CHAPTER 21 INTERNATIONAL TAX ENVIRONMENT AND TRANSFER PRICING ANSWERS & SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS QUESTIONS 1. Discuss the twin objectives of taxation. Be sure to define the key words. Answer: There are two basic objectives of taxation that are necessary to discuss to help frame our thinking about the international tax environment: tax neutrality and tax equity. Tax neutrality has its foundations in the principles of economic efficiency and equity. Tax neutrality is determined by three criteria. Capital-export neutrality is the criterion that an ideal tax should be effective in raising revenue for the government and not have any negative effects on the economic decision making process of the taxpayer. That is, a good tax is one that is efficient in raising tax revenue for the government and does not prevent economic resources from being allocated to their most appropriate use no matter where in the world the highest rate of return can be earned. A second neutrality criterion is national neutrality. That is, regardless of where in the world taxable income is earned it is taxed in the same manner by the taxpayer’s national tax authority. In theory, national tax neutrality is a commendable objective, as it is based on the principle of equality. The third neutrality criterion is capital-import neutrality. This criterion implies that the tax burden placed on the foreign subsidiary of a MNC by the host country should be the same regardless in which country the MNC is incorporated and the same as that placed on domestic firms. Tax equity is the principle that all similarly situated taxpayers should participate in the cost of operating the government according to the same rules. This means that regardless in which country an affiliate of a MNC earns taxable income, the same tax rate and tax due date apply. 2. Compare and contrast the three basic types of taxation that governments levy within their tax jurisdiction. Answer: There are three basic types of taxation that national governments throughout the world use in generating tax revenue: income tax, withholding tax, and value-added tax. Many countries in the world obtain a significant portion of their tax revenue from imposing an income tax on personal and corporate income. An income tax is a direct tax, that is, one that is paid directly by the taxpayer on whom it is levied. The tax is levied on active income, that is, income that results from production by the firm or individual or from services that have been provided. A withholding tax is a tax levied on passive income earned by an individual or corporation of one country within the tax jurisdiction of another country. Passive income includes dividends and interest income, and income from royalties, patents or copyrights paid to the taxpayer. A withholding tax is an indirect tax, that is, a tax borne by a taxpayer that did not directly generate the income that serves as the source of the passive income. The tax is withheld from payments the corporation makes to the taxpayer and turned over to the local tax authority. A value-added tax (VAT) is an indirect national tax charged on the sales price of a service or consumption good as it moves through the various stages of production and/or service. As such, a VAT is a sales tax borne by the final consumer. 3. Show how double taxation on a taxpayer may result if all countries were to tax the worldwide income of their residents and the income earned within their territorial boundaries. Answer: There are two fundamental types of tax jurisdiction: the worldwide and the territorial. The worldwide method of declaring a national tax jurisdiction is to tax national residents of the country on their worldwide income no matter in which country it is earned. The territorial method of declaring a tax jurisdiction is to tax all income earned within the country by any taxpayer, domestic or foreign. Hence, regardless of the nationality of a taxpayer, if the income is earned within the territorial boundary of a country it is taxed by that country. If a MNC was a resident of a country that taxed worldwide income, the foreign-source income of its foreign affiliates would be taxed in the parent country. If the host country also taxes the income of the affiliate earned within its territorial borders, the foreign affiliate would pay taxes on the same income both in the host country and in the parent country. To avoid this “evil,” some mechanism needs to be established to prevent double taxation. 