Taxation of Multinational Companies 1 7 eee . Objectives: Worldwide vs. territorial tax Tax credit Transfer price Arms’ length price Debt financing, royalty, head quarter overhead CFC POEM Multinational companies have business in more than one country and face different taxation system. Tax structure is different for example, one corporate income tax in one country but different corporate tax rates for different businesses in another country. UK has one corporate tax rate for all businesses whereas Bangladesh has six to seven corporate tax rates for different businesses. In Europe customs duties are almost zero whereas a multinational company (MNC) in Bangladesh has to pay customs duties for its import. In Bangladesh corporate tax rates are historically higher than personal tax rates whereas, in most of the countries personal income tax rates are higher than corporate tax rates. Why are tax rates different? The simple answer is many governments try to attract foreign investment for Teasons like installing higher technology, increasing exports, and increasing employment, Because of the variations in tax laws between countries, MNCs have more scopes to utilize creative tax strategies, mrt eg icy MNC depen don man a ot investing in foreign countries cae retum on Gaecinents ab eat ae factors, Pretax ae i ad can differ from that availableTaxation of Multinational Companies a1 domestically. A higher after tax rate of return abroad is a condition for investing and reinvesting abroad. Importantly, after-tax accumulations require considering not only the current taxes but also potential taxes in future. Secondly, a MNC can use higher transfer price and thus repatriate capital through this transfer price. It seems likely that this problem is more severe in developing countries as many of these countries lack sophisticated policies directed at stopping tax avoidance, such as controlled foreign corporation rules and transfer pricing regulations. In developing economies, profit-shifting activities could also be driven by the desire to hedge the company against political risks such as expropriation, and to protect the company from government or state failure. Territorial versus Worldwide Tax Countries which have higher corporate tax rates usually follow worldwide tax system, that is, will tax domestic income and foreign income but after giving tax credit. Some countries however, follow territorial tax system taxing income eared only within the country. These countries have a tax treaty under which businesses will pay tax only in the parent country. Another tax system is hybrid-worldwide system where a country may have worldwide tax with some countries and territorial tax with others. Which system a country should follow depends on many factors. For example, Bangladesh has less competitive advantage compared to other countries so it has tax treaties with most of the countries with FDI in Bangladesh. Second, a country has a motivation to do tax treaty because host country has a higher tax rate than the guest country, for example, Hong Kong with corporate tax rate of 16.5% has a motivation to do tax treaty with Bangladesh with 25% to 45% corporate tax rate under which Cathy Pacific, the Hong Kong Airlines pays no tax in Bangladesh but pays only in Hong Kong. Foreign Tax Credit AMNC has a motivation to invest in a country where tax rate is lower compared to the parent country. If a MNC has to pay tax in both theAp Advanced Issues in Taxation ble taxation and there no reason why it shall inves, in ¢ it suffers a competitive disadvantage with i, competitors in the parent country. In beeen this double taxation a country may do tax treaty so that rp y tax only in the home country or there is provision for deduction of tax Paid in the host country. So countries with the worldwide tax system ive foreign tax credits for taxes paid in the host countries. Tax credit cannot exceed the parent company tax rate. For many years tax policy in the US as well as the UK used variants of the foreign tax credit system. Other countries like Germany and France, however, chose to exempt foreign source income fully or almost fully from domestic taxation. But in one of the most striking trends in corporate taxation in recent years, there has been a significant switch to exempting foreign-source income from taxation. According to PwC Worldwide Tax Summaries, out of 37 high-income countries, 19 had an exemption system in 1998, rising to 27 in 2008. None of these 37 countries switched from exemption to a credit or other system during this period. These countries with territorial tax system have lower corporate tax rates than countries with worldwide tax system. countries it is dout a foreign country becaus This trend appears to conflict with two key results in the classical theory of international taxation. The first result states that countries should tax the foreign source income of multinational firms according to the foreign tax credit system to make sure that the allocation of capital in the world