Prepared by Shafiq Jadallah

1. Chapter 20 Multinational Tax Management Prepared by Shafiq Jadallah To Accompany Fundamentals of Multinational Finance Michael H. Moffett, Arthur I. Stonehill, David K. Eiteman

2. Chapter 20Multinational Tax Management • Learning Objectives • Identify the differences between tax systems employed by governments around the world • Compare corporate income and withholding tax rates used across countries and the way tax treaties affect MNEs • Explain how value added taxes are levied by some countries today • Compare tax liabilities of domestic and foreign source income for US based firms • Demonstrate how US based multinationals manage their excess foreign tax credits and deficits to minimize their global tax liabilities

3. Multinational Tax Management • Tax planning for MNE operations is extremely complex but a vital aspect of international business • The primary objective of multinational tax planning is the minimization of the firm’s worldwide tax burden

4. Tax Principles • Tax morality – the MNE must decide whether to follow a practice of full disclosure to tax authorities or to adopt the principle of “when in Rome, do as the Romans” • Tax neutrality – when governments levy taxes, they must consider not only the potential revenue from the tax but also the effect the proposed tax can have on private economic behavior • The ideal tax should not only raise revenue efficiently but also have as few negative effects on economic behavior as possible

5. Tax Principles • Domestic neutrality – the burden of taxation on each currency unit of profit earned in the home country should equal the burden of taxation on the currency equivalent profit earned by the same firm in its foreign operations • Foreign neutrality – the tax burden on each foreign subsidiary should equal the tax burden on its competitors in the same country • Tax equity – an equitable tax that imposes the same total burden on all taxpayers who are similarly situated and located in the same tax jurisdiction

6. National Tax Environments

7. National Tax Environments • Nations typically structure their tax systems along one of two basic approaches • Worldwide approach • Territorial approach

8. National Tax Environments • Worldwide approach is also referred to as the residential or national approach • It levies taxes on the income earned by firms that are incorporated in the host country regardless of where the income was earned • Territorial approach is also termed the source approach • It focuses on the income earned by firms within the legal jurisdiction of the host country, not the country of incorporation

9. National Tax Environments • Tax deferral – foreign subsidiaries of MNEs pay host country income taxes but many parent companies defer claiming additional income taxes on that foreign source income until it is remitted to the parent firm • If the worldwide approach was followed to the letter of the law, then the tax deferral privilege would end • Tax treaties provide a means of reducing double taxation • They typically define whether taxes are to be imposed on income earned in one country by the nationals of another country and if so, how much

10. National Tax Environments • Tax treaties • Tax treaties are bilateral, with the two signatories specifying what rates are applicable to which types of income • Tax treaties also typically result in reduced withholding tax rates • This is important to MNEs operating foreign subsidiaries earning active income and individual investors earning passive income

11. Tax Types • Income Tax – many governments rely on this tax as their primary source of revenue • Withholding Tax – passive income (dividends, royalties, interest) earned by a resident of one country within the jurisdiction of a second country are normally subject to a withholding tax in the second country • Government wishes a minimum payment for earning income within their tax jurisdiction knowing that party won’t file a tax return in the host country

12. Tax Types • Value-Added Tax – type of national sales tax collected at each stage of production or sale of goods in proportion to the value added during that stage • Other National Taxes – there are several other taxes levied which vary in importance from country to country • Turnover Tax – tax on purchase/sale of securities in stock market • Property and Inheritance Tax • Tax on Undistributed Profits

13. Foreign Tax Credits • To prevent double taxation, many countries grant a foreign tax credit (FTC) for income taxes paid to the host country • FTC’s vary widely by country and are also available for withholding taxes • Value-added taxes are typically deducted as an expense from pre-tax income so FTCs don’t apply • A tax credit is a direct reduction of taxes that would otherwise be due and payable • It is not a deductible expense because it does not reduce the taxable income

14. Foreign Tax Credits

15. US Taxation of ForeignSource Income • The US applies a worldwide approach to international taxation of US MNEs, but applies a territorial approach to firms operating domestically • Dividends received from US corporate subsidiaries are fully taxable at US tax rates but with credit allowed for direct taxes paid in the foreign country

16. US Taxation of ForeignSource 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 non-residents • Proportion of ownership held by US corporation in the foreign firm • Proportion of net income distributed, the dividend payout rate

17. US Taxation of ForeignSource Income

18. Excess Foreign Tax Credits • If a US based MNE receives income from a foreign subsidiary that imposes higher corporate tax rates than the US, total creditable taxes will exceed US taxes on that foreign income • This results in excess foreign tax credits • There are three basic ways to manage tax liabilities in order to minimize the MNE’s tax liability • Foreign tax credit limitation • Tax credit carry-forward/carry-back • Foreign tax averaging

19. Excess Foreign Tax Credits • Foreign tax credit limitation • The amount of credit a taxpayer can use in any one year is limited to the US tax on that foreign income • Foreign tax credits cannot be used to reduce taxes levied on domestic income • The total foreign tax creditable is limited according to this formula

20. Excess Foreign Tax Credits • Tax credit carry-forward/carry-back • Excess FTCs may be carried forward five years and carried back two years against similar tax liabilities • Unfortunately, since excess FTC arise from differing taxes, and tax rates change slowly, a firm may experience an excess FTC year after year • Tax averaging • In the US, it is possible to offset foreign tax credits derived from one source against another assuming that they are from the same type of income • This is termed tax averaging

