InternationalFinancialManagement

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CHAPTER21INTERNATIONALTAXENVIRONMENTANDTRANSFERPRICING

ANSWERS&SOLUTIONSTOEND-OF-CHAPTERQUESTIONSANDPROBLEMS

QUESTIONS

1.Discussthetwinobjectivesoftaxation.Besuretodefinethekeywords.

Answer:Therearetwobasicobjectivesoftaxationthatarenecessarytodiscusstohelpframeourthinkingabouttheinternationaltaxenvironment:taxneutralityandtaxequity.

Taxneutralityhasitsfoundationsintheprinciplesofeconomicefficiencyandequality.Taxneutralityisdeterminedbythreecriteria.Capital-exportneutralityisthecriterionthatanidealtaxshouldbeeffectiveinraisingrevenueforthegovernmentandnothaveanynegativeeffectsontheeconomicdecisionmakingprocessofthetaxpayer.Thatis,agoodtaxisonethatisefficientinraisingtaxrevenueforthegovernmentanddoesnotpreventeconomicresourcesfrombeingallocatedtotheirmostappropriateusenomatterwhereintheworldthehighestrateofreturncanbeearned.Asecondneutralitycriterionisnationalneutrality.Thatis,regardlessofwhereintheworldtaxableincomeisearneditistaxedinthesamemannerbythetaxpayer’snationaltaxauthority.Intheory,nationaltaxneutralityisacommendableobjective,asitisbasedontheprincipleofequality.Thethirdneutralitycriterioniscapital-importneutrality.ThiscriterionimpliesthatthetaxburdenplacedontheforeignsubsidiaryofaMNCbythehostcountryshouldbethesameregardlessinwhichcountrytheMNCisincorporatedandthesameasthatplacedondomesticfirms.

Taxequityistheprinciplethatallsimilarlysituatedtaxpayersshouldparticipateinthecostofoperatingthegovernmentaccordingtothesamerules.ThismeansthatregardlessinwhichcountryanaffiliateofaMNCearnstaxableincome,thesametaxrateandtaxduedateapply.

2.Compareandcontrastthethreebasictypesoftaxationthatgovernmentslevywithintheirtaxjurisdiction.

Answer:Therearethreebasictypesoftaxationthatnationalgovernmentsthroughouttheworlduseingeneratingtaxrevenue:incometax,withholdingtax,andvalue-addedtax.Manycountriesintheworldobtainasignificantportionoftheirtaxrevenuefromimposinganincometaxonpersonalandcorporateincome.Anincometaxisadirecttax,thatis,onethatispaiddirectlybythetaxpayeronwhomitislevied.Thetaxisleviedonactiveincome,thatis,incomethatresultsfromproductionbythefirmorindividualorfromservicesthathavebeenprovided.Awithholdingtaxisataxleviedonpassiveincomeearnedbyanindividualorcorporationofonecountrywithinthetaxjurisdictionofanothercountry.Passiveincomeincludesdividendsandinterestincome,andincomefromroyalties,patentsorcopyrightspaidtothetaxpayer.Awithholdingtaxisanindirecttax,thatis,ataxbornebyataxpayerthatdidnotdirectlygeneratetheincomethatservesasthesourceofthepassiveincome.Thetaxiswithheldfrompaymentsthecorporationmakestothetaxpayerandturnedovertothelocaltaxauthority.Avalue-addedtax(VAT)isanindirectnationaltaxchargedonthesalespriceofaserviceorconsumptiongoodasitmovesthroughthevariousstagesofproductionand/orservice.Assuch,aVATisasalestaxbornebythefinalconsumer.

3.Discusshowdoubletaxationonataxpayermayresultifallcountriesweretotaxtheworldwideincomeoftheirresidentsandtheincomeearnedwithintheirterritorialboundaries.

Answer:Therearetwofundamentaltypesoftaxjurisdiction:theworldwideandtheterritorial.Theworldwidemethodofdeclaringanationaltaxjurisdictionistotaxnationalresidentsofthecountryontheirworldwideincomenomatterinwhichcountryitisearned.Theterritorialmethodofdeclaringataxjurisdictionistotaxallincomeearnedwithinthecountrybyanytaxpayer,domesticorforeign.Hence,regardlessofthenationalityofataxpayer,iftheincomeisearnedwithintheterritorialboundaryofacountryitistaxedbythatcountry.

