10-2 International Taxation Chapter Topics Taxes and international business decisions. Differences in national corporate tax and withholding tax regimes. Overlapping tax jurisdictions and double taxation. Foreign tax credits. Controlled foreign corporations, Subpart F income, and foreign tax credit baskets. Tax treaties. Foreign currency translation for tax purposes. Tax incentives.
10-3 International Taxation Learning Objectives 1.Describe differences in corporate income tax and withholding tax regimes across countries. 2. Explain how overlapping tax jurisdictions cause double taxation. 3.Show how foreign tax credits reduce the incidence of double taxation. 4.Demonstrate how rules related to controlled foreign corporations, subpart F income, and foreign tax credit baskets affect U.S. taxation of foreign source income.
10-4 International Taxation Learning Objectives 5.Describe some of the benefits provided by tax treaties. 6. Explain and demonstrate procedures for translating foreign currency amounts for tax purposes. 7.Describe tax incentives provided by countries to attract foreign direct investment and stimulate exports.
10-5 The Impact of Taxes on International Business Decisions The location of international investments is affected by relative tax rates in the alternative countries The decision about the legal form of the foreign operation, branch or a corporation, is dependent on differential tax treatments. Method of financing, debt or equity, is affected by the rules governing taxation of interest and dividends in the host country.
10-6 Corporate Income Tax and Withholding Tax Regimes Types of Taxes Corporate income taxes are direct taxes on business income. These are imposed by most governments. The tax rates vary from zero percent in tax havens to over forty percent. Another type of taxes are withholding taxes. Withholding taxes are taxes on dividends and some other amounts paid to foreign citizens. Learning Objective 1
10-7 Corporate Income Tax and Withholding Tax Regimes Corporate income tax rates Significant variation in tax rates worldwide provides a distinct tax planning opportunity. Some countries tax at different rates based on the type of activity or nationality of the company owners. In addition to variation in tax rates, there is also variation in how taxable income is computed. Expenses that are deductible in one country are not deductible in others. Learning Objective 1
10-8 Corporate Income Tax and Withholding Tax Regimes Corporate income tax rates Since the mid 1980s, there has been a worldwide trend toward reduced tax rates. The U.S. started this trend with many other countries following suit in order to be competitive in attracting foreign investments. Tax haven countries take this trend to the extreme with some of these jurisdictions having zero percent tax rates. The Organization for Economic Cooperation and Development (OECD) has established guidelines to mitigate the negative impact of tax havens. Learning Objective 1
10-9 Corporate Income Tax and Withholding Tax Regimes Withholding taxes These taxes typically apply to three types of payments: dividends, interest, and royalties. Similar to corporate income taxes, withholding taxes vary across countries and by type of payment and recipient. Variation in withholding rates impact on tax planning. For example, a higher tax rate on dividends than interest payments would encourage relatively more debt financing and less equity financing. Heavy debt financing is referred to as thin capitalization. Learning Objective 1
10-10 Corporate Income Tax and Withholding Tax Regimes Value-added tax A substitute for sales taxes. These taxes are added into the price of the product or service at each stage. The U.S. does not have value-added tax but it is common in the the EU. It is also used in Australia, Canada, China, Hungary, Mexico, Nigeria, Turkey, and South Africa. Learning Objective 1
10-11 Tax Jurisdiction and Double Taxation Double taxation When two countries tax the same income, this is referred to as double taxation. This occurs when one country taxes the income earned by a foreign company in that country, and the same company’s home government taxes its foreign source income. Overlapping jurisdictions give rise to double taxation, and can even result in triple taxation. Learning Objective 2
10-12 Tax Jurisdiction and Double Taxation Taxation approaches Worldwide (nationality) approach – all income of a resident or company of a country is taxed by that country, regardless of where it is earned. Territorial approach – only income earned in that country is taxed. The worldwide approach is much more common. Learning Objective 2
