Taxation of multinational companies

Taxation of Multinational Companies
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Multinational corporations may be seen as different from domestic firms in that they operate in multiple economic cultural and political environments and are hence subject to different tax regulations. In the US, the federal government taxes the worldwide income of multinational firms registered in the country the same rates as those to domestic firms, the maximum being 35%. The firms may, however, seek a waiver for taxes paid in other countries for income earned outside the US. This has to be up to the company’s federal tax liability for the earnings made (Blouin, 2012, p. 16). Many companies are now finding it crucial to engage in tax planning to lower the amount of tax due. Tax payments for income from foreign subsidiaries can only be paid if such incomes are repatriated to the US. Failure to repatriate such incomes will, therefore, lead to lower tax payments. The major reason for tax avoidance is high corporation tax rates. This can be seen from the fact that many companies are continuously shifting their income to low-tax countries. The US is, for example, one of the most affected countries in this situation due to its high tax rates and non-favorable policies for multinationals. Although other countries in the OECD economies have been working to reduce their tax rates, the US has not made any changes in its tax rate since 1993 (Hasset and Mathur, 2011, p. 1). The 35% rate is, therefore, one of the highest in the region.

Most of the other countries including the UK, Italy, Germany, Japan, France, and Canada use a regional system that excuses the firms from paying taxes on their foreign incomes. Others exempt the firms only if the home and foreign tax systems are similar (Markle, 2015, p. 9). The exemption policy rather than the current US tax payment system motivates multinationals to make more income in foreign countries as there is no tax due on these incomes and encourages more tax avoidance through deferral of income among other techniques (Clausing, 2005, p. 45).
How do companies minimize tax?
Multinational corporations can exploit various tax policies to minimize their taxes. This means that the methods are legal and there is, therefore, no risk of lawsuits. Existing research has shown that the main way of tax avoidance is by shifting tax avoidance from high to low-tax jurisdictions (Contractor, 2017, p.29). Various techniques are involved. One of the most common methods of tax avoidance is the deferral of income from foreign affiliates. As noted earlier the US and other countries treat the Worldwide income from multinationals as taxable. A loophole, however, exists in the US about tax payment in that the additional tax on profits from foreign affiliates doesn’t have to be paid immediately and can, therefore, be differed indefinitely. It is also possible not to pay at all in the future (Gumpert and Schnitzer, 2016, p. 715). What the company needs to do is either reinvest in projects and operations in the low-income countries or stash such money in tax havens such as the Bahamas and the Cayman Islands. The accumulated profits that have not been repatriated to the US are estimated to be in the regions of $2 and $3 trillion (Hines and Rice, 1994, p. 153).
Another method through which multinationals can minimize loans is through the use of intracorporate loans. Governments all over the World usually deduct interest payments on company loans as expenses when calculating the tax due. Assuming that the borrower and lender are affiliates of a multinational corporation in different nations, the multinational firm can utilize this situation to pay less tax. The company may, for example, make an affiliate in a low-tax country to extend a loan to an affiliate company in a high-tax country such as the US. The result would be an overall reduction in the tax amount due. The objective would be to have an interest rate that is either lower or higher than the actual capital. There is incomprehensive and inadequate data on the extent of loans extended in this manner. This technique is however subject to more scrutiny from governments where the affiliates reside. With countries seeing more and more revenues lost through creative tax avoidance methods, there have been calls for stricter policies in potential loophole areas. One of such has been the restriction by various countries on the manner of interest deductibility in tax (Clausing, 2009, p. 715). The enforcement of such rules is however still lacking in developing countries which usually experience the poor implementation of policies. This method would, therefore, be more appropriate in developing countries with wide tax rate differences.
Multinationals can also minimize taxes through royalty payments for intangible goods. Multinational corporations can create an intangible good and give the power to manage the intangible good to one affiliate. The good is then made available to the affiliates in the MNC on a need basis after they pay royalties. This enables the multinational corporation to shift profits between the affiliates by changing the intra-firm price from time to time (Contractor, 2017, p.35). The location of the intangible goods is also usually an important aspect of the profit shifting ability of the firm and in the management of taxes for the multinational. The corporation should therefore always decide on the most appropriate affiliate to hold the intangible asset at any one given time. Holding the asset in an affiliate in low-tax jurisdictions enables the shifting of profits from the affiliates in the high-tax regions to the low-tax country where the asset is held (Dischinger and Riedel, 2011, p. 694). The transfer of profits to low-tax areas will consequently lead to a lower overall tax amount for the multinational corporation.
