TAXATION
Tax planning is crucial for any business because taxes can profoundly affect profitability
and cash flow. This is especially true in international business. As complex as domestic
taxation seems, it is simple compared to the intricacies of international taxation. The
international tax specialist must be familiar with both the home country’s tax policy on
foreign operations and the tax laws of each country in which the international company
operates.
Taxation has a strong impact on several choices.
Location of the initial investment
Choice of operating form, such as export or import, licensing agreement, overseas
investment
Legal form of the new enterprise, such as branch or subsidiary
Method of financing, such as internal or external sourcing and debt or equity
Method of setting transfer prices
Export of Goods and Services:
Many manufacturers find it easier and more profitable to sell expertise, such as patents or
management services, than to export goods or to invest abroad. Generally payment comes
from royalties and fees, and the foreign government usually taxes this payment. Because
the parent makes the sale of services, the sale also must be included in the parent’s
taxable income
To gain tax advantages from exporting, a U.S. can set up a foreign sales corporation
(FSC) according to strict IRS guidelines. To qualify as an FSC, a company must be engaged in
the exporting of either merchandise or services, such as engineering or architectural
services. Substantial economic activity must also occur outside the United States. An FSC
cannot be a mailbox company in Switzerland that simply passes documents from the
United States to the importing country. It must :
Maintain a foreign office
Operate under foreign management
Keep a permanent set of books at the foreign office
Conduct foreign economic processes (such as selling activities)
Be a foreign corporation
Foreign Branch:
A foreign branch is an extension of the parent company rather than an enterprise incorporated in a
foreign country. Any income the branch generates is taxable immediately to the parent, whether or
not cash is remitted by the branch to the parent as a distribution of earnings. However, if the
branch suffers a loss, the parent is allowed to deduct that loss from its taxable income, reducing its
overall tax liability.
Foreign Subsidiary:
While a branch is a legal extension of the parent company, a foreign corporation is an
independent legal entity set up in a country (incorporated) according to the laws of
incorporation of that country. When an MNE purchases a foreign corporation or sets up a
new corporation in a foreign country, that corporation is called a subsidiary of the parent.
Income that is earned by the subsidiary is either reinvested in the subsidiary or remitted as
a dividend to the parent company. Subsidiary income is either taxable to the parent or tax
deferred – that is, it is not taxed until it is remitted as a dividend to the parent. Which tax
status applies depends on whether the foreign subsidiary is a controlled foreign
corporation – CFC (a technical term n the U.S. tax code)- and whether the income is active
or passive.
Transfer Prices:
A major tax challenge as well as an impediment to performance evaluation is the extensive
use of transfer pricing in international operations. A transfer price is a price on goods and
services sold by one member of a corporate family to another, such as from a parent to its
subsidiary in a foreign country. Because the price is between related entities, it is not
necessarily an arm’s-length price – that is, a price us more likely than a transfer price to
reflect the market accurately.
Companies establish arbitrary transfer prices primarily because of differences in
taxation between countries. For example, if the corporate tax rate is higher in the parent
company’s country than in the subsidiary’s country, the parent could set a low transfer
price on products it sells the subsidiary in order to keep taxable profits low in its country
and high in the subsidiary’s country. The parent also could set a high transfer price on
products sold to it by the subsidiary.
Companies also may set arbitrary transfer prices for competitive reasons or because of
restrictions on currency flows. In the former case, if the parent ships products or materials
at a low transfer price to the subsidiary, the subsidiary would be able to sell the products
to local consumers for less. In the later case, if the subsidiary’s country has currency
controls on dividend flows, the parent could get more hard currency out of the country by
shipping products at a high transfer price or by receiving products at a low transfer price.
Because prices can be manipulated for reasons other than market conditions, arbitrary
transfer pricing makes evaluating subsidiary and management performance difficult. In
addition, the tax authorities of a country (such as the IRS, the Internal Revenue Service, in
the United States) can audit the transactions of an MNE to determine whether the prices
were made on an arm’s-length basis. If not, they can assess a penalty and collect back
taxes from the company.
Tax Credit:
Every country has a sovereign right to levy taxes on all income generated within its
borders. However, MNE run into a problem when they earn income that is taxed in the
country where the income is earned and where it might also be taxed in the parent country
as well. This could result in double taxation.
In U.S. tax law, a U.S. MNE gets a credit for income taxes paid to a foreign government.
For example, when a U.S. parent recognizes foreign-source income (such as a dividend
from a foreign subsidiary) in its taxable income, it must pay U.S. tax on that income.
