International Tax of the Company of an Automobile Parts Manufacturer Based in the United Kingdom - Essay Example

International Tax Part I – Company Background The chosen company is an automobile parts manufacturer based in the UK. Its main operation is in the automobile industry. The various products that are manufactured by the company are clamps, belts, motors, chains, control systems, gears, shafts, axle parts, etc that are used in various automobiles. It is a moderate sized company with all its operations in UK alone. The products are exported to other countries but the company does not have any branches or operations in foreign countries. It is a single company with no subsidiaries. In the recent years the demand for the products has increased especially from the east and other third world countries. Manufacturing parts in UK and then exporting to third world countries is not viable due to various financial factors. Hence the company has decided to set up a manufacturing unit in any of the third world country. This will help the company to maximize its profits, and at the same time give an opportunity to expand and explore new markets. The following report addresses the various issues that have to be considered from international tax perspective while expanding operations offshore. Part II - Report to the Board of Directors Introduction While setting up an overseas operation there are certain very important tax related issues that need to be considered before choosing an appropriate location. The issue might seem to be too complicated initially given the numerous nations and their individual legal and political systems but there appears to be abroad consensus among all the nations of the world regarding tax matters. And, this is surely a matter of utmost relief to companies that intend to operate across political boundaries as tax matters indeed create problems in estimating income earned by a subsidiary, more so what portion of it can be rightly considered as income of the consolidated entity. However, with the phenomenal rise of multinational corporations, the vexatious issue of which state should rightfully tax which portion of the income of a multinational business entity still poses certain questions for which unambiguous answers are hard to come by. Jurisdiction to tax Legally speaking, every state has the jurisdiction to impose tax, irrespective of whether the tax is generated within the domestic territory of the state (source country) or it is generated outside the domestic territory but by a legal entity that is normally resident of the state (residence country). In the international taxation regime that is adhered to by almost all the countries of the world, the country where the tax is generated has the first right to tax while the country of residence has an equal responsibility to prevent incidences of double taxation. Such an arrangement, however, is merely a matter of mutual convenience and does not necessarily reflect optimal distribution of taxes. Optimality in distribution of tax revenue between source country and residence country could be achieved if active income is taxed by the source country and passive income (Avi-Yonah 2004) is taxed by the residence country. Active income in this context is construed as the income generated through production process while passive income is the financial returns in the form of dividends, interest and royalty. Thus the country where actual production is undertaken should have the right to tax the surplus generated from that production process whereas the country from where the capital has come from should have the right to tax returns on capital invested (Ault 1992). However, the actual taxation norms between two countries are usually determined by tax treaties between the two concerned countries. Hence, it would always be beneficial to set up a subsidiary in a country that has a tax treaty with the country where the holding company is situated. Generally a Tax Treaty differentiates between source and residence and also active income and passive income. Such a treaty also allows the source country to tax on profits generated by the business while the residence country ensures that no double taxation takes place. While on the topic of profits generated by the business a very important related topic is that of transfer pricing. Transfer Pricing Transfer pricing denotes the price charged by associated parties when they transact between themselves (Arnold and McIntyre 2002). Profit is calculated as an excess of revenue over cost and inputs form the most important component of cost. So, if two associated companies wish to transfer their profit from a high tax regime to a low tax regime, the company situated in a high tax regime would charge below cost price for all its transactions with the company situated in a low tax regime. In this way the associated companies would be able to reduce their combined tax burden. To prevent such avoidance of tax, OECD Model Treaty states that transfer prices should be set in a manner that they reflect prices that would have been set if transactions were between two unrelated parties (Chorvat 2000). This is also known as ‘arm’s length principle’ where it is assumed that related parties should treat each other as unrelated parties in matters of transfer pricing and should not be closely associated with each other but remain at arm’s length of each other while deciding transfer prices. There are five widely accepted methods of deciding such arm’s length transfer prices. Comparable Uncontrolled Price Method: This method compares transfer prices set between related parties with prices that normally would have been charged had the transaction taken place between independent entities. If the transfer prices reasonably align with prices fixed independently, it would be assumed that arm’s length principle has been observed. Resale Price Method: This method is most appropriate