Università Bocconi A.A. 2005-2006

Università Bocconi, A.A: 2005-2006 1Mec – Comparative public economics 1

Università Bocconi A.A. 2005-2006

Comparative public economics

Giampaolo Arachi


Multinational tax planningMultinational tax planning

The decision to invest at home or abroadThe decision to repatriate or reinvestLimitations to tax deferralFTC limitationTax Planning under FTC limitation

References:

M. Scholes, M. A. Wolfson, M. Erickson, E. L. Maydew, T. Shevlin (SWEMS), Taxes and business strategy: a planning approach, Pearson Prentice Hall, third edition, 2005, ch. 11


The decision to invest at home or abroad The decision to invest at home or abroad

Assumptions: Tax base is the same in home and foreign countryDomestic tax rate greater than foreign tax rate: td > tf

FTC cannot exceed taxes paid abroad

Home country investment for n years accumulates to:1 + Rd (1-td)]n = (1+rd)n

Foreign country investment for n year accumulates to (after repatriation):

Foreign investment is more attractive if :Rd, tf lowRf, td, n high

t-1

tt1}-)]t-(1 R {[1 - )]t-(1 R[1

f

fdnff

nff

t-1

t-1)] r1 [

f

dnf


The decision to repatriate or reinvestThe decision to repatriate or reinvest

For each $ earned abroad:

1-tf can be repatriated or reinvested

After n years (1-tf )$ repatriated accumulate to:

(1 - td) [1 + Rd (1 - td) ]n = (1 - td) [1 + rd]n

After n year (1-tf )$ reinvested abroad accumulate to:

(1 - tf) (1 + rf)n – [(1 - tf) (1 + rf)n] (td-tf) (1-tf)

= [1 + rf]n (1 - td)

reinvest if rf > rd


US: Subpart F income and CFCs US: Subpart F income and CFCs

Provisions designed to prevent firms from forming paper companies in tax haven to record income from passive investment, sales, services, shipping operations or oil related activities

In general these rules work by subjecting Subpart F income to U.S. taxation as if the income was repatriated the the U.S. parent when the income is earned

Controlled Foreign Corporation (CFC)owned more than 50% in terms of voting power or market value

by US shareholdersA US shareholder is any US person owning at least 10% of the

voting stock


Subpart F income Subpart F income

Income from the insurance of risks outside the country in which the CFC is organized

Foreign based company income

Foreign personal holding company income or FPHCI (dividends, interest, rents, royalties, etc.)

Sales income

Service income

Shipping income

Oil and gas related income


CFC rules and inversion transactionsCFC rules and inversion transactions

Many foreign countries do not have CFC rules US based multinationals may be disadvantaged compared with

similarly positioned multinationals based abroadRistructuring of corporate groups so that the parent company

would be incorporated abroad (Cayman islands)

Inversion: placing of the former U.S. corporation under a newly created foreign parent corporation formed in a low tax jurisdiction that does not have CFC rules exploiting a non taxable transaction under Sections 351 and 368

Anti-inversion rules: outbound mergers and stock transfers do not qualify for tax-free treatment unless the shareholder of the transferred U.S. corporation receive less than 50% of the shares of the foreign acquiring corporation in the transaction


FTC limitationFTC limitation

where:FSI = foreign income earned through foreign branches + foreign

income repatriated from foreign subsidiaries + Subpart F Worldwide income = domestic source income + FSI

Usually

US tax on worlwide income = tUS x worldwide income

FTC limitation = FSI x tUS

income dwide tax worl U.S.* income Worldwide

(FSI) income source-Foreign


Excess FTCExcess FTC

How to minimize FTC excess given the FTC limitation?

Increase income and tax credit in low tax countries and reduce income and tax credit in high tax countries

Modify dividend payout policy: defer distribution in high tax countries and increase dividends from low tax countries


Example of FTCExample of FTCSubsidiary location

Country A Country B Together

1 Local taxable income 1000 1000 2000

2 Local tax rate 20% 40%

3 Local tax (2*1) 200 400 600

4 Net income (1-3) 800 600 1400

5 Dividend (50% payout *4) 400 300 700

6 Withholding tax (10%*5) 40 30 70

7 Dividend net of foreign taxes (5-6) 360 270 670

8 Deemed-paid credit (=(5/4)*3) 100 200 300

9 US taxable income =5+8 500 500 1000

10 US tax (35% of 9) 175 175 350

11 Foreign tax credit (8+6) 140 230 370

12 Net US tax 35 0 0

13 FTC tax credit carryforward 0 55 20


Example of FTCExample of FTCSubsidiary location

Country A Country B Together

1 Local taxable income 1000 1000 2000

2 Local tax rate 20% 40%

3 Local tax (2*1) 200 400 600

4 Net income (1-3) 800 600 1400

5 Dividend 520 240 720

6 Withholding tax (10%*5) 52 24 76

7 Dividend net of foreign taxes (5-6) 468 216 684

8 Deemed-paid credit (=(5/4)*3) 130 160 290

9 US taxable income =5+8 650 400 1050

10 US tax (35% of 9) 227.5 145 367.5

11 Foreign tax credit (8+6) 182 184 366

12 Net US tax 45.5 0 1.5

13 FTC tax credit carryforward 0 44 0


Separate basket limitationSeparate basket limitation

The FTC limitation must be computed separately for each basket of income

Any income not in a specific basket goes into the general limitation basket

Passive income Financial services income

Shipping income High withholding tax income

Foreign trade income FSC income

Income from noncontrolled CFC owned 10% or more


Tax Planning under FTC limitationTax Planning under FTC limitation

Firms in an excess credit positions have incentives to reduce their taxes paid in foreing countries

• Distribribute profit from foreign subsidiaries in ways that are tax deductible abroad– Interest on debt owned to the US parents or US subsidiaries – Rent on leases with the US parent or US subsidiaries– Royalties on licences

• Transfer Pricing for goods and services


Transfer PricingTransfer Pricing

OCSE guidelines Section 482 (US code)“Arm’s length pricing”Transaction between related parties must be priced as if they

involved unrelated parties

Problems: • transactions within related parties are systematically different

from those that take place at arm’s length in the market• goods and services transferred within a corporate group have no

ready market (e.g. intangible assets as patents and trademarks)

US approach“Advance pricing arrangements”

The firm submits its proposed transfer-pricing methodology to the IRS for review. If the IRS agrees, then in principle the firm’s tranfer pricing should not be challenged as long as the firm adheres to the agreement


State taxes – (Eu formula apportionment)State taxes – (Eu formula apportionment)

No transfer pricing regulation

Taxable income allocated across jurisdiction according to an average on percentage of sales, assets, labor cost

Università Bocconi A.A. 2005-2006

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