• Taxation and MNE

• Strategies used by MNE in reducing tax burdens:

– Affiliates – subsidiaries
– Tax havens
– Payments to and from foreign affiliates (transfer price)
etc
• Branch and subsidiary income
• An overseas affiliate of MNE can be organized as a
branch or a subsidiary;
• A foreign branch is not an independently
incorporated firm separate from the parent;
• Branch income becomes part of parent’s income;
• A foreign subsidiary is an affiliate organization of the
MNC that is independently incorporated;

• In the case of the US for example, a foreign

subsidiary is a company owned by a US corporation
but incorporated abroad and hence a separate
corporation from a legal point of view;

• Taxation of the income from a foreign enterprise can

be deferred if the operation is a subsidiary;

• Profits earned by a subsidiary are included only if

returned (repatriated) to the parent company;
• Thus, for as long as the subsidiary exists, earnings
retained abroad can be kept out of reach of the
resident country’s tax system;
• Example on the use of multinationals to defer the
payment of the tax;
• Controlled foreign corporations (CFC) rules
• In the US, CFC is a foreign subsidiary that has over
half of its voting stock held by US shareholders;
• The undistributed income of minority foreign
subsidiary of a US MNC is tax deferred until it is
remitted via a dividend;
• This is not the case with a CFC- the tax treatment is
much less favourable;
• Tax Havens
• A tax haven is a jurisdiction which serves as a means
by which firms and individuals resident in other
jurisdictions can reduce the taxes that they would
otherwise be obliged to pay there;
• tax havens may be identified by reference to the
following factors:
– no or only nominal taxes (generally or in special
circumstances);
– laws or administrative practices which prevent the
effective exchange of relevant information with other
governments on taxpayers benefiting from the low or no
tax jurisdiction;
– Lack of transparency;
• Tax competition – governments compete for taxes;
• Tax competition occurs when countries adapt their
tax policies strategically to make themselves
attractive to new enterprises or to keep themselves
attractive for existing ones;

• Perhaps the best known case of a successful country

in tax competition is Ireland;

• Low taxes in Ireland attracted considerable foreign

investment and thus contributed to the rapid
economic modernization of the country and the long
1990s boom (Genschel 2002);
• the new East European accession countries tried to
copy this success and thus attracted resentment
from old EU member states;

• Germany and France were particularly critical of the

East European low tax strategy;

• large EU member states’ complaints are

understandable because the low tax strategy of the
small countries is openly aimed at capturing their
capital and productive businesses.
• Small countries – large countries winners and losers
in tax competition
• Small countries benefit from reducing tax because
the resulting tax deficit on ‘home’ capital can be
over-compensated by the attraction of foreign
capital;
• From the perspective of small countries, reducing the
tax rate leads to the inflow of foreign capital,
especially from large countries and leads to an
income and welfare gain for them;
• In a situation of tax competition, the welfare of small
states rises while that of large states falls.
• Overall, the welfare loss of large countries is greater
than the gain experienced by small countries
(Bucovetsky 1991; Wilson 1991; Dehejia/Genschel
1999);
• In general, a very popular public opinion is that if a
state has a higher corporate tax rate than others,
then for tax reasons large companies will move their
production and jobs to low taxation countries;
• Relocation takes a number of factors into account –
access to market, factors of production etc;
• A company does not relocate solely because of tax
burdens (EC 2001);
• However, the above point does not apply to all
industries;
• Surveys show that companies choosing a location for
a financial services centre clearly focus their
attention on tax factors (Ruding Report 1992);

• An important reason for the stiff competitive

pressure in corporate taxation is that multinationally
integrated companies can perform ‘tax arbitrage’;

• They can avoid taxes by transferring ‘profits’ from

high to low tax jurisdictions;
• through this they can benefit from the good
infrastructure and other locational advantages in
high tax countries and the tax advantages offered in
low tax countries or tax havens;

• ‘profit shifting’ happens through various techniques

such as the (legal) manipulation of internal transfer
pricing for products or the skillful choice of financial
structures, especially debt rather than equity
financing;
• In this way multinational companies can book the
profits in low tax countries and their losses in high
taxation countries, without changing their location of
real production;

• Many empirical studies have investigated whether

and how strongly tax differences between countries
influence decisions on where companies transfer
their ‘profits’;

• Despite different approaches, all the studies come to

the same conclusion: the transfer of taxable profits is
very sensitive to taxation;
• Payments to and from foreign affiliates for the
purpose of shifting profit;
• Having foreign affiliates offers transfer price tax
arbitrage strategies (for shifting the profit);

• Transfer pricing
• The transfer price is the accounting value assigned to
a good or service as it is transferred from one
affiliate to another;
• Transfer pricing refers to the prices that related
parties charge one another for goods and services
passing between them;
• For example, if company ‘X’ manufactures goods and
sells them to its sister company ‘Y’ in another
country, the price at which the sell takes place is
known as the transfer price;
• These prices can be used to shift profits to
preferential tax regimes or tax havens;
• If, a subsidiary in a high-tax jurisdiction charges a
price below the “true” price (i.e. it transfers at a
price below the actual price), some of the group's
economic profit is shifted to the low-tax subsidiary;
• Consequently, the assessee is able to escape tax or
mitigate it but at the same time the tax base of high-
tax jurisdiction is eroded;
• Hence, unless prevented from doing so, corporations
or other related persons engaged in cross border
transactions can escape from paying tax by
manipulating the transfer prices;
• If one country has high taxes, do not recognize
income there- have those affiliates pay high transfer
prices;
• If one country has low taxes, recognize income there
– have those affiliates pay high transfer price to the
co. located in low tax jurisdiction;
• transfer pricing example.docx
• Most countries have transfer pricing rules which
regulate the prices charged by related cos.
• Most tax systems, including the U.S. transfer pricing
rules, follow the arm’s length principle;
• Under the arm’s length principle – transfer price
should be the price that would have been set if the
parties (to the transaction) were unrelated
enterprises acting independently;
• the underlying principle is that the prices charged by
related parties (mostly units of an MNC) to one
another should be consistent with the price that
would have been charged if both parties were
unrelated and negotiated at arm's length;
• Methods of determining the arm’s length price;
– Comparable Uncontrolled Price Method,
– Resale Price Method,
– Profit Split Method,
– Comparable Profits Method ,
– Cost Plus Method.