🧾Taxes and Business Strategy Unit 7 – International Business Taxation

Key Concepts in International Taxation

• Residence-based taxation taxes individuals and corporations based on their country of residence, regardless of where income is earned
• Source-based taxation taxes income based on where it is earned, regardless of the taxpayer's country of residence
• Double taxation occurs when the same income is taxed by more than one jurisdiction, often due to a mismatch between residence-based and source-based taxation
• Permanent establishment (PE) is a fixed place of business through which a company operates in a foreign country, triggering tax obligations in that country
  • Includes branches, offices, factories, and dependent agents
  • Excludes preparatory or auxiliary activities (storage, display, or delivery of goods)
• Controlled foreign corporations (CFCs) are foreign subsidiaries majority-owned by a parent company in another country, subject to special tax rules to prevent tax deferral
• Arm's length principle requires related parties to conduct transactions at prices and terms that would be agreed upon by unrelated parties in similar circumstances
• Withholding taxes are levied by the source country on certain types of cross-border payments (dividends, interest, royalties) made to foreign recipients

Global Tax Systems Overview

• Worldwide taxation system taxes residents on their global income, regardless of where it is earned, with credits or exemptions for foreign taxes paid to avoid double taxation (United States)
• Territorial taxation system only taxes residents on income earned within the country's borders, exempting foreign-sourced income from taxation (Hong Kong, Singapore)
• Hybrid systems combine elements of worldwide and territorial taxation, taxing some foreign-sourced income while exempting or deferring taxation on other types (Canada, Japan)
  • May tax passive income (dividends, interest) on a worldwide basis while exempting active business income
• Value-added tax (VAT) is a consumption tax levied on the value added at each stage of production and distribution, ultimately paid by the final consumer (European Union, Australia)
• Goods and services tax (GST) is a type of VAT that taxes the sale of goods and services at a uniform rate, with businesses receiving credits for GST paid on inputs (India, New Zealand)
• Carbon taxes and emissions trading schemes aim to reduce greenhouse gas emissions by putting a price on carbon dioxide and other pollutants (Canada, European Union)
• Digital services taxes (DSTs) are levied on revenue from digital advertising, online marketplaces, and user data, targeting large multinational technology companies (France, United Kingdom)

Cross-Border Transactions and Their Tax Implications

• Inbound transactions involve foreign companies investing or conducting business in a country, subject to that country's tax laws and regulations
  • Foreign direct investment (FDI) through subsidiaries, branches, or joint ventures
  • Provision of goods or services to customers in the country
  • Licensing or transferring intellectual property (patents, trademarks) to local entities
• Outbound transactions involve domestic companies investing or conducting business in foreign countries, subject to those countries' tax laws and potential double taxation
  • Establishing foreign subsidiaries or branches to serve overseas markets
  • Exporting goods or services to foreign customers
  • Licensing or transferring intellectual property to foreign entities
• Repatriation of profits from foreign subsidiaries to the parent company may trigger additional tax liabilities, depending on the countries' tax systems and any applicable tax treaties
• Withholding taxes on cross-border payments (dividends, interest, royalties) can create cash flow and administrative burdens for companies
• Transfer pricing arrangements between related parties in different countries can impact the allocation of profits and tax liabilities across jurisdictions
• Indirect taxes (VAT, GST) on cross-border transactions can create compliance challenges and potential double taxation if not properly managed

Transfer Pricing Strategies

• Cost-plus method determines the transfer price by adding an appropriate markup to the supplier's cost of production, reflecting the functions performed and risks assumed
• Resale price method calculates the transfer price by subtracting an appropriate gross margin from the final sales price to an unrelated customer, based on comparable transactions
• Transactional net margin method (TNMM) compares the net profit margin earned by a related party to that of comparable uncontrolled transactions, adjusting for differences in functions, assets, and risks
• Profit split method allocates the combined profits of related parties based on their relative contributions, using factors such as assets employed, risks assumed, and functions performed
• Comparable uncontrolled price (CUP) method uses the price charged in a comparable transaction between unrelated parties as the benchmark for the controlled transaction
• Advance pricing agreements (APAs) are binding contracts between taxpayers and tax authorities that set the transfer pricing methodology for future transactions, providing certainty and reducing audit risk
• Documentation requirements vary by country but generally include a master file (high-level overview), local file (detailed transactional analysis), and country-by-country report (global allocation of income and taxes)

