INTERNATIONAL TAX MANAGEMENT. Multiple Taxation Vs. Tax Neutrality Double Right to Tax: -The...

INTERNATIONAL TAX MANAGEMENT


• Multiple Taxation Vs. Tax Neutrality

Double Right to Tax:

- The Residence Principle: All residents of the country (that is, private persons living in the country, and incorporated companies established in the country) can be taxed on their worldwide income.

- The Source Principle: All income earned inside the country, whether by residents or non-residents, is taxable in this country. “Earnings” = from an activity

or from a property (dividends, interest income or royalties)

This implies that income can be taxed twice unless some form of relief for double taxation is provided


• When can a double or triple taxation occur?

- The case of Direct Exports

A pure exporter:

- is not a resident of the foreign country

- has no foreign activity, and does not receive any dividends, license income, or interest income from the

foreign country

The foreign country can invoke neither the residence principle, nor the source principle. Home taxes only


• When can a double or triple taxation occur? (cont.)

- The case of Foreign Subsidiary

- The WOS or JV is a resident of the host country host corporate taxes

- Parent receives income from the subsidiary

- Host country will invoke the source principle and tax dividends, interest fees, or royalties paid out to the parent. This tax is called a withholding tax.

- In addition, the parent’s home country will, in principle, invoke the residence principle, and tax all its residents on their worldwide incomes.



- The case of Foreign Subsidiary:

Double or triple taxation? Example:

- profit of BEF 170,000 before taxes

- Belgian corporate taxes BEF 70,000

- dividend BEF 100,000: bank will withhold BEF 25,000 from the (gross) dividend and transfer it to the Belgian tax administration

- “net” dividend of BEF 75,000 is to be declared in parent’s French tax return: potential additional taxes



- The intermediate cases: the Permanent Establishment

- Source principle activity is conducted in the country, that is, there is a permanent establishment. This

requires:

- a permanent physical presence (office, warehouse)

- some vital entrepreneurial activity abroad (not just storing goods, or advertising, or centralizing orders)



- The intermediate cases: the Permanent Establishment

Example:

- If the agent of a US corporation in Peru decides whether or not the order is to be accepted, or if there is local production, then there is a PE, and the profits made on the Peruvian sales are taxable in Peru

- BUT: branch profits are part of overall company’s profits, who is a resident of the home country double taxation of profits of branch/PE (not triple)


• Multiple Taxation Vs. Tax Neutrality

Relief from double taxation:

- unilateral measures in national tax codes

- bilateral tax treaty which supersedes the national rules. Often based on the OECD Model Tax Treaty


• An example of double taxation

German company with a branch/PE in Tunisia:

Double Taxation Exclusion Method Credit MethodTunisia

Branch Profit 100 100 100(35% tax) (a) (35) (a) (35) (a) (35)net profit 65 65 65

Germany

net Tunisian profit 65 65 65

taxable income 65 0 gross-up 35

40% German tax (b) 26 (b) 0 40tax credit (35)net tax due (b) 5

total taxes (a) + (b) 61 35 40net income 39 65 60


• An example of double taxation (cont.)

Total corporate tax burden, 61, is high relative to two possible benchmarks:

- if the same DEM 100 had been earned in Germany, taxes would have been only DEM 40

- if the branch had been an independent Tunisian entity, taxes would have been only DEM 35

Taxes are not neutral: a fiscal penalty associated with the fact that ownership and operations straddle two countries


• An example of double taxation (cont.)

Two alternative neutrality principles:

- Capital Import Neutrality: “Tunisian branch should be taxed the same way as a purely Tunisian entity (that is

at 35%)”

- Capital Export Neutrality: “The total tax burden should be the same whether the German firm earns its income at home or in Tunisia (that is, at 40%)”


• Capital Import Neutrality and the Exclusion System

Foreign-owned entity should be allowed to compete on an equal basis with a Tunisian-owned competitors

- German tax authorities exclude foreign branch profits from taxable income (exclusion method)

• Capital Export Neutrality and the Credit System: Overall corporate tax should be the same as if the branch had been located in Germany. Under this system, the German tax authorities:

- “gross up” the after tax income with all foreign taxes (i.e. they re-compute the before tax income), 100

- apply the home country tax rules to that income (tax 40)

- give credit for foreign taxes already paid (35)

Net German tax: 5. Total tax: 35 + 5 = 40


• Limitations to Tax Neutrality:

No universal neutrality

- tax rates differ CEN = CIN

- No real-world “CEN” system is fully CEN, no real world “CIN” system is fully CIN


• International Taxation of a Branch under the Credit System:

- Disagreement on profit allocation

- Excess tax credits

• Disagreement on profit allocation

Main problem is allocation of indirect costs which, by definition, cannot be allocated in any practical, logical way. National tax authorities may use different rules of thumb


• Disagreement on profit allocation (cont.)

