Chapter 17 Multinational Tax Management

Copyright © 2004 Pearson Addison-Wesley. All rights reserved Multinational Tax Management Tax planning for multinational operations is an extremely complex but vitally important aspect of international business. To plan effectively, MNEs must understand not only the intricacies of their own operations worldwide, but also the different structures and interpretations of tax liabilities across countries. The primary objective of multinational tax planning is the minimization of the firm’s worldwide tax burden.

Copyright © 2004 Pearson Addison-Wesley. All rights reserved Multinational Tax Management Taxes have a major impact on corporate net income and cash flow through their influence on foreign investment decisions, financial structure, determination of the cost of capital, foreign exchange management, working capital management, and financial control. Management must not pursue the objective of minimizing the firm’s worldwide tax burden without full recognition that decision making within the firm must always be based on the economic fundamentals of the firm’s line of business.

Copyright © 2004 Pearson Addison-Wesley. All rights reserved Tax Principles Tax morality: –In many countries taxpayers, corporate or individual, do not voluntarily comply with the tax laws –The MNE must decide whether to follow a practice of full disclosure to tax authorities or adopt the philosophy “When in Rome, do as the Romans do” –Most MNEs follow the full disclosure practice

Copyright © 2004 Pearson Addison-Wesley. All rights reserved Tax Principles Tax neutrality: –When a government decides to levy a tax, it must consider not only the potential revenue from the tax, or how effectively it can be collected, but also the effect the proposed tax can have on private economic behavior –For example, the US government’s policy on taxation of foreign- source income has multiple objectives: Neutralizing tax incentives that favor or disfavor US private investment in developed countries Providing an incentive for US private investment in developing countries Improving the US BOP Raising revenue

Copyright © 2004 Pearson Addison-Wesley. All rights reserved Tax Principles One way to view neutrality is to require that the burden of taxation on each dollar, euro, pound, or yen of profit earned in home country operations by a MNE be equal to the burden of taxation on each currency equivalent of profit earned by the same firm in its foreign operations (domestic neutrality). A second way to view neutrality is to require that the tax burden on each foreign subsidiary of the firm be equal to the tax burden on its competitors in the am country (foreign neutrality). In theory, an equitable tax is one that imposes the same total tax burden on all taxpayers who are similarly situated and located in the same tax jurisdiction.

Copyright © 2004 Pearson Addison-Wesley. All rights reserved Tax Principles Despite the fundamental objectives of national tax authorities, it is widely agreed that taxes do affect economic decisions made by MNEs. Tax treaties between nations and differential tax structures, rates, and practices all result in a less than level playing field for the MNEs competing on world markets. Nations typically structure their tax systems along one of two basic approaches: –The worldwide approach –The territorial approach

Copyright © 2004 Pearson Addison-Wesley. All rights reserved Tax Principles The worldwide approach, also referred to as the residential or national approach, levies taxes on the income earned by firms that are incorporated in the host country, regardless of where the income was earned (domestically or abroad). A MNE earning income both at home and abroad would therefore find its worldwide income taxed by its home country tax authorities. For example, a country like the US taxes the income earned by firms based in the US regardless of whether the income earned by the firm is domestic or foreign in origin.

Copyright © 2004 Pearson Addison-Wesley. All rights reserved Tax Principles The territorial approach, also termed the source approach, focuses on the income earned by the firms within the legal jurisdiction of the host country, not on the country of firm incorporation. Countries like Germany follow this approach and apply taxes equally to foreign or domestic firms on income earned within the country, but in principle not on income earned outside the country.

Copyright © 2004 Pearson Addison-Wesley. All rights reserved Tax Principles A network of bilateral tax treaties, many of which are modeled after one proposed by the Organization for Economic Cooperation and Development (OECD), provides a means of reducing double taxation. Tax treaties normally define whether taxes are to be imposed on income earned in one country by the nationals of another, and if so, how. Tax treaties are bilateral, with the two signatories specifying what rates are applicable to which types of income between themselves alone.

Copyright © 2004 Pearson Addison-Wesley. All rights reserved Tax Principles Taxes are classified on the basis of whether they are applied directly to income, called direct taxes, or to some other measurable performance characteristic of the firm, called indirect taxes. Some categories include: –Income tax –Withholding tax –Value-added tax –Other national taxes

Copyright © 2004 Pearson Addison-Wesley. All rights reserved Tax Principles To prevent double taxation on the same income, most countries grant a foreign tax credit for income taxes paid to the host country. A tax credit is a direct reduction of taxes that would otherwise be due and payable. If there were no credits for foreign taxes paid, sequential taxation by the host government and then by the home government would result in a very high cumulative tax rate.

Copyright © 2004 Pearson Addison-Wesley. All rights reserved US Taxation of Foreign Source Income As discussed, the US applies the worldwide approach to international taxation to US MNEs operating globally, but the territorial approach to foreign firms operating within its borders. Dividends received from US corporate subsidiaries are fully taxable in the US at US tax rates but with credit allowed for direct taxes paid on income in a foreign country.

