International Taxation: Debt International Taxation: Debt Financing, Taxation and Financing, Taxation and Transfer PricingTransfer Pricing

By Koy SaechaoBy Koy Saechao

OverviewOverview

Debt financingDebt financing Tax implications Tax implications for equityfor equity

International tax policies for host International tax policies for host and home governmentand home government

Tax management principlesTax management principles

Debt FinancingDebt Financing

Taxes are often considered with the Taxes are often considered with the treatment of debt financing. Debt treatment of debt financing. Debt management is affected by:management is affected by:

Interest payments as deductible expensesInterest payments as deductible expenses Treatment of capital losses (or gains)Treatment of capital losses (or gains) Valuation with Adjusted Present Value (tax Valuation with Adjusted Present Value (tax

shields)shields)

International TaxationInternational Taxation

General principle of international taxation: General principle of international taxation: There is a clear distinction between There is a clear distinction between returns to debt and returns to equity.returns to debt and returns to equity.

1.1. Tax deductibility of interest paymentsTax deductibility of interest payments2.2. Treatment of foreign exchange Treatment of foreign exchange

gains/lossesgains/losses

Corporate income tax is designed as a tax Corporate income tax is designed as a tax on the returns to equity onlyon the returns to equity only

International Tax International Tax PolicyPolicy

Equity returns are taxed in the host Equity returns are taxed in the host country, then may be taxed in country, then may be taxed in home country (possibly different home country (possibly different timing)timing)

Host government acts first

Home government Home government determines policies determines policies vis-à-vis the host vis-à-vis the host

governmentgovernment

Host GovernmentHost Government

Determine tax rates on corporate profits firstDetermine tax rates on corporate profits first

Set withholding taxes: taxes imposed on capital Set withholding taxes: taxes imposed on capital paid to the parent as they are taken out of the paid to the parent as they are taken out of the country.country.

– DividendsDividends– Repatriation of profitsRepatriation of profits– LicenseLicense– Royalty feesRoyalty fees– Other revenue paidOther revenue paid

““First Crack” to tax income produce within host First Crack” to tax income produce within host country’s boarderscountry’s boarders

Home GovernmentHome Government

Tax policies are complicated because Tax policies are complicated because they establish policies relative to they establish policies relative to previously determined host previously determined host country’s policiescountry’s policies

Policies must consider two factors:Policies must consider two factors: Treatment of foreign income and Treatment of foreign income and

foreign taxes paidforeign taxes paid Timing of taxationsTiming of taxations

Treatment of foreign Treatment of foreign income and taxes paidincome and taxes paid

TypeType SummarySummary ImplicationImplication

Exempt from Exempt from DomesticDomestic

Firm will not be taxed on any Firm will not be taxed on any income earned aboardincome earned aboard

Foreign tax rate governs Foreign tax rate governs taxes paid by the firmtaxes paid by the firm

Full Tax CreditFull Tax Credit Tax profits earned overseas Tax profits earned overseas are taxed at same rate as are taxed at same rate as profits earned at home, then profits earned at home, then give full tax credit for foreign give full tax credit for foreign taxes paidtaxes paid

Home tax rate generally Home tax rate generally governs taxes paid by the governs taxes paid by the firmfirm

DeductionDeduction Tax foreign profits at the Tax foreign profits at the domestic rate, then give domestic rate, then give deduction for taxes paiddeduction for taxes paid

Foreign taxes paid Foreign taxes paid therefore only reduce therefore only reduce total taxable income. total taxable income. There is some double There is some double taxation (not used much)taxation (not used much)

Double TaxDouble Tax Tax foreign profits, give no Tax foreign profits, give no recognition for foreign taxes recognition for foreign taxes paidpaid

Complete double taxation Complete double taxation occursoccurs

Example 11.1Example 11.1

Peripatetic Enterprises headquartered in Peripatetic Enterprises headquartered in Nide, has foreign income from Serendip.Nide, has foreign income from Serendip.

Foreign IncomeForeign Income $1000$1000

Serendip Tax RateSerendip Tax Rate 35%35%

Domestic Tax RateDomestic Tax Rate 45%45%

Example of Home Example of Home PoliciesPolicies

ExemptionExemption CreditCredit DeductionDeduction Double Double TaxTax

Foreign Foreign IncomeIncome

$1000$1000 $1000$1000 $1000$1000 $1000$1000

Foreign Foreign Taxes PaidTaxes Paid

$350$350 $350$350 $350$350 $350$350

Home Home Taxes PaidTaxes Paid

$0$0 $100$100 $293$293 $450$450

Net Net IncomeIncome

$650$650 $550$550 $357$357 $200$200

Peripatetic prefers tax exempt policy. Beyond that, tax credit over deduction, and prefers either of these over double

taxation.

