Chapter 8 Taxes and Multinational Corporate Strategy

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 8-1

Chapter 8Chapter 8Taxes and Multinational Corporate StrategyTaxes and Multinational Corporate Strategy

8.1 The Objectives of National Tax Systems

8.2 Types of Taxation

8.3 Taxation of Foreign-Source Income in the United States

8.4 Taxes and the Location of Foreign Operations

8.5 Taxes and Organizational Form

8.6 Taxes and Cross-Border Investment Activity

8.7 Summary


The income tax...The income tax...

The income tax has made more liars out of the American people than golf has.

Will Rogers


The objectives of tax neutralityThe objectives of tax neutrality

Domestic tax neutrality - incomes arising from foreign and from domestic operations are taxed similarly by the domestic government.

Foreign tax neutrality - taxes imposed on the foreign operations of domestic companies are the same as those facing local competitors in the host countries.


Violations of tax neutralityViolations of tax neutrality

Different tax rates are often assessed on income from:

different tax jurisdictions

different organizational forms

different asset classes

different financing instruments


Forms of taxationForms of taxation

Explicit taxes– income taxes

– withholding taxes on dividends, interest and royalties

– sales and value-added taxes

– property and asset taxes

– tariffs on cross-border trade

Implicit taxes– The law of one price revisited: “Equivalent assets sell

for the same after-tax expected return”

– Tax arbitrage ensures this condition in the long run, but not necessarily in the short run

– Countries with low tax rates often have low before-tax required returns as well


Taxes on foreign-source incomeTaxes on foreign-source income

There are two basic types of taxation systems:

A 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 incomeU.S. taxation of foreign source income

In the United States:

income from foreign subsidiaries is taxed as it is repatriated to the parent

income from foreign branches is taxed as it is earned


The organizational formThe organizational formof foreign operationsof foreign operations

The foreign operations of manufacturing firms are usually conducted through foreign subsidiaries

» Incorporation in the host country limits the parent’s liability

» Incorporation avoids host country disclosure requirements on the parent corporation’s worldwide operations

» Foreign branches can be used for start-up operations that are initially expected to lose money

Foreign branches are used by financial institutions» Foreign branches are tax disadvantaged if the foreign branch is

in a low-tax country

» FTC limitations can be less binding for foreign branches than for foreign subsidiaries


Foreign tax credits & FTC limitationsForeign tax credits & FTC limitationsin the United Statesin the United States

Tax statements as single subsidiaries

Swit. Italy German

a Dividend payout ratio 100% 100% 100%

b Foreign dividend withholding tax rate 5% 5% 5%

c Foreign tax rate 28% 36% 50%

d Foreign income before tax 1000 1000 1000

e Foreign income tax (-d*c) (280) (360) (500)

f After-tax foreign earnings (d-e) 720 640 500

g Declared as dividends (f*a) 720 640 500

h Foreign dividend withholding tax (-g*b) (36) (32) (25)

i Total foreign tax (e+h) (316) (392) (525)

j Dividend to U.S. parent (d-i) 684 608 475



Tax statements as single subsidiaries (continued)

Swit. Italy German

k Gross foreign income before tax (line d) 1000 1000 1000

l Tentative U.S. income tax (k*35%) (350) (350) (350)

m Foreign tax credit (i) 316 392 525

n Net U.S. taxes payable [min(l+m,0)] (34) 0 0

o Total taxes paid (350) (392) (525)

p Net amount to U.S. parent 650 608 475

q Total taxes as separate subsidiaries (o) ($1,267)



Parent’s consolidated tax statement

r Overall FTC limitation (k*35%) $1,050

s Total FTCs on a consolidated basis (-i) $1,233

t Additional U.S. taxes due [max(0, r-s)] $0

u Excess tax credits [max(0,s-r)] $183

(carried back 2 years or forward 5 years)

Overall FTC limitation

= (Total foreign-source income)(U.S. tax rate)

when the U.S. tax rate is a constant fraction of worldwideincome


Additional FTC limitationsAdditional FTC limitations

Income baskets– Active income

– Passive income

– Other (e.g. income from foreign sales corporations)

Subpart F income– Foreign holding company income

– Foreign base company sales income

– Foreign base company service income

Allocation of income and expense– Allocation of interest expense

– Allocation of research and development expenses

– Other expenses


Effect of shifting sales to low-tax countriesEffect of shifting sales to low-tax countries

Tax statements as single subsidiaries - original allocation

Swit. Italy German











Total foreign taxes as single subsidiaries = $1,233



Tax statements as single subsidiaries - after sales shift

Swit. Italy German











Total foreign taxes as single subsidiaries = $1,024




Swit. Italy German










Parent’s consolidated tax statement

Original sales Shifted sales

r Overall FTC limitation (k*35%) $1,050 $1,050

s Total FTCs on a consolidated basis (-i) $1,233 $1,024

t Additional U.S. taxes due [max(0, r-s)] $0 $26

u Excess tax credits [max(0,s-r)] $183 $0

(carried back 2 years or forward 5 years)


Off-shore finance subsidiariesOff-shore finance subsidiaries

The Tax Reform Act of 1986 removed the tax advantages of tax-haven affiliates

Many MNCs retain off-shore finance subsidiaries as reinvoicing centers. The location of a captive finance subsidiaries should have:

» Developed infrastructure including banking, transportation, and communication facilities

» Stable and convertible currency with access to the international currency and Eurocurrency markets

» Low income tax and withholding tax rates

» Low political risk


Transfer pricing and tax planningTransfer pricing and tax planning

Transfer price

Low High

Arg. Hungary Both Arg. Hungary Both

Tax rate 30% 40% 38% 30% 40% 32%

Revenue $5,000 $10,000 $10,000 $8,000 $10,000 $10,000

Cost of goods sold 3,000 5,000 3,000 3,000 8,000 3,000

Other expenses 1,000 1,000 2,000 1,000 1,000 2,000

Taxable income 1,000 4,000 5,000 4,000 1,000 5,000

Total taxes paid 300 1,600 1,900 1,200 400 1,600

Net income 700 2,400 3,100 2,800 600 3,400

Effective tax rate 38% 32%

on foreign operations


Host country tax rate

Tax status of US buyer Low High

Excess FTCs neutral neutral

No excess FTCs unattractive attractive

FTCs and foreign investmentFTCs and foreign investment

Chapter 8 Taxes and Multinational Corporate Strategy

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