Multinational Business Finance 12th Edition Slides Chapter 20

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Chapter 20

Multinational Tax Management

Copyright © 2010 Pearson Prentice Hall. All rights reserved.20-2


• Tax planning for multinational operations is an extremely complex but vitally important aspect of international business.

• To plan effectively, MNEs must understand not only the intricacies of their own operations worldwide, but also the different structures and interpretations of tax liabilities across countries.

• The primary objective of multinational tax planning is the minimization of the firm’s worldwide tax burden.



• Taxes have a major impact on corporate net income and cash flow through their influence on foreign investment decisions, financial structure, determination of the cost of capital, foreign exchange management, working capital management, and financial control.

• Management must not pursue the objective of minimizing the firm’s worldwide tax burden without full recognition that decision making within the firm must always be based on the economic fundamentals of the firm’s line of business.


Tax Principles

• Tax morality:– In many countries taxpayers, corporate or

individual, do not voluntarily comply with the tax laws

– The MNE must decide whether to follow a practice of full disclosure to tax authorities or adopt the philosophy “When in Rome, do as the Romans do”

– Most MNEs follow the full disclosure practice


Tax Principles

• Tax neutrality:– When a government decides to levy a tax, it must

consider not only the potential revenue from the tax, or how effectively it can be collected, but also the effect the proposed tax can have on private economic behavior

– For example, the US government’s policy on taxation of foreign-source income has multiple objectives:

• Neutralizing tax incentives that favor or disfavor US private investment in developed countries

• Providing an incentive for US private investment in developing countries

• Improving the US BOP

• Raising revenue


Tax Principles

• One way to view neutrality is to require that the burden of taxation on each dollar, euro, pound, or yen of profit earned in home country operations by a MNE be equal to the burden of taxation on each currency equivalent of profit earned by the same firm in its foreign operations (domestic neutrality).

• A second way to view neutrality is to require that the tax burden on each foreign subsidiary of the firm be equal to the tax burden on its competitors in the am country (foreign neutrality).

• In theory, an equitable tax is one that imposes the same total tax burden on all taxpayers who are similarly situated and located in the same tax jurisdiction.


Tax Principles

• Despite the fundamental objectives of national tax authorities, it is widely agreed that taxes do affect economic decisions made by MNEs.

• Tax treaties between nations and differential tax structures, rates, and practices all result in a less than level playing field for the MNEs competing on world markets.

• Nations typically structure their tax systems along one of two basic approaches:– The worldwide approach

– The territorial approach


Tax Principles

• The worldwide approach, also referred to as the residential or national approach, levies taxes on the income earned by firms that are incorporated in the host country, regardless of where the income was earned (domestically or abroad).

• A MNE earning income both at home and abroad would therefore find its worldwide income taxed by its home country tax authorities.

• For example, a country like the US taxes the income earned by firms based in the US regardless of whether the income earned by the firm is domestic or foreign in origin.


Tax Principles

• The territorial approach, also termed the source approach, focuses on the income earned by the firms within the legal jurisdiction of the host country, not on the country of firm incorporation.

• Countries like Germany follow this approach and apply taxes equally to foreign or domestic firms on income earned within the country, but in principle not on income earned outside the country.

• The territorial approach, like the worldwide approach, results in a major gap in coverage if resident firms earn income outside the country but are not taxed by the country in which the profits are earned.


Tax Principles

• If the worldwide approach to international taxation is followed to the letter, it would end the tax-deferral privilege for many MNEs.

• Foreign subsidiaries of MNEs pay host country corporate income taxes, but many parent countries defer claiming additional income taxes on that foreign source income until it is remitted to the parent firm.


Tax Principles

• A network of bilateral tax treaties, many of which are modeled after one proposed by the Organization for Economic Cooperation and Development (OECD), provides a means of reducing double taxation.

• Tax treaties normally define whether taxes are to be imposed on income earned in one country by the nationals of another, and if so, how.

• Tax treaties are bilateral, with the two signatories specifying what rates are applicable to which types of income between themselves alone.


Tax Principles

• Taxes are classified on the basis of whether they are applied directly to income, called direct taxes, or to some other measurable performance characteristic of the firm, called indirect taxes.

