International Taxation & Transfer Pricingl

8/9/2019 International Taxation & Transfer Pricingl

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International Taxation and

Transfer Pricing

Mayank KalsanSrishti Tulsyan

Naveen Pachisia


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Roadmapy Introductiony Initial concepty

Types of taxesy Tax burdeny Tax administration systemy Foreign tax incentives

y Taxation of Foreign Source Income & Double

Taxation

y Foreign Tax Credit

y U.S Taxation of Foreign Source Income

y Tax Treaties


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Continuedy Tax Planning Dimensions

y Subpart F Income

y Offshore Holding Companies

y Foreign Sales Corporations

y International Transfer Pricing

yTransfer Pricing Methodology

y Determining arms length prices

y Transfer Pricing In India


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Introduction

y Decisions on where to invest, what form of businessorganization to employ, how to finance, when andwhere to recognize elements of revenue andexpenses, and what transfer prices to charge aretypical decisions strongly influenced by taxconsiderations.

y Management has little control over tax.

y National tax systems are complex and diverse. Thedefinition of the taxable income, tax rates, incentives

etc could be different

y International tax agreements, laws and regulations


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Initial concept

The laws and regulations that governs thetaxation of foreign corporations and profit earnedabroad rests on a few basic concepts.Among these are the notions of Tax equity andtax neutrality

y Tax equity- means that taxpayer who aresimilarly situated should be similarly treated

yTax neutrality

1.Domestic neutrality- a foreign subsidiary issimply a domestic concern that happens to beoperating abroad

2.Foreign neutrality-hold that, domestic affiliates

abroad should be looked upon as foreign


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Types of taxes

A company operating abroad encountersvariety of taxes

yDirect taxes such as income taxes areclearly recognizable and normallydisclosed on most companies financialstatements

y Indirect taxes such as consumption taxesare not so clearly recognized or frequentlydisclosed


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Earning effects of direct vs.

indirect taxesdirect indirect

Revenues 250 250

Expenses 150 190Pretax income 100 60

Direct taxes(40 %) 40 -0-

After tax income 60 60


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Continued.

yWithholding tax- are those imposed bygovernments on dividends, interests androyalty payment to foreign investors. Thesetaxes are typically withheld at source bythe paying corporation

yValue added tax- this tax is typically leviedat each stage of production and distributionbut only on the value added at that

particular stageyBorder tax- value added tax are often the

basis of border taxes. Like import dutiesborder taxes generally aims at keeping

domestic goods prices competitive with the


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Tax administration systemsNational tax assessment systems also

affects relative tax burdens. Several majorsystems are currently in use

yClassical- under classical system, corporateincome taxes on taxable income are levied attwo levels, at corporate level and theshareholder level

yA corporation is taxed on income measuredbefore the dividends are paid andshareholders are than taxed on theirdividends.


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Corporate income 100--Income tax at 33% 33

= net income 67

Dividend 67

--Personal income tax @ 30% 20.10

= net income 46.90

Total tax paid (33.0+20.10)= 53.10


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ContinuedIntegrated system- under integrated

system , both corporate andshareholders taxes are integrated

ySplit rate system- A lower tax is leviedon distributed income than on retainedearnings. While corporate income is still

subject to double tax but the lower rateon distributed income results in a lowertax burden than classical rate system.

y

Tax credit or Imputation System- in this


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Foreign tax incentives

yMany countries offer tax incentives toattract foreign investments

y Incentives includes tax free cash grantsapplied towards the cost of fixed assetsof new industrial undertakings or relief

from paying taxes for certain timeperiods

y


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Continued.

