Eiteman/Stonehill/MoffettMultinationalBusinessFinance,SixteenthEdition

Chapter15:MultinationalTaxManagement

Copyright?2023PearsonEducation,Inc.

Copyright?2023PearsonEducation,Inc.

Copyright?2023PearsonEducation,Inc.

Chapter15

MultinationalTaxManagement

15.1 PrimaryObjective.Whatistheprimaryobjectiveofmultinationaltaxplanning?

Theprimaryobjectiveofmultinationaltaxplanningistopaythelowestglobaleffectivetaxrate.

15.2 TaxMorality.Whatismeantbythetermtaxmorality?Ifforexample,yourcompanyhasasubsidiaryinRussiawheresomebelievetaxevasionisafineart,shouldyoucomplywithRussiantaxlawsorviolatethelawsasdoyourlocalcompetitors?

TheMNEfacesnotonlyamorassofforeigntaxesbutalsoanethicalquestion.Inmanycountriestaxpayers,corporateorindividual,donotvoluntarilycomplywiththetaxlaws.Smallerdomesticfirmsandindividualsarethechiefviolators.TheMNEmustdecidewhethertofollowapracticeoffulldisclosuretotaxauthoritiesoradoptthephilosophy,“WheninRome,doastheRomansdo.”Giventhelocalprominenceofmostforeignsubsidiariesandthepoliticalsensitivityoftheirposition,mostMNEsfollowthefulldisclosurepractice.Somefirms,however,believethattheircompetitivepositionwouldbeerodediftheydidnotavoidtaxestothesameextentastheirdomesticcompetitors.Thereisobviouslynoprescriptiveanswertotheproblem,sincebusinessethicsarepartlyafunctionofculturalheritageandhistoricaldevelopment.

15.3 TaxNeutrality.Whatistaxneutrality?Whatisthedifferencebetweendomesticneutralityandforeignneutrality?

Theidealtaxshouldnotonlyraiserevenueefficientlybutalsohaveasfewnegativeeffectsoneconomicbehavioraspossible.Sometheoristsarguethattheidealtaxshouldbecompletelyneutralinitseffectonprivatedecisionsandcompletelyequitableamongtaxpayers.Thisistaxneutrality

Whenagovernmentdecidestolevyatax,itmustconsidernotonlythepotentialrevenuefromthetax,orhowefficientlyitcanbecollected,butalsotheeffecttheproposedtaxcanhaveonprivateeconomicbehavior.Forexample,theU.S.government’spolicyontaxationofforeign-sourceincomedoesnothaveassingleobjectivetheraisingofrevenue.

Onewaytoviewneutralityistorequirethattheburdenoftaxationoneachdollar,euro,pound,oryenofprofitearnedinhomecountryoperationsbyanMNEbeequaltotheburdenoftaxationoneachcurrencyequivalentofprofitearnedbythesamefirminitsforeignoperations.Thisiscalleddomesticneutrality.Asecondwaytoviewneutralityistorequirethatthetaxburdenoneachforeignsubsidiaryofthefirmbeequaltothetaxburdenonitscompetitorsinthesamecountry.Thisiscalledforeignneutrality.ThelatterpolicyisoftensupportedbyMNEsbecauseitfocusesmoreonthecompetitivenessoftheindividualfirminindividualcountrymarkets.

15.4 WorldwideversusTerritorial.Whatisthedifferencebetweentheworldwideandterritorialapproachestotaxation?

Theworldwideapproach,alsoreferredtoastheresidentialornationalapproach,leviestaxesontheincomeearnedbyfirmsthatareincorporatedinthehostcountry,regardlessofwheretheincomewasearned(domesticallyorabroad).AnMNEearningincomebothathomeandabroadwouldthereforefinditsworldwideincometaxedbyitshomecountrytaxauthorities.Forexample,acountryliketheUnitedStatestaxestheincomeearnedbyfirmsbasedintheUnitedStatesregardlessofwhethertheincomeearnedbythefirmisdomesticorforeigninorigin.InthecaseoftheUnitedStates,ordinaryforeign-sourcedincomeistaxedonlyasremittedtotheparentfirm.Aswithallquestionsoftax,however,numerousconditionsandexceptionsexist.TheprimaryproblemisthatthisapproachdoesnotaddresstheincomeearnedbyforeignfirmsoperatingwithintheUnitedStates.CountriesliketheUnitedStatesthenapplytheprincipleofterritorialtaxationtoforeignfirmswithintheirlegaljurisdiction,taxingallincomeearnedbyforeignfirmsintheirbordersaswell.

