CHAPTER21INTERNATIONALTAXENVIRONMENTSUGGESTEDANSWERSANDSOLUTIONSTOEND-OF-CHAPTERQUESTIONSANDPROBLEMS

QUESTIONS

Discussthetwinobjectivesoftaxation.Besuretodefinethekeywords.

Answer: Therearetwobasicobjectivesoftaxationthatarenecessarytodiscusstohelpframeourthinkingabouttheinternationaltaxenvironment:taxneutralityandtaxequity.

Taxneutralityhasitsfoundationsintheprinciplesofeconomicefficiencyandequity. Taxneutralityisdeterminedbythreecriteria. Capital-exportneutralityisthecriterionthatanidealtaxshouldbeeffectiveinraisingrevenueforthegovernmentandnothaveanynegativeeffectsontheeconomicdecisionmakingprocessofthetaxpayer.Thatis,agoodtaxisonethatisefficientinraisingtaxrevenueforthegovernmentanddoesnotpreventeconomicresourcesfrombeingallocatedtotheirmostappropriateusenomatterwhereintheworldthehighestrateofreturncanbeearned.Asecondneutralitycriterionisnationalneutrality. Thatis,regardlessofwhereintheworldtaxableincomeisearneditistaxedinthesamemannerbythetaxpayer’snationaltax authority.Intheory,nationaltaxneutralityisacommendableobjective,asitisbasedontheprincipleofequality.Thethirdneutralitycriterioniscapital-importneutrality. ThiscriterionimpliesthatthetaxburdenplacedontheforeignsubsidiaryofaMNCbythehostcountryshouldbethesameregardlessinwhichcountrytheMNCisincorporatedandthesameasthatplacedondomesticfirms.

Taxequityistheprinciplethatallsimilarlysituatedtaxpayersshouldparticipateinthecostofoperatingthegovernmentaccordingtothesamerules.Thismeans thatregardlessinwhichcountryanaffiliateofaMNCearnstaxableincome,thesametaxrateandtaxduedateapply.

Compareandcontrastthethreebasictypesoftaxationthatgovernmentslevywithintheirtaxjurisdiction.

Answer:Therearethreebasictypesoftaxationthatnationalgovernmentsthroughouttheworlduseingeneratingtaxrevenue:incometax,withholdingtax,andvalue-addedtax.Manycountriesintheworldobtainasignificantportionoftheirtaxrevenuefromimposingan incometaxonpersonalandcorporateincome.Anincometaxisa directtax,thatis,onethatispaiddirectlybythetaxpayeronwhomitislevied.Thetaxisleviedon activeincome,thatis,incomethatresultsfromproductionbythefirmor

IM-1

individualorfromservicesthathavebeenprovided.Awithholdingtaxisataxleviedonpassiveincomeearnedbyanindividualorcorporationofonecountrywithinthetaxjurisdictionofanothercountry.Passiveincomeincludesdividendsandinterestincome,andincomefromroyalties,patentsorcopyrightspaidtothetaxpayer.Awithholdingtaxisan indirecttax,thatis,ataxbornebyataxpayerthatdidnotdirectlygeneratetheincomethatservesasthesourceofthepassiveincome. Thetaxiswithheldfrompaymentsthecorporationmakestothetaxpayerandturnedovertothelocaltaxauthority. Avalue-addedtax(VAT)isanindirectnationaltaxchargedonthesalespriceofaserviceorconsumptiongoodasitmovesthroughthevariousstagesofproductionand/orservice.Assuch,aVATisasalestaxbornebythefinalconsumer.

Showhowdoubletaxationonataxpayermayresultifallcountriesweretotaxtheworldwideincomeoftheirresidentsandtheincomeearnedwithintheirterritorialboundaries.

Answer:Therearetwofundamentaltypesoftaxjurisdiction:theworldwideandthe territorial.Theworldwidemethodofdeclaringanationaltaxjurisdictionistotaxnationalresidentsofthecountryontheirworldwideincomenomatterinwhichcountryitisearned.The territorialmethodofdeclaringataxjurisdictionistotaxallincomeearnedwithinthecountrybyanytaxpayer,domesticorforeign.Hence,regardlessofthenationalityofataxpayer,iftheincomeisearnedwithintheterritorialboundaryofacountryitistaxedbythatcountry.

IfaMNCwasaresidentofacountrythattaxedworldwideincome,theforeign-sourceincomeofitsforeignaffiliateswouldbetaxedintheparentcountry.Ifthehostcountryalsotaxestheincomeoftheaffiliateearnedwithinitsterritorialborders,theforeignaffiliatewouldpaytaxesonthesameincomebothinthehostcountryandintheparentcountry. Toavoidthis“evil,”somemechanismneedstobeestablishedtopreventdoubletaxation.

Whatmethodsdotaxingauthoritiesusetoeliminateormitigatetheevilofdoubletaxation?

Answer:Thetypicalapproachtoavoidingdoubletaxationisforanationnottotaxforeign-sourceincomeofitsnationalresidents.Analternativemethod,andtheonetheU.S.follows,istogranttotheparentfirmforeigntaxcreditsagainstU.S.taxesfortaxespaidtoforeigntaxauthoritiesonforeign-sourceincome.

Thereisadifferenceinthetaxliabilityleviedonforeign-sourceincomedependinguponwhetheraforeignbranchorsubsidiaryformoforganizationalstructureisselectedforaforeignaffiliate. Pleaseelaborateonthisstatement.