One way a company can do this is through investment in a non-intangible asset such as research and development. As per the current tax policy rules, even if research and development activities’ costs have been incurred and paid by the parent company, patents can be transferred to a shell company in tax havens such as Panama, subsidiary or holding company in a low-tax jurisdiction which would be free to charge royalties to other affiliates and branches (Grubert and Mutti, 1991, p. 234). Governments across the World also allow royalty payment deductions in tax calculation even if the companies involved in the transaction are part of the same multinational corporation. R&D can significantly reduce the tax amount for an MNC.
Suppose for example that A, a Korean company which had previously done its R&D establishes a subsidiary B in the US. In the first scenario, the US subsidiary does not pay royalty to A while in the second scenario; the two agree that B will pay a 5% royalty for using the parent company’s R&D
First Scenario
Sales by B-2000
Less Total Costs-1400
Profit before tax-600
Less Tax@30%-180
Profit after tax-420
Second Scenario
Sales by B-2000 Less Royalty@5%-100
Less Total costs-1400
Profit before tax-500
Less Tax@30%-150
Profit after tax-350
Add Royalty remittance to A-100
Profit remitted-450
The total profit remitted to A increases from $420 to $550 after the tax obligation reduces from $180 to $150.
MNCs can also employ inversion to minimize their taxes. Inversion may be referred as the process where a company acquires or merges with another foreign company to shift its corporate headquarters to lower-tax jurisdictions. US-based MNCs that are used to maximum tax rates of 35% may, for example, seek to merge with companies from low-tax regions such as Ireland where the maximum tax rate is 12.5%. The savings for the company may be too huge while the loss to the country regarding revenue may also be quite significant. It was for example discovered in early 2016 that by merging with Allergan Plc, the New York-based Pfizer Inc. would avoid paying a tax amount to the tune of $35 billion to the US government (Browning, 2016). The amount was based on its disclosure that it held overseas earnings of about $74 billion and that it planned to keep this amount overseas. The company also had a $21.1 billion deferred tax liability dating back to 2014. The issue was a subject of concern by some labor union groups as well as Senate with most people calling on the president to use executive authority to prevent some benefits to companies with similar plans. The pressure saw Pfizer and Allergan scrap the $160 billion deal, making it a win for Obama who had been calling for tougher action from Congress against such activities that sought to take revenue away from the country (Humer and Banerjee, 2016). Inversion has received widespread criticism from politicians and various activist groups with most people viewing it as unpatriotic as the new areas where the company moves to will benefit from the revenue instead yet the community and the country had assisted the company greatly. The solution should, however, be to lower taxes as the reason for the movement is that companies feel exploited by the government.
MNCs can also utilize transfer pricing to minimize their tax obligations. Transfer pricing may refer to setting the price for services or goods sold in related business environments. The transfer price may be the cost incurred by a subsidiary company for goods sold by the parent company to it (Gyarteng, 2014, p.367). The subsidiary can either be a majority or wholly owned for transfer pricing to be effective in reducing tax obligations. An MNC and its subsidiaries do not have to transact at the market price they can always decide to either lower or raise the price in which they transact. Transfer pricing helps in shifting profits to either low or high-tax regions which effectively influences the tax paid by the MNC as a whole as well as the overall profitability (Cristea and Nguyen, 2016, p. 178).
Suppose for example that two companies, X and Y are both owned by the same multinational corporation, Z and that X sells 500 items to Y each year at $4 per item. Suppose that X sells to Y at $5 per item this year, X’s profit will rise by $500 while that of Y will fall by the same amount ceteris paribus. The total profit, however, increases from $3550 to $3625 after the price transfer
Initial situation (product at $4 each) After price change (product at $5 each)
Firm X Firm Y Firm X Firm Y
Tax @20% Tax @35% Tax @20% Tax @35%
Profit before tax 2000 3000 2500 2500
Tax 400 1050 500 875
Profit after tax 1600 1950 2000 1625
Total profit to Z 1600+1950=3550 2000+1625=3625
Multinational corporations must for income tax purposes assign global profits across the different countries and affiliates where they operate. The best strategy would be to authorize each affiliate to maintain a certain level of taxes by engaging with different subsidiaries in transfer pricing. MNCs can ensure that the overall tax rate applied to them is below the 35% charged by the US government by always shifting profits appropriately depending on the various tax rates in various countries.