Theterritorialapproach,alsotermedthesourceapproach,focusesontheincomeearnedbyfirmswithinthelegaljurisdictionofthehostcountry,notonthecountryoffirmincorporation.CountrieslikeGermanythatfollowtheterritorialapproachapplytaxesequallytoforeignordomesticfirmsonincomeearnedwithinthecountry,butinprinciplenotonincomeearnedoutsidethecountry.Theterritorialapproach,liketheworldwideapproach,resultsinamajorgapincoverageifresidentfirmsearnincomeoutsidethecountrybutarenottaxedbythecountryinwhichtheprofitsareearned.Inthiscase,taxauthoritiesextendtaxcoveragetoincomeearnedabroadifitisnotcurrentlycoveredbyforeigntaxjurisdictions.Onceagain,amixofthetwotaxapproachesisnecessaryforfullcoverageofincome.

15.5 DirectorIndirect.Whatisthedifferencebetweenadirecttaxandanindirecttax?

Taxesareclassifiedonthebasisofwhethertheyareapplieddirectlytoincome,calleddirecttaxes,ortosomeothermeasurableperformancecharacteristicofthefirm,calledindirecttaxes.

15.6 TaxDeferral.WhatismeantbytaxdeferralintheU.S.systemoftaxation?Whatisthedeferralprivilege?

Iftheworldwideapproachtointernationaltaxationwerefollowedtotheletter,itwouldendthetax-deferralprivilegeformanyMNEs.ForeignsubsidiariesofMNEspayhostcountrycorporateincometaxes,butmanyparentcountriesdeferclaimingadditionalincometaxesonthatforeign-sourceincomeuntilitisremittedtotheparentfirm.

Forexample,U.S.corporateincometaxesonsometypesofforeign-sourceincomeofU.S.-ownedsubsidiariesincorporatedabroadaredeferreduntiltheearningsareremittedtotheU.S.parent.However,theabilitytodefercorporateincometaxesishighlyrestrictedandhasbeenthesubjectofmanytaxlawchangesinthepastthreedecades.

15.7 Value-AddedTax.Whatisavalue-addedtax,andhowdoesitdifferfromanincometax?

Thevalueaddedtaxisineffectasalestaxonthevalueaddedateverystepoftheproductionanddistributionprocess,adjustedsothatthetaxisnotcumulative,i.e.,alaterstageofproductiondoesnotpaytaxontaxesalreadyleviedatearlierstages.

Theadvantagesofthevalue-addedtaxincludethefollowing:(1)Itisprobablymoreneutralinitseffectoneconomicdecisions,(2)thepopulaceisgenerallymoreawarethattheyarepayingthetax,and(3)itcanberebatedinthecaseofexports.Thelatter“advantage”putscountriesusingthevalue-addedtaxatanadvantageoverthosethatrelyonincometaxesontheprofitfromexportsbecauseincometaxescannotberebated.

15.8 WithholdingTax.Whatisawithholdingtaxandwhydogovernmentsimposethem?

Withholdingtaxesareaminimumtaxpaymentduegovernmentpriortoremittance,inthiscase,outsidethecountry.Thereasonfortheinstitutionofwithholdingtaxesisthatgovernmentsrecognizethatmostinternationalinvestorswillnotfileataxreturnineachcountryinwhichtheyinvest.Thegovernment,therefore,wishestoensurethataminimumtaxpaymentisreceived.Astheterm“withholding”implies,taxesarewithheldbythecorporationfromthepaymentmadetotheinvestor,andthetaxeswithheldarethenturnedovertogovernmentauthorities.Withholdingtaxesareamajorsubjectofbilateraltaxtreatiesandgenerallyrangebetween0%and25%.

15.9 TaxTreaty.Whatisusuallyincludedwithinataxtreaty?

Taxtreatiesnormallydefinewhethertaxesaretobeimposedonincomeearnedinonecountrybythenationalsofanother,andifso,how.Taxtreatiesarebilateral,withthetwosignatoriesspecifyingwhatratesareapplicabletowhichtypesofincomebetweenthemselvesalone.

