Critical Issues in International Financial Management



Strategic Tax Issues Confronting Managers of Global Enterprises

By John E. Karayan, JD PhD

This chapter provides an overview of key current tax issues faced by managers of global enterprises. Beginning with a framework for identifying tax saving opportunities in transactions arising in the ordinary course of business, the discussion moves on to key issues and sources for indirect tax planning. Then the discussion shifts to direct taxation, in particular the tax savings opportunities – and their other side, double taxation threats -- in income taxation due to tax treaties, repatriation of profits, transfer pricing, tax havens, and location choice decisions.

Introduction

Managers have long been faced with government regulations, such as worker protection, wage and price controls, and production standards (Braithwaite & Drahos 2000). However, the intensity of regulation has increased dramatically since the second world war; estimates that regulation costs 10% of a developed country’s gross domestic product are not unusual (e.g., Friedman 2003; see also the studies cited in Crain & Crain 2010, note 10). Although regulatory costs can be relatively larger for smaller businesses (World Bank 2013), managers of multinational enterprises face the additional complexity of dealing with multiple governments (Nicoletti, Scarpetta, & Boylaud 2000), whose rules and practices not only very tremendously but all too often conflict (cf. Braithwaite & Drahos 2000). This particularly is the case when dealing with taxation.

Taxes are charges not directly related to specific goods or services provided, which primarily are imposed in order to finance governments (FitzGerald 2012). They also are used for social engineering, such as redistribution of income (cf. Sanders 2014, and Cobham 2005) or internalizing environmental costs (Tol 2005). Some taxes are periodic, such as property or income taxes; others are transactional, such as value added taxes on sales or estate taxes at death. Taxes are calculated by applying a tax rate to a tax base (such as income or value). Tax rates can be flat (e.g., sales or property taxes), or change as the tax base changes (e.g., income, payroll, or estate taxes).

Strategic Tax Planning

Tax rules and practices are important for managers to know because taxes quite often add up to a large expense, and one with priority claim on an organization’s cash flow as well as a direct impact on a firm's bottom line (Karayan & Swenson 2006, at pp. xvi-xvii). Although the details of taxes are complex (see, e.g., Smith et al, 2014), and thus hard for managers to know, the goals and fundamental concepts can be grasped and used to identify strategic opportunities and threats (Karayan & Swenson 2006). Of course, taxes are only one of the many factors involved in organizational decision making. Sometimes tax considerations are a dominant factor – particularly in major transactions -- but most often they play only a minor role (id., at 5).

Karayan & Swenson (2006) propose the SAVANT™ framework to allow managers with a fundamental knowledge of taxation to identify and roughly evaluate strategic opportunities to manage tax costs in order to decide whether expert advice is warranted. In sum, SAVANT™ suggests that managers

need to stay focused on the firm’s strategic plan, anticipating tax impacts across time for all parties affected by the transaction. Managers add value by considering these impacts when negotiating the most advantageous arrangement, thereby transforming the tax treatment of items to the most favorable (id., at xvii.)

SAVANT™ identifies four basic categories of tax saving strategies. Creation involves taking advantage of tax subsidies, such tax credits for filming in a jurisdiction. Conversion entails changing operations so that more tax-favored categories of tax base result, such as capital gains. Timing involves techniques that move amounts being taxed (also called the tax base) to more favorable tax-accounting periods. Splitting involves tax rate arbitrage: spreading the tax base among two or more taxpayers to take advantage of differing tax rates. (Taxes can also be avoided through fraud (Barrett 1997; Cobham 2005), but implementing this strategy does not require reading books like this.)

Reflecting the Scholes-Wolfson paradigm (see, e.g., Callihan & White 1999), in their seminal work on strategic tax planning Karayan & Swenson (2006) reject the traditional goal of tax minimization currently plaguing multinationals like Caterpillar (Hagerty & McKinnon 2014), and articulate instead that the goal of managers of multinational enterprises more properly is optimizing tax costs. This requires balancing expected tax savings against the inevitable costs (cf., Scholes et al. 2014). Leading U. S. tax academic Professor Shevlin astutely illustrated this in a series of slides captioned “Why did the chicken cross the road? Because taxes were lower on the other side. Why didn’t all the chickens cross the road? Crossing the road can be costly”, with the final slide showing a chicken in the middle of a road about to be run down by a large truck (Shevlin 2013).