IM-2

Answer:Aforeignbranchisnotanindependentlyincorporatedfirmseparatefromtheparent,itisanextensionoftheparent.Consequently,active orpassiveforeign-sourceincomeearned athebranchisconsolidatedwiththedomestic-sourceincomeoftheparentfordeterminingtheU.S.taxliability,regardlessofwhetherornottheforeign-sourceincomehasbeenrepatriatedtotheparent. AforeignsubsidiaryisanaffiliateorganizationoftheMNCthatisindependentlyincorporatedintheforeigncountry,andoneinwhichtheU.S.MNCownsatleast10percentofthevotingequitystock.AforeignsubsidiaryinwhichtheU.S.MNCownsmorethan10butlessthan50percentofthevotingequityisaminorityforeignsubsidiaryorauncontrolledforeigncorporation. Activeandpassiveforeign-sourceincomederivedfromaminorityforeignsubsidiaryistaxedintheU.S.onlywhenremittedtotheU.S.parentfirmviaadividend.AforeignsubsidiaryinwhichtheU.S.MNCownsmorethan50percentofthevotingequityisacontrolledforeigncorporation.Activeforeign-sourceincomefromacontrolledforeigncorporationistaxedintheU.S.onlyasremittedtotheU.S.parent,butpassiveincomeistaxedintheU.S.asearned,evenifithasnotbeenrepatriatedtotheparent.

IM-3

PROBLEMS

TherearethreeproductionstagesrequiredbeforeapairofskisproducedbyFjordFabricationcanbesoldatretailforNOK2,300. FillinthefollowingtabletoshowthevalueaddedateachstageintheproductionprocessandtheincrementalandtotalVAT.TheNorwegianVATrateis24percent.

Production

Stage

Selling

Price

Value

Added

Incremental

VAT

1

NOK 450

2

NOK1,900

3

NOK2,300

TotalVAT

Solution:

Production

Selling

Value Incremental

Stage

Price

Added VAT

1

NOK 450

NOK 450 NOK108

2

NOK1,900

NOK1,450 NOK348

3

NOK2,300

NOK 400 NOK96

TotalVATNOK552

IM-4

TheDocketCompanyofAsheville,NCUSAisconsideringestablishinganaffiliateoperationinthecityofWellington,onthesouthislandofNewZealand.Itisundecidedwhethertoestablishtheaffiliateasabranchoperationorawholly-ownedsubsidiary. NewZealandtaxesincomeofbothresidentcorporationsandbranchoperationsataflatrateof33percent.Italso withholdstaxesatarateof15percentondividendspaidbyresidentcorporationstorecipientsintheUnitedStates.TheUnitedStateshasanincometaxrateof35percentonincomeearnedworldwide,butgivesataxcreditfortaxespaidtoanothercountry. Basedonthisinformation,isabranchorsubsidiarytherecommendedformfortheaffiliate?

Answer:IfDocketestablishesabranchoperationinNewZealand,itwillpayatotalof35percentonitsNewZealandsourceincome.Itwillpay33percentinNewZealandandanadditional2percentintheUnitedSatesafterareceivingataxcreditfortheNewZealandtaxes.IfDocketsetsupitsNewZealandaffiliateasawholly-ownedsubsidiary,thesubsidiarywillpaytaxesat33percentonNewZealandtaxableincomeanditmustalsowithhold15percentondividendspaidtotheparent.Totaltaxescreditswillbe[.33+.15–(.33x.15)]=.4305or43.05percentintheUnitedStates.Thus,taxeswillbe43.05percentifexcesstaxcreditsof8.05percentcannotbeusedand35percentiftheycan.Consequentlyabranchoperationistheadvisableformfortheaffiliateoperations.

IM-5

MINICASE:SIGMACORP.’SLOCATIONDECISION

Sigma Corporation of Boston is contemplating establishing an affiliate operation in theMediterranean.TwocountriesunderconsiderationareSpainandCyprus.Sigmaintendstorepatriateallafter-taxforeign-sourceincometotheUnitedStates.Atthispoint,Sigmaisnotcertainwhetheritwouldbebesttoestablishtheaffiliateoperationasabranchoperationorawholly-ownedsubsidiaryoftheparentfirm.

InCyprus,themarginalcorporatetaxrateis15percent.Foreignbranchprofitsaretaxedatthesamerate.InSpain,corporateincomeistaxedat35percent,thesamerateasintheUnitedStates.Additionally,foreignbranchincomeinSpainisalsotaxedat35percent.ThewithholdingtaxtreatyrateswiththeU.S.ondividendincomepaidfromCyprusiszeropercentand10percentpaidfromSpain.

ThefinancialmanagerofSigmahasaskedyoutohelphimdeterminewheretolocatethenewaffiliateandwhichorganizationalstructuretoestablish.ThelocationdecisionwillbelargelybasedonwhetherthetotaltaxliabilitywouldbesmallestforaforeignbranchorawhollyownedsubsidiaryinCyprusorSpain.

IM-6

SuggestedSolutionforSigmaCorp.’sLocationDecision

Foreign-sourceincomeofaforeignbranchofaU.S.MNCinCypruswouldbetaxedatarateof15percentinCyprus.Theafter-taxforeign-sourceincomewouldbegrossed-upforU.S.taxpurposes,andincometaxesattherateof35percentwouldbeleviedintheU.S.IftheCyprusaffiliatewasestablishedasawholly-ownedsubsidiary,thetotaltaxliabilityinCypruswouldalsobe15percentbecausethereisnowithholdingtaxondividendspaidtotheUnitedStates.AdditionaltaxesintheU.S.wouldbedue,bringingthetotaltaxliabilityuptotheU.S.incometaxrateof35percent.

Foreign-sourcei