Example:

Sales: DEM 1200/400, cogs 700/300 in Germany/Tunisia

Total indirect (overhead) costs: DEM 300, to be allocated- Germany: in proportion to cogs- Tunisia: in proportion to sales


Germany Tunisia Total

Sales 1200 400 1600(Direct Cost) (700) (300) (1000)contribution: 500 100 600(Overhead) - - (300)Total gross income - - 300

Sales 1200 400 1600(Direct Cost) (700) (300) (1000)(allocated overhead) 700/(700 + 300)*300 = (210) 1200/(1200 + 400)*300 = (75) (285)taxable income 290 25 315

Management Accounting System

Tax Returns

• Excess Tax Credits

If foreign taxes exceed the domestic norm: rarely a full refund of the excess taxes paid abroad

Example:

Suppose Tunisian tax rate is 45%. The German norm requires a total tax bill of DEM 40

- no additional German tax

- unused tax credit or excess tax credit of DEM 5

How to solve? Three ways:

1. International aggregation of foreign income

2. Aggregation of home and foreign income

3. Carry-forward or Carry-back rules


• Excess Tax Credits Example:

1. International aggregation of foreign income: Excess tax credits from one branch can be used to offset home country taxes due on income from branches in low-tax countries


Tunisia Hong Kong

tax rate 50% 25%

sales 220 200(costs) (120) (100)

branch profit 100 100(taxes) (50) (25)net profit 50 75

Germany

net branch profit 50 75gross-up 50 25taxable 100 100

total foreign taxable income

tax due (40%) 80(credit) 50 + 25 = (75)net tax due 5unused tax credit 0Total taxes paid (40% of 200) 80

200


2. Aggregation of home and foreign income (rare):


Tunisia Hong Kong

tax rate 50% 25%

sales 220 140(costs) (120) (100)

branch profit 100 40(taxes) (50) (10)net profit 50 30

Germany

net branch profit 50 30gross-up 50 10taxable 100 40


tax due (40%) 56(credit) 50 + 10 = (60)net tax due 0unused tax credit 4Total taxes paid (43% of 140) 60

140


3. Carry-forward or Carry-back rules:

- Carry-forward: use this year’s excess foreign taxes as a credit for future home country taxes

Refund is delayed, and limited to home country taxes that would be payable within the next few years

- Carry-back: if in the recent past we have paid more than DEM 4 in additional host country taxes, we can now

claim back

Refund of excess tax credits is limited to the home country taxes effetively paid in the last few years


• Excess Tax Credits:

3. Carry-forward or Carry-back rules. Example:

- Excess foreign tax of DEM 4 this year

- 2-year carry-back and a 3-year carry-forward

- German taxes on foreign income were DEM 1 two years ago, and DEM 1.5 last year


• Excess Tax Credits:

3. Carry-forward or Carry-back rules. Example (cont.):

The current (DEM 4) excess credit is treated as follows:

- DEM 1 will be carried back two years, resulting in a refund of DEM 1

- DEM 1.5 will be carried back one year, resulting in an additional refund of DEM 1.5

- The balance, 4 - 1 - 1.5 = DEM 1.5, will be carried forward, that is, can be used within the next 3 years

as a credit against possible German taxes on foreign income

Only occasional excess tax credits can be recuperated (possibly with a delay)


• Tax Planning for a Branch under the Credit System:

Corporate Point of View

General objective of tax planning: minimize taxes

- Minimize the risk that part of the indirect expenses are rejected for tax purposes

- Minimize excess tax credits by reallocation of profits:

- reallocation of indirect expenses

- change the transfer prices

- Tax Havens



Transfer Pricing

Effects:

- reducing taxes

- reducing tariffs

- avoiding exchange controls

- bolstering the credit status of affiliates

- increasing the MNC’s share of a JV’s profit

- disguising and affiliate’s true profitability

- reducing exchange risks



Transfer Pricing

Limitations:

- host country tax authorities may reject part or all of the increased expenses and accept only arm’s length prices

Effect: some expenses not being deductible anywhere, so that taxes would be higher than before the cost reallocation

