In this article we will discuss about International Tax Structures:- 1. Introduction to International Tax Structures 2. Examples of Tax-beneficial Structures 3. Forms of Business Entity 4. Financing of Overseas Entities.
Introduction to International Tax Structures:
Global tax management (e.g., planning) provides an opportunity to develop cross-border tax strategies to optimise global tax liabilities while adhering to all applicable laws.
A recent study listed the key global tax planning needs of multinationals, as:
(a) Tax efficient holding company locations.
(b) Cross-border financing and treasury solutions.
(c) Controlled foreign corporation tax planning.
(d) Tax treaties, profit repatriation and loss utilization strategies.
(e) Inbound and outbound investment structuring.
(f) Managing intellectual property and intangible assets.
(g) Tax efficient supply chain and shared services, and
(h) Regional tax issues, e.g. European Union tax harmonization.
Foreign operations may be conducted through various combinations of legal forms, financing methods and acquisition techniques. Although the choice is generally determined by commercial factors, the decisions affect the tax liability and, therefore, the tax planning.
Some specific tax planning considerations include:
a. How should the business activities and the functions of each operation or service entity within the group be distributed globally? What is the most appropriate business form for each entity within the group? What are the likely tax and non-tax risk factors affecting the transaction flow in each structure? Does it meet the business and organizational objectives?
b. How should the foreign investment or operations be financed? Should it be debt or equity, and in what ratio? Should it be financed by the parent company, or locally, or from third country sources? Can the funds be retained or used abroad or are they required to be repatriated to the home country?
c. Should the foreign operations be formed through the acquisition of an existing entity or the incorporation of a new legal entity? Should the acquisition be based on the purchase of shares or assets?
d. How does the tax system in the host country interact with the tax system in the home country? Can tax residence in the host country be avoided? Should an intermediary jurisdiction be used for tax purposes? What benefits do the treaties provide?
e. How are tax treaties interpreted in the Contracting States involved? What terms follow the meaning under the domestic law? What are the source and characterization rules? Are tax treaties under renegotiation? Are they likely to be amended in the foreseeable future? Etc.
The global structure of a multinational group is normally dictated by commercial and operational considerations. Tax minimization is not the overriding factor. Any planning should, therefore, be based on the corporate objectives and the business risks in such a structure.
The tax planners need to take a business view, i.e. compare the costs and risks of the structure with the present and future benefits. As far as possible, the tax structures should be kept simple. Complex structures are more likely to be both costly and risky.
Ideally, the international structure should be established before the set-up of the foreign operations. Any subsequent reorganization leads to additional overheads, such as capital gains tax on the transfer of investments and business, the stamp and registration duties on share transfers, and the possible need for exchange control and other consents.
There may also be a loss of tax attributes (e.g. tax losses) on the change of ownership. It is usually expensive, if not difficult, to change tax jurisdictions.
Examples of Tax-beneficial Structures:
The use of Intermediary Entities:
Some specific examples of tax planning using intermediary entities include:
(a) Use a holding company in a treaty country to own investments offshore. The holding company receives dividends under reduced withholding tax from various subsidiaries and retains the income tax-free under various tax concessions. For example, shareholdings may qualify for tax-free status under the participation exemption or the EC P-S Directive.
(b) Use an intermediary structure for a financing company that provides finance and/or treasury services to group companies. Its funds may be provided by the parent company or borrowed externally. The use of an appropriate jurisdiction with a treaty network could assist in reducing the withholding tax on interest receipts, which may be accumulated tax-free for use within the group.
(c) Transfer intellectual property rights to a licensing company in a nil-tax jurisdiction. This company then licenses the rights to various host countries under tax treaties, and accumulates the royalties tax-free.
To avoid the capital gains tax, the rights should be transferred before they are fully developed. However, if the future development costs are likely to be significant it may be preferable to retain them at home and claim the costs as tax deductions.
(d) Set up a management services or headquarters company offshore to co-ordinate or supply various services to group companies at a cost plus the profit mark-up. The management fee is tax-deductible in the host country, while the mark-up is accumulated in a tax-privileged jurisdiction.