• Some categories include:– Income tax

– Withholding tax

– Value-added tax

– Other national taxes


Tax Principles

• To prevent double taxation on the same income, most countries grant a foreign tax credit for income taxes paid to the host country.

• A tax credit is a direct reduction of taxes that would otherwise be due and payable.

• If there were no credits for foreign taxes paid, sequential taxation by the host government and then by the home government would result in a very high cumulative tax rate.


Transfer Pricing

• The pricing of goods, services, and technology transferred to a foreign subsidiary from an affiliated company, called transfer pricing, is the first and foremost method of transferring funds out of a foreign subsidiary.

• These costs enter directly into the cost-of-goods-sold component of the subsidiary’s income statement.

• This problem is particularly sensitive for MNEs.


Transfer Pricing

• Fund Positioning Effect– A parent company wishing to transfer funds out of a

particular country can charge higher prices on goods sold to its subsidiary in that country, to the degree that government regulations allow.

– A foreign subsidiary can be financed by the reverse technique, a lowering of transfer prices.

– A major consideration in setting a transfer price is the income tax effect.


Transfer Pricing

• Methods of Determining Transfer Prices– IRS regulations provide three methods to establish arm’s

length prices:

• Comparable uncontrolled prices

• Resale prices

• Cost-plus calculations

– In some cases, combinations of these three methods are used.


Transfer Pricing

• Other Considerations for Transfer Pricing– Managerial incentives and evaluation

– Effect on joint-venture partners

– Flexibility of host governments to transfer pricing strategies utilized


Tax Management at Trident

• The following exhibit summarizes the key tax management issue for Trident when remitting dividend income back to the United States from Trident Europe and Trident Brazil:

– Due to higher corporate income tax rates in Germany than the United States, dividends remitted to the United States parent result in excess foreign tax credits

– As a result of the lower corporate income tax rates in Brazil compared to the United States, dividends remitted to the US parent result in deficit foreign tax credits


Exhibit 20.6 Trident’s Tax Management of Foreign-Source Income


Tax-Haven Subsidiaries and International Offshore Financial Centers

• Many MNEs have foreign subsidiaries that act as tax havens for corporate funds awaiting reinvestment or repatriation.

• Tax-haven subsidiaries, categorically referred to as international offshore financial centers, are partially a result of tax-deferral features on earned foreign income allowed by some of the parent countries.


Tax-Haven Subsidiaries and International Offshore Financial Centers

• Tax-haven subsidiaries are typically established in a country that can meet the following requirements:– A low tax on foreign investment or sales income earned by

resident corporations and a low dividend withholding tax on dividends paid to the parent firm

– A stable currency to permit easy conversion of funds into and out of the local currency

– The facilities to support financial services activity

– A stable government that encourages the establishment of foreign-owned financial and service facilities within its borders


Exhibit 20.7 International Offshore Financial Centers


Mini-Case Questions: Stanley Works and Corporate Inversion

• If Stanley did indeed reincorporate offshore, how do you think the company would restructure its operations, both inside and outside the United States?

• Do you believe that the U.S. government should allow a company like Stanley to reincorporate outside the country in order to pay lower taxes?

• If you were John Trani, would you continue to pursue the outbound inversion or choose to stay put?


Exhibit 20.1 Comparison of Corporate Tax Rates: Japan, Germany, and the United States


Exhibit 20.2 Corporate Income Tax Rates for Selected Countries, 2008


Exhibit 20.3 Value-Added Tax Applied to the Sale of a Wooden Fence Post


Exhibit 20.4 Foreign Tax Credits


Exhibit 20.5 Effect of Low versus High Transfer Price on Trident Europe’s Net Income(thousands of U.S. dollars)


Exhibit 1 Stanley Works U.S. Tax Liabilities before the Outbound Corporate Inversion


Exhibit 2 Stanley Works U.S. Tax Liabilities after the Outbound Corporate Inversion


Exhibit 3 Prospective Changes in Stanley Works’ Earnings after Inversion

Multinational Business Finance 12th Edition Slides Chapter 20

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