Strategic Tax Management

ACT 123
Chapter 8 CHAPTER 8: MARKET PENETRATION: COMPANY AND
EMPLOYEE TAX PLANNING FOR OPERATING IN
FOREIGN COUNTRIES

Week 9
Chapter 8
Overview

 Globalization of a business allows a number of tax opportunities that can enhance the
value of the firm. The legal form in which a firm operates makes a difference on the timing
of income tax. If the country allows rapid depreciation or tax credits, the firm’s tax bill can
be reduced significantly.
 Treaties exist to minimize conflicts between countries, to attract foreign investment, to
avoid double taxation, and for other policy reasons.

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Chapter 8
Course Materials:

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Chapter 8
Strategy

 The firm’s decision to do business in foreign countries should be consonant with its
strategic plan. Once the firm has decided to go international, an important strategic
decision is entity choice. That is, what legal form (e.g., a corporation, a partnership).
 Locational choice should also fit into the firm’s strategic plan. Labor and material costs
may make plant location more desirable in a high-tax area. Alternatively, tax savings
resulting from a treaty or other agreement may influence the choice between two countries,
both of which would otherwise fit into the firm’s strategic plan.

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Chapter 8
Strategy

 Assume that a Philippine manufacturer in Example establishes an incorporated subsidiary in

Singapore. In its first year of operations, its net income is P10 million. Assume that this is
also its taxable income for both Philippines and Singapore purposes. It pays a Singapore tax
of 17% × P10,000,000 = P1,700,000. Because the Philippine tax rate is higher (at 30%), the
firm would like to set the transfer price as low as possible. However, this would result in a
cash shortfall for the subsidiary, which, at the critical start-up phase, is not advisable.
 Strategy and tax treatment treaties commonly provide for tax rates and tax benefits allowed
only by the host nations. Typically, these treaty-based rates are well below the general tax
rates. Besides setting specific rates and withholding rates, treaties also provide for
information-sharing policies between the tax enforcement agencies of the two countries and
require that at least one of the countries allow a tax credit to mitigate taxpayers’ double
taxation.

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Chapter 8
Strategy
 On Competitive Strategy. A recurrent theme throughout the text is that by effectively
managing taxes, a firm’s costs decrease, and it can then afford to lower prices and win
more market share. While a competitor may attempt to manage taxes, too, a firm can still
have the advantage if it has better knowledge of taxes in general and of its competitors’ tax
status in particular.
 Knowledge of a competitor’s tax rates can give one a better prediction of how the
competitor will act (or react) internationally.
Firm’s Effective Foreign Tax Rate
Competitor’s
Effective Foreign High Low
Tax Rate

High No strategic tax advantage Overseas strategic

to either advantage to the firm
Low Overseas strategic tax No strategic tax
advantage to the competitor advantage to either

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Chapter 8
Strategy
 If a firm has the advantage, it should go into the market (assuming this otherwise makes
good business sense), and the competitor should not (absent any nontax cost advantages
over the firm).
 How can a firm lower its effective foreign tax rate? One way is to operate in countries with
lower tax rates, but only if operating there makes overall business sense.
 Another way to get tax-strategic advantage over a competitor is through use of the foreign
tax credit limitation rules. Briefly, if a competitor is in an excess foreign tax credit status,
and the firm is not, the firm can generate more foreign income at a lower tax rate.
 Resident Citizens and Domestic Corporations are taxable on income derived from sources
within and without. The taxes they paid abroad may be claimed either as Itemized
deductions or Tax credit.

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Chapter 8
Strategy
 The foreign tax credit is subject to each of the following limitations:
(a)  The amount of the credit in respect to the tax paid or incurred to any country shall
not exceed the same proportion of the tax against which such credit is taken, which the
taxpayer's taxable income from sources within such country under this Title bears to his
entire taxable income for the same taxable year; and
(b)  The total amount of the credit shall not exceed the same proportion of the tax against
which such credit is taken, which the taxpayer's taxable income from sources without the
Philippines taxable under this Title bears to his entire taxable income for the same taxable
year.

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Chapter 8
Strategy
 For example, International Corporation, a domestic corporation, has the following data for
the calendar year. the corporation signified its intention to claim tax credits on income
taxes paid to the foreign countries:
Country Gross Income Allowed deductions Tax paid
Philippines P1,000,000 P800,000 P-
United States 400,000 200,000 80,000
Japan 300,000 200,000 25,000

The corporation can claim a tax credit of P86,000 only.

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Chapter 8
Strategy
Taxable Income
Philippine (1,000,000-800,000) P200,000
United States (400,000-200,000) 200,000
Japan (300,000-200,000) 100,000
Total Taxable Income P500,000
Income Tax Rate 30%
Total Income Tax Due 150,000
Foreign Tax Credit (lower between Limit A & B. (85,000)
Income Tax Payable 65,000

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Chapter 8
Strategy
 Limit A is determined by comparing each country’s proportionate income tax due. The proportion is
computed based on the taxable income derived from without.
Limit Actual Allowed
Payment Tax Credit
United States 60,000 80,000 60,000
(P200,000/500,000 x 150,000)
Japan 30,000 25,000 25,000
(P100,000/500,000 x 150,000)___________________________________________
Total Limit A 85,000
Limit B is computed based on the worldwide income derived from without.
Limit Actual Allowed
Payment Tax Credit
Limit 90,000 105,000 90,000
(P100,000/500,000 x 150,000)___________________________________________

The allowable limit is the lower between limit A and B

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Chapter 8
Anticipation
 When the firm decides to go overseas, it predicts implicitly whether tax rates will change
over time. If the firm is offered a tax holiday for a fixed period of time, it must anticipate
the amount of tax increase that will occur at the expiration time. Similarly, firms should
forecast the extent to which existing general tax rates and treaties will change.
 Because treaties are bilateral agreements, firms typically look for signals that changes may
occur.
 In setting transfer prices, the firm must also anticipate the likelihood of a tax audit and
subsequent tax adjustment occurring. Because there is some latitude in setting such prices,
and the tax authorities know that firms exploit this, audits of transfer prices are common.

