Matakuliah
Tahun
: F0142/Akuntansi Internasional
: 2006
Session 12
International Taxation Issues
1
Transfer Pricing and Motorola
Motorola, one of the world’s largest mobilephone companies, has operations that span
across the world. As such, it has control over
transfer prices between its operations in different
countries. In August of 2004, Motorola
announced that the Internal Revenue Service
was seeking an extra $500M in taxes from the
company. The IRS claims that Motorola set
transfer prices in order to avoid paying U.S.
taxes. They claim Motorola should have had an
additional $1.4 billion in U.S. income during the
period. As such, the IRS might force Motorola to
make adjustments that would shift profit from
other countries to the U.S.
2
International Tax Issues
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What kind of revenue is taxable?
How are expenses determined?
Should direct or indirect taxes be used?
How are cultural differences and attitudes
toward enforcement accounted for?
3
Direct Taxes
• Corporate Income Tax – Two Approaches
– Classic System
• Income taxed when received
• Earnings are taxed twice
– Integrated Systems
• Attempt to eliminate double taxation
• Two ways to integrate
– Rate split between income and for profits distributed (Germany)
– Imputation – tax remitted earnings and dividend earnings at the
same rate, but shareholders get a tax credit (as in EU)
• Corporate income taxes have come down
recently
4
OECD and EU Average Corporate Tax
Rates
5
Two Methods
• Territorial approach
– Tax income earned in the
country where it is
generated (Hong Kong)
• Worldwide approach
– Tax both domestic and
foreign source income
– Some countries alleviate
burden with tax credits,
treaties, and deferral of
foreign source income
6
Determination of Expenses
• Expenses are usually a matter of timing
• As useful lives of assets differ, tax burdens
differ
• Statutory tax rates and effective tax rates
differ due to
– Determination of expenses
– Tax base
• Broadened with U.S. Tax Reform Act of 1986
• Other OECD countries broadened tax bases in
1980s
7
Withholding Tax
• Income earned by a foreign subsidiary is
taxed in the foreign country
• Cash returns to the parent are made for
dividends and the use of patents,
trademarks, processes, etc.
• Normally a tax is levied on payments by a
subsidiary to a non resident investor
• Tax varies from country to country
• Depends on existence of tax treaties
8
Indirect Taxes
• Most important source of government
revenue in some countries (France)
• Examples
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Consumption (sales) taxes
Value Added Tax (VAT)
Excise Taxes
Estate and Gift Taxes
Employment Taxes
User Fees
9
Indirect Taxes
• Value Added Tax
– Major source of funding for the EU
– Tax is applied at each stage of production for
the value added by the firm to goods
purchased from the outside
– Tax burden ultimately falls on the consumer
– Major method of computation – subtractive
method
– Tax included in price of goods
10
Computation of VAT
11
Avoidance of Double Taxation of Foreign
Source Income
• Credits and Deductions
– Must be an income tax to be creditable (U.S.)
– Tax credits are only available for taxes directly
paid by the U.S. corporation
12
Tax Deduction vs. Tax Credit
13
Avoidance of Double Taxation of Foreign
Source Income
• Tax Treaties
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Minimize the effect of double taxation
Protect each country’s right to collect taxes
Provide ways to resolve jurisdictional issues
Tend to reduce or eliminate taxes on dividends,
interest, and royalty payments
• Model Tax Treaty was approved by the U.S. in
1977
• 1994 – U.S. and Canada sign a tax treaty
– Reduces tax rates on payments of dividends, interest,
and royalties
14
U.S. Taxation of Foreign Source Income
• The Tax Haven Concept
– Tax haven – a place where foreigners receive income
or assets without paying high rates of tax upon them
– Mailbox companies have sprung up in
• Liechtenstein, Vanuatu, Netherlands Antilles
– Countries with no income tax include
• Bahamas, Bermuda, Cayman Islands
– Countries with low tax rates (British Virgin Islands)
– Countries that exempt income from foreign sources
• Hong Kong, Liberia, Panama
– Countries that allow special privileges
15
U.S. Taxation of Foreign Source Income
• The Tax Haven Concept
– Goal is to shift income from high tax to tax haven
countries
– Usually accomplished by using a tax haven subsidiary
as an intermediary
– Income shifting is generally accomplished by transfer
pricing
– May countries are concerned about minimizing the
use of tax havens
• OECD plans to impose sanctions on countries offering
“harmful” tax competition
16
U.S. Taxation of Foreign Source Income
• Deferral principle – income is deferred
from U.S. taxation until it is received as a
dividend
– Exceptions to this principle – Subpart F
income of a Controlled Foreign Corporation
(CFC)
– A CFC is a foreign corporation in which “U.S.