10-13 Tax Jurisdiction and Double Taxation Basis for taxation The three most common bases for taxation are source, citizenship, and residence. Almost all countries tax income earned within their borders. That is, at its source. The citizenship basis taxes income of the country’s citizens regardless of source where they reside. The residence basis taxes income of the country’s residence regardless of source or citizenship. Learning Objective 2
10-14 Tax Jurisdiction and Double Taxation Basis for taxation – The U.S. approach The U.S. taxes on the basis of source, citizenship, and residence. Residence is defined by being a permanent resident (green card test). In combination with the worldwide approach, this means that a U.S. permanent resident that does not live in the U.S. is taxed on their foreign source income. Residence is also defined by residing in the U.S. for at least 183 days in a year (physical presence test). Learning Objective 2
10-15 Foreign Tax Credit (FTC) Background – Causes of double taxation Double taxation usually arises when a company is taxed on income earned in a foreign country and taxed on that same income by its country of residence. To alleviate double taxation in these cases, the country of residence generally defers to the country where the income was earned. In other words, source takes precedence over residence. Learning Objective 3
10-16 Foreign Tax Credit (FTC) Background – Solutions to double taxation One solution is for a country to adopt the territorial approach. Another solution is for a country to allow domestic companies to deduct taxes paid to foreign governments. A third solution is for a country to provide a tax credit to domestic companies for taxes paid to foreign governments. Most countries, including the U.S., use this approach. Learning Objective 3
10-17 Foreign Tax Credit (FTC) FTC – The U.S. approach The Internal Revenue Service (IRS) allows companies one of two options. One is to deduct all foreign taxes paid. The other is to receive a tax credit for all foreign income taxes paid. Given that the majority of such taxes are income taxes, companies tend to take the tax credit. Learning Objective 3
10-18 Foreign Tax Credit (FTC) FTC – Example Assume that GCO is a U.S. company has a branch in Mexico where the corporate income tax rate is 33%. The U.S. corporate income tax rate is 35%. GCO has foreign source income in Mexico of $50,000. GCO pays $16,500 of corporate income tax in Mexico and $20,000 of other taxes. GCO decides to do a calculation to choose between using taxes paid in Mexico as a deduction or tax credit. Learning Objective 3
10-19 Foreign Tax Credit (FTC) FTC – Example Deduction Credit Foreign source income $50,000 $50,000 Deduction for all taxes paid 36,500 0 U.S. Taxable income $13,500 $50,000 U.S. Income before tax credit $ 4,725 $17,500 Foreign tax credit 0 $16,500 Net U.S. tax liability $ 4,725 $ 1,000 Learning Objective 3
10-20 Foreign Tax Credit (FTC) FTC – Other The U.S. will not allow the credit to exceed the FTC limitation. This limitation cannot exceed either actual taxes paid to a foreign government. Or the taxes that would have been paid if the income was earned in the U.S. Excess FTC can be carried back one year or carried forward ten years. Learning Objective 3
10-21 Foreign Tax Credit (FTC) FTC baskets The Tax Reform Act of 1986 created FTC baskets. These baskets are defined by different types of foreign income. FTC is calculated separately for each of the nine baskets. Income from different baskets cannot be netted against one another. Learning Objective 3
10-22 Foreign Tax Credit (FTC) FTC baskets Passive income. High withholding tax interest. Financial services income. Shipping and aircraft income. Dividends of domestic international sales corporations. Foreign trade income or dividends of a foreign sales corporation. Foreign oil and extraction income. All other income. Learning Objective 3
10-23 Foreign Tax Credit (FTC) Indirect FTC (for subsidiaries) The U.S. allows an indirect FTC on foreign taxes paid by a foreign subsidiary of a U.S. parent. This FTC is not allowed until the income of the subsidiary is taxed in the U.S. The amount of income of a foreign subsidiary that is taxable in the U.S. is the before tax or “grossed-up” dividend. To qualify, the U.S. parent must own at least 10 percent of the voting stock of the foreign subsidiary. Learning Objective 3
