Many countries – including major U.S. trading partners – have moved to a form of "territorial" taxation that exempts most active foreign income from taxation.
A complex matrix of treaties and multi-country agreements govern international trade. Similarly, there’s no single international law governing international taxation. With no global authority to set a worldwide standard, each country is free to set its own standards. The resulting patchwork of national rules and regulations makes international tax planning and compliance more than a little complicated. Companies must carefully structure operations and define a strategy for each country in order to maximize legal tax advantages.
Understand the tax structure in each country
All countries tax income that’s generated within the country. Income generated from international operations may or may not be taxed, depending on the country. The United States uses a “worldwide” taxation system that taxes the active foreign income of U.S.-based multinational companies. However, many countries – including major U.S. trading partners – have moved to a form of “territorial” taxation that exempts most active foreign income from taxation.
A 2016 chart from the Tax Foundation, a Washington, D.C.-based policy institute, shows how countries treat foreign profits. Marginal corporate tax rates also vary by country. The United Arab Emirates tops the chart with a 55 percent rate. The United States is third, with a 38.9 percent rate, and Cameroon rounds out the top 20 with a 33 percent marginal corporate tax rate. The worldwide weighted GDP average is 29.5 percent. A dollar in profit earned in one country might equal 80 cents under one tax structure, but just 45 cents at the highest rate.
There are even more variables. Within countries, individuals and corporations may be subject to value-added taxes (VAT), sales taxes and various consumption taxes. Determining what is taxable, under what circumstances, and the tax rates involved in each transaction can be a laborious, country-by-country process. Yet, no company can do adequate tax planning without that sort of business intelligence.
Find the right balance in transfer pricing
Transfer pricing is a simple concept that carries many complex tax implications. When the subsidiaries of multinational corporations move goods, services or intangibles from one subsidiary to another, these movements have to be captured and reported as sales and expenses. The process by which companies set the value of the transfers is a controversial process, with critics highlighting it as an unfair tax avoidance strategy.
“Politicians on both sides of the Atlantic are putting increasing pressure on worldwide companies such as Apple, Google, Microsoft, Amazon and Starbucks to alter their transfer pricing arrangements and pay more corporation tax, yet these firms, and others like them are simply working within the confines of existing tax laws.”
Nevertheless, transfer pricing is not only legal, it’s a necessary accounting tool. Here’s how it works: Company A has a corporate headquarters in the United States, but wants to produce or sell goods in Thailand via an international subsidiary. Thailand’s marginal corporate income tax rate is 20 percent, a good deal lower than the U.S. rate. Although the U.S. uses a worldwide taxation structure, companies are allowed to deduct foreign taxes paid as an expense. That reduces their income tax bill in the U.S. and offers an incentive to maximize taxable income in Thailand to reduce the tax obligation in the United States.
Transfer pricing is an important part of this equation. When Company A “sells” products or intellectual property (i.e. permission to use patents or trademarks) to the Thailand subsidiary, it has to set a price. Unlike pricing set by the free market, however, this is a case of a company essentially selling to itself and setting the price independently of the market. Ideally, Company A would want to set a low transfer price to reduce its domestic revenue and tax obligation. Meanwhile, the Thailand subsidiary would increase its own profits because it gets the goods/services at a bargain price and pays lower taxes.
Tax laws require that transfer prices meet the “arms-length” standard, meaning that cost of the goods/services should be comparable to market prices. “Comparable” is a rather elastic term and often hard to quantify. Commodities, for instance, are easy to price: the price of oil is roughly the same worldwide. However, companies providing unique technology, intellectual property or specialized services can’t draw on a market price. They must find another company offering a “comparable” service to calculate transfer costs.
Multinationals must very careful with this process to avoid legal and political scrutiny. Too much profit in Thailand would raise a red flag that Company A may be trying to do an end run around U.S. tax laws. Remember that tax policy doesn’t exist in a vacuum. It’s a natural part of the political process, and any business must consider the political and public relations aspect of any tax strategy.
Consider the global implications of your tax strategy
A company’s international tax strategy is determined, in part, by how the company is structured. Each country has different tax rates, regulatory requirements, and registration requirements for foreign business entities. A company that manufactures in the United States and then sells the product overseas would necessarily have a different strategy than one with multiple foreign subsidiaries or partnerships. Those choices are business-based decisions that have tax implications.
However, some structural options are used mainly for tax advantage. Trademark and intellectual property holding companies are some of the most popular. They are variants on the transfer pricing strategy. Company A sets up a trademark holding company in a low-tax country, such as Ireland, and transfers ownership of all its trademarks to that entity. Then, Company A pays royalties to its holding company for use of the trademarks and counts those payments as deductible business expenses.
Tax experts must be an important part of the team assigned to create and structure holding companies. The American Bar Association’s Section on International Property Law highlighted the potential pitfalls of intellectual property holding companies at a workshop in 2015.
Double taxation treaties sometimes affect the structure and tax treatment of holding companies. They prevent a company from paying taxes twice on the same income. Most double taxation treaties contain exceptions for “tax avoidance measures,” which is why it’s imperative to have tax experts involved when holding companies are considered.
If the holding company’s structure appears to be mainly a vehicle for tax avoidance, then the multinational company could face unexpected tax liabilities in the U.S.
“In the United States, the majority of professional advisors are of the opinion that U.S. anti-conduit rulings related to interest payments apply equally to royalty payments. The IRS has not sought to pursue this line of attack, but has ruled (Ruling 80/263) that a ‘secondary withholding tax’ applies to certain royalty payments which ostensibly benefit from treaty protection.”
During the past decade, many countries have attempted to become more competitive and attractive to foreign investment by lowering marginal corporate tax rates and switching to a territorial taxation system. Technology has made companies increasingly mobile, so teams can easily collaborate/communicate with their international partners via web-based platforms. That makes international expansion a more attractive option than in the past.
The rapid pace of change is forcing both governments and multinational companies to focus on how corporate tax strategies mesh with political, economic and business goals. The most successful companies will be those who study their options, consult with experts and structure operations to their advantage.
Greg Castello is CFO for Flash Global.•