In this article we will discuss about International Tax Planning:- 1. Meaning of International Tax Planning 2. Need for International Tax Planning 3. Opportunities 4. Techniques 5. Methodology.
- Meaning of International Tax Planning
- Need for International Tax Planning
- Opportunities for International Tax Planning
- International Tax Planning Techniques
- International Tax Planning – a Methodology
1. Meaning of International Tax Planning:
International tax planning is the art of arranging cross-border transactions with the knowledge of international tax principles to achieve a tax effective and lawful routing of business activities and capital flows. The planning process follows the money flows in cross- border transactions, as they pass from the host country where they arise to the home country where they eventually end.
Tax planning helps to reduce the cumulative impact of taxation, as compared to the separate tax incidence in the countries through which the transaction flows. Its prime objective is to receive the after-tax flows of overseas income lawfully at minimal cost and risk.
Domestic tax planning is concerned primarily with the national rules of tax deductions, allowances and exemptions, and the different tax rates levied on various sources of income in a single jurisdiction.
International tax planning examines the interrelationship of two or more tax systems, the impact of juridical and economic double taxation, and the tax compliance rules in more than one country. It also involves additional considerations, such as tax incentives and exemptions for foreign income, availability of foreign tax credits, use of tax treaties and anti-avoidance measures.
International tax planning has been defined as a tax-driven proactive arrangement of a person’s affairs to minimize his tax results. It would normally be optimized when the after-tax profit is maximized.
Besides reduction in the overall effective tax rate, it may also lead to tax deferral and reduction in tax compliance costs. It not only looks at legal tax-saving opportunities but also at tax risks such as double taxation and prospects of counteracting tax legislation.
2. Need for International Tax Planning:
Tax is not usually a primary or overriding factor in the decisions to engage in overseas business activities or to invest abroad. These decisions are generally made on factors, such as business viability, availability of resources, market access and market potential.
Other persuasive factors include political and economic stability, government grants and incentives, geographical location, business infrastructure, availability of a skilled and low cost workforce, strong currency, etc. The decisions are (and should be) rightfully based on commercial, economic, and even social and political considerations.
However, once the initial decision has been made, tax often becomes an important business consideration. A survey conducted by the Ruding Committee revealed that almost half the multinationals in the European Union considered the tax rate on business profits as a decisive factor in deciding the country to locate their operations.
Other key considerations mentioned in the survey were the availability of treaties and the quality of the tax administration. These factors influence the long-term financial viability of the business and the ultimate return on the investment.
Generally, cross-border activities suffer a higher tax liability on a worldwide basis than just domestic or single-country transactions. They are subject to tax in more than one tax jurisdiction. Moreover, the taxpayer may have to cope with inconsistent tax laws, erratic tax authorities and high taxes in various jurisdictions.
Proper tax planning is, therefore, essential in an international business to reduce the distortions that arise due to the lack of harmonization in domestic tax systems. Without tax planning, it would suffer from excess tax payments and additional tax compliance costs.
3. Opportunities for International Tax Planning:
There are three levels of tax impact on cross-border transactions, as follows:
(i) Source or host country, i.e. taxes payable on the income earned through overseas subsidiaries or branches, and the withholding tax on the payments made by them;
(ii) Intermediary country (if used), i.e. taxes payable on the overseas income and the withholding taxes on the repatriation of profits or capital to the home country; and
(iii) Residence or home country, i.e. taxes payable on the profits and capital received at home, and sometimes even if not received, from entities in the other countries.
The opportunities for tax planning exist at each level. For example:
(a) The Taxation in the Source Country may be Reduced Through:
i. Local tax planning that optimizes the use of tax deductions, incentives, tax losses and special tax concessions available under the domestic law and tax treaties.
ii. Tax exemptions from the break or “fracture” of the connecting tax factors with either the source or the Residence State (or both).
iii. The use of various planning techniques to ensure that the taxable profits arise outside the country.
iv. The use of tax treaties and innovative planning techniques to reduce the withholding taxes or to obtain a tax-exemption.
v. The selection of the appropriate legal entity (e.g. branch or subsidiary) and the form of financing (debt or equity).
(b) The Intermediary Country Taxation on Remitted Income Flows may be Reduced Through:
i. The use of tax treaties to reduce the withholding taxes in the host country.
ii. The proper selection of offshore financial centres to minimize or avoid the corporate and withholding taxes.
iii. Tax arbitrage through a change in the nature or character of the payments made to the home country.
iv. The use of various tax concessions, such as the participation exemption and EC Directives.
v. The retention of funds offshore for reinvestment abroad or to achieve a tax deferral on remittances made to the home country.