Theindividualbilateraltaxjurisdictionsasspecifiedthroughtaxtreatiesareparticularlyimportantforfirmsthatareprimarilyexportingtoanothercountryratherthandoingbusinesstherethrougha“permanentestablishment.”Thelatterwouldbethecaseformanufacturingoperations.Afirmthatonlyexportswouldnotwantanyofitsotherworldwideincometaxedbytheimportingcountry.Taxtreatiesdefinewhatisa“permanentestablishment”andwhatconstitutesalimitedpresencefortaxpurposes.

Taxtreatiestypicallyresultinreducedwithholdingtaxratesbetweenthetwosignatorycountries,thenegotiationofthetreatyitselfservingasaforumforopeningandexpandingbusinessrelationshipsbetweenthetwocountries.ThispracticeisimportantbothtoMNEsoperatingthroughforeignsubsidiaries,earningactiveincome,andtoindividualportfolioinvestorswhoaresimplyreceivingpassiveincomeintheformofdividends,interest,orroyalties.

15.10 ActiveversusPassive.WhatdothetermsactiveandpassivemeaninthecontextofU.S.taxationofforeignsourceincome?

Activeincome,theincomearisingfrommanufacturingorprovisionofservices,isdifficulttoshiftacrossbordersbyownership.Passiveincome,howeverismoreeasilyshiftedandthereforemaygainunduedeferralofU.S.taxation.SubpartFincomeispassiveincome,subjecttoimmediateU.S.taxationevenwhennotremitted,isincomeofatypeotherwiseeasilyshiftedoffshoretoavoidcurrenttaxation.Itincludes(1)passiveincomereceivedbytheforeigncorporationsuchasdividends,interest,rents,royalties,netforeigncurrencygains,netcommoditiesgains,andincomefromthesaleofnonincomeproducingproperty;(2)incomefromtheinsuranceofU.S.risks;(3)financialserviceincome;(4)shippingincome;(5)oilrelatedincome;and(6)certainrelatedpartysalesandserviceincome.

Onetypeofpassiveincomewouldsimplybethedistributedprofitsofanothercompany,dividends,iftheforeigncompanyownedit.Withoutthedifferentialtreatment,itwouldonlymakesenseformostU.S.multinationalstocreateaholdingcompanyinataxhavenwhichwouldthenownalltheforeignsubsidiariesofthecompany.Then,alltheprofitsearnedbytheHoldingCompanywouldberetainedinlowtaxenvironmentwithoutincurringanyU.S.taxliabilities—anundesiredoutcomebytheU.S.taxauthorities!

15.11 TaxTypes.Taxesareclassifiedbasedonwhethertheyareapplieddirectlytoincome—directtaxes—ortosomeothermeasurableperformancecharacteristicofthefirm—indirecttaxes.Identifyeachofthefollowingasa“directtax,”an“indirecttax,”orsomethingelse:

a. CorporateincometaxpaidbyaJapanesesubsidiaryonitsoperatingincome

b. RoyaltiespaidtoSaudiArabiaforoilextractedandshippedtoworldmarkets

c. InterestreceivedbyaU.S.parentonbankdepositsheldinLondon

d. InterestreceivedbyaU.S.parentonaloantoasubsidiaryinMexico

e. PrincipalrepaymentreceivedbyU.S.parentfromBelgiumonaloantoawhollyownedsubsidiaryinBelgium

f. ExcisetaxpaidoncigarettesmanufacturedandsoldwithintheU.S.

g. PropertytaxespaidonthecorporateheadquartersbuildinginSeattle

h. AdirectcontributiontotheInternationalCommitteeoftheRedCrossforrefugeerelief

I. Deferredincometax,shownasadeductionontheU.S.parent’sconsolidatedincometax

j. WithholdingtaxeswithheldbyGermanyondividendspaidtoaUnitedKingdomparentcorporation

15.12 ForeignTaxCredit.Whatisaforeigntaxcredit?Whydocountriesgivecreditfortaxespaidonforeignsourceincome?

Topreventdoubletaxationofthesameincome,mostcountriesgrantaforeigntaxcreditforincometaxespaidtothehostcountry.Countriesdifferonhowtheycalculatetheforeigntaxcreditandwhatkindsoflimitationstheyplaceonthetotalamountclaimed.Normallyforeigntaxcreditsarealsoavailableforwithholdingtaxespaidtoothercountriesondividends,royalties,interest,andotherincomeremittedtotheparent.Thevalue-addedtaxandothersalestaxesarenoteligibleforaforeigntaxcreditbutaretypicallydeductiblefrompretaxincomeasanexpense.