(e) An offshore company may act as a repackaging, distribution or a “turnaround” company to move some of the profits from the high-taxed onshore companies to an offshore centre. Several jurisdictions offer special incentives and free-zone facilities for re-export operations.
The use of intermediary entities provides several tax-planning opportunities. For example, they help in treaty shopping or to take advantage of special tax incentives, exemptions and tax concessions. They allow finance to be raised from international capital markets at lower costs.
They assist in the transfer of funds through an acceptable profit extraction or diversion within a global organization. They hold the profits overseas for reinvestment, or defer their distribution to the home country until it can be done in a tax-beneficial manner.
Break the “Connecting Factor”:
Tax planning can help to break or “fracture” the connecting factors through a review of the residence and source rules in each country. Connecting factors create a tax liability due to the relationship between a tax subject or a taxable object and a tax jurisdiction.
The primary connecting factors are fiscal domicile or residence for the tax subject, and the source or situs for the tax object. Sometimes, the place of action, use or payer could also be a connecting factor.
Varying rules for residence and source under the domestic tax laws could result in the double taxation of certain income, or tax-free status in both countries. Dual residence status can be tax advantageous if “double dipping” is permitted to claim the deduction for the same expense in both jurisdictions.
Some countries have enacted specific anti- avoidance rules to prevent double dipping (Examples: Australia, Canada, United Kingdom, and United States). In the United States, a dual resident company cannot use its losses to offset profits in other group companies.
However, the losses may be carried forward for offset against its own profits. In Canada and the United Kingdom, the companies that are dual resident must also accept the treaty residence for domestic tax purposes.
Effective international tax planning breaks or “fractures” the connecting factors with either the source or Residence State.
Some examples of such tax planning measures are given below:
(a) Incorporate a company in a country where the sole requirement for tax residence is the location of management, and then manage the company from a country where the residence is based only on incorporation.
As a nonresident company in both jurisdictions, its foreign source income will be tax-exempt. If tax residence is essential, select a country that follows the territoriality tax regime, i.e., taxes domestic-source income only.
(b) Avoid unintended residence of a foreign subsidiary in a tax jurisdiction.
Some measures to prevent such situations in countries that base the corporate tax residence on management and control, include:
(i) The parent company should have no direct control powers and its role should be advisory;
(ii) The parent company should not exercise indirect control over the subsidiary through contractual arrangements;
(iii) The company must be managed by local directors and management, who are not acting as nominees; and
(iv) All the directors’ meetings must be held outside the parent country’s jurisdiction and be fully documented.
(c) Trade with a country that has a tax treaty. If there is no tax treaty, trade with and not within the country. The export of goods or services should take place, either directly from overseas or through independent agents. The delivery, payment and contracts should all be made outside the host country. If there is a tax treaty, ensure that there is no permanent establishment.
Foreign Presence without Foreign Taxes:
The tax treaties provide that no source tax is levied on active business income unless the enterprise has a permanent establishment in that country. The OECD MC Article 5 defines a “permanent establishment” as a “fixed place of business through which the business of an enterprise is wholly or partly carried on”.
Tax planning involves the effective use of the exemptions under this Article to maintain a foreign presence without a permanent establishment. For example, the Article provides that certain auxiliary and preparatory activities do not constitute a permanent establishment.
Moreover, dependent agents (e.g. own employees) are not a permanent establishment, unless they have the powers to conclude contracts and habitually exercise these powers. Similarly, the use of independent agents does not create a permanent establishment, provided they are acting in the ordinary course of their business.
A subsidiary is not necessarily a permanent establishment unless it can be regarded as a fixed place of business or a dependent agent.
Even if the foreign business presence requires a permanent establishment, it is only its attributable income that is taxable. The business activities can be “unbundled” into several components or segments to reduce the income attributable to the permanent establishment.
For example, a sales contract may include items such as know-how, training, long-term maintenance agreements and other services that need not be done through the permanent establishment. It may also be possible to perform the profit-making transactions outside the source country.
In certain cases, it is desirable to set up a permanent establishment under a treaty. A permanent establishment is taxed on a net basis (net of expenses) on its income, while passive income, unless effectively connected with a permanent establishment, is subject to a withholding tax on the gross amount.