(c) The Taxation on Profits Repatriated to the Home Country may be Reduced Through:
i. The use of appropriate global corporate structures that avoid, reduce or defer the tax liability.
ii. The optimal use of available foreign tax credits and exemptions to reduce domestic tax liabilities.
The opportunities for international tax planning are limitless. They are based on various techniques to eliminate, minimize or defer the tax burden after considering the transaction costs, the management structures and the business risks. They aim to reduce not just the foreign tax liabilities but also to increase the total income after tax over the entire transaction flow from the source to the ultimate destination.
The objective of the international tax planner is to maximize the after-tax income on the entire transaction flow from the host to the home jurisdiction. It is effective tax planning and not just minimization of taxes paid on the foreign earnings at each level.
While “effective tax planning” considers the role of taxes when maximizing after-tax returns, the “tax minimization” focuses exclusively on tax reduction. Thus, a “tax minimization” strategy may often add significant non-tax costs making a particular transaction not worth undertaking.
The extent of the tax benefit from the planning depends on several factors. In particular, it varies with the amount of income earned abroad, the difference between domestic and foreign tax rates, and the nature of the income.
For example, international tax planning may not be worthwhile if the overseas operations are very limited or not profitable, unless the losses are tax-deductible at home. Moreover, although international tax planning is more flexible than domestic planning, it is also much more complex.
It depends on the tax treaties and the domestic laws in more than one country. It requires an understanding of the tax laws and practices, tax treaties, and the anti-avoidance rules in various countries.
Any tax planning must be lawful and comply with the tax and other laws of each of the countries involved. These laws vary widely. While some countries take a fiscal view and counter any attempt to reduce their tax base, others are more flexible and adopt a more holistic view to achieve certain non-tax (e.g. social and economic) objectives.
They allow (and even encourage) tax planning through various incentives provided it meets these objectives even at a fiscal loss. Hence, unacceptable tax avoidance is one country may be acceptable tax planning in another country.
However, tax fraud or evasion is not tax planning. Tax planning is only acceptable if it is not considered abusive under the domestic tax law of the countries involved. Most countries have specific anti-avoidance legislation to prevent wholly artificial arrangements set up to circumvent the tax law and obtain tax benefits.
The planning, which is based on tax “loopholes” normally gives only short-term benefits, and could lead to expensive tax litigation. International tax litigation is expensive and should be avoided.
4. International Tax Planning Techniques:
As the amount of the tax liability is determined by the taxable income multiplied by the tax rate, the reduction in either of the two factors leads to a reduction in the tax payable.
Most planning techniques used today rely on the following principles:
i. Exemption from the tax.
ii. Reduction in the tax rate.
iii. Reduction in the tax base.
iv. Deferral of the tax payment.
v. Credit or exemption for foreign taxes paid.
vi. Treaty shopping.
vii. Use of hybrids.
(a) A State may decide to exempt (i.e. not tax) an income or tax it at a reduced rate for certain tax policy reasons (e.g., tax incentive). The ability to claim tax exemptions normally constitutes the best method of tax planning. The related expenses are generally not deductible, (“tax exemption”).
(b) A reduction of the tax rate may be either a reduced domestic rate or a reduced withholding tax. To benefit from a reduced tax rate, the taxpayer may re-characterize the income to a lower rate category, or apply a tax incentive.
The lower withholding tax may be achieved again by re-characterization of the income or capital or under a tax treaty. A tax rate reduction is a tax incentive. Tax incentives are offered by probably every country with a tax system, (“rate reduction”).
(c) Profits within a multinational organization may be shifted from a high tax to a low tax jurisdiction through appropriate business restructuring or profit extraction techniques. These techniques reduce profits in high-tax countries and increase profits in lower- taxed countries through legitimate shifting of activities within a multinational group.
Generally, it is easier to plan for a new income flow to be outside the jurisdiction’s tax net than to divert it once it has already been included in the taxable income, and has a tax history, (“base reduction”).
(d) A deferral of taxes is useful in so far as it provides for a benefit through a reduction in the time-value of money. Certain income (e.g. dividends) is taxable at home only when it is received.
Such income flows may be deferred unless they are required. Some countries regard such deferral as improper and have complex rules to tax them currently if their payment can be controlled by the receiving company, (“tax deferral”).