Ataxcreditisadirectreductionoftaxesthatwouldotherwisebedueandpayable.Itdiffersfromadeductibleexpense,whichisanexpensethetaxpayerusestoreducetaxableincomebeforethetaxrateisapplied.A$100taxcreditreducestaxespayablebythefull$100,whereasa$100deductibleexpensereducestaxableincomeby$100andtaxespayableby$100×t,wheretisthetaxrate.Taxcreditsaremorevaluableonadollar-for-dollarbasisthanaredeductibleexpenses.

15.13 EarningsStripping.Whatisearningsstripping,andwhataresomeexamplesofhowmultinationalfirmspursueit?

Amultinationalfirmmayallocatedebtdifferentlyacrossitsvariousforeignsubsidiariestoreducetaxliabilitiesinhightaxenvironments.Unitsinhightaxenvironmentsmaybeassignedveryhighdebtobligationsinanattempttomaximizetheinterestdeductibilityprovisionsofferedinthatcountryandthereforeminimizetaxableearnings.Oftentermedearningsstripping,thismethodistypicallylimitedbyhostgovernmentrequirementsforminimumequitycapitalizations—thincapitalizationrules.

15.14 ControlledForeignCorporation.Whatisacontrolledforeigncorporation,andwhatisitssignificanceinglobaltaxmanagement?

Acontrolledforeigncorporation(CFC)isanyforeigncorporationinwhichU.S.shareholders,includingcorporateparents,ownmorethan50%ofthecombinedvotingpowerortotalvalue.ItssignificanceinglobaltaxmanagementarisesfromthefundamentalassumptionbyU.S.taxauthoritiesthatallincomeearnedbyaCFCisunderthefullcontroloftheU.S.parentcompany,andanychoicetodelayrepatriationofpassiveincomeismadeonlytogaindeferralofU.S.taxation.

15.15 TransferPricing.Whatisatransferprice,andcanagovernmentregulatetransferprices?Whatdifficultiesandmotivesdoesaparentmultinationalfirmfaceinsettingtransferprices?

Atransferpriceistheamountpaidbyoneunitofacompany(domesticorinternational)forgoodsorservicespurchasedfromanotherunitofthesamefirm.Assuch,atransferpriceisneededforeveryintrafirmtransaction.Wherebuyerandsellerareindifferenttaxjurisdictions(i.e.,countries),governmentsareconcernedwiththepossibilitythattransferpricesareraisedorloweredfroma“normal”or“appropriate”levelinordertoavoidtaxes.

Inmostcountriestaxauthoritieshavetherighttodeclareagiveninternationaltransferpriceasataxavoidancedevice.Suchcountrieshavetherighttoresettaxableincometoahigherlevel.Taxpayerswilloften,however,fighttheseunilateralchanges,ifpossible,incourt.ThemotivesfortheparentMNEaretominimizetaxes,andthedifficultyisthattheburdenofproofisontheMNE,notthetaxcollector,toshowproofastowhyagiventransferpriceisreasonable.

15.16 FundPositioning.Whatisfundpositioning?

Fundpositioningistheuseofpricesortransactionsofdifferentkindstomovetaxableprofitsoutofhightaxenvironmentsandintolowtaxenvironments.Aparentfirmwishingtotransferfundsoutofaparticularcountrycanchargehigherpricesongoodssoldtoitssubsidiaryinthatcountry—tothedegreethatgovernmentregulationsallow.Aforeignsubsidiarycanbefinancedbythereversetechnique,aloweringoftransferprices.Paymentbythesubsidiaryforimportsfromitsparentorsistersubsidiarytransfersfundsoutofthesubsidiary.Ahighertransferpricepermitsfundstobeaccumulatedinthesellingcountry.Multiplesourcingofcomponentpartsonaworldwidebasisallowstheactofswitchingbetweensuppliersfromwithinthecorporatefamilytofunctionasadevicetotransferfunds.

15.17 IncomeTaxEffect.Whatistheincometaxeffect,andhowmayamultinationalfirmaltertransferpricesasaresultoftheincometaxeffect?

Amajorconsiderationinsettingatransferpriceistheincometaxeffect.Worldwidecorporateprofitsmaybeinfluencedbysettingtransferpricestominimizetaxableincomeinacountrywithahighincometaxrateandtomaximizetaxableincomeinacountrywithalowincometaxrate.Aparentwishingtoreducethetaxableprofitsofasubsidiaryinahightaxenvironmentmaysettransferpricesatahigherratetoincreasethecostsofthesubsidiary,therebyreducingtaxableincome.