4. What methods do taxing authorities use to eliminate or mitigate the evil of double taxation? Answer: The typical approach to avoiding double taxation is for a nation not to tax foreign-source income of its national residents. An alternative method, and the one the U.S. follows, is to grant to the parent firm foreign tax credits against U.S. taxes for taxes paid to foreign tax authorities on foreign-source income. 5. How might a MNC use transfer pricing strategies? How do import duties affect transfer pricing policies? Answer: A MNC might use transfer pricing strategies for two basic purposes: income tax liability reduction or funds repositioning. If the tax rate in the country of the selling affiliate is less than the tax rate in the buying affiliate country, a high markup policy on sales will leave little taxable income in the buying affiliate country to be taxed at the higher rate. Even if the tax rate in the buying affiliate country is not more than that in the selling affiliate country, a high markup policy will leave less funds to be removed from the buying affiliate country. In general, import duties work in the opposite direction from income taxes. For example, a high markup policy will decrease the income taxes due in the buying affiliate country, but increase the import duty due in that country. Generally, the income tax is more important in comparison to the import duty in its after-tax effect on consolidated net income. 6. What are the various means the taxing authority of a country might use to determine if a transfer price is reasonable? Answer: The U.S. and many other countries require the transfer price to be consistent with arm’s length pricing, i.e., be a price that an unrelated party would pay for the same good or service. The taxing authority can arbitrarily set the transfer price if it believes that transfer pricing schemes are being used to evade taxes or that taxable income is not being clearly reflected. There are three general methods to establish arm’s length pricing. One method is to use a comparable uncontrolled price at which the good or service would be priced between unrelated parties. A second method is the resale price approach; that is, reduce the price at which the good is resold by an amount sufficient to cover overhead costs and a reasonable profit for the selling affiliate. The third method is the cost-plus approach, where an appropriate profit is added to the cost of the manufacturing affiliate. 7. Discuss how a MNC might attempt to repatriate blocked funds from a host country. Answer: There are several methods a parent firm might use to repatriate profits from an affiliate in a host country that is blocking funds. Some of these measures should be enacted early on as a guard against future funds blockage. One is to establish a regular dividend policy that the host country becomes used to and expects. This assumes, however, the host country will let a reasonable amount of funds be repatriated. If this is not the case, the parent firm might attempt to use a high markup policy transfer pricing scheme. Since host countries are aware of transfer pricing strategies, a large change in the transfer price is likely not to go unquestioned by the host country. Thus, the parent firm should establish early on recognition of, and payment for, specific services that are being provided by the affiliate in addition to payment at an arm’s length price for the physical goods. For example, the parent firm might charge for a share of worldwide advertising, technical training of employees of the affiliate, appropriate overhead charges, or a royalty or licensing fee for use of well-recognized brand names, technology, or patents. The host country might accept these charges as reasonable, whereas a large transfer price that incorporates all charges into a single price might be questioned as unreasonably large. Additionally, the parent firm can create exports, by having the affiliate charged in the blocked currency for goods and services for which the parent would typically pay, or through direct negotiation appeal to the host country for more reasonable treatment, if it is in an important industry to the host country. PROBLEMS 1. There are three production stages required before a pair of skis produced by Fjord Fabrication can be sold at retail for NOK2,300. Fill in the following table to show the value added at each stage in the production process and the incremental and total VAT. The Norwegian VAT rate is 25 percent. _______________________________________________________________________ Production Selling Value Incremental Stage Price Added VAT _______________________________________________________________________ 1 NOK 450 2 NOK1,900 3 NOK2,300 Total VAT _______________________________________________________________________ Solution: Production Selling Value Incremental Stage Price Added VAT _______________________________________________________________________ 1 NOK 450 NOK 450 NOK112.50 2 NOK1,900 NOK1,450 NOK362.50 3 NOK2,300 NOK 400 NOK100.00 Total VAT NOK575.00 _______________________________________________________________________ 2. The Docket Company of Asheville, NC USA is considering establishing an affiliate operation in the city of Wellington, on the south island of New Zealand. It is undecided whether to establish the affiliate as a branch operation or a wholly-owned subsidiary. New Zealand taxes income of both resident corporations and branch operations at a flat rate of 28 percent. New Zealand withholds taxes at 5 percent on dividends for an investor who holds at least 10 percent of the shares in the subsidiary company that pays the dividend; 0 percent if the investor holds 80 percent or more of the shares in the subsidiary company and meets other criteria; 15 percent in all other cases. New Zealand does not withhold taxes on branch income. The United States has an income tax rate of 35 percent on income earned worldwide, but gives a tax credit for taxes paid to another country. Based on this information, is a branch or subsidiary the recommended form for the affiliate? Solution: If Docket establishes a branch operation in New Zealand, it will pay a total of 35 percent on its New Zealand source income. It will pay 28 percent in New Zealand and an additional 7 percent in the United Sates after a receiving a tax credit for the New Zealand taxes. If Docket sets up its New Zealand affiliate as a subsidiary, the subsidiary will pay taxes at 28 percent on New Zealand taxable income, but since the parent firm has 100 percent ownership, it will not have any taxes withhold on dividends paid to its parent. Total taxes credits will be [.28 + 0 – (.28 x 0)] = .28 or 28 percent in the United States. (See Example 21.2 for an explanation of this formula.) An additional 7 percent in taxes will be paid in the United Sates after a receiving the 28 percent tax credit, for a total of 35 percent. Consequently, in this case it does not matter whether the Docket Company establishes a branch operation or a wholly owned subsidiary under current tax law in New Zealand. 3. Affiliate X sells 10,000 units to Affiliate Y per year. The marginal tax rates for X and Y are 20 percent and 30 percent, respectively. The transfer price per unit is currently set at $1,000, but it can be set as high as $1,250. Calculate the increase in annual after-tax profits if the higher transfer price of $1,250 per unit is used. Solution: Total tax savings = 10,000 x ($1,000 - $1,250) x (0.20 - 0.30) = $250,000. 4. Affiliate A sells 5,000 units to Affiliate B per year. The marginal income tax rate for Affiliate A is 25 percent and the marginal income tax rate for Affiliate B is 40 percent. The transfer price per unit is currently $2,000, but it can be set at any level between $2,000 and $2,400. Derive a formula to determine how much annual after-tax profits can be increased by selecting the optimal transfer price. Note To Instructor: The solution to this problem is consistent with the example presented in the text as Exhibit 21.6. Solution: Let A and B be the marginal income tax rate for Affiliate A and B. Further let Q denote quantity, and let P be the current transfer price per unit and P* be the optimal transfer price per unit. The increase in annual after-tax profit (or the tax savings) can be stated as Q(P - P*)(A - B). For each unit there is a tax savings of (A - B) on (P - P*). Using the above numbers, there is a tax savings of (.25 - .40) = .15 for each additional dollar of cost transferred from the low tax affiliate to the high tax affiliate. Thus, at the maximum there can be a $60 = ($2,000 - 2,400)(.25 - .40) tax savings per unit from raising the transfer price from $2,000 to $2,400. In total, the tax savings is 5,000 units x $60 = $300,000. 