(e) Most countries provide relief for foreign taxes paid on income received at home to avoid double taxation. The amount and the timing of these reliefs vary widely under domestic tax laws of countries. They represent tax benefits that reduce tax at home and often require planning to optimize their use. (“Tax credits and exemptions”).
(f) Cross-border payments of passive income are often subject to a withholding tax at source. This withholding tax may be reduced to nil or a low rate of tax under double tax treaties. Prior planning may ensure that the payment is received in an intermediary jurisdiction where the tax burden is lowest, as “flow-through income”. Treaty shopping techniques are widely used with the help of intermediary entities e.g., holding companies, (“treaty shopping”).
(g) In recent years, new tax planning techniques have emerged that rely on hybrid situations where the same transaction, instrument or entity is taxed differently in two countries. Their use in tax planning may enable both avoidance of double taxation and also tax arbitrage through double dipping or non-taxation. (“Use of hybrids”).
Some common tax planning techniques using these principles are listed below:
(i) The Review of Tax Provisions and Compliance Rules under the Domestic Law (“Domestic Law”):
The starting point for any international tax planning is the knowledge of the tax rules and practices in the various jurisdictions involved in the transaction. Each country has the right to legislate its own tax laws and how they should be enforced.
The domestic law and practices alone decide who should be taxed, what should be taxed and how it should be taxed (as well as what is acceptable planning). Tax treaties cannot expand the tax base or generally determine how it should be computed.
(ii) The Reduction of the Pre-tax Profits through Deductible Expenses (“Tax Deductions”):
Several countries give additional tax deductions and allowances under the domestic law to encourage investment, stimulate savings and for other social and political considerations. The effective use of these “tax breaks” can reduce the tax liability.
(iii) The Use of Special Tax Concessions for Foreign Capital, Technology, etc. (“Tax Incentives”):
Many countries grant special tax concessions for foreign capital and technology. The host countries may give incentives to attract them, such as tax holidays or the use of tax-free zones for exports or employment generation. Many of these tax concessions may be given to nonresidents only (“ring fenced”).
(iv) The Optimal use of the Tax Loss Carry-overs (“Use of Tax Losses”):
Tax losses represent deferred tax benefits, and tax planning can help to optimize their use. Most countries allow carry-forward of past losses for specified (or unlimited) periods for set-off against future profits. Some of them permit carry-back of losses. Several jurisdictions allow a group of companies to net their taxable profits and losses under “tax consolidation” rules.
(v) The Provision of Special Deductions or Exemptions to Qualifying Dividends (“Economic Double Taxation”):
Many countries give relief under dividend-deduction or participation exemption rules to partly or fully exempt foreign dividends (and sometimes capital gains). Relief may also be given on the dividends through indirect credit for the foreign underlying taxes paid by the subsidiaries, or under the imputation system for domestic dividends.
(vi) The Split of Pre-tax Profits among the Various Tax-beneficial Jurisdictions through Source Allocation (“Profit Diversion”):
The tax base of a multinational organization may be split lawfully by appropriate structuring of the worldwide business activities. For example, the manufacturing unit may be set up in one country, while sales and marketing activities could be conducted through separate overseas entities.
The manufacturing activity itself may be split globally. For example, the taxpayer could use a low-tax base for the manufacture of value-adding (and profitable) components or semi-finished goods, and complete the low-profit processing and assembly in a high-tax location, or vice versa.
Similarly, construction or assembly projects can be unbundled with separate contracts for each scope of work. A turnkey project may be split into procurement, preparatory studies, technical drawings, engineering and consultancy services, technical support, and supervision activities.
Separate agreements may be signed for on-site and off-site work and for the provision of personnel, assembly, installation and testing activities. Separate offshore entities may be formed to hold or manage various assets or to provide group management services. Different group companies in more than one country may handle these contracts.
(vii) The Extraction of Pre-tax Profits from High-tax Countries through Legitimate Tax-deductible Charges or Expenses (“Base Erosion”):
International tax planning encourages a shift of taxable profits from high-taxed countries to low-taxed countries through tax- deductible expenses, such as interest, royalties or management fees. The tax base is reduced through a transfer of pre-tax profits under acceptable transfer pricing and commercial substance rules within the group.
It may have a licensing company, a research and development company, a regional management or “overseas headquarters company,” a service company, a financial holding, etc. Each of these entities may be set up in a commercially appropriate and tax-beneficial jurisdiction.
Such tax planning usually requires evidence that the expenses were incurred wholly and exclusively for the business purposes of the paying entity, and on an arm’s-length basis.
