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INTERNATIONAL TAX MANAGEMENT. Multiple Taxation Vs. Tax Neutrality Double Right to Tax: -The Residence Principle: All residents of the country (that is,

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Presentation on theme: "INTERNATIONAL TAX MANAGEMENT. Multiple Taxation Vs. Tax Neutrality Double Right to Tax: -The Residence Principle: All residents of the country (that is,"— Presentation transcript:

1 INTERNATIONAL TAX MANAGEMENT

2 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

3 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

4 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.

5 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

6 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)

7 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)

8 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

9 INTERNATIONAL TAX MANAGEMENT An example of double taxation German company with a branch/PE in Tunisia:

10 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

11 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%)”

12 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)

13 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

14 Limitations to Tax Neutrality: No universal neutrality -tax rates differCEN = CIN -No real-world “CEN” system is fully CEN, no real world “CIN” system is fully CIN INTERNATIONAL TAX MANAGEMENT

15 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 INTERNATIONAL TAX MANAGEMENT

16 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 INTERNATIONAL TAX MANAGEMENT

17 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 INTERNATIONAL TAX MANAGEMENT

18 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

19 Excess Tax Credits Example: 2.Aggregation of home and foreign income (rare): INTERNATIONAL TAX MANAGEMENT

20 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 back Refund of excess tax credits is limited to the home country taxes effetively paid in the last few years INTERNATIONAL TAX MANAGEMENT

21 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

22 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

23 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

24 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

25 Tax Planning for a Branch under the Credit System: 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 INTERNATIONAL TAX MANAGEMENT

26 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

27 Tax Planning for a Branch under the Credit System: Example INTERNATIONAL TAX MANAGEMENT

28 Tax Planning for a Branch under the Credit System: Tax Haven Example INTERNATIONAL TAX MANAGEMENT

29 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

30 Tax Planning for a Branch under the Exclusion System: Example Limitations: arm’s length rule, import duties INTERNATIONAL TAX MANAGEMENT

31 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

32 Remittances from a Subsidiary: Forms: -Capital transactions -Dividends -Non-dividend remittances: royalties, lease payments, interest, management fees -Transfer pricing INTERNATIONAL TAX MANAGEMENT

33 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

34 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

35 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

36 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

37 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

38 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

39 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

40 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

41 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 Income Amount of Tax Liab. x

42 International Taxation of a Subsidiary under the Credit System: Indirect Foreign Tax Credit. Example: INTERNATIONAL TAX MANAGEMENT

43 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

44 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 stockordinary income not capital gains INTERNATIONAL TAX MANAGEMENT

45 International Taxation of a Subsidiary under the Credit System: CFC - Baskets: 1. Passive Income 2. Financial Service Income 3. Shipping Income 4. High withholding Tax on Interest Income INTERNATIONAL TAX MANAGEMENT

46 International Taxation of a Subsidiary under the Credit System: 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 INTERNATIONAL TAX MANAGEMENT

47 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. 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 INTERNATIONAL TAX MANAGEMENT

48 International Taxation of a Subsidiary under the Credit System: Foreign Tax Credit: -Withholding Tax Credit:Full -Deemed Paid / Derivative Credit:either Full OR Deemed Paid Credit = = Proportion of Dividend x Foreign Tax paid INTERNATIONAL TAX MANAGEMENT Foreign Subsidiary paid dividend Foreign subsidiary’s after-tax earnings x F.Tax paid

49 International Taxation of a Subsidiary under the Credit System: Foreign Tax Credit: (cont.) -If no dividend is paidno 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

50 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

51 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

52 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

53 International Taxation of a Subsidiary under the Exclusion System Example: INTERNATIONAL TAX MANAGEMENT

54 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

55 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


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