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 entity’s
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 arm’s-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 country’s 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 country’s 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 country’s 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 country’s 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
 Don’t 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 arm’s-length transfer
pricing
 Varying interpretations of arm’s-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
unit’s 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 firm’s resources
 Help differentiate profitable from unprofitable operations
 Consistent with decentralized profit center orientation
 Easy to defend to tax authorities as arm’s-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)
 Arm’s-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 subsidiary’s 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 unit’s 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 arm’s-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
arm’s-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 arm’s-length principle is becoming less relevant for today’s
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 world’s
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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