To avoid the transfer pricing issue, it is preferable to ensure that at least one or more group entities in the value chain are unrelated. The expense deductibility may also depend on factors, such as the payment of withholding taxes, reasonableness tests, and full disclosures to the tax authorities.
(viii) The Tax Deferral of Foreign Profits (“Tax Deferral”):
Tax deferral provides a tax saving in terms of the time cost of money. The deferral may be achieved through the setup of intermediary companies, changes in the accounting periods, the use of different legal entities, etc.
The extent of the benefit from the deferral normally depends on four factors:
(a) The amount of foreign income,
(b) The difference between the effective domestic and foreign tax rates,
(c) The length of deferral, and
(d) The interest rate.
The use of an offshore company may allow the retention of undistributed profits abroad to defer the taxation in the home country. The profits may be timed for remittance tax-free when the offshore profits are needed.
The deferral of income remittances may not be tax beneficial in all cases. For example, if the effective home tax rate is lower than the tax paid abroad, or if the foreign source income is tax-exempt in the Residence State, the funds may be brought home without tax costs.
(ix) The Optimal use of Foreign Tax Credits (“Tax Credits”):
Many countries provide double tax relief through the credit method. They could be direct credits for withholding tax only, or may include indirect credits on dividends for the tax paid on the underlying income. Some countries give additional tax sparing or matching credits for the taxes that are waived due to incentives.
These tax credits are usually given under various limitations and their method of calculation varies widely. Unused tax credits often result in the deferral or loss of these tax benefits. Tax planning can optimise the availability and the use of foreign tax credits.
(x) The Review of Exchange Gains and Losses in Cross-border Transactions (“Exchange Risks”):
Cross-border transactions invariably lead to considerations of foreign exchange gains and losses, and their tax consequences. While many countries treat foreign exchange gains and losses as ordinary income, several countries differentiate them between revenue and capital gains and losses.
The tax treatment of the unrealized gains and losses also varies widely. Tax planning can help to ensure that the exchange losses are tax-deductible currently while the gains are tax-deferred.
(xi) The Exemption of Taxable Income due to the Lack of a Connecting Factor with a Tax Jurisdiction (“Connecting Factors”):
Tax authorities cannot impose a tax under domestic law, unless there is a factor connecting the tax subject (“taxpayer”) or the tax object (“taxable event”) with the tax jurisdiction. Tax planning involves a break or “fracture” of the connecting factors with either the home or host country, or both.
(xii) The use of Appropriate Legal Structure to Achieve the Business and Tax Objectives (“Legal Form”):
Foreign operations may be conducted through varying legal forms of business entities. These legal forms include companies, branches, agencies, licensing or franchise operations, joint ventures, consortiums, etc.
Each form has advantages and disadvantages for tax planning. For example, a company is a separate legal entity and its profits may not be taxed on shareholders until they are distributed as dividends.
A branch operation is an integral part of the enterprise and is usually taxable in both the host and home jurisdictions. A branch may, therefore, be used to claim tax deductions at home during the start-up loss period, and converted into a subsidiary when the operations are profitable.
International tax planning may also take the form of hybrid entities that take advantage of differing entity characterization in various jurisdictions. For example, an entity may be taxable as a company in one country and as a fiscally transparent partnership in another country.
(xiii) The use of the Optimal form of Financing to Minimize Taxation (“Debt or Equity”):
Although the form and mix of financing is based on commercial considerations, the choice impacts the tax liability. Generally, loan capital is both more flexible and tax advantageous, while equity may be preferred commercially. Dividends are usually subject to a higher tax than interest.
Dividends are paid out of post-tax income while interest is a tax-deductible expense. The form of financing may also involve hybrid instruments, which combine the benefits of debt and equity. Tax planning should also consider the form and currency of the equity and debt instrument and where the funds are lent or borrowed.
(xiv) The use of Tax Treaties to Avoid or Reduce Taxation (“Treaty Planning”):
Active business income is not taxed in the source State unless there is a permanent establishment. If it exists, only the income attributable to it is taxed. It is possible to avoid taxation if the place of business does not constitute a permanent establishment under a treaty.
Moreover, withholding taxes on various passive forms of income may be reduced under tax treaties. A reduction in the foreign withholding taxes decreases the total tax liability if the income received is tax-exempt at home. Under the credit relief method it avoids excess foreign tax credits.
