INTERNATIONAL

FINANCIAL
MANAGEMENT
EUN / RESNICK
Fifth Edition
Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin
Fifth Edition

Chapter Objective:

This chapter provides a brief introduction to the
international tax environment.
21
Chapter
Twenty-One
International Tax
Environment and
Transfer Pricing
21-1
Chapter Outline
The Objectives of Taxation
Types of Taxation
The National Tax Environments
Organizational Structures for Reducing Tax
Liabilities

The Objectives of Taxation
Tax Neutrality
Tax Equity
Types of Taxation
The National Tax Environments
Organizational Structures for Reducing Tax
Liabilities

The Objectives of Taxation
Types of Taxation
Income Tax
Withholding Tax
Value-Added Tax
The National Tax Environments
Organizational Structures for Reducing Tax
Liabilities
The Objectives of Taxation
Types of Taxation
The National Tax Environments
Worldwide Taxation
Territorial Taxation
Foreign Tax Credits
Organizational Structures for Reducing Tax
Liabilities
The Objectives of Taxation
Types of Taxation
The National Tax Environments
Organizational Structures for Reducing Tax
Liabilities
Branch and Subsidiary Income
Payments to and from Foreign Affiliates
Tax Havens
Controlled Foreign Corporation
The Objectives of Taxation
Types of Taxation
The National Tax Environments
Organizational Structures for Reducing Tax
Liabilities

21-2
The Objectives of Taxation
The twin objectives of taxation are:
1. Tax Neutrality
2. Tax Equity
21-3
Tax Neutrality
A tax scheme is tax neutral if it meets three criteria:

1. Capital Export Neutrality: the tax scheme does
not incentivise citizens move their money abroad.
2. National Neutrality: taxable income is taxed in
the same manner by the taxpayers national tax
authorities regardless of where in the world it is earned.
3. Capital Import Neutrality: the tax burden on a
MNC subsidiary should be the same regardless of where
in the world the MNC in incorporated.
21-4
Tax Equity
Tax Equity: regardless of the country in which an
affiliate of a MNC earns taxable income, the same
tax rate and tax due date should apply.
The principal of tax equity is difficult to apply;
the organizational form of the MNC can affect the
timing of the tax liability.

21-5
Types of Taxation
Income Tax
Withholding Tax
Value-Added Tax


21-6
Income Tax
An income tax is a tax on personal and corporate
income.
Many countries in the world obtain a significant
portion of their tax revenue from income taxes.
An income tax is a direct tax, that is one that is
paid directly by the taxpayer upon whom it is
levied.

21-7
Corporate Income Tax Rates in
Selected Countries
3
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Income Tax Rate
21-8
Withholding Tax
Withholding taxes are withheld from the
payments a corporation makes to the taxpayer.
The taxes are levied on passive income earned by
an individual or corporation of one country within
the tax jurisdiction of another country.
Passive income includes dividends and interest
income, income from royalties, patents, or
copyrights.
A withholding tax is an indirect tax.
21-9
U.S. Tax Treaty Withholding Rates
Selected Countries
Dividends
Country Interest
Paid by
U.S.
Corporation
Qualifying for
Direct Dividend
Rate Royalties
Nontreaty
countries 30 30 30 30
Australia 10 15 5 0
Belgium 15 15 5 0
Canada 10 15 5 0
China 10 10 10 10
France 0 15 5 5
Germany 0 15 5 0
Ireland 0 15 5 0
21-10
Value-Added Tax
A value-added tax is an indirect national tax
levied on the value added in production of a good
or service.
In many European and Latin American countries
the VAT has become a major source of taxation
on private citizens.
Many economists prefer a VAT to an income tax
because the incentive effects of the two taxes
differ sharply.
21-11
Value-Added Tax
An income tax has the incentive effect of
discouraging work.
A VAT has the incentive effect of discouraging
consumption (thereby encouraging saving).
VATs are easier to administer as well. While
taxpayers have an incentive to hide their income,
producers have an incentive to make sure that
their upstream suppliers in the production process
declare the value added (and pay the tax!).
21-12
Value-Added Tax Calculation








In this example, the tax rate is 15 percent. Suppose that stage
one is the sale of raw materials to the manufacturer; stage
two is the sale of finished goods to a retailer; stage three is
the sale of inventory from the retailer to the consumer.