IfaMNCwasaresidentofacountrythattaxedworldwideincome,theforeign-sourceincomeofitsforeignaffiliateswouldbetaxedintheparentcountry.Ifthehostcountryalsotaxestheincomeoftheaffiliateearnedwithinitsterritorialborders,theforeignaffiliatewouldpaytaxesonthesameincomebothinthehostcountryandintheparentcountry.Toavoidthis“evil,”somemechanismneedstobeestablishedtopreventdoubletaxation.

4.Whatmethodsdotaxingauthoritiesusetoeliminateormitigatetheevilofdoubletaxation?

Answer:Thetypicalapproachtoavoidingdoubletaxationisforanationnottotaxforeign-sourceincomeofitsnationalresidents.Analternativemethod,andtheonetheU.S.followsoncertaintypesofforeign-sourceincome,istogranttotheparentfirmforeigntaxcreditsagainstU.S.taxesfortaxespaidtoforeigntaxauthorities.

5.HowmightaMNCusetransferpricingstrategies?Howdoimportdutiesaffecttransferpricingpolicies?

Answer:AMNCmightusetransferpricingstrategiesfortwobasicpurposes:incometaxliabilityreductionorfundsrepositioning.Ifthetaxrateinthecountryofthesellingaffiliateislessthanthetaxrateinthebuyingaffiliatecountry,ahighmarkuppolicyonsaleswillleavelittletaxableincomeinthebuyingaffiliatecountrytobetaxedatthehigherrate.Evenifthetaxrateinthebuyingaffiliatecountryisnotmorethanthatinthesellingaffiliatecountry,ahighmarkuppolicywillleavelessfundstoberemovedfromthebuyingaffiliatecountry.Ingeneral,importdutiesworkintheoppositedirectionfromincometaxes.Forexample,ahighmarkuppolicywilldecreasetheincometaxesdueinthebuyingaffiliatecountry,butincreasetheimportdutydueinthatcountry.Generally,theincometaxismoreimportantincomparisontotheimportdutyinitsafter-taxeffectonconsolidatednetincome.

6.Whatarethevariousmeansthetaxingauthorityofacountrymightusetodetermineifatransferpriceisreasonable?

Answer:TheU.S.andmanyothercountriesrequirethetransferpricetobeconsistentwitharm’slengthpricing,i.e.,beapricethatanunrelatedpartywouldpayforthesamegoodorservice.Thetaxingauthoritycanarbitrarilysetthetransferpriceifitbelievesthattransferpricingschemesarebeingusedtoevadetaxesorthattaxableincomeisnotbeingclearlyreflected.Therearethreegeneralmethodstoestablisharm’slengthpricing.Onemethodistouseacomparableuncontrolledpriceatwhichthegoodorservicewouldbepricedbetweenunrelatedparties.Asecondmethodistheresalepriceapproach;thatis,reducethepriceatwhichthegoodisresoldbyanamountsufficienttocoveroverheadcostsandareasonableprofitforthesellingaffiliate.Thethirdmethodisthecost-plusapproach,whereanappropriateprofitisaddedtothecostofthemanufacturingaffiliate.

7.DiscusshowaMNCmightattempttorepatriateblockedfundsfromahostcountry.

Answer:Thereareseveralmethodsaparentfirmmightusetorepatriateprofitsfromanaffiliateinahostcountrythatisblockingfunds.Someofthesemeasuresshouldbeenactedearlyonasaguardagainstfuturefundsblockage.Oneistoestablisharegulardividendpolicythatthehostcountrybecomesusedtoandexpects.Thisassumes,however,thehostcountrywillletareasonableamountoffundsberepatriated.Ifthisisnotthecase,theparentfirmmightattempttouseahighmarkuppolicytransferpricingscheme.Sincehostcountriesareawareoftransferpricingstrategies,alargechangeinthetransferpriceislikelynottogounquestionedbythehostcountry.Thus,theparentfirmshouldestablishearlyonrecognitionof,andpaymentfor,specificservicesthatarebeingprovidedbytheaffiliateinadditiontopaymentatanarm’slengthpriceforthephysicalgoods.Forexample,theparentfirmmightchargeforashareofworldwideadvertising,technicaltrainingofemployeesoftheaffiliate,appropriateoverheadcharges,oraroyaltyorlicensingfeeforuseofwell-recognizedbrandnames,technology,orpatents.Thehostcountrymightacceptthesechargesasreasonable,whereasalargetransferpricethatincorporatesallchargesintoasinglepricemightbequestionedasunreasonablylarge.Additionally,theparentfirmcancreateexports,byhavingtheaffiliatechargedintheblockedcurrencyforgoodsandservicesforwhichtheparentwouldtypicallypay,orthroughdirectnegotiationappealtothehostcountryformorereasonabletreatment,ifitisinanimportantindustrytothehostcountry.

