Chapter 17Taxes & Multinational Corporate Strategy,17.1The Objectives of National Tax Systems17.2Types of Taxation17.3U.S. Taxation of Foreign-Source Income17.4Taxes and Organizational Form17.5Transfer Pricing and Tax Planning17.6Taxes and the Location of Foreign Operations17.7Taxes and Cross-Border Mergers and Acquisitions17.8Summary,The income tax.,The income tax has made more liarsout of the American peoplethan golf has. Will Rogers,The objectives of tax neutrality,Domestic tax neutrality - incomes arising from domestic and foreign operations are taxed similarly by the domestic governmentForeign tax neutrality - taxes imposed on the foreign operations of domestic firms are the same as those facing local competitors in the host countries,Violations of tax neutrality,Taxes vary on income from different sourcesTax jurisdictions: foreign or domesticOrganizational forms: foreign branches or incorporated subsidiariesAsset classes: interest, dividends, or capital gainsFinancing instruments: tax deductibility of interest on debt,Forms of taxation,Explicit taxesCorporate and personal income taxesWithholding taxes on dividends, interest and royaltiesSales or value-added taxesProperty or asset taxesTariffs on cross-border trade,Forms of taxation,Implicit taxesThe law of one price in after-tax form “Equivalent assets sell for the same after-tax expected return”Countries with low tax rates tend to have low before-tax expected and required returns,The effect of implicit taxes on required returns,ExampleCountry fTf = 50% and if = 20% yield a return of if (1 Tf ) = 20% (1-0.5) = 10% after-taxCountry dIf Td = 20%, what is id in equilibrium?,The effect of implicit taxes on required returns,Equal after-tax returns meansif(1-Tf)=id(1-Td) 20%(1-0.5) =id(1-0.2)=10% id = 10%/(1-0.2) = 12.5%A 20% return at a 50% tax rate is equivalent to a 12.5% after-tax return at a 20% tax rate.,Taxes on foreign-source income,Two basic types of taxation systemsA worldwide tax system taxes foreign-source income as it is repatriated to the parent company.A territorial tax system levies a tax only on domestic income. Taxes on foreign-source income are only paid in the country in which they are earned.,U.S. taxation of foreign source income,In the worldwide tax system of the United States income from foreign subsidiaries is taxed as it is repatriated to the parentincome from foreign branches is taxed as it is earned,The organizational formof foreign operations,Most manufacturing firms conduct their foreign operations through foreign subsidiariesIncorporation in the host country limits the parents liabilityIncorporation avoids host country disclosure requirements on the parents worldwide operationsForeign branches can be used for start-up operations that are initially expected to lose money,The organizational formof foreign operations,Foreign branches are sometimes used by financial institutionsAdvantageForeign tax credit (FTC) limitations can be less binding for foreign branches than for foreign subsidiariesDisadvantagesForeign branches can be tax disadvantaged if the foreign branch is in a low-tax countryForeign branches can expose the MNC to legal liabilities,FTC limitations in the U.S.,Tax statements as single subsidiariesCanadaIsraelItalyaDividend payout ratio (%)100100100bForeign div withholding rate (%)555cForeign tax rate (%)263640dForeign income before tax ($s)100010001000eForeign income tax (d*c)260360400fAfter-tax foreign earnings (d-e)740640600gDeclared as dividends (f*a)740640600hForeign div withholding tax (g*b)373230iTotal foreign tax (e+h)297392430jDividend to U.S. parent (d-i) 703608570,FTC limitations in the U.S.,Tax statements as single subsidiaries (continued)IrelandItalyFrancekGross foreign inc before tax (d)100010001000lTentative US tax (k*35%)350350350mFTC - Foreign tax credit (i)297392430nNet US tax payable (MAXl-m,0)5300oTotal taxes paid (i+n)350392430pNet amount to U.S. parent (k-o)650608570qTotal taxes separately (So)$1,172,FTC limitations in the U.S.,Parents consolidated tax statementrOverall FTC limitation (Sk*35%)$1,050 sTotal consolidated FTCs (Si)$1,119 tAdditional U.S. taxes due (MAX0,r-s)$0 uExcess FTCs (MAX0,s-r)$69 (carried back 2 years or forward 5 years)Overall FTC limitation= (total foreign-source income)(U.S. tax rate),Income basketsActive incomePassive incomeOther (e.g., income from foreign sales corporations),Additional FTC limitations,Income basketsSubpart F income a passive income basketForeign subsidiaries owned more than 10 percent (e.g. controlled foreign corporations, or CFCs)Foreign holding company incomeForeign base company sales or service income,Additional FTC limitations,Income basketsSubpart F incomeIncome and expense allocation Allocation of interest expenseAllocation of R&D expenseAllocation of other expenses,