International Taxation
Chapter 8: International Taxation
Learning Objectives
Describe differences in corporate income tax and withholding tax regimes across countries.
Explain how overlapping tax jurisdictions cause double taxation.
Show how foreign tax credits reduce the incidence of double taxation.
Demonstrate how rules related to controlled foreign corporations, Subpart F income, and foreign tax credit baskets affect U.S. taxation of foreign source income.
Impact of Taxes on International Business Decisions
Importance of Tax Issues: Critical in assessing multiple aspects of foreign operations:
Location Determination: Where to establish the foreign operation.
Legal Form Selection: Choosing whether to operate as a branch or a subsidiary.
Financing Decisions: Options for how the operation will be funded (equity vs. debt).
Financial Implications: Decisions are influenced by forecasts of after-tax profits and cash flows.
Types of Taxes and Tax Rates
1. Corporate Income Taxes
Imposition: Levied by governments, with significant global variability.
Tax Rate Range: Generally falls between 15% and 35%.
Multiple Tax Authorities: May require compliance with both national and local regulations.
Historical Trends: The average corporate tax rate globally decreased from approximately 40% in 1980 to about 24% in 2021; some jurisdictions offer zero corporate tax rates, commonly known as tax havens.
2. Withholding Taxes
Definition: Taxes deducted from payments such as dividends, interest, and royalties made to foreign entities.
Variety by Jurisdiction: Rates can differ based on the payment type and recipient nationality.
International Corporate Tax Rates (2021)
Country | Effective Tax Rate (%) |
|---|---|
Argentina | 24 |
Australia | 30 |
Brazil | 34 |
Canada | 26.5 |
China | 25 |
France | 26.5 |
Germany | 30 |
Ireland | 12.5 |
United States | 21 |
Global Average | 23.65 |
Corporate Income Tax Variations
Significance of Variation: Different tax structures around the world create opportunities for strategic tax planning within multinational corporations.
Basis of Taxability: Typically depends on the type of activity being pursued and the nationality of corporate owners.
Tax Holidays and Tax Havens
Tax Holidays
Defined as low to zero tax rates offered for a limited period to encourage foreign investments.
Requirements: Often contingent on meeting investment thresholds or job creation metrics.
Tax Havens
Characteristics: Regions or countries with exceptionally low to zero corporate taxes.
Examples: The Bahamas, the Isle of Man, and Ireland (which has attracted significant foreign direct investment).
Corporate Strategies: Notably, 376 of the Fortune 500 companies maintain at least one subsidiary in a tax haven.
Examples of Tax Strategy
Example of Tax Havens
Brazilian Company Scenario:
Selling Price: $100
Cost: $70
Profit: $30, subject to 34% Brazilian corporate tax.
Using a Tax Haven:
Selling Price: $100
Cost in Bahamas: $80
Profit: $20, tax-free due to no corporate tax in the Bahamas.
Withholding Taxes Overview
Applicability: Mainly concerns dividends, interest, and royalties with varying rates across different countries.
Influence on Tax Planning: The variation in withholding rates significantly impacts international tax planning.
Nontreaty Withholding Rates in Selected Countries (2021)
Country | Dividends | Interest | Royalties |
|---|---|---|---|
Australia | 30% | 10% | 30% |
Brazil | 0% | 15% | 15% |
China | 10% | 10% | 10% |
United States | 30% | 30% | 30% |
Tax Planning Strategies
Altering Financing Methods
Thin Capitalization: A strategy that suggests financing through debt instead of equity to maximize tax benefits. Interest payments are usually tax-deductible, while dividends are not.
Regulatory Limits: Various countries impose restrictions on permissible thin capitalization practices.
Value-Added Tax (VAT)
Definition: A type of indirect tax added to the price of products and services at each production or distribution stage.
Usage: Primarily utilized in the EU and other regions such as Canada, China, and Mexico.
Standard Rates in EU: Range from 17% to 27%.
Example of Value-Added Tax Calculation:
Sales Example: For a Swedish company with a sales figure of €100,000 and a VAT of 25%:
VAT Computation: €100,000 * 25% = €25,000
Tax Jurisdiction Approaches
1. Worldwide Approach
Definition: Tax imposed on the total earnings of residents, regardless of where the income is generated.
2. Territorial Approach
Definition: Income is taxed only if earned within the national boundaries.
U.S. Tax Model: Prior to 2017, U.S. taxation followed a worldwide approach, but post TCJA shifted towards a participation exemption system.
Tax Jurisdiction Bases
Basis for Taxation:
Source: Income earned within the country.
Citizenship: Taxation of citizens irrespective of their income source.
Residence: Taxes individuals based on residency status, regardless of citizenship or source.
Double Taxation
Definition: Occurs when the same income is taxed both in the source country and in the residence country.
Effects on Investment: Leads to reduced foreign investment options due to unfavorable tax burdens.
Capital-Export Neutrality
Concept ensuring that taxation does not deter global investment decisions.
Relief from Double Taxation
Solutions to Mitigate Double Taxation
Territorial Approach Adoption: Tax exemption for foreign-source income.
Deduction of Foreign Taxes Paid: By parent companies.
Foreign Tax Credits: To alleviate double taxation at the parent level.
Foreign Tax Credits in the U.S.
U.S. corporations may choose to:
Deduct all foreign taxes paid against foreign income.
Receive a credit for foreign taxes paid specifically on foreign income.