For example, technical service fees and lease rentals are treated as royalty income and subject to gross withholding tax in several countries. They may be re-characterized as business income, which is then either tax-exempt or taxable on a net basis if there is a permanent establishment under a treaty.
Forms of Business Entity Relating to International Tax Structures:
It is preferable to sell goods and services directly from the home country, or through independent agents, who do not form a taxable permanent establishment under a treaty. No overseas tax is payable if there is no permanent establishment. However, the business growth may make it necessary to establish a tangible presence for commercial reasons.
As the operations expand, a full-time representative or dependent agent may be appointed. A branch or a company is usually established when a full business presence is justified. A partnership (general or limited) or an equity joint venture may be an alternative entity in certain situations.
Other legal forms include licensing or franchising arrangements, joint ventures, economic interest groupings or consortiums, etc. A minority equity participation in a joint venture is often used for a strategic business alliance in high-risk technologies and markets.
Foreign operations may, therefore, be conducted through varying forms of business entities. Each form has advantages and disadvantages for tax planning.
An agent may be dependent or independent. Although the choice should be based on commercial considerations, it has tax implications. An independent agent, as a broker or a general commission agent or any agent of independent status acting in the ordinary course of his business, is not a permanent establishment (OECD MC Article 5(6)).
The agent must be economically and legally independent, and preferably not act for only a single principal. He must bear the entrepreneurial risks and be free to act without detailed instructions from the principal. An agent, who performs the economic activities that should be done by the enterprise, may have difficulty in proving that he is acting in the ordinary course of his business.
Under OECD MC Article 5(5), a dependent agent would form a permanent establishment of the enterprise if he has, and habitually exercises, an authority to conclude contracts involving the core business of the enterprise.
Therefore, a dependent agent, who does not have the authority to conclude binding contracts that form the business proper of the enterprise, or does not exercise this authority repeatedly, should not create a taxable permanent establishment.
To avoid a dependent agent having the authority to conclude contracts, it is advisable to insert the appropriate clauses in the agent’s contract of employment or commission agreement.
Licensing a foreign entity to manufacture or market goods or services can be a low-cost alternative to setting up one’s own business presence abroad. It requires little or no cash investment, and earns licensing royalties on the transfers of technology and other intangible rights.
Moreover, it provides the opportunities for the sale of specialized plant and equipment, raw materials or semi-finished components, training, technical assistance, etc.
The licenser benefits from the existing market penetration, the marketing and distribution systems, local knowledge and connections and the operational facilities of the licensee. However, there are a few disadvantages.
For example, once the overseas business activity is established, he may have problems in retaining effective control over the business conducted by the licensee. It may also limit his ability to establish his own presence in that market in future or to maintain or increase the royalty rates after a specified period.
There is also the potential risk of inadequate protection over the intangible property rights. Nevertheless, licensing is widely used and is an attractive low-cost way to expand the business abroad.
A franchising arrangement is a contractual relationship between the franchiser and franchisee. The franchiser grants a limited license to the franchisee for the franchiser’s business systems. He offers, or is obligated to maintain, a continuing interest in the business of the franchisee in areas, such as marketing, quality control, systems, know-how and training.
The franchisee makes a substantial capital investment in the business from his own resources and operates under the common trade name, marketing and systems provided by the franchiser.
The franchise arrangement combines the transfer of licensing rights with the business systems for which the franchiser receives various fees from the franchisee as royalties or service fees, contributions towards common expenses (e.g. marketing, advertising), etc. It also provides income from the goods and services sold by the franchiser.
As a mixed contract, the tax rules apply separately to each income component. Unlike a pure licensing arrangement, it is probable that the franchiser will be deemed to have a permanent establishment in the host country. He will also be exposed to transfer pricing issues and the product and service risks incurred by the franchisee.
A business presence can be maintained through a low-cost representative or liaison office. As a branch, a representative office becomes taxable in the source State since it is a permanent establishment. However, under OECD MC Article 5(4), a permanent establishment is not taxable if it confines itself to non-commercial preparatory and auxiliary activities.
