International Taxation
For multinational corporations, tax planning has become an extremely complex affair. It has often been stated that no multinational corporation possesses the ultimate tax expertise. There are just too many countries and regions involved and thus a web of tax regulations. Therefore, in addition to having their own experts, MNCs rely heavily on local tax experts and legal counsel. Taxes have a very important impact on foreign direct investment decisions. Taxes will determine the financial structure of a subsidiary, and they will influence pricing decisions. They may also lead to the formation of holding companies. An MNC may decide to establish a branch rather than a subsidiary because of a given tax situation. The absence of a tax treaty between the country of a would-be investor and the nation where a foreign investment is to take place might lead to cancellation of investment plans. An unfavorable depreciation allowance may keep the foreign investor out. This unit will deal with the different tax systems in the world and their impact on an MNCs global strategy. Basically, any tax system can be divided into direct and indirect taxes. Corporate and individual income taxes are direct; value added taxes, sales taxes, and import duties are indirect taxes. Corporate income taxes (taxes levied on earnings) vary among the industrialized nations. France, the United States, Holland, Canada, and Germany have rates of around 50 percent; Italy, the United Kingdom, and Japan have rates of between 36 and 40 percent. Less developed countries usually have lower corporate lax rates, in order to attract foreign investments. Thus, Brazil has a rate of 30 percent, and Indonesia has a 40 percent rate. A corporate tax is levied on taxable earnings. Taxable earnings are more significant than the tax rate itself. They determine what can be deducted before the tax is computed; in other words, these items are tax deductible. Countries differ greatly in determining taxable earnings. Some allow accelerated depreciation, whereby the asset (usually the plant of equipment) is written off at substantially higher rate during the first years than in the early years. Other countries allow tax-free investment reserves. These are used at a later stage for investment in underdeveloped areas of countries or are sent when countries are in recession. A recent type of tax that has won recognition in the European Common Market is value-added tax (VAT). This is a national sales tax levied at each stage of production or at the sale of consumer goods. The tax is assessed in proportion to the value added during that stage. Generally, manufacturing goods, such as plant and equipment, have been exempted from this tax. In most cases, food items also have been exempted. Here is an example of how VAT works. A tree owner who sells part of a tree to a lumber mill for $1 must set aside ten cents VAT to pay to the government. The lumber mill processes the tree into building material and sells the wood for $3 to a lumber wholesaler. The mill adds $2 in value, and thus sets aside 10 percent of the added value, or twenty cents, to pay to the government. And so the VAT continues until the final sale. The VAT system offers advantages, such as rebates on exports. Profitable and unprofitable firms are taxed alike, as there is no possibility of tax deductions to determine taxable income. A badly run company is, therefore, forced to improve or go out of business. Further, VAT is easy to calculate and collect. But VAT is often accused of having contributed to serious inflation in countries where it was introduced, notably in Western Europe. There are numerous other national taxes. A withholding tax is withheld from a foreign corporation and is levied on interest paid on loans. A withholding tax is also levied on dividends remitted to the parent company. A withholding tax is usually mitigated by a tax treaty which may lower, suspend, or abolish a withholding tax. In the case of the United States, tax treaties have been made with some twenty three countries, most of them industrial nations. The purpose of a tax treaty is to avoid double taxation in both the home and foreign country. The United States also eases its tax burden through foreign tax credits, which limits the combined foreign and United States tax on foreign income to the higher of the two rates. If the foreign tax is lower some of the United States tax is payable. If it is higher, no additional United States tax is payable. Some excess foreign tax may even be averaged out with other foreign taxes for the same year. Tax treaties allocate certain types of income to a particular country, rather than lump foreign earnings together in foreign source income. Moreover, tax treaties reduce withholding taxes on dividends and interest on loans, and they sometimes wipe them out completely. Tax treaties arc always bilateral, meaning they are agreements between two countries. Relatively few treaties have been signed between developed and less developed countries. This is because the flow of dividends, royalties, and interest is likely to be in only one direction - from the less developed to the developed country. The less developed country has NO investments in the developed country and therefore would not benefit from a tax treaty in which withholding taxes are lowered reciprocally. As we have seen, tax rates, whether withholding, corporate, or VAT, differ greatly among countries. Some countries have a zero corporate tax rate for the first few years o/a new subsidiary's existence. This is called a tax holiday. It is an investment incentive. Most incentives, however, relate to tax-deductible items. Some countries may allow 100 percent depreciation