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