Such services could include advertising, or supply of information, scientific research, or servicing of patent or know-how contracts, or as a purchasing office. In certain jurisdictions, a representative office can also maintain a supply of goods for delivery or display on a tax-free basis.
A branch of a company is the same legal entity as the head office and its other branches. The company retains full ownership and control over its branch. It operates under the name of the company and the financial results are included in the company’s accounts.
There are no minimum capital requirements, and no capital taxes or, stamp duties. The transfers of assets and funds from/to head office are not usually subject to taxation.
A branch can be set up easily and incurs low compliance costs, compared to a company. Unlike a subsidiary company, a branch does not have the problem of economic double taxation on the profits repatriated to the head office, unless a branch tax is payable.
A divisional structure as branches enables the pooling of current profits and losses of the company. Moreover, the controlled foreign corporation rules do not normally apply to branches since there is no tax deferral of the current income of the branch.
A branch engaged in the core business activities of the company is a taxable permanent establishment. It is taxable currently in both the home and host countries under their respective domestic rules and accounting practices. The dual taxation of the branch profits could lead to additional taxes, even when the head office is entitled to relief for the foreign taxes paid by the branch.
In the case of credit relief, any variation in the method of the tax computation could result in either insufficient or excess foreign credits for the foreign taxes paid by the branch. Moreover, although the branch losses can be offset against the home profits, the foreign taxes paid by profitable branches may be unrelieved in certain situations.
Many countries lack detailed rules for the allocation of the income and expenses to a branch as a permanent establishment. Moreover, domestic tax practices often vary. Branches are also generally subject to a closer scrutiny on profit allocation and transfer pricing issues by the tax authorities.
The rules governing the charge-out of expenses to the branch by the head office are often more restrictive than for a local company.
For example, management fees, interest and royalty payments from, and to, the head office or other sister branches may be disallowed (fully or partly) for tax purposes. Sometimes, it may be possible to avoid this disallowance by routing the transactions through an affiliated company within the group.
There may also be additional tax liabilities on a branch. Several countries subject a branch to a higher tax rate or a special branch tax on the remittances made to the head office. The disposal of branch assets could subject the company to pay capital gains tax in both the host and home countries. Therefore, a future conversion from branch to a subsidiary may be both costly in tax terms and difficult in some jurisdictions.
The branch is part of the company, both legally and for tax purposes. Unlike a foreign subsidiary, the company is usually entitled at home to a foreign tax credit (unless exemption relief applies) for the taxes paid by the branch abroad. Moreover, it has the same tax residence as the head office, and is entitled to the benefits under its tax treaties.
As a nonresident, it cannot benefit from the tax treaties of the host country where it is located. However, if the company is managed and controlled from the foreign branch, the country of its location can determine the tax residence of the company itself in certain jurisdictions.
A branch structure is usually considered unsuitable for long-term overseas investment or operations. As it is not a separate legal entity, it subjects the parent company to unlimited liability on its obligations. A branch may also create other issues, such as when local financing and incentives are available only to domestic companies.
The local regulations may require a public filing of the parent’s audited accounts, i.e. subject it to public disclosure. Several countries do not permit branch operations of foreign companies under their exchange controls or investment regulations.
Despite these disadvantages, it is common to set up a branch during the period of start-up losses and to convert it to a subsidiary later when it becomes profitable. Otherwise, a foreign branch normally suits a limited business presence or a short-term business venture, when the cost of a full subsidiary is not commercially justified.
It may also be useful tax planning for a holding company to operate overseas through a branch and not a subsidiary in certain situations. Unlike a subsidiary, the company can claim tax credit at home currently for the underlying taxes paid overseas by its branch. To avoid the exposure of unlimited liability to the parent company, it can be set up as the branch of a separate subsidiary company at home.
A company is usually (but not always) more tax-beneficial as an entity than a branch. Unlike a branch, a subsidiary company is not normally taxable as a nonresident permanent establishment.
Its status as a separate legal entity permits the deferral of tax by the parent company until its profits are declared as dividends. The arm’s-length nature of the transactions and the payments of passive income to the parent company are also easier to justify for tax purposes.