on machinery in the year of purchase, while others merely allow an accelerated depreciation in the first years. Some countries grant an investment credit for the purchase of machinery. Others may actually give a cash grant to purchase machinery. Countries which have initiated a system of tax incentives can be divided into three groups. One group consists of developed nations. A developed country incentives might be aimed at diverting domestic instruments from one type of investment in another (e.g., from commercial buildings to plants) or from a developed region to a depressed area. The second group of nations offering incentives is the less developed countries. They are seeking to industrialize but cannot do this by themselves. They need foreign capital, so they quite commonly offer tax holidays lasting from five to ten years. The third group consists of tax haven countries, where certain taxes are low or nonexistent. It is not the goal of such countries to attract foreign industry within their borders. Rather, a tax haven country benefits from financial and commercial activity that evolves around a tax haven subsidiary. Multinational corporations often establish subsidiaries in a tax haven for the purpose of buying products in a country outside the tax haven. Subsequently, the products are sold by the tax haven subsidiary, where corporate taxes are low. Thus, profits are much more substantial than if the products were sold directly from the manufacturing country to the country of final sale. This system is called transfer pricing. Tax authorities in other countries are well aware of this practice, but it is usually not worthwhile for them to make a case of it. Some tax havens are primarily places where funds earned and taxed in one foreign country can be channeled into other foreign countries without ever having been repatriated to the parent company. A parent company with many foreign subsidiaries is likely to establish a holding company in a tax haven. This company receives profits earned in one country and passes them on to another subsidiary for reinvestment. Such profits always remain outside the home country. Thus, a home country's tax on dividends from a foreign subsidiary can be deferred until the tax haven subsidiary transfer funds to the parent firm. Some well-known tax havens are Luxembourg, Lichtenstein, the Bahamas, Switzerland. Basically, these lax havens share certain qualities, such as a stable currency and relatively loose foreign exchange regulations. A tax haven must have facilities to support financial services. It must have a stable government which encourages foreign-owned holding companies that provide financial and commercial services. When a company is formed abroad, it is often advantageous to set it up in the form of a branch. A branch is not a separate legal entity; it is merely an extension of the parent company. A branch will normally incur losses in its first years, but the parent company can offset these losses against its own profits. In a foreign subsidiary, which is a separate entity, profits are only taxed in the foreign country if they have been repatriated to the parent company in the forms of dividends. A branch is advantageous in countries which do not impose a withholding tax on repatriated branch earnings but do on dividends from subsidiaries. A branch will always have its earnings taxed by the home country; a profitable subsidiary can defer the tax liability in the home country simply by postponing repatriation of dividends. Therefore, when a branch becomes profitable, it should, in most cases, be replaced by a subsidiary. Thus, the ideal tax system, in which profits increase and economic behavior stays the same (or at least does not deteriorate), is hard to find. Expanding vocabulary A. Say it in English Звільняти від сплати податків, бездоганне знання законів оподатковування, щоб уникнути подвійного оподатковування, мережа податкових правил, надмірний податок на доходи від іноземних інвестицій, податок обчислюється пропорційно доданій вартості, на кожному етапі виробничого циклу, несприятливий відсоток амортизації може перешкоджати залученню іноземних інвесторів, мати вплив на прийняття рішень про прямі іноземні інвестиції, податкові зобов'язання, вільне валютне регулювання, однак це недоцільно, дивіденди перелічують материнській компанії, повернення ПДВ з експорту, двосторонні податкові угоди, покладатися значною мірою на місцевих податкових експертів, пом'якшувати податки, мати вплив на ціноутворення, скасувати утримання податків на відсоток щодо вкладів і дивідендів, скасування інвестиційних планів, самостійна юридична особа, оподаткувати дивіденди, що повертаються в краї-ну-інвестор, сплата податку на дивіденди іноземних дочірніх компаній може бути відстрочена. В. Find in the text and give the translation Transfer pricing, withholding tax, tax holiday, taxable earnings, tax-deductible items, tax treaty, branch, subsidiary, tax haven, accelerated depreciation, value-added tax, to levy a tax, interest on loans is subtracted, writing off an asset at a substantially higher rate, this allows for, income taxes, import duties, a holding company, investment incentive, economic behavior deteriorates, the parent company can offset the losses against its own profits, an extension of the parent company, to have facilities to support financial services, the authorities are well aware of the practice, to divert domestic investments from a developed region to a depressed area, most incentives refer to tax-deductible items. Discussion 1. Why is it often stated that MNCs do not possess the ultimate tax expertise? 