International Taxation: Debt Financing, Taxation and Transfer Pricing

1. International Taxation: Debt Financing, Taxation and Transfer Pricing By Koy Saechao

2. Overview • Debt financing Tax implications for equity • International tax policies for host and home government • Tax management principles

3. Debt Financing Taxes are often considered with the treatment of debt financing. Debt management is affected by: • Interest payments as deductible expenses • Treatment of capital losses (or gains) • Valuation with Adjusted Present Value (tax shields)

4. International Taxation General principle of international taxation: There is a clear distinction between returns to debt and returns to equity. • Tax deductibility of interest payments • Treatment of foreign exchange gains/losses Corporate income tax is designed as a tax on the returns to equity only

5. International Tax Policy Equity returns are taxed in the host country, then may be taxed in home country (possibly different timing) Host government acts first Home government determines policies vis-à-vis the host government

6. Host Government Determine tax rates on corporate profits first Set withholding taxes: taxes imposed on capital paid to the parent as they are taken out of the country. • Dividends • Repatriation of profits • License • Royalty fees • Other revenue paid “First Crack” to tax income produce within host country’s boarders

7. Home Government Tax policies are complicated because they establish policies relative to previously determined host country’s policies Policies must consider two factors: • Treatment of foreign income and foreign taxes paid • Timing of taxations

8. Treatment of foreign income and taxes paid

9. Example 11.1 Peripatetic Enterprises headquartered in Nide, has foreign income from Serendip.

10. Example of Home Policies Peripatetic prefers tax exempt policy. Beyond that, tax credit over deduction, and prefers either of these over double taxation.

11. Contemporaneous Taxation: home country may choose to tax foreign equity returns during fiscal year in which they are earned. Used mostly for foreign branches of MNE. Branch is an extension of parent company Tax Deferral: taxation occurs at time profits are repatriated as dividends. Used for foreign subsidiaries of MNE. Subsidiary is an affiliate of a MNE that is incorporated in the country in which it operates Encourages profits to be reinvested abroad rather than repatriated. Timing of Taxation

12. Summary of International Tax Policies • First Crack Principle: Host country sets corporate tax rates • Home country reacts to host country’s policies by deciding treatment of foreign income and taxes, as well as timing of taxes. • MNEs prefer to invest where taxes are lower • Tax laws are more complicated then the framework presented. Subpart F: Subsidiary income taxed regardless of repatriation.

13. International Tax Management

14. International Taxation The goal to international tax management is to increase corporation-wide profits by reducing the total amount of taxes paid.

15. Management Issues • Relevant decisions for branches • Allocation of profits • Allocation of costs • Branch vs. Subsidiary (Aaron)

16. Branch Decisions We want to allocate pre-tax profits to maximize after-tax profits. • Review cost allocation amongst branches • Review pricing of goods transferred amongst subsidiaries (Transfer prices) General Rule: A dollar spent on generating income should be allocated to and deducted from revenue in the same country.

17. Case Study C&C Enterprise, a Multinational Company located in Chicago. Branches located in Japan, Canada, Ireland, Great Britain and Germany. The tax structure is based on worldwide tax principle: gross foreign branch income is taxed and a full credit is given for foreign taxes paid up to the amount of the US tax liability.

18. Cost Allocation Currently, expenses incurred at C&C Enterprise headquarters in Chicago total $50,000, each branch is charged $10,000. There is a proposal to allocate costs to high-tax countries in order to achieve the largest tax deductions possible. As such: • This decreases foreign taxes paid from $88,100 to $83,400 • US tax liability increases from $300 to $5000 • Net branch income remains unchanged, $171,600 Taxes are shifted from foreign countries to domestic country, but total taxes remain the same. By using the credit method, domestic country taxes total branch income regardless of where the income is earned or where the taxes are paid.

19. International Tax Management Principle I: If there are no excess tax credits, cost allocation decisions do not matter for branches. If there are excess tax credits, show branch profits in the lowest-tax jurisdictions by allocating costs to the highest-tax jurisdictions, without making negative profits.

20. Transfer Pricing Pricing of internally-traded goods. Management may suggest altering the company’s transfer prices to show profits in low-tax jurisdictions. The Vice-President of C&C Enterprises suggests raising transfer prices from $16 to $18 for countries with high-tax jurisdictions. By increasing the transfer prices, it: • Reduces total foreign taxes paid from $88,100 to $81,500 • Domestic tax liability increases from $300 to $6,900 • Net branch income remains unchanged, $171,600 Total net income remains unchanged because US tax liability increases while the foreign taxes paid decreases. Transfer pricing affects what government receives the tax revenue, but it does not affect the total taxes the corporation pays.

21. International Tax Management Principle II If there are no excess tax credits, transfer pricing decisions do not matter for branches. If there are excess tax credits, show branch profits in the lowest-tax jurisdictions by following a simple rule: If one branch is selling to a foreign branch, set the transfer price as high as possible when T*> T without making profits negative, and as low as possible when T*<T without making profits negative. T=Tax rate on profits earned by the branch T*=Tax rate on profit earned by the foreign branch.

22. Tariffs and Transfer Pricing Tariffs are additional costs imposed on goods and services imported to a country. Management can minimize import duties paid by setting transfer prices as low as possible. Tariffs are levied on the transfer prices selected and are deductible expenses in figuring the branches’ income taxes. Setting low transfer prices to $14: • Can minimize the import duty paid from $64,000 to $56,000 • Total foreign income taxes rise from $62,900 to $69,220 • The US tax liability falls from $3,740 to $140 • Net Branch Income increases $5,280 to $134,640 Because an import tariff is a deductible expense, it does not generate a US tax credit, thus affecting net branch income.

23. International Tax Management Principle III If there are no excess tax credits, use the lowest possible transfer price between branches in the presence of import tariffs. If there are excess tax credits, minimize branch taxes paid in the presence of import tariffs by comparing T* to [T + Td*(1-T*)]: Use the high transfer price if T*>[T +Td*(1- T*)] without making profits negative, and use the low transfer price if T*<[T +Td*(1- T*)] without making profits negative.

24. Summary of Tax Management Principles

25. International Taxation • Branch considerations • Branch vs Subsidiary Status (Aaron)

26. Questions