shareholders” hold more than 50% of the
voting stock
– U.S. shareholder – a person or enterprise that
holds at least 10 percent of the voting stock of
the foreign corporation
17
U.S. Taxation of Foreign Source Income
• Revenue Act of 1962 defined Subpart F income as
passive income
• Subpart F income is divided into eight groups
– Insurance of U.S. risks – income from parents is taxable to
the parent when earned by the CFC
– Foreign-base company personal holding company income
– dividends, interest, royalties and other income from
holding rights
– Foreign-base company sales income – income from the
sale or purchase of goods produced and consumed
outside the country where the CFC is incorporated
– Foreign-base company services income – income from
contracts utilizing technical, managerial, engineering, or
other skills
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U.S. Taxation of Foreign Source Income
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U.S. Taxation of Foreign Source Income
• Subpart F income is divided into eight
groups
– Foreign-base company shipping income – income
from using aircraft or ships for transportation outside
the country where the CFC is incorporated
– Foreign-base company oil-related income – income
from large oil or natural gas producers in a country
outside where the CFC is incorporated
– Boycott-related income – income from operations
resulting from countries involved in certain
international boycotts (such as Arab boycott of Israel)
– Foreign bribes – brides paid to foreign government
officials
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U.S. Taxation of Foreign Source Income
• Implications of Subpart F Income
– For CFCs active income is deferred, but
passive income must be recognized when
earned
• Exception – if foreign-based income of a CFC is
less than 5% of gross income of $1 million, none of
it is Subpart F income
– Essentially an American phenomenon
21
Tax Effects of Foreign Exchange Gains
or Losses
• Gains and losses from foreign currency
transactions are ordinary and are
recognized when realized
• Gains or losses cannot be recognized
while foreign currency balances are being
held
• IRS treats foreign currency transactions
from the two-transactions perspective
• IRS does not recognize gains and losses
until obligation has been settled
22
Tax Effects of Foreign Exchange Gains
or Losses
• U.S. tax law introduced the Qualified Business Unit
(QBU) – a trade or business for which separate books
are kept
• QBU earnings are divided into two parts
– Earnings distributed back to home office
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Translated at exchange rate on date of transfer
– Earnings retained in foreign office
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Translated at average exchange rate (profit-and-loss approach)
• Foreign Exchange Gain = Distribution X (AR-ER)
• Total branch profits in parent income includes the foreign
exchange gain
• Tax credit is computed using ER, the effective exchange
rate at the time the taxes were paid
23
Taxable Earnings from Foreign
Corporations
• Foreign subsidiaries are not taxed until a
dividend is declared, so the parent
company does not have to translate
statements into $
• Controlled Foreign Corporation
– Same rules apply to non-Subpart F income as
per a non-CFC situation
– Subpart-F income – a constructive dividend
has been declared at year-end, so translation
into $ is necessary
24
Tax Incentives
• Two major types
– Incentives to attract foreign investors
• Usually involve tax holidays
• Example – Brazilian government provides a 10
year holiday to invest in the northeast and
Amazon regions
– Incentives to encourage exports
• EU – many export products are zero rated – no
VAT
– Firms can offer products at lower prices
• U.S. and U.K. offer reductions in or
eliminations of property taxes for investments
25
Tax Incentives
• Foreign Sales Corporation Act of 1984 replaced
the Domestic International Sales Corporation
(DISC) legislation of 1972
• DISC income was taxed to its shareholders at a
reduced rate
• The FSC was established in response to
criticism that the DISC was just a paper shell
• WTO ruled that the FSC incorrectly applied the
territorial approach only to the export segment of
foreign source income
• FSCs were phased out by 2001
26
Tax Dimensions of Expatriates
• Finding of survey by Business
International
– U.S. is the only country from the sample
that taxes expatriates on worldwide
income
• U.S. does provide some relief through
the Foreign Earned Income Exclusion