Other tax planning opportunities include permitted use of profit extraction techniques and structures involving intermediary offshore entities. Group relief or tax consolidation with other resident companies under same ownership is allowed in several countries. It qualifies as a “resident” for treaty benefits in the other Contracting State.
A company, however, has more demanding set-up and compliance requirements. It is subject to anti-avoidance measures, such as thin capitalization rules, transfer pricing and controlled foreign corporation rules.
The dividend payments are subject to economic double taxation in countries using the classical tax system. Unlike a branch, the tax on the underlying profits out of which the dividends are paid may not be relieved.
There is usually no relief for the losses of the subsidiary. There may be capital taxes and stamp duties to pay on the issue of shares. In some countries, a local company also requires equity participation by local residents.
A subsidiary company is operationally more flexible than a branch. It signifies a long-term commercial presence in a country and provides for limited liability status. It is normally eligible for local finance through public listing or loan issue, and may benefit from local incentives.
Since a local company is easier to regulate than a branch, the laws and regulations in several countries require that foreign enterprises operate as a company and not as a branch.
Partnerships are regarded as fiscally transparent in some jurisdictions, while others treat them as corporate entities for tax purposes. Therefore, partnerships may be taxed either as “pass through entities” where the individual partners bear the tax, or as companies subject to corporate tax.
In partnerships that are fiscally transparent, the tax is levied not on the entity but on the individual partners. Nonresident partners are deemed to have a permanent establishment in the country where the partnership is organized.
Fiscally transparent partnerships cannot benefit from tax treaties, except through the treaties with the Residence State of each partner. Moreover, the liability of the partners is unlimited.
A partnership may be a suitable vehicle for tax purposes despite the unlimited liability on the partners. For example, partnerships as “pass-through entities” avoid the economic double taxation on dividends under the classical tax system. The foreign controlled corporation rules do not normally apply to fiscally transparent partnerships.
In a limited partnership, there is at least one partner with unlimited liability but the personal liability of “sleeping” partners is limited. A silent partnership arrangement is similar to a limited partnership, i.e. the silent partner contributes capital and is entitled to a specific share of the partnership profits and losses, usually taxed as a dividend.
The identity of the silent partner is not made public and he may not incur any liability for the partnership debts.
The term “hybrid” is used to describe an entity, instrument or transactions with different characterizations in different jurisdictions. Therefore, a hybrid entity is any entity which is treated for tax purposes differently in two countries. Hybrid instruments are treated as debt in one jurisdiction and equity in another jurisdiction.
In hybrid transactions, the same transaction is taxed differently in two jurisdictions. Several jurisdictions permit “hybrid” structures based on different tax treatment in two States. Hybrid entities are often used in international tax planning to avoid double taxation or to achieve double non-taxation.
Common law trust is widely used for both onshore and offshore planning. The separation of legal and beneficial ownership is applied to provide a structure, which enables a settlor to avoid income and capital gains tax as well as estate taxes and allow beneficiaries to enjoy tax-favoured income.
Trusts are also used for non-tax purposes such as asset protection, off-balance sheet transactions, charitable donations, etc. Moreover, they may beneficial in pre-immigration planning. Although many onshore jurisdictions have enacted anti- avoidance rules to counter any abuse, their use is still widespread.
The main use of trusts is for preserving family wealth and estate planning. The settlor transfers his assets to a trustee to manage and to distribute the income and capital either to specified beneficiaries (fixed interest trusts) or at his discretion (discretionary trusts) either during his lifetime (inter vivos trust) or after his death (testamentary trusts).
Trusts are also used for the transfer of assets and income to minors and disabled dependent beneficiaries under an accumulation and maintenance trust. The trustee accumulates the income and distributes them as specified under the trust deed.
In civil law jurisdictions, foundations are preferred. A foundation is an autonomous legal entity. Unlike a trust, which is a relationship between three parties: settlor, trustee and beneficiary, a foundation holds the assets in its own name, like a corporation.
Its assets are managed independently to meet the stated aims of the foundation, as specified by him in its by-laws. The by-laws may allow the founder to control the assets and their distribution to beneficiaries during his lifetime.