5. Affiliate A sells 5,000 units to Affiliate B per year. The marginal income tax rate for Affiliate A is 25 percent and the marginal income tax rate for Affiliate B is 40 percent. Additionally, Affiliate B pays a tax-deductible tariff of 5 percent on imported merchandise. The transfer price per unit is currently $2,000, but it can be set at any level between $2,000 and $2,400. Derive (a) a formula to determine the effective marginal tax rate for Affiliate B and, (b) a formula to determine how much annual after-tax profits can be increased by selecting the optimal transfer price. Solution: The solution to this problem is consistent with the example presented in the text as Exhibit 21.7.This problem extends the work in problem 1, above. When the ad-valorem import tariff is tax deductible, the effective marginal tax rate paid by Affiliate B is: (1 + Tariff)B - Tariff = (1 + .05)(.40) - .05 = .37. Hence, for each additional dollar of cost transferred from the low tax affiliate to the high tax affiliate there is an after-tax savings of: (P - P*)[A + Tariff - (1 + Tariff) B]. In total, the tax savings is: Q(P - P*)[A + Tariff - (1 + Tariff) B] = 5,000 x ($2,000 - 2,400)(.25 - .37) = 5,000 x $48 = $240,000. MINI CASE: SIGMA CORP.’S LOCATION DECISION Sigma Corporation of Boston is contemplating establishing a wholly owned subsidiary operation in the Mediterranean. Two countries under consideration are Spain and Cyprus. Sigma intends to repatriate all after-tax foreign-source income to the United States. In the U.S., corporate income is taxed at 35 percent. In Cyprus, the marginal corporate tax rate is 10 percent. In Spain, corporate income is taxed at 30 percent. The withholding tax treaty rates with the U.S. on dividend income paid is 5 percent from Cyprus and 10 percent from Spain. The financial manager of Sigma has asked you to help him determine where to locate the new subsidiary. The location decision of Cyprus or Spain will be based on which country has the smallest total tax liability. Suggested Solution for Sigma Corp.’s Location Decision The total (income and withholding) tax liability in Cyprus will be: [.10 + .05 - (.10 x .05)] = .145 or 14.5 percent. Additional taxes in the U.S. would be due, bringing the total tax liability up to the U.S. income tax rate of 35 percent. The total (income and withholding) tax liability in Spain will be: [.30 + .10 - (.30 x .10)] = .37, or 37 percent. Since this is greater than the U.S. income tax rate of 35 percent, no additional taxes would be due in the U.S. If there are excess foreign tax credits (equal to 2 percent of foreign-source taxable income) that can all be used by carrying them back one year and forward ten years, then the total tax liability will equal the U.S. income tax rate of 35 percent. If excess foreign tax credits cannot all be used, as is more typically the case, the total tax liability can be as high as 37 percent. Consequently, Sigma Corporation should establish its wholly-owned subsidiary in Cyprus. MINI CASE: EASTERN TRADING COMPANY’S OPTIMAL TRANSFER PRICING STRATEGY The Eastern Trading Company of Singapore ships prepackaged spices to Hong Kong, the United Kingdom, and the United States, where they are resold by sales affiliates. Eastern Trading is concerned with what might happen in Hong Kong now that control has been turned over to China. Eastern Trading has decided that it should reexamine its transfer pricing policy with its Hong Kong affiliate as a means of repositioning funds from Hong Kong to Singapore. The following table shows the present transfer pricing scheme, based on a carton of assorted, prepackaged spices, which is the typical shipment to the Hong Kong sales affiliate. What do you recommend that Eastern Trading should do? Eastern Trading Company Current Transfer Pricing Policy with Hong Kong Sales Affiliate Singapore Parent Hong Kong Affiliate Company Consolidated Sales revenue S$300 S$500 S$500 Cost of goods sold 200 300 200 Gross profit 100 200 300 Operating expenses 50 50 100 Taxable income 50 150 200 Income taxes (20%/17.5%) 10 26 36 Suggested Solution to Mini Case 2: Eastern Trading Company’s Optimal Transfer Pricing Strategy Eastern Trading is currently in a good situation. Because the income tax rate in Hong Kong is less than in Singapore, Eastern Trading’s present low markup transfer price strategy results in larger pre-tax income in Hong Kong, which is taxed at only a 17.5% rate versus the 20% rate on taxable income in Singapore. If Eastern Trading is free to repatriate profits from Hong Kong, it defers paying the additional tax due (20% - 17.5% = 2.5%) in Singapore until the profits are actually repatriated. Nevertheless, the marginal tax rate on Hong Kong taxable income will eventually be 20% upon repatriation. Therefore, since Eastern Trading is concerned about repatriation under Chinese control of Hong Kong, it might attempt to increase its transfer price. If Eastern Trading is successful in increasing the transfer price, more of the taxable income per unit will be taxed at the current time