International Accounting, 6/e

1. International Accounting, 6/e Frederick D.S. Choi Gary K. Meek Chapter 9: International Taxation and Transfer Pricing

2. Learning Objectives • Identify the major types of tax systems that exist around the world. • Understand what determines a multinational entity’s effective tax burden税收负担. • Understand concepts relating to the taxation of foreign source income and the rationale基本原理 behind the foreign tax credit外国税收抵免. • Identify the major variables that complicate international transfer pricing. • Explain the meaning of arm’s-length price正常的价格and the transfer pricing methods designed to achieve it. • Explain the concept of an advance pricing arrangement预约定价制度.

3. Initial Concepts • Tax neutrality税收中性 • Taxes have no effect on resource-allocation decisions. • Business decisions driven by economic fundamentals. • Should result in optimal allocation最优配置 of resources. • Tax equity税收公平分配 • Similarly situated taxpayers纳税人 pay same tax • Is a foreign subsidiary a domestic company operating abroad? • Is a foreign subsidiary a foreign company owned by a domestic one? • Disagreement over how to interpret this concept

4. Diversity of National Tax Systems • Types of taxes • Corporate income tax • First or second most widely used tax • Trend toward lowering and converging of income tax rates • Pressure to improve competitiveness of a country’s businesses and create an attractive investing environment • Driven by integration of the world economy and ability of businesses to move from high- to low-tax countries • Withholding tax代扣所得税 • Imposed on dividend, interest, and royalty payments特许使用费 to foreign investors • Withheld扣留 at the source • Often modified by bilateral tax treaties双边税收条约

5. Value-added tax增值税 • Consumption tax found in Europe and Canada • Levied on value added at each stage of production or distribution • Consumers ultimately bear the cost • Border tax国境税 • Customs or import duties关税 • First or second most widely used tax • Designed to keep domestic goods price competitive with imports • Transfer tax证券交易税 • Imposed on transfers of assets资产转让 between taxpayers

6. Diversity of National Tax Systems • Tax burdens税负 • Vary internationally due to: • Differences in statutory tax rates法定税率 • Differences in definitions of taxable income • How social overhead costs间接成本are paid for in a country • Lower direct taxes may result in higher indirect taxes • Or fewer and lower-quality public services that increase other costs • Effective tax rates实际税率seldom equal nominal tax rates • Thus, a low tax rate does not necessarily不一定 mean a low tax burden

7. Tax administration systems税务管理系统 • Classical system传统系统 • Corporate income is taxed twice: • At the corporate level • At the shareholder level when dividends are paid • Trend is away from classical system. • Integrated system综合系统 • Corporate and shareholder taxes integrated to reduce or eliminate double taxation of corporate income. • Tax credit, or imputation设算, system is a common variant. • Full imputation eliminates double taxation. • Partial imputation reduces double taxation. • Split-rate system分税制 is another variant变体. • Dividends (to shareholders) taxed at lower rate than corporate income

8. Foreign tax incentives国外的税收优惠 • Tax holidays免税期—Tax relief for certain period of time • Tax havens避税港—Low or no income tax countries • Harmful tax competition • Avoiding or evading回避 a country’s income taxes by using tax havens • Brass plate subsidiaries lack substantial activities and merely funnel漏斗 transactions through a tax haven • OECD经合组织 pressuring tax haven countries to adopt practices on exchange of information and transparency • International harmonization国际协调 • Multinational companies are pressuring for international tax harmonization • EU moving to harmonize corporate tax base rather than tax rates

9. Taxation of Foreign-Source Income and Double Taxation • Foreign tax credit • Designed to relieve double taxation in countries following worldwide principle of taxation • Credit against direct (not indirect) taxes paid • Income taxes paid on branch or subsidiary earnings • Withholding taxes代扣代缴 • Allowable tax credit proportional to dividends ÷ net income • Effect is to limit the total tax on foreign-source income to the higher of the home or foreign country’s tax rate

10. Limits范围 to tax credits • Designed to prevent foreign tax credits from offsetting taxes on domestic-source income • Excess foreign tax credits can be carried back one year and forward 10 years • Separate foreign tax credit limitation on these baskets: • Passive income非劳动收入 • General income一般收入 • Tax treaties税收协定 • Agreements between countries on taxation of income and withholding taxes • Applies to each country’s businesses operating in the other country • Foreign exchange considerations外汇注意事项 • Foreign income and taxes paid translated into U.S. dollars similar to FAS 52 treatment