International Tax Structures helps in Financing of Overseas Entities:
In any business, the two key questions on the financing of an overseas entities relate to:
(i) Should the investment be financed by equity or debt, or both?
(ii) If both, what should be the debt to equity ratio? These two questions raise a wide range of tax and non-tax issues and the answers depend on the specific circumstances and the jurisdictions involved.
Moreover, even after the decision to use debt is made by the parent company, there are several additional considerations, such as:
i. Who should provide the loan or debt? Should it be the parent company, an offshore or local financing subsidiary or a third party loan, or a combination of them? In the case of parent company financing are the loaned funds its own funds or borrowed from third parties, say a financial institution?
ii. What should be the currency of the debt financing? Should it be denominated in the host, home or a third currency? How will the exchange gains and losses on debt finance be treated for tax purposes? How can the exchange risks be minimized?
iii. Can the financing costs be paid out of subsequent profits of the foreign subsidiary? What is the withholding tax rate on interest income received from the host country? Is the interest expense on funds, if borrowed, deductible in the home country?
iv. What are the anti-avoidance rules in the host country relating to thin capitalization and transfer pricing? What is the impact of non-tax factors, e.g. exchange controls? Etc.
Equity financing can take several forms. For example, it may be through an issue of shares either to the public or to the parent and/or affiliated companies. The shares may be ordinary or preferred shares, redeemable or convertible preference shares, participating preference shares, or deferred shares.
They may be issued either at par or no par value. They may also have unequal rights on voting control, distribution of assets or management decisions.
Similarly, debt or bonds vary. The funds may be borrowed in the host, home or a third country. The interest may be payable at regular intervals or on maturity. Again the interest may be fixed or variable, or dependent on profits under a participating loan.
The loan may be unsecured, or guaranteed by the parent company directly, or under a back-to- back arrangement. They may be denominated in the local currency of the borrower or a foreign currency. The borrower may be obliged to comply with certain loan covenants under an agreement.
Therefore, there can be different types of shares and loans with varying terms depending on the business risks, repayment terms and financial returns, or hybrid instruments that combine the tax benefits of debt and equity. Examples include convertible loans, jouissance rights, option loans, subordinated loans, profit participating loans, etc. with varying tax elements of equity and debt.
Equity or Debt:
As mentioned above, an entity can choose to finance its business activities either through equity or loan capital, or usually both. The financing mix is dictated by economic or commercial considerations.
The choice is also affected by tax considerations. For example, dividends and interest are subject to differing withholding tax rates, exemptions and tax credit provisions. Both of them have advantages and disadvantages.
Equity financing may be more favourable in certain circumstances. For example, a dividend receipt may be preferable to interest income if there is a nil or low withholding tax on dividends in the host country and the foreign dividends are tax-exempt at home.
As a result, there may be little or no tax to pay on the dividend income. There may also be restrictions on the use of loan capital. It may be subject to exchange controls or thin capitalization rules.
The foreign subsidiary may not have sufficient taxable capacity, i.e. the current or future profits to claim an expense deduction for interest payments. The interest expense may be deductible only when paid, and not on an accrual basis or it may be non-deductible.
If there is a tax holiday or long gestation period with start-up losses, the interest costs may not be tax deductible currently, or may even be lost. Exchange gains and losses on capital loans may or may not be tax-deductible in the host or home country.
Under normal circumstances, debt is preferable to equity. As a dividend is distributed from taxed profits and the interest is paid from pre-tax profits, the borrower can reduce his taxes by financing primarily through debt (as opposed to equity capital). The loan may be obtained in any currency to minimize the foreign exchange risks.
It may also be possible to claim double deduction (“double dipping”) for the interest costs if the parent company borrows at home to invest in a foreign subsidiary, which then grants a loan to a sister subsidiary in the host country. Unlike dividends, interest income does not suffer from economic double taxation in the hands of the borrower and the lender.
There are other advantages in debt financing. As there is no withholding tax on loan repayment, it can be made out of the future profits of the borrowing entity tax-free. The return of the capital and interest is fixed, and not dependent on the company’s performance.