15.18 CorrectPricing.WhatisSection482oftheU.S.InternalRevenueCode,andwhatguidelinesdoesitrecommendwhensettingtransferprices?

Mosttransferpricingregulationsrequiretheuseofacorrectorarms-lengthpriceonatransactionthatissimilartothepricethatwouldbeseenintheopenmarketonasimilarproductorserviceandthereforenotconstructedtopursuesometypeoffundpositioningorothertaxreductionordeferralobjectivebythecompany.

15.19 Cross-Crediting.Definecross-crediting,andexplainwhyitmayormaynotbeconsistentwithaworldwidetaxregime.

Cross-creditingistheabilitytocross-creditforeigntaxcreditswithforeigntaxdeficitsinthesameperiod.IfaU.S.multinationalremitsprofitsfromtwodifferentcountries,oneinahigh-taxenvironment(relativetotheU.S.)andtheotherinlow-taxenvironment(relativetotheU.S.),iftheincomeisfromoneofthetwomajor“baskets”offoreignsourceincome(activeorpassive),theexcessforeigntaxcreditsfromonecanbecross-creditedagainsttheforeigntaxdeficitsoftheother.

15.20 Check-the-Box.Explainhowthecheck-the-boxregulatorychangealteredtheeffectivenessofSubpartFincomeregulations.

In1997theU.S.TreasuryattemptedtosimplifyU.S.taxesbyintroducingwhatiscalledcheck-the-boxsubsidiarycharacterization.TheU.S.Treasurychangeditsrequiredfilingpracticestoallowmultinationalfirmstocategorizesubsidiariesfortaxationpurposesbysimply“checking-the-box”onasingleform.

Oneoftheboxchoicesoffered,adisregardedentity,allowedtheunitto“disappear”fortaxpurposesasitsresultswouldbeconsolidatedwiththoseofitsparentcompany.Thesecombinedunitsaretermedhybridentities.Intheend,itallowedU.S.multinationalsthathavetieredownershipofoffshoreunitstoonceagainbeginrepositioningprofitsinlowtaxenvironmentsandgainessentiallypermanentdeferralforthoseearnings.In2007theU.S.Treasurycodifiedthisprocessinwhatisnowreferredtoasthelook-through-rulesonthistaxtreatmentofdisregardedentities.

15.21 MeasuringManagerialPerformance.Whatroledoestransferpricinghavewithinmultinationalcompanieswhenmeasuringmanagementperformance?Howcantransferpricingpracticeswithinafirmconflictwithperformancemeasurement?

Whenafirmisorganizedwithdecentralizedprofitcenters,transferpricingbetweencenterscandisruptevaluationofmanagerialperformance.Transferpricesthataresethighorlowforvarioustaxmanagementpurposesalsoaltertheprofitabilityoftheunitperformanceforevaluationofmanagement.Althoughnotwithinthecontroloflocalunitmanagement,pricesaresetforthe“greatergood”oftheentireMNE.Incasessuchasthese,allowancesoralternativemeasuresofpriceorperformanceneedtobeusedtoadequatelyevaluateindividualunitmanagementperformance.

15.22 TaxHavenSubsidiary.Whatisataxhaven?Isitthesamethingasaninternationaloffshorefinancialcenter?Whatisthepurposeofamultinationalcreatingandoperatingafinancialsubsidiaryinataxhaven?

Awhollyownedsubsidiarylocatedinalowtaxenvironmentcanactasataxhavenforcorporatefundsawaitingreinvestmentorrepatriation.Taxhavensubsidiaries,categoricallyreferredtoasInternationalOffshoreFinancialCenters,arepartiallyaresultoftaxdeferralfeaturesonearnedforeignincomeallowedbysomeoftheparentcountries.Taxhavensubsidiariesaretypicallyestablishedinacountrycharacterizedasalowtaxonforeigninvestmentorsalesincomeearnedbyresidentcorporationsandalowdividendwithholdingtaxondividendspaidtotheparentfirm.

15.23 CorporateInversion.Whatisacorporateinversion,andwhydomanyU.S.corporationswanttopursueitevenwhenitishighlycriticizedbypublicandprivatepartiesalike?

Corporateinversionisthechangingofacompany’scountryofincorporation.Itspurposeistoreducethecompany’seffectiveglobaltaxliabilitiesbyreincorporatinginalower-taxjurisdiction,typical