Chapter 16
International Taxation Issues
Transfer Pricing and Motorola
Motorola, one of the world’s largest mobile-phone
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.
International Accounting & Multinational Enterprises – Chapter 16 – Radebaugh, Gray, Black
International Tax Issues




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?
International Accounting & Multinational Enterprises – Chapter 16 – Radebaugh, Gray, Black
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
International Accounting & Multinational Enterprises – Chapter 16 – Radebaugh, Gray, Black
OECD and EU Average
Corporate Tax Rates
International Accounting & Multinational Enterprises – Chapter 16 – Radebaugh, Gray, Black
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
International Accounting & Multinational Enterprises – Chapter 16 – Radebaugh, Gray, Black
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
International Accounting & Multinational Enterprises – Chapter 16 – Radebaugh, Gray, Black
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
International Accounting & Multinational Enterprises – Chapter 16 – Radebaugh, Gray, Black
Indirect Taxes


Most important source of government
revenue in some countries (France)
Examples






Consumption (sales) taxes
Value Added Tax (VAT)
Excise Taxes
Estate and Gift Taxes
Employment Taxes
User Fees
International Accounting & Multinational Enterprises – Chapter 16 – Radebaugh, Gray, Black
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
International Accounting & Multinational Enterprises – Chapter 16 – Radebaugh, Gray, Black
Computation of VAT
International Accounting & Multinational Enterprises – Chapter 16 – Radebaugh, Gray, Black
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
International Accounting & Multinational Enterprises – Chapter 16 – Radebaugh, Gray, Black
Tax Deduction vs. Tax Credit
International Accounting & Multinational Enterprises – Chapter 16 – Radebaugh, Gray, Black
Avoidance of Double Taxation
of Foreign Source Income

Tax Treaties






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
International Accounting & Multinational Enterprises – Chapter 16 – Radebaugh, Gray, Black
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
International Accounting & Multinational Enterprises – Chapter 16 – Radebaugh, Gray, Black
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
International Accounting & Multinational Enterprises – Chapter 16 – Radebaugh, Gray, Black
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
International Accounting & Multinational Enterprises – Chapter 16 – Radebaugh, Gray, Black
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
International Accounting & Multinational Enterprises – Chapter 16 – Radebaugh, Gray, Black
U.S. Taxation of Foreign
Source Income
International Accounting & Multinational Enterprises – Chapter 16 – Radebaugh, Gray, Black
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
International Accounting & Multinational Enterprises – Chapter 16 – Radebaugh, Gray, Black
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
International Accounting & Multinational Enterprises – Chapter 16 – Radebaugh, Gray, Black
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
International Accounting & Multinational Enterprises – Chapter 16 – Radebaugh, Gray, Black
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


Earnings retained in foreign office




Translated at exchange rate on date of transfer
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
International Accounting & Multinational Enterprises – Chapter 16 – Radebaugh, Gray, Black
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
International Accounting & Multinational Enterprises – Chapter 16 – Radebaugh, Gray, Black
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
International Accounting & Multinational Enterprises – Chapter 16 – Radebaugh, Gray, Black
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
International Accounting & Multinational Enterprises – Chapter 16 – Radebaugh, Gray, Black
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
International Accounting & Multinational Enterprises – Chapter 16 – Radebaugh, Gray, Black
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)




Corporate profitability
Differential tax rates
Restrictions on repatriation of profits or dividends
Competitive position of foreign subsidiaries
International Accounting & Multinational Enterprises – Chapter 16 – Radebaugh, Gray, Black
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.
International Accounting & Multinational Enterprises – Chapter 16 – Radebaugh, Gray, Black
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
International Accounting & Multinational Enterprises – Chapter 16 – Radebaugh, Gray, Black
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
 Loans and Advances
 Performance of services
 Use of tangible property
 Use of intangible property
 Sale of tangible property
International Accounting & Multinational Enterprises – Chapter 16 – Radebaugh, Gray, Black
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
International Accounting & Multinational Enterprises – Chapter 16 – Radebaugh, Gray, Black
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
International Accounting & Multinational Enterprises – Chapter 16 – Radebaugh, Gray, Black
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
International Accounting & Multinational Enterprises – Chapter 16 – Radebaugh, Gray, Black
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
International Accounting & Multinational Enterprises – Chapter 16 – Radebaugh, Gray, Black