PROBLEMS

1.TherearethreeproductionstagesrequiredbeforeapairofskisproducedbyFjordFabricationcanbesoldatretailforNOK2,300.FillinthefollowingtabletoshowthevalueaddedateachstageintheproductionprocessandtheincrementalandtotalVAT.TheNorwegianVATrateis25percent.

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ProductionSellingValueIncremental

StagePriceAddedVAT

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1NOK450

2NOK1,900

3NOK2,300

TotalVAT

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Solution:

ProductionSelling Value Incremental

StagePrice Added VAT

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1NOK450NOK450NOK112.50

2NOK1,900NOK1,450NOK362.50

3NOK2,300NOK400NOK100.00

TotalVATNOK575.00

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TheDocketCompanyofAsheville,NCUSAisconsideringestablishinganaffiliateoperationinthecityofWellington,onthesouthislandofNewZealand.Itisundecidedwhethertoestablishtheaffiliateasabranchoperationorawholly-ownedsubsidiary.NewZealandtaxesincomeofbothresidentcorporationsandbranchoperationsataflatrateof28percent.NewZealandwithholdstaxesat5percentondividendsforaninvestorwhoholdsatleast10percentofthesharesinthesubsidiarycompanythatpaysthedividend;0percentiftheinvestorholds80percentormoreofthesharesinthesubsidiarycompanyandmeetsothercriteria;15percentinallothercases.NewZealanddoesnotwithholdtaxesontherepatriationofbranchprofits.TheUnitedStateshasanincometaxrateof21percent,butforcertaintypesofincomeaforeigntaxcreditisallowedfortaxespaidtoanothercountry.Basedonthisinformation,isabranchorsubsidiarytherecommendedformfortheaffiliate?

Solution:IfDocketestablishesabranchoperationinNewZealand,itwillpayatotalof28percentonitsNewZealandsourceincome.Itwillpay28percentinNewZealandand0percentintheUnitedSatesafterareceivingataxcreditfortheNewZealandtaxes.IfDocketsetsupitsNewZealandaffiliateasasubsidiary,thesubsidiarywillpaytaxesat28percentonNewZealandtaxableincome,butsincetheparentfirmhas100percentownership,therewillnotbeanytaxeswithholdondividendspaidtotheparent.Totaltaxescreditswillbe[.28+0–(.28x0)]=.28or28percentintheUnitedStates.(SeeExample21.2foranexplanationofthisformula.)NoadditionaltaxeswillneedtobepaidintheUnitedSatesafterreceivingataxcreditfortheNewZealandtaxes.Consequently,inthiscaseitdoesnotmatterwhethertheDocketCompanyestablishesabranchoperationorawhollyownedsubsidiaryundercurrenttaxlawinNewZealand.

3.AffiliateXsells10,000unitstoAffiliateYperyear.ThemarginaltaxratesforXandYare20percentand30percent,respectively.Thetransferpriceperunitiscurrentlysetat$1,000,butitcanbesetashighas$1,250.Calculatetheincreaseinannualafter-taxprofitsifthehighertransferpriceof$1,250perunitisused.

Solution:Totaltaxsavings=10,000x($1,000-$1,250)x(0.20-0.30)=$250,000.

4.AffiliateAsells5,000unitstoAffiliateBperyear.ThemarginalincometaxrateforAffiliateAis25percentandthemarginalincometaxrateforAffiliateBis40percent.Thetransferpriceperunitiscurrently$2,000,butitcanbesetatanylevelbetween$2,000and$2,400.Deriveaformulatodeterminehowmuchannualafter-taxprofitscanbeincreasedbyselectingtheoptimaltransferprice.

NoteToInstructor:ThesolutiontothisproblemisconsistentwiththeexamplepresentedinthetextasExhibit21.6.

Solution:LetAandBbethemarginalincometaxrateforAffiliateAandB.FurtherletQdenotequantity,andletPbethecurrenttransferpriceperunitandP*betheoptimaltransferpriceperunit.Theincreaseinannualafter-taxprofit(orthetaxsavings)canbestatedasQ(P-P*)(A-B).Foreachunitthereisataxsavingsof(A-B)on(P-P*).Usingtheabovenumbers,thereisataxsavingsof(.25-.40)=.15foreachadditionaldollarofcosttransferredfromthelowtaxaffiliatetothehightaxaffiliate.Thus,atthemaximumtherecanbea$60=($2,000-2,400)(.25-.40)taxsavingsperunitfromraisingthetransferpricefrom$2,000to$2,400.Intotal,thetaxsavingsis5,000unitsx$60=$300,000.