Timing of TaxationTiming of Taxation

Contemporaneous Contemporaneous TaxationTaxation: home country : home country may choose to tax may choose to tax foreign equity returns foreign equity returns during fiscal year in during fiscal year in which they are earned. which they are earned.

Used mostly for foreign Used mostly for foreign branches of MNE.branches of MNE.

Branch is an extension Branch is an extension

of parent companyof parent company

Tax DeferralTax Deferral: taxation : taxation occurs at time profits are occurs at time profits are repatriated as dividends. repatriated as dividends.

Used for foreign Used for foreign subsidiaries of MNE.subsidiaries of MNE.

Subsidiary is an affiliate Subsidiary is an affiliate of a MNE that is of a MNE that is incorporated in the incorporated in the country in which it country in which it operatesoperates

Encourages profits to be Encourages profits to be reinvested abroad rather reinvested abroad rather than repatriated.than repatriated.

Summary of Summary of International Tax PoliciesInternational Tax Policies First Crack Principle: Host country sets corporate tax First Crack Principle: Host country sets corporate tax

ratesrates

Home country reacts to host country’s policies by Home country reacts to host country’s policies by deciding treatment of foreign income and taxes, as deciding treatment of foreign income and taxes, as well as timing of taxes.well as timing of taxes.

MNEs prefer to invest where taxes are lowerMNEs prefer to invest where taxes are lower

Tax laws are more complicated then the framework Tax laws are more complicated then the framework presented. Subpart F: Subsidiary income taxed presented. Subpart F: Subsidiary income taxed regardless of repatriation. regardless of repatriation.

International Tax International Tax ManagementManagement

International TaxationInternational Taxation

The goal to international tax The goal to international tax management is to increase management is to increase corporation-wide profits by reducing corporation-wide profits by reducing the total amount of taxes paid.the total amount of taxes paid.

Management IssuesManagement Issues

Relevant decisions for branchesRelevant decisions for branches Allocation of profitsAllocation of profits Allocation of costsAllocation of costs

Branch vs. Subsidiary (Aaron)Branch vs. Subsidiary (Aaron)

Branch DecisionsBranch Decisions

We want to allocate pre-tax profits to maximize We want to allocate pre-tax profits to maximize after-tax profits. after-tax profits.

1.1. Review cost allocation amongst branchesReview cost allocation amongst branches2.2. Review pricing of goods transferred amongst Review pricing of goods transferred amongst

subsidiaries (Transfer prices)subsidiaries (Transfer prices)

General Rule: A dollar spent on generating General Rule: A dollar spent on generating income should be allocated to and deducted income should be allocated to and deducted from revenue in the same country. from revenue in the same country.

Case StudyCase Study

C&C Enterprise, a Multinational C&C Enterprise, a Multinational Company located in Chicago. Company located in Chicago. Branches located in Japan, Canada, Branches located in Japan, Canada, Ireland, Great Britain and Germany. Ireland, Great Britain and Germany.

The tax structure is based on worldwide The tax structure is based on worldwide tax principle: gross foreign branch tax principle: gross foreign branch income is taxed and a full credit is income is taxed and a full credit is given for foreign taxes paid up to the given for foreign taxes paid up to the amount of the US tax liability.amount of the US tax liability.

Cost AllocationCost Allocation

Currently, expenses incurred at C&C Enterprise Currently, expenses incurred at C&C Enterprise headquarters in Chicago total $50,000, each branch is headquarters in Chicago total $50,000, each branch is charged $10,000.charged $10,000.

There is a proposal to allocate costs to high-tax countries in There is a proposal to allocate costs to high-tax countries in order to achieve the largest tax deductions possible. As order to achieve the largest tax deductions possible. As such:such:

This decreases foreign taxes paid from $88,100 to $83,400This decreases foreign taxes paid from $88,100 to $83,400 US tax liability increases from $300 to $5000US tax liability increases from $300 to $5000 Net branch income remains unchanged, $171,600Net branch income remains unchanged, $171,600

Taxes are shifted from foreign countries to domestic Taxes are shifted from foreign countries to domestic country, but total taxes remain the same. By using the country, but total taxes remain the same. By using the credit method, domestic country taxes total branch credit method, domestic country taxes total branch income regardless of where the income is earned or income regardless of where the income is earned or where the taxes are paid. where the taxes are paid.

International Tax International Tax Management Principle I:Management Principle I:

If there are no excess tax credits, cost If there are no excess tax credits, cost allocation decisions do not matter for allocation decisions do not matter for branches. If there are excess tax branches. If there are excess tax credits, show branch profits in the credits, show branch profits in the lowest-tax jurisdictions by allocating lowest-tax jurisdictions by allocating costs to the highest-tax jurisdictions, costs to the highest-tax jurisdictions, without making negative profits.without making negative profits.

Transfer PricingTransfer Pricing

Pricing of internally-traded goods. Management may suggest Pricing of internally-traded goods. Management may suggest altering the company’s transfer prices to show profits in altering the company’s transfer prices to show profits in low-tax jurisdictions.low-tax jurisdictions.

