Chapter 16

International Taxation Issues

Transfer Pricing and Motorola

Motorola, one of the worlds 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 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?

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

OECD and EU Average

Corporate Tax Rates

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

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

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

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

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

Computation of VAT

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

Tax Deduction vs. Tax Credit

Avoidance of Double Taxation

of Foreign Source Income

Tax Treaties

Minimize the effect of double taxation

Protect each countrys 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

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

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

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

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

U.S. Taxation of Foreign

Source Income

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

U.S. Taxation of Foreign

Source Income
Implications

For CFCs active income is deferred, but passive

income must be recognized when earned

of Subpart F Income

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

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

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

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

Tax Incentives
Two

Incentives to attract foreign investors

major types

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

U.S.

Firms can offer products at lower prices

and U.K. offer reductions in or

eliminations of property taxes for investments

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

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

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

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.

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

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 arms 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

Intracorporate Transfer Pricing

Methods

for Determining Arms 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

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

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

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