Download - INTERNATIONAL TAX MANAGEMENT
INTERNATIONAL TAX MANAGEMENT
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
INTERNATIONAL TAX MANAGEMENT • 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
INTERNATIONAL TAX MANAGEMENT • 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.
INTERNATIONAL TAX MANAGEMENT • When can a double or triple taxation occur? (cont.)
- 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
INTERNATIONAL TAX MANAGEMENT • When can a double or triple taxation occur? (cont.)
- 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)
INTERNATIONAL TAX MANAGEMENT • When can a double or triple taxation occur? (cont.)
- 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)
INTERNATIONAL TAX MANAGEMENT
• 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
INTERNATIONAL TAX MANAGEMENT
• An example of double taxationGerman 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
INTERNATIONAL TAX MANAGEMENT
• 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
INTERNATIONAL TAX MANAGEMENT
• 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%)”
INTERNATIONAL TAX MANAGEMENT
• 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
INTERNATIONAL TAX MANAGEMENT
• 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 TAX MANAGEMENT
• International Taxation of a Branch under the Credit System:
- Disagreement on profit allocation- Excess tax credits
• Disagreement on profit allocationMain 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
INTERNATIONAL TAX MANAGEMENT
• Disagreement on profit allocation (cont.)Example:Sales: DEM 1200/400, cogs 700/300 in Germany/TunisiaTotal indirect (overhead) costs: DEM 300, to be allocated- Germany: in proportion to cogs- Tunisia: in proportion to sales
INTERNATIONAL TAX MANAGEMENT
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 CreditsIf foreign taxes exceed the domestic norm: rarely a full refund of the excess taxes paid abroadExample: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 income2. Aggregation of home and foreign income3. Carry-forward or Carry-back rules
INTERNATIONAL TAX MANAGEMENT
• 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
INTERNATIONAL TAX MANAGEMENT
Tunisia Hong Kong
tax rate 50% 25%sales 220 200(costs) (120) (100)
branch profit 100 100(taxes) (50) (25)net profit 50 75
Germanynet 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
• Excess Tax Credits Example:2. Aggregation of home and foreign income (rare):
INTERNATIONAL TAX MANAGEMENT
Tunisia Hong Kong
tax rate 50% 25%sales 220 140(costs) (120) (100)
branch profit 100 40(taxes) (50) (10)net profit 50 30
Germanynet branch profit 50 30gross-up 50 10taxable 100 40
total foreign taxable income
tax due (40%) 56(credit) 50 + 10 = (60)net tax due 0unused tax credit 4Total taxes paid (43% of 140) 60
140
• Excess Tax Credits Example: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 backRefund of excess tax credits is limited to the home
country taxes effetively paid in the last few years
INTERNATIONAL TAX MANAGEMENT
• 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
INTERNATIONAL TAX MANAGEMENT
• 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)
INTERNATIONAL TAX MANAGEMENT
• 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
INTERNATIONAL TAX MANAGEMENT
• Tax Planning for a Branch under the Credit System:
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
INTERNATIONAL TAX MANAGEMENT
• Tax Planning for a Branch under the Credit System:
Transfer PricingLimitations:
- 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
INTERNATIONAL TAX MANAGEMENT
• Tax Planning for a Branch under the Credit System:
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
INTERNATIONAL TAX MANAGEMENT
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
Germanynet branch profit 50 30 30 60gross-up 50 10 30 20taxable income 100 40 60 80
total foreign taxable income
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• Tax Planning for a Branch under the Credit System:
Example
INTERNATIONAL TAX MANAGEMENT
• Tax Planning for a Branch under the Credit System:
Tax Haven Example
INTERNATIONAL TAX MANAGEMENT
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
INTERNATIONAL TAX MANAGEMENT
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
INTERNATIONAL TAX MANAGEMENT
• 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
INTERNATIONAL TAX MANAGEMENT
• Remittances from a Subsidiary:
Forms:- Capital transactions
- Dividends
- Non-dividend remittances: royalties, lease payments, interest, management fees
- Transfer pricing
INTERNATIONAL TAX MANAGEMENT
• Remittances from a Subsidiary:
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
INTERNATIONAL TAX MANAGEMENT
• Remittances from a Subsidiary:
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
INTERNATIONAL TAX MANAGEMENT
• 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
INTERNATIONAL TAX MANAGEMENT
• 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
INTERNATIONAL TAX MANAGEMENT
• 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 TAX MANAGEMENT
• 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 TAX MANAGEMENT
• 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
INTERNATIONAL TAX MANAGEMENT
• International Taxation of a Subsidiary under the Credit System:
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
INTERNATIONAL TAX MANAGEMENT
• International Taxation of a Subsidiary under the Credit System:
Indirect Foreign Tax Credit: (Section 902, US I.R. Code)
- 10% ownership
Indirect Tax Credit =
subject to:
Max. Total Tax Credit =
INTERNATIONAL TAX MANAGEMENT
Dividend (incl. Withholding Tax)Earnings net of F.I. Taxes
x F. Tax.
Consolidated F. Profits & Losses
Worldwide Taxable IncomeAmount 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
• International Taxation of a Subsidiary under the Credit System:Indirect Foreign Tax Credit. Example:
INTERNATIONAL TAX MANAGEMENT
• International Taxation of a Subsidiary under the Credit System: 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
INTERNATIONAL TAX MANAGEMENT
• International Taxation of a Subsidiary under the Credit System:
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
INTERNATIONAL TAX MANAGEMENT
• International Taxation of a Subsidiary under the Credit System:
CFC - Baskets:
1. Passive Income2. Financial Service Income3. Shipping Income4. High withholding Tax on Interest Income
INTERNATIONAL TAX MANAGEMENT
• International Taxation of a Subsidiary under the Credit System:
Intercompany Transactions:IRS regards price in an arm’s length transaction
1. Non interest bearing loans2. No pay services3. Transfer of M/C or equipment at no charge4. Transfer of intangible property5. Sale of inventory
INTERNATIONAL TAX MANAGEMENT
• International Taxation of a Subsidiary under the Credit System:
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. income2. Foreign base company sales income3. Foreign base company service income4. Foreign base company shipping income5. Foreign base company oil-related income
INTERNATIONAL TAX MANAGEMENT
• International Taxation of a Subsidiary under the Credit System:
•Foreign Tax Credit: - Withholding Tax Credit: Full- Deemed Paid / Derivative Credit: either
FullORDeemed Paid Credit =
= Proportion of Dividend x Foreign Tax paid
INTERNATIONAL TAX MANAGEMENT
Foreign Subsidiary paid dividendForeign subsidiary’s after-tax
earnings
x F.Tax paid
• International Taxation of a Subsidiary under the Credit System:
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 TAX MANAGEMENT
• 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 TAX MANAGEMENT
• 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 TAX MANAGEMENT
• 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%
INTERNATIONAL TAX MANAGEMENT
profits royalties, interest
starting amount 100.00 100corporate tax (25.00) -after-tax 75 100
withholding tax (5%) (3.75) (17%) (17)net receipts 71.25 83
gross-up - 17taxable 3.5625 100
home tax 1.3894 39tax credit - 17net home tax 1.3894 22
Total taxes 30.1394 39
• International Taxation of a Subsidiary under the Exclusion System
Example:
INTERNATIONAL TAX MANAGEMENT
• International Taxation of a Subsidiary under the Exclusion System
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
INTERNATIONAL TAX MANAGEMENT
• International Taxation of a Subsidiary under the Exclusion System
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
INTERNATIONAL TAX MANAGEMENT