The Vice-President of C&C Enterprises suggests raising transfer The Vice-President of C&C Enterprises suggests raising transfer prices from $16 to $18 for countries with high-tax prices from $16 to $18 for countries with high-tax jurisdictions. By increasing the transfer prices, it:jurisdictions. By increasing the transfer prices, it:

• Reduces total foreign taxes paid from $88,100 to $81,500Reduces total foreign taxes paid from $88,100 to $81,500• Domestic tax liability increases from $300 to $6,900Domestic tax liability increases from $300 to $6,900• Net branch income remains unchanged, $171,600Net branch income remains unchanged, $171,600

Total net income remains unchanged because US tax liability Total net income remains unchanged because US tax liability increases while the foreign taxes paid decreases. Transfer increases while the foreign taxes paid decreases. Transfer pricing affects what government receives the tax revenue, pricing affects what government receives the tax revenue, but it does not affect the total taxes the corporation pays.but it does not affect the total taxes the corporation pays.

International Tax International Tax Management Principle IIManagement Principle II

If there are no excess tax credits, transfer pricing If there are no excess tax credits, transfer pricing decisions do not matter for branches. If there are decisions do not matter for branches. If there are excess tax credits, show branch profits in the lowest-excess tax credits, show branch profits in the lowest-tax jurisdictions by following a simple rule:tax jurisdictions by following a simple rule:

If one branch is selling to a foreign branch, set the If one branch is selling to a foreign branch, set the transfer price as high as possible when T*> T without transfer price as high as possible when T*> T without making profits negative, and as low as possible when making profits negative, and as low as possible when T*<T without making profits negative. T*<T without making profits negative.

T=Tax rate on profits earned by the branch T=Tax rate on profits earned by the branch T*=Tax rate on profit earned by the foreign branch.T*=Tax rate on profit earned by the foreign branch.

Tariffs and Transfer Tariffs and Transfer PricingPricingTariffs are additional costs imposed on goods and services Tariffs are additional costs imposed on goods and services

imported to a country.imported to a country.

Management can minimize import duties paid by setting transfer Management can minimize import duties paid by setting transfer prices as low as possible. Tariffs are levied on the transfer prices as low as possible. Tariffs are levied on the transfer prices selected and are deductible expenses in figuring the prices selected and are deductible expenses in figuring the branches’ income taxes. branches’ income taxes.

Setting low transfer prices to $14:Setting low transfer prices to $14: Can minimize the import duty paid from $64,000 to $56,000Can minimize the import duty paid from $64,000 to $56,000 Total foreign income taxes rise from $62,900 to $69,220Total foreign income taxes rise from $62,900 to $69,220 The US tax liability falls from $3,740 to $140The US tax liability falls from $3,740 to $140 Net Branch Income increases $5,280 to $134,640Net Branch Income increases $5,280 to $134,640

Because an import tariff is a deductible expense, it does not Because an import tariff is a deductible expense, it does not generate a US tax credit, thus affecting net branch income.generate a US tax credit, thus affecting net branch income.

International Tax International Tax Management Principle IIIManagement Principle III

If there are no excess tax credits, use the lowest If there are no excess tax credits, use the lowest possible transfer price between branches in the possible transfer price between branches in the presence of import tariffs. If there are excess tax presence of import tariffs. If there are excess tax credits, minimize branch taxes paid in the credits, minimize branch taxes paid in the presence of import tariffs by comparing T* to [T + presence of import tariffs by comparing T* to [T + Td*(1-T*)]:Td*(1-T*)]:

Use the high transfer price if T*>[T +Td*(1- T*)] Use the high transfer price if T*>[T +Td*(1- T*)] without making profits negative, and use the low without making profits negative, and use the low transfer price if T*<[T +Td*(1- T*)] without transfer price if T*<[T +Td*(1- T*)] without making profits negative. making profits negative.

Summary of Tax Summary of Tax Management Principles Management Principles

DecisionDecision No Excess Tax No Excess Tax CreditsCredits

Excess Tax Excess Tax CreditsCredits

Cost AllocationCost Allocation Does not matterDoes not matter Allocate costs to Allocate costs to high-tax countrieshigh-tax countries

Transfer PricingTransfer Pricing Does not matterDoes not matter Show profits in Show profits in low-tax countrieslow-tax countries

Transfer Pricing Transfer Pricing with Tariffwith Tariff

Low transfer priceLow transfer price Minimize total Minimize total taxes by taxes by comparing T* to comparing T* to [T +Td*(1- T*)][T +Td*(1- T*)]

International TaxationInternational Taxation

Branch considerationsBranch considerations Branch vs Subsidiary Status Branch vs Subsidiary Status

(Aaron)(Aaron)

QuestionsQuestions