For multinational corporations, tax planning has become extremely complex affairs. It has been stated that no multinational corporation possesses the ultimate tax expertise. Therefore, in addition to having their own experts, MNCs rely on heavily on local tax experts and legal counsel.
Taxes have a very important impact on foreign direct investment decisions. Taxes will determine the financial structure of subsidiary, and they will influence pricing decisions. They may also lead to the formation of holding companies. An MNC may decide to establish a branch rather than a subsidiary because of a given tax situation. The absence of a tax treaty between the country of a would-be investor and the nation where a foreign investment is to take place might lead to cancellation of investment plans. An unfavorable depreciation allowance may keep the foreign investor out.
Basically, an tax system can be divided into direct and indirect taxes. Corporate and individual income taxes are direct, value-added taxes, sales taxes, and import duties are indirect taxes. Corporate income taxes (taxes levied on earning) vary among the industrialized nations. France, the United States, Holland, Canada, and Germany have rates of around 50 percent; Italy, the United Kingdom and Japan have rates of between 36 and 40 percent.
Less developed countries usually have lower corporate tax rates in order to attract foreign investment. Thus, Brazil has a rate of 30 percent, and Indonesia has a 40 percent tax rate. A corporate tax is levied on taxable earnings. Taxable earnings are more significant than the tax rate itself. They determine what can be deducted before the tax is computed; in other words, these items are tax deductible. Countries differ greatly in determining taxable earnings. Some allow accelerated depreciation, whereby the asset (usually the plant or equipment) is written off at a substantially higher rate during the first years than in the later years. This allows for smaller taxable earnings in the early years. Other countries allow tax-free investment reserves. These are used at a later stage for investment in undeveloped areas of countries or are sent when countries are in a recession.
A recent type of tax that has won recognition in the European Common Market is value-added tax (VAT). This is a national sales tax levied at each stage of production or at the sale of consumer goods. The tax is assessed in proportion to the value added during that stage. Generally, manufacturing goods, such as plant and equipment, have been exempted from this tax. In most cases, food items also have been exempted.
Here is an example of how VAT works. A tree owner sells part of a tree to a lumber mill for $1 must set aside ten cents VAT to pay to the government. The lumber mill processes the tree into building material and sells the wood for $3 to a lumber wholesaler. The mill adds $2 in value, and thus sets aside 10 percent of the added value, or twenty cents, to pay to the government. And so the VAT continues until the final sale.
The VAT system offers advantages, such as rebates on exports. Profitable and unprofitable firms are taxed alike, as there is no possibility of tax deductions to determine taxable income. A badly run company is, therefore, forced to improve or go out of business. Further, VAT is easy to calculate and collect. But VAT is often accused of having contributed to serious inflation in countries where it was introduced, notably in Western Europe.
There are numerous other national taxes. A withholding tax is from a foreign corporation and is levied on interest paid on loan. A withholding tax is also levied on dividends remitted to the parent company. W withholding tax is usually mitigated by a tax treaty which may lower, suspend, or abolish a withholding tax. In the case of the United States, tax treaties have been made with some twenty-three countries, most of them industrial nations. The purpose of a tax treaty is to avoid double taxation in both the home and foreign country. The United States also eases its tax burden through foreign tax credits, which limits the combined foreign and United States tax on foreign income to the higher of the two rate. If the foreign tax is lower, some of the United States tax is payable. If it is higher, no additional United States tax is payable. Some excess foreign tax may even be averaged out with other foreign taxes for the same year.
Tax treaties allocate certain types of income to a particular country, rather than lump foreign earnings together in foreign source income. Moreover, tax treaties reduce withholding taxes on dividends and interest on loans, and they sometimes wipe them out completely. Tax treaties are always bilateral, meaning they are agreements between two countries.
Relatively few treaties have been signed between developed and less developed countries. This is because the flow of dividends, royalties, and interest is likely to be in only one direction---from the less developed to the developed country. The less developed country has no investments in the developed country and therefore would not benefit from a tax treaty in which withholding taxes are lowered reciprocally.
As we have seen, tax rates, whether withholding, corporate, or VAT, differ greatly among countries. Some countries have a zero corporate tax rate for the first few years of a new subsidiary’s existence. This is called a tax holiday. It is an investment incentive. Most incentives, however, relate to tax-deductible items. Some countries may allow 100 percent depreciation on machinery in the year of purchase, while others merely allow an accelerated depreciation in the first years. Some countries grant an investment credit for the purchase of machinery. Others may actually give a cash grant to purchase machinery. France, which gives grants of up to 30 percent of the purchase price o machinery and plant, ties the level of grants to the number of jobs created and to the location of the investment.
Countries which have initiated a system of tax incentives can be divided into three groups. One group consists of developed nations. These may have chronic unemployment problems like Great Britain and Northern Ireland. Others may have potential unemployment like France, where as a result of a reorganization of agriculture, many young farmers will eventually lose their jobs and will be available for industry. Still other developed nations may want to attract foreign investment because of chronic balance-of-payments problems. A developed country’s incentives might be aimed at diverting domestic investments from one type of investment to another (e.g., from commercial buildings to plants) or from a developed region to a depressed area.