Some countries, particularly those withfew natural resources, offer permanent

tax inducementThese so called tax havens includes

the followings

y

The Bahamas, Bermuda and theCayman islands which have no tax at all

yThe British virgin islands which havevery low taxes


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Main characteristics of tax havensy No or low taxes on all or certain types of income and capital.

y Lack of exchange controls : Many tax havens developeda dual currency control system, under which residents aresubjected to both local and foreign currency controls andnon-residents, only to the local currency controls.Companies set up in a tax haven are treated as non-

residents for exchange control purposes and their operationsconducted outside the tax haven, in foreign currency, are notsubjected to exchange controls.

y Relative importance of banking : In tax havens, the

banking sector gives different treatment to residents andnon-residents, suppressing or smoothing controls andimposing lighter or no taxation on the latter.

y Communications : Tax havens must be accessiblephysically and have facilities to deal with information. Thus, it

is necessary an infrastructure that provides good means of


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Use of tax havens contd.y Tax havens have been used for reducing tax

liabilities purposes and are particularly attractive

for individual taxpayers from high-tax countrieswho would be subject to high marginal tax rateson reported incomes in their countries.

y Earnings are channelled to tax havens where

they are subject to zero or very low tax rates andif the residence principle is fully applied, theseearnings might end up escaping taxation almostcompletely, leading the country where the

financial capital originated to lose tax revenue.


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TAX HAVENS AS A MEANS OF TAX

AVOIDANCE

a) Emigration and shifting of residence: Incountries with a relatively high level of taxation,

taxpayers may be tempted to avoid being subjectedto domestic taxes by moving their residence to a taxhaven country.

b) Base companies: For tax purposes, the mostimportant function of a base company set up in a taxhaven jurisdiction is to collect and shelter incomefrom high taxation in the taxpayers country ofresidence

The base company, be it a holding company, an

investment com an , a finance com an or a trade


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Example: the company T, resident incountry R, has developed a newproduct. It is patented in favor of a basecompany in a tax haven country whichgives license do third parties in country

S. The income arising from the sourcecountry S can be sheltered in the taxhaven country or lent to company Tagainst the payment of interest which is


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yExample:A company Z is a parent company withwholly-owned subsidiary in the source countryS. The country of residence of Z has no treaty

with source country S. Z transfers itsparticipation in C to a conduit company in thetax haven country A. The dividends receivedare not subject to a tax because of a

participation exemptions or a system ofindirect credit existing in the tax havencountry. Exemption from withholding taxes inthe source country S is claimed on the basis


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yInvestment incentives inMauritius Mauritius is not a tax haven, but a low tax

jurisdiction. The corporate tax rate for domestic andnon domestic activities is 15%. With tax incentives

for certain sectors, this is reduced to 3% for offshorecompanies, and to 0-5% for some ICT activities

No withholding tax on payments made toshareholders and on loan interest paid

No capital gains tax

No minimum capital

Minimum number of shareholders: one

No need for shareholder(s) to be resident inMauritius

Source:INDIA OPPORTUNITY HSBC Bank (MAURITIUS) Ltd November 2007


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Foreign Direct Investment (FDI) inflows into

IndiaYear US$ billion

2004-2005 3.7

2005-2006 5.5

2006.2007 15.7

y US$6.3 billion of last years total FDI inflows came fromMauritius.

y Mauritius accounted for US$10 billion out of a total of

US$ 25 billion in FDI inflows that India has been able toattract in the last three years, starting 2004-2005.

y In 2008, Mauritius and Singapore were the top source ofFDI into India, while inflows from Cyprus was more thanthat from Germany, Japan, Netherlands and France.

-

Source:INDIA OPPORTUNITY HSBC Bank (MAURITIUS) Ltd November 2007


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Taxation of Foreign Source

Income & Double Taxationy Territorial Principle ofTaxation

y Exempt from taxation the income of resident

corporations and citizens generated outsidetheir borders

y Foreign Tax Neutrality

yWorldwide Principle ofTaxation

y Tax resident corporations and citizens onincome earned within and outside their borders

y

Domestic Neutrality


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Foreign Tax Credit

y

Due to Worldwide principle of taxation,foreign earnings of a domestic companyis subject to full tax levies of both homeand host country

yTreat foreign taxes paid as a creditagainst the parents domestic tax liabilityor as a deduction from taxable income.