in Singapore at 20%. A 25% increase in the transfer price would raise it from S$300 to S$375 per unit. At S$375, the split would be as follows: Eastern Trading Company Current Transfer Pricing Policy with Hong Kong Sales Affiliate Singapore Parent Hong Kong Affiliate Consolidated Company Sales revenue S$375 S$500 S$500 Cost of goods sold 200 375 200 Gross profit 175 125 300 Operating expenses 50 50 100 Taxable income 125 75 200 Income taxes (20%/17.5%) 25 13 38 The higher transfer price would result in only S$64 left to be repatriated from Hong Kong instead of S$124. International Tax Environment Chapter Twenty-One Chapter Outline • The Objectives of Taxation – Tax Neutrality – Tax Equity • Types of Taxation – Income Tax – Withholding Tax – Value-Added Tax • The National Tax Environments – Worldwide Taxation – Territorial Taxation – Foreign Tax Credits • Organizational Structures – Branch and Subsidiary Income – Payments to and from Foreign Affiliates – Tax Havens – Controlled Foreign Corporation • Transfer Pricing and Related Issues The Objectives of Taxation • The twin objectives of taxation are: – Tax neutrality – Tax equity Tax Neutrality • A tax scheme is tax neutral if it meets three criteria: – Capital export neutrality: the tax scheme does not incentivize citizens move their money abroad. – National neutrality: taxable income is taxed in the same manner by the taxpayer’s national tax authorities regardless of where in the world it is earned. – Capital import neutrality: the tax burden on an MNC subsidiary should be the same regardless of where in the world the MNC in incorporated. Tax Equity • Tax equity means that regardless of the country in which an MNC affiliate earns taxable income, the same tax rate and tax due date should apply. • The principal of tax equity is difficult to apply; the organizational form of the MNC can affect the timing of the tax liability. Types of Taxation • Income tax • Withholding tax • Value-added tax Income Tax • An income tax is a tax on personal and corporate income. • Many countries in the world obtain a significant portion of their tax revenue from income taxes. • An income tax is a direct tax, or a tax that is paid directly by the taxpayer upon whom it is levied. Corporate Income Tax Rates in Selected Countries Withholding Tax • Withholding taxes are withheld from the payments a corporation makes to the taxpayer. • The taxes are levied on passive income earned by an individual or corporation of one country within the tax jurisdiction of another country. • Passive income includes income from dividends and interest, royalties, patents, or copyrights. • A withholding tax is an indirect tax. U.S. Tax Treaty Withholding Rates, Selected Countries Country Nontreaty Interest Paid by U.S. Corporation Qualifying for Direct Dividend Rate Royalties countries 30 30 30 30 Australia 10 15 5 0 Belgium 0 15 5 0 Canada 0 15 5 0 China 10 10 10 10 France 0 15 5 0 Germany 0 15 5 0 Ireland 0 15 5 0 Dividends Value-Added Tax • A value-added tax is an indirect national tax levied on the value added in production of a good or service. • In many European and Latin American countries the VAT has become a major source of taxation on private citizens. • Many economists prefer a VAT to an income tax because the incentive effects of the two taxes differ sharply. Value-Added Tax • An income tax has the incentive effect of discouraging work. • A VAT has the incentive effect of discouraging consumption (thereby encouraging saving.) • VATs are easier to administer as well. While taxpayers have an incentive to hide their income, producers have an incentive to make sure that their upstream suppliers in the production process declare the value added (and pay the tax). Value-Added Tax Calculation Production Stage Selling Price Value Added Incremental VAT 1 €100 €100 €15 2 €300 €200 €30 3 €380 €80 €12 Total VAT €57 = €100 .15 = €200 .15 = €80 .15 = €380 .15 In this example, the tax rate is 15 percent. Suppose that stage one is the sale of raw materials to the manufacturer, stage two is the sale of finished goods to the retailer, and stage three is the sale of inventory from the retailer to the consumer. Other Types of Taxation • A wealth tax is a tax levied not on income but on the wealth of a taxpayer. Property taxes are an example. • A poll tax is a tax on your existence. It was granted its name because it was collected from those who wished to vote. The National Tax Environments • Worldwide taxation • Territorial taxation • Foreign tax credits Worldwide & Territorial Taxation • With worldwide taxation, residents