11. Tax-Planning Dimensions规模 • Overview • Tax considerations should never control business strategy: the financial or operating strength of a business transaction must stand on its own • Constant changes in tax laws limit the benefits of long-term tax planning • Organizational considerations • Branch profits taxed to parent in full when earned • Taxes on subsidiary profits deferred until dividend paid to parent

12. Tax-Planning Dimensions • Controlled foreign corporations and Subpart F income • Deferral principle: income of foreign subsidiaries not taxable to parent until repatriated as a dividend • Tax havens give multinationals opportunity to avoid repatriating foreign profits by parking them in “brass plate” subsidiaries • Shareholders of CFCs are taxed on “tainted” (Subpart F) income even before dividend is paid • Subpart F income is passive, related party income

13. Tax-Planning Dimensions • Offshore holding companies离岸控股公司 • Own the shares of operating subsidiaries to gain tax advantages • Require complex planning and avoiding anti-treaty shopping rules • Financing decisions • Subsidiary in high-tax country borrows from one in low-tax country • Result is shifting income away from high-tax country, thereby reducing taxes • Pooling of tax credits • Excess tax credits from high-tax countries can be pooled with unused credits from low-tax countries

14. Tax-Planning Dimensions (contin) • Cost accounting allocations • Affiliates in high-tax countries allocated corporate overhead, personnel, and R&D costs • Result is maximizing tax deductions in high-tax affiliates • Location and transfer pricing • Set high transfer prices on items shipped from subsidiaries in low-tax countries • Set low transfer prices on items shipped from subsidiaries in high-tax countries

15. Tax-Planning Dimensions (contin) • Integrating international tax planning • Tax planning should be integrated into corporate decisions • Rely on tax experts in each jurisdiction • Communicate facts and coordinate tax advice • Tax decisions should fit the business • Put everything in writing – documentation is critical • Don’t do anything embarrassing

16. International Transfer Pricing: Complicating Variables • Tax considerations • Move profits from subsidiaries in high-tax countries to subsidiaries in low-tax countries • IRS can reallocate profits if transfer prices are used to avoid income taxes • IRS and many other governments require arm’s-length transfer pricing • Varying interpretations of arm’s-length pricing can catch multinationals “in the middle” • Resolving the problem can be time-consuming and expensive • Documentation is critical • Audits by tax authorities can be expected • Transfer pricing has become a major compliance burden • Can distort the multinational control system

17. International Transfer Pricing: Complicating Variables (contin) • Tariff considerations • Reduce transfer prices on items sent to high-tariff countries • Multinational must contend with customs officials in importing country and income tax administrators in importing and exporting countries • Competitive factors • Subsidize a new foreign subsidiary with low transfer prices on imported inputs • Shield an existing foreign subsidiary from competition the same way • Use transfer prices to improve profits of a foreign subsidiary seeking local financing • Use transfer prices to weaken local competition • Disadvantages • May invite antitrust actions by host government • May invite retaliatory actions by competitors • May become a permanent management crutch

18. International Transfer Pricing: Complicating Variables (contin) • Environmental risks • Inflation • Charge high transfer prices to subsidiary in high-inflation country to remove cash • Currency devaluations • Use inflated transfer prices to move funds out of subsidiary in devaluation-prone country • Foreign exchange controls • Reduce transfer price to import more product to subsidiary in country with such controls • Restrictionson profit repatriations • Use high transfer price on sales to the subsidiary to remove cash

19. International Transfer Pricing: Complicating Variables (contin) • Performance evaluation considerations • Difficult to set transfer prices that: • Motivate managers to make decisions that maximize their unit’s profits and are congruent with the goals of the company as a whole, and • Provide an equitable basis for judging the performance of managers and units of the firm • Freely negotiated prices may be best for the unit but not the firm as a whole • Dictated transfer prices that are best for the firm as a whole may be seen as arbitrary or unreasonable by the unit manager

20. International Transfer Pricing: Complicating Variables (contin) • Accounting contributions • Quantify the trade-offs in setting transfer pricing • Keep global perspective when mapping benefits and costs of transfer pricing strategy • Environmental influences must be considered for the group, not the individual units • Environmental risks are often conflicting and they change constantly