10-24 Controlled Foreign Corporations, Subpart F income, and FTC Baskets Controlled foreign corporation (CFC) A foreign corporation where U.S. shareholders own more than 50 percent of the stock. A U.S. shareholders is a U.S. taxpayer that owns at least 10 percent of the stock. Much CFC income is referred to as Subpart F income. Unlike the deferral of tax on foreign subsidiaries until received as a dividend, Subpart F income is taxable currently. There is a safe harbor for such income in jurisdictions with tax rate > 90% of the U.S. rate. Learning Objective 4
10-25 Controlled Foreign Corporations, Subpart F income, and FTC Baskets Summary of foreign source income taxation What is the legal form of the foreign operation? Is the operation a CFC? Is the operation located in a tax haven? Does the income qualify as Subpart F income? The answers to each of these questions affects the determination of how foreign source income is taxed. Learning Objective 4
10-26 Tax Treaties Tax treaties – bi-national agreements regarding how individuals from one country are taxed on income earned in the other country. Their purpose is to alleviate double taxation problems. Reducing double taxation helps facilitate international trade and investment. Tax treaties also involve information sharing between governments that helps in domestic enforcement. Learning Objective 5
10-27 Tax Treaties Model treaties The OECD model treaty is the basis for most bilateral treaties of developed countries. A key part of the OECD model is that host countries only tax business profits of foreign companies associated with permanent establishments. Recommend withholding tax rates is another key part of the OECD model. The United Nations model treaty is designed to serve as a basis for treaties between developed and developing nations. Learning Objective 5
10-28 Tax Treaties U.S. tax treaties The U.S. also has a model tax treaty that serves as a starting point when negotiating tax treaties. This model has zero percent withholding tax for interest and royalties and 15 percent for dividend payments. The U.S. has treaties with over 50 countries. One notable exception is Brazil, primarily due to lack of Brazilian investment in the U.S. Treaty shopping is a tax reduction tactic related to treaties that some countries are trying to stop. Learning Objective 5
10-29 Translation of Foreign Operation Income in a Foreign Currency Translation of foreign branch income Net income is translated into U.S. dollars at the average exchange rate for the year. Taxes paid to the foreign government, translated at the exchange rate on the payment date, are then added. This second step is referred to as “grossing up.” When earnings are repatriated to the U.S. and converted to U.S. dollars, the difference between this amount and the translated net income is a foreign exchange gain or loss. Learning Objective 6
10-30 Translation of Foreign Operation Income in a Foreign Currency Translation of foreign subsidiary income Dividends paid to the U.S. parent are translated at the spot rate on the date of payment. Taxes deemed paid on the dividend, translated at the spot rate on the date of payment, are then added, or “grossed up.” The translated amount of taxes deemed paid is used to determine the foreign tax credit. Learning Objective 6
10-31 Tax Incentives Tax holidays The term tax holiday refers to an incentive used by a government that partially or completely exempts a taxpayer for a period of time. Many Asian countries offer tax holidays to foreign companies. The primary reason for offering tax holidays is to encourage foreign investment. MNEs can enjoy significant tax reductions provided that profits are not repatriated. Learning Objective 7
10-32 Tax Incentives U.S. export incentives CFC and Subpart F income provisions prevent some tax avoidance strategies previously used by exporters. Domestic international sales corporation (DISC) was a short-lived export incentive program for U.S. companies. Foreign sales corporation (FSC) was another short-lived export incentive program for U.S. companies. Both of these programs were eventually repealed due to foreign opposition. The Extraterritorial Income Exclusion act (ETI) essentially replaced the FSC. Learning Objective 7
10-33 Tax Incentives American Jobs Creation Act of 2004 (AJCA) The AJCA was an attempt to spur job growth in the U.S. manufacturing sector, broadly defined. The program provides a deduction that effectively reduces income tax rates for domestic manufacturers. The deduction is available even to companies that don’t export. In addition, the AJCA contains a provision that allows for significant tax breaks on repatriations of foreign source income. Learning Objective 7