International Accounting, 7/e

Frederick D.S. Choi

Gary K. Meek

Chapter 12: International

Taxation and Transfer Pricing

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Learning Objectives
Identify the major types of tax systems that exist
around the world.
Understand what determines a multinational entitys
effective tax burden.
Understand concepts relating to the taxation of
foreign source income and the rationale behind the
foreign tax credit.
Identify the major variables that complicate
international transfer pricing.
Explain the meaning of arms-length price and the
transfer pricing methods designed to achieve it.
Explain the concept of an advance pricing
arrangement.
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Initial Concepts
Tax neutrality
Taxes have no effect on resource-allocation decisions.
Business decisions driven by economic fundamentals.
Should result in optimal allocation of resources.
Tax equity
Similarly situated taxpayers pay same tax
Is a foreign subsidiary a domestic company operating
abroad?
Is a foreign subsidiary a foreign company owned by a
domestic one?
Disagreement over how to interpret this concept
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Diversity of National Tax
Systems
Types of taxes
Corporate income tax
First or second most widely used tax
Trend toward lowering and converging of income tax rates
Pressure to improve competitiveness of a countrys businesses and create an attractive investing
environment
Driven by integration of the world economy and ability of businesses to move from high- to low-tax
countries
Withholding tax
Imposed on dividend, interest, and royalty payments to foreign investors
Withheld at the source
Often modified by bilateral tax treaties
Value-added tax
Consumption tax found in Europe and Canada
Levied on value added at each stage of production or distribution
Consumers ultimately bear the cost
Border tax
Customs or import duties
First or second most widely used tax
Designed to keep domestic goods price competitive with imports
Transfer tax
Imposed on transfers of assets between taxpayers

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Diversity of National Tax
Systems (contin)
Tax burdens
Vary internationally due to:
Differences in statutory tax rates

Differences in definitions of taxable income

How social overhead costs are paid for in a country

Lower direct taxes may result in higher indirect taxes
Or fewer and lower-quality public services that increase other
costs
Effective tax rates seldom equal nominal tax rates
Thus, a low tax rate does not necessarily mean a low tax
burden

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Diversity of National Tax
Systems (contin)
Tax administration systems
Classical system
Corporate income is taxed twice:
At the corporate level
At the shareholder level when dividends are paid
Trend is away from classical system.
Integrated system
Corporate and shareholder taxes integrated to reduce or eliminate
double taxation of corporate income.
Tax credit, or imputation, system is a common variant.
Full imputation eliminates double taxation.
Partial imputation reduces double taxation.
Split-rate system is another variant.
Dividends (to shareholders) taxed at lower rate than corporate income

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Diversity of National Tax
Systems (contin)
Foreign tax incentives
Tax holidays
Tax relief for certain period of time
Tax havens
Low or no income tax countries
Tax Havens and harmful tax competition
Avoiding or evading a countrys income taxes by using tax havens
Brass plate subsidiaries lack substantial activities and merely funnel transactions
through a tax haven
OECD pressures uncooperative tax havens to adopt practices on exchange of
information and transparency
OECD pressure has worked
International harmonization
Multinational companies are pressuring for international tax harmonization
EU moving to harmonize corporate tax base rather than tax rates

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Taxation of Foreign-Source
Income and Double Taxation
Foreign tax credit
Designed to relieve double taxation in countries following
worldwide principle of taxation
Credit against direct (not indirect) taxes paid
Income taxes paid on branch or subsidiary earnings

Withholding taxes

Allowable tax credit proportional to dividends net income

Effect is to limit the total tax on foreign-source income to
the higher of the home or foreign countrys tax rate

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Taxation of Foreign-Source Income and
Double Taxation (contin)
Limits to tax credits
Designed to prevent foreign tax credits from offsetting taxes on domestic-
source income
Excess foreign tax credits can be carried back one year and forward 10
years
Separate foreign tax credit limitation on these baskets:
Passive income
General income
Tax treaties
Agreements between countries on taxation of income and withholding taxes
Applies to each countrys businesses operating in the other country
Foreign exchange considerations
Foreign income and taxes paid translated into U.S. dollars similar to FAS 52
treatment (Chapter 6)