The benefits associated with this technique is that it can help minimize duty costs in high-tax areas by moving goods to these areas at minimum prices so that once the tax is applied on the base, the company will not feel exploited. Applying high prices for products from high-tax jurisdictions also help cushion the firms in these nations from the exorbitant rates hence maintaining their profitability (Faulkender and Smith, 2016, p. 16). The risks involved in this technique include potential disagreements among the branch managers concerning the best policies for price transfer. There might be higher additional costs in implementing the transfer pricing policies. It is also hard to estimate the best strategy about intangible goods and services. Mistakes that may cost the company greatly may therefore arise. Transfer pricing processes are therefore complicated and managers and others involve in the process should be extra cautious.
Implications of Tax avoidance methods
MNCs that undertake the various tax avoidance activities usually believe that they suffer from a competitive disadvantage compared to firms in areas with significantly lower tax rates. There seems to be a consensus that the tax rates in countries such as the US are too exploitative. Comparing with countries with a 10% or less tax rate. This is not subject to debate. Firms, therefore, see the need to maximize their shareholders’ value by applying various creative but legal mechanisms to lower these rates. It is the work of governments to, therefore, do a critical evaluation to determine the most appropriate tax rate that does not scare firms from paying taxes and which allows more investment into the country rather than a redirection of revenues into other nations.
Conclusion
Multinational corporations can make use of the various loopholes in global policies to reduce their taxes to create more wealth for their shareholders as this is the main objective of any business. Paying more taxes than is necessary can also inhibit the undertaking of crucial tasks such as R&D which is meant to make the company more aware of the market for maximum revenue profitability. The various techniques include transfer pricing, inversion, royalty payment for intangible goods, and deferral of income from subsidiaries. Transfer pricing, for example, helps reduce customs costs for goods shipped to high-tax areas and help shift profits to high-tax areas to cushion against the high rates. To reduce this activity, governments in nations with high tax rates should consider lowering the rates as lower rates also attract more investments rather than chasing investors away.
References
Blouin, J. (2012). Taxation of Multinational Corporations. Foundations and Trends in Accounting, 6(1), pp.1-64.
Browning, L. (2016). Pfizer Seen Avoiding $35 Billion in Tax Via Allergan Merger. [online] Bloomberg.com. Available at: https://www.bloomberg.com/news/articles/2016-02-25/pfizer-seen-as-avoiding-35-billion-in-tax-via-allergan-merger [Accessed 25 Feb. 2018].
Clausing, K. (2005). The Role of U.S. Tax Policy in Offshoring. Brookings Trade Forum, 2005(1), pp.457-482.
Clausing, K. (2009). Multinational Firm Tax Avoidance and Tax Policy. National Tax Journal, 62(4), pp.703-725.
Contractor, F. (2017). Tax Avoidance by Multinational Companies: Methods, Policies, and Ethics. Rutgers Business Review, 1(1), pp.27-43.
Cristea, A. and Nguyen, D. (2016). Transfer Pricing by Multinational Firms: New Evidence from Foreign Firm Ownerships. SSRN Electronic Journal.
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Faulkender, M. and Smith, J. (2016). Taxes and leverage at multinational corporations. Journal of Financial Economics, 122(1), pp.1-20.
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Gyarteng, K. (2014). International Tax Avoidance Schemes: An Investigation of Multinational Technology Companies. International Journal of Academic Research in Accounting, Finance and Management Sciences, 4(1), pp.365-370.
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Hines, J. and Rice, E. (1994). Fiscal Paradise: Foreign Tax Havens and American Business. The Quarterly Journal of Economics, 109(1), pp.149-182.
Humer, C. and Banerjee, A. (2016). Pfizer, Allergan scrap $160 billion deal after U.S. tax rule change. [online] U.S. Available at: https://www.reuters.com/article/us-allergan-m-a-pfizer/pfizer-allergan-scrap-160-billion-deal-after-u-s-tax-rule-change-idUSKCN0X3188 [Accessed 25 Feb. 2018].
Markle, K. (2015). A Comparison of the Tax-Motivated Income Shifting of Multinationals in Territorial and Worldwide Countries. Contemporary Accounting Research, 33(1), pp.7-43.