21. Transfer Pricing Methodology • Market vs. cost vs….? • Market-based transfer prices • Advantages • Show the opportunity cost of the transfer • Encourage the efficient use of the firm’s resources • Help differentiate profitable from unprofitable operations • Consistent with decentralized profit center orientation • Easy to defend to tax authorities as arm’s-length • Disadvantages • Does not give the firm much room to use transfer prices for strategic reasons • Often no intermediate market for the product or service in question • Multinationals engage in transactions that independent companies do not undertake • Relationships among affiliates under common control differ from transactions between unrelated parties • Cost-based transfer prices • Advantages • Are simple to use • Are based on readily available data • Can be used to strategically respond to tax differences, competitive circumstances, and environmental risks • May help avoid internal frictions • Disadvantages • May provide little incentive for selling units to control costs • Ignore competitive supply and demand relationships

22. Transfer Pricing Methodology (contin) • Arm’s-length principle • Intrafirm transactions are priced as if they took place between unrelated parties in competitive markets • The basis for most transfer pricing regulations by tax authorities around the world • The transfer price is hypothetical since: • Parties are related • Markets are not competitive

23. Transfer Pricing Methodology (contin) • Comparable uncontrolled price method • Used with commodity-type products • Appropriate when goods are sufficiently common and internal and external sales are comparable • Use same transfer price that unrelated parties are charged • Comparable uncontrolled transaction method • Applies to transfers of intangible assets • Use same transfer price (royalty rate) that unrelated parties are charged for the intangible

24. Transfer Pricing Methodology (contin) • Resale price method • Used when the buying unit is a distributor or sales subsidiary • Work backwards approach • Start with the sales price the sales subsidiary charges its (unrelated) customer • Then deduct the sales subsidiary’s costs and a normal profit • Cost-plus pricing method • Typically used when semi-finished goods are transferred between foreign affiliates, or where one entity is a subcontractor for another • Work forward approach • Start with the selling unit’s production cost • Then add a normal profit

25. Transfer Pricing Methodology (contin) • Comparable profits method • Set the transfer price so that profits on transactions between related parties are comparable to profits on transactions between unrelated parties who engage in similar business activities under similar circumstances • Profit-split methods • Used when product or market benchmarks are not available • Attempts to divide profits on related-party transactions in an arm’s-length fashion • Comparables profit-split method and residual profit-split method are two examples

26. Transfer Pricing Methodology (contin) • Other pricing methods • Other methods may be used if they better reflect arm’s-length pricing than one of the “acceptable” methods above • Best methods rule • Select the best transfer pricing method based on the facts and circumstances • U.S. and other countries have a best methods rule • Most countries prefer transaction-based methods over profit-based methods

27. Transfer Pricing Methodology (contin) • Advance pricing agreements • Multinational company and taxing authority negotiate an agreed-upon transfer pricing methodology • Binding on both parties • Binding for a fixed period of time • Reduces or eliminates the risk of a transfer pricing audit • Saves time and money for the multinational and taxing authority • Introduced in the U.S., now widely adopted by other countries

28. Transfer Pricing Practices • A variety of transfer pricing methods are found in practice • Managing the tax burden is a top objective of transfer pricing practices • Operational issues are also important, such as: • Maintaining competitive position • Promoting equitable performance evaluation • Motivating employees • Transfer pricing plays an increasingly important role in the strategic planning process • Transfer pricing increasingly used to contribute value in the multinational company

29. The Future • Are national taxes compatible with a global economy? • The principles upon which international taxation is based are being challenged • Electronic commerce over the Internet ignores borders and physical location • Sophisticated encryption techniques make it harder to identify taxpayers • The Internet makes it easy to shift activities to low-tax countries • Monitoring and taxing international transactions becoming more difficult • The arm’s-length principle is becoming less relevant for today’s multinationals • Fewer of them operate units as independent firms • Becoming more difficult to locate where profits are generated • Global brands • Global research and development • Regional profit centers • Brand names, intellectual property, and intangibles are hard to price

30. The Future (contin) • Increased cooperation among the world’s taxing authorities • Greater tax competition among countries • Some advocate a unitary tax as an alternative to transfer pricing • Total profits allocated to units based on economic presence in a country • The country then taxes its share of profits at the rate it chooses

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