The second group of nations offering incentives is the less developed countries. They are seeking to industrialize but cannot do this by themselves. They need foreign capital, so they quite commonly offer tax holidays lasting from five to ten years.
The third group consists of tax haven countries and areas, where certain taxes are low or nonexistent. It is not the goal of such nations to attract foreign industry within their borders, rather, a tax haven country benefits from financial and commercial activity that evolves around a tax haven subsidiary. Multinational corporations often establish subsidiaries in a tax haven for the purpose of buying products manufactured in a country outside the tax haven. Subsequently, the products are sold by the tax haven subsidiary, where corporate taxes are low. Thus, profits are much more substantial than if the products were sold directly from the manufacturing country to the country of final sale. This system is called transfer pricing. Tax authorities in other countries are well aware of this practice, but it is usually not worthwhile for them to make a case of it. The United States Internal Revenue Act tried to eliminate such tax avoidance schemes only when transfer price were artificially altered to accumulate income in tax havens rather than in the country of sale or in the manufacturing country. Some tax havens are primarily places where funds earned and taxed in one foreign country can be channeled into other foreign countries without ever having been repatriated to the parent company.
A parent company with many foreign subsidiaries is likely to establish a holding company in tax haven. This company receives profits earned in one country and passes them on to another subsidiary for reinvestment. Such profits always remain outside the home country. Thus, a home country’s tax on dividends from a foreign subsidiary can be deferred until the tax haven subsidiary transfers funds to the parent firm.
Some well-known tax havens are Luxembourg, Liechtenstein the Bahamas, Switzerland, and the Netherlands Antilles. Hong Kong also has its tax haven policy. Basically, these tax havens share certain qualities, such as a stable currency and relatively loose foreign exchange regulations. A tax haven must have facilities to support financial services. For example, it needs qualified office personnel and good telephone and telex communications. It must also have a stable government which encourages foreign-owned holding companies that provide financial and commercial services.
When a company is formed abroad, it is often advantageous to set it up in the form of a branch. A branch is not a separate legal entity; it is merely an extension of the parent company. A branch will normally incur losses in its first years, but the parent company can offset these losses against its own profits. In a foreign subsidiary, which is a separate legal entity, profits are only taxed in the foreign country if they have been repatriated to the parent company in the form of dividends. A branch is advantageous in countries which do not impose a withholding tax on repatriated branch earnings but do on dividends from subsidiaries. A branch will always have its earnings taxed buy the home country; a profitable subsidiary can defer the tax liability in the home country simply by postponing repatriation of dividends. Therefore, when a branch becomes profitable, it should, in most cases, be replaced by a subsidiary.
In the area of tax incentives, United States legislation plays a prominent role on the world scene. This is so because the large MNCs are mostly United States owned and because the United States takes an imaginative approach in encouraging business activities in specific parts of the world. The United States tax incentives center on several types of foreign-based operations. A Western Hemisphere trade corporation (WHTC) trades exclusively with Western Hemisphere nations. A WHTC, a domestic United States corporation, is allowed a special deduction for tax purposes, generally resulting in a 34 percent corporate tax as opposed to the regular 48 percent. The purpose of this incentive originally was to spur foreign direct investment in less developed nations, but so far this has not significantly materialized. WHTCs engage mainly in exporting. In order to be a WHTC, at least 95 percent of a corporation’s sales must come from outside the United States. A WHTC is included in a consolidated United States tax return, making it possible to offset WHTC losses with profits realized in affiliated companies.
Under the system of a domestic international sales corporation (DISC), shareholders pay taxes on 50 percent of the earnings. They are taxed regardless of whether they receive dividends or not. The other half of a DISC’s exporting business. Or it may be used to make loans to United States producers to export-related assets. As soon as a company no longer qualifies as a DICS, a tax is imposed on the shareholders for the previously deferred portion. The DICS itself is not subject to federal income tax. To qualify as a DISC, a corporation must receive at least 95 percent of its gross receipts from exports and exports-related investments. The DISC, whether as principal or agent, may export United /states manufactured goods, food, or extracted products.
The ideal tax system, in which profits increase and economic behavior stays the same (or at least does not deteriorate), is hard to find. And even if MNCs found this situation, the pressure on them is mounting. In 1974 the United Nations expressed concern about inter-company transfer pricing. Presently, 25% of world trade is between related companies. It is a safe assumption that transfer pricing will be under severe scrutiny by governments in the years to come. In a report on MNCs, the United Nations has also criticized the use of tax havens to avoid or defer taxes to the home country. Further, tax holidays have come under increasing attach by the United Nations, mainly because they enable MNCs to play one country against another. This is sometimes infringes upon the sovereignty of a nation. Therefore, the United Nations has tried to bring about agreement on setting a maximum length of tax holidays, limiting accelerated depreciation, and specifying the level and scope of investment grants.