It is easier to obtain and repay a loan without affecting any voting rights or control. Loans can be converted into equity, but the reverse is not permitted. Unlike equity, debt avoids capital and stamp duties, and capital gains tax. As loan capital is usually less expensive to service than equity, a higher leveraging also improves the return on shareholders’ funds.
The parent company may use its own funds or borrow the funds to acquire a foreign subsidiary. It may also provide the funds (as capital or loan) for this purpose to a foreign holding company in the host country or in a third country.
Similarly, loans for asset acquisitions or working capital for the foreign operations may be borrowed locally by the subsidiary, or lent by the parent company, or obtained through a finance company. Again, they may be own or borrowed funds of the parent company, or the finance company may have obtained them from the parent company or from third parties.
Therefore, the funds may be borrowed (partly or fully) in the home country, or the host country, or a third country. The choice partly depends on whether the interest costs are better offset against the profits at home or abroad.
If an interest deduction is required at home and is tax-deductible, the funds should be borrowed at home and then injected as share capital or loan to an offshore holding company or directly to the subsidiary.
Alternatively, if the interest deduction is required in the host country, the local holding company or subsidiary should borrow the funds. In cases where the borrowed funds are loaned by the parent to the foreign subsidiary, a double deduction can be claimed for the same amount in two countries.
The parent company should normally provide debt finance to its subsidiaries abroad, if:
(a) It pays little or no taxes on the interest income received at home,
(b) The foreign withholding tax on the interest is creditable, and
(c) The interest costs are deductible in the host country. The excessive use of related-party debt may be restricted by thin capitalization rules.
Under these rules, the interest on excess loan capital from related foreign shareholders is disallowed for tax purposes in the host country and treated as a constructive dividend payment. Moreover, back-to-back loans and third-party debt, guaranteed by the parent company, are often regarded as related-party debt.
The treatment of interest incurred on borrowings at home to acquire the shares of a foreign corporation varies. The interest should normally be deductible as an expense (or added to the capital cost of the acquired assets), but this is not always the case especially when the dividend income from the related investment is exempt.
Some countries allow the tax deduction for such interest costs against other taxable income, while others either limit the deduction, (Examples: Germany, Indonesia, Luxembourg, Singapore) or disallow them (Examples: Argentina, Australia, Austria, Brazil, Hong Kong, Netherlands). Therefore, the costs of acquisition (e.g. interest expense) of a foreign subsidiary may or may not be fully tax-deductible in the home State.
A common tax-planning objective is to claim a deduction for the interest expense on the funds borrowed for the acquisition of a foreign subsidiary against the income flows generated by the funds. A foreign subsidiary can generally borrow funds (local or otherwise) for its use, but not for its own acquisition.
Therefore, the cost and income arise in different taxable entities on the loans taken by the parent for investment as equity in the subsidiary. It is difficult to adjust the tax deduction for the interest expense in the parent company against the related profits earned in the foreign subsidiary, except through a worldwide tax consolidation or a post-acquisition merger.
Very few countries provide for worldwide tax consolidation. As an alternative, a local holding company may be set up to borrow the funds. The loan interest may then be offset against the profits of the subsidiary in the same jurisdiction if it can benefit from domestic tax consolidation rules.
Alternatively, the acquired company may be merged with the local subsidiary that incurs the debt. It may also be possible in certain countries to transfer the tax residence of the subsidiary to the parent State to claim domestic tax consolidation or group relief.
Foreign currency debt poses currency risks on the repayment of the principal and interest. This risk is avoided if the borrowed funds are denominated in the same currency as the matching income flows that service the use of the funds.
Therefore, it may be preferable to maximize local borrowings, unless the risk is not significant or can be minimized through hedging transactions. Many multinational entities prefer to manage this risk exposure within the group centrally in a favourable jurisdiction.
Various tax systems also influence the choice of financing. For example, only dividends to resident shareholders normally carry the dividend tax credit under the imputation system.
Nonresident shareholders may or may not get the imputed credit, and suffer from the economic double taxation on the dividend payments (similar to the classical system). Debt financing may be preferable since it avoids the economic double taxation applicable to dividend payments in such cases.