(xv) The use of “Third Country” Tax Treaties to reduce Taxes (“Treaty Shopping”):
Treaty shopping can help:
(a) To reduce withholding taxes,
(b) To avoid or defer remittances of taxable income to the home country,
(c) To help maximize foreign tax credits through dividend mixer companies,
(d) To avoid or defer capital gains tax on the sale of investments abroad, etc.
The use of intermediary treaty havens can help to reduce or eliminate the withholding or other taxes in the source country with little or no additional tax costs. They may reduce the tax through either “direct conduits” or “stepping-stone conduits”.
The essential difference between the two methods is that the direct conduit method makes use of an exemption from tax in the intermediary country, while the stepping-stone method reduces the tax liability in that country through a counterbalancing expense.
(xvi) The availability and use of Advance Tax Rulings (“Tax Rulings”):
International tax planning is not risk-free. It is subject to changes in tax rules and practices, as well as differing interpretations by tax authorities and judicial decisions in various countries. Several jurisdictions give advance tax rulings on the tax treatment of cross-border transactions.
They vary from the formal and comprehensive guidance under specific legislation to informal advice given by tax authorities without statutory obligation. These advance provide tax certainty to tax planning.
(xvii) The Selection of Tax-beneficial form of Transaction or Re-characterization of Transactions (“Tax Arbitrage”):
The income from the same transactions can often be structured differently for tax purposes (e.g., as sales, royalties, commissions, interest or service fees, etc.) by the taxpayer. Thus, it may be possible to select a tax-beneficial income type or to re-characterize the income subsequently through tax planning. The re-characterization can alter the applicable tax provisions for calculating the tax, credits or refunds.
(xviii) The Review of the Cross-border Transactions from Host to Home Jurisdiction (“Holistic Planning”):
The tax planning should follow the cash flow of the transaction from the host country where it arises to the home country where it ends (including intermediary jurisdictions, if used). Generally, cross-border transactions suffer a higher overall tax than just domestic transactions. The objective should be to reduce the aggregate tax liability to at least the domestic level, or less, and thereby maximise the net-of-tax return.
(xix) The Compliance with Domestic Tax Law and Anti-avoidance Measures in Various Jurisdictions (“Anti-avoidance Measures”):
Most countries have enacted complex tax rules to protect their domestic tax base. These anti-avoidance rules include transfer-pricing norms, anti-deferral or controlled foreign corporation rules, anti-treaty shopping rules, thin capitalization rules and various general and specific anti-abuse provisions.
(xx) The Effective use of Advisors on Tax Laws and Practices in Various Jurisdictions (“Tax Advisors”):
International tax planners often face problems due to lack of reliable and up-to-date tax information on various jurisdictions. Tax planning usually requires specialist knowledge of the tax laws and practices in various countries, and the related tax treaties.
Tax laws, treaties and practices are constantly changing, and are difficult to monitor. Moreover, they may be changed in future, either prospectively or retrospectively.A timely review of the plan with tax advisors in the various jurisdictions involved in the transaction is an essential tax planning measure.
5. International Tax Planning – a Methodology:
A sample check list for tax planning is given below:
Step One: Analysis of Existing Database:
i. Determine the facts, and applicable tax and non-tax factors.
ii. Analyse fully the host-to-home transaction.
iii. Review the domestic law and the tax treaties in each jurisdiction.
iv. Compute the tax liability and other costs.
v. Perform cost-benefit analysis.
Step Two: Design of Tax Planning Options:
i. Introduce multilateral or global tax planning.
ii. Identify suitable foreign intermediary countries.
iii. Select the form of transaction, operation or relationship.
iv. Examine relevant non-tax factors.
v. Check the availability of advance rulings.
vi. List all tax planning options.
Step Three: Evaluate the Plan:
(i) Determine the tax savings and non-tax costs if;
(a) The plan is not adopted,
(b) The plan is adopted and succeeds, and
(c) The plan is adopted and fails.
(ii) Compute the total costs from host-to-home.
(iii) Select the best tax option.
Step Four: Debug the Plan:
i. Get local advice on tax laws and practice.
ii. Obtain advance rulings, wherever possible.
iii. Check the applicability of treaties and protocols.
iv. Determine validity of entities in the jurisdictions.
v. Check compliance with anti-avoidance rules.
vi. Evaluate any significant risks or disadvantages.
vii. Review the long-term benefits and costs.
Step Five: Update the Plan:
i. Review regularly changes in tax laws, treaties and tax practices.
ii. Amend the plan accordingly.