International taxation issues

Main types of taxation

Taxation as costs Social security charges Local/regional taxes National corporate income taxes

Taxation on behalf of a third party Value added tax

Taxation of Multinational Firms (Corporate) income tax

Corporate net income: gross income - expenses Range: 0% (tax havens) - 59% (Iran)

Withholding tax on passive income: dividends, interest, royalties Income tax on firm’s creditors/suppliers Range: 0 - 30%

Value-added tax National sales tax, collected at all stages of

production Other national taxes

Value added tax

Imposed on customers at each stage of a product’s value-added chain, based on the value added at that point

Gross amount of VAT on sales and on purchases is netted in the accounting system and net amount is paid periodically to the tax authorities

Not part of revenue or expenses, but included in receivables and payables (cash flow effect)

Corporate income tax

Income tax payable = Taxable profit * Tax rate (f.i. 30%)

Taxable profit is not equal to accounting profit Differences?

Some expenses are not allowed tax-wise (entertaining, fines, excess depreciation, excess provisions, etc.)Special tax allowances (for capital investment, environmental protection, etc.)Income that is non-taxable

Deferred taxes arise from these differences

Taxable profit

Reconciliation statement:

Accounting profit before tax

Add back: disallowed expenses

Deduct: special tax allowances and non-taxable income

= Taxable profit

International taxation

The General Agreement on Tariffs and Trade (GATT) of the World Trade Organization (WTO) governs the tax treatment of branches and subsidiaries located abroad. If a branch or subsidiary is located in a signatory country, it is entitled to “national treatment” - that is, tax and regulatory treatment no less favorable than that accorded to national enterprises.

foreignbranch/

subsidiaryDividends(to parent

corp., otherinvestors)

RetainedEarnings

NetCorporateIncome

Taxationof earnedincome

1 - t*

Taxation ofdistributed

income

1 - t*

National Tax Environments

Double taxation problem

1. Conflict- two residences Persons/companies who are residents of

both of the Countries.

2. Conflict- residence v. source Taxation on the basis of source and

residence.

Taxation systems Worldwide (residential, national) taxation:

tax worldwide corporate income of domestic firms

Territorial (source) taxation:tax all income earned inside the country by domestic and foreign firms

In practice: both approaches used, with foreign tax credits to reconcile conflicts and prevent double taxation

Examples U.S.: historically, worldwide approach

U.S. firms’ earnings taxed @ 35% regardless of where earned (U.S., Europe, ...)

But, foreign firms operating in U.S. also face a 35% tax rate on U.S. income (territorial approach)

Germany 30-45% tax rate on all German earnings

(territorial approach)

Problem (conflicting tax systems): Germany taxes U.S. firms’ German earnings @ 30% Suppose U.S. taxes U.S. firms’ pre-tax German

earnings @ 35% Result: a lot of tax: 65%!!

Even if German taxes were treated as an expense (U.S. tax deduction) there’s still a lot of tax:• t* = German tax rate, t = U.S. tax rate• $1 pretax -> (1 - t) (1 - t*) = 1 - t - t* + t t* post-tax• Tax rate: t + t* - t t* = 54.5%!!

Solution: foreign tax credits • Germany taxes U.S. firms’ German earnings @ 30%• Firm gets a U.S. tax credit for German taxes paid that

partly covers its 35% U.S. tax liability on foreign income.

• Result: Tax rate = max(t, t*) = 35%. Example: $100 million worth of German income

German government gets $30 mln U.S. government gets $35 mln less $30 mln tax credit = $5 mln Total taxes: $30 mln + $5 mln = $35 mln Efffective tax rate: 35%

Tax credits: example #2

Tax rates Germany taxes some forms of German income at

45% U.S. rate: 35% on same income 45% tax credit exceeds 35% U.S. tax liability on

foreign income But: extra cannot be used to offset other U.S. taxes

Result: Total tax rate = 45% = max[U.S. rate, German rate]

German government gets it all

OECD Convention

OECD MODEL CONVENTION WITH RESPECT TO TAXES ON INCOME AND ON CAPITAL

RESIDENT

1. For the purposes of this Convention, the term "resident of a Contracting State"

means any person who, under the laws of that State, is liable to tax therein by reason of his domicile, residence, place of management or any other criterion of a similar nature, and also includes that State and any political subdivision or local authority thereof.

This term, however, does not include any person who is liable to tax in that State in respect only of income from sources in that State or capital situated therein.