Tax Treaties and Double Taxation Agreements

• Bilateral tax treaties between countries aim to prevent double taxation, promote cross-border investment, and combat tax evasion
  • Allocate taxing rights between the residence and source countries
  • Reduce or eliminate withholding taxes on cross-border payments
  • Provide mechanisms for resolving disputes and exchanging information
• OECD Model Tax Convention serves as a template for many bilateral tax treaties, focusing on income and capital taxes
• UN Model Double Taxation Convention gives more weight to source-based taxation, benefiting developing countries that are net importers of capital
• Mutual agreement procedure (MAP) allows taxpayers to request that competent authorities of treaty countries resolve cases of double taxation or treaty interpretation
• Limitation of benefits (LOB) provisions in tax treaties prevent treaty shopping by requiring taxpayers to meet certain tests (ownership, active trade or business, derivative benefits)
• Multilateral Instrument (MLI) modifies existing bilateral tax treaties to implement BEPS measures, such as preventing artificial avoidance of PE status and improving dispute resolution
• Tax information exchange agreements (TIEAs) facilitate the exchange of tax-related information between countries, even in the absence of a comprehensive tax treaty

International Tax Planning Techniques

• Deferral of foreign income taxation by retaining earnings in low-tax jurisdictions and delaying repatriation to the parent company's country
• Intellectual property (IP) migration involves transferring ownership of valuable IP to subsidiaries in low-tax jurisdictions, reducing the overall tax burden on royalty income
• Debt financing of foreign subsidiaries can generate interest deductions in high-tax countries and shift profits to low-tax jurisdictions, subject to thin capitalization rules
• Holding companies in favorable tax jurisdictions (Netherlands, Luxembourg) can be used to pool and manage foreign investments, access treaty benefits, and optimize repatriation of profits
• Hybrid mismatch arrangements exploit differences in the tax treatment of entities or instruments between countries to achieve double non-taxation or double deductions
  • Hybrid entities treated as transparent in one country and opaque in another
  • Hybrid instruments characterized as debt in one country and equity in another
• Captive insurance companies in low-tax jurisdictions can be used to manage risks and reduce the overall tax burden on insurance premiums
• Supply chain restructuring involves aligning the allocation of functions, assets, and risks with the desired tax outcomes, such as locating high-value activities in low-tax jurisdictions

Compliance and Reporting Requirements

• Country-by-country reporting (CbCR) requires large multinational enterprises to disclose key financial and operational metrics for each tax jurisdiction in which they operate
  • Revenues, profits, income taxes paid and accrued, number of employees, stated capital, retained earnings, and tangible assets
  • Aims to improve transparency and help tax authorities assess transfer pricing and BEPS risks
• Common Reporting Standard (CRS) is a global standard for the automatic exchange of financial account information between participating countries, combating cross-border tax evasion
• Foreign Account Tax Compliance Act (FATCA) requires foreign financial institutions to report information on U.S. account holders to the IRS, ensuring compliance with U.S. tax obligations
• Mandatory disclosure rules (MDRs) require taxpayers and intermediaries to report certain aggressive or abusive tax planning arrangements to the tax authorities
• Base Erosion and Profit Shifting (BEPS) Action Plan is a global initiative to address tax avoidance strategies that exploit gaps and mismatches in tax rules, consisting of 15 actions across three pillars
  • Coherence of corporate tax rules at the international level
  • Alignment of taxation with substance and value creation
  • Transparency and certainty for businesses and tax administrations
• Transfer pricing documentation must be prepared and maintained to support the arm's length nature of intercompany transactions and comply with local regulations
• Tax returns and information reporting vary by country but generally require disclosure of cross-border transactions, foreign assets, and overseas income

Current Trends and Future Challenges

• Digitalization of the economy creates challenges for traditional tax systems based on physical presence, leading to proposals for new nexus rules and profit allocation mechanisms
  • Significant economic presence concept based on factors such as user participation, data contribution, and network effects
  • Unified approach under BEPS Pillar One, which combines new nexus rules, simplified profit allocation, and enhanced dispute resolution
• Global minimum tax under BEPS Pillar Two aims to ensure that large multinational enterprises pay a minimum level of tax on their global income, reducing the incentive for profit shifting
  • Income inclusion rule (IIR) taxes the foreign income of a multinational group if the effective tax rate in a jurisdiction falls below the minimum rate
  • Undertaxed payment rule (UTPR) denies deductions or imposes source-based taxation if the IIR is not applied
• Increased scrutiny of tax havens and offshore financial centers, with pressure to improve transparency, exchange information, and adopt minimum tax standards
• Growing importance of environmental, social, and governance (ESG) factors in tax policy, with a focus on aligning tax incentives with sustainable development goals
• Heightened public awareness and reputational risks associated with aggressive tax planning, leading to greater emphasis on responsible tax practices and transparency
• Ongoing trade tensions and geopolitical uncertainties can impact cross-border investments and supply chains, requiring agile tax planning and risk management strategies
• Rapid technological advancements (blockchain, artificial intelligence) present both opportunities and challenges for tax authorities and taxpayers in terms of compliance, data management, and fraud detection