Indirect Taxes

Taxes generally fall into two basic categories. Unlike direct taxes, indirect taxes, such as tariffs, are not collected directly from those who bear the burden of the tax, such as the consumer of imports. For governments, this has the efficiency advantage limiting the number of taxpayers, as well as requiring compliance from more capable businesses. Indeed, Toder & Rosenberg (2010) cogently evaluate replacing payroll taxes or income taxes by an indirect tax on the value added by producers of goods and services. For a variety of reasons, indirect taxes are often favored by smaller governments and those in less developed economies (Boadway 2004; Fuest & Riedel 2009; FitzGerald 2012). Such taxes are important (Ernst & Young 2014b), and can be managed (Ernst & Young 2013). The key to good management most often is maintaining good accounting information systems, whether computerized or paper (id.).

Indirect taxes include sales taxes, a major source of funding for U. S. state and local governments, and value added taxes (VAT), a major source of funding for most European economies. (For tax planning regarding sales taxes, see Swenson, et al. 2004, at pp. 97-126; for a comprehensive discussion of VAT, see Carroll & Viard 2010. A list of custom’s duties and VAT rates for most countries can be found at United States Council for International Business, 2014.) Indirect taxes also include excise taxes and customs duties.

Excise taxes generally are a flat rate volume-related, impost on the consumption in the taxing country. More specifically, they are imposed on certain goods or activities produced for sale, sold, or operating within a jurisdiction. In this category fall many “sin” taxes, such as those on tobacco, alcohol, or marijuana taxes (Swenson, et al. 2004), as well as environmental taxes (see Cavaliere et al. 2006). In contrast, customs duties are taxes on goods being imported into the taxing country. These are alive and well (Ernst & Young, 2014a), notwithstanding long standing and generally successful efforts since the second world war (e.g., the General Agreement on Tariffs and Trade, now known as the World Trade Organization) to greatly reduce customs duties worldwide (Bown & Crowley 2013).

Indirect taxes are important (Ernst & Young 2014b), and increasingly so in recent years (id., at p. 10). The global great recession which began around 2009 has increased governmental desire for additional spending. At the same time, the recession has reduced the tax base for direct taxes such as property tax and income tax. Because indirect taxes are largely based on more recession-proof tax bases like consumption, many governments have responded by increasing their indirect rates. For example, between 2008 and 2013 the average European Union VAT rate increased by nearly 2 percentage point to over 21% while other countries have added new VAT or VAT-like goods and services taxes (id.). Harmonization of international VAT systems received a boost in 2014 with the OECD’s adoption of new guidelines for applying VAT across borders (OECD, 2014

While both of its partners in the North America Free Trade Agreement – Mexico and Canada – have VAT-like taxes, called goods and services taxes, the U. S. does not (Karayan & Swenson 2006, p. 29). A national VAT is not being considered in current legislative efforts to reform U. S. taxes (cf. PricewaterhouseCoopers 2014b). Although a legislative proposal for significant U. S. tax reform is before Congress ([U.S.] Joint Committee on Taxation 2014), it is unlikely that any major reforms will be enacted until the next President is in office (TTC 2014; Murphy 2014). However, most of the States in the union impose taxes on sales in the State of tangible personal property by retailers (Swenson, et al. 2004, at chapter 4) even if the retailers are not physically present in the jurisdiction (Goldenberg 2013). The sales tax base is similar to that for VAT taxes, except that instead of a credit for previous taxes on inputs, there is an exemption from sales taxes on inputs. Sales tax rates are well below the VAT rates imposed in the EU.