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Taxdeduction

Tax Credit

Foreign Taxable Income $1000 $1000

Foreign tax paid $200 -

Taxable income ( U.S. purpose) $800 $1000

U.S. tax @ 35% $280 $350

Less foreign tax credit $200

Resultant U.S. tax $150

Total tax burden $480 $350

Effective Tax rate 48% 35%

Economic

Effect of claiming

Foreign Tax

Creditand Deduction


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U.S Taxation of Foreign

Source IncomeyWithholding taxes on royalty and dividend

payments = 15 % in Countries A, C & D

y Income tax rates = 30 % in Country B

y Income tax rates = 40 % in Country C

y Indirect sales tax = 40 % in Country D

yForeign Indirect Tax Credit =Dividend (including any withholding tax) xCreditable foreign taxes

Earnings net of foreign income tax


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Royaltiesfrom A

Branchin B

Subsidiaryin C

Subsidiaryin D

Before tax earnings 100 100 60

Foreign Income Taxes 30 40 nil

After Tax earnings 7 0 60 60

Dividend Paid 30 30

Other foreign income 20

Foreign withholding taxes (15%) 3 0 4.5 4.5

U.S. Income 20 100 30 30

Dividend gross-up 20

Taxable Income 20 100 50 30

U.S. Tax (35%) 7 35 17.5 10.5

Foreign Tax Credit

Paid (3) (30) (4.5) (4.5)Deemed Paid (20)

Total (3) (30) (24.5) (4.5)

U.S tax (net) 4 5 (7) 6

Foreign Taxes 3 30 24.5 40

Total taxes ofU.S Taxpayer 7 35 17.5 46


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Limits to Tax CredityMaximum tax liability will always be the

higher of the host country and home

countrys tax rate

yLimit on the amount of foreign taxescreditable in any year

yForeign Tax credit limit =y Foreign Source Taxable Income x U.S tax

before credits

Worldwide taxable income


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Tax TreatiesyProfits earned by a domestic enterprise

in the host country shall not be subject to

its taxes unless the domestic entitymaintains a permanent establishmentthere.

yTax treaties affect withholding taxes on

dividends, interest and royalties paid bythe enterprise of one country to foreignshareholders

yThey usually grant reciprocal reduction in


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y Comprehensive

Agreements -With Respect toTaxes on Income

y Armenia

y Australia

y Bangladeshy Brazil

y Canada

y China

y Cyprus

y

Turkeyy UAE

y USA

y Uzbekistan

y Vietnam

y Zambia

y DTAA Limited

Agreements -With respectto income ofairlines/merchant shipping

y Afghanistan

y Bulgaria

y Czechoslovakia

y Ethiopia

y Saudi Arabia

y Switzerland

y UAEy Yemen

y Arab Republic

y DTAA - Other

Agreements /

Double

Taxation

ReliefRules

y African NationalCongress Mission

y Income-tax(Double TaxationRelief) (Aden)

Rules, 1953y Income-tax

(Double TaxationRelief)(Dominions)

Rules, 1956


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Treaties withholding Tax rates in United StatesCountry

Australia

Dividends

15

Interest

10

Royalty

5

Austria 15 10 10

Barbados 15 5 5

Belgium 15 15 0

Canada 15 10 0

Cyprus 15 10 0

Czech Republic 15 0 10

Denmark 15 0 0

Egypt 15 15 0

Estonia 15 10 5

Finland 15 0 5

France 15 0 5

Germany 15 0 0

Greece 30 0 0

Hungary 15 0 0

Iceland 15 0 0

India 20 15 10

Source: IRS Publication 515, Withholding of Tax on Nonresident Aliens and Foreign Entities (January 2006).