2. In order for investment reserves to be free of tax, what will they normally 3. How does value-added tax work? Where has it been introduced? Cite some 4. What are tax treaties meant to avoid? How is a system of foreign tax credit 5. Name some examples of fax incentives. What are they supposed to 6. Why would an MNC establish a company in a tax haven? Name four 7. Under what circumstances would a company establish a foreign branch Supplementary texts Text A TAX ROUT Estonia leads the way in corporate tax-cutting Tax rates in Central Europe are still painfully high, which is why so many governments have decided to cut them in the past few months. But with most also facing demands for more spending, they are having to gamble that lower taxes will eventually boost growth, and so boost tax revenues again. The Czechs kicked off the latest round of tax cuts, shaving corporate tax from 35% to. 31% from June 2000. The top rate of personal tax will come down too, as will the tax on dividends and interest. The Poles have followed suit, announcing plans for a gradual cut in corporate income tax over the next four years. By 2004 it will be down to just 22%. But predictably it is Estonia that has been the most radical. Its new government came to power this spring promising to abolish corporate tax altogether. It hasn't quite gone that far: "We wanted to promote an image of Estonia as business-friendly, but we didn't want to become an off-shore tax haven," says Terko Jakobson, a tax adviser at the finance ministry. So under a new draft law, currently in parliament, companies will be able to write off all investment against tax. More VAT But Mr Jakobson concedes that Estonia may eventually be forced to push up indirect taxes like VAT to compensate for the losses. The Czech Republic and Slovakia have already done so, edging more goods towards the EU's standard VAT rate of 22%. Po- land, meanwhile, is ending its tax breaks on corporate investment, which means that a few big companies will actually pay more, despite the simultaneous tax cuts. Only in Hungary and Bulgaria are some VAT rates coming down. In Bulgaria that was partly to boost domestic demand; in Hungary it's because the top rate was a whopping 25%. From Business Central Europe Text B Tax Europa War is breaking out all over Europe and business will start to enjoy the fruits of it in 2002. The hostilities are over tax: income tax, corporate tax, capital gains tax, fuel tax. You name it, and somewhere in Europe someone will be slashing it. Take tax on corporate profits. Ireland set the debasing trend with a low 28% in 1999. Germany followed in the summer of 2000, promising to reduce its rate from 40% to 25% over the next five years. France will slash its rates to 33% for large firms, and to 15% for small and medium-sized firms. Italy, Portugal and even Poland are all chasing them down. And as if blowing a raspberry at all this me-too-ism, Ireland now intends to cut its rate further to 12.5% by January 1st 2003. Ireland's tax on employee stock options will also fall, from 44% to nearer 20%. The big question is who will dare to follow the Irish down? Buoyed by resurgent growth and years of belt-tightening, European governments can now afford lower rates. Most of their budgets are in surplus in 2002. With monetaiy policy for most of Western Europe now controlled by the European Central Bank, tax is one of the few weapons left for governments wanting to attract investment and foster business. From The Economist TextC Gimme Shelter Boasting about attractive tax policies is unwise just now because of international efforts to crack down on "harmful tax competition". The OECD is currently preparing a list of countries that it thinks are indulging in harmful tax competition, which it plans to publish in June. Tax-competition skeptics point out that in most developed countries tax revenues as a proportion of GDP have in fact risen over the past 30 years, and that the share of taxes on corporate profits in overall tax revenues has remained much the same. On the other hand, there is plenty of evidence that lower tax rates have pulling power, and as economies become more open, the pulling power is getting stronger. A 1998 oecd report on harmful tax competition noted that total direct investment by 07 countries in tax havens in the Caribbean and South Pacific grew more than fivefold between 1985 and 1994, to over $200 billion. So-called tax havens accounted for 1.2% of world population and 3% of world GDP, but 26% of the assets and 31% of the net profits of American multinationals (though only 4.3% of their workers), according to a 1994 study. A more recent analysis, by James Mines of the University of Michigan, found that "taxation significantly Influences the location of foreign direct investment, corporate borrowing, transfer pricing, dividend and royalty payments." Another recent study asked, "Has US in- Veitment abroad become more sensitive to tax rates?" It analysed corporate tax-return data for 1984-92 (Ihc latest then available), and found that by the end of this period iIk- lypical American multinational had become twice as likely to locate its operations when- taxation was lowest as il had been at the beginning. Palling Corporate lax rates around the world also provide strong circumstantial evidence thai governments are trying harder to cater for international firms' and investors' appetite for lower taxes. From The Economist Comprehension tasks 1. Find out types of taxes mentioned in the articles. 2. Define them in your own words. 3. What are the trends in the tax policy of Western European/Central Euro 4. Why could Bill Gates be much more wealthy if he had started Microsoft in Bermuda? Follow-up activities 1. Is tax competition among countries a good or a bad thing?
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