Multinational Tax Management 1

Multinational Tax Management
• Tax planning for multinational operations is an extremely complex but important aspect of international business.
• To plan effectively, MNCs must understand not only the intricacies of their own operations worldwide, but also the different structures and interpretations of tax liabilities across countries.
• The primary objective of multinational tax planning is the minimization of the firm’s worldwide tax burden.

Multinational Tax Management
• Taxes have a major impact on corporate net income and cash flow through their influence on foreign investment decisions, financial structure, determination of the cost of capital, foreign exchange management, working capital management, and financial control.
• Management must not pursue the objective of minimizing the firm’s worldwide tax burden without full recognition that decision making within the firm must always be based on the economic fundamentals of the firm’s line of business. Tax morality
– In many countries taxpayers, corporate or individual, do not voluntarily comply with the tax laws
– The MNC must decide whether to follow a practice of full disclosure to tax authorities or adopt the philosophy “When in Rome, do as the Romans do”
– Most MNCs follow the full disclosure practice Tax neutrality
– When a government decides to levy a tax, it must consider not only the potential revenue from the tax, or how effectively it can be collected, but also the effect the proposed tax can have on private economic behavior
– For example, a government’s policy on taxation of foreign-source income may have multiple objectives: • Neutralizing tax incentives that favor or disfavor the country’s private investment in developed countries
• Providing an incentive for the country’s private investment in developing countries
• Improving the country’s BOP
• Raising revenue

Tax neutrality cont….
• One way to view neutrality is to require that the burden of taxation on each dollar, euro, pound, or yen of profit earned in home country operations by a MNC be equal to the burden of taxation on each currency equivalent of profit earned by the same firm in its foreign operations (domestic neutrality).
• A second way to view neutrality is to require that the tax burden on each foreign subsidiary of the firm be equal to the tax burden on its competitors in the host country (foreign neutrality).
• In theory, an equitable tax is one that imposes the same total tax burden on all taxpayers who are similarly situated and located in the same tax jurisdiction.

Tax Approaches
• Despite the fundamental objectives of national tax authorities, it is widely agreed that taxes do affect economic decisions made by MNCs.
• Tax treaties between nations and differential tax structures, rates, and practices all result in a less than level playing field for the MNCs competing on world markets. • Nations typically structure their tax systems along one of two basic approaches:
– The worldwide approach
– The territorial approach

The worldwide approach
• The worldwide approach, also referred to as the residential or national approach, levies taxes on the income earned by firms that are incorporated in the host country, regardless of where the income was earned (domestically or abroad).
• A MNC earning income both at home and abroad would therefore find its worldwide income taxed by its home country tax authorities.
• For example, a country like the US taxes the income earned by firms based in the US regardless of whether the income earned by the firm is domestic or foreign in origin.

The territorial approach
• The territorial approach, also termed the source approach, focuses on the income earned by the firms within the legal jurisdiction of the host country, not on the country of firm incorporation.
• Countries like Germany follow this approach and apply taxes equally to foreign or domestic firms on income earned within the country, but in principle not on income earned outside the country.

Tax treaties
• A network of bilateral tax treaties, many of which are modeled after one proposed by the
Organization for Economic Cooperation and
Development (OECD), provides a means of reducing double taxation.
• Tax treaties normally define whether taxes are to be imposed on income earned in one country by the nationals of another, and if so, how.
• Tax treaties are bilateral, with the two signatories specifying what rates are applicable to which types of income between themselves alone. Tax classifications

• Taxes are classified on the basis of whether they are applied directly to income, called direct taxes, or to some other measurable performance characteristic of the firm, called indirect taxes.
• Some categories include:
– Income tax
– Withholding tax
– Value-added tax
– Other national taxes

Tax credits
• To prevent double taxation on the same income, most countries grant a foreign tax credit for income taxes paid to the host country. • A tax credit is a direct reduction of taxes that would otherwise be due and payable.
• If there were no credits for foreign taxes paid, sequential taxation by the host government and then by the home government would result in a very high cumulative tax rate.

INTERNATIONAL TAX MANAGEMENT
• Multiple Taxation Vs. Tax Neutrality
Double Right to Tax:

The Residence Principle: All residents of the country (that is, private persons living in the country, and incorporated companies established in the country) can be taxed on their worldwide income.
 The Source Principle: All income earned inside the country, whether by residents or non-residents, is taxable in this country. “Earnings” = from an activity or from a property (dividends, interest income or royalties)  This implies that income can be taxed twice unless some form of relief for double taxation is provided

When can a double or triple taxation occur?
• The case of Direct Exports
A pure exporter:
- is not a resident of the foreign country
- has no foreign activity, and does not receive any dividends, license income, or interest income from the foreign country
• The foreign country can invoke neither the residence principle, nor the source principle.
Home taxes only

When can a double or triple taxation occur?
• The case of Foreign Subsidiary
 A subsidiary is a resident of the host country
& thus pay host corporate taxes
 Parent receives income from the subsidiary
 Host country will invoke the source principle and tax dividends, interest fees, or royalties paid out to the parent. This tax is called a withholding tax.
 In addition, the parent’s home country will, in principle, invoke the residence principle, and tax all its residents on their worldwide incomes. When can a double or triple taxation occur?
-

The case of Foreign Subsidiary:
Double or triple taxation? Example:
- profit of Ush.170 Billions before taxes
- Ugandan corporate taxes Ush.51Billions
- dividend Ush.119 Billions bank will withhold Ush.11.9
Billion from the (gross) dividend and transfer it to the
Ugandan tax administration
- “net” dividend of Ush.107.1 Billion is to be declared in parent’s Ush. tax return: potential additional taxes

Relief from double taxation
• unilateral measures in national tax codes • bilateral tax treaty which supersedes the national rules.