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Tax-Planning Dimensions
Overview
Tax considerations should never control business
strategy: the financial or operating strength of a
business transaction must stand on its own
Constant changes in tax laws limit the benefits of
long-term tax planning
Organizational considerations
Branch profits taxed to parent in full when earned
Taxes on subsidiary profits deferred until dividend
paid to parent
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Tax-Planning Dimensions
(contin)
Controlled foreign corporations and Subpart F
income
Deferral principle: income of foreign subsidiaries not
taxable to parent until repatriated as a dividend
Tax havens give multinationals opportunity to avoid
repatriating foreign profits by parking them in brass plate
subsidiaries
Shareholders of CFCs are taxed on tainted (Subpart F)
income even before dividend is paid
Subpart F income is passive, related party income

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Tax-Planning Dimensions
(contin)
Offshore holding companies
Own the shares of operating subsidiaries to gain tax
advantages
Require complex planning and avoiding anti-treaty
shopping rules
Financing decisions
Subsidiary in high-tax country borrows from one in low-tax
country
Result is shifting income away from high-tax country,
thereby reducing taxes
Pooling of tax credits
Excess tax credits from high-tax countries can be pooled
with unused credits from low-tax countries

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Tax-Planning Dimensions
(contin)
Cost accounting allocations
Affiliates in high-tax countries allocated corporate
overhead, personnel, and R&D costs
Result is maximizing tax deductions in high-tax
affiliates
Location and transfer pricing
Set high transfer prices on items shipped from
subsidiaries in low-tax countries
Set low transfer prices on items shipped from
subsidiaries in high-tax countries
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Tax-Planning Dimensions
(contin)
Integrating international tax planning
Tax planning should be integrated into corporate
decisions
Rely on tax experts in each jurisdiction
Communicate facts and coordinate tax advice
Tax decisions should fit the business
Put everything in writing documentation is
critical
Dont do anything embarrassing
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International Transfer Pricing:
Complicating Variables
Tax considerations
Move profits from subsidiaries in high-tax countries to
subsidiaries in low-tax countries
IRS can reallocate profits if transfer prices are used to avoid
income taxes
IRS and many other governments require arms-length transfer
pricing
Varying interpretations of arms-length pricing can catch
multinationals in the middle
Resolving the problem can be time-consuming and expensive
Documentation is critical
Audits by tax authorities can be expected
Transfer pricing has become a major compliance burden
Can distort the multinational control system
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International Transfer Pricing:
Complicating Variables (contin)
Tariff considerations
Reduce transfer prices on items sent to high-tariff countries
Multinational must contend with customs officials in importing country and
income tax administrators in importing and exporting countries
Competitive factors
Subsidize a new foreign subsidiary with low transfer prices on imported
inputs
Shield an existing foreign subsidiary from competition the same way
Use transfer prices to improve profits of a foreign subsidiary seeking local
financing
Use transfer prices to weaken local competition
Disadvantages
May invite antitrust actions by host government
May invite retaliatory actions by competitors
May become a permanent management crutch

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International Transfer Pricing:
Complicating Variables (contin)
Environmental risks
Inflation
Charge high transfer prices to subsidiary in high-inflation
country to remove cash
Currency devaluations
Use inflated transfer prices to move funds out of subsidiary
in devaluation-prone country
Foreign exchange controls
Reduce transfer price to import more product to subsidiary
in country with such controls
Restrictions on profit repatriations
Use high transfer price on sales to the subsidiary to remove
cash

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International Transfer Pricing:
Complicating Variables (contin)
Performance evaluation considerations
Difficult to set transfer prices that:
Motivate managers to make decisions that maximize their
units profits and are congruent with the goals of the
company as a whole, and
Provide an equitable basis for judging the performance of
managers and units of the firm
Freely negotiated prices may be best for the unit but not
the firm as a whole
Dictated transfer prices that are best for the firm as a whole
may be seen as arbitrary or unreasonable by the unit
manager

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International Transfer Pricing:
Complicating Variables (contin)
Resolving Trade-Offs
Quantify the trade-offs in setting transfer pricing
Keep global perspective when mapping benefits
and costs of transfer pricing strategy
Environmental influences must be considered for
the group, not the individual units
Environmental risks are often conflicting and they
change constantly