Indirect taxes can be managed (Ernst & Young 2013). Most often, the key to doing so is the straightforward but hard work of maintaining good accounting information systems, whether computerized or paper:

Dealing with indirect tax data is the key to effective indirect tax management. But the variety of indirect tax data required by different jurisdictions and the sheer quantity of relevant data now generated by large organizations can present a range of logistical issues... some of the challenges [include] large quantities of complex transactional data, and we outline some of the management approaches and technology tools that can help them achieve their goals. (Ernst & Young 2014a, at p. 2).

Generally, however, indirect taxes cannot be significantly reduced by tax planning which is not fairly intrusive on the day-to-day operations. Nor can significant savings be achieved by non-accounting specialists. Instead, managers and firms generally have had the greater success in optimizing the burdens of direct taxes (cf. Lee & Swenson 2012), particularly income taxes (e.g., Hagerty & McKinnon 2014).

Conventions to Reduce Double Taxation

Direct taxes are those collected directly from the taxpayer, such as income taxes, payroll taxes, property taxes, and estate/gift taxes. (For payroll tax planning techniques, see Swenson et al. 2004, at pp. 145 et seq.; for property taxes, see id., at pp. 127-144. For managing estate and gift taxes, see Khoury, et al. 2003, at pp. 480-599. ) For governments, direct taxes grant the great advantage of reaching a greater diversity and larger number of taxpayers, broader tax bases of wealth or income, and less resistance to imposing progressive tax rates (contra, Pomerleau 2014). These advantages, however, lead to collection inefficiencies, especially in less developed economies (Cobham 2005; cf. Boadway 2004).

Barriers to collection of income taxes can be reduced, however, by withholding at the sources of income, such as banks and employers (Huizinga & Nielsen 2003; see, generally, PricewaterhouseCoopers 2014a). In addition, the past 5 years has seen information barriers caused by hiding assets outside of a taxing country drop worldwide with many traditionally reticent countries (notably Switzerland) agreeing to share banking information with other countries (Bachetta & Espinosa 2000; cf. Tanzi & Zee 1999).

The most controversial reform in this area has been the U. S.’ wide-ranging, extraterritorial application of tax information reporting to non-U. S. financial institutions under the Foreign Account Tax Compliance Act (FATCA). Enacted March 18, 2010 as part of the Hiring Incentives to Restore Employment Act of 2010, Pub. L. 111-147 (H.R. 2847), FATCA requires foreign financial institutions (FFI) and other foreign withholding agents to withhold at a 30 percent rate on certain payments to an FFI unless the FFI has entered into an agreement (FFI agreement) to obtain status as a participating FFI and to, among other things, report certain information to the U. S. Treasury Department with respect to financial accounts held by U.S. citizens and residents, even if such reporting violates domestic law where the FFI is located United State Department of the Treasury Notice 2014-33 2014. (For a list of countries where FFI agreements already are in place, see United State Department of the Treasury Announcement 2014–17 2014.)

For cross-border enterprises, double taxation can result from more than one country taxing the income generated by the same transaction. The reason why this has long been considered problematic even by governments can be simply illustrated by positing that there are 2 countries with identical income tax systems both which impose a top income tax rate of 50%. If both countries impose their tax on the same item of income, 100% of the income will be taxed, leaving no after-tax return to the business and thus little incentive to engage in economic activity.

This problem has long been reduced through the use of bilateral tax treaties (Smith, et al., 2014, at chapter 2 p. 6). Greatly assisting worldwide harmonization, model treaties have been developed (e.g., Organization for Economic Cooperation and Development (OECD) 1997) and are widely used (Karayan & Swenson 2006, at p. 249). The resulting tax treaties have reduced double taxation primarily by limiting a government’s authority to tax only those businesses which have a significant presence in the country in the form of a “permanent establishment” (Smith, et al., 2014, at chapter 13, p. 5). Treaty countries thereby refrain from taxing profits resulting from sales to their residents effected remotely (e.g., over the Web) or transiently (e.g., by a traveling salesman). Instead, taxation generally does not result unless the seller maintains a significant physical presence in the taxing country, like an office. [Similarly, the U. S. bars its states from taxing businesses which do not have a significant presence – called nexus – in the taxing state, although nexus requires less of a physical presence than a permanent establishment

(Karayan 2009).]