economy is undistorted (Richman 1963). This result is based on the idea that, under the foreign tax credit system, firms will ultimately pay the same tax, irrespective of the investment location, so that their location choices are not distorted if corporate tax tates differ across countries, achieving so-called capital export neutrality (CEN). However, the US offers a gigantic loophole: after Paying each country’s taxes, the additional US tax on US ‘multinationals’ foreign affiliate profits can be deferred indefinitely nana simple expedient of not remitting those profits Bermuda, or a peralhes finds are parked in tax havens, such as accumulated, but nena eee eae a > ated, profits of American multinationalsTaxation of Multinational Companies 213 foreign subsidiaries—which have legally escaped US taxation are estimated between $2.1 and $3 trillion, Tax in the parent country = foreign income (tp — th) where t, is tax rate of parent country and ty is the tax rate of host country Example XYZ cement (pvt) of Bangladesh has a subsidiary in UK. Income before tax in the subsidiary BPS500 million, corporate income tax in UK 21%, and 35% in Bangladesh, dividend declared 40% of after tax income, withholding tax from dividend 10%, (When XYZ owns controlling interest say 60%, XYZ follows equity method where investment is debited and income is credited, and when dividend is declared, dividend receivable is debited and investment is credited. income = 500 x 60% = BPS300 income tax = 300 x (ty — th) = 300 x (0.35 — 0.2)= BPS42 ji) When XYZ owns non-controlling ownership say 20%, corporate income is not shown rather dividend declared is treated as income dividend income = 500 (1 —t,) x 0.40 x 0.6 = 500 x (1-0.21) x 0.4 x 0.6 = BPS31.6 Tax payable = 31.6 (0.35 - 0.21) = BPS4.42 Debt Financing and Profit Shifting Intra company loans to affiliates in developing countries respond more to tax rate changes than loans to affiliates in developed countries. If a developing country increases its tax rate the increase in debt financing of local affiliates of multinational firms is on average twice as large as the increase in debt financing that would occur ina developed country, as a result of the same tax rate increase. At the same time, the decline in debt financing in response to tax rate cuts is also larger (Fuest et al. 2011). MNCs can charge higher interest rates among its affiliates with oAdvanced Issues in Taxation 214 orate tax rates and get higher tax savings, Banglades, higher corp 1984 has no restriction on the deductibility of Income Tax Ordinance’ interest. Royalty Payments : + va resis io intensive, and most val sides in theip Le ae or intangible assets. Even if research ang development (R&D) costs have been incurred by home country of the MNC, current rules allow the transfer of the patents or brands toa holding company or subsidiary (in a low-tax country Which then charges royalties to headquarters and other affiliates (Dischinger & Riedel, 2008). Most governments allow deductions for royalty payments, which reduces tax liability to the licensee—even if the licensee is part of the same MNC, and even if no R&D had been performed in the licensee’s nation. Example 1 Suppose BAT (BD) paid TK10 million royalty to its parent company in UK and eamed a profit before tax of TK1000 million. Income Tax Ordinance w/s 30 (h) allows 8% of profit before tax as admissible expense. How much profit BAT (BD) has shifted to UK? Remember corporate tax rate for tobacco business is 45%, Solution Profit shifted = TK 1000 x 0.08 x 0.45 = TK36 million Other Central MNC/Parent Overheads and Costs Research and development and other categories of overheads, such as the costs of maintaining brand equity, and other central administrative Costs at headquarters, such as global information technology, supply- chain management, human Tesources, etc., cost are usually incurred by the parent firm and allocated among its affiliates. MNCs have motivation to alloc; i motiv ate a larger slice ids pie 10 Operations in higher-tax nations, eit erenieais BTaxation of Multinational Companies 215 Grossing up Gross dividend received from the host country = net dividend / withholding tax rate Gross corporate income in host country = net income / t, Branch versus Subsidiary Income from foreign branches is taxed in the home (parent) country as it is carned. But income of subsidiaries is generally deferred from home country taxation until it is repatriated Transfer Price Transfer price is the price charged by one segment of an organization for a product or service that it supplies to another segment of the same organization. The literature on transfer pricing in a single country setting focuses on goal congruence behavioral effects and autonomy. Transfer pricing problem in multinational companies is coupled with additional dimensions. MNCs avoid corporate tax by overpricing imports. Overpricing imports mean (i) foreign currency transferred abroad, (ii) cost of goods sold is higher and profit understated, and