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Transfer Pricing Methodology
Market vs. cost vs.?
Market-based transfer prices
Advantages
Show the opportunity cost of the transfer
Encourage the efficient use of the firms resources
Help differentiate profitable from unprofitable operations
Consistent with decentralized profit center orientation
Easy to defend to tax authorities as arms-length
Disadvantages
Does not give the firm much room to use transfer prices for strategic reasons
Often no intermediate market for the product or service in question
Multinationals engage in transactions that independent companies do not undertake
Relationships among affiliates under common control differ from transactions between
unrelated parties
Cost-based transfer prices
Advantages
Are simple to use
Are based on readily available data
Can be used to strategically respond to tax differences, competitive circumstances, and
environmental risks
May help avoid internal frictions
Disadvantages
May provide little incentive for selling units to control costs
Ignore competitive supply and demand relationships
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Transfer Pricing Methodology
(contin)
Arms-length principle
Intrafirm transactions are priced as if they took
place between unrelated parties in competitive
markets
The basis for most transfer pricing regulations by
tax authorities around the world
The transfer price is hypothetical since:
Parties are related
Markets are not competitive

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Transfer Pricing Methodology
(contin)
Comparable uncontrolled price method
Used with commodity-type products
Appropriate when goods are sufficiently common and
internal and external sales are comparable
Use same transfer price that unrelated parties are charged
Comparable uncontrolled transaction method
Applies to transfers of intangible assets
Use same transfer price (royalty rate) that unrelated parties
are charged for the intangible

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Transfer Pricing Methodology
(contin)
Resale price method
Used when the buying unit is a distributor or sales subsidiary
Work backwards approach
Start with the sales price the sales subsidiary charges its (unrelated)
customer
Then deduct the sales subsidiarys costs and a normal profit
Cost-plus pricing method
Typically used when semi-finished goods are transferred
between foreign affiliates, or where one entity is a subcontractor
for another
Work forward approach
Start with the selling units production cost
Then add a normal profit

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Transfer Pricing Methodology
(contin)
Comparable profits method
Set the transfer price so that profits on transactions
between related parties are comparable to profits on
transactions between unrelated parties who engage in
similar business activities under similar circumstances
Profit-split methods
Used when product or market benchmarks are not
available
Attempts to divide profits on related-party transactions in
an arms-length fashion
Comparables profit-split method and residual profit-split
method are two examples

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Transfer Pricing Methodology
(contin)
Other pricing methods
Other methods may be used if they better reflect
arms-length pricing than one of the acceptable
methods above
Best methods rule
Select the best transfer pricing method based on the
facts and circumstances
U.S. and other countries have a best methods rule
Most countries prefer transaction-based methods
over profit-based methods

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Transfer Pricing Methodology
(contin)
Advance pricing agreements
Multinational company and taxing authority negotiate an
agreed-upon transfer pricing methodology
Binding on both parties

Binding for a fixed period of time

Reduces or eliminates the risk of a transfer pricing audit

Saves time and money for the multinational and taxing
authority
Introduced in the U.S., now widely adopted by other
countries

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Transfer Pricing Practices
A variety of transfer pricing methods are found in
practice
Managing the tax burden is a top objective of
transfer pricing practices
Operational issues are also important, such as:
Maintaining competitive position
Promoting equitable performance evaluation
Motivating employees
Transfer pricing plays an increasingly important role
in the strategic planning process
Transfer pricing increasingly used to contribute
value in the multinational company
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The Future
Are national taxes compatible with a global economy?
The principles upon which international taxation is based are being
challenged
Electronic commerce over the Internet ignores borders and physical
location
Sophisticated encryption techniques make it harder to identify taxpayers
The Internet makes it easy to shift activities to low-tax countries
Monitoring and taxing international transactions becoming more difficult
The arms-length principle is becoming less relevant for todays
multinationals
Fewer of them operate units as independent firms
Becoming more difficult to locate where profits are generated
Global brands
Global research and development
Regional profit centers
Brand names, intellectual property, and intangibles are hard to price

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The Future (contin)
Increased cooperation among the worlds
taxing authorities
Greater tax competition among countries
Some advocate a unitary tax as an
alternative to transfer pricing
Total profits allocated to units based on economic
presence in a country
The country then taxes its share of profits at the
rate it chooses
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Chapter Exhibits

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Chapter Exhibits (contin)

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Chapter Exhibits (contin)

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Chapter Exhibits (contin)

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Chapter Exhibits (contin)

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Chapter Exhibits (contin)

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Chapter Exhibits (contin)

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Chapter Exhibits (contin)

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Chapter Exhibits (contin)

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