FIE441 Flashcards
Systems for corporate taxation
Formula Apportionment (FA)
A corporations should consolidate the income of its affiliates in to a single measure of taxable global income, which is then allocated among jurisdictions according to a common formula reflecting the corporate group’s activity within each jurisdiction.
Seperate accounting (SA) (used by most countries)
Each individual country computes the income generated by firms locted within its jurisdiction using arm’s length prices on intra-firm transactions, and subsequently applies the national tax rate to it.
==> SA is based on reported income, while FA is based on reported activity. Which is better depends on how easy it is for MNCs to shift profit by transfer prices. If easy FA is better.
Two types of profit shifting
- Transfer pricing
Overinvoice or underinvoice tangible and intangible goods and services to shift income to low-tax affiliates - Debt shifting
Borrowing and lending strategies where affiliates in high tax countries are overcharged on interest expenses so that taxable income is reduced (more debt means more interest deductions hence the term thin capitalization).
Briefly explain why we should – on average – expect affiliates of multinationals to feature larger capital investments than comparable domestic firms within the same industry.
(Under the assumption that costs of external and internal debt are separable,) MNCs’ affiliates and comparable domestic firms should – on average – feature the same external leverage. But, affiliates of MNCs will use internal debt in addition so that they reap additional tax savings and have lower effective capital costs. Lower effective capital costs then trigger larger capital investment in MNCs’ affiliates, relative to comparable domestic firms within the same industry.
Safe-harbor vs earnings-stripping
Binding TC rules negatively affect real investment. (there having both is never optimal)
Safe harbor rule has no (direct) impact on transfer pricing, while earning-stripping increases cost of transfer pricing.
Therefore switching from safe-harbor to earning-stripping reduces transfer pricing, but fosters debt financing. This is a good thing as transfer pricing has no effect on welfare/investment, and this change therefore still gives the beneficial tax-revenue effect, but gives more real investment than safe-harbor rule.
–> Transfer pricing is the big evil
==> Always optimal to replace binding safe-harbor with a regime with only earning-stripping
Where should a multinational locate its internal bank, doing all internal lending?
The MNC wants to maximize the internal debt tax shields (ti − t1) · r ∀i. Therefore, it is necessary to minimize the tax payments on interest income received (in the internal bank, being labelled as affiliate 1) from lending out internal debt. Hence, the internal bank should have the lowest possible tax rate.
Arbitrage condition
Return to equity (div plus capital gains) must equal opportunity cost p(t) (reutrn to alternative investment)
Reasons for/against JV’s
- *For**
- Legal requirements to have local partners
- Local partners having more experience in local markets
- MNC providing enhanced industry-specific skills
==> cooperation cost-reducing or productivity-enhancing
- *Against**
- Conflicts between minority owners and MNC due to profit-shifting
- Appropriation of technologies by local partners
- Conflicts when desire to resturcture production world-wide
TC+CFC??
- *Combination allowing for ‘double discrimination’ of MNCs**
- set weak TC rules to attract mobile capital / FDI
- investment of foreign MNCs more tax elastic than of home MNCs
- differentiated TC rules legally not possible
- tough CFC rule reducing tax advantage for less elastic home MNCs
With same interest for internal and external debt, why cannot the internal debt tax shield be bigger than the external one?
Internal debt creates tax payments in the internal bank (for interest income received there), which reduce the internal debt tax shield. For external debt, there are no such additional tax payments. Hence, for an identical interest rate, the internal debt tax shield can never be larger than the external one.
Problem with CFC rule
Conflict with EU law, applicability of CFC rules within EEA legally rather impossible.
Centralized vs decentralized decision making
Centralized: The HQ maximizes the global profit after tax setting TP as well as prices.
- Find optimal TP based on tax differences
- Instert TP into global after-tax profit and find optimal Q
Decentralized
- HQ sets the TP
- Each affiliate sets the price (or Q)
- -> Solved by backwards induction.
Thin-Capitalization (TC) rules vs CFC rules
- A thin-capitalization rule targets all affiliates within the country that sets the thincapitalization rule. A CFC rule only applies to affiliates of multinationals that are headquartered in the country that uses the CFC rule
- Binding TC rule denies tax deductibility of interest expenses in borrowing affiliates. Binding CFC rule denies low taxation of passive income generated in the internal bank.
- Tax-comp sets incentive to weaken TC rules. CFC rules on the other hand are rather compatible with tax-comp, because the do not affect incoming FDI, but they harm foreign affiliates of domestic MNCs.
Capital market equilibrium (with and without personal taxation)
Without
p(t)=i(t)
with p(t)=i(t)*(1-t(p))
Arm’s length principle: Definition
The price that would have been set between independent trading partners in the market place.
This is the international consensus for correct transfer price.
External vs internal debt: Basic Difference
External debt stems from third parties (the ‘capital market’), i.e., from creditors that are not part of the same (multinational) company. Internal debt is borrowed from related affiliates within the same trust (multinational company).