Exclusions: No credits for sales taxes, VAT, or excise taxes.
Example of Credit vs. Deduction:
Scenario involving ASD, a U.S. company:
Income: $100,000 foreign source,
Foreign taxes paid: $15,000,
Sales taxes paid: $10,000.
Calculation shows significant tax liabilities depending on chosen methodology (deduction vs. credit).
Foreign Tax Credit Calculation Process
FTC Calculation: Based on the lower value of:
Actual taxes paid to the foreign government.
Taxes that would have been incurred if the income was sourced from the U.S.
Excess Credits: Can be carried back one year or forward for ten years.
Tax Treaties Overview
1. OECD Model Tax Treaties
Framework: Suggests that profit taxation occurs only if there exists a permanent establishment.
Recommended withholding rates for various payments include:
5% for dividends,
15% for portfolio dividends,
10% for interest,
0% for royalties.
2. United Nations Model Tax Treaties
Tailored for interactions between developed and developing nations.
Emphasizes host country taxation rights during profit repatriation.
U.S. Tax Treaties
Provisions: Generally exempt interest and royalties from withholding taxes while maintaining a 15% maximum rate on dividends.
Scope: Treaties exist with over 50 countries, notably including all EU members except Venezuela, reflecting investment flow imbalances.
Treaty Shopping Concept
Definition: The practice of using a corporation in a low-tax jurisdiction to leverage better tax treaty benefits with a third country.
Example: A Brazilian firm may set up a subsidiary in a country with favorable tax treaties to reduce withholding rates on dividends.
OECD Base Erosion and Profit Shifting (BEPS)
Background: Developed in 2013 to address aggressive tax avoidance practices.
Key Strategies: Include setting rules for controlled foreign corporations (CFCs), limiting interest deductions, and ensuring transparency in tax planning.
Controlled Foreign Corporations (CFC)
Definition: A foreign corporation where U.S. shareholders own more than 50% of voting power or stock value.
Taxation: Income earned is taxed in the U.S. when realized by the CFC without exemptions for Subpart F income.
Subpart F Income Categories
Insurance income from U.S. risks.
Income from countries engaged in international boycotts.
Certain illicit payments.
Foreign base company income comprising:
Passive income (interest, dividends, royalties, etc.),
Sales income from sales outside of incorporation country,
Service income earned outside of incorporation country.
CFC Income Taxation Determination
Criteria based on proportion of Subpart F income:
If less than 5%, no taxation.
If between 5% and 70%, a portion is taxable.
If over 70%, all income is immediately taxable.
Safe Harbor Rule: Exemption if foreign tax rate surpasses 90% of U.S. rates.
Foreign Tax Credit (FTC) Baskets
Introduced by the Tax Reform Act of 1986, creating two buckets:
General income basket
Passive income basket
TCJA Update: 2017 added a foreign branch income basket; rules prevent mixing between baskets.
U.S. Tax Treatment of Foreign Operations
Factors Influencing Tax Treatment
Legal form of operation (branch vs. subsidiary).
Ownership percentage (CFC classification).
Level of effective foreign tax rate (whether it's a tax haven).
Nature of foreign source income (Subpart F income and FTC baskets).
General Guidelines
Foreign branches: Their gross pre-tax income contributes to U.S. income taxes.
Subsidiaries:
Not classified as a CFC: foreign income remains untaxed in the U.S.
Classified as a CFC with a sufficiently high effective tax rate: foreign income also remains untaxed in the U.S.
CFC with lower rates sees tiered taxation based on Subpart F metrics.
Flowchart for Determining U.S. Taxation of Foreign Operations
A visual tool to assist in understanding whether foreign income is taxable in the U.S. based on the specific circumstances of the foreign operation.
Questions include:
Is it a branch?
Is it a CFC?
What is the foreign effective tax rate?
Is it Subpart F income?
Tax Credit and Liability Calculations for Foreign Operations
Example involving a corporation with operations in Costa Rica and Uzbekistan:
Compute foreign tax credits (e.g., 30% of Costa Rican income and a specific calculation for Uzbekistan based on local rates).
U.S. Tax Reform: Other International Tax Provisions
Objectives: Focused on enhancing competitiveness for U.S. corporations and protecting domestic tax revenues.
Key Changes Introduced: Shift to a participation exemption system, deemed repatriation rules for accumulated foreign earnings, and the Global Intangible Low-Taxed Income (GILTI) tax structure.
Deemed Repatriation of Foreign Earnings
Impact Assessment: On 2017 tax returns, U.S. corporations had to include previously earned foreign income with specific tax rates applied:
15.5% on cash holdings,
8% on reinvested income.
Payment Options: Tax liabilities could be settled in installments over eight years, with credits available for dividends reinvoked in the U.S.
Global Intangible Low-Taxed Income (GILTI)
Concept emphasizing taxation on foreign subsidiary income exceeding a specified return, computed as:
Total foreign income minus allowable deductions, compared against a 10% specified return of tangible assets.
Inclusion Examples: Illustrative computations demonstrate the tax implications for foreign subsidiaries producing GILTI.
Base Erosion Anti-Abuse Tax (BEAT)
Applies to U.S. corporations reducing liability through payments to foreign affiliates.
Threshold Requirements: Include average revenues and extent of base erosion payments.
Calculation Mechanism: Determining BEAT owed involves comparing actual liabilities with projected liabilities without deductions for payments to foreign affiliates.