if the subsidiary company is only a reseller of the products manufactured by the holding company. In such cases an appropriate gross profit is deducted from the reselling price to determine whether the transfer price has been fixed in accordance to arm’s length principle. Cost Plus Method: This method is most appropriate for manufacturing companies where the output is valued at cost which is marked up by a reasonable quantum of profit per unit. However, it would not always be proper to opt for this method of transfer pricing simply because our company is involved in manufacturing industry. Comparable Profits Method: This method compares the rate of profit in similar transactions between unrelated parties with profitability rates in transactions between related parties. If there is substantial variation in profitability in transactions between related parties, authorities suitably modify the figures before charging tax (Ackerman and Chorvat 2004). Profit Split Method: This is basically a mathematical approach to split profits of the entire conglomerate among subsidiaries and holding companies in a ratio that corresponds to value added by each such unit. This method is adopted only when no other method is found suitable. Conclusion However it is still possible to evade taxes by manipulating transfer prices as it is rather difficult to find comparable prices and it is not all that difficult for a multinational company to establish residence at a low tax regime location often referred to as a tax haven. This would appear even more lucrative if the low tax regime has a tax treaty with the current high tax regime residence of the multinational (Hudson and Turner 2005). But it must be remembered that benefits of resultant tax reduction would only be temporary as international tax laws are progressively becoming stricter to prevent such tax evasion. Part III - Use of offshore centers to avoid tax by multinational companies Use of offshore centers to avoid tax is not a relatively new phenomenon. It probably started as a reaction to the numerous trade restrictions, protective tariffs, exchange control regimes that littered the global financial landscape as Second World War drew to a close. Though it was not unusual for countries to go into a protective shell after the upheaval of the War, as global economy gradually started picking up, individual economies also started easing their restrictions but all economies were not equally forthright in opening themselves up to become investor and entrepreneur friendly. This resulted in uneven taxation structure across economies and companies tried to leverage these differences to reduce their tax burdens and regulatory expenditures to the extent possible. The most prominent example of such an attempt by corporate entities to reduce their statutory obligations while scouring for Eurodollar loans was the use of Netherlands Antilles international finance subsidiaries by U.S. companies. This phenomenon rose to a peak during mid-1980s when almost every US corporate entity of repute had at least one Antilles finance subsidiary. This phenomenon however did not get a boost due to some insidious maneuvers by the offshore financial center; rather it arose due to disparities in the then prevailing US laws that imposed high withholding tax rates (up to 30%) on interest payments by US companies on non-US persons and either very minimal or complete exemption of withholding tax on interest paid to residents of the Netherlands Antilles. As the residence of a corporate entity is determined by its place of incorporation, almost all Eurodollar lenders set up Antillean NVs that reaped the benefits of tax exemption while transferring the interest amount to overseas parent companies. Thus, these NVs had very little left with them to be taxed by the Antillean authorities. This system of funding commonly referred to as "Antilles sandwich" structure became extremely popular and US manufactures were flooded with copious Eurodollar loans that helped the US economy to boost production and ease its then prevailing balance of payments problems to a very great extent. US treasury was initially very much supportive of this arrangement but as concerns within the country grew about loss of tax revenues and inability of US authorities to extract tax information from actual lenders, the special tax treaty with Netherlands Antilles was scrapped on June 29, 1987 and the withholding tax on interest payments to non-US residents was also abolished almost simultaneously. This signaled the demise of Antilles as a conduit for Eurodollar lenders to avail of tax benefits and the relevance of the location faded into insignificance (Boise and Morriss 2009). The story of Antilles brings forth four relevant observations about offshore financial centers and their relevance in global financing scenario. The first and foremost observation is that there will always be differences among legal regimes and multinational companies will always try to arbitrage these differences in order to make transactions less costly. Such an arbitrage need not necessarily be beneficial to only the transacting parties; it might also benefit the jurisdiction within which such arbitrage takes place. The second observation is differences among legal regimes are by definition temporary and so the attractiveness of an offshore jurisdiction is entirely dependent on statues that generate such differences and vanish entirely or diminish substantially if such statutes are repealed or amended. Thus, the third observation is if an offshore jurisdiction intends to retain its preeminence as a financially attractive destination it must be flexible enough to adapt to a world of constant changes over which it hardly has any control. Such flexibility must be prevalent in its administrative as well legal spheres. The fourth observation is the flexibility of an offshore jurisdiction depends entirely on its own