Where an individual is a resident of bothContracting States, then his status shall be:

a) he shall be deemed to be a resident only of the State in which he has a permanent home available to him;

if he has a permanent home available to him in both States, he shall be deemed to be a resident only of the State with which his personal and economic relations are closer (centre of vital interests);

b) if the State in which he has his centre of vital interests cannot be determined, or if he has not a permanent home available to him in either State, he shall be deemed to be a resident only of the State in which he has an habitual abode;

c) if he has an habitual abode in both States or in neither of them, he shall be deemed to be a resident only of the State of which he is a national;

d) if he is a national of both States or of neither of them, the competent authorities of the Contracting States shall settle the question by mutual agreement.

For companies

Where a person other than an individual is a resident of both Contracting States, then it shall be deemed to be a resident only of the State

A) in which its place of effective management is situated (one version)

B) in which he is incorporated (another version).

PERMANENT ESTABLISHMENT The term "permanent establishment" means 1. A fixed place of business through which

the business of an enterprise is wholly or partly carried on.

2. Dependant agent through which the business of an enterprise is wholly or partly carried on.

‘Physical PE’ This type of PE, normally considered as the

general definition of PE, requires several elements to be in place simultaneously. It

is necessary that the location would not only be a (a) place of business, which is

permanent from a geographical and (b) temporal point of view, but also that the

place of business is (c) at the disposal of the entrepreneur, (d) and that the

business is carried on through it.

The term "permanent establishment" includes especially:

a) a place of management; b) a branch; c) an office; d) a factory; e) a workshop, and f) a mine, an oil or gas well, a quarry or any

other place of extraction of natural resources.

A place of business Regarding the first requirement, any physical

location of any kind (no matter how small it is), which is used to carry on the business activity, is considered a place of business . The place of business may be located in business facilities of another enterprise .

Geographical permanence In relation to geographical permanence, there

should be a link between the place of business and a particular geographical point. However, it is not mandatory that the place of business be physically linked to the ground, as long as it remains in a particular location.

Temporal permanence

The period of time during which the fixed place of business itself is being set up by the enterprise should not be counted, provided that this activity differs substantially from the activity for which the place of business is to serve permanently”

Fixed place at the disposal of the entrepreneur For a fixed place (i.e. geographically and

temporally permanent) to be considered at the disposal of the entrepreneur, it is not necessary for him to have a formal legal right (owner or tenant). Therefore, effective use suffices

“Thus, for instance, a permanent establishment could exist where an enterprise illegally occupied a certain location where it carried on its business”

The human presence at the PE is not even necessary,

A building site or construction or installation project constitutes a permanent establishment only if it lasts more than twelve months (different terms in different agreements).

the term "permanent establishment" shall be deemed

not to include: a) the use of facilities solely for the purpose of storage, display or delivery of

goods or merchandise belonging to the enterprise; b) the maintenance of a stock of goods or merchandise belonging to the

enterprise solely for the purpose of storage, display or delivery; c) the maintenance of a stock of goods or merchandise belonging to the

enterprise solely for the purpose of processing by another enterprise; d) the maintenance of a fixed place of business solely for the purpose of

purchasing goods or merchandise or of collecting information, for the enterprise; e) the maintenance of a fixed place of business solely for the purpose of

carrying on, for the enterprise, any other activity of a preparatory or auxiliary character;

f) the maintenance of a fixed place of business solely for any combination ofactivities mentioned in subparagraphs a) to e), provided that the overall activityof the fixed place of business resulting from this combination is of a preparatoryor auxiliary character.

salesman who regularly visits the office of

the purchasing director of a customer nterprise. In this case, it is understood that the customer’s premises are not at the disposal of the enterprise for which the salesman is working and therefore do not constitute a fixed place of business of that enterprise

an employee of the parent company, who is allowed to use the office in the headquarters of a subsidiary company. The fact that the employee carries out activities related to the business of the parent company for a sufficient time leads to the conclusion that the office constitutes a PE.

transportation enterprise that uses a delivery dock at a customer’s warehouse everyday, for a number of years, with the purpose of delivering goods purchased by that customer. In this situation, it is considered by the commentary that the presence of the enterprise at the delivery dock is insufficient in terms of temporal permanence for a PE to arise.