5.AffiliateAsells5,000unitstoAffiliateBperyear.ThemarginalincometaxrateforAffiliateAis25percentandthemarginalincometaxrateforAffiliateBis40percent.Additionally,AffiliateBpaysatax-deductibletariffof5percentonimportedmerchandise.Thetransferpriceperunitiscurrently$2,000,butitcanbesetatanylevelbetween$2,000and$2,400.Derive(a)aformulatodeterminetheeffectivemarginaltaxrateforAffiliateBand,(b)aformulatodeterminehowmuchannualafter-taxprofitscanbeincreasedbyselectingtheoptimaltransferprice.

Solution:ThesolutiontothisproblemisconsistentwiththeexamplepresentedinthetextasExhibit21.7.Thisproblemextendstheworkinproblem4,above.Whenthead-valoremimporttariffistaxdeductible,theeffectivemarginaltaxratepaidbyAffiliateBis:

(1+Tariff)B-Tariff=(1+.05)(.40)-.05=.37.Hence,foreachadditionaldollarofcosttransferredfromthelowtaxaffiliatetothehightaxaffiliatethereisanafter-taxsavingsof:(P-P*)[A+Tariff-(1+Tariff)B].Intotal,thetaxsavingsis:

Q(P-P*)[A+Tariff-(1+Tariff)B]=5,000x($2,000-2,400)(.25-.37)=5,000x$48=$240,000.

MINICASE:SIGMACORP.’SLOCATIONDECISION

SigmaCorporationofBostoniscontemplatingestablishingawhollyownedsubsidiaryoperationintheMediterranean.TwocountriesunderconsiderationareSpainandCyprus.Sigmaintendstorepatriateallafter-taxforeign-sourceincometotheUnitedStates.IntheU.S.,corporateincomeistaxedat21percent.InCyprus,themarginalcorporatetaxrateis12.5percent.InSpain,corporateincomeistaxedat25percent.CyprusdoesnotwithholdtaxondividendincomepaidtotheUnitedStates.However,thewithholdingtaxtreatyrateSpainhaswiththeU.S.ondividendincomepaidis10percent.

ThefinancialmanagerofSigmahasaskedyoutohelphimdeterminewheretolocatethenewsubsidiary.ThelocationdecisionofCyprusorSpainwillbebasedonwhichcountryhasthesmallesttotaltaxliability.

SuggestedSolutionforSigmaCorp.’sLocationDecision

Thetotal(incomeandwithholding)taxliabilityinCypruswillbe:[.125+0-(.10x0)]=.125or12.5percent.AdditionaltaxesintheU.S.wouldbedue,bringingthetotaltaxliabilityuptotheU.S.incometaxrateof21percent.Thetotal(incomeandwithholding)taxliabilityinSpainwillbe:[.25+.10-(.25x.10)]=.325,or32.5percent.SincethisisgreaterthantheU.S.incometaxrateof21percent,noadditionaltaxeswouldbedueintheU.S.Ifthereareexcessforeigntaxcredits(equalto11.5percentofforeign-sourcetaxableincome)thatcanallbeusedbycarryingthembackoneyearandforwardtenyears,thenthetotaltaxliabilitywillequaltheU.S.incometaxrateof21percent.Ifexcessforeigntaxcreditscannotallbeused,asismoretypicallythecase,thetotaltaxliabilitycanbeashighas32.5percent.Consequently,SigmaCorporationshouldestablishitswholly-ownedsubsidiaryinCyprus.

MINICASE:EASTERNTRADINGCOMPANY’SOPTIMALTRANSFERPRICINGSTRATEGY

TheEasternTradingCompanyofSingaporeshipsprepackagedspicestoHongKong,theUnitedKingdom,andtheUnitedStates,wheretheyareresoldbysalesaffiliates.EasternTradingisconcernedwithwhatmighthappeninHongKongnowthatcontrolhasbeenturnedovertoChina.EasternTradinghasdecidedthatitshouldreexamineitstransferpricingpolicywithitsHongKongaffiliateasameansofrepositioningfundsfromHongKongtoSingapore.Thefollowingtableshowsthepresenttransferpricingscheme,basedonacartonofassorted,prepackagedspices,whichisthetypicalshipmenttotheHongKongsalesaffiliate.WhatdoyourecommendthatEasternTradingshoulddo?

Eastern