The risk of double taxation also can be reduced by the structure of a country’s income tax system. The vast majority of countries use a territorial system to identify which transactions will be taxed. (Smith, et al., 2014, at chapter 13, p. 6). Under a territorial system, income is not taxed unless its source is within the country’s border. Generally this requires the income producing object or activity to be located in the country. For example, territorial systems tax wages earned only when an employee performs services while physically located in the taxing country. Similarly, rents are taxed only if generated from property located in a country. Business income is taxed where the business is located; in U. S. taxation, this is called “effectively connected income” (see generally Smith, et al., 2014, at chapter 13).

Sourcing rules like these are more complex in the case of income from intangible properties, the presence of which is ephemeral (id., at pp. 7-9). For example, royalties generally by the use of an intangible, such as the screening of a film, are taxed only to the extent the property is used in the country (e.g., a local movie theater). Interest and dividends generally are sourced to the country where the paying bank or other payor is located; gains from the disposition of intangibles (“capital gains”) generally are sourced to the country where the owner of the shares, bonds, or other intangibles resides (see, generally, Karayan & Swenson, 2006, at pp. 241-268).

Impacts on Repatriation of Profits

Territorial systems generally have the side effect of deferring income taxes on activities outside the taxing country until the resulting profits are repatriated to the taxing country.

This provides incentives for domestic enterprises to employ capital outside the taxing country (e.g., by expanding non-domestic operations), or to store capital abroad and access it for domestic purposes via complex corporate loan structures.

A few countries, notably the U.S., tax the worldwide income of their citizens and residents (for a comparison of the tax systems of 189 countries, see PricewaterhouseCoopers 2014a). Thus, when it comes to income earned outside of the country, both the country of citizenship/residence and the country where the income is earned have authority to tax the income (e.g., Canada Income Tax Act Section 126.1(b)). The possibility that the same income is taxed by more than one country is mitigated in two basic ways. First is by excluding certain levels of wages and other compensation earned outside the country of citizenship/residence while on a long term (e.g., 12 month) assignment (e.g., under U. S. Internal Revenue Code Sections 911, et. seq.). The second mechanism is a credit against income taxes in the country of citizenship/residence for the income taxes imposed by the country where the income is earned (e.g., under U. S. Internal Revenue Code Section 901, et. seq.) Although simple in concept, the details are very complex (PricewaterhouseCoopers 2014a; see also Smith, et al., 2014, at chapter 13).

However, even in worldwide systems, multinationals usually can avoid immediate domestic taxation on foreign income by housing the income in foreign subsidiaries (PricewaterhouseCoopers 2014b). This is because corporations, even subsidiaries, generally are considered separate taxpaying entities. One key effect is deferring income taxes on activities outside the taxing country until the resulting profits are repatriated to the taxing country. In turn, this provides incentives for domestic enterprises to employ capital outside the taxing country (e.g., by expanding non-domestic operations), or to store capital abroad and access it for domestic purposes via complex corporate loan structures. (It also has the effect of deferring credits against domestic tax for foreign income taxes paid on the foreign income (see Smith, et al., 2014, at chapter 13, pp. 14-21)).

Firms thus tend to use techniques which defer recognizing current income only for earnings in countries where the effective tax rate is lower. Although this is tolerated for earnings legitimately generated in a low tax country, very complex rules – such as the controlled foreign corporation rules -- have been developed by the U. S. to limit multinational firms’ ability to artificially shift income into lower tax jurisdictions (see [U.S.] Joint Committee on Taxation. 2014). One key technique to accomplish this is known as transfer pricing (OECD 2013a; OECD 1998) which is discussed below.

Taxing cross-border income (and wealth) raises the specter of both tax evasion (see generally Fuest & Riedel 2009) and double taxation (Tanzi 1996a). To some extent, they are two sides of the same coin. “Tax evasion” is the wrongful avoidance of taxation by any country (see Barrett 1997). In contrast to tax evaders illegally attempting to avoid their legitimate tax burdens, “double taxation” is a term of art in international law which refers to the same tax base being subject to taxation in more than one country.