Copyright © 2004 Pearson Addison-Wesley. All rights reserved US Taxation of Foreign Source Income The amount of foreign tax allowed as a credit depends on five tax parameters: –Foreign corporate income tax rate –US corporate income tax rate –Foreign corporate dividend withholding tax rate for nonresidents (per the applicable bilateral tax treaty) –Proportion of ownership held by the US corporation in the foreign firm –Proportion of net income distributed (payout rate)

Copyright © 2004 Pearson Addison-Wesley. All rights reserved US Taxation of Foreign Source Income If a US based MNE receives income from a foreign country that imposes higher corporate income taxes than the US (or combined income and withholding tax), total creditable taxes will exceed US taxes on that foreign income. The result is excess foreign tax credits. The proper management of global taxes is not simple, and combines three different components: –Foreign tax credit limitations –Tax credit carry-forward/carry-back –Foreign tax averaging

Copyright © 2004 Pearson Addison-Wesley. All rights reserved US Taxation of Foreign Source Income Carlton Corporation is considering acquiring a profitable telecommunications manufacturing company in Brazil. The due diligence process includes an examination of the tax implications of paying dividends to Carlton from its existing subsidiary, Carlton Germany, and simultaneously paying dividends to Carlton from Carlton Brazil. The following exhibit summarizes the key tax management issue for Carlton.

17-17 Exhibit 17.6 Carlton’s Tax Management of Foreign-Source Income Efficient management of Carlton’s foreign tax position requires it to try and balance Deficit Foreign Tax Credits against Excess Foreign Tax Credits Pays taxes to US government separately on domestic-source income & foreign-source income Carlton Brazil Pays corporate income taxes in Brazil of 25% Dividend remitted after-tax Has paid less than US tax requirement of 35% on income Declares a dividend to its US parent Withholding taxes are deducted from the dividend before leaving Brazil of an additional 5% Deficit Foreign Tax Credit Carlton Pays corporate income taxes in the United States of 35% Carlton Germany Pays corporate income taxes in Germany of 40% Withholding taxes are deducted from the dividend before leaving Germany of an additional 10% Dividend remitted after-tax Has paid more than US tax requirement of 35% on income Declares a dividend to its US parent Excess Foreign Tax Credit

Copyright © 2004 Pearson Addison-Wesley. All rights reserved US Taxation of Foreign Source Income The rule that US shareholders do not pay US taxes on foreign-source income until that income is remitted to the US was amended in 1962 by the creation of special Subpart F income. The revision was designed to prevent the use of arrangements between operating companies and base companies located in tax havens as a means of deferring US taxes and to encourage greater repatriation of foreign incomes.

Copyright © 2004 Pearson Addison-Wesley. All rights reserved US Taxation of Foreign Source Income Subpart F income is subject to immediate US taxation even when not remitted. It is income of a type otherwise easily shifted offshore to avoid current taxation and includes: –Passive income received by the foreign corporation such as dividends, interest, rents, royalties, net foreign currency gains, net commodities gains, and income from the sale of non-income- producing property –Income from the issuance of US risks –Financial service income –Shipping income –Oil-related income –Certain related-party sales and service income

Copyright © 2004 Pearson Addison-Wesley. All rights reserved US Taxation of Foreign Source Income A MNE normally has a choice whether to organize a foreign subsidiary as a branch of the parent or as a local corporation. Both tax and nontax consequences must be considered. Nontax factors include the locus of legal liability, public image in the host country, managerial incentive considerations, and local legal and political requirements. A major tax consideration is whether the foreign subsidiary is expected to run at a loss for several years after start-up. A second tax consideration is the net tax burden after paying withholding taxes on dividends.

Copyright © 2004 Pearson Addison-Wesley. All rights reserved US Taxation of Foreign Source Income Over the years, the US has introduced into US tax laws special incentives dealing with international operations. To benefit from these incentives, a firm may have to form separate corporations for qualifying and nonqualifying activities. The most important US special corporation is a foreign sales corporation (FSC).

Copyright © 2004 Pearson Addison-Wesley. All rights reserved Exhibit 17.7 Foreign Sales Corporations (FSCs) US Manufacturer European Buyer Physical goods Foreign Sales Corporation completes the sale by re-selling the goods to the European Buyer. Foreign Sales Corporation (U.S. Virgin Islands) Goods are sold on paper to its Foreign Sales Corporation located in the U.S. Virgin Islands 1. The payment by the European Buyer is routed through the FSC. The FSC may charge the U.S. parent a commission, or simply pass the full payment on. 2. The tax benefits arise from the fact that up to 34% of the paper “profits” of the resale are excluded from U.S. taxation. 3. When the FSC pays a dividend to its parent on its profits, the dividend is not taxed by the U.S. tax authorities.

Copyright © 2004 Pearson Addison-Wesley. All rights reserved US Taxation of Foreign Source Income The primary tax issues facing a US-based MNE are: –Domestic-source income and foreign-source income are separated –Foreign-source income is separated into active and passive categories –If the remittance of active income from one subsidiary results in an excess foreign tax credit, and the remittance from a second subsidiary results in a foreign tax deficit, the credit may be applied to the deficit if the incomes are of the same “basket” under US tax law

Copyright © 2004 Pearson Addison-Wesley. All rights reserved Tax-Haven Subsidiaries and International Offshore Financial Centers Many MNEs have foreign subsidiaries that act as tax havens for corporate funds awaiting reinvestment or repatriation. Tax-haven subsidiaries, categorically referred to as international offshore financial centers, are partially a result of tax-deferral features on earned foreign income allowed by some of the parent countries.

Copyright © 2004 Pearson Addison-Wesley. All rights reserved Tax-Haven Subsidiaries and International Offshore Financial Centers Tax-haven subsidiaries are typically established in a country that can meet the following requirements: –A low tax on foreign investment or sales income earned by resident corporations and a low dividend withholding tax on dividends paid to the parent firm –A stable currency to permit easy conversion of funds into and out of the local currency –The facilities to support financial services activity –A stable government that encourages the establishment of foreign-owned financial and service facilities within its borders

Copyright © 2004 Pearson Addison-Wesley. All rights reserved Exhibit 17.9 International Offshore Financial Centers