International Taxation: Debt
Financing, Taxation and Transfer
Pricing
By Koy Saechao
Overview
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Debt financing Tax implications for
equity
International tax policies for host and
home government
Tax management principles
Debt Financing
Taxes are often considered with the treatment
of debt financing. Debt management is
affected by:
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Interest payments as deductible expenses
Treatment of capital losses (or gains)
Valuation with Adjusted Present Value (tax shields)
International Taxation
General principle of international taxation:
There is a clear distinction between returns
to debt and returns to equity.
1. Tax
deductibility of interest payments
2. Treatment of foreign exchange gains/losses
Corporate income tax is designed as a tax on
the returns to equity only
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
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.
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Dividends
Repatriation of profits
License
Royalty fees
Other revenue paid
“First Crack” to tax income produce within host
country’s boarders
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
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Treatment of foreign income
and taxes paid
Type
Summary
Implication
Exempt from
Domestic
Firm will not be taxed on any
income earned aboard
Foreign tax rate governs
taxes paid by the firm
Full Tax Credit
Tax profits earned overseas are
taxed at same rate as profits
earned at home, then give full tax
credit for foreign taxes paid
Home tax rate generally
governs taxes paid by the
firm
Deduction
Tax foreign profits at the domestic
rate, then give deduction for taxes
paid
Foreign taxes paid therefore
only reduce total taxable
income. There is some double
taxation (not used much)
Double Tax
Tax foreign profits, give no
recognition for foreign taxes paid
Complete double taxation
occurs
Example 11.1
Peripatetic Enterprises headquartered in Nide,
has foreign income from Serendip.
Foreign Income
$1000
Serendip Tax Rate
35%
Domestic Tax Rate
45%
Example of Home Policies
Exemption
Credit
Deduction
Double Tax
Foreign
Income
$1000
$1000
$1000
$1000
Foreign
Taxes Paid
$350
$350
$350
$350
Home Taxes
Paid
$0
$100
$293
$450
Net Income
$650
$550
$357
$200
Peripatetic prefers tax exempt policy. Beyond that, tax credit over
deduction, and prefers either of these over double taxation.
Timing of Taxation
Contemporaneous Taxation:
home country may choose
to tax foreign equity returns
during fiscal year in which
they are earned.
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Used mostly for foreign
branches of MNE.
Tax Deferral: taxation occurs
at time profits are
repatriated as dividends.
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Branch is an extension of
parent company
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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.
Summary of International
Tax Policies
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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.
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MNEs prefer to invest where taxes are lower
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Tax laws are more complicated then the framework presented.
Subpart F: Subsidiary income taxed regardless of repatriation.
International Tax Management
International Taxation
The goal to international tax management is
to increase corporation-wide profits by
reducing the total amount of taxes paid.
Management Issues
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Relevant decisions for branches
Allocation of profits
 Allocation of costs
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Branch vs. Subsidiary (Aaron)
Branch Decisions
We want to allocate pre-tax profits to maximize aftertax profits.
1. Review cost allocation amongst branches
2. 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.
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.
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:
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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.
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.
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:
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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.
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.
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:
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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.
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.
Summary of Tax
Management Principles
Decision
No Excess Tax
Credits
Excess Tax Credits
Cost Allocation
Does not matter
Allocate costs to
high-tax countries
Transfer Pricing
Does not matter
Show profits in lowtax countries
Transfer Pricing with Low transfer price
Tariff
Minimize total taxes
by comparing T* to
[T +Td*(1- T*)]
International Taxation
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Branch considerations
Branch vs Subsidiary Status (Aaron)
Questions