consequently paying lower taxes. Further in Bangladesh, price of pharmaceutical products of products are regulated by the government. Section 11 of the Drug (Control) Ordinance 1982 pre states that the government shall fix the maximum price at which any medicine will be sold (Chowdhury 2089) Cost of raw material + certain mark up In such situations, firms both domestic and multinationals will try to overstate the CIF price to get high mark up and selling price and higher profit. Although there is a risk of higher customs duties for imported raw materials, it is not always relevant for many products as there are no or little duties. In most of the cases, the net benefit of overpricing is higher than costs involved. The transfer pricing problem in multinational enterprises is more complicated than in domesticAdvanced Issues , 216 Taxa ion ises because MNCs are exposed to additional envy rise: pee a DViro enterp tions. Choi (1978) states “variables such as differen, ets a " ion, inflation rates, currency values, reg tariffs, o1 i ge AK a ns Tiction op Ss, fer and political risks complicate transfer pricing, fang trans! Arms Length Price Host country governments sometimes can restrict this behavior. Arms length price is one. It is the Price prevailing in ge market between independent buyers and sellers. It is an untelateg or unaffiliated price where the buyer and the seller are Unrelated gp unaffiliated and consequently the price is based on market forces rather than influenced and controlled by any relation or affiliation, fq the developing countries government authorities could not Cfiectively apply this mechanism of controlling overpricing as MNCs CaN exercise some power on the host country government and its bureaucrats (Chowdhury1989). Overprig, Nontax Factors There are nontax factors that affect the decision to locate production abroad. These include the size of a foreign market, Prospects, wage and productivity levels abroad, the foreign and legal environment, and distance from the home country its growth regulatory CFC Rules With increase in globalization, geographical boundaries of countries have become blu: red and many multinational groups try to get benefit of their global presence to minimize their overall tax costs by using low tax jurisdictions for ‘ax planning. One of such measures used by multinational groups is to park profits 1, no or low tax countries without actually bringing such Profits to ultimate parent company located in ‘elatively higher tax Jurisdiction. This practice sometimes Tesults in substantial h V perpetual deferral of tax payments on sud Profits, Controlled Foreign Corporation (CFC) Rules aim at taxation ofTaxation of Multinational Companies 217 such profits, which are parked in foreign companies in low or no tax jurisdictions, in the parent company's home jurisdiction. CFC Rules not only help in taxation of profits in the residence country of ultimate parent, to which such profits actually belong to, but such rules also have positive effects in source countries because taxpayers have no (or much less of an) incentive to shift profits into a third, low-tax jurisdiction, CFC rules are generally meant to counter propensity on the part of MNCs to defer taxes through parking of passive incomes (c.g. royalties, fees, interests, capital gains, profits made from buying and selling products from and to related parties, etc.) at the level of foreign subsidiaries, instead of repatriating the same back as dividends. For UK, a foreign company is a CFC if it’s a non-resident UK company that’s controlled by a UK resident person or persons. OECD has framed CFC rule regarding (i) deterrent effect; (ii) interaction with transfer-pricing rules; (iii) effectively preventing avoidance while reducing administrative and compliance burdens; and (iv) avoiding double taxation. Any profits diverted from the UK that will then be apportioned and charged on the relevant UK corporate interest- holders. There are also a number of entity level exemptions to reflect the fact that the majority of CFCs are set up for genuine commercial reasons. CFC Rules in India In India, concept of CFC was first introduced to Indian taxation regime as part of proposed Direct Tax Code, 2010, which was retained in revised draft of Direct Tax Code, 2013. As per CFC Rules introduced in Direct Tax Code, profits eared by a Controlled Foreign Company, located in territory with a lower rate of taxation, will be included in taxable profits of parent company located in India. For this purpose, Controlled Foreign Company shall be a company (a) which is a resident of a territory with lower rate of taxation, (b) shares of which are not traded on any recognized stock exchange in such territory, (c) which is controlled by Indian residents, individually or collectively, and (d) which is not engaged in active trade or business“ Advanced Issues in 7, 218 axa tion .d more than 25% of whose income comes from passive so, an dividend, interest, capital gains, income from house aol as ty annuity