However the U.S. IRS allows the parent company to reduce its tax liability by the amount of
foreign income tax already paid. However, it is limited by the amount would have had to
pay in the United States on that income. A tax credit is a dollar-for-dollar reduction of tax
liability and must coincide with the recognition of income.
NON-U.S. TAX PRACTICES:
Differences in tax practices around the world often cause problems for MNEs. Lack of
familiarity with the laws and customs can create confusion. In some countries, tax laws are
loosely enforced. In others, taxes generally may be negotiated between the tax collector
and the taxpayer- if they are ever paid at all.
Variations among countries in GAAP can lead to differences in the determination of
taxable income. This, in turn, may affect the cash flow required to settle tax obligations.
For example, companies n France can depreciate assets faster than would be the case in
the United States, which means that they can write off their value of inventories, which
increases their cost of goods sold and lowers taxable income.
Taxation of corporate income is accomplished through one of two approaches in most
countries: the separate entity approach, also known as the classical approach, or the
integrated system approach. In the separate entity approach, which the United States
uses, each separate unit – company or individual – is taxed when it earns income. For
example, a corporation is taxed on its earnings, and stockholders are taxed on the
distribution of earnings. The results is double taxation
Most other developed countries use an integrated system to eliminate double taxation.
The British give a dividend credit to shareholders to shelter them from double taxation.
That means when shareholders report the dividends in their taxable income, they also get
a credit for taxes paid on that income by the company that issued the dividend. That keeps
the shareholder from paying tax on the dividend because the company had already paid a
tax on it.
Countries also have unique systems for taxing the earnings of the foreign subsidiaries
of their domestic companies. Some, such as France, use a territorial approach and tax only
domestic source income.
Value- Added Tax:
A value- added tax has been around since 1967 in most Western European countries and is
used in other countries as well. A VAT is computed by applying a VAT tax rate on total
sales. However, any company that purchased materials or other inputs into its
manufacturing process from companies that might have already paid a VT on their sales
needs to pay the tax only on the difference between its sales and inputs that have already
been taxed. As the name implies, VAT means that each independent company is taxed only
on the value it adds at each stage in the production process. For a company that is fully
integrated vertically, the tax rate applies to its net sales because it owned everything from
raw materials to finished product.
Despite efforts by the EU toward harmonization among its members, the VAT rates
vary significantly among European countries. However the EU is narrowing differences in
rates for like categories of goods. The VAT does not apply to exports, because the tax is
rebated (or returned) to the exporter and is not included in the final price to the consumer.
This practice results in an effective stimulus for exports. In addition, it is considered by U.S.
tax officials and MNEs to be a subsidy to European exports, because the export price can
be lower than the domestic price of goods by the amount of the VAT.
Tax Treaties: The Elimination of Double Taxation
The primary purpose of tax treaties is to prevent international double taxation or to
provide remedies when it occurs. The United States has active tax treaties with more than
48 countries. The general pattern between two treaty countries is to grant reciprocal
reductions on dividend with holding and to exempt royalties and sometimes interest
payments from any withholding tax.
The United States has a withholding tax of 30 percent for owners (individuals and
corporations) of U.S. securities that are issued in countries with which it has no tax treaty.
However, interest on portfolio obligations and on bank deposits it is normally exempted
from withholding. When a tax treaty is in effect, the U.S. rate on dividends generally is
reduced to 15% and the tax on interest and royalties is either eliminated or is reduced to a
very low level.
An example is a protocol to the 1980 tax treaty between the United States and Canada.
It took effect on January 1, 1996, and it,
1. Reduces the withholding rate on dividends paid to a corporation owing 10 % or more of
the voting stock of the payer. The withholding rate amounted to 6% for payments in 1996
and 5% thereafter.
2. Reduces the withholding rate on interest to 10%
3. Reduces the tax resulting from the imposition of both U.S. estate tax and Canadian
income tax on transfers at death.
Several treaties and protocols were signed between the United States and foreign
countries with an effective date of January 1, 1996 and they were very similar.
Planning The Tax Function:
Because taxes affect both profits and cash flow, they are a consideration in MNEs’
investment decision process. If a U.S. MNE decides to generate revenues through exports,
it can set up an FSC to reduce its tax bill - assuming that the FSC survives the WTO process
or that the U.S. can come up with something else if the FSC has to be eliminated. When a
U.S. parent company decides to set up operations in a foreign country, it can do so through
a branch or a foreign subsidiary. If the parent expects the foreign operations to show a loss
for the initial years of operations, it should begin with a branch, because the parent can
deduct branch losses against its current year’s income.