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Treaties withholding Tax rates in India

Country Dividends Interest Royalty

Australia 15% 15% 15%

Canada 25% 15% 15%

China 1 % 1 % 1 %Germany 1 % 1 % 1 %

Malaysia 2 % 2 % 3 %

New Zealand 15% 1 % 1 %

Singapore 15% 15% 15%USA 2 % 15% 1 %

Non treatycountries Nil 2 % 1 %

Source:

Income Tax Department, 2007


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Tax Planning DimensionsyMultinationals have a distinct advantage

over purely domestic companies

because they have more geographicalflexibility in locating their production &distribution systems

yTwo caveatsyTax considerations should never replace

business strategy

yConstant changes is tax laws constrain


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Organisational ConsiderationsBranch

y Income consolidated

with that of the parentcompany

y Fully taxed in the year

earned whether remitted or not

y If initial operations are

forecast to generate

Subsidiary

y Option not available for

a subsidiary

y Earnings not taxed until

remitted

y When turn profitable -

advanta eous


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Subpart F Incomey The U.S taxes shareholders of controlled

foreign corporations (CFC) on certain

undistributed income of that corporationyA CFC is a corporation in which more than 50

% of the combined voting power or fair marketvalue is owned directly or indirectly by a U.Sshareholder

yA U.S. shareholder is a U.S. person whoowns directly, indirectly, 10% or more of

foreign corporation, such as U.S.


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Subpart F IncomeSubpart F income comprises varioustypes of income such as:

yPassive investment income

yNet gains on foreign exchange or commodities

yGains from the sale of investmentproperty

y Income from shipping operations in


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Offshore Holding CompaniesyA holding company is a company of

which the business activity is holding

shares in other companies.

yA parent company incorporated in a hightax country may form a subsidiary

company in a low tax or tax free offshorearea

yThis can give rise to opportunities for

deferring tax and for more effective cash


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IntroductionyA multinational enterprise has facilities

of many types located in many locations

in the worldyThe profits of each portion of business

are structured through intercompany

transactions like sales, licensing, leasingetc.

yTransfer pricing is a field of analysis thatreflects the price of goods, services or


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International Transfer Pricing

yAbout 40% of all international tradeconsist of transfer between relatedbusiness entities

yCross country transactions expose MNCto many environmental factors that bothcreate and negate the options forincreasing profits

y

Some factors are:y Taxesy Tariffsy Competitiony

Inflation risks


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Tax considerations

yCorporate profits can be increased bysetting transfer prices so as to moveprofits from subsidiaries in high taxcountries towards subsidiaries in lowtax countries

Eg:

A and B are wholly owned subsidiaries ofGlobal Enterprise in UK and USA.

A sells its product(500,000) to B at $6 per


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A(UK) B(USA) Globalenterprise

Sales $3000,000 $6000,000 $6000,000

Cost of sale $2100,000 $3000,000 $2100,000

Gross margin $900,000 $3000,000 $3900,000Operating Exp. $500,000 $1500,000 $2000,000

re tax income $ 00,000 $1500,000 $1900,000

Income tax $66,000 $525,000 $591,000

Net income $33 ,000 $975,000 $1309,000


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A(UK) B(USA) Globalenterprise

Sales $4250,000 $6000,000 $6000,000

Cost of sale $2100,000 $4250,000 $2100,000

Gross margin $2150,000 $1750,000 $3900,000Operating Exp. $500,000 $1500,000 $2000,000

re tax income $1650,000 $2500,000 $1900,000

Income tax $272,200 $87,500 $359,750

Net income $1377,750 $162,500 $1540,250


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Competitive factorsyTo facilitate the establishment of a

subsidiary abroad, parent company couldsupply the subsidiary with inputs invoiced

at low pricesyExcess profits earned in one country could

subsidize the penetration of another market

yTo improve the foreign subsidiaries accessto local capital markets

yThis may call forth anti-trust actions by host

government or retaliatory actions by host


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yPerformance Evaluation

considerationsTransfer prices are a major determinantof corporate performance

It is difficult for decentralized firms toset transfer price that both

(a) motivate managers to make

decisions that maximize their units wellbeing and are congruent with companysgoal