Production
Stage

Selling
Price

Value
Added

I ncremental
VAT

1

100

100

2

300

200

3

380

80





Total
VAT
= 100 .15
= 200 .15
= 80 .15
= 380 .15
15
30
12
57
21-13
Other Types of Taxation
A wealth tax is a tax levied not on income but on
the wealth of a taxpayer. Property taxes are an
example.
A poll tax is a tax on your existence. It is so called
because it was collected from those who wished
to vote.

21-14
The National Tax Environments
Worldwide Taxation
Territorial Taxation
Foreign Tax Credits
21-15
Worldwide Taxation
Tax national residents of the country on their
worldwide income no matter in which country it
was earned.
21-16
Territorial Taxation
Territorial taxation tax residents based upon
where the taxable event occurred.
21-17
Foreign Tax Credits
Allows taxpayers to recover somewhat from
double taxation.
Direct foreign tax credits are computed for direct
taxes paid on active foreign-source income of a
foreign branch of a U.S. MNC or on withholding
taxes withheld from passive income.
Indirect foreign tax credits are for income taxes
deemed paid by the subsidiary.

21-18
Organizational Structures for
Reducing Tax Liabilities
Branch & Subsidiary Income
Payments to and from Foreign Affiliates
Tax Havens
Controlled Foreign Corporation
Foreign Sales Corporation

21-19
Branch & Subsidiary Income
An overseas affiliate of a U.S. MNC can be
organized as a branch or a subsidiary.
A foreign branch is not an independently
incorporated firm separate from the parent.
Branch income passes directly through to the parents
income statements.
A foreign subsidiary is an affiliate organization of
the MNC that is independently incorporated.
Income may not be taxed in the U.S. until it is
repatriated, under certain circumstances.
21-20
Payments to and from
Foreign Affiliates
Having foreign affiliates offers transfer price tax
arbitrage strategies.
The transfer price is the accounting value
assigned to a good or service as it is transferred
from one affiliate to another.
If one country has high taxes, dont recognize
income therehave those affiliates pay high
transfer prices. If one country has low taxes,
recognize income therehave those affiliates pay
low transfer prices.
21-21
Transfer Pricing & Related Issues
The Transfer Price is the price that for accounting
purposes, is assigned to goods and services
flowing from one division of a firm to another
division.
Controversial even for a domestic firm.
Consider the example of a firm that has one division
that mills lumber and another that makes furniture. The
transfer price of the lumber is a political as well as
economic and accounting issue.
21-22
Transfer Pricing & Related Issues
For MNC, there exists the added complications of:
Differences in tax rates.
Import duties and quotas.
Exchange rate restrictions on the part of the
host country.
Most countries have regulations controlling transfer
pricing.
In the U.S., the tax code requires transfer prices to be
arms length prices.
21-23
Arms Length Price
A price that a willing seller would charge a
willing unrelated buyer.
The IRS prescribes three methods for estimating
an arms length price
Comparable uncontrolled price.
Resale price: the price at which the good is resold by the
affiliate is reduced by overhead and profit.
Cost-plus approach: an appropriate profit is added to the
cost of the manufacturing affiliate.
21-24
Blocked Funds
A form of political risk is the risk that the foreign
government may impose exchange restrictions on
its own currency.
Several methods exist for moving blocked funds:
Transfer pricing
Unbundling services
Parallel and back-to-back loans
Swaps
21-25
Blocked Funds
Additional strategies for unblocking funds:
Export creation
Direct negotiation
Using the blocked funds to buy goods and services for the
MNC.
For example, use the National Airlines of the host country for
travel of executives of the MNC, and pay for the tickets with the
blocked funds.
Transfer local expatriates from home payroll to the local
subsidiaries payroll.
21-26
Tax Havens
Tax havens are countries with low corporate
income tax rates and low withholding tax rates on
passive income.
Tax havens were once useful as locations for a
MNC to establish a shell company.
The Tax Reform Act of 1986 greatly diminished
the need for and ability of U.S. corporations to
profit from the use of tax havens.
21-27
Controlled Foreign Corporation
The Tax Reform Act of 1986 created a new type
of foreign subsidiary: the controlled foreign
corporation.
A controlled foreign corporation is a foreign
subsidiary that has over half of its voting stock
held by U.S. shareholderseven if these
shareholders are unaffiliated.
21-28
Controlled Foreign Corporation
The undistributed income of a minority foreign
subsidiary of a U.S. MNC is tax deferred until it is
remitted via a dividend.
This is not the case with a controlled foreign
corporationthe tax treatment is much less
favorable.
The result is that foreign tax credits are unlikely
to be completely used.
21-29
End Chapter Twenty-One
21-30