21. Excess Foreign Tax Credits • Tax averaging • This means that if income is derived from a high-tax country, creating excess FTCs, these credits can be used against a deficit FTC position from repatriating income from a low-tax country • The difficulty is the inability to average across different types of income

22. Subpart F Income • In 1962, the US government amended the rule that US shareholders do not pay US taxes on foreign source income until the income is remitted by creating the special subpart F income • This revision was created to prevent the use of arrangements between operating and base companies located in tax havens as a means of deferring US taxes

23. Subpart F Income • Subpart F Income is subject to immediate US taxation even when not remitted • It is income that includes • Passive income • Income from insurance of US risks • Financial service income • Shipping income • Oil-related income • Certain related party sales and service income

24. Branch versus LocallyIncorporated Subsidiary • As an MNE chooses whether to organize a foreign subsidiary as a branch or as locally incorporated subsidiary, both tax and non-tax consequences must be considered • One major tax consideration is whether or not the subsidiary will operate at a loss for several years • If so, it might be preferable to organize it as a branch to permit the parent to consolidate the losses for tax purposes • The second consideration is the net tax burden after paying withholding taxes on dividends • A branch’s income would only bear the burden of income tax in its host-country and is concurrently consolidated with the parent with no foreign corporate income tax or withholding tax

25. Tax Haven Subsidiaries andOffshore Financial Centers • Many MNEs have foreign subsidiaries that act as tax havens for corporate funds awaiting reinvestment or repatriation • Tax haven subsidiaries are usually located in countries that meet the following requirements • Low tax on foreign investment or sales income earned by resident corporations and a low dividend withholding tax paid to parent • Stable currency to permit easy conversion of funds; can be met by permitting and facilitating use of Eurocurrenies • Facilities to support financial services (i.e. communications, reputable banking services, etc.) • Stable government that encourages the establishment of foreign owned financial and service facilities within its borders

26. Tax Haven Subsidiaries andOffshore Financial Centers

27. Foreign Sales Corporations • Foreign Sales Corporations (FSC) were introduced in the Tax Reform Act of 1984 as a device to provide tax-exempt income for US persons or corporations having export oriented activities • Exempt foreign trade income of an FSC is not subject to US income taxes and is income from foreign sources that is not connected to the conduct of trade within the US • Exempt income is limited to 34% of the FSC’s total income

28. Foreign and domestic source income categories are separable. Tax credits or debits in one category cannot be applied in the other. U.S. taxation of foreign- source income depends on its classification as either Active or Passive. Foreign-Source Income Domestic-Source Income Subsidiary A: Earning Passive Income Subsidiary B: Earning Active Income Subsidiary C: Earning Active Income U.S. tax authorities tax only upon remittance. Income will be taxed by U.S. tax authorities as earned, regardless of remittance. U.S. tax gross-up results in excess foreign tax credit U.S. tax gross-up results in deficit foreign tax credit If same “income basket” tax credit applied to tax deficit US Taxation – Summary Points U.S.-Based Multinational Enterprise

29. Tax Management at Trident • Trident (the hypothetical MNE) has operations in Brazil and Germany and must manage its taxes when remitting income from these subsidiaries • The corporate tax rate in Germany is 40%, higher than the US rate of 35% • Because this rate is higher, the US parent will realize excess FTCs • The corporate tax rate in Brazil is 25%, thus the parent will not realize FTCs • Management would like to manage the dividend remittances to match the credits with the deficits

30. Trident Brazil Pays corporate income taxes in Brazil of 25% Trident Germany Pays corporate income taxes in Germany of 40% Declares a dividend to its US parent Declares a dividend to its US parent Withholding taxes are deducted from the dividend before leaving Brazil of an additional 5% Withholding taxes are deducted from the dividend before leaving Germany of an additional 10% Dividend remitted after-tax Dividend remitted after-tax Has paid less than US tax requirement of 35% on income Has paid more than US tax requirement of 35% on income Excess Foreign Tax Credit Deficit Foreign Tax Credit Tax Management at Trident Efficient management of Trident’s foreign tax position requires it to try and balance Deficit Foreign Tax Credits against Excess Foreign Tax Credits Trident USA Pays corporate income taxes in the United States of 35%

31. Summary of Learning Objectives • Nations typically structure their tax systems along one of two basic approaches: the worldwide approach or the territorial approach • Both approaches are attempts to determine which firms, foreign or domestic by incorporation, or which incomes are subject to the taxation of the host country • The worldwide approach levies taxes on the income earned by firms that are incorporated in the host country, regardless of where the income was earned • The territorial approach focuses on the income earned by firms within the legal jurisdiction of the host country, not the country of incorporation

32. Summary of Learning Objectives • A network of bilateral tax treaties 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 two signatories specifying what rates are applicable to which type of income • The value-added tax is a type of national sales tax collected at each stage of production or sale of goods in proportion to the value added during that stage

33. Summary of Learning Objectives • The US differentiates foreign source income from domestic source income; each is taxed separately and tax credits/deficits in one category may not be used against credits/deficits in another category • If a US based MNE receives income from a foreign country that imposes higher taxes than that of the US, total creditable taxes will exceed the US taxes on that foreign income. The result is excess foreign tax credits • All firms wish to manage their tax liabilities globally so that they don’t end up paying more on foreign sourced income than they do on domestic sourced income