(b) provide an equitable basis for


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Arms Length Price

ySection 482 of Internal Revenue Code,USA, requires that pricing of intra

company transfers be based on armslength pricing

yIt is the price that an unrelated partywould receive for the same or similargoods under identical or similar

situations


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Transfer Pricing Methodology

yMarket based transfer prices

yCost based transfer prices


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Market Based Transfer Pricing

yThe subsidiary supplies the productsat the market price of that product

yAdvantages

yEfficient use of the firms scarceresources

yUse is consistent with decentralizedprofit centre orientation

yConsistent with arms length method


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Shortcomings

yOften there is no intermediate market

for products or servicesyIf there is a market, still it would not be

perfectly competitive or internationally

comparable.yDoes not allow a firm to adjust prices

for competitive purposes


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Cost based systems

yIn this system the subsidiary sell itsproducts to the parent or other

subsidiary at its cost

yAdvantages

ySimple to use

yBased on readily available data

yEasy to justify before tax authorities


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Shortcomings

yProvide little incentive for sellers tocontrol their price

yProduction inefficiencies may simplybe passed on to buyers as inflatedprices

yThe problem of cost determination iscompounded internationally, as everycountry has different cost accounting


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If any person who is resident in India in anyprevious year proves that in respect of hisincome which accrued or arose to him duringthat previous year in Pakistan he has paid in

that country, by deduction or otherwise, taxpayable to the Government under any law forthe time being in force in that country relatingto taxation of agricultural income, he shall beentitled to a deduction from the Indianincome-tax payable by him - (a) Of theamount of the tax paid in Pakistan under any

law aforesaid on such income which is liable


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Transfer Pricing In India


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Transfer Pricing Regulations

y The Finance Act 2001 introduced the detailed TPR

w.e.f. 1st

April 2001y The Income Tax Act

yAS-18

y Other Relevant Acts


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Related Partiesy Requires disclosure of anyelements of the related

partytransactions necessaryfor an understanding ofthe financial statements.

y Control byownership

y 50% of the voting right

y Control over composition of board of directors

y

Power to appoint or remove the directorsy Control of substantial interest

y 20% or more interest in the voting power


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Income Tax Act and TPy Finance Act 2001 substituted the old section of 92 of

the ITA bysections 92,92A to 92 F.

y These sections are the backbone of Indian TPR.

y These sections define the meaning of related parties,international transactions, pricing methodologies etc.


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Associate Enterprise: 92Ay Direct Control/Control through intermediary

y Holding 26% of voting power

y Advance of not less than 51% of the total assets ofborrowing company.

y

Guarantees not less than 10% on behalf of borrowery Appointment of more than 50% of the BoD

y Dependence for 90% or more of the total raw material orother consumables


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Methods for determining arms length

prices Sec 92

yOECD ( Organisation for economiccooperation and development )

identifies several broad methods:

yComparable uncontrolled pricing method(CUP)

yResale pricing method (RPM)yCost plus pricing method (CPM)


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Comparable uncontrolled pricing

method

yTransfer prices are set by reference toprices used in comparabletransactions between independentcompanies or between the corporationand an unrelated third party

yDifferences in quality, trademark,brand names makes the direct


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Cost plus pricing method

yA markup is added to transferring affiliatescosts in local currency

yThe markup includes:y Financing costs related to export inventory,

receivables, assets employed

y

A percentage of cost covering manufacturing,distribution, warehousing and other relatedcosts to export operations

yAdjustments are made to reflect the

overnment subsid if an


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Other Pricing Methods

yComparable profits method

yComparable uncontrolled transactionmethod

yProfit split method (PSM)

y

Transactional Net Margin Method(TNMM)

yPowers of Assessing Officer

yConse uences of recom utation of


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Comparable uncontrolled transaction method

yApplicable to intangible assets

yIdentifies a benchmark royalty ratereferencing transactions in whichsame or similar intangibles aretransferred

yThis method relies on marketcomparables


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Profit split method

yThe operations of two or more parties arehighly integrated, making it difficult toevaluate their transactions on an individualbasis

yThe first step is to determine the total profitearned by the parties from a controlled

