CHAPTER 11
INTERNATIONAL TAXATION
Chapter Outline
I. Taxes are one of the most significant costs incurred by business enterprises. Taxes can be
an important factor in making decisions related to foreign operations including: in which
country should an operation be located, what should its legal form be, and should it be
financed with debt or equity.
II. The two major types of taxes imposed on profits earned by companies with foreign
operations are income taxes and withholding taxes.
A. Most countries have a national corporate income tax rate that varies between 20% and
35%. Countries with no or very low corporate taxation are known as tax havens.
MNCs often attempt to use operations in tax haven countries to minimize their
worldwide tax burden.
B. Withholding taxes are imposed on payments made to foreigners in the form of
dividends, interest, and royalties. Withholding rates vary across countries and often
vary by type of payment within one country. Differences in withholding rates provide
tax planning opportunities for the location or nature of a foreign operation.
III. Tax jurisdiction over income is an important issue. Two factors determine which country will
tax which income: (a) whether a country uses a worldwide or territorial approach to
taxation, and (b) whether a country taxes on the basis of source of income, residence of the
taxpayer, and/or citizenship of the taxpayer.
A. Most countries, including the U.S., tax income on a worldwide basis. The U.S. also
taxes on the basis of source, residence, and citizenship.
B. Overlapping tax jurisdictions results in double taxation. For example, the income
earned by a foreign branch of a U.S. company is subject to taxation both in the foreign
country and in the U.S.
IV. Most countries provide relief from double taxation through foreign tax credits. Foreign tax
credits are the reduction in tax liability on income in one country for the taxes already paid
on that income in another country.
A. Foreign tax credits allowed by the home country generally are limited to the amount of
taxes that would have been paid if the income had been earned in the home country.
B. The excess of taxes paid to a foreign country over the foreign tax credit allowed by the
home country is an excess foreign tax credit. In the United States, an excess FTC
may be carried back one year and carried forward ten years to reduce taxes otherwise
payable on foreign source income.
C. In the U.S., foreign source income must be allocated to two different FTC baskets – a
general income basket and a passive income basket. The excess FTC from one
basket may not be used to reduce the tax liability related to another basket.
V. Income earned by a foreign branch is taxable in the United States currently, whereas
income earned by a foreign subsidiary generally is taxable in the United States only when
received by the parent as a dividend.
A. However, income earned by a controlled foreign corporation (CFC) that can be moved
easily from one country to another (Subpart F income) is taxed in the U.S. currently,
regardless of whether it has been distributed as a dividend or not.
B. The rule that Subpart F income is taxed currently does not apply if it is earned in a
country with a corporate income tax rate at least equal to 90% of the U.S. rate.
VI. U.S. tax treatment of foreign source income is determined by several factors: (1) the legal
form of the foreign operation (branch or subsidiary), (2) the percentage owned by U.S.
taxpayers (CFC or not), (3) the foreign tax rate (tax haven or not), and (4) the nature of the
foreign source income (Subpart F or not; appropriate FTC basket).
VII. Tax treaties between two countries govern the way in which individuals and companies
living in or doing business in the partner country are to be taxed by that country.
A. Most tax treaties include a reduction in withholding tax rates.
B. The U.S. model treaty reduces withholding taxes to zero on interest and royalties and
15% on dividends. However, these guidelines often are not followed.
VIII. Foreign source income must be translated into home country currency for home country
taxation purposes.
A. Under U.S. law, foreign branch net income is translated into US$ using the average
exchange rate for the year and then grossed-up by adding taxes paid to the foreign
government translated at the exchange rate at the date of payment.
B. When branch income is repatriated to the home office, any difference in the exchange
rate used to originally translate the income and the exchange rate at the date of
repatriation creates a taxable foreign exchange gain or loss.
C. Dividends received from a foreign subsidiary are translated into US$ using the spot
rate at the date of distribution and grossed-up by adding taxes deemed paid translated
at the spot rate at the date of payment.
IX. Many countries provide tax incentives, such as tax holidays, to attract foreign investment.
A. Tax holidays can provide a significant benefit to MNCs as long as the income earned in
the foreign country is not repatriated back to the parent. Upon repatriation, the foreign
income becomes taxable in the home country and there is no offsetting foreign tax
credit because no foreign taxes were paid.
B. Some home countries grant tax sparing for their companies who invest in developing
countries, which provides a foreign tax credit for the amount of taxes that would have
been paid to the foreign government if there were no tax holiday.
X. The U.S. has provided a variety of tax incentives to export over the years – Domestic
International Sales Corporation (DISC), Foreign Sales Corporation (FSC), and
Extraterritorial Income Exclusion Act (ETI).
A. U.S. trading partners, especially in the European Union, have objected to each of
these export incentive regimes for violating international trade agreements.
B. The American Job Creation Act of 2004 repealed the ETI provisions and instead
allows companies to deduct a percentage of domestic manufacturing income from taxable
income. Manufacturing firms receive this deduction whether they export or not.