For a multinational endeavor, double taxation partly is due to different jurisdictions imposing income taxes on similar but different tax bases (see PricewaterhouseCoopers 2014a, which describes key aspects of tax systems in over 180 countries.) The slow, and incomplete, coordination of the business income tax base among Members of the European Union is an excellent example. Unlike indirect taxes, the EC [European Union] Treaty does not specifically call for direct to be harmonized. Instead, direct taxation has remained the sole responsibility of Member States. Instead, Article 94 of the Treaty requires that Member States to strive for approximate coordination. Harmonization has yet to occur, except in a few common policies (e.g., the parent-subsidiary rules found in European Union Council Directive 2003/123/EC.)

In other words, even in the EU, efforts to harmonize tax systems (in the EU, moving from 27 different corporate income tax systems into one tax system) have proven unsuccessful. The policy of having a common business income tax base was adopted in 2001 (European Commission 2001) and confirmed in 2003 (European Commission 2003). Called the consolidated corporate tax base, this policy not only would conform the definition of the tax base -- taxable income -- across the EU, but would also have the advantage to firms of being able to file a one tax return for the whole of their activity in the EU. However, it is still in the proposal stage (European Commission 2011).

It is unlikely that income tax base harmonization will soon appear in the EU; the prospects for worldwide tax harmonization are remote (compare FitzGerald 2012 with Tanzi 1996b). Indeed, income taxes are yet to be harmonized among the U. S. Federal government, its 50 States, and its other political subdivisions (Swenson, et al. 2003). To a greater extent than in the EU, however, voluntary efforts among the States such as the adoption of model statutes like the Uniform Division of Income for Tax Purposes Act (id., at pp. 49 et seq.) and membership in the Multistate Tax Compact (id., at pp. 66 et seq.) have resulted in increasing commonalties in the income tax base among these jurisdictions.

Furthermore, there are similar efforts by transnational bodies to develop model tax provisions to help conform certain aspects of international taxation. For example, in 2013, the OECD published a report on international income tax base erosion and profit shifting (BEPS). Known as the OECD BEPS Report, it concluded that although there was no empirical evidence that multinational enterprises were significantly eroding the international income tax base nor reducing tax revenues in any specific country. (OECD 2013a) The Report also noted that multinationals have a duty to their owners to take lawful steps to reduce tax burdens (id.), and that “planning strategies being castigated in the press simply involved multinationals legitimately using current rules” (Herrington, et al. 2013, at p. 1).

However, the Report concluded that the current system of international income taxation “does not reflect today’s economic integration across borders, the value of intellectual property or new communications technologies” (Organization for Economic Cooperation and Development (OECD), 2013b). As a result, the OECD issued an Action Plan proposing certain changes to reduce the legal base erosion and profit shifting opportunities embedded in current law (OECD 2013c).

The prescriptions presented generally are neither new nor innovative (Herrington, et al. 2013), except for those providing that certain “dematerialized digital” enterprise can be found to have a “virtual permanent establishment” (Collins, Holle, & Strong 2014, at p. 2). Similar to developments in U. S. state and local tax nexus allowing a state to tax businesses with no physical presence in the state (Fields, Newmark, & Call 2013; cf. Susko & Schubmehl 2013), firms with sufficient “virtual” presence could be taxed by a country even though none of the firm’s employees or agents ever set foot in the country. A rapid endorsement in principle of the Action Plan by G20 leaders (Zailer, et al. 2014) suggests that there may be greater political support for change than there has been in the past (Collins, Holle, & Strong 2014).

Transfer Pricing

Perhaps the most contentious issue in income tax base erosion is transfer pricing (Markle 2012). For a variety of legitimate business reasons, related parties often sell goods and services to each other. This may entail a parent company providing common management services – e.g., accounting or information technology -- to a subsidiary (Bartelsman & Beetsa 2003). It also may entail two controlled by the same parties buying and selling inventory to each other (e.g., Monsanto’s new climate insurance subsidiary located in San Francisco selling data to Monsanto’s agri-science subsidiary locate in the U. K.) Because such arrangements set the prices for the transfer goods and services between related parties, the theory behind choosing the appropriate pricing of such sales is called “transfer pricing” (see, generally, OECD 2013b).