payments, etc. Further, appropriate provi =, been mado in Direct Tax Code to ensure that profits of CEC, which ae taxed in hands of parent company once, are not taxed again a a profits are actually repatriated in form of dividend by Cr to pat company. However, Direct Tax Code is yet to become law in Ip cig and presently there are no statutory provisions in existing Inc ome Tay Act for enactment of CFC Rules. MCS such, CFC Rules ys. POEM under Indian Income tax law Under existing Income tax Act, the Government has recently introduced concept of Place of Effective Management (POEM), A, pet POEM, even a foreign company can be said to be resident in Inds and its global income can be subject to tax in India, if place of its effective management is held to be in India. POEM has been further defined as a place where key management and commercial decisions are necessary for conduct of business of an entity. Statutory Guidelines by Government of India for determination of POEM have been issued recently in 2017. POEM gives a wide power to Indian tax authorities to allege that all foreign companies, whose Parent company is an Indian company and key business decisions are taken by Promoters and directors located in India, be treated as Indian resident and their global income be taxed in India, irrespective of: (i) whether such foreign company is located in a tax haven territory of lower taxation or not; (ii) whether such foreign company is formed for bona- fide global business expansion of Indian multinationals or merely for reaty abuse and parking global profits in low tax jurisdictions outside India, The wide concept of POEM unne Cessaty harassment and I deterrent for Indian ©perations outside In companies, €xecutiny especially in oil & and its potential of being misused for itigation by tax authorities can be a big multinationals from setting up genuine business dia. POEM is also be seen as a threat by foreigt 8 large projects in India through project offices 888 and infrastructure sector or having majorityTaxation of Multinational Companies 219 their global business operations in India or those having other forms of permanent establishment in India, as Indian tax authorities may allege these foreign companies to be residents in India and tax their global income in India. Questions 1. Differentiate between worldwide tax system and territorial tax system. Why does a country follow worldwide and another country territorial tax policy? ‘What is the possible problem of worldwide tax system? How is the problem of worldwide tax system addressed? What is a tax treaty? How does it address double taxation problem? Can there be a uniform tax law around the world? Explain. Can citizens avoid paying taxes by living and working abroad? What are the differences between a MNC operating as a foreign branch and a foreign subsidiary? ‘Are there any restrictions on foreign tax credit? Why they exist? Do lower tax rates in host countries imply higher after tax returns in host country compared to parent country? Explain. What is transfer price? How is it related to MNCs? . Why do MNCs in Bangladesh have motivations for higher transfer price? Explain. . Why MNCs do not raise capital from host country stock market? . What is CFC? What is its purpose? . What is POEM? What is its purpose? What is its threat? . What tax policy Bangladesh government should adopt to counter tax avoidance strategy of a MNC with regard to royalty, interest, and head quarter overhead expenditure?me “Ny Advanced Issues in 15, 220 Nation Exercises "1, XYZCo. Ltd. is a Bangladeshi company also does Dusines 5 India and Nepal. It has pretax income of TKAS mytjen © 2013. It owns 68% of its Indian subsidiary which report pretax income of TK30 million in the same year, xyz dicey owns its Nepal operations, considered as a branch Which recorded pretax income of TK18 million in the year, Assume all earnings are reinvested in the country where they were camed. Corporate tax rates are 27.5% in Bangladesh, 2994 India, 26% in Nepal. What is XYZ’s 2013 Bangladesh tax liability after foreign tax credits? 2. ABC Pharmaceuticals is a multination company in Bangladesh. Recently, the company has imported some Pharmaceuticals from its parent company in US. The details are as follows: Antisera $6000, Therapeutic glands $10000, Bandages $ 8000.Insurance costs and freight-in are $5000 and $3000 respectively. For simplicity, assume that all the above Products are subject to customs duty 12% and VAT 15%, The collector of customs knew that MNCs sometimes over-invoice their imports particularly when they import from their parent companies. So he collected prices from independent sources as such: India World average Antisera $2500 $4000 Therapeutic glands 4800 6200 Bandages 5000 5500 Required: () The value for assessable value, (ii) customs duty, (ii) uty paid value, iv) VAT. Compute these whe according to bill of cnty and arms? length Price, (v) corporation tax benefit assuming Corporate tax rate of 28% and 50%, The exchange rate is $1 = Tk. 78.