Both debt and equity financing affect taxation. If loans from the parent finance foreign
operations, the repayment of principal is not taxable, but the interest income to the parent
is taxable. Also, the interest that the subsidiary pays is generally a business expense for
that entity, which reduces taxable income in the foreign country. Dividends are taxable to
the parent and are not a deductible business expense for the subsidiary. One reason why
international finance subsidiaries are set up outside the United States is to escape with-
holding tax requirements.
An MNE aiming to maximize its cash flow worldwide should concentrate profits in tax-
haven or low-tax countries. This can be accomplished by carefully selecting a low-tax
country for the initial investment, setting up companies in tax-heaven countries to receive
dividends, and carrying out judicious transfer pricing.
Growing Importance of International Accounting:
1)In today’s society, business and cultural environment are playing a significant change in
the life of many people. More and more businesses are beginning to operate both
domestically and internationally. The expansion of business has lead the world into a new
era filled with creative technology, making life easier. With the effects of international
pressures, businesses sometimes need to adapt to or try to influence culture. Culture is
what people value and believe. Trying to change a person’s perspective about one’s culture
is not easy. Yet, cultural environment is changing slowly, as people are more concern with
what is going on economically, politically, financially, and social and legally. Due to these
changes, international factors are becoming more important. Along with that comes for
accounting change. Many businesses have to conduct a lot of surveys and advertisements
to see what consumers are looking for. Global business has created many jobs,
competition, technology, and much more. With these differences in mind every business
might have its own accounting system. This is because of cultural, economic, political, and
legal system differences. Laws that are convenient and easy to understand in the US might
have no meaning at all to another country. Usages of vocabulary can have a great effect in
business depending on what the word means. Developing countries might have a much
simpler accounting system than those of the developed countries. Every country has its
own style of living and working conditions. If one accounting system were use to satisfy
everyone country it would be confusing and worthless to certain countries because of
differences in things like taxes, sizes of business, compensation plan, or rules and laws.
Since the world has a different perspective of how the world should be manage decisions
are made very differently. So, it is important for businesses to notice of what is going on
around the world to stay competitive and survive.
2) Since the economy is constantly changing and effecting people’s life, stock market is
getting more and more important. Stock market is becoming more important because
many people are relying on it to earn a savings for the future. People are concern with
what is going on in the economy for they are afraid of another recession. If the stock
markets are not functioning positively, this tells people that the country in not in a good
financial standard and that product prices will increase. As a matter of fact it can cause
unemployment, low financial standing. And the slowing down of the economy as a whole.
When this happens people will consume a lot less. To avoid this tragedy, many people are
learning more and paying closer attention to the stock market so they can make better
investment decisions. Especially people that are retired or going to be retiring. They are
the ones who rely on the stock market to support their living. Similarly, young people are
investing early because they are better educated and are more involved in society. By
investing early will help them early will help them earn a good saving for future uses when
its time for them to retire.
3) The most important international pressures for change in accounting during the early
years of the twenty-first century would be culture, ethics, and legal systems. Cultural
differences causes people to think and do things differently. It is because of these
differences that people holds a different ethical view. Depending on what culture a person
is from, his or her perspective of society, institutions, values, laws, etc. are interpreted
differently. What seems ethical and legal to certain culture may be irrational to a stranger.
For instance, country A might be more concerns about pollution while country B worries
about providing it’s people with the highest living standard possible. What seems legal may
not seem ethical to certain people. With so many new technology and businesses in
today’s world, people’s life can be said to have gotten more complicated. In fact,
businesses are expected to deal with the differences in accounting system because people
will not yield their way of practices just for one business. Besides it is hard for such thing to
happen because every country has it’s own requirements and so a standard accounting
system is just too hard to deal with. Therefore, accounting development in the global
economy should coincide with people’s opinion (culture) and laws and be preparing to
adapt to changes while doing business.
4) Constraints on change are very important to national cultural differences. Majority of
people does not like changes. In fact they would even resist changes. This is because
people tend to think that their culture is superior and successful everywhere. Nobody likes
to be wrong. People always want to be perfect and right. Besides they feel that their
culture is comfortable and easily to adapt to. Yet, they do not consider the consequences
from other people’s ideas because they were raise to accept their culture as a give fact.
However, most of them do not notice that they are changing bit by bit. People are
beginning to accept ideas from other culture without realizing it. This is a result of
education and technology. As people are building up their knowledge, they share
information with other people from different nationalities. Thus, causing a change in
culture slowly in the long run since no one knows exactly where the original information
came from.
