Chapter 16 Taxes Multinational Corporate Strategy

1. Chapter 16Taxes & Multinational Corporate Strategy

2. The income tax... The income tax has made more liars out of the American people than golf has. Will Rogers

3. The objectives of tax neutrality

4. Violations of tax neutrality Different tax rates and regimes… Tax jurisdictions Foreign or domestic Organizational forms Foreign branches or incorporated subsidiaries Asset classes Interest, dividends, or capital gains Financing instruments Tax deductibility of interest on debt

5. Forms of taxation Explicit taxes Corporate and personal income taxes Withholding taxes on dividends, interest and royalties Sales or value-added taxes Property or asset taxes Tariffs on cross-border trade

6. Forms of taxation Implicit taxes The law of one price in after-tax form “Equivalent assets sell for the same after-tax expected return” Countries with low tax rates tend to have low before-tax expected and required returns

7. The effect of implicit taxes on required returns Example Suppose Td = 50% and Tf = 20%. Pre-tax required return on an asset in the domestic currency is id = 20%. If the law of one price holds in its after-tax version, what is the pre-tax required return if on the asset in the foreign currency?

8. The effect of implicit taxes on required returns Equal after-tax returns means… if(1-Tf) = id(1-Td) 20%(1-0.5) = id(1-0.2) = 10% ? id = 10%/(1-0.2) = 12.5% A 20% pre-tax return at a 50% tax rate is equivalent to a 12.5% after-tax return at a 20% tax rate.

9. Taxes on foreign-source income Foreign-source income is income from foreign operations Two basic systems of taxation… A worldwide tax system taxes foreign-source income as it is repatriated to the parent company A territorial tax system levies a tax only on domestic income. Taxes on foreign-source income are only paid in the country in which they are earned.

10. Taxes and the organizational formof foreign operations In most worldwide tax systems… Foreign branch income is taxed as it is earned Incorporated foreign subsidiary income is taxed as it is repatriated to the parent

11. Incorporated foreign subsidiaries Most manufacturing companies conduct their foreign operations through a foreign corporation that is incorporated in the host country Income from an incorporated foreign subsidiary is taxed by domestic tax authorities as it is repatriated to the parent Incorporation in the host country limits the parent’s liability Incorporation avoids host country disclosure requirements on the parent’s worldwide operations

12. Foreign branches Foreign branches are legally a part of the parent, so branch income is taxed by the domestic tax authority as it is earned A possible advantage of a foreign branch Can be used for start-up operations that are expected to generate initial losses Possible disadvantages of a foreign branch Can be tax disadvantaged if the branch is in a low-tax country Can expose the MNC to legal liabilities

13. U.S. taxation of foreign source income Taxes on a foreign corporation depend on the parent’s level of ownership and control Passive income basket Dividends from foreign corporations owned less than 10% in market value and voting power General limitation income basket 10/50 corporation: Dividends from ownership of 10% or more but less than or equal to 50% in terms of market value or voting power Controlled foreign corporation (CFC): Dividends from ownership of more than 50% in terms of market value or voting power

14. IRS “check-the-box” regulations Check-the-box regulations allow a U.S. parent to choose whether a foreign corporation is treated as a corporation or as a flow-through entity for U.S. tax purposes If the U.S. parent “checks the box” for each CFC, then all transactions of the flow-through entities below the Swiss Holding Company flow through to the Swiss Holding Company and are otherwise ignored for U.S. tax purposes

16. FTC limitations in the U.S.

17. FTC limitations in the U.S.

18. FTC limitations in the U.S.

19. Interest expense is allocated according to the proportion of foreign and domestic assets on the corporation’s consolidated tax return An exception is qualified nonrecourse indebtedness that supports a specific physical asset with a useful life of more than one year Allocation-of-income rulesimpose additional FTC limitations

20. Most other expenses are allocated according to either foreign sales or gross income from foreign sources Other expenses include Research and experimentation expense General and administrative expenses Allocation-of-income rulesimpose additional FTC limitations

21. Effect of shifting sales to low-tax countries

22. Effect of shifting sales to low-tax countries

23. Effect of shifting sales to low-tax countries

24. Offshore finance subsidiaries The Tax Reform Act of 1986 removed the tax advantages of tax-haven affiliates for U.S. firms Many MNCs retain off-shore finance subsidiaries as reinvoicing centers Reinvoicing centers should be in countries with Low tax rates (income and withholding) A stable and convertible currency with access to international currency and Eurocurrency markets Low political risk A sophisticated workforce Developed financial & economic infrastructures

25. Transfer pricing and tax planning MNCs have an incentive to shift taxable income toward low-tax countries Shift revenues to low-tax countries Shift expenses to high-tax countries Most national and international tax codes require that transfer prices be set as if they are arms-length transactions between unrelated parties

26. An example of the tax games people play… A U.S.-based MNC produces beef in Argentina for export to Hungary Revenues are $10,000 in Hungary Production expense is $3,000 in Argentina $1,000 of fixed expense in each country The income tax rate in Argentina is 35% The income tax rate in Hungary is 18% At what price should the transfer from Argentina to Hungary be made? Transfer pricing and tax planning

27. Transfer price Market-based Cost-plus Arg Hun Both Arg Hun Both Tax rate 35% 18% 35% 18% Revenue 8000 10000 10000 5000 10000 10000 COGS 3000 8000 3000 3000 5000 3000 Other expenses 1000 1000 2000 1000 1000 2000 Taxable income 4000 1000 5000 1000 4000 5000 Total taxes paid 1400 180 1580 350 720 1070 Net income 2600 820 3420 650 3280 3930 Effective tax rate on foreign operations 31.6% 21.4% Transfer pricing and tax planning

28. Transfer pricing and tax planning Aggressive transfer pricing can be advantageous when a firm has Operations in more than one tax jurisdiction High gross operating margins (such as in the electronics and pharmaceutical industries) Intangible assets resulting in intermediate or final products for which there is no market price (e.g., patents or proprietary production processes)

29. Taxes and cross-border acquisitionsby U.S. firms