Università Bocconi, A.A: Mec – Comparative public economics 1 Università Bocconi A.A Comparative public economics Giampaolo Arachi

Università Bocconi, A.A: Mec – Comparative public economics 2 Multinational tax planning The decision to invest at home or abroad The decision to repatriate or reinvest Limitations to tax deferral FTC limitation Tax Planning under FTC limitation References: M. Scholes, M. A. Wolfson, M. Erickson, E. L. Maydew, T. Shevlin (SWEMS), Taxes and business strategy: a planning approach, Pearson Prentice Hall, third edition, 2005, ch. 11

Università Bocconi, A.A: Mec – Comparative public economics 3 The decision to invest at home or abroad Assumptions: Tax base is the same in home and foreign country Domestic tax rate greater than foreign tax rate: t d > t f FTC cannot exceed taxes paid abroad Home country investment for n years accumulates to: 1 + R d (1-t d )] n = (1+r d ) n Foreign country investment for n year accumulates to (after repatriation): Foreign investment is more attractive if : R d, t f low R f, t d, n high

Università Bocconi, A.A: Mec – Comparative public economics 4 The decision to repatriate or reinvest For each $ earned abroad: 1-t f can be repatriated or reinvested After n years (1-t f )$ repatriated accumulate to: (1 - t d ) [1 + R d (1 - t d ) ] n = (1 - t d ) [1 + r d ] n After n year (1-t f )$ reinvested abroad accumulate to: (1 - t f ) (1 + r f ) n – [(1 - t f ) (1 + r f ) n ] (t d -t f ) (1-t f ) = [1 + r f ] n (1 - t d ) reinvest if r f > r d

Università Bocconi, A.A: Mec – Comparative public economics 5 US: Subpart F income and CFCs Provisions designed to prevent firms from forming paper companies in tax haven to record income from passive investment, sales, services, shipping operations or oil related activities In general these rules work by subjecting Subpart F income to U.S. taxation as if the income was repatriated the the U.S. parent when the income is earned Controlled Foreign Corporation (CFC) owned more than 50% in terms of voting power or market value by US shareholders A US shareholder is any US person owning at least 10% of the voting stock

Università Bocconi, A.A: Mec – Comparative public economics 6 Subpart F income Income from the insurance of risks outside the country in which the CFC is organized Foreign based company income Foreign personal holding company income or FPHCI (dividends, interest, rents, royalties, etc.) Sales income Service income Shipping income Oil and gas related income

Università Bocconi, A.A: Mec – Comparative public economics 7 CFC rules and inversion transactions Many foreign countries do not have CFC rules  US based multinationals may be disadvantaged compared with similarly positioned multinationals based abroad  Ristructuring of corporate groups so that the parent company would be incorporated abroad (Cayman islands) Inversion: placing of the former U.S. corporation under a newly created foreign parent corporation formed in a low tax jurisdiction that does not have CFC rules exploiting a non taxable transaction under Sections 351 and 368 Anti-inversion rules: outbound mergers and stock transfers do not qualify for tax-free treatment unless the shareholder of the transferred U.S. corporation receive less than 50% of the shares of the foreign acquiring corporation in the transaction

Università Bocconi, A.A: Mec – Comparative public economics 8 FTC limitation where: FSI = foreign income earned through foreign branches + foreign income repatriated from foreign subsidiaries + Subpart F Worldwide income = domestic source income + FSI Usually US tax on worlwide income = t US x worldwide income FTC limitation = FSI x t US

Università Bocconi, A.A: Mec – Comparative public economics 9 Excess FTC How to minimize FTC excess given the FTC limitation? Increase income and tax credit in low tax countries and reduce income and tax credit in high tax countries Modify dividend payout policy: defer distribution in high tax countries and increase dividends from low tax countries

Università Bocconi, A.A: Mec – Comparative public economics 10 Example of FTC Subsidiary location Country ACountry BTogether 1Local taxable income Local tax rate20%40% 3Local tax (2*1) Net income (1-3) Dividend (50% payout *4) Withholding tax (10%*5) Dividend net of foreign taxes (5-6) Deemed-paid credit (=(5/4)*3) US taxable income = US tax (35% of 9) Foreign tax credit (8+6) Net US tax FTC tax credit carryforward05520

Università Bocconi, A.A: Mec – Comparative public economics 11 Example of FTC Subsidiary location Country ACountry BTogether 1Local taxable income Local tax rate20%40% 3Local tax (2*1) Net income (1-3) Dividend Withholding tax (10%*5) Dividend net of foreign taxes (5-6) Deemed-paid credit (=(5/4)*3) US taxable income = US tax (35% of 9) Foreign tax credit (8+6) Net US tax FTC tax credit carryforward0440

Università Bocconi, A.A: Mec – Comparative public economics 12 Separate basket limitation The FTC limitation must be computed separately for each basket of income Any income not in a specific basket goes into the general limitation basket Passive incomeFinancial services income Shipping incomeHigh withholding tax income Foreign trade incomeFSC income Income from noncontrolled CFC owned 10% or more

Università Bocconi, A.A: Mec – Comparative public economics 13 Tax Planning under FTC limitation Firms in an excess credit positions have incentives to reduce their taxes paid in foreing countries Distribribute profit from foreign subsidiaries in ways that are tax deductible abroad –Interest on debt owned to the US parents or US subsidiaries –Rent on leases with the US parent or US subsidiaries –Royalties on licences Transfer Pricing for goods and services

Università Bocconi, A.A: Mec – Comparative public economics 14 Transfer Pricing OCSE guidelines Section 482 (US code) “Arm’s length pricing” Transaction between related parties must be priced as if they involved unrelated parties Problems: transactions within related parties are systematically different from those that take place at arm’s length in the market goods and services transferred within a corporate group have no ready market (e.g. intangible assets as patents and trademarks) US approach “Advance pricing arrangements” The firm submits its proposed transfer-pricing methodology to the IRS for review. If the IRS agrees, then in principle the firm’s tranfer pricing should not be challenged as long as the firm adheres to the agreement

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Università Bocconi, A.A: Mec – Comparative public economics 16 State taxes – (Eu formula apportionment) No transfer pricing regulation Taxable income allocated across jurisdiction according to an average on percentage of sales, assets, labor cost