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Chapter 8
Anticipation and Timing
 If the firm anticipates a change in foreign tax rates or rules, it may want to adjust the
timing of its investments. Timing also affects ongoing transactions.
 Transfer prices, within reason, can be adjusted periodically to reflect changing relative tax
rates. If the Philippine parent transits into a lower tax rate, either the transfer price or the
quantity of inventory can be adjusted to shift more income into the Philippines.

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Chapter 8
Anticipation and Time Value
 Regarding organizational form, time value is most salient for corporate subsidiaries. In
corporate setting, payment of dividends can be postponed almost infinitely, such that their
net present value (NPV) can be nearly zero. Provided the company will not accumulate
earnings without legitimate purpose. Other organizational forms have no such advantage.
For example, share of partner in a business partnership is deemed received by the partner,
and, hence, subject to final tax of 10%.

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Chapter 8
Value-Adding
 Related to strategy is the fundamental idea that the pretax economics of overseas
investment must be sound. Accordingly, foreign tax incentives should influence location
choice only at the margin. If a planned operation is profitable solely because of tax
benefits, it should be avoided.
 Similarly, entity choice is affected by value-adding. On the firm’s balance sheet, joint
ventures, partnerships, branches, and the like are simply reported as an investment asset
and are not shown in detail.

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Adjusting Value-Adding for Risk
 Foreign ventures pose additional risk management problems for the firm. Part of this is
mitigated by entity choice. Direct export involves minimal risk; joint ventures and
partnerships provide local risk-sharing partners. Branches and subsidiaries put more of the
firm’s operations at risk.
 From a nontax perspective, operating risk can be mitigated by organizational form.
Forming a joint venture with a local operation adds the local’s knowledge. Forming as a
corporate like entity also gives the parent firm loss protection against liabilities generated.
by the foreign venture. This advantage should be weighed against the likelihood that, for
tax purposes, the parent’s loss may be classified as a capital loss.

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Chapter 8
Adjusting Value-Adding for Risk
 Besides operating risk, a major source of international risk is from currency rate
fluctuations. A risk occurs, for example, if the dollar devaluates and the firm is holding
dollars (or has to pay on a contract not denominated in dollars). A gain can occur if the
dollar goes up in value, and the firm holds dollars at year-end or pays on contracts
denominated in other currencies.
 Foreign currency exchange (FOREX) gains/losses from collection of receivables and
payment of liabilities are considered realized and are considered taxable gains/deductible
losses since these are considered completed transactions, but FOREX gains/losses resulting
from year-end conversion of foreign-currency denominated receivables and payables are
considered unrealized gains/losses and should be treated as a temporary tax difference.

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Chapter 8
Value-Adding and Transactions Costs
 Legal and accounting costs are higher for the corporate form and lowest for direct exports.
These costs vary by country and size of operation. In addition to import and export duties,
there are other transaction taxes to consider.

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Chapter 8
Negotiating
 Often local officials, especially in developing countries, can be negotiated with. This is
particularly true with regard to property taxes and other localized fees.
 Transfer prices on the part of the buying and selling firms may be negotiated. This is
particularly important if managers are evaluated on accounting profits. For example, if the
overseas selling subsidiary (manufacturer) is in a low-tax jurisdiction, tax minimization
implies setting the transfer price high. Yet this hurts the profits of the purchasing firm,
which in turn might result in reduced bonuses for the purchaser’s managers. Thus, tax and
performance objectives may need to be weighed.

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Chapter 8
Negotiating
 One way to manage international taxes is to negotiate with international authorities for
relief. A firm can negotiate local taxes as well as licenses and other fees. Negotiating
national taxes, such as the corporate income tax, is much more difficult to do.
 A final area of negotiation is with respect to transferring employees overseas. In some
cases, key employees must be transferred overseas against their preferences. In such cases,
the firm can help persuade them to move through incentives. Note that resident citizens are
taxable on income derived from within and without the Philippines. Non-resident citizens
such as OFW are taxable only on income derived from within. Their salaries abroad are not
subject to Philippine Taxation. Favorable taxes in the foreign country itself may be part of
the negotiation.

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Chapter 8
Transforming
 By utilizing a foreign subsidiary, a Philippine parent effectively transforms taxable income
into nontaxable income by deferral. Income of foreign subsidiary is not taxable in the
Philippines, unless it is declared dividends. Such dividends from foreign corporation forms
part of gross income of a domestic corporation in the computation of taxable income,
which will be subject to regular corporate income tax.

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Chapter 8
Assessment
 8-1.
 Globalization provides a number of tax opportunities that can enhance value of a firm. Effective tax management
entails familiarity with the home country and foreign tax structures.
 Discuss the impact of globalization to tax strategies of the company. Minimum of 500 words.
 8-2.
 Knowledge of a competitor’s tax rates can give one a better prediction of how the competitor will act (or react)
internationally.

Firm’s Effective Foreign Tax Rate

Competitor’s Effective Foreign
Tax Rate: High Low

High No strategic tax advantage to either Overseas strategic tax advantage to the firm
Overseas strategic tax advantage to the
Low No strategic tax advantage to either
competitor
 Enumerate at least five countries to which the Philippines has tax treaties. Summarize the content of the treaties per
country and discuss the corresponding competitive advantage of Philippine Corporation operating in such foreign
countries against domestic corporations of the respective countries.

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End