize the effect of double taxation Protect each country’s 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
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
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
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
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
U.S. Taxation of Foreign Source Income
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
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
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
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
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
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
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
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
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
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.
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
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 “arm’s 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
Intracorporate Transfer Pricing
Methods for Determining Arm’s 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
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
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
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