of a country are taxed on their worldwide income, no matter in which country it was earned. • With territorial taxation, residents of a country are taxed based on where the taxable event occurred. Foreign Tax Credits • Allow taxpayers to recover somewhat from double taxation. • Direct foreign tax credits are computed for direct taxes paid on active foreign-source income of a foreign branch of a U.S. MNC or on withholding taxes withheld from passive income. • Indirect foreign tax credits are for income taxes deemed paid by the subsidiary. Organizational Structures • Branch & subsidiary income • Payments to and from foreign affiliates • Tax havens • Controlled foreign corporation • Foreign sales corporation Branch & Subsidiary Income • An overseas affiliate of a U.S. MNC can be organized as a branch or a subsidiary. • A foreign branch is not an independently incorporated firm separate from the parent. – Branch income passes directly through to the parent’s income statements. • A foreign subsidiary is an affiliate organization of the MNC that is independently incorporated. – Income may not be taxed in the U.S. until it is repatriated, under certain circumstances. Payments to and from Foreign Affiliates • Having foreign affiliates offers transfer price tax arbitrage strategies. • The transfer price is the accounting value assigned to a good or service as it is transferred from one affiliate to another. • If one country has high taxes, don’t recognize income there—have those affiliates pay high transfer prices. • If one country has low taxes, recognize income there— have those affiliates pay low transfer prices. Transfer Pricing & Related Issues • The transfer price is the price that, for accounting purposes, is assigned to goods and services flowing from one division of a firm to another division. • Controversial even for a domestic firm. – Consider the example of a firm that has one division that mills lumber and another that makes furniture. The transfer price of the lumber is a political as well as economic and accounting issue. Transfer Pricing & Related Issues • For MNCs, there exists the added complications of: – Differences in tax rates. – Import duties and quotas. – Exchange rate restrictions on the part of the host country. • Most countries have regulations controlling transfer pricing. – In the U.S., the tax code requires transfer prices to be “arms length” prices. Arms-Length Price • A price that a willing seller would charge a willing unrelated buyer. • The IRS prescribes three methods for estimating an arms length price: – Comparable uncontrolled price. – Resale price: the price at which the good is resold by the affiliate is reduced by overhead and profit. – Cost-plus approach: an appropriate profit is added to the cost of the manufacturing affiliate. Blocked Funds • A form of political risk is the risk that the foreign government may impose exchange restrictions on its own currency. • Several methods exist for moving blocked funds: – Transfer pricing – Unbundling services – Parallel and back-to-back loans – Swaps Blocked Funds • Additional strategies for unblocking funds are: – Direct negotiation – Export creation • Using the blocked funds to buy goods and services for the MNC. E.g., use the National Airlines of the host country for travel of executives of the MNC, and pay for the tickets with the blocked funds. • Transfer local expatriates from home payroll to the local subsidiaries payroll. Tax Havens • Tax havens are countries with low corporate income tax rates and low withholding tax rates on passive income. • Tax havens were once useful as locations for an MNC to establish a shell company. • The Tax Reform Act of 1986 greatly diminished the need for and ability of U.S. corporations to profit from the use of tax havens. Controlled Foreign Corporation • The Tax Reform Act of 1986 created a new type of foreign subsidiary: the controlled foreign corporation. • A controlled foreign corporation is a foreign subsidiary that has over half of its voting stock held by U.S. shareholders— even if these shareholders are unaffiliated. Controlled Foreign Corporation • The undistributed income of a minority foreign subsidiary of a U.S. MNC is tax deferred until it is remitted via a dividend. • This is not the case with a controlled foreign corporation—the tax treatment is much less favorable. • The result is that foreign tax credits are unlikely to be completely used. Solution Manual for International Financial Management Cheol S. Eun, Bruce G. Resnick 9780077861605
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