Università Bocconi A.A. 2005-2006
Comparative public economics
Giampaolo Arachi
Università Bocconi, A.A: 2005-2006
Mec – Comparative public economics
1
Multinational tax planning
Alternative approaches to multinational taxation
Choice of foreign entity
Taxation of foreign income
Foreign tax credit
References:
M. Scholes, M. A. Wolfson, M. Erickson, E. L. Maydew, T.
Shevlin (SWEMS), Taxes and business strategy: a
planning approach, Pearson Prentice Hall, third
edition, 2005, ch. 10
Università Bocconi, A.A: 2005-2006
Mec – Comparative public economics
2
Multinational tax planning
Alternative approaches to multinational taxation
Choice of foreign entity
Taxation of foreign income
Foreign tax credit
References:
M. Scholes, M. A. Wolfson, M. Erickson, E. L. Maydew, T.
Shevlin (SWEMS), Taxes and business strategy: a
planning approach, Pearson Prentice Hall, third
edition, 2005, ch. 10
Università Bocconi, A.A: 2005-2006
Mec – Comparative public economics
3
Alternative approaches to multinational taxation
Worldwide system: In a pure worldwide tax system, resident
individuals and entities are taxable on their worldwide income,
regardless of where the income is derived.
Territorial system: In a pure territorial tax system, the country
taxes only income derived within its borders, irrespective of the
residence of the taxpayer.
No country uses a pure worldwide or territorial system.
Example: The U.S. taxes citizens, whether they are U.S. residents
or not, resident aliens and U.S. corporations on their worldwide
income
In contrast foreign corporation and non resident aliens are taxed
only on the income derived within the U.S.
Università Bocconi, A.A: 2005-2006
Mec – Comparative public economics
4
Alternative approaches to multinational taxation
Territorial system
Germany, France, Switzerland, Benelux
Many countries levy withholding taxes on
Dividends
Interest
Royalties
Tax sparing clause: such clauses allow residents of the capital
exporting country a credit against domestic tax for profits or gains
derived in the developing country in respect of which all or
specified taxes are subject to exemption or reduction in the latter
country.
Università Bocconi, A.A: 2005-2006
Mec – Comparative public economics
5
Company residence
UK
A company is resident in the United Kingdom if:
• it is incorporated in any one of its three company jurisdictions, i.e. England and
Wales, Scotland and Northern Ireland;
• its business is centrally managed and controlled in the United Kingdom; or
• its business is de facto centrally managed and controlled in the United Kingdom, as
might be the case of a non-resident subsidiary of a UK parent
Italy
A company is considered resident if its legal seat, place of effective management or
main business purpose is in Italy for the greater part of the financial year. The place
where the company was incorporated is not relevant.
The legal seat (sede legale) is the place indicated in the company's articles of
incorporation. In some cases, this cannot be determined since not all entities
subject to corporate income tax are required to state their legal seat in their articles
of incorporation. The place of effective management (sede dell'amministrazione) is
the place from where the company's directors manage the company, i.e. the place
where the main decisions are made. The main business purpose (oggetto principale
dell'attività) is the purpose indicated in the articles of incorporation if they are in the
form of public deed or private authenticated deed. Otherwise, the main business
purpose is determined by the actual activity of the company.
Università Bocconi, A.A: 2005-2006
Mec – Comparative public economics
6
Dual resident companies
EXAMPLE
A, B and C are companies in a multinational group
A is UK incorporated and UK resident
B is a dual resident investing company and is US incorporated C is US incorporated
and US resident
A and B are members of a UK sub-group
B and C are members of a US sub-group
A and C each have profits of £100
B has a loss of £100
A has an asset on which a chargeable gain has accrued over a period of time. A
could transfer the asset to B on a no gain/no loss basis. B would immediately sell
the asset to a third party and realize a chargeable gain of £100 liable to Corporation
Tax (ignoring indexation etc).
Then B could set its loss of £100 against the gain in accordance with the normal
rules giving relief for charges, trading losses etc. As far as the United States subgroup is concerned, however, B would be treated as acquiring the asset from A at its
current market value. So, any gain (or loss) on the subsequent sale of the asset
outside the group would be negligible. B would therefore make a loss of £100 (or
thereabouts) in United States tax terms which could be set against C's profits. The
group still would have got relief of £200 for B's loss of £100.