transactionyThe second step is to split the profit

between the parties based on the relative

value of their contribution considering the


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Transactional Net Margin Method

y The net profit realised by the enterprise from an internationaltransaction entered with an associated enterprise iscomputed in relation to costs incurred or sales effected orassets employed or to be employed by the enterprise orhaving regard to any other relevant base

y The profit margin realised by the enterprise or by anunrelated enterprise from a comparable transaction or anumber of such transactions is computed having regard tothe same base

y The net profit margin referred to as above arising incomparable uncontrolled transactions is adjusted to take intoaccount the differences, if any, between the internationaltransactions and the comparable uncontrolled transactionswhich could materially affect the amount of net profit margin


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International Transactions: 92 By Transaction between two or more AE of which

either both or anyone is a non-resident.

y Transactions:

y Purchase/Sale/Lease

y

Provision of servicey Lending or borrowing


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Some Transactions subject to ALP

Purchase at little or no cost.

Payment for services never rendered.

Sales below MP/ Purchase above MP

Interest free borrowings

Exchanging property

Selling of real estate at a price differentfrom MP

Use of trade names or patents at

exorbitant rates even after their ex ir .


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Indian Transfer Pricing Regulations Intra-group cross-border sale, purchase, lease or

cost sharing transactions involving intangible

property are inter-alia covered by the newTransfer Pricing code.

Methods prescribed (by section 92C) for the

determination of the Arms Length Price (ALP) ofa transaction may not be adequate for valuation

of intangibles.

It may be necessary to apply other internationally


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Indian Transfer Pricing Regulations

(Contd) Use of such Other methods is permissible

under laws of other countries like US, UK, etc,

and is also allowed by the OECD Guidelines.

OECD Guidelines recognize that the general

ALP and methods can be difficult to apply to

transactions involving IP.

Indian rules also need to recognize these

internationally applied valuation

methods/approaches and adopt a consensual


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Transfer Pricing Penalties

y In order to ensure compliance with the arm'slength principle, the I-T Act has prescribedstiff penalties

y Transfer Pricing "adjustments" in India arenow treated as concealment of income,deserving harsh penalties of up to 300 percent.

yThe Indian TP regulations are broadly basedon OECD guidelines. These guidelines areinternationally applied by various countriesfor resolving TP issues.


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Double Taxation Relief

A DTAA is an agreement entered

between two countries in order toavoid taxing the same income twice.The double taxation is of two kinds:-Juridical double taxation: a personis taxed on the same income indifferent contracting states.Economic double taxation: the


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Thus in order to avoid the burden ofbeing taxed twice,the country may framelaws to grant relief.

Double taxation relief is of 2 types :-

Unilateral Relief

Bilateral relief

In case of unilateral relief, the country ofwhich the tax payer is resident providesrelief to the tax payer through its domestictax laws irrespective of the country fromwhich the tax payer earned his


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Sec 90Agreement with Foreign

countriesy The CG may enter into an agreement with any

foreign government for granting relief in respect of

(a)Income on which tax has been paid both under the

IT Act and income tax in that foreign country.(b)For the avoidance of double taxation of income

under this Act and under the corresponding law inforce in that country, or

(c) For exchange of information for the prevention ofevasion or avoidance of income-tax chargeableunder this Act or under the corresponding law inforce in that country, or investigation of cases of suchevasion or avoidance,

(d) For recovery of income-tax under this Act andunder the corresponding law in force in that


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(2)Where the Central Governmenthas entered into an agreement withthe Government of any countryoutside India under sub-section (1)for granting relief of tax, or as the

case may be, avoidance of doubletaxation, then, in relation to theassessee to whom such agreement


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Some Cases Peico Electronics & Electricals Ltd.

Parent: Phillips Netherlands and its

subsidiaries

Asea Brown Boveri

Parent: ABB Switzerland and its

subsidiaries

Videocon Group

Collaborators: Toshiba Co., Mitsubishi


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Thank You!

Documents

International Taxation & Transfer Pricingl