International Taxation: Debt Financing, Taxation and Transfer Pricing

By Koy Saechao

Overview


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:
  

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)
Home government determines policies visvis--vis the host government

Host government acts first

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.
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


Treatment of foreign income and taxes paid

Type
Exempt from Domestic Full Tax Credit

Summary
Firm will not be taxed on any income earned aboard Tax profits earned overseas are taxed at same rate as profits earned at home, then give full tax credit for foreign taxes paid Tax foreign profits at the domestic rate, then give deduction for taxes paid Tax foreign profits, give no recognition for foreign taxes paid

Implication
Foreign tax rate governs taxes paid by the firm Home tax rate generally governs taxes paid by the firm Foreign taxes paid therefore only reduce total taxable income. There is some double taxation (not used much) Complete double taxation occurs

Deduction

Double Tax

Example 11.1
Peripatetic Enterprises headquartered in Nide, has foreign income from Serendip.
Foreign Income Serendip Tax Rate Domestic Tax Rate $1000 35% 45%

Example of Home Policies

Exemption Foreign Income Foreign Taxes Paid Home Taxes Paid Net Income $1000 Credit $1000 Deduction $1000 Double Tax $1000

$350

$350

$350

$350

$0

$100

$293

$450

$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: Taxation: home country may choose to tax foreign equity returns during fiscal year in which they are earned.


Tax Deferral: taxation occurs Deferral: at time profits are repatriated as dividends.


Used mostly for foreign branches of MNE. Branch is an extension of parent company

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

 

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. MNEs prefer to invest where taxes are lower 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 corporationreducing the total amount of taxes paid.

Management Issues


Relevant decisions for branches

Allocation of profits  Allocation of costs


Branch vs. Subsidiary (Aaron)

Branch Decisions
We want to allocate pre-tax profits to maximize afterpreaftertax 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 highto achieve the largest tax deductions possible. As such:
  

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 lowestjurisdictions by allocating costs to the highesthighest-tax jurisdictions, without making negative profits.

Transfer Pricing
Pricing of internally-traded goods. Management may suggest altering internallythe company s transfer prices to show profits in low-tax lowjurisdictions. The Vice-President of C&C Enterprises suggests raising transfer prices Vicefrom $16 to $18 for countries with high-tax jurisdictions. By highincreasing the transfer prices, it:
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 lowestsimple 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:
   

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*)]: Td*(1Use the high transfer price if T*>[T +Td*(1- T*)] without +Td*(1making profits negative, and use the low transfer price if T*<[T +Td*(1- T*)] without making profits negative. +Td*(1-

Summary of Tax Management Principles

Decision Cost Allocation No Excess Tax Credits Does not matter Excess Tax Credits Allocate costs to highhigh-tax countries Show profits in lowlowtax countries Minimize total taxes by comparing T* to
[T +Td*(1- T*)] +Td*(1-

Transfer Pricing

Does not matter

Transfer Pricing with Low transfer price Tariff

International Taxation
 

Branch considerations Branch vs Subsidiary Status (Aaron)

Questions