BUT: for components there often is no arm’s length price; and the true cost of goods sold and the

normal profit margin are ill-defined

- import taxes levied on the traded goods will increase



Transfer Pricing: Example

Increase the transfer price for technical and management assistance rendered by the Hong Kong branch to the Tunisian branch by DEM 40


Tunisia Hong Kong Tunisia Hong Kong

tax rate 50% 25% 50% 25%

sales 220 100 220 140(costs) (120) (60) (160) (60)

branch profit 100 40 60 80(taxes) (50) (10) (30) (20)net profit 50 30 30 60

Germany

net branch profit 50 30 30 60gross-up 50 10 30 20taxable income 100 40 60 80


tax due (40%) 56 56(credit) (60) (50)net tax due 0 6unused tax credit 5 0Total taxes paid (43% of 140) 60 (40% of 140) 56

140140

before after


Example



Tax Haven Example


US Income 10.00 10.00US Cost 9.00 4.00

1.00 6.00US Tax (34%) 0.34 2.04

0.66 3.96

US Buys from Tax Haven 9.00 4.00Cost of Prod. 3.00 3.00

6.00 1.00Tax (0%) 0.00 0.01Available 6.00 1.00

Total 6.66 4.96

• Tax Planning for a Branch under the Exclusion System:

Rule: allocate as much profits as possible to the branch with the lowest overall tax burden

Example

An Italian company has a branch in France. French tax on branch profits is 30%, and the Italian corporate tax is 35%. 2 Cases: 100% or 75% exclusion privilege


branch parent branch parentprofit 100 100 100 100taxes (30) (35) (30) (35)after-tax 70 65 70 65

taxable foreign 0 - 17.5 -taxable foreign 0 - 6.125 -

Total taxes 30 35 36.125 35

=> shift profits to

100% exclusion 75% exclusion

France Italy

• Tax Planning for a Branch under the Exclusion System: Example

• Limitations: arm’s length rule, import duties


• Remittances from a Subsidiary: an Overview

Branch: firm is immediately and automatically the sole owner of all cash flows that arise from the foreign investment, and can use them anywhere for any purpose (barring exchange controls)

Foreign Subsidiary: must make explicit payments if ownership of the funds is to be transferred to the parent or to a related company. Any such a transfer has tax repercussions


• Remittances from a Subsidiary:

Forms:

- Capital transactions

- Dividends

- Non-dividend remittances: royalties, lease payments, interest, management fees

- Transfer pricing



Transactions “On Capital Account”:

The subsidiary may

- Buy back some of its own shares from the parent, or buy stock issued by the parent or by sister companies

- lend funds to its parent or sister companies, or amortize outstanding loans prematurely, or

agree to alter the credit periods on intra-company sales



Transactions “On Capital Account”: (cont.)

No immediate income taxes in either country. But:

- income taxes in later periods, on dividends or interest

- regulatory agencies may dislike cross-participation

- tax authorities of both countries may treat share repurchases or subscriptions to the parent

company stock as disguised dividends, and tax them as such


• Dividends:

Differences between a WOS paying out dividends and a branch that generates cash flows:

1. Timing option in payout and taxation (deferral principle): home country taxation of foreign

profits can be postponed by deferring the payout of dividends

2. Amount that can be paid out as dividends by a subsidiary is smaller than the subsidiary’s total cash flow

Dividends are paid out of profits, which are net of depreciation charges


• Dividends: (cont.)

3. Loss of home tax shield on losses made by the branch. (no international consolidation for tax

purposes)

4. Withholding taxes on dividends, not on branch profits

tax disadvantages associated with a full-equity WOS. But these disadvantages can be

mitigated by unbundling the payout stream, that is, by remitting cash under other forms than just dividends


• Other forms of Remittances (Unbundling)

- Royalties, interest, or management fees

- lease payments made to parent (principal and the interest on the implicit loan)

These are tax deductible expenses to the subsidiary and therefore reduce the subsidiary’s tax bill; but to complete the picture, we also have to think of the recipient’s taxes, both in the host country (withholding taxes) and in the company’s home base (corporate income taxes, hopefully with some relief for the withholding tax)


• International Taxation of a Subsidiary under the Credit System

Principle of credit system still applies:

- each payment is reassessed and grossed up with the foreign taxes that have been levied on the income

- foreign taxes are used as a credit against the home country tax payable on the recipient;s total foreign income

The only complication: tax credit that accompanies a dividend


• International Taxation of a Subsidiary under the Credit System:

IRS Point of View

- Controlled Foreign Corporation (CFC)

- Subpart F Income

- Deemed Paid or Derivative Credit



Direct Foreign Tax Credit: (Section 901, US I.R. Code)

- On a US taxpayer

- Tax paid on the earnings of foreign branch operations of a US company

- Foreign withholding taxes deducted from remittances

- Not on sales tax or VAT



Indirect Foreign Tax Credit: (Section 902, US I.R. Code)

- 10% ownership

Indirect Tax Credit =

subject to:

Max. Total Tax Credit =


Dividend (incl. Withholding Tax)

Earnings net of F.I. Taxesx F. Tax.