– Foreign country must be their tax home
– Must have foreign income
– Citizen of another country or present for
entire tax year or 330 days out of any 12
consecutive months
27
Intracorporate Transfer Pricing
• Transfer pricing – the pricing of goods and
services between all combinations of parents
and subsidiaries
• Transfer pricing is often used to take advantage
of tax havens
• Factors influencing transfer pricing decisions
(Tang survey, 1992)
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Corporate profitability
Differential tax rates
Restrictions on repatriation of profits or dividends
Competitive position of foreign subsidiaries
28
Intracorporate Transfer Pricing
• “The Corporate Shell Game” – Newsweek
Newsweek magazine gave an overly simplistic,
hypothetical example of a U.S. company that manufactured
goods through its German subsidiary and sold them to its
Irish subsidiary, which in turn sold the goods back to the
U.S. parent company. The goods were manufactured at a
cost of $80 by the German subsidiary and sold for the
same amount to the Irish subsidiary. Even though the tax
rate in Germany is 45 percent, there is no tax on the
transaction. The Irish subsidiary then sells the goods to the
U.S. parent for $150, earning a profit of $70. Because the
tax rate in Ireland is only 4 percent for that transaction, the
Irish subsidiary pays only $2.80 in tax. The U.S. parent
then sells the goods for $150, earning no profit and paying
no tax, even though the U.S. tax rate is 35 percent. Thus,
the U.S. company ends up paying only $2.80 in income
taxes, and this amount is paid in Ireland.
29
Intracorporate Transfer Pricing
• Transfer pricing has become increasingly
important with the increase in MNEs
• Ernst and Young Transfer Pricing 2003 Global
Survey Results
– 86% of MNE parent companies and 93% of
subsidiaries identified transfer pricing as the most
important international tax issue they deal with
– If companies must make an adjustment, 1 in 3 with be
threatened with a penalty and 1 in 7 will pay a penalty
– 40% of adjustments result in double taxation
• Sales of goods are the most audited, while
audits of services and intangibles are increasing
30
Intracorporate Transfer Pricing
• U.S. Rules
– Section 482 of IRS code governs transfer pricing
– IRS may reallocate income, deductions, credits, and
allowances if it feels tax evasion is occurring
– Transactions must be at “arm’s length”
– IRS is concerned with five areas
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Loans and Advances
Performance of services
Use of tangible property
Use of intangible property
Sale of tangible property
31
Intracorporate Transfer Pricing
• Methods for Determining Arm’s Length
Prices
– For tangible property there are six methods
• Comparable uncontrollable price method – market
price determines transfer price
• Resale price method – used if comparable
uncontrollable price method cannot be used
• Comparable profits method – less common
• Cost-plus method – costs of manufacturing plus a
normal profit margin
• Profits split method – less common
• Other methods – less common
32
Tax Planning in the International
Environment
• Choice of Methods of Serving Foreign Markets
– Exports of goods and services and technology
• Should the firm service products for the parent country
or abroad?
• Consider the benefits of a sales office abroad
• If licensing technology, be aware of withholding taxes
and relevant tax treaties
– Branch operations
• Good to open a branch office at first to offset home
country income with foreign losses
• Branch remittances are not usually subject to withholding
taxes
33
Tax Planning in the International
Environment
• Choice of Methods of Serving Foreign
Markets
– Foreign Subsidiaries
• Income is sheltered from taxation in home country
until a dividend is remitted (except for passive
income of a CFC)
• Cannot recognize losses by the subsidiary in the
parent company
• More valuable after start-up years
34
Tax Planning in the International
Environment
• Factors on Location of Foreign Operations
– Tax Incentives
• Can reduce cash outflow of an investment project
– Tax Rates
– Tax Treaties
• Example – Withholding tax between U.S. and U.K. is
15%, but both countries have 5% withholding agreement
with the Netherlands
• An arrangement could be made to send dividends from
the U.K. to Holland, then to the U.S., and the 15% tax
would be partially avoided
• Tax planning decisions should not crowd out
management control and other essential issues
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