Two alternative neutrality principles
• Capital Import Neutrality: e.g. Ugandan branch should be taxed the same way as a purely Ugandan entity
 Foreign-owned entity should be allowed to compete on an equal basis with a Ugandan-owned competitors
• Capital Export Neutrality: e.g. The total tax burden should be the same whether the Kenyan firm earns its income at home or in Uganda
 Overall corporate tax should be the same as if the branch had been located in Kenya. Under this system, the Kenyan tax authorities

Taxation of a Branch under the Credit System:
Key problems:
- Disagreement on profit allocation
- Excess tax credits
• Disagreement on profit allocation

Main problem is allocation of indirect costs which, by definition, cannot be allocated in any practical, logical way. National tax authorities may use different rules of thumb • Excess Tax Credits
 If foreign taxes exceed the domestic norm: rarely a full refund of the excess taxes paid abroad
•

How to solve the problem?
1.

International aggregation of foreign income: Excess tax credits from one branch can be used to offset home country taxes due on income from branches in lowtax countries 2. Aggregation of home and foreign income
3. Carry-forward or Carry-back rules
 Carry-forward: use this year’s excess foreign taxes as a credit for future home country taxes. Refund is delayed, and limited to home country taxes that would be payable within the next few years
 Carry-back: if in the recent past we have paid more than a specified limit in additional host country taxes, we can now claim back. Refund of excess tax credits is limited to the home country taxes effectively paid in the last few years

International Taxation
• The goal to international tax management is to increase corporation-wide profits by reducing the total amount of taxes paid.

• Relevant decisions for branches
• Allocation of profits
• Allocation of costs

• Branch vs. Subsidiary

Branch Decisions
• We want to allocate pre-tax profits to maximize after-tax 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.

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.

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 lowesttax jurisdictions
• Transfer Pricing

– Pricing of internally-traded goods.
Management may suggest altering the company’s transfer prices to show profits in low-tax jurisdictions.

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.
• Because an import tariff is a deductible expense, it may not generate a tax credit, thus affecting net branch income.

Transfer Pricing
• Governments restrict the extend to which managers can transfer prices.
• They strive for arms-length transaction…. Easy to monitor in competitive market.
• Firms can use RESALE PRICE Method or COSTPLUS Method (reasonable markup price above the cost of the good).
• Price set must have an economic meaning, as well as to reduce taxes.
• Can be audited by Governments.

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 low-tax countries

Transfer Pricing with Tarif

Low transfer price Minimize total taxes Tax Havens Introduction

• These are foreign jurisdictions that offer financial secrecy laws in an effort to attract investment from outside their borders. • These jurisdictions are commonly referred to as “tax havens”, because in addition to the financial secrecy they provide, they impose little or no tax on income from sources outside these jurisdictions. Tax Havens Introduction Cont...
• Tax haven service providers and their clients know their actions are veiled from tax authorities by banking and commercial secrecy laws and by lack of tax treaties or tax information exchange agreements. • They create paper entities to disguise the real parties to the transactions, and many are willing to create false documents to disguise the real nature of transactions.

Tax Havens Introduction Cont...
• Some tax havens have gone so far as to offer asylum or immunity to criminals who invest sufficient funds. They permit the formation of companies without any proof of identity perhaps even by remote computer connections.
• Generally though such extremes are found in emerging nations where the stability and security of the financial, legal, political systems is questionable
• The largest concentrations of assets are attracted to the stable secure environments of the established tax havens –those that have existed a number of years and enjoy the diplomatic protection of former colonial powers Tax Havens Examples

• Australia, Bahamas, Bahrain, Barbados,
Bermuda, British Virgin Islands, Costa
Rica, Cyprus, Dominica, Gibraltar, Greece,
Ireland, Latvia, Liechtenstein, Malta,
Mauritius, Monaco, Panama,
Switzerland, Thailand, etc

Types of Benefits

The concessions and benefits may come in different forms:
• It may be a zero income tax for all
• a complete tax exemption for all international business operated by non-residents
• An ultra-low income tax for international businesses
• Local tax exemption for non-residents of that jurisdiction
• zero tax on receipt and distribution of dividends
• tax holidays for certain types of investments
• favorable tax treatment through treaties and agreements with the investor's home country
• In addition, some countries offer superior legal protection from creditors and potential litigants who might attempt to seize an individuals’ wealth.

What is Common Across these Tax Havens
• Very stringent privacy laws, Secrecy laws and
Non-disclosure policies
• Do not release account information to other governments and law enforcement agencies
• Do not have any financial information exchange policies except where drug trafficking and terrorism are suspected
• Most of these Tax Havens have a legal system based on the British common law

Domestic black money

• Domestic black or unaccounted money is definitely important.
• At least Domestic black money is used in our economy and to that extent it is productive. • But the money kept in Swiss Banks is neither useful to Kenya nor it benefits
Kenyan