laws and political structure and their ability to modify according to the requirement of the day. Antilles could not amend its laws and administrative process fast enough to retain its attractiveness as an offshore destination once the tax treaty was repealed and thus lost its status as an ideal offshore center. It would be proper at this stage to examine the characteristics that identify an offshore financial center or what is more popularly known as tax havens. The central feature of a tax haven is that its laws can be used to evade tax in other jurisdictions where taxation rates are much higher. The main characteristics of tax havens are their secrecy in functioning of banks as well as secrecy in actual corporate identities or ownership of assets. It is very difficult to obtain genuine information about legal entities as companies or trusts that own assets and monitor fund flows arising out of those assets if their residence is in any tax haven. These tax havens also generally have very low tax rates or, in some instances, no tax at all on income earned by residents under its jurisdiction (Booijink and Weyzig 2007). Multinational companies innovatively arbitrage this difference in tax rates among jurisdictions to lessen their tax liabilities. Business entities as web based companies that do not require a large asset set up in a particular location or employ a substantial labor force have tried to reduce their tax exposure by setting up their businesses in tax havens. During the last two decades of the previous century, several multinational corporations had set up offshore companies for the purpose of‘re-invoicing’. These so-called re-invoicing companies simply re-invoiced consignments that were sent to them at lower rates and made a profit by doing so. However, as the profit was earned in a tax haven there was hardly any tax liability on these re-invoicing companies. Multinational corporations thus used to ‘skim’ profits by under invoicing in the high tax regimes at their place of operation and then re-invoicing at tax havens. However, such pricing scams have been practically non-existent these days on account of more sophisticated taxation structure implemented in most countries. The main economic activity in tax havens now center on mutual funds, banking, pensions and life insurance. The modus opernadi is somewhat like this. There is an intermediary company incorporated in the tax haven that handles the fund flow. Funds are deposited with this intermediary company which then lends that money to entities situated in high-tax jurisdiction and earns interest out of the money so lent. Though such a transaction does not avoid tax in the jurisdiction where the main customer is situated, it does avoid any possibility of multiple taxation (Gupta 2010). Many high tax regimes have implemented several provisions in their taxation structure to prevent avoidance of tax liability through routing of funds via tax havens. Such provisions include, inter alia: The income or gains to an individual through investments in companies located in tax havens are taxed on the basis of actual location of accrual Incorporation of transfer pricing rules in accordance with the guidelines provided by OECD Imposition of withholding tax when payments are made to offshore entities Imposition of exit charges which are nothing but tax on notional capital gains on companies that emigrate from a high tax regime to a tax haven United States has inked deals – Tax Information Exchange Agreements (TIEA) – with quite a few tax havens to ensure flow of information related to identity of entities and quantum of funds flow through those tax havens France has made it illegal for a company situated in a tax haven to go for a public issue of bonds (Vevstad 2010) At the London G20 summit on 2 April 2009, member countries voiced their concern about the tax evasion and avoidance that is being carried out by multinational companies through tax havens and brought out a blacklist of countries they considered as tax havens. Though there have been lots of arguments and counterarguments about the countries that should appear in that list one needs to analyze the issue dispassionately before branding tax havens as a scourge that must be stamped out at any cost. Pierre Mirabaud, Chairman of the Swiss Bankers Association, in an interview with The Washington Times expressed their apprehension about the ‘sinister’ motives that Swiss bankers saw behind G20 nations’ continuous pressure to loosen their strict codes of secrecy that has been the hallmark of Swiss banking for nearly a century and a half. Switzerland happens to be the largest offshore destination handling about 27% of the global market with Swiss banks managing about $2.42 trillion of offshore funds. Mirabaud was particularly critical of the manner in which US authorities fined the Swiss banking giant UBS $780 million and forced it to part with the details of 300 account holders who, the US authorities alleged, were engaged in tax evasion and frauds. However, UBS stood its ground and refused to divulge the details of another 50,000 account holders that US authorities had requested for. He accused that the US was violating international tax laws in pressurising UBS to divulge details that it was not bound to under Swiss laws and stated that Swiss banks have neither any legal responsibility nor any legal jurisdiction to ensure that US citizens were not violating tax laws prevailing in their country. However, to avoid being branded as a tax haven Switzerland agreed to adopt international standards concerning tax-evasion issues pertaining to foreign bank accounts but the country has no intentions of relaxing its norms of secrecy. Mirabaud was also severely critical of other tax havens as Jersey and Guernsey who had agreed to share tax related information but in reality do not have any genuine information about who are the actual investors or account holders (Zarocostas 2009). Even without going into the merits or otherwise of the issues put forward by Mirabaud, one can surely say that the fight between so-called tax havens and high-tax regimes is essentially and tax competition between two regimes that forces high-tax regimes to be very cautious before spending public money and simultaneously allows entrepreneurs access to low cost investment funds. US have alleged that tax abuses had cost US treasury nearly $100 billion every year in lost tax revenues. While the figure is hotly contested, it cannot be denied that the money had been funnelled back into the US economy to create jobs and wealth of Americans instead of being sucked up by the Treasury and used for dubious purposes as funding the Iraq War. And what none should forget is contrary to general perception, tax havens do not siphon off capital from high-tax areas, rather they allow investors a climate where they can make a better and more informed investment decision (Stewart 2010). Part IV – Annotated Bibliography 1. The article ‘Change, Dependency, and Regime Plasticity in Offshore Financial Intermediation: the Saga of the Netherlands Antilles’ by Craig M. Boise and Andrew P. Morriss was surely an important input in preparing this essay. The article provided a detailed study of tax evasion done by multinational companies by exploiting the loopholes of the tax treaty United States had with Netherlands Antilles. As this was the first officially accepted record of tax evasion by routing funds and stationing business entities in a tax haven, this article provided a very good understanding of how tax havens came into existence. The important point that the article made was the authorities of a tax haven are not intrinsically criminal in nature. They only took advantage of a series of laws that created a situation where companies could legally avoid taxes simply through a little bit of manipulation (nothing illegal about it). The historical backdrop of the entire issue, right from 16th century provided a clearer perspective about the entire issue of tax competition and tax havens. However, the article restricted itself only to one case and thus looking into other resources became necessary to obtain a wider and more comprehensive analysis of the subject. 2. The article ‘New Financial Imperialism’ by Robert Stewart provided a refreshing and rather novel perspective to the issue of tax havens. The author was passionate about what he thought was unfair domination of developed western countries over rest of the developing world. Any attempt by these developed nations at reducing the influence of tax havens has been described by the author as another form of imperialist domination – one that did not involve brutal military force but an even more lethal force of financial superiority. In trying to put forward his point of view, the author oftentimes sounded more like a propagandist using fiery rhetoric to establish his credentials but in the process came out with a number of genuine reasons as to why tax havens should not be viewed as a den of diabolic criminals. The author instead portrayed tax havens as poor countries trying to come up the economic ladder against all odds and unfair discrimination by developed countries. 3. The article ‘Swiss Bankers Fear Economic War with G-20’ by John Zarocostas helps one to understand how the quest by developed countries to prevent tax evasion through tax havens might ruin one of the best banking systems ever to have been developed. The famed secrecy of Swiss Bankers has been described in a proper light where though they are always eager to help prevent illlegal activities and would not mind paying substantial fines if they have unwittingly broken laws of the land are, however, not willing to divulge details of their depositors simply because some economic superpower wants to know them. Such a heightened sense of professionalism and propriety adds a new dimension to Swiss Banking widely reviled in some circles as being the safest and most efficient tax haven in the world. References Ackerman, Robert, and Elizabeth Chorvat. "Modern Financial Theory And Transfer Pricing." 10 George Mason Law Review, 2004: 637-639. Arnold, Brian J., and Michael J. McIntyre. International Tax Primer. The Hague: Kluwer Law International, 2002. Ault, Hugh J. "Corporate Integration, Tax Treaties and the Division of the International Tax Base: Principles and Practices." 47 Tax Law Review, 1992: 565. Avi-Yonah, Reuven S. "The Structure Of International Taxation: A Proposal For Simplification." 74 Texas Law Review, 2004: 1301-1306. Boise, Craig M., and Andrew P. Morriss. "Change, Dependency, and Regime Plasticity in Offshore Financial Intermediation: the Saga of the Netherlands Antilles." Texas International Law Journal. Volume: 45. Issue: 2, 2009: 377-402. Booijink, Laurens, and Francis Weyzig. "Identifying Tax Havens and Offshore Finance Centres." tax justice network. July 2007. http://www.taxjustice.net/cms/upload/pdf/Identifying_Tax_Havens_Jul_07.pdf (accessed December 21, 2010). Chorvat, Elizabeth. "Forcing Multinationals To Play Fair: Proposals For A Rigorous Transfer Pricing Theory." 54 Alaska Law Review, 2000: 1251. Gupta, Vibhuti. "Tax haven - What is it?" CAlley.com. August 31, 2010. http://www.caalley.com/art/art10_0831.html (accessed December 21, 2010). Hudson, David M., and Daniel C. Turner. "International and Interstate Approaches To Taxing Business Income." New York Journal of International Law and Business 562, 2005: 580-581. Stewart, Robert. "The New Financial Imperialism." Freeman, Volume: 60, Issue: 5, June 2010: 19-21. Vevstad, Vegard. "International Taxation." International Expansion. November 14, 2010. http://www.internationalexpansion.org/international-taxation/international-taxation/ (accessed December 21, 2010). Zarocostas, John. "Swiss Bankers Fear Economic War with G-20." The Washington Times, March 27, 2009: A01. Read More