Legitimate business concerns often impact the pricing methodology chosen. For example, many firms require than their subdivisions purchase inventory and services from other subdivisions in order to utilize spare capacity. Although this might result in the purchasing division paying more than it might were it to freely access the market, this is done because it optimizes the net income of the group of companies. Similarly, purchases from within a corporate group might be mandated to assure just-in-time deliveries in order to reduce the group’s overall inventory holding costs, or to avoid educating or financing possible competitors.

International tax rules long have required such transaction to be priced at current market rates (Webb 2004). The reason is simple. If a firm has a subsidiary in a country with a 25% tax rate (e.g., a typical EU country), and a subsidiary in a country with a 35% tax rate (e.g., the U. S.), then the firm’s overall tax burden could be reduced merely by having an EU seller charge an artificially higher price to a related purchaser located in the U. S. Although market prices are readily in many commodity markets, they are not observable for a host of goods and services. This is widely recognized by tax authorities throughout the world when the products or services sold are not standard, but instead are custom-tailored to the purchaser specifications.

Even greater difficulties arise in determining the market price for the sale of intangibles, such as the right to use patented production processes. The trend for more and more economic activity which involves intangibles has exacerbated the challenges to both taxpayers and tax authorities in determining market prices. A variety of pricing methodologies have been developed, such as cost-plus pricing, comparable profits methods, and the profit-split methods, but information asymmetries between multinational enterprises and tax auditors is feared by many higher tax countries as a cause of wrongful profit shifting and tax base erosion.

Location Choice, Unfair Tax Competition, and Tax Haven Abuse

A similar concern has been raised about unfair tax competition between developed and developing nations (Webb 2004), often subsumed in calls to shut down abusive uses of tax havens (U. S. Joint Committee on Taxation 2011; The Wall Street Journal 2014b.) Tax havens are countries with relatively low income tax rates (see Mintz & Chen 2014 for an argument that the U. S. is a tax haven; see also Donohoe, McGill, & Outslay 2012). Lower income tax rates can affect the locations chosen by multinational enterprises for expanding or simply relocating their operations (for the poverty reduction advantages of a developing country which adopts competitive tax rates, see Dollar Kleinberg, & Kraay 2013; for rich country concerns, see European Commission's Directorate-General for Taxation and Customs Union 2009; see also European Commission's Directorate-General for Taxation and Customs Union 2012 for an application to financial instruments). However, lower tax rates are only one of many considerations involved in location choice; concerns about transportation costs, necessary infrastructure, rule of law, political stability, and labor availability often dominate tax considerations in choice firms’ location choices (Moore, Steece, & Swenson 1997; Devereux & Griffith 2003; cf. Jaumotte, Subir, & Papageorgiou 2013).

Ireland long offer significantly lower income tax rates than those imposed by the U. S., as well as the EU, to high tech companies. This resulted in substantial operations being located in Ireland which could have been located in the U.S or other EU countries. Although countries like France and Germany have complained that Ireland is engaged in unfair tax competition, the EU has yet to make significant step towards harmonization corporate tax rates. The major concern, instead, is with the abuse of tax havens through techniques like unfair transfer pricing which improperly shifts profits earned in higher tax countries to tax havens.

Summary

This chapter provided an overview of key current tax issues faced by managers of global enterprises. Brevity was necessitated by the nature of this book; multi-volume treatises have been published on each of the issues discussed. However, the discussions are replete with references to sources of information for readers wishing greater details. Beginning with a framework for identifying tax saving opportunities in transactions arising in the ordinary course of business, the discussion moved to indirect tax planning. Then the discussion shifted to direct taxation, in particular the tax savings opportunities – and their other side, double taxation threats -- in income taxation due to tax treaties, repatriation of profits, transfer pricing, tax havens, and location choice decisions.

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