Università Bocconi, A.A: 2005-2006
Mec – Comparative public economics
7
Multinational tax planning
Alternative approaches to multinational taxation
Choice of foreign entity
Taxation of foreign income
Foreign tax credit
Università Bocconi, A.A: 2005-2006
Mec – Comparative public economics
8
Choice of foreign entity
Branch: it is an entity which is not formally separated from the
parent company for tax purposes
Subsidiary: is formally separated from the parent company
US Check the box election: U.S. parent firms elect whether to
treat their wholly owned foreing entities as corporations for U.S.
tax purposes or as branches.
The election si made by actually checking a box on a special form
filed with the IRS.
A different election can be made for each foreign entity
Tax treatment depends also on other features
CFC (if parent company owned more than 50% of voting power or
market value)
Università Bocconi, A.A: 2005-2006
Mec – Comparative public economics
9
Branch vs Subsidiary
Branch
Subsidiary
Pros
Easy to set up
Losses from foreign operations are
immediately deductible against domestic
income
In some cases it may exploit the same
deductions and credits granted to the
parent company
Property can be transferred to a branch
without taxation on appreciation
Deferred taxation
Easy to participate in nontaxable
reorganizations
Limited liability
May exploit favorable tax treatment at
local level
Cons
No tax deferral
Some countries may require disclosure of
data on worldwide operations to tax
authorities
Liability is not limited to the assets
employed abroad
Business reorganization may be taxable
Losses from foreign operations cannot be
deducted against domestic income
Some countries may require disclosure of
data on worldwide operations to tax
authorities
Not all foreign taxes give the right to a
domesti tax credit
It is costly to set up a subsidiary
Università Bocconi, A.A: 2005-2006
Mec – Comparative public economics
10
Multinational tax planning
Alternative approaches to multinational taxation
Choice of foreign entity
Taxation of foreign income
Foreign tax credit
Università Bocconi, A.A: 2005-2006
Mec – Comparative public economics
11
How should the income of a foreign subsidiary
be taxed?
General rule: taxes on income should be paid only on
income
If worldwide taxation a tax credit should be granted for
taxes paid abroad
Simple concept – very difficult to implement
Which is the right measure of income?
Which taxes are levied on income?
Usually
Tax credit only for explicit taxes on income
Other taxes may be deducted
Università Bocconi, A.A: 2005-2006
Mec – Comparative public economics
12
Multinational tax planning
Alternative approaches to multinational taxation
Choice of foreign entity
Taxation of foreign income
Foreign tax credit
Università Bocconi, A.A: 2005-2006
Mec – Comparative public economics
13
Foreign tax credits: U.S.
Direct foreign tax credit
Branches: taxes paid on earnings of a foreign branch
Subsidiaries: witholding taxes levied on dividends or other forms of
passive income paid to U.S. parent corporations
Indirect foreign tax credits
Taxes paid on the underlying “earning and profits” that produced the
dividend
U.S. allows tax credits only for foreign taxes levied on income a
and witholding taxes on the repatriation of income
Foreign property taxes, value added taxes and excise taxes are
not eligible for the foreign tax credit unless an exception is made
under a tax treaty
Foreign taxes not eligible for the foreign tax credit can be taken as
a deduction for U.S. tax purposes, just like any other business
expense
No credit is given for more in taxes than would have been paid had
the income been earned in the U.S.
Università Bocconi, A.A: 2005-2006
Mec – Comparative public economics
14
Example of FTC
Subsidiary location
Country A
Country B
Together
1
Local taxable income
1000
1000
2
Local tax rate
20%
40%
3
Local tax (2*1)
200
400
600
4
Net income (1-3)
800
600
1400
5
Dividend (50% payout *4)
400
300
700
6
Withholding tax (10%*5)
40
30
70
7
Dividend net of foreign taxes (5-6)
360
270
670
8
Deemed-paid credit (=(5/4)*3)
100
200
300
9
US taxable income =5+8
500
500
1000
10
US tax (35% of 9)
175
175
350
11
Foreign tax credit (8+6)
140
230
370
12
Net US tax
35
0
0
13
FTC tax credit carryforward
0
55
20
Università Bocconi, A.A: 2005-2006
2000
Mec – Comparative public economics
15