Business carried on “through” a fixed place

“the words ‘through which’ must be given a wide meaning so as to apply to any situation where business activities are carried on at a particular location that is at the disposal of the enterprise for that purpose”

an enterprise engaging in paving a road, as a case where the business is carried out through the place where the activity takes place.

a painter, who spends 3 days a week in his client’s office building to perform the most important functions of his business (i.e. to paint), and therefore carries on his business through that building

Both examples are arguable, given that the office building and the road are the object of the business

Agency PE’

Business through agents

where a person — other than an agent of an independent status— is acting on behalf of an enterprise and has, and habitually exercises, in a Contracting State an authority to conclude contracts in the name of the enterprise, that enterprise shall be deemed to have a permanent establishment in that State in respect of any activities which that person undertakes for the enterprise,

unless the activities of such person are limited to those which, if exercised through a fixed place of business, would not make this fixed place of business a permanent establishment under the provisions of that paragraph.

Business through independent agent An enterprise shall not be deemed to have a

permanent establishment in a Contracting State merely because it carries on business in that State through a broker, general commission agent or any other agent of an independent status, provided that such persons are acting in the ordinary course of their business.

An employee is the classical example of legal dependence, notwithstanding non-employees may be also legally dependent.

In what economic dependence is concerned, it will be determined by whether the entrepreneurial risk has to be borne by the agent or by the enterprise he represents. The number of principals for whom the agent acts and eventual contractual protection from losses or existence of a guaranteed remuneration are factors that should be taken into account, since they can determine how much risk is borne by the agent.

management office that supervises and coordinates all departments of an enterprise in a certain region. That office would normally be considered a PE if that activity constituted an essential part of the business operations of the enterprise

after sales service- if in a fixed place of business established for the delivery of spare parts to customers, activities such as maintenance or repairs of machinery are done,(as it implies going beyond the pure delivery mentioned in sub-paragraph (a) of paragraph 4), a PE may arise

facilities such as pipelines and cables, which have a major importance nowadays. The use of these facilities by an enterprise solely for the purpose of transporting its products has preparatory or auxiliary character if that transport is merely incidental to the business of that enterprise and not its main business activity

First, when in addition to an activity that is preparatory or auxiliary, other activities that are not of that nature are carried on through the fixed place of business, the place of business may be considered a PE.

Second, when two or more preparatory or auxiliary activities are carried on imultaneously through a place of business, the decision whether there is a PE or not, will rest upon the preparatory or auxiliary character of the overall business activity.

Business through subsidiary

The fact that a company which is a resident of a Contracting State controls or is controlled by a company which is a resident of the other Contracting State, or which carries on business in that other State (whether through a permanent establishment or otherwise), shall not of itself constitute either company a permanent establishment of the other.

BUSINESS PROFITS

1. The profits of an enterprise of a Contracting State shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein.

If the enterprise carries on business as aforesaid, the profits of the enterprise may be taxed in the other State but only so much of them as is attributable to that permanent establishment.

Branches vs. subsidiaries

Branches permit pooling of losses with parent Subsidiaries permit tax deferral, if foreign tax

rate is lower. Can change status of operation (branch at

early loss-making stage; subsidiary later)

CREDIT METHOD

1. Where a resident of a Contracting State derives income or owns capital which, in accordance with the provisions of this Convention, may be taxed in the other Contracting State, the first-mentioned State shall allow:

a) as a deduction from the tax on the income of that resident, an amount equal to the income tax paid in that other State;

b) as a deduction from the tax on the capital of that resident, an amount equal to the capital tax paid in that other State.

Transfer pricing

Transfer prices are the prices at which goods and services change hands between subsidiaries of a group Artificially fixing transfer prices is a way of determining where

profits are taxed Double tax treaties usually state that transfer prices must be

“at arms’ length” or at market rates Intra-group charges (like royalties for use of intellectual

property and interest charges) are also usually structured according to a tax treaty

Transfer pricing

Temptation German income rates: 45% U.S. income rates: 35%

Manipulate intracompany transfer prices so that no German net income

Transfer pricing

Example: GM-Germany imports car engines from GM-U.S. Cost of engines is a liability to GM-Germany:

higher price implies lower net income(taxed @ 45%)

Cost of engines is revenue to GM-U.S.:higher price implies higher net income(taxed @ 35%)

Increasing price reduces total taxes

Transfer pricing Governments watch corporations closely

for attempts to manipulate transfer prices to evade local taxes IRS can reallocate gross income, etc.

between corporate units Burden of proof on firm: “guilty until proven

innocent” Some wiggle room for firms when value of

intracompany goods, services, etc., cannot easily be established