1. Università Bocconi, A.A: 2005-2006 1 Mec – Comparative public economics 1 Università Bocconi A.A. 2005-2006 Comparative public economics Giampaolo Arachi

2. Università Bocconi, A.A: 2005-2006 2 Mec – Comparative public economics 2 Multinational tax planning The decision to invest at home or abroad The decision to repatriate or reinvest Limitations to tax deferral FTC limitation Tax Planning under FTC limitation References: M. Scholes, M. A. Wolfson, M. Erickson, E. L. Maydew, T. Shevlin (SWEMS), Taxes and business strategy: a planning approach, Pearson Prentice Hall, third edition, 2005, ch. 11

3. Università Bocconi, A.A: 2005-2006 3 Mec – Comparative public economics 3 The decision to invest at home or abroad Assumptions: Tax base is the same in home and foreign country Domestic tax rate greater than foreign tax rate: t d > t f FTC cannot exceed taxes paid abroad Home country investment for n years accumulates to: 1 + R d (1-t d )] n = (1+r d ) n Foreign country investment for n year accumulates to (after repatriation): Foreign investment is more attractive if : R d, t f low R f, t d, n high

4. Università Bocconi, A.A: 2005-2006 4 Mec – Comparative public economics 4 The decision to repatriate or reinvest For each $ earned abroad: 1-t f can be repatriated or reinvested After n years (1-t f )$ repatriated accumulate to: (1 - t d ) [1 + R d (1 - t d ) ] n = (1 - t d ) [1 + r d ] n After n year (1-t f )$ reinvested abroad accumulate to: (1 - t f ) (1 + r f ) n – [(1 - t f ) (1 + r f ) n ] (t d -t f ) (1-t f ) = [1 + r f ] n (1 - t d ) reinvest if r f > r d

5. Università Bocconi, A.A: 2005-2006 5 Mec – Comparative public economics 5 US: Subpart F income and CFCs Provisions designed to prevent firms from forming paper companies in tax haven to record income from passive investment, sales, services, shipping operations or oil related activities In general these rules work by subjecting Subpart F income to U.S. taxation as if the income was repatriated the the U.S. parent when the income is earned Controlled Foreign Corporation (CFC) owned more than 50% in terms of voting power or market value by US shareholders A US shareholder is any US person owning at least 10% of the voting stock

6. Università Bocconi, A.A: 2005-2006 6 Mec – Comparative public economics 6 Subpart F income Income from the insurance of risks outside the country in which the CFC is organized Foreign based company income Foreign personal holding company income or FPHCI (dividends, interest, rents, royalties, etc.) Sales income Service income Shipping income Oil and gas related income

7. Università Bocconi, A.A: 2005-2006 7 Mec – Comparative public economics 7 CFC rules and inversion transactions Many foreign countries do not have CFC rules  US based multinationals may be disadvantaged compared with similarly positioned multinationals based abroad  Ristructuring of corporate groups so that the parent company would be incorporated abroad (Cayman islands) Inversion: placing of the former U.S. corporation under a newly created foreign parent corporation formed in a low tax jurisdiction that does not have CFC rules exploiting a non taxable transaction under Sections 351 and 368 Anti-inversion rules: outbound mergers and stock transfers do not qualify for tax-free treatment unless the shareholder of the transferred U.S. corporation receive less than 50% of the shares of the foreign acquiring corporation in the transaction

8. Università Bocconi, A.A: 2005-2006 8 Mec – Comparative public economics 8 FTC limitation where: FSI = foreign income earned through foreign branches + foreign income repatriated from foreign subsidiaries + Subpart F Worldwide income = domestic source income + FSI Usually US tax on worlwide income = t US x worldwide income FTC limitation = FSI x t US

9. Università Bocconi, A.A: 2005-2006 9 Mec – Comparative public economics 9 Excess FTC How to minimize FTC excess given the FTC limitation? Increase income and tax credit in low tax countries and reduce income and tax credit in high tax countries Modify dividend payout policy: defer distribution in high tax countries and increase dividends from low tax countries

10. Università Bocconi, A.A: 2005-2006 10 Mec – Comparative public economics 10 Example of FTC Subsidiary location Country ACountry BTogether 1Local taxable income1000 2000 2Local tax rate20%40% 3Local tax (2*1)200400600 4Net income (1-3)8006001400 5Dividend (50% payout *4)400300700 6Withholding tax (10%*5)403070 7Dividend net of foreign taxes (5-6)360270670 8Deemed-paid credit (=(5/4)*3)100200300 9US taxable income =5+8500 1000 10US tax (35% of 9)175 350 11Foreign tax credit (8+6)140230370 12Net US tax 3500 13FTC tax credit carryforward05520

11. Università Bocconi, A.A: 2005-2006 11 Mec – Comparative public economics 11 Example of FTC Subsidiary location Country ACountry BTogether 1Local taxable income1000 2000 2Local tax rate20%40% 3Local tax (2*1)200400600 4Net income (1-3)8006001400 5Dividend520240720 6Withholding tax (10%*5)522476 7Dividend net of foreign taxes (5-6)468216684 8Deemed-paid credit (=(5/4)*3)130160290 9US taxable income =5+86504001050 10US tax (35% of 9)227.5145367.5 11Foreign tax credit (8+6)182184366 12Net US tax 45.501.5 13FTC tax credit carryforward0440

12. Università Bocconi, A.A: 2005-2006 12 Mec – Comparative public economics 12 Separate basket limitation The FTC limitation must be computed separately for each basket of income Any income not in a specific basket goes into the general limitation basket Passive incomeFinancial services income Shipping incomeHigh withholding tax income Foreign trade incomeFSC income Income from noncontrolled CFC owned 10% or more

13. Università Bocconi, A.A: 2005-2006 13 Mec – Comparative public economics 13 Tax Planning under FTC limitation Firms in an excess credit positions have incentives to reduce their taxes paid in foreing countries Distribribute profit from foreign subsidiaries in ways that are tax deductible abroad –Interest on debt owned to the US parents or US subsidiaries –Rent on leases with the US parent or US subsidiaries –Royalties on licences Transfer Pricing for goods and services

14. Università Bocconi, A.A: 2005-2006 14 Mec – Comparative public economics 14 Transfer Pricing OCSE guidelines Section 482 (US code) “Arm’s length pricing” Transaction between related parties must be priced as if they involved unrelated parties Problems: transactions within related parties are systematically different from those that take place at arm’s length in the market goods and services transferred within a corporate group have no ready market (e.g. intangible assets as patents and trademarks) US approach “Advance pricing arrangements” The firm submits its proposed transfer-pricing methodology to the IRS for review. If the IRS agrees, then in principle the firm’s tranfer pricing should not be challenged as long as the firm adheres to the agreement

15. Università Bocconi, A.A: 2005-2006 15 Mec – Comparative public economics 15

16. Università Bocconi, A.A: 2005-2006 16 Mec – Comparative public economics 16 State taxes – (Eu formula apportionment) No transfer pricing regulation Taxable income allocated across jurisdiction according to an average on percentage of sales, assets, labor cost