Class Notes 12
Tax and Transfer Pricing
Momo Deretic
Sauder School of Business
Each country has its own tax rules
Rules differ in tax rates, income bases
(i.e., what is taxed), and timing of income
recognition.
A resident of one country earning income
in another country may potentially be
subject to tax on the same income both in
the home country and in the country of
business. When the same income is
taxed twice, it is called double taxation.
Entities
The basis of taxation will depend on the
legal entity involved.
If a MNE sets up an entity that is incorporated
in a foreign country, it is a foreign subsidiary.
The foreign subsidiary is a separate legal
entity from the parent.
If an MNE operates directly in a foreign
country without incorporating, the foreign
operation is a branch. A branch is part of the
same entity as the parent.
Branches versus subsidiaries
If a Canadian company sets up a branch in
Chile, the branchs earnings are subject to both
Canadian and Chilean tax
If a Canadian company sets up a subsidiary in
Chile, and the Chilean subsidiary does not do
business in Canada, then Chile only taxes the
earnings of the Chilean subsidiary. However, the
dividends, royalties, interest payments flowing
from the subsidiary to the Canadian parent are
subject to Canadian taxes.
Export earnings are not taxed by importing country
Withholding Taxes
In addition to applying business income tax rates
to business income, most countries impose
withholding taxes on dividends, interest,
royalties and management fees.
Withholding taxes can potentially trigger double
taxation in two ways:
(1) Business income that is repatriated to a parent is
taxed first at business income tax rates and then
again on the payment of the dividend.
(2) All the payments subject to withholding taxes are
also subject to regular income tax in the country of
the recipient.
Foreign Tax Credits (FTCs)
To alleviate the burden of double taxation, most
countries offer foreign tax credits (FTCs).
Foreign tax credits are a direct reduction of tax
in the country offering the FTC.
Generally, the foreign tax credit will be the lesser
of:
the foreign taxes paid, or
domestic taxes owed on foreign income
In effect, a taxpayer ends up paying a total tax at
the higher rate of the two countries.
Treaties
Most developed and many less developed
countries have tax treaties with each other that
are intended to reduce or eliminate the effects of
double taxation.
They also set upper limits to withholding tax
rates.
Since each tax treaty is different, the withholding rates
can vary, depending on which countries are involved.
For example, interest paid by a Canadian resident to an
American resident is subject to a 15% withholding tax;
but interest paid by a Canadian resident to a British
resident is only subject to a 10% withholding tax.
Canada's taxation of foreign subsidiaries
Taxes depend on the degree of ownership, the
type of income and which country the income
comes from
Dividend income on portfolio investments is subject to
regular Canadian tax. A foreign tax credit can be
claimed with respect to the foreign withholding taxes
paid.
Dividends received from foreign affiliates (foreign
corporations in which the investor owns at least 10%
of any class of shares) are often tax exempt
Taxation of direct investment in Canada
Income from an active business earned in a treaty
country (i.e., a country with which Canada has a tax
treaty) is exempt from Canadian tax. Suppose, for
example, Northern Telecom sets up a subsidiary in
Portugal (which is a treaty-country). The subsidiary sells
NT products (which is an active business) and then pays
dividends to Northern Telecom Canada. That dividend
income is totally exempt from Canadian income tax.
Income from an active business earned in a non-treaty
country is subject to tax when a dividend is paid.
However, Canadian tax law, however, allows for tax
credits for foreign tax payments.
Thin Capitalization
One obvious way of minimizing tax when investing in a high tax
country is to finance the subsidiary with debt rather than equity.
That way normal earnings will be taxed in the home country rather
than in the country where the income is earned. Most high tax
countries (such as Canada) therefore have a thin capitalization rule.
If the debt-equity ratio of a foreign parent's investment in a Canadian
subsidiary exceeds 3:1, part of the interest expense is not
deductible.
Foreign parents will therefore normally try to finance their Canadian
operations with a debt-equity ratio of just under 3:1.
Canada U.S.
Interest payment
U.S.
affiliate
loan
Tax Havens
Bermuda and the Cayman Islands have no
business taxes, while Panama and Liberia do
not tax income from foreign sources. MNEs can
set up affiliates in these tax haven countries and
shift income from affiliates in high tax countries
to the affiliate in the tax haven.
When governments of developed countries
discover loopholes by which a tax haven can be
used, they typically change the rules to shut the
loophole down. Moreover, Canada has a
general anti-avoidance rule, designed to reverse
any abusive tax manoeuvre.
Shifting income to tax havens
Canco sets up a financing company in the Cayman
Islands that provides a loan to Canco's affiliate in
Sweden. The interest payment to the Cayman Island
affiliate lowers the taxable income of the Swedish
affiliate and is not taxed in the Cayman Islands.
Interest payment
Canco
Sweden
Canco CY
loan
Transfer Pricing
Whenever one entity sells a good or service to another
entity, there must be a price. When the entities are
related corporations, the price is called a transfer price.
Transfer pricing is an issue in the sale of goods, the
provision of services by head office, and royalty charges
between related corporations.
When the corporations are related, there is potential for
abuse, since the firms could potentially select a price
that minimizes total taxes, but does not reflect economic
reality.
Tax law therefore requires that prices be at fair market
value.
Unfortunately (or fortunately for tax planners), fair market
value for internal transactions is usually difficult to
determine. Usually, there is a range of prices that could
reasonably be considered fair.