Consolidated F. Profits & Losses

Worldwide Taxable Income

Amount of Tax Liab.

x

tax rate 20% tax rate 50%

Pre tax Profit 100 100F. Tax (20) (50)

80 50100% Div. With 40 25withholding Tax (10%) (8) (5) 4 2.5

72 45 36 22.5But Dividend Income (gross) 80 50 40 25Foreign Tax paid 20 50 20 50

100 100 60 75US Tax 34 34 20.4 25.5D.T. Credit (8) (5) 4 2.5Indirect T Credit (20) (50) 10 25US Tax 0.6 (21) 6.4 (2)

50% Payment


Indirect Foreign Tax Credit. Example:



Controlled Foreign Corporation (CFC): Tax Reform Act of 1986

A CFC is a foreign corporation owned more than 50% of voting power or market value by US shareholders. If the US individual owns less than 10% voting rights is not

considered a US shareholder



CFC Status Disadvantage:

- Loss of tax deferral on so called Subpart F Income

- Loss of tax deferral on earnings & profits reinvested by CFC in US property

- Gains on sale of stock ordinary income not capital gains



CFC - Baskets:

1. Passive Income

2. Financial Service Income

3. Shipping Income

4. High withholding Tax on Interest Income



Intercompany Transactions:

IRS regards price in an arm’s length transaction

1. Non interest bearing loans

2. No pay services

3. Transfer of M/C or equipment at no charge

4. Transfer of intangible property

5. Sale of inventory



Subpart F Income: (1962 Revised Act only on CFC)

- Income from the insurance of risks of the country outside CFC’s country

- Foreign base company income:

1. Foreign personal holding Co. income

2. Foreign base company sales income

3. Foreign base company service income

4. Foreign base company shipping income

5. Foreign base company oil-related income



•

Foreign Tax Credit:

- Withholding Tax Credit: Full

- Deemed Paid / Derivative Credit: either

Full

OR

Deemed Paid Credit =

= Proportion of Dividend x Foreign Tax paid


Foreign Subsidiary paid dividend

Foreign subsidiary’s after-tax earnings

x F.Tax paid


Foreign Tax Credit: (cont.)

- If no dividend is paid no taxes except for “Subpart F” passive income

- When subsidiary is not controlled (less than 10% holding) only credit for direct taxes, no indirect credit

- Joint ventures same as WOS, but dividend is on % of ownership


• International Taxation of a Subsidiary under the Exclusion System:

Exclusion of foreign income typically applies to foreign dividends only. For royalties, interest payments, or lease payments, the foreign tax is just a low or zero withholding tax. Therefore, tax code will

- prescribe a credit system for non-dividend remittances

- or grant a much smaller exclusion percentage


• International Taxation of a Subsidiary under the Exclusion System:

Tax planning

- compute the overall tax burden per form of remittance (host country corporate taxes, withholding taxes, home country tax)

- remit as much as possible under the lowest-tax form


• International Taxation of a Subsidiary under the Exclusion System

Example:

- 95% exclusion for dividends- standard credit system for non-dividend income- Corporate taxes are 39%


profits royalties, interest

starting amount 100.00 100

corporate tax (25.00) -

after-tax 75 100

withholding tax (5%) (3.75) (17%) (17)

net receipts 71.25 83

gross-up - 17

taxable 3.5625 100

home tax 1.3894 39tax credit - 17net home tax 1.3894 22

Total taxes 30.1394 39


Example:



Potential Loophole:

- avoid host country taxes by paying out non-dividend remittances

- avoid home taxes by receiving dividends

Trick: non-dividend remittances paid to an off-shore holding company located in a tax haven. Holding company then transfers the income as dividends to

the parent



To close this loophole:

- no bilateral tax treaties with tax havens; unilateral rule offering partial rather than full exclusion

- look through rule: taxes are based on economic substance rather than on legal form; that is, the dividends would be taxed as the underlying

royalties or interest fees

- refuse an exclusion for dividends from law-tax countries, from foreign companies that enjoy a special low-tax status, or from incorporated mutual funds


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